New Insurance Could Reduce Borrowers' Costs

Further, if all borrowers eligible for mortgage insurance were paying prime rates, the potential for predatory practices would be sharply reduced. Elimination of risk-based pricing would eliminate opportunistic pricing of mortgages at the point of sale, which is one of the most important sources of abuse.

With default risk covered by MPI, rather than a combination of traditional mortgage insurance and rate-risk premiums, vulnerability to financial crises would be substantially reduced. Today, only mortgage insurance premiums are placed in reserve accounts to protect against future losses. Interest-rate-risk premiums, if not needed to meet current losses, become investor income. With MPI replacing rate-risk premiums, the process of reserving for contingencies would be extended to cover all default risk, not just collateral risk.

In addition, risk underwriting would shift to more dependable hands. Mortgage insurance companies already offer underwriting to lenders as a service, but with MPI they would do it for all loans except those that don't qualify for MPI.

Lenders and investment banks tend to extremes, becoming excessively liberal when market sentiment is euphoric and then excessively tight when sentiment shifts back. This tendency is fostered by their ability to pass along most default risk to the next party in the chain. Insurers, by contrast, have a long-term orientation because they are on the hook for a loan until it is repaid or the insurance is terminated.

In addition, by keeping mortgages in good standing until they are paid off, MPI would block the contagious erosion of investor confidence that stems from increasing numbers of nonperforming loans. This has been a central feature of the current crisis.

Next week, I will discuss what would be needed from the government to make MPI work.

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.

© 2008 Jack Guttentag

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