What is the future for Lenders Mortgage Insurance?Future Landscape 6. What if? 1. Historical Reasons...

What is the future for Lenders Mortgage Insurance?

Aaron Cutter & Susie Bowden

Contents

1. Historical Reasons for LMI2. Recap of recent LMI experience3. LMI’s place in the sub-prime picture4. Australia v US Mortgage Market5. Future Landscape6. What if?

1. Historical Reasons for LMI

• Capital• Risk Transfer• Product Innovation• Risk Selection

Capital

• Support ADI return on capital– Reduce level of ADI capital– LMI providers (arguably) expect a lower return

than ADIs– LMI providers accept volatile returns

• Facilitate growth in smaller players and entry of non-bank lenders

Risk Transfer - Diversification

• Removes volatility from lenders’ losses• Delinquency rates and losses different

by lender in the recent benign economic times

• Even in “recent” down-turns LMI providers help smooth losses

Product Innovation

• Security for lenders• Global experience

Risk Selection• Discouraging inappropriate lending• Providing outsourced expertise to lenders

– fraud detection models,– credit score – underwriting standards.

2. Recap of Recent LMI Experience

• Australian Experience• US Experience

Australia

• Recent LMI losses have been very low (til 2007)• Favourable national economic environment• But history shows losses can be large (80s and 90s)• Where to for 2008 and 09?

0%

20%

40%

60%

80%

100%

120%

91/9

2

92/9

3

93/9

4

94/9

5

95/9

6

96/9

797

/98

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9

99/0

0

00/0

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01/0

202

/03

03/0

4

04/0

5

05/0

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06/0

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07/0

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Loss

Rat

io

0%

5%

10%

15%

20%

Econ

omic

Fac

tors

Loss Ratio House Price Appeciation

Unemployment Mortgage Rates

?

Source: APRA Statistics, ASB

United States of America

• Up until 2006, stable experience• Then very unfavourable conditions producing loss ratios in the

hundreds

0%

50%

100%

150%

200%

250%

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Loss

Rat

io

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

Eco

nom

ic F

acto

rs

Loss Ratio House Price Appeciation

Unemployment Mortgage Rates

Source: S&P, U.S. Bureau of Labour Statistics

Big falls in US house prices

50

100

150

200

250

300

Jun-

91

Jun-

92

Jun-

93

Jun-

94

Jun-

95

Jun-

96

Jun-

97

Jun-

98

Jun-

99

Jun-

00

Jun-

01

Jun-

02

Jun-

03

Jun-

04

Jun-

05

Jun-

06

Jun-

07

Jun-

08

Hous

e P

rice

Appr

ecia

tion

(% p

.a.)

Miami USA

“Small” falls in Aus house prices

50

100

150

200

250

300

Jun-

91

Jun-

92

Jun-

93

Jun-

94

Jun-

95

Jun-

96

Jun-

97

Jun-

98

Jun-

99

Jun-

00

Jun-

01

Jun-

02

Jun-

03

Jun-

04

Jun-

05

Jun-

06

Jun-

07

Jun-

08

Hou

se P

rice

Appr

ecia

tion

(% p

.a.)

Miami USA NSW Australia

3. LMI’s Place in the Sub-Prime Crisis

• Traditional US lending structure• Traditional securitisation• Recent departure from tradition

