Mortgage Loan Minimum Standards Manual Updated July 2007
EBRD Contract No:
C13407/C13408/UKF-2003-07-01 Mortgage Loan Minimum Standards Manual
ACKNOWLEDGEMENTS
This Mortgage Loan Minimum Standards Manual was written on behalf of the European Bank for Reconstruction and Development (EBRD) by advisors working for Bank of Ireland International Advisory Services. The writing of this manual and its application to Romania has been funded by the Financial Institutions Business Group within the EBRD. The UK Government under the UK/EBRD Technical Corporation (South Eastern Europe) has funded the application of this manual to Bulgaria and Croatia. The authors, under the direction of the EBRD, were Mr Rory Spain and Mr Gregory Allen.
Rory Spain is a career banker with more than 30 years experience in commercial banking with Bank of Ireland. For the past 15 years, Rory has almost exclusively been involved on the central development of the Bank of Ireland Group Mortgage business. He has been responsible for the design, development and implementation of a mortgage system within Bank of Ireland; the review of existing legislation and procedures in Northern Ireland prior to setting up the Mortgage business there; managed the research and development of a securitisation programme and delivered business and technical mortgage training to a wide variety of staff. He has also bee responsible for the design and delivery of a specialist Mortgage Practice Training programme on behalf of Bank of Ireland and the Institute of Bankers in Ireland. This programme has been delivered to over 4000 bank staff in Ireland. He continues to be the External Examiner for this qualification. In addition, Rory has undertaken numerous assignments relating to the Mortgage Business in emerging and developing markets..
Gregory Allen is a banking adviser and trainer specialising in the areas of Mortgages and Securitisation. As Head of Operations within the Bank of Ireland’s ICS Building Society, Mr Allen was responsible for the development of new mortgage based products within the Group, reflecting the changing needs of the Irish Market. In addition, Mr Allen was responsible for a team which managed the first asset backed Securitisation of the Bank of Ireland residential mortgages. This included substantial interaction with the Rating Agencies. More recently, Mr Allen has been involved in the provision of training in Ireland and Spain in the area of Mortgage Practice and Financial Management for Banks.
The authors would like to thank the following for their insights and contributions: Brian Kane (Standard and Poors, London) Ray Lawless (Mortgage Business, Bank of Ireland) Ray Weyer (Bank of Ireland International Finance)
The application of this manual to the aforementioned countries in South East Europe was greatly assisted by Bank of Ireland partner organisations within each of the countries where extensive research was compiled on the housing market and great assistance provided in the organisation of the research visit. The authors benefited significantly from their contributions:- Mr Radu Radut, International Banking Institute, Romania Ms Gergana Slancheva, International Banking Institute of Bulgaria Mr Mario Malezan, Croatian Banking Association.
During the research visits the Authors were given the opportunity to visit a number of financial insitutions within each of the countries. They would like to thank them very much for their time and cooperation.
Romania Banc Post Banca Commerciale Romania Banca Transilvania Domenia Credit.
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Bulgaria Bulgarian Post Bank United Bulgarian Bank Biochim Bulgarian American Credit Bank
Croatia Splitska Bank Privredna Bank.
They were also able to visit the National Banks and many others working within the industry such as Government Ministries, estate agents and insurance companies. We would also like to extend our appreciation to each and everyone who participated in the research meetings.
The manual was helped enormously by staff of the EBRD both within the local offices in Romania, Bulgaria and Croatia and also in the EBRD London office where the Financial Institution’s Staff made many helpful comments and suggestions.
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CONTENTS
INTRODUCTION
Part 1 The Minimum Standards and Best Practices
1. THE MORTGAGE PROCESS 1
2. MORTGAGE DOCUMENTATION 3
3. STRUCTURE OF MORTGAGE BUSINESS OPERATION 8
4. PROPERTY VALUATION 11
5. PROPERTY OWNERSHIP 14
6. INSURANCE 17
7. CREDIT AND RISK MANAGEMENT 22
8. IMPACT OF BASEL II 29
9. LENDING CRITERIA 36
10. SECURITY REQUIREMENTS 38
11 MANAGEMENT INFORMATION, IT AND ACCOUNT MANAGEMENT 40
Part 2 Overview of Primary and Secondary Markets
1. GENERAL OVERVIEW 1
2. UNDERSTANDING SECURITISATION 3
3. MORTGAGE SALES CHANNELS 11
4. MORTGAGE MARKET SEGMENTS 12
5. MORTGAGE PRODUCTS 14
6. SELF-BUILD PROJECTS 22
7. ARREARS MANAGEMENT AND REPOSSESSION 24
8. INTEREST RATES 25
9. INFORMATION TECHNOLOGY 26
APPENDICES Appendix 1: The Mortgage Process Appendix 2: Sample Application Form: Appendix 3: European Agreement on a Voluntary Code of Conduct on Pre-contractual Information for Home Loans Appendix 4: EBRD Environmental Guidelines for Residential Mortgages Appendix 5: Mortgage Bank and Mortgage Bond Laws in Europe Appendix 6: Investor / Rating Agency Sample Report Appendix 7: Cross Section of Mortgage Market Across Europe Appendix 8: Comparison between Secured Mortgage Bonds in Europe
GLOSSARY OF TERMS
BIBLIOGRAPHY
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INTRODUCTION
This manual has been written with the express intention that all banks and other financial institutions that received mortgage lines of credit from EBRD will comply with the minimum standards and best practices in the manual to ensure that the mortgages written can be included in either Mortgage Bond or Mortgage Backed Securities’ issues. Financial Insititutions are recommended to apply the minimum standards and best practices for these reasons. The information contained within this manual is based on the research undertaken by the writers and the standards that they have experienced in western European Banks. It is not intended to be definitive and there is no doubt that further improvements to mortgage lending practices will be identified as banks further develop this business.
The manual is divided into two parts, both of which are of importance. Part 1 contains the core Minimum Standards and Best Practices, which have been divided into the following categories: • The Mortgage Process • Mortgage Documentation • Business Operations • Property Valuations • Property Ownership • Insurance • Credit and Risk Management Standards • Impact of BASEL II • Lending Criteria • Security Requirements • Management Information/IT and Account Management
Within each of these categories, the document outlines Minimum Standards, Best Practices, reasons for Minimum Standards/Best Practices, possible investor/rating agencies requirements and further points to note.
Part 2 provides the reader with further operational information and detail and it is strongly recommended that all heads of departments, front line managers and mortgage staff become fully conversant with it.
In addition to this document, a ‘List of Minimum Standards and Best Practices’ has been produced to allow easy reference and guidance for senior managers of the lending institutions.
The minimum standards and best practices introduced in relation to the origination and management of mortgage loans will assist lenders to meet requirements for the possible future issue of Mortgage Bonds or Mortgage Backed Securities. In order that a mortgage book can be considered suitable for the issue of Mortgage Bonds or Mortgage Backed Securities a lending institution must be aware of the likely requirements of both Credit Rating Agencies and Investors. Throughout the manual the personal experience of the writers and the outcome of their research are incorporated to provide such likely requirements.
Moreover, the application of such minimum standards and best practices is prudent for the ongoing management of the primary mortgage business.
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Part 1 The Minimum Standards and Best Practices Mortgage Loan Minimum Standards Manual
1 THE MORTGAGE PROCESS
OVERVIEW OF EBRD MINIMUM STANDARDS AND SUGGESTED BEST PRACTICES
MS /01 i. The lender must have a written description of all the steps involved in Minimum making a mortgage loan, from the initial contact with the client up to Standards the signing of legal agreements, varying the terms of those agreements and up to redeeming the mortgage. This description should comprise a flow chart showing the steps involved and a written description of each of the steps.
ii. The lender should have procedures in place to make sure that all staff that play a material part in the process receive training to ensure that they understand and are familiar with it.
iii. A clearly defined organisational structure should be in place and include responsibilities, accountabilities and roles in all aspects of the mortgage process.
REASONS FOR MINIMUM STANDARDS & BEST PRACTICES
The process from beginning to end is long and detailed. It can be summarised into a ‘big picture’. Each member of staff, whether they be in a ‘front end’
Reasons for sales role or a back office administration role, needs to understand the ‘big Minimum picture’ and be competent to discuss it and explain it to customers. This is to Standards avoid later legal or other challenges by the client. The lenders need to demonstrate that they have a fair procedure that makes sure the borrower is fully aware of the commitment they are entering into and has taken the decision to enter into that commitment on a properly informed basis. This is subject to any relevant consumer protection provisions applicable in the jurisdiction
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POINTS TO NOTE
To understand the various steps in the mortgage process, Appendix 1 charts the various steps: VEL STEPS Customer given approval in principle Customer wants to buy/build suitable home which should take into account pre- approvals. Customer needs a mortgage Customer makes application Review if application fits underwriting criteria Approve/defer/decline application Offer to Customer (if approved)/ Implement Local Legal Norms. Offer accepted Legal requirements completed Mortgage drawndown Mortgage Account Management.
