Disjointed Risk Measurement Stalls Finance Reform Before It Starts. Is It Time the Industry Found an Alternate Route?
By Patrick Sinks
Though many experts have said housing finance reform is unlikely this year, the time is now to explore the fundamentals of how that reform could happen. Uniform and transparent measures of credit risks will play a key role—whether it’s in 2016, 2017, or beyond.
The State of Risk Measurement
Most people involved in the mortgage industry don’t think about weights and measures, but ensuring these uniform standards is essential for commerce, and it’s a core function of government. Although the government has established weights and measures in some areas of housing finance—for example, APR—it unfortunately has not done so in the important area of credit risk. The term “credit risk” means different things to different policymakers, and it differs in the context of housing finance programs, too. This continuing lack of a uniform and clearly articulated definition of credit risk has produced unintended consequences, and it stalls prospects for housing finance reform.
A little background: The mortgage insurance (MI) industry provides credit default protection on residential mortgages and intersects with federal housing policy in two important ways. The first point of intersection is with Fannie Mae and Freddie Mac, the government-sponsored enterprises (GSEs), and occurs because the majority of insurance written by the MI industry since 2008 has been for loans purchased by the GSEs. MI is commonly used to satisfy the credit enhancement requirement for low down-payment (generally less than 20 percent) mortgages found in the GSEs’ corporate charters. In 2008, the federal government took control of the GSEs through a conservatorship process. The Federal Housing Finance Agency (FHFA) is now the conservator of the GSEs and has the authority to control and direct their operations. Although bank portfolio lending has revived a bit since 2008, private label securitization of mortgages remains stagnant. Because of this, GSE-purchased mortgages—or conventional conforming mortgages—constitute the main outlet for fixed-rate mortgage originations by lenders and the main source of insurance business for the MI industry. As such, any action taken by the GSEs or the FHFA—or any housing finance policy that affects the GSEs, for that matter—will have notable influence on the MI industry.
The second point of intersection is with the Federal Housing Administration (FHA) and its Mutual Mortgage Insurance Fund. The FHA has coexisted with the MI industry since the mid-1950s, and they overlap in significant respects. The FHA and the MI industry each seek to serve the entire prime mortgage market where mortgage insurance is needed, including the sub-markets related to first-time homebuyers and low down-payment borrowers. Unlike homeowners insurance and auto insurance, where government facilities generally provide insurance only for those unable to obtain private insurance, the government facility provided by the FHA insures loans the private MI industry is able to and seeks to insure.
The Great Recession complicated matters even further. When the GSEs were put into conservatorship, the implicit guarantee supporting the GSEs was made explicit, with the U.S. Treasury as the backstop credit guarantor. At the same time, the FHA enjoys permanent and indefinite authority to draw on the U.S. Treasury for funds if needed—and it did in 2013. So, despite a market distinction between conventional conforming mortgages and government mortgages, the GSEs and the FHA actually share the same backstop credit guarantor—the U.S. Treasury itself.
Additionally, the dire circumstances of the housing crisis in 2008 and 2009 forced dramatic actions, notwithstanding the Treasury guarantee. The GSEs increased their guarantee fees and loan-level price adjustments (LLPAs), imposed adverse market delivery charges, and generally tightened credit underwriting standards to stabilize operations. The MI industry also adjusted pricing and terms for similar reasons. As a result, capacity for new conventional conforming mortgages was dramatically curtailed, and pricing for such mortgages was materially increased. Because the FHA did not immediately adjust pricing or terms, government mortgages became more available and cheaper for many borrowers than conventional conforming mortgages—at least based on monthly payments. The resulting consequence of all these changes was a dramatic increase in the FHA’s volume and subsequent U.S. Treasury support.
The Current Problem
In 2009 and 2010, the US Treasury and HUD studied the housing finance market and issued their white paper titled “Reforming America’s Housing Finance Market” in February 2011. The paper largely promoted the use of private markets and capital—and that was understandable. As an example, the paper recommended returning the FHA to its traditional role as a targeted supporter of affordable mortgages and simultaneously called for the private sector to absorb more risk in front of the taxpayer.
