Thus, one would think that PMI companies would have taken the brunt of the foreclosure crisis and protected other institutions from losses. But, this isn't what happened. Why?
This practice declined dramatically in the early 21st century. Instead, borrowers making small down payments took out multiple loans at the same time. One, a conventional loan at low interest rates with no private mortgage insurance, and in addition, a second loan without private mortgage insurance at a high interest rate for the balance of the borrowered portion of the purchase price.
So, a buyer wishing to buy a $200,000 house with a $10,000 down payment would take out a $160,000 conventional loan and a $30,000 high interest second loan, rather than taking out a single $190,000 loan with private mortgage insurance that would have to be kept in place until the principal balance on the loan was paid down to $160,000.
The trend towards multiple lien mortgages and away from private mortgage insurance, coincided with a trend towards smaller down payments and the rising use of home equity loans to convert home equity into cash as sustained growth in real estate prices made homeowners feel rich, and made lenders comfortable that appreciation would soon add equity to homes purchase with little money down.
Between 2003 and 2007, the percentage of first-time home buyers with no-money-down loans rose to 45% from 28%, according to the National Association of Realtors. Of first-time home buyers with down payments, the average amount they deposited fell to 2% from 6% of the purchase price of a home.
Private mortgage insurers, meanwhile, were losing business. In 2003, the industry wrote $376 billion in new insurance. Within three years, that number had fallen 40%, according to the Mortgage Insurance Companies of America, a trade group. Another indicator of the industry's financial health also showed signs of stress — its "combined ratio," which is the percentage of insurance premium income that insurers have to pay out in claims and expenses, rose to 65% in 2006 from 48% in 2003.
These uninsured second mortgages circumvented the conservative systemic risk reducing requirement of Fannie Mae and Freddie Mac that low down payment mortgages that they bought be insured and the requirement of private mortgage insurers that there be some down payment from the purchaser.
Buyers usually have to make a down payment of at least 3% to 5% to qualify for PMI loans. Major investors in mortgages, namely Fannie Mae and Freddie Mac, which provide liquidity in the mortgage market by buying home loans, require insurance on loans with less than 20% equity.
Incidentally, this further exonerates Fannie Mae and Freddie Mac as sources of bad policies that drove the financial crisis. The practices that caused the problems took place in spite of their policies, not because of them.
The Internal Revenue Code encouraged the systemic risk increasing practice of using second mortgages to turn low down payment loans into conventional ones that the secondary market would purchae, by allowing homeowners to deduct interest paid on second mortgages on a home, but not on private mortgage insurance premiums. Private mortgage insurance premiums were not tax deductible prior to the 2007 calendar year, and this tax deductibility remains temporary and subject to limitations.
The good news from this turn of events for private mortgage insurers is that while they have been battered by the collapse of the housing bubble, their declining sales in the early 21st century has reduced their exposure to foreclosure losses.
As of April 2008, "Major mortgage insurers such as PMI Group (PMI), Radian (RDN) and MGIC Investment (MTG) each lost more than, or nearly, $1 billion last year. In turn, the already small stocks have shed some 80% to 90% of their value over the past 52 weeks. With credit losses yet to peak, Standard & Poor's expects few mortgage insurers to turn a profit from underwriting again before 2010."
This is hardly good news. But, the subprime mortgage originators and the investment banks that securitized those loans and issued credit default swaps to enhance the creditworthiness of mortgage backed securities, are all bankrupt or facing bargain basement takeover attempts after falling stock prices wiped out investors anyway. In contrast, all of the major private mortgage insurers from before the financial crisis remain in business as free standing companies today.
Simply staying in business is truly remarkable for companies that are designed to cushion other financial institutions from losses in the event of mortgage foreclosures, during the largest wave of foreclosures the country has seen since the Great Depression and a huge collapse in housing prices.
Furthermore, now that investor money to fund uninsured second mortgages with little or no equity cushion has almost completely evaporated, regardless of the interest rate the investors could be paid, the private mortgage insurance business is picking up dramatically. The newly insured mortgages are likely to be fairly low risk because mortgage underwriters have greatly tightened their underwriting standards by requiring some equity, better documentation of ability to pay, and better credit from would be borrowers. And, the private mortgage insurance tax deduction is a huge subsidy to the private mortgage insurance industry that makes its product more affordable now.
Footnote: Bad Loans Go Bad Early
While mortgages are typically amortized over thirty years (although ten and fifteen year loans aren't unheard of to secure interest rate reductions for borrowers with good credits, and forty year amortizations and "interest only" loans were common for buyers in expensive markets trying to afford more house), the average mortgage is oustanding for only about ten years on average. The average homeowner refinances a mortgage or sells a home after ten years. For that reason, controlling for creditworthiness, mortgage interest rates tend to track ten year Treasury bonds, rather the thirty year Treasury bonds.
