Backstopping the Mortgage Market
The reinsurance industry sees plenty of opportunity in the $1.7 trillion mortgage market, taking on risk from private mortgage insurers and directly from Fannie Mae and Freddie Mac.
PMIs Ceding Risk: Last year, six private mortgage insurers ceded about 15% of their premiums to reinsurers, a practice that was virtually unknown prior to the global financial crisis a decade ago.
Reinsurers Dive Into Mortgages: Under Fannie Mae’s and Freddie Mac’s credit risk transfer programs, reinsurers have taken on $17 billion of mortgage exposure over the past five years.
Turning to Capital Markets: Arch Capital and other players now regularly turn to capital markets, selling insurance-linked securities that act as mortgage reinsurance.
The reinsurance industry is playing a major role in the transformation of housing finance, plunging into a market that barely existed prior to the global financial crisis a decade ago. Dozens of reinsurers have taken advantage of new opportunities to take on mortgage credit risk, business that has proven lucrative at a time when more traditional lines have been lackluster.
Reinsurers participate in housing finance in several ways, including taking on credit risk directly from private mortgage insurers and by participating in credit-risk transfer programs run by Fannie Mae and Freddie Mac, the two government-sponsored enterprises that have been operating under federal conservatorship since 2008. More than 30 reinsurers are involved, including Renaissance, Everest, Third Point, Partner and Transatlantic.
Arch Capital Group, which operates the nation's largest private mortgage insurer, has been especially aggressive, raising $1.3 billion from capital markets for mortgage reinsurance and launching a controversial pilot project with Freddie Mac that offers a new opportunity for reinsurers to get involved at the front end of mortgage lending.
“Reinsurers are a very key component in terms of providing institutional-based capital,” said Gina Subramonian Healy, vice president for credit risk transfer at Freddie Mac. “We're looking at long-term operating partners with a strong track record and well-diversified balance sheet. And that's a real important element in providing resiliency and liquidity to the mortgage market.”
Prior to the global financial crisis of 2007-09, reinsurance was hardly known in the mortgage industry. Most conventional mortgage loans were repurchased and held by Fannie and Freddie. Borrowers who could not come up with a 20% down payment were required to buy private mortgage insurance, but that was pretty much all the protection the GSEs had against the biggest financial catastrophe since the Great Depression. Today the risk is spread far more widely, with the two GSEs, the mortgage insurance industry, reinsurers and, increasingly, capital investors all playing a role.
“U.S. mortgage insurance exposures, which generally have been an obscure product line for reinsurance companies, have now become very pronounced in reinsurers' lines of business,” according to a Best's Special Report, The Emergence of U.S. Mortgage Exposure in Reinsurance.
“Each company probably has its own specific motivation, but there are several factors playing a role—the diversification benefit of adding mortgage risk to a reinsurer's risk profile, the perceived generous premiums compared with premiums in the property/catastrophe business [and] stricter mortgage origination standards since the credit crisis,” said Emmanuel Modu, managing director, insurance-linked securities for A.M. Best. He also cited a new standard promulgated by the GSEs, Private Mortgage Insurer Eligibility Requirements, which increased capital requirements for private mortgage insurers and created an opening for reinsurers.
An A.M. Best webinar, Evaluating Mortgage Risk in Reinsurance, in February examined how A.M. Best analysts evaluate mortgage risk covered by reinsurers based on a new criteria procedure “Evaluating Mortgage Insurance.”
Andrew Rippert, Arch Capital
We look at that and we say, how can we design a better mortgage insurance business model that makes us a more reliably consistent counterparty so that we’re there through the ups and downs of the cycle to make good on the things that we signed up to insure?
A Growing Opportunity
Reinsurers began to get involved in the market several years after the crisis as mortgage insurance companies that survived started to cede some risk in the United States and other countries, including Australia. (Prior to the housing industry crash, there were 11 private mortgage insurance companies operating in the U.S., but with bankruptcies and consolidations, only six remain in business today.) In 2017, about 15% of gross premiums written by PMIs was ceded to nonaffiliated reinsurers, according to A.M. Best.
“The mortgage insurers have realized that keeping all of that risk on their books is difficult,” said Andrew Davidson, president of Andrew Davidson & Co. and an expert in mortgage-backed securities. “As a monoline, they're not in a position to bear the sort of extreme risk of a financial crisis, particularly a housing crisis, and by ceding some of this risk they can really concentrate on what they're good at—sourcing the business [and] underwriting the business.”
