Private mortgage insurance.

Before extending a mortgage, lenders typically require borrowers to make a sizable down payment to reduce both the risk of default on the loan and the amount they stand to lose if a foreclosure is necessary. Moreover, borrowers often pay significant closing costs. Together, the down payment and closing costs can be substantial relative to the borrower's savings, particularly for first-time homebuyers and households with lower incomes.

Mortgage lenders usually require a down payment of at least 20 percent of the appraised value of a home. But they will accept smaller down payments if repayment of the mortgage is backed by a type of insurance, paid for by the borrower, known as mortgage guarantee insurance. Mortgage insurance for low-down-payment loans is available from the federal government, primarily through programs administered by the Federal Housing Administration and the Department of Veterans Affairs, and from the private sector.

Insurance on a mortgage comes into play when the homeowner defaults on the loan and the proceeds from the subsequent sale of the mortgaged property fail to cover the remaining debt plus the costs associated with the sale. In such a case, the mortgage insurer reimburses the lender for the shortfall, generally in full if the insurance is governmental but only up to certain limits if the insurance is private. Because insurers bear at least part of the risk of loss on home loans, they must carefully review the qualifications of prospective borrowers and the value of the collateral provided by the property being purchased.

Early forms of mortgage insurance arose in the private sector around the turn of the century and developed until the onset of the Depression. The private mortgage insurance industry then collapsed, and its function was assumed by the federal government, which was the only source of mortgage insurance from the mid-1930s through the late 1950s. Today, mortgages backed by government insurance continue to play a significant role in the home finance market, but mortgage insurance offered by the private mortgage insurance industry is also widely used by homebuyers and those refinancing their existing mortgages. Private mortgage insurance backed nearly 1.2 million single-family home loans extended in 1993, representing about 45 percent of all the insured mortgages granted that year (table 1).

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This article reviews some of the history of the mortgage insurance industry, outlines the way the mortgage insurance business is conducted, examines the financial implications for a borrower choosing between governmental and private mortgage insurance, and discusses the disposition of recent applications submitted to private mortgage insurers. Little information has been available heretofore about the disposition of applications. This year, however, the private mortgage insurance industry released data on the disposition of the cases that private insurers acted on during the fourth quarter of 1993 and on the characteristics of the households in those cases (see box, "Data Disclosed by the Private Mortgage Insurance Industry"). The article summarizes the new information and draws some comparisons with data on applications for government insurance and with mortgage applications generally.

PRIVATE MORTGAGE INSURANCE: A HISTORICAL PERSPECTIVE

The private mortgage insurance (PMI) industry can trace its origin to the early years of this century and the activities of title insurance companies in New York State.(1) The state legislature authorized the issuance of mortgage guarantee insurance in 1904, but the law permitted insurers to guarantee the payments only on mortgages owned by the institution that originated the loan. In 1911, New York amended the law to permit mortgage insurers to purchase and resell mortgages. To enhance their ability to sell mortgages to investors, insurers guaranteed the property title as well as the loan.(2)

Until the Depression, rising real estate values made it possible for most mortgaged properties that were in default to be sold without a loss. This experience reinforced a widely held perception that insuring mortgages was a low-risk business. But the sharp decline in real estate values in the early years of the Depression--together with the low capitalization, questionable business practices, and weak regulation of the PMI industry--resulted in the collapse of the industry.

Government efforts to revive the housing industry during the Depression led to the establishment by the Federal Housing Administration (FHA) of the Mutual Mortgage Insurance Fund to provide mortgage insurance on FHA loans.(3) After World War II, the federal government's role in providing insurance on mortgages expanded with the creation in the Veterans Administration (VA) of a mortgage insurance program for veterans.(4)

FHA and VA home loan insurance programs apply to a wide range of prospective homebuyers, but both programs have significant limitations. The FHA, for example, limits the size of the mortgages it will insure. The VA programs guarantee only a portion of the loan amount up to a congressionally established ceiling and are available only to veterans. In addition, the property and credit underwriting standards of both the FHA and VA exclude some prospective borrowers.

The PMI industry re-emerged in 1957 with the establishment of the Mortgage Guarantee Insurance Corporation (MGIC). Throughout the 1960s and 1970s, the industry generally flourished because rising home values limited the incidence of, and losses from, mortgage defaults. In this environment, companies tended to focus more on growth and less on credit quality. In the 1980s, as house price inflation slowed--and prices fell in some areas--homeowners who could not make their mortgage payments often were unable to resolve their problems by selling their homes; instead, they defaulted on their mortgages. In addition, some PMI companies suffered substantial losses from fraud and inadequate risk diversification. Weak companies could not survive as independent entities, and industry consolidation followed. By the end of the 1980s, only half of the firms from the early 1980s remained.

In the past few years, tighter underwriting standards and an end to an excessive reliance on continuing increases in house prices to mitigate credit risk has brought the industry back to financial health.(5) Today, eight PMI companies are active (table 2).(6) The two largest, MGIC and GE Capital Mortgage Corporation, accounted for roughly 52 percent of the private mortgage insurance written and 62 percent of the outstanding dollar amount of private mortgage insurance in force in 1993.

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Comparing the revenues and profitability of the PMI companies is complicated by differences in the products they offer and in the strategies they pursue. However, the ratio of premiums earned to total insurance in force is a measure of the average payment made by a borrower with PMI across different products and through time. Generally, companies that specialize in insuring mortgages with lower credit risks tend to have lower premiums than companies that insure products with a wider range of credit characteristics. Regardless of the premiums charged, the rates of return in 1993, as measured by the ratio of net income to insurance in force, seem similar among the well-established firms.(7)

Overall, the re-emergence of the PMI industry has greatly expanded the opportunities for homebuyers to take out conventional mortgage loans with low down payments. PMI is now available on a wide variety of loan programs and may be used for the purchase of homes with values far exceeding the FHA loan limits.

