The historic election of 2016 has presented a bright opportunity for comprehensive overhaul of the housing finance system after eight years of gridlock and just keeping the government-sponsored enterprises on life support.
While the GSEs being place into conservatorship and the Federal Housing Administration coming to the brink of financial ruin should have resulted in sweeping changes to the housing finance system, the current structure still feels more like an episode of "The Walking Dead" than an efficient delivery mechanism for mortgage finance across a dramatically changing technological and demographic landscape.
But a new president, buoyed by the new administration's party controlling both houses of Congress, brings momentum and hope for this new government to usher in dramatic and long-lasting changes in the secondary mortgage market. The criteria for such change include dramatically reducing the federal footprint in housing finance; bringing greater clarity to the mission of the FHA and refocusing attention on the actuarial soundness of the Mutual Mortgage Insurance Fund (MMIF); and revisiting a number of mortgage regulations that have created unnecessary drag on the market.
Comprehensive housing reform means tackling both GSE and FHA reform together. These markets do not operate independently from each other. When the FHA decides to lower mortgage insurance premiums, for instance, that action directly affects the FHA's volume and quality of loans that would otherwise go to the GSEs, and vice versa when guarantee fees are changed by the GSEs.
One of the outcomes from the mortgage crisis was that the market became blurred along three artificial lines: the FHA, the GSEs and private issuers. Over time, this market segmentation, coupled with relatively underdeveloped risk and pricing capabilities at the FHA encouraged adverse selection against the FHA. Lenders optimized the disposition of loans according to their highest value, resulting in the FHA being the choice for the riskiest loans.
The FHA served an important countercyclical role during the crisis as private capital fled the system at the worst possible moment. However, the FHA's expansion of access to borrowers seeking higher loan limits, many of whom had access to other private sources of credit, moved them further from their traditional role of serving low- and moderate-income borrowers. Reliance on loan limits to determine FHA borrower eligibility rather than on income measures expands federal subsidies to borrower classes that do not need such benefits. This is one glaring problem with FHA policy that requires attention.
Moreover, the FHA can adjust mortgage insurance premiums and thereby effect desired public policy to serve its perceived social mission. For example, by holding down MIPs below what otherwise would be actuarially sound, it reduces costs to homeowners while shifting those costs to the mortgage insurance fund through higher credit losses over time. Such policies allow the FHA to serve a larger segment of the borrower population, but expose the MMIF to much higher risk over the long term. Conversely, setting credit policies too high prevents certain borrower segments from obtaining credit through the FHA's various programs.
Striking the right balance between the FHA's social mission and its duties to maintain the MMIF's financial integrity is complicated and made more difficult by a lack of clarity in defining the agency's target borrowers. Such an exercise is about determining what segments of society merit public support as well as establishing a clear risk appetite that aligns to these goals. First and foremost, the FHA needs to get back to its historical roots of focusing on access to mortgage credit for low- and moderate-income borrowers. The size of the market should ideally be no greater than the FHA's historical, pre-crisis share of 10% to 15%. Sensibly, achieving a target must be done gradually so as not to disrupt the mortgage market.
Formalizing the FHA's countercyclical role should be a priority for any reform of the agency. Applying ad hoc changes in premiums, loan limits and other policies during a crisis can introduce confusion to markets and yield unintended outcomes.
For instance, raising loan limits during the crisis provided a mechanism for quickly allowing the FHA to support the mortgage market at a critical time. However, by leaving it in place, it has expanded the eligible borrower population to people that have ready access to credit post-crisis. There currently is no mechanism in place to systematically scale back the FHA's market expansion. This policy vacuum essentially postpones any market realignment from occurring that would naturally encourage private capital to return in substance.
The new government should develop a set of countercyclical policies and practices. Taking a cue from the Federal Reserve's targeting of key macroeconomic factors in developing its monetary policy, a set of policy targets for housing and mortgage markets would provide the FHA with clear direction on when to expand and contract its business during crisis. Policy targets such as local home price trends, credit spreads on mortgage securities, and other pertinent housing and mortgage metrics could provide the FHA with direct feedback on the health of these markets.
Unlike many other holders of credit risk, the FHA has no formal mechanism to transfer credit risk to the capital markets. As a result, the FHA winds up holding 100% of the credit risk even though it may be economically advantageous to engage in risk-sharing arrangements with various market participants. For instance, both GSEs are required to have suitable credit enhancement for loans above an 80% loan-to-value ratio. Private mortgage insurers provide first-loss coverage of between 25% and 35% depending on the LTV level. Such arrangements allow the GSEs to distribute risk across other counterparties rather than concentrate risk on their balance sheet.
As a way of both reducing the risk of the MMIF and gaining experience with such structures, the FHA should begin to selectively test a variety of credit risk transfer structures with qualified counterparties. However, in order to engage sophisticated investors in credit risk transfer structures, the agency will need to build its analytical, data and credit structuring capabilities well beyond what is in place today.
Without question, the FHA is an essential part of the housing finance system. While it has been maligned for the financial challenges of the MMIF in recent years, we must keep in mind that the FHA has served this country well for nearly 80 years.
However, like many institutions, the FHA has not kept pace with important structural changes in its market. The advents of securitization and other sophisticated capital markets risk transfer mechanisms have left the FHA at a competitive disadvantage compared with other market participants. The lack of a clearly defined mission for the FHA along with the potential conflict between its social and financial missions makes the MMIF susceptible to periodic bouts of distress. The agency requires reforms to put it on secure financial footing to ensure its legacy for borrowers for the next 80 years.
Clifford Rossi is Professor-of-the-Practice and Executive-in-Residence at the Robert H. Smith School of Business at the University of Maryland. He currently serves as the chief risk and regulatory advisor for Five Bridges Advisors, and previously served as the chief economist for Radian, a mortgage insurance company.
