Who isn’t pleasantly surprised when we discover that something we’re doing or eating or drinking has unexpected benefits?
For instance, drinking red wine in moderation may reduce the risk of heart disease for some. Smiling boosts your immune system. Crossword puzzles help stave off dementia. Red peppers improve night vision. You can look it up.
Here’s one: Mortgage insurance (MI) can materially improve your capital position and stress test results. This MI benefit is probably not all that unexpected. After all, every claim payment dollar received is a dollar of capital preserved. However, it is not a benefit that many lenders have traditionally considered in their capital management plans and capital adequacy stress testing.
Until now.
Motivating this change is the effort among banks and credit unions to develop models to determine expected loss in preparation for the Current Expected Credit Loss (CECL) accounting standard. The 291-page CECL doesn’t prescribe any one approach to determining expected credit loss, but the principle-based standard has left many risk managers and modelers to conclude that a bottom-up (loan-level) approach is the best way to tackle the ongoing analytical requirements under CECL.
As a result, many lenders have told us they will be moving away from the top-down methodologies they’ve employed for stress testing and move toward an alignment of modeling approaches under a single, bottom-up credit risk quantification framework that can meet the analytical needs of both CECL and capital adequacy stress testing. Since they’ll be incorporating MI into their CECL expected loss analysis, they’ll also incorporate it into their stress loss analysis.
For these lenders, this credit risk quantification framework will be applied broadly to establish loss reserves, manage capital adequacy, and make critical decisions relating to capital allocation and loan pricing. If you’re a mortgage professional, this should interest you, since these models will inform how much capital is allocated to portfolio products and what loan rates are appropriate. It will be in your interest to assure that the full benefit of MI is considered.
In his recent blog, Garrett Hartzog, our director – Product Development, noted that CECL will increase the Allowance for Loan and Lease Losses (ALLL) for many lenders and, as a result, reduce net operating income. Garrett points out that, by purchasing MI, lenders can reduce expected loss, reduce the ALLL and preserve net operating income.
In much the same way, a lender can use MI to reduce credit losses in stress scenarios, preserve capital, and meet regulatory capital thresholds.
The Federal Reserve has said it will eventually incorporate CECL into CCAR. Currently, in supervisory stress tests a bank’s ALLL is generally the amount needed to cover projected loan losses over the next four quarters. This approach spreads out the difference between the bank’s current ALLL and the stress ALLL over the stress period’s duration to smooth the impact on capital. If the Fed were to incorporate CECL into the supervisory stress tests today, it would require that lifetime credit losses in stress scenarios are reflected in the ALLL “day one.” This would likely introduce volatility to stress test results, which is why the Fed released a statement in December noting that it “plans to maintain the current framework for calculating allowances on loans in the supervisory stress test until the impact of CECL on banking organizations’ financial reporting is better known and understood.”
In the meantime, lenders subject to supervisory stress tests – and those that run stress tests for capital planning purposes – should consider incorporating MI into a bottom-up loss forecasting methodology that can also address CECL. From an MI perspective, this will help inform decisions about which loans should be insured, how much loan-level coverage is appropriate for various risk cohorts, and what MI premium type and plan is the best fit to help achieve corporate objectives.
More importantly, it will reveal the value of MI in protecting capital from mortgage losses across all economic cycles.
This is part of a new blog series from MGIC Connects that highlights the value proposition of mortgage insurance. Check out The Value of MI: Credit Losses for more insights.
Tags: balance sheets, CECL, Mortgage Insurance
