Fixing the Crisis Through Mortgage Payment Insurance
June 6, 2008
by Jack Guttentag and Igor Roitburg
This paper argues that a systemic weakness in the way the mortgage finance system currently deals with default risk has contributed greatly to the current mortgage crisis. To stem foreclosure losses, we need to begin the process of fixing the system. Our proposal will reduce foreclosure losses in the short run, make the system less vulnerable to crisis in the long run, and also reduce the financing costs of most borrowers. The proposal places major reliance on the private sector with only a limited and temporary role for the Federal government.
The systemic weakness is the prevailing system of risk-based interest rate pricing -- the practice of charging higher interest rates on loans that are perceived to be riskier than the best ("prime") mortgages. This interest rate increment is referred to as the "risk premium". And, while interest rate risk-based pricing has made more borrowers eligible for loans than ever before, it has also made the system vulnerable to default episodes, and increased costs to less-than-prime borrowers beyond those justified by expected losses. The benefits of interest rate risk-based pricing can be captured, without the accompanying vulnerability and over-charges, by converting it to mortgage insurance risk based pricing.
With few exceptions, interest rate risk premium dollars not needed to cover current losses are realized as income by investors. They are not reserved and available to meet future losses. This increases the vulnerability of the system. In addition, because risk premiums reflect the return investors require to compensate for the risk of "going broke," they are substantially higher than premiums based on long-run actuarial loss experience. Yet in the absence of reserving, they are never high enough to meet the losses that occur in a crunch, such as the one we are in now.
Furthermore, risk premiums (along with underwriting requirements) can change markedly over short-periods with changes in market sentiment. Hence, they contribute to instability, easing during periods of euphoria such as 2000-2005, and then sharply reversing course when sentiment changes, as in 2006-2008.
A better way to manage mortgage default risk is through a new type of mortgage insurance called mortgage payment insurance, or MPI. Under MPI, the insurer would guarantee timely payments to investors after borrowers default. If the default is not corrected, payments from the insurer continue until the foreclosure process is completed. At that point the investor is reimbursed for the unpaid balance plus foreclosure costs up to an agreed upon cap similar to the cap on traditional mortgage insurance. Caps on insurance coverage can be adjusted to equate expected losses with those of prime loans.
Under MPI, borrowers would pay different mortgage insurance premiums, depending on the risk, but interest rates would not vary with risk. Unlike interest rate risk premiums, insurance premiums would be reserved and available to pay for losses when they occur, reducing the vulnerability of the system to future shocks. Also, unlike interest rate risk premiums, insurance premiums would reflect long-run actuarial loss experience which will reduce overall cost to most borrowers.
For several reasons, MPI will cost insurers little more than the strictly collateral risk coverage they provide now, and in many cases will cost less. First, insuring against cash flow risk and collateral risk in combination is incredibly efficient because all of the payments the insurer advances in its role as cash flow insurer reduce dollar for dollar the ultimate amount they must pay at foreclosure. Second, the enhanced protection against loss that MPI provides to investors lowers interest rates, and lower rates reduce losses to both investors and insurers on loans that go to foreclosure. The rate plus insurance premium paid by less-than-prime borrowers under an MPI system would be substantially lower than the rate paid under the system of interest rate risk-based pricing.
MPI can help alleviate the current credit crisis. Existing defaulted loans carrying traditional mortgage insurance could be converted to MPI conditional on contract modifications that reduce interest rates and lower mortgage payments. This would save many borrowers from losing their homes and reduce losses to insurers and investors.
On new loans carrying MPI, however, recent deterioration in the credit ratings of private mortgage insurers will prevent the elimination of interest rate risk premiums. To solve this temporary problem, we propose that the Government National Mortgage Association (GNMA) provide a back-up guarantee to private mortgage insurers issuing MPI. GNMA would receive a reasonable insurance premium comparable to the premium it earns now for providing a similar guarantee on FHA and VA securities.
MPI backed by a GNMA guarantee will make it possible for the private mortgage insurers to offer new loans for home purchase, as well as refinance existing loans in default, at prime interest rates plus MPI insurance premiums and underwriting requirements that reflect long-run actuarial expectations of losses. MPI should enable the GSEs to purchase these loans and provide much needed liquidity to the marketplace. This will lower the average cost to borrowers, and avoid the extremes of excessive market ease followed by excessive stringency that arises from interest-rate risk-based pricing.
Note: A series of 5 articles based on this paper was published in the Washington Post beginning May 1, 2008.
The housing finance system, while still functioning, is in a crisis state. Interest rate risk premiums -- the rate increment on mortgages classified as riskier -- are several times larger than they were 2 years ago. Day-to-day rate volatility, which can cause havoc in the relationships between borrowers and loan providers, is larger than we have ever seen it.
Underwriting requirements -- the conditions that lenders require to approve a loan – have tightened across the board. Loans without a down payment are pretty much gone, and loans allowing borrowers to avoid documenting their income are much harder to obtain and much more costly. Loans are taking longer to get approved, and sometimes lenders change the rules in mid-stream.
Recently, a borrower scheduled to close on a home purchase in 4 days with a mortgage approved by one of the largest lenders in the country was notified by the lender that her down payment had to be increased from 5% to 10%. The reason for the bank’s action is instructive. The area in which the property is located was reclassified as one with high potential for property value decline. And the reclassification was based on a high and rising level of foreclosures in the area. Foreclosures lead to distress sales and downward pressure on prices.
This is a 180 degree change from 2 years ago. At that time, the prevailing assumption was that rising house prices would generate equity on loans that were originally made with no down payment. Now the concern is that falling prices will wipe out the equity on loans made with down payments that are too small.
A swing from a prevailing expectation that house prices will rise to an expectation that they will fall causes a major tightening of underwriting requirements. Indeed, the only reason the tightening has not been even larger is that the house price declines expected are temporary. The prevailing view is that they will last only until we get out from under the foreclosure crunch.
This places the foreclosure problem front and center as the critical policy issue. Most of the emphasis has been on the human toll from having families forced out of their homes, which is understandable. But reducing the number of foreclosures also is the key to reestablishing a well-functioning mortgage market going forward.
The Administration and Congress are trying to find a solution, but the proposals swirling around Washington seem to have little chance of having a meaningful impact in the short term. The one that appeared to have the best chance of passage when this was written, HR5830, is enormously complicated and requires an extensive new administrative infrastructure.
The thesis of this paper is that the current crisis exposed a systemic weakness in the way the mortgage industry deals with default risk, and that the way to turn the market around is to fix the system. The cure is within the capacity of the private sector, and specifically the mortgage insurance industry.
Our core proposal is for a new type of mortgage insurance that would manage default risk much more effectively than the way we do it now. This new kind of insurance will reduce the vulnerability of the system to future default crises, substantially reduce mortgage risk premiums, AND get us out of the current mess.
We hasten to add that to make it all work effectively, the Federal Government is needed during a transition period, as a backup guarantor and as a provider of liquidity. Both functions would be phased out as they are no longer needed. The major delivery systems would be private and could be quickly mobilized.
Mortgage Default Risk
Investors in mortgages face two kinds of risk from borrowers who default. Collateral risk is the risk that the investor who forecloses on a loan and sells the property will fail to recover the unpaid balance of the loan plus the foreclosure costs. On loans with small down payments on which the collateral risk is the highest, private mortgage insurance is available to protect investors.
Investors also face cash flow risk. While they ultimately may be made whole from their collateral and mortgage insurance, until that happens a loan in default is a non-performing asset which is not generating any income and is not saleable except at substantial loss. There is no insurance now available against cash flow risk on individual mortgages.
Borrower Payments For Default Risk
Borrowers are charged for default risk in two ways. The first and larger charge is to impose a risk premium in the interest rate. The risk premium is a rate increment above that charged on a "prime" transaction, which carries the lowest risk. The greater the perceived risk, the larger is the premium.
A weakness of the interest rate risk premium system is that, with few exceptions, risk premium dollars not needed to cover current losses are realized as income by investors. They are not reserved and available to meet future losses. This is a serious limitation because losses tend to bunch.
