Private mortgage insurers, having found the front door to many home finance transactions locked, are increasingly going around the back.
In recent years these companies have lost a significant chunk of business to piggyback second mortgages, a product that many lenders have encouraged homebuyers with little for a down payment to take in lieu of insurance. But with the housing market slowing and defaults rising, some insurers are trying to ply their expertise in managing residential credit risk by offering protection to fixed-income investors.
As a result, the lines between mortgage insurance and bond insurance — historically provided by two distinct groups of companies — are getting blurrier.
Last week, for instance, the Walnut Creek, Calif., mortgage insurer PMI Group Inc. created a subsidiary, PMI Guaranty Co., that will focus on writing mezzanine and “remote loss” coverage for securitized pools of mortgages — as opposed to the “first-loss” protection provided by standard mortgage insurance.
The unit, which has a AA debt rating from Fitch Inc., is being capitalized with $200 million.
PMI Group is also the largest shareholder of a bond insurer, Financial Guaranty Insurance Co.
Executives at PMI and another mortgage insurer, Radian Group Inc. of Philadelphia, have talked for some time about ways in which their core business is converging with bond insurance, often referred to as “financial guaranty.”
Dimitri Papatheoharis, the senior vice president of structured products at Radian’s capital markets unit, said that companies in the bond insurance business traditionally were not viewed as competitors to mortgage insurers, but that the landscape now allows any buyer of credit risk to compete head-to-head.
“We’re seeing mortgage insurers provide enhancement products for pools of mortgages” like loans with a loan-to-value ratio of over 80%, “so they’re getting some on the back end,” he said.
That is why it no longer sounds like sour grapes when someone like David Katkov, the president and chief operating officer of PMI’s U.S. mortgage insurance unit, asks: “What about all those people who did piggyback loans? Does everyone fully understand the risk of high-loan-to-value loans using something other than mortgage insurance? That’s the pertinent question, and one which regulators have asked.”
It isn’t lost on Mr. Katkov that many of the products ripe for the “enhanced” insurance offered by his company’s new subsidiary began life as piggyback loans.
“The whole marketplace has changed dramatically in terms of people’s willingness to expand on LTVs,” he said. “Our stock-in-trade is making credit decisions on high loan-to-value products. … The core competency of our company, and of mortgage insurance, is understanding the credit default risk on high-LTV loans.”
Hence, PMI’s new unit is “a natural extension of our franchise.”
Geoffrey M. Dunn, an analyst at Keefe, Bruyette & Woods Inc. in San Francisco, said the progression of mortgage insurers into the mortgage-backed securities market was a “natural and necessary evolution of their strategy.”
Traditional mortgage insurance “has fixed pricing that has not changed since the mid-1980s,” but in the newer business lines, the insurers “have some pricing power,” Mr. Dunn said.
Richard P. Smith, an analyst at Standard & Poor’s Corp., said mortgage insurers’ teaming up with their bond counterparts, which have expertise in securitizing pools of loans, is a trend still in its infancy.
“It’s a whole new idea for mortgage insurers, where they can syndicate the risk out,” Mr. Smith said. “They are experts at analyzing risk, but why keep it and have this big balance sheet? Let someone else who wants the risk take a piece of it. That’s the theme that’s playing out.”
Mortgage insurers are parceling out this risk at a time when hedge funds and institutional and foreign investors appear to have an insatiable appetite for yield as credit spreads tighten.
“As a general statement, investors seem to be willing to take risk in the mortgage capital markets,” Mr. Katkov said.
Larry Cordell, Radian’s chief economist, said there are “more vehicles now than ever before” for laying off credit risk. “The underlying collateral is still the same — mortgages. It’s just a different structure than primary mortgage insurance.”
For instance, Mr. Papatheoharis said Smart Homes, a reinsurance vehicle that Radian introduced in 2004, “transfers a portion of the risk we take on the front end to the capital markets to mitigate the undercertainty surrounding nontraditional mortgages.”
Notes sold by the reinsurer range from investment grade to high-yield.
“In terms of mitigating the uncertainty, our losses are capped,” Mr. Papatheoharis said. “When we write insurance on these nontraditional, more uncertain products, we try to mitigate our risk.”
Mr. Cordell also pointed out that risk is distributed more broadly today.
“If you go back to the 1970s, with the savings and loan debacle, you had mortgage loans concentrated in savings and loans and commercial banks, and it spread” to the government-sponsored enterprises, he said. “With the development of the nonagency market, you have a lot more borrowers, but also a lot more players taking on risk.”
According to Mr. Papatheoharis, the risk is distributed globally. “We have Japanese, Chinese, Middle Eastern investors that buy mortgage-backed securities, and to the extent that mortgages default and losses are high, the shocks are absorbed around the world,” he said.
So far that shock absorber has not been put to the test.
“The sellers of protections, the sellers of insurance, are still winning,” said Scott Kirby, the head of structured products at RiverSource Investments LLC, a fund-management unit of Ameriprise Financial Inc. “Even though people are waiting for a dramatic increase in default rates and delinquencies, we’re not really seeing it. Instead, they’re buying protection,” often in the form of credit default swaps, “because they’re worried about deterioration.”
But one group has been conspicuously cautious about taking mortgage risk — traditional bond insurers.
Carl Webb, a managing director at MBIA Inc., an Armonk, N.Y., company that guarantees municipal, asset-backed, and mortgage-backed securities, said the insurer has “limited exposure” to pay option adjustable-rate mortgages and other nontraditional products.
“It’s not a space that [bond] insurers have participated a lot in,” Mr. Webb said. “A lot of these deals are getting done without insurance, because investors want spread. They want yield.”
He repeated the often-heard warning that in a rising interest rate environment with housing prices falling, some borrowers will not have enough equity in their homes to hold off a default.
“It’s not a space we want to be in,” he said. “We just don’t want to take that bet.”
Mark Adelson, head of structured finance at Nomura Securities in New York, said the fact that bond insurers have stayed out of the market is a strong signal.
“The bond insurers have, in large measure, backed away from home equity asset-backed securities, because the issuers can do it cheaper,” he said. “When they start backing away from the sector because they’re not getting paid enough, I view that behavior as important information. If I see people running out of a building, I figure there’s something wrong.”
