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The local nature of housing.

THE LOCAL NATURE of HOUSING

The energy belt's demise gave rise to regional underwriting. MGIC explains how it works.

During the last decade, mortgage insurers witnessed major regional economic swings that have taught several important lessons regarding real estate finance risk. First and foremost we have learned that real estate finance is not risk-free--particularly high-ratio financing, or loans exceeding 80 percent loan-to-value (LTV). Appreciation in home values, thought of as a sure thing until the early 1980s, has recently proven anything but a given. Property values can even decline, as we've seen recently. Once that happens, initial borrower equity, credit worthiness, appraisal accuracy and a host of other factors all impact on mortgage lending performance.

Events during the 1980s confirmed the local nature of housing market activity. While some areas experienced high default and foreclosure rates, others realized significant increases in property values. For example, Houston and Denver suffered devastating losses in residential lending while many markets in the Northeast enjoyed unprecedented appreciation. Even today, while Houston and Denver are recovering, there remains variance of risk within the submarkets that comprise these metro areas.

Also, real estate markets are cyclical. Constant appreciation is unlikely to exist anywhere. The well-publicized decline in home prices in New England and Arizona and softening in certain segments of California demonstrate that even once-booming markets aren't exempt. Recently, however, the peaks and valleys of cycles have heightened. As a result, residential losses have been exacerbated in the downturns.

Numerous forces have contributed to changes in the fundamental nature of the residential housing market. In particular, changing demographics will heighten the risk of mortgage lending in the 1990s. There has been a decline in the number of people in the 25-34 age bracket. This shift in the population mix will lessen the demand for housing, as new household formations decrease from an annual average of 1.5 million in the 1980s to a projected 1.2 million in the 1990s.

The balance between supply and demand remains a key determinant of housing values. When there are significant imbalances, dramatic swings in property values occur. In places such as Houston and Denver, where there was an extreme oversupply of housing coupled with economic downturn, the results were disastrous. Inevitably, these changed demographics create greater risk of housing oversupply relative to demand in most U.S. markets.

Risk management options

Given the developments of the last decade and emerging demographic trends, mortgage lenders and insurers need to establish new approaches to effectively manage risk.

To identify a proper risk management strategy, it is critical to understand that the risk of mortgage default is proportional to initial borrower equity, or (LTV) ratio. The changing environment and demographics will have the most impact on loans with higher LTVs, or less borrower equity. Traditionally, the low down payment, high-risk category has been defined as loans with less than 20 percent down payment. But that threshold of higher risk should probably be lowered in many areas because it is a function of potential property value declines. Generally, 90 percent LTV loans are two times more likely to default as 80 percent LTV loans and 95 percent LTV loans are two times as risky as 90 percent LTV loans. This relationship has been upheld by studies on the mortgage insurance (MI) industry conducted by Temple, Barker & Sloan, Inc., a Boston-based research firm and has proven true throughout the 33-year history of the Mortgage Guaranty Insurance Corporation (MGIC).

Interestingly, statistics on mortgage foreclosures in Texas show that the risk of mortgage default can penetrate far below the 80 percent LTV level. For example, while Fannie Mae's incidence of foreclosure was 14 percent on 90 percent LTV loans purchased on Texas properties originated during 1981 and 1982, the foreclosure rate through April 1989 was 8 percent on 80 percent LTV loans, 3.8 percent on 75 percent LTV loans and even 1.8 percent on 70 percent LTV loans. This experience suggests that not only are high-ratio loans vulnerable to default, but loans with 25 percent or more down payments also deserve special risk-management consideration.

We have seen various responses to these new, higher risk developments. Some lenders have ignored the risk or have refused to accept that lower than commonly presumed LTVs carry risk and have continued "business as usual" with their lending practices. These responses have resulted in the introduction of loan programs that significantly increase risk of loss. The limited documentation programs, especially on higher LTVs and discounted ARMs, are inherently much riskier in this new environment.

