Though there have been numerous MBS deals that have had underlying mortgage loans carrying fraud insurance in the past, rating agencies have only recently started to take notice of the value of such insurance.

Last week, Fitch held a press conference about the fraud policy currently being offered by Illinois Union Insurance Co., which is a subsidiary of Ace USA. Because of some acquisitions, the insurance will eventually be underwritten by Safeco Surplus Lines Co., a unit of Safeco Corp.

After Fitch, Standard and Poor's is said to be holding a similar press conference in a couple of months and will also be writing an analysis of this type of insurance in the near future. Moody's Investors Service, on the other hand, is supposedly still in the process of scrutinizing the policy.

About the product

Although the interest from the rating agencies is somewhat new, the product has been around for awhile. About 275,000 loans have been insured since June 2000.

Though it is called fraud insurance, experts say that there is really no need for fraud per se to exist before loss on a loan can be recovered through the policy. The term more accurately refers to a failure in data integrity. So this could mean that a misstatement of a piece of information exists or that some information financial or otherwise was concealed.

"There is no fraud that needs to be proven," said Arthur Prieston, president of PBIS Insurance Services, which is the managing general agent for Ace USA and Safeco Surplus Lines. "It is more about data integrity as it relates to the primary elements of a particular loan such as income and employment."

Prieston added that the policy would also cover losses associated with the appraisal of a loan, but that it would not cover a misinterpretation that is merely an evaluation or appraisal error. In other words, the error in evaluation has to cause an error in the representation of a particular borrower, such as the amount of debt that he or she has.

Lender quality

According to the Fitch press release, the policy is "currently being offered to prime and subprime issuers on a case-by case basis..."

Prieston said that the insurance policy could only be applied to lenders, originators or aggregators that are of high quality.

"I think it's important that not every lender or originator could qualify for this coverage," said Prieston at the Fitch press conference. "This coverage was designed to benefit those lenders and originators who have adopted some preventive steps and programs and who have a commitment to quality in origination."

He added that originators in general are becoming increasingly subject to a declining economic environment and are clearly exposed to significant single-risk exposure.

For instance, if 20% of the loans in a deal come from a particular region and they are subject to fraudulent appraisals then the losses would be considerable, especially for investors who own the first-loss piece because they take the initial hit on problematic transactions.

"Having the policy would benefit investors who buy MBS because they know that if the coverage is in place, there is a lower possibility of single-risk exposure," said Prieston.

However, not all policies are created equal. In the Option One sample of loans that Fitch analyzed to study the benefits of the policy, the coverage does not include stated income refinancings. Prieston, however, said that this is particular to the Option One case and that certain policies for other lenders actually do include this type of refinancing. In other words, the application of the fraud insurance policy differs from lender to lender.

Fitch analysis

To determine the value of this type of insurance, Fitch used fraudulent loans from Option One's 2000 funding portfolios.

The rating agency analyzed 151 loans from the portfolios. After running the loans through their models, Fitch found that 141 loans (93%) from that sample appeared to contain financial misinterpretations that could be covered by the policy. Through the analysis, the rating agency determined that there would be a five basis point benefit per loan for each year with the application of the insurance.

Analysts said that though the insurance coverage is for three years, the rating agency considered the benefit of the coverage to last only for two years because most of the fraud that occurred involved a first-payment default which happens during the first two years of a loan.

So since each year would have a five basis point benefit, the total benefit would amount to 10 basis points.

However, Fitch determined that in the Option One case specifically, there would be no benefit at present as far as the application of fraud insurance is concerned. This is because H&R Block, which is Option One's single-A rated parent, had issued a hard fraud representation and warranty. And since Ace USA is single-A-plus rated, there is no additional advantage currently.

"However, with issuers in the marketplace that do not have a rated parent there could be a benefit of approximately ten basis points based upon similar product composition and collateral types," said Fitch senior director Cheryl Go at the press conference. "So if you are looking at this policy, it needs to be seen on a case by case basis."

However, experts say that the issue with Option One is that the loans had representations and warranties even before the insurance was applied. If the insurance was applied before the representations and warranties were there, then the loans would have had better execution and the benefit of having the fraud insurance would be maximized.

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