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For more information, visit genworth.com.au For information on this report please contact Ric Simes T: +61 2 9376 2500 E: ric.simes@accesseconomics.com.au Kristen Foster Head of Government & Industry Affairs Genworth Financial T: +61 2 8248 2205 E: kristen.foster@genworth.com Report prepared by Ric Simes Mike Thomas Matt Wright Contents Executive Summary ........................................................................ii Charts 1 Background.................................................................................1 Chart 2.1 Australian wholesale lenders 1.1 What is LMI?
........................................................................2 1.2 Benefits of LMI ....................................................................3 1.3 Approach and scope of the analysis................................4 2 Role and benefits of LMI ..........................................................5 2.1 History of LMI in Australia..................................................6 2.2 Market discipline ................................................................9 2.3 Economic stability .............................................................10 2.4 Productive efficiency .........................................................11 2.5 Policy alignment ................................................................13 2.6 Structural advantage over alternatives...........................16 share of housing market ............................................7 Chart 2.2 Banks’ housing loan characteristics .........................8 Chart 2.3 Genworth portfolio performance.............................9 Chart 2.4 Genworth (US) MI premiums and losses ................10 Chart 2.5 Securitised home loans ............................................11 Chart 2.6 Genworth MI market, by lender ..............................13 Chart 2.7 Housing credit............................................................14 Chart 2.8 First home buyers ......................................................15 Chart 2.9 Rent as a proportion of average earnings .............16 Chart 3.1 Residential securitisation
 (A$ billion) ......................22 3 Regulation and competition ...................................................17 Figures 3.1 Current arrangements around LMI in Australia.............18 3.2 Post-GFC implications for mortgage lending sectors...19 3.3 The continued role for LMI in Australia ..........................21 4 Implications................................................................................23 4.1 For lenders (risk and leverage).........................................23 4.2 For borrowers (price and equity) .....................................23 4.3 For the economy (efficiency and stability)......................24 4.4 Conclusion..........................................................................24 References.......................................................................................25 Figure 2.1 The Canadian mortgage lending sector.................8 Figure 2.2 Housing accessibility.................................................15 Glossary APRA CRM GFC HLIC LGD LMI LTV LVR MI NBFI RMBS Australian Prudential Regulation Authority Credit risk mitigant Global financial crisis Housing Loans Insurance Corporation Loss given default Lenders mortgage insurance Loan to value Loan to value ratio Mortgage insurer Non-bank financial institution Residential mortgage backed securities ECONOMIC VALUE OF LMI • ACCESS ECONOMICS • i LMI has provided access to home ownership to LMI has played a role in supporting prudent a wider range of
 creditworthy lending and competition borrowers between lenders Executive Summary Current value of LMI to the Australian economy Lenders mortgage insurance (LMI) provides protection to financial institutions against losses arising from borrower default on high loan-to-value (HLTV) residential mortgages, typically for the life of the loan and on a non-cancellable basis.
LMI facilitates borrower access to such HLTV housing finance options while reinforcing prudent lending standards and supporting a more resilient and stable financial system (Genworth, 2010a).

Governments and regulators in many developed markets have recognised the importance of mortgage insurance in managing risks throughout their financial systems, as demonstrated by actions by the United States, Canada and the United Kingdom.
In addition, the Joint Forum 1 has supported the widespread use of LMI for high LVR loans in its deliberations on reforms to financial regulation in the wake of the global financial crisis (GFC).

LMI has made a valuable contribution to the Australian economy.

Since its introduction in 1965, LMI has improved efficiency, equity and risk management in the Australian home lending market.

financial practices such as the maintenance of robust lending standards.

Each of these benefits is considered below.


However, the environment in which mortgage insurers (MIs) operate is undergoing pronounced change.

The impact of the GFC on competition in lending and the related reform of financial regulation herald a changed financial landscape in Australia.

MIs are anticipating and adapting to the challenges to their traditional business model in a time of heightened uncertainty.
The outcome of this process will determine the extent to which MIs are able to continue to perform their important economic role in the future.

1 The Joint Forum was established under the aegis of the Basel Committee on Banking Supervision (BCBS), the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) to deal with issues common to the banking, securities and insurance sectors.
Home ownership Australia’s financial system has been transformed over the past Financial deregulation led to new entrants into the financial system—including mortgage originators—and smaller financial 30 years through sweeping deregulation and the introduction of new communication technologies.

The system has become more competitive and efficient.
In addition, and importantly for the understanding of the role of LMI, the system has become more equitable, with access to finance becoming available to a wider range of credit-worthy borrowers.

institutions being better able to compete with the larger banks.

In many instances, it was these institutions that developed new products and targeted new customers, thereby creating more equitable access throughout society to financial markets.
LMI has played a role in this transformation by both supporting prudent lending for high LVR mortgages and facilitating a more No longer do borrowers have to have a well-established credit competitive landscape.

profile and a large deposit before they can contemplate applying for a mortgage.

Beneficiaries from this improved access to finance include: • many low to middle income households; LMI was introduced in Australia by the Federal Government to increase home ownership.
The government-owned Housing Loans Insurance Corporation (HLIC) was subsequently privatised and purchased by GE Mortgage Insurance (now Genworth Financial) in 1997.

Privatisation of LMI achieves the same social outcomes as the original government scheme, but avoids the challenges involved when government needs to deliver a service throughout the • single people, especially women, who had previously faced community.
Similarly, LMI improves the effectiveness of the various additional hurdles accessing credit.

government policies to assist first-home buyers to enter the housing market.
LMI has a strong story in housing finance and financial markets LMI has contributed to home ownership, competition and financial system stability at NO cost to Government It’s important the role of LMI is preserved in the post-GFC framework LMI complements government policy to promote greater access • relatively new entrants into the workforce with a stable relatively to home ownership, competition between lenders and prudent well paying job; and ii • ECONOMIC VALUE OF LMI • ACCESS ECONOMICS ECONOMIC VALUE OF LMI • ACCESS ECONOMICS • iii Chart i: Banks’ housing loan characteristics Source: APRA, RBA % 24 16 8 % 45 30 15 0 Share of new loan approvals Owner occupiers Investors 80 ≤ LVR < 90 LVR ≥ 90 Interest only Low documentation Other 2008 2009 2008 2009 % 24 16 8 % 45 30 15 0 LMI provides an effective option for financial “Supervisors should consider how to use institutions to manage risks such coverage effectively in associated with their mortgage books conjunction with LTV require - ments to meet housing goals and needs”—Joint Forum, 2010 LMI has expanded the pool of potential home-owners to include borrowers who are capable of servicing a mortgage, but do not meet the standard eligibility requirements.
Without LMI, these home owners would have to postpone their purchase, or remain in Financial stability The GFC has made improving financial system stability a major goal of governments around the world.

LMI can contribute to improved risk management within individual financial institutions and across rented accommodation.

High LVR loans account for a substantial the system through: share of total new mortgages in Australia.
For example, the top left panel in Chart 1 shows that in 2009 more than one-third of new loan approvals for owner-occupiers had an LVR greater than or equal to • most importantly, providing extra scrutiny of lending practices and giving additional information to prudential supervisors; 80%, including 16% with an LVR greater than or equal to 90%.
• providing bank management with feedback on how their Lenders use LMI because it is the insurance product that most mortgage book is performing, including against their peers; Diversification aids risk management and from the financial This value is widely recognised by the financial authorities, as institution’s perspective, LMI provides an effective option within its illustrated by the Joint Forum stating: suite of measures that it will utilise to manage risk.
Depending on the nature of the institution’s overall balance sheet, LMI may be used to manage risks associated with varying levels of its mortgage books, with smaller institutions in Australia tending to rely more heavily on it.

Mortgage insurance provides additional financing flexibility for lenders and consumers, and supervisors should consider how to use such coverage effectively in conjunction with LTV requirements to meet housing goals and needs in their respective markets.
Supervisors should explore both public The extent of the use of LMI is dependent on how the parameters and private options (including creditworthiness and reserve in the capital regulations are set.
Financial institutions have requirements), and should take steps to require adequate alternative options for managing risks including using products in mortgage insurance in instances of high LTV lending — accurately reflects their potential loss given default (LGD) and • pooling risk in a way that improves the alignment of information capital markets—although some products, such as credit default e.g.

greater than 80 % LTV— The Joint Forum, 2010:17).


reduces the level of capital they need to carry to meet regulatory and incentives (i.e.

keeping some ‘skin in the game’); swaps, proved to be less than effective during the GFC—and requirements.

MIs have strong incentives to provide mortgage insurance widely and efficiently because it improves their capacity to manage their risk in a way that maximises their long-term profits.
The Canadian mortgage lending sector has been one of the most efficient and least volatile of all advanced economies during the GFC, partly attributed by Bank of Canada Deputy Governor Murray to ‘mortgage insurance and prudent underwriting standards’ (Murray, 2010).
• effectively making system capital reserves for mortgage defaults more fungible, lowering the average cost of capital; • exerting a countercyclical influence on the credit cycle, through capital and lending practices; and keeping the risk on their balance sheets.

