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.
How banks allegedly got away with demanding kickbacks through sure-bet reinsurance deals harks back in part to the actions of the insurers themselves. As the excess-of-loss arrangements became more favorable to the banks, mortgage insurers complained regularly that they were bad business for them. Standard & Poor's agreed. The worst deals were slashing insurers' profit margins without reducing their risk, it declared in a 2003 report.
Finally, MGIC Chief Executive Curt Culver stood up. He was a longtime industry hand who arrived at the company in 1982 and took over as its leader in 2000. Two years later Culver announced MGIC would cap at 25% the share of total premium revenue shared with banks' captive reinsurance units.
"Frankly, the returns are unacceptable," Culver told analysts during a 2003 earnings call. "How can you run a company where you lose money on each policy that you write and justify that business?"
Revolting against the deals was certain to cost MGIC short term market share, Culver admitted. But the pain would be limited if other insurers followed suit. "I would think the whole industry would like to see this happen," said Culver, who still runs MGIC.
Analysts and ratings agencies applauded. MGIC's step "could constitute a critical mass that emboldens most or all of the industry to discontinue the 4-10-40 product as well," S&P wrote in 2003.
The faith that Culver and the ratings agency put in the industry proved misplaced. Countrywide started yanking business from MGIC even before its prohibition of 4-10-40 deals went into effect, internal company email obtained by HUD shows. Meanwhile, MGIC rivals rushed to take away customers. Culver ultimately abandoned MGIC's hard line.
"We tried to stem the tide, and that was unsuccessful," says Michael Zimmerman, MGIC's head of investor relations.
The episode has left MGIC in an awkward position. It concedes the captive reinsurance deals were terrible business propositions while insisting it willingly entered into them. Doing deals in exchange for business referrals "would be a violation of Respa," Zimmerman says, referring to the 1974 Real Estate Settlement and Procedures Act that prohibits payment of unearned fees. Rather it was unspecified "market forces" that prompted MGIC to enter into the deals, Zimmerman says.
"A KICKBACK SCHEME"
Individual homeowners proved equally impotent in opposing the banks. Fannie Mae, Freddie Mac, and private investors required borrowers with low down-payments to purchase mortgage insurance, which protects them against default. Home buyers pay for the policy; lenders are the beneficiaries.
Few homeowners were ever told about the excess-of-loss arrangements, HUD's inspector general alleges. Even if they were, it would have been of no practical benefit since mortgage insurers charge standard rates.
Class action attorneys likewise did little to alter industry practice. Respa recognizes private litigation as form or redress against kickbacks in the housing market. Under Respa, plaintiffs lawyers filed a series of class actions in 2000 on behalf of homeowners against industry leaders including PMI Mortgage Insurance Co., Triad Guaranty and GE Mortgage Insurance Co (later spun off as Genworth).
A "concerted kickback scheme" is how attorneys described the arrangements in a suit brought in the U.S. District Court for the Southern District of Georgia against GE. The reinsurance fee that GE was paying to captive reinsurers "far exceeds the value of the risk assumed by the captive company and on terms more favorable than that provided to other reinsurers," attorneys for Milberg, Weiss, Bershad, Hynes & Lerach LLP and other firms wrote in wrote in Douglas V. General Electric Mortgage Insurance Co. Ten years later the HUD inspector general's report used virtually identical language.
Courts dismissed some suits, but banks paid millions of dollars to settle others. It did little to alter their behavior. In Douglas V. General Electric, for example, thousands of homeowners received $35.47 each; their law firms received around $2 million. The four other settlements had similar terms.
Banks did agree in the settlements to have actuaries sign off on the validity of future reinsurance deals. Even so, they do not appear to have foreseen a significant change in their practices. GE Mortgage Insurance warned in a Securities and Exchange Commission filing of the possibility that it would be sued again within a few years for similar behavior.
"Any future claims made against us could allege … that we violated the terms of the injunction," the company warned.
That class action attorneys failed to reform the industry is perhaps not surprising. If their financial incentive to do so was limited, so was their leverage: the court in the Douglas case noted that the plaintiffs' case faced procedural weaknesses. Attorneys involved in the 2000 case did not respond to interview requests.
"Litigation is a rough tool to try to reform industry practice," says Diane Thompson, an attorney for the National Consumer Law Center. Even so, "there's a general principle that you don't just do coupon settlements, that you want to get injunctive relief," she adds.
One entity that faced fewer obstacles in enforcing Respa was HUD, which can address alleged violations through administrative actions or referrals to prosecutors. However, during the formative years of the housing bubble, the agency largely limited itself to pursuing misconduct by individual companies.
"I haven't seen them do much that went to systemic lending practices," says Thompson of HUD's early efforts.
A spokesman for the department disagrees, arguing that HUD never signed off on the terms of specific captive reinsurance deals. Conversely, there is no record that HUD ever looked into whether the deals violated Respa, even as banks' rapidly expanded their captive mortgage reinsurance operations in ways that raised red flags at Bear Stearns, S&P and among the plaintiffs' bar.
In its 2009 presentation on captive mortgage reinsurance to the Department of Justice, officials from its inspector general's office concluded that HUD had missed opportunities to act. If DOJ prosecutors took the case, as the investigators argued they should, they needed to be aware of the "perception that the Department [HUD] allowed captive mortgage insurance arrangements" and then opposed them "after the fact," the investigators wrote.
