JUNE 4, 2013

INSURANCE

INDUSTRY OUTLOOK

Table of Contents: SUMMARY 1 IMPROVING HOUSING FUNDAMENTALS 3 FINANCIAL PERFORMANCE IS IMPROVING 4 PROFITABLE POST-2008 BUSINESS CONTRIBUTES TO PROFITABILITY 6 CAPITAL RAISES BOLSTER REGULATORY CAPITAL 6 DEMAND FOR PRIVATE MORTGAGE INSURANCE IS GROWING 7 HIGH QUALITY NEW BUSINESS BENEFITS FROM TIGHT UNDERWRITING STANDARDS 8 POSITIVE OUTLOOK, BUT A NUMBER OF OBSTACLES TO NAVIGATE 9 MOODY’S RELATED RESEARCH 11

Analyst Contacts: NEW YORK

+1.212.553.1653

Brandan Holmes +1.212.553.6897 Assistant Vice President - Analyst [email protected] Helen Remeza +1.212.553.2724 Vice President - Senior Analyst [email protected] Stanislas Rouyer +1.212.553.3684 Associate Managing Director [email protected]

US Mortgage Insurers: Positive Outlook Moody’s has revised its outlook for the US mortgage insurance industry from ‘negative’ to ‘positive’. The outlook change reflects improving financial performance of the insurers, steadily declining new delinquencies, and stronger regulatory capital profiles, mainly the result of capital raises and a restructuring. However, while our outlook for the industry is positive, we recognize that meaningful risks remain, given the lack of clarity around the regulatory and operating environment with respect to ongoing housing finance reform, the fact that the industry is in the early stages of its recovery from the financial crisis and remains burdened by substantial capital needs, and the still meaningful exposure to losses from legacy portfolios.

Summary After navigating its way through the financial crisis, the mortgage insurance industry has started to move on from its low point, and is positioned for continued growth and a return to profitability. General macroeconomic conditions, including housing fundamentals are improving and we don’t expect any further regulatory actions against active industry participants. New insurance written is growing at an increasing pace, and new delinquencies continue their slow and steady decline towards normalized levels. Also, new capital has recently been introduced to the industry, in the form of capital raises, an acquisition in process, and two new entrants to the sector. While industry conditions are clearly improving, and the mortgage insurers are on the path to recovery, meaningful risks remain. The change in outlook reflects the following economic and regulatory dynamics: »

Steady improvement in housing market fundamentals. US house prices are on an increasing trend, while unemployment is decreasing at a steady, albeit moderate pace. The improving housing environment helps create conditions for continued improvement in legacy books and low delinquencies on the new book, especially given the tight current underwriting standards.

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Financial performance is improving. Moody’s rated mortgage insurers, in aggregate, reported operating profit for the first time since the onset of the financial crisis. Profitability is mainly being driven by a combination of declining delinquencies and the impact of very profitable post-2008 business comprising an increasing share of the companies’ portfolio mix.

Yulia Davletova +1.212.553.1370 Associate Analyst [email protected]

INSURANCE

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Demand for private mortgage insurance is growing. The main driver of growing demand for private mortgage insurance is the series of rate increases by the Federal Housing Administration (FHA), which is enabling the private insurers to recapture significant market share from the FHA. Delays in GSE reform as well as an expected uptick in US household formations should support growth in demand over the medium-term. Such growing opportunity, combined with still modest capital levels in the sector has a moderating effect on competitive pressures on pricing among the growing number of insurers.

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High quality new business benefits from tight underwriting standards. Business written since 2009 has been subject to very stringent underwriting standards, ensuring a high quality, and profitable insured portfolio. The Qualified Mortgage rule, which sets into law tighter underwriting requirements, will go a long way in enabling the mortgage insurance industry to grow a high quality, and if priced appropriately, profitable insured portfolio.

While the industry is making strides in its return to profitability and the overall housing environment has turned positive, there are some headwinds. There is little clarity about the role of private mortgage insurance in a reformed US housing finance environment, and some companies may need further recapitalization to secure their position going forward. Also, many insurers remain exposed to significant losses in their legacy portfolios. Another downturn in housing, or increasing unemployment could drive delinquencies up again. Definition of an Industry Outlook

The Industry Outlook (positive, stable or negative) indicates our forward-looking assessment of fundamental credit conditions that will affect the creditworthiness of mortgage insurers over the next 12-18 months. As such, the outlook provides our view of how the operating environment for mortgage insurers, including macroeconomic, competitive and regulatory trends, will affect, among other things, asset quality, capital, funding, liquidity and profitability. Since outlooks represent our forward-looking view on credit conditions that factor into our ratings, a negative (positive) outlook suggests that negative (positive) rating actions are more likely on average. However, the Outlook does not represent a sum of upgrades, downgrades or ratings under review, or an average of the rating outlooks of issuers in the industry, but rather our assessment of the direction of credit fundamentals overall within the industry broadly. TABLE 1

Moody’s Rated Mortgage Insurers Company

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IFS Rating

Outlook

Essent Guaranty Inc.

