Definition and Purpose
Mortgage default insurance (MI) is a specialized form of
credit insurance or guarantee that protects mortgage lenders and investors, as
beneficiaries, against loss by reason of borrower default on individual
mortgage loans—most often loans secured by individual housing units. MI is not
to be confused with mortgage life insurance, mortgage disability insurance, and
mortgage payment protection insurance, which protect borrowers, as
beneficiaries, by repaying some or all of their mortgage obligations in the event
of borrower death, disability, or other defined loss of income such as
unemployment. MI is also distinct from, though closely related to, “financial
guaranty insurance,” which protects investors against losses from defaults on
mortgage-backed securities (MBS) and bonds whose underlying collateral
typically includes individual mortgage loans.
The benefits of MI, depending on an individual country’s
needs and circumstances, can include:
- Increasing access to homeownership
financing for borrowers of limited means
-
Expanding lenders’ housing finance opportunity by reducing credit risks
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Helping to grow mortgage secondary and capital markets by attracting
risk-averse investors
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Stimulating economic activity through increased housing construction
-
Strengthening mortgage lending standards, standardization, and housing finance
sector stability
Beyond advancing homeownership or other primary housing
policy goals such as improving the quality of the housing stock, the main
underlying objective of MI is to protect and stabilize a country’s banking and
housing finance sector in the event of economic catastrophe, i.e., severe
recession or depression. MI risk is unusual in terms of its long-term cyclical
exposure and its dependence upon government economic policies.
Background and Evolution
Mortgage insurance and guarantee programs exist in more than
30 countries on all continents. Nearly two-thirds of all MI programs globally
are government-sponsored, although program sponsorship and structure vary greatly
and include privately capitalized firms, non-profit/NGOs, and a growing variety
of public-private partnership arrangements. Most programs today are relatively
small, with limited operating experience that has yet to include survival
through a period of significant economic stress and falling home values.
Mortgage insurance began over 100 years ago in the United
States as an adjunct to title insurance and was used to stimulate private
investor interest in purchasing “guaranteed mortgages” from mortgage companies.
All such guarantee programs failed with the advent of the Great Depression in
the early 1930s due to inadequate reserves, ineffective regulation, conflicts
of interest, and bad property appraisal practices.
Government-sponsored MI began in the United States in 1934
with the creation of the Federal Housing Administration and the Mutual Mortgage
Insurance Fund. The primary purpose was economic and financial stimulus, via
new housing construction. This unsubsidized FHA program has operated
successfully for over 75 years.
The 1950s and 1960s saw government-sponsored MI programs
initiated internationally, including in Canada, Australia, the Netherlands, the
Philippines, the Dominican Republic and Guatemala. During these two decades, private-sector
MI providers also began operating in the United States, Canada, Australia, and
the UK.
In the late 1980s, established MI programs in some developed
markets—both public and private—encountered severe economic stress, resulting
in risk and financial management and regulatory reforms. Beginning in the late
1990s many new public and private MI programs were established in Europe,
Africa, the Mideast, Latin America and Asia, in support of both primary lending
and emerging securitization markets. The recent credit crisis is testing the
staying-power of some countries’ MI programs.
Conditions and
Coverage
Key success factors for a country-based MI program include:
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Functional legal and regulatory system for title registration, contract
enforcement, financial institutions.
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Functional primary mortgage market, including loan underwriting, loan
administration, transaction costs, property
valuation
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Available information and data, including property sales prices, borrower credit,
mortgage performance
-
Government economic policies conducive to economic and financial sector
stability, personal savings
The most frequent use of MI is in situations in which borrowers
have not accumulated a sufficient cash deposit (down payment) to meet minimum
lender requirements; where lenders are reluctant to lend to informal sector
borrowers; and where capital market investors seek a cost-effective credit
enhancement, including for investment rating purposes. Many countries offer
lenders a regulatory inducement to secure MI coverage—particularly on high LTV
ratio loans—either in the form of a substantial reduction in bank risk-based
capital requirements, or via an outright regulatory mandate. Such regulatory
inducements are also considered to be a useful deterrent to “adverse selection
of risk” by insured lenders.
MI typically entails a contract between the lender and the
MI provider that defines the terms of coverage, its cost, and provisions for
claims recovery. Premiums charged to the lender are typically passed through to
the borrower. Premium rates may vary according clearly identifiable risk
classes, such as loan-to-value ratio (LTV), type of mortgage instrument, terms
of coverage, and other significant factors affecting risk of borrower default. Experience
based premium pricing models are driven by projections of both the frequency
and the severity of claims losses. MI premiums may be charged through from
lender to borrower as part of the interest rate, as an annual or monthly
add-on, or as an up-front lump sum that may or may not be added to the initial
principal balance of the loan.
Coverage may
include either 100 percent of the loan balance or some designated partial
(usually first loss) percent coverage. Likewise, MI coverage may extend for the
life of the insured loan or for some predetermined or lender-discretionary
shorter period. Some type of risk-sharing between insurer and lender is often
viewed as a useful deterrent to “moral hazard.” Coverage typically excludes
fraud.
MI programs underwrite credit risks originated by lenders in
several different ways, including:
-
individual loan document review
-
electronic document or data transfer, with automated approval based upon
predetermined criteria
-
underwriting approval authority delegated to the lender by contract, with
periodic reporting and audit
Public Role in MI
Public MI programs, even without direct subsidies, typically
include a social purpose, including some form of socioeconomic targeting. Such
program targeting often includes some combination of income, home price or
insured loan limits. Certain types of public subsidy programs, such as down
payment assistance, can be productively combined with public MI; however, the
public MI program itself should not provide subsidies that undermine its
capital reserves and increase exposure to the national treasury.
