We got a little bit of mail after last week's article, " A Crime Called Private Mortgage Insurance; Alex Pollock on the Political Finance of Covered Bonds," although the comments fell all over the spectrum. More than a few readers thought we were being too nice to the private mortgage insurance industry and the commercial banks they service. But we think that the quotation from former President Ronald Reagan's favorite economist, Frederic Bastiat, says it all when it comes to US housing policy and the American political economy in general.

Several readers complained that there was no discussion of the use of captive insurers by banks to drain income away from private mortgage insurance underwriters. Others wanted to plumb the depths of the link between private mortgage cover and collateralized debt obligations. We'll be getting back to both issues in a future issue of The IRA news and commentary service.

Of note, the latest Event of Default report from our friends at the Ramius unit of Cowen & Co indicates deal acceleration and liquidation is picking up, but because of rising bid prices. Of 475 CDOs surveyed in the Event of Default report each month (total original collateral balance of ~$427.8bn), 193 deals are in liquidation or have been liquidated already (~$197.4bn). One new CDO was added to the list this week: (1) Sharps CDO I Ltd., $351mm High-Grade ABS CDO (current collateral balance ~$86.5mm) underwritten by Deutsche Bank ("DB"/Q4 2010 Bank Stress Rating: "A+"). This phenomenon of rising bid prices for all manner of private label crap is a direct result of the Fed's QE and a lack of duration in the markets generally, but the liquidations are driven by a desire to extinguish legal and financial exposure.

We heard several times from Edward Pinto at American Enterprise Institute, who complained about our characterization of private mortgage insurance (MI) as an ongoing criminal enterprise and financial fraud lacking basic prudential controls and adequate reserves. By the way, to our friend Yves Smith at Naked Capitalism, we don't use the acronym "PMI" because that is an active ticker for a private MI underwriter. All in an effort to be fair, you will appreciate.

Pinto previously worked as counsel at MGIC Investment Corp ("MTG"), and also did a stint at Fannie Mae and the Michigan State Housing agency. He just co-authored a white paper on housing finance with Peter Wallison and Alex Pollock we referenced earlier. Actually, the paper is white but the ink is mostly back. Pinto noted in an email that MGIC has 25% reserve cover on expected losses and also that in the case of Countrywide, MGIC contested many loans as fraudulent and the arbitration eventually settled. He also made an important point regarding the timing of loss recognition:

"MI policies are quite specific; claims can be made only after foreclosure. Delays in the foreclosure process increases severity since an MI is on the hook for interest during the delay. Delay is not in an MIs interest."

Pinto is 100% right about delay being bad for ultimate loss severity, but his argument does not make us feel better. In fact, Pinto's comment begs the question with respect to the top four mortgage servicers and the GSEs, who are in our view dragging their feet on loss recognition and liquidation of REO. Why hurry when the REO bid is falling away? Ed's argument basically strengthens our belief that the MIs are in, economic terms at least, agents for the TBTF banks and housing GSEs. The former suck revenue out of the private mortgage underwriters via reinsurance kickbacks and are now delaying REO liquidations.

But the bigger issue is what Ed's observation says about MI and large bank solvency given the current direction of housing prices. Within the industry and regulators, we continue to see evidence of the "waiting for the bounce" tendency with respect to recognizing impairment of credit loss exposures, but the evidence of growing risk in terms of future losses on existing, currently performing, "never late" first and second liens is building. For those of you who thought we were too harsh on Wells Fargo ("WFC"/Q4 2010 Bank Stress Rating: "B") last month when we downgraded the bank in The IRA Advisory Service , read the March 24, 2011 report from Laurie Goodman at Amherst Securities, "The Case for Principal Reductions." Goodman writes:

"We reiterate the case for principal reductions and present some thoughts on dealing with moral hazard. We also argue that the cost of doing nothing and exacerbating the home price depreciation/negative feedback loop is quite high... Equity is the single most important predictor of default behavior..."

