The first thought that springs to mind at the mention of mortgage risk is the film The Big Short. Though an excellent film, memorable for its eccentric method of explaining financial instruments, the film and its characters are now embedded in the minds of the public at the mention of mortgage risk. Who could forget the NINJA loan salesman? Any mention of mortgage causes a negative response – at Capsicum Re, we call this ‘The Big Short Complex’ – but is this fair considering the new reality of the mortgage risk market?
The mortgage risk landscape of 2018 is very different to the pre-crisis years of the 2000s thanks to three key changes: the change in underlying US default risk, stricter underwriting guidelines and the emergence of a global market for mortgage risk.
Product risk, not borrower risk, fuelled the housing bubble amid the real estate crash of 2007. The amount of borrower risk was relatively consistent throughout the early 2000s, when there were reasonable lending standards in the market. Since the crisis, there has been a huge market correction, which has seen lenders virtually cease to offer risky loans and limit the amount of borrower risk they are prepared to take. The rate of borrower risk now stands at two thirds of the level that was steadily maintained throughout the pre-bubble and bubble years. If the current default risk was doubled, the risk would still be “well within the pre-crisis standard of 12.5% from 2001 to 2003 for the whole mortgage market,” according to research by the Urban Institute.
A stricter mortgage underwriting regime has been implemented in the US with the help of the Dodd-Frank Act,which was passed in 2010. There are two titles that made profound changes to the mortgage world within the Act:
- Title Xcreated the Consumer Financial Protection Bureau (CFPB), a regulatory agency overseeing financial products offered to consumers.
- Title XIV, (the Mortgage Act) prohibited or restricted many old mortgage lending practices. It created a new category of loans called ‘qualified mortgages’ (QM), satisfying the requirement that mortgage lenders use verified and documented information to determine that the consumer has a “reasonable ability to repay the loan,” before it is granted.
The single most important change for private mortgage insurance (PMI) was the change to mortgage lending requirements These new lending standards have helped create a new underwriting reality that makes mortgage risk more attractive as an investment, as lending is no longer so risky. The new standards will help protect capital against any future economic recessions, countering The Big Short narrative.
Global Mortgage Risk
The final challenge to The Big Short Complex is the emergence of a global market for products and capital. In today’s mortgage indemnity market, risks are only accepted when they meet strict underwriting requirements, demonstrated by the abundance of appropriate products across the globe, with diversified capital behind them. An example is theNewBuy scheme in the UK, which was set up by Capsicum Re’s mortgage MD, Steven Rance to help alleviate housebuilders’ capital issues and the lack of consumer mortgage availability.
This is just one of several innovative solutions (others include Arch Capital Group’s MRT, and the government-sponsored entities’ credit risk transfer programs) that have changed the global mortgage market.
These changes serve to highlight TheBig Short Complex for what it is – a hangover from the Global Financial Crisis. It neither reflects the current practises, nor the global nature of the mortgage world as refreshed risk appetites, new innovative solutions and prudent underwriting have brought about change for the better. While we would like to change this initial negative response to mortgage risk, to forget the narrative completely would be a mistake. It is a good reminder of what can happen when underwriting procedures are relaxed, and products created which don’t serve the economic health of the market.