Reform of U.S. mortgage finance system and its secondary market (i.e., GSE Reform) has been a topic of discussion and debate since Fannie Mae and Freddie Mac were placed in conservatorship nine years ago (9/6/2008). During 2013 and 2014, there was momentum with several legislative developments (Corker-Warner and Johnson-Crapo - Housing Finance Reform and Taxpayer Protection Act). And this year the Mortgage Bankers Association put out a comprehensive white paper and there are Senate Banking committee hearings underway. While the timing and outcome of any GSE Reform legislation is highly unpredictable, it may be beneficial to review two key concepts in such reform: Guarantors and a federal backstop guarantee. Most GSE and mortgage finance system reform proposals include these concepts. These are as important to support the liquidity of the conventional MBS market.
Specifically, this post reviews an approach to capitalizing Guarantors so as to bear substantially all but catastrophic losses. In addition, a concept to provide the final backstop using a mortgage insurance fund with sufficient reserves is outlined. The analysis here is admittedly overly simplified but it may provide a high-level assessment of the approach to capitalizing these entities.
Overview of Key Participants in New Secondary Market:
The following graphic depicts some of the key participants in the new mortgage finance system and identifies their role in loss sharing due to declines in home prices and mortgage defaults:
Home Value Decline and Mortgage Loss Waterfall:
The waterfall for bearing losses associated with declines in home values and borrower mortgage defaults starts with the homeowner's equity. The complete expected waterfall is as follows:
- Homeowner equity bears the first losses generally between 5% and 20% (or more) of home value at origination;
- Private mortgage insurance will generally cover losses equal to the difference between 20% of the home price and the down payment made by the homeowner;
- Guarantors are expected to bear all other loss, except truly catastrophic; and
- Residential mortgage insurance fund would bear any catastrophic losses.
Bank – Capital Requirements:
Since commercial banks can originate and hold residential mortgage loans – and bear the entire risk of credit loss, let’s review their required capital standards.
The following are the important elements under the Basel capital rules adopted by the federal bank regulatory agencies:
- Mortgage loans have a risk weighting of 50 percent.
- Minimum Total Capital Ratio (risk-weighted) of 10.5%, including the 2.50% capital conservation buffer (assume no SIFI designation).
- Minimum Tier 1 Leverage Ratio (not risk-weighted) of 5.00% for “well capitalized” designation under Prompt Corrective Action thresholds.
- Minimum Tier 1 Common Equity Ratio (risk-weighted) of 7.00%, including the 2.50% capital conservation buffer (assume no SIFI designation).
Guarantors – Capital Requirements:
Guarantors are at the core of the envisioned mortgage finance system. These private sector firms will (1) aggregate mortgages from banks, thrifts, credit unions and mortgage companies, (2) arrange for transfer and sharing of some, but not necessarily all, of the credit risk to investors and mortgage insurers and (3) securitize mortgage loans into mortgage-backed securities through a centralized platform (common securitization platform - FHFA, Fannie Mae and Freddie Mac websites).
Given their role in managing, holding, transferring and sharing mortgage credit risk, these Guarantors need to be well capitalized. The buck - actually multiple billions of bucks - must stop at the Guarantor level. Today, there is approximately $4.8 trillion of conventional mortgages underlying Fannie and Freddie MBS. For purposes of this analysis, let’s assume that Guarantors are capitalized similar to commercial banks and thrifts under their current risk-based capital regulations. We will also assume that Guarantors can include credit risk transfer bonds as a component of secondary capital to meet the total capital ratio requirements.
- Minimum Tier 1 Leverage Ratio (non risk-weighted) of 5.00% for “well capitalized” designation under Prompt Corrective Action thresholds. Tier 1 Leverage Ratio calculated as tangible equity divided by tangible total assets. This ratio is most important. The minimum target ratio must bear some relationship to AAA-rated credit enhancement tranches for residential mortgage-backed securities and the first loss levels and other loss sharing retained directly by the Guarantors.
- Minimum Total Capital Ratio (risk-weighted) of 10.5%, including the 2.50% capital conservation buffer (assume no SIFI designation). This ratio is calculated on risk-weighted assets with residential mortgages risk-weighted at 50 percent.
- Minimum Tier 1 Common Equity Ratio (risk-weighted) of 7.00%, including the 2.50% capital conservation buffer (assume no SIFI designation). Under bank capital regulations, Tier 1 capital is common equity; therefore, the Guarantor should meet this standard with common equity.