HUD officials may have failed to intercede during the housing boom, but Vermont insurance regulators went a step further in enabling the mortgage reinsurance business to flourish, the inspector general's office concluded.
Insurance is regulated by the states, and Vermont has long promoted itself as a captive insurance haven as a way to capture industry tax dollars. The state's insurance division boasts on its web site of the "friendly" approach to captive insurance taken by Vermont, which ranks as among the world's top three domiciles along with Bermuda and the Cayman Islands. Among the captive reinsurance units set up in Vermont were those of Countrywide, GMAC and Citigroup.
Documents from the investigation show that the Captive Insurance Division of Vermont's Department of Banking, Insurance, Securities and Health Care approved insurance structures and accounting maneuvers that the HUD investigators would later conclude violated both the law and basic principles of insurance. Vermont regulators signed off on actuarial opinions from banks and insurers that failed to accurately describe the terms of the reinsurance deals in question, overpaid banks for the risk they were taking and allowed banks to claim insurance trust accounts were capitalized with money that had been explicitly deemed off-limits for claims-paying purposes, HUD investigators alleged.
In one instance, Countrywide captive insurance subsidiary Balboa Reinsurance asked its actuaries to determine how much it would need to set aside to cover insurance losses, according to documents obtained by HUD investigators.
"We believe that a reserve of $0 would provide adequate provision for all of Balboa's outstanding loss and loss adjustment expense liabilities," the actuaries wrote in an undated analysis. The deal was structured in such a way that the actuaries believed Balboa would never need to pay claims.
The terms were so favorable to Balboa that it actually proved troublesome, documents from Countrywide's insurance subsidiary show. The company did not want to disclose in accounting statements that its captive insurance subsidiary was getting paid for taking no risk. Setting aside assets to cover claims would give the deals a patina of legitimacy, but it did not "conform to statutory accounting guidelines" for insurance, according to the company's own analysis.
Faced with the prospect of either tacitly admitting that it was not taking on actual risk or filing financial statement that did not conform to accounting guidelines, Balboa was rescued by Vermont insurance officials.
"Balboa has received approval from its Vermont regulators to establish such a reserve as permitted practice," the company's analysis concluded.
David Provost, deputy commissioner of Vermont's captive insurance division, said he disagreed with the HUD investigators' contention that there hadn't been an adequate transfer of risk to the captive reinsurers. State insurance officials have discretion in approving accounting decisions, and actuarial opinions can be subjective, he added.
"I think we have placed reasonable reliance on the opinions of the actuaries that opined on the transactions," he told American Banker. "It sure seems that HUD or others could have looked at a few contracts or hired an actuary to determine if this was suitable in their eyes, rather than waiting twenty-plus years to conduct a very expensive investigation."
The collapse of housing prices did what corporate executives, lawyer and regulators failed to accomplish — it shut down captive mortgage reinsurance business.
As the residential bust unfolded mortgage insurers got hammered. Triad Guaranty was ordered by state regulators to cease writing new business. Other firms lost more than 90% of their market value.
How banks ultimately fared on the deals isn't entirely clear. Plaintiffs attorneys launched a second round of class action suits in 2007 alleging that Wells Fargo and Bank of America (which acquired Countrywide in 2008) reinsurance subsidiaries paid no claims whatsoever between 2000 and 2006.
Given mortgage insurers' devastating losses in the years since, the banks' subsidiaries have had to pay some claims. Data provided by Vermont's insurance regulator shows that between 2008 and 2009 the banks' captive reinsurers paid enough claims to create an outflow of more than $1.5 billion. But the deals were back to being net profitable by 2010, and how much the bust has cost banks is not public.
Such information was redacted from class action filings in the U.S. District Court for the Eastern District of Pennsylvania, where both Wells and B of A have been sued for allegedly receiving mortgage reinsurance kickbacks. Both companies are now in the process of settling those cases. Bank of America did not respond to a request for comment on the overall profitability of its captive reinsurance deals, and Wells Fargo declined to address that matter. Both banks have maintained that the reinsurance deals were legitimate.
There is reason to believe the banks were net winners on the reinsurance deals, however. According to MGIC's investor relations head Zimmerman, his company has passed on more in net premiums to reinsurers than it has recovered from them to cover claims.
An even larger issue than kickbacks and risk-sharing is at issue, industry observers say. Given the timeframe in which the excess-of-loss policies were rolled out, the arrangements may have helped undermine lenders' underwriting standards. Originally, risk-sharing among mortgage insurers and banks was supposed to ensure that both had an interest in minimizing claims. By adopting excess-of-loss structures that sheltered the banks from substantive losses, banks created an incentive to underwrite riskier mortgages.
These days the mortgage insurers' losses are coming back to bite the banks. With their capital decimated and little to lose, the insurers are now aggressively seeking to make the banks share the pain. In the second quarter of this year alone, Radian denied or rescinded coverage on $193 million in claims due to what it says are underwriting practices that render some policies ineligible for coverage. Radian intends to deny at least $650 million more in future claims. Other insurers are making similar moves. Early this year, PMI Group Inc. told investors it aims to recoup $1.3 billion by denying claims.
"What this all led to is the mortgage insurers becoming not insurers but [insurance policy] rescission companies," says Graham Fisher's Rosner.
As banks have learned in other parts of the housing market, when the entire system gets into trouble all bets on transferring risk are off.