Question about government providing insurance on mortgage defaults

[kitkat65]

I'm not sure I'm getting the advantage of this.

The financial institution buys an insurance policy from the government for a high risk mortgage. Supposedly the premiums for such a policy would pay for the default if it happens. However, no accumulative premium amount for that policy is going to cover the cost of that one defaulted mortgage. Are they hoping that only a portion of these policies would be paid out thereby making it a wash? What if the majority or all of the loans defaulted, wouldn't we still have paid out a lot of money for nothing? And who owns the property after it's defaulted? The government or the bank? How do they determine the true value of the property? Would it be based on the actual mortgage amount - which is inflated - or the true value of the property?

What am I missing?

[MNDemNY]

1. This way the taxpayers get ALL of the downside, with NO chance at any of the up-side.

Socialize the risk, privatize the profit.

[Warren Stupidity]

2. Exactly.

This is a total bullshit plan. Also it does nothing to unfreeze the credit market, which is supposedly the real disaster here that requires a 700B infusion of t-bill backed paper money.

[kitkat65]

3. Yeah, that's how I'm seeing it, but they're framing it as not burdening the taxpayers

Why don't Sanders and Dodd frame it as just a fancy unaccountable way of forestalling the inevitable?

[flvegan]

4. I'm assuming that it's sort of like the Lender's Policy in title, but only

insuring default.

So, for example:

Mortgage is $200k, so that's the policy limit. It gets paid on for 5 years, then defaults. It's in a judicial state, so the mortgage plus fees and costs, etc put the Final Summary Judgment at $198k. The bank is the highest bidder at the sale and gets the property. Being insured, they don't care about selling it through normal routes to recoup as much of that $198k that they're in for. They auction it for $80k. They're "out" $118k which is under the $200k policy limit and the govt pays the bank the $118k.

They're insuring the dollar value of the mortgage, not the real property itself.

[The Magistrate]

5. There Is No Advantage To It, Ma'am

Essentially. it is like setting up a health insurance company chartered to sell policies only to people with pre-existing conditions, or a life insurance company chartered to sell policies only to persons already resident in an intensive care unit. The likelihood of having to pay out soon on the policies would be so great that the premiums would have to be pretty close to the pay-out to accumulate a pool that could pay the claims.

The detailed questions you ask are excellent ones, and to the best of my knowledge the right wing con-men of the Republican House delegation have not made public sufficient details to allow anyone to answer them. That is because this is not a serious policy proposal, but only a political stunt, aimed at de-railing negotiations between the Congress and the administration and the financial community, and at trying to escape blame for the consequences of the policies they have promoted for years, by absenting themselves from the vote for the unpalatable necessities required to clean up the mess they have made.

[kitkat65]

6. I have another question then

Has passing the risk onto third-party investors made this problem worse or would the result of subprime lending have been the same?

And am I correct in the assumption that there is no real money or true cash involved - that all the missing value is only on paper?


On edit: Sorry of these are stupid questions. I'm trying to understand it but it all seems so . . . incestuous. Who had the most to gain for being so irresponsible?


I'm basing the first question on the following from Wikipedia

The mortgage lenders that retained credit risk (the risk of payment default) were the first to be affected, as borrowers became unable or unwilling to make payments. Major banks and other financial institutions around the world have reported losses of approximately US$435 billion as of 17 July 2008.<4><5> Owing to a form of financial engineering called securitization, many mortgage lenders had passed the rights to the mortgage payments and related credit/default risk to third-party investors via mortgage-backed securities (MBS) and collateralized debt obligations (CDO). Corporate, individual and institutional investors holding MBS or CDO faced significant losses, as the value of the underlying mortgage assets declined. Stock markets in many countries declined significantly.

[The Magistrate]

7. Passing It On Has Made It Worse, Ma'am

Indeed, passing it on has made it possible in the first place.

The market in 'debt securities' insulates the person or firm who makes the loan originally from the traditional check on extending credit, namely the healthy fear of never seeing the money again. When the lender can immediately re-coup the amount lent by selling the borrower's note to another party, or 'hedge the bet' by buying a contract from a third party that will pay something close to the amount of the note if the borrower proves unable to pay, the lender is in a situation where the risk the loan might not be repaid seems to disappear, at least from the lender's immediate point of view. In this situation the lender will feel comfortable making loans which actually carry a considerable risk of default, and which would probably never have been made if the only means by which the sum advanced could be recouped was payment by the borrower, or forced sale of the collateral put up by the borrower (the house or condominium, in the case of a home mortgage). Thus a great many more loans than 'normal' are made, and to people who can be expected reasonably to have more difficulty in successfully meeting their payments over the term of the loan.

