October 23, 2024 •Josh Goldberg
With contributions by Mike Easterly and Sarah Cunningham
Even though the Federal Housing Administration (FHA) Mutual Mortgage Insurance Fund experienced a modest dip in its capital reserve last year, many in the mortgage industry continue to hope that FHA will cut the premiums it charges to borrowers to insure their mortgages against default, as the reserve remained well above the statutory minimum.
Should that be FHA’s course of action? The answer is complicated because of the agency’s governmental status and its role in the market, both of which affect the way it charges borrowers for the risk of default.
Consider first Fannie Mae and Freddie Mac, which operate more like commercial lenders even though they remain under government conservatorship. For them, capital reserves are a buffer against losing so much that they cannot stay in business. Reserves cover unexpected losses—the amount that they may lose in times of extraordinary stress—less expected losses, which is the cost of defaults they anticipate they can cover in the ordinary course of business.
Figure 1: Expected versus unexpected losses
Figure 1 illustrates the concepts of expected and unexpected losses graphically. As indicated, the horizontal axis measures the value of potential losses, while the vertical axis describes the probability of that level of loss. Fannie and Freddie fund the losses to the left of the dotted line with their income from everyday operations. From the right of the dotted line to the shaded area, they rely upon their capital reserve buffer. For that, Fannie and Freddie have investors—including the U.S. government, which owns 80% of the preferred stock under conservatorship.
Investors require compensation for providing capital, which they set according to the rate of return they would receive from assets with similar risks. Thus, Fannie and Freddie must ensure that they earn a market rate of return on the capital they set aside. Indeed, one way to think about the cost of capital is that it is the market’s price for risk.
Fannie and Freddie incorporate their cost of capital into the guarantee fees (g-fees) they charge. They start with an estimate of what they need to charge to break even on a loan. This break-even fee can be decomposed into two main components: expected loss and the cost of capital. In equation format, the break-even g-fee is:
Break-Even G-Fee = Expected Loss + (Capital * Required Return)
Using hypothetical numbers, we can provide an illustration of a break-even g-fee calculation. Assume that Fannie or Freddie expects a 3% probability of default and a 35% loss given default, leading to an expected loss of 1.05%. Meanwhile, they estimate 7.65% in unexpected losses. If the market-based cost of capital is 5%, then they use a cost of 38.25 basis points (0.3825%) per loan for unexpected losses (5% cost of capital, multiplied by 7.65% unexpected losses). Add to that a 21-basis-point cost for expected losses (1.05% divided by the 5-year expected life of the loan), and you get an annualized guarantee fee of 59.25 basis points. In practice, Fannie and Freddie must also incorporate a few smaller line items, such as float costs and administrative expenses, but this approximation is close enough.
Actual fees charged to customers are strategic decisions. Fannie and Freddie balance their target market shares, the maintenance of relationships with key customers, and regulatory expectations on minimum risk-adjusted returns to come up with a g-fee that they charge to each customer. They also distribute their annualized guarantee fees between an upfront fee, which increases or decreases based upon the borrower’s risk, and an annual fee, which is the same for all borrowers.
Like Fannie and Freddie, FHA experiences expected and unexpected losses and maintains a capital reserve. However, FHA is a federal government entity, and its capital reserve plays a different role. Unlike Fannie and Freddie, experiencing a large, unexpected loss that reduces the capital reserve is unlikely to prevent it from lending, as FHA guarantees have the full faith and credit of the U.S. government as a backstop against insolvency. Furthermore, as a government entity FHA has a cost of capital that is essentially the risk-free rate that the government pays on Treasury borrowing. If FHA guided its lending decisions by that metric, it could easily underprice all competitors in the market.
For FHA, the capital reserve is a policy tool. By law, FHA must maintain a minimum capital reserve ratio of 2%. This means that the economic net worth of the Mutual Mortgage Insurance Fund must be at least 2% of the outstanding value of insured mortgages. The capital reserve requirement is not set according to a stress loss or the cost of capital, but by estimating the net present value of the expected inflows and outflows over the lives of the loans the agency insures. The capital reserve ratio effectively serves as a benchmark that requires agency leadership to consider the costs of policy actions. The capital reserve ratio also serves a useful purpose in triggering an immediate response should it fall below 2%. In that instance, FHA would need to take action to restore reserves, such as increasing fees or otherwise reducing risk on guarantees. As such, the capital reserve ratio is a form of risk appetite for the agency.
Decisions about fees rest upon a balance between achieving FHA’s mission and minimizing risk to taxpayers, which is a policy decision. Capital guides these decisions by making the impact of these risks more tangible for policymakers.
Photo by Jakub Żerdzicki on Unsplash