WORD ON THE STREET: Private mortgage insurance has long played an important role in facilitating homeownership, and has recently provided an element of stability to the market. An examination of this particular industry holds lessons that can inform the overall mortgage finance system.
A discussion about the role of mortgage insurance must begin by stressing the importance of giving families the opportunity to buy homes when they do not have enough accumulated wealth to make a big down payment, which is what the primary purpose of mortgage insurance. This is not about speculative, ‘no money down’ schemes; this is about the first step to building family economic security and realizing the long-term benefits of homeownership. Many of us have climbed the homeownership ladder with a modest down payment and a loan made possible by some form of mortgage insurance – be it private mortgage insurance, Federal Housing Administration (FHA) insurance or the Department of Veterans' Affairs (VA) program.
Access to this type of financing is critically important, because homeownership continues to be the cornerstone of household wealth in the U.S. At a macro level, real estate holdings make up the largest element of household assets in the U.S. Its value to individual families is equally profound, and increases as you move down the income spectrum, with home equity constituting more than three quarters of the wealth of low-income families. Among families earning between $20,000 and $50,000, those who own homes have 19 times the wealth of those who rent.
We have long recognized that among those three primary constraints, reducing the down-payment barrier is the best way to increase ownership opportunity for more low-income or minority households. The median sales price of a single-family home in the U.S. in 2009 was $172,100; making a 20% down payment required $34,420 in assets – greater than the entire annual income of roughly one-third of all U.S. households.
In the average year, of all the home mortgages made, nearly one-third are to families with less than 20% equity, and among these are families who will later buy another house.
It is well understood that low equity is associated with higher risks – if a borrower with little home equity loses their job, for example, he or she cannot easily sell the house to pay off the mortgage. This basic understanding is part of why FHA/VA insurance was developed, why the government-sponsored enterprises' (GSEs) charter requires certain other forms of credit enhancement to buy loans with a loan-to-value (LTV) ratio of less than 80%, and why banks are required to hold more capital for the higher LTV mortgages they hold.
Even in the wake of the foreclosure crisis, we have evidence that this risk can be managed through financing that has enabled hundreds of thousands of working families with modest incomes to become successful homeowners. This was accomplished not through exotic mortgages that created only an illusion of homeownership, but through consumer-centric policies and practices that removed barriers to homeownership for first-time, minority and low-income families. These programs did not develop out of financially engineered sleight of hand that failed to account for risk; they evolved through decades of careful innovation, such as Community Reinvestment Act lending programs, new approaches introduced by the mortgage insurance companies and the GSEs, adjustments to underwriting guidelines, pre-purchase counseling and down-payment assistance programs.
These efforts paid off in a steady increase in homeownership rates between 1995 and 2004. Note that at that time, the subprime boom was just getting into full swing, and that during the peak years of 2004 to 2007, homeownership rates actually leveled off and started to decline through the foreclosure crisis.
Why the model works
The private mortgage insurance model provides, on a much larger scale, another answer as to the right way to support high-LTV lending. An industry built on insuring mortgages with low down payments has weathered the mortgage crisis, paid substantial claims without any federal support, and even managed to attract new capital.
In simple terms, private primary mortgage insurance is required by many investors and lenders when funding higher LTV mortgages. It covers the amount of the loan that is above a certain threshold percentage of the value of the property, and puts the mortgage insurer in first loss position. In the event of default, after being paid by the insurer, the lender or investor can expect to recover much, if not all, of the remaining balance from the sale of the property. The lender/investor is the beneficiary, but the insurance is typically paid by the borrower as part of the monthly mortgage payment.
Traditionally, mortgage insurance premiums vary by LTV and a few other factors. Private mortgage insurance rates must be filed with and approved by state insurance regulators. The mortgage insurance industry only insures a portion of the high-LTV, single family mortgages made in the U.S.
These loans can also be facilitated through FHA/VA/Ginnie Mae, banks making high-LTV mortgages without insurance, or lenders securitizing them through private-label securities, which, theoretically, would be structured to absorb all default risks, including those associated with low equity.
Another mechanism that was particularly popular in the mid 2000s was the combination of an 80% first mortgage with a purchase money second lien for 10% to 20%. These second liens can be retained by the originating lender (typically depositories), or securitized along with the first lien. But unlike mortgage insurance, in the last few years, many of the alternatives have fallen short or required direct or indirect taxpayer support.
Countercyclical capital risks
Mortgage insurance rates are relatively static. Mortgage insurers must obtain state regulator approval to change rates in many states, and this can be a slow process. More importantly, state regulators mandate high capital and reserving requirements, which impose a natural price floor. By contrast, during the buildup of the mortgage bubble, less regulated, alternative sources of credit enhancement became increasingly cheap relative to the institutional monoline sources (primary mortgage insurance and FHA insurance).
Although the FHA now holds a record high market share – 21% in 2009 – at the height of the subprime boom, its share dwindled to a mere 2.6%, and that of private mortgage insurers likewise fell below 9% to a long-term low. On the other hand, because of regulatory and GSE requirements, the mortgage insurance companies had a decent level of reserves heading into the crisis.