Individual flow charts, processes and procedures are developed for specific ‘market segments’ and these are included in the appropriate section in Part Two entitled Mortgage Market Segments.
Refer to Chapter 4 in Part 2, for further information on Mortgage Market Segments Refer to Appendix 1 for supporting information
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2 MORTGAGE DOCUMENTATION
OVERVIEW OF EBRD MINIMUM STANDARDS AND SUGGESTED BEST PRACTICES
MS/02
i. Development of all documentation supplied in the Mortgage process Minimum must involve suitable qualified legal advisers Standards ii. The application form should include the following details: • Personal details, including postal codes • Occupation and Income • Financial assets • Current Debt/Repayments • Bank Account Details • Details of legal body-according to local legal norms (e.g. Lawyer etc) • Current living accommodation • Details of property to be purchased/built, including postal codes • Amount of Loan required • Full costs of transaction • Full source of funds to cover the cost • Type of Mortgage required • Term /repayment schedule • The Application Form(s) should meet Consumer Protection legislation and must include explicit consent to enquire from a credit bureau if existing in relevant country. (see sample application form in appendix)
iii. Verification: Lenders must ensure verification of the information in the mortgage application by requesting the following documents: • Completion of standard conditions in application form (including rd authority for lender to assign/sell on the mortgage to a 3 party.) • Certificate of Income from Employer • State certificate of earnings/tax paid (according to local legislation) • Certified Audited Accounts – (self employed) • Independent confirmation tax is up to date • Savings/Loan statements • Rent accounts (if relevant) • Valuation/Structural Survey report. • National Identity Cards (according to local legislation) • Marriage Certificates or proof of marriage, as the case may be, if relevant. • Divorce/separation agreements, if relevant • Architects certificates – for self build products • Cadastre Excerpts, if applicable.
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iv. The Mortgage offer should be documented in an offer letter and/or mortgage loan agreement that is legally binding, complies with consumer legislation, safeguards the customer and the bank and Minimum will stand in a court of law. The contents of the letter/agreement Standards should include: • Name & Address of Customer, including its postal code; • Address of property being mortgaged, including its postal code; • Amount of Credit advanced; • Period of the Agreement; • Number of repayments; • Total amount Repayable; • Cost of the Credit; • Interest Rate (APR ‘Annual Percentage Rate’ if the practice of the respective country has such a banking instrument) This is the equivalent, on an annual basis, of the present value of all loan repayments and charges, future or existing, agreed between the creditor and the consumer. • Security Required; • General Conditions; • Consents required in order to enable the sale of mortgage and legal charge to 3rd parties, transfer of data to 3rd parties and the appointment of a 3rd party administrator / servicer, including consent for access to credit bureau’s data, if existing in the respective country.
v. Lender must comply with the European Voluntary Code for Pre Sale information – as amended and published from time to time by the EU. (as described in appendix 3)
vi. The following at a minimum should be provided post sale: • written confirmation of the key terms of the loan once the contract is signed and subsequent notification, at least on an annual basis, in cases where the structure of fees change (e.g., redemption penalties, statement fee, re-mortgage, early repayment charges etc.) • .annual statements to the borrower detailing the principal outstanding, repayments and interest payments made during the year and any penalty interest. • written notification if the mortgage is sold to another lender etc . • written notification of early repayment charge / arrears charges lender to have arrears / repossession policy or equivalent internal regulations
vii. Documentation by its nature is spread across the totality of the mortgage process. A mortgage business will develop a wide range of other documents to cover specific activities and situations. The following is a list of documents lenders should have: • Consumer guides to process/products; • Relevant marketing material; • Application Form(s) – meeting Consumer • legislation/Secondary Market requirements; • Credit Assessment Template/Form/system; • Letter(s) of Offer/Loan Agreement – meeting legislative/ secondary marker requirements (including sale to 3rd parties.);Mortgage Deed – meeting legislative/secondary markerequirements; • Certificate of Title Report; • Assignment of Policies Forms; • Valuation/Property Appraisal Form.
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BP/02
Best Practices i. Although compliance with Consumer Protection Legislation is mandatory, Best practice would include a range of risk warnings/advice on offer letter/loan agreement such as:
• Advice that home is at risk if payments are missed. • Advice that interest rates may be adjusted up and down from time to time unless the product provides for a fixed interest rate. • Advice to obtain independent legal advice before signing the contract.
REASONS FOR MINIMUM STANDARDS
The Loan Application: The Loan application enables the lender to collect all the relevant information
/verifying documentation to adequately assess the application. The interview Reasons for Minimum is a key activity in the assessment process. Standards
The Offer Letter/ Mortgage Loan Agreement: The offer letter (when accepted) is the formal contract between the lender and the customer.
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POINTS TO NOTE
Application Form Mortgage business can be obtained through a range of channels including: Direct over the counter enquiries Indirectly through introducers Telesales call centres Via the Internet
The process of evaluating applications and taking decisions has to be adapted to each medium.
Traditionally lenders have gathered information by using a mortgage application form and this is reinforced by additional facts collected at a face-to-face interview. Many businesses now use an on line data collection process in addition to/or instead of a mortgage application form but the required information does not change.
The data collection enables the lender to: Assemble information about the applicants financial circumstance (status) in order to assess if the customer will be able to service the repayments on the loan Assemble information relating to the property on which the loan will be secured.
This represents a ‘belt and braces’ approach. If the borrowers‘ability to service the debt deteriorates the lender can rely on the security to recover the outstanding debt.
Assessment of ‘ability to repay’ and valuation of security go hand in hand but it is the first of these, which is most important. Even with excellent security there is no point in lending to a person who will find it difficult or impossible to maintain regular repayments. Such a situation causes stress and hardship for the customer and can lead to unnecessary administrative work and loss for the lender.
We will discuss’ ability to repay’ in much greater detail in the chapters on Credit and Risk Management.
Most people agree that it is wise for a mortgage seeker to have an initial discussion with their lender before selecting a property and completing a formal application. Many lenders provide an ‘approval in principal’ which will indicate the level of borrowing available to the customer subject to documentary evidence.
Offer Letter or Mortgage Loan Agreement: Once the Underwriting Department approves a mortgage the next step is to issue a Letter of Offer or a Mortgage Loan Agreement. An Offer Letter is a very important legal document and once it is accepted by the Customer it becomes a binding legal contract under which the Lender agrees to lend and the Customer agrees to borrow a specified sum of money, for a specified term, at a specified interest rate (defined variable or fixed) with specified security and on specified terms and conditions. An accepted Letter of Offer is therefore the legal basis of the Lenders relationship with the borrowing Customer. In the event of a dispute regarding the loan it is theisdocument that will be referred to. Accepted Letters of Offer must be treated as one would treat items of Security. They should be retained in the security file. They should not be written on or defaced as this may affect the validity of the Loan. The terms and conditions in a Letter of Offer will be comprehensive for information purposes. The key areas are set out under the Minimum Standards at the beginning of the Chapter. A range of consents are required of the Customer including specific consent for the sale of the mortgage for Securitisation / Mortgage Bonds purposes.
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WHAT INVESTORS AND RATING AGENCIES MAY
REQUIRE
Investors and Rating Agencies have evidence that loan decisions are made on What Investors the basis of interview supported by collection/retention of comprehensive data and Rating Agencies May Require. Lenders should carefully retain the Application form, offer letter/mortgage loan agreement and supporting documents for possible review at a later stage by auditors acting for Investors/Rating Agency in the event of a Mortgage Bond or Securitisation issue.
Refer to Appendix 2 for a sample mortgage application form. Refer to Appendix 3 for the European Voluntary Code of Conduct.
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3 STRUCTURE OF MORTGAGE BUSINESS OPERATION
OVERVIEW OF EBRD MINIMUM STANDARDS AND SUGGESTED BEST PRACTICES
MS/03
Minimum i. Regardless of whichever organisational structure the lender adopts Standards it should be supported by necessary checks and controls to ensure policies in relation to mortgages are adhered to.
BP/03
i. Research shows that many of the largest and most successful Best Practices mortgage lenders have centralised their operations with Branches being responsible for Business Development, Sales and Customer Service. ii. Where a decentralised model is adopted, it should be supported by regular audit checks and balances by Head Office to ensure compliance with policy.
REASONS FOR BEST PRACTICES/MINIMUM
STANDARDS
• Where a Decentralised model of operation is in place, branch managers implement bank policy in relation to: application standards and documentation, loan assessment, issue of offer documents, taking Reasons for Best Practice and perfecting security, issuing the loan cheque and account and arrears management. The decentralised model would be supported by regular audit checks and balances by Head Office to ensure compliance with policy. • Financial institutions need to demonstrate that capital and shareholder funds are being managed prudently and that adequate risk management controls are in place.
