Mortgage Insurance in the Post-Crisis Market: Why Is the Market Rigged Against Mortgage Borrowers?

July 6, 2010, Revised August 14, 2010

In contrast to homeowners insurance, which typically is purchased directly by borrowers from insurers selected by them, mortgage insurance is purchased from insurers selected by the mortgage lender. As a result, many borrowers pay inflated premiums, and few are aware that they have options in the kind of premium plan they select -- see Mortgage Insurance in the Post-Crisis Market: Do You Know Your Options? Almost all are directed into monthly premium plans. Yet for many borrowers, the total cost over the period the borrowers will have the mortgage will be higher on a monthly premium plan than on a single financed-premium plan. In every case, furthermore, the increase in payment will be larger on a monthly premium plan. 

 The PMI Market Is Rigged Against Borrowers

Why aren’t borrowers offered the option? Because from the standpoint of the loan officer or mortgage broker dealing with the borrower, adding a complex decision to the process can only slow it down, and it adds nothing to their bottom line. In many cases, they can’t offer the option even if they want to because the lender discourages it.

Another indication that this market is rigged against borrowers is that the premiums may vary considerably from one PMI company to another. In shopping the plain-vanilla transaction I described last week, I found that one company was 33% lower than most of the others on monthly premium plans, and 40% lower on single-premium plans. Price disparities of this size would not exist if the companies competed for the patronage of borrowers.  

PMIs Market to Mortgage Lenders

The problem is that PMI companies compete for the patronage of lenders, not borrowers. Lenders direct borrowers to the PMI company selected by the lender, which only coincidentally would be the insurer providing the lowest premium to the borrower.

Lenders select insurers based primarily on the services that the insurers provide to the lenders.  These services have changed over the years. Back in the 60s, before the development of organized secondary markets and mortgage-backed securities, PMI companies acted as facilitators in the purchase and sale of mortgages. In today’s market, the companies provide underwriting support to lenders. One lender I know has a PMI-paid employee in his office who underwrites every loan at no cost to the lender. Of course, all mortgage insurance is directed to the insurer providing that service.  

Mortgage Insurance Versus Homeowners Insurance

It is interesting to compare the marketing of mortgage insurance with that of homeowners insurance. Because lenders select the mortgage insurer, the PMI companies must sell to them, with the consequences described above. In contrast, borrowers select the company from which they purchase homeowners policies, which means that the insurers market to borrowers. This saves borrowers a ton of money on homeowners insurance. In the occasional instances when lenders buy homeowner policies for borrowers who escrow their insurance payments but have allowed their policy to lapse, the premium typically is 2 to 3 times as high as the one the borrower had been paying. 

Why Lenders Select Mortgage Insurers

Why do lenders select the firm providing mortgage insurance but not the firm providing homeowners insurance? The risk associated with homeowners insurance policies has nothing to do with mortgages – every homeowner has such a policy, or should have one, whether they have a mortgage or not. Lenders are comfortable with policies issued by any highly-rated company.

Mortgage insurers, in contrast, assume a risk that otherwise would be borne by the lender. When private mortgage insurance first began in the 50s, lenders usually retained the mortgages they wrote, along with the associated risk. It was plausible under those conditions for the lender to require the right to approve the insurer who stood between them and loan losses. Today, however, all but a small trickle of conventional mortgages are sold to Fannie Mae and Freddie Mac, and those agencies determine the acceptability of mortgage insurers. There is no longer any defensible reason for lenders to select the insurer.

We have lived with this situation so long that it seems normal, rather than the absurdity that it is. It is bad enough that the borrower must pay for insurance that protects the lender, but on top of that the borrower overpays to compensate the insurer for the free services the insurer must provide to the lender in order to earn the business. 

 PMI Reform

The remedy is very simple. Lenders should be barred from selecting or referring borrowers to any mortgage insurer, and should be obliged to accept insurance from any insurer acceptable to Fannie Mae or Freddie Mac. Of course, lenders can continue to select the insurer if they pay the premiums themselves, passing the cost on to borrowers in the mortgage price.

In the best of all possible worlds, which would emerge following the adoption of my proposed rule, borrowers would have a choice of paying a higher rate to a lender purchasing its own policy, or purchasing mortgage insurance directly from the insurer offering the lowest premium. Insurers marketing to borrowers would compete not only on price but on information, including guidance on which of the different premium plans would best serve the borrower’s needs.

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