A New System to Prepare for the Next Crisis

Last week, I discussed what I see as a serious weakness in the way the mortgage system deals with default risk. Essentially, interest rate risk premiums collected from borrowers that are not needed to meet current losses are paid as income to investors and not reserved to meet future losses.

Because major default episodes occur infrequently, perhaps every 12 to 15 years, the system is never adequately prepared for one when it happens. It certainly was not prepared for the one we are now in.

The remedy is to reserve a much larger portion of the risk-based dollars paid by borrowers.

But how do you do that? A friend of mine, real estate lawyer Igor Roitburg, last year proposed a solution that struck me as ingenious. He has a patent pending for what he calls mortgage payment insurance, or MPI. I have an interest in that patent.

The way the system works now, investors in mortgages face two kinds of risk from borrowers who default. Collateral risk is the risk that the investor who forecloses on a loan and sells the property will fail to recover the unpaid balance of the loan plus the foreclosure costs. On loans with small down payments -- those for which collateral risk is the highest -- private mortgage insurance is available to protect investors.

In addition, investors face cash-flow risk. While they ultimately may be made whole from their collateral and mortgage insurance, until that happens a loan in default is a nonperforming asset, which is not generating income and is not salable except at a substantial loss. There is no insurance available against cash-flow risk on individual mortgages.

On conventional loans -- those not insured by the Federal Housing Administration or the Department of Veterans Affairs -- investors pass the cost of both risks to borrowers. The major charge is an interest rate risk premium. The greater the perceived risk, the higher the interest rate. On loans with small down payments, lenders can also require borrowers to buy collateral-risk insurance from private mortgage insurers.

Private mortgage insurers place about half the premiums they collect in reserve accounts. Rate risk premiums, on the other hand, are not reserved to any significant extent.

The vulnerability of the system could be reduced by extending the reserving principle to cover both collateral risk and cash-flow risk. The best way to do this would be to have private mortgage insurance policies cover both types of risk, with the borrower paying a single mortgage insurance premium. The insurers would reserve a major part of the premiums, as they do now on policies that cover only collateral risk.

This new type of insurance is what we call mortgage payment insurance, recognizing that it covers both collateral risk and cash-flow risk. Traditional mortgage insurance covers only collateral risk.

Under MPI, the insurer would guarantee timely receipt of the payments by the investor so that the loan remains in good standing when the borrower defaults. This is the cash-flow-insurance part of the policy. 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.

The insurance premiums covering both types of risk would vary from loan to loan, but because the insurer assumes the default risk, there would be no interest rate risk premium. All borrowers would pay the prime interest rate on the type of mortgage they select.

The incremental cost of MPI above the cost of traditional mortgage insurance should be small. That's because, one way or another, the insurer ultimately gets back all of the payments it advances. If the loan returns to good standing, the insurer would be reimbursed for the advances it made. If the loan defaults, the advances would reduce -- dollar-for-dollar -- the bill the insurer has to pay after foreclosure.

And here is the kicker: Because MPI would remove the risk premium from the interest rate, the interest rate would be lower, reducing the cost to the insurer. On loans that default, a lower rate means more rapid amortization and therefore a lower balance, and it also means smaller accruals of unpaid interest that the insurer would pay when a loan is foreclosed. In many cases, the interest rate reduction would mean that MPI cost the insurer less than traditional mortgage insurance.

I think that MPI can do more than protect investors. I think it can protect the system against future default crises, reduce costs to borrowers and help get us out of the current mess. I will explain more in future columns.

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

Distributed by Inman News Features