One of the most noticeable fall-outs of the current credit crunch are ‘higher’ LTV loans. Anyone trying to borrow above 75% currently will struggle to find a suitable product let alone a reasonable rate.

In a blog a few days ago I made the point this isn’t the 1990s for a number of different reasons. One additional difference between now and then was the scope of products that remained available. Direct comparison between events 18 years apart is never straight-forward, but in the early 1990s – in the midst of the recession, with high inflation, rising unemployment and falling house prices - you could still obtain higher LTV products. Why?

The answer is obviously multi-faceted including such things as dominance of the lending market by mutual building societies (hence no or very low reliance on capital markets for funding and perhaps a greater social conscience), and also perhaps maybe a little naivety around loan performance in such a market. The biggest factor however was the existence of Mortgage Indemnity Guarantees or MIGs.  

If you can issue loans where the lending typically above 75% is covered by an insurance policy, the risk is substantially diminished if not reduced altogether. At the time of the 1990 down-turn, virtually all business was and indeed had been for a considerable time preceding, underwritten with a MIG in place. This was insurance where the premium was in most cases actually passed onto to a third party insurance company, such as Eagle star, Royal and Sun alliance etc rather than simply taken as additional profit or put aside internally. In other words a genuine hedge with a third party firm underwriting the risk. When the crunch came, payouts running into hundreds of millions were made to the lenders.

The myth of risk-based pricing 

As a result of the 1990s downturn, insurers began to raise premiums and also became more cautious and difficult on pay-outs. Accordingly many lenders began to effectively self-insure by putting the MIG premiums aside and calling them Higher Lending Charges (HLCs) or similar. However, as margins tightened and as MIG premiums often ran into many hundreds of pounds, the obvious temptation was to ignore the MIG premium, charge a fee, and take that as profit day one as a risk-based pricing charge.

As we moved into the 2000s, there was an increasing media clamour for MIGs to be removed entirely, often on the pretext that it wasn’t treating customers fairly. It was argued that lenders often charged higher rates anyway above 75%, so why ‘double’ charge with the addition of a MIG? Well quite simply, the risk premium in the form of a higher rate a lender charged above 75%, as we are now discovering, in no way compensated adequately for the default probability and ultimate loss severity that higher LTV loans actually posed. Depending on the asset class, loans 90% or above have a default probability of at least 5 times that of loans below 75% and in a falling market, the ultimate losses are many times this amount.

Many of the loans in question were bundled up into RMBS paper and sold onto investors, who are now bearing the losses rather than the originating lenders in question. In effect the risk of the assets were passed on, at a significantly cheaper cost than conventional insurance, but as we are seeing now, in a downturn, the market has effectively evaporated as no one at present wants to buy new paper. Whilst it can be argued that the insurance market works in a similar way, in that the premiums all go up when the claims start coming in,  the speed, severity and overall impact on the market would have been very different.

In short the disappearance of MIG from the market in the years preceding this current downturn has had a profound and negative effect on lenders ability to manage products and risk.

 
The future of MIG 

Stephen Knight, in his speech at the CML Conference on 2 December 2008, raised the idea of the government directly insuring more risky loans to higher LTVs and/or to FTBs.  Whilst this may sound to some a highly interventionalist and potentially costly move, this overlooks two important facts.

(1) The markets have ceased and continue to cease to function, so trying to somehow get the market to do this element with house prices still falling is well nigh impossible - without direct government intervention these loans will not get written and the house price decline will be that bit more painful and prolonged.
(2) There is precedent for this type of intervention, particularly in Holland with the NHG (National Mortgage Guarantee). This is effectively a quasi government organisation that provides insurance on certain types of loans for people who may be otherwise unable to obtain a mortgage, typically, FTBs wanting a high LTV and /or lower income families. It works in the same way as MIG with a premium based on the percentage and amount of advance charged upfront.

With effective government insurance, RMBS paper consisting of NHG loans have traded at a significant premiums to other RMBS loans. Even if you assume that you do not currently have the ability to trade these loans in the markets, lenders should have the ability to gain significant regulatory and capital relief with this insurance hedge underlying the loans, making the whole lending process cheaper and more efficient. Whilst the government would bear the risk, they would be receiving significant premiums upfront and (let’s be honest here) ultimately even if the lenders make these loans without insurance, the government are effectively ultimately underwriting the risk anyway!

The government already underwrites the top, risky slice of 100% Homebuy equity sharing loans AND offers unsecured loans to students – so they are technically already in this space.  Offering lenders protection from, say, 85% LTV to 95% LTV for FTBs is less risky than the other areas in which the government invests and should return a profit.

MIG may well be dead, but its return in the current market would be very welcome.