The main objective of our proposal is to break the back of the financial crisis by sharply reducing mortgage foreclosures while liquefying a major part of the existing mortgage stock. A second purpose is to provide the foundation for a more stable housing finance system in the future.
Proposal For Mortgage Payment Insurance
Mortgage Payment Insurance (MPI): Our proposal is centered on a new type of mortgage insurance called Mortgage Payment Insurance (MPI).Under MPI, a private mortgage insurer (PMI) guarantees that investors will continue to receive scheduled payments of interest and principal on time following a borrower default. If the default is not corrected, payments from the insurer continue until the foreclosure process is completed. At that point the investor is reimbursed for the unpaid balance plus foreclosure costs.
MPI differs from traditional mortgage insurance (TMI) in protecting against cash-flow interruptions as well as losses from foreclosure. In contrast to TMI, the MPI program proposed here to deal with distressed mortgages has 100 percent coverage, with part of the coverage provided by the government. The purpose is to restore market confidence. A second MPI program designed for new loans has exposure caps similar to those of traditional mortgage insurance, with no government exposure.
Loan Level Versus Security-Level Insurance: The proposed plan for MPI operates at the individual loan level. The plan will make use of the existing actuarial risk-based pricing and loan underwriting capacities of the PMI industry. The provision of insurance, and the modification of loan contract terms to make them affordable to borrowers, would be part of a single process.
The alternative approach of providing insurance at a portfolio or security level appears simpler, because one policy could replace a thousand, but appearances are deceiving. After insuring a security, the individual loans in distress must still be dealt with one by one, and incentives for the servicer/investor to modify contracts in order to avoid foreclosure, which are already too weak, would disappear entirely once the portfolio or security is insured. Payment insurance on a security or portfolio is thus similar to the asset purchase program in that both have a messy and politically charged phase two where government must assume responsibility for contract modifications.
Required Government Support: To make a significant portion of the existing mortgage stock eligible for MPI, mortgage balance write-downs are needed, part of which will have to be provided by government. We call this the "government advance." The purpose of the government advance is to increase the financial incentive to modify loans instead of foreclosing on them. However, a significant part (if not all) of the write-down cost will be recoverable from borrowers in the future. This is discussed below.
To make loans insured by PMIs marketable in the current economic climate, government will also have to assume reinsurance risks on MPI. However, government will receive a piece of the insurance premium paid by borrowers, most of which should turn out to be profit.
Plan for Dealing With Distressed Mortgages: With permission of the borrower, investors will be given an opportunity to obtain MPI on any owner-occupied home mortgages they own. To qualify for MPI, the balance of the mortgages will have to be written down to 90 percent of the current property value, but the government advance will cover 10 percent of the reduction. If the loan has a second lien, the government advance will cover 12 percent, with the investor responsible for removing the second lien. If a loan has an existing TMI policy, the investor and the PMI will negotiate the share of the write-down assumed by each.
The government advance will be secured by a second lien owned entirely by the government. The lien will be non-interest-bearing for the first five years, after which it will accrue interest at a rate set by the government. The lien must be repaid on sale of the property, or after 10 years if the property has not been sold. The payment will be for the amount owed, or 50 percent of the appreciation of the property from the value stipulated in the MPI policy, whichever is less.
The MPI provided under the proposed program will carry full faith and credit reinsurance by the government National Mortgage Insurance (GNMA), which will assume responsibility for payments in the event of a PMI failure. To encourage PMIs not to be overly restrictive in their underwriting, for three years the government will absorb the first 10 percent of loss on all claims. The PMI's liability would be 40 percent of the loss, after the 10 percent paid by the government. Government will also take the last 50 percent of loss. GNMA will receive a reinsurance premium of 20 basis points.
The interest rate on the modified loan will be the lower of a) the existing rate; b) the rate that will make the new payment including the insurance premium equal to the existing payment; c) the rate that will make the new payment plus taxes, insurance and other debt service 38 percent of the borrower's income; and d) the 10-year Treasury constant maturity rate plus 1 percent.
With MPI, the investor is fully protected against the risk that a contract modification will be followed by a default. Hence, no special program is needed to deal with this problem.
MPI offered by PMIs at market terms is a logical and extremely economical extension of traditional mortgage insurance (TMI). While MPI provides much more valuable protection to investors than TMI, in most cases it will cost insurers less, and therefore should not result in higher insurance premiums.
PMIs play a central role in the program, since they will be responsible for:
- Determining the new interest rate, following the rules stipulated above.
- Establishing actuarially based insurance premiums to be paid by the borrower.
- Assuring that the borrower has provided informed consent to the transaction.
- Obtaining the appraisal upon which the new loan balance is based.
The parameter values cited above are subject to modification. They are as follows:
Maximum new balance as percent of current market value: 90 percent
Government write-down as percent of current market value: 10 percent
With second lien: 12 percent
Interest rate on lien (first five years): 0 percent
Interest rate on lien (after five years): to be determined
Percent of appreciation: 50 percent
Period until repayment is due: 10 years
Government's reinsurance liability
First loss position: 10 percent
Period: three years
Last loss position: 50 percent
Modified interest rate
Maximum expense-to-income ratio: 38 percent
Spread over Treasury 10-year rate: 1 percent
MPI on New Loans: Coincident with the program for dealing with distressed mortgages, PMIs with support from Fannie Mae and Freddie Mac may offer MPI on new purchase loans and refinances as part of a program to stimulate economic recovery and strengthen the housing finance system. This MPI would have a coverage cap acceptable to the agencies, on the order of 30-35 percent depending on the loan type and other factors.