Each will have costs and advantages and, as evidenced by the record in Australia, prudential requirements that are consistent with the use of balance of risk management measures will tend to be optimal.
The experience provides a solid base on which to develop regulatory responses to • providing a capital buffer to shocks to the financial system and the GFC.

broader economy emanating from the housing sector.
LMI has a strong story in housing finance and financial markets LMI has contributed to home ownership, competition and financial system stability at NO cost to Government It’s important the role of LMI is preserved in the post-GFC framework iv • ECONOMIC VALUE OF LMI • ACCESS ECONOMICS ECONOMIC VALUE OF LMI • ACCESS ECONOMICS • v Chart ii: Genworth MI market, by lender 100 Source: Genworth Share of premiums % 80 60 40 20 0 MIs in the Australian market have helped Changes to regulatory capital proposed small lenders to enter the under Basel II do not appear market, increasing the choice to take into account the role and competition for borrowers of LMI in strengthening prudential supervision and systemic stability 2004 2005 2006 2007 2008 2009 2010 Major banks CUBS* Non-ADIs Other banks *Credit Unions and Building Societies Future value of LMI to the Australian economy Competition One of the biggest challenges for the Australian authorities coming out of the GFC is how to restore competition in the retail lending market.
Many of the innovations in lending have been introduced by smaller lenders and subsequently adopted by the major banks.

The existence of MIs in the Australian market has helped small lenders to enter the market and helped them access Genworth provides around half of LMI in the Australian market, by The ability of MIs to continue making their valuable contribution to If the financial balance between LMI and its capital adequacy and gross premiums.
Smaller lenders—especially non-major banks and the Australian economy depends on financial institutions of varying risk management substitutes alters, such that lenders use less LMI non-ADIs—have always relied disproportionately heavily on LMI.

scales and types continuing to use mortgage insurance as a risk (and only on the riskiest loans), hedging of lenders’ risks may Genworth’s customer base shows the split between major banks, and capital management tool for a material part of their books.
The become less efficient.

Scrutiny of the level of risk carried on loan building societies and credit unions and non-ADIs (Chart ii).

The GFC has seen a sharp shift in the mortgage market to the major books will fall.

Risk-pooling benefits, including fungible capital, will dramatic shrinkage of the non-ADI share is noteworthy because banks.

While these banks have historically tended to have been be diminished.
The alignment of information and incentives may this sector of the market has been a source of much innovation and less reliant on LMI than other parts of the markets, they are likely become more skewed.

Countercyclical properties of LMI will have cost effective funding via securitisation, increasing competition and competition in lending.

to continue to make use of LMI as long as regulatory arrangements a reduced impact.

Financial system stability would not be improved.

choice for borrowers.


‘The increased pressure that the nonbanking sector places on banks led to the banks emulating many of the new products that were being offered.

The Australian Banker’s Association agree that foreign banks and the nonbanking sector forced the banks to ‘accept reduced margins and to roll out new technology and new products, and to otherwise respond to competitive pressures’ (House of Representatives Standing Committee on Economics, 2008:12).
Small lenders proliferate in the innovative, albeit sometimes riskier, part of the mortgage market and LMI allows them to manage these risks and lower their cost of capital to cost effective levels.

Small institutions use LMI more than large banks because they have smaller balance sheets with which to self insure against default risk and access capital markets on less favourable terms.
Credit rating agencies’ support for prospective fund raising in capital markets is contingent on small lenders obtaining LMI.

The presence of a viable and effective level of competition ensures consumers in metropolitan and regional areas have access to the widest range of products and levels of service.

remain supportive.
remain supportive.

At the same time, the Government and the ACCC are concerned Critically, Australia does not have a government-backed alternative about the increased concentration of the residential mortgage to the private MIs, presumably because the authorities consider the market coming out of the GFC.
If MIs reduce their presence in the existing arrangements to be satisfactory and/or Governments Australian market, or raise their prices, the cost of raising funds for prefer private capital to play this role, unlike in Canada and the US, small lenders could increase.

It is likely that this would reduce where there is also a public MI function.
further the level and range of financial products offered to Governments and financial authorities are introducing wide- ranging reforms to financial regulations that may affect the provision of LMI in Australia.

While the net impact of proposed reforms is being studied and taken into account by the authorities, the staggering of the introduction of the changes means the households and small business.

Moreover, households and small businesses’ cost of borrowing may rise due to reduced competition.
For some, their access to funds could be restricted, if lenders are given an incentive to reduce volumes of high LVR loans provided to viable borrowers.

various costs and benefits may not be spread evenly.

For example, LMI has served Australia well and equitably and global regulators proposed changes to capital reserve requirements for large banks recommend its use.
Yet, changes in regulation and the marketplace may result in a substantial decrease in Australian lenders’ use of threaten to adversely affect the way MI serves the market.

The cost LMI, contrary to the Joint Forum’s recommendations.

of changes to regulation that compromise the capacity of MIs to The changes to regulatory capital proposed under Basel II do not appear to take into account the role of LMI in strengthening prudential supervision and systemic stability.
provide this service falls on home buyers, competition in lending and financial stability.

Clearly, retaining the positive roles played by private MIs in Australia in risk and leverage, price and equity, efficiency and stability is preferable.
Access Economics vi • ECONOMIC VALUE OF LMI • ACCESS ECONOMICS ECONOMIC VALUE OF LMI • ACCESS ECONOMICS • vii Regulatorychanges that reduce incentives for lenders LMI is a credit risk mitigant that protects to use mortgage insurancemay a mortgage lender against have unintended adverse consequences for access to housing finance borrower default 1.1 What is LMI?
For this reason, and in the face of potential regulatory change LMI is a credit risk mitigant (CRM) that protects a mortgage lender LMI began in the United States in the 1930s, as a government policy that could adversely affect the ability of the Australian LMI sector against borrower default.

It is in practice insurance to cover to promote home ownership (Allen and Chan, 2000).
It was later to serve the market, Genworth Financial has commissioned the gap if the proceeds generated through foreclosure on a de - introduced into Australia in 1965, again as a government policy Access Economic to undertake a study into the current and future faulted residential property are insufficient to meet a borrower’s initiative designed to increase home ownership (Allen Consulting, value of LMI in the Australian economy.

outstanding obligation—otherwise known as ‘loss given default’ 2005).
LMI in Australia was at this time provided by the government- Coming out of the GFC, the Federal Government is concerned by the increased concentration in the residential mortgage market, as well potential risks and also in non-erosion of lending (LGD) or ‘first loss cover’.

LMI is typically applied to high LVR loans owned Housing Loans Insurance Corporation, which was sub - (over 80%), as the expected LGD for such loans is considerably s equently privatised and purchased by GE Mortgage Insurance higher.
(now Genworth Financial) in 1997. standards to underpin financial system stability.

The trigger for In its application, LMI has two primary implications for the lender: The Australian LMI market was worth $896 million in gross this study is the potential recalibration of the existing financial regulatory system that may run counter to Government policies in housing, banking and financial stability.
Depending upon the outcomes of this adjust ment process, the incentives for lenders to pursue LMI over self-insurance and hedging in capital markets may skew, in which case there could be unintended adverse consequences for access to housing finance.

This report explores how the role of LMI may evolve.

1. a reduction in the capital requirements that would normally be associated with the level of risk on a lender’s books; and 2. a transfer of the risk of borrower default from the lender to a third party.
LMI is therefore an instrument providing the primary benefit of capital relief to lenders.

premiums in the 12 months to June 2009 (APRA, 2009).

1 Background Lenders mortgage insurance (LMI) plays an important role in the Australian economy, extending beyond the act of insuring mortgages.
LMI has a strong story in housing finance and financial markets LMI has contributed to home ownership, competition and financial system stability at NO cost to Government It’s important the role of LMI is preserved in the post-GFC framework 1 • ECONOMIC VALUE OF LMI • ACCESS ECONOMICS ECONOMIC VALUE OF LMI • ACCESS ECONOMICS • 2 1.2 Benefits of LMI LMI plays an important role in the Australian economy, extending beyond the act of insuring mortgages.
This role includes providing For the economy: • stability—the risk pooling effect of LMI implies the risk of over- the following series of direct and indirect benefits, at the individual, industry and economy-wide levels: For borrowers: • utility—an increase in lenders (as enabled by LMI) naturally promotes competition and innovation, and as a result, more choice in lending products and services for borrowers; and • equity—LMI extends lending to those borrowers who are typically excluded altogether and brings forward access to lending for those borrowers who do not have a sufficient deposit at the time of loan application.
exposure for any single financial intermediary is greatly reduced.
LMI also carries natural counter-cyclical properties that serve to offset the pro-cyclical tendencies of the lending market and the economy more broadly; • balance—between efficiency and sufficiency where higher risk lending occurs, given lenders are only required to hold capital in reserve to support the regulatory determined average level of default risk in the economy, but only because the LMI safety net exists for those situations where the economy-wide average level is less than the actual/expected level of default for any single lender/borrower; For lenders: • leverage—securitisation (as enabled by LMI, to obtain • efficiency—information and incentives align to produce economic efficiency gains, given MIs have the balanced necessary credit ratings) allows lenders to transfer credit risk incentives of growing the size of the market and prudently to a third-party and earn a return.
At the same time, it thereby managing the level of default risk, and MIs’ scale and scope frees-up lender capital for another series of borrowers; and means information asymmetries are minimised enabling trade • risk—increased scrutiny is placed on banks through the to occur in a more efficient manner; systemic process that LMI initiates with the lender concerning • competition—LMI lowers capital barriers to entry and credit policy and lending processes and active risk manage - therefore allows a greater range of lenders into the market, ment is improved by augmenting information provided to bank ensuring greater levels of competition and innovation (in price management with audit reports from MIs.
As a result, exposure and service); to individual default and the probability of bank default is reduced.

