Reinsurance Loss-Share Pacts: Next Pain Point

The following article appeared in American Banker: 
 
As mortgage lenders struggle to contend with the double-barreled threat of rising defaults and lower origination volume, a third, less discussed source of risk is now starting to emerge. 
 
Lenders' loss-sharing arrangements with mortgage insurance companies, a source of revenue that in recent years seemed barely an afterthought in terms of financial risk, are now moving to the forefront as the insurers who are on the hook for defaults enforce those agreements. 
 
The pain may be the sharpest for Countrywide Financial Corp., which appears to have taken on far more mortgage reinsurance risk than any other lender, and for which reinsurance earnings have been a larger factor than for its leading competitors. 
 
The Calabasas, Calif., company has reported that, as of Sept. 30, it had reinsured $109.5 billion of mortgages in its servicing portfolio and that it could lose up to $1 billion on that coverage. It said it had reserved $128.2 million for such losses, though it had experienced none so far. 
 
One mortgage insurer, Triad Guaranty Inc., has been unequivocal about the importance of reinsurance to its future. In an interview last month, Mark K. Tonnesen, the chief executive of the Winston-Salem, N.C., company, said that, for mortgage books that have high losses, the pattern of claims costs to primary insurers is reversed from the typical pattern in which such costs mount as the book ages. 
 
"Our profits are depressed in the short term as we pay out high levels of claims, such as it was in the third quarter, and then, later on, approximately 18 to 24 months in the book year, we begin to exceed the threshold on the … reinsurance arrangements" and reinsurers pay the claims, he said. 
 
MGIC Investment Corp., the nation's largest mortgage insurer, has played down the value of reinsurance deals to primary insurers and in the past resisted efforts by lenders to take a larger piece of the business (see related story on this page). 
 
But the company has also said such arrangements will supply near-term assistance during the current downturn, and predicted last week that reinsurers will have to pay out $500 million to $1 billion for loans from 2006 and 2007. While those figures would pale next to the total bill expected to be tallied in terms of delinquency and default costs, it is money out the door at a time when mortgage lenders already face challenges in generating profits. 
 
Lender reinsurance came into being in the mid-1990s and is now a growing practice. Typically, lenders agree to cover claims after defaults on pools of their loans exceed a specified threshold, but only up to a second threshold, when lenders' liability ends. For sharing the risk, lenders share in the mortgage insurance premiums. 
 
The newsletter Inside Mortgage Finance has reported that the $235.9 million of premiums Countrywide collected last year was 30.4% of the total paid to all mortgage reinsurers last year. In 2005, its $191.9 million was 26.8% of the total. In 2004, its $169.2 million of premiums was 24.1% of the total. 
 
Reinsurance earnings have been important to Countrywide, accounting for 5% of its pretax net income last year and 4.3% in 2005. In the third quarter, pretax net income of $68.2 million from reinsurance was among the few bright spots in the company's $1.2 billion loss. 
 
During an Oct. 26 conference call on its third-quarter results, David Sambol, Countrywide's president, identified its insurance business as a strong point, saying reinsurance activities were benefiting from a continuing shift away from piggyback loans to mortgage insurance and a larger overall appetite in the market for risk protection. 
 
Countrywide's reinsurance coverage has grow