(This is Part 4 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 3, "Mortgage insurance cheaper under new plan"; and Part 5, "Struggling borrowers get fresh start under new plan.")
In previous articles, I described 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 which point the investor is reimbursed for the unpaid balance plus foreclosure costs.
Under an MPI policy, mortgage insurers assume all of the default risk except the small amount associated with caps on coverage, and the risk that the insurer itself will fail, as discussed below. Assuming the caps are adjusted to meet investor requirements, and that insurer solvency is not at issue, 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.
A system based on MPI would be much less vulnerable to serious default episodes, such as the one we are in now. More reserves would be available to meet the losses that occur, reducing the erosion of investors’ capital. Underwriting would shift to insurers who have a long-run orientation and are not caught up in short-term swings in market sentiment. Keeping defaulted mortgages in good standing until they are paid off would moderate the contagious erosion of investor confidence that stems from rising numbers of nonperforming loans.
But there is a problem in getting there from where we are now. The core benefit of MPI is the elimination of interest-rate risk premiums at little or no cost to the insurer, but that will happen only if investors have complete confidence in the insurers. That would not have been a problem two 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 downgraded.
The program needed is an option for insurers 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. I 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.
With MPI backstopped by GNMA, insurers would be positioned to reduce borrower costs on new purchase loans and refinances. They will also be able to use MPI effectively to modify contracts on loans currently in default, reducing the number that go to foreclosure.
These programs will be discussed in more detail in the last article of this series next week.
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.
It is not an industry bailout — the probability that the contingent liability assumed by GNMA will ever cost the government anything is very small. Indeed, it could more accurately be viewed as a bailout prevention measure, eliminating the need for the more extensive government support that will become necessary if the situation deteriorates further.
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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