The blame game for the development of the current mortgage crisis is now in full swing, and, with one exception, no major participant escapes unscathed:
• Lenders and investment bankers drastically relaxed their underwriting standards in response to the euphoria associated with rapidly rising home prices during 2000-2006. They approved loans that could not possibly be repaid without an indefinite continuation of house-price inflation.
• Bank regulators ignored the breakdown of underwriting standards until it was much too late to take effective action.
• Mortgage brokers and loan officers encouraged borrowers to buy more house than they could afford, and to accept toxic mortgages that they did not fully understand.
• Consumers allowed themselves to be seduced into buying houses they couldn't afford, into purchasing second and third homes on speculation, and into depleting their existing equity through cash-out refinances, in order to maintain lifestyles they could not sustain.
• Rating agencies provided AAA and AA ratings to securities issued against pools of new types of extremely risky loans when they had no adequate statistical basis for estimating potential losses on the loans.
• Fannie Mae and Freddie Mac invested in such securities, taking large losses and weakening their capacity to be a source of strength during the crisis period.
• The Federal Reserve kept interest rates low well past the point where they should have raised them, and as a regulator, was asleep at the same switch as all the other regulatory agencies.
The exception is the private mortgage insurance industry. It is the one sector that has not been cited as contributing to the crisis.
Since the industry was reconstituted in the late 1950s, it has enabled borrowers to obtain conventional loans - those not insured or guaranteed by the federal government - with down payments of less than 20 percent. Insurance premiums were scaled to down payment: the smaller the down payment, the higher the premium.
PMIs must place half of their premium inflow in contingency reserves that can't be touched for 10 years except to meet unusually large losses. This encourages the companies to set premiums based on estimates of losses over long periods, so premium rates change infrequently. And it severely dampens the temptation to make a lot of money in a short period by taking advantage of ebullient markets. PMIs can't pay themselves premiums net of losses in the current year, as most lenders and investment banks can.
The PMIs did not fully participate in the euphoria and excess that preceded the crash. They did insure some risky loans that would not have been acceptable to them earlier, but for the most part they stuck to their guns. As a result, their market share declined with the emergence of "piggybacks."
Lenders discovered that they could make 95 percent and even 100 percent loans by getting other lenders to offer second mortgages for the amounts over 80 percent of property value. Piggybacks carried higher rates than the first mortgages, but in many cases the cost to the borrower was smaller than the cost of mortgage insurance. The interest on piggybacks was deductible where mortgage insurance premiums were not. In addition, borrowers could pay off the seconds in full at any time, whereas getting rid of PMI was a hassle.
Of course, the PMIs did not give up market share willingly. They induced Congress to make mortgage insurance premiums deductible, at least for a period, but this had only a small impact.
Had PMIs followed the prevailing pattern during the go-go years, they would have cut their insurance premiums sharply and gone after the riskier loans. But they didn't, and the piggyback market thrived until the crisis hit. At that point, the market got an object lesson in the value of PMI. First-mortgage lenders discovered that piggybacks provided substantially less protection against loss than PMI. As home prices declined and the crisis grew, a large proportion of piggybacks lost all or virtually all of their value, and the piggyback market has all but vanished.
And borrowers experiencing payment problems discovered that having to deal with two lenders was a substantial barrier to getting loan contracts modified. In contrast, mortgage insurers will often help borrowers negotiate modified contracts with first-mortgage lenders.
Nonetheless, the PMIs have been badly hurt. Losses have been eroding their capital and reserves, and their stock prices have tumbled badly. Yet the industry is doing exactly what it was set up to do, which is to cover losses to lenders during a period of stress, out of reserves that they accumulated during periods of prosperity. The industry should play a more prominent role in the very different housing finance system that emerges in the future.
• Jack Guttentag's column appears every Sunday in Homes Plus. Contact him via his Web site at www.mtgprofessor.com.
Inman News Service