House Financial Services Subcommittee Issues Testimony From Housing Policy Council President DeMarco
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Thank you for the invitation to participate in today's hearing. I am here on behalf of the
The topic of the hearing is the
Critical Context - The GSEs Have a Single Purpose with Specified Targets
* Provide stability in the secondary mortgage market;
* Respond appropriately to the private capital market;
* Provide ongoing assistance to the secondary market for residential mortgages (including activities relating to mortgages on housing for low- and moderate-income families involving a reasonable economic return that may be less than the return earned on other activities) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing; and
* Promote access to mortgage credit throughout the Nation (including central cities, rural areas, and underserved areas) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing./1
I served as the Acting Director of FHFA from 2009 to 2014. As a safety and soundness regulator,
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1 The third and fourth purposes listed are further developed in their charters in the context of meeting affordable housing goals and satisfying duty-to-serve requirements. These purposes are tied to those requirements. 12 U.S.C. Sec.1451 Note (
2 The Housing and Economic Recovery Act of 2008 (P.L. 110-289) amended the Federal Housing Enterprise Financial Safety and Soundness Act of 1992 (12 U.S.C. Sec.4501 et seq.) to establish FHFA as the safety and soundness regulator and the mission regulator for the GSEs. Before 2008, the
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The statutory purposes of
On
For purposes of today's discussion, I will divide FHFA's most recently announced pricing changes into two buckets. First, there are the adjustments FHFA made to the pricing grids that establish the upfront fees. Second, FHFA introduced, then rescinded, a new upfront fee adjustor based on the borrower's debt-to-income (DTI) ratio.
There is nothing new or novel about the pricing grids. According to FHFA, the recently announced changes were an effort to more accurately reflect the risk of borrowers based on their credit risk profile and to align with changes made in 2020 capital rules. The result lowered the fees for some borrowers and raised them for others. Most of the changes were modest in size. One effect of these changes has been that many of the highest risk borrowers realize a reduction in such fees and certain moderate-risk borrowers realize an increase. These changes have provoked much debate in recent weeks, with reasonable people taking different positions on the appropriateness of the changes.
The new DTI-based pricing element has received less attention but was immediately a major concern for HPC members. It was an unexpected addition that created unintended problems for both lenders and borrowers.
Summary of HPC's Views
The DTI pricing element was unworkable and had negative consequences for borrowers.
The new DTI-based pricing element required higher fees for borrowers with debt-to-income ratios greater than 40 percent. DTI, however, is difficult to measure and can change throughout the 3 https://www.fhfa.gov/Media/PublicAffairs/Pages/FHFA-Announces-Updates-to-Enterprises-SF-Pricing-Framework.aspx underwriting process. As a result, the inclusion of the DTI element in the pricing grids could cause a borrower's loan pricing to change multiple times before loan closing, resulting in multiple loan disclosures and borrower confusion.
Given the operational challenges associated with calculating DTI and the negative consequences for borrowers, HPC and others asked FHFA for an implementation delay during which lenders could review the operational challenges posed by the change. FHFA granted that extension, but after additional evaluation, HPC concluded the proposed pricing element simply was not workable. We sent a detailed letter to FHFA on
On
The adjustments to the pricing grids appear reasonable, but pricing should be aligned with credit risk and capital requirements.
In contrast to the operational challenges posed by the DTI-based pricing element, the other adjustments to the pricing changes announced in
HPC's position on these pricing adjustments is that the upfront fees and the other on-going fees charged by the GSEs (collectively "guarantee fees") should align with borrower credit risk and be consistent with how such risk is factored into risk-based capital requirements. Manipulating these fees in a way that misaligns pricing and risk or pricing and capital requirements is not a constructive way to advance safety and soundness or to promote sustainable access to mortgage credit.