• avoided public cost—as governments consider equitable access to home ownership a policy priority, LMI limits govern - • market size—LMI has provided banks with a bigger market ment financial outlay by transferring (a proportion of) risk and to lend to by increasing the size of the pool of potential funding to the private sector; and home buyers.
In Australia, LMI plays an important role… …for borrowers, lenders and the economy 1.3 Approach and scope of the analysis • policy tensions—there is a tension between policies that By way of overview, insights are drawn from reports and data held seek to extend home ownership to a greater portion of the (and publically available) by APRA and RBA.

This is complemented population (i.e.


to riskier borrowers) and policies that aim to by evidence from industry professionals and analysis provided by increase the soundness of the financial sector (i.e.

to reduce the Genworth Financial.

level of risk).

LMI helps policy makers to reconcile conflicting policy goals.

This analysis proceeds as follows: LMI enables the majority of these benefits through the information and incentives its risk management/business model is based on.
• Chapter 2: An explanation of the full-extent of LMI’s economic role in Australia; • Chapter 3: Insights into the existing regulatory structure and anticipated key regulatory adjustments expected to impact the LMI sector in Australia; and • Chapter 4: Potential changes to LMI and flow-on to the Australian economy.

Any issues that remain unsolved will be flagged for further consideration.
LMI has a strong story in housing finance and financial markets LMI has contributed to home ownership, competition and financial system stability at NO cost to Government It’s important the role of LMI is preserved in the post-GFC framework 3 • ECONOMIC VALUE OF LMI • ACCESS ECONOMICS ECONOMIC VALUE OF LMI • ACCESS ECONOMICS • 4 In 1965, the Government established the The nature of LMI’s benefits have expanded from a Housing Loans Insurance largely social focus to incorporate Corporation (the first LMI in significant cost-efficiency gains Australia) with the objective of increasing home ownership 2 Role and benefits of LMI The role and value of LMI extends economy-wide, as an accumulation As outlined below, these direct and indirect benefits of LMI can be LMI has supported the development of a more equitable and significant cost to Commonwealth finances, with these programs described in terms of: efficient Australian mortgage lending industry since its inception in financing 37% of all residential mortgage originations by 1962 • historically in Australia (supporting mortgage lending 1965.
Broadly, LMI: (Genworth, 2007).

2.1 History of LMI in Australia of the functions it performs for developments); mortgage lenders and the financial • market discipline in mortgage lending; sector more broadly, Australian borrowers (particularly in the riskier lending segments) and the Australian Government.
• promoting economic stability; • productive efficiency gains; • policy alignment (in competition and equity); and • structural advantages over alternative risk transfer and capital adequacy approaches.

This chapter proceeds with a more detailed consideration of each of these factors.
LMI has a strong story in housing finance and financial markets LMI has contributed to home ownership, competition and financial system stability at NO cost to Government It’s important the role of LMI is preserved in the post-GFC framework • began as a home ownership equity initiative to expand the At this time, the Government was also socially reliant upon the range of Australian borrowers; • provided capital support to enable the growth of building societies in the lead up to Australian financial market deregu - lation in the 1980s; • extended that support to the banking sector as financial deregu - la tion released the constraints on a bank’s ability to lend to low-deposit borrowers; and • supported the development of a private securitisation market in the 1990s, increasing the level of competition in mortgage lending to the benefit of all borrowers.
The following elaborates on the context and developmental impact of the introduction of LMI in Australia, and how the nature of its benefits transitioned from a largely social focus to later incorporate significant cost-efficiency gains.

1950 to 1965 Homeownership was becoming an increasingly central political and social theme just prior to the introduction of LMI, compound - ing through the 1950s and into the 1960s.
Indeed attaining ownership through access to mortgage lending became a central tenant of mainstream Australia (Genworth, 2007).

In response to this political pressure, the Government commenced its program of socially-driven mortgage lending.

In the 1950s, the Government was reliant on the War Services Home program and Commonwealth-State Housing Agreements to induce sufficient levels of home ownership.

However, this came at ceiling on interest rates that savings banks could charge on mortgage loans.
However, the unintended consequence of this regulation was that the simultaneous cap on interest that could be paid on deposits limited the volume of deposits made.

This in-turn forced a rationing of bank credit, according to a series of restrictive timing and loan value constraints that ultimately favoured only lower risk borrowers—a situation which led to great dissatisfaction amongst the adversely affected public.
LMI was established in Australia in 1965 by the Federal Government—in the form of the government-underwritten Housing Loans Insurance Corporation (HLIC).

The HLIC had the primary policy objective of increasing home ownership—through greater capture of low-deposit borrowers—in an efficient and effective manner.
A supplementary aim was to leverage additional capital into the mortgage lending sector through enhanced credit- worthiness of intermediaries (namely building societies) and the development of a secondary market for mortgage loans (Genworth, 2007).

1965 to 1980 In light of its policy goals, the Government was successful in its design and implementation of LMI.

The implementation of LMI correlated with the great expansion of building societies and a notable reduction in the rationing of credit.
Furthermore strong competition in mortgage origination between savings banks and buildings societies ensued into the 1970s, with building societies the greatest customer of the HLIC at this time.
5 • ECONOMIC VALUE OF LMI • ACCESS ECONOMICS ECONOMIC VALUE OF LMI • ACCESS ECONOMICS • 6 Chart 2.1: Australian wholesale lenders share of housing market Source: RBA Wholesale lenders’s share of housing approvals RMBS issuance Major banks CUBS & regional banks Mortgage originators % 15 10 5 $b 24 16 8 0 1990 1994 1998 2002 2006 2010 % 15 10 5 $b 24 16 8 0 Chart 2.2: Banks’ housing loan characteristics Source: RBA, 2010 % 24 16 8 % 45 30 15 0 Share of new loan approvals Owner occupiers Investors 80 ≤ LVR < 90 LVR ≥ 90 Interest only Low documentation Other 2008 2009 2008 2009 % 24 16 8 % 45 30 15 0 However, the other factor correlating with the rapid expansion of service offering to the traditionally disinterested (credit rationed) source—major banks also began issuing RMBS as a means to 80%, including 16% with an LVR greater than or equal to 90%.
the largely unregulated building societies was the heavy-handed retail banks, and to the benefit of low-deposit borrowers whose diversify their funding base (Debelle, 2010).

The competitive Furthermore, its financial stability promoting functional parameters approach to banking regulation.

At this time, controls were placed ability to access the mortgage market was uninterrupted.
pressure securitisation created saw the mortgage rate to short-term have made LMI a beneficial economic intervention, in complement on (Debelle, 2010): • interest rates banks could charge on loans and pay on deposits; 1993 to 2007 By 1994, given the dominance of banks in Australian mortgage • the quality of loans banks could make and who they could lend lending and in the context of a strong recovery from the earlier bank rate spread reduce to approximately 175 basis points by 1997. to its social roles.
Reinforcing this view, LMI is presently a feature in In addition to interest spreads and regulatory change, this competitive development was also supported by LMI.

The credit enhancement LMI provided to securitisation was a critical element the housing finance sectors of around 30 nations (Genworth, 2010a), a notable example of which is Canada (see Figure 2.1).

in obtaining investor acceptance of RMBS.


Reflecting this, HLIC was Figure 2.1: The Canadian mortgage lending sector to; and • loan segment coverage across trading banks, savings banks and finance companies.

Each of these controls was effectively an imposed cost disadvan - tage compared to the unregulated financial sector.

1980 to 1993 These market structures were set to change in the 1980s with the onset of Australia’s financial deregulation agenda.
The restrictive limitations on loan values and allocation of bank deposits (the ‘prescribed assets ratio’) that were holding back competition from savings banks in the high LVR segment were dropped.

Furthermore, the distinction between savings banks and trading banks was removed.

