Where mortgage insurance went wrong

Lenders' inability to fund their own loans puts housing finance at risk

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Add Comment Add Comment | Comments: 0 | Posted Oct. 11, 2010

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Lenders' inability to fund their own loans puts housing finance at risk

Jack Guttentag
Inman News

Last year, I unwisely committed to writing an article on mortgage insurance for an international encyclopedia. When all too soon it became time to deliver, I realized that the encyclopedia was looking for both a global and historical perspective, neither of which I had.

I remedied my ignorance about programs in other countries by mining articles written by Roger Blood, who has consulted on mortgage insurance programs abroad and is an expert's expert on the subject.

While mortgage insurance began in the U.S., programs now exist in some 34 countries, according to Blood's count. In 14 countries, the insurance is public; in eight, it is private; in seven (including the U.S.), there are both public and private programs; in four, insurance is offered by a mixed public/private entity; and in one, it is offered by a nonprofit.

The historical perspective I needed came from the Aldrich Report, published in 1934 by a commission appointed by the governor of New York State to examine the practices of title and mortgage guaranty corporations chartered by the state. Mortgage guaranty, as it was then called, was an integral part of the operations of these firms.

The firms in this industry mostly began as title insurers, but gradually they moved into mortgage banking. They originated loans, holding them if necessary but selling them if possible. Mortgage insurance evolved primarily as a device to facilitate sales. Insurance was attached to mortgages that were sold, and to certificates issued against mortgages that the firms owned. The certificates were sold to the public, and were typically collateralized by mortgages that could not be sold directly. Loans were all interest-only, so the insurance was a guarantee of the interest on the due date, and return of principal at some future date.

Until the Great Depression, these firms were tremendously profitable. They collected loan origination fees, title insurance fees, and retained the spread between the rate on the mortgages they owned and the rate paid certificate holders. In 1930, there were 50 of them in N.Y., plus a few scattered around in other states. But by the end of 1933, all had ceased operations. The 16 largest N.Y. firms had $1.8 billion of guarantees outstanding on Dec. 31, 1933, but only $721 million of the mortgages securing those guarantees was not in default.

In an attempt to fill the void and encourage shell-shocked lenders to make mortgage loans, the federal government in 1934 created the Federal Housing Administration (FHA). At the outset, FHA hardly made a dent because lenders did not trust it. Fannie Mae was chartered in 1938 to buy FHA mortgages -- to demonstrate that they were safe.

Attitudes toward FHA did gradually change, and in the first decade after World War II, confidence had returned to the market and FHA had become an important part of the system. The way was clear for a new beginning for private mortgage insurance.

In 1956, Mortgage Guaranty Insurance Corp. (MGIC) was chartered as the first of a new breed of private mortgage insurers. The founders mined the Aldrich report as I did, and drew lessons about what was needed to avoid the disasters that befell the earlier ventures.

One critical lesson was that firms offering mortgage insurance should be subjected to laws and regulations that recognized their unique features, of which the most important is their exposure to very infrequent but very large shocks. The legal and regulatory structure should require them to be prepared for such shocks through the accumulation of contingency reserves that cannot be touched except in an emergency, or until many years have elapsed.

A second lesson drawn from the Aldrich Report was that mortgage insurance should be a stand-alone business, not involved with other kinds of insurance or with loan originations. Both principles were embedded in the legislation passed by the state of Wisconsin in 1956 as prelude to the charter granted to MGIC.

Later, the National Association of Insurance Commissioners (NAIC) established a Mortgage Guaranty Insurance Model Act that also recognized these principles, while adding many more. This model act has been the point of departure for many countries looking to develop mortgage insurance systems.

The validity of the first lesson regarding the need for contingency reserves is beyond dispute, but not so with the stand-alone business model. An alternative approach would have recognized important synergies between mortgage banking and mortgage insurance, and would have applied rules regarding reserving to the mortgage insurance function within firms that performed other functions as well. Combined with other rules requiring transparency and standardized insurance contracts, we could have developed an industry of mortgage lenders who could fund their own loans.

Such a system plus a few additional tweaks would have closely resembled the Danish model, which is the most efficient and also the safest housing finance system in the world. When ours crashed in '08, it was business as usual in Denmark. And the Danish system is wholly private, whereas our system today is about 5 percent private. The other 95 percent consists of loans insured by FHA or purchased by Fannie Mae and Freddie Mac.

We may have made a wrong turn in the 1950s.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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