Debt

Before extending a mortgage, lenderstypically require borrowers to make a sizable down payment to reduce both the risk of default on the loan and the amount they stand to loseif a foreclosure is necessary. Moreover, borrowers often pay significant closing costs. Together, the down payment and closing costs can be substantial relative to the borrower's savings, particularly for first-time homebuyers andhouseholds with lower incomes.

Mortgage lenders usually requirea down payment of at least 20 percent of the appraised value of a home. But they will accept smaller down payments if repayment of the mortgage is backed by a type of insurance, paid for by the borrower, knownas mortgage guarantee insurance. Mortgage insurance for low-down-payment loans isavailable from the federal government, primarily through programs administered by the Federal Housing Administration and the Department of Veterans Affairs, and from the private sector.

Insurance on a mortgagecomes into play when the homeowner defaults on the loan and the proceeds from the subsequent saleof the mortgaged property fail to cover the remaining debt plus the costs associated with the sale. In such a case, the mortgage insurer reimburses the lender for the shortfall, generally in full if the insurance is governmentalbut only up to certain limits if the insurance isprivate. Because insurers bear at least part of the risk of loss on home loans, they must carefully review the qualifications of prospective borrowers and the value of the collateral provided by the property being purchased.

Early forms ofmortgage insurance arose in the private sector around the turn of the century and developed until theonset of the Depression. The private mortgage insurance industry then collapsed, and its function was assumed by the federal government, which was the only source of mortgage insurance from the mid-1930s throughthe late 1950s. Today, mortgages backed by government insurance continue toplay a significant role in the home finance market, but mortgage insurance offered by the private mortgage insurance industry is also widely used by homebuyers and those refinancing their existing mortgages. Private mortgage insurance backed nearly 1.2million single-family home loans extended in 1993, representing about45 percent of all the insured mortgages granted that year (table 1).

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This article reviews some of thehistory of the mortgage insurance industry, outlines the way the mortgage insurance business is conducted, examines the financial implications for a borrower choosing between governmental and private mortgageinsurance, and discusses the disposition of recent applications submitted to private mortgage insurers. Little information has been available heretofore about the disposition of applications. This year, however, the private mortgage insurance industryreleased data on the disposition of the cases that private insurers acted on during the fourth quarter of 1993 andon the characteristics of the households in those cases (see box, "Data Disclosed by the Private Mortgage Insurance Industry"). The article summarizes the new information and drawssome comparisons with data on applications for government insurance and withmortgage applications generally.

PRIVATE MORTGAGE INSURANCE: A HISTORICAL PERSPECTIVE

The private mortgage insurance (PMI) industry can trace its origin to the early years of this century and the activities of title insurance companies in New York State.(1)The state legislature authorized the issuance of mortgage guarantee insurance in 1904, but the law permitted insurers to guarantee the payments only on mortgages owned by the institutionthat originated the loan. In1911, New York amended the law to permit mortgage insurers to purchase and resell mortgages. To enhance their ability to sell mortgages to investors, insurers guaranteed the property title as well as the loan.(2)

Untilthe Depression, rising real estate values made it possible for most mortgaged properties that were in defaultto be sold without a loss. This experience reinforced a widely held perception that insuring mortgages was a low-risk business. But the sharp decline in real estate values in the early yearsof the Depression--together with the low capitalization, questionable business practices, and weak regulation of the PMI industry--resulted inthe collapse of the industry.

Government efforts to revive the housing industry during the Depression led to the establishment by the Federal Housing Administration (FHA) of the Mutual Mortgage Insurance Fund toprovide mortgage insurance on FHA loans.(3) After World War II, the federal government's role in providing insurance on mortgages expanded with the creation in theVeterans Administration (VA) of a mortgage insurance program for veterans.(4)

FHA and VA home loaninsurance programs apply to a wide range of prospective homebuyers, but both programs have significant limitations. The FHA, for example, limits the size ofthe mortgages it will insure. The VA programs guarantee only a portion of the loanamount up to a congressionally established ceiling and are available only to veterans. In addition, the property and credit underwriting standards of both theFHA and VA exclude some prospective borrowers.

The PMI industry re-emerged in 1957 with the establishment of the Mortgage Guarantee Insurance Corporation (MGIC). Throughoutthe 1960s and 1970s, the industry generally flourished because rising home values limited the incidence of, and losses from, mortgage defaults. In this environment, companies tended to focus more on growth and less on credit quality. Inthe 1980s, as house price inflation slowed--and prices fell in some areas--homeowners who could not make their mortgage payments often were unable to resolve their problemsby selling their homes; instead, they defaulted on their mortgages. In addition, some PMIcompanies suffered substantial losses from fraud and inadequate risk diversification. Weak companies could not survive as independent entities, and industry consolidation followed. By the end of the 1980s, only half of the firms from the early1980s remained.

In the past few years, tighter underwriting standards and an end to an excessive reliance on continuing increasesin house prices to mitigate credit risk has brought the industry back to financial health.(5) Today, eight PMI companies are active (table 2).(6)The two largest, MGIC and GE Capital Mortgage Corporation, accounted for roughly 52 percent of the private mortgage insurance written and 62 percent of theoutstanding dollar amount of private mortgage insurance in force in 1993.

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Comparing the revenues and profitabilityof the PMI companies is complicated by differences in the products they offer and in the strategies they pursue. However,the ratio of premiums earned to total insurance in force is a measure of the average payment made by a borrower with PMI across different products and through time.Generally, companies that specialize in insuring mortgages with lower credit risks tend to have lower premiums than companies that insure products with a wider rangeof credit characteristics. Regardless of the premiums charged, the rates of return in 1993, as measured by the ratio of netincome to insurance in force, seem similar among the well-established firms.(7)

Overall, the re-emergence ofthe PMI industry has greatly expanded the opportunities for homebuyers to take out conventional mortgage loans with low down payments. PMI isnow available on a wide variety of loan programs and may be used for the purchase of homes with values far exceeding the FHA loan limits.

THE BUSINESS OF MORTGAGE INSURANCE

Lenders that originate and hold mortgage loans or financial instruments derived from such loans face two distincttypes of risk, interest rate risk and credit risk. Interest rate risk exists because market interest rates change over time. Whenmarket interest rates rise relative to the rate on an outstanding mortgage, the value of the mortgage falls. Lenders may protect themselves from interest rate risk invarious ways, but such measures increase costs.

Credit risk is the possibility that borrowers may fail to repay their loan obligations as scheduled. In the case of default, the lender is able to take actionagainst the borrower, for example by foreclosing on the property securing the loan. But foreclosure entails a varietyof costs--unpaid interest from the time of delinquency through foreclosure, legal expenses, costs to maintain the property, and expenses associated with the sale of the property--and therefore even if the asset has not lost value, the lender may incur a loss.