Since this program will not carry any government reinsurance, we expect that Fannie Mae and Freddie Mac will be the major purchasers in the short term. To make the program go, the agencies must commit to purchase these loans at their lowest posted rates. This is consistent with the long-term interest of the agencies, whether they become government agencies, are fully privatized, or revert back to their previous mixed status.
A major reason that the GSEs should support MPI is that MPI will sharply reduce the systemic vulnerability of the housing finance system. Since it is now completely clear that the GSEs cannot separate their own fortunes from those of the system, they have a vital stake in how the system evolves in the future.
Further, MPI would eliminate the need for risk-based pricing by the GSEs, which creates needless controversy. All risk-based pricing would be done by PMIs. In addition, by increasing the premium income of PMIs, MPI would help them ride out the crisis, reducing the need for the agencies to cope with further downgrades and possible failures
Strengthening the System:The proposed plans for MPI will provide the foundation for a more stable housing finance system in the future. Insurers will allocate about half of their insurance premiums to contingency reserves, as they do now on loans carrying TMI. Contingency reserves cannot be touched for 10 years unless there is an emergency. In addition, PMIs take all or virtually all the default risk other than that assumed by the government, eliminating the practice of shifting the risk to parties far removed from the point where risk decisions are made.
The Cost of Mortgage Payment Insurance
Investors in mortgages face two kinds of default risk. 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.
It is natural to assume that since MPI covers both the cash-flow risk and the collateral risk, the required mortgage insurance premiums would be substantially larger than those on TMI. In fact, more often than not they are smaller, and when they are larger, they are not much larger!
This astounding fact stems from two sources. The first is that insuring against cash-flow risk and collateral risk in combination is incredibly efficient. All of the payments the insurer advances in its role as cash-flow insurer are simply prepayments - dollar for dollar - of the ultimate amount they must pay at foreclosure in their role of collateral risk insurer. The only net loss to the insurer is the interest opportunity cost on the funds advanced, which turns out to be small.
The second reason that MPI premiums are so small is that, by assuming all the default risk instead of just a piece of it, MPI eliminates interest-rate risk premiums, and lower rates reduce losses 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.
Creating a More Stable Housing Finance System
Extending the Reserving Principle: Borrowers today pay for default risk in two ways. The first and larger charge is to impose a risk premium in the interest rate. The risk premium is a rate increment above that charged on a "prime" transaction, which carries the lowest risk. The greater the perceived risk, the larger the premium.
A weakness of the interest-rate risk premium system is that, with few exceptions, risk premium dollars not needed to cover current losses are realized as income by investors. They are not reserved and available to meet future losses. This is a serious limitation because losses tend to bunch.
For example, interest-rate risk premiums collected on loans originated in 2000 had very low losses because of the marked appreciation in house prices in subsequent years. Most of the risk premiums collected on these loans became investor income. Loans originated in 2006, in contrast, had large losses but none of the excess premiums from the 2000 vintage were available to help meet those losses.
Another weakness of the interest-rate risk premium system is that premiums are based not on long-run actuarial loss experience but on the return investors require to compensate for the risk of "going broke." These are substantially higher than premiums based on actuarial experience. Yet in the absence of reserving, interest-rate risk premiums are never high enough to meet the losses that occur in a crunch, such as the one we are in now.
In addition, interest-rate risk-based premiums along with underwriting requirements can change markedly over short periods with changes in market sentiment. They ease during periods of euphoria such as 2000-2005, and then sharply reverse course when sentiment changes, as in 2006-2008.
The second method of charging borrowers for default risk is to charge a mortgage insurance premium. Today, borrowers may be required to purchase mortgage insurance if their down payment on a home purchase, or their equity in a refinance, is less than 20 percent.
In contrast to interest-rate risk premiums, more than half of the mortgage insurance premiums collected from borrowers are placed in contingency reserves that cannot be touched for 10 years except in an emergency. The reserves that accumulate during long periods when losses are small are available when a foreclosure crunch comes - as right now.
The reserving process requires mortgage insurance companies to view expected losses over a long time horizon. While premium structures change over time, such changes are based on revised estimates of losses over long periods, rather than on short-term swings in market sentiment.
The upshot is that a mortgage system in which borrower payments for risk are reserved is more stable, and the average premium paid by borrowers is much lower, than one in which borrower payments are divided between current losses and income. Unfortunately, for every risk-based dollar paid by borrowers today that is subject to reserving, they pay 10 or more risk-based dollars that are not subject to reserving. Adoption of MPI would tend to move the system in the direction of greater reserving.
Eliminating the Agency Problem: In discussions of the current crisis, one feature of the existing housing finance system that has been much commented upon is that the parties making risk decisions are not the parties that end up assuming the risk. This is what economists term an "agency" problem, where one party (the agent) is supposed to act in the interest of another (the principal), even though their interests are not the same.
Various techniques have been developed to assure that the actions of the agent are consistent with the interests of the principal. For example, when loan originators sell loans, the purchaser often has the right to sell them back if they don't meet the principal's requirements. The problem is that these mechanisms don't always work the way they are supposed to, and during a period of euphoria in the market, such as we experienced during 2000-2005, they may not work at all.
MPI eliminates the agency problem in connection with default risk. The PMI underwrites the loan, and the PMI assumes all or virtually all of the risk.
Igor Roitburg is president at New York-based RCC Real Estate Group LLC, a commercial real estate company. He is former land acquisition manager and corporate counsel for builder Toll Brothers.
Jack Guttentag 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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