What happens when credit risks come home to roost?

The housing market boom of recent years has given rise to a couple of strange economic bedfellows: fiscal pragmatism on the part of buyers looking for affordable financing options, and marketing ingenuity on the part of lenders looking to extend the run on a good thing. For a while, low interest rates alone drove an affordability factor that put home ownership—or upgrades to a bigger or better home—within the reach of many more consumers than otherwise would have been able to make purchases. As home price appreciation escalated in many areas—putting up a potential obstacle to purchases—lenders, capitalizing on demand and market opportunities, developed new and sometimes exotic types of mortgage products that enabled buyers to keep their dreams alive and the market afire. Leading the way were offerings such as ARMs (adjustable-rate mortgages) and IOs (interest-only loans). Their monikers sum up their appeal.

The concern now is that as interest rates trend upward, the industry's "risk discipline" has been muted by a seemingly myopic focus on short-term gains, given the recent surges in home prices. Many people still don’t believe there is high risk in the housing market, while many others believe they have to track with the market regardless of the risk involved. Nevertheless, a growing amount of statistical evidence and analysis by industry observers and advisors indicates that there is a significant level of risk associated with many of the newer loans—risk for homeowners and for those who underwrite or insure mortgages. And for numerous banks and insurance companies, that risk is compounded by the fact that individual mortgages are highly correlated in a manner unlike traditional insurance risks. Thus, the volatility of defaults can be significant, resulting in large swings as economic tides raise—and lower—all boats.

Consider this closer look at several key drivers of the current risk levels:

Home price appreciation

House prices have been rising at unprecedented rates in recent years, well in excess of inflation rates (see graph).

The upshot is that housing is generally less affordable—across virtually all U.S. regions. The strong home price increases have fueled a significant upsurge in second home and investor purchases. Such leveraged investment in housing where multiple properties are owned by individuals with large debt burdens has led to still higher prices, resulting in a kind of feedback loop. Forty percent of home purchases in 2005 were second homes, 28% of which were investment properties and 12% of which were vacation properties¹. Softness in the housing market could become contagious if such leveraged investments in housing were to unwind through forced sales or foreclosures.

Further exacerbating the affordability issue is the fact that the ratio of house price to buyer income is alarmingly higher in recent years, most notably since 2000 (see graph).

In addition, the total financial-obligation “package” of home ownership, including mortgage payment, property taxes, and homeowner’s insurance premium, has increased dramatically over the past six years.

The tremendous growth of second lien mortgages such as home equity loans and lines of credit has also contributed to homeowners’ debt burden. These loans sit atop the borrower’s first mortgage and further erode the borrowers’ equity cushion and substantially increase the risk of borrower default. More than 40% of first mortgages originated in fourth quarter 2005 were accompanied by a second mortgage, according to SMR Research, compared to less than 15% in 2001.

This is a particular concern in the private mortgage insurance industry, which consists of seven companies that insure home mortgages, mostly on what is known as high loan-to-value (LTV) ratios, or loans with little to no equity. But it’s also a growing concern among lenders, who increasingly are holding some of these loans on their own balance sheets or have a stake in the reinsurance of the loan. What insurers and lenders have in common in this dynamic market is the need to constantly evaluate and manage their credit risks.

Still others warn of the day when home prices start to drop. PMI, a leading mortgage insurance company, publishes a quarterly risk index based on its proprietary statistical model, which gives its perception of the likelihood that home prices will decline within two years at the Metropolitan Statistical Area (MSA—a designation used by the U.S. government to indicate a city and its suburbs) level. Based on the spring 2006 report, PMI is forecasting a greater than 50% chance of pricing drops over the next two years in MSAs comprising 35% of the population of the top 50 MSAs. The graph below demonstrates this prediction. Further, the proportion of MSAs falling into this category has grown from virtually nil only a few years ago. As of spring 2005, PMI forecasted a greater than 50% chance of pricing drops over the next two years in MSAs comprising less than 5% of the top 50 MSAs, weighted by population. As a note, a value of 100 indicates a 10% probability of a price decline over the next two years and, similarly, a value of 500 indicates a 50% probability.

Market consensus also points to home price declines over the next year. The Chicago Mercantile Exchange recently began trading futures on housing index values for 10 large MSAs. At press time, the futures prices imply expected price decreases over the next year in the indexes for all 10 MSAs that are traded.

