Did Some Type of Insurance or Credit Default Swap Pay Off Your Mortgage?

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I’m not entirely sure where exactly the rumor started, but somehow the idea has surfaced that when a homeowner defaults on his or her mortgage, that loan is being paid off by various types of insurance policies and credit default swaps, and as a result, the “banks” aren’t losing money on the millions of defaulted loans going into foreclosure.

There are even some saying that the loans defaulting are being paid off multiple times by multiple insurance policies and swaps.

I recently saw someone online saying that as a result of multiple insurance payouts a bank could receive millions of dollars on a $200,000 loan that went into default.  And this same Website went even further claiming that this is why the banks don’t want borrowers to bring their payments current in order to reinstate their loans… because by forcing a defaulted $200,000 loan into foreclosure, the bank avoids having to repay the millions they received when the loan went into default.

It’s just not true.  There are lot’s of reasons why servicers can want loans to go into foreclosure, but insurance isn’t involved.

Here are the facts about the different types of mortgage default insurance… after that we’ll look at credit default swaps.  It’s not like there are an unlimited number of types of insurance policies that cover mortgage defaults, in fact for our purposes there are only three and I’ll refer to them as: loan level insurance, pool insurance, and payment insurance.

Loan level insurance vs. pool level insurance.

First of all, insurance protection at the loan level was only available on “conforming loans,” which for the most part are Fannie and Freddie loans… insurance on sub-prime loans wasn’t offered.

With this type of insurance, if insured loans went into default, the insurance would only reimburse the owner of the loans between 12 – 30 percent of the EQUITY PORTION of the loans, which is the down payment percentage.  So, for example if a loan made with 20 percent down goes into default, the insurance would only reimburse 12 to 30 percent… of the 20 percent… it would not cover any of the 80 percent.

So, let’s say we’re talking about a $100,000 home purchased with $20,000 down that goes into default.  The default insurance could pay 12 to 30 percent of the $20,000… which is a $2,400 to $6,000 payout… but that’s ONLY 3 to 7.5 PERCENT of the $80,000 that the investor loaned out by investing in the loan.

Whether the policy would reimburse 12 or 30 percent just depends on how much the investor was willing to shell out each month in insurance premiums… obviously, it costs less if you want 12 percent coverage than 30 percent.  But the point is that this type of insurance NEVER pays a percentage of the BOTTOM 80 PERCENT, and common sense will tell you why.

In the years before the mortgage meltdown, the assumption was that when a borrower defaulted on his or her loan, and the investor foreclosed and re-sold the property… the foreclosed home would sell for at least 80 percent of its value… and if property values were rising… maybe even more.  Since you only buy insurance to protect yourself from the risk of loss, no one felt the need to buy insurance on the bottom 80 percent of a loan, since the value of the property would offset that risk.

Also, losses on a foreclosed property are not taken by mortgage backed securities until the property has been repossessed and sold… only then can the amount of any loss be ascertained and only after the loss has been recorded can a claim be filed with the insurance carrier.  The insurance we’re talking about does not reimburse investors when loans default… because no one knows how much the loss is until the property is sold.  Only after foreclosed properties have been sold and the losses taken by the investor could a claim be filed with the insurance carrier.

It shouldn’t be hard to understand how this process works as it’s no different than car insurance works in the event you’re ever in a serious accident.  First you notify your insurance carrier that you were in an accident and that your car has been damaged.  Then the carrier sends an adjuster out to examine the damage, and if he or she says the car has been totaled, the insurance carrier takes possession of your totaled car and issues you a check per your policy limits, etc.  You don’t get to keep your totaled car AND get a check from the insurance carrier… they take the car and you get paid per your policy.

Well, it’s the same kind of thing here.  Once a home is repossessed and sold, that’s when the loss can be determined because the more the home sells for at auction or wherever, the less the loss to the investor who bought the insurance policy.  So, the insurance carrier would never write a check for a loss that hasn’t been taken yet… that would be like paying off your car and letting you keep it so you could sell it to a salvage lot or whatever.  Insurance companies are never in the business of paying out more than the policy dictates, or more than you’ve lost.

In addition, conforming loans were the only loans eligible for such insurance coverage.  The non-Fannie and non-Freddie loans, the Alt-A and the sub-prime loans were NEVER INSURED, and it’s easy to understand why.  The cost to insure anything goes up as the risk goes up, so the non-conforming would have been too costly to insure.  In addition, non-conforming, Alt-A and sub-prime loans were often made with a lot less than 20 percent down, so insurance coverage that would pay 12 percent of nothing down wouldn’t be worth much, now would it?

