Credit Risk Transfer in a New World – The Waterfall of Risk Falls Squarely on Private Capital
This article was originally published on the GoRion blog. Last month I highlighted the role of the front-end insurance risk share process around Credit Risk Transfer (CRT). I reviewed what the front-end risk share model is in the current state and noted the expanded efforts underway to broaden the pool of MI’s and reinsurers as counterparties to expand the front-end offerings. This is in addition to the already successful back-end CRT which has found great success thus far. So, the key question for 2017 is what does CRT look like in a post housing reform environment where much of the capital at risk is not the government credit guarantee but is comprised of private capital? First, it is important to remind readers of some of the reasons CRT is successful and oversubscribed by the credit investors. The path to expand investment of private capital has been built by the GSE’s in the current CRT efforts by their continuous improvement in the quality of credit, process, and workflow. The private sector can leverage these standards as they expand their own offerings. The post crisis credit and servicing guidelines have added certainty to credit investors and interest from private capital has subsequently surged. While we are all appreciative of the clarity of government standards and the credit guarantee in housing finance, the thinking is that progress and innovation will be more prominent if there are opportunities to expand offerings for mortgages by leveraging the private sector. Most agree it is attractive to find more participation of capital in housing through private markets though it has been slow to advance post crisis. CRT has stimulated that advancement and creativity and will continue to be a positive force in the next stages of housing finance. One concept around this innovation is to leverage CRT in the private sector. This forward thinking was recently documented in the paper, Toward a New Secondary Mortgage Market, by Michael Bright and Ed DeMarco. Women in Housing Finance (WHF) hosted a lunch session on November 10, 2016 with Michael Bright, Director of the Milken Institute, and Ed DeMarco, Senior Fellow, Milken Institute during which Michael and Ed discussed their paper. My interest in this subject, other than the overall discussions that have taken place over the past eight years, was how they thought “CRT” was a central component of the new Secondary Mortgage Market. This next section explores some of those ideas. This is NOT a commentary on which way housing reform should go. In fact, if there is one common concept across most thought processes on housing reform, it is the government role of explicit guarantee for the catastrophic tail risk. The most interesting part of this proposal is that it seems to be less disruptive than other proposals. Further, it places significant private capital ahead of government at risk capital in the new housing world order. This contemplation was evident in the overview as discussed by the Milken scholars. The next section speaks to some of the details in this review. Many of the concepts are shared in other papers that attempt to place private capital well in front of the “at risk” government guarantee.
The Capital At Risk in the Fully Functioning Market, Funded by the Private Sector, Rolls Up to 8%Summary of private capital ahead of government guarantees:
- 4% through CRT shed in first loss position.
- An additional 2% of capital needed by way of purchasing a share ownership, of a mutual concept.
- Additional capital as funded by industry and loans, deal by deal, up to 2% which is contributed to the insurance fund managed by the regulator, in this case the Federal Housing Finance Agency (FHFA). This is funded by the industry, much like the FDIC funding in case of a stress event.