Recently, the University of Maryland’s Clifford Rossi shined a light on impediments to an otherwise resurgent mortgage insurance industry. While the analysis had a number of useful insights, Rossi’s assertion that risk sharing strategies underway for Fannie and Freddie could have wide-ranging benefits, notably for MI companies, wades into risky territory.
Writing for the American Banker, Rossi posited, “Right now, housing finance is languishing and for the time being the MI industry’s fortunes have been the best they’ve been in years. But hitching their wagon to benign credit conditions and a limited business model is no way to secure a vibrant future. The housing finance system would be on much better footing if the MI industry were permitted to expand its natural role in risk diversification.”
Since 2013, the Federal Housing Finance Agency (FHFA), in its role as conservator, has required Fannie and Freddie to transfer as much of their pooled loans to the private sector as possible. Experts at the Urban Institute who support the concept acknowledge in a new report that FHFA is still in the learning phase about how to best undertake this significant policy change. Now the agency is embarking on ways to transfer mortgage credit risk at the time the loans are originated, at the front end. Supposedly, by giving private sector players, including mortgage insurers, a bigger piece of the mortgage business, taxpayers would be less likely to have to provide bailouts as was the case with Fannie and Freddie in the 2008 financial crisis.
But there are some flaws in the government’s premise. One is that the risk-sharing strategies currently being undertaken are serving mainly to whittle away at Fannie and Freddie’s core business, which is the opposite of what the Housing and Economic Recovery Act requires. When the enterprises unload risk in the market, they are also giving up guarantee fees, which are their chief source of revenue. We are in uncharted waters as we erode the business model underpinning companies that have had a singular role in providing countercyclical market liquidity and then hand off their business to players with neither the mandate nor the capacity to perform that role.
Rossi rightly credits the MI companies that came through the 2008 financial crisis for providing, “an important countercyclical anchor to the housing market by continuing to write mortgage insurance even as the financial storm was raging.” The MI companies might have been an anchor but historically Fannie and Freddie have been the anchors. Risk sharing threatens to make them less reliable stabilizers.
Second, the MI industry has nothing close to the capital Fannie and Freddie provide the marketplace. Together the GSEs back some $5 trillion in mortgages. Rossi is correct that the MI industry has been rebounding. Indeed, it could have nearly $10 billion in capital and industry leaders say they will be able to raise much more money over time. While that might be true, it is only a drop in the bucket of capital that is needed. Even the Wall Street banks have nothing close to the amount of capital needed. Rossi is correct to note that they “ran for the exit at the first sign of trouble in the private-label securities market” during the 2008 crisis. As former FDIC Chairman William Isaac has noted, risk sharing is not a substitute for capital.
Rossi suggest that the patchwork of state insurance regulations is creating a drag in the MI industry. Certainly, state-based insurance regulation imposes inefficiencies on companies that operate nationwide. However, if there is one lesson learned from the 2008 crisis, it is that sound regulatory practices are important. Since the crisis, more rigorous standards on how much cash to have on hand to cover even catastrophic losses have been put in place. But going into the crisis, mortgage insurers were not rigorously regulated. Many MI companies survived the financial crisis and regained their financial footing primarily due to the regulatory framework in place for the GSEs through FHFA. If MI companies acquired a larger share of the GSEs’ business through risk-sharing and a severe market downturn occurred, only the toughest regulatory standards would spare taxpayers from having to provide emergency funding directly to mortgage insurers or indirectly through the GSEs to avert of a broader economic crisis.
Mortgage insurance companies have an important role to play in the housing finance marketplace but they cannot supplant the role of Fannie and Freddie. Neither can the nation’s biggest banks. Transferring or sharing risk is a common tool used by large enterprises for financial management. But the risk sharing underway at FHFA is undermining the business model of Fannie and Freddie and operating on the flawed assumption that there is the will or the capital in the banking and mortgage insurance sectors to match the role the GSEs’ function or better protect taxpayers.