If you don’t live in a cave, you have probably hears about the current crisis in banking and housing. Many banks and mortgage companies have already failed (Netbank, Indymac, and others), and many more are expected to follow. But if the banks hedged their risks appropriately, the pain of the housing crisis would be mostly limited to the private mortgage insurance companies, such as MGIC Investment Corp (MTG).

Traditional wisdom states that you need a 20 percent down payment to purchase a house. The 20 percent down payment is the method a borrower can use to prove loan worthiness. The large down payment, and a good credit score were the traditional means a bank used to establish credit worthiness for such a large purchase. If a borrower wanted a home loan with less then a 20 percent down payment, they were structured as a piggyback loan. The piggyback loan consisted of two loans, one for 80 percent of the value of the house, and a second loan at a higher interest rate for the difference between the smaller down payment (sometimes nothing at all), and 20 percent. In addition, banks and mortgage lenders issuing piggyback loans required the owner to purchase additional private mortgage insurance. The mortgage insurance premiums paid by the owner was a protective insurance policy designed to hedge the banks risk against default. Companies such as MGIC, who sold the mortgage insurance, would cover the first 20 percent of loss and the banks would cover the rest.

But just as in the DOT COM era, the bubble got a hold of bank CEO’s, and greed and stupidity took over. The logic seemed simple at a time when competition for home loans was fierce and banks were fighting for their share of the loot. You know how the story goes; everything that could be overlooked was overlooked. $500,000 no money down home loans, often structured as interest only arms with negative amortization, were freely given out to anyone with a heart beat, and sometimes the heartbeat was optional. But the banking CEO’s figured there was no risk because houses were increasing in value by 10 or 15 percent per year - or so they WERE. It was a borrowers market and given the choice of a loan from a bank that required the additional mortgage insurance purchase, and one that didn’t, the decision was obvious. Just as the commercials say, banks had to compete, and when banks compete, banks LOSE. They dropped their demands for private mortgage insurance, effectively killing the hedge and taking on all the risk themselves.

Fast forward to present day and banks are now learning the painful lesson that mortgage insurance policies won’t help them if they never existed. Meanwhile, the impossible has suddenly become the probable. Housing values across the country continue to drop, and borrowers who never had any skin in the game find it easier to walk away and hand the keys back to the bank. And the banks are left wishing they had the private mortgage insurance in place to buffer the pain.