Mortgage Insurance: Past and Present - A Perspective from Germany

The home ownership rate in Germany is one of the lowest in Europe; countries such as Great Britain and the US have achieved significantly higher rates. Housing construction too has been impacted by government aid cuts; when the government allowance for owner/occupiers was abolished, a feverish search

began for sustainable concepts that would make home ownership possible for wider sections of the population. As attempts are made to integrate housing promotion into the statesubsidized system of private old age provisioning, German financial services providers are beginning to secure residential mortgage loans by way of Mortgage Insurance. This insurance product enables lenders to offer residential mortgage loans to borrowers with a substantially lower down payment than was usual in the past. Moreover, Mortgage Insurance can reduce the level of regulatory capital a lender will need to hold under the new Basel Il Capital Accord, reflected through the Solvabilitätsverordnung (SoIvV) in Germany. Mortgage Insurance, which has proven itself abroad for years, is now establishing itself in the German market.

How Mortgage Insurance Works

With Mortgage Insurance, lenders can protect themselves against losses that may occur if a borrower were to default on the repayment of a residential mortgage loan. This coverage allows lenders to make this type of loan more readily accessible to their customers by lowering the down payment that most borrowers must have, and by dispensing with additional security or rights of subrogation towards their customers. This, in turn, allows lenders access to new target groups such as those who have not yet been able to save the often-required 20 % down payment because of long periods of study and training or those who wish to use their savings for other purposes.

Borrowers cannot take out Mortgage Insurance directly; the insured party is the lender. Mortgage Insurance reduces or imbibes the loss for the lender in the event of non-performing loans. It serves as "first loss cover" if the proceeds generated through foreclosure or sale of the property are not sufficient to meet the borrower's outstanding obligations including accrued costs. The coverage options are flexible and may be geared individually to the needs of the respective lenders; thus, they range from coverage of the entire loan to coverage of fractional amounts. Moreover, arrangements may be made for the coverage to be constant, proportional or amortizing.

The following graph shows an example of an Ml covered loan. The borrower equity of euro10K makes up 5% of the loan, Mortgage Insurance covers the next 41 % of the loan and the remaining 54% is residual risk that remains with the lender.

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Benefits for Lender and Borrower

Both the lender and the borrower gain from Mortgage Insurance. Above all, the lender has the benefit of an improved protection against losses should the borrower default on the mortgage. In addition, Mortgage Insurance allows the lender access to further market segments with a corresponding potential for growth in mortgage lending. A research study by Mercer Oliver Wyman, which was commissioned by the Mortgage Insurance Trade Association in 2005, states that Germany represents the biggest opportunity for mortgage market growth (see "Real Estate Banking 2005", ? 18 et seq). Moreover, where capital market transactions such as synthetic securitizations or True Sale transactions are concerned, Mortgage Insurance is an acknowledged credit enhancement.

The borrower benefits from Mortgage Insurance because the product enables lenders to more readily offer low downpayment mortgages - meaning consumers who may not be able to save the traditional 20% down payment, but who could otherwise afford loan repayments, can purchase a home earlier.

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Home ownership rate: A comparison of industrial countries

Besides the lender and its customer, there is also a third beneficiary: the government. Mortgage Insurance can make a decisive contribution towards increasing the home ownership rate and, consequently, also towards private old age provisioning - an objective that all German governments, across all political camps, have so far subscribed to. The growing public debate on alternative ways to promote home ownership clearly illustrates the importance attached to living in one's own four walls, which is still regarded as one of the main pillars of private provisioning for old age - and which will gain further in importance as state aid is scaled back. What is more, the risk and funding involved is passed on to the private business sector. Thus, Mortgage Insurance can help to generate a positive stimulus for the housing sector without burdening national finances.

The Origins of Mortgage Insurance

The first reference to Mortgage Insurance in Germany appeared in the "Kaufmännisches Miniatur-Lexikon" of 1907. "The purpose of this business is to protect mortgage creditors against losses that may occur as a result of the insufficient value of their mortgages [collateral]." While first referenced close to a century ago, the benefits of Mortgage Insurance are only just beginning to gain acceptance in the German property finance landscape, despite having proven itself in countries such as the United States of America for decades. There, Mortgage Insurance is looked upon as a natural component of residential mortgage lending; divided into a private and a public sector - it boasts a long tradition. Of course, the USA and Germany are characterized by widely differing economic and political frameworks and the differences between the two countries are clearly reflected in their respective home ownership rates.

