The Washington Post
The Players Who Stayed Clean
By Jack Guttentag
August 2, 2008
There's plenty of blame to go around for the mortgage crisis. But one sector of the business has escaped much of that blame, largely because it continued to act prudently when others didn't. That's private mortgage insurance.
To review, here are some of the other players and the mistakes they made:
- Lenders and investment bankers drastically relaxed their underwriting standards in response to the euphoria associated with rapidly rising home prices from 2000 to 2006. They approved loans that could not possibly be repaid without an indefinite continuation of house-price inflation.
- Bank regulators ignored the breakdown of underwriting standards until it was much too late to take effective action.
- Mortgage brokers and loan officers encouraged borrowers to buy more house than they could afford and to accept toxic mortgages that they did not fully understand.
- Consumers allowed themselves to be seduced into buying houses they couldn't afford, into buying second and third homes on speculation, and into depleting their equity through cash-out refinances to maintain lifestyles they could not sustain.
- Rating agencies provided AAA and AA ratings to securities issued against pools of new types of extremely risky loans when they had no adequate statistical basis for estimating potential losses on the loans.
- Fannie Mae and Freddie Mac invested in such securities, taking large losses and weakening their capacity to be sources of strength during the crisis.
- The Federal Reserve kept interest rates low well past the point at which it should have raised them, and as a regulator was asleep at the same switch as all the other regulatory agencies.
Since the late 1950s, the private mortgage insurance industry has enabled borrowers to obtain conventional loans—those not insured or guaranteed by the federal government—with down payments of less than 20 percent. Insurance premiums were scaled to down payment: The smaller the down payment, the higher the premium.
Private mortgage insurance companies must place half of their premiums in contingency reserves that can't be touched for 10 years except to meet unusually large losses. This encourages the companies to set premiums based on estimates of losses over long periods, so premium rates seldom change. And it severely dampens the temptation to make a lot of money in a short time by taking advantage of ebullient markets. Private mortgage insurers can't pay themselves premiums net of losses in the current year, as most lenders and investment banks can.
The private mortgage insurers did not fully participate in the euphoria and excess that preceded the crash. They did insure some risky loans that would not have been acceptable to them earlier, but for the most part they stuck to their guns. As a result, their market share declined with the emergence of "piggyback loans."
Lenders discovered that they could make 95 percent and even 100 percent loans by getting other lenders to offer second mortgages for the amount over 80 percent of property value. Piggybacks carried higher rates than the first mortgages, but in many cases, the cost to the borrower was smaller than the cost of mortgage insurance. The interest on piggybacks was deductible, whereas mortgage insurance premiums were not. In addition, borrowers could pay off the second mortgages in full at any time, while getting rid of private mortgage insurance was a hassle.
Of course, the mortgage insurers did not give up market share willingly. They induced Congress to make mortgage insurance premiums deductible, at least for a time, but this had only a small impact.
Had mortgage insurers followed the prevailing pattern during the go-go years, they would have cut their insurance premiums sharply and gone after the riskier loans. But they didn't, and the piggyback market thrived until the crisis hit. At that point, the market got a lesson in the value of private mortgage insurance. First-mortgage lenders discovered that piggybacks provided substantially less protection against loss than did mortgage insurance. As home prices declined and the crisis grew, a large proportion of piggybacks lost all or almost all their value, and the piggyback market has all but vanished.
Borrowers experiencing payment problems discovered that having to deal with two lenders was a substantial barrier to getting loan contracts modified. In contrast, mortgage insurers will often help borrowers negotiate modified contracts with first-mortgage lenders.
Nonetheless, the mortgage insurers have been badly hurt. Losses have been eroding their capital and reserves, and their stock prices have tumbled. Yet the industry is doing exactly what it was set up to do: to cover losses to lenders during a period of stress, out of reserves that they accumulated during periods of prosperity. The industry should play a more prominent role in the very different housing finance system that emerges in the future.
Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site,http://www.mtgprofessor.com.