Examining Risk Adjustment and Cross-Subsidization Among Markets

According to new commentary by Senior Visiting Fellow Don Layton, NYU Furman Center, the Federal Housing Finance Agency (FHFA), the regulator and conservator of Freddie Mac and Fannie Mae, the two government-sponsored enterprises (GSEs), has been very prominent in the news lately. This is due to the controversy surrounding how the agency has changed the specific amounts by which the two GSEs risk-adjust the interest rates at which they purchase mortgage loans.

The core claim made by critics is that the changes, implemented on May 1, are a mechanism for a new and major economic cross-subsidy from less risky borrowers to more risky ones. They allege that such a mechanism was created by the Biden administration to redistribute wealth and income in a surreptitious manner. Meanwhile, the FHFA has stated that there is no intention to do such redistribution and that the changes resulted instead from updating the GSE risk adjustments, mostly set about a decade ago, to be consistent with the rule it adopted in 2020 for minimum required capital.

The purpose of this article is to use its occurrence as a springboard to address the very serious and not broadly understood or openly discussed interrelated topics of interest rate risk adjustment and the embedded and often hidden cross-subsidies that today are found at the four government mortgage agencies, i.e., the two GSES plus the Federal Housing Administration (FHA) and the U.S. Department of Veterans Affairs (VA).

Layton's view is that the current way they operate—which varies considerably between the four agencies—would be significantly improved if they all applied three key principles:

• Do risk-adjusting on a practical and easily implementable basis, very much enabled by today’s information processing capabilities.
• Separately and directly target the borrowers that policymakers decide should be specifically subsidized by a below-market interest rate, and just as overtly determine how the cost of such subsidies will be paid for.
• Provide transparency to policymakers and the general public about how it all works, including information on all the cross-subsidies involved and the accuracy of the risk-adjusting.

The FHFA implemented on May 1 a previously announced change in the GSE "pricing grids," i.e., the level of the G-fee as it varies for different levels of creditworthiness. The grids are structured to show the specific G-fee that would apply for any class of product, as measured by a combination of credit score and the loan-to-value (LTV) ratio, all organized via a 9X9 grid into 81 "cells."

In late April, reactions to the new GSE G-fee grids—which until then had been the object of discussion mainly within the industry and housing policy community—broke out into the realm of cable news, social media, and politics. Conservatives were very vociferous in opposing the changes, most notably in two prominent Wall Street Journal editorials: "Upside Down Mortgage Policy" and "Spinning Federal Mortgage Fees". The changes then became the subject of hearings and legislation in the Republican-controlled House of Representatives to reverse them. Lawsuits by state-level Republican officials were also threatened. This was a classic media-political firestorm about a relatively technical topic that is normally of interest only to those inside the mortgage system.

The accusations, although not always precisely stated, have at their core one of three interrelated claims.

The most extreme criticism is that the new G-fee grids were implementing an "upside-down" credit risk charging scheme, i.e., charging most or all low-risk borrowers a high G-fee (and thus interest rate) so that the GSEs could then charge most or all high-risk borrowers a low one. This was described on the one hand as unfair since it relied on overcharging low-risk borrowers "who had played by all the rules" and, on the other hand, as unduly incentivizing bad loans at the GSEs (by charging too little for high-risk loans) in a quasi-replay of the lead-up to the mortgage bubble of 2005 to 2008. This claim is simply untrue. The second of two articles from the Urban Institute showed quite clearly, and I believe accurately, that the GSE G-fee grids remain distinctly "right side up," i.e., having higher interest rates for higher risk.

A less extreme version of the criticism is that the changed G-fee grid, while it still maintained a traditional "right side up" approach where higher-risk loans were charged higher G-fees, significantly flattened the grid. This means that the FHFA incrementally increased the G-fee on most low-risk loans and reduced it on most high-risk loans. Critics also claimed that the Biden administration did this as some sort of stealth income or wealth redistribution program. Again, this was criticized for unfairly penalizing low-risk borrowers. In fact, it is absolutely true that the flattening did occur for most. The FHFA stated that this was solely the result of updating risk estimates, mostly made over a decade earlier, to be consistent with the regulatory capital requirement adopted by the FHFA in 2020.

At this point, the controversy is mainly about the motivation for the changes. The third criticism is that government mortgage agency programs designed to help LMI borrowers—especially at the GSEs—are rife with credit underwriting problems and that the announced G-fee changes would add even more high-risk loans with inadequate revenue to cover their risks, all inevitably leading to a replay of the subprime crisis. In my view, this criticism is not valid. While the risk of such loans, on average, is undoubtedly somewhat higher than the overall average among those financed by the GSEs, their risk also appears to be within the usual range of acceptable creditworthiness of the GSEs.

On May 15, the FHFA issued a request for information (RFI) on the pricing grids. This was obviously in reaction to the criticism. The RFI document itself has given the FHFA an opportunity to explain what it did and why and to educate the public on various aspects of the topic. It also asked for input on a wide range of questions. Comments are due in ninety days.

The FHA: Minimal Risk Adjustment; Cross-Subsidies Should Be Better Targeted

The FHA’s business model is to insure mortgages that are then issued via GNMA. Its market share has roughly averaged 10% over the last several decades, with considerable variation through the economic cycles.

The FHA does minimal adjusting of its interest rates for varying levels of credit risk. For example, its current agency fee, the MIP, on its core product of the 30-year fixed-rate, single-family purchase loan is almost entirely "flat": an upfront 1.75 percent plus a per-annum amount as shown immediately below:

• For up to 90% LTV:                                               0.50% for the first 11 years
• From above 90% to under 95% LTV:                 0.50% for the life of the loan
• Above 95% LTV:                                                     0.55% for the life of loan

According to Layton, this is minimal adjustment for credit risk. He notes that this applies only to loans of "normal" size (i.e., no higher than an amount known as the conforming loan limit, which is adjusted each year to match house price inflation; it is currently $726,200). For "high balance" loans, available only in defined high-cost geographies, an extra 0.20% is added to the per-annum rate to reflect not credit risk but an apparent policy decision that such larger loans are not as socially worthy.

To read the full analysis, including more data, charts, and methodology, click here.