Tom Adams: How Treasury’s “Kick the Can” Strategy Exacerbates Mortgage Market Woes (Mortgage Insurer Edition)

By Tom Adams, an attorney and former monoline executive

Barron’s published a detailed take down of the mortgage insurance industry weekend that highlights how Treasury’s approach to the mortgage mess will ultimately make matters worse. As the article points out, in the fairly likely scenario that mortgage claims exceed the amount of capital the insurers have available to pay them, the parties taking the biggest hit will be Fannie Mae and Freddie Mac. That means taxpayers are probably on the hook for more bailouts.

Despite having questionable capital reserves for the future claims they face, mortgage insurers are still continuing to write significant insurance business. Why would anybody want to continue to buy insurance from such shaky companies?

The continuing business of the mortgage insurers help shed light on the fact that virtually the entire mortgage industry is run through zombie companies that ought to have expired years ago. Mortgage insurers are yet another example of the failure of the Treasury Department’s “kick the can down the road strategy” to address the collapse of the real estate market. Despite their underwriting failures, the mortgage insurers, and their tied-at-the-hip companions, Fannie and Freddie, continue to play a dominant role in the mortgage markets and, by their continued existence, prevent any real resolution to the problems facing the market.

The sorry recent history of mortgage insurers has been told, in one form or another, many times over the past few years. Facing stiff competition from piggyback second liens offered by lenders to borrowers to eliminate the need for burdensome, expensive protection for low downpayment loans, mortgage insurers diversified into riskier loan products. Not surprisingly, this resulted in an unprecedented level of losses for the insurers.

As the losses mounted and their capital dwindled, mortgage insurers struggled to stay afloat using a number of tactics. First, they sought waivers of their required capital levels. In many ways, the most important regulators for the mortgage insurers are Fannie and Freddie because nearly all of their business comes from these institutions. In fact, mortgage insurance exists mostly because Fannie and Freddie are not permitted to insure loans with loan to value ratios above 80%, unless such amount over 80% is insured against loss. Fannie and Freddie and rating requirements for the insurers they use. Failure to maintain such levels means the insurer cannot insure any new loans for the GSEs, which is effectively a death sentence. After incurring a large amount of losses relative to their capital, the weakest mortgage insurer, Triad, was unable to convince the GSEs to waive their capital requirements and the company was cut off from new GSE business. Within days, Triad went into “runoff”, which is how insurance companies are wound down by their insurers. Now Triad is paying roughly 60% of their insured claims and writing an “IOU” for the remaining portion.

This was like a Lehman moment for the mortgage insurance companies and the GSEs. The GSEs likely realized that cutting off mortgage insurers was a form of mutually assured destruction and were faced with a choice – continue to accept insurance from companies who may well be too weak to ever pay out on the claims some time in the future or cut them off and accept an immediate write down to the value of the insurance in their portfolio. Guess what the GSEs chose?

In classic Geithnerian fashion, the GSEs have elected to continue to waive the capital requirements for many of the mortgage insurers. The mortgage insurers face additional, less restrictive capital requirements from their various state insurance departments, but they have successfully lobbied these regulators for waivers, as well, though some, as noted in the Barron’s article, are bumping up to these thresholds now.

To some observers, this mortgage insurance business model has some Ponzi like characteristics. The insurers are dependent on future business to bail out the bad business written in prior years. While they continue to pay out on their current insurance (subject to significant levels of claim rescission for defaulted mortgages which the insurers contend were fraudulently originated), their ability to continue cover their past mistakes is dependent on convincing their customers to give them new funds, in the form of insurance on newly originated loans. Of course, their hope is that these new loans will default at a lower rate than the insurance they wrote in the past despite the continued weakness in the real estate market, especially for low down payment loans. In a variation on the typical Ponzi scheme, the GSEs, as providers of the future income, know full well that if they stop requesting the insurance, their investment in prior insurance will be written down. So, with a gun to their heads, they continue to allow the mortgage insurers to write new business and together they hope that things will get better and that by pushing today’s problems to sometime in the future, they can somehow pretend they have a legitimate business today.

This, in a nutshell, is what passes for the mortgage industry today. Nearly all mortgage loans written today are done so because they receive the guaranty of a government sponsored enterprise, most of such loans going to Fannie and Freddie. Approximately 15-20% of the loans Fannie and Freddie buy have LTVs over 80% and, thus, are insured by one of the mortgage insurers Fannie and Freddie are in receivership and continue to make sizable claims on taxpayer dollars due to ongoing losses. These losses would be even larger now if they followed the letter of the their guidelines and cut off undercapitalized insurers, as they did to Triad.

Any threat to this on-going scheme, such as the Qualified Residential Mortgage (QRMs) restriction for risk retention which, as proposed would define such mortgages as having LTVs of below 80%, without regard to mortgage insurance, is considered dangerous and most be attacked because it would result in millions of potential homeowners being excluded from the ability to buy their homes. As detailed by Felix Salmon, mortgage insurance lobbying is behind the QRM debate on the risk retention rules, arguing that such sensible restrictions would hurt innocent homeowners (not to mention not so innocent executives at mortgage insurance companies).

But what interest do taxpayers really have in preserving this zombie mortgage industry? By allowing the farce to continue, the same institutions which demonstrated their inability to properly manage risk exposures to the mortgage market are kept alive, as are their problematic policies and management of the market. Had they failed, like any legitimate business (including a number of the mortgage insurer’s “non-essential” subsidiaries), the zombies would be resolving their past failures with their creditors. In their place, new institutions might have been permitted to develop which properly analyzed and managed their risk to the mortgage market.

