FrontDoor.com

With all the talk of good news on the recession front there remains the little matter of reality. The real estate market cannot possibly return to normal until we clear out local inventories of unsold houses, meaning in many markets homes which have been foreclosed. But now a new idea has begun to emerge: Reduce foreclosure numbers before they're created by subsidizing owners, buyers and investors. How? By tapping into the mortgage insurance system.

One of the major reasons for the current financial meltdown has been the effort to avoid mortgage insurance. This is about as good an example of delusional financial thinking as one can find. Lenders have traditionally wanted buyers to purchase with 20 percent down. Few buyers have such cash so instead they opt for a strong co-signer, a mortgage insurance plan that promises to pay back part of the loan in the event of default. With FHA, VA and private mortgage insurance the consumer can buy real estate with little down and even nothing down under the VA plan.

With mortgage insurance we solve the problem of missing down payment money but such insurance is not free. The cost of mortgage insurance varies but it can mean fees at closing, monthly premium charges or both. Somehow the notion arose during the past few years that we don't really need mortgage insurance. The way around mortgage insurance costs was to finance with piggyback loans and one mortgage equal to 75 percent to 80 percent of the purchase price an a second loan for some or all of the balance. Now the lender has a first lien which can easily be sold to investors and a second lien which can often be sold as well. As to piggyback borrowers, no mortgage insurance payments for them.

Piggyback loans seem fairly shrewd, at least as long as property values continue to rise. In a market with upward prices, if a borrower got in trouble the home could be readily sold to pay off the loans and foreclosure would be avoided. Alas, in the past few years three problems arose: First, most local markets have seen home values fall. Second, many piggyback loans included financing where the initial payments were so low that even interest costs were not covered. The unpaid interest was added to the loan balance, meaning that mortgage debt was growing at the very time home values were falling. Third, if you don't pay for mortgage insurance you don't have coverage when things go wrong.

In situations where there's mortgage insurance if a borrower defaults the lender has big protection: The mortgage insurance policy typically provides coverage for 20 to 25 percent of the original loan amount plus a variety of foreclosure costs. So far, so good, the lender is happy to have mortgage insurance coverage. But now we have to consider the fate of the mortgage insurance companies. Like all insurance firms they want to hold down claims. As it happens the mortgage insurance system to date has worked as exactly as intended. However, paying claims also means that the mortgage insurance companies have had big losses. Those claims are offset with reserves but the point remains that a loss is a loss.

NEXT: Claim advances >>