Risk Transfer Alone Is Not a Viable Solution for GSEs

Eight years after Congress placed Fannie Mae and Freddie Mac into conservatorship, their long-term future and that of the housing finance system appear no clearer.

Yet most everyone agrees about the importance of returning private capital to the mortgage market, regardless of what happens to the two government-sponsored enterprises. Lately, policymakers have supported using expanded risk-sharing as a way for Fannie and Freddie to raise more private capital. But using risk-sharing alone without more equity is not the best approach for ensuring the safety of the mortgage finance system.

Two recent news developments have shined a brighter spotlight on the need for more private-market support of the GSEs. First, Treasury Secretary-designate Steven Mnuchin signaled in a television interview that he would support getting the two companies "out of government ownership," though it was unclear if that meant restoring them to their pre-conservatorship status or some other form.

The second development was the introduction of a bill by House Reps. Ed Royce, R-Calif., and Gwen Moore, D-Wis., mandating that Fannie and Freddie dramatically increase their use of credit risk transfer programs.

Credit risk transfer — or "CRT" — is a set of highly promoted tools that allow Fannie and Freddie to access private-sector capital to hedge potential losses in their guarantee book. Under CRT deals, investors typically pay upfront for specially-created debt securities that are meant to help shoulder credit losses suffered by the GSEs. They have proven especially important as the government — seemingly interested in pursuing a longer-term strategy to wind down the two companies — has restricted the GSEs from raising other kinds of capital.

But policymakers and market commentators who believe that CRT can in effect replace equity capital need to understand the risks of doing so. In practice, CRT is less stable during times of market stress than equity capital, moderately expensive compared to other credit protection markets, and of insufficient size to fully replace equity support. CRT is an important tool to supplement regulatory capital, but it is not a replacement for equity — such as retained earnings, a rights offering, a mutual cooperative, an IPO or a utility model.

To be sure, how much capital Fannie and Freddie need, and the form it takes, is at the heart of a broader debate about the nation's long-term housing finance system. This debate includes whether the former Fannie and Freddie shareholders — whose shares lost value as a result of the conservatorship — stand to benefit from strengthening the companies' private capital base, as well as whether the GSEs continue to serve their housing mission.

But whether or not they leave conservatorship, and how they do it, is a separate debate from how best to ensure the strength of the companies' balance sheets. As long as Fannie and Freddie exist, they should have core capital. Proposals that overemphasize CRT, such as Royce and Moore's bill, do not serve as an adequate replacement for core capital. They basically form a synthetic capital base.

Right now, Fannie and Freddie are in conservatorship, operating without capital. That's unsafe, and the current FHFA risk-sharing programs alone do not fully address this issue.

Equity capital (generated by retaining profits or raising common equity) is needed to support both unexpected losses and loss-provisioning stemming from expected losses. Synthetic regulatory capital, like that provided by CRT, is capital in excess of equity capital that further helps to buffer against unexpected and catastrophic risk such as that experienced during the financial crisis. In short, synthetic regulatory capital is simply icing on the capital cake.

The GSEs need equity capital to ensure mortgages can be made to qualified borrowers when economic conditions are both good and bad. Conversely, the investor base for CRT debt securities is dominated by credit investors such as insurance companies, money managers and hedge funds. These investors are rightfully focused on profit opportunities and not the stability of mortgage markets. Accordingly, the very time in the housing finance cycle when CRT will be of most value to the GSEs is exactly the time when it is likely to be the most expensive and the least available as these investors flee to safety.

In fact, in early 2016, the market for CRT securities became quite expensive during a period of widening credit spreads. The GSEs bought protection from the even smaller but more stable reinsurance markets to satisfy their regulatory-mandated risk transfer requirements. However, the total market for CRT is relatively shallow to the amount of risk that needs to be transferred to support the $5 trillion agency mortgage market. To expand the CRT market, the GSEs would have to offer substantially higher yields to attract more CRT capital. But this would have the impact of raising the cost of mortgages to borrowers. This is why it is important not to mandate fixed issuance volumes of CRT securities without regard to current market conditions.

Policymakers need to understand that CRT transfers much less credit risk than may be expected. Statements that quote the successful transfer of risk on the face value of billions of dollars of loans can be rather misleading because CRT only hedges a portion of credit risk. For example, through the third quarter, Fannie and Freddie have sold securities to the private market tied to $1.2 trillion in mortgages, but with only $35 billion in actual risk transferred. Furthermore, a critical issue with CRT is that the stated protection "offered" at the onset of the deal declines as the loans pay off. Under reasonable market-based scenarios, a CRT offering 4% of loss protection declines quickly and does not remain 4% of the underlying loan pool for very long. This has the potential of exposing the GSEs to tail risk.

The last financial crisis made clear that every financial institution needs large amounts of permanent equity capital to protect taxpayers from bailouts. Mandating more risk-sharing without a concurrent, commensurate increase in permanent equity capital by Fannie and Freddie, as implied by Royce and Moore's bill, goes too far in one direction. For the safety and health of the U.S. economy and taxpayer, policymakers should expand the private capital debate to include an appropriately balanced mix of both CRTs and permanent equity.

Landon D. Parsons and Michael ("Mickey") Shemi are a senior advisor and senior vice president, respectively, in the financial institutions advisory group at Moelis & Co. The views expressed in this article are those of the authors and not necessarily the views of their employer. Moelis advises clients of different perspectives who may have an interest in the outcome of mortgage finance policy.