Last in a series.
The Federal Housing Finance Agency has quietly been exploring the viability of various credit risk sharing arrangements, a project overshadowed by the also-laudable effort to build a new securitization platform.
A lot rides on when private capital might be induced to come back to the mortgage market depending on what the FHFA and the government-sponsored enterprises Fannie Mae and Freddie Mac find out in this project. However, structures providing a mechanism for investors with differing credit risk preferences to select how much risk they are willing to bear, augmented with private mortgage insurance, should greatly expand investor interest.
Among the credit enhancements to be tested by the government-sponsored enterprises as part of their pilot are the expanded use of private mortgage insurance, credit derivatives and the senior-subordinated structures that were used extensively for nonagency securitizations in the years preceding the mortgage crisis. A senior-subordinated structure that includes a private mortgage insurance component has a number of virtues that place it at the head of the credit enhancement class.
Consider a pool of GSE-guaranteed mortgages estimated to have a certain level of credit losses over the life of the loans. While selling a portion of that risk, such as the first 3% of losses, might make the remaining pool appealing to some investors, carving the credit risk into various tranches would attract a broader base of investors.
To better understand how this works, see the graphic above, showing how a mortgage pool's losses are chopped into six rated tranches plus a mortgage insurance component. In this structure, mortgage insurance acts as a first-loss buffer wherever actual losses on the horizontal axis may be realized. Then the senior-sub structure follows a sequential loss waterfall where lower rated tranches (e.g., BB) absorb losses first before they are taken by the next highest-rated tranche.
What makes this structure appealing is that investors can directly buy the slice of credit risk that suits their risk appetite. Senior-subordinated structures, while best known for their spectacular losses during the crisis, could play a significant role in mortgage securitization with such new requirements as risk retention and Qualified Mortgage standards.
As the GSEs go about their credit enhancement work this year, FHFA must factor in a number of considerations for them, including the impact of the Qualified Mortgage and Qualified Residential Mortgage Rules, risk retention requirements and even the potential for a catastrophic-loss guarantee by the federal government. Lenders selling loans to the GSEs get a temporary pass on QM. However, the credit enhancement valuation exercise will depend on the quality of the underlying collateral. If we assume the proposed QRM definition holds at an 80% loan-to-value ratio (an unlikely scenario, admittedly), the mortgage risk profile could look different from even the GSE risk profile today. Thus it makes sense to test a few possible higher LTV outcomes.
As a separate exercise, the FHFA should make some effort to understand the impact of risk retention on the market. Finally, it should assess alternatives to the use of rating agencies in establishing loss subordination levels for each credit tranche. A prerequisite to jump-starting the secondary market is a process that objectively, accurately and systematically rates credit risk levels in a mortgage pool.
A critical player in the credit enhancement process will be the private mortgage insurance industry. Though maligned for heavy losses suffered during the crisis, this industry has desirable qualities that could help accelerate the return of private capital to mortgage markets including the market for Federal Housing Administration loans.
First, these companies are privately capitalized with considerable reserves. True, some private MI companies suffered catastrophic losses and went out of business. That is exactly what should happen. Better that the insurers eat those losses than taxpayers.
Moreover, these companies have decades of experience assessing mortgage credit risk. Capital is flowing back into these veterans and into new MI companies, building capacity for an expanded role in secondary market activities.
And importantly, there could be a major role for the private MI companies to partner with FHA to develop risk-sharing arrangements similar to what the Department of Veterans Affairs has in place. Such activities could reduce taxpayer exposure to FHA credit losses and help stabilize the agency's insurance fund.
The FHFA's credit enhancement experiment should give us an indication of how far off we are from seeing a meaningful return of private capital to the mortgage secondary market. Essential ingredients for getting ready for that day are credit structures that accurately assess risk levels that can attract a wide range of investor risk appetites and extensive use of private mortgage insurance.
Clifford V. Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland.