I found a more recent (December 12) and more detailed explanation of Jack Guttentag’s idea for preventing the next mortgage crisis.
The piece if very long but worthwhile.
Jack’s Solution to The Current Crisis
First, Jack and his co-author Igor Roitburg discuss how to get out of the current crisis.
I don’t think their strategy for getting out of the current mess would work because it calls for reducing loan balances to 90% of the current market value for loans in default. My guess is that would cause far more defaults than the current foreclose-not-forgive system.
I also think it’s likely that by the time the government and banks are able to design and implement a program, home prices in Phoenix will have already bottomed out in most areas.
However, the second part of their article about how to prevent future crises has an intriguing idea.
Jack’s Solution to Preventing Future Mortgage Crises
Mortgage Payment Insurance. That’s the gist of their solution.
Investors in mortgages face two kinds of default risk. 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 on which the collateral risk is the highest, private mortgage insurance is available to protect investors.
Investors also 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 non-performing asset which is not generating any income and is not saleable except at substantial loss. There is no insurance now available against cash flow risk on individual mortgages.
Lenders charge higher interest rates for riskier borrowers to help cover this cash flow risk.
That is, currently lenders have two ways of handling the risk of loans going bad.
1) Private Mortgage Insurance (PMI). The lender will likely require the borrower to buy private mortgage insurance if the borrower puts less than 20 percent down when purchasing a home. The home buyer pays for the PMI which protects the lender from the home buyer defaulting. When a lender forecloses on a property and sells it, the lender rarely gets back what it is owed. PMI will pay the lender the difference. (This gives you the basic idea.)
IMPORTANT: About half of PMI premiums are held in reserve by the PMI company for 10 years to cover future losses.
2) Interest Rate Risk Premium. Lenders also charge higher interest rates for riskier loans. Why do lenders need to charge higher interest rates if the the borrower it already paying for PMI? PMI won’t cover all the lender’s losses in a foreclosure. In particular, the cash flow risk, the risk of not getting paid any principal or interest for many months during the foreclosure process. So the lender charges a higher interest rate to help compensate for that risk.
IMPORTANT: Very little of the interest rate premium is held in reserve. And none of the premiums paid on loans made in 2000, for instance, will be held to cover losses on loans made in 2006, for example.
Mortgage Payment Insurance (MPI)
Jack’s proposed solution is a new product for PMI companies called Mortgage Payment Insurance (MPI) which would operate like an expanded PMI – it would cover foreclosure losses like PMI and it would also cover missed payments (the cash flow risk).
This MPI would cover all foreclosure risk so there’s no need for the interest rate risk premium. More risky borrowers would pay higher MPI but the interest rate on the loan itself would not be higher since the lender gets paid no matter what.
MPI would be more expensive than PMI, of course, but Jack believes it would be surprisingly inexpensive.
Advantages of Mortgage Payment Insurance (MPI)
The biggest advantage of this scenario is that about half of the MPI premiums would be held in reserve to cover future losses.
That means premiums paid on loans in 2000 would have been available to cover losses taken on loans made in 2006. This would add much greater stability to the entire mortgage financing system.
Traditional PMI has operated well, according to Jack, even in the current crisis because of its reserves.
On the other hand, the lenders that charged those huge interest rate premiums on sub-prime loans, for example, just took the money and then folded when the foreclosure rate increased more than they expected. They had few reserves set aside for losses. (This is a simplification.)
Another advantage of Jack’s proposal is the efficiency of having one organization (PMI companies) calculating the entire risk instead of just part of the risk of the loan.
In addition, the PMI companies didn’t get caught up in the irrational exuberance of the boom and didn’t greatly miscalculate the risk involved as did the lenders who charged interest rate premiums.
Further, the PMI companies who calculate the risk would ultimately be responsible for covering the losses. Since PMI companies aren’t passing the risk along, they will more accurately assess the risks they themselves will be responsible for covering.
In the previous system, loan originators didn’t care if they greatly under-estimated the risk as long as they could quickly sell the loan. The new buyer of the loan would then assume the (greatly under-estimated) risk… and that’s what brought down the global financial system.
Note: Right now in Maricopa County, Arizona there isn’t a lot of PMI being used to cover loans because the PMI companies consider Maricopa County a “declining” market and require at least 10% down. (If the buyer puts 20% down, the lender usually doesn’t even require the buyer to purchase PMI.) Once prices bottom out, the PMI companies will likely go back to only requiring 5% down, or perhaps less. Once that happens, the non-FHA mortgage market will take off again. (Thank goodness for FHA!)