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.