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Rebel with a cause; Jerry Friedman's wholesale mortgage insurance venture cuts out hordes of regional salespeople and streamlines claims and underwriting staff as well.

Jerry Friedman's wholesale mortgage insurance venture cuts out hordes of regional salespeople and streamlines claims and underwriting staff as well. The result is a radical new idea for a very lean mortgage insurance company that passes on its savings to lenders in the form of lower premiums.

A year ago Gerald (Jerry) L. Friedman was pounding the pavement of downtown Manhattan trying to sell potential investors on his idea for a wholesale mortgage insurance company, eventually to be named Amerin Guaranty Corporation. Friedman had grown restless after retiring at the end of 1990 from another firm he founded in 1983, the Financial Guaranty Insurance Corporation (FGIC).

The departure from FGIC, which insures municipal bonds, came as a result of the GE Capital division's acquisition of the firm. As he walked briskly along the canyons of Wall Street and its environs, it was, as Yogi Berra used to say, deja vu all over again.

Friedman, now 55, had done the same thing back in the early 1980s to get FGIC off the ground, after spending 20 years in Milwaukee for the company his Uncle Max Karl founded in 1957 - the Mortgage Guaranty Insurance Corporation (MGIC). Friedman, himself, says he resigned from MGIC in 1981 in protest of its acquisition by United Baldwin.

Ten years ago, he also was pounding the streets, as one acquaintance put it, "with a briefcase in his hand and no job," selling a different, and more sophisticated, way of doing business in municipal bonds. But in the case of this most recent pavement pounding, in 1992, he was trying to convince investors to buy into a radical departure from the way mortgage insurance has been done for more than 30 years.

Friedman, whose Uncle Max was the father of mortgage insurance, believes that the industry is ripe for a revolution from business as usual. That's because, in spite of a decade of turmoil and crisis in the 1980s, the mortgage insurance industry has only changed around the edges, Friedman says.

According to data collected by Moody's Investors Service, the mortgage insurance industry earned net premiums of $6.8 billion in the 10 years from 1981 to 1990 and paid $7.3 billion in claims to cover bad loans. The cost of putting that business on the books was $2.2 billion, pushing expenses to $9.5 billion. Thus, on an operating basis, the industry lost $2.7 billion in 10 years. Because the mortgage insurers also earned $2 billion on investments of premiums during the same time, the net loss was reduced to $700 million.

The very foundation of mortgage insurance was rocked in the 1980s by several "major macro events," Friedman says, events that should have tipped off those in mortgage insurance that major changes were necessary. Sitting behind his desk in the handsome home office of his sprawling Greenwich, Connecticut, home, Friedman ticks off the major events. First, the standard loan-to-value (LTV) for home mortgages rose from 90 percent to 95 percent. Second, adjustable-rate mortgages were successful and became a fixture in the marketplace. Third, Fannie Mae and Freddie Mac became preeminent forces in the market as portfolio lenders vanished. Fourth, inflation subsided considerably. The net effect was that "it didn't bail everybody out of their errors," Friedman notes. Fifth, there was "an erosion of morality in America," as bankruptcy become more tolerable and "people left keys on the desk" and walked away from their homes and their mortgages. This sent claims against mortgage insurers soaring. The average number of claims, or par, jumped from two out of a hundred to six out of a hundred.

"Usually when an industry goes through a crisis, it's time for a change," Friedman says, but even after five bad years for the mortgage insurance industry between 1983 and 1987, the mortgage insurers "all were run basically the same." The only significant change was an increase in premiums. This seemed perplexing. "Why isn't this industry changing?" Friedman asked himself in 1988. It was "an opportunity for the mortgage insurers to become more efficient."

It may, at first, seem a bit odd that Friedman was obsessed with the fortunes of the mortgage insurance industry since he had left that business years earlier. But, as Friedman notes, he had good reason to follow the business - 35 percent of FGIC's business was insuring housing bonds. To help FGIC rate housing bonds, he developed an internal rating system for the mortgage insurance companies that backed the mortgages that were pooled and packaged into these offerings.

Keeping tabs on the mortgage insurers led him to begin to question the way business was being done. Indeed, by 1988, as the mortgage insurance industry recovered from its woes, Friedman had an epiphany. The time had come for mortgage insurance to go wholesale.

