Mortgage insurers are headed for a downturn, Moody's Investors Service warns.

Increased competition may lead the insurers to consolidate, the New York bond rating agency said in a report released last week.

"We're at the top of the cycle for the industry," said Moody's analyst Stanislas Rouyer.

Moody's is comfortable with its investment-grade ratings for the seven mortgage insurers it rates, Mr. Rouyer said. But because of increased competition, profitability is coming under pressure, he said. He expects to see some companies diversify into other businesses, leave the market-or merge.

"Wall Street is probably looking at the industry very carefully," Mr. Rouyer said. "It's more likely to be in a consolidation mode than in an expansion mode."

Not all mergers would work, he said. Insurers with overlapping clienteles would not combine well, because many lenders prefer to maintain relationships with two or three insurers. But teaming a company that deals mostly with small originators and brokers with one that does business with the bigger ones would make sense, Mr. Rouyer said.

Some insurers may choose to stop insuring new loans, enjoy the returns on their portfolios until the loans pay off, and then wind down, Mr. Rouyer said, though "I don't think anybody's considering it now."

Part of the pressure comes from consolidation in mortgage banking. "Instead of dealing with small, fragmented originators," he said, insurers "are starting to deal with bigger, more focused lenders." This forces the insurers to make more concessions to their customers, he said.

Fannie Mae and Freddie Mac requires insurance on mortgages with down payments of less than 20%. However, alternatives to insurance are emerging, Moody's noted.

One is the piggyback mortgage, which combines a 10%-down first mortgage covering 90% of a home's price with a second mortgage for the remaining 10%.

Earlier this year Freddie Mac's Moderns deal showed how the government- sponsored agencies can insure some of their credit risk exposure without mortgage insurers' help. Moderns securitized the credit risk of a loan portfolio, transferring the exposure to investors.

The capital markets may not always have the appetite for such risks, Mr. Rouyer said; since the global market debacle of late August, investors have grown risk-averse. Still, "the trend toward securitization of risk is hard to reverse."

Most recently, Freddie Mac sparked controversy with an amendment to a congressional bill that would let the agency self-insure low-down payment loans. Though the provision was killed, the attempt was "a clear illustration of the trend," Mr. Rouyer said.

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