by Calculated Risk on 3/26/2007 09:33:00 AM

According to the Census Bureau report, New Home Sales in February were at a seasonally adjusted annual rate of 848 thousand. Sales for January were revised down to 882 thousand, from 937 thousand. Numbers for November and December were also revised down.


Click on Graph for larger image.
Sales of new one-family houses in February 2007 were at a seasonally adjusted annual rate of 848,000 ... This is 3.9 percent below the revised January rate of 882,000 and is 18.3 percent below the February 2006 estimate of 1,038,000.


The Not Seasonally Adjusted monthly rate was 71,000 New Homes sold. There were 88,000 New Homes sold in February 2006.

On a year over year NSA basis, February 2007 sales were 19.3% lower than February 2006. February '07 sales were the lowest since February 1997 (69,000).


The median and average sales prices were up. Caution should be used when analyzing monthly price changes since prices are heavily revised.

The median sales price of new houses sold in February 2007 was $250,000; the average sales price was $331,000.


The seasonally adjusted estimate of new houses for sale at the end of February was 546,000.

The 546,000 units of inventory is slightly below the levels of the last six months. Inventory numbers from the Census Bureau do not include cancellations - and cancellations are at record levels. Actual New Home inventories are much higher - some estimate about 20% higher.


This represents a supply of 8.1 months at the current sales rate.


More later today on New Home Sales.

by Tanta on 3/26/2007 08:10:00 AM

There is a tradition in the mortgage business of distinguishing between two major types of mortgage fraud, called “Fraud for Housing” and “Fraud for Profit.” The former is the borrower-initiated fraud—inflating income or assets, lying about employment, etc.—that is motivated by the borrower’s desire to get housing (not the same thing as “real estate”), by means of getting a loan he or she doesn’t actually qualify for. It may require some collusion by the loan originator or appraiser, but it may not. It is usually the least expensive kind of fraud to lenders and investors, since the goal is getting (and keeping) the property, so the borrower is at least usually motivated to make the payments. The problems come about, of course, because these borrowers failed to qualify honestly for a reason. Borrower-initiated fraud loans may be considered “self-underwritten,” and such loans do have a much higher failure rate than the “lender-underwritten” ones. Their only saving grace is that the lender tends to recover more in a foreclosure than in a fraud for profit case. Penalties to the borrower rarely ever come in the form of prosecution; losing the home and becoming a subprime borrower for the next four to seven years—with the credit costs that implies—are the borrower's punishment.

Fraud for profit is simply someone trying to extract cash—not housing—out of the transaction somewhere. If it is borrower-initiated fraud, it’s not a borrower who wants a house; it’s a borrower who wants to flip a piece of real estate or launder money or in some other way grab the cash and leave the lender holding the bag. Most of it, however, is initiated by a seller, real estate broker, lender, or closing agent (or all of them in collusion). It generally requires additional collusion by bribable appraisers, although it can certainly be initiated by a corrupt appraiser looking for a kickback, or can merely take advantage of a trainee or gullible appraiser. This is the flip scam, straw borrower, equity skimming, misappropriation of payoff funds, identity theft kind of fraud. It may not be as common as fraud for housing, at least in some markets, but it’s much, much more expensive to the bagholder. At minimum, the fraud-for-housing borrower wants to take clear, merchantable title to the property and maintain it at an acceptable level. That’s either unnecessary expense or (in the case of title) a hurdle to be gotten over by the fraud-for-profit participant.

The problem with this traditional distinction is that, recently, we seem to have an epidemic of predator meeting predator and forming an alliance: a borrower willing to commit fraud for housing meets up with a seller or lender willing to commit fraud for profit, and the thing gets jacked up to a whole new level of nastiness. Consider the “cash-back purchase” scam we keep hearing about: that’s a perfect example of a borrower who wants a house, a seller who wants an illegitimate profit, and a broker or appraiser or settlement agent who wants a kickback all conspiring to defraud the lender: it’s hard to call it either fraud for housing or fraud for profit because it’s both.

