Insuring dreams: Mortgage guaranty insurers are successfully navigating a mixed environment of low interest rates, increasing unemployment and increasing property values. (Mortgage Guaranty: Property/Casualty).

Despite the current economic downturn, the U.S. housing market remains hot, which is good news for the mortgage guaranty insurance industry.

The Office of Federal Housing Enterprise Oversight estimates that home prices rose 6.89% during the fourth quarter of 2002, compared with the same period in 2001 .According to the National Association of Realtors, 5.57 million homes were sold in 2002, a 6% increase from the 5.30 million sold in 2001. The mortgage guaranty insurance industry reported $3.7 billion in underwriting revenue, an 11% increase over 2000.

The primary and secondary mortgage markets play a critical role in the U.S. economy by facilitating the flow of liquidity to the housing market, said Gary Davis, a senior financial analyst with A.M. Best Co. 'Mortgage insurers also play a critical role by providing additional market capital that bridges the loan-to-value requirements of government-sponsored enterprises and primary lenders, so home buyers can bridge the gap between their resources and lender requirements."

Mortgage guaranty insurance protects the lender or investor against borrower default, and is primarily used on high-ratio mortgage loans, said Mike Zimmerman, vice president of investor relations for Mortgage Guaranty Insurance Corp. "It's a critical element of the home mortgage finance system," he said. Mortgage guaranty insurance, also known as private mortgage insurance, allows borrowers to own a home without the need for a high down payment. A high-ratio mortgage loan has a loan-to-value ratio of more than 80%.

Mortgage guaranty insurance, however, doesn't cover losses from hazards, such as floods, storms, earthquakes, fire or hurricanes, Zimmerman said. "So, if a home is destroyed by a hurricane and the borrower also defaults on the mortgage, the home must be restored before a claim could be submitted to the mortgage guaranty insurer."

Fannie Mae and Freddie Mac, by far the largest secondary market purchasers of residential mortgage loans, are required by their charters to have mortgage guaranty insurance on all loans they acquire with a loan-to-value ratio of 80% or more.

Mortgage guaranty insurance claims usually include losses for loan principal and past-due loan interest, and losses associated with the property's resale if sold for less than the original price, Davis said. Typically, a claim will occur three to five years after the loan is secured. Then, as home equity builds, claim activity declines.

The handling of mortgage guaranty claims is unique, compared with other property/casualty businesses. For instance, claims frequency doesn't directly correlate to the frequency of defaults, partly because of efforts by the insurer to work with homeowners to help them avoid default. In contrast, homeowners insurance claims typically are the result of a past loss event, which can't be avoided.

Also, mortgage guaranty insurers have a choice when settling a claim. "They can pay their share of the covered loss, such as the percentage that covers the past due amount and attorney's fees," Davis said. "Or if it makes economic sense, the company can pay the entire amount of the loss and take title to the property to sell it."

Drivers of the Business

Several factors are influencing the evolution of the mortgage guaranty industry, which grew more than 3,000% since the early 1980s, Davis said. For instance, the industry benefited from the extreme shift in interest rates from the double digits experienced in the 1980s to the single digits of the 1990s. "These were the largest swings the U.S. economy ever sustained, and they made money cheap," he said.

The country's population growth is another factor. Changing demographics drive the need for housing, Zimmerman said. "We're looking at population growth in the next decade of 34 million people or more, with half of the growth coming from immigration," he said. "Household formations also will be very strong, with two-thirds of those formations coming from minority groups."

Minorities and immigrants are disproportionately high users of low down-payment financing, Zimmerman said. "So the population segment growing the most rapidly is the segment our industry serves."

The economic boom of the 1990s also drove the industry's growth. "More people are buying homes due to population growth, and people are buying larger homes, which results in the overall growth in mortgage originations," said Dan Walker, chief risk officer for United Guaranty Corp., the holding company for United Guaranty Residential Insurance Co. "And the average cost of a home has grown substantially. All of these trends have combined to mushroom the size of the U.S. mortgage market."

Government-sponsored enterprises, such as Freddie Mac and Fannie Mae, and banks have made large commitments to community-based home buying programs that have expanded home ownership opportunities, said Ken Lard, executive vice president of sales and marketing for Triad Guaranty Insurance Corp. For instance, Chase Home Finance, a division of JP Morgan Chase Bank, recently announced a $500 billion commitment to finance low-to-moderate income, minority borrowers through 2010. Likewise, Fannie Mae committed $1 trillion through its foundation about three years ago to expand home ownership and revitalize urban or inner-city areas, Lard said.

A Monoline Business

Mortgage insurance also differs from other property/casualty lines in that it is required to maintain a monoline business structure, which ensures that reserves related to mortgage insurance are not mixed with reserves for other business lines.

The basis for the monoline structure dates back to the original form of mortgage insurance in the early 1900s, when losses in other property/casualty business lines took surplus away from mortgage insurers. So, when the business line was reintroduced in 1957, policymakers looked at what caused the failures in the 1920s.

"One cause was their ability to write multiple lines, which stretched capital too thin," said Zimmerman. With the losses the companies faced in other business lines, there weren't enough reserves to cover the mortgage guaranty losses. "When insurance regulations were drafted, enabling the modern-day mortgage insurance companies to operate, it was determined that they should be monoline-meaning that their capital is dedicated 110% to the mortgage guaranty business."

Regulations also require a unique contingency-reserve structure and capital requirements to address the catastrophe potential for mortgage-default risk, which prevents companies from entering this business line without a long-term commitment, said Davis. The monoline structure makes their results more susceptible to volatile market conditions, however.

The contingency loss reserve is in addition to the case-basis reserve. "When borrowers are reported delinquent, we establish a reserve which is an estimate of the amount of loss if the loan goes to claim," Zimmerman said. "We're also required for statutory accounting purposes to set aside an additional reserve equal to 50% of the earned premium each year, which goes into contingency loss reserve."

The amounts contributed to the contingency reserve are used to pay extraordinary losses, if any, and are released into surplus after 20 years, which is the time period when most of the risk is deemed to have passed, he said.

United Guaranty estimates the mortgage guaranty industry had contingency reserves of nearly $11.2 billion at year-end 2001. The new rules issued when the line was reintroduced are for catastrophe protection in case of another severe recession, said Walker of United Guaranty. "They protect both the mortgage insurance industry and traditional property/casualty companies that operate with significantly lower capital per dollar of premium."

Regulation

Mortgage guaranty insurers are regulated by state insurance departments and, indirectly, by the government-sponsored enterprises through underwriting requirements and their dominance in the residential mortgage financing market, Davis said.

Rates are filed in each state, although mortgage insurers generally look at the entire market as one "generic pool from an actuarial standpoint" to set rates, Triad Guaranty's Lard said. "The way lenders do business, it would be incredibly onerous to have separate rates for each state. And they would have no way of disclosing rates to borrowers."

So, a company's rates are based on the loan-to-value ratio, the borrower's creditworthiness and the covered proportion of the mortgage loan. For instance, premiums for a mortgage loan with a 90% loan-to-value ratio would be less than for a mortgage loan with a 95% ratio. "Ultimately, we are looking at our potential exposure if we have to take the property back and dispose of it," Lard said. "Obviously the greater amount of equity in the loan, the less exposure we have."

Underwriting the Risk

The mortgage guaranty industry looks at four broad risk factors during its underwriting process: the collateral, the borrower, the mortgage loan instrument and the lender. These factors are similar to those reviewed during the mortgage loan process.

Of the four, the collateral, or property value and market, is the most important, Zimmerman said. "Mortgage insurance can't be cancelled or repriced by the insurer," he said. "Therefore, verifying the value of the mortgaged property is a key step in the underwriting process. But if the property can be sold for at least the amount of the unpaid loan principal, no claim is submitted."