Since the purpose of the upfront fees is to provide a risk-based component to guarantee fees, it makes logical sense for these fees to be based on risk. To do otherwise risks serious distortion in the cost of mortgage credit, which can result in detrimental outcomes such as inflated house prices and unstable markets. Indeed, the severe mispricing of mortgage credit risk in the runup to the Great Recession was a root cause of that disaster. Furthermore, as I explain later in my testimony, the last time
As for the recent changes, they appear to be reasonably aligned with credit risk after accounting for the new capital framework, the cost of private mortgage insurance, and recognition that the riskiest cells in the grid represent very few Enterprise purchases. That said, only FHFA has the detailed data and models to explain fully how the grids align with risk and the recently finalized risk-based capital framework. This opacity has proven to be controversial and therefore, HPC and its members recommend increased transparency from FHFA regarding the pricing across the risk categories, relative to the capital standards.
While market participants often seek to moderate price adjustments as risk increases to avoid dramatic gradations in pricing, increasing the price of credit as risk increases is a sound principle. It is also a necessary one to ensure the efficient allocation of capital and the stability and the safety and soundness of our financial system.
If market pricing produces a sub-optimal allocation of credit to certain categories of borrowers, there are better, and more effective, policy responses. In spite of the statutory allowance for affordable housing goal loans realizing lower rates of return than the rest of the business, pricing should not be deployed to promote or advance the affordable housing mission activities of the GSEs (especially when used to directly subsidize higher risk borrowers). There are more direct, and more effective, means for promoting homeownership than inducing more risk for borrowers and the secondary mortgage market.
In the balance of my statement, I provide some background on guarantee fees and their relationship to risk and on broader but related policy issues.
History, Objective and Structure of Guarantee Fee Pricing
What is a Guarantee Fee?
When
* Expected and unexpected losses associated with the credit guarantee they provide to MBS investors, which repays the MBS investor the full principal balance should a borrower default on a mortgage loan that collateralizes the MBS;
* the company's operating costs, and
* a return on capital.
G-fees have two components: base g-fees and upfront fees. Base g-fees are expressed in basis points and embedded in the mortgage rate. The base g-fees are not aligned with borrower risk, although they may vary by product type. According to FHFA's most recent report to
Upfront fees are assessed at the loan level based on borrower risk characteristics. They are priced in basis points and assessed against the loan balance. Determining how the upfront fee relates to the interest rate the borrower pays on a mortgage requires a calculation that reflects prepayment probabilities. As a general rule, dividing the upfront fee by four-to-six (FHFA used six in its
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4 The Director of FHFA is required to submit an annual report to
5 Ibid. Footnote 5.
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In other words, the average upfront fee is just 23 percent of the total g-fee.
The History of Guarantee Fees Relative to Capital Standards
Prior to 2008, the two GSEs did not engage in loan-level risk-based pricing. Both companies collected guarantee fees from sellers for the delivery of loans, but did not charge an upfront fee or vary the guarantee fee based on the risk characteristics of the loan. As already noted, guarantee fees at this time fell well short of a level commensurate with the actual credit risk assumed by the GSEs. Furthermore, FHFA's predecessor agency was constrained by statute to implement an inadequate statutory capital standard enacted in 1992. Further, prior to 2008, the g-fees charged by the GSEs were not uniform for all lenders. Favorable pricing was offered to lenders that delivered a high volume of loans, regardless of risk profile.
In
In
When
The Enterprise Regulatory Capital Framework (ERCF), established in 2020, is supposed to be the basis for the capital component of that pricing determination. However, FHFA's most recent g-fee report to
The ERCF capital standards are substantially higher than the 2017 framework and HPC supported the introduction of the ERCF standards, including the modifications subsequently made by Director
The fundamental purpose of the ERCF is to direct the GSEs to maintain a sufficient level of capital to compensate for the risks that arise in the operations and management of the companies. Capital standards are a traditional and proven safety and soundness tool for financial regulators, and the ERCF is based on a comprehensive analysis of the risk characteristics of each GSE's book of business and the appropriate levels of capital that must be available to address credit, market, and operational risk exposure, in both normal economic conditions as well as periods of market stress. In turn, GSE pricing is designed to generate sufficient revenue to cover the modeled risk of loss, ensure the companies satisfy these capital requirements, and earn a target rate of return./9
FHFA's annual g-fee reports to
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6 Ibid. Page 2.
