Voices

National Mortgage News - - Contents - By Ted Tozer

Fan­nie Mae and Fred­die Mac’s ef­forts to of­fer low down pay­ment mort­gages in­clude mul­ti­ple lay­ers of pro­tec­tion against credit losses. But an anal­y­sis of these mea­sures sug­gests the gov­ern­mentspon­sored en­ter­prises are ac­tu­ally over­charg­ing the low-in­come bor­row­ers and first-time home­buy­ers they’re sup­posed to be help­ing.

The GSEs’ fed­eral char­ters re­quire a min­i­mum 20% credit en­hance­ment on ev­ery mort­gage Fan­nie Mae and Fred­die Mac pur­chase.

The sim­plest way to meet this con­gres­sional re­quire­ment is for the bor­rower to have a 20% down pay­ment.

Al­ter­na­tively, if the bor­rower’s down pay­ment is less than 20%, pri­vate mort­gage insurance can be ob­tained for the loan.

The lower the down pay­ment, the higher the re­quired PMI cov­er­age, which ef­fec­tively pro­vides two lay­ers of loss ab­sorp­tion be­fore Fan­nie Mae and Fred­die Mac take a loss.

As the dis­cus­sion con­tin­ues about what to do with Fan­nie Mae and Fred­die Mac, one ques­tion con­tin­ues to be a ma­jor ob­sta­cle to a sus­tain­able so­lu­tion: Will a new hous­ing fi­nance sys­tem be able to sup­port well- qual­i­fied, low- to­mod­er­ate in­come fam­i­lies as well as the cur­rent sys­tem?

But to re­ally an­swer this ques­tion, it’s nec­es­sary to un­der­stand to what ex­tent, if at all, the GSEs are cross- sub­si­diz­ing their pric­ing. This anal­y­sis is based on the lim­ited pub­lic in­for­ma­tion on GSE pric­ing, in­clud­ing loan- level price ad­just­ments, ob­served from the GSE LLPA pric­ing charts since the GSE and Fed­eral Hous­ing Fi­nance Agency pric­ing method­ol­ogy is very opaque.

An­a­lyz­ing and un­der­stand­ing the amount of credit risk Fan­nie and Fred­die hold at var­i­ous LTV ra­tios leads to the ques­tion of how they price credit risk. Let’s con­sider a bor­rower with a 660 credit score and a 5% down pay­ment who wants to buy a $200,000 house.

The loan has to be credit en­hanced to the point that the GSE would only ex­pe­ri­ence a credit loss if the over­all losses on the home were in ex­cess of $ 40,000. To do this,

the bor­rower would need to pay an LLPA of $ 4,275 and buy a mort­gage insurance pol­icy to sup­ple­ment the down pay­ment, which gives the GSE $67,000 of credit loss pro­tec­tion — in essence, a 66.5% LTV loan.

To ef­fec­tively eval­u­ate the LLPA ta­ble, one must un­der­stand the GSEs’ credit risk ex­po­sure at var­i­ous loan-to-value ra­tios. Ta­ble 1 shows the LLPA a home­buyer would have to pay at var­i­ous credit scores and LTV lev­els.

One would ex­pect the LLPA charged for this loan to be equiv­a­lent to the LLPA charged on a 66.5% LTV loan, since the GSE loss sever­ity ex­po­sure is the same. How­ever, the fee charged for a 70% LTV loan is only $ 1,400. The 95% LTV bor­rower must pay an ex­tra

$ 2,875. What’s more, an ap­par­ent high LTV penalty ap­pears at all credit score lev­els.

Be­cause of the lack of trans­parency by the GSEs and FHFA, there is spec­u­la­tion about the ra­tio­nale for the ap­par­ent bias against high LTV loans.One rea­son could be the coun­ter­party risk the GSEs have with the PMI com­pa­nies.

Dur­ing the hous­ing cri­sis, three PMI com­pa­nies were seized by state reg­u­la­tors. The state reg­u­la­tors slowed down the claims-pay­ing process at these three com­pa­nies to as­sure all claims would be paid even­tu­ally.