What, in the past, might have kept the two fraud types separate—the fact that a normal borrower would not see it in his or her best interest to borrow more money than necessary to pay more than fair market value for a home—disappeared in the mania of buy-more-borrow-more and pass the “screwing” on to the next sucker who buys it from you. As soon as borrowers became convinced that paying substantially more for the property than the current seller did just a few months ago is always and everywhere a good sign, you could no longer rely on the “rational agent” borrower to at least limit his fraudulent tendencies to lying on the loan application in order to get away from apartment life. You actually see them agreeing to sign “secret” sales contract clauses that will require them to borrow more than the fair market value of the property, and then give the excess loan proceeds to someone who won’t be helping to repay the debt. Or accepting “down payment assistance” from an interested party, in order to buy a property whose price is inflated by the amount of the “assistance.” That this doesn’t seem to strike them as self-defeating tells you a lot about how uninformed or misinformed we are, how far into a true mania we’ve gotten. In the old days, you used to be able to count on RE frauds to display basic self-interest, naked or camouflaged.

Telling the difference between the victims and the victimizers, the predators and the prey, and the fraudulent and the defrauded, is getting a lot harder when you have borrowers not required to make down payments able to lie about their incomes in order to buy a home the seller is overpricing in order to take an illegal kickback. The lender is getting defrauded, but the lender is the one who offered the zero-down stated-income program, delegated the drawing up of the legal documents and the final disbursement of funds to a fee-for-service settlement agent, and didn’t do enough due diligence on the appraisal to see the inflation of the value. Legally, of course, there’s a difference between lender as co-conspirator and lender as mark, utterly failing to exercise reasonable caution, but it’s small comfort when the losses rack up. With tongue only partially in cheek, I’m about to suggest a third category of fraud: Fraud for Bubbles.

Everybody likes to hear lurid or merely entertaining stories from veterans of the Loan File Wars about weird fraud cases.
A recent CNN piece quotes a Clayton analyst as having found a mortgage note signed by “M. Mouse” (hat tip, Andrew!). How did anyone miss that? I have my own war stories, but to be honest with you, I’m still hesitant to share much about them. I realize that in the internet era it’s a losing battle, but still: every time you talk publicly about a fraud scenario, you’re giving someone an idea—either to try to perpetrate the scam, or to evade the tricks people like me use to find their traces in a loan file. I can remember training loan officers to look carefully at a W-2, and to recalculate the withholding taxes, since so many fakers of W-2s would either forget to do that, or wouldn’t do it right. Imagine how distressed I was when one of my loan officers went home and fixed that bug in his fake W-2 template.

What I want to do instead is to make some general observations about why so much fraud is missed by lenders. Obviously, there are lenders who are colluding with borrowers, or who are defrauding investors or borrowers or some other party; that’s either “fraud for housing” or “fraud for profit” or the new hybrid of the two. To me, that’s the least interesting problem (although it’s an important one). I want to talk about the extraordinarily widespread “insufficient caution” problem in this industry: the lenders who are just too easy to defraud. It seems to me that this problem gets to the heart of a lot of the issues we keep talking about here: toxic mortgage products, loose standards, out of control home price bubbles, and the endless chain of “disintermediation,” outsourcing, temping, dumbing down, fragmenting, and otherwise morphing of the business of home mortgage lending into a big fraud magnet. It often seems as if the industry just stopped believing that it could ever really be at risk.

My theory of the Fraud for Bubbles is, in a nutshell, that it isn’t that lenders forgot that there are risks. It is that the miserable dynamic of unsound lending puffing up unsustainable real estate prices, which in turn kept supporting even more unsound lending, simply masked fraud problems sufficiently, and delayed the eventual “feedback” mechanisms sufficiently, that rampant fraud came to seem “affordable.” So many of the business practices that help fraud succeed—thinning backoffice staff, hiring untrained temps to replace retiring (and pricey) veterans, speeding up review processes, cutting back on due diligence sampling, accepting more and more copies, faxes, and phone calls instead of original ink-signed documents—threw off so much money that no one wanted to believe that the eventual cost of the fraud would eat it all up, and possibly more.

On the one hand, everyone does know that you can’t run a mortgage lending business with the same level of anti-fraud measures they use at Domino’s to keep from wasting pizzas on prank calls. On the other hand, we are starting to see—and I predict we will start to see a cascade of—stories of lenders with such lax internal controls that if they did remember the risks, you have to conclude they just tried to repress those memories. Go back and read the Cease and Desist order for Fremont. Does it sound like an operation that believes in the reality of risk? Is everyone still convinced that “hey, we sell the risk to someone else” still means squat when it comes to fraud and misrepresentation?

I said I didn’t want to get into too much detail, but I’ll tell you right now that some kinds of fraud are so easy to spot it’s pathetic. You don’t need to have the borrower sign “M. Mouse” on the note. Asking for income documentation, ordering tax return transcripts prior to closing, requiring settlement agents to fax the final purchase contract to the lender for approval prior to close, enforcing arm’s-length transaction rules: this stuff isn’t hard to do, and it will not catch everything but it will sure catch a lot, and it’ll catch it before you close, which is really the cool part. So what’s the response whenever you suggest these things? It costs too much. It takes too long. It drives up transaction costs and therefore puts a drag on home prices. It “unfairly” takes its bites out of our favorite new borrower segment: first time homebuyers, self-employed entrepreneurs, real estate “investors.” It makes loans harder to sell and securitize instantly and cheaply. It makes it harder for an originator to make those representations and warranties based on the bliss of ignorance. It could bring down the whole secondary market as we know it!

So I’ve heard all that before; you need not hand it to me again in the comments. You need, if you are inclined to find any of that compelling, to tell me in somewhat more detail how your cost/benefit analysis works. You can always find one anecdote of one legit, deserving borrower who wouldn’t get a loan if I controlled for fraud as much as I’d like to. You can’t always get me to believe that it’s worth it to originate or buy 49 fraudulent loans in order to get that one good one. You certainly can’t get me to believe that I’m the one who is risking everyone’s “confidence” in the secondary mortgage market.

I suspect most of us feel, generally, that fraudsters—borrowers, lenders, anyone else—who get burned just got what they deserved. True enough. But lending fraud, like warfare, creates quite a bit of “collateral damage,” in all senses of the term. Those honest homeowners watching their neighborhoods collapse after the fraud-bombs finally detonated are not probably very comforted by the fact that it wasn’t their fault. So when we debate the question of potential “bailouts,” we keep running up against the question of who needs or deserves the bailout. If you want to do something to assist the honest homeowner who bought with an 80% loan but is now upside down because of the neighbors’ fraud, how do you do that without, inevitably, helping out the lender who facilitated that fraud, too? If you want to do something to protect the stability of the honest lenders, how do you do that in a way that doesn’t, inevitably, also protect the scumballs and incompetents?

Getting into a bubble is easy. Getting out?

by Calculated Risk on 3/25/2007 03:41:00 PM

From the LA Times: 'Short sale' brought them relief -- which IRS is going to tax

Question: I understand that a "short sale" means the mortgage lender agrees to accept as payment in full a sale for a home's market value even if it is below the mortgage balance. ... The lender agreed to accept a short sale for $183,785 though our mortgage balance was $210,000. But we received IRS Form 1099 from the lender showing we had taxable "debt-relief" income of $26,215. How can we be taxed on money we didn't receive?

Answer: As an alternative to foreclosure when a mortgage borrower stops making payments, some lenders will accept a "short sale" of the property for less than the mortgage balance. ...

However, the IRS says debt relief is taxable. ...

I believe this is also true when a homeowner resorts to jingle mail. A common scenario might be a homeowner who refinanced their home with cash out, and then discovers they can no longer make the payments, and that they have no equity in their homes. If the homeowner then just mails the keys to the lender - jingle mail - I believe the homeowner will receive a tax bill for the difference between what what the house sells for in foreclosure and what they owed. I also believe the lender might pursue the homeowner for any losses (the 2005 Bankruptcy Law made it more difficult for homeowners to declare Chapter 7 bankruptcy).

UPDATE: In the comments, attorney Bill McLeod writes:

... there are some new forms and new requirements, and I have to make my clients gather far more documents than I ever had to before BAPCPA became law, but a struggling homeowner can still file Chapter 7 if this [is] the option they are considering.

Anyone in this difficult situation should consult with an attorney and tax advisor.

by Tanta on 3/25/2007 11:37:00 AM

With a deep curtsey to Mozo Maz, as I'm not wearing a hat to tip:

The Charlotte Observer seems to have gotten the right party's attention ("Loans builder arranged will get federal review"):

Federal housing officials will review whether Beazer Homes USA complied with federal rules in arranging government-insured loans for buyers in its subdivisions.

The Department of Housing and Urban Development,
responding to an Observer investigation, will look at lending records from Charlotte and other cities where a large share of Beazer loans ended in foreclosure, officials said Friday.

The review casts Beazer into the growing pool of lending-industry participants under government scrutiny for the
way they sold mortgage loans to low-income families in the past decade.

Good on the Charlotte Observer's team of reporters and editors for doing what journalism is supposed to be. Good on HUD for responding the Observer.

Now if only we could get HUD onto these problems before they end up in the newspaper. . . .

by Tanta on 3/25/2007 08:34:00 AM

David S. Hilzenrath reports in yesterday's Washington Post:

Freddie Mac, still fixing weaknesses that came to light in 2003, yesterday issued its first timely annual report in five years, which showed that the giant mortgage funding company lost $480 million in the fourth quarter. That compared with a profit of $684 million in the comparable period a year earlier.
. . .
"Families are finding it hard to stay in their homes as deteriorating house prices, regional job losses and increasing mortgage payments are making their homes less affordable," chairman and chief executive Richard F. Syron said in a prepared statement.

Last year, Freddie experienced a slight deterioration in the creditworthiness of loans "as more loans transitioned through delinquency to foreclosure" and as "the expected severity of losses" on individual homes increased, the company said.
. . .
Freddie reported that the delinquency rate on its single-family home mortgages -- the percentage of loans at least 90 days past-due or in foreclosure -- declined to 0.53 percent last year, from 0.69 percent the year before.

There were also less favorable developments. The company lost $126 million last year on loans it had to repurchase from other investors because they were late 120 days or more. In 2005, there were no such losses, spokesman Michael Cosgrove said.

For a company the size of Freddie Mac, $126 million is not a crippling loss. But it shows that the repurchase problem--in this case, apparently, of loans sold with recourse--is affecting everyone in the food chain. Freddie's report also may indicate that the problem for prime and near-prime will be loss severity, not loss frequency. Subprime, it seems clear, faces the same or worse severity problems, but of course at much higher frequencies.

by Tanta on 3/24/2007 01:51:00 PM

I had meant to post something on this a while ago; it’s a March 15 press release from HUD.

Assistant Secretary for Housing - Federal Housing Commissioner Brian Montgomery today reaffirmed the need to modernize the Federal Housing Administration (FHA) and give homeowners a better alternative to exotic high-cost mortgages. . . .

The National Association of Realtors reports that last year 43 percent of first-time homebuyers purchased their homes with no downpayment. Of those who did make a downpayment, the majority put down two percent or less. Modernization legislation, which overwhelmingly passed the House last year, would replace the FHA's stringent three percent minimum cash investment requirement with a flexible plan that allows homeowners to put down almost no money down, one, two or even ten percent.

To prevent the FHA from being priced out of many housing markets, the FHA's modernization legislation would also increase loan limits. Today, few buyers of homes in California or much of the Northeast have been able to use FHA financing because FHA's loan limits aren't high enough to meet the cost of most homes in those regions. By increasing and simplifying loan limits, FHA would once again be a major player in high-cost areas.

FHA modernization legislation would also create a new, risk-based insurance premium structure that would match the premium amount with the credit profile of the borrower. It would replace the current structure, in which there is standard premium amount for all borrowers, while still protecting the soundness of its Insurance Fund.

So, we have some interesting new terms to work with:

“Flexibility”: This is a good idea because a program that “allows” no down payment can also “allow” a 10% down payment. The old program “required” a 3% down payment, and “allowed” anything larger than that. That was inflexible, you see.

“Simplicity”: This is a good idea because a “simple” definition of a moderately-priced home—and thus a maximum FHA loan—can allow FHA to be a “major player” in the game of helping house prices keep going up and up and up. The “complex” definition of a moderately-priced home, on the other hand, might allow FHA to function as a drag on runaway home price appreciation by limiting financing options and thus helping to force prices downward.