Baa3

Positive

Genworth Mortgage Insurance Corp.

Ba2

Negative

Mortgage Guaranty Insurance Corp (MGIC)

B2

Under Review for Upgrade

Radian Guaranty Inc.

Ba3

Positive

United Guaranty Residential Insurance Co. (UGRIC)

Baa1

Stable

INDUSTRY OUTLOOK: US MORTGAGE INSURERS - POSITIVE OUTLOOK

INSURANCE

Improving Housing Fundamentals Two key drivers of mortgage performance are house prices and employment. Rising house prices increase the amount of equity that borrowers have in their homes, thereby reducing the likelihood of default and improving recoveries. Lower unemployment means that more borrowers are able to make payments on their loans. Key indicators of both house prices and employment have shown steady improvement over the past year, and contribute a great deal to a positive operating environment for mortgage insurers. At the end of Q1 2013, US home prices had increased for five consecutive quarters, with the CaseShiller1 index showing a 11% year-on-year gain over March 2012. Corroborating the improvement in housing is the rate of new housing starts, which increased by approximately 29% year-on-year for the 12 month period to April. While the recovery is still in the early phase and could be upset by a range of macroeconomic and other shocks, including a sharp increase in interest rates, or ill-conceived housing reforms, the trend toward a more robust housing environment is positive for mortgage insurers. CHART 1

US House Prices S&P/Case-Shiller National U.S. Home Price Index (seasonally adjusted) (L) S&P/Case-Shiller 20 Metro YOY Price Change % (R) 200 180 160 140 120 100

20% 15% 10% 5% 0% -5% -10% -15% -20% -25%

Source: S&P Dow Jones Indices

US Unemployment, at 7.5% in April (see chart 2), reached its lowest level post-crisis and supports borrowers’ abilities to continue making mortgage payments. While continued stress in the Eurozone could place pressure on the US economy, we expect US GDP growth in the range of 1.5-2.5% for 2013 and 2%-3% for 2014. US unemployment should remain in the 7-8% range for 2013 and decrease to the 6.5-7.5% range in 20142. We expect the continued decrease in unemployment and marginally higher GDP growth to support a continued decline in mortgage delinquencies.

1

S&P/Case-Shiller 20 Metro Area Home Price Index

2

Moody’s Update to Global Macro Outlook 2013-14: Loss of Momentum

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INDUSTRY OUTLOOK: US MORTGAGE INSURERS - POSITIVE OUTLOOK

INSURANCE

CHART 2

US Unemployment Unemployment rate (L)

Total non-farm employment (thousand persons) (R)

Unemployment Rate (%)

12

140,000 138,000

10

136,000 8

134,000

6

132,000 130,000

4

128,000 2

126,000

0

124,000 Dec Apr Aug Dec Apr Aug Dec Apr Aug Dec Apr Aug Dec Apr Aug Dec Apr Aug Dec Apr Aug Dec Apr 05 06 06 06 07 07 07 08 08 08 09 09 09 10 10 10 11 11 11 12 12 12 13

Source: Moody's, Bureau of Labor Statistics

Financial Performance is Improving US mortgage insurers reported positive results for the first quarter of 2013; the industry, in aggregate, reported a small profit, on an adjusted operating basis, for the first time since the onset of the financial crisis.3 The primary drivers of the improved profitability are lower incurred losses, the result of lower new delinquencies and stabilization of reserve assumptions, and higher levels of very profitable, post2008 new business. Net Investment Income currently contributes significantly less to earnings than was the case pre-crisis. This is primarily the result of net cash outflows from elevated claim payments and lower returns on the portfolios from decreasing interest rates. We expect investment income to remain pressured due to anticipated high claims payments on the backlog of delinquent loans, and as interest rates remain depressed relative to historical levels.

