|Proportion of total $ outstanding. Source|
Part of the Ginnie Mae package of requirements, together with low down payments, is mortgage insurance. This provides protection to the investor, in case of default, but tends to be somewhat expensive. I wonder if the expansion in the late 1990s and early 2000s of subprime and low down payment mortgage options came about because private alternatives developed that created less expensive forms of mortgage insurance. This graph suggests that there wasn't a change in the prominence of low down payment mortgage options; there was just a shift from Ginnie Mae to private loans. This explains why survey and loan level data for the period doesn't appear to back up the broadly held belief that down payments were unusually low during the boom. One oddity for me has been that people who worked in the mortgage business tend to agree with the consensus that there was a rise in low down payment loans. But, if the reality is that those loans were being funded in private pools instead of through the channels that would have facilitated Ginnie Mae funding, then they would have that impression, and all of these apparently contradictory pieces of evidence would be true.
Let's think about what would happen with a Ginnie Mae mortgage. The mortgage would be issued, and the mortgage borrower would buy mortgage insurance. A mortgage insurance firm would accept monthly payments from the borrower, which they would pool and invest as a safety net for investors who could then treat pools of Ginnie Mae mortgages as safe securities.
The mortgage insurer sounds a lot like the lower tranches of a private MBS to me.
These are really just two different forms of financial engineering. Are they that different?
Mortgage insurance seems to me like a sort of equity tranche that is required to keep its income in reserves for the other tranches. It seems possible that MBSs could be designed to mimic this risk profile. On the other hand, an MBS without deferred payments on the bottom tranches and with a broader range of lower rated tranches as a result is sharing risk more broadly, in a way that might even be more robust than a traditional mortgage insurer.
And, aren't investors in CDOs constructed from the original pools of securities sort of the equivalent of investors or re-insurers involved with a mortgage insurer?
It seems to me that the greatest difference may be in the market exposure. On the borrowers side, this might have allowed the cost of these functions to fluctuate more efficiently with changing risk aversion and financial innovation so that the cost of these functions reflected market conditions. I wonder how much this difference led to the stagnation of Ginnie Mae activity. The market for MBS investors is much more efficient than the market for mortgage insurers. Were private MBSs simply outbidding mortgage insurers in the competition for non-conventional mortgages? I know that one reaction to that statement is that they were outbidding mortgage insurers and Ginnie Mae by offering gross yields that were too low for the risk involved. But, I don't see how a mispricing would lead to a price collapse followed by a default crisis and a collapse of credit markets. Why wouldn't that just lead to a shift in yields? Shifts back and forth in yield spreads happen all the time. This seems like a problem that normally fluctuating financial markets would be able to handle without a crisis.
On the lenders' end, this efficiency led to more volatility. A mortgage insurer has natural exposure to a range of cohorts. The lack of competitive efficiency that kept mortgage insurance costs high also led to a natural sort of diversification. The millions of pre-2006 mortgages paying fees to the insurer would help buffer the large losses on the 2006 and 2007 cohorts. In the private MBS market, there might be pockets of funds or investors with focused exposure on the troubled cohorts. This was especially the case, in practice, since the switch from GSEs to private pools was recent, and young cohorts made up a large fraction of the available pools. In this way, the sharp pullback in the GSE pools after 2003 increased systemic risk by creating an unavoidable anti-diversification of investment exposure in the private pools.
But, even more importantly, while a mortgage insurer would be treated as a constant in a Ginnie Mae pool, in the private pool, where the insurance was bundled with the investments themselves, the cost of the insurance fluctuated with market prices. In a way, the advantage of the insurance model here is an accounting fiction. In a market collapse like we saw in 2006-2008, the health of mortgage insurers will fluctuate, and mortgage insurers have had problems, as have most firms in the mortgage industry over the past decade. But the opacity of their form of intermediation allows their clients to ignore those fluctuations until they become imminently problematic.
So, in 2007, when defaults were really only beginning to climb, house prices were collapsing in an unprecedented way, and the Fed was making it clear that they were going to do little to stop it, investors in private pools were left holding securities whose prices could collapse as much from falling expectations as from falling current incomes. That's what functioning financial markets do. They bring information back in time.
While MBS investors in that context were the first to find themselves in a liquidity crisis, a mortgage insurer in that context would not find meeting their short-term cash needs that difficult. And, the lack of competitive efficiency might even allow them to raise rates temporarily above competitive levels in anticipation of coming defaults.
In the end, if our consensus public credit and currency policy is to allow a 25% drop in nominal house prices, it probably doesn't matter that much. I doubt that any realistic credit system with low down payments would withstand that sort of volatility. But, were the risk profiles of the private pools really that different than the Ginnie Mae pools we had been using for decades?