Since the payments will be due in a systemic crisis

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reserves (or capital) behind to honor the insurance payments. Since the payments will be due in a systemic crisis and the insurer is large, it is more likely than not that the insurer will be bailed out. At any rate, even if the insurer were not to be bailed out, it is hard to imagine that reserves will be adequately set aside for a systemic crisis as at least some costs of the insurer’s default are borne by the rest of the system. The tale of the financial crisis of 2007-2009 is that insurers provided excessive insurance on structured mortgage products that were tied to macroeconomic variables, and were undercapitalized and insufficiently liquid given the correlated risks of that insurance. For example, according to Inside Mortgage Finance, of the $960 billion of private mortgage insurance that was outstanding in 2007, 80% was held by just six companies: Mortgage Guaranty Insurance (21.8%), PMI Mortgage Insurance (18.8%), Radian Guaranty (14.9%), Genworth Financial (12.9%), United Guaranty (13.1%), and Republic Mortgage Insurance (11.5%). A substantial portion -- $173 billion -- was issued by these six insurers to satisfy the guidelines of Fannie Mae and Freddie Mac. In terms of the relative size of private and government markets, in 2007, $357 billion was newly underwritten by private insurers, and $105 billion by the government insurers: FHA and VA. And from January 1, 2007, to December 31, 2007, the above insurers (which were publicly traded independent companies) lost an average 60% of their stock market capitalization. Almost all of them experienced financial distress the following year. Short of banning private mortgage insurance, or requiring heavy capitalization, it is not clear how the private market can solve the systemic risk problem. Reducing the size of the insuring firms will not work because all of the firms will fail at the same time given the macroeconomic nature of mortgage insurance risk. For all of these reasons, we are agnostic with respect to the complete privatization option, at least in the near future. However, if privatization was the chosen route, then the credit-risky MBS market would have to be given time to develop, and private mortgage guarantee functions may have to be fully capitalized. During the transition to privatization, the guarantees on the existing conforming mortgages would remain in place and be assumed by the GSE RTC. In addition, new conforming mortgages could be originated by the GSE RTC, but their numbers should be reduced gradually. The wind-down scenario for the guarantee function could be set up in a similar fashion as that
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116 for the retained portfolio. In particular, new guarantees could fall at 10% per year from their 2009 peak, unless market conditions permit a faster wind-down. 8.2.3. A Hybrid Solution The question is how to balance the benefits of nationalization – the public guarantees of mortgages with its enhanced liquidity for the mortgage market -- against the difficulty in pricing these guarantees and the resulting lack of market discipline, which induces moral hazard and excess risk taking. With privatization, the exact opposite is true.
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Christopher Reinemann
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