“Modernization”: This is a good idea because having a large, fairly homogeneous risk pool, with some individual variation in credit quality, that is all priced the same way for insurance purposes, only worked in the Dark Ages. The new, modern, risk-based approach is much cooler, because there is no question that we know, precisely, how to price that risk, and that whole “group insurance policy” thing is never cheaper than individually-underwritten policies.

You may add those terms to the “Ownership Society” dictionary.

by Calculated Risk on 3/23/2007 07:19:00 PM

"[T]he persistent imbalance in housing supply and demand ... is fueling intense competition and pricing pressure among homebuilders and other participants in the new home and resale markets."
Jeffrey Mezger, CEO, KB Home, March 22, 2007

The above comment raises the question: Why not adjust the price to balance supply and demand?

This diagram shows the normal Supply and Demand relationship. When supply shifts (dark blue to light blue) then the price falls from P0 to P1.

And when demand shifts, perhaps due to the changes in lending standards (from dark red to light red), the prices falls again, this time from P1 to P2.

So, with the current changes in supply and demand, we would expect falling prices, but no "imbalance in housing supply and demand".

In fact new home prices have been falling. KB Home reported their average selling price declined 5% in Q1 2007 (compared to Q1 2006). And most homebuilders have been providing incentives (upgrades, free landscaping, etc.) that can be viewed as price reductions too.

The above diagram works well for commodities, like corn, but the housing market is far more complicated. First, housing markets are local - most housing services aren't transportable - and one area of the country might have different dynamics than other areas. Second, there are reasonable substitute goods for new homes (mostly existing homes and some rentals) that compete with homebuilders for purchasers of housing services.

Note: usually existing homes compete directly with rentals. However this impacts new home sales too because of the typical chain reactions that occur in the housing market.

During periods of weakness, prices in the existing home market typically exhibit strong persistence and are sticky downward. Sellers tend to want a price close to recent sales in their neighborhood, and buyers, sensing prices are declining, will wait for even lower prices. This means real estate markets do not clear immediately, and what we usually observe is a drop in transaction volumes.

This sticky price phenomenon in the existing home market is actually good for new home sales. The homebuilders can lower their prices, and stimulate demand. This probably helped the builders in 2006. However when existing home supply reaches a certain point, prices start to fall in the existing home markets too. Also, when lenders start taking short sales, and banks are selling REOs (bank Real Estate Owned), this puts additional pressure on prices.

Click on graph for larger image.

This graph shows monthly existing home inventory since January 2004. The National Association of Realtors (NAR) noted today: "Raw inventories peaked last July at 3.86 million, and supplies topped at 7.4 months in October." However, NAR didn't note that inventories usually increase through mid-summer, and inventories will probably be well over 4 million this summer.

In fact, if inventories grow at the same percentage rate as last year, inventory levels will reach 4.8 million in August. If inventories grow by the same quantity as 2006, inventories will be over 4.6 million by August.

With tighter lending standards, demand will probably fall too. Credit Suisse recently estimated new home sales would fall by 21% in 2007. BofA estimated a decline of 15% for new home demand in 2007. We will probably see a similar decline in existing home sales.

This graph shows annual existing home sales and inventory for the last 30 years (2007 estimated). The graph shows an estimated inventory increase to 4.5 million units, and sales falling to 5.7 million units (my estimate is 5.6 to 5.8 million existing home sales in 2007).

Inventory of 4.5 million units, and sales of 5.7 million, means 9.5 months of supply this summer. For the more optimistic, use 4 million units of inventory, and sales only falling to 6 million units, giving 8 months of supply.

Usually 6 to 8 months of inventory starts causing pricing problems, and over 8 months a significant problem. With current inventory levels at 6.7 months of supply, inventories are now well into the danger zone. By mid-summer, months of supply will likely be a significant problem.

And this takes us back to the supply demand imbalance. The huge overhang of existing home supply makes the market appear to be out of balance to the new home builders.

by Calculated Risk on 3/23/2007 12:31:00 PM

From the NYTimes: The Subprime Loan Machine. This story describes the rise of automated underwriting; both the benefits and the pitfalls.

“Automated underwriting put the credit score on such a pedestal that it obscured the other important things, like is the income actually there,” said Professor Retsinas of Harvard. “Before there was A.U., down payment mattered a lot. Where we’ve crossed the line in recent years is to say, we don’t need down payment.”

