Tuesday, October 7, 2008

Private mortgage insurance and credit default swap

Private mortgage insurance, or PMI, is insurance that most lenders require of borrowers who put less than 20 percent down on a home (or greater than 80 percent loan-to-value or LTV).  Once the principal is reduced to a LTV of  80, the PMI is often no longer required.   Whether it be that the principal has been paid down to a LTV of 80 or that the home has appreciated or both.  The cost of a PMI policy with a down payment of 0-4.99 percent is 0.96 percent of the mortgage.    The national average cost of a home for the subprime buyer is $183,917.  The average LTV of a subprime buyer is 87.18.  This means that the down payment combined with the difference paid for the home versus the actual appraised value is $2,109.62.  The annual PMI policy premium in this case is $1,434.55 using 0.78 times the mortgage as the preimium or monthly it is $119.55.  The monthly payment using the average interest rate of a subprime buyer which is 8.81 percent has a total payment in the amount of $1574.31 including the PMI policy.  

PMI protects the lender not the home owner in the event that the house is foreclosed on.   It also pays the lender the costs that it can't recover after foreclosing on the loan and the costs associated with selling the mortgaged property.  PMI does not protect the owner of the policy.  Even if you have a PMI policy a foreclosure from being in default on payments will result in the loss of the home.  The subprime market currently has 57.3 percent of loans that are past due.  Another 10.7 percent in the subprime market are in foreclosure.   
When the government bailed out AIG it put the government in the PMI business.  AIG's subsidiaries include United Guaranty Residential Insurance Co., the fifth-largest private mortgage insurer in the United States with a 12 percent share of the $357 billion in new private mortgage insurance written in 2007.  The largest is GIC Investment Corp.   Last year it lost $613.6 million.  About 85.6 percent of the loans MGIC insures are prime, with 10 percent classified as A-minus and 4.2 percent as subprime/bad credit.   It is difficult to find the total amount of mortgages that have PMI insurance. 

Credit default swaps (CDS) are typically used to obtain capital relief. In this structure, the mortgage lender enters into a credit default swap agreement with an intermediary bank that guarantees to repay foreclosure-related losses on the lender’s mortgage portfolio.  When you think about PMI it is a CDS.


Jacob said...

Very interesting. I'd like to know how to find out when the sellers of CDS:s and PMI:s actually have to pay up, and to what degree that is projected to happen in the near future. It seems to me that this would be a rather critical piece of market moving information.

Distressed Volatility said...

Interesting, yea I actually do not have a PMI policy. I was looking at this at the counterparty risk perspective, since it could've been a house of cards if AIG was left to go bankrupt. From the hearing today, one of the senior officials said they sold $20 Billion CDSs to Goldman Sachs....And from this bloomberg article below other I-banks were exposed because they provided $441 billion in backing to Wall Street and when the Gov gave them the emergency capital, $37 billion went to the investment banks.. If AIG failed it would've created a domino effect of cross-defaults and these companies were already so distressed at the time...So how could it have been prevented????

There has to be a way to have CDS obligations conservatively calculated on the books with liquid collateral and strict capital ratios in place to make sure a ratings downgrade or a rapid write down wouldn't effect a counterparty's HUGE obligation.. Bascially to protect the whole system when there's a distressed asset crisis. I bet Paulson would've bailed out Lehman if they had as many obligations as AIG, but maybe they did, who knows..



Oh yea and also if the CDS seller breaches a capital ratio, they'd have to liquidate liquid collateral, raise additional capital, or somehow transfer the total obligation somewhere else...Just to make sure the situation would be taken care of quickly. If I'm reading this correctly, I think that's what this exchange is for,

CME, Citadel Launching CDS Exchange

"By putting the swaps on an exchange, speculators could participate, allowing it to function like a futures market and mitigating the risk."

"Regulators and major brokerage houses have been pushing for a centralized clearing solution to eliminate counterparty credit risk in order to free up capital for lending."



anyway thanks for stopping by


Glennda said...

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