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Mortgage Insurance Reserves: A Lesson in Managing Risk
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A cardinal principle of securitization is that each security must stand on its own. For legal and operational reasons, reserves cannot be shifted between securities. Thus, even though the losses on securities issued from 2000 to 2004 were generally small, none of the funds in those reserve accounts have been available to meet losses on securities issued in 2006 and 2007, which have been high.
A paradox of this system for pricing default risk is that interest-rate risk premiums are both too large and too small. If properly reserved, the risk premiums prevailing before the crisis would have been many times larger than those now required to meet the default crunch. Because they were not properly reserved, they are completely inadequate. Today, risk premiums are much higher than before the crisis, but without proper reserving, they will be too small to cover losses from the next bulge in defaults.
A solution exists, and it does not require the dismantling of the existing system. The key is to expand the role of mortgage insurance and extend the reserving principle to the entire system.
If this could be done, it would result in a sharp drop in risk premiums paid by borrowers and a sharp drop in vulnerability to systemic crises. It could even help get us out of the current mess. I will talk more about this in the future.
(I would like to acknowledge real estate lawyer Igor Roitburg for his contributions to this article.)
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:/
Copyright 2008, Jack Guttentag
Distributed by Inman News Features
