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FHFA’s Credit Risk Program and the Future of GSE Legislation

By Michael A. Stegman

Thursday, September 8, 2016

This post is the fourth in our Housing America Series, aimed at elevating the need for housing policy reforms—from housing finance to affordability—as we move through a pivotal federal election and transition.


If there is one feature of a reformed housing finance system that has broad bipartisan buy-in, it is that private capital should take the vast majority of mortgage credit risk. Since 2012, Federal Housing Finance Agency (FHFA) leadership has made this a central component of their strategic plans for de-risking government-sponsored entities (GSEs) Fannie Mae and Freddie Mac and reducing taxpayer exposure while they remain in conservatorship. The vehicle for bringing private capital into the mix is commonly referred to as credit risk transfer, or CRT. By year-end 2015, the GSEs had collectively transferred to private investors at least some of the risk on $837 billion of unpaid principal balance to private capital through various forms of CRT. The FHFA has also directed Fannie and Freddie to substantially ramp up their CRT activities in 2016 and beyond.

If there is one feature of a reformed housing finance system that has broad bipartisan buy-in, it is that private capital should take the vast majority of mortgage credit risk.

While the centrality of risk-sharing in the Housing Finance Reform and Taxpayer Protection Act of 2014, commonly known as Johnson-Crapo, was not in dispute, there were continuing disagreements on this subject as the bill was being voted out of committee: How much risk-sharing should be achieved through back-end and front-end structures? Could guarantors with permanent sources of capital and who price credit risk over the full economic cycle coexist with more volatile, cyclically-sensitive, and transaction-based CRT structures (the concern being that capital markets investors would underbid guarantors’ pricing during good economic times and either pull out of the market altogether or charge higher prices when the economy heads south)? It is fair to say these disagreements were a contributing factor in preventing Johnson-Crapo from moving to a Senate floor vote.

Since then, CRT has been frequently mentioned in reform proposals as a principal means of putting private capital in front of a catastrophic government guarantee, turning FHFA into a sophisticated laboratory for the design, testing, and scaling of back-end risk sharing mechanisms. In fact, FHFA’s recent call for stakeholder advice on how to adopt additional front-end credit risk transfer structures is an important development on the path to long-term housing finance reform.

CRT has been frequently mentioned in reform proposals as a principal means of putting private capital in front of a catastrophic government guarantee.

In response to FHFA’s request for comment, researchers from the Urban Institute and Moody’s Analytics recently posted a broad set of recommendations on how FHFA could significantly improve the GSEs’ risk-sharing programs. Their prescription for further developing the CRT market merits close attention because two of the collaborators, Jim Parrott and Mark Zandi, have also co-authored a proposal that is widely expected to become Secretary Hillary Clinton’s opening bid for legislative GSE reform should she win the presidential election. How they think about broadening FHFA’s mix of front- and back-end CRT structures to determine their impacts on consumers and the broader financial system is important. The wide-ranging recommendations in the Urban-Moody’s paper for improving FHFA’s CRT program include developing, piloting, scaling, and evaluating the effects of these additional CRT structures:

  • Lender recourse across lenders of all sizes;
  • Deep cover mortgage insurance;
  • Back-end capital markets transactions by loan-to-value ratios and credit score ranges; and
  • Catastrophic risk transfers.

The one thing that is missing from the proposal is a timeline. How long would it take FHFA to complete this work, which the authors implicitly argue is critical to crafting and finalizing a legislative solution for GSE reform?

The ambitious CRT expansion plan proposed in the Urban-Moody’s paper would strive to shed empirical light on the ongoing debate of whether guarantors can healthily coexist with capital markets transactions. The paper’s authors imply it is preferable to see how various CRT structures perform in times of economic stress before permanently memorializing particular types of risk-sharing in legislation and that it is better for FHFA—while the GSEs are still in conservatorship—to determine empirically how much higher a return capital markets players would demand to cover their risk. The hope is that FHFA will be able to observe how investors respond to an economic downturn and the kinds of strains these responses will put on the broader financial markets: Will the GSEs, in their words, be forced to absorb costs and pass them on to borrowers, or will the two institutions pull back on their risk-sharing when the risk is most critical to share?

The CRT expansion plan proposed in the Urban-Moody’s paper would strive to shed light on the ongoing debate of whether guarantors can coexist with capital markets transactions.

These are the big takeaways from the Urban-Moody’s recommendations: Barring an unexpected near-term economic shock, it is unlikely that housing finance reform will be an immediate administration legislative priority if Secretary Clinton is elected president. In the near-term, through formal and informal means, the Clinton team will be looking to encourage the FHFA to accelerate, expand, and diversify its risk-sharing program while assessing its impacts over a fuller economic cycle.

Secondly, with the better part of three years at the helm of FHFA under his belt and an impressive record of stewardship and creative leadership, the next president is likely to find Director Mel Watt amenable to engaging more substantively in GSE reform during his final two years at the helm, despite his reluctance to do so during the Obama administration. If that turns out to be the case, we should all have confidence in a better outcome for America’s families and the economy.

KEYWORDS: GSES, MORTGAGE, FEDERAL HOUSING FINANCE AGENCY, FANNIE MAE, FREDDIE MAC, 2016, HILLARY CLINTON, MEL WATT, JOHNSON-CRAPO BILL, HOUSING AMERICA SERIES