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Fewer borrowers are refinancing into Federal Housing Administration loans, allowing private mortgage insurers to pick up some of the slack.

The shift is coming at a time when insurance premiums on FHA loans continue to rise.

Consequently, private mortgage insurers accounted for 36% of insurance written in the second quarter, the highest level since 2008, the Royal Bank of Scotland (RBS) pointed out in a new research report.

"This trend is likely to continue in anticipation of new FHA legislation," explained RBS co-head of agency mortgage-backed securities strategy Sarah Hu. The legislation in question would substantially reform the FHA and how it does business.

She added, "If passed, the bill would require the FHA to establish a minimum annual mortgage insurance premium while increasing its maximum level from the current statutory limit of 1.55% to 2.05%. This rising insurance premiums could price out some Ginnie Mae borrowers in FHA refinance transactions and encourage them to refinance into conventional loans."

While the 'FHA-to-Conventional' refi shift may not be favorable to Ginnie Mae, there may be no material change to overall prepayments, RBS suggested.

But more changes could be coming at the FHA — changes that would make insuring FHA loans even more expensive and possibly less desirable when compared to conventional products.

In July, the Senate Banking Committee passed new legislation entitled, ‘The Federal Housing Administration Solvency Act of 2013,’ introduced by Committee Chairman Tim Johnson, D-SD, and Sen. Mike Crapo, R-ID.

The bill focuses on improving the FHA’s financial health and strengthening underwriting standards. Additionally, the legislation calls for enhancing lender accountability measures.

If passed, the bill would require the FHA to charge a minimum annual mortgage insurance premium of 55 basis points — no minimum currently exists — to assure the long-term solvency of the FHA.

Additionally, the agency would increase the maximum annual mortgage insurance premium by 50 basis points to 205 basis points. The fees would be reassessed annually to ensure it properly compensates for the risk of FHA mortgages.

Depending on the FHA’s financial status, the bill could become standalone legislation, or it could become part of larger legislative reforms, RBS explained.

"Nonetheless, with stricter underwriting rules and higher insurance premiums, FHA mortgages are becoming more difficult to obtain," said Hu and RBS agency MBS strategist Ashley Gam.

They added, "Meanwhile, the FHA has already taken steps over the recent years to increase their insurance premiums, which could price out some Ginnie Mae borrowers in FHA refinance transactions and encourage them to refinance into conventional loans with more competitive private insurance."

The private mortgage insurance business is seeing business pick up as the housing market enters a new phase of the recovery.

For instance, private MI wrote coverage for $49 billion in new mortgages during the second quarter, up 27% from the first quarter of 2013, data from Inside Mortgage Finance shows.

One of the possible reasons for the sudden shift is that some FHA borrowers have chosen to refinance into conventional loans.

"If they refinance into a conventional loan, they will face private mortgage insurance, risk-based loan level pricing adjustments and an adverse market delivery charge if the property was located in a soft housing market," RBS strategists stated.

Another reason borrowers and loan officers are increasingly attracted to private mortgage insurance for home purchases and refinancing stems from the cost savings available with private MI, explained United Guaranty chief operating officer Brian Gould. 

"FHA has raised prices and instituted policies that require many borrowers to pay MI for the life of the loan—in some cases up to 30 years," Gould stated.

He continued, "In some scenarios, FHA’s non cancellable insurance premiums could be as much as four times the cost of United Guaranty MI over the life of a borrower’s loan. There is more opportunity for private mortgage insurers, including United Guaranty, to increase market share. As the government moves to shrink the risk it is taking on, the private MI industry should continue to benefit."

As the government-sponsored enterprises charge loan level pricing adjustments based on credit quality, some FHA borrowers with good credit may find it cheaper to refinance into conventional mortgages.

As the market moves into higher Ginnie Mae coupons, borrowers generally face higher insurance premiums because higher coupons have lower FICO scores and thus face much higher loan-level pricing adjustments, according to RBS.

The bottom line is that higher FHA insurance premiums have made it cheaper for some Ginnie Mae borrowers to refinance into conventional loans, which makes sense given that FHA borrowers are likely to face lower fees in these type of refis.

"Since the FHA is not part of the GSEs, the declining FHA market share may not have a direct impact on reducing the GSEs’ share," Hu told HousingWire.

She concluded, "However, since GNMA MBS are explicitly guaranteed by the government (versus implicit guarantee for GSE loans), this does suggest private MIs are playing an increasingly important role in the market."

Going forward, the private mortgage insurance penetration level in the overall market -- excluding Home Affordable Refinance Program -- will increase by more than 3% of total originations in 2013, said Genworth U.S. Mortgage Insurance (GNW) director of capital markets Kenny Turner. 

"Due to FHA’s recent price increases and policy changes, private MI now is less expensive than FHA coverage – upfront and over the life of the loan – for nearly all borrowers who make more than a 3.5% downpayment on a loan up to $625,000," Turner said.

He concluded, "We expect the Administration to continue with its plans to encourage the use of private capital to take more up-front risk and reduce the government’s role in the housing market.”   

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