Banks Get Hoisted by Their Own Petard

08/25/2008 12:00 am EST

Focus: MARKETS

Terry Savage

Author, The Savage Truth on Money

Whatever happened to Private Mortgage Insurance? You remember PMI, don't you? It was an extra payment of about $50 per month per $100,000 of your mortgage loan. At the time they explained this wasn't to protect you; it was designed to protect the lender against the possibility of loss in case you defaulted on your loan payments.

I remember writing columns about how to make sure you paid PMI only until your home equity reached 20%-which happened quickly to many borrowers as their home increased in value. At that point, you could discontinue paying PMI, saving a lot of money every month.

Back in 1994-not so long ago-maybe one of every two homebuyers had less than the required 20% down payment, but were able to secure loans because they paid for Private Mortgage Insurance.

Okay, well where is that PMI now that the banks need it? Why are they writing off billions as they foreclose on home loans? I haven't seen one bank mention that there are losses on loans, but credits to their income statement as the PMI insurance makes restitution.

Could it be that along with subprime mortgages, many lenders finagled around the requirement for private mortgage insurance? In fact, many did just that-offering two mortgages, or even three, to complete the loan package. They would make one large loan for 80% of the financing, along with one or two smaller loans, at higher rates, to cover the remaining 20% of the financing. Thus, the large loan did not require PMI.

As an example from Bankrate.com, under the "80-10-10" plan, the 10% down payment on a $100,000 house is $10,000. The first mortgage is $80,000 at 7.5%, which comes to a monthly payment of $559. The second mortgage for $10,000 has a 9.5 % interest rate, making a monthly payment of $84. Total monthly payments of the two loans: $643.

Compare that with a $10,000 down payment, one mortgage of $90,000 at 7.5% has a monthly payment of $629, plus PMI of $31.45, making a total payment of $660.45.

By this type of accounting legerdemain the borrower saved $17.45 a month in payments.

But the lenders only fooled themselves! Without insurance, they face losses on both loans. Shouldn't bank shareholders be calling them to account? And shouldn't the Mortgage Bankers Association have waved a red flag? 

Just another example of the pennywise, pound-foolish greed of many of our nation's leading banking institutions in the recent subprime-housing debacle. Are they getting what they deserve?  What do you think? Please join the conversation at SavageMoney.

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