The S-Curve

How Lowering Capital Costs Affects Higher Risk Loans

Richard Cooperstein

How Lowering Capital Costs Affects Higher-Risk Loans

Government-sponsored enterprises (or GSEs) are companies that provide guarantees and financing to originators through the mortgage secondary market. The size and resilience of the GSE secondary market maximizes diversification and liquidity which reduces financial risk and cost of capital. This benefit accrues to conforming borrowers through lower mortgage rates and resiliently available financing. 

Capital Safe Investments

One hundred years of the stock price performance of public utilities shows higher dividends, combined with lower returns and capital costs than an index of large companies. Theory indeed predicts that companies in protected markets would have lower income volatility that translates into lower stock price volatility and lower required returns.

This can be seen empirically by comparing two ETFs (exchange traded funds), XLU, the largest and oldest utility ETF, launched in 1998, versus SPY, the S&P 500 index. Since inception, XLU’s price return is about 130% (compared to SPY’s 280%), and its 10-year annualized return is 11% (compared to SPY’s 16%).  However XLU pays a persistently higher dividend yield of 2.9% compared to 1.2% for SPY, and shows lower price volatility with a beta of 60%, compared to SPY’s beta of 100%.  This is evidence that protected markets are safer havens to beat inflation with lower risk.  Firms generally price to a 12%-15% return on equity, while regulated utilities generally price to 5-10% ROE.  Even though ETFs are not individual companies, XLU and SPY’s performance have implications about GSE capital cost, which is the largest component of guarantee fees.

The Benefits of Lowering GSE Capital Costs

Fannie Mae and Freddie Mac (the GSEs) charge guarantee fees to compensate for the risk of guaranteeing and securitizing mortgages.  These fees are included in the mortgage rate.  The GSE guarantee conveys the lowest possible rate on mortgage backed securities through to borrowers.  Lowering guarantee fees on higher-risk loans would lower mortgage rates and cumulatively, could save borrowers up to $3,000.   

For example, for a $300,000 mortgage at 4%, the monthly P&I payment would be $1432. However, lowering the guarantee fee (and the mortgage rate) by 25 basis points lowers the payment $43 per month.  This saves borrowers more than $3000 over seven years. 

Lowering GSE capital costs to 6%-8% from 12%, could reduce guarantee fees by 25 bps for loans that require more capital without sacrificing financial resiliency. These borrowers are more likely to be lower-income, first-time homeowners or minority households. So, allowing the GSEs to retain federal backing as regulated utilities, and thus recognizing that GSE capital costs are lower than for fully private firms, can lower mortgage rates for higher risk loans which are more likely to be underserved populations.   

Making Homeownership More Accessible to Lower-Income Families and Underserved Groups

Homeownership is the largest source of inter-generational wealth for working- and middle-class families, and the gateway is access to a mortgage.  Especially for those whose access to homeownership has historically been hindered, financial security is enhanced by affordable credit.  This regulated utility framework shows that the right public-private combination can focus enduring benefits on underserved communities to help build credit and long-term financial stability. National standards and lower mortgage rates help avoid predatory lending and never-ending debt — so that these households have a better chance to thrive in the financial marketplace.

Building wealth in underserved communities can begin by boosting individual wealth and lead to more local commercial activity. This can start the flywheel of positive economic community feedback that middle class and white neighborhoods are accustomed to.

As the largest mortgage financing provider, the GSEs have repeatedly shown resilient presence in the market in sharp contrast to mortgage segments that are not federally backed.   They now operate more like regulated utilities and intermediate most risk into the public capital markets with an effective regulator setting standards for capital, credit and returns.  The final component is to recognize their lower cost of capital and thus allow guarantee fees and mortgage rates to reduce accordingly.