For example, interest rate risk premiums collected on loans originated in 2000 had very low losses because of the marked appreciation in house prices in subsequent years. Most of the risk premiums collected on these loans became investor income. Loans originated in 2006, in contrast, had large losses but none of the excess premiums from the 2000 vintage were available to help meet those losses.
Another weakness of the interest rate risk premium system is that premiums are based not on long-run actuarial loss experience but on the return investors require to compensate for the risk of "going broke." These are substantially higher than premiums based on actuarial experience. Furthermore, interest rate risk-based premiums along with underwriting requirements can change markedly over short-periods with changes in market sentiment, easing during periods of euphoria such as 2000-2005, and then sharply reversing course when sentiment changes, as in 2006-2008.
The second method of charging borrowers for default risk is to charge a mortgage insurance premium. Borrowers may be required to purchase mortgage insurance if their down payment on a home purchase, or their equity in a refinance, is less than 20%.
In contrast to interest rate risk premiums, more than half of the mortgage insurance premiums collected from borrowers are placed in reserve accounts. The reserves that accumulate during long periods when losses are small are available when a foreclosure crunch comes – as right now.
The reserving process requires mortgage insurance companies to view expected losses over a long time horizon. While premium structures change over time, such changes are based on revised estimates of losses over long periods, rather than on short-term swings in market sentiment.
Furthermore, the premiums arising out of a reserving process are significantly lower than those charged when there is no reserving. This will be discussed further below.
The upshot is that a mortgage system in which borrower payments for risk are reserved is more stable, and the average premium paid by borrowers is much lower, than one in which borrower payments are divided between current losses and income. Unfortunately, in our current system the number of risk-based dollars paid by borrowers that are subject to reserving is much smaller than the number that are not.
Traditional mortgage insurance on individual mortgages, which we will call TMI, is insurance against collateral risk. It usually comes into play after foreclosure when the insurer pays for any shortfall (up to an agreed upon cap) between the net proceeds of the property sale and the loan balance (including accrued interest) plus expenses.
Our proposal is for a new type of mortgage insurance which we call mortgage payment insurance, or MPI, and it covers both collateral risk and cash flow risk. Under MPI, the insurer would guarantee timely receipt of the payments, so that the investor continues to receive the payments when the borrower defaults. This is the cash flow insurance part of the policy. If the default is not corrected, the payments continue until the foreclosure process is completed, at which point the investor is reimbursed under the collateral risk insurance part of the policy.
Any cure payments by the borrower would go to the insurer to reimburse it for the advances made. To avoid the risk of loan servicers allowing MPI payments to run on indefinitely, PMIs would limit the period allowed the servicer to foreclose. The maximum period would depend on typical foreclosure timelines and vary by state.
The insurance premiums covering both types of risk would vary from loan to loan, but since the insurer assumes the default risk there would be no interest rate risk premiums. All borrowers would pay the prime interest rate on the type of mortgage they select. This assumes that the insurer’s credit is not in question, an issue discussed later, and that the coverage cap is adjusted to the level required by investors to provide prime pricing.
NOTE: The authors have a patent pending on MPI.
It is natural to assume that since MPI covers both the cash flow risk and the collateral risk, the required mortgage insurance premiums would be substantially larger than those on TMI. In fact, more often than not they are smaller, and when they are larger, they are not much larger!
This astounding fact stems from two sources. The first is that insuring against cash flow risk and collateral risk in combination is incredibly efficient. All of the payments the insurer advances in its role as cash flow insurer are simply prepayments – dollar for dollar – of the ultimate amount they must pay at foreclosure in their role of collateral risk insurer. The only net loss to the insurer is the interest opportunity cost on the funds advanced, which turns out to be small.
The second reason that MPI premiums are so small is that, by assuming all the default risk instead of just a piece of it, MPI eliminates interest rate risk premiums, and lower rates reduce losses on loans that default. A lower rate means more rapid amortization and therefore a lower balance, and it also means smaller accruals of unpaid interest.
Here is an example based on wholesale price quotes covering two loans as of November 27, 2007, when the market was less unsettled than it is today. The loans were the same except for a few critical differences that made one of them prime and the other Alt-A. Their features are shown in Table 1.
Table 1
Note: Loan is 30-year fixed-rate, property is in California, and lock period is 30 days. Rates are wholesale at zero points as of November 21, 2007, insurance premiums are from the MGIC Rate Finder at that time. Note that rate risk and mortgage insurance premiums have both risen since the table was prepared in November, 2007. In attempting to update the table, we found that the Alt-A loan was no longer being priced, by the market or by MGIC. See the discussion under "Excessive Interest Rate Risk Premiums" below.
The prime loan was to purchase the home as a primary residence with full documentation, whereas the Alt-A loan was to take cash-out by refinancing an investment property with no documentation. The Alt-A loan carried a rate 3.875% higher, and a mortgage insurance premium .62% higher.
We assumed the Alt-A loan went into default followed by foreclosure and calculated losses with a TMI policy. We then used the same default/foreclosure scenario to calculate the losses on an MPI policy with the interest rate reduced to 6%.
We found that the total losses were $23,937 lower with MPI, with the detail shown in Table 2 below. Both insurer and investor share in this loss reduction. The insurer’s cap (maximum loss exposure) is reduced by $5,200 while the investor’s losses are reduced by $18,800.
Note: It is assumed that the loan defaults after 36 months, it takes 12 months after default to foreclose and another 12 months after foreclosure to sell the property to a third-party purchaser, house value at foreclosure is 10% lower than at origination, loss on cash flow advances is calculated at 6%, and foreclosure expenses are based on those developed by HUD in Providing Alternatives to Mortgage Foreclosure: A Report to Congress, March 1996.
Our example involved a relatively large rate reduction. Smaller rate reductions generate smaller savings, as shown in Table 3 below. The costs there are calculated in the same way as in Table 2, except that the interest rate on the Alt-A loan, and therefore the rate reduction associated with MPI, takes different values.
If there is no interest rate reduction, MPI will cost the insurer more than TMI, but not much more, and the investor will always incur a smaller loss with MPI.
Excessive Interest Rate Risk Premiums
Note that in moving from the prime loan to the Alt-A loan, the TMI premium rose by only .62% while the interest rate premium rose by 3.875%. The increase in risk premium charged by the lender was more than 6 times larger than the increase charged by the insurer, despite the fact that the increase in risk exposure was substantially higher for the insurer because the insurer is in the first loss position.
Extending our model, loss to the insurer occurs if the property value appreciates by less than 30%, whereas loss to the investor doesn’t occur unless the property value declines by more than 2.5%! The property value has to decline by 35% before the investor’s loss equals the insurer’s loss.
On the assumption that the mortgage insurance premium accurately reflected the losses expected over a long time horizon, the interest rate risk premium was grossly excessive.
Interest rate risk premiums are excessive mainly because they are not reserved and depend on investor sentiment that is heavily influenced by current market conditions – as opposed to long-term actuarial loss experience. When losses escalate, as they have during 2007-2008, the prevailing view is that the interest rate risk premiums charged borrowers in prior years must have been too small, which results in marked price adjustments. Interest rate risk premiums are now substantially larger than they were earlier, and eligibility cutoffs, where loans become unavailable at any price, occur at lower values of risk variables.
This reaction by the market is understandable, perhaps unavoidable in the current environment. But relative to what they would be in a reserving environment, interest rate risk premiums are grossly excessive. In a system in which insurers offer MPI and all borrowers pay the prime rate, the interest rate plus MPI insurance premium paid by non-prime borrowers would be substantially smaller than the interest rate plus TMI insurance premium they pay now.
Will All Mortgages Carrying MPI Be Priced at Prime?
Perhaps the best way to answer this is to place ourselves in the position of a price-setting investor, such as Fannie Mae, and ask the following question: assuming Fannie is willing to price a prime loan at 6% with TMI, should it be willing to take a riskier loan at 6% if it carried MPI and if the insurer’s credit is beyond reproach?