3

4

Q1 2013 US Mortgage Insurance Earnings Comment - Declining Delinquencies Drive a Return to Marginal Profitability

JUNE 4, 2013

INDUSTRY OUTLOOK: US MORTGAGE INSURERS - POSITIVE OUTLOOK

INSURANCE

CHART 3

Mortgage Insurer Profitability Net Premiums Earned Underwriting Expense Adjusted Pre-Tax Operating Income

4,000

Losses Incurred Net Investment Income

2,000 0 (2,000) (4,000) (6,000) (8,000) 2006

2007

2008

2009

2010

2011

2012

Q1 2013*

*Q1 2013 Grossed-up to 12 months Source: SNL Financial Inc. Aggregate includes lead statutory mortgage insurance entities for: Essent, Genworth, MGIC, Radian, UGRIC

One of the primary drivers of the return to profitability is lower incurred losses, caused mainly by lower new delinquencies. Favorable macroeconomic conditions, including house prices and employment have provided significant tailwinds for the mortgage industry. As shown in chart 4, delinquencies on GSE loans have decreased from a high of almost 1.8 million at the end of 2009 to approximately 1.1 million at the end of 2012, a decrease of 38%. The sustained, decreasing trend in serious delinquencies seen in the GSEs portfolios is mirrored by the number of new delinquencies reported by mortgage insurers. CHART 4

US Delinquencies and Foreclosures New Delinquencies - Genworth (L)

New Delinquencies - MGIC (L)

New Delinquencies - Radian (L)

60+ Days Delinquent GSE Inventory (R)

New Delinquencies

60,000 50,000 40,000 30,000 20,000 10,000 0

2000 1800 1600 1400 1200 1000 800 600 400 200 0

Source: U.S. Federal Housing Finance Agency, Company Reports

Of note, is that fact that delinquent inventory ramped up very quickly between 2008 and 2009, but has been significantly slower in its descent to normalized levels reflecting the slow economic recovery, still elevated unemployment rate and house price still below the peak reached prior to the crisis. Also positive for the mortgage insurers, is our expectation of steady, or possibly higher persistency on profitable recent vintage business. With interest rates at historically low levels since 2011, and expected to start increasing as the Federal Reserve Board winds down its Quantitative Easing (QE) program, we

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do not expect to see significant refinancing activity on recent vintages. While this would negatively affect new origination, mortgage insurers are less adversely affected by lower refinancing volume as more of their new business comes from purchases that are less sensitive to interest rates. On the other hand, higher persistency also means that single premium policies are likely to remain on the books longer than had previously been the case. We don’t consider this a meaningful credit negative for insurers with a higher concentration of single premium business, as the negative effects of extending out single premiums will be offset by the higher persistency on the monthly premium business, they will, however, enjoy less of the upside from higher persistency than their peers.

Profitable Post-2008 Business Contributes to Profitability The overwhelming majority of post-2008 business has been written on prime mortgages, with borrowers of very high credit quality, and generally higher down-payments on their mortgages. The high quality of the loans, together with favorable pricing, has lead to new business being very profitable for the industry. As shown in chart 5, the proportion of pre-2009, or legacy business, comprising Risk-in-Force has decreased steadily, and new business is expected to surpass legacy business as a percentage of Risk-inForce in the near-term. Natural run-off of the legacy business and increasing volume of new insurance written (NIW) are key drivers of the shift in mix towards new business. As seen in chart 5, private mortgage insurer NIW has increased significantly from its post-crisis low in 2010, providing the main impetus to the shift in mix. As NIW continues to increase, the shift towards new business in the portfolios will accelerate. This, together with lower new delinquencies on the legacy book will continue to improve earnings. CHART 5

Percentage of Legacy Risk-in-Force Genworth (L)

MGIC (L)

Radian (L)

New Insurance Written ($' million)

100%

180,000

90%

160,000

80%

140,000

70%

120,000

60%

100,000

50%

80,000

40%

60,000

30% 20%

40,000

10%

20,000

0%

0 2010

2011

2012

Q1 2013*

Source: Company filings, Inside Mortgage Finance

Capital Raises Bolster Regulatory Capital Significantly, MGIC and Genworth were able to bring their statutory risk-to-capital ratios below the regulatory mandated 25:1 level, bringing the entire industry in compliance with this capital metric (see chart 6). MGIC, who along with Radian took advantage of receptive capital markets, bolstered the

