- GSEs programmatically use (re)insurance to transfer mortgage credit risk
- Rate of mortgage loan default low due to impact of regulatory changes affecting banks and loan originators
- GSEs ceded over USD 20 billion of limit into the global (re)insurance market
Fannie Mae and Freddie Mac – government-sponsored entities (GSEs) in the United States – purchase hundreds of thousands of mortgage loans and assume the risk of mortgage credit default, interest rate volatility and prepayment. The GSEs began transferring mortgage credit default risk only in the last few years. The organizations are now programmatically using (re) insurance to transfer that credit risk and plan to continue to do so. (Re)insurers seeking growth may look to this market as a diversifying risk with several different options available –market changes and safeguards in place make it even more viable, according to John Tedeschi, Executive Vice President, Guy Carpenter.
“Mortgage credit risk” is the risk a borrower defaults on a loan. “In the context of a (re)insurance transaction, a default produces a loss only when the net resale value of a property after legal and foreclosure costs is less than the mortgage balance held by the lending institution. The strong U.S. economy and stringent loan underwriting practices have been generating loss ratios of virtually zero for participating (re)insurers,” says Tedeschi.
“The rate of mortgage loan default is low due to the impact of regulatory changes affecting banks and loan originators as well as GSEs,” he explains. “The stringent underwriting standards that were introduced by the regulations following the 2008 financial crisis have dramatically reduced the number of loans originated and vastly improved the credit quality of the loans. Additionally, Freddie Mac and Fannie Mae are using new technology that allows them to quickly verify many of the numerous underwriting requirements for securing a loan, such as employment, assets and property-value assessments.”
At the same time, a number of macro-economic factors are impacting the housing and mortgage markets. He continues, “A strong economy and low unemployment rate are contributing to a low loan default rate and a strong housing market. Importantly, the value of U.S. homes remains robust, driven by limited housing supply and interest rates that are still low. Healthy housing values generally propel housing prices to exceed the value of their mortgage loans, reducing the potential for loss. The GSEs offer (re)insurance transactions for recently originated loans based on three main risk categories:
- 30-Year fixed rate mortgages that have consumer loan-to-value (LTV) in excess of 80 percent (for loans with down payments of less than 20 percent). These loans are credit-enhanced via a requirement for the consumer to purchase private mortgage insurance, offering further protections for (re)insurers in this category.
- 30-Year fixed rate mortgages where the LTV is between 60 percent and 80 percent. This class is attractive to some (re) insurers for two reasons: one, because the consumer holding the mortgage has substantial skin in the game; and two, the home price would need to decline significantly for the (re) insurer to be exposed to a loss.
- 15- to 20-Year fixed rate mortgages are the fastest amortizing loans, which help de-risk (re)insurers and attract those who want to come off risk quickly.”
The GSEs also offer reinsurance transactions that transfer risk on loans that were originated in the past and for risk transfers for loans yet to be originated.
Reinsurers benefited from the fact that there were very few mortgage loan defaults generated by the natural catastrophe events of 2017. “On an ongoing basis, the GSEs work closely with mortgage servicing companies to offer forbearance to help soften the financial consequences of disasters, often allowing consumers to remain in their homes, defer monthly mortgage payments and reduce default risk,” he says.
“The GSEs have ceded over USD 20 billion of limit into the global (re)insurance market,” he notes. “Their continuing focus on de-risking their portfolios heralds additional demands for capacity and opportunities for new counterparties.”
He concludes, “As (re)insurers seek opportunities for profitable growth, the residential mortgage credit risk market provides portfolio diversification and capital management benefits. Guy Carpenter provides guidance to clients about participation in mortgage credit risk transactions.”