Homeowners insurance a hidden risk for secondary market

Homeowners insurance is labeled as one of the hidden costs for property owners, and their escalating prices could have an impact on the secondary and capital markets, in terms of loan salability and performance.

While both Fannie Mae and Freddie Mac declined to be interviewed for this article, they jointly created a blog post on May 20 explaining their home insurance requirements, which call for a replacement cost value policy, rather than the alternative, for actual cash value. The latter allows insurers to estimate the cost of things like the age and wear and tear of the property, and then deduct the total depreciation amount from the insurance claim payout.

The premiums for an ACV policy are typically more affordable, but also the payout is likely lower, said the post from Terri Merlino, senior vice president and chief credit officer for Freddie Mac's single-family business, and Cyndi Danko, who holds the same titles at Fannie Mae.

"In recent months, however, we have received feedback from industry participants about the ability of lenders and servicers to comply with our requirements to obtain a property's RCV," the blog said. "In an effort to be responsive to these concerns, on May 8, 2024, Freddie Mac and Fannie Mae issued an Industry Letter and a Selling and Servicing Notice, respectively, providing a temporary pause on the GSEs documenting non-compliance with these RCV policies."

During the pause, and in conjunction with their regulator at the Federal Housing Finance Agency, Fannie Mae and Freddie Mac are "conducting additional research to evaluate the reported obstacles to lender and servicer compliance with these requirements." They are also reviewing concerns regarding the RCV requirements.

Compounding the availability issue is that flood damage is not covered by a typical homeowners policy, while residents of some states can find limitations on items like earthquake, wildfire and windstorm.

Matic, an insurance agency, noted in its mid-year premium trends report about the difficulty among homebuyers in obtaining coverage, with one in particular having secondary market implications.

Almost two-thirds of mortgage lenders surveyed, 63%, told Matic that at least one borrower they recently worked with had a problem securing home insurance. Among the common issues was the borrower's debt-to-income ratio becoming too high once the cost of insurance was factored in.

Meanwhile, 16% of lenders said they felt very knowledgeable about the current insurance landscape, while 66% had a desire to learn more so they could better assist their customers.

"Given that the cost of insurance affects a borrower's total escrow payment, it's essential for mortgage enterprises to stay informed about the current insurance landscape and provide their loan officers with tools and resources to address insurance issues," an online post about the findings said.

Delayed loan closings because of the difficulty in obtaining insurance was cited as an issue by 47% of respondents; that impacts both secondary market loan delivery and hedging strategies, Ben Madick, Matic CEO said in an interview.

It is, however, a curable defect, and the rules currently allow for such coverage to be force placed if the borrower does not obtain it or lets it lapse.

So there are two separate issues concerning the industry. "We have to worry about the additional work that's required by the lender in their manufacturing process to get a customer to close and have a valid policy for closing," Madick said. "But as a bond holder in the secondary market, you have to make sure that customer has the collateral protected."

To mitigate this issue, Madick suggested use of excess and surplus coverage, which is a specialty market that provides insurance on things standard carriers won't cover, according to Nationwide.

"I don't know if we're going to get a lot more [lender-placed insurance], but the combination of more LPI and more alternatives to the typical standard is growing, and the cost of both of those is tremendously higher on a per-risk basis than a typical policy," Madick noted.

The RCV policy standard makes sense when it comes to collateral protection, especially at the bond level, he said.

Loan officers are recommending higher deductibles to their customers in order to lower the premium, Madick noted. But that means if a claim is made, more money is coming out of the consumer's pocket.

But the secondary market does not have to be concerned about the consumer being able to handle the deductible if a claim is made, because the collateral is protected to the bondholder.

"If there is a loss caused by one of these events, they would be made whole, and it wouldn't be considered a loss through insurance," Madick said. "Yes, there's a loss in the customer default, but at the same time, the bondholder is covered."

