The FHFA’s proposal for restructuring the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac has important implications for private mortgage insurance companies (PMIs), an industry where the stakes could not be higher for its long-term viability. http://www.fhfa.gov/webfiles/23344/StrategicPlanConservatorshipsFINAL.pdf A critical step in recovery for the secondary mortgage market is shrinking the federal government’s presence in mortgage financing activities. The FHFA has put on the table a couple of alternatives for reinvigorating private capital that rely on various forms of credit enhancement, either thru securitization structures and/or variations of traditional private mortgage insurance contracts. As the FHFA works through these options, it is important that they and other policymakers not write-off private mortgage insurance as a potentially viable form of credit enhancement based on the weakened state of the industry. To be sure, there are many lessons to be learned from the mortgage crisis that could vastly improve the long-term viability of private mortgage insurers during periods of extreme credit stress. However, the concept of private mortgage insurance has merit as an effective credit enhancement that could well play a significant role in a newly designed housing finance system.
PMIs are often referred to as creatures of the GSE charters, specifically requiring both Fannie and Freddie to obtain insurance for any loan above a 80% loan-to-value (LTV) ratio. In this capacity for decades leading up to the mortgage crisis, PMI companies operated in all economic cycles, providing effective credit enhancement for a traditionally higher risk segment of the conventional conforming mortgage market. Historically strict capital requirements imposed on PMIs (maximum 25:1 risk-to-capital ratios) contributed largely to this long period of stable performance leading up to the crisis. Further, beyond providing a vehicle for private capital to enter the mortgage finance system, PMIs through their capital requirements provide a countercyclical buffer in the event of market downturns and thus provide ongoing stability during times of stress. With private capital an important criteria for restructuring the housing finance system, credit enhancements providing countercyclical responses in down markets should be featured in any new structure.
There is no question the mortgage insurance industry has been under extreme duress since the crisis, with several firms no longer able to write new insurance due to their weak capital positions. This situation has led to many observers calling for the eventual demise of the industry as legacy PMIs implode under the weight of massive credit losses sustained after the housing bust. But while in apparent dire straits, it may be premature to call for the death of an industry that could provide an important way forward in housing finance. And it is important to remind ourselves what brought on this problem. Fundamentally, the losses sustained by PMIs lead back to fundamental issues of moral hazard and adverse selection compounded by competition among mortgage insurers. In a paper on the PMI industry, I trace these issues in part back to market power exerted by the GSEs and large mortgage originators through industry consolidation. Rossi QRM Study It is hard to call the PMIs unwilling victims of the GSEs and large lenders when they accepted the risk; however, it calls out a weakness in the system generally and not endemic of PMIs that must be remedied in any post-crisis housing finance system. Partly this can be addressed through stronger underwriting criteria. Conceptually, the qualified residential mortgage (QRM) provisions that are part of the Dodd-Frank risk retention provisions are a mechanism for enforcing greater discipline on credit risk-taking, although the early proposals were overly restrictive. For many years leading up to the housing boom, US mortgages could be described as fairly ordinary from a credit risk perspective, with few exotic features such as low documentation, or layered risks. This well-controlled credit risk profile for mortgages kept the industry out of major trouble for many years and any replacement for the GSEs must assure a certain level of credit quality. A number of legacy PMIs saddled with credit losses from the boom have faced the cruel reality of a truly private market and have ceased doing business. As unfortunate as this outcome is, it reminds us of why it is so important to promote private mortgage investment; namely that failure is not rewarded by government bailouts. In this regard, the PMI industry has at least shown a stark contrast between itself and the GSEs rescued by the good graces of the US taxpayer.
The FHFA’s intention to consider deeper MI arrangements as part of its proposal for restructuring the housing finance system indicates a willingness to put all viable options on the table. And capital markets also seem to be signaling in small ways their support for mortgage insurance though the ability of two new entrants to the market to raise capital. Those that dismiss the virtues of a viable private mortgage insurance industry due to inherent flaws in structure of the legacy mortgage finance system reject the possibility of an effective form of credit enhancement that promotes a deep and liquid market for mortgages financed largely by private capital.