As the U.S. starts to reverse course on the amount of support for housing finance, the U.K. is wading into the government guarantee business with an interesting private-public arrangement that our legislators should pay attention to.
The United Kingdom's Treasury office recently released a report outlining a new guarantee scheme as part of the Help to Buy program, aimed at perking up the country's housing market, which, like ours, was ravaged during the financial crisis.
The program has two components; one designed to assist first-time homebuyers and high-loan-to-value-ratio borrowers with subsidized home equity loans and the second a mortgage guarantee program for qualifying mortgages. Eligible mortgages under the guarantee program must have LTV ratios between 80% and 95% on a maximum property value of £600,000 for borrowers with good credit histories and income. While a controversial element of the program is the eligibility of homes that are nearly triple the average home price in the U.K. (reminiscent of our own issues around Federal Housing Administration loan limits up to $729,750), the program's approach to sharing risk with private lenders has much to be admired.
In that regard, the program offers a practical example of what could be an effective way to provide a federal guarantee while limiting the potential for adverse selection that has dogged the FHA for years.
Under the Help to Buy guarantee program, lenders could opt in to buy government insurance for losses incurred above 80% of the purchase value of the property. In that layer, the lender would still be on the hook for 5% of the losses that occur above the 80% threshold and the guarantee would be in place for up to seven years.
Consider the following example applied to a $200,000 property in the U.S. on a 95% LTV loan. The lender would bear all the loss on the first 80% of the mortgage. But to induce the lender to take on higher-LTV mortgages, for the remaining 15% slice of risk, the government would step in to cover $28,500 of losses (95% of $30,000 for this portion of risk) while the lender picks up the remaining $1,500 in exposure above 80% LTV.
Under a scenario where the borrower defaults and the lender recovers $130,000 on the loan, the lender would lose $30,000 on the portion up to 80% of the original home's value, plus the $1,500 it takes under the risk-share arrangement with the government above 80% LTV. The government loses the full amount of its exposure of $28,500. By contrast, under a typical private mortgage insurance arrangement in the U.S., where an insurer may provide 30% coverage on a 95%-LTV mortgage, in the above example the MI company would cover $57,000 on an unpaid principal balance of $190,000 (assuming no other claimable costs such as delinquent interest). The lender would thus be only $3,000 out-of-pocket on this loan. And under current FHA programs the government would bear the full amount of this risk.
Imposing a risk-share requirement on the top end of the loan on the lender encourages strong underwriting practices and thus mitigates the possibility of adverse selection for the government insurance. It is very likely that years from now we will find that having government dictate underwriting standards via qualified mortgage rules was a very bad policy decision. Risk-sharing arrangements would impose self-discipline on markets directly by imposing financial costs on to those lenders engaging in poor origination practices. As a result, markets would respond with greater efficiency than under a regime where the government sets the rules of the game, which is likely to lead to suboptimal outcomes.
In recent testimony to Congress, Teresa Bryce Bazemore, president of Radian Guaranty – one of four out of seven private mortgage insurance companies to survive the crisis – recommended that the FHA enter into a "modern risk-share agreement" where private mortgage insurance takes a first loss position via deeper MI coverage with the government retaining the rest. The U.K. Help to Buy guarantee program provides a good example of how such a private-public risk-sharing arrangement could be structured among MI companies, lenders and the government, leading to improved underwriting, better risk transference among private investors and much lower taxpayer exposure to the mortgage sector.
Clifford Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland.