June 12, 2015

Joshua Rosner
646/652-6207
jrosner@graham-fisher.com
Twitter: @JoshRosner

Deep MI, CSP: The MBAs New and Dangerous Mission Creep
Between 2000 and the financial crisis the term mission creep was aptly
and often used by large banks, mortgage lenders and the private mortgage
insurance (PMI) industry to warn of the threat of the government
sponsored enterprises (GSEs) Fannie Mae and Freddie Mac creeping over
the borders of their intended functions.
The GSEs were created and chartered as secondary-market firms and
intended to provide liquidity to the primary mortgage market, and transfer
credit risk into the hands of investors. Mission creep was, in fact, a real
threat not only to those primary market players but also to systemic
stability. When the GSEs activities blurred the lines between primary
market lenders and secondary market liquidity providers, as example
through their automated underwriting systems, they transitioned away
from being the backbone of a countercyclical insurance regime to ensure
that liquidity to the primary mortgage origination market would continue
in adverse economic periods.
As the crisis descended on the economy and mortgage markets, the
problems of the GSEs and the primary market players became highly
correlated. While this should have been a lesson for policymakers and the
mortgage industry, it has not yet been learned. Instead, over the past few
years we have witnessed increasing efforts by primary market players to
get a larger role and foothold in the secondary market. With the GSEs
muzzled in conservatorship and prohibited from engaging in activities that
could be argued to be lobbying, there are few voices to warn of the
dangerous path we are on of a new mission creep led by the primary
market players, who seek to comingle functions across those two distinct
markets. Unless there are independent and honest voices brought to bear
on this matter, we will recreate the same dangerous and pro-cyclical
system that failed.
It is understood that Corker-Warner, Crapo-Johnson, Rep. Hensarlings
PATH Act and the recently introduced Title VII of Sen. Shelbys reform
bill (authored by Sen. Corker) would be generous gifts to the big banks
and PMIs. Given the false assumption that private capital attracted in good
times would remain available in bad times, these bills do little to provide
necessary countercyclical buffers beyond a further backstop of the federal
governments safety net for these same institutions.

Please refer to important disclosures at the end of this report.

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June 2015

With legislative efforts having stalled, the largest primary market players
in concert with PMIs and rating agencies are now seeking to exert public,
political and administrative pressure to force their way into the secondary
market. This can be seen through their efforts, with the assistance of
captured or nave legislators,i to gain access to the secondary market
Common Securitization Platform (CSP) that FHFA is forcing the GSEs to
build. It can also be seen through their efforts to gain acceptance of deep
MIii as a means to reduce the fees charged by the GSEs for insuring
mortgages originated by those largest lenders and to generate new revenue
and income streams for the PMIs and rating agencies.
The CSP
While the purpose of this brief is to raise some red flags about unspoken
risks of deep MI. Still, it is worth briefly highlighting three of the key
concerns we have with the too-big-to-fail institutions purchased support
for gaining access to the CSP.
1- The GSEs, as secondary market providers of liquidity for
support of the primary market, were never intended to insure or
guarantee all mortgages, even all of those mortgages that are
conforming and conventional. They were intended to ensure
liquidity, in the form of insurance, in instances where primary
market lenders did not have sufficient access to, or where there
was not sufficient access in, the primary market.
If the GSEs properly priced the cost of the insurance they
provided (g-fees) to the primary market then those largest
primary market lenders who choose not to hold loans on
balance-sheet and have direct access to capital markets, would
be able to package and securitize mortgage-backed securities,
as private label securities (PLS), at comparable rates to those
they would find as a result of a GSE insurance wrap. In good
times this would reduce the size and need of the GSEs
(secondary market). As a result, only those smaller lenders who
did not have direct access to the capital markets would require
GSE insurance wraps. Through the GSEs these smaller firms
would be able to compete, on a level playing field, with their
larger peers. In adverse economic times, though, wellcapitalized GSEs would be able to properly price the credit risk
and cost of insurance so that any firm that did not have direct
access to markets would be able to continue to support the
allocation of capital to the mortgage market of the real
economy.

