Emmanuel Modu, AM Best
The unprecedented nature of the COVID-19 pandemic and its economic impact make it very difficult for re/insurers to measure the risk in their mortgage portfolios, say AM Best’s Emmanuel Modu and Michelle Li.
On April 7, 2020, AM Best revised its outlook for the private mortgage insurance segment from stable to negative, owing to the expected increase in losses on mortgages due to higher unemployment and significant contraction in gross domestic product.
An additional analysis was performed on the impact of the COVID-19 pandemic on the mortgage-related activities of the reinsurance industry, namely the reinsurance programmes of Fannie Mae and Freddie Mac (the US government-sponsored enterprises [GSEs]), and the reinsurance programmes of private mortgage insurers.
Factors that affect the primary mortgage market also influence the broad secondary markets such as mortgage-backed securities and mortgage reinsurance.
“There are challenges to determining how an expected increase in the uptake of mortgage forbearance will necessarily lead to higher delinquency rates and eventually to claims.”
Over the past five years, reinsurers have been assuming incrementally more US mortgage risk from two main sources: GSEs and private mortgage insurers. The GSEs transfer mortgage credit risk to the reinsurance market through their reinsurance credit risk transfer (CRT) programmes: Agency Credit Insurance Structure (ACIS), sponsored by Freddie Mac, and Credit Insurance Risk Transfer (CIRT), sponsored by Fannie Mae.
The six US private mortgage insurers transfer mortgage risk to the reinsurance market through quota share or excess of loss transactions. For all practical purposes, the fortunes of the private mortgage insurers are tied to the GSEs because they provide insurance on mortgages that are purchased by the GSEs, which effectively set capital standards and other requirements to which the private mortgage insurers must adhere.
Various factors drove the increased involvement by reinsurers in the mortgage space:
- The mandate by the Federal Housing Finance Agency (FHFA), in its role as conservator of the GSEs, requiring the GSEs to cede a substantial portion of the credit risk of their pooled mortgages to the private sector;
- The need for the private mortgage insurers to meet risk-based capital requirements imposed by the GSEs through the Private Mortgage Insurer Eligibility Requirements (PMIERs);
- The strategy of the private mortgage insurers to “originate, manage, and distribute” their risk through the use of traditional reinsurance and reinsurance from the capital markets;
- Prolonged soft market conditions experienced by most lines of business in the property/casualty reinsurance sector, driven by competition between reinsurers and competition from the alternative capital sector; and
- Augmented knowledge of mortgage risks by large diversified reinsurers due to their move to hire in-house mortgage expertise and their ability to make use of extensive mortgage performance data released by the GSEs since the 2008 credit crisis.
Obstacles to estimating the impact of COVID-19
The unprecedented nature of the COVID-19 pandemic and its economic impact have made it extremely difficult for re/insurers that take on mortgage-related risk to estimate ultimate claims. Our ongoing conversations with mortgage industry participants suggest that it may still be too early to estimate their exposures. Not enough time has elapsed in the servicer reporting cycle to gauge the full effect of the pandemic-induced economic hard stop.
Private mortgage insurers and the two GSEs that have released their first quarter 2020 financials have reported that their delinquency rates have not materially increased yet from the prior quarter. An analysis by Inside Mortgage Finance, however, indicates that the increase in GSE-related 30-day delinquencies in April could be about 3.5 to 4 times the level in March.
In addition, there are challenges to determining how an expected increase in the uptake of mortgage forbearance will necessarily lead to higher delinquency rates and eventually to claims.
The GSEs have offered forbearance assistance to borrowers with liquidity issues arising from either their being furloughed or losing their jobs due to the economic fallout of the pandemic. The forbearance period can last up to one year, after which the lender could offer further loan modifications or deferral options to borrowers. This affects reinsurers because virtually all the mortgage business they currently reinsure in the US is related to mortgages purchased by the GSEs.
“The GSEs may have to make some accommodations for the heightened delinquency notifications that will inevitably accompany the pandemic-induced forbearance and modification programmes.”
A Mortgage Bankers Association (MBA) survey indicated that forbearance of all mortgage loans as of May 10, 2020 was approximately 8.16 percent, a huge jump compared to 0.25 percent during the week of March 2, 2020. The forbearance figure is expected to further increase as evidenced by the fact that Fannie Mae has assumed that the uptake could be 15 percent, depending on the severity of the economic conditions.
There is significant uncertainty in the final forbearance number because some servicers are reporting a surprising number of forbearance requests among those who are actually current on their mortgage payments. This suggests that some borrowers are taking preemptive measures to increase their liquidity positions. Nevertheless, mortgage market participants are unsure about the cure rate of loans in forbearance or what portion of these loans will result in claims.
Delinquencies are expected to dramatically increase in the second quarter of 2020 due to forbearance and job loss. While forbearance, loan modifications, and provisions of the Coronavirus Aid, Relief, and Economic Security Act (CARES) Act will help homeowners weather the effect of the pandemic, it is likely that the cohorts of borrowers that take advantage of such forbearance programmes will produce higher losses.
In addition, the sheer size of the cumulative jobless claims (resulting in an unemployment rate of about 15 percent, second only to the Great Depression-era unemployment rate) since the effect of the pandemic became apparent points to higher losses associated with mortgages, although some of the unemployed may get their jobs back at the end of this crisis.
