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The core problem is that the lender receiving free insurance protection has zero incentive to terminate it. On the contrary, lenders have every reason to keep the insurance in place because it generates more revenue for the insurer, who is selected by and therefore beholden to the lender. While a direct payment by an insurer to a referring lender is illegal, there are legal methods by which insurers can demonstrate their appreciation to the lenders who select them.

There is a very simple way to protect borrowers from paying for mortgage insurance that is no longer needed to protect the lender: Require that lenders pay for the insurance that protects them. This radical idea would have the mortgage insurance market work like every other insurance market, where the rule is that the party who is insured pays for the insurance.

If this almost universal rule were extended to the mortgage market, the cost of the insurance would then be embedded in the price of the mortgage alongside all the other costs of making a home loan. Lenders would decide when to terminate insurance on individual loans based on whether they believed the risk remaining in the loan justified their continued payment of the premium. The borrower would be out of it.

Requiring lenders to pay for the mortgage insurance that protects them would generate another major benefit for borrowers: The insurance premiums that would be embedded in the mortgage price would drop like a rock. In the existing system, lenders have zero interest in lower premiums for borrowers, because high premiums increase the value of lender referrals to insurers, and therefore encourage larger paybacks to lenders. But if lenders had to pay for the insurance themselves, they would use their market muscle to minimize their costs.

Bad rules create new problems that require additional rules to fix, but the fix is never as good as getting the original rule right.

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.

©2013 Jack Guttentag

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