Ninth in a series.

Somewhat overshadowed by events in the single-family residential mortgage market have been Fannie Mae and Freddie Mac's multifamily finance programs. In anticipation of GSE reform, policymakers should consider shaping the Dodd-Frank risk retention requirements in a way that brings private investment back into the multifamily mortgage business. A short window of opportunity exists to accomplish this now.

Fannie Mae's and Freddie Mac's multifamily financing activities have long been touted as consistently successful and highly profitable programs, even during the recent years of unprecedented losses that thrust the government-sponsored enterprises into government conservatorship. The agencies today hold or guarantee nearly $400 billion in multifamily debt, with $62.6 billion originated in 2012. Yet their respective delinquency rates have remained under 1%. Industry players argue that for multifamily lending to continue in its current capacity, agency reform must keep the federal backstop in place.

Profitability, however, is not a strong argument to keep these programs going if such lending doesn't truly require a federal subsidy to survive. In allowing each multifamily mortgage to take on an explicit federal guarantee, there is an untold cost to taxpayers. Much of the profit from this subsidy, however, ends up in the hands of the correspondent mortgage bankers, which typically earn 150-350 basis points on each loan they originate—a very handsome profit at the expense of taxpayers.

Even as capital has returned to commercial real estate, the private sector has had difficulty competing against the agencies and their subsidized interest rates for multifamily. Fannie and Freddie's combined market share is now roughly 60%—about double what it was before the credit crunch. For private capital to find its way to multifamily, it must pursue riskier loans that fall outside the parameters of the GSE programs, such as construction financing or properties that have yet to achieve stabilized rental incomes.

Industry pros such as Tom White of SeaChange Consulting Group and Charlie Wilkins of Compass Group have made other arguments for privatization as well. Without the federal subsidy, they argue, multifamily financing terms would more accurately reflect the risk of lending. Bubbles created by cheap debt that typically lead to overbuilding would be circumvented, and the moral hazard of risks taken under the assumption of socialized loss would be avoided.

Furthermore, debt for multifamily properties provided by the agencies does nothing to enhance affordability for renters, as the industry has never proven any connection between multifamily interest rates and the rents that tenants actually pay. If policymakers observe a need for more affordability in rental housing, increasing the amount of tax credits available for low income housing tax credit development would be a more effective way of achieving that goal.

If a catastrophic liquidity shortage in the future arises, the government can always step in to provide assistance by loosening restrictions on the Federal Housing Administration's multifamily mortgage program or through targeted quantitative easing whereby the Fed would purchase either individual multifamily MBS or bifurcated multifamily CMBS. Some argue that even those measures wouldn't be necessary, as history has already shown that private investment is strong enough to fill the gap if Fannie Mae and Freddie Mac quit the multifamily market. The LIHTC sector serves as such a model—it survived the flight of the GSEs when the two agencies stopped buying affordable housing tax credits in 2008. And when CMBS issuance froze in 2008, a similar scene played out with commercial properties: portfolio lenders and life insurers stepped up to provide capital and fill the space left vacant by conduits.

Another solution exists that would satisfy concerns of liquidity from the multifamily side and attract private capital. As it stands today, regulators tasked with implementing Dodd-Frank are still trying to formulate a plan for commercial mortgage-backed securities that wouldn't shut down the industry. In their initial risk-retention proposal, released in March 2011, the six agencies involved (FDIC, HUD, the Fed, SEC, OCC, and FHFA) took a lenient stance on CMBS risk retention by allowing a B-piece investor to purchase the risk-retention piece and effectively stand in for the issuer. They took a tough stance, however, on the premium capture reserve account, which requires issuers to hold all back-end profits from the initial sale of securities at issuance in escrow to protect against potential losses to bondholders over the life of the bonds.

The private sector reacted in protest, arguing that removing the ability to capitalize those profits would cause lenders to flee the CMBS market. Implementation of these regulations was originally set for April 2013, but with no consensus from industry on this issue, that deadline won't be met. A new timeline has not been proposed, but the agencies are expected to issue a revised set of regulations this year followed by an open comment period.

Perhaps regulators should reverse course: ease up on the reserve account, and put some of the teeth back into credit risk retention. In so doing, the regulators could formulate a risk-retention policy that encourages inclusion of multifamily loans into CMBS pools. This would pull multifamily lending back into the private sector while bringing renewed confidence to a still-fragile CMBS market.

To accomplish this, risk-retention credits should be granted for multifamily loans included in a CMBS securitization. These credits would be used to determine how much of the 5% risk retention can be sold to a B-piece buyer. Total risk retention for each issuance would always be 5%, but the split between the issuer and the B-piece buyer would be calculated and determined by the volume and risk of the multifamily debt. So in a given loan pool, a greater proportion of multifamily debt relative to debt of other property types would allow the issuer to offload more of the risk retention, while a smaller proportion of multifamily debt would require the issuer to retain more of the risk retention. Credits could be adjusted according to the risk profile of the loan, which would discourage inclusion of high-risk loans. And a risk retention floor, perhaps set at 2%, would require that every CMBS issuer maintains some skin in the game.

Adding prime multifamily loans to issuances would enhance credit quality and increase asset diversification, which would generate more demand for securities—effectively greasing the wheels for greater volume of CMBS. To lower their retained risk, CMBS issuers would place a premium on multifamily loans, which would translate into lower interest rates for multifamily lenders. This would effectively create an incentive that could take the place of the federal subsidy, and return multifamily to the private sector.

Next: Private mortgage insurance after the GSEs.

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. Daniel Siesser is a vice president at Key Bank.