Traditional Lending Structure

RMBS1RMBS1 RMBS2RMBS2 RMBSnRMBSn

LenderLender InstitutionalInvestors

InstitutionalInvestors

CDO1CDO1 CDO2CDO2 CDOnCDOn

CDO2CDO2

Package

Invest

Invest

Borrow

MIMI GSEsGSEs

Wall StreetWall Street

Byp

ass

GS

Es

Insure





CDO2CDO2

Package

Invest

Invest

Borrow

MIMI GSEsGSEs


Byp

ass

GS

Es

Insure





CDO2CDO2

Package

Invest

Invest

Borrow

MIMI GSEsGSEs


Byp

ass

GS

Es

Insure

Traditional Securitisation





CDO2CDO2

Package

Invest

Invest

Borrow

MIMI GSEsGSEs


Byp

ass

GS

Es

Insure





CDO2CDO2

Package

Invest

Invest

Borrow

MIMI GSEsGSEs


Byp

ass

GS

Es

Insure





CDO2CDO2

Package

Invest

Invest

Borrow

MIMI GSEsGSEs


Byp

ass

GS

Es

Insure

Recent Departure from Tradition





CDO2CDO2

Package

Invest

Invest

Borrow

MIMI GSEsGSEs


Byp

ass

GS

Es

Insure





CDO2CDO2

Package

Invest

Invest

Borrow

MIMI GSEsGSEs


Byp

ass

GS

Es

Insure





CDO2CDO2

Package

Invest

Invest

Borrow

MIMI GSEsGSEs


Byp

ass

GS

Es

Insure

4. Australia v US Mortgage Market

• Mortgage Products• Lending Practices• Property Markets

Mortgage Products• US

– Increase in sub-prime loans (i.e. high risk of default)– ARMs with ‘teaser’ rates (3/27s or 2/28s)– Sub-prime loans grew “nearly ten-fold in nine years”– Negative amortisation loans

• Australia– Less than 1% non-conforming – ARMs with teaser rates not offered in Australia

Lending practices• US

– ARM 2/28s offered to those less able to afford the repayments

– Serviceability calculated on an optimistic basis– Lenders by-passing LMI

• Australia– serviceability is generally calculated at a buffer over

benchmark interest rates• But

– Australian households are move leveraged – Some questionable underwriting has occurred

Property Markets• US

– Property slumps have been geographically isolated– Now, the US has experienced a nationwide downturn– Mortgage products and practices led to speculative

bubble and its bursting in some states– auto-manufacturing sector in trouble at the same time

• Australia– Property slumps also have been geographically isolated– Recently, property market has remained reasonably

stable– Could a nationwide property downturn occur

5. Future Landscape

• The Mortgage Market• LMI and Capital• Risk Selection and Product Innovation• Risk Transfer

The Mortgage Market

• Consolidation of the LMI providers• Regional banks will be at a

disadvantage to the larger banks • Assistance with quality control and

intellectual support

Capital

95.01 –100%

90.01 –95%

85.01 –90%

80.01 –85%

70.01 –80%

60.01 –70%

< 60.01% 0%

10%20%30%40%50%60%70%80%90%

100%

Cap

ital R

isk

Wei

ght

ADI Risk Weight – With LMI LMI Risk WeightADI Risk Weight – no LMI Basel I ADI plus LMI

• Capital previously main driver of LMI use

• Capital benefits are lower under Basel II for Standard Approach banks

• Capital position is complex for IRB banks

• Reasons for LMI may move toward true risk assessment and mitigation

Relative capital levels required by LVR

Risk Selection & Product Innovation• LMI providers still facilitate market discipline• The majority of the LMI business can be

expected to be unchanged• LMI may become the quasi ‘gold stamp’ of

underlying business

Risk Transfer - Diversification

0

100

200

300

400

500

600

700

800

A B C D E F G H I J K L M N O P Q R S T U V W X Y Total

Del

inqu

ency

rate

rela

tivity

Jun-07 Jun-08

Delinquency rate (3 months in arrears) for Australian lenders as at 30 June

2007 and 30 June 2008

0

250

500

750

1,000

1,250

1,500

A B C D E F G H I J K L M N O P Q R S T U V W X Y Total

Del

inqu

ency

rate

rela

tivity

30-Jun-07 30-Jun-08

Relative delinquency rate for US lenders as at 30 June 2007 and 30

June 2008 – Prime loans

• LMI does provide true insurance risk transfer • In very stressed environments the level of risk transfer is

arguably lower• Maximum benefit provided by global LMI

6. What if?

0%

100%

200%

300%

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500%

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700%

800%

Sep-08

Dec-08

Mar-09

Jun-0

9Sep

-09Dec-0

9Mar-

10Ju

n-10

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Mar-11

Jun-1

1Sep

-11Dec-1

1Mar-

12Ju

n-12

Sep-12

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Jun-1

3

Future Claim Costs Relativity between “baseline” Australian losses and a US like scenario

• 7 times current level of losses = 200% loss ratio

Where will it settle

• Market consolidation and Basel II may lead to a declining LMI industry

• However, risk selection/acceptance and transfer have significant value

• How these opposing forces finally settle will determine whether overall use of LMI becomes less or more…

What is the future for Lenders Mortgage Insurance?Future Landscape 6. What if? 1. Historical Reasons...

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