It should. The insurer’s credit is better than that of the prime borrower. Further, in the event of a default, the payments will continue to be made on the riskier loan but not on the prime loan. While the riskier loan will have a higher incidence of default, in the event of default the loss to the investor with MPI is lower. How these balance out is not clear, but if there is any added risk, the coverage can be adjusted to shift it to the insurer, with the borrower paying for it in a higher insurance premium. Any such adjustment would not materially reduce the borrower’s cost saving.
An MPI-based mortgage system would eliminate interest-rate risk-based pricing because MPI would be the lowest-cost way to protect against default risk. All loans would have MPI except those that are prime without it, or not insurable. Loan to loan differences in default risk would be reflected in differences in mortgage insurance premiums.
In this system, financing costs to non-prime borrowers would be substantially lower. Further, the system would be much less vulnerable to default crises such as the one we are in now.
Lower Costs to Borrowers: Mortgage insurers assume almost 100% of the default risk under an MPI policy. A very small amount remains because of the cap on insurer liability. Assuming the cap is adjusted to meet investor requirements, the only material risk remaining to the investor is the risk that the insurer itself will fail, as discussed below. Assuming that risk is nil, interest rate risk premiums disappear. Borrowers would pay different mortgage insurance premiums, but they would all pay the prime interest rate.
MPI would cost insurers little more, and in many cases less than their traditional limited insurance. Hence, the total financing cost to borrowers would drop, with the cost imposed on riskier borrowers dropping the most.
The case in tables 1-3 above illustrate how large the savings can be. Assuming the TMI insurance premium of 1.29% in Table 1 is properly priced to meet losses under that policy, it is more than adequate to meet the lower losses under an MPI policy. Hence, the 3.875% rate premium, which investors require when they are protected only by TMI, is redundant if they have MPI.
Further, with all borrowers eligible for mortgage insurance paying prime rates, the potential for predatory practices would be sharply reduced. Elimination of risk-based pricing would eliminate opportunistic pricing of mortgages at the point of sale, which is one of the most important sources of abuse.
In addition, borrowers would have an important ally in the mortgage insurers, who have a financial interest in seeing that borrowers are not over-charged. Higher rates mean greater risk exposure for the insurer. Insurers would have the clout and information needed to protect borrowers because the basic paradigm of insurer/lender relations would be reversed.
Since the private mortgage insurance industry began, it has been beholden to the lenders because lenders select the insurers to whom they refer borrowers. With MPI, lenders and insurers (and by extension, borrowers) would be on a more equal footing because borrowers could go to insurers first knowing that MPI is a de facto loan approval that will allow them to borrow at the prime rate.
Reduced Systemic Vulnerability: With default risk covered by MPI, rather than by a combination of TMI and rate risk premiums, vulnerability to financial crises would be substantially reduced. Today, only TMI premiums are placed in reserve accounts to protect against future losses. With minor exceptions, interest rate risk premiums not needed to meet current losses become investor income. With MPI replacing rate risk premiums, the process of reserving for contingencies would be extended to cover all default risk, not just part of the collateral risk. As a rough order of magnitude, reserves available to meet losses might be ten times larger.
In addition, risk underwriting would shift into more dependable hands. Mortgage insurance companies already offer underwriting to lenders as a service, but with MPI they will do it for all loans except those that don’t qualify for MPI.
In setting underwriting requirements, lenders and investment banks have a short run orientation that can lead to sharp swings in how liberal or restrictive the requirements are. They become excessively liberal when market sentiment is euphoric, as it was during 2000-20006, and then excessively tight when pessimism reigns, as is the case now. This tendency is encouraged by their ability to pass along most default risk to the next party in the chain. Insurers, in contrast, have a long-term orientation because they remain on the hook for a loan until it is repaid or the insurance is terminated.
In addition, by keeping defaulted mortgages performing until they are paid off, MPI would block the contagious erosion of investor confidence that stems from increasing numbers of non-performing loans. This has been a central feature of the current crisis.
A Gaming Analogy: Imagine a world where all home mortgages are placed in securities, of which there are two types. Both promise to pay the investor the prime rate, but protect them in different ways. On an RRP security, borrowers pay interest rate risk premiums, which are placed in a reserve fund, with each security having its own fund. On an MPI security, protection is provided by MPI policies on all the mortgages.
Make the following assumptions: Every security faces a market environment that is determined by a single twirl of a roulette wheel, which has 15 slots, 14 of them blue and one red. If blue comes up, as it will 93.3% of the time, the environment is one in which house prices increase by 5% a year for the life of the security, and investors lose 1/10 of 1% of loan balances. If red comes up, as it will 6.7% of the time, prices will decline by 5% a year for 4 years before leveling out, and losses will be 6% of loan balances.
In this world, the reserve needed by insurers to cover losses of .10% on 93.3% of the loans they insure, and losses of 6% on 6.7% of them is about .50%. Their premium will be about twice this, or 1%. When an MPI security comes up red, they have the reserves to meet the claims.
In contrast, every RRP security stands on its own. For investors to be fully protected against the possibility that the roulette wheel comes up red, the reserve must be 6% on every security. This is too high to be workable. But RRP securities may nonetheless be created if MPI securities are not available.
If borrowers were charged a risk premium of, say, 3%, the RRP security would be extremely profitable for all concerned 93.3% of the time. If the wheel comes up blue 6 times running, which with our assumed probabilities will happen about 66% of the time, issuers and investors may come to believe the wheel has been fixed so that only blue comes up – a phenomena that Guttentag and Herring referred to as "disaster myopia". [See Upheaval in the Sub-Prime Mortgage Market] If the agencies that investors depend on to tell them whether or not a security is safe share the myopia, basing their analysis on the last 6 turns of the wheel, the stage is set for disaster when the wheel comes up red. This is a pretty good description of what actually happened during 2000-2007.
The gaming analogy illustrates very well why interest rate risk premiums are both two large and too small. They are too large in the sense that most of the time they far exceed what is needed to meet losses, and they are too small in the sense that they are inadequate to meet losses when a default crunch does occur.
Fixing the Crisis With MPI
MPI could be used right now to reduce the number of foreclosures, and reduce losses on the foreclosures that occur. The appropriate treatment varies with the situation, as follows:
*Loans in default that carry TMI.
*Loans in default that do not have TMI.
* Purchase loans & high-rate existing loans in good standing.
*Existing loans in good standing with negative equity
Loans in Default That Carry TMI: We estimate that there are about 600,000 loans now in default that carry TMI. Case-by-case efforts to modify these loans will make only a tiny dent in the total. There are major impediments to such modifications (see Foreclosures That Shouldn’t Happen But Do), and even when these impediments are removed, the process is costly and time-consuming. MPI makes possible wholesale modifications covering large numbers of loans that are in the interest of all parties - insurers, investors, borrowers and servicers.
If loans in default carry TMI, the insurer is already on the hook for the coming loss, up to the cap on the policy. If the net proceeds from sale of the property do not cover the unpaid balance including accrued interest plus foreclosure expenses, the investor is protected up to the cap amount for any deficiency.
In more normal conditions, deficiencies in coverage seldom arise. In the current market, however, house price depreciation has made deficiencies the rule rather than the exception. Under these circumstances, the deal using MPI shown below will make both the insurer and the investor better off. In the process, a significant number of borrowers will be saved from foreclosure.
Existing TMI policies are converted to MPI at the currently prevailing prime interest rate, provided that the monthly mortgage payment declines by10% or more.
The major benefit arises when the payment reduction resulting from the rate reduction allows the borrower to return to good standing. Everyone – borrower, investor, insurer and servicer - are better off. The downside to the investor is that some of these loans may cure themselves without the investor having to reduce the interest rate. After some extensive modeling, we have determined that "losses" to the investor from this source would be much smaller than the gains from loans that return to good standing that would not have cured themselves.
Loan servicers acting for themselves, as opposed to their actions as agent of the investor, have a self-interest in making the package deal described above because the resumption of payments under MPI also means a resumption of servicing fees. Most loans are serviced under contract with investors, with servicing fees paid as a withdrawal from monthly payments. When borrowers stop paying, servicing fees stop. As payments on loans in default resume under MPI, servicing fees resume.
