Mortgage insurance companies adversely affected by the Office of Federal Housing Enterprise Oversight's (OFHEO) new risk-based capital rule are bracing themselves for the worst case scenario, but are at the same time optimistic that OFHEO may reconsider the capital differential that now exists between triple-A and double-A-rated mortgage insurance companies.

As OFHEO's new rule stands, parties would be required to hold more capital against mortgages insured by double-A insurers than triple-A insurers, a distinction that wasn't made. This puts the double-A-rated insurers at a serious business disadvantage in the agency mortgage market.

In a recent filing, PMI Group Inc. said that if the company is unable to address the capital differential, this would have serious implications for its business. Representatives from the company said that this statement was made to let investors know what the worst-case scenario is.

"We certainly don't expect the worst-case scenario to pass but we cannot absolutely guarantee that it may not happen," said Glenn Corso, senior vice president, investor and corporate relations at PMI.

Corso said not only is there a possiblity that OFHEO may reconsider the capital differential that now exists, it is also difficult at this point to determine the precise impact of the differential on the capital Fannie Mae and Freddie Mac may need to hold against their portfolio holdings.

Other sources said the GSEs may pass along the higher capital cost from the loans insured by double-A-rated MI companies to the marketplace by charging higher guarantee fees. However, Fannie and Freddie may opt not to do this. The incremental capital that they would need to hold relative to high ratio loans is a very small portion of the overall risk within the OFHEO regulation, which deals with various kinds of risks, including the different credit, interest-rate and operational risks.

Though there is a good likelihood of a positive outcome, the double-A-rated mortgage insurers are not taking the threat lightly.

In its filing, PMI said that is considering vaious options to address the rule. PMI's Corso said that a more likely solution for the company would be to create a triple-A subsidiary (using capital from the holding company and excess capital from the mortgage insurance business) that would only cater to the GSEs.

The company is also considering reinsurance as well as creating a product that would be capital neutral for Fannie and Freddie purposes. Though PMI is also thinking of perhaps obtaining a triple-A rating, this is the least of their options because this would necesitate a secondary stock offering which would dillute existing stock holders.

Other double-A-rated mortgage insurers are also gearing up.

If the proposal takes effect as it is, "We are in a position to neutralize the differential in a cost-effective manner where [MGIC Investment Corp.] is not going to be at a competitive disadvantage," said Geoffrey Cooper, director of public policy and corporate relations at MGIC.

Radian Group Inc. has presented data to OFHEO on the default history of double-A and triple-A insurers.

"What we are finding is that the haircut differential is not supported by the research that we are doing," stated Frank Filipps, chairman and CEO at Radian.

What is at stake?

"If the rule goes into effect as written then there will be a significant difference in the way double-A mortgage insurers and triple-A mortgage insurers are going to be treated in OFHEO's capital rule and it could very well make it more attractive for the GSEs to use a triple-A mortgage insurance vs. a double-A," said Charles Titterton, a director at S&P.

Sources say that this considerable competitive advantage should be seen in light of the fact that GSE loans make up 60% to 70% of the mortgage insurance that the MI companies write.

The regulation may also spur consolidation within the private mortgage insurance sector and bring back more large-cap financial services providers similar to General Electric Capital Corp. and American International Group (AIG). GECC and AIG are the holding companies of the only two triple-A MI companies, General Electric Mortgage and United Guaranty.

Large-cap companies could create capital set-aside agreements with subsidiaries allowing the smaller firm to get a triple-A rating because it has sufficient access to capital, a source said.

On the other hand, there are other publicly traded MI companies that do not have access to low-cost capital. These firms have to raise capital through stock issuance or create debt.

Market players, however, are optimistic that the GSEs would try to alleviate the differential because of the desire to diversify their risk and not merely concentrate on two MI providers.

Meanwhile, the rule is set to be published in Federal Register in early September. A representative from OFHEO said possible changes to the rule would probably be made within a week or two of its publication.

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