| March 9, 1999, Reviewed
November 29, 2007
Competition in the market for
mortgage insurance is perverse, in that it is not directed at the
borrowers who buy the insurance. Rather, it is directed at the
lenders who select the insurer, which has the effect of raising
costs to the insurer and premiums to the borrower.
"I realize that since I
don't have the cash to make a 20% down payment, I must purchase mortgage
insurance, but I was flabbergasted to discover that I couldn't shop for it. The
loan officer said that the lender selected the insurer, and it didn't matter
anyway because all the mortgage insurance companies charged the same insurance
premiums. Is that right? Is there no competition in this market?"
The loan officer is largely right
on the futility of shopping for mortgage insurance. While you could insist on
selecting the insurer, there isn't much point to it because the premiums charged
by different companies are either identical or so close that the difference
wouldn't pay you for the trouble.
Competition in the Mortgage insurance Market Is Perverse
There is competition in the
mortgage insurance market, but it is the kind that raises prices rather than
reducing them. Some economists call this "perverse competition".
Perverse competition arises in
markets where the consumer purchasing a big-ticket item from A must also
purchase a smaller item from B, C or D, and A is in a position to direct or
refer the buyer to one of them. Since B, C and D can get access to the consumer
only through A, they
compete among themselves for A's favor in ways that raise their costs, and hence
prices to the consumer.
This is exactly how the mortgage
insurance industry works. (It also describes the title insurance industry, see
Is
Title Insurance Overpriced?). The
consumer pays for the insurance, but ordinarily has no direct contact with the
insurer. All merchandising by the insurers is directed toward lenders. So long
as they can't be accused of steering their customers to an insurer that charges
more than another insurer, lenders are largely indifferent to the price charged
the consumer. Their goal is to profit from their strategic position as a
referral source. Competition by the insurers for referrals of business generates
benefits for lenders, not consumers.
Referrals
to Mortgage Insurers
Lenders are not paid directly for
referrals of mortgage insurance business. Under The Real Estate Settlement
Procedures Act of 1974 ("RESPA"), referral fees are illegal. But there
is more than one way to skin a cat. Mortgage insurers have always provided
services of one sort or another to lender-customers, free or at bargain prices.
In recent years, an increasing number of lenders have established captive
mortgage reinsurance affiliates which have no other purpose but legitimizing
referral fees. "Performance notes" sold by insurers to lenders that
carry very attractive yields (15% or higher) serve the same purpose.
The Department of Housing and Urban
Development (HUD), which must administer RESPA, has set up elaborate rules
regarding both of these devices that lenders must follow to avoid violating the
law. These rules don't help the consumer. On the contrary, they legitimize the
practice of concealing referral fees, while raising the cost of receiving them.
So long as consumers are the ones paying for mortgage insurance, they probably
would be better served if referral fees were legal and open for all the world to
see, and lenders were not forced to incur significant expense to collect them.
For elaboration of this argument, see
Questions About
Mortgage Referral Fees.
Reducing Mortgage Insurance Premiums
But the best remedy by far is to
eliminate perverse competition by requiring that mortgage insurance be paid for
by the lender. This rule would immediately drive down mortgage insurance
premiums, since insurers would then be obliged to compete in terms of premiums
rather than referral fees. It would eliminate the costly charade of converting
referral fees into something that doesn't look like a referral fee. And it would
end the contentious issue of when, and under what circumstances, consumers can
cancel their mortgage insurance. If lenders buy the insurance, cancellation
becomes an issue between the lender and the insurer, which is where it belongs.
To be sure, if lenders buy the
mortgage insurance, they will pass on the cost to consumers in the rate, but
that's OK. The premiums added to the rate will be lower, and borrowers can shop
for rates. Furthermore, the rate increase that the lender tacks on to cover the
cost of insurance is deductible to the borrower, where a mortgage insurance
premium paid by the borrower is not. In contrast to most
"pro-consumer" rules in the home loan market, which raise costs to
lenders but accomplish little else, this rule would confer immediate and
measurable benefits.
Copyright Jack Guttentag
2007
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