One last thought… ask yourself the question… did you fill out a health questionnaire asking you if you have been diagnosed as being HIV positive or anything like that.  Because if not, the chances that an insurance company would agree to insure you against you defaulting on your loan would be pretty slim, right?  I mean, otherwise, people dying would all run out and get mortgages, right?  They’d die the following month and some insurance carrier would be stuck paying off their half a million dollar loans, right?  That’s just not how insurance ever works.

Pool Insurance…

 

There was also “reinsurance,” which would have been issued on the top tranches of a mortgage backed security.  Bottom tranches would not be insured because they were too risky.

When talking about insurance on a pool of loans, what constitutes a default is much more complicated than is the case at the loan level simply because the policy covers a pool of loans… so it’s not about covering the losses from one loan defaulting.  Pool insurance might cover the loans in a pool past a certain threshold  of defaults, or at a certain amount of losses in the aggregate, but not based on any one loan and its related losses.

And again, this type of insurance wouldn’t pay out anything until the losses to the pool were realized, meaning that the homes were repossessed and sold.

The insurance companies that offer this type of insurance are known as the “monoline insurers,” because in 1989, the State of New York enacted Article 69, which amended the state’s insurance law to make “financial guaranty insurance” a separate line of coverage, and the new law prevented other types of insurers, such as property and casualty, life, and multiline insurers, from offering it.  For years, the monolines claimed this exclusive focus made them stronger, but when the meltdown in the sub-prime bond market hit in July of 2007, their limited focus made it a certainty that they would be wiped out.

However, IN THE CASE OF BOTH TYPES OF INSURANCE, whether the reinsurance type issued on a security or the private insurance available on a conforming loan, “MOST OF THEM HAD CATASTROPHIC LOSSES, AND SOME OF THEM WENT BANKRUPT, according to Bill Ashmore, President of Impac Mortgage Holdings, Inc.  (Click that link to hear me interview Bill on a recent podcast.  And Impac is the mortgage bank that did things right, modifying loans when no one else would.  If you haven’t read about them, click that link and you’ll be amazed.)

The two largest were MBIC and AMBAC… and MBIC, AMBAC, Radian… all defaulted, with some or all suing investors that purchased their policy’s for misrepresenting the risks of their insured investments.

In early 2008, to give you an idea of how fast this last meltdown actually melted down… when Fitch downgraded monoline insurer Ambac from AAA to AA, it triggered downgrades on more than 100,000 Ambac-insured bonds worth roughly half a trillion dollars.  The monolines also got into the market of insuring CDOs, or Collateralized Debt Obligations, which today, for the most part we call “toxic assets.”  So, you can just imagine how well that venture went at the end of the day.

Once insuring CDOs, it was only logical that the monolines, like Ambac and MBIA, get involved in placing large bets on CDOs through the use of credit default swaps, but at the same time, others in the market were using the same sort of contracts to bet against MBIA and Ambac.

Ambac filed for bankruptcy in November of 2010, subsequently filing lawsuits against just about everybody on Wall Street, from JPMorgan to Bank of America to Credit Suisse to Bear Stearns… alleging improper underwriting and more.  Last month, Ambac received permission to emerge from bankruptcy and recently, Ambac sued JPMorgan Chase saying that it has incurred over $200 million in claims on seven RMBS deals that Bear Stearns fraudulently induced it to insure.

According to Reuters, the securities in question have loss over $1.8 billion.

MBIA filed for bankruptcy in 2009, and a whole line of banks showed up to challenge the filing, claiming that MBIA wouldn’t be able to make good on its credit default swaps if it went ahead with its plan to restructure into two units.  Since then, MBIA has settled its credit default swap liability with Morgan Stanley and others, and… well… the saga continues.

The point is this… there was some loan level default insurance purchased by some investors in conforming loans, but the coverage only reimbursed 12-30 percent of the borrower’s down payment amount.  And there could also have been pool insurance on some of the highly rated tranches of a given security… BUT… since the insurance carriers filed bankruptcy when they were overrun by default claims most investor claims were either never paid, or paid at a significantly reduced amount.

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Credit Default Swaps…

Credit Default Swaps got their publicity as a result of the federal government’s $182 billion bailout of AIG back in the Fall of 2008, and before we go into that situation any further, there are two things you can know to be facts about those that were on the right side of those swaps.