While they are paying a huge amounts in claims – including an estimated $30 billion to Fannie Mae and Freddie Mac that directly offsets taxpayer exposure – they point to their countercyclical capital requirements as key to their value in a volatile industry and the reason they have not required public capital or support. In the overheated markets leading up to the mortgage crisis, the lack of consistent oversight enabled risk to be laid off where low or no capital requirements existed.
At the time, this looked like innovation; but, in hindsight, it was recklessness. The lesson learned is that an effective and responsible mortgage finance system must consider total system capital at risk on each loan and inhibit capital arbitrage.
Another virtue of the mortgage insurance industry is its expertise in setting risk standards. As an industry that understands the risks and invests capital, it has an important role in developing underwriting and product standards. We are too familiar with how the underwriting rule book was thrown out the window with such products as option adjustable-rate mortgages and stated-income loans.
On the other hand, mortgage insurance companies with their institutional knowledge of high-LTV lending, engendered a better understanding of the true risks posed and how to mitigate them. Moreover, with their own capital at risk, they live or die by whether they get the standards right. The issue of standards also applies to loss mitigation.
Because foreclosure is likely to be the most costly outcome for the mortgage insurer, the insurer's interest is often aligned with keeping the borrower in the home. And because the mortgage insurer bears the first loss in the event of foreclosure, it holds some sway in establishing delinquent-loan management standards. Historically, insurers have been innovators in developing foreclosure-avoidance strategies.
A third virtue of the mortgage insurance industry lies in its role as a pooler of risk. For example, if you want a group of lenders to be able to withstand losses to some statistically derived level based on historical experience – say, 8% – then each institution is required to hold 8% capital against their loans.
Theoretically, that makes sense – but in reality, only some of the portfolios will get into trouble, they will lose more than they reserved and will fail, while the others will over-reserve.
But to prevent any failures, each lender would have to hold more than 8%, which would be more costly and inefficient. Instead, when risks are transferred, a few mortgage insurance companies can absorb losses from the high-loss lenders using surpluses generated by the low-loss lenders and the overall capital required to assure systemic soundness is reduced. This is a basic principle of insurance.
Pooling risk also has benefits when applied across geographic regions of the country, or across individual securities. This also works across time, as demonstrated by the fact that mortgage insurers set aside capital in the good years to draw upon in the lean times.
These days, we hear a lot about regulatory failures, but mortgage insurance is one story of regulatory success. At a centralized level, the GSEs – and their regulator and counterparty risk requirements – set de facto regulations. At the same time, the role of state insurance regulators is vital to the outcomes we are discussing today.
Among these regulatory mechanisms, the higher standard generally prevails, thus preventing regulatory arbitrage. This regime stands in stark contrast to that of the broader mortgage market, where federal preemption and regulatory gaps allowed lenders to go around the rules.
The evidence strongly suggests that the state regulatory system, combined with a federal oversight role, led to systemic safety and soundness, at least within the privately insured market.
Looking beyond the crisis, it is reasonable to expect that access to prime credit in these communities is likely to remain scarce, due to weak appraisals and other neighborhood conditions classified as "risky." Unfortunately, income losses from the recession are also disproportionately affecting minorities. Further, the loss of homes, wealth and income will impact credit scores for years to come. Thus, we are facing a perfect storm in which all three of the key constraints to homeownership – down payment, income and credit – are tightening and putting homeownership further out of reach.
As prime credit options shrink, we are likely to see a re-widening of the homeownership gap between the haves and have-nots. Rebuilding our hardest-hit communities will require the affirmative involvement of all market participants.
Today is for retrenching. Underwriting guidelines are justifiably conservative. But we must make sure that the pendulum has not swung too far and that we are able to accurately distinguish real risks from perceived risks going forward. To that end, mortgage insurers must also be held accountable to public policy goals of enabling access to safe mortgage products. This caveat applies not just to underwriting, but also to pricing.
Mortgage insurance embeds a basic level of risk-based pricing: Borrowers with less money down have to buy an insurance product. Currently, Fannie and Freddie and the mortgage insurers may add a number of price adjustments based on characteristics of borrowers, properties and/or weaker markets. The cumulative result runs the risk of replicating subprime pricing while lacking transparency to the borrower.
Two of the key lessons that we should carry forward from the financial crisis are the importance of transparency in pricing, and the fact that adding costs to more vulnerable borrowers or those in weaker markets can actually contribute to weaker performance.
Further, how can one judge risk in markets that are underserved? Expanding access to safe and affordable mortgage products with careful underwriting can support profitable lending to populations otherwise perceived to be high-risk.
What am I suggesting? Perhaps some kind of public purpose role for mortgage insurers, or some provisions included in secondary market reform. For example, a proposal by the Mortgage Finance Working Group lays out a framework for a ‘Housing Innovation Finance Fund.’ Through partnerships between public and private providers, the fund would find new ways to expand mortgage access to underserved markets.
When done correctly, high-LTV mortgages are essential for the U.S. housing system to offer opportunities and a pathway to the middle class. Mortgage insurance brings significant value to the industry by deploying private capital while conducting safe and sustainable high-LTV lending.
Janneke Ratcliffe is associate director of the University of North Carolina's Center for Community Capital. She can be reached at email@example.com. This article is adapted from recent testimony given before the U.S. House of Representatives' Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises.