Private mortgage insurers brought some rowdy lenders to the real estate party of the last decade. Now the insurers may be making it easier for some of their guests to skip out on the cleanup.
Over the last few months, insurers have begun cutting settlements with lenders, accepting cash payments in return for not investigating or rescinding coverage on mortgages that were the product of sloppy or fraudulent underwriting.
Though such settlements make good business sense for lender and insurer alike, they threaten to shift further losses to the government. Fannie Mae and Freddie Mac own $160 billion of insurance on low-down-payment mortgages, and the federal wards have long relied on the nimble insurers as their first line of defense in detecting flawed loans that can be forced back upon the lenders that produced them.
By settling without investigating, the insurers are effectively sidelining themselves, leaving the GSEs responsible for detecting bad mortgages and fighting lenders over defaulted loans that the insurers originally vouched for.
Whether intentionally or not, lender-insurer settlements drive a wedge into the long-standing alliance between insurers and the GSEs seeking to minimize their losses on defaulted loans. This could cause short-term losses for Fannie and Freddie's federal conservator — and potentially realign the interests of key mortgage industry players.
"It creates a situation where there's the potential for arbitrage, where the private insurers and the lenders realize their nets will increase if they screw Fannie and Freddie," said David Reiss, a Brooklyn Law School professor who focuses on real estate and regulation.
The agreements may pose risks not just to the government, but to the future of the still-weak private insurance industry as well. It is unclear how settlements would square with the terms of Fannie's requirements for approved mortgage lenders, and in a statement to American Banker, the chairman of the House Financial Services subcommittee on capital markets said a recent warning by Fannie may indicate insurers are abandoning their obligation to vet the quality of loans they insured.
"Fannie Mae's disclosure of potential losses due to legally questionable side agreements between lenders and mortgage insurers certainly raises eyebrows," said Rep. Paul Kanjorski, D-Pa. "We must examine this situation further, and I intend to urge the Federal Housing Finance Agency to use its full authority to scrutinize such arrangements."
A Red Flag
Historically, mortgage lenders have thoroughly investigated defaulted mortgages they insured for Fannie and Freddie. If an insurer could ferret out fraud and sloppy underwriting, it would rescind its coverage of the loan and leave the lender to deal with its own mess.
This was a matter of self defense. But insurers' diligence also benefited Fannie and Freddie, which were responsible for losses exceeding the partial coverage insurers provide. The GSEs use insurer findings of lender misconduct as a trigger to force a lender to repurchase bad loans.
The relationship between insurer and agency was symbiotic: by rescinding coverage on bad loans, the aggressive, smaller insurers in the first loss position also protected their lumbering hosts that provided the market for insurance in the first place.
Settlements mark an abrupt change in this relationship, and buried in Fannie Mae's own financial statements is evidence that such deals are causing concern.
As a result of the lender-insurer deals struck in the second quarter, "mortgage insurers will require fewer mortgage insurance rescissions for origination defects," Fannie stated on page 97 of its quarterly filing with the Securities and Exchange Commission. Because Fannie relied in part on those insurers to flag loans that didn't meet its requirements, "to the extent we did not uncover loan defects independently … we may be at risk of additional loss."
Information about the size of such deals to date is generally not publicly available, though MGIC Investment Corp. disclosed that, in the second quarter, it waived its rescission rights on some loans as part of a settlement regarding its rescission practices.
"[W]e continue to discuss with other lenders their objections to material rescissions," the company added.
There is no data on the size or efficacy of Fannie's fraud detection operations as compared with those of the insurers, making it impossible to predict how many bad mortgages may go undetected because of the insurers' passivity.
Fannie's disclosure of its concern on settlements is limited to a single paragraph. But for the wording to have been included in Fannie's quarterly filing, Fannie's accountants had to conclude potential losses rose to the level of a material threat.
"It is unclear how prevalent this type of agreement between mortgage insurers and lenders may become or how many loans it may impact," Fannie concludes.
In response to a question from American Banker, Fannie added that it is working with insurers to make sure it is informed of such settlements.
Fannie independently reviews insured mortgages, it said, and whether an insurer chooses to investigate or rescind coverage on a mortgage is a matter of its own discretion.
"We're just going to say we're aware of the issue," said a spokesman for Freddie, which would likely be affected by settlements similar to the ones that Fannie disclosed. The GSEs' conservator, the Federal Housing Finance Agency, declined to speak about the issues raised in Fannie's one-paragraph disclosure.
The trade group Mortgage Insurance Companies of America also declined to discuss the settlements and their impact on Fannie.
"This is not a public policy issue, so there is no industrywide position or response," a spokeswoman for the group wrote in an e-mail.
Five large insurers either did not return calls before deadline or declined to speak.
For its part, the Mortgage Bankers Association said that settlements were simply a reasonable way to avoid a lengthy and costly fight with insurers.
"I think our lenders are just trying to get all of these repurchases behind them," said Michael Carrier, associate vice president of secondary and capital markets at the MBA. There isn't anything nefarious about lenders' desire to settle cases, he said, noting that Fannie and Freddie sometimes settle claims related to their own uninsured portfolio.
Carrier also questioned whether insurers' and the GSEs' combined scrutiny of loans might be excessive. MBA members have complained that Fannie and Freddie already are picking apart loan files in search of immaterial defects to rationalize a repurchase request.
"I could see how another set of eyes might be able to uncover more instances in which repurchases could be requested," he said. "But lenders are looking at it like it's two against one now."
How settlements would fit into the private mortgage insurers' role as protectors of government credit isn't obvious. Nor is it clear that bilateral settlements are even compatible with some mortgage insurers' obligations to Fannie.
Fannie's requirements for mortgage insurers that went into effect at the beginning of 2005 prohibit some mortgage insurance "partners" from entering into "risk-sharing arrangements with mortgage lenders without Fannie Mae's prior written consent." They define risk sharing as a "contractual arrangement … in which the qualified mortgage insurer is reimbursed for some portion of its losses by another entity."
Brooklyn Law's Reiss said that, while insurers might assert that their settlements didn't amount to risk sharing, "Fannie and Freddie would have a good argument that that is a distinction without a difference."
The mortgage insurer requirements could ably argue that the agreement was written broadly enough to encompass any potential side deals with lenders, he said.
"Fannie and Freddie are good at protecting themselves, and they were represented by the top law firms in the country," Reiss said.
Rep. Kanjorski, who held subcommittee hearings on mortgage insurance in July, said he intends to revisit the insurers' role within the broader context of housing market reform.
"We need to align the interests of mortgage insurers with the interests of the government-sponsored enterprises," Kanjorski said. "It is therefore alarming that lenders and mortgage insurers may now be ignoring their legal agreements with Fannie Mae, and by proxy with the American taxpayer."