So long as home prices are rising, mortgage insurers take in premiums and pay out virtually nothing in claims. But when the tides change, and home prices decline, this corner of the insurance industry can suffer outsize losses.
One listener asked if Essent Group's (NYSE:ESNT) sky-high profitability is sustainable in the long run, and the answer is: probably not.
In this Industry Focus: Financials segment, host Gaby Lapera and contributor Jordan Wathen discuss the long cycles in mortgage insurance, and why the industry can be profitable for decades before facing insolvency and bankruptcy when home prices fall.
A full transcript follows the video.
This video was recorded on May 22, 2017.
Gaby Lapera: Are Essent's 68% net margins too good to be true? Some background for listeners, Essent is a mortgage insurer. That's the private mortgage insurance you need to buy if you put down less than 20% on down payment for a house.
Jordan Wathen: Yeah. This is a billion-dollar question. The answer is, it's hard to say. I guess, come back when home values are going down rather than up. Mortgage insurance is just tough. On a long timeline, it seems like all mortgage insurers eventually go to zero, because the industry basically went extinct during the Great Depression. Half of them blew up in the 1980s, many of them blew up, or almost blew up, in 2008. So you have these long, generational cycles of profits, and then house values go down and they lose a fortune, because they're basically taking the first loss on houses. Personally, I don't spend too much time following it because the cycles are so long, and because it's one of those industries where the government plays a really big role. So if the government comes out and wants to promote homeownership, they could really ruin the mortgage insurance industry if they want to. Or they could make it obscenely profitable by making it harder. It's just an industry that, truthfully, I don't understand too well. And I think you would really have to have your finger on the pulse of Washington politics to really understand it.
Lapera: Yeah, and not just Washington politics, but, like you mentioned, the housing cycle tends to be very boom and bust, and the problem is private mortgage insurers are not the ones writing the loans for the houses. In that case, it's two steps of underwriting. It's the bank's underwriting plus the insurer's underwriting that is creating this policy for this person. So if the bank did a really bad job underwriting that house, then the insurers are definitely going to lose out. So it's just something that has a lot of variables and is hard to control. So just think about that before you consider investing in private mortgage insurance.
Wathen: That's a good point. Because these cycles are so long, someone could theoretically join a mortgage insurance company out of college, become an executive, and through that whole timeline where they move up the company, basically, they operate in an industry during the time when they experience almost no losses. So all they've been rewarded for is underwriting more and more and more insurance. Psychologically, it's something that's really difficult to grasp, because eventually, the losses do come -- it's just a matter of time. But someone could easily see 10-30 years of excess profits, and then all of a sudden, it's just complete wipeout in one year when house values go down.
Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.