During the past year, mortgage insurance has become an increasingly important component of credit enhancement in the home equity market. Mortgage insurance gained traction in the home equity market in 2000 and has already been used on about 10 deals thus far in 2001. Furthermore, mortgage insurance (MI) has covered well over 50% of the loans in these deals. In addition, most of the mortgage insurance has covered a significant percentage of each covered loan - so called "deep MI". In many cases, the mortgage insurance represents more than 75% of the credit enhancement.
Overview
Mortgage insurance typically provides coverage for a mortgage pool at the individual loan level. Each loan is insured up to a specified percentage. Losses that exceed this specified amount must be absorbed by an alternate source of credit enhancement.
Unlike a monoline insurance policy, the coverage under a typical mortgage insurance policy would be reduced by certain excluded risks and may be further reduced by claims denials and reductions as discussed more fully below.
Calculation of coverage amount
Mortgage insurance in the home equity market generally works the same as in the conforming and jumbo market. The MI coverage can be expressed in several ways. One way is the difference between the actual LTV and covered LTV: that is a 90% LTV insured down to 50%, may be said to have 40% coverage. Another, and more accurate way is to express the coverage as a percentage of the loan amount. In the above example, this would be 44% or (90-50)/90.
Even more precisely, the dollars of mortgage insurance coverage is expressed as a percentage of the sum of: (1) principal balance, (2) accrued interest and (3) eligible expenses.
Policy exclusions and limitations
There are generally three reasons why an insurance policy may not cover a particular loss amount. Rating agencies evaluate and assess the magnitude of these risks and establish additional credit enhancement requirements based on this assessment. These Non-Covered Amounts (NCA) can be categorized in three ways:
Claim Adjustments: A claim adjustment would result in a partial reduction of a claim. Such a claim reduction may result, for example, from foreclosure expenses exceeding permitted amounts. The bulk of these claims adjustments result from servicer error. These servicer errors may include: delays in foreclosure, delayed REO sales, and exceeding specified expenses on certain fees. Rating agencies will incorporate the servicer quality when determining the risk of servicing error related adjustments.
Claim Denials: Claim denials result from outright denial of an entire claim. Such a denial may occur, for example, if the loan violated a rep and warrant (e.g. multifamily property was represented as single-family). Data provided by MGIC and presented at a recent Fitch conference revealed that 82% of claims denials would have been covered under a standard hazard policy (i.e., the loss was related to property damage covered under a standard hazard policy) and therefore would not have resulted in a loss to investors or the servicer.
Exclusions: Policy exclusions are risks that are explicitly not covered by the policy. Such risks typically include: special hazard (e.g., earthquakes) and fraud.
Historical adjustments have been nominal
A recent report by Fitch indicated that the "amount of these adjustments is nominal (less than 1%) by all accounts." Furthermore, while these adjustments were generally experienced on prime mortgage loans, there is no reason to believe that this would differ for subprime loans. However, most of these observations have occurred in good economic times and it is uncertain whether the same numbers would occur in an economic environment in which claims activity increased substantially.
Impact of MI on rating of a securitization
Because mortgage insurance represents third-party credit enhancement, a transaction backed by mortgage insurance will be linked to the rating of the MI provider. This means that a downgrade (upgrade) of the MI provider may lead to a downgrade (upgrade) of the securities supported by the MI policy.
Degree of the linkage to MI company
The factors determining the linkage are as follows:
Availability of other credit support: If the MI coverage is a relatively small part of the total credit support, the securities issued will be less impacted by a change in rating of the MI provider.
Rating of bond issued: Generally, the lower the rating of the bonds, the lower the linkage to the rating of the MI provider. For example, a triple-B investor will have limited risk of downgrade to the MI provider as most of these providers are rated at least double-A.
Performance of underlying loans: If the underlying transaction is performing well, a downgrade of the mortgage insurer may have a more limited impact on the rating of the securities.
Step-down Structure and Amount of other Credit Enhancement: The amount of other credit support will also determine exposure to the MI company. Further, strict stepdown rules and/or faster build-up of credit support will mitigate the risk of a downgrade of the MI provider.
MI changes downgrade risk relative to a senior/sub deal
While linkage to a third party credit enhancement provider may seem to increase the downgrade risk of a deal, this is not necessarily the case. Though it is true that MI insurance increases the risk for bondholders to a downgrade of the MI provider, it reduces the risk of downgrade associated with the collateral performance in a senior/sub deal. Furthermore, the greater the linkage of the rating to the MI provider, the lower the linkage to the performance of the underlying loans. This is because if most of the credit enhancement is provided by the MI company, poor performance of the collateral will have a minimal effect on the rating of the bonds.
Finally, home equity investors may indirectly be diversifying their exposure to the home equity market through the MI insurance. How does this happen? Because the overwhelming risk for MI companies is in the prime mortgage market; the downgrade of the MI provider will be less correlated to the risk of the home equity market. Therefore, investors should enjoy the benefits of diversification into the conforming mortgage market without the downside - greater prepayment risk and tighter spreads. For investors who believe that the conforming/jumbo mortgage market will perform relatively well in a recession, buying a home equity deal with MI insurance would be an interesting way to participate.
Variability of losses can impact MI benefit
Because MI is available at the loan level, losses on a loan that exceed the coverage level cannot be absorbed by MI on other loans that do not exhaust all of the MI coverage. The benefit of MI therefore, in part, is a function of the variability of the severities experienced in a particular deal. For example, if a pool that experiences an average severity of 50% is covered by an MI policy that covers all loans to a 50% severity, one may assume that there is no additional credit risk (exclusions and claim denials and rejections aside). However, some loans may have a severity much lower than 50% while others may have a severity greater than 50%. The loans with a severity greater than 50% will suffer losses exceeding the MI coverage. The additional losses from highly variable loss pools will not be revealed in an analysis of losses where severity is uniform.
Rating agencies take this risk into account when assessing the value of the MI policies. Moody's, for example, reported that it assumes a greater degree of variability of severity at higher rating levels. Pools with a higher degree of variance will require credit support in addition to that available from the MI policy, relative to a low variance portfolio.
We evaluated the loss severity for several large sub-prime issuers. A total of 4,084 loans from the MIC loan level database for first-lien home equity loans were analyzed. We found the weighted average loss severity to be 37 with a standard deviation of 21. As described more completely in the full report, the right skewed distribution of loss severity increases the number of loans whose losses exceed the MI coverage.
Who are the players?
Thus far, the three largest participants providing MI for subprime mortgages are: MGIC, PMI and Radian Guaranty. These insurers carry a double A rating by all three rating agencies.
Conclusion
The use of mortgage insurance in the home equity market has exploded over the past year. The emergence of this new player in the subprime market has benefited issuers and investors alike. We expect this trend to continue and hope this article helps investors to understand some of the issues surrounding the use of MI in subprime home equity deals.
In the complete article we also discuss reporting issues, claims payment alternatives and differences in MI policies.