Other lenders have taken a conservative approach and eliminated the highest risk segments of their lending. For example, some lenders have eliminated the 95 percent LTV loan and established a ceiling at 90 percent. This approach ignores the variances in markets at given favorable points in the appreciation cycle. It also serves to exacerbate the housing affordability issue, which is becoming more acute and will remain a challenge in the 1990s.

One seemingly logical approach would be to differentiate between varying risks by pricing mortgages according to a risk assessment model. In this manner a lender or insurer could, theoretically, continue to serve all segments of the housing market, albeit at a higher cost to the borrower for higher risk segments of business. Using this approach, Freddie Mac follows a graduated scale of guarantor fees and requires steeper fees for high-ratio loans with lower fees for 80 percent-and-under LTV loans. An even higher fee is changed for 95 percent LTV loans. This approach is feasible to an extent, but it also adds to the home affordability hurdles facing many potential buyers. This flexible pricing approach is also limited in terms of managing risk in distressed areas. Based on MGIC's experience, the premium required to actually insure the loss in distressed areas would be greater than the market could bear.

MGIC applies certain aspects of the stratified pricing approach but also incorporates regional underwriting guidelines. The use of regional underwriting guidelines and local market evaluations is the cornerstone of a risk management strategy that MGIC believes is essential for achieving profitable results while continuing to prudently serve homebuyers. The private MI industry primarily serves the low down payment segment of the housing market. MGIC's goal is to help people buy and keep their homes.

The idea of establishing regional underwriting guidelines for different markets was a difficult concept to embrace. MGIC and the MI industry traditionally followed national underwriting guidelines. Freddie Mac, Fannie Mae and most lenders still employ national underwriting guidelines.

Until regional underwriting is understood and widely implemented, it is likely that excessive risk will be taken in some markets or, if conservative guidelines applicable nationwide, an important segment of the market will not be served. In the remainder of this article, we will describe in greater detail how MGIC performs market evaluation and utilizes regional underwriting guidelines to effectively manage risk.

Company organization

MGIC's Risk Management Department was established on January 1, 1986. A key aspect of MGIC's organizational structure is that risk management reports directly to the president and is independent of the sales and underwriting operation. Maintaining an objective assessment of market risk requires the support of the highest level of management--support that will ultimately impact the policies and practices of the company.

MGIC's field operations are organized into four geographic divisions. Two vice presidents each manage two risk management units. Each division's risk management unit includes one or more market analysts. Additional staff in Milwaukee supports the division's risk management function and provides detailed analysis on the makeup and performance of MGIC's insured loans.

Market analysis

The market analysis performed by MGIC can be characterized as a hands-on, "touch and feel" approach. It is directed, comprehensive and updated regularly.

The process starts with the quarterly analysis and reports generated by the Headquarters Risk Management Department. External economic data is collected, maintained and reported for the top 100 metropolitan statistical areas (MSA's) in the country. Detailed internal reports on MGIC insurance writings and loan default and loss performance are also provided for these markets. External reports monitor employment trends, new housing starts, housing units sold, vacancy rates, marketing times, median sales prices and similar statistics that help assess the balance of supply and demand for housing in that market. The internal analysis includes tracking by LTV category, loan type, property type, loan purpose, loan amount and other characteristics including the five digit zip code area and the lender.

This quarterly monitoring permits us to quickly identify changes in market trends and/or changes in MGIC writings and loss performance. In this manner, we identify and prioritize markets for on-site review and analysis. These on-site reviews provide comprehensive and detailed information on sub-markets, including detached versus attached properties, price ranges, neighborhoods and additional information on employment and population trends. Type of employment and the degree of economic diversification are extremely important in the overall market evaluation to determine appropriate underwriting. Market analysts preparing these assessments draw heavily from local MGIC personnel, lenders, real estate agents, appraisers and other sources who understand current trends, as well as the market's strengths and weaknesses.

