he cyclical nature of the title insurance industry is on full display as the highs of 2002-2005 are being followed by the lows of 2007 and 2008. Title insurance revenue has surely fallen off, adversely influenced by downturns in both the housing and mortgage markets. However, GAAP operating revenue for the six publicly traded title underwriters was down a moderate 9% for the first nine months of 2007. The real story behind the current unfavorable title insurance market is the deterioration in operating margins, falling to 2.3% from 6.6% in 2006. These operating margins pale in comparison to an industry operating margin in excess of 14% in 2003 during the peak years. Industry results for 2008 are likely to show significant weakness. Title insurance remains a labor-intensive, high fixed-cost business, and as revenues continued to decline, reducing headcount is the underwriters' most effective tool to improve profitability. At the same time, losses for cyclical peak policy years 2004-2006 have developed adversely relative to original expectations, suggesting that over taxed resources and less cautious underwriting produced larger than anticipated claims losses. Finally, fraud and agent defalcation schemes tend to be uncovered during down cycles when deal flow is reduced. • The fortunes of the title insurance industry are tied to the mortgage and housing markets, both of which are expected to further decline in 2008. The Mortgage Bankers Association of America (MBAA) is forecasting mortgage originations to fall by nearly one-fifth in 2008 with the burden relatively evenly split between refinance and purchase transactions. Housing starts as well as sales of new and existing homes deteriorated in 2007 and are forecast to continue to fall in 2008. Home values lost a modest 2%-3% on a national average basis, but will experience additional declines due to the existing inventory of unsold homes. • It is important to understand that Fitch's rating outlook on the title insurance industry is meant to look through cyclical results and focus on the underlying fundamentals. In Fitch's opinion, the balance sheets of title insurance underwriters are strong enough to weather the current downturn, supporting Fitch's Stable Rating Outlook on the title insurance industry.
Rating Outlook ⎯ Stable Fitch's Rating Outlook for the industry remains Stable, as ratings are assigned at a level that reflects a company's performance through good markets and bad. Consequently, Fitch's Stable Rating Outlook should be interpreted as a barometer of durability in underwriter ratings and not an indication of how the industry is currently performing. The Stable Outlook indicates that rating changes in the near future are unlikely unless an underwriter significantly underperforms peers or underlying balance sheet fundamentals become impaired. Fitch believes that the seven title insurance companies in its rating universe, representing approximately 95% of industry revenues, remain well positioned to withstand the current market down cycle without adjustments to either financial strength or issuer default ratings. The Stable Outlook continues to be supported by solid balance sheets as measured by moderate financial leverage, redundant reserve positions and strong absolute levels of surplus as well as risk-adjusted surplus. Rating changes for individual companies over the next 12-18 months are thus more likely to result from a divergence in operating performance or balance sheet fundamentals relative to peers than for cycle-related variability in operating results. Fitch does not foresee a change in the industry Rating Outlook in the near term. Factors that might lead to a change in Rating Outlook include, among others, an extended market down cycle that produces significant operating losses and adverse movement in capital adequacy, or changes in market practice or development of substitute products that lessen overall demand or profit potential for title insurance. Rating Changes In spite of the severity of the current market down cycle ratings within Fitch's title universe remained virtually unchanged from the prior year. The one notable exception was the First American Corporation (FAF) and its operating subsidiaries (First American), which saw its Rating Outlook revised to Negative from Stable on Aug. 2, 2007. FAF's insurer financial strength (IFS) rating was upgraded to ‘A+' from ‘A' in 2006 based on its position as a premier provider of title insurance and real estate ancillary services. The company was seen as differentiating itself from peers and was consequently expected to perform better than the industry during the subsequent down cycle. However, FAF's performance has been worse relative to competitors over the last few quarters. Specific issues leading to FAF's Negative Rating Outlook include: lower risk-adjusted capital (RAC) score following a second-quarter pretax reserve charge of $238 million, uncertainty surrounding loss reserve adequacy and recent operating performance that is inconsistent with the rating category. Fitch will continue to monitor First American's performance in the near term but plans on resolving the Outlook status near the conclusion of the second quarter of 2008. If negative rating pressure exists at the conclusion of Fitch's review of First American, Fitch's likely rating action would be a one-notch downgrade of all ratings.