THE BUSINESS OF MORTGAGE INSURANCE

Lenders that originate and hold mortgage loans or financial instruments derived from such loans face two distinct types of risk, interest rate risk and credit risk. Interest rate risk exists because market interest rates change over time. When market interest rates rise relative to the rate on an outstanding mortgage, the value of the mortgage falls. Lenders may protect themselves from interest rate risk in various ways, but such measures increase costs.

Credit risk is the possibility that borrowers may fail to repay their loan obligations as scheduled. In the case of default, the lender is able to take action against the borrower, for example by foreclosing on the property securing the loan. But foreclosure entails a variety of costs--unpaid interest from the time of delinquency through foreclosure, legal expenses, costs to maintain the property, and expenses associated with the sale of the property--and therefore even if the asset has not lost value, the lender may incur a loss.

Among the steps lenders can take to mitigate credit risk is the requirement that borrowers whose mortgages have high loan-to-value ratios obtain private mortgage insurance.(8) PMI reduces credit risk by insuring against losses associated with default up to a contractually established percentage of the claim amount (see box, "Claims under Private Mortgage Insurance"). Defaults on these loans may result in a loss to the insurer; therefore PMI companies address credit risk in many ways in pursuing their business strategies:

* First, a PMI company may simply not insure a particular type of mortgage contract or a mortgage secured by a specific type of property, ceding that business to competitors.

* Second, in determining whether to insure a particular loan in a chosen line of business, PMI companies act as a review underwriter, evaluating both the creditworthiness of the prospective borrower and the adequacy of the collateral offered as security on the loan. They will deny insurance to prospective borrowers judged to impose undue credit risk on the insurer and lender; lenders, of course, are free to extend credit to such borrowers, but they must do so without the protection of PMI.

* Third, insurers may underwrite some mortgages more strictly than others and thus limit their exposure to losses.

* Fourth, they may charge a higher premium to insure riskier mortgages, although state regulation can limit or set the premiums charged for different types of mortgage insurance.

* Fifth, the PMI companies can limit the extent of their coverage of losses, either directly (by limiting the proportion of the mortgage insured) or by using reinsurance or pooling arrangements.

* Sixth, PMI companies can mitigate credit risk through credit counseling and early intervention once a borrower falls behind on payments.

In assessing the risk of the borrower, PMI companies evaluate both the ability and the willingness of the borrower to repay the mortgage loan. In determining the borrower's ability to repay, insurers examine sources of income, debt-to-income ratios, asset holdings, employment history, and prospects for income growth. Insurers gauge willingness to repay primarily by reviewing the borrower's credit history, including rent and utility payment records in some cases.

PMI companies also evaluate the characteristics of the property securing the mortgage. For example, because insurers generally perceive condominiums, manufactured homes, and properties with two, three, or four units as riskier sources of collateral than single-family detached dwellings, they usually treat them more stringently.

In addition, insurers consider the use of the property securing the mortgage. Dwellings to be used as vacation homes, second homes, or investment properties are generally underwritten to standards that are more strict than those for owner-occupied, primary residences. For example, the maximum loan-to-value ratio allowed for second homes is often lower than that for primary residences. In the extreme, some PMI companies have chosen not to offer insurance for particular uses of property, such as investment.

Furthermore, insurers examine the characteristics of the mortgage itself and adjust the price of insurance coverage accordingly. The loan-to-value ratio on the mortgage is a primary indicator of default risk; hence, the higher the ratio, the higher the premium.(9) Insurers also generally assess higher premiums on adjustable rate mortgages because these mortgages can potentially impose larger payment burdens on borrowers and because they have historically exhibited an inferior payment record.(10) Finally, insurers assess lower premiums on shorter-term mortgages because such mortgages result in a more rapid accumulation of equity by the borrower and therefore impose less risk of loss.

The PMI companies often use the credit underwriting guidelines of the two large government-sponsored mortgage agencies, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), when deciding whether to approve an application. Many lenders desire to sell their mortgages to these agencies, and both Fannie Mae and Freddie Mac require PMI before they will consider purchasing a low-down-payment mortgage. Thus, PMI companies have a strong motivation to assure lenders that mortgages insured by PMI companies conform to the standards set by these organizations.

When examining the risks described above, many PMI companies rely heavily on automated underwriting systems to identify and quickly approve applications that are acceptable for insurance. PMI employees further evaluate applications that fail the automated review. Computer automation of underwriting thus allows PMI companies to focus their efforts on applicants with marginal or unusual credit histories and other special circumstances and is generally perceived to have widened the availability of PMI.

A fundamental strategy of insurance underwriting is to diversify risk.(11) In the case of PMI companies, risk diversification means limiting geographic concentrations of insurance, dealing with numerous lenders, and restricting the insurance written for any one particular project. The importance of these tactics is illustrated by the large losses in the 1980s of PMI companies that had significant concentrations of insurance in "oil patch" states.

An integral part of the PMI business is the management of problem mortgages. Foreclosing on properties is both time-consuming and costly, and insurers attempt to avoid it. Insurers try to work with delinquent borrowers, mostly through lenders, but sometimes directly with borrowers. Insurers often stress counseling as a way of helping borrowers overcome payment difficulties. Insurers will try to determine the prospects for bringing the mortgage back to scheduled payments and may work out a plan with the borrower to do so. In some cases, however, encouraging borrowers to sell their properties may be the least costly method, for both insurer and borrower, of resolving problems.

