The mortgage crisis that began in 2007 produced home price declines worse than those seen during the Great Depression. Such severe national market conditions truly tested the mortgage insurance industry’s worth as a critical source of private capital in the mortgage finance markets. The industry passed the test, but not without a few battle scars. Since 2007, the mortgage insurance industry has paid more than $50 billion in claims to lenders and investors. A significant portion of these claims payments benefited US taxpayers. However, three mortgage insurance companies ceased writing business during that same period. As an industry, we have openly and actively acknowledged the need to incorporate lessons learned from the financial crisis into our business model. Those efforts have been happening on two fronts: new mortgage insurer eligibility requirements for the GSEs and a new Mortgage Guaranty Insurance Model Act from the National Association of Insurance Commissioners (NAIC).
A significant piece of post-crisis reform was settled last month with the publication of the new Private Mortgage Insurer Eligibility Requirements (PMIERs) by Freddie Mac, Fannie Mae and the Federal Housing Finance Agency (FHFA). While there are many operational requirements — addressing topics such as underwriting of loans and lenders, master policy terms and conditions, and quality control practices — the focus has been on the financial requirements. At the heart of that attention lies the question of whether a mortgage insurer will have the cash it needs to pay claims when due.
A similar effort is under way with the state regulators of insurance and their coordinating body, the NAIC. Since 2012, the NAIC Mortgage Guaranty Insurance Working Group (MGIWG) has been working to develop a new model act for mortgage guaranty insurance. A “model act” is legislative language intended to be adopted by all states, so there are consistent requirements for insurers in every state. The proposed model act, like PMIERs, contains many operational requirements. And, again like PMIERs, much of the focus is on the financial requirements.
Previously, mortgage insurer capital adequacy was measured by the Risk-to-Capital (RTC) ratio. The “R” in RTC represents the amount of risk faced by an insurer, which in traditional mortgage insurance, is the amount of the loan multiplied by the depth of coverage. So, for example, a $200,000 loan amount with 25% coverage represents $50,000 of Risk In Force to an insurer. The “C” in RTC represents the amount of capital held by the insurer, which includes the insurer’s net worth (the difference between its assets and liabilities) and its contingency reserve. The contingency reserve is established for the protection of policyholders against the effect of losses resulting from adverse economic cycles. Mortgage insurers are required to put 50% of premium into the contingency reserve for 10 years, creating a countercyclical system that builds capital prior to a stress period. The generally accepted standard for mortgage insurance was that the amount of risk should not exceed the amount of capital by 25 times, which translates to a maximum RTC of 25:1. However, the contingency reserve ensured that companies were operating well below the 25:1 level leading into the recent crisis.
One of the lessons learned from the crisis is that not all mortgage risk is the same. So, a shared goal of the PMIERs and the NAIC has been to increase the amount of risk sensitivity in the financial requirements for mortgage insurers. To no surprise, both models rely on similar tables of requirements by loan-to-value (LTV) ratio and credit score. In addition, both models feature “multipliers” that increase the capital requirements for certain significant features, such as cash-out refinancing (higher risk, requires more capital) or shorter loan terms (lower risk, requires less capital). Finally, both models also feature mechanisms that change the requirements, depending on when the loans were originated, capturing the changing risk over time through the housing cycle.
PMIERs and the proposed NAIC model differ in two significant respects. First, the PMIERs require companies to hold a certain level of total available assets. It’s important to note the calculation of total available assets does not recognize renewal premium as a source of assets for claims payment. The NAIC model is a capital requirement, creating some differences around the treatment of reserves, and it explicitly includes the estimation of renewal premium, investment income and operating expenses. Given that during this recent crisis, premiums covered roughly half of the losses, this creates a substantial difference between the models.
Second, PMIERs aggregates loans by origination year on a retrospective basis to capture risk over time. The current periods are 2004 and prior, 2005-2008, 2009-2012H1, and 2012H2 and later. There is no explicit mechanism in PMIERs for determining when to cut off a group and start a new one, and the capital requirements in each group may be adjusted as the performance of the group is realized over time. In contrast, the proposed NAIC model groups loans based on the economic conditions known at the time the loans are originated. Four types of markets are specified, based on the relationship of home prices to per capita income. A market in which home prices are close to their long-term trend level is stressed with a 10% decline in home prices. In the most severe stress, for a market with home prices significantly above their trend level, home prices are subject to a 35% decline. In addition to the four market stress levels, the proposed NAIC model also features an additional factor for the relative risk of the lending environment, as measured by the average number of risky attributes on each new loan. As the overall level of stacked risk factors increases in the market, mortgage insurers will be required to hold significantly more capital for all loans, not just for those with the additional risky attributes. The assignment of markets and the underwriting risk factors are applied prospectively to all loans originated in a quarter, based on conditions in the market going into that quarter, and those assignments stay with the loans for their lives.
Both new capital models feature considerably increased sensitivity to risk. This sensitivity is both to the loan-level risks and to the risks created by market conditions over time. Mortgage insurers will have to meet whichever of the two is the stricter standard, creating a very conservative and countercyclical set of rules that were developed by the GSEs, the FHFA and the NAIC (with input from the mortgage insurance companies) to ensure that MI providers have sufficient financial strength to weather another economic storm.Tags: Mortgage Industry, Mortgage Insurance, PMIERs