The business of buying these notes, and of taking the 'default' side of these hedging bets, makes sense only when done in great volume. If thousands of loans are involved, you do not need to calculate the individual risk of each loan; you can say with some certainty that 'x percent' will eventually default under the economic conditions at the time you make the buy or take the bet, and pitch your price to allow for this, by paying, or offering to pay if you lose the bet, face value minus 'x percent', and minus also something for your profit. The problem comes when conditions change, or if your calculation of the proportion of defaults proves inaccurate. Both things are operating at present. Economic conditions have changed greatly over the years since the housing boom set in; people's incomes have not risen, their costs of living have increased, they have less money in aggregate to pay their debts with. In many instances, the calculation of default rates included assumptions of rising prices for the underlying assets, and hence easy re-financings of debts, that would act to keep the default trimmed down greatly; with housing prices falling, and refinancing impossible for many, the anticipated default rates are now much greater than originally envisioned. Thus the 'debt securities' backed by housing loans are not worth their face value anymore, and many more bets that defaults would not occur have to be paid off than the pin-striped bookie anticipated he would have to shell out over.

Further, the practice of passing on the debt by these means involves more than one 'third party' level. The firm that bought the note from the original lender, or bet the original lender there would be no default, generally sold the paper on to someone else, or made a hedging bet with someone else, so that its bet with the original lender was insured, and someone would pay it if it had to pay out. And the firm they entered into that transaction with probably turned around and did the same thing with yet another firm. At some point, the larger firms engaged in this practice begin selling the paper back into the market retail, and smaller banks and businesses begin buying paper from large investment firms, and counting it as assets on their balance sheets. The original risk of default, that the originating lender thought was being passed on at the start of the process, arrives back in that firm, only in the guise of an interest bearing note on a prestigious, much larger firm with a tony address and excellent reputation, very different from the addresses and names of the persons originally lent to, but still at bottom nothing but those same individuals' obligations to pay, bundled together.

The collective default, or proportion of collective default, of all these individuals, becomes then the default of the firm that issued the paper, which other firms are now holding as an asset. The inability of the issuing firm to pay the interest, or to pay off its lost bets, becomes the destruction of the value of its paper carried as an asset on the books of other firms. The thing can gather steam like the proverbial snowball rolling down-hill, which could not have any power except for the height from which it starts, to which it has been kited up by this system of passing on the obligations of individuals to pay an originating lender, in the form of a security.

If all of this has a whiff of the old children's game of 'hot potato', or a fellow with three walnut halves and a pea, that is no accident. In many ways, it is simply an application of the practice of money-laundering to 'normal' financial transactions....

[kitkat65]

9. On the surface, it's all so mind-numbingly stupid - what the hell were these people thinking?

"If all of this has a whiff of the old children's game of 'hot potato', or a fellow with three walnut halves and a pea, that is no accident. In many ways, it is simply an application of the practice of money-laundering to 'normal' financial transactions...."

So, why is no one questioning whether or not fraud was involved? It seem there's going to be a bailout whether we like it or not, but I can't fathom why no one is suggesting investigations. Bringing the richest country in the world's financial system down on it's knees for personal financial gain borders on treason to me. And if we don't learn exactly how and who made it happen, it's bound to happen again.

I really appreciate your insight, Magistrate. You're making me feel old with the Ma'am thing, though. ;)

[The Magistrate]

10. It Is Indeed Stupid, Miss, To Suppose Risk Can Be Avoided

There is always a reckoning....

Greed blinds, and people consistently over-rate the chances their schemes and endeavors will succeed.

There certainly is suspicion of fraud, and it has been announced that the F.B.I. is commencing investigations of the major firms that failed or were bought out, such as Lehmann Bros., and the A.I.G. combine. It is quite likely the accounting practiced at the highest levels of this was dodgy to the point of criminal violation. Many people probably knowingly marked these these up at inflated valuations over the years of this run. It would be good all around if some of those who participated could be sent to do jail time, even in 'Club Fed' surroundings. Businessmen are a lot more deterrable than muggers; they generally have better impulse control, and something to lose....

"Round and round and round she goes, and where she'll stop, nobody knows, 'cept the good Lord and He don't tell, 'cause He gets a cut off the pit boss...."

[kitkat65]

11. Reckoning. I like the sound of that.

Heads on pikes? Maybe not, but certainly the seizure of property and assets as well as incarceration.

I consider this to be national security issue as well. At the most, it weakens our strength on so many levels; at the least, it's a distraction.

Hmm. Could we consider those who perpetuate such fraud to be enemy combatants?

Thanks again for your responses, sir.

[DustyJoe]

8. PMI

The home I bought in 1986 I had to buy and pay 80.00 a month of my mortgage as 'personal mortgage insurance' in case I defaulted. Did this go away during this bubble ?.