As a result, a number of building societies and credit unions converted to banks—thereby allowing them to expand their capital base (Debelle, 2010)—and the incentive for banks to lend to the low-deposit segment was introduced.
Indeed by the end of the 1980s, building societies’ share of mortgage originations had halved from the peaks of 40-50% reached in the 1970s (Genworth, 2007).

Furthermore, as at 1993, Australian banks had surpassed building societies as HLIC’s biggest customer.

During this time LMI had seamlessly made the transition from a service offering to the emerging building societies, to a recession, mortgage rate to short-term bank rate spreads peaked at about 430 basis points (Debelle, 2010).
This (in-part) created an opportunity for the establishment of non-bank ‘wholesale’ mort - gage lenders.

With an ability to offer standard lending rates 1–1.5% below that charged by the incumbents, and offering an array of new mortgage products—including, home equity loans, interest only loans and low documentation loans—these new entrants accounted for around 8% of all mortgage originations by 1996. achieving record levels of business at this time (Genworth, 2007).
From that point through to the onset of the GFC, the market for RMBS increased rapidly (Chart 2.1)—with the LMI sector following suit.

2007 onwards This period saw large banks utilise LMI more than ever and ensured The ability of wholesale lenders to enter and compete in mortgage banks stayed lending to 95% LVR, albeit more carefully which also lending can also be attributed to the development of a private helped ensure financial system stability.
The imposed disciplines of residential mortgage backed securities (RMBS) market.

Where LMI can be attributed to some of the credit for Australia’s financial previously state government-backed securitised products had tried sector stability and performance in the lead up to and during the and failed (at significant cost to government), the opportunities for recent global financial crisis.

MIs avoidance of the emerging non- private-labelled products had emerged.
This aligned with the conforming segment and natural counter-cyclical properties—as removal of the last major barrier to private securitisation, when in means by which to maintain the resilience of the financial sector— 1995 the Reserve Bank of Australia removed its requirement that provided a valuable balance to the incentives for growth.

all securitised products held by a bank attract a capital at risk weighting of 100% (Genworth, 2007).
In sum, as a key historical development in Australian mortgage lending, LMI has provided wider access to credit and promoted Wholesale mortgage lenders then provided the demand impetus greater financial innovation, to the benefit of all Australian to meet this eased supply constraint.

Securitisation provided a borrowers.

High LVR loans account for a substantial share of total source of funds to these non-deposit taking intermediaries, and new mortgages in Australia.
For example, the top left panel in did so in a cost-efficient manner.

Regional banks, credit unions and Chart 2.2 shows that in 2009 more than one-third of new loan building societies all made significant use of this low cost funding approvals for owner-occupiers had an LVR greater than or equal to The Canadian mortgage lending sector has proven to be one of the most efficient and least volatile of all industrialised nations, and despite the proximity/ties to the US market (Wachter, 2010).
This, as stated by John Murray (Murray, 2010), Deputy Governor of the Bank of Canada, is a reflection of Canada’s: • prudent lending practises; • strong housing sector; • lesser reliance on wholesale financing and securitisation; and • LMI and associated prudent underwriting standards.

In Canada, the Canadian Mortgage Bond Program is an effective model.
Indeed, the Canadian Government mandates LMI for all high LTV loans and provides a government-backed guarantee on these policies in the case of a catastrophic credit event.

As a result, the Canadian mortgage lending sector has seen continuous improvement in underwriting standards and price reductions for high risk borrowers.
7 • ECONOMIC VALUE OF LMI • ACCESS ECONOMICS ECONOMIC VALUE OF LMI • ACCESS ECONOMICS • 8 Chart 2.3: Genworth portfolio performance Source: Genworth Cash Rate L,H,S Unemployment Rate L,H,S GNW Portfolio e t a R h s a C 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% As a percentage of total outstanding housing loan 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00 Chart 2.4: Genworth (US) MI premiums and losses Source: Genworth 192% 218% $4.8 204% $4.4 $3.8 $3.4 79% 19% 51% 15% ‘80 ‘81 ‘82 ‘83 ‘84 ‘85 ‘86 ‘87 ‘88 ‘89 ‘90 ‘91 ‘92 ‘93 ‘94 ‘95 ‘96 ‘97 ‘98 ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 Loss ratio (%) Net premiums Earned ($B) 2.2 Market discipline 2.3 Economic stability LMI has helped facilitate access to mortgages to a wider range of LMI therefore reinforces operational disciplines at both origination LMI promotes stability in the Australian financial system through • Firstly, LMI enables the continued accessibility and afford- borrowers, without compromising credit discipline.
and during the life of the loan.

MIs also have their own capital on the risk-pooling its structure enables and the counter-cyclical forces ability of lending to high LVR borrowers during economic Increased scrutiny is placed on banks through the systemic process the line throughout the duration of the insured loan.

its implementation provides.

All individuals in the Australian that LMI initiates with the lender.
LMI adds an additional layer of As a result of MI scrutiny, more ‘bad loans’ are likely to be weeded due diligence for those loans being insured, through the loan level out, reducing the average probability of individual borrower economy benefit from a diversification of risk and reduced severity in the business cycle.

insurance evaluation that is performed.

This is beyond the level of default.

At the same time, exposure to individual default and there - A pooling effect is enabled by LMI.
The pooling effect includes the downturns, given the safety-net ‘contingency capital’ it pro - vides 3.

Conversely at the peak of the cycle, the due diligence performed as part of LMI agreements will discourage imprudent lending—that is, to the more speculative investors/borrowers4.

scrutiny and audit routines that the Australian Prudential Regulation fore the probability of bank default is reduced.
The transfer of the diversification of default risk across: • Secondly, mortgage insurance companies continue to face Authority (APRA) performs—which is generally restricted to the remaining risk in the case of securitisation further supports this find - loan ‘pool’ level—and is ultimately cross-checked by APRA when ing (as discussed further below).
In effect, LMI provides systematic the mortgage insurers themselves are audited for adequacy and improvement and complementary audit measures to those exist - prudency.

APRA is understood to request that lenders provide ing, ensuring more consistent and robust underwriting standards.

them with copies of all LMI audit reports.

In a sense therefore, this is also a market feedback function that can provide early warning to regulators of declining quality in lending standards.
The above chart shows the performance of Genworth’s portfolio in Australia during the GFC.

The delinquency rate rose modestly, in line with the increase in the unemployment rate, as occurs during More broadly, LMI is incentivised to enhance scrutiny at various every economic cycle.

• geography; • lenders; • time; and • loan product.

strong reserve requirements that are additive to basic insurance capital standards (Genworth, 2010b).
A counter-cyclical sys- tem of reserves building, or dynamic provisioning—with the greatest additions made in the periods of most intense loan origination—along with a ‘contingency reserve’ of 50% of prem - ium revenue for a period of 10 years, support capital sufficiency The key implication of this is the risk of over-exposure for any single in credit events (Chart 2.4).

financial intermediary is greatly reduced.


The safety net can there - fore perform its role—insurers will have the capacity to honour all points in the risk management process, including through: Notably, the MI business models withstood the GFC; in Australia claims in a credit event.
• the agreed/acceptable credit parameters and loan underwriting and even at the epicentre of the shocks in the US, mortgage criteria, including debt-to-income ratios, borrower qualification standards across loan products, and data to be collected and insurers did not fail and continued to write premiums and meet claims payments throughout 2. reported; • efforts to develop and maintain reliable property valuation process and credit reporting; and • the requirement for ongoing and comprehensive reporting of loan performance—informing capital reserve calculations and providing early warning of any emerging default trends.
To expand, mortgage default losses rarely occur uniformly across national economies.

There are almost always geographic regions or individual lenders that are disproportionately affected (Genworth, 2010a), where the variance is a reflection of local economic conditions at the time and varying loan origination and servicing capabilities.
Therefore, where risk can be pooled market-wide, individual losses are absorbed within the distribution of all risk held, thereby providing added levels of financial system stability.

In further support of this stability function, LMI carries natural counter-cyclical properties that strengthen the financial system’s resilience to economic downturns and limit the build-up of credit risk.
This includes: • Third, MIs have no incentive to under-price risk, and therefore borrowers are less inclined to overpay for assets (due to cheap finance) and are more constrained in what they can borrow— therefore reducing price pressures in supply constrained property markets 5.

These properties therefore serve to offset the pro-cyclical tendencies of the lending market and the economy more broadly.
The implication of this is a smoothed economical cycle, with the benefits of reduced interventions and therefore cost to government and likelihood of market distortions.

In summary, reduced risk amongst (effective) insurers, along with the counter-cyclical properties of lending tied to LMI, provides for a more stable and resilient financial system.

2 In the US, since 2008 MIs have paid out over US$11.2 billion in claims to investors and banks.
The downturn is the most severe experienced, but all US MIs have continued to write new business, except for Triad Guaranty Insurance Corporate which is in voluntary run-off and continues to meet existing claims.

MIs have raised substantial amounts of new capital and the industry has ample regulatory capital (Genworth, 2010b).

