GSE Reform Must Include FHA Reform

In terms of reforming the secondary mortgage market, all eyes are currently on the bill, sponsored by Sens. Tim Johnson, D-S.D., and Mike Crapo, R-Idaho, that the Senate Banking Committee is set to vote on April 29.

Lost in all of the discussion, however, is how the federal government plans to coordinate pricing and policy across what would be its two mortgage insurance funds. One thing is certain: guarantee fees will rise in a post-Fannie Mae/Freddie Mac environment and that has implications on the solvency of the Federal Housing Administration's Mutual Mortgage Insurance Fund.

Johnson-Crapo is dead-on-arrival if it can't maintain bipartisan support in the House and the Senate. In an attempt to keep this support going, FHA reform has traditionally been treated separately.  

However, putting FHA reform on the table in the negotiation process could bring government-sponsored enterprise reform to a close while minimizing the potential for adverse selection against the MMI fund that would otherwise leave it with the riskiest segment of mortgages to be insured.

There is a long history between the housing GSEs and the FHA that has led, at times, to significant disparities in pricing and credit underwriting between these entities. Lenders, in deciding where to place their loans after origination must choose between retaining the mortgage in their portfolio with no government guarantee, or securitizing it with one of the GSEs or FHA.

This "best execution" assessment takes into account the credit eligibility guidelines of each disposition alternative as well as prevailing mortgage-backed securities prices, guarantee, upfront delivery and servicing fees, private mortgage insurance premiums and operating expenses. After considering this information, the best execution is the alternative where the lender nets the highest price. Peeling this analysis back a bit provides insight into how GSE reform in the absence of FHA reform could put stress on the MMI fund, which is already weakened following the crisis.

From a lender perspective, the decision whether to hold a mortgage in their portfolio must consider not only credit risk exposure, but also the interest-rate risk the loan presents. Taking this into account, lenders tend to prefer holding products, such as adjustable-rate mortgages rather than fixed-rate mortgages, all things equal. It is no surprise then that most GSE and FHA-insured mortgages are fixed-rate instruments.

Taking into account risk-based capital standards, and a target rate of return of 15%, holding a high loan-to-value loan in portfolio could cost the lender roughly 150 basis points of capital and credit costs according to my estimates. Such costs make a secondary market execution a more attractive alternative.

At the same time, raising costs in a post-GSE market by as much as 50 basis points (as Moody's Analytics predicts) may tilt the decision toward FHA assuming its current insurance premiums are maintained. An increase in these costs reduces the value of the execution to the lender, making FHA a likely landing spot for higher risk loans.

We have already seen that story play out during the mortgage crisis, where FHA stepped in to provide a countercyclical role in supporting the market when private capital fled. At other times, significant underpricing of FHA premiums, particularly for high-risk loans made FHA a preferred disposition outcome. The countercyclical role played by the FHA is even more critical in a securitization market that is, for the most part, privately capitalized. Reforming the GSEs without also taking on FHA reform in a coordinated fashion risks weakening the MMI fund.

Pushing against the need to raise premiums for FHA insurance is the agency's mandate to provide affordable access to credit to low- and moderate-income groups. As a result the agency is conflicted in its ability to maintain actuarial soundness for the insurance fund, which places the agency in an untenable position long-term.

GSE reform that includes a 10% first-loss requirement for private investors may be an appropriate way to revitalize secondary mortgage markets, but raising costs significantly relative to FHA premiums lacks a comprehensive approach needed to get housing finance right once and for all. As such, FHA reform would serve as a major enhancement to the Johnson-Crapo proposal as it could ensure long-term viability of both the MMI and new Mortgage Insurance Fund.

Proposals to allow the FHA to engage in credit risk-sharing arrangements, establish targets allowing it to scale up and down with market cycles and remove it from HUD, among others, would strengthen rather than detract from GSE reform. Ignoring FHA reform in this process because it complicates GSE reform and risks getting legislation passed is the wrong outcome for housing finance policy. In the end, this move risks perpetuating a bifurcated mortgage market where winners and losers are made and that usually spells trouble for taxpayers.

Clifford Rossi is the Professor-of-the-Practice at the Robert H. Smith School of Business at the University of Maryland and and a principal in Chesapeake Risk Advisors LLC.