Loans in Default That Do Not Have TMI: When loans in default do not carry TMI, the investors are on the hook for the entire loss. The insurer will not assume the risk except as a new loan that meets its underwriting requirements, and carrying an MPI insurance premium scaled to the risk. These deals must be done one at a time.
To meet its requirements as an insurable loan, the insurer will require the investor to write down the loan balance to 90% or 95% of current property value, and reduce the interest rate to the prime rate. If there is a second mortgage, the investor will have to negotiate a payoff with the second mortgage lender.
The investor would take a loss on the modification, but it would be far smaller than the loss that would have resulted from foreclosure of the original loan. The investor might also receive an equity certificate equal to the write-down of the balance (or balances, if there is a second lien), which would entitle it to a share of the future appreciation in the value of the house.
The borrower gets a new start with 5% or 10% equity, no unpaid interest, and a reduced payment based on the lower rate. Because the payment reduction will be partly offset by a new mortgage insurance premium, this plan will work best with higher-rate mortgages.
The insurer gets an MPI policy which it has underwritten as a piece of profitable business.
This application of MPI to loans that do not now have TMI is very similar to the proposed "FHA Housing Stabilization and Homeownership Retention Act of 2008" (HR5830), which would authorize FHA "to insure refinance loans for substantial numbers of borrowers at risk of foreclosure…" The essentials – writing down the loan balance, providing the existing investor a claim on future appreciation, and re-underwriting the loan – are the same. But there are some major differences:
*HR5830 stipulates some detailed conditions including underwriting requirements designed to protect FHA against excessive losses, such as maximum debt to income ratios. The Act is full of such rigidities, which may result in no or limited response by the private sector. MPI underwriting rules and conditions, in contrast, will be formulated by the private insurers in consultation with the investors who will be acquiring the new loans.
*HR 5830 would create a new Federal administrative infrastructure (an "Oversight Board") with heavy responsibilities related to determination of fees, underwriting rules, insurance premiums, and the like. The Board would be drawn from the Treasury, Federal Reserve Board, and HUD. There is no time limit in HR 5830 for establishing the Board. The MPI plan, in contrast, would use the existing private infrastructure.
*Under HR5830, the Federal Government assumes direct insurance liability for every mortgage written. With the MPI plan, private insurers would assume this liability, with the Federal Government’s role limited to that of re-insurer. This is discussed below.
Purchase Loans and High-Rate Existing Loans in Good Standing: Insurers will offer MPI on new purchase loans as a way to generate income and bolster reserves. For non-prime deals, the terms will be far better than those available in the current market. More precisely, the insurance premium that non-prime borrowers will have to pay will be much smaller than the sum of TMI premiums and interest rate risk premiums they now pay.
Insurers will also offer MPI to existing borrowers who currently pay high rates and have enough equity to meet underwriting requirements.
The major argument of this paper is that MPI, in addition to making a less-vulnerable and more borrower-friendly housing finance system, could help fix the current mortgage mess. MPI would reduce 1) the number of foreclosures, 2) investor losses on loans that do foreclose, and 3) financing costs to non-prime borrowers.
For existing loans with TMI that are in default, converting a TMI policy into an MPI policy should be no problem. Investors, insurers and borrowers will be better off than they are now. But on new loans, there is a potential problem connected to the acceptability of private mortgage insurance.
The core benefit of MPI, the elimination of interest rate risk premiums at little or no cost to the insurer, will materialize only if investors have complete confidence in the insurers. That would not have been a problem 2 years ago, when all the companies were rated AA or AAA. It is a problem today because the insurers have been weakened by their large payouts on foreclosed loans, and they have all been down-graded by the rating agencies.
To make MPI work with maximum effectiveness, insurers need an option to purchase reinsurance from GNMA, a wholly owned Federal agency, which would commit to make the mortgage payments if the private insurer cannot. This is the same type of guarantee that GNMA now provides on securities issued against pools of FHA and VA mortgages.
GNMA has charged 6 basis points for its guarantee, and it has been a consistent source of profit for the Government from the beginning. We would expect a similar guarantee fee on privately insured loans, and a similar experience. GNMA’s reinsurance would come into play only if the private insurer went broke.
There is no reason why a benefit directed to one industry should be permanent, and once the market has been normalized and the insurers have rebuilt their reserves, there should be no further need for it. A good way to minimize the support period is to build automatic premium increases into the program. This would provide a strong incentive for the insurers to rebuild their capital as quickly as possible.
With MPI backstopped by GNMA, investors including the Federal agencies Fannie Mae and Freddie Mac, and investment banks that purchase mortgages not eligible for purchase by the agencies, will pay a price based on the prime rate. Since borrowers will know what the prime rates are, the lenders who sell to the secondary market, and the brokers who feed loans to lenders, will compete on their markups over the prime rate, and on service.
Why should the Federal Government provide special support to the mortgage insurance industry? The major reason is that it will turn the market around at a critical juncture, while initiating a reform process that will make the entire housing finance system less vulnerable and more equitable in the future.
The proposed Government support is not an industry bailout. The probability that the contingent liability assumed by GNMA will ever cost the Government anything is very small.
Indeed, the proposed role for Government could more accurately be viewed as a bailout prevention measure. It will eliminate the need for the more extensive Government support that will become unavoidable if the situation deteriorates further.
To encourage private mortgage insurers to offer and investors to accept MPI on new loans, we recommend that Congress pass Federal legislation enabling the Government National Mortgage Association (GNMA) to re-insure private mortgage insurers that issue MPI. The GNMA guarantee should cover all payments (including the final payment) due the investor pursuant to the MPI policy in the event that the private mortgage insurer fails to pay.
The GNMA guarantee should be made available only to new MPI policies issued by any private mortgage insurer on owner-occupied principal residences.
GNMA should be paid a guaranty fee of about .06% of the loan balance per year on all mortgages that it guarantees. The guaranty fee should not change once the loan has been originated, but should rise after about three years, and periodically thereafter, on newly issued MPI policies. In the event insurance is terminated by the borrower under the Homeowners Protection Act of 1998, or under provisions for termination of Fannie Mae or Freddie Mac, GNMA should no longer be paid the guaranty fee.
If an insurer at some point elects to forego a GNMA guaranty on new loans carrying MPI, outstanding loans should retain the guaranty and GNMA should continue to receive the guaranty fee on those loans.
Mortgage insurers eligible for the GNMA guaranty should be licensed to do business in all 50 states, and should be eligible to insure loans acceptable to both Fannie Mae and Freddie Mac. Eligible insurers also should have programs in place acceptable to the Federal Reserve Board for a) the wholesale conversion to MPI of loans in default on which they currently have insurance, and b) new loan programs using MPI covering purchase loans and refinances, including refinances of loans currently in default that do not now have mortgage insurance and that require contract modifications by investors to become eligible for MPI.
by Jack Guttentag and Igor Roitburg
The Case For Mortgage Payment Insurance: Executive Summary
This paper argues that a systemic weakness in the way the mortgage finance system currently deals with default risk has contributed greatly to the current mortgage crisis. To stem foreclosure losses, we need to begin the process of fixing the system. Our proposal will reduce foreclosure losses in the short run, make the system less vulnerable to crisis in the long run, and also reduce the financing costs of most borrowers. The proposal places major reliance on the private sector with only a limited and temporary role for the Federal government.
The systemic weakness is the prevailing system of risk-based interest rate pricing -- the practice of charging higher interest rates on loans that are perceived to be riskier than the best ("prime") mortgages. This interest rate increment is referred to as the "risk premium". And, while interest rate risk-based pricing has made more borrowers eligible for loans than ever before, it has also made the system vulnerable to default episodes, and increased costs to less-than-prime borrowers beyond those justified by expected losses. The benefits of interest rate risk-based pricing can be captured, without the accompanying vulnerability and over-charges, by converting it to mortgage insurance risk based pricing.
