How to Restart the Private Market for Mortgage Credit

Market Composition and Problem Statement

• The U.S. single-family mortgage market is approximately $10 trillion, with roughly 75% of originated mortgages relying on taxpayer-backed credit support (FHA, VA, Rural Housing, or GSE guarantees).
• Half of the U.S. mortgage market ($5 trillion in mortgage-backed securities) involves credit risk remaining on the balance sheets of Fannie Mae and Freddie Mac, which are in government conservatorship.
• The primary policy goal is to gradually transfer this credit risk burden from taxpayers back to private capital markets.

Credit Risk Transfer (CRT) Initiatives by Government Agencies

• The Federal Housing Finance Agency (FHFA) has directed Fannie Mae and Freddie Mac to sell portions of their retained credit risk to private investors.
• The Treasury Department supports the acceleration of credit risk transfer, viewing it as a critical development for market stability.
• CRT volumes have grown since the program's 2013 inception, rising from a few transactions to a market value of approximately $25 billion across 30 deals.
• The GSEs have set a goal to transfer 90% of the unpaid principal balance (UPB) in their expanded risk-share program within 2016.

Structures and Mechanisms of Risk Transfer

• Fannie Mae/CAS (Connecticut Avenue Security) & Freddie Mac/Stacker: Debt instruments issued where principal repayment is linked to the performance of a reference pool of mortgages (e.g., 60-80% LTV).
• Reinsurance: The GSEs retain the first 1% of losses, while private reinsurers cover losses between 1% and 3% of the UPB, retaining all losses beyond that threshold.
• PennyMac Special Purpose Vehicle (SPV): A structure where the originator deposits cash (approx. 3.5% of loan principal) to receive a portion of the guarantee fee, providing "skin in the game" and aligned interests.
• Mortgage Insurance (MI): USMI proposes increasing coverage depth from 75% to 50% loan-to-value (LTV) to shift loss protection further away from GSEs without legislative changes.
• Front-End vs. Back-End Transfer: Most current transfers occur at the back end; stakeholders advocate for front-end transfers to improve pricing transparency and small lender access.

Investor Participation and Capital Sources

• Asset managers constitute roughly 50% of CRT investors, followed by hedge funds at 31%.
• Real Estate Investment Trusts (REITs) currently hold only 2% of CRT assets due to tax, regulatory, and statutory limitations on their participation.
• Private mortgage insurers have raised over $9 billion in new capital and meet eligibility requirements (PMIRs) with risk-based capital ratios doubled from roughly 4% to 7-8%.

Challenges and Market Frictions

• Liquidity Constraints: Non-investment-grade tranches and equity layers suffer from limited liquidity, with only 5-6 investors active in these segments during market volatility.
• Regulatory Barriers: NAIC capital ratings and Basel III/IV requirements disadvantage banks in holding non-agency RMBS and credit risk tranches, pushing them toward holding loans directly.
• Small Lender Access: Smaller originators lack the capital for mortgage servicing rights or the volume to securitize directly, relying on aggregators like PennyMac to access secondary markets.
• Data Standardization: Historical lack of loan-level disclosure and standardized data hinders accurate pricing; a Common Securitization Platform is proposed to address opacity.

Private Label Securities (PLS) Outlook

• The pre-crisis PLS market collapsed and remains inactive largely because Fannie Mae and Freddie Mac's high loan limits absorb most demand.
• Economies of scale are insufficient for jumbo private label markets until the GSE "box" (conforming loan limits) is reduced or underwriting criteria are adjusted.
• Reviving PLS requires uniform information, reliable servicing data, and standardization of rep and warranty agreements.
• Private label markets cannot restart until credit risk transfer mechanisms are fully established to build trust in underlying loan data.

Policy and Legislative Recommendations

• Legislative Action: Congress must address the 40 Act and tax consequences for REITs to broaden the investor base for mortgage credit risk.
• All-of-the-Above Strategy: Effective risk transfer requires multiple vehicles (CRT, MI, banks, non-agency) rather than reliance on a single mechanism.
• Systemic Risk Mitigation: Shifting risk away from GSE balance sheets reduces the moral hazard of "private gains, public losses" that contributed to the 2008 crisis.
• Transparency Focus: Front-end risk transfer and standardized data are critical to ensuring borrowers benefit from competitive pricing and market confidence.

Forward-Looking Statements

• Panelists expect investor appetite for mortgage credit risk to remain strong, provided regulatory tweaks encourage bank participation and liquidity.
• The private label market is anticipated to evolve gradually, dependent on the successful standardization and scaling of GSE credit risk transfer programs.
• Policymakers signal an accelerated timeline for reform, with growing bipartisan support to deepen private capital participation before the next economic cycle.
• Mortgage insurers assert they can expand coverage depth immediately to serve as a transition to a more private-capital-heavy system.