SOURCES OF MORTGAGE INSURANCE

From the lender's perspective, the mortgage insurance provided both by private mortgage insurers and by government agencies such as the FHA and the VA reduces credit risk, but the level of protection varies. PMI companies typically limit coverage within a range of 20 percent to 25 percent of the claim when a mortgage defaults, whereas the FHA, for instance, covers 100 percent of the unpaid balance of the mortgage to the lender as well as some, but not necessarily all, of the costs associated with foreclosure and the sale of the property. For marginally qualified borrowers, some lenders might prefer the added protection afforded by FHA insurance and they may encourage borrowers to apply for these mortgages. Lenders may have other incentives to encourage applicants to apply for one loan program over another. For example, FHA-insured mortgages provide lenders with greater income from loan servicing than do the mortgages covered by PMI. On the other hand, the origination of mortgages insured by PMI often requires less paperwork.

From the perspective of homebuyers, the costs and availability of the insurance offered by FHA, VA, and private companies can differ markedly. The homebuyers' knowledge of these alternatives varies with their experience, their willingness to shop among lenders, and the extent of information provided by real estate agents and others. Real estate agents, as well as others, sometimes encourage homeowners to select one type of insured mortgage product over another.

Incentives for Using Government Insurance

Most households are able to purchase homes or refinance an existing mortgage without mortgage insurance and thus avoid the added cost of the insurance. Many households, however, lacking the assets necessary for a sizable down payment and closing costs, can qualify only for a mortgage with a high loan-to-value ratio and thus must purchase mortgage insurance. In addition, some households prefer making a small down payment toward a mortgage even if they have the funds for a larger down payment; they, too, are normally required by the lender to purchase mortgage insurance.

Households often choose mortgages backed by the FHA or the VA instead of mortgages backed by private insurers because the agencies will insure mortgages that require a considerably smaller amount of cash at closing and will use more liberal underwriting guidelines when evaluating the credit-worthiness of the applicant.(12) For example, the FHA insures mortgages that require smaller down payments and, unlike PMI companies, the FHA allows the borrower to finance both closing costs and the mortgage insurance premium.(13) In addition, the FHA allows households to use gifts from other for the entire down payment. Generally, insurers backing conventional low-down-payment mortgages limit the proportion of the down payment that may be paid from gifts. Moreover, the FHA allows households to carry relatively more debt and still qualify for a mortgage, an underwriting practice that is often important to lower-income and first-time homebuyers.

Comparison of Costs

Comparing the costs to a homebuyer of purchasing a home with an FHA-insured mortgage relative to the costs of a mortgage backed by PMI is difficult. The initial fee for government insurance is higher than for PMI, but government agencies allow the borrower to finance this fee as part of the mortgage. Furthermore, the FHA refunds part of the initial premium when the borrower prepays the mortgage within a specified period. On the other hand, PMI in some circumstances can be dropped once the household has accumulated at least a 20 percent equity position in the property, whereas the household must prepay the mortgage to drop FHA insurance. The price of FHA insurance also does not vary by the size of the borrower's down payment, whereas the premium rate for PMI is lower for households making larger down payments.(14) Overall, households that have low debt payments relative to income and that are taking out mortgages with loan-to-value ratios between 80 percent and 95 percent are more likely to choose a mortgage backed by PMI.

A calculation of the expenses incurred by a 1993 borrower purchasing a $100,000 home with the minimum required down payment (table 3) shows that the cash required at closing would be substantially greater for a mortgage with PMI ($8,250) than for one with FHA insurance ($,615).(15) The lower cash outlays associated with the FHA-insured mortgage mainly reflect the FHA's willingness to allow the borrower to finance the closing costs and the FHA insurance premium. As described in the example below, an FHA-insured mortgage will be more attractive to households with fewer assets.

3. Generalized comparison of mortgage financing under FHA insurance and

private mortgage insurance for a typical mortgage on a $100,000 house Dollars except as noted

                 Item                FHA           PMI
Sales price of home                100,000      100,000
  PLUS: Closing costs financed(1)    2,300            0
EQUALS: Acquisition cost           102,300      100,000
  LESS: Minimum down payment(2)      4,615        5,000
EQUALS: Maximum mortgage amount
   (before initial mortgage insurance
   premium)                         97,685       95,000
  PLUS: Initial mortgage insurance
   premium financed(3)               2,931            0
EQUALS: Total financed             100,616       95,000
Loan-to-value ratio (percent)(4)
  FHA calculation                       95.5        ...
  Actual                               100.6         95
Cash required at closing
  Closing costs                          0        2,300
  Down payment                       4,615        5,000
  PMI(5)                               ...          950

     Total                           4,615        8,250

Total monthly payment(6)
  Years 1-10                           778.97       735.87
  Years 11-30                          778.97       716.87

NOTE. ... Not applicable.

(1.)Assumed to be 2.3 percent of selling price, determined by calculating the ratio of the average closing costs to the average sales price of homes purchased in 1993 under the FHA section 203(b) home loan program.

(2.)Minimum FHA down payment equals 3 percent of the first $25,000 plus 5 percent of the remaining amount financed, excluding the initial mortgage insurance premium. Minimum down payment for PMI is 5 percent of the sales price.

(3.)Initial mortgage insurance premium is 3 percent of the maximum mortgage amount.

(4.)FHA loan-to-value is the maximum mortgage amount divided by the acquisition cost. Actual loan-to-value is the total amount financed divided by the sales price.

(5.)Initial premium of 1 percent of the maximum mortgage amount.

(6.)The mortgage in both the FHA and PMI cases is assumed to be for thirty years at 8 percent. The monthly payment is the sum of the loan payment (principal and interest) plus the monthly insurance premium, which under FHA is 0.5 percent (annual rate) of the maximum mortgage amount. The premium charged for PMI typically declines after a specified period; here it is assumed to be 0.49 percent (annual rate) of the maximum mortgage amount for the first ten years, and 0.25 percent (annual rate) thereafter.

