Transcript Housing Finance in Emerging Markets: Policy and

Housing Finance in Emerging Markets:
Functions, Instruments and Risks
Conference:
Housing Finance in Emerging Markets: Policy and Regulatory
Challenges
The World Bank, Washington D.C.
10 March, 2003
Presented by:
Dr. Michael Lea
President of Countrywide International Consulting Services
Outline of Presentation
Discussion of the Organization and Economics of the
Housing Finance Business
Overview of the Key Functions of Housing Finance
Brief Review of Mortgage Instruments and Mechanisms for
Funding
Identification of Basic Risks, How They Can Be Managed,
and How Policies Can Reduce Risk for Housing Finance
Providers
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Economics of
Mortgage Lending
Goals of the Mortgage Lending Business
Maximize Value of Franchise (ROE)
All Other Goals Contribute to the First
Customer satisfaction
Employee motivation
Investor confidence
Regulator and policy maker confidence
Constraints
Market (competitive product, input markets)
Risk (tolerance for variation in ROE)
In particular, the ability to manage interest rate risk
4
Bundled Mortgage Finance Model
Originate
Service
Borrowers
Portfolio
Lender
Manage
Risk
Deposits
Fund
Bonds
5
Portfolio Lending Perspective
Mortgage As a Core Portfolio Asset
Focus on Spread Between Mortgage and Funding Yields
Must be sufficient to cover costs of origination and servicing,
compensate for expected losses and provide a sufficient
return on equity
Spreads Vary Widely in Relation to Risk, Competitive
Environment, Costs of Doing Business, Inflation
Mortgage As a Key Customer Relationship Product
Creates long term relationship that can facilitate cross-selling
of other financial products
May lead to loss-leader pricing
6
Strengths and Weaknesses of the Portfolio
Model
Strengths
Weaknesses
Personalized service
Liquidity and interest rate risk
mgt. difficult
Same entity is originator and
servicer
Borrowers want long, depositors
seek short duration
Ability to cross-sell other financial
services
Operating Efficiency May Be Low
Permanent funding source
(depositories)
One entity does wide variety of
diverse functions
Incentive compatibility in
controlling credit risk
Less incentives for quality
control
Competition May Be Weak
Originator takes default risk
Lenders limited to those with
permanent funding
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Functional Perspective
Mortgage Lending Functions Viewed As Separate
Businesses
Goal Within Each Business Is Maximization of Shareholder
Wealth
Integrated Lenders Can Treat Each Function As a Stand
Alone Business
Allocate risk capital to each business line and require
separate reporting of results
Eliminate hidden cross-subsidies
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Unbundled Mortgage Finance
Retail
Mortgage
Bank
Investor
(Final or
Conduit)
Correspondent
Lender
Borrower
Mortgage
Broker
Wholesale
Mortgage
Bank
Mortgage
Insurer
Servicer
Portfolio
Lender
Functions: Marketing
Financial Risk Mgt.
Underwriting
Packaging
Warehousing, Pooling
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Credit Risk Management
Servicing
Borrower
Strengths and Weaknesses of the
Unbundled System
Strengths
Weaknesses
Specialization Creates Incentives
for Cost Minimization, Innovation
Agency Problems From Having
Many Entities Involved in Lending
Process
Funding Through Sale of Assets
Exerts Market Discipline
Investors must monitor
originators & servicers,
increasing cost
Can’t bury “mistakes” in the
portfolio
Conduits May Have Excessive
Market Power
Incentives for higher quality
underwriting, servicing
Risks May Be Overly
Concentrated As Well
Better Interest Rate Risk
Management
Need to Maintain Higher Quality
Standards Increases Cost and
Technology Spend
Mortgage securities with different
durations sold to investors best
equipped
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Key Drivers of Profitability
Competitive Environment
Does mortgage pricing cover cost, risk? Do lenders have
pricing power in the market? Are there barriers to entry to new
lenders?
Volume
Can lenders generate sufficient scale to cover fixed costs?
