Part 3 – Challenging the Force-Placed Insurance Business Model: Pre-Dodd-Frank Fee Income
To understand why the words “force-placed insurance” appear in the Dodd-Frank Law 331 times, we have to look back on how the money-center banks partnered with the force-placed insurance trackers to generate fee income.
Government Sponsored Enterprise
In 1981, the Government Sponsered Enterprise (GSE), Fannie Mae, issued its first mortgage pass-through called a mortgage-backed security. These Mortgage-Backed Securities were the beginning of the secondary mortgage market and a fee income-based revenue model for larger banks. In the Community Redevelopment Act of 1992, the Bush administration required GSE’s to meet affordable house goals set annually by HUD and approved by Congress. The levels of GSE participation was 30% that year and increased to 55% by 2007.
In 1999 the Clinton Administration expanded the program to include inner-city housing as defined by the existing Community Reinvestment Act (CRA). The stage was set for loan originators to originate sub-standard loans and sell them to Wall Street via mortgage-backed securities.
Force-Place Insurance Partners with Money-Center Banks
The GSE move to mortgage-backed securities led to money-center banks partnering with insurance trackers. This partnership led to the demise of the force-placed insurance industry.
Let’s loosely define money-center banks, which is not the official definition from Investopedia. I define a money center bank as a bank whose net interest income is less than fifty percent of their total income. The more significant revenue stream is fee income, not net-interest margin.
After the introduction of the secondary mortgage market, the money-center banks’ business model changed. The secondary market enabled a larger number of loan originations that would not be limited by the bank’s capital requirements. The secondary market traded fee income for balance sheet loans. The fee income model included the following fees:
- Originate a Mortgage – Origination Fees
- Sell the loan to a GSE – Loan Sale Fees
- Retain Loan Servicing – Servicing Fees
- Force-Placed Insurance – Fees Through Underwriting Profit
Most bankers understand the first three fees listed above, but how did these large banks get involved in force-placed insurance?
More history… Before the GSE secondary market, banks negotiated force-placed insurance premium rates because many of the force-placed policies had to be paid by the lender during non-accrual and foreclosure procedings. Now with the secondary markets or Wall Street owning the assets, the lenders were no longer incented to negotiate low Force-PIaced Insurance premium rates.
The money-center banks worked with insurance trackers and raised force-placed insurance premium rates, which led these lenders to create their own captive insurance companies. As an example, force-placed insurance flood rates in Florida had traditionally been set at $3.30 per $100 insured. One of the rates discovered during a class-action lawsuit was $8.33.
Wall Street owned the mortgage assets and was a party to the money-center bank’s loan servicing contract. The Liability for paying uncollected force-placed insurance premium was squarely in the hands of Wall Street via the loan servicing contract. Wall Street provided the fourth income stream shown above through the banks’ captive insurance company’s underwriting profits.
Wall Street Foots the Force-Placed Insurance Bill
The pain felt by Wall Street paying Force-Placed Insurance premium was tolerated until the sub-standard loans described above began to default in 2007. Lenders typically escrow sub-standard mortgages to ensure payment of insurance and taxes. Once these loans started to default, the money center loan servicers used a loophole in the then-current RESPA rules to their advantage.
Under the Real Estate Settlement Procedures Act (RESPA), an escrowed borrower could not be force-placed unless the loan was delinquent more than 90 days. Money-center loan servicers would often hold escrow insurance payments on delinquent borrowers. As a result, the borrower’s insurance company would cancel due to the non-payment of premiums. As soon as the borrower was delinquent for 90 days, and there was no insurance in place, the servicers would be free to force-place, and use this escrowed insurance premium to pay part of the force-placed insurance premium, and bill the balance to Wall Street. These lenders inflated the force-placed insurance rates to guarantee an underwriting profit to the bank-owned captive insurance company. It is estimated that this practice generated over $2.3 of the $3.0 billion in Force-Placed Insurance premium in 2009 alone.
History tells us that the original force-placed insurance business model was flawed, but the money-center banks partering with insurance trackers gave the force-placed insurance industry its black eye. I do not wish to name any lenders or insurance trackers in the blog, as the industry has corrected itself via regulation and class-action lawsuits. This information is readily available with some some research on the web.
In Part 4, we will dive into how Dodd-Frank, along with dozens of class action lawsuits, began to rehabilitate the force-placed insurance industry.
Please comment within the LinkedIn Group “Bankers & Force-Placed Insurance” so that we can keep the discussion within the group.