Friedman was struck by the fact that municipal bond insurance was sold without a huge sales force. "At FGIC, we were running our whole multibillion [dollar] business through one microcomputer and with 10 to 15 people," Friedman recalls. Why, then, was such a large sales force needed to sell mortgage insurance? The only answer he could come up with was that business had always been done that way. Things had not changed after the decade of crisis because "no one was willing to break stride'"

And the reason that no one wanted to change, he says, is that they had learned nothing from the crisis. Amazingly to Friedman, the industry had failed to see that "the days of a captive sales force were numbered."

Friedman, rebel with a cause, saw the industry's failure to innovate as an entrepreneurial opportunity. To meet the challenge, he decided he wanted to start a lean new company without a huge sales force, which he calls "the legion of donut bearers." In his new company, a small sales force would call on the top level of highly rated lending organizations and offer them a lower premium. This meant that the ancillary services provided by the existing sales forces of mortgage insurers would be discarded by the lenders that opted to get insurance from Amerin Guaranty. By incorporating this new, lower premium into the mortgage rate quote, a lender could lower rates charged to borrowers to compete more aggressively for business, or it could choose to increase its profits. "Therein lay the seed of a new company that would be less like a traditional insurance company and more like an investment banking boutique in nature, with only high-quality business," Friedman says.

Friedman's next step was to take the idea to the FGIC board of directors. FGIC's major investors were represented on the board, including GE Capital, J. P. Morgan, Shearson-Lehman, Lumberman's Mutual (Kemper), General Reinsurance and Friedman's family. Everyone liked Friedman's new idea for a mortgage insurance company, except General Electric. GE already had a mortgage insurance subsidiary, having started its own business in Cincinnati in 1981. Then, GE greatly expanded the business in 1983 with the acquisition of the American Mortgage Insurance Company, the second oldest mortgage insurer, which was incorporated into GE Capital Mortgage Insurance Companies (GEMICO).

So, it was hardly surprising that GE opposed this new venture proposed by Friedman. Indeed, GE, which originally held 23 percent of FGIC's stock in 1983, had increased its stake to 38 percent in 1986 by buying out Merrill Lynch's 16 percent stake, becoming the strongest voice on the board. Recalls Friedman, "They weren't too happy about FGIC's board considering launching a second business of private mortgage insurance."

In spite of GE's opposition, the board approved Friedman's idea for a new company, and FGIC bought a shell company with which to launch it. The details of the venture's new strategy began to take shape. Aside from eliminating a sales force aimed at the regional offices of lenders, Friedman's earliest proposal for a new mortgage insurer also contained a coinsurance provision that left 30 percent of the responsibility for defaults with the mortgage lender, giving only 70 percent of it to the mortgage insurer. This covered only the portion of the loan above 80 percent of value of the house. As Friedman did his due diligence on the new business, he found that the coinsurance provision was impractical, partly because very few mortgage lenders are of sufficient investment grade to convince rating agencies that the insurer would not have to cover the lender's share of the loss, which made it harder to sell the loans into the secondary market.

Even as Friedman began to flesh out, the details of the new venture, GE moved to acquire 100 percent of FGIC in 1988, including the stake owned by Friedman's family. After GE gained control of the shell company that was to be the vehicle for the new venture, GE was free to move against it. They took the shell and "buried it," Friedman recalls, "virtually killing it." After selling his share of FGIC, Friedman then "sort of retired," staying on for two more years to help GE complete the transition to new management.

On January 1, 1991, Friedman completely retired from FGIC. In spite of GE's action against the new venture, Friedman says he had then and continues to have "a wonderful relationship with GE." With the launching of Amerin Guaranty - a novel and direct competitor with GE's mortgage insurance arm - one might wonder if the relationship can still accurately be described as wonderful. One might also wonder why GE did not get an agreement from Friedman back in 1988 not to enter the mortgage insurance business in return for GE's acquisition of his FGIC shares. GE is not willing to comment.

One might also wonder why Friedman did not just take his money, relax and enjoy an early retirement. FGIC had made him wealthy and had allowed him to build a striking "classic contemporary" house in exclusive Greenwich, where he purchased an existing home on fashionable Lake Drive and tore it down to build his dream house. It is a home designed by noted architect Warren Platner, who had also designed the MGIC corporate headquarters back in Milwaukee. The choice of the architect was made by both Jerry and his wife, Sheree, who recently earned a degree as an architect from the Pratt Institute. But living the good life was just not enough for the restless Friedman, still enamored of an appealing opportunity. The idea of a wholesale mortgage insurer just kept challenging him to come up with a way to make it happen.

