State Foreclosure Laws, Risk Shifting, and the Private Mortgage Insurance Industry

Abstract

State Foreclosure Laws, Risk Shifting, and the Private Mortgage Insurance Industry ABSTRACT The large losses suffered by private and government mortgage insurers during the last several year has renewed in identifying the risk factors associated with residential lending. This paper focuses on the effect of state foreclosure laws on that risk. Data on loss rates incurred by PMIs over the period 1980-1986 reveal that a judicial foreclosure requirement and a statutory right of redemption add significantly to mortgage risk. Anti-deficiency judgment statutes preclude the amelioration of such risk. Estimates of the losses due to such laws are included Introduction One result of the mid-localized recessions in the agricultural and oil sectors of the economy has been an increase in residential loan defaults and foreciosures. Both government (FHA and VA) and private mortgage insurance (PMI) company claims have risen sharply since the early 1980s. (1) In 1986 the combined ratio of the loss and expense ratios for all PMI's was a record 168.9 percent. By comparison, the ratio was only 55 percent in 1979. Direct losses paid as a percent of the previous year's risk in force were .17 percent for 1980 and 1.35 percent for 1986. By 1986 the weighted average risk-to-capital ratio for the industry reached a record 25.8:1, several companies required capital infusions from their parent companies, and others had their ratings reduced by the rating agencies. (2) Besides localized recessions, other frequently noted risk factors have been mentioned as deepening the financial difficulties of the PMI industry. They include the introduction of new loan types (negatively amortizing Arms and GPMs), an increase in insured investor (non-owner occupied) properties, and a greater proportion of over-90 percent loan-to-value ratio loans originated by lenders. The consensus appears to be that the PMI industry failed both to adequately underwrite the risks associated with the characteristics of loans they insured and to charge premiums which reflected those risks. Throughout the early and mid-1980s, PMI companies charged uniform premiums regardless of the loan's characteristics, including location of origination. (3) It should not be surprising that in the fact of uniform premiums, differential amounts of risk were shifted to the insurers. Among the risks that may have been differentially shifted, there is one that has received little attention in the literature. That is the risk associated with the legal structure of the default-foreclosure process of the state within which the mortgaged property is located. This structure varies dramatically. The laws in some states facilitate the foreclosure process and thereby ameliorate lender-insurer losses. The laws in others, in an attempt to provide greater protection to the mortgagor, cause the process to be more lengthy and costly. This study demonstrates the extent to which different foreclosure laws create loan risk differentials which have been refelected in the losses of private mortgage insurers. The period of the interest is 1980 through 1986. (4) The manner in which state foreclosure laws affect residential loan risk is briefly discussed. A model is then presented wherein this risk is shifted disproportionately to private mortgage insurers that charge uniform premiums. Empirical evidence then shows that such risk caused substantial losses for PMI's from 1980 through 1986. Findings are then summarized and suggestions for future research are offered. State Foreclosure Laws and Loan Losses (5) Aside from minor differences, there are three primary distinctions in state foreclosure laws. They all affect the size of residential loan losses. First, states are almost equally divided between those that employ a judicial foreclosure procedure and those that employ a power-of-sale procedure. …