7 Ibid. Page 12.
8 Ibid.
9 While the GSEs remain in conservatorship, they continue to rely upon taxpayer support to satisfy their capital requirements.
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As noted above, the most recent g-fee report (
Pricing to Achieve Both Target Rate of Return and Risk Management- Practices to Minimize Risk Ultimately hitting the target rate of return requires the GSEs to price their loans at a level that will generate the revenue required to fully satisfy the ERCF. This means that pricing must adequately cover the risk of loss, expected and unexpected, with earnings sufficient to hit the target rate of return on capital. Using g-fee pricing to advance other objectives, such as subsidizing high-risk borrowers, runs counter to prudent risk management. In other words, pricing to achieve a target rate of return is essential to compensate for risk of loss that cannot be eliminated or mitigated through the GSEs' underwriting, which is intended to minimize the frequency or likelihood of borrower default, and loss mitigation programs, which moderate the severity of losses for those loans that do default.
To be more precise, absent the first loss risk absorbed by private mortgage insurers, the GSE underwriting standards serve as the primary means to control and contain the amount of risk (i.e., level of defaults) that each GSE is willing and able to bear. The risk to be contained is associated with the borrower, the property that will be the collateral for the mortgage, and the transaction terms. The credit characteristics of the borrower include: a) ability to repay the mortgage; b) past history in satisfying financial obligations; and c) cash available for a downpayment and reserves once the transaction is completed. The value of the property, which may be needed to repay the loan should a borrower default, determines the allowable size of the loan. And, finally, the terms of the loan, such as how quickly it will amortize, affect the overall risk profile of the mortgage transaction.
The GSE loss mitigation programs are designed to reduce the severity of losses to the GSEs. These programs allow a borrower in financial distress to suspend or miss payments, then recover and reperform or pay off the loan by surrendering or selling the collateral. The recovery could include resolving the arrearages through some form of immediate or deferred repayment or by restructuring the loan. Should the borrower be unable to resolve the missed payments, the property may be sold or transferred to pay off the outstanding indebtedness. Any of these measures will cost the GSEs less than a foreclosure, thus reducing the severity of their losses (and the adverse impact on households and neighborhoods).
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10 According to FHFA: "The transition to the ERCF will have important implications for returns and profitability gaps. Higher capital requirements and flatter risk gradients in the ERCF compared to CCF result in a lower and flatter return profile and profitability gap profile across the credit risk spectrum. Returns on loans with lower credit risk characteristics under the ERCF will be considerably lower compared to CCF and returns on loans with higher credit risk characteristics will be notably lower compared to CCF." See the
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Risks of loss that cannot be minimized or mitigated through underwriting or loss mitigation must be covered by the loan pricing. Between the base g-fee and the loan-level pricing via upfront fees, the GSEs must generate sufficient revenue to compensate for these losses. The pricing is the lever that supports and reflects the risk management determinations and practices of the GSEs. It is not a risk management tool itself but is the mechanism that must be calibrated relative to the GSE appetite for and ability to manage risk through underwriting or loss mitigation.
Common Misconceptions Regarding Pricing for Risk and Reaching Traditionally Underserved
Borrowers
Given some of the recent commentary relating g-fee pricing to support for the GSEs' housing mission, this section provides HPC's perspective that g-fee pricing should support risk management and safety and soundness and that other tools are best used to promote homeownership.