With few exceptions, interest rate risk premium dollars not needed to cover current losses are realized as income by investors. They are not reserved and available to meet future losses. This increases the vulnerability of the system. In addition, because risk premiums reflect the return investors require to compensate for the risk of "going broke," they are substantially higher than premiums based on long-run actuarial loss experience. Yet in the absence of reserving, they are never high enough to meet the losses that occur in a crunch, such as the one we are in now.
Furthermore, risk premiums (along with underwriting requirements) can change markedly over short-periods with changes in market sentiment. Hence, they contribute to instability, easing during periods of euphoria such as 2000-2005, and then sharply reversing course when sentiment changes, as in 2006-2008.
A better way to manage mortgage default risk is through a new type of mortgage insurance called mortgage payment insurance, or MPI. Under MPI, the insurer would guarantee timely payments to investors after borrowers default. If the default is not corrected, payments from the insurer continue until the foreclosure process is completed. At that point the investor is reimbursed for the unpaid balance plus foreclosure costs up to an agreed upon cap similar to the cap on traditional mortgage insurance. Caps on insurance coverage can be adjusted to equate expected losses with those of prime loans.
Under MPI, borrowers would pay different mortgage insurance premiums, depending on the risk, but interest rates would not vary with risk. Unlike interest rate risk premiums, insurance premiums would be reserved and available to pay for losses when they occur, reducing the vulnerability of the system to future shocks. Also, unlike interest rate risk premiums, insurance premiums would reflect long-run actuarial loss experience which will reduce overall cost to most borrowers.
For several reasons, MPI will cost insurers little more than the strictly collateral risk coverage they provide now, and in many cases will cost less. First, insuring against cash flow risk and collateral risk in combination is incredibly efficient because all of the payments the insurer advances in its role as cash flow insurer reduce dollar for dollar the ultimate amount they must pay at foreclosure. Second, the enhanced protection against loss that MPI provides to investors lowers interest rates, and lower rates reduce losses to both investors and insurers on loans that go to foreclosure. The rate plus insurance premium paid by less-than-prime borrowers under an MPI system would be substantially lower than the rate paid under the system of interest rate risk-based pricing.
MPI can help alleviate the current credit crisis. Existing defaulted loans carrying traditional mortgage insurance could be converted to MPI conditional on contract modifications that reduce interest rates and lower mortgage payments. This would save many borrowers from losing their homes and reduce losses to insurers and investors.
On new loans carrying MPI, however, recent deterioration in the credit ratings of private mortgage insurers will prevent the elimination of interest rate risk premiums. To solve this temporary problem, we propose that the Government National Mortgage Association (GNMA) provide a back-up guarantee to private mortgage insurers issuing MPI. GNMA would receive a reasonable insurance premium comparable to the premium it earns now for providing a similar guarantee on FHA and VA securities.
MPI backed by a GNMA guarantee will make it possible for the private mortgage insurers to offer new loans for home purchase, as well as refinance existing loans in default, at prime interest rates plus MPI insurance premiums and underwriting requirements that reflect long-run actuarial expectations of losses. MPI should enable the GSEs to purchase these loans and provide much needed liquidity to the marketplace. This will lower the average cost to borrowers, and avoid the extremes of excessive market ease followed by excessive stringency that arises from interest-rate risk-based pricing.
Note: A series of 5 articles based on this paper was published in the Washington Post beginning May 1, 2008.
Introduction: Scope of the Mortgage Crisis
The housing finance system, while still functioning, is in a crisis state. Interest rate risk premiums -- the rate increment on mortgages classified as riskier -- are several times larger than they were 2 years ago. Day-to-day rate volatility, which can cause havoc in the relationships between borrowers and loan providers, is larger than we have ever seen it.
Underwriting requirements -- the conditions that lenders require to approve a loan – have tightened across the board. Loans without a down payment are pretty much gone, and loans allowing borrowers to avoid documenting their income are much harder to obtain and much more costly. Loans are taking longer to get approved, and sometimes lenders change the rules in mid-stream.
Recently, a borrower scheduled to close on a home purchase in 4 days with a mortgage approved by one of the largest lenders in the country was notified by the lender that her down payment had to be increased from 5% to 10%. The reason for the bank’s action is instructive. The area in which the property is located was reclassified as one with high potential for property value decline. And the reclassification was based on a high and rising level of foreclosures in the area. Foreclosures lead to distress sales and downward pressure on prices.
This is a 180 degree change from 2 years ago. At that time, the prevailing assumption was that rising house prices would generate equity on loans that were originally made with no down payment. Now the concern is that falling prices will wipe out the equity on loans made with down payments that are too small.
A swing from a prevailing expectation that house prices will rise to an expectation that they will fall causes a major tightening of underwriting requirements. Indeed, the only reason the tightening has not been even larger is that the house price declines expected are temporary. The prevailing view is that they will last only until we get out from under the foreclosure crunch.
This places the foreclosure problem front and center as the critical policy issue. Most of the emphasis has been on the human toll from having families forced out of their homes, which is understandable. But reducing the number of foreclosures also is the key to reestablishing a well-functioning mortgage market going forward.
The Administration and Congress are trying to find a solution, but the proposals swirling around Washington seem to have little chance of having a meaningful impact in the short term. The one that appeared to have the best chance of passage when this was written, HR5830, is enormously complicated and requires an extensive new administrative infrastructure.
The thesis of this paper is that the current crisis exposed a systemic weakness in the way the mortgage industry deals with default risk, and that the way to turn the market around is to fix the system. The cure is within the capacity of the private sector, and specifically the mortgage insurance industry.
Our core proposal is for a new type of mortgage insurance that would manage default risk much more effectively than the way we do it now. This new kind of insurance will reduce the vulnerability of the system to future default crises, substantially reduce mortgage risk premiums, AND get us out of the current mess.
We hasten to add that to make it all work effectively, the Federal Government is needed during a transition period, as a backup guarantor and as a provider of liquidity. Both functions would be phased out as they are no longer needed. The major delivery systems would be private and could be quickly mobilized.
Mortgage Default Risk
Investors in mortgages face two kinds of risk from borrowers who default. Collateral risk is the risk that the investor who forecloses on a loan and sells the property will fail to recover the unpaid balance of the loan plus the foreclosure costs. On loans with small down payments on which the collateral risk is the highest, private mortgage insurance is available to protect investors.
Investors also face cash flow risk. While they ultimately may be made whole from their collateral and mortgage insurance, until that happens a loan in default is a non-performing asset which is not generating any income and is not saleable except at substantial loss. There is no insurance now available against cash flow risk on individual mortgages.
Borrower Payments For Default Risk
Borrowers are charged for default risk in two ways. The first and larger charge is to impose a risk premium in the interest rate. The risk premium is a rate increment above that charged on a "prime" transaction, which carries the lowest risk. The greater the perceived risk, the larger is the premium.
A weakness of the interest rate risk premium system is that, with few exceptions, risk premium dollars not needed to cover current losses are realized as income by investors. They are not reserved and available to meet future losses. This is a serious limitation because losses tend to bunch.
For example, interest rate risk premiums collected on loans originated in 2000 had very low losses because of the marked appreciation in house prices in subsequent years. Most of the risk premiums collected on these loans became investor income. Loans originated in 2006, in contrast, had large losses but none of the excess premiums from the 2000 vintage were available to help meet those losses.
Another weakness of the interest rate risk premium system is that premiums are based not on long-run actuarial loss experience but on the return investors require to compensate for the risk of "going broke." These are substantially higher than premiums based on actuarial experience. Furthermore, interest rate risk-based premiums along with underwriting requirements can change markedly over short-periods with changes in market sentiment, easing during periods of euphoria such as 2000-2005, and then sharply reversing course when sentiment changes, as in 2006-2008.
The second method of charging borrowers for default risk is to charge a mortgage insurance premium. Borrowers may be required to purchase mortgage insurance if their down payment on a home purchase, or their equity in a refinance, is less than 20%.
In contrast to interest rate risk premiums, more than half of the mortgage insurance premiums collected from borrowers are placed in reserve accounts. The reserves that accumulate during long periods when losses are small are available when a foreclosure crunch comes – as right now.
