US Housing Finance: Our Vision for a Privately Led System
There’s a growing consensus today that the US government’s huge footprint in the $10.5 trillion mortgage market needs to shrink, with the private sector taking the lead. But there is less agreement on how the transition to a new system should take place. Here’s our perspective as investors in the mortgage market on what is needed to get the ball rolling.
In prior blog posts, I argued that a housing market entirely without government involvement is unrealistic, because it would likely result in a significant rise in mortgage rates that would shut many potential borrowers out of the market. Nonetheless, I have also argued that private investors need to take the lead in financing the purchases of American homes.
Given the size of the US mortgage market, this change is not going to happen overnight. But there are steps to facilitate the transition that can be taken now, without new legislation. My colleagues Michael Canter and Matthew Bass outline some of these steps in their recent white paper, Increasing the Role of Private Capital in the Mortgage Market.
We see two main market-based approaches that could be successful. First, for securitizations of the highest-quality mortgage pools, government-sponsored enterprises (GSEs) such as Freddie Mac could purchase reinsurance (likely in the form of a credit-linked note) to transfer the first-loss risk (the first 10%, for example) to private investors, based on the performance of a reference pool of mortgages.
For instance, the GSE could sell securities tied to the performance of 2010 vintage 4.5% coupon, 30-year fixed-rate mortgages. The investor in the credit-linked note would receive a coupon (a reinsurance premium for taking this risk). Importantly, the price of this reinsurance would serve as a market signal for the pricing of GSE guarantee fees.
For relatively low-quality collateral, we’d suggest an alternative structure, in which the GSE would not guarantee a certain percentage of losses. For example, the GSE could issue two classes of bonds from a securitization: a nonguaranteed class that would absorb the first 10% of loan losses, and a separate fully guaranteed class that would represent the remaining 90% of the securitization. There are precedents for both of these types of transactions in recent years.
Given factors such as aging populations, underfunded retirement liabilities and a prolonged period of low interest rates, we’d expect strong demand for the income-producing first-loss mortgage securities described above. In particular, we think that this new asset class could be very attractive for longer-term investors like pension funds, sovereign-wealth funds and insurers with longer-dated liabilities.
How big could this market grow? We wouldn’t be surprised to see it reach more than $250 billion in size. As a guide to the market’s potential, it’s instructive to take a look at the evolution of the high-yield corporate bond market. Initially, investors in this market were largely opportunistic, but over time the investor base broadened as investment guidelines were adjusted to accommodate the new asset class. As new investors have entered the market, the outstanding issuance of US high-yield debt has grown to $1.2 trillion. We think that a first-loss mortgage market could potentially evolve in a similar fashion.
The arrival of this new asset class would not only be good news for investors, but would contribute to a more stable housing market, and that should be a relief to all homeowners and American taxpayers.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams
Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income, Michael S. Canter is Director of Structured Asset Research and Portfolio Management, and Matthew D. Bass is VP of Structured Assets, all at AllianceBernstein.