They did very, very well.  The investors that bet against the bonds backed by sub-prime loans by buying credit default swaps were the winners in the meltdown for sure.  Many made billions of dollars when these bonds defaulted or were downgraded by the credit ratings agencies, Moody’s, Fitch and S&P.

But credit default swaps are not issued at the loan level, they pay their holder based on a bond’s or CDO’s default… credit default swaps could never pay off an individual loan.  Also, the investors that bought these swaps didn’t own the loans or even the bonds, in fact, that’s a big part of the debate about credit default swaps.  You didn’t have to own the bond or the CDO to invest in a credit default swap that was betting on that bond’s or CDO’s default, so when these investors cashed in, the money wouldn’t have paid off loans because the investors didn’t own the loans, bonds or CDOs.  They were just placing a side bet that the bonds and CDOs would fail… without owning anything.

The other things you can know about AIG’s bailout is 1. Why it was done, and 2. That AIG repaid the federal government as of January 2013.

According to PolitiFact.com…

The federal government gradually sold its stake. Last month, the Treasury sold the last shares for an overall “positive return” of $22.7 billion. Andrew Ross Sorkin, a New York Times columnist and author of Too Big to Fail, called AIG the “turnaround of the year.”

Now, it’s also important to know that not everyone was satisfied with the math involved in the amount repaid by AIG, because some have pointed out that bailout figures don’t take into account the tax breaks that AIG got as part of the deal.

Again, from PolitiFact.com… and also from the New York Times’ DealB%k article in March, “Bailout Watchdogs Criticize AIG Tax Breaks”

Former members of an oversight panel said in March that a special tax exemption offered by the Treasury in 2008 amounted to a “stealth bailout.”  It allowed AIG to count net operating losses against future tax bills, which “some estimate has contributed to $17.7 billion in profits for the company,” according to the group of former oversight panelists, including chair Elizabeth Warren, now a Democratic senator from Massachusetts.

So, at the end of the day, did AIG repay the government’s loans of $182 billion?  Yes.  Did the government receive a “positive return” of $22 billion for taxpayers?  Yes.  But, when you consider the entire U.S. bailout of AIG… including the special tax breaks AIG received… was the government’s investment in AIG all that profitable? No, it was not.

Simply put, the government decided to bail out AIG because it was scared to death of what would happen if it didn’t bail the giant insurer out.  You see, unlike Lehman Bros., AIG did have more than enough assets that could act as collateral for the loan, but think about what happens when anyone has to sell non-cash assets in a hurry… they sell the assets for a lot less than would be the case if they sold them over time.  Just consider your car that you own outright.  If you place an ad and wait for a buyer you’ll get a certain price, but if you have to sell your car today, chances are that you’ll get a lot less.

So, AIG had enough assets to cover the $182 billion, but the government didn’t want to see AIG forced to sell that amount of assets in the equivalent of a fire sale because that would have driven the prices of the assets down quite a bit… and that would have hurt millions of people who also held the same assets in their own portfolios.  For example, let’s just say that AIG owned a million shares of a company like Microsoft… just imagine what would happen to the stock price of Microsoft had AIG sold a million shares in a hurry… it would drop like a stone.

So, if you remember that week in September 2008, Lehman had filed bankruptcy and global financial markets were already reacting badly to say the least, so the government decided not to force AIG to liquidate such an enormous amount of assets and instead to become AIG’s largest shareholder by buying 92 percent of the company’s common stock… roughly a billion and a half shares.

And, although I hate to have to admit it, looking back it was probably the right thing to do… and maybe the only thing to do… meaning that, had they not bailed out AIG things would have been much worse for everyone on Main Street as well as Wall Street.

The overriding point here, however, is that you can hate the bailout of AIG or the investors who profited handsomely by investing in credit default swaps that bet against bonds and CDOs backed by sub-prime loans, but their profits didn’t pay off anyone’s mortgage because the investors in the swaps didn’t own the bonds or CDOs.  

Frankly, even if a Credit Default Swap had paid off an investor who also owned a bond or CDO backed by sub-prime loans, including yours… it wouldn’t change whether you owe your loan.  Credit Default Swaps were a side bet on movements in the credit markets, made by large Wall Street investors, and would have nothing to do with anyone’s responsibility to make their mortgage payments as agreed.

And servicers weren’t the ones buying credit default swaps… servicers don’t own the loans, they only service the loans.  Wall Street investors bought credit default swaps… servicers would have no reason or interest in credit default swaps.