Exotic new products

Further escalating concerns about the riskiness of the home lending market is the vulnerability created by some of the loan products that consumers have found so appealing in recent years:

Low-doc loans This product was originally developed for use by the self-employed and those willing to pay extra for the speed and convenience of not having to produce a lot of paperwork; thus the name, which signifies low, or minimal, documentation. Lenders look to documentation of a borrower’s income and assets when underwriting the loan. Scarcity of documentation sometimes also means low quality, or less reliable or less stable income or assets. Use of these products has been on a steady increase since 1998, and their use quadrupled between 2002 and 2004.

Adjustable-Rate Mortgages (ARMs) The largest mortgage originator in the U.S. has reported tremendous growth in adjustable rate loan products over the last two years, specifically 70% year-on-year growth between 2003 and 2005. During this same period, year-on-year growth for fixed-rate mortgage was minus 17%. ARMs come in a variety of types, including:

• Option ARMs, which is perhaps the most risky of this type and offers the borrower three payment choices: amortizing over various periods of time, paying interest only for a period of time, or paying an amount less than interest that is known as the minimum payment. It doesn’t take a mathematician to figure out that making payments less than the interest portion will result in a loan balance that increases, rather than decreases, with time. One major banking lender has said that its portfolio of option ARM loans increased from under $50 billion to more than $70 billion between 2003 and 2005.
• Hybrid ARMs generally have a lower fixed interest rate for a set number of years (i.e., usually three to seven), after which the loan resets and then varies annually. That variation is often tied to a well-known market rate, such as the Treasury bill short-term rate.
• Interest-Only Loans—These instruments (IOs) were originally intended for higher-net-worth clientele or people who were expecting a large increase in personal income over a relatively short period of time. But in recent years, their prevalence has extended far beyond those rarefied populations. IOs allow the borrower to make only interest payments on the loan for a fixed period, after which the loan amortizes over the remaining term. Risks associated with IOs for most borrowers would include the potential impact of interest rate increases and the shock of the payment amount once the loan amortizes.

Interest rate movements

As interest rates go up, many lenders naturally are concerned about their loan volume going down. Higher rates have already effectively shut down the recent deluge of home refinancings, so the search for other consumer buttons to push goes on. In order to cover fixed costs and grow market share, lenders will continue to look for other ways to keep volume coming in the door.

In addition, the increase in interest rates is bound to result in a high level of “payment shock” among consumers who opted for one of the ARM products. These factors in combination are likely to produce more mortgage default losses. According to DB Global Markets Research, for example, hybrid ARM loans subject to interest rate resets in 2006 will total $400 billion; for 2007 that total skyrockets to $1 trillion. And there are even gloomier predictions from others who make these projections: Loan Performance, for instance, puts the hybrid ARM volume reset between 2006 and 2007 at an estimated $2 trillion.

In the past year alone, the delinquency rate for ARM loans more than 90 days past due has increased 141%, compared to only a 27% increase for fixed-rate mortgages². Looking ahead to when the large volume of 2004 and 2005 hybrid ARM mortgages reset in 2007 and 2008, it is likely that borrowers who experience subsequent resets in monthly mortgage payments will fall even farther behind.

Consider this example of a borrower who opted for a typical 3/1 ARM interest rate on a home in 2004 with an initial rate of 4.2% (a 3/1 is a loan with a fixed interest rate for the first three years that becomes an ARM in the fourth year). Based on 3/1 ARM to one-year ARM spreads and the July 2006 one-year Treasury bill index rate, payments on that loan will soon reset to an increase of nearly 40%. On a $200,000 loan, that means a payment of $965 will jump to $1,315. For 2005 originations, based on similar assumptions, the payment will increase about 30%, from $1,030 to $1,330.

Altogether, one industry analyst predicts that the reset of ARM loans valued at $1.888 trillion from origination years 2004 and 2005 will result in first loan defaults of $300 billion and produce losses of $110 billion. If there’s a silver lining to this ominously dark cloud, it is the small consolation that these losses would be spread out over a period of about five years³.