Jerry Friedman could not sit still, quite simply, because he is "the quintessential entrepreneur," says Ann C. Stern, president of FGIC and one of the key people who helped Friedman turn FGIC into an overnight success in 1984 and 1985. Like many entrepreneurs, Friedman has the ability to develop a vision for a new venture. He also has a talent for communicating that vision to employees. "You can't underestimate the power of Jerry with an idea," Stern says. In the space of a single interview, Friedman was so compelling in his description of his vision for FGIC, Stern says, he sold her on joining the company. He lured her away from a coveted job as a partner at a law firm, which is what she had always wanted and had already earned at Wood, Dawson, Smith & Hellman.

Stern, like others who have come to know Friedman, has found him to be one of the most focused people she has ever met, one who demands of his employees a full commitment to the company's success. In fact, Stern says, Friedman was so focused that his austere countenance earned him the office nickname of Darth Vader of Star Wars fame. The name came from the striking image of Friedman, with his thin, pale face, walking through the doorway of his office, a doorway lavished with decorative black lacquered wood with a 1930s Art Deco flair, the design hallmark of FGIC's old offices. (The firm moved earlier this year to far lighter and brighter quarters.)

The lavish office design at FGIC was part of an image that Friedman had sought to convey for his newly launched firm, one that was solid and backed by plenty of capital and one that told Wall Street that business was done here a different way. To achieve the desired effect, Friedman hired Italian designer Emilio Ambaz to decorate the office. In addition to the ebony lacquer, there were also walls of silk suspended from the ceiling to the floor, back lit from lights recessed into the ceiling. When the air moved through the silk strands, they shimmered. The office wags gave the silk walls the moniker "Garbor" an allusion to the famed film actress and the glamorous image she conveyed. (Oliver Stone found the offices so lavish he wanted to film part of his movie Wall Street there, but FGIC finally said "no," because it would have completely disrupted the company's business, Stern says.)

When Friedman was free to pursue his idea again in 1991, he began to ask mortgage lenders what they wanted in a mortgage insurer that they were not getting currently. They told him, Friedman says, that they would like experience-based premiums. They wanted their good experience in doing business with creditworthy borrowers to be reflected in a lower premium for mortgage insurance. "We found the industry hungry for profits because their profit margins were severely depressed," Friedman says. So he set about devising a way to provide lower premiums for high-quality lenders, to make, in effect, mortgage insurance a profit center for these lenders. This required fashioning the savings so that it flowed through to the lender, not the borrower. This part was relatively easy. The lender would offer the mortgage insurance as part of the overall quoted mortgage rate rather than as an add-on to the rate charged to the borrower.

Friedman then devised a business model for Amerin Guaranty that would allow him to offer premiums at around 32 basis points, which was 8 basis points and 22 percent lower than the industry's standard premium of 40 basis points. The 8 basis points could then either be kept by the lender to increase profit margins or be used to lower the interest rate in an effort to gain market share.

After four years, Amerin Guaranty will adjust the premium level based on the experience of the lender, Friedman says. The premium can go up by 5, 10 or 15 basis points, if losses are somewhat above par, he adds. Even at an increase of 15 basis points, the adjusted premium will not exceed the standard insurance premium, Friedman claims. After four years, the premium also can be lowered by 5 or 10 basis points.

The experience-based premium, like the coinsurance provision before it, apparently transfers some of the risk back to the lender. This element of the business is seen as controversial by some lenders, especially those who may not qualify for the lower premium. It will likely create some concern on the part of both lenders and other mortgage insurers, who have refused to introduce experience-based premiums in the past. GE Capital Mortgage Insurance Companies looked into the question of variable premiums based on the lender's claims experience and decided against it, according to Mark Goldharber, a spokesman for the company. "A loan portfolio is driven by regional losses," explains Goldharber. Thus, a lender with loan concentrations in a region with high losses, such as the oil patch in the 1980s, would be penalized under Amerin Guaranty's approach. "We see the fundamental role of our mortgage insurance product to be one of absorbing the losses rather than passing them back to the lenders." A big mortgage insurer can do this, Goldharber explains, because its risk is dispersed all across the nation and not concentrated in any single region. Other major mortgage insurers, such as MGIC and PMI Mortgage Insurance Co., also are dispersed nationally in their exposure to loan losses.