3 This may not hold true, or hold true to a lesser extent, where the availability of capital is impacted in a downturn and/or other factors that would inhibit further lending occur.
4 The pressure to erode lending standards is greatest at the top of the cycle.

5 A decline in risk premiums is typically observed at times of credit-induced asset price bubbles (Wachter, 2010).

9 • ECONOMIC VALUE OF LMI • ACCESS ECONOMICS ECONOMIC VALUE OF LMI • ACCESS ECONOMICS • 10 Chart 2.5: Securitised home loans Source: RBA 25 20 15 10 5 0 As a percentage of total outstanding housing loans.
25 20 15 10 5 0 1990 1993 1996 1999 2002 2005 2008 2.4 Productive efficiency LMI promotes efficiency through transferring MIs’ scale and scope allows them to ‘specialise’ credit risk from lenders to in the service of assessing and insurers and investors, managing HLTV risk subject to capital adequacy Productive efficiency is optimised where an allocation of inputs is Insurance markets exist to allow risk to be transferred to those most • MIs’ scale and scope allows them to ‘specialise’ in the service of • Conversely, setting the capital adequacy ratio at the economy- such that the only way to increase output of one commodity is to willing to hold it, and therefore those who need to be compensated assessing and managing HLTV risk.
This implies information wide average level of loss (without LMI cover) leaves the reduce output of another.

This means the value of the economy’s least.

Namely, this will be those parties who seek to hold an entire asymmetries are minimised and therefore trade is enabled to possibility of lender default and financial system instability, production/productive capacity is maximised—a primary goal of (normal) distribution of risk, and can therefore reliably price a risk- occur in a more efficient manner.
should actual borrower default losses (real risk) exceed expected economic policy.

Here, LMI promotes productive efficiency through transfer service at a rate sufficient to ensure a positive economic the transfer of credit risk from lenders to insurers and investors, subject to the constraint of ensuring sufficient capital holdings.

Securitisation enables lenders to transfer credit risk to a third-party and earn a return.
At the same time, it thereby frees-up lender capital to another series of borrowers, as part of an on-going cycle where the lender is continually taking a margin on each round of lending.

In essence, this is a multiplier effect that promotes growth return.

Given sufficient scale and scope, insurers are arguably the most accurate at assessing and pricing risk 7.
It is also argued that insurers are more forward looking in their risk assessment—given their ‘through-the-cycle’ business model and regulatory require - ments—and that third-party capital at risk provides similar incentive in the system to ensure prudent mortgage underwriting as if the lender itself had capital at risk.

Investors recognise these structural differences between banks and losses (average risk) for a particular lender(s).
insurers and price risk accordingly—that is, insurance capital will Given LMI is a ‘first loss cover’, LMI provides the financial sector a typically be cheaper than banking capital for a given level of risk.

Insurers are able to capitalise on this difference in the cost of capital (imperfect arbitrage), and thereby bridge capital and insurance safety net (contingent capital).

This overcomes the shortcomings of the ‘siloed’/non-fungible 8 nature of lender capital in times of default (Genworth, 2010a).
The difference in the capitalisation markets.

As a result, a productive efficiency gain is realised, and required is an efficiency gain, in that the capital is then free to be further unexploited surplus in the economy is captured through the put to its most productive use (from both the lenders’ and the extension of the mortgage market to higher risk segments.

borrowers’ perspectives).

Pooled capital is able to be allocated as in mortgage lending.
As a financial investment and leverage tool, In comparison, many lending institutions are said to lack multi-cycle Insurance capital can be lower as a result of benefits of and where losses occur.

securitisation has quickly become an essential component of residential loan data, most particularly on those highest risk diversification.

housing finance (Chart 2.5).

However, a sufficiently high product credit rating is necessary to sell Residential Mortgage Backed Securities (RMBS).
The rating is issued by an independent credit rating agency and will depend upon the riskiness of the pool of mortgages being securitised, which is a function of the age of loans and type of loans and the proportion of the pool that is high LVR and uninsured.

LMI therefore enables securitisation through the credit risk mitigation (third-party capital) it provides, which in-turn reduces the risk-based premium that must be provided to the RMBS investor.

6 segments.
6 segments.

This is also particularly relevant to those relatively new entrants to the mortgage market and/or smaller less traditional lenders.

This inadvertently limits their ability to validate any risk formulas they apply to their lending portfolios, and can con - sequently lead to an under-pricing of risk.
Beyond matters of competency, it is also the case that incentives exist for lenders to under-price risk where origination fees and market share are paramount, and originator capital at risk is low or nil (Wachter, 2010).
Therefore, where MIs hold the risk, information and incentives align: As an outcome of these productive efficiency roles and benefits, Following from this, at the same time as LMI drives productive LMI is likely to promote greater levels of value-add in the Australian efficiency, LMI supports balance between efficiency and suffi - economy, without compromising economic stability.

This is because ciency.


That is, lenders are only required to hold capital in reserve by definition, improved productive efficiency implies improved to support the regulatory determined average level of default risk values of production and at the same time as production values are in the economy, but only because a safety net exists for those improving incentives exist for capital sufficiency to be maintained.
situations where the economy-wide average level is less than the Improved efficiency is a welfare enhancing outcome, which can be actual/expected level of default for any single lender.

The benefits shared across all parties connected to a transaction—in this case, of this are: borrowers, lenders and insurers.
• If all lenders were required to hold reserves to support the greatest potential level of default in the economy, this would be To summarise the economic benefit of securitisation with LMI—a • MIs have the balanced incentives of growing the size of the for the average lender and therefore the financial sector on- lending institution can generate greater productive value for a set market and prudently managing the level of default risk average, inefficient.
volume of capital, and without diminishing credit quality.

(Wachter, 2010); and 6 Note that some securitisation does occur without LMI; however the shortcomings of this—such as the level of subordination it requires—limit its appeal to investors.

7 MIs accumulate (over time and markets) extensive loan level data from which robust economic and behavioral models of mortgage default can be constructed.
8 The capital excess to one lender’s requirements cannot be used to pay claims to another lender’s higher than average delinquencies.
11 • ECONOMIC VALUE OF LMI • ACCESS ECONOMICS ECONOMIC VALUE OF LMI • ACCESS ECONOMICS • 12 Share of premiums % Including securatisation from September 1997 Chart 2.6: Genworth MI market, by lender 100 Source: Genworth Chart 2.7: Housing credit Source: RBA 80 60 40 20 0 2004 2005 2006 2007 2008 2009 2010 Major banks CUBS* Non-ADIs Other banks *Credit Unions and Building Societies 2.5 Policy alignment % 80 60 40 20 0 Banks Credit unions and building societies Other (mainly finance companies and wholesale lenders) 1980 1986 1992 1998 2004 2010 % 80 60 40 20 0 The economic underpinnings of LMI support various current have smaller balance sheets with which to self insure against default • a home buyer whose income was significantly reduced by (amongst other social outcomes) is what makes exclusion from the Government political agendas, particularly in the areas of com - risk and access capital markets on less favourable terms.
Small unpaid maternity leave but who has re-entered the workforce market an inequitable outcome.

Over time, a wealth gap develops petition, allocative efficiency and equity, and at the same time institutions are also more geographically concentrated and there - and meets the suitability requirements of a loan and has the between existing homeowners (who are gaining additional wealth reduce Government financial outlays to the benefit of all other fore more susceptible to regional downturns.
capacity to repay the loan but only has a 15% deposit.

and borrowing capacity) and those who are yet to purchase their areas for intervention.
In economic theory, the most socially desirable outcome occurs Allocative efficiency can therefore be directly improved where LMI Competition in Australian mortgage lending is indirectly improved where each member of society is equally satisfied with the bundle overcomes these particular upfront loan qualification requirements, by the existence of LMI, in that LMI lowers the capital barrier to market entry.
That is, by providing a means to transfer loan book risk and therefore lowering lender reserve requirements (and capital of goods and services they consume, and therefore the only way to make one consumer better off is to make another worse off 9.
One of the conditions in achieving this social optimum is allocative charges), and by enabling RMBS through the improved credit- efficiency, which is in the context of MIs’ role in mortgage lending, rating of insured high LVR and low-doc loans, LMI frees-up lender improved by greater access to debt for those borrowers, such as capital for further lending.
This reduced-barrier for entry is critical first-time buyers who do not have access to a large deposit, and to any smaller and/or non-traditional lender, seeking to establish through improved choice (in terms of price and level of service) for in the Australian market.

all borrowers.

for these particular equal or lower risk borrowers.

LMI also improves allocative efficiency indirectly, through the increased number of lenders it encourages into the mortgage market.
An increase in service providers naturally promotes competition and innovation, and as a result, more choice in lending products and options for borrowers.

Those borrowers more affect - ed by price and less affected by service and add-ons can consider the new cost-effective product offerings.
At the same time, those Genworth provides around half of LMI in the Australian market, by LMI is about housing affordability in a prudent setting—it brings who value service add-ons at a rate greater than the additional gross premiums.

