Why GSE Reform Needs a Rethink
I can agree that we need to address how Fannie and Freddie operate. It isn’t as if there is only one problem, either. The GSEs took on too much leverage. They started buying sub-prime mortgages. They had a finance structure that made no sense at all. It isn’t just a problem for people that want a mortgage, for shareholders, or for people that have been outgunned by GSE lobbyists. It is an issue that should concern anyone that pays taxes. Taxpayers have been forced to recapitalize the GSEs.
But even when all of that is acknowledged, the ongoing value of the GSEs is irrefutable. Right now, the GSEs are the only force preventing a complete meltdown in our housing markets. Fannie and Freddie are buying about two-thirds of all new mortgage debt and just about all of the outstanding conventional loans being made.
Private investors are just not interested. Managers have determined that the low returns are not at all appropriate for the risk that they bring to a portfolio.
The new loan-level-pricing-adjustment (LLPA) operationalizes the intent of the GSEs to fix their own problems. LLPA is a program that charges lenders for the loans that they deliver to the GSEs. It is a risked-based pricing scheme: loans with any features that have correlated to poor performance are tagged with a 25 to 250 basis point fee. Loans to investors, to borrowers with lower credit scores, and on loans where the interest rate is not fixed. The most impactful fee, though, is for high loan-to-value mortgages.
Generally, the GSEs become hesitant to buy anything where the LTV is above 85. Unfortunately, loans are still being made at or above that point. The great majority of those loans are not underwritten through conventional channels. Rather, they become FHA loans. Remember that one of the logical needs for GSE reform is to protect taxpayers. Pushing loans to FHA does nothing to provide them with relief. For the GSEs, it is a step that helps to preserve their capital. For the taxpayers, it is a wash. The taxpayer is still on the hook for some of the principal if a loan sours.
The taxpayers might experience a gain if the new policies could do more to support homebuying. Unfortunately, the LLPA shrinks the market. Buyers that could have bought (low LTV, high credit) can still buy. They just buy at low rates. The LLPA pushes buyers on the margin out. Their costs go up, or they pay additional fees.
Rental Housing
The LLPA also means that the GSEs sudden loss of support for home ownership is accompanied by a simultaneous change that increases the cost of capital for the purchase of investment properties. An investor loan creates its own price trigger. It isn’t a small amount, either. For a loan with an LTV below 75 – a very safe loan – the LLPA adds 175 basis points onto the cost of the loan. Above 80 and the fee blossoms to 375 basis points. Very few borrowers pay the entire 175 basis points in their interest rate. Instead, the fee is paid for through the interest rate, through higher closing costs and through adding principal.
The problem with this is that we need to have more investors buying property. In the last few years of the housing boom, there was a lack of investment in rental housing. The greatest gaps are in multifamily units and in the small but affordable single family home.
The LLPA is an answer that makes sense on a chalkboard, but it doesn’t square up with our moment. The huge inventory of unsold homes has to go to some use. Those homes are not going to disappear. With fees the level of investment will be curbed and more of those homes will be in limbo. That is not good for our neighborhoods. Ultimately, the GSEs need to pick. Either they go back to seeking to be about home ownership, or they go over to affordable rental units.