Is there an ability to manage volume variability
Cut costs in slow downs, raise margins in up turns
Funding
Access to competitive funding source (e.g., can wholesalefunded lenders compete with retail-funded lenders?)
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Key Drivers of Profitability
Understanding and Managing Risk
A function of the volatility of the economy, legal and regulatory
infrastructure, adequacy of consumer information
Management expertise a critical ingredient
Access to data, markets for re-distributing risk
Understanding the Customer
Are they driven by price, service, product
Identifying profitable customers
Ability to cross sell
Understanding the Business
Do managers and employees have access to the right information, at
the right time, to do their jobs effectively
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Origination
Origination Functions
Marketing
Counseling
Taking Application
Locking Prices
Processing
Underwriting
Funding and Closing
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Important Steps in Origination
Take the application in branch, via the internet, telemarketing or remote
loan officer applications
Point of sale emphasis in developed systems
Collect data on employment, deposits, income, credit, assets and liabilities
Centralized credit bureau an important component of modern mortgage markets
Electronic credit information facilitates automated underwriting
Order property valuation to determine market value and condition of
collateral
Importance of professional, independent appraisers
Necessity of property value and characteristic databases
Facilitates Automated (Statistical) Property Valuation
Provide proper disclosures (cost and terms of credit, conditions for
providing loan etc.)
Consumer regulation a major issue in developed markets
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Underwriting
Principles
Character: Credit history, regard to obligations, debt use,
employment stability
Capacity: Ability to make payment, cash for the purchase and
reserves, other assets
Collateral: Value and condition of property, LTV
Compensating Factors: mortgage insurance, counseling, cosigners, large down payment, rental history
Procedures
Verify accuracy of application information
Confirm the loan meets specific lender or investor guidelines
Lock in interest rate and loan terms
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Automated Underwriting
and Credit Scoring
Credit Reports and Credit Scoring are used to determine
credit stability and allow instant feedback on credit quality
Credit scoring is a statistical modeling technique that
evaluates the degree of risk posed by a prospective
borrower or existing customer
Automated Underwriting combines credit reports and
scoring, loan program and pricing information to approve
loan at point of sale or refer to underwriter
Assumes past performance of like borrowers profile can
predict future performance
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Closing
Major Contributor to Time and Risk in Origination
Functions
Verify clear title, occupancy permits, etc.
Confirm final terms of the loan and remaining conditions; List
all fees and cash required for final payment
Verify insurance policies are active
Prepare all necessary legal documents and obtain signatures
(notary)
Transfer cash to appropriate parties
Ensure that property transfer and liens are properly recorded
Delivery of documents and file to servicer
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Risks in Origination Process
Credit Risk: Non-verification of borrower ability and willingness to
pay can contribute to higher default rates
Fraud: Misleading or inaccurate information provided by appraiser,
guarantor, credit information provider
Agency Risk: Third party does not follow guidelines of principal
(e.g. broker, appraiser, attorney)
Commitment Risk: The risk that an interest rate commitment
(“rate lock”) is offered on a loan but the lender cannot earn an
adequate sales price to cover the costs of providing the
commitment.
Pipeline Risk: The risk that a closed loan will change in value
between the time of closing and shipment to an investor.
Documentation Risk: The risk that a closed loan is underwritten
improperly and does not conform to the investor’s requirements.