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POINTS TO NOTE
A lender when preparing for the issue of Mortgage Bonds or Mortgage Backed Securities must consider the merits of Centralisation against Decentralisation of the mortgage business
Centralised Operations: A Centralised operation means that a dedicated ‘Mortgage Centre’ is developed with responsibility for: Product Development * Marketing* Pricing * Underwriting Policy* IT Systems* Finance* Loan assessment Issue of Offers Loan Drawdown Security taking/perfection Account management Arrears management HR/Training*
It is likely that the functions marked * would be carried out in conjunction with similar functions in the institution’s Head Office.
The role of Branches and other sales outlets would be to develop the mortgage business from their customer base and outside opportunities. Applications for mortgage finance would be prepared locally and sent to the Centre by either paper or electronic form. Supporting documentation would be sent in a similar way. Their role would be principally Sales and Customer service with all other key functions centralised.
Should a Mortgage Bond or Mortgage Backed Securities issue be launched it is likely that staff from the Mortgage Centre would play a leading role.
Decentralised Operations: A decentralised operation means in essence that lending authority (as defined by credit policy), offer letter issue, loan drawdown and security taking are carried out locally. The model looks as follows; Product Development* Marketing* Pricing* Underwriting policy* IT systems* Finance* Application preparation and processing Loan assessment Issue of Offer Loan drawdown Security taking/perfection Account management Arrears management HR/Training* (The functions marked * to be carried out centrally).
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WHAT INVESTORS AND RATING AGENCIES MAY
REQUIRE
Rating Agencies and Auditors acting on behalf of Investors will assess the
What investors process procedures and standards of lenders. and Rating Agencies May require.
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4 PROPERTY VALUATION
OVERVIEW OF EBRD MINIMUM STANDARDS AND SUGGESTED BEST PRACTICES
i. Lenders must ensure that a proper property valuation is done by a reputable and ‘bank approved’ valuer. In assessing the profile of the Valuer, the lender must ensure that: a) the valuer is a competent Minimum professional and a member of a recognised professional body (if such Standards bodies exist); and b) the valuer has adequate Professional Indemnity Insurance (if self-employed). ii. The Valuation Report presented to the lender must contain the following details: • Applicants name & address of the property, including the postal code. • Description of property/estimation of age • Dimensions/floor area • Number/type of rooms • Vacant or tenanted • Any extensions/Planning permission(obtained or required as the case may be) • Services – water, gas, electricity and/or other utilities, as available. • If under construction – stage reached/work & time to complete • Evidence of subsidence/landslide, if any • Rights of way across /through property. • Market value • Purchase Price • Reinstatement/replacement cost • Repairs identified • Recommendations • Signature/qualification/name of firm • Environmental Factors. see EBRD’s Environmental Procedures for Mortgage Loans(www.ebrd.com)
REASONS FOR BEST PRACTICES/MINIMUM STANDARDS
• Provides the lender with an independent assessment of the property that is being offered as security. • The LTV should be based on the lower of the market value and the Reasons for Minimum purchase price. • Standards Establishes the value for insurance purposes • Highlights repairs required etc.
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POINTS TO NOTE
The property valuation or appraisal is an independent assessment of the state of the property and it’s value. This is a critical activity as it defines in effect how much the customer can borrow as a % of the value of the property. (LTV – the loan to value ratio)
It is not an in depth survey. If the property is old or there are concerns over its suitability then a full Structural Survey should be carried out.
Property Valuation
It is a superficialinspection of a property designed to provide a lender with specific information to assess the adequacy of the security (mortgage or hypotec) offered for the loan. A copy is given to the applicant and the applicant usually pays the cost. Property valuations are the norm for modern/new houses. The valuer may recommend a structural survey.
The completion of a property valuation is an integral part of all mortgage applications (except in the case of a survey) It is a requirement that a competent professional valuer who has adequate Professional Indemnity insurance carry out an independent assessment of the property. The valuer should be a member of a recognised professional body of valuers.
The role of the valuer is to advise the lender as to the open market value of the property and any factors likely to affect its value. ‘Open market value’ is the best price at which a sale could be affected unconditionally for cash on the date of the valuation. Some lenders further discount the Open Market Value (OMV) figure to what they might consider mortgage-lending value. This could arise if there had been recent price volatility. An assessment of the reinstatement cost for insurance purposes (should the property be destroyed in an accident) for the property in its current form, including outbuildings, site clearance, re-housing costs and professional fees will also be provided.