The difference in the minimum down payments made under the two programs is relatively small, but financing the closing costs and the mortgage insurance premium means that the FHA borrower has less equity relative to the value of the home. In addition, the borrower's monthly housing expenses are higher for the FHA mortgage. The higher loan-to-value ratio and monthly housing expenses suggest that FHA borrowers may be more prone to default if they encounter financial difficulties.

Under the FHA insurance program, the borrower's initial cash outlays are lower, but the monthly payments are higher. If the borrower is constrained by the amount of available cash at closing, the FHA may be the only alternative. On the other hand, if the borrower has sufficient cash on hand and is concerned about the amount of debt to be carried and the higher monthly payment, then PMI may be preferable.

A comparison of two borrowers with equal incomes who both have sufficient cash to choose either an FHA-insured or PMI-backed mortgage ($8,250, shown in table 3) suggests that the household with PMI could accumulate greater wealth over the life of the mortgage (table 4). With the requirements for a smaller initial outlay of cash, the FHA program allows the borrower to place $3,635 of his or her savings in a savings account. However, with the smaller loan size associated with PMI and the consequently lower monthly payments, the PMI borrower is able to invest the monthly payment difference each month, also in a savings account. Summing up the net worth of each borrower at any particular time, the FHA borrower generally will carry greater mortgage debt (column 1 in table 4) but will also have the compounded earnings from the $3,635 savings account (column 3). The PMI borrower has a savings account that is accumulating faster, however, because of the lower monthly payments (column 2). Even counting the potential refunds from FHA as a source of wealth for the FHA borrower who chooses to sell the home (column 4), the PMI borrower still begins to accumulate greater wealth after only one year (column 5).(16)

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Another major determinant of who uses PMI is the congressionally imposed limit on the size of a mortgage that can receive FHA insurance. The limit varies by area, depending on whether the region is considered high-cost or low-cost. For high-cost areas, the limit in 1993 was 95 percent of the local median sales price up to a maximum of $151,725, whereas for low-cost areas the maximum was $67,500.(17) Unlike the FHA, PMI companies may insure mortgages of any size.

A person whose desired mortgage is within the size limits established for FHA loan programs may still have to choose PMI because of other restrictions associated with FHA loans. For example, the FHA limits the availability of insurance in projects with high proportions of rental units and does not provide insurance for most of the adjustable rate mortgage products offered in the conventional mortgage market. In addition, some housing developments are not approved for FHA insurance, and some loan programs for first-time homebuyers rely exclusively on conventional mortgages with PMI.

REVIEW OF 1993 PMI ACTIVITY

The eight private mortgage insurance companies recently made data publicly available that, for the first time, describes the disposition of applications for insurance by the characteristics of the mortgage borrower. These data are comparable to those supplied by mortgage lenders under the Home Mortgage Disclosure Act (HMDA). The PMI data cover applications for mortgage insurance acted on only during the fourth quarter of 1993. The companies limited their 1993 data to this quarter to allow themselves adequate time to develop procedures for receiving, tracking, and reporting activity in a manner consistent with the requirements of HMDA. Information about the PMI industry indicates that fourth-quarter activity accounted for nearly 30 percent of all 1993 PMI commitments written on home mortgage loans.(18) The nature of the fourth-quarter mortgages and their disposition may or may not be representative of the rest of the year.

For applications pertaining to properties in metropolitan statistical areas (MSAs), the PMI companies identified properties by census tract number. Lenders covered by HMDA, in contrast, currently identify property location by census tract only for loans in metropolitan areas where they have, or are deemed to have, a home or branch office.(19)

For the eight PMI companies, the Federal Financial Institutions Examination Council prepared disclosure statements detailing a company's activities for each MSA in which it had business. In total, the FFIEC prepared disclosure statements relating to 1,894 MSAs, an average of 237 MSAs for each PMI company. In contrast, the typical lender covered by HMDA in 1993 received a disclosure statement that included information on an average of only 3.7 MSAs.

Volume of Applications for PMI

In the fourth quarter of 1993, PMI companies acted on roughly 456,400 applications for insurance: 265,400 for insurance to back home-purchase mortgages on single-family properties and 191,000 to insure refinancings of existing mortgages (table 5). Most applications dealt with mortgages of less than $150,000. The average size of the home-purchase mortgages was $116,200.

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The mortgage size distribution and the average mortgage size for home-purchase mortgages are only slightly different from those for refinancings. This relationship is somewhat surprising because of the large proportion of first-time homebuyers in the home-purchase category; such homebuyers typically have lower incomes than other homeowners and consequently take out smaller loans than homeowners who are refinancing.

Characteristics of Applicants for PMI

In 1993, more than two-thirds of the PMI applicants seeking home purchase mortgages had incomes that exceeded the median for the MSA in which the property securing the loan was located (table 6). The distributions of PMI applicants by income differ between those seeking loans to purchase homes and those applying for insurance to refinance an existing loan. In particular, the proportion of insurance applicants in the highest income group (income greater than 120 percent of the median family income in their MSA) was significantly larger for refinancings than for home-purchase mortgages. Once again, this difference probably reflects the high proportion of first-time, and perhaps younger, homebuyers in the home-purchase category.

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The racial and ethnic characteristics of PMI applicants were similar to those of mortgage applicants covered by the HMDA data. Most applicants for loans backed by PMI were white, and about half were seeking insurance for mortgages to be secured by properties located in neighborhoods in which the nonwhite and Hispanic population was less than 10 percent of the total.(20) Overall, about three-fifths of the applicants were seeking insurance to help buy a home or refinance mortgages on properties located in the non-central-city portion of MSAs.

