Tag Archives: fhfa

A Troubling Gap in Earthquake Coverage

Earthquakes are among the most devastating and economically destructive natural disasters, with the 1994 Northridge earthquake still ranking as the fifth-costliest disaster in U.S. history. Yet unlike other common perils such as floods, fires and windstorms, the overwhelming majority of earthquake risk in the U.S. is completely uninsured. Even in California, the most earthquake-exposed state in the union, only about 13% of residences maintain coverage for earthquake damage, according to the most recent survey completed by the state insurance department.

The primary cause of this low percentage is that, unlike those other risks, earthquake coverage is not required to secure the collateral of mortgages owned or guaranteed by the government-sponsored enterprises (GSEs) known as Fannie Mae (the Federal National Mortgage Association), which accounts for 21% of the $14.99 trillion U.S. mortgage debt outstanding. and Freddie Mac (the Federal Home Loan Mortgage Corporation), which accounts for 12%.

This exposure should be of concern to policymakers. Ten years ago this month, Fannie Mae and Freddie Mac both were taken into conservatorship by their regulator, the Federal Housing Finance Agency (FHFA), and were granted a $187 billion capital injection from the U.S. Treasury Department. While each of the GSEs has subsequently repaid its debt to the government, including a 10% return on investment, the Treasury continues to provide financial support through senior preferred stock purchase agreements. Currently, the Treasury owns $200 billion of the GSEs’ senior preferred stock.

See also: Spreading Damage From Wildfires  

Should a major earthquake strike in the U.S.—as is inevitable—Fannie Mae and Freddie Mac both would see the destruction of potentially billions of dollars in structures that serve as collateral for their mortgage portfolios and mortgage guarantees. In addition to requiring direct Treasury outlays to the GSEs, the low takeup rate of earthquake insurance also means that taxpayers almost certainly would be asked to shoulder a disproportionate amount of disaster recovery costs through state and federal disaster aid.

The FHFA acknowledges that it does not currently track the GSEs’ exposure to uninsured earthquake risk. This paper seeks to quantify the size of that uninsured liability and to propose a means to transfer these implicit taxpayer guarantees to the private sector. Our data analysis comprises three components:

  • Using seismic maps published by the U.S. Geological Survey, we identify 249 counties across 21 states that are substantially exposed to the largest earthquake risks.
  • Using property-level databases published by the FHFA, we find that, as of 2016, the GSEs held $355.71 billion of unpaid principal for mortgages in those 249 counties, including $210.1 billion held by Fannie Mae and $145.61 billion held by Freddie Mac.
  • Making certain base assumptions about the proportion of principal that is attributable to structural value and regional surveys of earthquake insurance takeup, we estimate the total value of uninsured earthquake-exposed collateral held by the GSEs, as of 2016, is $204.68 billion.

Finally, we propose that Congress move immediately to require a report on risk transfer by the GSEs. Building on their recent credit risk transfer programs, we believe Fannie and Freddie should be required by the FHFA to transfer at least a portion of their earthquake exposure to the private market through a combination of traditional reinsurance transactions and catastrophe bond securitizations.

See also: 5 Tips for Avoiding Personal Injury Claims  

To finance such transactions, the GSEs should require mortgage originators to assess an appropriate credit charge to take on mortgages in earthquake-prone regions. To provide incentives for property owners, that charge could be waived for properties that demonstrate continuous earthquake coverage or significant investment in seismic retrofitting mitigation.

You can find the full paper here.

Smarter, Faster Trades — and Without Fraud

New York Times senior economic correspondent Neil Irwin did great public service in his Upshot column provocatively titled, “Why Can’t the Banking Industry Solve Its Ethics Problems?

While Irwin addressed the issue for investors in general, his column should hold particular interest for those in the insurance business because insurers are such large investors and generate such a high percentage of their operating profit from investments. In terms of commercial and multifamily real estate mortgages alone, insurers hold more than $900 billion of investments, according to the Mortgage Bankers Association’s Q4 2013 report. (That’s $343 billion in commercial and multifamily mortgage debt plus $567 billion in commercial mortgage-backed securities, collateralized debt obligations and asset-backed securities.) The Federal Reserve tallies life insurance companies’ holdings of residential mortgage-backed securities (RMBS) at $365 billion as of the end of the first quarter, 2014. Insurers need the investment industry to clean up its problems if they are to get maximum value from these huge investments.

