Tuesday, November 27, 2012

In order for the private sector to step into the mortgage market, g-fees need to rise

We've had a number of e-mails asking about the difference between the FNMA bond coupon and the actual mortgage rates (see discussion). The financing costs that the US government (the GSEs) pays is of course lower than the mortgage rate charged to the consumer. Much of that difference is from the so-called g-fees. Since the government effectively guarantees mortgages funded via the GSEs, it needs to get paid for that guarantee. In the past g-fees were significantly underpriced relative to the private sector. That was part of the reason for the housing bubble - the financing was artificially cheap. It was also the reason the GSEs' government bailout was so expensive - Fannie and Freddie didn't charge enough for the risk they took (and didn't reserve enough capital).

That's about to change. The only way to shift at least some of the mortgage business to the private sector (currently the GSEs and the FHA own or guarantee over 90% of the US mortgage market) is to price the risk closer to where it would be priced in the private sector. Otherwise the private sector will never enter this market - other than to sell the mortgages banks originate to the government and keep the origination fees (which is what banks do now).

The taxpayer also needs to recoup the Fannie and Freddie rescue expenses. That means the GSEs will need to raise their g-fees, which according to JPMorgan is exactly what they plan to do (chart below).

Source: JPMorgan

G-fees should be at the level that would allow a bank to achieve a reasonable return on regulatory capital (under Basel III) when holding mortgages on balance sheet to maturity/prepayment. According to JPMorgan, that fee should be in a 71-95bp range for standard mortgages in order to achieve a 15-20% ROE. Of course raising g-fees is not always the most beneficial action from the political perspective. And some politicians are going to put up a fight:
Equities.com: - United States Senators Robert Menendez (D-NJ), Frank R. Lautenberg (D-NJ), Chuck Schumer (D-NY), Kirsten Gillibrand (D-NY), Richard Blumenthal (D-CT), Joseph Lieberman (I-CT), and Bill Nelson (D-FL) called on Acting Federal Housing Finance Agency (FHFA) Director Ed Demarco to abandon a proposal to increase the guarantee fees ("g-fees") on loans guaranteed by Fannie Mae and Freddie Mac in five states, warning it is unfair to states with strong consumer protection laws and will increase the cost of homeownership. FHFA's proposed rule would hike g-fees beginning January 1, 2013 in New Jersey, New York, Connecticut, Florida and Illinois.

In a letter to DeMarco [included here], the Senators argued that the agency's proposal would unfairly penalize homeowners in the five states that better protect consumers from lending and foreclosure abuses: "The main reason cited by FHFA for its proposed rule, is that state and local policies designed to protect homeowners from improper lending and foreclosure practices and that reduce the likelihood of future defaults, have increased the financial costs faced by the GSEs. However, in its effort to recoup the foreclosure-related costs faced by the GSEs in the short-term, FHFA is creating undue barriers that could undermine vital consumer protections and restrain residential lending."
Keeping g-fees low is fine of course, as long as the US government plans to continue dominating the mortgage market. But if that's not the long-term plan and the GSEs' influence should be reduced, g-fees will need to go up.

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