Bank expert Chris Whalen has a little bombshell in his current newsletter. It’s so obvious that it should not only have occurred to me but pretty much everyone on the real estate beat. And that begs the question why no one has even mentioned it.

One of the actors in the subprime/Alt A market was private mortgage insurers. For those of you lucky enough to be unfamiliar with this concept, PMI is insurance paid for by the borrower for the benefit of the lender. The effect of PMI is to insure the property value on highly levered transactions. Lenders were quite happy to lend up to 80% of appraised value based on semi-decent income; it was considered unlikely before the crisis that home values would fall all that much in a specific geography even in a recession. But for the amount in excess of 80%, the lender wanted extra protection. In steps the PMI insurer. If the borrower wants to make only a 10% downpayment, he would need to get a PMI policy to insure down to the 80% risk that the lender was prepared to shoulder. (Update: note that the insurable event is a default on the loan, not a change in property value).

Given the prevalence of PMI insurance, their thin capitalization, and the big wipeout in home values, they should be as dead as the monolines. But they aren’t. That’s because they are engaging in insurance fraud, namely, refusing to pay out legitimate claims.

And perversely, as Whalen tells us, they are getting quite a bit of help from Fannie and Freddie not making claims at all. Why not? Well, if the GSEs did put in claims, the PMIs would quickly go bust and Fannie and Freddie would report losses. So the failure to put in claims is yet another variant of “extend and pretend”. But in this case, there’s good reason to believe the numbers are very large:

Both investors and Congress need a lot more details about the purchases of defaulted loans by Fannie and Freddie. We need to know exactly how many dud loans have migrated back to the GSEs, what their loan loss reserve is, how much of that loan loss reserve is “covered” by the MIs and how much “capital” the MIs have against these exposures. The GSE are letting dead loans sit on their books in part to avoid recognizing the losses, an event that would drive many of the MIs into bankruptcy. If you look at how slow the process of final loss recognition by Fannie and Freddie is proceeding, then you’ll understand why the publicly disclosed loss rates reported by Fannie and Freddie have been falling. Instead of demanding insurance payments, the GSEs are doing everything in their power to keep the MIs looking like going concerns so that they can count the MI “receivable” as a good asset. This is why the GSEs direct LTV based LLPAs to the MIs, to keep some cash flowing their way, and… If there was a proper mark-to-market on the MIs (like all proper insurance/reinsurance businesses do), then the MIs would be massively insolvent. The GSEs would have to take another huge amount of capital from Treasury. Geithner and the GSEs are trying to avoid it, and to date are getting away with it. Sad to say, nobody at the FHFA seems to have a clue about this issue. But we understand that a certain independent minded committee chairman on Capitol Hill is preparing for hearings on this monumental act of fraud against the taxpayer, not to mention the holders of GSE debt.

Now the losses on the underwater PMI (or MI as Whalen prefers to call it) are only one part of the picture. An even uglier part of the equation is the dead loans still being carried at face value:

As the GSE warehouse of delinquent and defaulted loans grows by billions of dollars each month, there is still no demand for payment from the MIs by the FHFA. As we noted in an earlier comment, we figure that there is as much as $200 billion in defaulted loans sitting on the books of Fannie and Freddie at cost — that is, close to par value

Loss severities are now running at 70%. They are only going to rise as housing prices are forecast to fall further in most markets and more borrowers are fighting foreclosure, which increases the cost of foreclosing. But if you take Whalen’s $200 billion top estimate and take a conservative 70% in loss severities, that gets you to $140 billion in unreported losses at the GSEs. So an estimate of north of $100 billion seems plausible.

Whalen also tells us how the latest round of stress tests are even more divorced from reality than the first iteration:

….we review the Fed’s latest stress test exercise and discuss what it means for the banking industry and the US economy. While the US central bank did not provide results for specific institutions, the assumptions in the Comprehensive Capital Analysis and Review (CCAR) are more instructive than the Big Media seems to notice. Indeed, a close reading of the CCAR document provides a compelling argument for why the Fed should not be supervising financial institutions. For example, the Fed has a down 6% for housing prices in its “stressed scenario,” but that is about where we are now. Incredibly, the central bank also has a down 5% for HPI [housing price inflation] in 2012, again in a “stressed” scenario. This implies that the Fed’s “normal” estimate for HPI is positive for 2011-2012? Hello?

I’ve said it repeatedly, but it seems I can never say it enough: the financial power that be have long ago ceased being in the business of anything remotely connected with reality. They honestly seem to believe if they can get enough people to believe their propaganda, reality will come to conform to it.

In my entryway, I have some Rockwell Kent prints, namely, his Apocalypse series, on display (yes, I’m sure readers will regard that as fitting). One, which didn’t strike me as particularly apocalyptic when I bought them, is called “Degravitation” and shows Wall Street people flying to the sky. Maybe I can sell copies to the Fed and Treasury as motivational pictures, since it does seem to depict the business they are really in.