Mortgage Insurance

The Lenders Mortgage Insurance (LMI) or Mortgage Guaranty Insurance, also known as Private mortgage insurance (PMI) in the US, protects against lender or investor loss by reason of borrower default (credit failure) accompanied by insufficient recoverable value in the property securing the insured loan.[1] It is paid – directly or indirectly – by the borrower. It is not to be confused with the Mortgage Payment Protection Insurance which will match mortgage payments of the borrower in the event of job loss or ill health. In many markets where LMI is available government-controlled insurance agencies have a pivotal role.

The role of LMI in developed and less developed markets

In countries with a developed primary market, mortgage insurance operates, first and foremost, through permitting higher loan-to-value ratios, thus reducing the size of the down payment necessary in a typical loan situation.[2] Second, it may be used to allow an increase above the typical/normal ceiling for the (net) payment burden (the proportion of income that must be utilized to pay the mortgage). Yet, the mortgage insurance is not limited to the coverage of single mortgage loans. The portfolio insurance insures not a single loan but a pool of loans. It is used in order to increase the rating of securitised loan pools.
In countries with less developed markets, where banks with minor experience in mortgage lending charge high rates to compensate for the lack of information, the establishment of mortgage guaranty insurance is promoted with the argument, that it may help to lower interest rates.
Countries which have chosen to legislate specifically around mortgage insurance are the United States, Canada, Australia and Mexico.

LMI in the United States

Mortgage Insurance has its biggest stance in a national system of housing finance in the United States.[3] The insured loan portfolio had a value of 960 billion US dollars in the end of 2007. In the same year alone, this class of insurance newly insured loans amounting to 357 billion US dollars. LMI is available from the Federal Housing Administration, a government agency, and private insurance companies.
The insurance companies are subject to a tight regulation and supervision.[4] Key features of current regulations in the United States that are especially applicable to mortgage default insurers generally include the monocline restriction, the size of the required minimum capital related to total risk outstanding and specific conflict-of-interest-restrictions. Of special importance is the monocline restriction under which the mortgage insurers must be chartered to conduct this particular line of business separately from all other lines. The capital reserves of each mortgage insurer must increase proportionately with the total amount of contingent risk. In addition, regular contributions to a Contingency Reserve are mandatory. With the conflict-of-interest restrictions the mortgage insurers are either restricted in their ability to guarantee the repayment of loans originated by parent or affiliated lending institutions, if those are banks or other institutional mortgage lenders, or entirely not permitted to be owned or controlled by those.
In the United States, all mortgage loans exceeding a loan-to-value-ratio (LTV) of 80 percent must carry LMI.[5] Together with a reduction of the required risk-based regulatory capital for loans carrying qualified mortgage insurance this regulation is aimed at the prevention of adverse selection, which would almost necessarily occur if lenders could choose, case by case, which loans to insure and which loans to “self-insure”. However, “piggyback” mortgages offer a possibility to avoid LMI. A piggyback mortgage is a second loan that closes simultaneously with the first. In that way the LTV ratio of a first position mortgage is lowered to under 80 per cent or less so that the need for LMI is eliminated. Of course, both loans taken together have a LTV higher than 80 per cent, often even exceeding 100 per cent.  Since the beginning of the subprime mortgage and financial crisis it is almost impossible for homebuyers to get piggyback mortgages.
The annual cost of LMI for the insurance coverage varies and is expressed in terms of the total loan value in most cases, depending on the loan term, loan type, proportion of the total home value that is financed, the coverage amount, and the frequency of premium payments.[6] There are three basic types in which the LMI is payable: the Borrower-Paid LMI (BLMI), the Lender-Paid LMI (LLMI) and the One Time Financed LMI.
The BLMI is paid for by the borrower who usually pays a monthly premium for the insurance coverage. This remains in effect normally until the loan balance reaches 78% of the home’s value at the time the loan was provided. It is the most common form used.
The LLMI is paid for by the lender; yet, the cost of the premium is built into the interest rate charged on the loan. Until recently, LMI was not a tax-deductible expense (and is currently only for certain cases), but as the interest payment on mortgages is tax-deductible, this method offers tax advantages for the borrower. This advantage is thwarted, however, by the fact that this form does not allow the LMI to drop off at 78% of the home’s value.
The One Time Financed LMI is paid for by the borrower in one lump sum, covering the entire life of the loan, while allowing this premium to be financed into the mortgage loan. This option offers as well great tax advantages, yet, like the LLMI, this type of LMI does not drop off at any time during the loan.

