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How Mortgage Markets Can Price Risk Efficiently

The Nobel Memorial Prize in Economic Science was just awarded to Eugene Fama for his theory that markets efficiently price financial instruments. The caveat is that this doesn't apply to loans and securities priced by undercapitalized government-backed lenders, the source of the irrational exuberance cited by co-winner Robert Shiller that led to the home price bubble.

The Federal Housing Administration counts as capital the present value of future gross revenue before credit expense, meaning, essentially, that it is severely undercapitalized. Like Fannie Mae and Freddie Mac, the U.S. Treasury forgoes the tax on the return to this implicit capital and pays no after-tax return to the government or mutual policyholders. Capital requirements for Fannie and Freddie as well as banks and other lenders and investors were also negligible – averaging only about 1% – and borrower down payment requirements weren't much higher during the subprime lending bubble. These opaque capital subsidies allowed them to under-price risk.

The recent FHA request for a taxpayer bailout completes the trifecta. The government-sponsored enterprises – Fannie Mae, Freddie Mac and now FHA/Ginnie Mae – have all required a taxpayer bailout over and above these opaque costs. Had capital been required at historical levels, the subprime lending debacle would not have occurred. Prospectively, any borrower subsidies to meet housing goals should be explicitly budgeted and targeted to homebuyers so well-capitalized markets can efficiently price and manage both credit and interest rate risk.

Establishing minimum capital requirements remains the key regulatory responsibility, as well as mitigating excessive risk in the likely event these aren't sufficiently high. Bank, GSE and private-label securitization regulations that relate to borrowers – the qualified mortgage and qualified residential mortgage rules – should restore the original Fannie and Freddie requirement of a minimum cash down payment of 20% or mortgage insurance down to a 75% loan-to-value ratio, eliminating the use of purchase money seconds in lieu of insurance.

Private mortgage insurance both mitigates and diversifies the underlying risk of individual mortgages and state regulators are less politicized than FHA's HUD oversight without the associated taxpayer capital subsidies. Greater reliance on PMIs and pool insurers transfers this risk from the GSEs, but it remains concentrated in a few firms, posing a systemic risk as both mortgage and pool insurers failed in the last cycle. Credit default swaps efficiently transferred risk from the regulated government-backed banking system, but were often written by even less well regulated banks, e.g., AIG's Treasury-regulated thrift subsidiary that wasn't required to post the requisite capital.

Senior subordinated securities and collateralized debt obligations efficiently transferred risk from issuers, but the risks were not always transparent to the mostly regulated and government-backed investors. The recent Freddie Mac senior subordinated Structured Agency Credit Risk securities and similar forthcoming Fannie Mae securities reduce their risk, but not necessarily that of taxpayers if other taxpayer-backed lenders leverage these investments.

Speculators can play the key role in mitigating systemic risk given the right instruments efficiently priced and actively traded. The CDS market was thin and prices were not a good leading indicator of rising credit risk during the last crisis. A liquid market for credit-linked futures could contribute to more transparent and efficient credit risk pricing as Treasury futures have for interest rate risk.    

Fixed-rate mortgage lending incorporates two types of interest rate risks: the loss for lenders using short-term debt when rates rise and the loss for maturity-matched lenders due to the free borrower prepayment option when rates fall. In addition, a falling rate environment is typically associated with rising credit losses as house prices often fall as well. During the last decade, Fannie and Freddie's strategy of buying back mortgage-backed securities with short-term debt didn't result in interest rate losses due to the Federal Reserve's low interest rate policy, but their credit losses skyrocketed.

Firms that borrow short and lend long without hedging are guaranteed to fail when interest rates raise enough, as savings-and-loans and technically Fannie Mae did in the 1980s. Deposit-based lenders can use interest rate swaps and/or futures markets to transfer the interest rate risk of fixed rate mortgages, but the availability of swaps is limited by the availability of long-term fixed rate liabilities, down about 80% since the 1970s in response to high and volatile interest rates according to the Federal Reserve Flow of Funds Accounts. Options are used to manage the risk of mortgage loan commitments prior to closing, but MBS has proven to be the only effective way to transfer lender prepayment risk for closed loans. The free borrower prepayment option remains an unhedgable investor risk.

Private markets won't eliminate fixed rate mortgage lending but borrowers – rather than taxpayers – will have to pay for the risk.

Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates and an executive scholar at the Burnham-Moores Center for Real Estate of the University of San Diego.

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