Second of two-part series
Eight years ago a Bear Stearns research report on the mortgage insurance industry warned of a grave threat: In exchange for steering home buyers to the insurers, mortgage lenders were demanding unjustifiably lucrative reinsurance deals.
"We find it difficult to understand how some of these arrangements conform" with legal prohibitions on mortgage kickbacks, Bear analysts wrote.
Six years later in 2009, amid the wreckage of the biggest housing bust in history, federal investigators concluded that what Bear had opined were sweetheart deals were in fact just that. Beginning in the late 1990s major U.S. banks began coercing insurers into cutting them in on what would ultimately amount to $6 billion of insurance premiums in exchange for assuming little or no risk, alleged investigators in the inspector general's office at the Department of Housing and Urban Development. Inspired by the over-sized profits, bankers further were found to have sold unwary home buyers more mortgage insurance than they required.
As reported by American Banker on Sept. 9, the HUD inspectors presented their findings to the Department of Justice a year and a half ago in a bid to spark a case against many of the nation's largest banks. The DOJ has taken no public action to date and declines comment. It is one of several entities that appears to have failed to address the apparent wrongdoing, despite ample warning signs. They include the HUD officials who oversaw home lending for two decades, state regulators, mortgage insurers and class action attorneys.
While their institutions reaped large short-term profits from the captive reinsurance arrangements, in the end the bankers may have outsmarted even themselves by foisting insurance risk onto others.
"It gave the banks a false sense of confidence that they didn't need to pay attention to underwriting standards," says Joshua Rosner, managing director of Graham Fisher & Co., an independent research boutique.
The alleged reinsurance kickbacks evolved from what was originally prudent practice. Bankers wanted to share in the profitable business of insuring mortgages against default. Insurers welcomed them to ensure careful underwriting. Early reinsurance agreements fulfilled both objectives by granting banks the premium revenue equal to the risk they incurred.
That began to change in the late 1990's at the behest of Angelo Mozilo, the pugnacious chief executive who built Countrywide Financial Corp. into the nation's largest home lender. Under Mozilo, Countrywide pushed into non-traditional areas such as low-doc lending, property appraisals and title insurance. In mortgage insurance, Countrywide became the first lender to forge a risk-sharing arrangement known as "excess-of-loss."
Under a 1996 deal with Amerin Guaranty, a mortgage insurer absorbed in 1999 by Radian Group Inc., Countrywide's captive insurance subsidiary split risks unevenly. The agreement put the insurer in the first-loss position, meaning that Countrywide would only pay claims if they rose to a high level. Goodbye to proportional loss-splitting.
HUD's assistant secretary for housing declared in a 1997 opinion letter that such deals were acceptable, as long as they were not the result of coercion and transferred risk. "The reinsurance transaction cannot be a sham," the HUD letter stated.
With the pattern in place and the mortgage market heating up, home lenders pressed for increasingly favorable terms. That included so-called "4-10-40" deals in which the mortgage originators received 40% of premiums in exchange for reimbursing insurers for no more than 10% of claims-and even then only after the most likely 4% of losses were incurred.
Within a few years, excess-of-loss deals had become outright shams, the HUD inspector general's office later concluded. In addition to the 4-10-40 structures, investigators found terms were altered in numerous ways to benefit lenders, including SunTrust, GMAC, CitiMortgage and Countrywide. The biggest tweak was to make policies "self-capitalizing." Banks were required to put only "nominal initial capital" into the trusts that backstopped the reinsurance policies, according to a 2000 presentation to CitiMortgage by a predecessor of Genworth Financial. Banks' stakes were largely funded only as premiums came in from home buyers.
The extent to which this occurred and the degree to which it advantaged the banks struck the HUD inspector general's office as highly unusual. The banks were supposedly providing catastrophic reinsurance, but the policies appeared to render it impossible that they'd ever suffer significant losses. In the event of catastrophic losses, a bank could simply walk away from its nominal initial investment and leave the insurer to bear the other costs.
Actuaries hired by the insurers signed off on such deals as meeting the narrow requirements for risk transfer. However, the policies were a bad deal for insurers in almost every circumstance, HUD investigators concluded. If defaults remained low, banks would pocket large premiums without paying any claims; if defaults were high, banks' losses would be capped at the amount of their small initial investments, plus the premiums paid by homeowners and passed along to them by their mortgage insurance partners. In other words, it appeared to be a no-lose proposition for the banks.