A Comparison of Applicants for PMI and for Government Insured Mortgages

The vast majority of mortgages insured by the FHA and VA have high loan-to-value ratios at the time of origination. For example, among all FHA single-family mortgages originated in 1993, 94 percent had a loan-to-value ratio exceeding 80 percent, and 78 percent had a ratio exceeding 90 percent.(21) The vast majority of mortgages backed by PMI also have high loan-to-value ratios, but the pool of FHA-insured mortgages includes many with loan-to-value ratios that exceed PMI limits. Because PMI companies, the FHA, and the VA all serve households applying for mortgages with low down payments, comparisons of the characteristics of the applicants applying for insurance under each program are appropriate.

We conducted such a comparison, using data on FHA and VA lending activity drawn from information filed for 1993 by lenders covered by HMDA. The comparisons are limited to applications for mortgages secured by properties in MSAs. In addition, the samples of applications used for the comparison was restricted to mortgages that fell within the size limits established by the FHA for single-family mortgages.

Our comparison indicates that the majority of applicants for both government-backed and privately insured home-purchase loans had incomes that were below the median family income for their MSA (table 7). Applicants for the governmentbacked programs, however, were relatively more likely to have modest incomes: for example, for home-purchase loans, 68 percent of FHA applicants and 65 percent of VA applicants had incomes that were below the median family income for their MSA, compared with 54 percent of the applicants for PMI.

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A comparison between applicants of the different insurance programs based on neighborhood income finds a smaller difference. For example, 16 percent of the PMI applicants sought insurance for home-purchase mortgages for properties in low- or moderate-income census tracts, compared with 18 percent of the FHA applicants and 16 percent of the VA applicants. Thus, the insurance programs seem to have a similar distribution of applicants across neighborhoods grouped by income, but the FHA and the VA generally serve a lower-income clientele.

The distribution of applicants by racial or ethnic characteristics indicates that the FHA and VA received a higher proportion of requests for insurance from black applicants than did PMI companies, whereas the latter had a higher proportion of Asian applicants. Relative to the VA, the FHA and the PMI companies both had a larger proportion of Hispanic applications, a result that perhaps reflects a lower proportion of Hispanic veterans. The government insurance programs were also more likely to receive applications secured by properties in census tracts where minority residents exceeded 10 percent of the population and in census tracts in central cities.

Disposition of Applications for Mortgage Insurance

PMI companies approved most of the applications for insurance that they acted on during the fourth quarter of 1993--roughly 85 percent of applications for insurance to back home-purchase loans and 87 percent to back refinancings (table 8). The insurers denied about 12 percent of home-purchase applications and about 10 percent of refinancing applications; in a relatively small percentage of cases, applications were withdrawn by the lender or files were closed after additional information needed by the insurer to make a decision was not provided.

Most applications for PMI were approved in 1993, but the approval rate varied substantially across metropolitan areas. In particular, applications for insurance for home-purchase mortgages secured by properties located in all California MSAs and in most Florida MSAs had relatively high rates of denial. Denial rates in California were as high as 33 percent in some areas, including Los Angeles. In California, the aggressive pursuit of customers by mortgage originators and a weak housing market may have led to higher proportions of marginally qualifed applicants for mortgage insurance. The explanations for high denial rates in Florida are less certain, but suggestions range from a high proportion of condominiums and second homes to a local economy that is prone to greater volatility in housing prices. In contrast, many MSAs in the Midwest--including Chicago, Detroit, and St. Louis--had denial rates well below the national average.

Multiple Applications

In general, the relatively high approval rates for PMI are to be expected; lenders submitting applications for insurance know the prospective borrower's credit circumstances and the credit underwriting guidelines used by the PMI companies.(22) However, unlike mortage lenders, who charge a fee to applicants, PMI companies do not charge for the submission of applications; consequently multiple PMI applications are potentially more common than multiple mortgage applications and may skew the statistics.

For example, if lenders submit the applications of only the marginally qualified applicants to more than one PMI firm, then denial rates may be inflated. If, on the other hand, lenders need quick approvals and low premiums to attract well-qualified applicants, then denial rates may be deflated because multiple applications for insurance would be more common for these borrowers.

Overall, only 4.1 percent of the applications in the 1993 data appear to have involved multiple applications (see box, "Multiple Applications"), and they appear to be, for the most part, from applicants who are only marginally qualified. For example, among the multiple applications, the denial rate for insurance for home-purchase mortgages was about 49 percent, compared with 10 percent for all home-purchase applications excluding the multiple applications (the rate for all home-purchase applications, 11.9 percent, is shown in table 8).

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Disposition by Applicant Income and Race

In general, income and its stability can be expected to affect an applicant's ability to qualify for mortgage insurance, although they are usually considered in relationship to the existing and proposed debt burden rather than as an absolute measure of creditworthiness. Other factors consider when evaluating creditworthiness include the size of the loan, assets available for down payment and closing costs, employment experience, and credit history. Nevertheless, on average, low-income households have fewer assets and lower net worth and experience more frequent employment disruptions than high-income households; this combination of factors often results in a denial of an application.

The 1993 fourth-quarter data indicate that the rates of approval and denial for PMI vary somewhat among applicants grouped by their income (table 8). For example, about 87 percent of the applicants for insurance for home-purchase loans whose incomes placed them in the highest income group were approved for insurance, compared with 79 percent in the lowest income group (income less than 80 percent of the median of their MSA). Approval and denial rates for applicants from middle-income groups were similar to those for the highest income group. The same patterns were found for applications for insurance on refinancings.

As examination of the racial or ethnic characteristics of applicants indicates that, compared with white applicants, greater proportions of Asian, black, and Hispanic applicants had their applications for private mortgage insurance turned down. For insurance for home-purchase loans, for example, 20.8 percent of Asian applicants, 23.3 percent of black applicants, 26.4 percent of Hispanic applicants, and 12.1 percent of white applicants were denied.(23) The rate of denial also generally increased as the proportion of minority residents in a neighborhood increased (table 9).

