The Mortgage Professor
Mortgage Insurance Reserves: A Lesson in Managing Risk
An enormous amount of ink has been spilled on the mortgage market crisis, and I have contributed my share. Yet I am now convinced that the most important factor underlying the crisis has been overlooked, even though it has been in plain view all along.
It is the way in which the mortgage industry manages default risk.
There are two systems for doing this. In both, the borrower pays a premium that is scaled to estimated risk of the transaction. But, while one system has worked well, the other has been a disaster.
The system that has worked well is mortgage insurance. Borrowers purchase mortgage insurance if their down payment on a home purchase or their equity in a refinancing is less than 20 percent. Mortgage insurance covers a lender's losses up to an agreed-upon amount.
The seven companies that sell mortgage insurance place more than half of every premium dollar they collect from borrowers in reserve accounts. This is mandated by law. The well-founded premise is that mortgage losses tend to bunch during major periods of default, which occur about every 12 to 15 years. The reserves accumulate during long periods when losses are small, then are available when a crunch finally comes -- as it has now.
The stocks of these companies have taken a hammering, but their capital has remained intact. All losses have been paid out of reserve accounts accumulated for that purpose.
This is in sharp contrast to the rest of the system, where losses have depleted enormous amounts of capital. The mortgage insurers are doing the job for which they were chartered.
The second system, and unfortunately the larger of the two, is to charge borrowers a risk premium in the interest rate. The risk premium can be viewed as a rate increment above that charged on a "prime" transaction, one that carries the lowest risk.
As characteristics of the borrower, property and transaction diverge from those of a prime loan, rate increments increase. In the mainstream segment, risk premiums can run between 1.5 percent and 2 percent; in what is called the alt-A segment, characterized generally by weak documentation, they can get to 3 percent and sometimes more; and in the subprime segment, characterized generally by poor credit, they can reach 5 percent or more.
The weakness of the risk premium system is that, with a few exceptions, and in sharp contrast to how the mortgage insurance system works, risk premium dollars not needed to cover current losses are realized as income by investors. That money is not available to meet future losses. This makes the system extraordinarily vulnerable to a major default episode, such as the one we are in now.
Portfolio lenders, who hold the mortgages they originate, do carry loan loss reserves, but the tax laws discourage significant contributions to these accounts. In any case, most loans are sold in the secondary market and end up as the collateral underlying mortgage-backed securities.
Every mortgage security carries "credit enhancement" -- special protections for investors. One common form of enhancement, called "excess spread," channels part of the risk premiums into a special reserve account, which is available for meeting losses. However, at some point the funds in the account that are not needed to meet losses are paid out to investors who have purchased the right to them.