Another potential concern over Amerin Guaranty's wholesale approach is that it might encourage lenders to be extremely conservative in their underwriting. Says Goldharber, "That could be critically important to affordable housing and the Community Reinvestment Act." If other mortgage insurers adopt the Amerin approach, it could lead more lenders to underwrite their production with extreme caution so that the claims experience is modest enough to preserve the discount pricing of the wholesale mortgage insurer. Such a development could potentially restrict the amount of lending that is done with traditionally lower down payment, first-time borrowers who lack substantial equity cushions to make their loans less risky.

Neither Fannie Mae nor Freddie Mac has indicated that this is a serious concern for them with regard to the wholesale approach introduced by Amerin Guaranty. While Fannie Mae refused to comment on its decision to approve Amerin Guaranty, Freddie Mac issued a statement on behalf of Gerald Langbauer, Freddic Mac vice president for institutional credit risk. The Freddie Mac statement was: "After reviewing the application, we felt it was appropriate to approve the proposed program. We feel it is not our role to impede the introduction of new ideas and programs into the market place. However, it is our role to review all applications to make sure that they meet the standards we have established for mortgage insurers. We will work with mortgage servicers on a negotiated-contract basis for the purchase of [Amerin Guaranty-] insured loans or loans insured by other [mortgage insurers] utilizing similar products. In the end, it is the marketplace that will determine the viability of new products and programs."

Most mortgage lenders have been reluctant to comment publicly on Amerin Guaranty's wholesale product. A few have welcomed the new firm and its new approach. Says Angelo Mozilo, president and chief executive officer of Countrywide Funding Corporation, Pasadena, California, "I'm always in favor of every attempt by people to be creative in bringing greater efficiency to the marketplace." Countrywide has pioneered in this field, Mozilo notes, and passed the savings along to the customer.

John Robbins, president of American Residential Mortgage Corporation, La Jolla, California, says there is room for another mortgage insurer. The key question, Robbins says, is just how financially sound Amerin Guaranty will be. If lenders are convinced the new firm is well capitalized, they might try the new product on a pilot basis. Robbins also wants to see how good Amerin Guaranty will be in terms of its customer service; how it will take care of lenders with only a tiny work force. If Amerin Guaranty succeeds in all these areas, Robbins predicts that other mortgage insurers will offer similar products.

Robbins, like other observers, finds Amerin Guaranty intriguing because of the past successes of its founder, Friedman, and other key personnel, such as Stuart Brafman, who is the firm's new president and chief operating officer and who is running the firm from Chicago. (Friedman will be in Chicago regularly but will continue to live and work most of the time out of his Greenwich home.) Brafman, who has known Friedman since they were both boys growing up in Milwaukee, also worked for many years at MGIC, then went off to Australia to introduce mortgage insurance there. Friedman persuaded him to take the top position at Amerin Guaranty. "It's only because of this experience they are creating the kind of interest in the marketplace they are creating," Robbins says.

The investors, too, are impressed with the management of Amerin Guaranty. Says Tom Hallagan, investment director at Aetna Investment Group in Hartford, Connecticut, a firm that has invested in Amerin Guaranty, "The management is clearly the key factor, especially their experience and track record." Says Alan E. Goldberg, a managing director at Morgan Stanley's merchant banking department, another key investor, "As in any investment, what was most compelling was the people. Jerry Friedman, by reputation and background in municipal bonds and residential mortgages, is an expert in financial guarantees. He has had a string of success, starting with AMBAC at MGIC and including FGIC." AMBAC was a division of MGIC that Friedman started.

Investors were also impressed by Friedman's business plan for Amerin Guaranty. Hallagan notes that while doing his due diligence, he talked with mortgage originators to see how the idea would sell. Several major lenders "were very excited about it," Hallagan says, because it will give them the chance to reduce costs and further diversify the number of mortgage insurers they rely on. Furthermore, Friedman's bare-bones approach amounts to a variable-cost model, Hallagan says. "With low brick-and-mortar costs, you don't have to do a lot of business to cover costs."

