In May of 2012, FedFin published a white paper on the future of credit insurance. We said then that private mortgage insurance (MI) would face a strategic reckoning because the pre-crisis model of monoline state-insurance regulation would not last. Comforted by rising mortgage volumes in 2012 and 2013, not to mention higher FHA premiums, some MIs thought they had beat the reaper. That was, though, until the Federal Housing Finance Agency on Thursday proposed a set of standards MIs must meet to do business with the GSEs, counterparties on whom their franchises depend. Key to the new rules are bank-like capital and liquidity standards. Heads-up, anyone who wants to take a first-loss tranche ahead of the USG as the GSEs are sent to their reward.
Why did FHFA do what it did to the MIs and why does it matter not just to them, but also to anyone who wants to provide a first-loss position ahead of the taxpayer? First and foremost, MIs had a most unhappy experience during the crisis. Several of the largest MIs went into receivership and were then unable to pay claims in full despite the vaunted bullet-proof nature of their premium-contingency reserves. Another major MI might well have followed its failed colleagues but for the fact that its parent was taken over by the feds for sins well beyond any in the subsidiary mortgage insurer. All of the surviving MIs had to raise billions of dollars in new capital to stay afloat.
Failed MIs didn’t pay claims in full, but survivors also didn’t pay all those which RMBS investors – the GSEs very much included – thought they were owed. MIs rescinded coverage on billions in mortgages on grounds that underwriting failures and/or fraud vitiated the MI’s obligation just as arson vitiates fire insurance. There was some truth to this, but investors did not care and still blamed the MIs. The combination of failed MIs and rescinded coverage cost the GSEs dearly. It also made the FDIC’s tab bigger in several very large bank failures (e.g., Indy Mac), because that agency similarly didn’t get what it thought it was owed when mortgages it owned went in receiverships to claim.
All of these bygones could have gone by – a similar set of non-payment came from municipal-bond insurers – but for the systemic nature of the customers the MIs serve. Fannie and Freddie are of course effectively U.S. Government agencies, meaning that their risk is our risk. If a counterparty can’t buffer Fannie or Freddie under stress, the GSEs could falter at a time when their presence is most vital to preserving housing-market liquidity and preventing a 2008 re-run. This is why MI is in FHFA’s Bull’s-eye, one placed before it when global regulators called for bank-like rules for MIs and Treasury followed suit with a demand for systemic designation.
One might think MIs are the only ducks in policy-makers’ guns, but the debate over who could provide a first-loss tranche ahead of the U.S. government was very much in evidence as the Senate wrestled over who could take this position in first the Corker-Warner and, then, the Johnson-Crapo bills. The issue was fought to a stalemate in concert with the rest of the GSE-reform legislation, but it won’t go away.
With the Treasury now asking for input on how to restart private-label mortgage securitization without legislation, the question of how to protect the taxpayer is very much with us despite the legislative lull. Treasury could decide that some big banks are great first-loss providers because they meet standards at least as stringent as those FHFA proposes for MIs. So they do, although the very stringency of these rules makes taking on high-risk, first-loss positions a challenging proposition. Non-banks including surviving muni-bond insurers are lining up for their chance to take this on, but only – as was evident in the Senate’s struggles – if they don’t have to hold a lot of capital or come under rules comparable to those governing the big banks now and the MIs in the immediate future.
Could Treasury now and Congress later craft a new RMBS structure that ignores the costly fate of the MIs and still lets relatively unregulated, uncapitalized firms in ahead of the taxpayer if the non-banks promise to be very, very good? I doubt it. FHFA didn’t spend all the time it did and craft the tough rules it has for the MIs just to tidy up the rulebook. If FHFA, Treasury, and the broader policy community want public-private risk-shares that go beyond the small experiments the GSEs have launched so far, the regulatory criteria for eligible counterparties must be crafted, road-tested, and enforced. MIs are first on the firing line, but far from last.