The information gathered from this comprehensive review allows the risk management department to assess the current strength of markets. During the last five years, it has become apparent that underwriting guidelines play a major role in managing market risk. During this period MGIC has adopted standard guidelines to follow, depending on how a market is classified.

Exhibit 1 highlights the underwriting guidelines used by MGIC depending on whether a market is rated "A," "B," "C" or "D." The "A" guidelines are the standard MGIC guidelines employed in most markets across the country. The "B" guidelines are used in markets that have demonstrated signs of a weakening economy and are experiencing some decline in home prices. The "C" and "D" guidelines are employed in places where the evidence of market weakness and price declines are more extreme, such as in parts of the energy states.

The guidelines govern various geographic territories ranging from one state at the broadest level, to one county at the most targeted level. When applied to an entire MSA, the guidelines apply to the various counties that comprise the MSA.

The purpose of the guidelines is to define the limits of prudent risk in that particular market. Because mortgage insurers want to help keep people in homes, the guidelines generally require greater borrower cash equity at purchase for higher risk markets. As stated earlier, the amount of borrower equity is the single largest determinant of mortgage default. The guidelines also reflect somewhat more stringent credit evaluation by requiring excellent credit history and a cash reserve after closing. Generally, borrowers in markets are evidencing some weakness, must demonstrate their ability and willingness to pay. Marginal credit risks have a significantly higher probability of default in any market, but especially in weaker housing markets.

While the Exhibit 1 guidelines reflect some restrictions, note that a regional underwriting approach conversely allows for more liberal guidelines in strong markets. For example, while standard MGIC guidelines allow loans on attached housing up to 90 percent LTV, loans to 95 percent LTV are permitted on attached housing units in California, Hawaii and parts of the East Coast, where such housing has demonstrated market acceptance and housing markets are generally strong. In markets that have shown longer-term strength and stability, MGIC has waived the two-month principal, interest, tax and insurance (PITI) requirement on 95 percent LTV loans and allows the portion beyond 3 percent of the down payment requirement to come from a gift from parents or grandparents.

Timing

Mortgage market participants must be careful not to move too quickly nor wait too long to respond when adjusting underwriting in a deteriorating market. There is no simple or easy answer to this, but timing, coordination and communication with all principal participants is critical.

At MGIC this communication and coordination starts with our field sales and underwriting management. Market analysis results are discussed, challenged and debated. Afterward, we agree on an overall market risk assessment. Risk management objectives are then clearly set and alternatives are discussed that generally include the establishment of special, or regional underwriting guidelines.

Often, the market analysis is shared with MGIC's customers, to solicit their input and assist with determining appropriate action. In some cases, alerting lenders to our concerns and reaching a consensus on the risk is sufficient to control MGIC's exposure; it provides a valuable service to our customers simultaneously. In other cases, the immediate implementation of special underwriting guidelines is deemed the best alternative.

Case studies

Real estate markets in the energy states, including Alaska, Texas, Oklahoma, Colorado and Louisiana precipitated the use of regional underwriting guidelines. The need for special, more restrictive, guidelines in these markets ultimately became obvious in the past decade after the widespread occurrence of property value declines. MGIC has adopted versions of the special guidelines shown in the exhibit and closely monitors levels of economic development in these markets. As these areas show evidence of recovery and strength, the special guidelines are relaxed.

Two markets that were not as obviously affected by a downturn in housing also illustrate alternative approaches to a regional underwriting strategy. They are Arizona and New England. These regions are receiving much publicity today, but were paid scant attention more than two years ago when MGIC's market analysis first identified pending problems in those residential real estate markets.

Let us examine Arizona first. More than two years ago, MGIC's monitoring of external data showed a slowdown (not decline) in employment growth. Meanwhile, new housing starts continued unabated. New housing starts not only failed to slow, they continued to grow at an increasing rate. Our review of lending practices led us to conclude that new construction activity was unlikely to slow down anytime soon. The resulting oversupply of housing became more and more certain. In 1988, MGIC implemented special underwriting guidelines restricting the maximum loan-to-value to 90 percent LTV and generally eliminating seller contributions. Attached housing was deemed ineligible for insurance by MGIC.