Another factor impacting pricing and availability is the reinsurance market. Mortgage-backed securities spreads have been tightening as of late, and similarly, so have the spreads for reinsurance. That is making the capital flow to the insurers stable again, Madick said.

Hidden homeownership costs related to rising insurance premiums got a 37% share of a theoretical 100 points of default risk for the remainder of this year by servicers surveyed in Auction.com's 2024 Seller Insights report.

"It represents its most significant risk for higher delinquencies in what is a fairly low risk environment," said Daren Blomquist, vice president of market economics at Auction.com. Servicers are generally not expecting this risk to cause a huge surge in delinquencies, but it is the biggest factor right now.

Bank servicers gave this particular risk a 40% share, as did the government agencies and GSEs in the Auction.com survey.

The next largest factor was rising consumer debt delinquencies, with a 32% share.

When a securitized mortgage becomes delinquent, the servicer is responsible for advancing the bondholder the principal and interest payments. Making those payments can be a financial drain for servicers, which in turn becomes an issue for Fannie Mae, Freddie Mac and Ginnie Mae, which guarantees payments on government loan products included in securitizations.

Insurance costs have significantly increased in 2023 compared with the pre pandemic year of 2018.

"You see some pretty eye-popping increases in those insurance rates, and so that certainly could, for a borrower who is already stretched financially, push them over the edge in terms of delinquency," said Blomquist.

Even though most mortgages originated in the past decade-plus have been fixed-rate, with the P&I not changing, the taxes and insurance portion of their monthly payment is not set in stone.

With the rise in the occurrence of natural disasters in recent years, even for existing homeowners the cost of insurance has gone up. In some cases, the policy has been canceled altogether and getting a replacement can be costly.

A correlation might be made between rising foreclosure starts in Florida, Texas and California, where natural disasters have impacted the availability of insurance.

While no data explicitly states this, those rising rates, especially in certain hard-hit communities "could be an early sign that some of these insurance issues are having an impact," Blomquist said.

CoreLogic is looking at both the cause and effect of higher home insurance costs on the markets, said George Gallagher, senior leader — principal: climate risk, natural hazard and spatial solutions.

No action has been taken yet by the secondary marketplace to mitigate any impact from those factors.

Federal agencies, along with Fannie Mae, Freddie Mac and Ginnie Mae, all have a concern about what climate risk or change can have across the portfolio.

"So they have been looking at it for a while, but in the absence of any very specific regulation, you haven't seen the impact on pricing for secondary offerings yet," Gallagher said. "I'm going to keep emphasizing yet, and I don't have a timetable for when 'yet' is going to transfer into 'now it's occurring.'"

Gallagher believes the initial actions in this area will contemplate what the DTI impact on borrowers has been from rising insurance rates.

But since the properties are anonymous once they are put into an MBS, no exact understanding at the investor-level is possible on which loans are affected, Gallagher said.

"I'm not sure when the change will occur, or even if the change will occur, but I think you're seeing a lot of interest in understanding with more granularity the potential impacts of a wildfire zone versus a non-wildfire zone for example," he continued.

Meanwhile, another layer to this is technical default. That is where the borrower, even though they might be current payment-wise, is considered by the secondary market to be in default because the homeowners policy has lapsed or has been canceled.

"The industry is having tremendous difficulty in making sure that insurance is affordable and available, and those are actually two different issues," Gallagher said. "Sometimes it's just very unaffordable, and in many places, especially in California, it has become unavailable from a private carrier."

He reiterated a statement he made at this year's Mortgage Bankers Association Secondary and Capital Markets conference, where he quoted Jeremy Switzer of Pennymac declaring the industry needs to treat homeowners insurance like a one-year adjustable rate mortgage because of climate change.

This is not an issue that affects 100% of loans and while it is not a universal problem, he credits the servicing industry for raising awareness for people who have been good borrowers for a long period of time and because of rising rates related to natural disasters or climate change, it is affecting them going forward, Gallagher said.