Credit Risk Transfer: Front End Execution – Why Does It Matter?
This article was originally published on the GoRion blog.
Last month I described an overview of the activities of Credit Risk Transfer (CRT) as outlined from the Federal Finance Housing Agency (FHFA) guidance to Fannie Mae and Freddie Mac (the GSEs). This three-year-old program has shown great promise and success in creating a deeper residential credit investor segment and has enabled risk increments to be shifted from the GSEs and taxpayer to the private sector.
The FHFA issued an RFI to solicit feedback from stakeholders on proposals from the GSEs to adopt additional front-end credit risk transfer structures and to consider additional credit risk transfer policy issues. There is firm interest in this new and growing execution for risk transfer by investors who have confidence in the underwriting and servicing of mortgage loans through new and improved GSE standards.
In addition to the back-end industry appetite for CRT, there is also a growing focus to increase risk share at the front-end of the origination transaction. In particular, the mortgage industry and insurers (MIs) are interested in exploring risk sharing more actively on the front-end of the mortgage process. The MIs desire to participate in this new and growing market opportunity would increase their traditional coverage to much deeper levels than the standard 30% coverage.
Front-End Credit Risk Transfer
In 2016 FHFA expanded the GSE scorecards to include broadening the types of loans and risk transfer which included expanding to the front-end CRT. In addition to many prescriptive outlines on CRT, they also included wording such as “…Work with FHFA to conduct an analysis and assessment of front-end credit risk transfer transactions, including work to support a forthcoming FHFA Request for Input. Work with FHFA to engage key stakeholders and solicit their feedback. After conducting the necessary analysis and assessment, work with FHFA to take appropriate steps to continue front-end credit risk transfer transactions.”
Two additional ways to work with risk sharing on the front-end are using 1) recourse transactions and 2) deeper mortgage insurance.
Recourse as a form of credit enhancement is not a new concept. In years past, some institutions would sell loans with recourse to the GSEs but it was usually determined to be capital intensive and not an efficient way of selling loans to the secondary markets. However, some of the non-depositories have found recourse to be an attractive way to sell loans to the GSEs.
To date from 2013 through December 2015, the GSE’s have executed 12 deals with recourse on $12.6 billion in UPB. The pricing and structures are very different and the transactions are not transparent. While this can be attractive to both parties if structured adequately, the transactions are not as scalable and each deal requires significant review and assessment. Arguments against recourse note this diminishes opportunities for the small to medium sized player who would like to participate in this new form of reduced g-fee structure and front-end CRT transaction.
Penny Mac shared their perspective on this activity at a recent CRT conference. They use the recourse structure with Fannie Mae and it leverages their capital structure and allows flexibility. Importantly, Penny Mac reminds us that both parties’ interests are aligned as there is skin in the game for quality originations.
Deeper Mortgage Insurance
The GSE model has a significant amount of counter-party risk with MIs through their standard business offerings. Through their charter, they require credit enhancements on loans of 80% or higher Loan to Value (LTV). This traditionally plays out to be 30% first loss coverage of such loans. For example, a 95% LTV loan is insured down to 65%. The mortgage insurers are integral to most of the GSE’ higher LTV books of business. Per the RFI, as of December 2015, the MI industry collectively has counter-party exposure of $185.5 billion, covering $724.5 billion of loans. So as a general course of business, this is already a risk they share of higher LTV lending without adding any additional exposure.
Through the crisis, the MIs were unable to pay dollar for dollar initial claims. This has caused hesitation on embracing a more robust model with more counter-party risk than the model of today. It is well documented that the MIs did pay a great deal of claims and buffered the GSEs by taking the first loss on billions of dollars before any losses were incurred by the GSEs. While much of that has been paid back, memories are long and this has generated pause as to how to value the insurance which is different than the back-end transactions. Today the MI industry is in much better shape through capital raises and increased standards directed from the GSEs and state regulators. (Our recent blog post on mortgage insurance haircuts explores this phenomenon in greater detail.)
FHFA instituted the PMIERs which required higher capital for the MI business transacted with the GSEs. The state regulators also increased the regulatory capital for the residential insurance sector and today the industry has strengthened their hand as a partner to the GSEs. In fact, the industry has new entrants who do not have the legacy books of losses which also adds new opportunities for the GSEs to expand the counter-party pools.
The MI companies can be a front-end model and play a more significant role in the risk share business by having deeper MI on the front-end (to 50% coverage) as a way of de-levering the GSE’s and ultimately, the taxpayers. And, like the GSE’s, MI’s may also participate in reinsurance markets to shed risk and balance out their own portfolios. Other market participants may also participate in this type of transaction and we will observe what opportunities avail themselves in the longer term. While nothing is ever black and white, there appear to be benefits to expanding the risk share efforts to the front-end of the business.
1) Strong execution: Pricing and executing on mortgage risk, at the front of the origination will allow for options in a counter-cyclical volatile market.
2) Transparency: Moving risk metrics and pricing to the front-end will drive more front-end price transparency for mortgage credit risk.
3) Inclusive institutional partnering: Smaller entities may participate in a front-end risk share effort thereby creating opportunities outside of the largest financial institutions.
4) Inclusive borrower process: Front-end CRT may reach more borrowers and provide options as more institutions can take part of this opportunity.
5) Expands options for CRT in pilot phase: By driving the risk share to the front-end, the GSE’s reach their goals in de-risking their credit guarantee while providing a timely trade off of G-fee and MI pricing on the front-end of the transaction.
As part of the RFI response, the trade representing the MIs summarized principal benefits of front-end CRT as follows:
- Increased CRT availability and market stability
- Reduced first-loss holding risk
- Beneficial stakeholder familiarity and equitable access
- Increased transparency.
The full letter may be found at usmi.org.
In summary, whether it is recourse to a lending institution or participation in the front-end MI cost structure, pricing this risk at origination will continue to bring forward price discovery and transparency. This means the consumer and lender will be closer to the true credit costs of origination. With experience pricing and executing on CRT, it may become clearer where the differential cost of credit lies. The additional impact of driving more front-end CRT will be scalability and less process on the back-end for the GSEs. By leveraging the front-end model, GSEs will reach more borrowers and utilize a wider array of lending partners through this process.
As of November 8, we experienced a historic election which may take us in new directions. However, credit risk transfer is an option that may be used in the future regardless of GSE status, even if they 1) revert back to the old model with recap and release; 2) re-emerge after housing reform post legislation; or 3) remain in conservatorship and continue to be led by FHFA down this path.
**Footnote: All data was retrieved from the Federal Housing Finance Agency, FHFA, Single Family Credit Risk Transfer request for input, June 2016. More information may be found at FHFA.gov.
This is the second installment in a monthly Credit Risk Transfer (CRT) series on the GoRion blog. CRT is a significant accomplishment in bringing back private capital to the housing sector. This young effort, three years strong, has already shown promising investor appetite while discussions are underway to expand offerings to front-end risk share executions. My goal in this series is to share insights around CRT as it evolves with the private sector.