The opportunity for reinsurers grew in 2013 when Fannie and Freddie, under the direction of the Federal Housing Finance Agency, launched so-called credit risk transfer (CRT) programs to privatize some of their risk and insulate taxpayers against a potential repeat of the 2008 disaster. Under Freddie's Agency Credit Insurance Structure (ACIS) and Fannie's Credit Insurance Risk Transfer (CIRT) programs, some $17.2 billion of original mortgage exposure has been transferred to the reinsurance industry (as of June 2018), with at least 30 reinsurers participating.
In addition to the reinsurance deals, Fannie and Freddie have been transferring credit risk directly to capital markets through unsecured debt notes in programs known as STACR and CAS, which have attracted more than 220 institutional investors including hedge funds, money managers and insurers. All told, the two GSEs have obtained credit risk coverage on more than $2.2 trillion worth of mortgage loans.
“We did some, but certainly not enough, credit risk transfer before the crisis,” said Rob Schaefer, vice president for credit enhancement strategy and management at Fannie Mae. “It's in our DNA now.” He noted that the market for mortgage-backed securities took “a couple of decades” to reach $2.2 trillion in loans sold, a milestone the GSEs have reached in just five years with their CRT programs.
Initial CRT deals were based on a pool of loans freshly added to GSE portfolios, but more recently Fannie and Freddie have created front-end deals, in which reinsurers commit to taking on credit risk for loans up to two years in advance, within specified guidelines. Pricing on the reinsurance is adjusted based on the exact composition of the loan portfolios.
“There is a lot of demand given the size of the U.S. housing market,” said Jeff Krohn, managing director of Guy Carpenter's mortgage credit practice. But even with more than 45 reinsurers participating in the mortgage credit market globally, “there's still room for more reinsurers in the space,” he said. About $1.7 trillion in mortgages was originated in 2017, according to the Mortgage Bankers Association.
Julie Rodriguez Aldort, Butler Rubin Saltarelli and Boyd
To me, the fact that reinsurance is involved seems like it would ultimately be a good thing, because you’ve got more people to shoulder the burden.
An Active Participant
No reinsurance company has been more active in the post-crisis mortgage business than Arch Capital. Organized in 2001 as a specialty property and casualty insurer and reinsurer, Arch established a mortgage insurance business in Europe after the global financial crisis and then did two reinsurance transactions with mortgage insurers in 2011 and 2012, including one in Australia.
Shortly after that, Arch bought the remnants of bankrupt mortgage insurer PMI Group and began operating as a U.S. mortgage insurer in 2014. More recently Arch bought AIG's United Guaranty mortgage insurance unit in a $3.4 billion deal, vaulting Arch into position as the nation's largest private mortgage insurance provider.
At the same time, Arch began participating in the CRT programs and turning to the capital markets for additional funding. Since 2015, Arch and United Guaranty have closed four deals—most recently in March—raising a total of $1.3 billion in reinsurance for home loans by issuing insurance-linked securities in the so-called Bellemeade transactions, special-purpose vehicles similar in structure to catastrophe bonds. Arch expects to continue coming to market with similar ILS deals twice a year.
For reinsurers, the economics of the mortgage business are attractive, offering investors an opportunity to earn a 15% to 20% return on capital, according to Guy Carpenter.
“It's additional premium, and the risks associated with that premium are not highly correlated with the other risks that the reinsurers are typically taking on,” said Davidson.
Krohn noted that both Fannie and Freddie have published their underlying mortgage data sets, allowing reinsurers to analyze historical performance with proprietary and third-party models in a “very granular way.”
“There are a number of ways for them to get comfortable with the risk and make the case to management that it's something that they should be writing relative to other lines of business like property cat, where rates have been pressured for years,” Krohn said.
In March, Arch roiled the industry by partnering with Freddie Mac on a pilot project known as Integrated Mortgage Insurance, or IMAGIN, in which Arch and a pool of five other reinsurers agree in advance to provide mortgage insurance for high LTV loans that meet certain criteria—putting them in a first-loss position without the need for private mortgage insurance. A new Arch subsidiary, Arch Mortgage Risk Transfer, is acting as intermediary between Freddie Mac and the reinsurers. Neither the precise criteria for the loans nor the names of the other reinsurers have been disclosed publicly.
A trade group representing the mortgage insurance industry (with the exception of Arch), complained about a “lack of transparency” in the program.
“We believe that the IMAGIN pilot violates the spirit of the congressional charter for Freddie Mac and represents a significant blurring of the bright line separation between primary market and secondary market activities,” said Lindsey Johnson, president and executive director of the trade group, U.S. Mortgage Insurers. She said the program puts taxpayers at greater risk “by circumventing the high capital and regulatory standards that MIs are held to today.”