Read that last sentence again please all of you in Washington who think 90 LTV loans will help end the crisis. It is no accident that states such as Illinois, Nevada, Missouri, and Maryland are all considering legislation to ban appraisers from using involuntary foreclosure sales in home valuations. In a rational world where programs such as HAMP were really effective to restructure underwater loans and, of necessity, say 50% of all HELOCs were written down to zero, both the TBTF banks and the MIs would be insolvent. Indeed, we have argued that the TBTF banks are still concealing tens of billions of dollars in defaulted loans under the canards of modification or troubled debt restructuring. This is the big picture context with respect to both discussion of private mortgage market reform and also the Fed's recent banks stress tests.

We say it again: loss rates on FDIC resolutions are running over 30% in this crisis vs. 11% in the 1990s real estate bust. This implies that many FDIC-insured banks on the troubled list are book insolvent today. This comment with respect to net asset value especially applies to the top four banks in the government-guaranteed cartel which, along with the three GSEs, controls the secondary market for mortgage loans, particularly if US housing prices do not recover significantly this year. We still have a down 10% projection in the MacroMarkets forward HPI survey, but note that our colleague Gary Shilling is talking -20% or more in 2011. Now we know why the Fed's Division of Supervision and Regulation sandbagged the assumptions regarding home prices in the CCAR. It appears that the Fed merely used the CoreLogic forward HPI projections with no stress factor applied whatsoever.

We also heard from Mike Zimmerman at MGIC, who complained about being called a criminal and, like Pinto, said that MGIC was not in the business of paying out claims on fraudulent loans. You'll get no trouble from us on that score. We're worried about payouts on valid claims. Zimmerman and several others took issue with our view that the MIs are spending serious money in Washington to make sure that they continue to be a protected part of mortgage cartel -- call it an "earmark" on high yield housing loans. With respect to negotiations over the definition of a qualified residential mortgage and the role of the MIs in enabling subprime lending, Adam Ziebel reported in The Wall Street Journal last week:

"The regulations could have threatened mortgage insurers like MGIC Investment Corp., PMI Group Inc. Radian Group Inc. and Genworth Financial Inc. Those companies allow borrowers to take out loans with down payments lower than 20% if they agree to pay premiums to compensate for increased risk."

While we don't think that Ed Pinto, Mike Zimmerman or their colleagues in the private MI world are criminals in a personal sense, we do take strong issue with the private MI model in economic and political terms. The fact is that MI carries less capital vs. expected losses than most other types of insurance, yet the risk of loss in covering the top of the stack in RMBS is far greater than the low beta risk exposures in traditional insurance lines. That basic fact, to us, says it all.

In a classic issue of The IRA, "Seeking Beta: Interview with Robert Arvanitis," September 29, 2008 , we discussed the difference between low-beta insurance risks such as death, fire or ship sinkings, which are not correlated to the financial markets and the economy, and high beta risks or exposures which are highly correlated to the financial markets. Credit default swaps, directors and officers liability, and RMBS default insurance are all high beta risks with significant correlation to the financial markets, as we learned with the case of American International Group ("AIG"). This is why as Alex Pollock described last week with respect to Indy Mac, for example, the Federal Home Loan Banks require such high collateralization rates on advances to banks where residential mortgages are the security. Indy Mac had 100% over-collateralization on its advances from the FHLBs, which are essentially a repo transaction.

Providing first loss cover on a home mortgage with little or no equity down is a very risky proposition even in a stable economy, as Laurie Goodman's comment above illustrates. This is "high beta" risk that is greatly correlated to the economy and interest rates, but also is impacted by low beta risk factors such a demographics. This is why members of Congress need to sweep aside arguments from the housing industrial complex that we need to go back to 90 or 100% LTV lending as a way to prop up the housing market. Low or no money down lending actually destabilizes markets and creates net systemic risk. But the larger fiscal issues facing Congress illustrate why getting a rational approach to housing policy may be impossible.

Given the reckless fiscal policies followed by both major American political parties, taking first loss credit risk on RMBS seems like an act of insanity. Not only does the current MI model not adequately cover the risk from RMBS in a relatively stable economic environment, but when you add the distorting effects of government debt issuance and "corrective" intervention in the housing and financial markets, the risk management task becomes truly ridiculous. The extreme swings in Fed interest rate policy going back to Paul Volcker's 21% short interest rates on through to today's zero interest rate regime under Fed Chairman Ben Bernanke adds such volatility to the loss estimate task as to render the analysis entirely speculative.

