In view of the occurrence of subprime mortgage crisis in the United States, Mortgage Insurance Companies Association (MICA) have reported that large mortgage insurers of its members have recorded $2.6 billion in losses in 2008. The report sparks concerns that rising foreclosure rates of the borrowers could force the mortgage industry into a money crunch. For example, Shares of Radian Guaranty, Triad, and PMI Mortgage Insurance Group have lost 90 percent of their share value in 2007; Triad Guaranty Insurance Corporation fails to meet capital requirement in March 31, 2008 and may even going to be out of business. As a consequence, the phenomenon that the defaults of the borrower will spill over into the default probabilities of the mortgage insurer needs to be considered, and it is termed ‘counterparty default risk’. However, when the mortgage insurer fails to meet the risk-to-capital ratio and the government is forced to allow continuing their operations in order to avoid the systematic economic crisis, capital forbearance occurs. It is essential to incorporate the counterparty default risk and capital forbearance, generally not considered by the previous studies, into the pricing model of mortgage insurance?particularly in the case of a mortgage crisis.
Mortgage insurance plays an important role in the functioning of housing finance markets since it transfers the risk exposures on borrowers’ defaults from lenders to mortgage insurers and facilitates the creation of secondary mortgage markets. Private mortgage insurance, known as mortgage guaranty insurance, guarantees that, in the event of a default, a mortgage insurer will pay the mortgage lender for any loss resulting from a property foreclosure up to the 20 to 30 percent of the claim amount (Canner and Passmore, 1994). Mortgage insurers operate under state insurance laws and most states regulate the industry in three special ways: (1) A contingency reserve equal to one-half of all premiums received must be maintained for 10 years; (2) A 4% capital ratio applies to risk in force; (3) A monoline requirement forces a firm to write only mortgage insurance.
Due to the subprime mortgage crisis, the rising foreclosure rates of the borrowers results in the capital scarcity of some mortgage insurers. To help private mortgage insurers, some policies of capital injection are published. For instance, Freddie Mac announced that private mortgage insurers do not need to meet the increasing capital requirements when the credit ratings of mortgage insurers have been downgraded below AA. Moreover, on March 19, 2008, the regulator of Fannie Mae and Freddie Mae, the Office of Federal Housing Enterprise Oversight (OFHEO) agreed to reduce the existing 30 percent OFHEO directed capital requirement to 20 percent. The OFHEO estimates that this reduction should provide up to $200 billion of immediate liquidity to the mortgage backed securities market.
The Housing and Economic Recovery Act enacted on July 30, 2008, is intended to ensure the safe and sound operation of Fannie Mae and Freddie Mae by injecting capital into the two large U.S. suppliers of mortgage funding. Furthermore, to solve the short of capital and ensure the operation, the Federal Reserve was forced to bail out American Insurance Group (AIG), the largest insurance company in the world, by providing an emergency loan of $85 billion for AIG to sell off assets to repay losses on September 16, 2008.
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Valuing Mortgage Insurance Contracts with Counterparty Risk and Capital Forbearance
