GSEs Should Spread the Risk (and Share the Profits)

Political discourse these days, particularly on the left, often takes the form of haranguing the much-vaunted “1 percent” to “spread the wealth” to the remaining 99 percent, as though such redistribution would solve society’s ills.  The inadequacies of this idea notwithstanding, perhaps the discussion—at least in the context of the mortgage giants Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac)—can shift to something that is both more achievable and more beneficial to taxpayers:  spreading the risk.

Citizens Against Government Waste (CAGW) has long inveighed against the excesses of these government-sponsored enterprises (GSEs) and the dire consequences to taxpayers of failing to rein them in, as Fannie Mae and Freddie Mac have notoriously privatized the financial gains but socialized the financial risks.  In his June 25, 2003 testimony before the House Subcommittee on Capital Markets and [GSEs], CAGW President Tom Schatz warned that: “It is clear that because of their size and market concentration, Fannie Mae and Freddie Mac are too big to fail… no matter how many times the GSEs say that they are private companies, independent of the government, everyone knows that is not the case.  The American taxpayer is on the hook if anything goes wrong with the GSEs, and therefore, effective regulation and accountability must be of paramount importance.”

Unfortunately, this warning was proven correct during the Great Recession of 2008, as both Fannie and Freddie required massive taxpayer bailouts and are now under conservatorship of the federal government through the Federal Housing Finance Agency.  Even worse, lessons may have been lost as policymakers allow the GSEs to resume activities that perpetuate themselves, rather than winding them down.

Consider the following:

• The GSEs are significantly overcharging American homeowners for the mortgage risks that they insure.  Private mortgage insurance companies charge roughly 60 basis points (0.6 percent) to insure against losses on the first (and also riskiest) third of a mortgage’s value for loans with modest (less than 20 percent) down payments.  But the GSEs charge an average of 85 basis points (0.85 percent) to insure the remaining (much less risky) balance of the mortgage loan.  In fact, any objective actuarial analysis would indicate that the GSEs should be charging only about 15 basis points (0.15 percent) for that level of risk.  To more fully appreciate the scope of this scam, it is important to understand that, when borrowers reach 20-30 percent equity in their property, they are (statistically) much less likely to default.  However, if they do, the balance remaining on such mortgages is more likely to be recovered by the lenders, as only the most catastrophic market circumstances would reduce property values below 70-80 percent of the mortgage.
• The GSEs are overcharging despite insuring the safest loans.  The GSEs have also become quite adept at pushing off riskier mortgages to the Federal Housing Administration with its 100% government guarantee (yet another increased risk to taxpayers).
• The GSEs’ costs have been allowed to increase by 31 percent over the last four years, although their mortgage volume has declined in every year.
• The GSEs asked for and received regulatory approval for CEO pay of $4 million.  Fortunately, Congress has taken some action to reverse this decision.

There is a growing movement to significantly reduce the role of the GSEs by replacing their guarantee with well-capitalized private sector companies in a program known as “risk sharing.”  Just as wiser stock market investors diversify their holdings to mitigate the impact of riskier investments (and particularly to minimize potential losses), taxpayers would be well-served if GSEs relinquished their stranglehold on mortgage guarantees by adopting credit risk sharing practices with the private sector.

An easy and scalable way to do risk sharing is with entities already in existence in the marketplace that could be larger, if they were not being starved by the GSEs’ market dominance.  Specifically, the private mortgage insurance (PMI) industry is the ideal market response to alleviate government (i.e., taxpayer) exposure.  For example, PMI could easily expand coverage to one-half the value of a mortgage (rather than the current one-third) and can take on this additional risk with a far more reasonable premium than the GSEs are charging.  This private “deeper cover” would put the GSEs in a catastrophic insurance role where they would be much less likely to need further taxpayer bailouts.

Indeed, because this is such a good idea that threatens the GSEs’ “corner” on the market, they’ve started to utilize complex financial structures to preempt the activity.  These “back end” risk sharing deals are done after the GSEs assume all of the risk:  they then pick and choose how to package it up and selling it at a price that turns the most profit to themselves.  Yet such deals are simply another example of the GSEs wanting to control the market:  they control who will get the deals.  By comparison, deeper cover private mortgage insurance continues to let lenders place the insurance and the additional risk is never assumed by the GSEs in the first place.

While GSEs are quick to reap the benefits of virtually controlling the mortgage market, the downside to taxpayers is that the latter are on the hook.  And if the private sector is encouraged to participate in this sector, then, yes, they will share in the profits of these endeavors, but the profit motive should not be vilified, especially as PMI reduces considerably the taxpayers’ risk of another bailout.

The benefits of greater PMI participation in the mortgage market are underscored in “Analysis of Deep Coverage Mortgage Insurance,” a study prepared for U.S. Mortgage Insurers by Milliman, Inc.  Among the key findings of the Milliman study is that risk share with mortgage insurers accomplishes savings for borrowers.  First, credit risk sharing nearly doubles the amount of loss protection (before GSEs’ exposure kicks in) when a borrower defaults on a mortgage.  Further, it allows the GSEs to reduce their committed capital for such risk by approximately 75 percent, resulting in lower GSE “guarantee fees” (G-fees) that they charge borrowers.  Moreover, it reduces borrower costs by approximately $2,300 over the average life of the loan.

Legislation to increase credit risk sharing is being contemplated in both chambers of Congress.  Senate Banking Chairman Richard Shelby (R-Ala.) supports the inclusion of PMI provisions in the year-long appropriations bill (omnibus), while House Financial Services Chairman Jeb Hensarling (R-Texas) is close to introducing stand-alone legislation that would allow greater PMI participation.  CAGW welcomes such efforts to increase private sector assumption of risk, so that the potential for “Mortgage Meltdown 2.0” (and the inevitable taxpayer bailout that would surely follow) is significantly reduced.

The merits of greater market involvement practically speak for themselves.  However, if the simple logic is not enough to sway lawmakers to accomplish these reforms, then a harbinger of things to come (absent such action) is that one of the GSEs (Freddie Mac) has declared a net loss of $475 million and a comprehensive loss of $501 million for the third quarter of 2015, caused mainly by the “use of derivatives,” according to Freddie Mac CEO Donald Layton.

“Losses like this, combined with multimillion-dollar CEO salaries at the GSEs are the warning shots of a return to the pre-crisis model of private gains and public losses that wrecked the economy,” said Rep. Ed Royce (R-Calif.), a House Financial Services Committee member.  “We can’t simply put the blinders on and say that Fannie and Freddie are just like other companies when taxpayers are on the hook if they go in the red.”

This development increases the likelihood that, in the near future, Freddie Mac will have to be bailed out by Treasury, where some $80 billion sits as a backstop.  However, adoption of these risk sharing proposals would help to ensure the solvency of the GSEs, thus reducing taxpayers’ risk.

The privatization of Fannie Mae and Freddie Mac (that is, getting taxpayers off the hook for any more failures) has perennially been listed as one of CAGW’s Prime Cuts, a compendium of recommendations to reduce waste and inefficiency in the federal government.  While risk sharing with deeper cover private mortgage insurance lacks the satisfaction of simply doing away with Fannie and Freddie in one stroke, this approach has significant potential to reform the GSEs from the inside out.  Pushing the GSEs into a catastrophic loss position will make it easier to finally do away with them entirely, or at least put them in a place where they will be less likely to hurt taxpayers as much as they already have.