by Tanta on 2/14/2008 08:29:00 AM

I had a feeling this sort of thing might get underway:

McLean, VA – Freddie Mac (NYSE: FRE) today announced it is temporarily changing its Private Mortgage Insurer Eligibility Requirements [PDF 160K] in order to increase the claims-paying and capital retention capacities of its mortgage insurance counterparties during the current market correction.

Effective on or after June 1, 2008, Freddie Mac-approved private mortgage insurers may not cede new risk if the gross risk or gross premium ceded to captive reinsurers is greater than 25 percent. Beyond limiting the allowable cede to 25 percent, the temporary policy does not limit the mortgage industry's use of captive reinsurance.

Triggered by the ongoing decline in home prices and poor performance of subprime, Alt A and other higher-risk mortgages, Freddie Mac says the temporary change is intended to allow mortgage insurers to retain more insurance premiums to pay current claims and re-build their capital base.

Today's announcement applies to all Freddie Mac-approved private mortgage insurers. In addition, Freddie Mac is now requiring all eligible private mortgage insurers to provide additional information about their business activities to better monitor the state of the industry.

Private mortgage insurance enables Freddie Mac to buy loans when a borrower makes a downpayment of less than 20 percent of the purchase price. In a captive reinsurance structure, the mortgage insurer cedes a portion of its premium income to a special trust set up to cover an agreed upon share of losses from a pool of mortgages.

Freddie Mac also announced it is suspending its Type II Insurer requirements otherwise automatically applicable to mortgage insurers that are downgraded below AA- or Aa3 by the rating agencies provided the mortgage insurer commits to submitting a complete remediation plan for our review and approval within 90 days of the downgrade. Freddie Mac also reserves the right to impose additional restrictions in its sole discretion.

The GSEs have enormous exposure to the MIs. Their own risk management depends on how they maintain eligibility standards for MI carriers; if they accept policies written by lower-grade insurers with less certain claims-paying ability, their own reserves for loss have to increase. On the other hand, if they cut off an insurer that gets notched under AA-, they're not just losing new insured mortgage business, they're increasing the pressure on the MI by cutting off its main source of new policies written. The problem with a downgraded MI for the GSEs: you can't live with them, and you can't shoot them.

So the "workout" proposals begin. Whether this is a wise response that will avert major catastrophe in the MI business, or the first step in following a failing MI down, is anyone's guess. I personally can't see how they can not "work things out" with the MIs right now, even as I see it as just one more reason that Congress needs to give it a rest with these plans for the GSEs to take on more and more of the risk of failing private sector mortgage portfolios.