«by MICHAEL GUDGER FAO AGRICULTURAL SERVICES BULLETIN 129 The designations employed and the presentation of material in this publication do not imply ...»
This chapter explores these issues. The U.S. industry operates within the largest, deepest and most liquid capital market in the world. It is a very large financial service industry (about US$ 2 billion per year in premium income), is profitable, and is expanding the range of products that it markets in the USA and abroad, principally in Europe and Asia. If we can understand the conditions under which guarantees are successful as commercial ventures, we may make substantial progress in describing the sufficient as well as the necessary conditions for guarantees to work in developing countries.
The choice of the USA. as a research laboratory is guided by several considerations.
Guarantees operated by insurance companies are not an exclusively U.S. phenomena. They exist in over 30 countries, but few are "monoliners" with guarantees as their principal or the only business. Outside the U.S., most guarantees are issued by general insurance companies.
The U.S. almost alone offers pure examples of companies that offer only financial guarantees.
Thus, the structure, administration and finance of the companies are not affected by other classes of operations. The U.S. is one of the few countries where the complete data for the analysis is freely available to researchers in published and audited financial statements.
The guarantee industry in the USA is divided into two basic components: Mortgage Guarantee Companies, which issue financial guarantees on individual mortgages, usually for those with less than 20% equity for a down payment. Bond Guarantee Companies initially provided protection to holders of mutual bonds to insure timely payment of principle and interest, but now cover a broad spectrum of non-municipal securitizations and structured corporate debt. These are the second component of this industry.
In the USA home mortgage lenders act principally as loan originators for secondary markets, Federal National Mortgage Association (Freddie Mac) and Federal Home Loan Mortgage Association (Fannie Mae). Banks make home mortgage loans and sell them in the secondary market, which set the criteria for "conforming" loans that lenders can easily sell. Mortgagees who cannot meet the 20% down payment required for a conforming 80% Loan to Value (LTV) mortgage, buy Private Mortgage Insurance (PMI) sold by a mortgage guarantee company. The guarantee thus effectively substitutes for the 20% cash collateral required for conforming loans.
The 80% LTV market became saturated fairly quickly and most mortgage guarantee companies began to issue 90% LTV guarantees. In recent years this market has also become saturated and some or even most companies now issue guarantees for LTV of 95% and 97%, thus fostering the purchase of "affordable" housing by low income families with the cash flow to service debt but without the assets to make much of a down payment.
In addition to facilitating home ownership, the mortgage guarantee market is a source of capital for many business start ups and for enlarging an existing business. Many people borrow against their equity in their homes by refinancing with mortgage insurance to "take out cash" for a variety of purposes. This source of finance is particularly important for SMEs organized as sole proprietorships, partnerships and family owned businesses, which often have difficulty obtaining institutional credit.
In the bond guarantee market, municipalities with weak credit ratings and agencies and project authorities with no credit history can buy a guarantee, which enables them to market their bonds as investment grade debt. Back by this guarantee, the interest rate at which they borrow is lower than they would have had based on their own credit rating alone. As investment grade obligations, their bonds are fully and easily placed in debt markets. Without the guarantee, they would have to sell in the "junk" debt market, pay a much higher interest rate and perhaps not fully place the bonds.
Many guaranteed issues are general obligation and tax backed bonds. Others are revenue bonds (backed by project cash flows) issued to fund hospitals, housing, transportation, roads, schools, parks and recreation facilities, sewer and water facilities, investor-owned utilities and recently for environmental remediation. Bond guarantees enable poorer municipalities to access credit markets on better terms and have created a ready market for unseasoned agency debt.
Beginning about 1993, there was a slow down in the rate of municipal bond issuance. In response, bond guarantee companies have moved increasingly into structured corporate finance and asset-backed securitizations to sustain growth in premium volume. This business now constitutes about 15% of the total amount of guarantees issued by the larger guarantee companies, and is growing rapidly. Recently, many of these companies have begun to establish subsidiaries in Europe. Several have set up subsidiaries in Japan to write guarantees throughout the Pacific Basin. The structured corporate finance and asset backed deals are likely to continue to grow rapidly while the municipal business remains more or less static.
At the present rate, the transformation from municipal bond insurers into corporate finance insurers will be completed within a decade, with the corporate portion of the portfolio being much larger and more profitable than the municipal guarantee business.
Bond insurers have also moved to guarantee pools of small (even micro) loans by guaranteeing credit card receipts, consumer loans, auto loans and even pawn shop loans.
Increasingly, new products come to financial markets with a guarantee so that the market will not require a high risk premium. These third party credit enhancements have played a major role in introducing new classes of business to debt markets. Their volume has grown enormously. It appears that the types of guaranteed derivative products that can be placed is more a function of the imagination of those creating the structured financings than any inherent limit in the guarantee industry, which by most measures has excess capital.
