I’m not an expert on game theory, but the rule of thumb I have run across is to win in games with more than two parties, you must assemble a coalition that has more than 51% of the aggregate power within the game.
Practical rule number two is that the one on the winning side that arranges/controls the communications/relationships tends to walk off with a larger proportion of the stakes won in the game.
I learned this early as a young actuary working on my pricing models, and noted that those that really made out well in insurance were the successful agents. They brought two parties, insured and insurer together, who most of the time would not have found each other. Then, they did policyholder service for the company and the customer controlling the flow of information in the process. There were times when I thought it would be useful for the company to talk more directly to the insured, but marketing sometimes objected, and so we didn’t. The agents owned all the loyalty in the transactions.
As an older actuary, I saw this writ large when I was running an annuity division. Using regression, I did what I think was one of the industry’s most advanced studies of deferred annuity withdrawal. The Society of Actuaries produced a similar (but broader) study roughly one year behind me. One of the main results of the study was that withdrawal rates spike when the surrender charge ends. The reason is because most agents try to roll the business to a new product so that they can earn another commission. (Trivia note: I learned that those policyholders that did not roll along with the agent were very sticky business.)
Multiparty transactions exist because there is something complex going on, and the multiple parties each serve a need, providing a service, or eliminating a risk. Let’s move to the concept of buying a house. Here is my informal list of all of the parties:
- Realtor for the Seller — helps convince the buyer to buy.
- Realtor for the Buyer, or, sub-agent for the seller — helps the buyer find a good property to buy.
- Title insurer — assures that there are no mistakes in the transfer of title.
- Mortgage insurer — insures mortgage lender against default when there is little equity for the buyer.
- Property & Casualty insurer — protects the lender and buyer against losses from property damage, or injury to people on the property.
- Mortgage lender (first lien) — provides most of the money for the purchase
- Mortgage lender (second lien and beyond) — provides some money for the purchase, but in foreclosure gets paid after the first lien lender.
- Appraiser — gives an estimate of the value of the property so that the first lien lender does not lend too much.
- Home Inspector — finds defects in the property so that the buyer can adjust his price down.
- Taxation authorities — collect taxes, so that services that make the community livable are provided.
- Community Association — enforces neighborhood standards, so that property values are enhanced.
- There are more, but I can’t think of them…
Note: I did the “smiley-face” version of the roles parties play in the process. I could have done the cynical version, but didn’t. Also note that not all of the parties are needed on a given transaction. The complexity erupts because the buyer needs to borrow to complete the transaction, and the lender wants protection.
Now, going back to my earlier thoughts, in this case, the first-lien mortgage lender has things set up to his advantage. Many of the parties to the sale of a house exist to protect his interests. It is the dominant party in this sort of transaction. This leads to two current problems:
- Mortgage reinsurance captives owned by banks originating the loans.
- P&C Insurance that is forcibly placed by the lender when the buyer does not make P&C insurance payments.
On the first point there was an article today that I found surprising because it is so late to the game. Don’t get me wrong, it is a good article, but for an insurance analyst that spent time analyzing the mortgage insurers, it is old news. As I wrote back in 2003 (and published in 2010):
In addition, lenders that originate low down payment mortgages often force the mortgage insurers to cede low-risk parts of the business to reinsurance captives controlled by the lenders. This is a continuing problem, with many of the mortgage insurers refusing to go along with the most uneconomic reinsurance deals.
It got worse from there, with more mortgage insurers giving in, and lenders demanding a larger proportion of the profits. Nominally they were reinsurance premiums, but for the most part they were closer to being commissions. Why did the mortgage insurers go along with this? Because the first-lien lenders were the dominant party in the transactions, controlling most of the other parties. As a result, borrowers putting small amounts of money down ended up paying more for their mortgage insurance because of the pseudo-commission paid to the mortgage lender because of the captive reinsurer. As I have sometimes said, “Reinsurance is the ultimate derivative; it can obscure almost any transaction.”
On force-placed insurance I have written as well, and it sounds a lot like this post. The similarity is that the insurance is primarily designed to protect the mortgage lender, and the mortgage lender again collects a commission in the process because it is at the hub of communications. The mortgage agreements give them discretionary power.
My simple rule to average people when involved in complex transactions is this: be cynical. No one is interested in your well-being, and most of the transactional terms are skewed against you. To the extent that you can borrow less, and eliminate some of the parties that would be a part of the transaction, it is to your good that you do so. The best situation is that you buy for cash, if you have it.
Now, this same sort of analysis can be applied to securitizations, and other multiparty transactions. Watch for who has control; it is a valuable option to have. But that is an essay for another day.