By taking these actions, MGIC reduced its writings by more than 50 percent between 1987 and 1989. More importantly, thus far we have avoided the heavy losses that some lenders and other secondary investors are currently experiencing in Arizona.

The weakness in the Arizona housing market was precipitated by over-zealous construction that impacted virtually all segments of the market. In New England, however, the weakness is much narrower and the impact more subtle. During the mid-1980s, significant price appreciation had been experienced in all sectors of the New England housing market. In the last half of 1987, however, as a result of MGIC's ongoing market monitoring, we became increasingly concerned about the growing supply of condominium units and the marketability of many apartment conversion projects. Discus- sions with local real estate experts and lenders convinced us to restrict the maximum LTV on attached housing to 90 percent. This guideline was implemented by MGIC on January 1, 1988.

In addition, MGIC's internal procedures were strengthened as well. As part of our risk management activities, MGIC defines high-risk characteristics for condominium projects. If one or more of those characteristics are present according to the appraisal, this triggers a separate review by a project analyst in risk management. High-risk characteristics are determined by measuring the portion that is investor-owned, the land-use in the area and high- and low-end price ranges. They also include special characteristics applicable only to a particular market such as size of the units, style, conversions and so forth. In New England we added several factors to our high-risk definition, particularly conversion projects and square footage of units. This revised definition triggered further reviews and helped to avoid many of the market's condominium problems. Because condominium prices have declined approximately 15-20 percent during the last 18-24 months, MGIC reduced its writings of condominium loans by more than 40 percent and confined its insured writings to a more acceptable risk.

Another segment of the New England market that has suffered is the higher-priced home, typically $250,000 and up. When the stock market fell in October 1987, we evaluated the potential impact on the financial services industry. Despite the preliminary conclusion and eventual evidence of price declines in this residential segment, MGIC did not implement special guidelines. The reason was that very few home loans in this price range were high-ratio loans. Therefore, lenders typically would not require mortgage insurance on them.

New England's recent market history exemplifies the need to fully understand all segments of a housing market. If MGIC had adopted special guidelines to reflect general market trends, we would have overreacted to the market segment that is primarily served by the MI industry. Furthermore, the condominium segment required the implementation of risk management controls that went beyond simply establishing a 90 percent LTV limit.

In setting its risk management strategy, MGIC addresses four major risk factors. This article has focused on the market-based risk factors. The other three risk factors center around the lender, the mortgage product and the credit and collateral risk of the individual loan.

Regional underwriting guidelines are one important component in a campaign to manage market risk. To achieve profitable results in the 1990s, MGIC believes that all four of these categories of risk must be properly managed. Therefore, regional underwriting guidelines cannot be developed and administered independently of an assessment of the other risk factors. Risk management policies adopted in any given market, therefore, should consider market conditions, lender practices, type of mortgage and property.

It should be emphasized that MGIC's regional guidelines are geared to high-ratio (less than 20 percent down payment) loans. This constitutes virtually 100 percent of the MI industry's writings. For lenders and other secondary investors who may operate across the entire LTV spectrum, this strategy will need to be slightly modified.

In the 1990s, MGIC believes that regional underwriting guidelines will become an essential aspect of risk management strategy to achieve profitable results in mortgage lending. [Exhibit 1 Omitted]

Gordon H. Steinbach is executive vice president, risk management, of the Mortgage Guaranty Insurance Corporation, Milwaukee. He has been with MGIC since 1973.
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No portion of this article can be reproduced without the express written permission from the copyright holder.
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Title Annotation:regional underwriting
Author:Steinbach, Gordon H.
Publication:Mortgage Banking
Date:Jun 1, 1990
Words:3026
Previous Article:Marketing evolution.
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