New Insurance Could Reduce Borrowers' Costs
Last week, I described a proposal for a new type of mortgage insurance called mortgage payment insurance, or MPI.
This insurance would cover cash-flow risk as well as collateral risk, as opposed to traditional mortgage insurance, which covers only collateral risk.
Cash-flow risk is the risk of an interruption in the scheduled payments from the borrower to the investor. Collateral risk is the risk that proceeds from a foreclosure sale will not be sufficient to pay off the loan balance and reimburse the investor for foreclosure expenses.
Real estate lawyer Igor Roitburg, a friend of mine, came up with the idea for MPI. He has a patent pending on it; I have an interest in that patent. No insurers offer such a program now.
Under MPI, the insurer would guarantee timely receipt of the payments so that the investor continues to get the payments after the borrower defaults. If the default is not corrected, the payments would continue until the foreclosure process is completed, at which point the investor would be reimbursed under the collateral-risk-insurance part of the policy.
According to calculations Roitburg and I performed, MPI would cost the insurer little more than traditional mortgage insurance, and in many cases it would cost less.
Here is an example based on wholesale price quotes for two loans as of Nov. 27, 2007, when the market was less unsettled than it is now. Both loans were for $400,000 with 10 percent down on a single-family house in California, to a borrower with a 700 FICO credit score.
The first was for a prime loan with full documentation that would have been used to buy the house as a primary residence. The interest rate was 6 percent, and the mortgage insurance premium at 25 percent coverage was 0.67 percent.
The second was a risky loan -- a cash-out refinance on an investment property with no documentation. The rate was 9.875 percent, and the mortgage insurance premium at 25 percent coverage was 1.29 percent. The risky loan thus carried a rate 3.875 percentage points higher and a mortgage insurance premium 0.62 percentage points higher.
We assumed that the risky loan went into default followed by foreclosure and calculated the loss to the insurer. We then used the same default/foreclosure scenario to calculate the loss on an MPI policy with the interest rate reduced to 6 percent. Because the insurer assumes all the default risk with MPI, the rate-risk premium charged to the borrower should disappear.
We found that the insurer's losses were actually lower with MPI than with a traditional insurance policy. While the insurer made payment advances, the advances simply prepaid the amount due at foreclosure dollar for dollar. And because of the lower interest rate with MPI, the loan balance and the unpaid interest due were lower, reducing the loss. The insurer did lose the interest it could have earned on the payment advances, but this was much smaller than the reduction in the amount due.
MPI potentially reduces the cost to borrowers who are less than prime, which is most people. Assuming that the traditional insurance premium of 1.29 percent in my example is properly priced to meet losses under that policy, it is more than adequate to meet the lower losses under an MPI policy. Hence, the 3.875 percent rate premium, which investors require when they are protected by traditional mortgage insurance, is redundant if they have MPI.