Big Banks Win, Taxpayers Lose as Fannie Insurance Overhaul Spiked

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As the overseer of mortgage giants Fannie Mae and Freddie Mac, the Federal Housing Finance Agency has a duty to safeguard taxpayer dollars. But the regulator may have done just the opposite earlier this month.

On February 11, the FHFA held a conference call to inform a group of mortgage trade associations that it had vetoed a Fannie Mae proposal to buy force-placed insurance directly from underwriters. The news was greeted warmly by those listening in, given that Fannie's plan had threatened to cut mortgage banks from their profitable positions as middlemen.

Fannie's plan would have lowered the cost of some homeowners' insurance significantly and saved the government-sponsored enterprise at least $145 million annually, sources familiar with Fannie's plan and program documents state.

The FHFA's decision left plan supporters and others at a loss for an explanation save one -- that the FHFA buckled under pressure from insurers and bankers, protecting controversial business practices that have drawn the ire of state insurance officials and consumer advocates alike.

"Incompetence or corruption. It's got to be one or the other," said Robert Hunter, a consumer advocate and former Texas insurance commissioner whose opinions dovetail with those of people closer to Fannie.

The FHFA disputes such assertions but declined to publicly discuss its reasons for rejecting Fannie's plan.

"Similar to how FHFA has proceeded on other issues, FHFA will work with Fannie Mae, Freddie Mac and key stakeholders … to address issues associated with force placed insurance," FHFA spokeswoman Denise Dunckel wrote in response to emailed questions.

Fannie Mae declined to comment on its regulator's rationale through spokesman Andrew Wilson. Inside the mortgage giant, officials had carefully vetted the plan and were confident that their cost-savings calculations were airtight, according to documents obtained by American Banker. (See the Fannie document in which the GSE laid out its rationale here.)

"Given the magnitude of savings for FNM and homeowners… it is crucial that an approval be given as soon as possible," project documents declared in December. "Lowering [force-placed insurance] costs will help some homeowners avoid default."

Force-placed insurance itself has been part of the mortgage landscape for decades. When a person buys a home with 20% down, virtually all mortgage contracts require him to maintain property insurance. If he doesn't, the mortgage servicer has the right to "force-place" a replacement policy to protect the creditor's 80% stake.

The bill for the replacement coverage — which is generally far higher than that of the original policy — is charged to the borrower. If the homeowner fails to pay up, the bank passes on the cost to mortgage investors and guarantors, of which Fannie Mae is the largest.

During the housing boom, force-placed insurance was an overlooked corner of the hazard insurance business. When housing prices collapsed, however, millions of borrowers defaulted, creating a massive foreclosure backlog and turning force-placed insurance into a multi-billion dollar industry.

Force-placed insurers assume unusual risks and have always charged relatively high premiums. What has drawn criticism in recent years is a web of financial ties between insurers and big banks that critics say has dramatically inflated costs.

Two specialty insurers — QBE and Assurant — have transformed the force-placed market into a near-duopoly by locking down major bank clients. American Banker first reported in 2010 that the insurers provided banks that gave them business with commissions or lucrative reinsurance deals.

But what duties mortgage servicers performed to earn that money was unclear. In one case, JPMorgan Chase (JPM) collected insurance commissions through an insurance agency that employed no agents, depositions in a series of class actions revealed.

As the housing bust dragged on, regulators began to question whether the bank-insurer relationships amounted to a kickback scheme. They also grew uncomfortable with a market where the bills were passed along to others and banks had an incentive to buy the priciest coverage available.

New York's Department of Financial Services launched a probe in the fall of 2011 and held hearings on the force-placed market last May. "This is an industry … that has just a massive problem," Superintendent Benjamin Lawsky said at the time. He expressed particular concern with "large commissions being paid by insurers to the banks for what appears to be very little work."

Insurance commissioners in California and Florida have also launched probes of the force-placed market.

The public controversy surrounding force-placed insurance revolved around its high cost for struggling homeowners. But Fannie Mae took notice as well.

As guarantor of roughly 18 million home loans, it ultimately picks up the tab for force-placed insurance when borrowers don't. The GSE's hazard insurance costs rose from around $25 million a year before the financial crisis to $631 million in 2012.