Measuring risk

Risk assessment is considerably more complicated today because it is so widely spread around. Pieces of the home loan market risk are owned by insurers, investors, banks, hedge funds, and Fannie Mae and Freddie Mac, just to name the biggest players. Because the industry risk is so highly correlated, a sudden increase in foreclosures would have a significant impact on many different parties.

As the old saying goes, “You can’t manage what you can’t measure.” The first step, then, is to identify the risks you face and measure them as accurately as possible. Mortgage risk, for example, can be measured by analyzing distribution of a portfolio with respect to such key characteristics as loan-to-value ratio, FICO score, interest rate, geographic region, product types held, loans in delinquency, and more. It’s also helpful to benchmark your portfolio against competitors and to perform periodic loan persistency and mortgage default loss analyses.

Accurate risk measurement can be accomplished using a risk metric tool that segments a portfolio’s risk factors (e.g., FICO scores, LTV, interest rate distribution) and bench-marks those against an aggregate peer group. The resulting data can then be used for forecasting and managing the credit risks.

Mitigating risk

The thousands of individual loans discussed in this article are correlated because they are driven by the same set of economic and market phenomena, and we believe the risk of loan delinquencies and foreclosures is therefore also correlated. What, then, can be done to mitigate these risks? As mentioned, the first step is to understand and measure your risk. Once you have a handle on its nature and scope, you can begin to develop a mitigation strategy. Depending on circumstances, there are a number of ways to offset or mitigate your particular risks, so let’s look at a few.

For loans already originated:

• High LTV is a statistically strong indicator of potential loss, so credit-enhance high-LTV loans with mortgage insurance.
• Securitize the loans by offloading risk to a secondary market, such as mortgage-backed securities.
• Offload risk through a synthetic product, such as a credit default swap (CDS). Using this tool, a lender pays an investor a fixed fee to reimburse the lender an amount that is a function of mortgage default losses. House price index futures can also be used to hedge the risk of home price decreases.

For new loans, in addition to the items above:

• Understand how and where the risk stands and revise underwriting guidelines to prevent exacerbation of existing problem areas.
• Develop strong underwriting guidelines; don’t fall prey to unbridled competition for market share. The CEO of the largest U.S. mortgage lender recently told analysts his company is being more cautious as the housing market cools and competition among lenders intensifies. Further, his firm has been careful to give option ARM loans only to borrowers with relatively strong finances.
• Ensure that your portfolio is diversified on several levels. Loans originated in different years, for example, spread the risk associated with prepayment and default. Similarly, spread the loans around geographically. Loan defaults tend to be driven by regional economic recessions, so a well-spread geographic portfolio can help weather regional economic downturns and corresponding mortgage losses.

As the housing boom subsides, there undoubtedly will be risk for those who took advantage of its earlier opportunities. The key to surviving and prevailing in the home lending market is to identify areas of risk exposure and to manage them effectively, both now and in the future. To quote Louis Pasteur, “Chance favors only the prepared mind.”

1. Knox, Noelle, “Second Homes 40% of Market Highest Level Ever Helps Drive Up Prices,” USA Today, April 5, 2006, Page 1A, www.usatoday.com/printedition/news/20060405/1a_lede05.art.htm.

2. Simon, Ruth, “Homeowners Start to Feel The Pain of Rising Rates,” The Wall Street Journal, Eastern Edition, August 10, 2006, Page D1.

3. Cagan, Christopher L., “Mortgage Payment Reset the Rumor and the Reality,” First American Real Estate Solutions, February 8, 2006.

Michael Schmitz is a principal and consulting actuary based in Milliman’s Milwaukee office. Mike has designed and built capital models for credit risk exposures for clients including rating agencies, banks, insurance companies, reinsurers, and governmental entities. In addition to working with financial guaranty insurers, he has been a consultant to the private mortgage insurers on topics including reserving, pricing, financial analysis, mortgage portfolio credit risk, product development, structured transactions, and transfer of risk analysis. He also specializes in property and casualty insurance, and has extensive experience in reinsurance and commercial lines, including workers’ compensation, professional liability, reinsurance, and other long-tail lines.

Kyle Mrotek is an actuary based in Milliman’s Milwaukee office. He specializes in property and casualty insurance, particularly financial risks and commercial lines. His project experience includes reserve evaluations, rate analyses, and financial modeling. His consulting assignments have involved reinsurance, government, pools, and alternative risk transfer.