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Differences in denial rates for PMI applicants grouped by race or ethnicity reflect a variety of factors, including the proportion of each group with relatively low incomes. The data show that 17 percent of the white applicants for insurance on home-purchase loans had incomes of less than 80 percent of the median family income for their MSA (data not shown in tables). The comparable ratios were about 29 percent for blacks, 26 percent for Hispanics, and 17 percent for Asians. These differences in the distribution of applicants for insurance by income account for some of the differences in denial rates. However, within each income group, white applicants had lower rates of denial than Asians, blacks, or Hispanics (table 10).

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The pattern of denial rates for PMI for home-purchase loans by race or ethnic characteristic differs from the pattern in HMDA data in one notable way. In the HMDA data, the denial rate for Asian applicants is usually close to that for whites; in the PMI data, it is much higher--about 21 percent for Asians versus 12 percent for whites (18 percent versus 10 percent excluding multiple applications). Part of the explanation of the disparity between PMI denials for Asians and for whites lies in the fact that proportionally more Asians than whites sought insurance in California. Considering only properties whose MSA location was reported, white and Asian applicants in California were both denied at about the same rate--30 percent for whites and about 31 percent for Asians; but 40 percent of all applications by Asians were for California properties, compared with only about 9 percent of applications by whites. Excluding the applications from California, the rjection rate was 14 percent for Asians and 10 percent for whites.

The difference in denial rates for PMI for white applicants as compared with Asian, black, and Hispanic applicants raises questions about the influence of race on the disposition of applications. The existence of racial discrimination cannot be determined, however, from the data submitted by the PMI companies--they provide little information about the characteristics of the properties that applicants seek to purchase or refinance and about the financial circumstances of the applicants that affect their expected mortgage payment performance. For example, the level of debt carried by applicants, their credit histories, and their employment experiences are not disclosed. Without this information and information about the specific underwriting standards used by PMI companies, the fairness of the decision process cannot be assessed.

AFFORDABLE HOUSING INITIATIVES

As noted earlier, the essential feature of mortgage insurance is that it allows homebuyers to acquire a house with a small down payment. Usually, home-buyers who can afford only a small down payment also have low or moderate incomes; in this sense, mortgage insurance promotes home ownership for such households.

Over the past several years, PMI companies have introduced new programs targeted at low-and moderate-income households.(24) Often these programs involve other parties, including Fannie Mae and Freddie Mac and state housing finance authorities. Working with secondary market agencies through programs such as Fannie Mae's Community Home Buyers and Freddie Mac's Affordable Gold, the PMI companies expand their regular 95 percent loan-to-value ratio programs by allowing the borrower to use gifts and other nonborrower sources of funds as part of the down payment. These programs also use more flexible underwriting criteria. To offset the additional potential risk anticipated from such loans, borrowers are required to complete a homebuyer education course. Often the prepurchase counseling for homebuyers is undertaken with community groups and other nonprofit organizations.

State housing authorities generally issue taxexempt bonds to fund mortgages with high loan-to-value ratios granted to first-time homebuyers. PMI companies issue a special form of mortgage insurance ("pool insurance") to enhance the credit quality of these bonds.

Another recent PMI industry initiative provides insurance for mortgages with 97 percent loan-to-value ratios. As with the programs described above, financial counseling is typically a mandatory component of these products. In addition, PMI companies use early intervention techniques in these programs for households that fall behind in their mortgage payments. Mortgages generated through these programs may be held in portfolio by the lender, whereas others may be sold into the secondary market.

Finally, the industry is examining and modifying its traditional products to make them more attractive to all households, including low- and moderate-income households. For example, PMI companies have recently introduced monthly payment programs that allow the borrower to pay the initial premium over time rather than as a lump-sum advance payment. This type of initiative lowers the amount of funds the borrower needs at closing to acquire a house and thereby allows households with fewer assets to become homeowners.

Generally, affordable housing programs initiated or supported by PMI companies have not been available long enough to determine their risks and profitability or their impact on first-time homebuyers. In addition, many lenders are not yet familiar with the full range of products that PMI companies offer to promote homeownership.(25) However, insurance products associated with affordable housing initiatives are expected to contribute to the financial performance of the PMI companies by opening new markets as well as by supporting their traditional core businesses. An example of the latter effect is that some special programs encourage applications from borrowers who were unaware that they could qualify for mainstream insurance programs. But like the traditional PMI programs, the affordable housing initiatives also face competition from the FHA and from lenders who extend mortgages to low- and moderate-income homebuyers without requiring mortgage insurance.

Data Disclosed by the Private Mortgage Insurance Industry

During 1994 the Federal Financial Institutions Examination Council (FFIEC) received and processed data from eight PMI companies regarding applications for insurance that they acted on in the fourth quarter of 1993. The FFIEC prepared disclosure reports for the PMI companies in formats similar to those created for financial institutions covered by the Home Mortgage Disclosure Act (HMDA).(1) The compilation was carried out under the auspices of the Mortgage Insurance Companies of America (MICA).(2) In asking the FFIEC to undertake the report preparation, MICA was responding to growing public and congressional interest in learning more about the activities of PMI companies as they relate to issues of fair lending, affordable housing, and community development.

To supply the data, each PMI company records data in a loan application register for each application for private mortgage insurance acted on in a given period. The information covers the action taken on the application (approved, denied, withdrawn, or file closed); the purpose of the mortgage for which insurance was sought; the race or national origin, the sex, and the annual income of the mortgage applicants; the amount of the mortgage; and the geographic location of the property securing the mortgage. The FFICE compiled the data into disclosure statements summarizing the information for the public.

