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Working Papers

Eyes Wide Shut? The Moral Hazard of Mortgage Insurers During the Housing Boom

Working paper #823
Neil Bhutta and Benjamin J. Keys

Insurance companies have incentives to take excessive risk at the expense of their beneficiaries. Consistent with this premise, we document that private mortgage insurance (PMI) companies dramatically expanded insurance on high-risk mortgages at the tail-end of the housing boom, contradicting the industry’s own research regarding house price risk. In the U.S., Congress mandates PMI for high-leverage mortgages purchased by Fannie Mae and Freddie Mac (the GSEs) to serve as a private market check on their risk-taking. We draw on industry and regulatory filings and reports, and use several loan-level data sources to examine PMI application denial rates, default rates on PMI-backed loans, and growth rates of high-leverage lending around the GSE conforming loan limit. We conclude that PMI companies’ incentive to underprice risk and to be under-capitalized facilitated GSE risk-taking, rather than helping to discipline the market.

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