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Urban Institute researcher urges more caution with GSE risk transfers

What happens when market conditions deteriorate?

As the government puts more and more effort into distancing taxpayers from mortgage credit risk, care should be taken to insure borrowers are protected against mortgage rate volatility.

While recent efforts to transfer risk to the private markets, via the government-sponsored enterprises, are effective so far, these efforts aren’t fail proof and could instead result in mortgage rates becoming significantly more volatile, according to a new blog post from the Urban Institute.

Research associate Karan Kaul explains in the post that the main avenue the government relies upon to bring in private funds are capital markets risk-transfer transactions: Fannie Mae’s Connecticut Avenue Securities (CAS) and Freddie Mac’s Structured Agency Credit Risk (STACR).

Both Fannie and Freddie invest heavily in their mission to shift some of the credit risk it faces from the taxpayers and onto the private market, announcing credit risk sharing deals a handful of times of a year.

The most recent deal from Freddie was in April, which marked its third credit risk-sharing deal of 2016 and the 20th STACR deal since the program’s inception in 2013. Fannie’s latest was in April as well and was its 10th Credit Insurance Risk Transfer deal since the program began in 2013.

As a result of this, Kaul said that Fannie Mae laid off credit risk to private investors for a fifth of its mortgage portfolio while Freddie did the same for a third.

While this solution works for now, he explained that it could quickly change should markets destabilize.

From the blog:

When markets are stable, investors see little risk and are comfortable with lower returns on their money. As volatility and risk increase, investors demand higher returns.

But what happens when market conditions deteriorate?

Today, the guarantee fees borrowers pay on mortgages backed by the GSEs are set by the Federal Housing Finance Agency. The fees do not change with market conditions, largely insulating borrowers from significant mortgage rate volatility. But in a future housing finance system, private capital (rather than the government) will bear most credit risk.

Kaul’s suggestion to avoid this problem, diversify sources of private capital.

Right now, there is a significant about of debate around housing reform. Over the last year, community lendersaffordable housing advocatescivil rights groupsinterested observersfinancial analysts, and others have called for a change in governmental policy that would enable Fannie Mae and Freddie Mac to rebuild their capital.

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