Private mortgage insurers have stepped up their rejections of claims on defaulted loans, compounding the pain that banks and other lenders have felt from the housing crisis.
In the second and third quarters, insurers denied 20% to 25% of claims, up from a historic rate of 7%, according to Moody's Investors Service. Though the insured party is usually Fannie Mae or Freddie Mac, lenders that do business with the government-sponsored enterprises stand to lose when claims are rejected.
This is because, when insurers deny claims, they also rescind the policies. The mortgages in question typically have loan-to-value ratios above 80%, which means Fannie and Freddie cannot hold them without the insurance. So when insurers cancel policies, the GSEs in turn make lenders buy back the loans.
"Buybacks are really the pink elephant on lenders' balance sheets that no one wants to talk about," said William Armstrong, the chief executive of Blueberry Systems, a Greenwood Village, Colo., developer of software that captures data discrepancies to prevent repurchase requests.
Fannie and Freddie have already been forcing lenders for more than a year to repurchase greater numbers of faulty loans for reasons other than insurance rescissions. The spike in rescissions is accelerating this trend.
Freddie said in its third-quarter financial report that servicers had repurchased $960 million of loans from it during the period, nearly double the amount a year earlier. Fannie does not disclose its volume of repurchase requests, but in its third quarter report, the GSE said that its repurchase requests have been increasing since the beginning of 2008, and that it expects them to remain high into next year.
Peter Pollini, a principal of the consumer finance group at Pricewaterhouse Coopers, said repurchasing a loan whose insurance has been rescinded hits the lender with a "double-whammy."
"They have a nonperforming loan that has been brought onto the balance sheet, and they can't sell it, and they have to take the full risk on that loan," Pollini said.
Insurance rescissions and buybacks reflect the dramatic loosening of underwriting standards in the middle of the decade.
"Certain product types were flawed the day they were made," said David Katkov, an executive vice president and chief business officer at PMI Group in Walnut Creek, Calif.
Most loans whose claims are denied have "multiple reasons why they failed," said Katkov, whose company is the second-largest private mortgage insurer as measured by insurance in force. For example, a borrower could have a low FICO score combined with a high loan-to-value ratio, no documentation of income and a questionable appraisal, he said. The combination of all those risk factors on the same loan would make it fall outside PMI guidelines. "How is that loan ever going to perform the way I priced it to perform?"
At PMI, "we're all about paying legitimate claims," Katkov said. "My policy is very explicit. If you went over here and did something that is black, and I said you need to do something that is white, I'm not going to be obligated for that loan."
But others say the mortgage insurers are incorporating rescissions into their business models, using claim denial to get through the crisis. "Lenders are not happy, and the consumers paid a premium for nothing," said Rhonda Orin, a managing partner at the Washington law firm Anderson Kill & Olick. "Lenders counted on private mortgage insurance when they made the loans, and now you have insurers saying the mere fact that a mortgage goes into default means the borrower gave false information, and they're rescinding the policy instead of paying the claim. We call that post-loss underwriting."
The seven private mortgage insurers have rejected $6 billion of claims since early 2008, Moody's said. During the same period, they paid out an aggregate $18 billion to $20 billion in claims.
It is unclear how long rescission rates will remain at today's historically high level.
Katkov said he is not prepared to say claims are near their peak. But he said the loans made during the middle of the decade, when now-discredited practices like not documenting borrower incomes prevailed, "are getting close to the end of their life." Claims on newer loans are more driven by economic fundamentals like job losses, he said. This suggests that future claims will be harder to deny, though Katkov would not forecast rescission rates.
Banks repurchased $7.1 billion of defaulted single-family loans from various investors in the third quarter, National Mortgage News has reported, up from $1.9 billion in the second quarter. JPMorgan Chase repurchased the most loans last quarter, $2.7 billion, the newspaper said, and Bank of America Corp. was No. 2, with $2.3 billion repurchased.
B of A did not return calls. Tom Kelly, a spokesman for JPMorgan Chase, said most of its buybacks were of loans from Ginnie Mae pools. Such loans are insured by government agencies like the Federal Housing Administration, a part of the Department of Housing and Urban Development (HUD). So bringing them back on the balance sheet did not affect JPMorgan Chase's reserves or chargeoffs, Kelly said.
But there also is concern that the Federal Housing Administration (FHA), whose capital reserves have dwindled, could become more aggressive in rejecting claims.
"HUD is acting more and more like an insurer where, if they are faced with a potential loss, they will look at the file just like a mortgage insurer, and they won't pay the claim if there is a problem," said Dan Cutaia, the president of Fairway Independent Mortgage in Sun Prairie, Wis. "That's a big change because FHA has been pretty lax over the years."
Laurence Platt, a partner at K&L Gates, said lenders could take comfort that FHA has higher thresholds for claim rejections than private insurers, which can deny a claim if information is materially untrue.
"FHA has to show the lender knew or reasonably should have known if information is incorrect," he said. "So the lender never bears the risk of pure borrower fraud unless it could reasonably have been caught."