Cost Control: Managing loan volume variability and fixed costs of
production (branches, permanent staff)
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Managing Risk in Origination
Automating the Process
Electronic Applications
Reduces processing time/one time entry
Improves accuracy
Creates data base for later use
Facilitates flow of information through the various processing steps
Electronic Credit reports and Automated Underwriting
Increase accuracy
More objective underwriting
Improve the Flow of Information to Decision Makers
Activity-based reporting and costs
Quality control policies and procedures
Real time information on pipeline for funding, hedging
Convert Fixed Cost to Variable Cost
In US wholesale channel and commissioned loan officers are variable costs
Funding Through the Secondary Markets
Creates discipline for underwriting, documentation, quality control
Rating agency and investor review can lead to quality improvement
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Servicing
Functions of Servicing
File Set Up
Document Control
Quality Control
Collections/Loss Mitigation
Payment Processing
Processing
Foreclosure/Bankruptcy
Insurance and Tax
Management
Real Estate Management and
Disposition
Customer Service
Investor Accounting
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Servicing Objectives
File Set Up: Fast, error free entry of new loan data/documents into the
servicing system
Quality Control: Avoid losses by catching errors and fraud early; ensure
proper documentation and adherence to investor guidelines (reduce
probability of repurchase
Payment Processing: Focus on efficiency, avoid loss through error
Customer Service: Handle requests and maintain customer satisfaction
and retention
Document Control: Protect lender’s security, efficient handling of
documents
Collections: Avoid foreclosure and improve cure rate on delinquent loans
Foreclosure and Repossession: Minimize loss severity, liquidate property
to recover as much value as possible
Taking the property is a last resort for lenders but the possibility has strong
deterrent value
Investor Accounting: Ensure Accurate And Timely Disbursement Of
Funds To Investor
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Collections and Loss Mitigation
Early Stage Management Critically Important
Catching problems early may prevent defaults
Trick is to act quickly before borrower passes the point of no return
Newest approach: Take preventative action before trouble begins
Presort borrowers to identify those most likely to have payment problems using
predictive scoring systems
High-risk borrowers given shorter leash, more labor-intensive servicing
Serious Arrears Costly: Timely Action Essential
Rising interest accruals
Legal fees
Property value and condition declines
Maintenance costs increase
Risk of economic downturn increase
Forbearance May Be Preferable to Foreclosure
Securitization may discourage forbearance
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Default Management Process
Borrower
Defaults
Evaluate
Options
Begin
Foreclosure
Work out plan (forbearance)
Bring account current (waive late fees)
Recast rate or term
Forgive or capitalize interest in arrears
Refinance
Deed in lieu of foreclosure
Short sale
Foreclosure
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Obtain
Title
Continue
Negotiations
Market
Property
Risks in Servicing
High Level Of Defaults/Delinquencies
May reflect poor underwriting, volatile economy, ineffective collection
policies
Staff/Volume Imbalance - poor planning, managing loan volume
variability (cost control)
Errors Made In Other Departments That “Come To Roost” In
Servicing
Securitization focuses attention on servicing functions of reporting,
documentation, performance
Fluctuations in Value of Servicing Asset
In secondary market system, servicing rights may be capitalized and
held on the balance sheet. Value of servicing asset will vary with
changes in interest rates, prepayment
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Managing Risks in Servicing
Automation
Facilitates cost control, information flow for managers, investors;
reduces incidence of errors
Data Collection and Analysis
Understanding default and prepayment based on analysis of portfolio
Pro-active collections can reduce default loss
Quality control procedures can reduce errors and improve efficiency
Cost Control
The “Loan Factory” – loan processing is a commodity business
Outsourcing
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Loan Servicing Economics
In Secondary Market System a Profitable Business
Servicer receives fee (bp/month on outstanding balance)
Other sources of income: float, late fees, investment of
escrow balances
Strong incentive to minimize costs (processing, arrears)
Portfolio lenders can turn servicing into a profit center as
well
Transfer pricing and cost accounting
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Mortgage Instruments
Mortgage Instruments
Two Instruments
Mortgage is pledge of property as security for an obligation
Promissory Note defines debt and makes borrower liable for
obligation
Recording (Registration) of Mortgage
Not essential to validity of obligation
Protects mortgagee from subsequent acts of mortgagor
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Mortgage Design
Design Objectives