This article is very good, but Tanta notes that it doesn't mention Nicolas Retsinas previously "served as Assistant Secretary for Housing-Federal Housing Commissioner at the United States Department of Housing and Urban Development, and as Director of the Office of Thrift Supervision."

The following two articles look at the impact of the housing bust on communities (hat tip: Wayne):

From the NY Times: Foreclosures Force Suburbs to Fight Blight

“It’s a tragedy and it’s just beginning,” Mayor Judith H. Rawson of Shaker Heights, a mostly affluent suburb, said of the evictions and vacancies, a problem fueled by a rapid increase in high-interest, subprime loans.

“All those shaky loans are out there, and the foreclosures are coming,” Ms. Rawson said. “Managing the damage to our communities will take years.”

From the Charlotte Observer: Failed mortgages fly under the radar

An Observer analysis of county records found 35 Mecklenburg developments of low-priced homes built in the past decade with foreclosure rates of 20 percent or higher. Dozens of residents say the concentrations have damaged their communities. Prices fell. Renters moved in. Crime sometimes rose.

by Calculated Risk on 3/23/2007 10:07:00 AM

The National Association of Realtors (NAR) reports: Existing-Home Sales Rise Again in February

Click on graph for larger image.

Total existing-home sales – including single-family, townhomes, condominiums and co-ops – rose 3.9 percent to a seasonally adjusted annual rate1 of 6.69 million units in February from a downwardly revised level of 6.44 million in January, but are 3.6 percent below the 6.94 million-unit pace in February 2006.

The above graph shows NSA monthly sales for 2005, 2006 and 2007. This shows that March is the first key month of the year.

Total housing inventory levels rose 5.9 percent at the end of February to 3.75 million existing homes available for sale, which represents a 6.7-month supply at the current sales pace compared with a 6.6-month supply in January. Raw inventories peaked last July at 3.86 million, and supplies topped at 7.4 months in October.

A few key points:

1) March is the beginning of the spring selling season.

2) Inventory is at a record levels for February (30% above Feb 2006).

3) Existing home sales are reported at the close of escrow. This means these contracts were mostly signed in December and January. So these numbers are prior to the subprime implosion of mid-February.

by Tanta on 3/22/2007 10:24:00 PM

In our last episode, we found our hero, MI, throwing itself in front of our hapless lender, bravely absorbing the first impact of the real estate train wreck. Before we go on to talk about other issues, let’s make sure we understand what “loss position” means. If you’re used to thinking of insurance in terms of things like auto or health, you’re used to being "the insured." You're also in the first loss position: that’s what a “deductible” is. It means that in an insurable event, you will take the first loss up to your deductible amount, and only if the losses exceed that limit will the insurer step up and take the rest of it. MI doesn’t work that way (with the possible exception of “captive reinsurance” issues, which we’ll talk about below).

MI is designed to be the first loss position: it covers losses up to the coverage level amount, and only if losses exceed that amount will the lender (who is “the insured”) take the rest of it. It's rather like the reverse of a deductible. The lender/investor doesn’t spend its own money until the MI has spent all the money it is contractually obligated to spend first.

This may answer the questions some people had about how the insurer and the lender might be somewhat differently motivated when it comes to mitigating losses on a loan. The MI will be pushing for collection efforts, forbearance, modifications, and so on, whenever it’s prudent (in the MI’s perspective), because the MI pays first in a foreclosure and doesn't want to do so unnecessarily. The lender might want to foreclose sooner rather than later, because in an early foreclosure, most losses are likely to be covered by the MI. Who gets its way is a question of how the fine print in the policy reads. The lender/servicer is not obligated by law to follow the MI’s requirements. It is obligated by sheer self-interest: if you don’t follow the MI’s servicing rules, the MI won’t pay the claim.

Mortgage insurance policies can come in several flavors. The most common is the primary policy. This is a policy that insures some percent of the losses on an individual loan. Primary policies can be written on a flow basis or a bulk basis. “Flow” means that policies are written on a loan-by-loan basis, as they are originated. An originator could then take a pool of loans that have already been covered with flow primary policies, and securitize them. If the amount of coverage on the existing flow primary policies is sufficient, no further insuring of the pool of loans is necessary. “Bulk” means that policies are written to cover individual loans, but they are written all at once, after the loans have already been closed, on a big portfolio of loans.