Valuation Report
Information contained in the valuation report has a bearing on the following:
The Loan to Value ratio (LTV) The amount of insurance cover on the building* The conditions upon which the advance is granted Any repairs to be carried out/if funds are to be retained pending completion of the repairs. If the loan should be granted on the security of the property.
*Properties should always be insured for the reinstatement value not the market value – as it is the reconstruction cost which is the critical figure for insurance purposes.
Structural Survey
This is a comprehensive and detailed assessment of the property to identify defects – both minor and serious, which would not be evident from a valuation. An engineer or an architect usually carries it out. As the granting of a loan by a lender is not a guarantee of a soundly constructed house free from flaws and defects it follows that a purchaser would be well advised to arrange their own structural survey if they have any concerns about the property.
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In general the rule of thumb is that valuations are carried out on modern/new properties while structural surveys are carried out only on older properties.
Refer to EBRD Environmental Guidelines for Residential Mortgages, as amended from time to time .(www.ebrd.com)
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5 PROPERTY OWNERSHIP
OVERVIEW OF EBRD MINIMUM STANDARDS AND SUGGESTED BEST PRACTICES
MS/05:
i. The customer should either have: Minimum a) Freehold legal title* which gives them all rights to use the property Standards without limit in time, except for the right of the State to take over the property in certain circumstances paying compensation based on at least full market value. or
b) Leasehold title with the term of the lease equal to or not less than 75 years (or, if lower, the legal maximum term under the national law) from the end of the mortgage. Minimum residual should not be less than 20 years so that it will take term of mortgage into account. or
c) In the case of a civil legal system, the customer should have freehold in rem right to property. This title will have three components: possession, use and disposition.
(* Freehold title is absolute ownership in perpetuity. However it is subject to the superior right of the State. The risk of expropriation is always present in many jurisdictions. Restitution is still an open issue in several transition economiesand should be properly assessed. In the event of a compulsory purchase of the property by the state – e.g. road building/infrastructure purposes – then the market value would be paid by the state to the owner.)
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REASONS FOR BEST PRACTICES/MINIMUM STANDARDS
Lenders must be able to grasp/execute tangible security in the event of loan
Reasons for default. Minimum Standards
POINTS TO NOTE
Property Ownership: As a general definition ‘ownership’ is the right to have exclusive enjoyment of something. Ownership is absolute where it is without conditions and is complete. In most countries, if the state needs to acquire land for social/infrastructure purposes then a ‘compulsory purchase order’ is issued and the owner is compensated with the market value of the property.
Ownership can be: Sole: one person owns the property. Joint: two or more people own the property with equal or unequal shares. All must agree to sell. Tenants in Common: Two or more owners – each have a right to sell their portion independently.
Best practice: Most common situation in a Family Home is for Joint Ownership with equal shares. This is often the case in transition countries for married spouses, where spouses have equal rights on all property acquired during marriage. If one party owns the property then Family Legislation should protect the rights of the other party.
Types of Title There are two basic types of title or ownership – Freehold and Leasehold.
1) Freehold: legal title which gives them all rights to use the property without limit in time, except for the right of the State to take over the property in certain circumstances paying compensation based on at least full market value.
2) Leasehold: This is where the freeholder has granted a lease on the land for a period of years and thereby given to the leaseholder a proprietary right over the property which is opposable to third parties. The leaseholder has complete possession of the land/property for that term subject to a once off or regular payment. Leases can be for anything from say 5 years to 999 years. A lease generally indicates an interest for a reasonably long period. Tenancy: this is a short-term lease (e.g. letting a house or apartment for 6 months.) Tenancy is not a title, it gives no right in remain in the property, only a contractual right.
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Lenders will approve mortgages only for people who have Freehold title or a Leasehold Title with a substantial unexpired term on the lease.
Registration of Title
Many countries have over the last century updated and improved their property registration systems. The Land Registry is now the norm in most countries. In the Land Registry the owners’ title is registered and changes of ownership are registered as well as burdens/rights on the property (e.g. Mortgages).
Documentary Evidence
Evidence of Title is a Land Certificate (for Freehold) and A Lease for (Leasehold) situations. The Land Certificate is usually in 3 parts: 1. The Property – this shows the location/description /county and Folio number. 2. The Ownership – type of title and the details of ownership. Burdens – Mortgages/rights of way/right of residence (e.g. a parent) etc. 3. Right of Residence (e.g. a parent has given a farm/property to a child subject to a right to live in the property) – these would rank below the rights of a lender under the mortgage. The Life Tenant would complete a Deed of Confirmation. This is likely to vary significantly from country to country.
