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Front-end risk sharing threatens small lenders

The government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac now offload much of the default risk on the loans they purchase through the sales of securities. These are called back-end risk-sharing deals because they provide risk coverage after the GSEs have purchased loans. Recently, the GSEs' regulator, the Federal Housing Finance Agency (FHFA), sought input from the industry on developing front-end risk-sharing models, where the loans are partially de-risked before the GSEs purchase the loans. Most industry trade groups support the idea of front-end risk-sharing, but nonbank trade association the Community Home Lenders Association (CHLA) recently sent FHFA a letter opposing all forms of upfront risk-sharing, including an expanded role for private mortgage insurers. CHLA’s Executive Director Scott Olson spoke with Scotsman Guide News about why he believes front-end models could be a threat to small nonbank lenders.

Does CHLA oppose all forms of up-front risk-sharing?

OlsonOur principal concern is with the so-called securitization type deals, where the risk-sharing is derived or related to the [mortgage-backed securities] deals. On the upfront [private mortgage insurance] PMI-type deals, where it is like a loan-level risk -sharing, we would certainly be open to that, but only if there are protections for small lenders. One, that there is a prohibition against volume discounts. The PMIs could basically cut better deals on pricing with the larger lenders, and we would go back to an unlevel playing field. The key thing that we are recommending is that if they are going to do upfront risk-sharing with PMIs, with guarantors, on a loan-level basis, then there needs to be a ban on differential pricing based on loan volume or loan-lender size.

On the issue of transparency, why do you say that upfront risk-sharing is less transparent than back-end deals?

There was an article written in August by Mark Zandi, Jim Parrott and Laurie Goodman with the Urban Institute that says exactly what we are saying here, which is that front-end deals are not transparent. On the back-end deals, the GSEs are working with different players, and we tend to know the structures. It is not clear on the front-end deals. It is certainly not clear what the pricing is, number one.

How could large, vertically integrated banks and lenders use upfront risk-sharing to box out smaller lenders?

There are several large Wall Street banks. The obvious ones are JP Morgan, Wells Fargo and Bank of America that are major securities players, and also have a very large bank that has been active in the mortgage origination market. So, the essence of the concern is that these securities could dominate the issuance of these [risk-sharing] markets, and then turn around and exclusively make the proceeds available to their bank affiliate, or potentially turn everybody into a correspondent. In other words, OK, we’ll work with outside parties, but it is basically as a correspondent. The large, vertically integrated securities firms, those that have large bank affiliates who do mortgage origination, would be motivated to and have the expertise, inside track and economies of scale to dominate an upfront risk sharing market, [so] they would exclusively funnel the loans through their bank affiliates, and we would be frozen out, or potentially not as competitive.   

Why is CHLA less fearful of deeper coverage by private insurers?

The reason that we don’t have these same kinds of competitive concerns with the PMI is that [the private insurance companies] are not vertically integrated. They are not in the mortgage origination business. So, our position has been, as long as they are dealing with lenders on an equal footing, then we don’t necessarily have a problem with it. We understand that the FHFA and the GSEs may have some concerns about counterparty risk, and we are not weighing in on that. That is something for them to determine. With respect to a level playing field and how it affects the GSE market, [private mortgage insurance] is just something that we would be more comfortable with, provided that those protections are in place.  

Given that FHFA is seeking comment, it would seem that the idea of doing more front-end risk sharing has gained traction. Is that a big threat to smaller nonbank originators?

I think it could be a significant threat to the objective that FHFA has outlined of [maintaining] a level playing field. CHLA is pleased that FHFA is taking comment and is reviewing this stuff.  Essentially you have about 80 to 90 percent of new loans being done on some sort of risk-sharing basis. But this is still called a pilot stage, where they are testing different things out to see how they work. FHFA eventually will move from this pilot phase to a more permanent, regularized phase. We would be disappointed if they were mandating or encouraging more upfront risk-sharing. That is why we are weighing in, and think this is a really crucial time.

Do think that decision will be made before Congress settles on comprehensive housing-finance reforms?

I think that is very possible. It has already happened. Admittedly, there was a bill that passed the Senate banking committee a couple of years ago that had a risk-sharing requirement, but FHFA and the GSEs have launched this completely without any congressional directive. It is something that they could move to fruition before Congress ever adopts comprehensive reform.

And you don’t think that is a good idea, to act without congressional directive?

No, we think that is fine. We think that testing [risk-sharing] out and making sound conclusions about which way you go is a good idea. Honestly, as somebody who used to work in Congress, I think it is better to have a system that is based on trying things out [rather] than being in a situation where Congress had to guess what the best forms are. So, this is fine that they are doing this.

But you don’t support moving forward with upfront risk sharing, right?

We would hope that they would discourage upfront risk-sharing, except through PMI upfront risk sharing the way we have outlined it. Given that Congress could take many years to finish comprehensive reform, it is entirely possible that they will move forward on more definitive policies on risk-sharing in general. It is up to FHFA, but the fact that they are taking in comments obviously indicates that they are thinking seriously about this. 


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