Prior to the collapse of the subprime residential mortgage-backed securities (RMBS) market, few people outside of the insurance industry or Wall Street were even aware of monoline financial guarantee insurers, the companies that guarantee the principal and interest of mortgages, bonds, and other financial debt instruments. Today it is difficult to pick up a newspaper without seeing something about the "meltdown" in the subprime RMBS market and the disproportionate economic damage it is causing.

As we prepare to go to press (April), the meltdown in subprime mortgage and collateralized debt obligations (CDOs) has spread out quickly from RMBS to threaten the financial stability of not only the insurers that guarantee mortgages but the entire debt market, affecting everything from credit cards to student loans to public works projects. The most dramatic fall-out to date has been the sudden illiquidity of investment bank Bear Stearns, the associated buyout by JPMorgan Chase, and the federal backstop of certain Bear Stearns underperforming assets.

Some have characterized the situation as another example of "the perfect storm," wherein a series of small, individually unlikely events begins a chain reaction leading to disaster. A more appropriate model is described in Nassim Nicholas Taleb's book "The Black Swan: The Impact of the Highly Improbable,"¹ which argues that history is marked by random, unpredicted events—followed by people trying to explain away the randomness after the fact.

What exactly happened to subprime?

What happened is easy to describe. How deep it will go and what it might mean in the long term for financial markets and the economy is far more difficult to predict.

The residential real estate market became overheated, with home prices constantly rising in a persistently low-interest-rate environment. Loans were inexpensive and easy to obtain. Many people who had not previously been able to buy homes fell victim to the "teaser" interest rates of adjustable-rate mortgages (ARMs).

As the property collateralizing them continued to rise in value, mortgages appeared to be a low-risk investment. Adding to the sense of security, debt insurance was cheap and readily available. At the same time, the debt market was becoming more complex and securitized, with a sharp rise in the number and variety of structured credits such as CDOs and credit derivatives such as credit default swaps (CDSs).

The subsequent surge in mortgage funding fueled additional home price appreciation, which encouraged still more euphoric borrowing and further investing in the mortgage-backed security market, which further inflated the mortgage/housing bubble.

The situation fostered undisciplined lending and instances of outright fraud in the residential mortgage market. Subprime loans to borrowers with less favorable credit histories multiplied. Property was purchased with no money down and sketchy credit checks. ARMs and interest-only and payment-option loans (where unpaid interest can be added to the principal) proliferated. Nearly 23% of all mortgages taken out in 2005 were interest-only ARMs, and more than 8% were payment-option ARMs. In some markets, the numbers were much higher: In California, 34% of all new mortgages in 2005 were interest-only.²

Subprime loans were also bundled together and sold, divided into tranches comprising different levels of risk and interest rates. The higher-level tranches of subprime mortgage pools could receive an AAA rating and were attractive to pension funds. Meanwhile, the lower tranches were attractive to hedge funds and other investors inclined to take on greater risk in order to capture a higher yield in a low-interest-rate environment.

As long as housing prices continued to rise, the situation appeared to be a good deal for all concerned — home ownership was made available to more people and investors profited.

When housing prices began to fall and bad-credit borrowers began to miss payments in 2007, it all started to unravel. Unable to borrow further against their properties, mortgagees began to default, often walking away from their properties. Banks and mortgage companies could not recoup their losses by selling reclaimed homes in a real estate market that was rapidly losing value. Wall Street investment firms and hedge funds saw the value of their CDOs plummet and began to take losses. Total write-downs and other credit losses for the largest financial services firms total an estimated $163 billion.³ These losses have led to the sale of other assets to meet margin calls and cash needs, resulting in the de-leveraging that is customary during the bust phase of bubbles.

Bond insurance: an unfolding story

As we write, financial guarantee insurers⁴ have been particularly affected. These bond insurers have taken billions of dollars of write-offs on their financial statements. The losses have included both reserves for credit impairments in which insurers expect to pay claims and even larger mark-to-market losses on their credit derivative portfolios, which include credit default swaps on collateralized debt obligations.