WHAT INVESTORS AND RATING AGENCIES MAY REQUIRE
Investors and Rating Agencies need comfort that the mortgage customer owns What Investors the property and it is good security for the loan. and Rating Agencies may require.
Refer to Appendix 5 for information on Mortgage and Mortgage Bond Law in Europe, as may be amended from time to time.
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6 INSURANCE
OVERVIEW OF EBRD MINIMUM STANDARDS AND SUGGESTED BEST PRACTICES
MS/06 i. Life Assurance: A Life Assurance policy on the life/lives of the borrower(s) to cover the outstanding principal for the term of the loan. Minimum The policy is to be assigned to the lender and its value will decrease Standards in line with outstanding balance of the loan.
ii. Buildings Insurance: An index linked property policy to cover the replacement/reinstatement value* of the property. The initial cover to be in line with the replacement/reinstatement cost in the valuer’s report. This cover is to be adjusted in line with a suitable index of construction costs. The policy is to be in the joint names of the customer and the lender or the interest of the lender should be noted in the insurance policy,as the case may be.
*This is the amount the property should be insured for each year and it should cover the replacement cost of the building should it be damaged or destroyed. This cost is linked to either a construction industry index of costs or to the Consumer Price Index. In addition to the main building, the following should be included in the insured amount – out buildings, site clearance, temporary re housing costs and professional fees.
BP/06
i. Contents insurance: It is prudent for customers to insure the
Best Practices ‘contents’ of their homes as well.
ii. Mortgage Indemnity Guarantee (MIG): If the lender intends to provide higher LTV loans then what is published in the Lending Policy Loan to Value criteria (LTV) then a MIG policy arrangement should be put in place. This enables the lender to lend more/customer to borrow more with the risk being underwritten by an insurer. The customer pays the premium. Individual lenders have different LTV standards. Best practice indicates that with mortgage loans above 80% LTV should be supported by MIG.
iii. A House Builders Guarantee Scheme: (if available at reasonable cost): in many countries the Construction industry working with Government guarantees (limited in time/cover) the quality of new residential properties. Builders in the scheme guarantee minimum standards and properties in course of construction are inspected.
iv. Where there is an uncertainty regarding title, Property Title Insurance should be sought, if available in the local market. This would come on top of any State guarantee for the data in the Land Register which is likely to be able to be called upon.
v. Mortgage Payment Protection Insurance: In the event of loss of job or income this policy will continue to meet payments for a period of time.
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R EASONS FOR BEST PRACTICES/MINIMUM S TANDARDS
Protection provided for Customer/Lender/Investors.
• If the customer dies, the life policy will repay the remaining
Reasons for mortgage. Minimum • Standards If the building is destroyed or damaged, the building policy will provide replacement /renovation funds.
POINTS TO NOTE
In this section we will cover a range of insurances related to Mortgage finance and Property. These include: Life assurance Buildings & contents insurance Mortgage Indemnity guarantee House Builders Guarantee Scheme
Life Assurance: Lenders require life assurance to cover the risk that the borrower will die during the course of the mortgage. It is a requirement also of rating agencies and Investors. There are numerous types of life assurance products, each with varying degrees of complexity, which are complimentary to a mortgage.
We will concentrate on the key ones here and these are: a) Term assurance b) Whole of Life assurance c) Endowment assurance a) Term assurance: The key feature of term assurance is that it provides life cover for a fixed period of time in return for a fixed premium. The life company will pay out the sum assured on death within the term. Term assurance is the cheapest form of life cover available. Term assurance is the most popular form of protection for a mortgage and is referred to as: Mortgage Protection/Decreasing Term Assurance
Here is how it works: At the start of the policy the assurance amount is set equal to the amount borrowed. The term of the policy will be equal to the term of the mortgage e.g. 20 years. However the cover reduces each year in line with the anticipated reducing capital balance of the mortgage. The policy assumes this declining capital balance based on an interest rate the assurance company deems to be sufficient. By the end of the term the cover will be reduced to zero as it is anticipated that the mortgage is now repaid in full. The policy lapses at the end of the mortgage term. If the customer dies during the course of the mortgage the policy will pay off the outstanding amount. Otherwise there are no payments to the customer.