Flow primary policies can be “borrower paid” or “lender paid.” Bulk primary policies are always “lender paid.” This part is confusing, because in real-world terms, the borrower is always paying for the MI somehow. The difference is really in how the borrower pays it (which can impact how well the risk is priced, as we’ll see).

When we use the term “borrower paid,” we mean that the mortgage insurance premium for the individual loan is set by the insurer before the loan is closed, according to the insurer’s underwriting guidelines, and is paid out of the borrower’s monthly loan payment (the “T&I” or “escrow” portion). Some premiums are paid monthly; the servicer takes the monthly part out of the borrower’s payment and remits it to the MI each month. Some are paid annually; the servicer puts the monthly part of the borrower’s payment into an escrow account, and then remits the annual premium to the MI when it is due (after sufficient funds have built up in the escrow account). The borrower never pays the MI premiums directly; this is important. The borrower is not the insured; the lender is. The servicer must collect premiums from the borrower and then send them to the MI. The borrower is not responsible for making sure that happens; the borrower is only responsible for making the MI part of the monthly payment to the servicer as specified in the loan closing documents. The MI’s job is to make sure the servicer is doing its job.

The industry term “lender-paid” refers to a situation where the borrower’s closing docs do not specify a monthly premium portion to be paid into escrow. Instead, the borrower just pays a higher interest rate on the loan, and the lender pays the MI premium out of its interest income, which (ideally) reduces the yield on a lender-paid loan to the equivalent of the yield on a borrower-paid loan. In this regard, it works like servicing fees: the servicer takes the required slice off the interest payment needed to pay the MI premiums, and then passes through the remainder to the investor. You can see why it’s still really paid by the borrower: it comes out of the interest payments the borrower makes. It’s called “lender-paid” because it does not come out of an escrow account funded directly by borrower T&I payments.

Lender-paid primary flow insurance (LPMI) got really popular for a while, because it was marketed as “tax advantaged.” (Countrywide’s product is actually called “TAMI,” Tax Advantaged Mortgage Insurance.) The idea is that mortgage interest is tax-deductible but mortgage premiums are not (although that’s changing); the borrower could make more or less the same monthly payment on the lender-paid plan, but deduct more on the tax return because it was interest instead of premium.

Some of us think this wasn’t always such a great deal for the borrower; it depends on the fine print in the closing documents. Specifically, the higher-rate lender-paid deal is OK as long as you get a nearly free option to modify your loan back to market rates once your LTV drops under 80%. (“Nearly free” would mean you paid only the cost of a new appraisal to verify LTV; you would have to pay that to cancel borrower-paid insurance, too.) If you aren’t given such an option, lender-paid MI can cost you more over time even with the deduction, since it’s costlier to get rid of it (you’d basically have to pay refinance costs and hope rates are low at the time). Anyone who wishes to insist that LPMI is a great deal for the consumer should ponder the fact that rating agencies and securitizers tend to prefer it to borrower-paid MI precisely because it is marginally more persistent, meaning that borrowers pay higher rates longer than they pay monthly insurance premiums. If and when prevailing rates rise substantially, some borrowers will find it difficult or unpleasant to try to “refi” out of LPMI.

Bulk policies, of course, are all LPMI (since the MI is added to the loans in bulk transactions, after they’re closed, they have to be LPMI instead of borrower-paid. You can’t go back to a borrower after you’ve closed the loan and say, hey, we decided you need to start paying MI.) There are two important issues for bulk: first, these are still loan-level policies; it’s really just a matter of writing a whole lot of individual policies at once, rather than on a flow as-the-loans-close basis. Second, from the insurer’s perspective, bulk policies are nearly always of weaker average credit quality than flow policies. It’s rather like the difference between pork loin and sausages. Bulk loan portfolios are the “sausages,” and they’ll always have some percentage of “filler.” As long as they still taste something like pork loin—that is, as long as the averages across the portfolio of loans is OK—then they’re still insurable. But the premium structure for bulk is different from flow, to take the credit quality differences into account.