Smaller lenders—especially non-major banks and forward access to lending for those borrowers who do not have a interest or fee they incur, retain this option.

non-ADIs—have always relied disproportionately heavily on LMI, sufficient deposit at the time of loan application.
This is a more as shown by the breakdown of Genworth’s customer base (Chart socially efficient outcome where those borrowers who fall within 2.6).

For example, smaller lenders have accounted for 20-30% of these categories of exclusion and delay have the same (or more) Genworth’s business in recent years, but accounted for around inherent ability to meet the ongoing obligation as the average 10–20% of housing credit (Chart 2.7).

borrower.
borrower.

Consider for example: The government seeks to promote competition in any sector, due • a recent PhD graduate, commencing a career on an above to the gains to the consumer (allocative efficiency) and production average income, but with a lack of saving after years of studying (productive efficiency) alike.

This is particularly relevant to the mort - full-time; gage lending sector where it can be clearly seen (Chart 2.7) that market advantages are derived from size and penetration.
Small institutions need to use LMI more than large banks because they • a first home buyer with a successful career and ability to service a debt but difficulty in achieving a significant deposit due to rental costs; and As the introduction of these competing offerings will make no borrowers worse-off, and enable some borrowers to be more satisfied with what they consume, this is by definition an allocative efficiency gain.
Apart from increased efficiencies, LMI also promotes equity considerations, which get to the primary motivation for the Govern - ment establishing LMI in the first place.

At the same time as inequality in access to mortgage lending for particular borrowers exists, the ‘wealth effect’ economic benefit of home ownership 9 Economists refer to this condition as Pareto efficiency.

13 • ECONOMIC VALUE OF LMI • ACCESS ECONOMICS first home (and who find themselves further beyond reach).
The opportunity cost of delayed/denied home ownership hereby validates the need for the equity function LMI performs.

Having said this, governments face financial outlay in the pursuit of almost any social objective.

As such, the cost-effectiveness of an intervention is often considered amongst the key parameters in policy determination.
LMI, which began its life as a government supported policy (in the form of the HLIC), has since been privatised and therefore achieves the same level of social outcomes with the cost and other challenges of delivery transferred to the private sector.

There is no cost to Government or taxpayers with a private model.
Presuming the extension of the mortgage lending segment to those high LVR loans, particularly the first home buyer segment of the market is still a social priority for the Australian Government (see below); LMI represents an avoided cost for the public sector.
LMI has a strong story in housing finance and financial markets LMI has contributed to home ownership, competition and financial system stability at NO cost to Government It’s important the role of LMI is preserved in the post-GFC framework ECONOMIC VALUE OF LMI • ACCESS ECONOMICS • 14 70000 60000 50000 40000 30000 20000 10000 0 Chart 2.8: First home buyers Source: ABS cat.

no.
5609 # of Owners occ Loans # First Home Buyers % First Home Buyers Figure 2.2: Housing accessibility Chart 2.9: Rent as a proportion of average earnings Chart 2.9: Rent as a proportion of average earnings Source: Kennedy, 2010 Source: Kennedy, 2010 Average earnings (%) 40 35 30 25 20 40 35 30 25 20 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Sources: ABS, Real Estate Institute of Australia, Treasury 35% 30% 25% 20% 15% 10% 5% 0 2.6 Structural advantage over alternatives In Australia at present, the demand for housing is growing at a rate greater than supply, and as such, the price of housing is increasing as the market attempts to ration the existing resource/allocation across the population cohort looking to buy.
Moreover, while HLTV borrowers capable of meeting repayments remain in the rental market, they bid up the price of scarce rental accommodation.

Rental costs are proportionally higher than at any time in the last 15 years (Chart 2.9).

Higher rental costs reduce the capacity for potential home-buyers to save for a deposit on a home.
As a result, the government is facing pressure to intervene in the market and provide a means of facilitating borrower access, particularly for those first home buyers who lack the wealth to leverage in the way that existing home owners do.

Indeed, this issue is gaining such prominence that it has been raised as an item on the agenda for the Council of Australian Governments.
In their latest meeting in April of this year, the state and territory governments of Australia agreed to improve their understanding of demand-side pressures and identify supply-side constraints in their respective jurisdictions, with a view towards removing any government impediments to affordability and supply.

The continued social priority of improving housing accessibility /affordability is hereby established.
High LVR loans are estimated to account for 25% of all loans The alternative means by which a lender can limit risk and ensure MI pricing may be adjusted as delinquencies rise, but is relatively originated in the Australian mortgage lending sector (Genworth, capital adequacy include: 2010a).
The additional cost to government of an alternative inter - vention to promote the continuation of this lending segment —should a privatised LMI industry not be able to meet demand— would be at the cost of alternative public policy priorities, or would mean the reduction in the Government’s ability to achieve this social outcome.

Either way, the transference of cost back onto • self insurance; • credit default swaps (CDS); • bond insurance; and • reduced lending to particular segments.
public finances would be to the detriment of lenders, borrowers In light of these alternatives, a consideration of the structural and the Australian economy.

advantages of LMI is appropriate.

stable over the cycle compared to CDS.

The extent of the losses sustained by institutions exposed to CDS and the breakdown of CDS markets during the GFC clearly demonstrated the risks of using these derivatives.
Bond insurance on structured mortgage finance products is underwritten at the pool-level, utilising rating agency statements and economic assumptions.

As such, the underwriting overlooks traditional risk-assessment criteria such as income verification, asset valuation and credit history.

This failure to independently assess the Self insurance is a premium in the form of a fee or higher interest creditworthiness of the underlying loans in the pool casts doubt margin to carry additional risk.
Self insurance is in effect taking the over the effectiveness of this method of pricing and providing for risk that the borrower will not default or the total defaults will not risk.

Indeed mortgage insurers argue this approach is less accurate materially weaken the lender’s financial position.

In effect, this is a at predicting both the probability of default and the loss-given- less viable option for smaller lenders, given higher risk premiums default of a pool of loans (Genworth, 2010a).
they have to pay to obtain funding.

Reduced lending, in particular to those segments typically Credit default swaps (CDS) are not insurance policies but rather considered to be of greater risk, is to the detriment of all parties uncapitalised credit derivatives.

Their features/characteristics imply concerned.

It implies the exclusion from or delay to home- they should not be considered legitimate CRM in all circumstances.

ownership for those high LVR, mostly first home borrowers.
That is, the lack of regulatory requirement for issuers of CDS to It also implies direct reductions in lender loan books and therefore hold capital to honour the obligation implies they are inherently reduced values of production from the sector.

riskier than LMI.

Indeed, market participants are required to capital - ise the commitment, which is therefore reliant upon the market mechanism/price to determine the level of protection at time of settlement.
As a traded instrument, they carry the added con - sequence of increasing market volatility (speculation and arbitrage).

The broader benefits from each of these alternatives are less than LMI provides, which is a reflection of the differing intent of these instruments.
LMI has a strong story in housing finance and financial markets LMI has contributed to home ownership, competition and financial system stability at NO cost to Government It’s important the role of LMI is preserved in the post-GFC framework 15 • ECONOMIC VALUE OF LMI • ACCESS ECONOMICS ECONOMIC VALUE OF LMI • ACCESS ECONOMICS • 16 3 Regulation and competition LMI provides a counter-cyclical capital buffer Regulatory incentives/requirements and more stringent loan provide for the externalities assessment, consistent with that have made LMI a the regulatory goal of beneficial service for the promoting a more resilient financial system banking sector 3.1 Current arrangements around LMI in Australia LMI influences the Australian mortgage lending sector primarily In Australia, the mortgage lending and insurance market is banking sector.
In addition to this, standardised Authorised through the regulatory requirements function, and indirectly regulated and enforced by the Australian Prudential Regulation Deposit-taking Institutions (ADIs) in Australia qualify for a con - through the imposition of ratings agencies.

LMI can therefore be Authority (APRA).


In effect, APRA is the implementation and en - cessional risk weight on standard loans with a LVR above 80%, considered to play a quasi-regulatory role, as both a safety net forcement agency for the policy directives established by the provided the loan is fully secured by a registered mortgage over and an economic efficiency (value-add) promoting device.
Financial Stability Board (FSB)—the primary international body of a residential property and the mortgage’s value is insured Group of Twenty nations and international financial organisations, through an APRA registered LMI provider.
These regulatory incen - In light of MIs’ quasi-regulatory role and having regard to the market discipline role they play and the structure of the financial with the mandate to: regulatory system, a motivation for this report is potential recali - • assess the vulnerabilities affecting the financial system; bration of the existing financial regulatory approach of bank and insurance mortgage capital regulators.
Depending upon the out - comes of this adjustment process, the incentives for lenders to obtain LMI on a broad cross section of high LVR loans may skew.