- Credit Risk Transfer Bonds (or similar instruments) would qualify as secondary capital as a component of capital for compliance with the Total Capital Ratio requirement, subject to certain limits to be established by the primary regulator..
- First Loss Coverage is a minimum of 10% of first loss risk as under Corker-Warner / Johnson-Crapo legislative proposals (2013-2014). This requirement results in credit enhancement protection for the residential mortgage insurance fund at or near levels equivalent to AAA-rated super-senior tranches. This First Loss Coverage can be achieved through a mix of common equity and credit risk transfer bonds. In this example, the common equity plus credit risk transfer bonds (50/50 split) as percent of total MBS guaranteed must be a minimum of 10 percent.
- Regulatory Agency overseeing these Guarantors would have the authority to establish these capital levels, authorize allowable forms of capital (common equity, preferred equity, loss-absorbing bonds, etc.) and augment these capital levels as appropriate during or in anticipation of periods of economic stress. Any form of capital must bear some share of any losses that occur.
In this example, the network of Guarantors would need to have approximately $262 billion of common equity and issue $226 billion in credit risk transfer bonds in order to provide the financial strength to absorb all losses, except catastrophic losses, and meet the various capital requirements identified. Total capital resources are approximately $488 billion. For reference, this is approximately 25 percent of the total equity capital underlying the banking industry.
There would be a federal regulatory agency with oversight of the multiple Guarantors and the mortgage insurance fund / corporation. This regulatory agency would establish initial insurance reserve levels, insurance assessments and capital structure for the mortgage insurance fund in addition to capital requirements and structure for Guarantors. And this regulatory agency would have authority to raise capital levels at Guarantors and reserve levels and insurance assessments at the insurance fund as economic conditions and fund performance dictate. This regulatory agency could be the Federal Housing Finance Agency, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency or a new or consolidated agency.
Residential Mortgage Insurance Fund (RMIF):
The RMIF would function to provide a financial backstop to the Guarantors for any catastrophic losses in the guaranteed MBS market. Several elements of the RMIF identified in this concept include: (1) RMIF insurance assessment, (2) RMIF insurance fund reserves and (3) credit-linked bonds (CLBs).
- RMIF Insurance Assessment - 3 basis points annually on outstanding guaranteed conventional MBS.
There would be an explicit fee for this federal backstop. The RMIF would assess each mortgage in a guaranteed MBS with a monthly fee. For purposes of this note, the RMIF assessment would be at an annualized 3 basis points paid monthly from the cash flows of the guaranteed MBS similar to how mortgage servicing fees are paid. While the RMIF assessment fee will be new, it is not expected to increase the cost of a mortgage. The specific source for this fee will be out of the current guarantee fee charged on each mortgage loan today. In 2017, this guarantee fee (net of the 10 basis point Temporary Payroll Tax Cut Continuation Act of 2011 fee collected by Fannie Mae and Freddie Mac and passed through to the U.S. Treasury) averaged approximately 47 basis points on new MBS guaranteed by Fannie Mae and Freddie Mac.
- RMIF Insurance Fund Reserves - 0.5% of outstanding guaranteed conventional MBS.
The RMIF would be required to hold reserves against all outstanding guaranteed MBS. The level of reserves would be a minimum of 0.50% of outstanding guaranteed MBS. For example, if after 7 years, guaranteed MBS totals $4.7 trillion (approximately outstanding MBS issued by Fannie Mae and Freddie Mac currently), then the RMIF reserves must be a minimum of approximately $24 billion. The RMIF would be capitalized from earnings and CLBs. Alternatively, to reduce the level of CLBs, the RMIF may be initially capitalized through an assessment on most or all participants in the mortgage origination and aggregation system. For example, an assessment of 0.50% on all existing Fannie Mae and Freddie Mac guaranteed MBS outstanding payable over several years (5 - 10 years) and transfer the catastrophic loss coverage of these MBS to the RMIF immediately. RMIF reserves would be invested in U.S. Treasury securities of various maturities with a limit on either individual maturity or on total portfolio average life. Limiting investments to only U.S. Treasury securities both eliminates any credit risk taken on the part of the RMIF and ties RMIF support to the U.S. Treasury relating to the federal backstop concept.