Critical Acclaim

The core competency of mortgage insurance is the diversification of risk.[7] The actuarial risk of the insured loans is spread geographically (across markets), across time and across different loan-to-value-ratios. The extent of diversification of risk that mortgage insurance offers cannot be replicated by internal risk diversification of even the biggest banks. Together with the imposition of a consistent third party underwriting review standard on all loans insured, a well structured mortgage insurance program can reduce the risk premium that is charged for the credit risk.
LMI can also contribute to borrowers’ ability to afford home purchases by permitting a higher loan-to-value ratio. This opens the market for housing finance to people with relatively low equity thus potentially increasing the rate of home owners in the society.
However, by possibly encouraging higher loan-to-value-ratios, LMI is likely to increase the risk of default, neutralising the advantages of improved risk diversification at least partially. Financing home purchases without or with a low down-payment is also possible in housing finance systems without (a prominent role) of LMI. Yet, this option is restricted to customers with an excellent creditworthiness and ability to pay. As mortgage insurance companies most likely do not restrict their activities to this narrow customer group, the availability of LMI bears the inherent risk that money is lent to people who cannot afford it. Financing without equity plus the costs of LMI incurs a heavy financial burden and high risk on private households.

LMI in times of financial and real estate crises

The critical risk for LMI is “catastrophic” as in the case of economic depression at the regional or national level widespread foreclosures may occur.[8] When the catastrophic risk becomes effective the mortgage insurance companies have to stand most likely losses for several years in a row – the periodical litmus test for the sector.
During the boom years in the United States, LMI did insure some risky loans that would not have been acceptable to them earlier, but for the most part they stuck to their underwriting standards.[9] As a result, their market share declined with the emergence of “piggybacks”. In the beginning of the current crisis, the mortgage insurance companies took on a supportive role for the market by significantly expanding their insured loan portfolio when the supply of “piggyback loans” collapsed. This has in turn increased the exposition of the insurance companies vis-à-vis high-risk credit products. Necessarily, the induced cutback on this risk negatively impacts the supply of mortgages. However, without LMI mortgages with loan-to-value-ratios above 80 percent would be most likely not available at all.
Nevertheless, LMIs have been badly hurt; losses have been eroding their capital and reserves, and their stock prices have tumbled badly.[10] Fitch Rating assumes that some insurance companies will need capital infusions to not fall below the regulatory required minimum capital. Yet, so far, the industry is doing exactly what it was set up to do, which is to cover losses to lenders during a period of stress, out of reserves that they accumulated during periods of prosperity.
In the 1980ies, as well a time of crisis, the LMIs had proven already their stabilising function, by fulfilling the claims of the insured worth 5 billion US Dollar.[11]
Financial experts believe that though the mortgage insurers were not conservative enough in their underwriting policy in the United States prior to the crises, they have been of all credit risk transfer instruments the one which comes off best in respect to a constant credit supply. Contrary to LMI, the instrument of securitisation and the quasi-insurance products, the credit default swaps, have shown a severe proneness to crisis.     


 [1]  Cp. Struyk, Raymond/ Whiteley, Douglas E.: Mortgage Default Insurance in the U.S.: Implications for Russia, Washington 2002, S. 3. In the following: Struyk/ Whiteley, Mortgage Insurance.

 [2] In the following cp. ibid, p. 5.

 [3] In the following cp.: Kofner, Stefan: Die Hypotheken- und Finanzmarktkrise, Frankfurt/Main 2008, p. 97. In the following: Kofner, Krise.

 [4] In the following cp.: Struyk/ Whiteley, Mortgage Insurance, pp. 5-7.

 [5] In the following cp. ibid, p. 7.

 [6] In the following cp.: Ed Nailor Mortgage Team: PMI in a Nutshell (IAN), s.l. 2008. [http://www.ednailor.com/2008/01/17/private-mortgage-insurance-in-a-nutshell/]

 [7] In the following cp.: Kofner, Krise, p. 102-103.

 [8] In the following cp.: Struyk/ Whiteley, Mortgage Insurance, p. 3.

 [9] In the following cp.: Kofner, Krise, pp. 104-106.

[10] In the following cp. ibid, pp. 107-109.

[11] Cp. ibid, pp. 101-102.

 

 

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