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2- If the largest firms get direct access to the CSP, those smaller
firms would likely lose their ability to compete with the larger
firms as they would not generate the same volume of loans and
would therefore suffer relatively higher execution costs. As a
result, they would be increasingly likely to sell their volumes to
the larger players. This would turn the smaller players into the
same third party originators that failed during the crisis and
create further concentration in the primary market.
3- If the largest firms were to gain access to the CSP it is likely
that within a few short years they would use their lobbying
power to suggest, without any real proof, that by being allowed
to vertically integrate real estate sales into their allowable
activities they could reduce the costs to homebuyers.
Obviously, given the broad competition in real estate sales,
compared to the heavily concentrated and oligopolistic nature
of the mortgage origination industry, this argument is
threadbare.
Although we have other concerns with the idea of granting primary market
firms with direct access to the secondary market CSP, we will address
those in a future note.
Deep MI
Over the past year, we have witnessed the Mortgage Bankers
Associations (MBAs) efforts to try to advance the notion of deep MIiii.
These efforts have grown louderiv, more full of hyperbole and less
considerate of the risks of deep MI. This is not traditional mortgage
insurance, in which the GSEs require a borrower to buy either
directly or through a bulk policy mortgage insurance on any portion
of a mortgage that exceeds an 80% loan-to-value ratio, and when the
borrower builds enough equity in their home, the mortgage insurance
is cancelled thus reducing the revenues to the PMI firms. This is a
new product selected and paid for by lenders, and the numerous
problems in its design would become new operating costs to the GSEs.
Because the GSEs calculate the cost of an insurance wrap that a lender
must pay to cover the risk the GSEs bear, both for the MI as counterparty
and for the underlying loan, the g-fee reflects those costs. The Mortgage
Bankers Association is now pushing the notion that by buying PMI
directly and more deeply than the 80% LTV, they can justify and should
receive a lower cost on the g-fees they pay the GSEs. While this sales
pitch sounds sensible on its face, it ignores the risks incurred and appears
little more than another effort of the mortgage industrial complex to
creep into the secondary market and to assure new volumes of loans,

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June 2015

insurance contracts and ratings assignments. Below we highlight a few of

the concerns we have with this proposal.
1- The PMI industry has a horrendous track record of pricing risk,
remaining adequately capitalized and paying claims. This has
been proven during several mortgage cycles and resulted in
large-scale failures in the industry during the 1930's, 1950's,
and 1980s and in this crisis. In fact, had the GSEs not been
placed in Conservatorship, and provided forbearance to the
MIs, it is unlikely any of the legacy firms would have
survived.
2- The PMI industry remains less well capitalized today than it
even was in 2007. Today the industry has only about $8 billion
in capital; in 2007 it had about $11 billion. Given that the
GSEs have about $5 trillion of business on their books it is
clear the PMI industry doesnt even have sufficient capital to
insure the top 20% of their books, let alone the capital to insure
down to 50% or 60% of their books of business.
3- As state regulated insurance firms, whose holding companies
and operating subsidiaries are often situated in different states.
It is difficult, if not impossible even for state regulators to
assess claims paying ability or ensure that claims are paid.
4- While capital standard requirements governing the ability of
the GSEs to do business with a PMI have been strengthened,
and are proper authorities of the GSEs and their regulator, it
must be remembered that due to the failures of state insurance
regulators, the GSEs were forced to provide forbearance to
struggling MIs in this crisis. Five of the ten PMI firms that the
GSEs did business with exceeded state 25:1 risk-to-capital
ratios and three of those five either entered runoff, deferred
payments to the GSEs or became unable to write new business.
5- Although the MBA would like policy-makers to see it as such,
the reality is that deeper MI is not fully funded credit
protection. When, as happened during the crisis, a PMI
becomes insolvent or state insurance regulators prevent the MI
from paying full or partial claims the GSEs will not have the
benefit of credit protection.
6- Since the MIs business is almost exclusively tied, and highly
correlated with the business of the GSEs it is likely that their
claims paying ability would be most impaired at the time the
GSEs would most need to rely on their claims paying abilities.
7- Since the lender, and not the GSEs would purchase the deep
MI coverage, it would be difficult, or impossible for the GSEs
to manage their exposures to any particular MI. This is
nonsensical given that the GSEs would be the ultimate

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beneficiary of any MI policy and should therefore be able

control their exposures to particular MIs.
8- As we witnessed in the crisis, the largest lenders were able to
extract the lowest G-fees from the GSEs. It is reasonable to
expect that, given their larger volumes of loans, the largest
banks will almost certainly be able to negotiate cheaper
premiums than smaller lenders. Leading to further
concentration of the lending industry to the detriment of
smaller lenders.
9- Deep MI appears to be little more than a scheme to ensure the
PMI and credit rating firms remain relevant in a world in which
there are more and better ways to transfer and to analyze risk.
Increasing use of transfer securities, by the GSEs, has proven
both efficient and effective. If, eventually, market access to
credit risk transfers allows the GSEs to transfer risks that
would otherwise be backed by PMI, that would become an
existential threat to the PMIs business volumes.
10- Unlike regular PMI, for which the GSEs or their regulator
defines the standards, deep-PMI is designed for the based on
the economics of the structures of an asset-backed security.
This is precisely the problem of financial engineering that
proved difficult for the ratings industry to model and track and,
more importantly, it would require levels of disclosures - to
investors - that would not likely be forthcoming.
11- Failure of the trustee in an MBS deal can result in the
cancellation of insurance.
12- Failure of a servicer to meet PMI guidelines may result in a
reduction of coverage on already issued MBS.
13- Deep PMI creates incentives to originate higher average LTV
loans. This increase in consumer leverage was proven, during
the crisis, to have deleterious impacts to macro-economic
stability.
14- Deep MI can reduce losses for lower loss severities but in cases
of higher severity losses, the deep MI is only able to absorb a
portion of the loss.
15- Deep MI is little more than another attempt, by the mortgage
industrial complex, to arbitrage the GSEs, investors and
consumers:
a. Where the borrower ultimately pays for standard MI,
that borrower is relieved of their duty to pay when they
accumulate enough equity to be relieved. While it is
claimed that deep MI shifts the entire costs of the
coverage onto the issuer, this would almost certainly
come at increased costs to the borrower while passing
the financial benefits of reduced G-fees on to mortgage