Discussion of the potential for regulatory change is here contextualised by an outline of current regulatory arrangements in Australia, and findings from the major inquiries and reviews post-GFC.

The chapter concludes with a discussion of the contin - ued role for LMI in Australia, in light of the new regulatory goals.
• identify and oversee action to address them; and • promote cooperation and information sharing among authorities responsible for financial stability The FSB therefore sets operational requirements for the global financial and insurance market, to ensure the health and stability of the global financial system.

Since its inception, LMI has leveraged positive outcomes for Australian borrowers, lenders and the economy alike, through its quasi-regulatory status.
In its function, LMI provides a counter- cyclical capital buffer and more stringent loan assessment, consistent with the regulatory goal of promoting a more resilient tives/requirements ultimately provide for the externalities that have made LMI a beneficial service to those beyond just the immediate parties involved in its transaction.

However, as discussed earlier, from the lenders’ (and APRA’s) perspective there are alternative means to LMI by which risk and capital adequacy can be managed.
The approach the lender ulti - mately pursues is a reflection of both the financial incentives (for which an equation sets the trade-off between alternatives) and the regulatory structure in offering lower regulatory capital for insuring high LVR loans.

The current arrangements demonstrate how LMI’s interaction with existing regulatory requirements provides flexibility for lenders in how risk and capital adequacy is managed, to their benefit and others.
In the simplest sense, the level of capital a lender chooses to hold is determined by the following three factors:10 • regulatory requirements; • internal risk management systems; and • imposition of ratings agencies.
LMI has a strong story in housing finance and financial markets LMI has contributed to home ownership, competition and financial system stability at NO cost to Government It’s important the role of LMI is preserved in the post-GFC framework 10 Note the latter two factors are economic considerations; the first is legal.

At this stage, economic considerations are less likely to change than regulatory.

Also note that these may not align and that one is likely to be more binding than another.
17 • ECONOMIC VALUE OF LMI • ACCESS ECONOMICS ECONOMIC VALUE OF LMI • ACCESS ECONOMICS • 18 The Joint Forum has promoted an increased role for LMI Global supervisors stress the importance of prudently underwritten mortgage and origination standards 3.2 Post-GFC implications for mortgage lending sectors As the global economic downturn eases, regulators are increasingly It is therefore apparent that global regulatory change is in the Of relevance to MIs from this proposed intervention is the potential In light of these recommendations and the full range of primary reflecting on the circumstances that led to the onset of this trend pipeline and ultimately will be implemented in the Australian for a material reduction in the capital incentive to insure high LTV and ancillary functions LMI is incentivised to perform—supervisory in the first place, with a particular focus on the mortgage origination financial system.
The Basel Committee on Banking Supervision’s loans.

Should leverage become a greater issue in financial oversight, market feedback and discipline—direct support for LMI process across jurisdictions and the importance of ‘skin in the recent consultative paper Strengthening the Resilience of the regulation than the current focus on inherent risk, the role for LMI has been an additional outcome of the Joint Forum’s review: game’.
Early conclusions being reached include the need for con - Banking Sector highlights a series of key issues for global is naturally reduced.

It must remain the case that lenders are oversight (The Joint Forum, 2010).
Disparate supervision led to • The inclusion/retainment of lender capital at risk in securitised LMI is concerned—are as outlined below (Genworth, 2010a): tinuous improvement (as opposed to recently observed erosion) in consideration, which include: the standards of mortgage underwriting, as well as the need for greater safeguards in the system against financial boom and bust cycles (that is, counter-cyclical measures).
Focus of the reviews As part of a review of mortgage origination in the lead-up to the GFC, the Joint Forum concluded that many mortgage loan originators were under-capitalised and lacked adequate regulatory • Adoption of leverage ratios as a gross exposure backstop, in place of risk-based ratios.
The leverage ratio is thereby likely to become the binding constraint on the amount of lending a deposit-taking institution can do for a given level of capital, taking over from the existing risk-adjusted standards.

This might imply lenders are able to hold riskier assets without penalty, so long as leverage does not exceed the mandated maximum.

inferior mortgage underwriting and fraud, which transpired into products.

The belief being material risk-retention will prevent unprecedented mortgage defaults.
Indeed, the level of default deterioration in underwriting standards and reduce debt- during the GFC, in markets such as the US, was at such a level that bubbles caused by off-balance sheet lending.

A consequence it has undermined the credibility of capital adequacy standards of this would be a reduction in the lending multiplier-effect, as the key instrument of regulatory control (Genworth, 2010a).
The with loan originators required to hold more capital against natural inference from this finding is that minimum capital securitised mortgages.

requirements alone are not enough to ensure the stability of lending markets.

In light of this, amended capital requirements (with a focus on building counter-cyclical resilience) are likely to be considered as a key measure for improving the quality of mortgage underwriting.
LMI has a strong story in housing finance and financial markets It’s important the role of LMI is preserved in the post-GFC framework LMI has contributed to home ownership, competition and financial system stability at NO cost to Government incentivised to pay insurers more than the insurers’ cost of equity /debt for the service of risk reduction, and for a sufficient volume of loans.

If not, the LMI model will be undermined, as will the direct and indirect benefits that it provides to the broader economy.
Mortgage insurance provides additional financing flexibility for lenders and consumers, and supervisors should consider how to use such coverage effectively in conjunction with LTV requirements to meet housing goals and needs in their respec - tive markets (The Joint Forum, 2010:17).
Support for LMI The key recommendations from the Joint Forum’s review and Interpreting this further, LMI is recognised by the Joint Forum for its ability to capture systemic risks in mortgage lending and thereby assessment of the most appropriate means to ‘close the gaps’ in strengthen the financial system, in a flexible manner.
regulatory supervision—so far as promoting an increased role for Once again, this comes back to an inherent ability to ensure prudently underwritten mortgages and origination standards, with - • Recommendation No.
7—A requirement that regulators adopt out compromising the ability to lend where these prudency minimum underwriting standards that focus on an accurate conditions are met: assessment of a borrower’s ability to repay their loan obligation; Indeed, by focusing on prudent underwriting, supervisors can • Recommendation No.
8—Mandating that all mortgage origi - help institutions and markets avoid the broad-based issues and nators be subject to consistent underwriting standards and disruptions experienced in recent years and potentially help oversight, as well as effective enforcement mechanisms; and restore securitisation/structured finance markets (The Joint • Recommendation No.

9—Stipulating that national policymakers Forum, 2010:15).
should establish appropriate public disclosure of market-wide Acknowledging a ballooning securitisation market is an undesirable mortgage underwriting practises.

outcome for the stability and integrity of the financial system, a robust and appropriately sized securitisation market is desirable.
19 • ECONOMIC VALUE OF LMI • ACCESS ECONOMICS ECONOMIC VALUE OF LMI • ACCESS ECONOMICS • 20 Recent US legislation recognises LMI The GFC caused small lenders to lose market as a factor that is proven to share; LMI supports reduce the risk of default competition in lending on high LTV loans Chart 3.1: Residential securitisation (A$ billion) Major banks Source: RBA CUBS & regional banks 24 Mortgage originators 3.3 The continued role for LMI in Australia 16 8 0 1990 1994 1998 2002 2006 2010 24 16 8 0 Deregulation and financial innovation—as supported by LMI— Furthermore, as discussed earlier in this report, the counter-cyclical 5.
Restrictions on prohibitions on balloon repayments, negative the banks to ‘accept reduced margins and to roll out new have greatly increased access to and competition in household system of reserves building—with the greatest additions made in amortization, prepayment penalties, and other dangerous loan technology and new products, and to otherwise respond to finance.

In the face of regulatory change to ensure more ‘skin in the the periods of most intense loan origination—along with a features.
game’, LMI continues to provide the opportunity for higher levels ‘contingency reserve’, support capital sufficiency in credit events.

of contingent capital, without compromising (and possibly further The implication of which is that this third party capital is accu - enhancing) the competitive landscape and the level of lending.
Indeed, mandating LMI on high LVR loans11 would in-effect align with those new outcomes international regulators are now seeking mulated in order to be sufficient even under catastrophic risk scenarios.

Indeed the credit risk transfer standards LMI achieves meet those recently propagated by the Joint Forum (Genworth, —that is, material risk retention to ensure the incentive for prudent 2010a).
Indeed the Joint Forum recommendations for supervisors underwriting—and would do so without compromising Australia’s and regulators to incentivise the use of mortgage insurance for healthy and vital securitisation sector, nor Government finances.
HLTV loans are part of the Dodd-Frank Wall Street Reform and LMI and proposed risk retention requirements Recognising that the recent abuses of the mortgage origination process were the greatest where originators had no or little ‘skin in the game’, regulators see material risk retention as a key dis - Consumer Protection Act, recently signed into law in the US.
The Act recognises “five factors that have been proven to lower the risk of default for use in defining the term Qualified Residential Mortgages”: incentive to future reductions in the prudency of mortgage lending.

1.