Note: in the Corker-Warner Bill (Housing Finance Reform and Tax Payer Protection Act of 2013), the targeted reserve levels were 1.25% after 5 years and 2.50% after 10 years. If the Guarantors are properly capitalized, the reserve level required should not need to be at these levels.
- Credit-Linked Bonds (CLBs) - issue $25 billion over five years.
The RMIF would be allowed to transfer risk through the issuance of credit-linked bonds (or other risk-sharing instruments). These CLBs could be comparable to the bonds issued by Fannie Mae and Freddie Mac today in their credit risk transfer programs. The use of CLBs would allow RMIF reserves to be in place immediately ahead of the cumulative buildup of the monthly RMIF net income - primarily derived from assessment fees. In this example, $5 billion of CLBs are issued annually for the first five years for a total of $25 billion. The regulatory agency with oversight of the RMIF would regulate structure, including tranches, for these CLBs. These CLBs would have a final maturity of a minimum of 10 years and would be total loss absorbing. Given that these bonds would have prior loss support from the Guarantors for all but the catastrophic losses, the expectation is that these bonds would be highly rated – perhaps, AAA (super-seniors to the Guarantor capital positions).
Financial Analysis of RMIF Concept:
The following is a simplified presentation of an abbreviated balance sheet and income statement for the RMIF:
The following assumptions were used to create this pro forma analysis:
- $1 billion MBS issued annually; 200% PSA assumed for analysis purposes only.
- Liquidity established as 5% of outstanding Credit-Linked Bonds.
- Risk transfer utilizes Credit-Linked Bonds in addition to RMIF capital; assume $25 billion issuance over 5 years.
- 3 bps annualized assessment fee paid monthly on outstanding guaranteed MBS.
- Investments must be in U.S. Treasuries; assume 5-year maturities.
- Operating expenses assumed at 1 bps of outstanding guaranteed MBS, including cost of regulatory agency staff, systems and MBS monitors (similar to Asset Monitors in covered bond transaction).
- Credit-Linked Bonds are AAA-rated (super-seniors) given prior support from Guarantor - multiple tranches possible; assume 10-year maturity; 50 bps spread to 10-yr CMT.
- Assume no losses to the RMIF.
The following table depicts loss allocations across participants in the mortgage finance system assuming a 12% default rate and varying the home value declines or loss rates (including disposition costs). This analysis would suggest that the Guarantor with bank-like minimum capital requirements would absorb losses at this level with no catastrophic losses for RMIF.
The following summarizes the capitalization of the Guarantor network and a Residential Mortgage Insurance Fund based upon banking industry capital standards, 10 percent first loss coverage under prior legislative proposals and assessment of a minimum standard for the insurance fund reserves:
Residential Mortgage Insurance Fund:
- 50 basis points minimum reserve level as percent of guaranteed MBS
- 3 basis points annual insurance premium on outstanding guaranteed MBS
- Reserves comprised of fund equity plus credit risk transfer bonds (total loss absorbing bonds)
- Requires reserves of approximately $24 billion
- 10% “first loss” coverage of guaranteed MBS
- Total capital ratio minimum of 10.5 percent
- Tier 1 common equity ratio minimum of 7 percent
- Total capital includes common equity plus credit risk transfer bonds
- Requires total capital of approximately $488 billion
- Regulatory agency would design final capital rules for Guarantors
This analysis is meant to place some numbers around the various concepts that have been raised under previous and current GSE reform proposals and legislation. One open, but very important, question is whether Guarantors can achieve a sufficient return on capital at the levels identified here to attract the required $262 billion in common equity. For this level of capital support - 5% leverage ratio (10% risk coverage is 50% equity and 50% CRT bonds), return on capital may be in range of 6% or less. If leverage ratio target is 4% (10% risk coverage is 40% equity and 60% CRT bonds), return on capital may be slightly below 7%. The goal is to position a reformed mortgage finance system so that taxpayers are protected if a catastrophic event occurred again.
The analysis raises the questions as to:
- What is the acceptable mix of capital to meet a Corker-Warner / Johnson-Crapo 10% risk retention objective?
- What is the minimum required level of equity capital? 5%? 4%? Other?
- What types of capital should be allowed (common equity, preferred equity, CRT bonds, other loss-absorbing capital instruments)?
- What return on capital will be sufficient to attract the required capital?
There are many organizations with capabilities to advance this concept much further along and to apply more stringent analytics to the financial analysis and assessment. This analysis is only meant as an initial step in that process.