Rather than continuing to stifle innovation with their failed policies and propped up businesses, new companies or policies that took new, more realistic views of the way we finance mortgage lending might have emerged. Instead, the GSEs and mortgage insurers remain wedded to the failed foreclosure system, pricing analysis and mortgage structures that have helped keep the mortgage and real estate markets at depression levels.

Among the innovations that these parties have successfully stifled so far are principal modifications, actual risk (or market) based pricing for loans, new mortgage loan structures to replace 30 year fixed rate mortgages, credit underwriting that actually takes into account downpayments and counterparty credit, and a host of challenges to the foreclosure process.

The zombie mortgage insurers described in the Barron’s article help give a view of the astonishing breadth of Geithner’s “kick the can down the road” strategy: rather than recognize losses that are knowable and virtually certain today, banks, mortgage insurers, GSEs, title insurers and mortgage servicers cross their fingers for the future and fight any change to their lifeblood, while continuing to enrich their executives despite their incompetence (while Fannie and Freddie have seen turnover in the senior management ranks, the mortgage insurer senior personnel has been remarkably consistent since the crisis). Given the importance of the real estate and mortgage markets to the overall economy, this dogged adherence to a failed strategy comes at a tremendous cost to the country.

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  1. Conscience of a Conservative

    Disagree on a few points. First the designation of QRM will not be of any benefit to the existing m.i. companies. No one buying a securitization will value the guarantee of junk insurer. Second these companies are not insurers as they don’t reserve for bad loans until the loan becomes questionable and even then attempt to walk from loans certain loans at claim time.

    The m.i. insurance companies are another sign of our failed housing policies. The core problem is that homes are not affordable. The obvious solution is to allow prices to fall or deal with stagnant incomes, but instead government attacks the problem via subsidized credit subsidies and tax credits which just shifts the burden to the tax payer and increases home prices for the benefit of the home seller

    1. R Foreman

      > The core problem is that homes are not affordable.

      ..and they’re not affordable because the official US Gov’t policy is to prevent deflation. Of course if they embrace deflation then their liabilities balloon by many times and we get an explicit default, so instead they try the route of implicit default and (attempted) gradual devaluation. Will this turn into a route, with all hands rushing for the exits at once ? We shall see.

      What is funny is that so few of our elected officials realize that a sovereign nation doesn’t need to borrow money. It’s like this mass brain fart they’re all having… complete cooption by monied interests.

      1. Bam_Man

        Official US policy is to ensure all assets (stocks, bonds and real estate) are perpetually over-priced.

        This is the government’s response to 30 years of stagnant incomes and the rationale behind “the ownership society”.

        Of course to keep these assets continuously over-priced the Government (through its proxies – the Fed, US Treasury and GSE’s) must sanction and facilitate multiple ongoing Ponzi schemes.

  2. Tammy Metropolis

    “the parties taking the biggest hit will be Fannie Mae and Freddie Mac. ” Isn’t that just a hit on you, me and the taxpayer makes three? Legendary accounting swindles, formulated by and for the private sector and the perpetrators are still walking free – hiding in academia, or rising to another level of supreme incompetence in other areas of Government.

    Housing prices should return to where they were in 1998, they were already irrationally overpriced at that time, but still more affordable then the schizophrenia that the gangsters would like to preserve. Which explains denial, a river at the Treasury Department.

  3. Swift Benny

    This article is largely red-herring. Any non-academic chicken scratch that starts off with some imaginary separation of Government/Non-Government entities is pure bilge. Innovation is another code word for “don’t regulate me man” which is why fraud and organized crime reached such epic proportions, laws were rewritten, no one is getting into serious trouble for destroying and stealing wealth nationwide.
    Only the victims/hacks are asking for principle reductions, no one else gives a shit. Housing is a basic need, the Private/Government shell game represents the actions of a thief. Please, get some real f%^king jobs.

  4. Jack Reduction

    Realtors, appraisers and loan sharks, right up there with used car salesman, skip tracers and security guards. Yep, real important growth industry in the USA.

    ” Given the importance of the real estate and mortgage markets to the overall economy, this dogged adherence to a failed strategy comes at a tremendous cost to the country. “

  5. ep3

    yves, i was talking to a friend yesterday who had stopped making payments a couple years ago on his house. his mortgagor is bank of america. he had stopped paying because the house was worth less than owed. so i asked how that was going. he said they settled. the bank tacked on to the current mortgage everything owed backwards and adjusted his payment. So now he owes nearly double what the house is worth. and no offense to my friend, but the house is a dump. it would be worth something cuz it shares a lake access drive with other homes. my friend says a couple other homes on the same drive have gone for 30k or less. and he has to drive his kids to school everyday because Michigan has schools of choice. So he’s stuck and can’t move.
    Just wanted to give you another example of how horrible people are getting screwed. maybe if enough voices rise up, something might happen.

  6. Ransome

    Before the broker-dealers intruded with the commissioned lending model, executive outsize rewards, and the banks instituted a credit card model of collateralized lending using your home as a piggy bank, the system worked pretty good for 60 plus years.

  7. DavidE

    It’s really bad policy to let insolvent financial companies remain in business. Lehman was insolvent for almost 2 years. If Geithner had forced Lehman to close in early 2007, the losses would have been much less.

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