From: Gary S. Gevisser
Sent: Friday, January 21, 2005 12:23 PM PT
To:
Cc: rest; karen.richardson@awsj.com; Edgar.garcia@wamu.net;
Subject: FW: A remarkable "Achilles Heel" in the insurance
firmanent.
Attention: Officers and Directors of
the Board of
Hey
“Bull” McDermot,
Gsg
-----Original
Message-----
From: Anonymous
Sent: Friday, January 21, 2005 11:56 AM
To: gsg@sellnext.com
Subject: A remarkable "Achilles Heel" in the insurance
firmanent.
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January
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Outside
Audit The
Home-Buying Boom By KAREN RICHARDSON Cheered on by happy investors, mortgage insurers have rollicked their way to robust results during the U.S. home-buying binge of the past five years. But as their customers' loans pile up, mortgage insurers could see more-volatile earnings and greater risk to their financial and credit positions -- in part thanks to the same accounting quirk that has helped them shine in recent years. Millions of people who can't afford to put down 10% or 20% of a home's price are required by their mortgage lenders to buy policies from mortgage insurers, which, by agreeing to shoulder some risk of missed loan payments, can lower the buyer's down payment to as little as 3%. Banks and most other insurers must set aside money, or must reserve, for estimated future losses when they lend money or write a policy. Mortgage insurers don't. In fact, they don't have to book reserves until the delinquencies are reported. While banks' and other insurers' rules for reserving can
sometimes lead to accounting abuses, the exemption at issue for mortgage
insurers allows them to book assets on their balance sheets without
accounting at the same time for all their liabilities. Accounting experts say
it's like, say, a chain retailer not reserving for customer returns. The exemption from reserving that covers mortgage insurers was a result of passing the buck: In 1982, the Financial Accounting Standards Board was drafting new guidance but deferred in part to another accounting rule maker, the American Institute of Certified Public Accountants, or AICPA, which was working on its own project involving accounting for mortgage insurers. Then, instead of waiting until AICPA reached its final conclusions, the FASB decided to issue its rule No. 60 and just exempt the mortgage-insurance industry from a few clauses being examined by AICPA, including rules for "claims cost recognition," or reserving for future losses. AICPA acknowledges it never came up with separate guidance for mortgage insurers, an eventuality that "just left a hole in generally accepted accounting principles for those companies," says Steve Belcher, a FASB fellow who has researched No. 60. The companies disclose this exemption in their regulatory filings, where they explain that they follow "industry practice" in reserving for losses. Many analysts and investors have been happy to shrug off the matter, contenting themselves with the industry's rapid growth in the past five years. For instance, Mortgage Guaranty Investment Corp., or MGIC, with a market value of about $6 billion, beat analysts' consensus estimates last week when it reported fourth-quarter earnings of $134.5 million, up 30% from a year earlier. MGIC's stock price has risen, albeit choppily, about 67% since the start of 1999. Elsewhere, shares of Radian Group Inc., with a market value of about $4.5 billion, and PMI Group Inc., with a market capitalization of $3.9 billion, have more than doubled since the start of 1999.
The companies' reserving method exacerbates that volatility: By waiting until a default arises to set a reserve, the companies compress the time they have to respond. If their estimates of cash losses arising from reported defaults aren't perfect, and defaults increase quickly, these companies will be repeatedly hit with the need to raise reserves over time, putting pressure on their capital. Mortgage insurers' earnings can end up taking big hits from last-minute reserving, which some analysts predict could begin to happen this year as defaults are expected to rise. Conversely, earnings can get a boost when companies "front-end-load their income recognition" and ignore expected losses, says Ken Posner, specialty-finance analyst at Morgan Stanley. "In a weakening economy, you can actually have earnings underestimate the economic value of a company because you're getting all those reserves at once," Mr. Posner adds. "It just becomes more volatile than accounting for banks and other financial institutions." The historical trend bears out concerns: Mortgage defaults are most prevalent in the third year of a loan, and as 2001 and 2002 were bumper years for the business, some companies could start seeing more losses this year and next "as the insurance book added in 2002 and 2003 reaches its peak loss years," wrote George Sacco Jr., a mortgage-finance analyst at J.P. Morgan Chase & Co., in a September report about PMI Group. Indeed, the boon in mortgage finance, stoked by record-low interest rates and rapidly appreciating home values, likely encouraged some U.S. consumers to borrow more than they could afford, analysts say. And so-called subprime mortgages -- higher-rate loans to borrowers with questionable or nonexistent credit histories -- have proliferated in the past decade. Write to Karen Richardson at karen.richardson@awsj.com1
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But the
industry's income growth has been volatile in recent quarters as a result of
a slow reduction in mortgage volumes and efforts by some companies to
diversify their businesses.
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