BY the way… here’s AIG’s “Thank You America” ad that aired in January of this year.  (Hey, at least they said thank you… I don’t remember Goldman Sachs or any of the others saying thank you, do you?)

There was Mortgage Payment Insurance too…

Insurance coverage that will make a borrower’s mortgage payment in the event that the borrower is unable to do so, usually as a result of unemployment or temporary disability, would have had to be purchased by the borrowers, and not by the bank or investors.  And since a very, very small percentage of borrowers purchase this type of policy anyway… its role in this crisis was insignificant.

You know the type of insurance I’m referring to… you might have received an offer to buy such an insurance policy inside your credit card bill or in a mailer from your bank.  It would have offered to make your mortgage payment in the event you couldn’t, and you probably ignored it because you always figured that if you ran into financial problems, you could either borrow against your equity to get through the crisis, or worst case, you could always sell your home.  What you didn’t ever imagine was that your home’s value could drop in half faster than you could do anything about it… and that’s exactly what happened here starting in 2007.

There was no reason you should have imagined your home’s value falling that quickly, by the way, such a thing had never happened in this country before, not even during the 1930s did home values fall as fast as they did in 2007 and 2008.

What happened in 2007, as I’ve explained countless times before over the last four years, is that Wall Street investment bankers broke the credit markets by selling bonds with ratings that weren’t correct… ratings that didn’t accurately reflect the risk involved in buying them.  And when, beginning on July 10, 2007, investors realized that they couldn’t trust the ratings on these bonds, they dumped them at fire sale prices, causing the mortgage backed securities and secondary mortgage market to collapse or freeze, among others, and soon it was impossible to get a mortgage.

No mortgages mean homes can’t sell and that means prices fall and fall fast.  By the time anyone on Main Street knew what was happening, it was already too late and they were underwater… unable to refinance… unable to sell… and as the economy spiraled down, foreclosures were inevitable.

After that, our government either did nothing or failed at whatever it tried.  And so here we are today.  And it’s not fair by a long shot… none of it.

What I find particularly unfair and entirely wrong is that it was clearly our government’s intent to create a fair process with objective criteria through which borrowers could seek to avoid foreclosure through modification of their loans… because doing so would benefit everyone involved… homeowners, investors, and our economy as a whole.  And yet this goal has continued to be flat out ignored by the mortgage servicers who get their marching orders from the banks that have more than survived… they’ve continued to thrive financially from Treasury policy and taxpayer largess.

These banks continue to in essence ignore the intent and even written agreements of and with the federal government.  They continue to be able to treat borrowers in default or who are seeking to avoid foreclosure however they see fit… without repercussion.  And as a result, we are all paying the price as we struggle to survive in an economy that cannot recover in any meaningful way… and all while the acts of the Fed allow the rich to get richer, on a tab that will ultimately be paid by us all.

So, yes I understand how we got here and the difficulties involved in changing what was done in the past.  I understand that bailing out homeowners in 2009 would have also meant bailing out the investors in the bottom tranches… which would have been an even larger bailout of banks and would have meant rewarding the worst of the behavior on Wall Street related to lending and securitization.  I get it… I really do.

But, it’s 2013… soon to be 2014… and there’s NO excusable reason that we still have a loan modification process that can reasonably be described as at least unfair and too often even torturous for those seeking to avoid foreclosure.

Even California’s mortgage settlement monitor, UCI Law professor Katherine Porter and others in her most recent report and article in the OC Register, said it clearly… (click HERE for full text of article if not a registered subscriber to the OC Register.)

Porter wrote in her report, the restriction against dual tracking does not kick in until the lender deems the loan-modification application to be “complete.”  “The path to becoming ‘complete’ often requires dozens of back-and-forth communications between homeowners and banks,” Porter said. “It drags on for months, creating uncertainty and frustration and putting families at risk of foreclosure.”

An Orange County consumer advocate said servicer compliance is improving, but not quickly enough, and that dual tracking continues. “We are still witness every day to consumers losing their homes due to the serious flaws in the process for evaluating and granting mortgage modifications that the monitor describes,” said Natalie E. Lohrenz, a housing and credit counselor with the Consumer Credit Counseling Service of Orange County.  “Dual tracking happens even when the client is extremely active in reaching out to their lender with assistance from a counselor,” she said.