The strain of these losses and market conditions is calling the financial guarantee insurers’ AAA ratings into question. Rating agencies have threatened to downgrade and, in some cases, actually have downgraded some of the largest financial guarantee insurance companies. Downgrades coupled with market conditions have triggered liquidation of collateral assets by financial institutions holding securities backed by mortgages and insured by the companies, forcing them to dump even more assets onto a market with little demand for risky assets. Downgrades have also put pressure on municipal bonds, which are more stable but are insured by the same financial guarantee insurance companies, making it both more expensive and more difficult for states and localities to raise money for public projects.

Monoline mortgage guarantee insurers have also taken billion-dollar losses in the form of direct payments on defaulted mortgages combined with large reserves for expected future defaults, which has led the rating agencies to reassess the ratings of some mortgage guarantee insurers. These insurers typically maintain a minimum AA- rating in order to insure loans purchased by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), and most have been rated either AA or AA-. However, the rating agencies recently downgraded several of the mortgage guarantee insurers to levels below AA-. In response, Freddie Mac requested that those companies submit a remediation plan within 90 days to restore their AA- ratings. Ironically, the demand for mortgage insurance has surged as alternative forms of credit enhancement have largely disappeared and the mortgage insurers have tightened their underwriting guidelines.

Credit conditions continue to tighten, making credit card, student loan, auto, and other debt more expensive and difficult to obtain. This affects the availability of credit, even to borrowers with good histories.

The sudden liquidity crisis at Bear Stearns, which occurred with stunning speed and prompted a remarkably swift intervention by the Federal Reserve and rival bank JPMorgan, was an unprecedented event and a major shock to the financial system, demonstrating just how deep, far-reaching, and serious the ramifications of the crisis could be.

And there may be more to come. The world's largest bond fund company, PIMCO, reports massive resets of certain rates totaling $30 billion to $60 billion per month in resets throughout 2008. PIMCO indicates that some of the resets from the initially low teaser rates could range from 400 to 700 basis points and anticipates that the economy will be affected by these resets throughout 2008 and 2009 with potentially more homeowners defaulting on their loans if/when they become unaffordable.

As we write, proposals from different quarters for a possible bailout of the bond insurance industry come and go, receiving mixed responses from the players. Some insurers are considering radical surgery to isolate the damage—cutting the CDO and mortgage-backed segments of their books off from their more stable municipal bond businesses, splitting into two companies. At least two monolines are claiming the right to cancel payments on some guarantees they wrote, claiming their counterparties fraudulently entered into credit default swaps. Warren Buffett, chairman of Berkshire Hathaway Inc., has stepped in and started his own bond insurance company to help municipalities and states obtain insurance for their public debt, offering as much as $800 billion in secondary insurance.

But one thing is certain even at this stage: The effects of the meltdown are already beginning to ripple out from financial guarantee and mortgage guarantee insurers to companies that write other types of insurance. To begin with, various insurance companies in all areas of the business are also investors with different levels of exposure to asset-backed securities. Beyond that, directors and officers (D&O), professional liability errors and omissions (E&O), life, title, and other lines are beginning to feel the effects of the crisis, as class action and other litigation abounds and housing prices plummet.

Assessing the ripple effect

Directors and officers/professional liability errors and omissions

There are mixed views from industry insiders at this point about the impact of the subprime situation on D&O and E&O loss costs, pricing, and availability.

There was a sharp up-tick in the filing of securities class action suits related to subprime issues during the latter half of 2007. One hundred companies were sued from July through December 2007, reversing a trend of eight consecutive quarters of below-average litigation, according to Stanford Law School, which tracks such actions.⁵ The financial services sector was hardest hit, with 47 companies sued in 2007, more than quadruple the number from the year before. Sixty-eight percent of those cases (32) involve allegations related to the subprime market.⁶ The collapse of Bear Stearns, to take just one event, is certain to prompt a number of lawsuits in 2008.

We already know that D&O rates for financial services firms rose almost 20% in the fourth quarter of 2007 when compared with fourth-quarter rates for 2006.

Despite these numbers, there are views that the D&O/E&O industry conditions will not be largely influenced by the subprime mortgage crisis. "There may be losses," Paul Newsome, a managing director and insurance analyst at Sandler O'Neill and Partners, told National Public Radio’s MarketWatch, "but the results may be so good overall in the D&O business that this might not show up on the radar much."

Any optimism in this sector is based in part on the general and long-term trend of fewer securities class action suits over the last decade, the result of the 1995 Private Securities Litigation Reform Act (PSLRA). Even with the recent spike arising from the subprime market meltdown, the current level of total activity in securities class action filings is still 14% below the average for the 10 years prior, 1997 to 2006.

Others point out that when it comes to D&O/E&O, "the sting is in the tail," and that it could take years for the full effect of the subprime situation to hit the market. Reinsurance broker Guy Carpenter believes total subprime losses to D&O alone could top $3 billion, while other analysts have estimated that the damage could reach $9 billion.⁷

This view was reaffirmed in April, when Fitch Ratings estimated $3 billion to $4 billion in D&O liability and E&O claims related to litigation stemming from the subprime mortgage crisis. Fitch noted further that "insurers' potential losses could be substantially higher if credit issues spread to sectors not directly tied to the subprime mortgage market or if market conditions lead to increased bankruptcies."

Title insurance

According to Paul J. Struzzieri, a principal and consulting actuary in the New York property and casualty practice of Milliman, the primary effect of the deterioration of the subprime mortgage market on title insurance companies is the loss of business and revenue they are suffering as the housing market softens and fewer homeowners refinance.

A.M. Best confirms, reporting that demand for title insurance is down significantly as the current subprime situation depresses the housing market and makes loan origination more difficult.⁸ On March 22, however, U.S. News and World Report noted that the title insurance industry was the U.S. stock market's "top-performing industry so far" in 2008. Morningstar analyst Jim Ryan told the publication that title insurance firms "are very well capitalized companies with huge reserves that can wait out bad times."

Struzzieri points out one trend in the title insurance industry that highlights increased efforts by lenders trying to recover losses from insurance policies. "Title insurance companies often issue closing protection letters (CPLs), which reimburse the lender for losses incurred in connection with closings of real estate transactions conducted by an agent of the insurer," he says.

"Historically, most CPL claims brought against title insurance companies have involved fraud, dishonesty, or negligence on the part of the agent in handling the lender's funds, or, to a lesser extent, when the agent fails to comply with the lender's written closing instructions. Recently, however, lenders have been using the 'failure to comply with written closing instructions' portion of the CPL coverage with increasing frequency. For example, title insurers have seen sharp increases in CPL claims seeking recovery for what lenders have lost in real estate transactions involving foreclosures and defaults, alleging that the agent didn't follow every single instruction to the letter. Often, the claims are made even when the failure to precisely follow the closing instructions did not lead or contribute to the loss."

So far, Struzzieri says, it is too early to tell if the lenders' claims using this strategy will be successful, but title insurers are nonetheless expending resources responding to these claims. The title industry has responded by tightening the CPL language in an attempt to restrict recoveries to situations where the failure to follow instructions relates to the status of the title or the priority of the mortgage. Therefore, while Struzzieri believes that this is not destined to become a major problem for title insurers in the future, it is indicative of how fervently all those who have suffered losses are looking for ways to make someone else pay.

Life insurance

An article by two of our Milliman colleagues, Steven I. Schreiber and Philip Simpson,⁹ notes that as much as $15 billion of securities has been issued to capital market investors on transactions involving life insurance risks. Most of these deals have included a "wrap" from a financial guarantor, making the securities more attractive to investors. The availability of these wraps has been reduced significantly as a result of the subprime mortgage and CDO troubles, making it difficult to bring new transactions to market with a wrap.