Monetary policies crafted to enable the fiscal excesses of Congress and successive administrations from both political tendencies have turned banks and financial institutions into high-beta vehicles that spew securities of similar risk profile. Our politicians are entirely depraved creatures, who habitually dangle access to "affordable housing" in front of key lobbies as a pretext for reelection -- this even as they vote for trillions of dollars in new public deficits. As Dallas Fed President Richard Fisher said last week, "If we continue down on the path on which the fiscal authorities put us, we will become insolvent. The question is when," he said in a speech at the University of Frankfurt (Daily Bail).

In a political sense, MI is an enabler for the Washington racket called "affordable housing" and thus a tax on consumers, most of whom cannot even explain how a residential mortgage is priced. Think of the cost of MI as a tax on home owners just like a private bank pays higher FDIC insurance premiums for cover on supposedly risky brokered funds. Click here to see our comment at the recent FDIC roundtable on core and brokered deposits. And with all things in the world of analytics, you cannot paint with too broad a brush. To that point, we got this note from Dave in Massachusetts:

"I am an investment advisor and recently bought out first home. I have $1mm liquid net worth but have the problem that only $80,000 is in fully taxable, liquid (and available for withdrawal) accounts. The remainder is in tax deferred and tax free accounts (401ks, IRAs, and ROTH IRAs). As such, it was in my interest to minimize my down payment on the home to preserve my limited available cash. In addition, I have an 800 FICO. We ended up with a 5% down / 95% mortgage. We needed PMI to complete the transaction (hence your suggestion to shut them down would have been a big problem for me!). In this case, I could make a 2% upfront payment to eliminate the .95% annual PMI premiums. I am not a credit risk and the PMI mechanism allowed me to acquire our home. Eliminating all PMIs does not necessarily make sense."

Now based on his description, Dave seems to be a pretty good credit risk even at 95 LTV. Due to tax considerations, he chose to use MI to complete a home purchase with little money down, again illustrating the credit arbitrage value of private MI. But the financial professional then goes on to add: "PMIs are not insurance. I agree with you on this point but perhaps the alternative solution is to make them into insurance - i.e. - significant reserves, regulatory enforcement, etc. The whole financial instrument insurance vehicle has gone off the tracks in the last 15 years (PMIs, MBIA, etc)."

Dave raises a good point and one that goes to the heart of the private MI solvency issue, as well as the discussions of covered bond legislation in Congress. In order to even begin to be effective as insurance (instead of a form of regulatory arbitrage), MI would have to be priced an order of magnitude above current premium levels. This implies an increase cost for mortgage loans above 80% LTV of a couple of percentage points, but unfortunately that is the true economic cost of the risk.

A mortgage with no equity and private MI cover for the first 10% of loss exposure is still only partly secured, especially in a market where loss given default (LGD) is well above 50%. Aggregate LGDs for large banks for all exposures currently are above 90%, BTW, according to The IRA Bank Monitor. So when the happy squirrels from the mortgage bankers or realtors or private MI lobbies come to your office advocating 90 LTVs for the QRM standard, ask them: How much more taxpayer money they want to shovel into the furnace in the name of affordable housing?

We don't see any members of the National Association of Realtors offering to disgorge a portion of the supra normal sales commissions members earned during the housing bubble to offset the 30+ % loss rate to the FDIC on failed banks. If investment and commercial bankers must have a large portion of their compensation subject to government regulation and even clawbacks for their risk taking decisions, should not a realtor or mortgage broker who negotiates a 90% LTV loan be subject to commission clawbacks as well? Let's see legislation to put realtors, brokers and even appraisers in the line for first loss exposure on the high-risk loans that they originate and then we'll be impressed by talk of "privatization" of housing risk.

