Comeback in Sight for Private Mortgage Bonds: Interactive Graphic

Regulators have been trying to price Fannie Mae and Freddie Mac out of their dominant shares of the secondary market for home loans. After a pair of giant price increases, the strategy may soon bear fruit.

The fees Fannie charges to guarantee new mortgages have nearly doubled over the last year, far surpassing levels that prevailed the previous decade. Prices for private-label mortgage bonds (those without federal guarantees) already make them a financially sensible destination for a sliver of high credit-quality originations, some analysts reckon.

A few more twists of the dial — additional fee hikes, a reduction in the size of loans Fannie and Freddie are allowed to guarantee — could open the way to large-scale issuance without direct government support. (The following graphic shows guarantee rates over time. Text continues below.)

The Federal Housing Finance Agency, which oversees Fannie and Freddie, is trying to encourage greater market participation by private capital to cut the government’s exposure to defaults.

Guarantee fees on mortgages Fannie covered during the first quarter increased 25.5 basis points from the year prior to 54.4 basis points as a ratio of principal balance. Annualized guarantee revenue divided by the average size of Fannie’s book of single-family business increased 6.7 basis points during the same time to 33.5 basis points. (It takes time for changes in pricing policies to filter through the portfolio since existing mortgages are subject to rates set when they closed.)

Freddie does not provide aggregate rates for new business, but its annualized guarantee revenue rose 7.2 basis points over the same period to 30.4 basis points of its average book of business.

Both government-sponsored enterprises instituted two major rate increases last year: 10 basis points in April connected with the extension of a payroll tax cut, and another 10 basis points in the fourth quarter. The second increase was mandated by the FHFA as a part of its effort to encourage private sector lending under its strategic plan.

From 2004 through 2006, when issuance of private mortgage bonds surged with home prices, guarantee revenue ranged from about 16 basis points to about 22 basis points of outstanding mortgages. At the time, Fannie and Freddie reported intense price competition. (Accounting recognition of guarantee fees was also buffeted by changes in interest rates, which influence the speed at which borrowers refinance and thus the life of loans and the period over which upfront charges are amortized.)

In a report last month, Barclays analysts figured nonagency execution is now “somewhat competitive” for about $30 billion of purchase originations annually, or about 12% of the purchase mortgages Fannie and Freddie packaged into bonds in the preceding year. The analysts compared interest rates on agency mortgage bonds and guarantee fees, on the one hand, with rates on triple-A nonagency mortgage bonds and the size of “credit enhancement” tranches prescribed by ratings agency criteria for mortgages of different credit quality on the other. Barclays estimated yields for these loss-absorbing layers with a weighted average rate for bonds ranging from double-A to unrated, and used this piece as a proxy for the price of credit risk — or the guarantee fee equivalent — in the nonagency universe.

Barclays stuck with its forecast of $12 billion to $15 billion of nonagency issuance this year, which already represents something of a comeback for a market that came to a standstill after the financial crisis. If the ceiling for GSE mortgages were reduced from $625,000 to $417,000, $80 billion to $90 billion of issuance could flow into nonagency bonds, the analysts wrote. A further increase in guarantee fees on the order of 10 to 15 basis points could prompt a shift “on a much larger scale.”

For policymakers, the big question is how much to reduce the federal role in mortgage finance. Phillip Swagel, an economics professor at the University of Maryland and visiting scholar at the American Enterprise Institute, has advocated a competitive system that puts a lot of private capital in front of government insurance. In Senate testimony last month, he argued the government would inevitably intervene if the availability of mortgages again becomes imperiled. “A housing finance system that is notionally fully private will inadvertently recreate the implicit guarantee in the previous system that failed so badly.”