Disclosure statements for each PMI company are publicly available at its corporate headquarters and at a central depository in each MSA. In addition to a disclosure statement for each PMI company, the central depository has aggregate data for all of the companies active in that MSA. The PMI data can also be obtained by calling the Federal Reserve Board's HMDA Assistance Line at [phone].

The initial report of PMI activity covered applications acted on during the fourth quarter of 1993. For 1994 and beyond, the PMI companies plan to submit data covering the full year.

(1.)For a comprehensive discussion of the requirements of HMDA and an assessment of the data, see Glenn B. Canner, Wayne Passmore, and Dolores S. Smith, "Residential Lending to Low-Income and Minority Families: Evidence from the 1992 HMDA Data," Federal Reserve Bulletin, vol. 80 (February 1994), pp. 79-108.

(2.)The costs to the FFIEC for receiving and processing the data, preparing disclosure statements and other reports, and dissemination of the data are being covered by the PMI companies through MICA.

Claims under Private Mortgage Insurance

The claim amount on a defaulted loan generally includes the outstanding balance on the loan, delinquent interest payments, expenses incurred during foreclosure, costs to maintain the property, and advances the lender made to pay taxes and hazard insurance on the property. After foreclosing and taking title to a property, a lender may submit a claim to the mortgage insurer.(1) At this point, the PMI company has two options: (1) pay the full claim amount and take title to the property or (2) pay the lender the designated percentage of the coverage of the total claim amount as indicated in the policy and let the lender retain title to the property. The option selected by the PMI company will depend on its estimate of the potential value of the property net of sales expenses.

(1.)In some cases a formal foreclsoure may be avoided, such as when a borrower voluntarily conveys title to the lender.

Multiple Applications

Among the 456,404 applications for PMI acted on in the fourth quarter of 1993, 18,844, or 4.1 percent, appear to be multiple or "duplicate" applications. Multiple applications were identified by searching the mortgage insurance application data for records with identical census tracts, purpose of loan, race or ethnic status, applicant income, and loan size. For matches on applicant income and loan size, differences of $1,000 were allowed when identifying matches. In the overwhelming number of cases, a multiple match consisted of only two records, indicating that lenders typically did not submit a given application to more than two PMI companies.

Applications from Hispanics, blacks, and Asians--and from applicants not in the highest income category--were more likely to be sent to multiple PMI companies (compare table 6 with the table below). In addition, denial rates are substantially higher for all categories of applicants with multiple application records (compare table 8 with the table below).

Distribution and denial rate of PMI applications sent to more than one PMI company, by purpose of loan, characteristics of applicant, and characteristics of census tract in which property is located, 1993:Q4 Percent

                        Home purchase         Home refinancing

     Characteristic

                     Percentage     Denial   Percentage     Denial
                     distribution    rate    distribution    rate
All applications

     sent to more


     than one


     company            100          48.9      100           45.5

Race or ethnic
group of applicant
American Indian/

     Alaskan


     native               .1         77.8         .2         70.0

Asian/Pacific

     Islander            4.2         58.9       7.1          59.4

Black                    7.2         65.5       3.8          65.6
Hispanic                11.4         62.2       7.2         68.8
White                   74.8         45.9      79.5          42.2
Other                     .2         60.0         .1         71.4
Joint (white/

     minority)           2.0         61.4       2.1          54.9


     Total             100           ...      100            ...

Income of applicant
(percentage of MSA
median)(1)
Less than 80            22.4         56.9      11.7          62.2
  80-90                 16.8         47.9      14.5          48.7
100-120                 17.7         44.6      17.6          43.1
More than 120           43.1         46.9      56.3          42.1

     Total             100           ...      100            ...

                        Home purchase         Home refinancing

     Characteristic

                     Percentage     Denial   Percentage     Denial
                     distribution    rate    distribution    rate
Racial composition
of census tract
(minorities as
percentage of
population)
Less than 10             39.9        40.9         33.2      31.0
10-19                    23.9        48.3         23.8      44.5
20-49                    22.5        54.9         29.1      54.3
50-79                     8.9        63.2          8.9      61.7
80-100                    4.7        64.8          5.1      67.6

     Total              100          ...        100         ...

Income of census
tract(2)
Low or moderate          14.2        59.0         11.6      59.8
Middle                   48.4        48.8         48.8      46.3
Upper                    37.4        45.3         39.6      40.4

     Total              100          ...        100         ...

Location of census
tract(3)
Central city             38.6        50.6         35.3      47.5
Non-central-city         61.4        47.9         64.7      44.5

     Total              100          ...        100         ...

Memo
Number of

     applications


     sent to more


     than one

company                      12,387                   6,457

(1.)MSA median is median family income of the metropolitan statistical area (MSA) in which the property related to the loan is located.

(2.)Low or moderate: median family income for census tract less than 80 percent of median income for MSA of tract; Middle income: 80 percent to 120 percent; Upper income: more than 120 percent.

(3.)For census tracts located in MSAs.

Source. Federal Financial Institutions Examination Council, preliminary data.

(1.)For a comprehensive history of the PMI industry, see Charles Rapkin and others, The Private Insurance of Home Mortgages: A Study of Mortgage Guaranty Insurance Corporation, Institute for Environmental Studies (University of Pennsylvania, 1967).

(2.)During the period preceding the Depression, the industry developed a business similar to the current one for mortgagebacked securities. The companies offered "participations," which involved the issuance of certificates to a group of investors who were entitled to receive periodic payments based on the interest income and principal repayments generated by the underlying mortgages. However, one significant difference between current and former market practices was that issuers of participations retained the right to substitute mortgages underlying a specific certificate so long as the substitute had the same face value as that of the original loan. The abuse of this right contributed to investor losses during the Depression.