The Benefits of Risk-Based Pricing for Consumers
There are significant consumer benefits associated with risk-based pricing. Foremost, risk-based pricing provides consumers with a clear signal of the relationship between risk and what they will pay. Reliable information on the relative riskiness of a major financial transaction like a mortgage can positively influence consumer actions, providing incentive for consumers to reduce their risk to qualify for a mortgage loan at a better rate.
Second, historical analysis shows that some lower-income households are advantaged by risk-based pricing. Many lower-income households do not have low credit scores, and without risk-based pricing, these lower-income households (amongst those borrowers who actually pay fees) would subsidize higher-income homebuyers and homeowners with weak credit performance. In short, it is a mistake to simply equate credit score with income.
Third, even with risk-based pricing, GSE pricing continues to provide cross-subsidization of higher risk borrowers by lower risk borrowers, as evidenced by more than a decade's worth of FHFA g-fee reports to
Finally, in
The Role of
The media attention and coverage on the new pricing grids most often ignored the role of private mortgage insurance. From the consumer's perspective, the cost of credit protection on their loan is the sum of their MI premium and total g-fees. Thus, to understand the full price to a consumer, the MI price should be added to the GSE fees. Similarly, to understand the actual risk of various lower down payment loans to the GSEs, the extent of mortgage insurance protection must be considered.
MI is one of the permitted forms of credit enhancement that is statutorily required for all mortgages with loan-to-value (LTV) ratios greater than eighty percent. In operation, the amount of MI credit protection to the GSE increases as the LTV increases and the insurance premium for that coverage also increases. That is, very low down payment mortgages usually have much deeper MI protection than mortgages with moderate down payments.
When overlaid on the GSE grids, the combined g-fee plus MI payment for a given credit score increases as LTV increases. What is most important about the MI coverage, however, is the recognition that It represents private capital standing in front of the GSEs. The mortgage insurers take the first loss risk position, accepting losses that would otherwise be borne by the GSEs. Further, the private mortgage insurers core business is pricing and managing mortgage credit risk associated with lower down payment mortgages and they provide another level of risk management. MIs put their own capital at risk and thus perform their own underwriting to verify and affirm the acceptability of the loan for delivery to the GSEs. This type of redundant risk management enhances the safety and soundness of the GSEs and the housing finance system.
Reaching the Underserved
The best way to produce sustainable homeownership for traditionally underserved borrowers is not reduced pricing or more lenient underwriting, both of which increase risk and the cost of losses. Rather than ignoring the risk or accepting the risk and compensating for it by charging all borrowers more, the government would better serve these borrowers with forms of assistance that lower their risk. This support should take the form of assistance funds or subsidies that help a borrower meet the applicable underwriting standards. For example, funds could be used to create reserve accounts or to provide equity into the transaction, both of which would improve the borrower's risk profile. Another idea would be to encourage borrowers to shorten the term of their mortgage, which would result in a faster build-up of homeowner equity. I have testified before this Committee on these ideas before and an excerpt from that testimony is attached to this statement.
Current Methods for Promoting the Housing Mission Lack Transparency and Are Poorly Targeted HPC and its members credit FHFA for being clear in stating their intention with the various pricing changes made last year and this year. The most recent announcement was previewed in the
Of note, the annual g-fee reports fail to specify the target return on equity used to determine what portions of the book are above or below that target. At a minimum, market participants and other stakeholders would be much better informed if FHFA would disclose two key facts in its g-fee studies.
First, what is the target return on equity that determines whether reported g-fee gaps are positive or negative. Second, while FHFA reports loan characteristics that produce a negative gap (that is, fails to earn the target return on equity), readers do not know whether the GSEs expect to generate a profit or a loss on those loans. Are the expected returns positive but below the target, or are the GSEs actually losing money on particular segments of their business?
HPC and its members would also like to point out that this entire discussion of g-fees reflects how poorly targeted the pricing framework is for accomplishing the GSEs' housing mission.