Fannie spent months considering ways to cut costs. It ran into a significant hurdle from the outset, people familiar with the effort say. Banks and insurers told Fannie officials that their force-placed insurance arrangements constituted private contracts. They declined to disclose to Fannie how much it was paying and for what purposes its money was being used.

"Fannie Mae has limited ability to track premiums, claims, refunds, deductibles, and other key [force-placed] information," states a 2012 force-placed project brief summing up the "current state" of the market.

Bank and insurer advocates dispute the contention that the industry obfuscated, but concede that Fannie has been unable to obtain details on its force-placed insurance bills.

Fannie officials eventually resorted to scrounging through state insurance filings to find basic data about insurance written on its mortgage portfolio.

Fannie's data-gathering problem and its cost concerns stemmed from a common issue: The mortgage servicers who actually bought the force-placed policies weren't the ones paying for it.

Fannie officials eventually concluded that the simplest fix was for the GSE to buy insurance for itself. Such a move would cut banks out of the equation and enable Fannie to leverage its size into bulk discounts.

The GSE's staff briefed the FHFA on the idea on February 17 of last year and faced no objections, according to documents related to its force-placed insurance plan. Fannie issued a request for proposals to a dozen insurers about a month later. All were asked to design a program that saved money and increased transparency and competition.

The respondents ranged from smaller specialty insurance shops like Proctor Financial to Assurant and QBE, whose combined clients include 19 of Fannie Mae's 20 top servicers. The companies were supposed to design a model and provide a bid for doing the work.

The big players fared poorly. Assurant's proposal failed to meet the GSE's minimum requirements for consideration, Fannie documents show. The company declined to discuss its bid, but says it stood ready to work with the GSEs on possible force-placed insurance changes.

QBE did only slightly better; it came in last among four viable proposals. QBE quoted the highest prices, $1.01 in premiums per $100 of coverage. In the category of "Problem Solving/Innovation," it received a score of 0%. QBE declined comment for this story.

"The incumbents' proposals weren't serious," says a person familiar with Fannie's deliberations.

Smaller entities did better. The insurer American Modern offered the lowest rate, providing the same coverage as QBE at $0.73 per $100 of insurance. Fannie liked the plan but worried that choosing a single carrier would limit competition and concentrate risk.

The winner was OSC (a subsidiary of Breckenridge Insurance Group), a broker and services provider that proposed splitting Fannie's insurance among a group of insurers. At $0.80 per $100 of coverage, its rates were slightly higher than American Modern's, but OSC excelled at program design, Fannie concluded. It had also pulled off a coup by partnering with Zurich Insurance, a Swiss reinsurer with a $400 billion balance sheet, a superior A+ rating from insurance rating company AM Best and historical experience in the force-placed market.

Zurich stood ready to take on all of Fannie's business if necessary, but under OSC's model any qualified insurer could take a piece of the GSE's business by joining a consortium of carriers willing to divide Fannie's risk. Among the proposal's attractions were "market driven pricing," and "one entity fully accountable to Fannie Mae and servicers," Fannie documents state.

Fannie put thought into preventing excessive market disruption as well, the documents show. Incumbent insurers willing to match Zurich's prices would be permitted to retain existing business. If they didn't, banks could still hire them to administer force-placed programs. Insurers were also welcome to join the Zurich consortium.

Mortgage industry analysts praised the plan.

"It seemed like a clear way for the GSE (and hence the taxpayer) to save money," writes Laurie Goodman, a mortgage bond analyst for Amherst Securities, in an email to American Banker. "If Fannie was able to implement its plan, private label [mortgage security] investors would clearly be interested in replicating it."

Fannie showed the FHFA the various proposals and revealed its preference for the OSC/Zurich plan on May 9. The regulator raised no objections, according to sources and contemporary documents. Fannie sent the FHFA "final project recommendations" on September 28. A week later FHFA officials sat in on a meeting at which Fannie's risk management committee approved the OSC project. The FHFA also participated in calls on October 12 and 22 in which Fannie officials explained the plan to New York and Florida insurance officials involved in force-placed rate probes.

