The debate over the future of the secondary mortgage market continues to swirl in political circles and on Wall Street. Many believe that the secondary market needs more competition that will go beyond government-sponsored entities, and that establishing a line of business for the private guarantee of mortgage-backed securities would bring much-needed private capital to the industry.
Its clear that the secondary mortgage market should be standardized in some ways. For instance, moving the GSEs to a single security should increase liquidity and lower costs for taxpayers. But in general, MBS guarantors should compete whether they are new entrants or housing giants Fannie Mae and Freddie Mac.
Some market-watchers question the value of competition in this area. They doubt price competition would be feasible, since both public and privateguarantors would be restricted by the same capital standards and qualified mortgage limitations. But think of a close parallel: thousands of banking institutions in the country are subject to similar capital standards and regulation, and yet a variety of business models flourish.
Others have argued that price competition would be impossible in such a scenario. The idea is that any competitor with the lowest price for the safest business would skim the cream off of the market, leaving other guarantors unable to earn a market return. Adverse selection is always a concern. But pricing for risk is rarely one-dimensional. A loan-to-value ratio or credit score does not fully capture the tradeoff between risk and return, and different investors may have different views of relative risk.
Product development and differentiation could also see growth in a more competitive environment, even with QM loan limitations. For instance, new adjustable-rate mortgage products that are viable under QM have recently been developed as portfolio products. The current market is predominantly fixed-rate. But if interest rates rise as expected, it is likely that the ARM share of the market will increase from the current 5% to 10% or even 15%. Future guarantors would also compete in product development for a range of housing needs such as condos just as the GSEs do now.
Beyond pricing and product strategy, service matters, too. The GSEs have both had experienced, knowledgeable sales forces with deep understandings of the lenders operating in the primary market. This knowledge has enabled them to provide differentiated service offerings, along with product and service bundles that fit large and small, bank and non-bank, publicly-held and privately-owned customers.
Superior service can win customer loyalty even if the product and pricing strategy is not always the "best." As with any other business, there are aspects that are difficult to quantify, but nonetheless extremely important.
But competition makes for even better service. In fact, even the potential for additional competition can have an impact. Economist William Baumol coined the term "contestable markets" to recognize the fact that if new competitors could potentially enter a market, even the threat of entry can help to ensure that incumbents will provide good service. This will help all participants to keep their pencils sharpened with respect to pricing and product strategy.
Of course, poor service can also have an impact. In the post-crisis environment, many lenders were unhappy with the GSEs' approach to repurchase demands and warrant enforcement. In a more competitive market, this behavior could have led lenders to move away from the GSEs. In the absence of such competition, lenders have had little negotiating leverage.
As a step toward realizing the potential for competition in the secondary mortgage market, the Mortgage Bankers Association has been advocating for the GSEs and their regulator, the Federal Housing Finance Administration, to offer upfront risk-sharing options. Our proposal would give lenders an opportunity to lower their guarantee fees by providing them with deeper private mortgage insurance coverage, lender recourse, or some other form of credit enhancement to bear risk ahead of the GSEs.
Making risk-sharing options available to lenders at the point of sale, rather than on the back end, would allow additional private capital and competition to flow into the secondary market. This would be a valuable method for testing proposed secondary market reforms before fully committing to them. While Congress and other stakeholders consider the future of the GSEs, such a program would prove the merit and potential of additional competition in the secondary mortgage market.
If the GSEs were required to de-risk loans prior to acquisition through deeper mortgage insurance coverage, lender recourse, or other upfront credit enhancements, the result would be greater competition and more price transparency that could likely lead to savings for many borrowers. Greater use of upfront risk-sharing would also place more private capital ahead of the GSEs, protecting the taxpayer and diversifying credit risk holders.
Many changes broadly embraced by advocates of secondary mortgage market reform, such as an explicit and fully-paid-for government guarantee, can only come through legislation. That said, steps can be taken by both FHFA and the GSEs in the interim to benefit consumers and embolden investors today.
Michael Fratantoni is the Mortgage Bankers Association's chief economist and senior vice president of research and industry technology.