September 18th, 2017

Public Sector Risk Financing Perspectives in the United States: The Market for Mortgage Credit Risk (Re)insurance: Part I

Posted at 1:00 AM ET

krohn_jeff_photo_crop-sm1tedeschi_john_photo_sm2Jeffrey Krohn, Managing Director, and John Tedeschi, Managing Director

The global financial crisis of 2008 exposed the U.S. mortgage industry, taxpayers, and the global capital markets to the loss potential of residential mortgage credit risk. The total shakeup of the U.S. housing sector resulted in:

  • a return to prudent underwriting criteria;
  • incorporation of very strict rules on documentation of income, employment and debt;
  • market standardization in mortgage products;
  • more rigorous valuation standard on home price appraisals;
  • incorporation of Private Mortgage Insurer Eligibility Requirements (PMIERs) for private mortgage insurance (PMI); and
  • a Federal Housing Finance Agency (FHFA) directive mandating government sponsored entities (GSEs) Fannie Mae and Freddie Mac to begin transferring credit risk on the hundreds of billions of dollars of U.S. mortgages issued each year.

Mortgage credit risk is associated with the risk of borrower default on a loan. In the context of the GSEs, a default produces a loss when the net resale value of a property after PMI, legal, and foreclosure costs is less than the mortgage balance held by the lending institution.

The graphic below illustrates a USD 200,000 single family dwelling where the buyer makes a 10 percent down payment on the property and takes out a loan on the outstanding home value in the amount of USD 180,000. Lenders selling their loans to the GSEs require PMI for loans where the buyer’s down payment is less than 20 percent of the home value. Typically on a 90 percent loan-to-value mortgage, PMI provides coverage on 25 percent of the loan balance, leaving the GSEs at risk for the remaining balance.

home-owner-example

In the United States, mortgage credit risk (re)insurance is used by both the private mortgage insurers and GSEs. The PMIERs, which became effective on January 1, 2016, govern the standards by which private mortgage insurers must hold capital. As permitted in other global solvency regimes, reinsurance is a permissible capital management tool in the United States; it is recognized as capital on the private mortgage insurer’s balance sheet and is a lever that several private mortgage insurers have employed.

Beginning in 2013, under an FHFA mandate, the GSEs initiated their Credit Risk Transfer (CRT) program that spreads mortgage credit risk to the global capital and (re)insurance markets. In doing so, the GSEs reduce taxpayer exposure, minimize fluctuations in the availability of homeowner credit, create market efficiencies and oversights, and build a durable liquid market for U.S. single family credit risk.

Link to Part II>>

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