Prerequisites for Mortgage Default Insurance (MI) Success Edward J. Szymanoski,,U.S.Departmentof Housing and Urban Development Dubna,, Russia February, 2004
Background! Introduction of Government-backed MI in U.S. Banking crisis during the Great Depression» Mortgage money hard to find» Terms very unattractive Creation of Federal Housing Administration (FHA) in 1934! Original purpose of FHA Encourage private mortgage lending with better terms Stimulate job growth by financing housing construction! FHA A Great Success Self sustaining program Over 30 million mortgages insured to date Set standards for underwriting mortgages Paved the way for today s successful private MI industry
Prerequisites for Successful MI Need to Consider Nature of mortgage default losses Role of capital in private business Role of government
Nature of Mortgage Default Losses Following is an example of a mortgage loan at set-up:! 100 (Property Value)! 80 (Mortgage Balance)! 20 (Equity) Note: Equity at loan set-up usually represents borrower down payment. Over time, equity = current property value minus mortgage balance.
Nature of Mortgage Default Losses Mortgage Dynamics: Stable National Economy and Local Housing Market Money Property Value Positive Equity Mortgage Balance Time
Nature of Mortgage Default Losses Mortgage Dynamics: National Recession or Local Market Downturn Money Negative Equity Property Value Mortgage Balance Time
Nature of Mortgage Default Losses! Stable National Economy and Local Housing Market If borrower defaults due to loss of income (job loss, death, divorce, or other life-crisis event) POSITIVE equity protects lender from loss Lender can access equity by forcing a sale through foreclosure! National Recession or Local Market Downturn If borrower defaults due to loss of income NEGATIVE equity means loss for lender Foreclosure sale will not pay off full loan balance During recession or local downturn borrowers more likely to experience loss of income! Thus losses for lenders increase dramatically when national or local economy is weak
Role of Capital! Capital protects long-run solvency of business from short-run run financial difficulty! Capital usually held as liquid assets Used to pay for unexpected losses! Source of Capital: business owners or investors! Riskier businesses need more capital! Riskier businesses pay higher return on capital! Cost of capital affected by risk sharing MI is a form of risk sharing Risk sharing can lower the cost of capital
Role of Government! MI backed by the (national) government makes sense When mortgage default risks high or hard to measure When cost of capital prohibitive for private MI company» Government can pay unexpected MI losses out of general revenues» Does not need to actually set aside liquid assets as capital Government guaranty is not without cost» Citizens (taxpayers) pay when high losses incurred! FHA entered the US market in 1934 Risks high and hard to measure Early private MI companies wiped out by default rates nearing 50% by 1933
Role of Government! Government MI works best when Effectively risk-managed» Borrowers pay user fees (premiums)» Taxpayers cover catastrophic loss» Government monitors private partner performance Private sector partners share some losses» Incentive for good management and stewardship
Role of Government! Private MI makes sense when Risks lower and easier to measure Capital costs for private MIs manageable! Private MI can operate more efficiently than government! Citizens (taxpayers) not at risk for losses! Today in the U.S. Most MI comes from private companies FHA operates to serve higher risk borrowers
Conclusion: Prerequisites for Successful MI! Banking and Legal System Risks Acceptable Banks able to make mortgages but need to share risks» To keep loan terms affordable for borrowers» To access secondary mortgage markets for liquidity Legal support for enforcement of mortgage terms! Economic stability Interest rates relatively low and stable Housing prices market based and stable! Social Attitudes Support Mortgage Lending Public acceptance of debt financing Public understands responsibility to repay debt