Borrower affordability
Borrowers have diverse needs
Lender profitability
Instruments have different risk-return profiles
General Rule About Mortgage Design
Changing design to solve one problem always creates a new
problem
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Fixed Rate Mortgages
Fixed Rate Level Payment Mortgage
Works well in low inflation environment
Unanticipated inflation helps borrowers hurts lenders
Anticipated inflation leads to affordability problems (“tilt
problem”)
Protects borrowers against interest rate risk
Graduated Payment Mortgages
Payments start low and rise over time
Improves affordability and partially offsets tilt
But lengthens duration and creates negative amortization
Reduces interest rate risk protection
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Adjustable Rate Mortgages
Allows Lenders to Manage Moderate Inflation
Three Major Types
Discretionary: Determined by lender
Rollover: Short term, fixed rate periods during long term
amortization
Indexed: Rate change tied to external rate
Transfers Interest Rate Risk to Borrowers
Better match for depository portfolio lenders
Higher credit risk due to potential payment shock
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Indexed Mortgages
Conventional Mortgages Do Not Perform Well With High
and Volatile Inflation
Mortgage Designs Must Balance Affordability and
Profitability
Two Major Designs
PLAM (Price Level Adjusted Mortgage)
DIM (Dual Indexed Mortgage)
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Indexed Mortgages (cont’d)
PLAM
Interest rate fixed at “real” rate
Payment and balance adjusted by price index
Works well if incomes and property values rise with inflation
Can lead to payment shock or negative equity if income or property
values do not rise with inflation
DIM
Separates payment and accrual rates
Solves problem that incomes may not rise with inflation
Payment rates typically indexed to wages
Dangers of minimum wage indexing
But creates new problem
DIM may not amortize
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New Mortgage Designs
Equity Release Mortgages
Allows elderly home owners to consume some or all of their
equity
Borrowers receive payments in exchange for portion of equity
or capital gains
Flexible Mortgages
Allow uneven repayment patterns
Integrated Mortgages
Link mortgage with checking account, savings accounts,
insurance policies etc.
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Funding and Risk
Management
Funding Options
Deposits
Other Corporate Liabilities
Whole Loan Sales
Mortgage Bond Sales
Mortgage Security Sales
Liquidity Facilities
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Funding Mortgage Assets
Maximize the Value of the Earning Asset Through Selection
of the Lowest Cost Funding on a Risk Adjusted Basis
Portfolio Lenders: Maximize spread through mix of retail and
wholesale funding of various terms and equity in
accordance with risk management guidelines
Secondary Market Lenders: Best execution on sale of
mortgage (maximum price upon sale)
Pricing incorporates target profit margin
Temporary lenders need warehouse funding
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Financial Institution Risks
Credit Risk: Loss Due to Default on Loan Obligation
Liquidity Risk: Risk That the Money Will Be Needed Before
It Is Due
Interest Rate Risk: Risk That Interest Rate Changes Will
Affect the Value of Assets and Liabilities
Basis Risk: Risk that margins on assets and liabilities will vary
over time
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Financial Institution Risks: II
Prepayment Risk: Risk That Mortgage Will Be Repaid
Earlier Than Scheduled
Inflation Risk: Risk That Unexpected Inflation Will Affect the
Value of Assets and Liabilities
Foreign Exchange Risk: Risk That Movements in Exchange
Rates Will Affect the Value of Assets And/or Liabilities
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Financial Institution Risks: III
Operations Risk: Risk That the Organization, Controls,
Information Systems and Technologies Are Inadequate
to Safeguard the Institution
Agency Risk: Risk That an Agent or Intermediary Will
Misuse the Funds
Political Risk: the Risk That the Legal and Political
Framework Within Which the Lending Takes Place Will
Change
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Cushions to Absorb Risk
Equity Capital
Basel II will more explicitly link equity requirements and risk broadly
defined
Managerial Controls and Policies
Must have an understanding of how interest rates impact balance
sheet and income statement
Importance of data, measures
Must have policies regarding tolerance for and management of
various risks
Portfolio Structure
Inflows and outflows of funds
Maturities and interest re-setting periods of assets and liabilities
Management Judgment
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How Policy Makers Can Reduce Risk in
Housing Finance
Origination
Centralized credit bureau
Centralized house price database
Accurate, efficient and low cost title and lien registration
Encourage competition
Stable economy
Servicing
Stable economy
Effective foreclosure regime
Funding
Stable economy
Strong and flexible regulatory system for institutions, instruments
Develop capital markets and sources of long term funding
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