“The housing counselors at the Legal Aid Society of Orange County have a very difficult time reaching the single points of contact,” she said. “It has been my experience that servicers are still playing games with homeowners and housing advocates. Unfortunately, it is still extremely difficult to process a loan-modification request.”

But alas… I don’t even see homeowners or the foreclosure defense movement as even having reform of the loan modification process in its sights.  Mandating reforms of the loan modification process doesn’t even seem to be our target anymore… as it was in the beginning… and as it must be if we are to protect homeowners from the fate accompli that is foreclosure.

Today, I even bring up loan modification as an answer and I get attacked for doing so, even though it’s clearly our best… if not our only real hope of saving homeowners on the scale needed.

Instead, far too many of us are gravitating towards baseless theories like the one about “insurance having paid off our loans so we shouldn’t have to,” which simply isn’t anywhere near true, as I hope to have established in this article.  I don’t like having to write articles like this one, by the way… I wish there was some way out of this mess that was easier or simpler… but there just isn’t.  If there was, we wouldn’t have lost six million homes to foreclosure already, and be losing another million a year to boot.

Even Neil Garfield of Living Lies, who has probably offered more theories as to how homeowners might try to fight foreclosure than anyone on the planet, including the one about insurance having paid off your loan, admits in a recent post

“The only way out of this which has received some traction in the courts is to allege that contrary to the requirements of HAMP and HARP and other programs, the servicer and creditor did NOT “Consider” the modification proposal, which of course is an accurate portrayal of the the real world of loans that are subject to claims of securitization —  even though those claims are probably false.”

 

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Here’s the industry response to the Porter article above…

A spokesman for the California Mortgage Bankers Association issued a statement in response to the reports, but did not address the specific findings.  “The process of assisting borrowers is one of continual improvement, and lenders and servicers continue to strive to help borrowers whenever possible,” said association spokesman Dustin Hobbs. “As (the) industry works to incorporate new state and federal law and regulation, in addition to the settlement, borrowers will continue to receive assistance from lenders and servicers.”

That is the same statement, essentially verbatim, that the industry made countless times in 2009, 2010, 2011… almost nothing has changed.  And that should be completely unacceptable to every single American homeowner… or renter.

All Americans should be in favor of fundamental fairness in the foreclosure process.  All Americans should demand that their elected representatives stop ignoring the situation when servicers fail to follow the rules that they promised the government they would follow.

What happened in our economy was not the fault of homeowners.  But, even years after the government said that foreclosure should be the last resort… it’s homeowners who are being left alone to face giant financial institutions in order to remain in their homes.

It’s not fair… it’s flat out wrong.  But we have to fight the right battles… believing things that aren’t true doesn’t make homeowners scary to anyone on the other side of this fight.  The truth of this crisis is plenty bad enough… we’re certainly not going to win anything by being wrong.

Mandelman out. 

Comments

  1. Amicusman says

    Mr. Mandelman:

    Regrettably, your very informative post will fall on the deaf ears of the legal illiterates, who spew the "credit default nonsense, bloggers who regurgitate the party line of the former, and the others who've drunk the Kool-Aid and espouse the other stall arguments, "produce the note," "MERS," "securitization," that have been ripping off homeowner's last dimes.

    The theory that lenders that received funds through loan securitizations or credit default swaps must waive their borrowers' obligations fails as a matter of law. Federal courts have repeatedly rejected precisely this theory:

    For example, in Flores v. Deutsche Bank Nat'l Trust Co., 2010 WL 2719848, (D. Md. July 7, 2010), the borrower argued that his lender "already recovered for [the borrower's] default on her mortgage payments, because various 'credit enhancement policies,'" such as "a credit default swap or default insurance," "compensated the injured parties in full." The court rejected the argument, explaining that the fact that a "mortgage may have been combined with many others into a securitized pool on which a credit default swap, or some other insuring-financial product, was purchased, does not absolve [the borrower] of responsibility for the Note." See also Fourness v. Mortg. Elec. Registration Sys., 2010 WL 5071049, (D. Nev. Dec. 6, 2010) (dismissing claim that borrowers' obligations were discharged where "the investors of the mortgage backed securities were paid as a result of . . . credit default swaps and/or federal bailout funds); Warren v. Sierra Pac. Mortg. Servs., 2010 WL 4716760, (D. Ariz. Nov. 15, 2010) ("Plaintiffs' claims regarding the impact of any possible credit default swap on their obligations under the loan . . . do not provide a basis for a claim for relief").

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