Why does fraud occur so repeatedly? Irwin ponders.

The answer: gamed markets.

Since the Great Depression, investments systems have relied on enforcement after the fact. If companies were investigated, prosecuted and found to have done something wrong, they were punished. Typically, this is now done through fines and stricter monitoring, meaning that current and future staff – not those in place at the time of the fraud – and shareholders bear the costs. Sometimes, individual perpetrators are forced to retire (with pensions). Only in the past few years have the Department of Justice, Federal Housing Finance Administration and Securities and Exchange Commission begun extracting hefty fines and settlements with the largest banks, such as: Citigroup’s $7 billion, JPMorgan Chase’s $13 billion and Bank of America’s $6.3 billion with FHFA and the reported $17 billion with DOJ in connection with residential mortgage-backed securities.

As Irwin notes, fraud continues to occur despite extensive efforts to address the problems that led to the near-collapse of the financial system that spawned the Great Recession.

Gaming the system through high-speed trading remains legal. As long as there is no insider trading, traders can greatly increase the speed of their transactions with network equipment, software and advantageous location of their computers.

Insider trading is illegal but hard to root out. Successful prosecution almost always entails a whistleblower coming forward to provide regulators with precise information. And coming forward as a whistleblower entails consequential career risks.

Two innovations address these systemic challenges by providing better information for the market in real time and creating a feedback loop that improves that information – rather than waiting until after the fact to police bad guys. The innovations are interactive finance and confidence accounting.

First, Interactive finance rewards institutions and individuals with financial or strategic advantage for revealing information that details risk. That information could be, for instance, about the changing value of a house, about the payment history of the mortgagee, other financial information about the borrower, etc. That information would stay with the mortgage even if it became part of a pool that was sliced and diced into mortgage-backed securities, so that a potential buyer could probe and could track changes in real time, rather than rely on a single-point-in-time evaluation by a ratings agency. Interactive finance – not enforcement – would keep agencies from giving their highest ratings to securities whose underlying assets were suspect, as happened with sub-prime mortgages in the buildup to the Great Recession.

Marketcore, an intellectual property firm I advise, offers such interactive finance technology. It supports the determination of risk for financial products, continuous revaluation and analysis of components of pooled securities, among other capabilities that make markets and clear them.

Its technology diminishes incentives for fraud by making opacity and concealment anachronistic and replacing them with transparency. The IP also charts effective pathways to employ crowd data and meta data for timely detection of risk, building on the growing availability of information in a “big data” world and allowing for a generational improvement in detecting risk and rating credit.

Second, confidence accounting yields greater transparency and accuracy than traditional, prudential valuation. In confidence accounting, you don’t just set a value for an asset. You say there is an xx% chance that the valuation will fall within a certain range. You then roll up all the assessments and have a probability-based understanding of the likely range of total value. You can also use the estimations as a feedback loop and identify people or institutions that consistently overstate value – if someone says asset values will fall within a certain range 95% of the time, do those values, in fact, fall within that range 95% of the time?

As risk expert David M. Rowe explains in a current Risk blog (citing work by Ian Harris, Michael Mainelli and Jan-Peter Onstwedder) confidence accounting can illuminate “the degree of uncertainty around valuation estimates…including how to partition uncertainty surrounding current valuation from the more familiar concept of risk from uncertain future events, and the messy issue of how to aggregate valuation uncertainty for specific positions into the implied uncertainty of net worth.”

Through these two innovations, interactive finance and confidence accounting, banks would have much easier times detecting rogues and suppressing rascals. In the process, banks would not only increase their own wellbeing but that of their shareholders, employees and the investing public, including insurance companies.

Going forward is now a simple business decision for us all. We must pick up the pieces of what we have learned and refashion and rebuild data-refreshing business models in which everyone can participate as an information merchant. We must deliver a common architecture in which data is consistently revalued, in a system that continually rewards disclosures about risks and values.

Interactive finance and confidence accounting are emergent technologies poised to  play key roles shaping and defining smarter, faster, ethical trades in 21st century finance.