(This is Part 2 of a five-part series. Read Part 1, "Lenders wise to beef up default-risk reserves.")

The first article in this series pointed to a serious weakness in the way the mortgage system deals with default risk. Interest-rate risk premiums collected from borrowers that are not needed to meet current losses are paid out as income to investors and not reserved to meet future losses.

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

The first article in this series pointed to a serious weakness in the way the mortgage system deals with default risk. Interest-rate risk premiums collected from borrowers that are not needed to meet current losses are paid out as income to investors and not reserved to meet future losses. Because major default episodes occur infrequently, perhaps every 12 to 15 years, the system is never adequately prepared for one when it happens. It certainly was not prepared for the one we are now in.

The remedy for this systemic vulnerability is to reserve a much larger portion of the risk-based dollars paid by borrowers. This article explains how to do that.

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 nonperforming 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.

On conventional loans (those not insured by FHA or VA), investors pass the cost of both risks to borrowers. The major charge is an interest-rate risk premium — the greater the perceived risk, the larger the premium. On low-down-payment loans, lenders can also require borrowers to purchase collateral-risk insurance from private mortgage insurers (PMIs).

PMIs place roughly half of all the premiums they collect in reserve accounts. Rate risk premiums, on the other hand, are not reserved to any significant extent.

The vulnerability of the system could be reduced by extending the reserving principle to cover both collateral risk and cash-flow risk. The best way to do this is to have private mortgage insurance policies cover both types of risk, with the borrower paying a single mortgage insurance premium. The insurers would reserve a major part of the premiums, as they do now on policies that cover only collateral risk.

We call this new type of insurance "mortgage payment insurance," or MPI, recognizing that it covers both collateral risk and cash-flow risk. Traditional mortgage insurance, or TMI, covers only collateral risk.

Under MPI, the insurer would guarantee timely receipt of the payments so that the loan remains in good standing 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.

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.

The incremental cost of MPI above the cost of TMI at worst is very small. That’s because one way or another, the insurer ultimately gets back all of the payments it advances. If the loan returns to good standing, the insurer will be reimbursed for the advances it made. If the loan defaults, the advances will reduce — dollar-for-dollar — the bill the insurer has to pay after foreclosure.

And here is the kicker: Since MPI removes the risk premium from the interest rate, the interest rate will be lower, and this reduces cost to the insurer. 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 that the insurer must pay when a loan is foreclosed. In many cases, the interest-rate reduction will cause MPI to cost the insurer less than TMI.

This is a mind-boggling insight, which I can write without blushing because it is not mine. The insight is Igor Roitburg’s, although I have verified it. I have been working with Roitburg to develop MPI since he approached me with the idea last year.

In the following weeks I will explain how MPI can protect the system against future default crises, reduce costs to borrowers, AND help get us out of the current mess.

Roitburg has a patent pending for MPI in which I have an interest.

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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