The reserving process requires mortgage insurance companies to view expected losses over a long time horizon. While premium structures change over time, such changes are based on revised estimates of losses over long periods, rather than on short-term swings in market sentiment.
Furthermore, the premiums arising out of a reserving process are significantly lower than those charged when there is no reserving. This will be discussed further below.
The upshot is that a mortgage system in which borrower payments for risk are reserved is more stable, and the average premium paid by borrowers is much lower, than one in which borrower payments are divided between current losses and income. Unfortunately, in our current system the number of risk-based dollars paid by borrowers that are subject to reserving is much smaller than the number that are not.
Introducing Mortgage Payment Insurance
Traditional mortgage insurance on individual mortgages, which we will call TMI, is insurance against collateral risk. It usually comes into play after foreclosure when the insurer pays for any shortfall (up to an agreed upon cap) between the net proceeds of the property sale and the loan balance (including accrued interest) plus expenses.
Our proposal is for a new type of mortgage insurance which we call mortgage payment insurance, or MPI, and it covers both collateral risk and cash flow risk. Under MPI, the insurer would guarantee timely receipt of the payments, so that the investor continues to receive the payments when the borrower defaults. This is the cash flow insurance part of the policy. If the default is not corrected, the payments continue until the foreclosure process is completed, at which point the investor is reimbursed under the collateral risk insurance part of the policy.
Any cure payments by the borrower would go to the insurer to reimburse it for the advances made. To avoid the risk of loan servicers allowing MPI payments to run on indefinitely, PMIs would limit the period allowed the servicer to foreclose. The maximum period would depend on typical foreclosure timelines and vary by state.
The insurance premiums covering both types of risk would vary from loan to loan, but since the insurer assumes the default risk there would be no interest rate risk premiums. All borrowers would pay the prime interest rate on the type of mortgage they select. This assumes that the insurer’s credit is not in question, an issue discussed later, and that the coverage cap is adjusted to the level required by investors to provide prime pricing.
NOTE: The authors have a patent pending on MPI.
Cost of Mortgage Payment Insurance Versus Traditional Mortgage Insurance
It is natural to assume that since MPI covers both the cash flow risk and the collateral risk, the required mortgage insurance premiums would be substantially larger than those on TMI. In fact, more often than not they are smaller, and when they are larger, they are not much larger!
This astounding fact stems from two sources. The first is that insuring against cash flow risk and collateral risk in combination is incredibly efficient. All of the payments the insurer advances in its role as cash flow insurer are simply prepayments – dollar for dollar – of the ultimate amount they must pay at foreclosure in their role of collateral risk insurer. The only net loss to the insurer is the interest opportunity cost on the funds advanced, which turns out to be small.
The second reason that MPI premiums are so small is that, by assuming all the default risk instead of just a piece of it, MPI eliminates interest rate risk premiums, and lower rates reduce losses on loans that default. A lower rate means more rapid amortization and therefore a lower balance, and it also means smaller accruals of unpaid interest.
Here is an example based on wholesale price quotes covering two loans as of November 27, 2007, when the market was less unsettled than it is today. The loans were the same except for a few critical differences that made one of them prime and the other Alt-A. Their features are shown in Table 1.
Table 1
Characteristics of Prime and Alt-A Loans
| Loan Characteristic | Prime Loan | Alt-A Loan |
| Price or Value: | $444,444 | $444,444 |
| Loan ($) / (LTV): | $400,000 / 90% | $400,000 / 90% |
| TMI Coverage: | 25% | 25% |
| Borrower FICO: | 700 | 700 |
| Property Type: | Single Family | Single Family |
| Occupancy: | Primary Residence | Investment |
| Loan Purpose: | Purchase | Cash Out Refi |
| Documentation: | Full | None |
| Loan Rate: | 6.000% | 9.875% |
| TMI Premium: | .67% | 1.29% |
Note: Loan is 30-year fixed-rate, property is in California, and lock period is 30 days. Rates are wholesale at zero points as of November 21, 2007, insurance premiums are from the MGIC Rate Finder at that time. Note that rate risk and mortgage insurance premiums have both risen since the table was prepared in November, 2007. In attempting to update the table, we found that the Alt-A loan was no longer being priced, by the market or by MGIC. See the discussion under "Excessive Interest Rate Risk Premiums" below.
The prime loan was to purchase the home as a primary residence with full documentation, whereas the Alt-A loan was to take cash-out by refinancing an investment property with no documentation. The Alt-A loan carried a rate 3.875% higher, and a mortgage insurance premium .62% higher.
We assumed the Alt-A loan went into default followed by foreclosure and calculated losses with a TMI policy. We then used the same default/foreclosure scenario to calculate the losses on an MPI policy with the interest rate reduced to 6%.
We found that the total losses were $23,937 lower with MPI, with the detail shown in Table 2 below. Both insurer and investor share in this loss reduction. The insurer’s cap (maximum loss exposure) is reduced by $5,200 while the investor’s losses are reduced by $18,800.
Table 2
Breakdown of Cost Savings on MPI at 6% Relative to TMI at 9.875%
| Incremental Costs of MPI | |
| Payment Advances, Default to Foreclosure | $28,778 |
| Interest Cost of Payment Advances to Insurer | 805 |
| Total | 29,583 |
| Cost Savings of MPI | |
| Interest Charges Due at Foreclosure | 38,752 |
| Larger Borrower Equity at Default | 8,085 |
| Larger Borrower Equity at Foreclosure | 5,878 |
| Interest Gained on Payment Advances by Investor | 805 |
| Total | 53,520 |
| Net Saving on MPI | 23,937 |
Note: It is assumed that the loan defaults after 36 months, it takes 12 months after default to foreclose and another 12 months after foreclosure to sell the property to a third-party purchaser, house value at foreclosure is 10% lower than at origination, loss on cash flow advances is calculated at 6%, and foreclosure expenses are based on those developed by HUD in Providing Alternatives to Mortgage Foreclosure: A Report to Congress, March 1996.
Our example involved a relatively large rate reduction. Smaller rate reductions generate smaller savings, as shown in Table 3 below. The costs there are calculated in the same way as in Table 2, except that the interest rate on the Alt-A loan, and therefore the rate reduction associated with MPI, takes different values.
Table 3
Loss Reductions on MPI as a Function of Interest Rate Reduction
| Loss Reduction From Using MPI Rather Than TMI | |||
| Interest Rate Reduction | Total Loss Reduction | Loss Reduction to Insurer | Loss Reduction to Investor |
| 3.875% | $23,937 (17.3%) | $5,180 | $18,757 |
| 3.000% | $18,963 (14.2%) | $3,936 | $15,027 |
| 2.000% | $13,014 (10.2%) | $2,449 | $10,565 |
| 1. 000% | $6,755 (5.6%) | $884 | $5,871 |
| 0.500% | $3,501 (3.0%) | $71 | $3,430 |
| 0. 000% | $160 (0.0%) | -$765 | $925 |
If there is no interest rate reduction, MPI will cost the insurer more than TMI, but not much more, and the investor will always incur a smaller loss with MPI.
Excessive Interest Rate Risk Premiums
Note that in moving from the prime loan to the Alt-A loan, the TMI premium rose by only .62% while the interest rate premium rose by 3.875%. The increase in risk premium charged by the lender was more than 6 times larger than the increase charged by the insurer, despite the fact that the increase in risk exposure was substantially higher for the insurer because the insurer is in the first loss position.
Extending our model, loss to the insurer occurs if the property value appreciates by less than 30%, whereas loss to the investor doesn’t occur unless the property value declines by more than 2.5%! The property value has to decline by 35% before the investor’s loss equals the insurer’s loss.
On the assumption that the mortgage insurance premium accurately reflected the losses expected over a long time horizon, the interest rate risk premium was grossly excessive.