The other five PMI com­pa­nies paid their claims on time and in full.

All hous­ing fi­nance par­tic­i­pants that sur­vived the mort­gage cri­sis have ad­justed poli­cies to strengthen the over­all sys­tem. For ex­am­ple, the FHFA has min­i­mized fu­ture risk to the GSEs from the use of MI by be­com­ing an un­of­fi­cial reg­u­la­tor of the PMI com­pa­nies and set­ting cap­i­tal stan­dards that are dou­ble pre- cri­sis lev­els.

There was con­tro­versy around PMI com­pa­nies re­scind­ing cov­er­age for fraud and poor un­der­writ­ing dur­ing the cri­sis, sim­i­lar to the buy­backs the GSEs re­quired. The MI rescis­sions were detri­men­tal to the ser­vicers and ad­van­ta­geous to the GSEs. The GSEs re­quired ser­vicers to buy back MI re­scinded loans, which en­tirely elim­i­nated the GSE credit risk.

To be­come bet­ter part­ners with the lend­ing com­mu­nity, the PMI com­pa­nies have rewrit­ten their mas­ter poli­cies to limit and clar­ify the com­pany’s abil­ity to re­scind cov­er­age.

Given these MI in­dus­try en­hance­ments, it is hard to see how any lin­ger­ing con­cerns about the PMI in­dus­try jus­tify the in­cre­men­tal $2,875 be­ing charged to the hy­po­thet­i­cal bor­rower men­tioned above.

An­other pos­si­ble rea­son for the in­creased fees on high LTV loans is the po­ten­tial for greater losses to the GSEs, even after fac­tor­ing MI claims be­ing paid. Stick­ing with the ex­am­ple of a 660 credit score bor­rower buying a $200,000 home, Ta­ble 2 demon­strates the loss ex­po­sure to the GSEs at var­i­ous LTV and de­fault prob­a­bil­ity lev­els.

The GSEs do not charge LLPAs or re­quire mort­gage insurance on loans orig­i­nated with 60% LTV ra­tios. Sim­ply put, it’s un­likely the GSEs would suf­fer a loss if a loan with that much eq­uity de­faults. So in this sce­nario, their lim­ited risk ex­po­sure on the first $ 120,000 of the orig­i­nal pur­chase price is the same, re­gard­less of the credit en­hance­ments pro­tect­ing the re­main­ing $ 80,000.

While it’s true that bor­row­ers with smaller down pay­ments present a greater de­fault risk, the gap be­tween the LLPAs charged on 70% LTV and 95% LTV loans is so great than in­creas­ing the loss fre­quency by a fac­tor of 10 justifies less than half the $2,875 dif­fer­ence.

Based on this anal­y­sis, the cross sub­si­diza­tion ap­pears to be over­charg­ing high LTV bor­row­ers and sub­si­diz­ing low LTV bor­row­ers by about $1,775. Put an­other way, 95% LTV mort­gages would have to de­fault at a rate of nearly 24 to 1 com­pared to 70% LTV loans to jus­tify the dif­fer­ence in LLPA fees.

Re­quir­ing bor­row­ers to pay a fee that dis­pro­por­tion­ately re­flects the risk to the govern­ment- spon­sored en­ter­prise is detri­men­tal for low- in­come in­di­vid­u­als and fam­i­lies, par­tic­u­larly first- time home­buy­ers and peo­ple of color.

The GSE bias against high LTV lend­ing has pushed bor­row­ers to Fed­eral Hous­ing Ad­min­is­tra­tion who would nor­mally be served through GSE products.

Hous­ing re­form ad­vo­cates need to be con­scious of and open- minded about how a new hous­ing fi­nance sys­tem af­fects and sup­ports the un­der­served be­cause the lack of trans­parency in the cur­rent sys­tem has pushed po­ten­tial bor­row­ers to the out­skirts.

Ted Tozer is a se­nior fel­low in the hous­ing fi­nance pro­gram at the Milken In­sti­tute Cen­ter for Fi­nan­cial Mar­kets. He was pres­i­dent of Gin­nie Mae from 2010-2017.

Ted Tozer

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