With the GSEs "Nationalized," Will There Still be a Market for Mortgage Insurance?

Implications: The GSEs succeeded in supporting the creation of a broad, deep, liquid national market for mortgages.  They used their market power to impose standardization on mortgage terms and underwriting.  Thus was born the "conforming mortgage." Mortgage insurance is an artifact of this history.  It is an inefficient and (at the individual whole loan level) unnecessary credit enhancement.  But the rumors of MI's demise are premature. The last thing the new management of the GSEs want to do is spook the markets with sudden moves, loud noises or big changes. That said, there will be pressure to impose much more rigorous capital allocation/portfolio risk management controls.  Politically, they can't reduce volume, per se, immediately at least, but the management of counterparty risk exposure to the MIs may well become more active. Bad news for weaker MIs.   Later the survivors will again be caught between price competition and "innovation" (bad risk) in a smaller market.

Analysis: The weird hybrid public (risk)/private (profit) enterprises and erstwhile political juggernauts that we know and loathe today are not what their Congressional sponsors had in mind when Fannie and Freddie were first chartered.  In fact, one can argue plausibly that the so-called GSEs ("Government Sponsored Enterprises") became the monsters that they are because they succeeded too well in carrying out those charters. 

We have a broad, deep and (until very recently) liquid national market in mortgage products in large part because Fannie and Freddie made (and backstopped) that market.  Once the market was humming, they should have been either dismantled or purely privatized, but that's another story.

One of the tools used by the GSEs to make the market function smoothly was standardization.  They used their market power to impose basic requirements for the underwriting and documentation of the mortgages that would be eligible for their purchase.  Thus was born the "conforming loan."

As we all know, one of the immutable characteristics of the conforming mortgage loan is that the ratio of the amount of the loan to the appraised value of the mortgaged property cannot be more than 80%.  However (again another story), this sound credit underwriting bulwark against default was deemed too prejudicial to the interests of the young, first-time home-buyer, trying to scrape together a down payment.  So, an exception was allowed . . . and an industry was created.  The LTV of a conforming loan can exceed 80%, so long as an approved provider of credit enhancement (mortgage insurance) indemnifies the holder of the mortgage against any loss on the amount of the loan in excess of 80% LTV.

A moment's reflection will tell you that (all other things being equal) the difference among 80%, 90%, 95% or 100% LTV mortgage loans is in the degree of risk of loss.  And if a mortgage insurance company can figure out the cost in potential losses represented by those relative degrees of risk in order to set the premiums it needs to charge to make a profit, then a buyer of the mortgages should likewise simply (and much more efficiently overall) be able to figure out how much less to pay for a 90% LTV loan than for an 80% loan. 

So, MI is an artifact of the historical development of the US mortgage markets and of the governmental subvention to promote the development of those markets -- since gone horribly wrong.  More bluntly, if MI hadn't been invented for that purpose, there would be no need now to create the product in its current form. 

Credit enhancement may well be a useful tool in the markets for mortgage products but probably only at the whole loan pool or securitized bond level.  To add another layer of underwriting, another set of documents, regulations and disclosures in order to deliver credit enhancement loan by loan at the individual level is cumbersome and inefficient in the extreme. 

The executives of the MI industry have known this very well.  And they have known that, if Congress chose to allow the GSEs to eliminate the concept of the "conforming loan," then the industry's raison d'etre could be wiped out -- literally with the stroke of a pen.  But they and their investors and the equities analysts saw very little chance of that risk being realized.  Everyone was too fat and happy with the status quo to think about tinkering with it in such a fundamental manner.

That was then.  Now my clients are asking, what about MI?  Will there still be a need/market for MI? 

Ironically, I believe, the pending (sort of) "nationalization" of the GSEs will probably be good for the Mis in the short run.  The whole idea is to bring order and rationality back to the mortgage markets by assuring the participants that the buyers of last resort are still in business, with the wherewithall and the will to keep buying.  The last thing the new managers of the GSEs will want to do is spook the markets.  No sudden moves; no loud noises; no big changes.

However, the representatives of the new "owner" also have a mandate for reform, especially for reform of the GSEs' balance sheet management.  The current crisis has demonstrated how the big banks' sophisticated enterprise risk management tools could not keep up with their multifarious, multinational accumulations and correlations of credit risk.  In contrast, the GSEs deal only in mortgages and morgage-backed securities.  Their access to and cost of funding have been second only to the US Treasury.  In other words, they only have to manage interest rate risk, duration risk, basis risk and (specialized) credit risk.  But their systems for pricing, hedging, allocating capital and otherwise managing these risks were so inadequate (or, maybe, so trumped by greed), that they went off the cliff.  (Oh, and their regulator was also pathetically over matched, but once again that's another story).

In straightening out this mess, it cannot escape the attention of the new management that the GSE's have accumulated huge counterparty credit exposures to the MIs.  That is, if a major MI  were to go bust, many billions of dollars of mortgage loans on the GSEs' books that have been priced and reserved as "conforming" would suddenly have to be recharacterized as high LTV and, therefore, higher risk.  And it won't escape their attention that some of the major MIs are in . . . tenuous financial shape. 

Again, I don't think we'll see any sudden or dramatic changes in this respect, but I would expect that the GSEs will begin to manage down their concentrations of exposures to the weaker MIs.  To the extent that those companies may have been planning on growing their way out of their problems, this will be very bad news.

If the weak get weaker, then the strong will get stronger, right?  And, if the surviving companies can grow thei share of a robust (in terms of credit quality) market, they will be all the more profitable, right? 

To some extent, the stronger survivors and any big, credible new entrants in the industry may thrive in the near to mid-term.  However, since GE got out of the business, there have been no triple-A MI companies, and I think the GSEs will inevitably have to charge more than they have historically for the concentrated counterparty risk in buying loans with mortgage insurance. 

In addition, the mortgage origination industry, which is where the decision is made whether to use mortgage insurance and how much to pay for it, is still consolidating and will be competing fiercely for share in a mortgage market that will be smaller and slower-growing than that which supported the growth of their huge origination/asset-gathering infrastructure.  So, the MIs are facing a marketplace in which they will be selling a commodity product to an oligopsony of buyers who will themselves be cost constrained and highly motivated to limit their customers' (the mortgage borrowers') costs at the point of sale. 

Hmm.  How do you "succeed" in such a marketplace?  You either cut prices.  Or improve service (increasing costs).  Or you "innovate."  Unfortunately, what history (and not just recent history) teaches about the MI industry is that when they "innovate," they're really just finding new and different ways to take more risk and/or get paid less for it.

Whatever happens to the GSEs and whoever calls the shots there, I find it hard to be enthusiastic about the MI industry's prospects.