Also important is the stability of a specific property's market. "We look at the type of home, its location and the local market conditions," said Len Sweeney, senior vice president of strategic planning and corporate development for United Guaranty. "For instance, are house values rising or decreasing in a particular market?"

The borrower is the next risk factor to be evaluated. "We're looking at someone's ability to repay the loan," Lard said. "The last thing anyone wants to do is to put a buyer into a home if, ultimately, you're going to have to take it away from him. None of us wants to set someone up for failure."

Mortgage guaranty insurers' evaluations include the borrower's credit history and credit score, employment status, income stream including primary and secondary fund sources, capacity to save, the level of reserves remaining at the time of closing and ratio of debt to total income.

The third risk factor is the type of mortgage loan being secured, because different mortgage instruments have different risk levels. "A 30-year fixed-rate mortgage is the most common and also one of the lowest risk instruments we insure," Zimmerman said. "Adjustable rate mortgages, where the borrower's payments may adjust after a period of time, are more risky If interest rates go up, the borrower may not be able to afford the higher payment."

The financial institution securing the actual mortgage is the fourth major factor considered by mortgage insurers. "We look at their track record, the type and quality of the loans they originate, as well as their servicing expertise," Zimmerman said. For instance, some financial institutions specialize in high-risk loans, while others are better at working with troubled borrowers to keep them in the property, he said.

There are factors you can't underwrite, however, Lard said. These include such issues as divorce, death, illness and unemployment. As well, there are other aspects mortgage insurers try to manage, such as high unemployment in particular geographic areas. "We may make tighter underwriting decisions based on a geographic location," he said.

Refinancing--A Bittersweet Deal

The current low interest-rate environment has resulted in significantly increased refinance activity by homeowners. But for most mortgage insurers, it's a bittersweet opportunity.

"From a production standpoint, refinance activity may open avenues for small companies to gain additional market share," said Lard. "But in reality, you're just taking one loan off your books and replacing it with another."

It also drives up mortgage insurers' front-end expenses. "Refinancing activity generates more volume, but the cost of acquisition is higher," said Walker. Part of the expense includes the cost of underwriting the new policy and canceling the old one. "And because housing has been appreciating, many borrowers no longer require PMI [private mortgage insurance] after refinancing, so renewal business is in significant run off."

There is a bright spot concerning the refinancing business, however. Generally, the portion of business recaptured is more profitable, said Zimmerman. "Refinanced loans stay on the books longer because they have lower interest rates, and this means more annual renewal premiums." It also means better loan performance because refinancing borrowers are seasoned homeowners who have a proven track record of making monthly payments and maintaining homeownership, he said.

Staying Balanced

Constantly changing regional and national economic conditions can severely impact the mortgage guaranty insurance industry During periods of economic growth, such as in the 1990s, mortgage guaranty insurers performed extremely well, far outdistancing the property/casualty industry in terms of profitability, Davis said. So, one of the greatest risks to the mortgage insurance industry is an economic downturn, whether it's at the regional or national level.

Interest rate movements and other economic conditions, such as unemployment rates, affect the number of delinquent borrowers and may have a negative impact on real estate values. "We all fear deflation--falling prices and high unemployment," Sweeney said. This scenario can cause a mortgage insurer to post higher-than-normal losses.

To mitigate this risk, mortgage insurers look for geographical diversification, both nationally and internationally, balancing the proportion of high-risk and low-risk loans, and working with delinquent borrowers to keep them in their homes.

"The relative health of local real estate markets also is very important," Zimmerman said. "When we underwrite a mortgage loan we have some idea about how the market where the property is located will perform over the next 18 months or so. But projecting that expectation Out over a longer period is difficult. Therefore, geographic diversification is critical in minimizing exposure to loss," he said.

