The Piggyback Risk

Ever since the first FHA mortgage was written, lenders required an added level of insurance when writing a mortgage on a property that the owner had less than a 20% equity participation. FHA called this insurance MIP (Mortgage Insurance Premium). From the borrower's prospective, this required him to pay an additional upfront insurance payment in additional to the customary closing costs and an additional monthly insurance premium in addition to his normal housing expenses. From the lender's prospective, they could close on a mortgage in which the borrower had little or no cash investment in the property knowing that in the event of a default there was insurance available to absorb a portion of the lender's loses.

Learning from this government program, the insurance industry developed policies that lenders could use on non-government mortgages. Mortgage Insurance (MI) was offered to borrowers to enable them to purchase a home without investing 20% of of the purchase price. These MI policies have more flexibility than FHA's MIP. A borrower could elect to pay based on an annual policy, a monthly policy or can even elect to pay a higher interest rate on his mortgage and have the lender pay for the insurance. Instead of dealing with a flat rate for all mortgages , as in the case of MIP, private MI companies price the premium base on the risk profile of the borrower. For example, a borrower investing 15% of the purchase price carries less risk of default than a borrower investing 3% and is therefore entitled to pay a lower premium.

In addition to reducing the risk to the lender, MI also added one more level of underwriting approval on a mortgage application. Not only does the lender's staff investigate the details of the transaction and of the borrower's qualifications but the MI company also underwrites the application and is a second set of eyes looking over everything prior to a mortgage being committed.
In an attempt to offer borrowers more options in mortgage financing the industry developed a new program known as the piggyback. The piggyback is the utilization of 2 mortgages instead of one when financing a property. Although there are numerous reasons to do this, we are only going to look at one in particular. That is, using a combination of 2 mortgages to replace the need for MI. On the surface, there shouldn't be a problem here. The first mortgage is typically written as an 80% loan-to-value (LTV) and priced as a first mortgage should be. A second mortgage is then underwritten and priced as a higher risk loan. From the borrower's prospective this usually meant that the overall cost of the financing would be less that when MI is added onto a high LTV first mortgage. Saving a consumer money is a good thing so this became a popular mortgage program to be recommended by originators.

Unfortunately, the default rate on piggyback mortgages is proving to be higher than on first mortgages written with MI. Since there is no insurance company involved, the lender is exposed to all losses in the event of foreclosure.

The reason for this stems from the fact that insurance companies are better equipped to identify the magnitude of risk associated with an event and price the premium to suit. A mortgage written with MI added onto it wasn't generating more profits for the investors than a piggyback it was more accurately priced to reflect the risk of default. When lenders developed the piggyback, their analysis concluded that the higher interest rate they were receiving on the 2nd mortgage was adequate coverage for the projected performance of the mortgages. For a few years, their analysis proved correct. Market conditions changed and the default rate grew.
This is why we will be seeing tighter underwriting standards, as well as higher pricing, on piggyback mortgages going forward. Many lenders will likely stop accepting applications for piggybacks in response to the miscalculation of the risk associated with this form of financing.

Like most industries, the mortgage industry mirrors a pendulum motion. It swings towards more liberal underwriting standards until it goes too far. It then swings back to a more conservative period until is moves too far in that direction. It then begins the cycle all over again.