June 9, 2016

If we aren’t careful with GSE risk transfer, mortgage rates could become volatile

June 9, 2016

Taxpayers are on the hook today for most mortgage credit risk, a burden that is decreasing by a recent influx of private capital. But data from our May chartbook (page 23) make it clear that we can’t get complacent with the main avenue we’ve relied upon to bring in private funds: capital markets risk-transfer transactions—Fannie Mae’s Connecticut Avenue Securities (CAS) and Freddie Mac’s Structured Agency Credit Risk (STACR). Continuing to rely predominantly on such deals to reduce taxpayer risk could make mortgage rates more volatile. Avoiding this outcome is straightforward: diversify the private capital sources.

Through the CAS and STACR deals, Fannie Mae has laid off credit risk to private investors for a fifth of its mortgage portfolio while Freddie has done the same for a third. The Federal Housing Finance Agency, which regulates Fannie and Freddie (the government-sponsored enterprises, or GSEs), strongly supports these deals and now requires Fannie and Freddie to transfer risk on at least 90 percent of newly acquired single-family loans in 2016.

High mortgage rate volatility

Fannie and Freddie sell multiple tranches of these securities to investors, each with a different level of risk. Most deals have two higher-risk tranches (B and M3) and two safer tranches (M1 and M2). What interest rates are investors demanding for taking on this risk?

From their introduction in 2013 to year-end 2015, CAS and STACR rates remained mixed, with the riskiest tranches (B and M3) exhibiting significant volatility and the safest tranches (M1 and M2) experiencing much less.

When markets are stable, investors see little risk and are comfortable with lower returns on their money. As volatility and risk increase, investors demand higher returns.

But what happens when market conditions deteriorate? The sharp decline in oil prices toward the beginning of 2016 coupled with worries about a slowdown in China increased investors’ perception of risks, pushing investors to demand higher interest rates than before.

STACR Spreads at issuance, High-LTV pools (81 to 95%)

Borrowers are insulated from rate volatility right now

Today, the guarantee fees borrowers pay on mortgages backed by the GSEs are set by the Federal Housing Finance Agency. The fees do not change with market conditions, largely insulating borrowers from significant mortgage rate volatility. But in a future housing finance system, private capital (rather than the government) will bear most credit risk.

In such a system, market conditions will inform and influence the mortgage rate. And if that system depends heavily on capital markets transactions, that rate volatility—like that experienced earlier this year—will be directly and consistently passed on to borrowers. The worst-case scenario is a housing finance system that is so dependent on capital markets that a pullback by investors during times of acute market stress would severely constrain credit availability. The only way to avoid such scenarios is to diversify our sources of private capital.

The Urban Institute has noted previously that other sources of private capital such as lender recourse, reinsurance, and private mortgage insurance have their own pros and cons, and overreliance on any one would create problems. This latest data show how.

Frances Darden examines mortgage documents in the living room of her home in Boston's Dorchester neighborhood,  May 3,  2007. Darden was approved for nearly $900,000 in loans to buy two multi-family homes, despite the fact that she is on disability and receives just $1,800 a month. Photo by Steven Senne/AP

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