Interest rate risk premiums are excessive mainly because they are not reserved and depend on investor sentiment that is heavily influenced by current market conditions – as opposed to long-term actuarial loss experience. When losses escalate, as they have during 2007-2008, the prevailing view is that the interest rate risk premiums charged borrowers in prior years must have been too small, which results in marked price adjustments. Interest rate risk premiums are now substantially larger than they were earlier, and eligibility cutoffs, where loans become unavailable at any price, occur at lower values of risk variables.
This reaction by the market is understandable, perhaps unavoidable in the current environment. But relative to what they would be in a reserving environment, interest rate risk premiums are grossly excessive. In a system in which insurers offer MPI and all borrowers pay the prime rate, the interest rate plus MPI insurance premium paid by non-prime borrowers would be substantially smaller than the interest rate plus TMI insurance premium they pay now.
Will All Mortgages Carrying MPI Be Priced at Prime?
Perhaps the best way to answer this is to place ourselves in the position of a price-setting investor, such as Fannie Mae, and ask the following question: assuming Fannie is willing to price a prime loan at 6% with TMI, should it be willing to take a riskier loan at 6% if it carried MPI and if the insurer’s credit is beyond reproach?
It should. The insurer’s credit is better than that of the prime borrower. Further, in the event of a default, the payments will continue to be made on the riskier loan but not on the prime loan. While the riskier loan will have a higher incidence of default, in the event of default the loss to the investor with MPI is lower. How these balance out is not clear, but if there is any added risk, the coverage can be adjusted to shift it to the insurer, with the borrower paying for it in a higher insurance premium. Any such adjustment would not materially reduce the borrower’s cost saving.
Fixing the System With MPI
An MPI-based mortgage system would eliminate interest-rate risk-based pricing because MPI would be the lowest-cost way to protect against default risk. All loans would have MPI except those that are prime without it, or not insurable. Loan to loan differences in default risk would be reflected in differences in mortgage insurance premiums.
In this system, financing costs to non-prime borrowers would be substantially lower. Further, the system would be much less vulnerable to default crises such as the one we are in now.
Lower Costs to Borrowers: Mortgage insurers assume almost 100% of the default risk under an MPI policy. A very small amount remains because of the cap on insurer liability. Assuming the cap is adjusted to meet investor requirements, the only material risk remaining to the investor is the risk that the insurer itself will fail, as discussed below. Assuming that risk is nil, interest rate risk premiums disappear. Borrowers would pay different mortgage insurance premiums, but they would all pay the prime interest rate.
MPI would cost insurers little more, and in many cases less than their traditional limited insurance. Hence, the total financing cost to borrowers would drop, with the cost imposed on riskier borrowers dropping the most.
The case in tables 1-3 above illustrate how large the savings can be. Assuming the TMI insurance premium of 1.29% in Table 1 is properly priced to meet losses under that policy, it is more than adequate to meet the lower losses under an MPI policy. Hence, the 3.875% rate premium, which investors require when they are protected only by TMI, is redundant if they have MPI.
Further, with all borrowers eligible for mortgage insurance paying prime rates, the potential for predatory practices would be sharply reduced. Elimination of risk-based pricing would eliminate opportunistic pricing of mortgages at the point of sale, which is one of the most important sources of abuse.
In addition, borrowers would have an important ally in the mortgage insurers, who have a financial interest in seeing that borrowers are not over-charged. Higher rates mean greater risk exposure for the insurer. Insurers would have the clout and information needed to protect borrowers because the basic paradigm of insurer/lender relations would be reversed.
Since the private mortgage insurance industry began, it has been beholden to the lenders because lenders select the insurers to whom they refer borrowers. With MPI, lenders and insurers (and by extension, borrowers) would be on a more equal footing because borrowers could go to insurers first knowing that MPI is a de facto loan approval that will allow them to borrow at the prime rate.
Reduced Systemic Vulnerability: With default risk covered by MPI, rather than by a combination of TMI and rate risk premiums, vulnerability to financial crises would be substantially reduced. Today, only TMI premiums are placed in reserve accounts to protect against future losses. With minor exceptions, interest rate risk premiums not needed to meet current losses become investor income. With MPI replacing rate risk premiums, the process of reserving for contingencies would be extended to cover all default risk, not just part of the collateral risk. As a rough order of magnitude, reserves available to meet losses might be ten times larger.
In addition, risk underwriting would shift into more dependable hands. Mortgage insurance companies already offer underwriting to lenders as a service, but with MPI they will do it for all loans except those that don’t qualify for MPI.
In setting underwriting requirements, lenders and investment banks have a short run orientation that can lead to sharp swings in how liberal or restrictive the requirements are. They become excessively liberal when market sentiment is euphoric, as it was during 2000-20006, and then excessively tight when pessimism reigns, as is the case now. This tendency is encouraged by their ability to pass along most default risk to the next party in the chain. Insurers, in contrast, have a long-term orientation because they remain on the hook for a loan until it is repaid or the insurance is terminated.
In addition, by keeping defaulted mortgages performing until they are paid off, MPI would block the contagious erosion of investor confidence that stems from increasing numbers of non-performing loans. This has been a central feature of the current crisis.
A Gaming Analogy: Imagine a world where all home mortgages are placed in securities, of which there are two types. Both promise to pay the investor the prime rate, but protect them in different ways. On an RRP security, borrowers pay interest rate risk premiums, which are placed in a reserve fund, with each security having its own fund. On an MPI security, protection is provided by MPI policies on all the mortgages.
Make the following assumptions: Every security faces a market environment that is determined by a single twirl of a roulette wheel, which has 15 slots, 14 of them blue and one red. If blue comes up, as it will 93.3% of the time, the environment is one in which house prices increase by 5% a year for the life of the security, and investors lose 1/10 of 1% of loan balances. If red comes up, as it will 6.7% of the time, prices will decline by 5% a year for 4 years before leveling out, and losses will be 6% of loan balances.
In this world, the reserve needed by insurers to cover losses of .10% on 93.3% of the loans they insure, and losses of 6% on 6.7% of them is about .50%. Their premium will be about twice this, or 1%. When an MPI security comes up red, they have the reserves to meet the claims.
In contrast, every RRP security stands on its own. For investors to be fully protected against the possibility that the roulette wheel comes up red, the reserve must be 6% on every security. This is too high to be workable. But RRP securities may nonetheless be created if MPI securities are not available.
If borrowers were charged a risk premium of, say, 3%, the RRP security would be extremely profitable for all concerned 93.3% of the time. If the wheel comes up blue 6 times running, which with our assumed probabilities will happen about 66% of the time, issuers and investors may come to believe the wheel has been fixed so that only blue comes up – a phenomena that Guttentag and Herring referred to as "disaster myopia". [See Upheaval in the Sub-Prime Mortgage Market] If the agencies that investors depend on to tell them whether or not a security is safe share the myopia, basing their analysis on the last 6 turns of the wheel, the stage is set for disaster when the wheel comes up red. This is a pretty good description of what actually happened during 2000-2007.
The gaming analogy illustrates very well why interest rate risk premiums are both two large and too small. They are too large in the sense that most of the time they far exceed what is needed to meet losses, and they are too small in the sense that they are inadequate to meet losses when a default crunch does occur.
Fixing the Crisis With MPI
MPI could be used right now to reduce the number of foreclosures, and reduce losses on the foreclosures that occur. The appropriate treatment varies with the situation, as follows:
*Loans in default that carry TMI.
*Loans in default that do not have TMI.
* Purchase loans & high-rate existing loans in good standing.
*Existing loans in good standing with negative equity
Loans in Default That Carry TMI: We estimate that there are about 600,000 loans now in default that carry TMI. Case-by-case efforts to modify these loans will make only a tiny dent in the total. There are major impediments to such modifications (see Foreclosures That Shouldn’t Happen But Do), and even when these impediments are removed, the process is costly and time-consuming. MPI makes possible wholesale modifications covering large numbers of loans that are in the interest of all parties - insurers, investors, borrowers and servicers.
If loans in default carry TMI, the insurer is already on the hook for the coming loss, up to the cap on the policy. If the net proceeds from sale of the property do not cover the unpaid balance including accrued interest plus foreclosure expenses, the investor is protected up to the cap amount for any deficiency.