As may be seen in the graph, homeownership in the United States is above the average with 69 percent. While Germany, with just 42 percent, is second lowest - ahead only of Switzerland. Certainly, a great many US families have become homeowners thanks to the widespread and firmly established instrument that is Mortgage Insurance. In 2005 alone, the leading US Mortgage Insurance providers helped more than 1.5 million families' to achieve home ownership.

The beginnings of US Mortgage Insurance reach back to the late 19th century when the first insurance firms of this kind were founded in New York. Just how important Mortgage Insurance has become to the US lending business and to the economy as a whole, down through the decades, may be gauged by considering the recession and, connected to it, the US real estate crisis at the beginning of the 1980s. In 1984, more than half of all insured mortgage loans had an equity share of less than ten percent. In that decade, US mortgage insurers paid out more than USD 6 billion') in claims to lenders, protecting them from substantial loss.

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Even in the comparatively prosperous years of the 1990s, insurance claims of more than USD 8 billion' were paid out. Once again, the Mortgage Insurance industry proved its strength and efficiency, regardless of the different economic cycles. In the US today, the total of residential mortgage loans covered by private Mortgage Insurance is in excess of USD 700 billion2.

Mortgage Insurance in Germany

The German property finance market is extremely fragmented. Over 2,000 banks and other financial services providers compete to win customers. However, changes such as the previously mentioned abolition of the government aid for owner/occupiers, or the introduction of Basel Il and the Capital Requirements Directive, mean the property market is in a state of transition and undergoing change. New tools are called for which will enable lenders to differentiate themselves from the many competitors in the market - enabling them to increase their own market share, manage credit risks and to make home ownership more readily accessible to the German people.

Mortgage Insurance under the Basel II Accord and the German Solvency Regulation (SoIvV)

High loan-to-value mortgage loans compose a highly specialized and particularly risky segment of the property finance market. In terms of risk behaviour, it differs greatly from the remainder of a lender's loan portfolio. The following chart shows how sensitive such loans are in their reaction to a change in the economic cycle:

Other factors such as high property prices, economic variables or market conditions also affect the lender's mortgage business-related risk considerably.

For decades now, international markets have deployed Mortgage Insurance as an effective means of mitigating credit risk. As an addition to the value-added elements it brings to lenders, the New Basel Accord (Basel II) has included Mortgage Insurance as an instrument providing capital relief.

Under the provisions of Basel I, insurances are deemed to be a corporate risk and are consequently subject to a risk weight of 100 %. Under Basel II, however, lenders operating under the Standardised Approach are given the opportunity to substitute the risk weight of the guaranteed asset item for the risk weight of the guarantor. If the mortgage insurer is rated AA, the risk weight of the guaranteed asset item would be reduced to 20 % (see table on the calculation of risk weights with/without Mortgage Insurance). Banks using the IRB-Approach (Internal Rating Based Approach) will be allowed to model the benefits of the Mortgage Insurance and consequently reduce their loss given default assumptions. This, in turn, should allow them to achieve lower risk weights. It should, however, be noted that the credit risk-reducing mechanisms under the IRB Approach will not fully be taken into consideration until after 3 years due the application of floors on the recognition of capital reduction benefits.

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The table below shows the capital backing needed with the Standardised Approach

In the new Solvency Regulation (SolvV), which came into force on January 1, 2007, the Federal Ministry of Finance and the Federal Financial Supervisory Authority (BaFin) for the first time allow the use of Mortgage Insurance as a credit risk mitigation mechanism. Section 164 of the SoIvV regulates that guarantees for mortgage loans will be recognized as reducing risk if the guaranteed payment is made not later than 24 months after the occurrence of the event for which the guarantee is given. It is to be assumed that in exceptional cases it may take longer than two years to work out non-performing property loans. In such cases, for lenders wishing to use Mortgage Insurance as a credit risk mitigant, it is necessary for the Mortgage Insurance contract to enable a payment to be made under the policy before the actual loss has been ascertained.

FOOTNOTE

' Based on US market data - MICA (US) 1 Based on Genworth Financial US data

AUTHOR_AFFILIATION

By Matthias Dous, Genworth Financial Mortgage Insurance Limited, Germany