Subprime Turmoil and Title Insurance The rising number of mortgage defaults, especially in the sub prime space, should not necessarily cause alarm for title insurance companies. While a mortgage default accelerates any potential title insurance claims, the default in and of itself does not cause title claims. Title insurance provides the land owner assurance that the title they purchased is free and clear of any encumbrances. The fact that a title insurance policy covers events that occurred in the past make it a unique insurance offering and allows title insurers to underwrite to a theoretical zero loss ratio. Therefore, a thorough underwriting process should uncover most title defects; however due to a price/benefit constraint the title search may not uncover every encumbrance before a policy is underwritten. Title claims tend to be discovered in the midst of transactions such as a property sale or a mortgage default or foreclosure, thus an increase in defaults above historical averages may result in an acceleration of losses. However, provided that the underwriting process was robust a loss commensurate with the premium charged should occur. Mortgage insurance, on the other hand, is designed to pay the lender any financial shortfall it may incur due to a foreclosure. Consequently an increase in foreclosures directly increases a mortgage insurer's underwriting losses. An exception exists in the case of fraud where it is more likely that a mortgage default would lead to a title insurance claim. Title insurer's resources were stretched thin during the housing and refinance boom, increasing the likelihood that thorough underwriting guidelines were not strictly followed. Title Insurance Industry Outlook for 2008 Title insurers' operating results continued to deteriorate at the close of the third quarter of 2007, showing no near-term relief from the current market downturn. Title insurance revenue for Fitch's universe for the first nine months of 2007 fell 9% from the same period in 2006, but the decline was more pronounced comparing third-quarter revenue from 2007 to 2006. Fitch is expecting a moderate 3%-5% deterioration in title insurance revenues for 2008, and an improvement in results beginning in 2009. Please refer to Fitch's Public Title Insurer Universe ⎯ GAAP Operating Results table to see financial results for the six publicly traded title insurance companies. Title operating earnings for the first nine months of 2007 fell by more than two-thirds to $295 million for the six publicly traded title underwriters, representing a weak operating margin of 2.3%. Two underwriters actually reported pretax losses for its title insurance segments during the period, while a third was essentially break even. To be sure, operating margins have fallen precipitously in 2007, but this level of earnings during a down cycle is to be expected. In fact, one only has to revisit 2000 to find a similar industry operating margin of 2.4%. Fitch is expecting operating margins in a range between 2% and 4% during 2008, representing a small improvement as current expense cutting gains traction relative to falling revenue. However, there should be no expectation that the industry will return to the level of profitability seen in the peak of the cycle, 2003-2005. GAAP earnings announcements during the year included reserve charges for adverse development in prior policy years. Specifically, loss ratios from policy years 2004-2006 have been higher than originally expected. As shown in the Industry Ultimate Loss Ratios table, title insurer loss reserves have developed unfavorably as current estimated loss ratios for the most recent policy years are significantly higher than the originally reported loss ratios. The policy years with high loss ratios reflect periods of extremely high activity that stretched resources and resulted in a deterioration in underwriting quality. Reserve strengthening taken by title insurers during the first nine months of 2007 replaced more than half of the industry's estimated $646 million deficiency. Expense ratios also increased during the year as revenue fell faster than underwriters were able to cut expenses. In the face of further revenue contraction, expense control was a consistent theme in third quarter earnings calls. Realistically, reducing headcount is the most effective way to improve operating margins in the existing environment even though companies have been downsizing throughout the year. Five out of the six public title companies reported significant increases in expense ratios during 2007 relative to 2006 as shown in the GAAP Operating Ratios table above. Expense ratios should decline in 2008 as expense savings initiatives from 2007 take hold. The cyclicality of the title insurance industry is tied to the impact of interest rates and other economic factors including mortgage and housing markets. Interest rates are expected to remain relatively flat through 2008 after the Federal Reserve lowered its target rate by 50 basis points in September and 25 basis points in October. These rate cuts came after the Federal Reserve raised rates 17 times between June 2004 and June 2006. It seems unlikely, however, that interest rate cuts will revive mortgage originations or the suffering housing market. According to Freddie Mac, the average 30-year fixed mortgage rate has moved within a tight band between 6.2% and 6.7% during 2007 and is currently 6.4%. The MBAA forecast a small increase in mortgage rates during 2008 to 6.8% and holding essentially steady through 2009. Please refer to the Mortgage Rates table for a graphic presentation of both 30-year fixed and 1-year adjustable mortgage interest rates over the past several years. Total 1-4 family mortgage origination activity declined by nearly 15% during 2007 to approximately $2.3 trillion. The decline was balanced between refinancings and purchases. For 2008, MBAA's mortgage origination forecast is $1.9 trillion, with refinancing activity accounting for 47% of the total originations. The large number of consumers utilizing adjustable-rate mortgages has kept mortgage refinancings at a higher level than historical standards. The innovations in mortgage lending that have favored adjustable-rate mortgages will prevent refinancing volume from falling to the previous "steady-state" of approximately one-quarter of mortgage originations. Please refer to the Mortgage Originations ⎯ 1-4 Family table for a 15-year history of actual results as well as forecasts for 2007 and 2008 mortgage originations and the split between purchase and refinancing. Direct title order activity remains a credible leading indicator of future title insurance revenue, which continues to point to further revenue declines in 2008. The Direct Title Orders Opened table shows results for the five national title insurance underwriting groups. The table illustrates the significant decreases in orders opened during the third quarter of 2007, while year-to-date 2007 orders reflect a more moderate decline compared to the same period in 2006. This third-quarter figure indicates that the slowdown in title insurance business is accelerating. Housing starts are estimated at 1.36 million for the full year of 2007, down 24% from 2006 levels. Expectations for 2008 are for a 15% decline in housing starts. Sales of both new and existing homes fell substantially in 2007 and are forecast to fall again by approximately 10% in 2008, according to estimates from MBAA. Please refer to the Key Measures of Real Estate Market Activity table to see 10 years worth of industry trends on housing starts and sales of new and existing homes. The slowdown in sales of new and existing homes resulted in growing inventories of homes that is currently greater than 10 months, which is considerably higher than the record low of 3.6 months in January 2005. The existing high level of home inventory means that the fortunes of the housing market will not turn around quickly. The big question is whether the economy is strong enough to withstand the ailing housing market or if a housing recession will trigger an economic recession.
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