In more normal conditions, deficiencies in coverage seldom arise. In the current market, however, house price depreciation has made deficiencies the rule rather than the exception. Under these circumstances, the deal using MPI shown below will make both the insurer and the investor better off. In the process, a significant number of borrowers will be saved from foreclosure.
Existing TMI policies are converted to MPI at the currently prevailing prime interest rate, provided that the monthly mortgage payment declines by10% or more.
The major benefit arises when the payment reduction resulting from the rate reduction allows the borrower to return to good standing. Everyone – borrower, investor, insurer and servicer - are better off. The downside to the investor is that some of these loans may cure themselves without the investor having to reduce the interest rate. After some extensive modeling, we have determined that "losses" to the investor from this source would be much smaller than the gains from loans that return to good standing that would not have cured themselves.
Loan servicers acting for themselves, as opposed to their actions as agent of the investor, have a self-interest in making the package deal described above because the resumption of payments under MPI also means a resumption of servicing fees. Most loans are serviced under contract with investors, with servicing fees paid as a withdrawal from monthly payments. When borrowers stop paying, servicing fees stop. As payments on loans in default resume under MPI, servicing fees resume.
Loans in Default That Do Not Have TMI: When loans in default do not carry TMI, the investors are on the hook for the entire loss. The insurer will not assume the risk except as a new loan that meets its underwriting requirements, and carrying an MPI insurance premium scaled to the risk. These deals must be done one at a time.
To meet its requirements as an insurable loan, the insurer will require the investor to write down the loan balance to 90% or 95% of current property value, and reduce the interest rate to the prime rate. If there is a second mortgage, the investor will have to negotiate a payoff with the second mortgage lender.
The investor would take a loss on the modification, but it would be far smaller than the loss that would have resulted from foreclosure of the original loan. The investor might also receive an equity certificate equal to the write-down of the balance (or balances, if there is a second lien), which would entitle it to a share of the future appreciation in the value of the house.
The borrower gets a new start with 5% or 10% equity, no unpaid interest, and a reduced payment based on the lower rate. Because the payment reduction will be partly offset by a new mortgage insurance premium, this plan will work best with higher-rate mortgages.
The insurer gets an MPI policy which it has underwritten as a piece of profitable business.
This application of MPI to loans that do not now have TMI is very similar to the proposed "FHA Housing Stabilization and Homeownership Retention Act of 2008" (HR5830), which would authorize FHA "to insure refinance loans for substantial numbers of borrowers at risk of foreclosure…" The essentials – writing down the loan balance, providing the existing investor a claim on future appreciation, and re-underwriting the loan – are the same. But there are some major differences:
*HR5830 stipulates some detailed conditions including underwriting requirements designed to protect FHA against excessive losses, such as maximum debt to income ratios. The Act is full of such rigidities, which may result in no or limited response by the private sector. MPI underwriting rules and conditions, in contrast, will be formulated by the private insurers in consultation with the investors who will be acquiring the new loans.
*HR 5830 would create a new Federal administrative infrastructure (an "Oversight Board") with heavy responsibilities related to determination of fees, underwriting rules, insurance premiums, and the like. The Board would be drawn from the Treasury, Federal Reserve Board, and HUD. There is no time limit in HR 5830 for establishing the Board. The MPI plan, in contrast, would use the existing private infrastructure.
*Under HR5830, the Federal Government assumes direct insurance liability for every mortgage written. With the MPI plan, private insurers would assume this liability, with the Federal Government’s role limited to that of re-insurer. This is discussed below.
Purchase Loans and High-Rate Existing Loans in Good Standing: Insurers will offer MPI on new purchase loans as a way to generate income and bolster reserves. For non-prime deals, the terms will be far better than those available in the current market. More precisely, the insurance premium that non-prime borrowers will have to pay will be much smaller than the sum of TMI premiums and interest rate risk premiums they now pay.
Insurers will also offer MPI to existing borrowers who currently pay high rates and have enough equity to meet underwriting requirements.
The Role of Government in Fixing the Mortgage Mess
The major argument of this paper is that MPI, in addition to making a less-vulnerable and more borrower-friendly housing finance system, could help fix the current mortgage mess. MPI would reduce 1) the number of foreclosures, 2) investor losses on loans that do foreclose, and 3) financing costs to non-prime borrowers.
For existing loans with TMI that are in default, converting a TMI policy into an MPI policy should be no problem. Investors, insurers and borrowers will be better off than they are now. But on new loans, there is a potential problem connected to the acceptability of private mortgage insurance.
The core benefit of MPI, the elimination of interest rate risk premiums at little or no cost to the insurer, will materialize only if investors have complete confidence in the insurers. That would not have been a problem 2 years ago, when all the companies were rated AA or AAA. It is a problem today because the insurers have been weakened by their large payouts on foreclosed loans, and they have all been down-graded by the rating agencies.
To make MPI work with maximum effectiveness, insurers need an option to purchase reinsurance from GNMA, a wholly owned Federal agency, which would commit to make the mortgage payments if the private insurer cannot. This is the same type of guarantee that GNMA now provides on securities issued against pools of FHA and VA mortgages.
GNMA has charged 6 basis points for its guarantee, and it has been a consistent source of profit for the Government from the beginning. We would expect a similar guarantee fee on privately insured loans, and a similar experience. GNMA’s reinsurance would come into play only if the private insurer went broke.
There is no reason why a benefit directed to one industry should be permanent, and once the market has been normalized and the insurers have rebuilt their reserves, there should be no further need for it. A good way to minimize the support period is to build automatic premium increases into the program. This would provide a strong incentive for the insurers to rebuild their capital as quickly as possible.
With MPI backstopped by GNMA, investors including the Federal agencies Fannie Mae and Freddie Mac, and investment banks that purchase mortgages not eligible for purchase by the agencies, will pay a price based on the prime rate. Since borrowers will know what the prime rates are, the lenders who sell to the secondary market, and the brokers who feed loans to lenders, will compete on their markups over the prime rate, and on service.
Why should the Federal Government provide special support to the mortgage insurance industry? The major reason is that it will turn the market around at a critical juncture, while initiating a reform process that will make the entire housing finance system less vulnerable and more equitable in the future.
The proposed Government support is not an industry bailout. The probability that the contingent liability assumed by GNMA will ever cost the Government anything is very small.
Indeed, the proposed role for Government could more accurately be viewed as a bailout prevention measure. It will eliminate the need for the more extensive Government support that will become unavoidable if the situation deteriorates further.
Concluding Comment: Recommendations For Federal Legislation
To encourage private mortgage insurers to offer and investors to accept MPI on new loans, we recommend that Congress pass Federal legislation enabling the Government National Mortgage Association (GNMA) to re-insure private mortgage insurers that issue MPI. The GNMA guarantee should cover all payments (including the final payment) due the investor pursuant to the MPI policy in the event that the private mortgage insurer fails to pay.
The GNMA guarantee should be made available only to new MPI policies issued by any private mortgage insurer on owner-occupied principal residences.
GNMA should be paid a guaranty fee of about .06% of the loan balance per year on all mortgages that it guarantees. The guaranty fee should not change once the loan has been originated, but should rise after about three years, and periodically thereafter, on newly issued MPI policies. In the event insurance is terminated by the borrower under the Homeowners Protection Act of 1998, or under provisions for termination of Fannie Mae or Freddie Mac, GNMA should no longer be paid the guaranty fee.
If an insurer at some point elects to forego a GNMA guaranty on new loans carrying MPI, outstanding loans should retain the guaranty and GNMA should continue to receive the guaranty fee on those loans.
Mortgage insurers eligible for the GNMA guaranty should be licensed to do business in all 50 states, and should be eligible to insure loans acceptable to both Fannie Mae and Freddie Mac. Eligible insurers also should have programs in place acceptable to the Federal Reserve Board for a) the wholesale conversion to MPI of loans in default on which they currently have insurance, and b) new loan programs using MPI covering purchase loans and refinances, including refinances of loans currently in default that do not now have mortgage insurance and that require contract modifications by investors to become eligible for MPI.