Documentation and verification of ability to pay the mortgage; However, a consequence of this will be the reduced leverage /increased capital charges mortgage originators face, which can have detrimental impacts in tight capital markets.
The option of having third-party capital in a first-loss position, and the associated 2.

Ratio of mortgage payments to monthly income, and other ratios that help determine the ability of the borrower to repay; 3.

Underwriting standards and loan features to prevent payment benefit of achieving the ultimate policy aim—incentives for pru - shock; competitive pressures’ (House of Representatives Standing Committee on Economics, 2008:12).
The significant development outlined above is that in the US, the epicentre of the GFC, there is a recognition that MI provides a Moreover, with MIs insuring credit risk, credit quality was not safeguard at the point of origination and encourages sound under - compromised during the GFC and overall default rates since the writing and responsible lending principles.

start of the GFC were not out of line with historical norms.
The Joint Forum’s view that supervisors consider that 80% LTV Prior to the GFC, a small ADI typically relied on a roughly even split mortgages should have mortgage insurance underlying the loan between deposits and securitisation to raise funds, while non-ADIs would help protect the banking system from mortgage risk.

It depended entirely on securitisation (Davies, 2009).
However, during would also assist segments of the housing market, such as first the GFC the securitisation market dried up despite the local home buyers, to access the market if the loan is suitable.

housing market showing itself to be sound.

Accordingly, this disproportionately affected those smaller and non-ADI lenders that have been important sources of innovation and competition in the home lending sector.
Reiterating the role of LMI in supporting competition in lending Small banks and non-bank financial institutions (NBFIs) need to have access to funds at economic rates to compete with the major banks.

LMI cover allows them to access capital markets at prices at which they can compete with major banks.
In turn, The increased pressure that the non banking sector places on banks led to the banks emulating many of the new products dent origination—without the need to ration credit, provides a valuable alternative here.

4.

For loans with a combined loan to value ratio of greater than that were being offered.
The Australian Banker’s Association 80% coverage by mortgage insurance at origination; and agree that foreign banks and the non banking sector forced LMI has a strong story in housing finance and financial markets LMI has contributed to home ownership, competition and financial system stability at NO cost to Government It’s important the role of LMI is preserved in the post-GFC framework 11 As has occurred in Canada.
21 • ECONOMIC VALUE OF LMI • ACCESS ECONOMICS ECONOMIC VALUE OF LMI • ACCESS ECONOMICS • 22 In Australia, LMI has supported Government Regulators and policymakers need to consider policy and delivered gains in the broader beneficial effects efficiency and equity in access of LMI when contemplating to home ownership, competition changing financial regulation in lending and financial stability 4 Implications The integrity of an insurance pool relies 4.1 For lenders— on the balance between premium revenues and claims payed.
risk and leverage As the financial balance between LMI and its closest capital 4.3 For the economy— efficiency and stability At the economy-wide level, economic efficiency (value-add) and adequacy and risk management substitutes alters, key implications stability throughout the business cycle may be compromised by: Should the LMI sector be facing a skewed distribution of risk— as lenders bring more good/low risk in-house (adverse selection)—holding premiums constant12, claims payed will be on-average greater than premiums charged, and MIs will face default risk.
will be felt in: 1.

The level of risk carried on loan books due to reduced scrutiny.

2.

Information asymmetries returning at the cost of 2.

Reduced securitisation will translate to reduced lending.

economic efficiency; The rigour and discipline LMI introduces into the mortgage lending 3.
Incentives skewing (with potential impacts to capital sufficiency); Critically, unlike financial systems in other nations such as the sector more than counters any additional risk of lending to higher United States and Canada, the Australian system does not LVR borrowers.

provide a government-backed alternative to the private LMI sector—a deliberate policy choice of successive Australian governments.
The implication of which is, ultimately in the long term, should the sector no longer become profitable, 4.2 For borrowers— price and equity the option of LMI may no longer be available to lenders and Flowing downstream from the implications at the lender level, borrowers.
However before this, in the short term, MIs may borrowers (consumers) potentially face a divergence in equity have to keep raising premiums which would make HLTV /utility, through price and supply impacts: lending less available and affordable.

1.
Higher cost of borrowing and reduced choice in mortgage Given the potential adjustments to capital requirements as product, due to reduced competition in the mortgage lending part of global financial regulatory reform, and therefore market—as non-banks are forced to exit the market due to potential adjustments to capital incentives for lenders to continue to utilise LMI in Australian mortgage lending, the reduced ability to securitise loans and thus raise capital—and potentially inefficient risk pricing13.
following implications are expected to be realised at the corresponding levels.

2.

Reduced capacity to borrow as lenders reduce volumes of high LVR loans held in an effort to balance risk/return and meet capital reserve requirement.

LMI reduces the chance of intergenerational inequality developing in home ownership.

Competition in lending and financial stability are also established policy goals, with substantial emphasis on regulating to improve on market outcomes.
Again, LMI has made a contribution towards attaining policy goals that is recognised globally, including by the Joint Forum.

The changes to regulatory capital proposed under Basel II do not appear to take into account the role of LMI in The resilience of the MI business model during the GFC and the widespread use of LMI under the current regulations indicate that MIs do not need special support or incentives.
However, changes to regulations that have the potential to reduce the incentives for lenders to use LMI will alter the balance of risk throughout the broader economy.

The continued strong role of LMI in the future is 1.

Lowered risk-pooling benefits (including lost fungible capital); strengthening prudential supervision and systemic stability.

4.

Competition between lenders reduced, at the cost to economic efficiency; 5.
Reduced counter-cyclical benefits of insurance; and integral to a successful mortgage market in Australia.

Its strength 6.

Added cost to public sector finances (at the cost of policy initiatives).

4.4 Conclusion Extending home ownership has long been an underpinning of government housing policy in Australia.

LMI has helped to achieve this desired social outcome by expanding the pool of potential would underpin a robust housing market and help guard against a US-style sub-prime crisis.
That LMI is a private model in the financial system that does not impose upon government budgets and contributes to and achieves housing affordability, housing accessibility, risk manage - ment, market discipline and provides capital buffers is a strong story and tradition that should be recognised by governments.
home-owners to include suitable borrowers who otherwise Regulators and policymakers need to take into account the broader would have to postpone their purchase, or remain in rented beneficial effects of LMI on economic efficiency and financial accommodation.

stability in their deliberations over changes to prudential regulations so as to safeguard a strong continued LMI function in the Australian market.
Access Economics: 2010 12 Which they would need to do to ensure the ratchet effect of higher premiums and further adverse selection does not occur.

13 Should lenders be presented with more incentives to hold greater levels of default risk in-house, it’s most likely they will themselves directly charge borrowers for the increased risk they hold, through an upfront and/or interest rate premium.
Under the presumption that lenders are less effective at predicting and therefore pricing risk than insurers (holding profit margin constant), some low risk borrowers may face a less desirable offering in the situation where risk is on-average underpriced.
23 • ECONOMIC VALUE OF LMI • ACCESS ECONOMICS ECONOMIC VALUE OF LMI • ACCESS ECONOMICS • 24 References Allen, D. and Chan, T., 2000, The Efficiency of Residential Mortgage Guarantee Insurance Markets Allen Consulting Group, 2005, Economic Benefits of Lenders’ Mortgage Insurance APRA, 2009, Statistics—Half Yearly General Insurance Bulletin—June 2009 Author unknown, 2007, DRAFT The Public Provision of Mortgage Lending Insurance in Australia—Chapter 2 Housing Finance and Mortgage Insurance in Australia: 1945-2006 History of mortgage insurance, Genworth, 2007 Davies, M., 2009, Household debt in Australia, BIS Papers No.
46 Debelle, G., 2010, The State of the Mortgage Market—Address to Mortgage Innovation Conference Edey, M., 2010, Competition in the Deposit Market—Australian Retail Deposits Conference 2010 Genworth Financial, 2010a, Submission to the Consultative Paper on Strengthening the Resilience of the Banking Sector 2010b, Private Mortgage Insurance Industry Discussion, Office of the Comptroller of the Currency House of Representatives Standing Committee on Economics, Competition in the banking and non-banking sectors, November 2008, p 12 Kennedy, S. 2010, Housing Supply and Affordability, Address to the Council of Capital City Lord Mayors’ Towards a National Urban Policy Summit, 27 May 2010 Murray J, Deputy Governor Bank of Canada, 2010, Banking on a Better System: Lessons from Canada http://www.bankofcanada.ca/en/speeches/2010/presentation_070410.pdf RBA, 2010 Financial Stability Review, March 2010 The Joint Forum, 2010, Review of the Differentiated Nature and Scope of Financial Regulation: Key Issues and Recommendations (Jan 2010) Wachter, S., 2010, DRAFT Procyclicality and Lending Standards Through- the-Cycle: The Role of Mortgage Insurance 25 • ECONOMIC VALUE OF LMI • ACCESS ECONOMICS