Although formal FHFA approval was the only hurdle remaining to the program, agency officials began asking questions that suggested unfamiliarity with the tenets of Fannie's plan: How much did Fannie spend on force-placed insurance? Why did Fannie pick the OSC consortium? Who approved the program? Could Fannie demonstrate that Zurich was a suitable counterparty?

By late December, however, the FHFA was asking Fannie for information that people familiar with the Fannie plan believed would be used to provide a final check-in with FHFA Acting Director Edward DeMarco.

"There were no real issues left," says someone familiar with the Fannie plan.

Fannie officials expected bank insurance industry advocates to push back against price cuts and market changes. But they figured that regulatory probes and bad press had severely hurt the industry's credibility and leverage.

Details of the specific moves to foil Fannie are hazy. What is clear is that by early this year, the industry had shifted its sights from swaying Fannie toward convincing the FHFA to stall the process.

"We are very concerned about the lack of transparency and the absence of public input regarding this significant initiative," the American Bankers Association wrote the agency on January 2. "We strongly encourage FHFA to request public comment."

Other trade groups followed suit. "The Consumer Mortgage Coalition (CMC), the Financial Services Roundtable (FSR), Housing Policy Council (HPC), and Mortgage Bankers Association (MBA) are concerned with the course of action currently being pursued by Fannie Mae," a broadly circulated letter from the groups reads.

In response to the second letter, Fannie Mae staffers provided the FHFA with suggestions for a point-by-point rebuttal. The regulator instead drafted its own reply, sending it to the industry groups on February 4.

Signed by Meg Burns, Senior Associate Director for Housing and Regulatory Policy, the letter thanked the trade groups for their interest and comments. But it did not appear to offer them a seat at the table.

"A formal 'notice and comment' would be inappropriate to GSE business decisions," the letter states, adding that the FHFA expected to make a decision regarding the plan before the end of March. "For the moment, the RFP process is confidential," the letter stated.

The FHFA opted to keep its cards close to its vest with Fannie as well. People familiar with the GSE's plan were told informally that it had been brought to FHFA director DeMarco but had no such confirmation. The regulator declined to comment on its decision-making process.

On Friday February 8, the FHFA informed Fannie it was vetoing the plan. GSE staffers were baffled. They became even more so when the FHFA convened a call the following Monday with the Mortgage Bankers Association, the Consumer Mortgage Coalition and other trade groups.

"Why weren't consumer and fair lending groups on the call?" asks Birny Birnbaum, executive director of the Center for Economic Justice. "It should not be surprising that the judge favors the only side able to present its case."

The FHFA announced during the call that Fannie's RFP process was definitively dead, people with knowledge of the talk say. (In a subsequent statement to American Banker, the FHFA described it as "paused.") The FHFA asked the industry to work with the GSEs and provide data.

"We were pleased that they are asking the entire industry to submit all the data," says Anne Canfield, executive director of the Consumer Mortgage Coalition, a mortgage industry trade association. "We're not opposed to wringing more cost savings out of this thing… my suggestion is, let's get the data together."

Where Fannie goes from here, if anywhere, is unknown. Shortly after the FHFA explained its decision to mortgage servicers, Burns said the agency had no timeframe or expected approach for a follow-up program.

"They're not in a big rush," says a backer of the Fannie plan. "They're going to form a committee and have a lot of conversations."

Critics of the existing force-placed market regard the FHFA's decision as a major defeat. The enormous reservoir of distressed and defaulted mortgages in Fannie's portfolio — 600,000 homes — means that the value of force-placed reforms is frontloaded. As foreclosures clear out the backlog, Fannie's potential savings diminish.

Consumer advocacy groups including the Center for Responsible Lending and the National Consumer Law Center jointly issued a statement calling the FHFA's decision a "giveaway" that "harms nearly everyone while preserving unfair practices."

Not everyone lost. The day after the FHFA's Monday conference call the share price of the leading force-placed insurer, Assurant, surged 6.7%, adding roughly $200 million to its market value.

"Fannie Mae … held significant power to change the pricing in the market," Compass Point Research analyst Kevin Barker wrote that morning. "We still expect pressure on force-placed insurance premiums... but this is a decisive positive for force-placed insurance."

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