So, even if a given region of the country sees a downturn in the housing market, mortgage guaranty insurers are geographically diverse enough to weather it. "There has not been a national price depression in home values since the Great Depression," Walker said. "The worst was the mid-1980s with the Oil Patch crisis in Texas, Louisiana, Oklahoma and Colorado. Otherwise, it's only been small, localized setbacks."

United Guaranty also is looking outside the U.S. market to geographically diversify its risk and expand market share, Walker said. "We're doing business in Israel and Hong Kong, which are rapidly developing markets."

Limiting their number of high-risk loans is another way mortgage guaranty insurers manage their risk. "From a risk standpoint, we have the ability to target certain areas and monitor our risk concentration by state," Lard said. "This goes for all higher-risk loan segments. We manage the amount of production we'll take from a particular lender in a high-risk category to mitigate our ultimate exposure."

Loss mitigation is another strategy mortgage guaranty insurers will use to manage their risk. "Mortgage insurers may work with servicers to capitalize delinquent payments to bring the mortgage up to date," Sweeney said. "We prefer to have the borrower stay in the home and will work with lenders and borrowers on alternatives to foreclosure."

A Promising Future

Underwriting results for mortgage insurers typically follow the economy, with underwriting margins falling during periods of increasing unemployment and improving during periods of favorable employment.

"During the 1980s, the industry's investment income and capital gains could not offset the large losses and high expenses stemming from foreclosures", Davis said. In addition, mortgage insurers experienced not only poor results from high loss ratios, but also high expense ratios from anemic revenue growth.

History hasn't fully repeated itself with the latest downturn in the U.S. economy. The November 2002 National Association of Realtors Housing Affordability Composite Index was 140.3, which indicates that a typical family has enough income to afford a median-priced home.

The country's current economic situation--low interest rates, increasing unemployment and increasing property values--has presented an interesting scenario for mortgage insurers. Industry observers see the housing market remaining strong, which is good news for mortgage guaranty insurers. "The housing sector has remained buoyant," Sweeney said.

But a boom does create the potential for claims if it is followed by a significant downturn, Zimmerman said. "Although real estate values in the middle market have remained strong and stable across the U.S., unemployment continues to increase--particularly in the manufacturing sectors--resulting in a higher number of delinquencies," he said. "But we're not expecting proportionately higher claims, because real estate values are holding up well," he said.

RELATED ARTICLE: The Rebirth of Mortgage Guaranty Insurance

Mortgage guaranty insurance re-emerged in 1957 when an attorney from Milwaukee named Max Karl founded the "modern day mortgage guaranty insurance company" by forming Mortgage Guaranty Insurance Corp., said Mike Zimmerman, vice president of investor relations for the company.

"Mortgage guaranty insurance existed in the early 1900s," said Zimmerman. "But most of those companies went out of business during the Depression because they were poorly capitalized, weakly regulated and didn't have adequate risk management controls."

In fact, private mortgage insurers today must have their financial strength highly rated by various rating agencies, he said. "These rating agencies employ stress tests to determine the insurers' ability to withstand economic depression scenarios and establish minimum capital requirements."

"Max Karl was a real estate attorney and was dealing with what he felt was undue bureaucracy in getting mortgage loans approved by the Federal Housing Administration, the government-backed residential mortgage guaranty insurance program," Zimmerman said. "He thought there had to be a better way to help families achieve home ownership." In 2002, the mortgage guaranty insurance industry wrote $337 billion of new business for 2.31 million families, he said.

Typically, mortgage guaranty insurance covers the first 20% to 30% of a loss incurred by a lender or investor should the borrower default, so it is primarily used on high-ratio mortgage loans, Zimmerman said. A high-ratio mortgage loan typically has a loan-to-value ratio of more than 80%.

"Mortgage insurance gives the borrower the opportunity to get into a home with less money down," said Len Sweeney, senior vice president of strategic planning and corporate development for United Guaranty. "The single largest barrier to owning a home is the down payment requirement."

