Valuing lender-paid mortgage insurance in mortgage-backed security and asset-backed security transactions

Lender-paid mortgage insurance (MI) can provide substantial credit enhancement in mortgage-backed and mortgage-related asset-backed transactions. In some cases, lender-paid MI has contributed more than 75 per cent of the total credit enhancement for the most senior classes.

Lender-paid MI offers insurance coverage at the individual loan level. In most respects, lender-paid MI policies are generally similar to traditional borrower-paid policies. Lender-paid MI has no impact on the frequency of borrower default, but it serves to reduce the severity of loss when borrowers default.

Because lender-paid policies offer coverage on individual loans, the benefit from the policies is limited to the amounts paid by the insurer on each individual defaulted loan, ie the insurance does not ‘cross-collateralise’ the loans. Therefore, if the loss on a defaulted loan is less than the maximum coverage of the insurance policy, the additional coverage cannot be applied to losses on other defaulted loans whose claims exceed their insurance coverage. The wider the range in loss severity on defaulted loans, the less the benefit that lender-paid MI offers. The amount of credit enhancement that lender-paid MI brings to a transaction is directly related to the level of coverage, the number and quality of loans covered, and to any exclusions from coverage. The benefit is also dependent on a loan originator's business practices, particularly with respect to appraisals. Overstated appraisals may cause the MI coverage to be insufficient to cover actual losses. In addition, a servicer's ability to foreclose on defaulted loans and to process claims in a timely fashion is important, because failure to perform these actions may result in a claim adjustment or denial. Because lender-paid MI cannot be cancelled in securitised transactions, it is marginally more durable than borrower-paid MI. Finally, the benefit from lender-paid MI also depends on the rating of the insurance provider. Generally, the insurance provider should have a rating of Aa3 or higher for the Aaa classes in a transaction to get the full credit that the insurance can provide. Because the benefit is dependent on the insurer's rating, transactions that rely on mortgage insurance for a significant percentage of their total credit enhancement are susceptible to downgrade risk if the insurer's rating drops. Copyright © 2002 Henry Stewart Publications