Banks and credit unions may be able to leverage insurance placed on some of their longest-duration loans under the new loss accounting standard, potentially easing the punitive nature of an allowance that spans the lifetime of the loan.
The current expected credit loss model, or CECL, will force banks to reserve for lifetime losses at origination. Many in the industry expect this frontloading will have the greatest impact on the longest-duration loans, including mortgages that are often several decades long.
But mortgage insurance can be recorded as a credit enhancement under CECL, which means banks and credit unions are able to use it to lower or offset some of the lifetime allowance. That, in turn, could help constrain the provision.
"CECL is kind of a wake-up call for some [mortgage lenders]" said Garrett Hartzog, product development director at mortgage insurer MGIC Investment Corp. "That mortgage insurance gets credited in CECL — we think this is a big deal."
The lifetime allowance calculation includes the probability of default, the exposure at the time of default and any expected recoveries. Institutions that include insurance policies in their calculation can reduce their loss exposure or increase their recoveries, but the policy has to apply at the loan level and travel with the credit or instrument, said Cristian deRitis, senior director of consumer credit analytics at Moody's Analytics. The guidance exempts other credit enhancements like pooled insurance and freestanding contracts like credit default swaps.
Currently, mortgages that do not have a 20% down payment must carry a credit enhancement like insurance before it can be sold to government servicers like Fannie Mae and Freddie Mac. It is used less often when a lender keeps a loan in portfolio, Hartzog said.
A lender can file a mortgage insurance claim after the loan defaults, and the payout can cover a portion of the unpaid principal balance, accrued interest and certain expenses. There are six large U.S. private mortgage insurers: Arch Capital Group Ltd., Radian Group Inc., MGIC, Essent Group Ltd., Genworth Financial Inc. and NMI Holdings Inc.
Mortgage insurance could potentially assuage industry concerns that a higher reserve on a mortgage portfolio will translate into higher interest rates, deRitis said. Banks have told regulators that CECL could have unintended consequences in lending activity, including reduced availability, shortened maturities and increased pricing, especially for residential mortgages and small business loans.
"You don't get all the way to zero [for expected losses] but you can get pretty close ... a few basis points," he said. "You can really minimize the exposure dramatically."
Click here to read more of our coverage on how banks are complying with CECL and IFRS 9.
Click here to read S&P Global Market Intelligence's analysis of CECL's impact on the industry as part of our updated five-year outlook, and here about how CECL may have fared during the Great Recession.