Fannie Mae and Freddie Mac are required by their charters to purchase private mortgage insurance or one of two other seldom-used forms of credit enhancement on all loans with a loan-to-value ratio above 80%, Zimmerman said. "History has shown that loans with down payments of less than 20% have a much higher probability of defaulting than those with down payments greater than 20%."

Today, the mortgage guaranty insurance industry is dominated by GE Mortgage Insurance Corp., Mortgage Guaranty Insurance Corp., PMI Mortgage Insurance Co., Radian Guaranty Inc., Republic Mortgage Insurance Co. and United Guaranty Corp., said Gary Davis, a senior financial analyst with A.M. Best Co.

Contributing Factors To Growth in Mortgage Guaranty Insurance Market

* Increased presence in the low-to-moderate income market.

* Increased lending to inner cities.

* Enhanced marketing efforts by individual companies and the industry as a whole.

* Single-digit interest rates drawing first-time home buyers into the market.

* Greater public awareness of the availability of mortgage guaranty insurance.

* Greater emphasis on the use of mortgage insurance as a credit enhancement to meet risk-based capital requirements for banks and savings institutions.

* Increased use of mortgage insurance by trading-up buyers for tax benefits, since mortgage insurance remains deductible.

* Significant increases in the conforming limits for secondary mortgage-market participants (Fannie Mae, Freddie Mac).

Source: Mortgage insurance Companies of America Fact Book 2001-2002

Mortgage Guaranty Insurance Market Participants 

U.S. Market

* American Guaranty Corp.

* Commonwealth Mortgage Assurance

* Colonial Mortgage Insurance Co.

* Forestview Mortgage Insurance Co.

* GE

-- General Electric Mortgage Insurance Corp.

-- General Electric Residential Mortgage Insurance Corp.

* Home Guaranty Insurance Corp.

* Integon Mortgage Guaranty Corp.

* Investors Mortgage Insurance Co.

* Mortgage Guaranty Insurance Corp.

* PMI Mortgage Insurance Co.

* Proctor Financial Insurance Group

* Radian Group Inc.

* Republic Mortgage Insurance Co.

* Triad Guaranty Insurance Corp.

* United Guaranty Residential Insurance Co.

* U.S. Mortgage Insurance Corp.

* Verex Assurance Inc.

Source: Mortgage Insurance Companies of America and A.M. Best Co.

The Impact of Federal Legislation

Mortgage guaranty insurers are affected by federal legislation, particularly the Homeowners Protection Act of 1998. "The HPA legislation applies to most loans originated on or after July 29,1999," said Gary Davis, a senior financial analyst with A.M. Best Co.

According to the legislation, mortgage guaranty insurance must be cancelled if a borrower has a good payment history and the mortgage balance is 78% of the original value of the home. Borrowers also can request cancellation of the insurance when their loan-to-value ratios have been reduced by 20%. However, a lender can retain coverage for half of the mortgage period on so-called "high risk" loans, Davis said.

HPA requires the following:

Initial Disclosure--For loans originated on or after July 29, 1999, lenders must give borrowers a written notice at closing that explains they have mortgage guaranty insurance on their mortgage and at what point they have the right to request cancellation.

Annual Disclosure--Lenders must send borrowers an annual reminder that they have mortgage guaranty insurance and have the right to request cancellation once cancellation requirements have been met.

Borrower-Initiated Cancellation--For most loans originated on or after July 29, 1999, a lender must cancel mortgage guaranty insurance at the request of the borrower whose mortgage balance is 80% of the original value of the house. The borrower must be current with mortgage payments and have no other loans on the house.

Automatic Termination--For most loans originated on or after July 29, 1999, mortgage guaranty insurance will be canceled automatically when the mortgage balance reaches 78% of the original value of the house. The borrower must be current with mortgage payments and have no other loans on the house.