(3.)Establishment of the Mutual Mortgage Insurance Fund was authorized by section 202 of title II of the 1934 National Housing Act. As the purposes of the act have expanded over the years, the FHA has added new insurance programs to its portfolio.

(4.)The Veterans Administration became the cabinet-level Department of Veterans Affairs (VA) on March 15, 1989. Technically, the VA offers loan guarantees rather than mortgage insurance, but the two forms of assurance are similar in function and both are referred to here as mortgage insurance. Other government agencies also provide home loan insurance but on a much smaller scale.

(5.)The tighter underwriting practices of recent years have helped reduce the proportion of insured loans with loan-to-value ratios of greater than 90 percent, from 47.6 percent in 1985 to 32.4 percent in 1993. The share of other higher-risk loans, such as mortgages secured by condominiums and non-owner-occupied properties and mortgages that allow negative amortization, has also declined. See David M. Graifman, "Mortgage Insurance: The Party Continues," Standard and Poor's Structured Finance (May 1994), pp. 13-17.

(6.)A few other PMI firms exist, but they do not currently write new mortgage insurance. For additional information about the PMI industry, see Mortgage Insurance Companies of America Factbook & Directory of Membership (Washington: Mortgage Insurance Companies of America, 1994).

(7.)Amerin Guaranty Corporation is new to the PMI industry.

(8.)Some lenders will grant low-down-payment mortgages without insurance. Most often such mortgages are extended as part of an affordable housing program, although lenders may choose to self-insure other low-down-payment mortgages as well.

(9.)Research has consistently found that mortgages with higher loan-to-value ratios default more frequently than those with lower ratios. See Roberto G. Quercia and Michael A. Stegman, "Residential Mortgage Default: A Review of the Literature," Journal of Housing Research, vol. 3 (1992), pp. 341-79.

(10.)In recent years, the ninety-day delinquency rate for adjustable rate mortgages purchased by Fannie Mae has been roughly 50 percent to 100 percent higher than the delinquency rate on fixed rate mortgages. See John M. Dickie, "Residential Delinquencies and Foreclosures: First Quarter 1994" (memorandum, U.S. Department of Housing and Urban Development, July 14, 1994).

(11.)For further information about the risk diversification and monitoring practices of PMI companies, see Roger Blood, "Managing Insured Mortgage Risk," in Jess Lederman, ed., The Secondary Mortgage Market: Strategies for Surviving and Thriving in Today's Challenging Markets, rev. ed (Probus, 1992).

(12.)The VA mortgage guarantee program is open only to veterans. It is usually the first choice of eligible households that can afford only a small down payment.

(13.)Recently, PMI companies have allowed part or all of the initial fees for insurance to be paid monthly.

(14.)However, the FHA discontinues the annual premium after a specified number of years for mortgages with loan-to-value ratios of less than 95 percent. For example, for FHA mortgages originated in 1993 that had a loan-to-value ratio of less than 90 percent, the FHA will discontinue the annual premium after seven years.

(15.)In 1994 the FHA lowered its initial premium from 3 percent of the mortgage to 2.25 percent.

(16.)The wealth advantage of the FHA borrower during the first year (shown in row 1 of table 4) reflects the lower cost of FHA insurance if the borrower holds the FHA-insured mortgage for only one year. This lower cost is a consequence of the FHA insurance refund policy. However, if to acquire the refund the FHA borrower incurs closing costs when taking out a conventional mortgage, the refund advantage may be lost.

In addition, the conditions placed on the PMI borrower's ability to drop the PMI insurance affect this cost advantage. Some lenders allow borrowers to drop PMI with minimal charges once sufficient equity has accumulated in the property; other lenders do not allow PMI to be dropped, forcing the PMI borrower to refinance in order to drop the insurance. If the PMI borrower must refinance, then the relative advantage of the FHA refund is maintained. Furthermore, PMI companies may refund part of the initial premiums if a mortgage is terminated within the first year.

(17.)The maximum mortgage limit of $151,725 became effective March 15, 1993. The FHA also establishes higher limits for properties with two, three, or four units and for properties in Alaska and Hawaii. For instance, in 1993 the single-family limit in Honolulu was $227,550. See 58 Fed. Reg. 13950, March 15, 1993.

(18.)When this article was written, the data described were still subject to revision. Final data, which are available to the public, may differ somewhat from the data used here.

(19.)That is, in the case of depository institutions, the HMDA rule for reporting property location is based on office location, whereas mortgage companies are deemed to have an office in an MSA if they receive applications for, or purchase, five or more loans in a given year on property in that MSA.

(20.)About 23 percent of the PMI application records submitted to the FFIEC lacked data on race or ethnic origin. This proportion is much larger than that for HMDA records and reflects, according to industry representatives, the initial complications of starting a new data collection process.

(21.)FHA Trends of Home Mortgage Characteristics: Section 203(b) Mortgages Insured, U.S.A., Calendar Year 1993, FHA Comptroller, Information Systems Division (Department of Housing and Urban Development, n.d.).

(22.)The approval rate for one PMI company, Amerin Guaranty Corporation, is 100 percent because the firm delegates the decision to approve an application for insurance to the lending institution. Thus, Amerin is notified about applications for insurance only when a lender has selected them as the insurance provider.

(23.)If multiple applications are removed from the sample, denial rates for all racial groups are lower: 17.9 percent for Asian applicants, 19.4 percent for black applicants, 22.2 percent for Hispanic applicants, and 10.3 percent for white applicants.

(24.)PMI companies, like many government programs, do not use uniform definitions for low- or moderate-income households.

(25.)The Community Affairs staffs of the Federal Reserve Banks indicate that lenders generally are aware of the affordable housing initiatives of only the largest two or three PMI companies.