Andrew Rippert, CEO of Arch Capital's global mortgage group, defended the IMAGIN pilot, which will run for an initial 12 months, or until $2.5 billion in loans are covered.
“It took us several years to develop this program, and we went through a fairly rigorous review to make sure it's charter compliant and to make sure it's compliant with state regulations,” he said. “In addition, all the reinsurers participating on this panel have gone through extensive review by Freddie Mac.”
Healy, of Freddie Mac, said the program was approved by its regulator and clearly allowed by its charter.
“It's really about bringing in greater efficiencies and competition that overall lowers the cost for the borrowers and helps level the playing field for lenders,” she said. “This is all about innovation. We're bringing in new sources of private capital to support high LTV lending through all cycles.”
Johnson noted that private mortgage insurers are required to adhere to Private Mortgage Insurer Eligibility Requirements, or PMIERS, a set of financial standards imposed by Fannie and Freddie on the industry post-crisis. But Rippert said reinsurers post assets in trust against their obligations, effectively meeting similar standards. Rippert added that reinsurers tend to be highly diversified multiline carriers accustomed to dealing with catastrophic losses, while mortgage insurers are generally monolines that are 100% correlated to volatility in the housing market.
That said, he added: “We're the biggest mortgage insurance company in the U.S., and we're not going to just willingly shoot ourselves in the foot and destroy our own business.”
He noted that several mortgage insurers did not survive the latest housing industry downturn. “We look at that and we say, how can we design a better mortgage insurance business model that makes us a more reliably consistent counterparty so that we're there through the ups and downs of the cycle to make good on the things that we signed up to insure?”
Arch is not the only mortgage insurance company to turn to capital markets for reinsurance. In March, Essent Guaranty completed a $424.4 million deal with Radnor Re 2018-1, a newly formed special purpose insurer, for excess of loss reinsurance coverage on mortgage insurance policies written in 2017. Essent Group CEO Mark Casale said in May that such deals would become a “standard part” of its capital and credit management. NMI Holdings, another private mortgage insurer, did a similar, smaller deal last year.
Jeff Krohn, Guy Carpenter
“There are a number of ways for them to get comfortable with the risk and make the case to management that it’s something that they should be writing relative to other lines of business like property cat, where rates have been pressured for years.
While the future of housing finance is up in the air due to the unsettled status of Fannie and Freddie, industry executives say the diversification of risk should protect the GSEs and the mortgage insurers against a future housing bust, should one occur.
“To me, the fact that reinsurance is involved seems like it would ultimately be a good thing, because you've got more people to shoulder the burden,” said Julie Rodriguez Aldort, a partner at the Chicago-based law firm Butler Rubin Saltarelli & Boyd with a practice in reinsurance and mortgage insurance.
The mortgage insurance industry, she noted, “paid a steep price” in the housing crisis. “We all learned a big lesson from that,” she said. “It looks like for the most part the companies are recovering and being creative about how to be better prepared the next time around.”
“The most important change is there is a regulatory framework in place,” said Susan Wachter, professor of real estate and finance at the University of Pennsylvania's Wharton School. “So there is less likelihood that there will be a race-to-the-bottom competition among the insurance firms.”
She noted that the worst excesses of the housing crisis have been eliminated from the marketplace, including aggressive, poorly priced instruments such as option-ARM mortgages, interest-only mortgages and Alt-A mortgages sold without any documentation of ability to repay.
“That's not to say we can't have a crisis again,” Wachter added, noting that the housing bubble inflated and burst in a very short time frame a decade ago—just a few years. “Real estate and housing are vulnerable to bubbles,” she said. “This is not a market where we can say, 'oh, we had a one-off problem in 2004-07 and that won't happen again.' We have to have information, and it has to be monitored continuously.”
Several proposals are circulating for how to reform housing finance after a decade of conservatorship for Fannie and Freddie. Ironically, the system seems to be working well enough that the urgency for reform has faded, especially with midterm elections approaching.
“My personal view is if you look at the GSEs, their system is functioning extremely well currently,” said Davidson. “It's just not clear that there is an alternative that functions better than what we have currently. … Why change a system that's basically working to something that might look good on paper but bears the risk that it won't actually function as well?”
Krohn, of Guy Carpenter, agreed, saying the CRT program, improvements to the loan production process and the influx of capital have de-risked U.S. taxpayers—not completely, but significantly. “The world is a safer place, and I think the GSEs and the mortgage insurers are all in a much better position to weather the future peaks and valleys that the housing market may encounter,” he said.