Up-Front Risk-Sharing Through Deeper Credit Enhancement
Up-front risk-sharing allows lenders to secure deeper credit enhancement in exchange for lower guarantee fees (g-fees) and loan-level price adjustments (LLPAs). This credit enhancement can take many forms, including "deeper cover" private mortgage insurance (MI), lender recourse and structured finance. In 2016, Fannie Mae and Freddie Mac (the GSEs) began pilot programs to use up-front risk-sharing mechanisms to transfer mortgage credit risk. These programs represent an important first step toward implementing the recommendations made in MBA's proposal for more permanent and diverse up-front risk-sharing to increase private capital in mortgage markets and better protect taxpayers.
- Prior to 2016, GSE up-front risk-sharing transactions had been limited to structured recourse deals with just a few larger lenders. These structures are innovative and effective, but the GSEs did not make use of other proven approaches-such as deeper MI and lender recourse-which would better enable lenders of all sizes to compete on a level playing field. Highly structured transactions are likely not scalable to smaller lenders nor have they been tested during adverse market conditions.
- In the second half of 2016, both GSEs introduced pilot programs to expand their use of up-front risk-sharing. These programs have tested variants on deeper MI coverage.
- Through the GSEs' latest Scorecard, the Federal Housing Finance Agency (FHFA) is encouraging the GSEs to advance their credit risk transfer programs, including through consideration of front-end approaches.
- Concerns about the financial strength of the MI industry and individual MIs have been addressed by recent capital raises and new capital requirements. Notably, FHFA released new Private Mortgage Insurer Eligibility Requirements (PMIERs)-which became effective in late 2015-that establish financial and operational standards for MI firms that insure loans acquired by the GSEs.
- Greater use of up-front risk-sharing would place more private capital ahead of the GSEs, thereby better protecting taxpayers. This is a better alternative for attracting private capital back to the market than prior efforts to raise g-fees in an effort to "crowd-in" private capital.
- Mortgage pools would be de-risked before they reach the GSE balance sheets.
- Because up-front risk-sharing would attract private capital from entities that do not currently participate in the GSEs' other credit risk transfer programs, mortgage credit risk would be further diversified.
- Up-front risk-sharing also provides additional execution options to lenders and has the potential to benefit borrowers through increased pricing competition and more stable product availability.
- Lender utilization of up-front risk-sharing would be driven by the relative pricing of alternative executions and-importantly-by reductions in g-fees and LLPAs that reflect risk mitigation from the additional MI coverage. This requires a degree of deal- and program-level transparency that the GSEs have not previously provided.
- Many smaller and mid-sized lenders would also benefit from greater availability of shared and full recourse executions in exchange for lower g-fees and LLPAs.
MBA's Position/Next Steps:
- MBA strongly supports the GSEs' use of pilot programs to test up-front risk-sharing, and believes that these programs should be expanded and fine-tuned as the GSEs and market participants learn lessons from the initial transactions.
- MBA believes that private capital should cover most mortgage credit risk exposure (down to an effective loan-to-value ratio of 50-60 percent), leaving the GSEs to cover only catastrophic risk.
- MBA encourages the GSEs to continue testing new approaches to up-front risk-sharing to increase and diversify the sources of private capital in mortgage markets, to provide additional executions for lenders of all sizes and business models and to potentially lower costs for borrowers. Multiple forms of credit enhancement should be tested-including "deeper cover" private MI, lender recourse and structured finance.
- MBA plans to continue working with FHFA and the GSEs to further the development of up-front risk-sharing programs.
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