Andrew Harrer/Bloomberg
The Federal Housing Finance Agency, acting as guardian of Freddie Mac and Fannie Mae, recently made some modest changes to the price of mortgage risk. These modest price changes have created a storm of reactions. Even the editorial board of The Wall Street Journal heavy on denouncing the cross-subsidies and income redistribution effects of these changes. The most cited is the flattening of the credit score curve. (Borrowers with low credit scores now pay about 1.25 percentage points more upfront than borrowers with high credit scores compared to 2.0 percentage points previously.)
Having spent a lifetime then analyzing and pricing mortgage risk, I was amused and noted the intensity of the reaction to Washington politics and vested interests protecting profits. But it is useful to strip away the rhetoric and discuss some fundamental political questions. When viewed through this lens, FHFA’s recently announced changes to Loan Level Pricing Adjustments (LLPAs) are consistent with the safety and soundness and purposes of government-sponsored company statutes.
I will focus on three key questions.
First, do GSEs need to earn the same return on principal on each loan they purchase to remain profitable and present low risk to taxpayers?
Of course not. The GSEs offered a fixed guarantee fee that applied to all borrowers for many years. LLPAs only started in 2008 when the GSEs wanted additional income to boost profits. The issue of profitability and risk relates to the entire company, and the questions we should be asking ourselves are what are the profits and what is the company’s overall leverage relative to risk? In 2008, GSEs were charging very little (0.15 percentage points on their outstanding loan portfolios) and had only 0.45 percentage points of capital against credit risk.
In fact, risk-based pricing often encourages loosening of credit standards and was used to justify expansion into lower credit quality loans because the GSEs thought they were getting higher risk-adjusted returns on Alt-A products. and subprime. Therefore, flatter prices accompanied by tight credit policies may be the lowest risk and profitable strategy. FHFA’s modest change to flatten the credit curve creates no risk for taxpayers and may very well be beneficial.
Second, should financial firms price to earn the same return on regulatory capital for each asset?
Of course not. Regulatory capital is just one measure of economic risk to protect companies from unexpected losses. There are many other considerations for how companies trade, including leverage ratios, demand elasticities, competition, and so on. Would JPMorgan Chase use the Basel Accords as the sole basis for all of its pricing decisions? There is no evidence that the FHFA’s new pricing deviates from its recently enacted risk-based capital framework, but even if it did, that would not be a cause for concern.
Finally, what additional considerations beyond credit risk should be taken into account in GSE’s pricing decisions?
First, the risk of prepayment. It always baffles me that LLPAs factor in credit risk but not prepayment risk. Prepayment risk is the risk that borrowers will pay off their mortgage sooner or later than expected. An early prepayment leads to a lower overall principal and interest income stream over the life of the loan, which reduces the overall profitability of that loan. Because people with lower credit scores don’t prepay as quickly as people with higher credit scores, the net impact of people with lower credit scores on yields and the performance of a company is complicated. Second, the GSE bylaws direct them to consider setting lower return targets for low- and moderate-income families. Third, as has often been noted, price affects which loans go to the Federal Housing Administration versus the GSEs. Policy makers may want to consider this. When I ran FHA, I argued vehemently against risk-based pricing at FHA because it would unnecessarily expand FHA’s footprint.
Former acting FHFA director Ed DeMarco wanted pricing to take into account state foreclosure laws and charge more for states with longer foreclosure terms. Others have wanted the GSEs to assess the risk of an earthquake from the “big” one that will happen one day. Now some are looking to put a price on climate risk. All of these have faced or will face political pushback as inappropriate factors for the GSEs to consider, since they were authorized by Congress to create a liquid national secondary market, not to set policy on these matters. Therefore, blind adherence to purely risk-based pricing may not be a desirable policy objective or consistent with the GSE’s charter.
It seems that the FHFA price changes were well considered. Whether intentional or not, the flattening of the credit rating curve is very consistent with incorporating prepayment risk into the pricing framework.
That being said, I would recommend a change to the new pricing scheme. The additional LLPA for debt-to-income ratios above 40% is an unwanted complication in mortgage pricing. Debt-to-income ratios are difficult to measure, so the difference between a DTI of 39% and 41% is negligible; creating a DTI cliff at 40% will put a lot of work into finding more revenue to get below the 40% threshold. The debt-to-income ratio also has a weak correlation with risk, partly because it is not well measured. And the mismeasurement of real (permanent) income is not the same across all protected classes, as documented in Milton Friedman’s 1957 article, “The Permanent Income Hypothesis.” Therefore, he would recommend the removal of this fee.
In conclusion, the FHFA’s recently announced changes to the LLPA are consistent with the safety and soundness and purposes of the GSE charter. Eventually, explicit regulatory guidance on what factors to consider when setting prices would be helpful, as long as the GSEs come out of conservatorship and are free to set their own prices.