Posing the question, "Is this the end of the road for the life securitization market or just 'a bump in the road?'," Schreiber and Simpson come down solidly on the side of the bump. "The difficulties the financial guarantors are facing do not change the fact that there are real benefits to insurers from these transactions." The market for life securitizations still exists, even in the absence of wraps, as demonstrated by the successful value-in-force (VIF) transactions completed by Bank of Ireland and Unum in October 2007.¹⁰ The bump in the road is not going to bring life securitizations to a halt.

Short term, Schreiber and Simpson expect to see insurers placing more business in private transactions, which may entail:

• Banks providing the funding
• The wrapped market coming back in the long term
• More transactions being placed in unwrapped tranches

"[G]iven the interest and needs of insurance companies, we do expect to see continued development in the structured life insurance marketplace," say Schreiber and Simpson.

A difficult event to characterize

Like a true black swan event as described by Taleb, the causes and ramifications of the subprime meltdown are complex. But unlike a black swan, the initiating event — the collapse of the subprime mortgage market itself—was not an unpredictable outlier.

Many people sounded alarms about the potential instability of mortgage-backed securities well ahead of the event, including Milliman in these pages.¹¹

There are direct and indirect consequences from the collapse of subprime. The direct consequences of the subprime meltdown were predictable: a housing recession, a tightening of credit, going forward perhaps more regulation from the federal government and less inclination among investors to buy into complex debt instruments (at least for the time being).

But the indirect or secondary consequences are too complex to predict with any confidence. For example, it is impossible to predict whether or not another event like the collapse of Bear Stearns could worsen and extend the severe loss of confidence affecting the capital markets and ratings agencies, making it even more difficult for the economy to bounce back in the near term.

There are more surprises in store and much still to learn before we will know with any certainty what the full and long-term impact of the sudden deterioration of the mortgage market might be on the insurance industry and the overall economy.

What we can say for certain is that the insurance industry, along with the entire financial community, will emerge from the subprime debacle with a renewed awareness of risk, and may even end up being stronger for the experience.

Joy Schwartzman is a principal with the New York office of Milliman. She has expertise in balance sheet review and valuations for mergers, acquisitions, and financing transactions for property/casualty insurance companies. Her client work has included loss reserving, rate analysis, and financial forecasting for start-up companies; pricing and reserving studies for reinsurance companies; and capital adequacy analyses.

Michael Schmitz is a principal and consulting actuary in the Milwaukee office of Milliman. His practice focuses on financial risks such as mortgage guarantee, financial guarantee, and credit enhancement products. He has assisted large U.S. banks in their management of credit risk. In addition to working with financial guarantee insurers, he has consulted to the majority of the insurers that comprise the private mortgage insurance industry.

1 Taleb defines a black swan as an event with the following three attributes: It lies outside the realm of regular expectations; it carries an extreme impact; and, after the fact, it is deemed to be explainable and predictable. Examples of a black swan noted by Taleb are 9/11 and the success of Google.

2 Veena Trehan, "The mortgage market: What happened?" NPR.org, April 26, 2007.

3 "Swiss Re limits subprime damage," International Herald Tribune, February 29, 2008.

4 Also referred to as bond insurers or monoline insurers throughout this article.

5 "Subprime litigation may dent D&O insurers," MarketWatch, Jan. 3, 2008.

6 Ibid.

7 "Guy Carpenter Specialty Practice Briefing," November 2007, Guy Carpenter & Company LLC.

8 "A.M. Best Special Report: Insurance industry's subprime exposure may be modest, but contagion is certain," Claims-Portal.com.

9 Steven Schreiber and Philip Simpson, "Insurance-linked securities: A bump in the road," International Investment & Securities Review 2008, Euromoney Yearbooks.

10 Bank of Ireland obtained Equity Core Tier 1 capital credit for its VIF, while Unum used a block of disability income policies to redeploy capital and improve return on equity by approximately 70 basis points.

11 Michael Schmitz and Kyle Mrotek, “What happens when credit risks come home to roost?” Insight, Nov. 1, 2006.