As financial regulators fret about risk migration to nonbank financial intermediaries, a new race to the sunny side of the regulatory street is already underway. As detailed in a comprehensive Bloomberg article, insurance companies are increasingly investing in high-risk whole residential-mortgage loans, doing so either with no capacity to service them unless they rely on parent-company private-equity firms to do so somehow. What could go wrong?
This transaction is redolent – indeed, it’s a repeat – of how nonbanks barged into mortgage finance before the great financial crisis without a clue about the real risks they ran. Well, I recall Bear Stearns’ big bet on mortgages placed without any concomitant servicing capacity because, as they said at the time, mortgages never go to foreclosure. Speculative house-price increases led them to this sanguine conclusion because there hadn’t been many foreclosures for a couple of years, but neither Bear Stearns’ mortgage portfolio nor the firm is here today to ruminate over hard lessons learned in the 1980s.
Bear Stearns’ failure quickly became a systemic threat, with wider damage delayed until the 2008 crash thanks only to the first of the Fed’s high-cost subsidized mergers that bred moral hazard that fired speculation up to a still more frenzied height until Lehman Brothers failed.
As before the great financial crisis, insurance companies are investing in high-risk mortgages because yield-chasing and capital arbitrage rewards them, at least for now. The whole mortgage loans insurance companies are buying carry wide spreads over RMBS is only in part because loans are not securitized at greater investor cost thanks to guarantee fees. These mortgages are also generally ineligible for low-cost agency securitization because they do not meet the risk criteria essential for qualified-mortgage (QM) status. As the CFPB defines this, non-QMs are loans to borrowers with uncertain ability to repay, high-risk terms and conditions, or other indicia of risk Congress told banks and GSEs to avoid when it wrote this category into the Dodd-Frank Act.
According to Bloomberg, the insurance companies placing these high-risk bets are often those owned by private-equity firms, perhaps the reason the insurance company doesn’t feel the need to ask awkward questions about servicing capacity because their parents demand ASAP high return and management is loath to deny them. Or, perhaps, the insurance companies know only the look of their investments, not understanding how delinquency and default require the servicer and/or owner of the loan to take an array of costly, operationally-intense actions designed to prevent foreclosure. Insurance regulators are also unlikely to know that with mortgages comes servicing and with servicing comes cost and risk. Banks pay for this with stringent capital standards mandated after the great financial crisis. These are nowhere written in insurance-capital standards because insurers have never held mortgages that needed servicing; they held only RMBS, where it’s someone else’s headache.
Complex and costly servicing standards are another vestige of the great financial crisis, a time when the banks that then dominated mortgage servicing couldn’t handle the obligations this entailed in a crisis, needlessly turning homeowners out and sharply increasing foreclosure rates along with community distress. Banks have largely been forced out of the servicing business due to the overall capital changes to mortgage obligations and hard lessons about resulting liability.
Nonbank mortgage originators have stepped in and serviced loans but rarely do so for non-QMs precisely because of the cost and risk this entails. In part due to all the new borrower-protection rules, nonbank mortgage servicers still went through the wringer in 2020 and remains a systemic-risk worry for both the FSOC and IMF.
Thus, insurance companies betting on whole non-QMs are at the roulette table. Insurance companies owned by private-equity firms also face unique risks beyond those arising from hoped-for servicing capacity. Treasury’s Federal Insurance Office has identified this and Senate Banking Chair Brown hammered it home at a hearing in late 2022. When insurance companies take high-risk assets off the hands of parent private-equity firms, policy-holders are at greater risk because private-credit is a high-risk gamble all its own.
Happily, insurance-company high-risk mortgage holdings seem small so far. But, as we keep learning the hard way, big risks often start small and yield-chasing and regulatory arbitrage have never ended well.