There would be far greater transparency of how much financial support actually reaches low- and moderate-income families and communities if the subsidy was directly allocated to those borrowers, not embedded in the price a GSE charges the lender. For example, suppose the elimination of upfront fees on goals loans cost the GSEs
An Important Price Distortion That Needs Attention
Under the statutorily-mandated affordable housing goals and the associated FHFA mandates, the GSEs are expected to purchase a specified mix of so-called housing goal loans. Several of these goals are associated with loans made to low-income and very-low-income persons. As a practical matter, however, the current target level of affordable loans materially exceeds what the market is capable of producing, given today's market conditions. That is, the number of affordable housing transactions in the market fall short of the goals.
As a result, there is a bidding war for these loans but there is no mechanism to ensure the homebuyer benefits. Moreover, competition between the two GSEs over goals loans does nothing to expand the number of borrowers reached. The GSEs are direct participants in such bidding wars in two ways. First, they use their own cash window to compete against loan aggregators, pricing loans at a level that is not commensurate with the risk. Second, they penalize loan sellers for delivering too many non-goals loans.
Such penalties come in the form of pricing penalties and limits on non-goals loans the GSE will purchase.
In other words, each GSE is incentivizing a given loan seller to sell its affordable loans to them and to sell their other production to the other GSE in order to make the GSE's goals numbers look better.
This is unsustainable. It distorts the market and the deadweight losses it produces do not benefit affordable housing. As one HPC member put it to me, "this unintended consequence turns the goals into merely a math exercise without a benefit to additional borrowers."
Larger Policy Questions for
The recent public discussion of g-fee pricing highlights two larger public policy challenges that are fully appropriate for this committee to consider.
Congress Has Provided FHFA Limited Direction on Pricing - Fortunately, that Direction Encourages Pricing to Reflect Borrower Risk
More specifically,
Absent further Congressional direction, and so long as the GSEs remain in conservatorship, FHFA should periodically review and update the g-fees. In doing so, it should be motivated to align pricing with risk.
Lessons for Housing Finance Reform
HPC believes that restoring a commercial market setting discipline, for both capital and pricing, in the secondary mortgage market requires Congressional action. The current debates over FHFA's recent announcements highlight one of the shortcomings of utility model proposals. Namely, such models put a government entity like FHFA right back in the center of making pricing decisions over mortgage credit risk.
The mortgage market is inherently cyclical and interest rates themselves can move quickly and substantially, as we have recently witnessed. Regulated price-setting mechanisms will never keep up. If we want private capital to absorb risk, pricing and capital rules need to align with risk. If a market-based system produces a sub-optimal allocation of credit or number of homeowners from a public policy perspective, then that should be addressed directly by government programs and subsidies, not by manipulating how we price mortgages for default risk.
Concluding Remarks
In 2008,
As conservator, the FHFA Director stands in the shoes of the boards and senior management of the conserved companies. While the conservator's authorities are substantial, I do not believe
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11 Section 401 of the Temporary Payroll Tax Cut Continuation Act of 2011, P.L. 112-78. The increase is not retained by the Enterprises but is passed through to the
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As the conservatorships approach their 15th anniversary, it is asking a lot of an FHFA Director to continue to serve as both the regulator and conservator for these companies, continuing to make what would otherwise be private business decisions while regulating the companies. Setting prices for corporate credit guarantees of individual mortgages is a responsibility at the core of the secondary mortgage market activities, yet we are relying on administered rather than market-motivated processes to price this risk.
Furthermore, we need to understand that FHFA is no longer an independent agency as that term has been traditionally understood. Since the
I conclude by encouraging this Committee and the Administration to focus on bringing these conservatorships to an end in a way that is both politically and economically stable and sustainable.
On behalf of HPC and its members, thank you for inviting me to participate today.
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Original text here: https://docs.house.gov/meetings/BA/BA04/20230517/115954/HHRG-118-BA04-Wstate-DeMarcoE-20230517.pdf
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