Mortgage Default Insurance in the U.S.

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

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TABLE OF CONTENTS

Mortgage Default in the U.S.: Implications for Russia

A. General Discussion

B. U.S. Federal Housing Administration Insurance

C. What is Appropriate for Russia Now?

D. Resources

Mortgage Default in the U.S.: Implications for Russia¹

Mortgage guaranty insurance, sometimes called default insurance, protects against lender or investor loss by reason of borrower default (credit failure) accompanied by insufficient recoverable value in the property securing the insured loan. There are several aspects of mortgage insurance that distinguish it from other forms of casualty insurance:²

• The critical risk for mortgage default insurance is "catastrophic." In other words, mortgage default risk is not limited to the normal risk that an individual homeowning household might experience in terms of financial adversity, resulting in foreclosure. Rather, a "catastrophic" risk refers to the widespread foreclosures that may occur as a result of economic depression at the regional or national level. To mitigate this risk, it is desirable for mortgage default insurance to be issued over diverse regions of a country and for a large number of loans to be insured. This concept is referred to as risk dispersion, and it becomes an important factor for regulatory and rating agencies when they evaluate or rate a mortgage insurance company's claims-paying ability.
• The horizon of risk assumed under each individual mortgage insurance policy is unusually long. Home mortgages are long-term instruments, normally from 25 to 30 years. To serve its intended purpose, therefore, mortgage insurance must be noncancelable by the mortgage insurance company. As a practical matter, the premium price for the life of the loan is determined when the loan is made by the lender, despite the likelihood of changing conditions during the life of a mortgage loan.
• There is an unusual combination of credit and collateral risk. The "event of loss" under a mortgage insurance policy is the borrower's failure to make required periodic payments. The risk of actual loss also depends on the occurrence of a second event following borrower default, namely, the lender's inability to recover the full debt owed through disposition of the collateral property.
• Inflation reduces, rather than increases, the risk of mortgage insurer loss, because it increases the value of the property and therefore the spread between the property value that would be realized at auction in the event of foreclosure and the loan amount.³
• Establishing long-term catastrophic loss reserves is necessary to address the unique risks associated with the contingent probability of future economic depression. Consequently, mortgage default insurance has greater capital requirements than other insurance lines. The catastrophic loss reserve for private mortgage insurers in the United States is called the Contingency Reserve. The Contingency Reserve is governed by some specific state regulatory requirements that mandate the amount of earned premium contributions as well the conditions under which the mortgage insurer may withdraw funds from the Contingency Reserve.

Because of the potential size of the loss from claims by a single loan originator and the points just listed, key policy provisions include the following:

• The loan originator and servicer must be qualified by the insurer.
• The policy is noncancelable by the insurer for the life of the loan.
• The claim for loss includes the unpaid principal, interest due and unpaid, legal costs (up to a specified limit), delinquent taxes, delinquent property insurance premiums, required property maintenance, and any other foreclosure-related costs that are approved by the mortgage insurer.
• Following default and prior to the loan becoming more than a specified number of payments (six for private mortgage insurance), in default, the property must be foreclosed and clear title rendered to the insurer to perfect the claim.

Banks require that borrowers who desire a loan where the loan-to-value ratio is greater than 80 percent purchase mortgage default insurance with the bank as the beneficiary. The borrower bears the cost of the insurance premium either as an addition to the monthly payment or by the bank charging a higher interest rate for the loan to cover the cost of the mortgage insurance.

This paper describes the structure of mortgage insurance in the United States from the perspective of the potential usefulness of such insurance in the Russian Federation. The first part provides a general discussion covering key aspects of such insurance. In this part, it is assumed that the issuer of the mortgage insurance is a private entity. The second part of the paper describes one default insurance product of the Federal Housing Administration, a U.S. government agency that issues default insurance policies to banks for certain classes of borrowers and homes being purchased. The program is the Federal Housing Administration's primary program for insuring mortgage loans given for the purchase of individual housing units for owner occupancy. The final section outlines an idea for how to proceed with the development of such insurance in the Russian Federation.

Note: This report is available in its entirety in the Portable Document Format (PDF).

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

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