By Jack Guttentag
Saturday, May 17, 2008

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.

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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