U.S. mortgage and bond guarantee companies are growing. The return on equity averages around 15% per year and most companies are profitable in most years. These companies appear to have overcome the difficulties that plague almost all (if not all) the guarantee funds that serve SME and micro-borrower markets in many countries. They have several
characteristics that recommend them for study, as follows:
a) These companies require no subsidy. Most pay shareholders a return on capital invested in the form of dividends and /or additional stock.
b) They obtain their capital almost entirely from the private sector. Over the last decade their shares have appreciated substantially in the stock market, rewarding their investors with capital gains.
c) They have established a mass market for products that are voluntarily bought by borrowers as credit enhancements which can modify the amount and/or the terms and conditions of the loan.
d) The mass market enables them to issue guarantees with minimal, if not trivial, overhead costs per operation.
e) They have developed credit-underwriting standards to measure and to price their risks.
f) Guarantee companies have developed cost-effective credit surveillance standards that permit them to detect credit quality deterioration and take action to control losses.
g) They have automated the credit evaluation process by applying sophisticated credit scoring models.
h) The have "commoditized" the guarantee products by developing a range of standard guarantee products, thus allowing borrowers seeking guarantees to compare pricing offered by different companies.
i) They have developed knowledge about the risks they guarantee that enables them to determine and charge premiums adequate to pay claims and cover administrative overhead.
j) The guarantee market is very competitive, requiring issuers to control their costs and keep them competitive.
k) Guarantee companies continually innovate, developing new products in efforts to expand their market shares and develop new sources of revenue.
l) They arguably produce massive additionality by enabling borrowers to deal with lenders and credit markets that they would not have access to without a guarantee or to obtain access on more favorable terms and conditions than would be possible without a guarantee.
Guarantees address the collateral constraint directly in the home mortgage market, while in the bond and structured corporate finance market they reduce the risk premium.
The growth of the U.S. guarantee industry is particularly remarkable in introducing a third party into the traditional relationship between lender and borrower. Lenders traditionally carefully studied the financial situation of a loan applicant, analyzing collateral and credit history before approving a loan. To an increasing extent, lenders are passing that function to guarantee companies for certain classes of credit, principally those with which they have little expertise, such as municipal finance, and where the collateral is very weak, such as 80-97% LTV home loans.
The following tables show the size of the home mortgage guarantee industry and the magnitude of the transfer of credit risks to guarantee companies for home mortgages which lenders do not retain and for municipal bonds seeking higher credit ratings.
The mortgage guarantee portion of the U.S. financial guarantee industry is composed of 13 companies, insurers and reinsurers. The table summarizes financial data for the 11 largest companies. The companies in Table Two have make up over 95% of the total market for mortgage guarantees. Mortgage guarantees in the USA generates about $1.4 billion dollars of premiums per year from a portfolio of risk in force of just over $84 billion. Mortgage guarantee companies total revenues are about $1.7billion and net incomes are around $640 million per year. The total assets of the 11 mortgage guarantee companies are about $6.8 billion and their total capital is about $4.5 billion.
There are ten specialized bond insurers and reinsurers. Additional bond guarantee business is conducted by general insurance companies and by foreign insurers. However, the data in Table Two include well over 90% of the total bond guarantee business. Financial guarantees issued on municipal bonds and securitizations and structured corporate debt generate about $690 million in premium income on originations having a net par value of $105 billion. The total assets of the bond insurers equal about $11.5 billion while their total statutory capital is about $6.6 billion.
The two industries' total capital is about $11 billion. The insurance in force and the net par exposure of the two industries approaches $1 trillion.
The following sections present several case studies of both types of guarantee companies, which are studied to determine their applicability to developing countries. The cases include companies that are remarkably different. One is one of the smallest and most profitable companies that has found a niche market despite a very low volume of operations and consequently very high overheads. The other company is the giant of the industry, backed by a very strong parent company. It has seen its traditional market eroded and has created whole new classes of business to sustain growth.
HOME MORTGAGE GUARANTEE INSURERS: TWO CASE STUDIES
Triad Guaranty Insurance Corporation:
Triad Guaranty Insurance Corporation is a start up, is quite successful, but has yet to be challenged by adverse conditions produced by a recession. It is thus both interesting as a success and as a laboratory to see what happens during a future recession. Triad issues private mortgage insurance to residential mortgage lenders. It is the smallest of the 8 active mortgage insurers with only 1.7-% of the new business written. As noted, private mortgage insurance is a requirement imposed by secondary debt markets for most home purchases and refinancings when the conventional residential first mortgage loans is made to a borrower with equity of less than 20% of the value of the mortgage (LTV). The guarantee protects lenders from default losses and enables home ownership when the mortgagee has acceptable credit and adequate income to service the mortgage, but lacks the cash required by the borrower to meet the 20% cash collateral requirement. Alternatively, it allows homeowners to lower their equity to below 20% by taking some of the value of the home in cash for other purposes.21 The salient features of Triad that are of interest to the development community seeking
models that may have some applicability in developing countries are:
• Triad is now 7 years old and as shown below is quite profitable, although it is yet to go through a recession when mortgage defaults typically rise.
There is no effective limit on the purpose for which the funds may be used. As noted, some goes for business purposes, but in other cases, the funds are used for consumption, education, investment and even speculation. The lender is generally unconcerned and most often unaware of how the funds will be used.
This is one of the reasons that “cash out” refinancing is popular. In other classes of lending, banks generally want to know to use of the loan funds and in most cases exercise some control over their use, often disbursing them in tranches against receipts (construction loans for example).
• Triad has a statutory ratio of less than 60. This means that its losses and expenses are less than 60% of the premium income.
• The company has both grown its capital and has paid shareholders a dividend in cash and stock. In 1996, its return on assets was about 12% and its return on capital was nearly 15%. Both of these ratios have nearly doubled over the last 4 years.
• As a private company, it receives no subsidy.
• By almost any set of measures the company is viable as an ongoing business that has attracted private investors and shareholders to supply the capital needed to engage in the guarantee business.