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June 2015

bankers (and, due to increased business volumes, the

rating agencies and PMIs);
b. Mortgage bankers would also benefit from the lower
required subordination and reduced yields paid to MBS
investors even though the rating enhancements are
theoretical and modeled rather than based on long
history of empirical experience;
c. The complexity required to properly calculate any
justified reduction in G-fees would also likely be
lobbied and politicized, to the benefit of the issuers, and
would stretch the ability of a primary federal regulator or the GSEs - to properly model that G-fee based on
any historical experience; and
d. Without a clear and stated mechanism to address future
downgrades of the ratings of a PMI company there
would be no effective mechanism to require or enforce
a 'topping up' of collateral pools to protect investors.
Moreover, there is no historically tested experience in
ensuring that investors are protected in these
circumstances.
Once again, we would warn regulators and policy-makers those industry
efforts to create new structures, rather than repairing existing and
transparent structures, leads to a loss of economic productivity and risks
creating the basis for the next crisis.
i

Letter from Senators Bob Corker, Mark Warner, Mike Crapo, Jon Tester,
Dean Heller, Heidi Heitkamp, Pat Toomey, Mark Kirk to The Honorable
Mel Watt Director Federal Housing Finance Agency, March 17, 2015,
available at:
http://www.corker.senate.gov/public/_cache/files/221a4274-f6fd-432db03b-949cc055498e/Senate%20CSP%20Letter%2003172015.pdf (See:
A CSP that is accessible and valuable to not only to Fannie Mae and
Freddie Mac, the Government Sponsored Enterprises ("GSEs"), but also
private sector participants in the secondary mortgage finance market,
would facilitate positive transformation in the nation's housing finance
system.) Note: The only shareholder owned and governmentally
chartered secondary-market firms are the GSEs and the home loan banks.
This is clearly an attempt at mission creep by firms that are not chartered
or regulated for secondary market activities. Allowing such firms access
to the secondary market will only serve to increase systemic risk and
reduce the effects of competition, in the primary markets, from smaller
lenders.
ii
Letter from David H. Stevens, President and Chief Executive Officer of
the Mortgage Bankers Association to the Federal Housing Finance

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Agency, September 5, 2014, available at:

https://www.mba.org/Documents/mba.org/files/MBALtrtoFHFAonPMIE
RsProposal.pdf (See: FHFA should adopt a program to allow for deeper
MI coverage on high LTV loans, and coverage on loans with LTVs below
80%, accompanied by a reduction in G-fees. Importantly, this would
require lowering the floor on loss factors to account for these lower risk
loans)
iii
GSE Up-Front Risk-Sharing, Mortgage Bankers Association,
available at: https://www.mba.org/issues/residential-issues/gse-up-frontrisk-sharing (See: MBA strongly supports requiring the GSEs to test new
approaches to risk-sharing that include the use of deeper up-front risksharing. MBA submitted comments on FHFA's Request for Input on
Guarantee Fees and Request for Input on PMIERs and in both letters
reiterated the need for, and benefits of, deeper up-front risk-sharing. MBA
will continue to push for reductions in LLPAs through deeper risk-sharing.
Congress should urge FHFA to implement a deeper risk-sharing pilot
program.)
iv
More Competition Would Rally Mortgage Market, Editorial by
Michael Fratantoni, Chief Economist of the Mortgage Bankers
Association, American Banker, June 10, 2015, available at:
http://www.americanbanker.com/bankthink/more-competition-wouldrally-mortgage-market-10747991.html?utm_campaign=abla%20daily%20briefingjun%2011%202015&utm_medium=email&utm_source=newsletter&ET=a
mericanbanker%3Ae4543084%3A474409a%3A&st=email (See: Making
risk-sharing options available to lenders at the point of sale, rather than on
the back end, would allow additional private capital and competition to
flow into the secondary market.)

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