The mismanagement of subprime loans in 2007-2009 was a major cause of the financial collapse that put us in the current recession. Between the borderline fraudulent allocation of debt to borrowers that could not afford to maintain their end of the obligation, to the inappropriate valuation of the insurance contracts underlying those transactions (and therefore encouraging them), a massive asset-valuation bubble was created.
Today, we’re seeing the re-emergence of a similar market for low-quality debt assets through the return of the ‘NINJA’ (no income, no job or assets) borrower in the car-loan industry, student loan market, and now back in mortgages. That being said, the new NINJA mortgage borrower comes with a bit of a twist that changes the way in which the industry adapts to the implications of the new trend.
Recently, some banks have started allowing subprime borrowers obtain mortgages without an income, so long as they purchase and whole life insurance plan at the same time as obtaining the mortgage. The reasoning behind this purchase is that the bank can then adjust their risk profile against the mortgage by providing the bank with an extra income source from the life insurance policy itself (an extremely lucrative product for a bank).
From there, whole life insurance policies come along with a cash-surrender value, and can therefore be leveraged in a way that would actually allow the beneficiary (ie. the customer) to tap into the funds build up within the policy in the event that they start having trouble making payments on their mortgage. From the bank’s perspective, this adds an extra measure of safety against the risk of the subprime mortgage, albeit in a somewhat convoluted way. That being said, the implications of a whole life insurance then add an additional layer of sophistication to the overall situation that is being created with this type of product.
Whole life insurance policies are protected from creditors in the event of bankruptcy. This makes them extremely valuable tools for protecting the wealth of a client against situations like divorce and default, because it allows them to maintain control over a portion of their assets, so long as they can continue making the payments towards the policy itself. For a lending bank that controls both a mortgage and a life insurance policy for a single client, this means that, if the client defaults on their mortgage, the life insurance policy will remain intact, and the bank will be able to continue pulling in the revenues associated with that line of business.
Granted, the bank has lost money on a high-risk mortgage, but they will continue to earn on the payments that the customer makes on their life insurance policy, even if that customer goes completely bankrupt. What’s more, these life insurance policies will often also have escalating payments, meaning that the bank will make incrementally greater incomes from the client as they proceed with the policy.
The end result of both of these situations is still a situation where banks are taking on great deals of risk through the provision of a subprime mortgage. What’s more, the presence of both a life insurance policy along-side a mortgage means that there is potentially an opportunity for shady bankers to again game the system by selling off the low-quality debts to third party holders, mitigating the risks of the collateralize obligation against the longer-term returns associated with the life insurance policy.