The discussion over reform of the US housing sector, covered bonds and all the rest ultimately must deal with a central fact, namely that there is very little constituency in the private investment community to take first loss exposure on RMBS. In the post-WWII period, investors were trained to treat agency paper as high-yield government debt, with greater market volatility and prepayment risk, but essentially little or no credit risk. The secular bull market in housing collateral encouraged the illusion that there was no credit risk in home ownership, either to the government or private investors, and was driven by economic growth and powerful demographic factors.

Today, however, we have the opposite situation, where the demographics and economic trends are a negative influence on collateral values. Proponents of privatization of the housing market argue that the US government cannot continue to underwrite all of the mortgage market and that "it is completely unsustainable." We agree and think that the GSE's should charge fees that are more market based and less subsidized by the US taxpayer, but again to our earlier point, this implies pricing for RMBS that is several points above current loan production. Let's raise the GSE cap to $1 million while we are at it.

Our friends on Capitol Hill say that large numbers of investors are willing and able to begin purchasing private label securities, but as long as the TBTF banks have cheaper funding options through the GSEs, banks will ALWAYS continue down that path. Again, absolutely correct, but we do not think that most of our friends in the pro-reform vanguard understand what the private market implies. Remember, the current market for RMBS is priced to reflect market and interest rate risk only. The vast majority of investors in GSE paper do not anticipate any credit losses and aggressively litigate when such losses are threatened.

In testimony before the House Financial Services Committee in February 2010, Michael A.J. Farrell, Chairman, CEO, Annaly Capital Management, provided an excellent overview of the current market for RMBS. People involved in the discussions about housing market reform should read Farrell's testimony carefully. He notes that of $7.5 trillion in RMBS funded by private investors, $5.5 trillion is held by rate sensitive investors in Agency MBS, with about $2 trillion in credit sensitive private label MBS. He also stated that:

"The balance, or about $2.5 trillion, is held in raw loan form, primarily on bank balance sheets. Since our country's banks have about $12 trillion in total assets, there is not enough money in the banking system to fund our nation's housing stock, at least not at current levels. It is thus axiomatic that without a healthy securitization market our housing finance system would have to undergo a radical transformation."

Farrell also notes a number of reasons why the private label market is not restarting, most important among them that there's still a good supply of seasoned and restructured private label paper trading at significantly higher yields than many people believe is the true cost of private sector issuance. As we ourselves noted in an earlier comment on housing reform, "Toryism, Socialism and Housing Reform: Real and Imagined," March 7, 2011 , until you convince the holders of the $5.5 trillion in agency paper that Farrell describes above to take first loss risk exposure on RMBS, or create a private insurance market to absorb at least part of that risk, talk of true privatization is just talk.

But aside from little details like investor preferences and credit loss appetite, the biggest threat to housing reform is the huge degree of market intervention in the financial sector led by the Federal Reserve Board. The current policies of Chairman Bernanke and the other starship troopers who populate the Federal Open Market Committee are stoking a global bubble in structured credit products and derivatives that is so volatile and so completely unpredictable that we almost have to expect a major financial institution to fail as and when the Fed ends QE and credit spreads reprice to "normal."

With each headline of earthquakes, revolution or European debt woes, credit spreads on US dollar denominated risk exposures tighten. "Good is bad" in the marketplace of 2011, as in the case of the tightening credit spreads of the major MIs. We hear in the channel that a certain large broker dealer which was not allowed by the Fed to increase its dividend payout caught a 2x4 in the face because of a position in the CDS of MBIA ("MBI"), which ran from 70bp to 30bp in a matter of days. The rally reportedly crushed a number of shorts. We described the view of the MBIA litigation in The IRA Advisory Service this past week.

In a marketplace where observed volatility is this high, even with the Fed removing trillions of dollars in duration from the markets via QE, just how are private obligors going to price trillions of dollars in first loss RMBS exposure in this imaginary private market that pro-reform elements in Congress have in mind? Fact is, when the Fed ends QE. market dependence upon the GSEs for liquidity support will grow. Like we said, raise the G fees and the conforming loan limit in the name of market forces, but we still think Congress needs to find some ways to increase the volume of mortgage loan refinancing and modifications, and pronto.