What is the “Basel III Endgame” and why is PMI Rate Pro writing about it?

If you ask the average person on the street what they think about the Basel III Endgame, they’ll probably act embarrassed that they aren’t up on their superhero movies. ? While it isn’t a movie, there was undoubtedly a lot of suspense leading up to its release, as well as plenty of negative reactions – including from us here at PMI Rate Pro . . . but let’s start at the beginning.

When you hear Basel in the context of banks, it refers to multinational agreements regarding bank capital that were hashed out by the Basel Committee on Banking Supervision.? This committee is made up of central bankers from more than two dozen countries.

Care to guess where the committee is based?? Hint:? it’s in the name.

So even though the Basel III Endgame isn’t a movie, the committee seems to operate like Hollywood when it comes to sequels.? The original Basel Capital Accord came out in 1988, and was followed by Basel II in 2004 and Basel III in 2010.

These are complex rules, but let’s just focus on mortgage for a second.? For banks that are subject to Basel, there is currently a choice between the Standardized Approach and the Advanced Approach.? Since the Advanced Approach is based upon internal models, and is thus specific to the bank in question, we’ll focus on the Standardized Approach.

A look at the standardized approach

In the U.S., a “prudently underwritten” mortgage gets a risk weight of 50%, while a loan that isn’t prudently underwritten gets a risk weight of 100%.? Once you know your risk weight, you can figure out what sort of capital you have to have on hand.? We’ll focus on total capital, and in this case, you simply multiply the risk weight by 8%.? This means that a prudently underwritten loan would require 50% 8% capital, which equals 4%.? A loan that isn’t prudently underwritten would require 8% 100% capital – or 8%, which is double what a prudently underwritten mortgage would require.

What is a prudently underwritten mortgage?? It’s a mortgage where the LTV ratio is less than 90%, unless . . .

. . . the mortgage has mortgage insurance with enough of a coverage level to bring it down to an LTV of less than 90%.? In other words, a 90% LTV mortgage requires 8% capital, but a 90% LTV mortgage with 1% MI coverage only requires 4%.

Frankly, that approach seems excessively binary, but the message is clear:? for high-LTV lending, mortgage insurance is a critical ingredient to the loan being prudently underwritten.

Evolving capital frameworks and the mistreatment of Mortgage Insurance

While we were awaiting the full implementation of Basel III in the US, the Federal Housing Finance Agency introduced the Enterprise Regulatory Capital Framework (ERCF).? This brought a “bank-like” capital approach to the GSEs, and included a granular treatment of mortgage risk that included capital relief for mortgage insurance that is scaled based upon the amount of coverage in place.

When we heard that the Basel III Endgame was coming, we expected to see something far more granular than the Standardized Approach, and yet not as granular as what the GSEs use.? And that’s what happened.? We were also expecting higher capital requirements than Basel implementations in other countries, and that’s what happened.

What we weren’t expecting was its treatment of mortgage insurance, nor the commentary that attacked the industry.

In the notice of proposed rulemaking, they begin with explaining how LTV is calculated.

The proposed calculation of LTV ratio would be generally consistent with the real estate lending guidelines except with respect to the recognition of private mortgage insurance, as described below.?

So right off the bat, we have an acknowledgment that mortgage insurance is going to be treated in a manner that deviates from how mortgage lending actually works.? This approach could best be described as “let’s play make-believe”, which is fine for thought experiments but bad for rulemaking that relates to the real world.

And what are we pretending?

For purposes of the LTV ratio calculation, a banking organization would calculate the loan amount without making any adjustments for credit loss provisions or private mortgage insurance.

While we understand the appeal of being conservative, this isn’t the way to do it.? After all, which is more conservative:? 1) refusing to grant credit for mortgage insurance in order to be conservative, which means that a bank has more risk on its books; or 2) giving credit for mortgage insurance, thus encouraging banks to tap an additional source of loss absorbing capital.??

We might be biased, but frankly using mortgage insurance presents a significant upside to banks from a real-world perspective.

But perhaps there is a good reason for this.

Not recognizing private mortgage insurance would be consistent with the current capital rule’s definition of the eligible guarantor, which does not recognize an insurance company engaged predominately in the business of providing credit protection (such as a monoline bond insurer or reinsurer) and also reflects the performance of private mortgage insurance during times of stress in the housing market.

There’s a lot to unpack here, but let’s start with “eligible guarantor.”? Basically, what they are saying is that if you want to get credit protection for a bond, mortgage, etc. you cannot get capital relief for that protection if you use a company that specializes in providing credit protection.

Take a minute to contemplate this.? You can’t get capital relief from the entities that best understand how to manage loss-absorbing capital. ? Regulators would prefer banks accumulate credit risk on their own balance sheets rather than distribute that risk to other sectors of the financial system.

Clearly, there is reform that needs to happen here.? The ERCF evidently recognizes the benefit of insurance and reinsurance companies providing mortgage insurance and credit risk transfer (CRT) to Fannie and Freddie.? Perhaps banking regulators could take a page from the FHFA’s playbook.

Why Mortgage Insurance industry benefits, resilience should be recognized

But now let’s pivot to “the performance of private mortgage insurance during times of stress in the housing market.”

Triad Guaranty went into runoff in 2008.? PMI Mortgage Insurance into runoff in 2011.? Republic Mortgage Insurance Company voluntarily went into runoff in 2012 because its parent corporation decided it was better to wrap things up and move on.

More than 15 years later, despite no new business in the meantime, Triad is currently still paying claims.? 75% of the claim is being paid in cash, and 25% in a deferred payment obligation (an IOU).? PMI Mortgage Insurance is paying claims with 81% cash and 19% deferred payment obligation.? RMIC is paying all of its claims in cash.

Think about it – after the worst financial crisis since the Great Depression, banks can count on 75% to 100% of their MI claim payment from the companies that went out of business.

Show me another industry where a company can be essentially shut down, and yet they make good on their obligations to the same extent.

Frankly, the industry's performance isn’t a reason to refuse to give any credit.? The performance of the industry is exactly the reason why banks should receive credit for MI when they calculate their capital requirements.

We have more to say on this topic, so expect to see the second installment in the near future.

PMI Rate Pro also intends to respond to the Notice of Proposed Rulemaking to help regulators understand the mistakes they are making in the Basel III Endgame as it relates to mortgage insurance.

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About PMI Rate Pro: PMI Rate Pro is a cutting-edge technology company hyper-focused on PMI. Our Pricing Engine delivers prices from all 6 MI providers across 5 standard insurance products, all with a single click of a button. The quotes can be displayed in order by best price, or in order based on our risk allocation algorithm. PMI Rate Pro has two products: MIQuote – Web application that quotes PMI and MIPrice- API product that is a pricing engine.?

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