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Turn Out the Lights, the Party's Over ...

The Problem with Mortgage Insurance

Volume 14, No. 3, First Quarter 2008

By Joseph J. Launie, Ph.D., CPCU, FACFE

During the early years of Monday Night Football, Don Meredith would start singing “Turn out the lights, the party's over” once the outcome was no longer in doubt. This greatly annoyed Howard Cosell.

The subprime mortgage crisis has led to a great deal of discussion, much of it focusing on the high level of foreclosures. The impression is left that the financial institutions were overwhelmed by a wave of foreclosures that were unexpected and unforeseeable.

That may not be entirely accurate. In recent years, the ranks of mortgage banking have been invaded by a swarm of fast-buck operators. Many of these operations lacked the ethics of a roof rat. Throwing money around with an abandon that would embarrass a drunken sailor, these operators made loans of up to 100 percent of the equity of various properties to people whose credit rating was dubious at best. Rather than being unforeseen, foreclosure was anticipated and expected. The idea was, the mortgage broker would get the fees from this high volume of mortgages. When you lower the standards to zero, sales increase. The fundamental dynamic of this operation was a real estate market in which prices were monotonically rising. While the borrower had no equity to start with, the rising market provided the foreclosing financial institutions with a safety cushion so that they could foreclose and make money on the property as well.

Since they were generating billions of dollars of these loans, new money had to come from somewhere. Naive capacity was found in the bond market, where mortgage-backed bonds could be peddled to investors who had no clue about the risk. The market was facilitated by bond brokers who asked few questions and would not have understood the answers.

Many people are surprised by the extent of the trouble caused to financial institutions by the subprime mortgage crisis. The extensive damage to financial institutions occurred in part because mortgage-backed bonds are tricky financial instruments under the best of conditions.

The issuing financial institution originates a group of mortgages for single-family dwellings. The institution then bundles these mortgages into packages and issues bonds backed by the mortgages. The mortgages in turn are collateralized by the single-family dwellings. The issuer receives back the funds loaned the homeowners from the bond purchasers. This looks risk-free for the issuer so far. It would be, except that the issuer most likely will retain the servicing of the portfolio. The servicing entity collects the payments from the homeowners, sends out the late notices and handles the foreclosures. It gets a small percentage fee on the total portfolio value, which adds up quickly. It also gets to keep the late fees.

The very big fly in the ointment is the fact that under the terms of the bond indenture, the servicing company must forward to the bondholders a payment for every mortgage in the portfolio, whether or not the servicing company has received the payment. This takes place on the settlement day, usually around the 15th of the month. Mortgages are in the portfolio until foreclosure is completed. Since foreclosure can take six months or longer, the liquidity demands from mortgages slipping toward foreclosure can be significant. The servicing company’s problems do not end with foreclosure. If the mortgage was insured, then the house must be turned over to the mortgage insurance entity under its terms. This is not an instantaneous transaction. More time passes, and more payments must be forwarded by the issuer. If the mortgage is not insured, then the house must be sold to liquidate the collateral and compensate the bondholder. This can be a really long and expensive process, particularly in a down market.

It does not take a particularly high percentage of foreclosures to cause significant liquidity problems for issuers. If they cannot meet the cash calls on settlement day, then the bonds go into default. If the bonds have been used to create various derivatives, then the stack of dominoes which starts falling can be long indeed.

This wild party was made possible by the regulators who let the buzzword deregulation cover up gross negligence. Winston Churchill wrote a book called While England Slept. The story of this fiasco should be entitled While the Regulators Slept. Legitimate lenders welcome regulation to protect themselves and the borrowers from reckless, unscrupulous players. A basic axiom in the financial markets is, “You cannot compete with stupidity.”

Should it really have surprised the authorities that economic activity flourishes in the unregulated areas? Or that the activity in those areas includes exactly those transactions forbidden in the regulated areas? When a mortgage is offered with an artificially low rate for six months or a year to a borrower who qualifies at that payment level, a red flag should go up. If the buyer could not have qualified at the higher rate, then foreclosure is not just reasonably foreseeable; it is virtually inevitable.

The only long-term solution for this weakness in the mortgage sector is for real estate values and prices to go up. There are some structural problems the economy must overcome to achieve this. Consumer confidence in the future is low. For an important segment of the economy, part of that malaise can be traced to the shift from defined-benefit to defined-contribution pension plans. Substituting the risk of the market for the security of a defined-benefit plan has shaken the confidence of this segment of the population. The defined-contribution shift enabled corporate employers to shift market risk from themselves to their employees. This shift ignored the fact that the employers were far more sophisticated regarding market risks. In fact, so sophisticated that they decided to shift the risk to their employees. It would be difficult to argue that the employees’ collective market decisions would be superior to the portfolio decisions formerly made by corporate pension-fund managers. Therefore it is likely that the employees ended up with fewer assets and certainly more risk. The pension-fund shift to defined-contribution plans certainly represented a victory for the employers over their employees, but you cannot sink half a ship.

If one household faces a more uncertain future because it has had the security of a defined-benefit pension plan replaced with the market uncertainty of a 401K, that is the household's problem. If an entire segment of the population loses confidence in the future course of the economy because of pension uncertainty, that becomes everyone's problem. Lack of consumer confidence can drag down the entire system. Those employees have a dual role — they are also consumers.

The relentless drive on the part of corporations to cut costs in order to be competitive on a worldwide basis has led to a smaller domestic workforce. However, who did they think their customers were? Those employees who have been laid off or redirected into less-lucrative employment after their jobs disappeared overseas are less robust consumers. The parking lots of the former huge Midwestern auto manufacturing plants used to be filled with new cars. Those employees were good customers. These structural changes in the labor force will work themselves out over time, but until they do, they can drag down overall consumer confidence. Real estate prices will rebound as part of a general rebound in the economy. Strong leadership is needed.

All fun parties eventually come to an end. This party crashed when the real estate market stopped rising and turned downward. Price cycles have been a characteristic of markets since Adam Smith was pricing fresh strawberries, but the players in the mortgage loan business acted as if a price downturn was impossible.

When Don Meredith sang on Monday Night Football, although one team was clearly a loser, the other one was a winner. Winners are hard to find as this party ends.

It is the market downturn in real estate values that has caused the wave of foreclosures. Rather than losing their ability to pay, borrowers have lost the motivation to pay as their equity ebbs away, passing zero and becoming negative. The borrowers with no equity to protect can use the foreclosure period for free rent and walk away, leaving lenders with collateral worth less than the loan. In a downturn, while a few borrowers may lose their jobs, all borrowers are affected by dropping real estate prices.

Once prices went down, the foreclosure game became a lot less fun. Now the lenders were stuck with collateral worth less than the amount of their loans. Since they were operating in a highly leveraged status, they went under quickly. This house of cards is still collapsing. The final bill has yet to come due, but it will be large. As we survey the wreckage of still another experiment in financial deregulation, the words of a 1960s song provide a sad echo. “When will they ever learn? When will they ever learn?”