Smaller G-Fees for Riskier Loans and Bigger Lenders

Last week the Office of InspectorrnGeneral (OIG) of the Federal Housing Finance Agency (FHFA) issued arnreport on FHFA’s initiative to use guarantee fees charged by FanniernMae and Freddie Mac to encourage the reentry of private money intornthe secondary mortgage market. FHFA plans to gradually raise thosernfees, commonly called G-fees, to allow more private competition withrnthe government sponsored enterprises (GSEs), reduce their marketrndominance, and eventually wind them down. While it was tangential tornthe thrust of the OIG report, there was something of a history lesson on therncross-subsidization of mortgage-backed securities (MBS) utilized by the GSEs and FHFA’s efforts to balance the system. </p

OIG defines a subsidy as a grant orrnother financial assistance typically given by the government tornsupport a business entity. In the case of mortgage financing, thernperceived implicit government guarantee and the ability of the GSEsrnto issue debt at a lower rate than private sector have provided arnsignificant pricing advantage to the mortgage-backed securities (MBS)rnissued by the GSEs. Consequently the GSEs have transmitted at leastrna portion of their funding advantage to investors in the form ofrnreduced G-fees.</p

In addition to the reduced fees enabledrnby federal support the GSEs have engaged in cross-subsidization, i.e.rnthe practice of charging higher prices to one group of consumers inrnorder to lower the prices for another group, across risk profiles. In the case of the GSEs this occurs when certain higher risk loanrnpools are subject to lower guarantee fees than they would otherwisernpay based on the pool’s credit risk profile because of the higherrnfees charged on lower risk pools. Historically, OIG says the GSEsrnutilized several types of cross-subsidization. </p<ul<li

When doingrnbusiness with large lenders the GSEs usually employ swap programs. In a swap the GSEs obtain whole mortgage loans, securitize them andrnswap the resulting MBS back to the original lenders. Lenders whornparticipate in swaps pay guarantee fees directly to the GSEs on thernMBS they obtain. Alternatively, particularly when dealing withrnsmaller lenders, the GSEs pay cash for the mortgages, securitizernthem and sell the MBS to investors. The selling lenders effectivelyrnpay the guarantee fees. MBS collateralized by mortgage pools soldrnon a cash basis to the GSEs by smaller lenders were subsidizingrnthose collateralized by pools sold on a swap basis by largerrnlenders. Prior to 2008, when the GSEs were placed in federalrnconservatorship, they tended to negotiate volume-based guarantee feerndiscounts to large lenders. </p</li</ul<ul<li

MBSrncollateralized by lower risk mortgages were cross-subsidizing higherrnrisk mortgages. Lower risk mortgage pools were likely to containrnmortgages with 15-year fixed-rate rates, higher credit scores,rnand/or low LTV ratios. Higher risk mortgages were likely to berncomprised of loans with 30-year fixed rates or adjustable rates, lowrncredit scores, and/or high LTV rates yet the GSEs did not chargernG-fees that reflected the higher risk.</p</li<li

Mortgagesrnoriginated in non-judicial foreclosure states were subsidingrnmortgages originated in judicial foreclosure states wherernforeclosure processes tend to be more expensive and protracted. Traditionally the GSEs have not distinguished between the variousrngeographic locations of mortgage pools nor considered staternforeclosure laws in their pricing decisions.</p</li</ul

In August 2012 FHFA required the GSEsrnto take steps to reduce cross-subsidization based on lenders sizesrnand product risk. The aggregate weighted-average G-fee increase atrnthat time was expected to be 10 basis points but the actual increasernfor each MBS pool is expected to vary by product and executionrnmechanism. FHFA also ordered the GSEs to aim for uniform pricingrnacross all lenders regardless of their loan volume by applyingrndifferential increases for swaps and cash purchases. For example,rnincreases would be larger for lenders delivering larger volumes ofrnmortgages than those delivering smaller volumes and larger forrnadjustable rate mortgages and those with maturities longer than 15rnyears than for 15-year fixed-rate mortgages. </p

FHFA also announced it was solicitingrnpublic comment on increasing fees in states where foreclosure-relatedrncosts are statistically higher than average. This solicitationrngenerated 60 letters from members of Congress, state attorneysrngeneral and major trade organizations. Many sought transparencyrnregarding FHFA’s calculations of foreclosure related costs and othersrnquestioned the impact on low-income borrowers and on the housingrnrecovery in the five states affected by the higher costs. FHFA willrnmake a decision about this change later this year.</p

OIG says that FHFA’s G-feerncross-subsidization initiatives are likely to have importantrnramifications for the GSEs’ financial soundness. It quotes GSErnofficials as saying their internal analysis indicates that recent feernincreases are nearing sufficient levels to encourage private sectorrnfinancing of lower risk mortgage products but that fees would have tornrise considerably higher to attract that interest in higher riskrnproducts. </p

Thus there is, OIG says, a significantrnrisk that the gradual increase in fees will introduce adversernselection. The private sector could conceivably capture arnsignificant share of the GSEs’ lower risk mortgage business leavingrnthem with an increasing share of higher risk loans and the potentialrnof incurring significant credit losses. FHFA disputes this sayingrnthat the cross-subsidization initiative mitigates the adversernselection risk by ensuring that guarantee fees appropriately reflectrnthe risks of all types of GSE mortgage assets and that profits fromrnconcentrating increases on higher risk loans should prove attractivernenough to encourages the private market to compete with the GSEs forrnthese assets. This, OIG says, remains to be seen.

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