Mortgages that go bad tend to go bad even earlier, and this is particularly true of subprime loans. The longer a homeowner has owned a home, the more likely it is that the home has appeciated, due to the tendency of price bubbles and collapses to average out over time, and due to inflation. And, in any loan other than an "interest only" loan, principal amounts fall over time. So, the equity cushion of the lender grows over time, shifting the risk of loss in the event of default and foreclosure from the lender to the borrower.
Loans that go bad are overwhelmingly new ones. A New York Times review of metro New York City foreclosures a little more than a year ago found that:
[O]n Long Island, the average age of a loan in foreclosure last month was a little more than two years, according to Long Island Profiles. In January 2004, the average length of time it took borrowers struggling with loans was five years before losing their property through foreclosure.
Early foreclosures are particularly common in subprime loans, but quite early in most mortgages. A January 2005 study of subprime foreclosures, citing a 2001 study by HUD of the same subject found that:
[L]oans by subprime lenders in Baltimore were on average 1.8 years old at the start of foreclosure, compared to 3.2 years for prime and FHA loans.
Similarly, a December 2003 study of foreclosures in a set of 12,000 new mortgages by a federal government agency found that: "the average age of the loans at foreclosure in the data set was approximately 30 months or 2½ years."
The result is that the effect of loose loan underwriting at the peak of the housing bubble will produce most of the resulting foreclosures quickly, and that the benefits of tighter loan underwriting after the subprime mortgage crisis is likely to appear within two or three years of the establishment of stricter lending standards in mid-2007.
PMI companies and other firms that take losses when loans go bad, will likely be out of the wilderness by 2010 and may start to see improvement sometime in 2009, regardless of what Congress and government agencies do to intervene. Indeed, measures that slow down the foreclosure process, like Citibank's recently announced several month moritorium on new foreclosures, while good for homeowners in trouble, may actually prolong the foreclosure driven element of the financial crisis.
Second Footnote: Other Promising News For PMI Companies
The fact that each major PMI company has suffered $1 billion in losses in the housing bubble collapse is actually good new for new investors. It means that all earning of each company for the next many years will be tax free due to net operating loss carry forwards. This both creates a strong incentive to keep the existing entities alive, and also discourages competition from entering the PMI market since the competition's earnings would be taxed, while the existing companies' earnings would be tax free.
A second aspect of the PMI companies that is attractive is that their exposure is limited and easier to quantify than many toxic mortgage assets. Unlike a typical securitize mortgage or credit default swap, a PMI company is not always on the hook for the full amount of the mortgage, only for the insured portion of the loan (typically less than 17% of the purchase price of the house). In normal times, this means that the PMI company is exposed to virtually all of the risk of loss in a foreclosure. But, in the extraordinary times that we are in now, when some housing markets have seen housing price declines of 40% of more, many loans facing losses beyond those covered by PMI. Most observers expect real estate prices in bubble collapse markets to fall more before they go up, but no one knows how much they will fall. Since many financial decisions are driven by worst case scenarios, this makes PMI exposures look better than other kind of bad mortgage and guarantee exposures.
Furthermore, since PMI companies are in the business of valuating default risk exposure and pricing it, their estimates of their exposure to losses in this crisis are more credible than that of the many New York derivative and investment banking firms that set up mortgage backed securities and credit default swaps which the financial markets are now trying to value without having any real experience in doing so.
Finally, there is the issue of leverage. PMI companies are far less leveraged than either commercial or investment banks. PMI Group, Inc., for example, had liabilies that were just 34% of assets at the end of the second quarter of 2008, and only about a quarter of the outstanding liablities are long term debt. Furthermore, about 90% of those assets are cash and investment securities. This lack of leverage gives PMI companies great staying power.
Similiarly, the absolute numbers are encouraging. PMI Group, Inc. had a book value at the end of the second quarter of 2008 of $3.76 billion. Its losses so far in the financial crisis have been about $1 billion, and as explained above, those losses are likely to be fairly short lived. Yet, the company's market capitalization is only about $154 million. The company is a value even on a liquidation value basis, even if it sustains $1.5 billion more in losses and loses $2 billion in the financial markets in the next few years. Yet, one would prsume that PMI has a more conservative investment strategy than the S&P 500 and that $1.5 billion in additional losses is in the high end of what is likely going forward.
Other major players, like most insurance companies, are also not highly leveraged.