What is called “pool insurance” is a pig of a different color. Pool insurance is a way of covering a big group of loans, like bulk, but unlike bulk, pool insurance is not a primary policy. A primary policy covers a maximum percent of the losses on an individual loan. It is not “cross-default” insurance, meaning that if you don’t lose the whole maximum claim amount on a given loan, you can’t apply the remaining claim amount to another defaulted loan. With pool insurance, you can apply the total policy maximum to different loans. Pool insurance can be applied to a pool of loans that already have primary policies, a pool of loans that do not have primary policies, or a mixture of the two. It generally has a maximum dollar amount or percent of pool balance that it will cover; individual loan losses are applied to that limit until it is reached, and then the remaining pool balance is uninsured. When there is a loss on a loan with a primary policy, the primary policy pays first to its maximum claim amount, and then the pool insurance kicks in for any remaining loss.

So pool insurance can either supplement or replace primary coverage, depending on the pool, the agreement, and the underlying loans. Pool insurance is often called “lender paid,” but it’s really mostly used in securitizations and so it’s more properly considered “bondholder paid.” It’s a form of credit enhancement, and like any other credit enhancement, its cost comes out of the yield of the underlying loans. It is cost-effective to the bondholder only to the extent that the underlying loans 1) throw off enough income to leave a reasonable net yield after the cost of the credit enhancement and 2) are of high enough credit quality themselves to be eligible for relatively inexpensive premiums.

Bulk and pool insurance can be like a belt added to the primary flow policy suspenders. You will sometimes hear of lenders—we’re hearing quite a bit of this lately—adding MI to a portfolio of loans that they’ve held for some time. The idea is that they sniffed the wind and decided perhaps more insurance coverage would be a good idea. This may make the shareholders of those portfolio lenders feel better.

Before getting too warm and fuzzy over it, though, shareholders might remember two things: MI companies can smell change in the air just as much if not more than lenders can; being on the hook for losses does tend to sharpen one’s wits. Buying insurance while you’re young and healthy (flow primary) tends to be cheaper than buying it when you’re sicker and older (bulk or pool policies acquired after “sniffing the wind”). Furthermore, “lender-paid” MI is a profitable proposition to the lender only insofar as the lender originally set the borrower’s interest rate at closing to a level high enough to cover the insurance costs. Having to go back and insure an originally uninsured or underinsured portfolio can mean having to spend interest income that did not originally “budget” for insurance. Ouch. So a lender who announces that it has just insured (or increased the insurance on) some part of its portfolio is telling you that 1) it thinks the outlook is worse than what it predicted when it closed the loans and 2) it just reduced its income on that portfolio and 3) it thinks that loss of income is worth it, which tells you, in essence, how much worse the outlook is.

Today’s final topic is this “captive reinsurance” thing. In short, that’s a setup in which a lender forms a subsidiary which “captures” part of the mortgage insurance premium. In exchange, it agrees to take some part of the MI’s exposure. A typical arrangement might involve the lender’s captive taking 25% of the premium in exchange for covering 25% of the first loss.

The devil, with these things, is always in the details; whether this is a good deal or bad deal for either party depends on which 25% the captive is taking. It could involve a split, meaning the captive pays 25 cents for every 75 cents the insurer pays, starting with the first dollar paid. Or, it could mean the captive pays the first 25% of losses, and then the MI pays any remaining losses up to 75% of the maximum claim. Or the MI could pay the first 25%, the captive the second 25%, and the MI the last 50%. You have to read the agreement; these things aren’t exactly standardized.

Suffice it to say that, in the boom years, they were a real money-maker for lenders, since losses were so low what with bubble prices and endless refis. Whether they will continue to be, and whether some lenders may yet re-discover the meaning of that old phrase about chickens coming home to roost, is yet to be seen. On the whole, my personal view is that if there’s a sucker at the table somewhere, it probably isn’t the MI. They are in the business of insuring against losses, and most of them have been at it long enough to have been there, done that, got scars to show for it. A few of these “new, quickly growing mortgage lenders!” who emerged more or less in the boom may not necessarily be pricing their risk quite exactly right, in my view.

So far, we haven’t addressed the big question of how, then, the MI’s underwriting guidelines stack up against everyone else’s. That’s a critical question, if you want to know how much risk the MIs have taken on, and how likely they are to withstand the losses they might have to take. But it’s also a subject for the next installment.