This leaves private mortgage insurers and traditional reinsurers alike trying to find ways to estimate the loss and loss adjustment expense (LAE) reserves they should record on their mortgage exposures. With no exact historical precedence that duplicates a widespread government-mandated economic hard stop and a disaster designation by the Federal Emergency Management Agency (FEMA) in all 50 states, private mortgage insurers have resorted to making their best estimate of losses based on some scenarios, including:
- A repeat of the 2008 credit crisis;
- Moody’s Analytics economic scenarios;
- Comprehensive capital analysis and review adverse loss scenarios;
- Claims associated with prior severe storms in FEMA-declared disaster areas;
- Use of third-party models with built-in stresses on unemployment, housing price decline, and recovery periods; and
- Other disaster scenarios that may relate to a combination of unemployment, housing prices, and economic recoveries.
Reinsurance of GSE mortgage risk
To comply with the FHFA’s mandate of de-risking their portfolios, the GSEs transferred single-family mortgage credit risk on $709 billion of unpaid principal balance with a total risk-in-force of $24 billion in 2019 through three structures:
- Securities issuance: these securities are issued by Connecticut Avenue Securities (CAS) by Fannie Mae and Structured Agency Credit Risk (STACR) by Freddie Mac.
- Reinsurance: this involves traditional reinsurers providing coverage for the ACIS and CIRT transactions by Freddie Mac and Fannie Mae, respectively.
- Lender risk-sharing: this involves a seller of loans to the GSEs taking back, through a contractual arrangement, a portion of the associated credit risk.
Securities issuance constituted about 60 percent of mortgage credit risk transfer in 2019, with reinsurance at 21 percent and lender risk sharing programmes at 19 percent. Therefore, the reinsurance credit risk transfer is an important tool available to the GSEs for managing mortgage credit risk.
In fact, it provides the GSEs with yet another outlet for shedding credit risk in order to meet their diversification goals, and gives them some flexibility to move between markets if one leg of their de-risking triumvirate becomes dislocated due to market conditions.
From 2013 through the first quarter of 2020, the GSEs transferred a total of approximately $26.5 billion of exposure limit to the reinsurance industry (Figure 1).
Effect of current economic conditions
In 2019, credit risk transfer to the traditional reinsurance market was $4.8 billion and so far in 2020, it stands at $2.1 billion. It is unlikely that all three legs of the CRT structures will continue at their normal pace given market conditions.
In Freddie Mac’s first quarter 2020 10-Q filing with the SEC, the GSE stated the following: “While CRT remains a critical component of our business strategy and we intend to continue to pursue our existing CRT strategies, there may not be sufficient investor demand for single-family CRT transactions at acceptable prices for the foreseeable future, and it is uncertain if there will be adequate demand for them over the longer term based on the potential impacts of the pandemic on mortgage performance.”
Fannie Mae made a similar statement in its first quarter 2020 10-Q filing with the SEC: “In recent weeks, we have been significantly restricted in our ability to enter into credit risk transfer transactions due to detrimental market conditions as a result of the COVID-19 outbreak. We do not anticipate being able to enter into new credit risk transfer transactions until market conditions improve. Credit risk transfer transactions are an important tool that we use to manage the credit risk of our loan acquisitions.”
For the reinsurance CRT structures to be fully resuscitated, the spreads on the STACR/CAS deals would probably have to narrow considerably because the economics of the securities in these transactions impact the ACIS/CIRT reinsurance transactions.
In addition, the GSEs may have to make some accommodations for the heightened delinquency notifications that will inevitably accompany the pandemic-induced forbearance and modification programmes.
To understand how the economic condition brought on by the COVID-19 pandemic will affect the current outstanding ACIS/CIRT transactions, it’s important to first understand their general structure.
Broadly speaking, the pool of mortgages for which the GSEs seek credit protection consists of specified origination dates, original loan-to-value ratios, mortgage types and origination terms. The coverage period for the reinsurance associated with the pools is normally between 10 and 12.5 years.
Each ACIS transaction offered by Freddie Mac normally consists of multiple excess of loss layers while each CIRT transaction offered by Fannie Mae consists of just one layer.
Figure 2 is an illustration of the structure of ACIS 2017-2, a Freddie Mac transaction, while Figure 3 is an illustration of the structure of CIRT 2017-3, a Fannie Mae transaction. We note that the ACIS/CIRT transactions are partially collateralised based on the credit rating of the reinsurers providing the protection.
Over the past few years, AM Best has been determining specific net capital charges associated with ACIS/CIRT transactions, as well as mortgage-related reinsurance agreements. The net capital charges are then included in the reserves risk calculations for the reinsurers engaged in the transactions. The process for determining the net capital charge and incorporating such risks into reinsurers’ credit evaluations are fully described in AM Best’s criteria procedure, “Evaluating Mortgage Insurance”.
The mortgage credit losses since the advent of the ACIS/CIRT transactions have been especially low, primarily driven by good market conditions, better mortgage underwriting standards (and the elimination of risky mortgage products), and the implementation of the PMIERs risk-based capital requirements.
Under benign circumstances, the limits of most transactions have been reduced relatively quickly due to scheduled amortisations and prepayments, which have been quite robust, especially in a low rate environment.
This article is a modified excerpt from the Best’s Special Report “Mortgage Reinsurance and the COVID-19 Pandemic”.
Emmanuel Modu is a managing director, insurance-linked securities at AM Best. He can be contacted at firstname.lastname@example.org
Michelle Li is a senior financial analyst, insurance-linked securities, AM Best. She can be contacted at email@example.com
COVID-19, Mortgage reinsurance, Emmanuel Modu, Michelle Li