Mortgage insurance cheaper under new plan

Part 3: Fixing the housing finance system

(This is Part 3 of a five-part series. Read Part 1, "Lenders wise to beef up default-risk reserves"; Part 2, "Borrowers, insurers would save with new mortgage insurance"; and Part 4, "Help from feds not a bailout"; and Part 5, "Struggling borrowers get fresh start under new plan.")

Last week, I described a new type of mortgage insurance called mortgage payment insurance, or MPI. MPI covers cash-flow risk as well as collateral risk, as opposed to traditional mortgage insurance (TMI), which covers only collateral risk.

Cash-flow risk is the risk of an interruption in the scheduled payments from the borrower to the investor. Collateral risk is the risk that proceeds from foreclosure sale will not be sufficient to pay off the loan balance and reimburse the investor for foreclosure expenses.

Under MPI, the insurer would guarantee timely receipt of the payments, so that the investor continues to get the payments after the borrower defaults. 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.

The incredible thing about MPI is that it will cost the insurer little more than the cost of TMI, and in many cases it would cost less. Here is an example based on wholesale price quotes covering two loans as of Nov. 27, 2007, when the market was less unsettled than it is today. Both loans were for $400,000 with 10 percent down on a single-family home in California, to a borrower with a 700 FICO score.

The prime loan was to purchase the home as a primary residence with full documentation. The interest rate was 6 percent and the TMI premium at 25 percent coverage was 0.67 percent. The risky loan was a cash-out refinance on an investment property with no documentation. The rate was 9.875 percent and the TMI premium at 25 percent coverage was 1.29 percent. The risky loan thus paid a rate 3.875 percent higher, and a mortgage insurance premium 0.62 percent higher.

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We assumed the risky loan went into default followed by foreclosure and calculated the loss to the insurer with a TMI policy. We then used the same default/foreclosure scenario to calculate the loss on an MPI policy with the interest rate reduced to 6 percent. Since the insurer assumes all the default risk with MPI, the rate-risk premium should disappear.

We found that the insurer’s losses were actually lower with MPI than with TMI. While the insurer made payment advances, the advances simply prepaid the amount due at foreclosure dollar for dollar. And because of the lower interest rate with MPI, the loan balance and the unpaid interest due were lower, reducing the loss. The insurer did lose the interest it could have earned on the payment advances, but this was much smaller than the reduction in the amount due.

The potential of MPI to reduce the cost to borrowers who are less than prime, which is most of them, is mind-boggling. Assuming the TMI insurance premium of 1.29 percent in my example 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 percent 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.

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. Interest-rate risk premiums, if 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 collateral risk.

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.

Lenders and investment banks tend to extremes, becoming excessively liberal when market sentiment is euphoric, and then excessively tight when sentiment shifts. This tendency is encouraged by their ability to pass along most default risk to the next party in the chain. Insurers, by contrast, have a long-term orientation because they are on the hook for a loan until it is repaid or the insurance is terminated.

In addition, by keeping mortgages in good standing until they are paid off, MPI would block the contagious erosion of investor confidence that stems from increasing numbers of nonperforming loans. This has been a central feature of the current crisis.

Next week: What is needed from government to make MPI work?

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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