Friedman claims that Amerin Guaranty's expense ratio is "considerably less than half" of the industry's expense ratio. The industry's ratio ranges from 25 to 32 percent of the revenue in premiums. "We can tolerate more adverse claims and survive a severe recession or depression," Friedman says. Estimating the size of the privately insured mortgage market at $500 billion to $550 billion during an average year, Friedman says that if his firm insures less than 10 percent of that market ($50 billion to $55 billion), it will be profitable. "We hope to achieve that level of business in a reasonably short time," he says.

Amerin Guaranty plans to use 100 percent delegated underwriting, allowing it major cost savings. Most mortgage insurers have tried delegated underwriting, but many found that during the 1980s, this practice left them strapped with too many losses. As a result, most mortgage insurers sharply reduced their delegated underwriting. Amerin Guaranty intends to set up guidelines that lenders will have to meet and will monitor the lender's compliance with those guidelines. Mozilo, for one, believes that delegated underwriting can work, if properly monitored.

Delegated underwriting could remove one of the few remaining roadblocks to speedy loan processing that still remain, according to Mark Kamm at SMR Research Corporation of Budd Lake, New Jersey. SMR favorably reviewed Amerin Guaranty's business plan in the firm's 1992 edition of Giants of the Mortgage Industry.

In addition, Amerin Guaranty plans to have a streamlined claims procedure that will save time and eliminate all the hassles, according to Friedman and Brafman. Friedman found through studying historical trends that the typical claim for unpaid principal and interest, attorney's fees and maintenance expenses was 115 percent of the amount insured. For example, on a $100,000 mortgage, of which $20,000 is insured, the typical claim is $23,000 (115 percent of $20,000).

Typically, the claims process itself is filled with delays and disagreements, causing the total losses to rise while the issues are sorted out. Amerin Guaranty, however, will provide coverage of 23 percent for those loans that normally get 20 percent coverage. Amerin also will provide automatic claims payment equal to the average claim on a given type of mortgage, Friedman says. There will be no hassles. "We want to be easy to do business with," Brafman says. SMR's Kamm believes that the savings on streamlined claims processing and delegated underwriting combined is much greater than the savings on a reduced sales force.

In addition to Aetna and Morgan, Stanley, Friedman was able to line up J. P. Morgan, Leeway & Co., and the General Motors pension fund. He also put up a chunk of the Friedman family fortune in the venture. Initial capitalization is $75 million with $125 million in backup capital. This was sufficient to lead the credit rating agencies to give Amerin Guaranty the minimum rating needed to do business. Standard & Poor's Corporation gave the firm a AA and Moody's handed them a rating of Aa3. Some of the big names in mortgage insurance have AAA ratings, including GEMICO and United Guaranty (owned by insurance powerhouse AIG). Moody's confirmed a Aa2 rating of PMI's financial strength on December 10, after downgrading the mortgage insurer from Aaa and placing them under review for possible further downgrade on September 11, 1992. MGIC is rated Aa3 by Moody's.

James Schmidbauer, assistant vice president who follows mortgage insurers for Moody's, found Amerin Guaranty's business plan "sufficient for us to feel comfortable that the policyholder would have protection." He is unconvinced, at present, as to whether Amerin Guaranty will, in the long term, prosper. "It will take time to see if management can implement its plans and can adjust to the reaction of other market participants," Schmidbauer says. It's likely that other mortgage insurers, if Amerin Guaranty is successful, will match Amerin Guaranty's product offerings. "Insurance is somewhat of a commodity," he explains. This means other firms can easily match it. Says Schmidbauer, "Can they get the quality product [business with top creditworthy lenders] they want at the price they're charging? And, even if they can get good quality, is it sufficient? It will be interesting to see if they can achieve that." The three key concerns - price, quality and volume - could all be affected if other firms decide to make competitive forays into the wholesale mortgage insurance field, the analyst predicts.

Kamm, at SMR Research, views the potential competition positively, claiming Amerin Guaranty's entry into the business has the potential to revolutionize the mortgage insurance industry. says the new firm has taken erable mission, "to turn private mortgage insurance from an often time-consuming, expensive, retail-delivered, borrower-pay product into a quick, cheap, wholesale, lender-pay product." The whole industry will probably be watching intently in the coming months to see if Friedman can make a strong early start toward that goal.

Robert Stowe England is a freelance writer based in Washington, D.C.
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Author:England, Robert Stowe
Publication:Mortgage Banking
Date:Jan 1, 1993
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