Sometimes it pays to be owned by a corporate behemoth. Just ask G.E. Capital Mortgage Insurance and United Guaranty Inc., two mortgage insurers that have faced difficulty the past few years holding onto their market share positions. That pressure may ease as the result of new capital rules for Fannie Mae and Freddie Mac.

For almost three years, both GECMI and UGI have known that pending risk-based capital rules for Fannie Mae and Freddie Mac likely would favor them because both are AAA rated firms, thanks in large part to the financial strength of their corporate parents.

In GECMI's case, that corporate parent is (obviously) General Electric. In UGI's case, the parent is insurance conglomerate American General. Both mortgage insurers had been rubbing their hands in glee in anticipation of the rules and what they could mean for their business prospects against the other five mortgage insurance companies.

Well, in July the Office of Federal Housing Enterprise Oversight (the regulator of Fannie and Freddie) finally released its risk-based capital rules and GECMI and UGI couldn't have been more delighted. The rules do, in fact, favor AAA-rated insurers by allowing the government-sponsored enterprises to hold lower reserves against loans insured by them. Under the new rules, Fannie and Freddie would have to put aside reserves of only 5% against loans insured by AAA-rated insurers, compared with 15% for AA-rated firms.

Take a $100,000 mortgage, of which $20,000 is insured. That means should the loan go bad, Fannie or Freddie would depend on the insurer for that $20,000. The chance of the GSE collecting that $20,000 depends on the credit worthiness of the insurer. The new guidelines say there is only a 5% risk that an AAA-rated insurer won't be able to pay, while there's a 15% chance that the AA-rated insurer wouldn't be able to pay. As a result, Fannie Mae or Freddie Mac would have to put aside reserves of only $5,000 on a $100,000 loan guaranteed by an AAA-rated insurer, but $15,000 for a similar loan insured by one that is AA-rated. That's a big difference.

Theoretically, this might lead Fannie and Freddie to shift more of their business to the AAA firms, leaving the others in the cold. Or, it might pay less for mortgages insured by AA-rated insurers to compensate for the higher reserve requirements.

Credit Ratings of Mortgage Insurers
Firm Name Rated
by S&P
Rated by
Moody's
Ranked by Size
of MI Business
G.E. Capital MI AAA Aaa 3
MGIC (*) AA+ Aa2 1
PMI Mortgage (*) AA+ Aa 2
Radian (*) AA Aa3 4
Republic MI AA Aa3 6
Triad (*) AA Aa3 7
United Guaranty AAA Aaa 5

Note: Firms listed alphabetically.
(*) Firm is publicly-traded under its own name.
Source: Keefe, Bruyette & Woods/Quarterly Data Report

Whether this will actually happen is anyone's guess, but the situation — to say the least — is a bit ironic: GECMI and UGI, which stand to benefit, have been the most outspoken (behind the scenes, of course) critics of Fannie and Freddie. They are charter members of FM Watch, a lobbying group formed to check what they consider to be the GSEs' expansionist tendencies. Said one former mortgage insurance official: "To say that Fannie and Freddie hate GE and UGI would be an understatement." David Graifman, an analyst at New York-based Keefe Bruyette & Woods, notes that the two mortgage insurers are, "probably the GSEs' least favorite."The new risk-based capital rule — which took the OFHEO [Office of Federal Housing Enterprise Oversight] eight years to design, groom and finally release — is considered pretty much a finished product.

Or is it?

Two years ago, the mortgage industry had a chance to comment on an early draft of the rule. Not surprisingly, GECMI and UGI urged OFHEO to keep the distinction between AAA and AA, while the other five mortgage insurers — MGIC, Milwaukee; PMI Group, San Francisco; Radian Group, Philadelphia; Republic Mortgage, Winston-Salem; and Triad Guaranty, Winston-Salem — urged parity between the two ratings. Fannie and Freddie also urged OFHEO to treat AAA and AA firms similarly. After all, the last thing in the world the GSEs want is to do more business with two of their biggest adversaries.

Because the risk-based capital rule is so new and complex, it's too early to tell how much it will hurt the five mortgage insurers with AA ratings from Standard & Poor's. It is also possible, though probably not likely, that Fannie and Freddie might successfully lobby their regulator not to distinguish between AAA and AA when it comes to the mortgage insurers.

When the rule was first released in mid-July, stocks of the four publicly traded mortgage insurers — MGIC, PMI, Radian and Triad — sold off a bit but then recovered. (Republic is owned by a larger insurer called Old Republic International.) The knee-jerk reaction was that everyone but GECMI and UGI were toast. But after taking a deep breath, analysts that follow the mortgage-insurer stocks, as well as the mortgage insurers themselves, realized the sky was hardly falling.

GECMI and UGI had little to say about the risk-based capital rule, even though they stand to benefit the most. The only thing that Charlie Reid, UGI's chairman, would say was: "I have nothing but great respect for my competitors."

Because the rule has a five-year phase-in period, few involved think anything negative will happen overnight. MGIC spokesman Jeff Cooper said, "We're not sure what ultimately will happen but we think we can get to AAA if necessary."

And KBW's Graifman said it's unlikely that the GSEs would shift all their business to the AAA-rated insurers because that itself would increase Fannie's and Freddie's risk by concentrating a huge percentage of their risk in only two companies.

Currently the mortgage insurers — as well as Fannie, Freddie, and others — are scrambling to analyze the computer modules and "source code" contained in the rule. Sanford C. Bernstein analyst Jonathan Gray, who covers both the mortgage insurers and the GSEs, says it is much too early to tell "if this is going to be a nuclear winter or whether it's insignificant."

One possibility, according to Gray and others, is that the five mortgage insurers can raise additional capital and eventually get to an AAA rating over five years. Another option is cutting some type of financial agreement with Fannie and Freddie to negate the rule whereby Fannie and Freddie take on more risk. In other words, GECMI and UGI shouldn't be popping the champagne quite yet.

Already Looking for Greener Pastures?

There are two other possibilities. Some of the mortgage insurers could merge, increasing their financial strength and thus entering AAA heaven. But there are potential anti-trust problems with the merger scenario, especially if the largest mortgage insurer (as measured by policies-in-force), MGIC, buys the No. 2, PMI. GECMI is ranked third, Radian fourth, and UGI fifth.

Another "out" for the mortgage insurers is to reduce the amount of business they do with Fannie Mae and Freddie Mac, which would alleviate, a bit, the worry over ratings. Frank Filipps, chairman and chief executive of Radian, said that if Radian can get to AAA, it might cost his company as little as two cents a share in annual earnings. But interestingly, and by design, Radian is trying to diversify its revenue stream away from being overly dependant on doing business with the GSEs.

"Five years ago 95% of our revenues came from conforming loans," said Filipps. "Today, it's only 66% and in three years it will be less than 50%." For all these reasons, Radian is far from losing any sleep over its future. Neither is PMI. PMI senior vice president Glenn Corso said the change might very well cost his company as little as five cents a share in earnings. "This makes life a little more complicated," said Mr. Corso, "but we have several options open to us. We're not hitting the panic button by any means."

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