MI, including both private and public programs, needs
effective regulation, the most important element of which is a requirement to
build and hold segregated capital reserves that are adequate to pay all claims
in the event of economic catastrophe. In order to avoid the need for
government“bailouts” of public MI or
insolvency of private providers, MI programs should be required to operate
under sound business principles, including actuarially based pricing and
independent financial audits. Financial regulators that grant risk-based
capital relief to banks that use public or private MI protection need to know
that those insurance and guarantee programs will be amply capitalized to pay
claims over time and under stress.
Various forms of public-private MI partnerships have emerged
with some success over recent decades, including:
-
government-sponsored programs reinsured by private MI providers (e.g., Hong
Kong, United States)
-
private MI programs reinsured by a public MI provider (e.g., Canada)
-
public sponsorship with joint public-private governance structure (e.g., the Netherlands)
-
public and private financial support for special purpose NGO (e.g., South
Africa)
Related Products
Insurance and guaranty products that are variants or closely
related to MI, as discussed above, include:
- “timely payment” or “cash flow” guarantees on loans in default, payable to MBS
holders (e.g., the United States’ “Ginnie Mae” program)
-
“mortgage payment protection” (MPP) insurance covers borrower’s monthly
mortgage payments in the event of loss of income/employment
(e.g., in Mexico, the UK, other European countries)
-
“gap insurance” protects lenders against default-related losses during the
interim period between loan closing and proper title and mortgage
registration (e.g., in Poland)
-
“mortgage life insurance” pays off the mortgage debt in the event of death of
primary breadwinner. Such coverage is required
by lenders in many developing markets.
Key Cases to Watch
Canada
The
Canadian MI system has been increasingly recognized for its “best practices,” which
include:
-
statutory requirement for banks to use MI coverage on all high LTV loans
-
government backing of private MI providers in the event of insolvency
-
bank regulator use of MI underwriting limits to help prevent irresponsible
lending
While some smaller countries’ mortgage markets may not
generate sufficient lending volume to support multiple (i.e., both public and
private) MI providers, the Canadian system bears watching—including how well it
manages to maintain a “level playing field” for public and private MI programs.
United States
The dominant public MI program—the FHA—has had severe losses since 2007, which
has precipitously eroded its statutory capital from three times the required minimum
to about one quarter of the amount required. While premium rates have been
substantially increased and underwriting standards tightened, a weak,
post-subprime national market is looking to the FHA to assume an enormous
volume of new underwriting risk. Interested observers are closely watching to
see whether in 2010 FHA’s capital begins to recover or falls further below
required minimums.
The private MI industry, also fulfilling the role of
“economic shock absorber,” incurred over US$20 billion in losses during 2008-09, versus only $2.7 billion in 2005-06. Paying
out such massive claims has put the companies close to their regulatory capital
limits and constricted new-business-writing capacity. Some new private capital has
been raised, and recovery appears likely.
Of special note has been the successful introduction, by
both a state-based public guaranty fund and some private providers, of an ancillary
MI benefit directly for borrowers in the form of limited “mortgage payment
protection” (MPP) insurance in the event of involuntary loss of employment. For
no added premium, the standard MI coverage carried by lenders will now advance
up to (typically) six monthly payments to help the borrower avoid foreclosure
while he or she seeks another job or relocates.
Peru
Peru’s
Fondo MiVivienda guarantee fund demonstrated its ability to induce private
lenders to move “down-market” from serving only “A”-level borrowers to also
serve profitably “B” and “C+”-level borrowers. Can this MI success story be
further replicated in Peru or other national markets?
The Netherlands
Operational since 1995, the Netherlands’ Waarborgfonds Eigen Woningen (WEW) MI
program has succeeded in reducing lender risk-based capital by over 90 percent
and lowering borrowers’ mortgage interest rates by about 0.5 percent or more. Of
special note is this program’s premium rate—recently increased to a current one-time
charge of only 0.55 percent. This premium charge remains far lower than other
country-based MI programs, both public and private. To date, WEW has managed to
pay its claims and maintain reasonable reserves under its uniquely low rate
structure. Will the Netherlands’ financial and housing market stability, good
credit risk management, and remarkably strong borrower credit culture enable such
low MI charges to be sustained over the long run?
Lithuania
Established in 1998, the Lithuanian Mortgage Insurance Company (“UAB”) is 100
percent government-owned, but does not enjoy a sovereign guaranty of claims
payments. UAB operated successfully and grew until the credit crisis of
2007-08, when volume fell sharply and defaults and claims multiplied. Although
the government recently tripled UAB’s capital reserves to 25 million Euros, without
a backup sovereign guarantee private lenders remain wary of UAB’s claims-paying
capacity and are reluctant to purchase MI coverage on newly originated loans. Will
the program continue to fulfill its mission, with ample capital and/or a backup
government guarantee sufficient to restore banking sector confidence?
The Philippines
The government-sponsored and -backed Home Guaranty Corporation insured home
loans in the Philippines since the 1950s. However, in the 1980s it also began
insuring large-scale housing development loans whose risks ripened into massive
claims losses, exceeding the Fund’s capital and resulting in a call on the
government to make good on its backup guarantee. The national legislature
delayed action, and it took many years to clear the backlog of unpaid claims. Will
HGC’s program reforms provide the long-term sustainability and private-sector
confidence essential to its housing policy mission?
India, Singapore,
Thailand and Brazil
These four countries are at various stages of
developing or seriously exploring new country-based MI programs. India has
progressed furthest, with a program launch imminent; Singapore has adopted a
special MI regulation; the Government Housing Bank of Thailand is in the
advanced planning stages of developing an MI program; and Brazil is at an
earlier research/reconnaissance stage.
Links to Publications
European Mortgage Federation, Study of the Efficiency of Mortgage Collateral in the European Union, Brussels 2008