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INDUSTRY OUTLOOK: US MORTGAGE INSURERS - POSITIVE OUTLOOK

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statutory capital of its MI subsidiary following the issuance of approximately $1.1 billion of equity and convertible notes during Q1 2013. Genworth received a capital infusion from its parent company, as part of that group’s restructuring. Radian, which issued approximately $700 million downstreamed $115 million of the proceeds to its MI subsidiary to bring its risk-to-capital ratio below 20:1. The GSEs and the NAIC, together with State insurance regulators are currently in the process of updating capital requirements for the mortgage insurers. While they have not yet communicated updated requirements, we expect that they would be more stringent than the current 25:1 level and any forbearance for weaker players would be limited, given that the industry as a whole is in a significantly stronger capital position compared to a year ago. The sector’s recent recapitalization is a positive step towards compliance with the eventual, updated capital requirements, and because it helps position the industry as a viable source of mortgage credit protection in the evolving US housing finance landscape. Some of the weaker insurers may not meet updated capital requirements, and may have to raise additional capital or pursue a “good-bank, bad-bank” approach to meet capital requirements at the lead mortgage insurance entity. This approach, conditionned on GSE approval, could involve the recapitalization an existing affiliate to write new business, while managing an orderly runoff of legacy books in an entity with lower capital levels. CHART 6

Regulatory Risk-to-Capital 2011

2012

Q1 2013

50

44.7

45 40

32.9

35

36.9 26.4

30 25

20.3

20

20.4

15.8

15

21.5

20.8 18.6

16.3 12

10 5 0 Essent

Genworth

MGIC

Radian

UGRIC

Note: UGRIC and Essent Risk-to-Capital not publicly available for all periods. UGRIC 2011 RTC using Q3 2011 Source: Company Filings

Demand for private mortgage insurance is growing Most mortgage insurance coverage has, since the beginning of the financial crisis, been on loans eligible for purchase by the GSEs, reflecting the limited private sector activity and the insurers’ weak credit profile that excluded them from private sector solutions. That being said, the mortgage insurers are evaluating ways to serve the private sector market, anticipating that it will become more meaningful over time. While there is significant uncertainty about the role of private mortgage insurance in the future US housing finance environment, there are a number of developments that will drive growth in private mortgage insurance over the medium-term.

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INDUSTRY OUTLOOK: US MORTGAGE INSURERS - POSITIVE OUTLOOK

INSURANCE

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GSE Reform, while still on the agenda, does seem to have lost some urgency given the stabilization in housing and significant profits earned by the GSEs recently. The delay in GSE reform means that mortgage insurers will continue to enjoy the benefits of a government granted franchise for the near to medium-term.

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The Federal Housing Administration (FHA) picked up a significant portion of mortgage insurance market share during the financial crisis. Beginning in 2011, private mortgage insurers have regained significant market share from the FHA, the pace of which has been accelerated by a series of increases in FHA rates. We expect this trend to continue as the FHA shifts away from insuring loans that qualify as conforming loans under the GSE programs.

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One of the key objectives of housing reform has been to transfer more mortgage risk to the private sector. In line with this, the scorecards set up as part of the GSEs conservatorship require that they meet target amounts of risk transfer to private capital over the next few years. Private mortgage insurers are likely be important providers of risk transfer.

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From 1997 to 2007, new households formed at a rate of approximately 1.5 million per year, but fell to a rate of approximately 500 thousand from 2008 to 20104. While the rate picked up again in 2011, to about 1.1 million, a significant backlog of unformed households remains from those three years with very low rates of formation. As unemployment recedes and the younger generation enter formal employment, we expect some level of catch-up in household formations, in-turn driving up mortgage originations, especially in the higher than 80% loan-to-value space, as much of the pent up demand for housing will be from first time homebuyers. We expect that private mortgage insurers will benefit from this trend.

Aside from factors that directly affect demand for mortgage insurers, demand is also impacted, indirectly, by changes in demand for GSE versus Ginnie Mae (GNMA) mortgage backed securities. With the pricing differential between GNMA and GSE securities normalizing, lenders will be less inclined to offer an FHA loan when borrowers can get a cheaper conforming loan with private mortgage insurance.

High Quality New Business Benefits from Tight Underwriting Standards New business written post-2008 has been of a high quality, benefiting from tightened underwriting standards. There have been significant improvements in a number of areas of mortgage quality, three of the key indicators of which are shown in table 2; Credit Profile (FICO), Loan-to-value (LTV) and the level of Prime versus non-Prime mortgages.

4

8

Data from the Federal Reserve Bank of Cleveland and the U.S. Census Bureau

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INDUSTRY OUTLOOK: US MORTGAGE INSURERS - POSITIVE OUTLOOK

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TABLE 2

Mortgage Insurance Portfolio Quality, 2007 Vintage Compared to 2012 Vintage 2007 Vintage

2012 Vintage

>=740

28.5%

75.9%

680-739

38.5%

21.6%

620-679

27.9%

2.5%

5.1%

0.0%

95% And above

25%

1%

Lower than 95%

75%

99%

Prime

58%

99.9%

Non-Prime (Alt-A, Alt-A minus)

42%

0.1%

Credit Quality (FICO)