Unfortunately, the path to achieving those goals was not clearly defined, and unsurprisingly obstacles have arisen. The obstacles are not small and must be resolved before the publication’s aims can be met.
In the case of the FHA, the biggest issue lies in the government’s failure to establish a uniform and transparent measure of credit risk. Although the credit risk of government mortgages and conventional conforming mortgages is ultimately backstopped by the same entity, private capital from the MI industry reduces the exposure to the U.S. Treasury on conventional loans. These loans should, therefore, be favored over government mortgages whenever possible.
Regardless of the logic in favoring conventional mortgages, the credit risk associated with government mortgages is measured differently and less stringently than the credit risk associated with conventional ones, and this means more business moves toward the FHA and away from the GSEs and private capital.
Hiccups and Hurdles
Recall the overlap in service areas between the MI industry and the FHA. It should have been a relatively easy task for the MI industry to progressively return to its historical market share within the prime market while the FHA contracts—which actually occurred through the latter half of 2014.
However, private expansion and public contraction—both goals outlined in the white paper—stalled and then reversed in 2015. Two events occurred to cause the reversal of this path. In January 2015, the FHA announced a 50-basis-point reduction in its annual mortgage insurance premium, and in April 2015, the GSEs and FHFA finalized the updated Private Mortgage Insurance Eligibility Requirements (PMIERs). These two events sent inconsistent messages regarding the credit risk of low down-payment mortgages for the prime market.
The FHA’s premium rate reduction increased business volumes for the FHA, resulting in about a 5 percentage point shift in insured market share from the private MI industry to the FHA. Left unexplored and unexplained was the analytic rationale for the reduction in the FHA’s premium rates. Beyond noting that the FHA annual premium rates were at a historical high and that lower premiums would expand credit access, no further detail was given.
In the meantime, the PMIERs approached the credit risk of low down-payment mortgages for the prime market in a dramatically different way. The PMIERs established risk-based asset requirements for MI companies that are based on borrower, loan, and collateral attributes of the insured mortgages, and that generate higher asset requirements for “riskier” mortgages. MI premiums for certain segments have increased as a result, but the higher risk-based LLPAs that were imposed by the GSEs in 2009 have remained the same.
From an overall housing finance system perspective, the result was simple: The same person borrowing the same amount of money for the same term to purchase the same house would receive different prices from the two facilities, despite the fact that they are backed by the same backstop guarantor. Further, the different treatment may also increase the FHA’s market footprint—not reduce it in a manner consistent with the white paper’s goals.
To solve this issue, the industry can’t simply adjust FHA and MI premium rates, but instead, it needs to highlight the nature of the problem and the opportunity. Having the U.S. Treasury as the backstop for most of the residential mortgage market is seen by many in the industry as a problem, but it also represents an opportunity for the government to resolve an unaddressed inconsistency.
There is evidence of the additional risk associated with low down-payment lending. The question is how much additional risk is there, and how is that risk measured and paid for? The lack of clarity in the current system prevents policymakers from determining whether or how the private MI industry, the GSEs, and the FHA might work in a more complementary fashion. The overall housing finance system can be more effective if all parties work in concert, and beginning dialogue among industry leaders could help move this goal along.
In addition to an open dialogue about the system, related issues such as credit access and efficient delivery of credit subsidies need to be considered as well, but only after the government adopts uniform measures of credit risk and makes those measures publicly available to all market participants. Otherwise, important foundational questions regarding appropriate roles for the private and public sectors will remain unanswered.
Patrick Sinks has served as MGIC Investment Corporation’s CEO since March 2015. He began his career with the company at its primary subsidiary Mortgage Guaranty Insurance Corp. (MGIC) in 1978 as a member of the accounting team. He earned several promotions culminating with the role of SVP - Controller and Chief Accounting Officer before being selected by the company’s CEO, Curt Culver, to eventually succeed him as MGIC’s leader. Sinks was then moved to the sales side of the business as SVP-Field Operations and was subsequently promoted to President and COO.