July 2007 Part 1 18 The Minimum Standards and Best Practices Mortgage Loan Minimum Standards Manual b) Whole of Life Assurance Whole of life policies provide either continuous cover or cover until a specified age is attained. Premiums are paid for the life of the policy or for a specific period. Policies can be either With profit or Non profit. With profit policies share in the profits of the life company whereas non-profit policies do not. These policies will always provide a lump sum to the customer either at the end of the term or into the customer’s estate at death. The premiums on Whole of life Policies are more expensive than on Mortgage Protection. c) Endowment Assurance The Endowment mortgage will be described in the chapter entitled ‘Mortgage Products’ in Part 2’. While traditional policies such as term and whole of life are designed mainly for ‘protection’ purposes, the endowment policy combines both protection and savings elements. The proceeds of the endowment policy are designed to repay the capital amount of the mortgage on maturity. With profits ‘guaranteed’ policies or a low- cost ‘not guaranteed’ policies are available. The premium on the ‘guaranteed’ policy would be substantial.
Buildings and Contents Insurance: Lenders, Rating Agencies and Investors will insist on Buildings insurance and in some countries legislation also requires it. Generally buildings and contents are covered under the same policy but there is no obligation to insure contents -however it’s prudent to do so. a) Buildings Insurance: Buildings insurance will guard against financial loss due to fire, flood, subsidence, accidental damage and a number of other ‘perils’.
The borrower is required to keep the premises covered for its ‘reinstatement’ (this area is covered in the chapter ‘Property Valuation’) cost throughout the course of the mortgage and this means regular reviews on building costs. Insurance companies ‘index link’ the policies to movements in the construction prices or to the Consumer Price index (if there is no construction price index.). However, it is the customer’s responsibility to have the property adequately insured. The lender also has a keen interest in this as insurers invoke what is known as the ‘average clause’ in relation to claims on underinsured buildings.
Here is how the average clause works:
HOUSE A HOUSE B Property value €100000 €100000 Insured for €100000 €80000 Claim €2000 €2000
Calculation €2000 X €100,000 = €2000 €2000 X €80,000 = €1600 100,000 100,000
Less policy excess €100 €100 Amount paid €1900 €1500
The effect of the ‘average clause’ is that if a property is not insured for its proper value, insurance companies will not pay the whole claim amount even if it is substantially below the maximum insured claim. Lenders will insist that they are either jointly named on the policy or their ‘interest’ is noted. This means that the insurer is obliged to inform the lender if premiums are unpaid and the lender has a right to recover the proceeds if the property is damaged or destroyed. The need to also name subsequent persons who have acquired the mortgage loan in the case of the sale of mortgage loans should be covered, otherwise all insurance policies will need to be reissued in the case of securitisation.
Contents insurance is generally taken as a % of the value of the buildings cover usually ranging between 30% and 50%. However individual valuable items should be specified and insured separately. Lenders do not have an interest in this element of the policy.
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Mortgage Indemnity Guarantee
For mortgages over a stipulated LTV (Loan to Value) ratio lenders may insist on obtaining a Mortgage indemnity Guarantee also known as a MIG or an Indemnity Bond.
A MIG is an insurance policy that covers the difference between the amount lent to the customer and the risk the lender is prepared to take. Lenders may carry a risk of 80% LTV but at the same time they may be willing to lend up to 90% LTV – depending on credit policy.
The premium is one off and is paid by the customer. The benefit for the customer is that they can borrow an amount greater than would otherwise be possible and the benefit for the lender is that they do not carry the total risk.
The MIG offers no protection to the borrower. In the event of a claim, the borrower remains liable for the full amount owed. If the insurance company pays out under the policy it can claim the amount paid from the borrower. This is called ‘subrogation’ and is a basic principle of insurance.
Here is how it works: Let’s assume the lenders credit policy is to carry risk of 80% LTV. The property being purchased costs €85000 and the loan application is for 90% LTV which is €76500. Normally, the lender will lend 80% of €85000, which is €.68000.
Example: Purchase price 85000 Valuation 85000 Amount of Loan (90%) 76500 80% of purchase price 68000 Amount to be bonded 8500 Cost** 255 ** The cost of the bond in this instance is calculated at 3% of the bond amount. In general the higher the LTV the higher the cost i.e. the insurer is taking a greater risk. Some governments also charge a levy on the premium.
House Builders Guarantee Scheme: In order to improve the quality of construction some Governments, working with representatives of the construction industry, have introduced a regulatory framework for the private house building sector. The scheme specifies a high standard of construction and requires inspections of houses being built to ensure compliance with the standards of construction specified. The guarantee covers housing estates, once off houses and apartments and is available to builders who join the scheme and meet its requirements.
One scheme provides the following guarantees to the purchasers of all newly constructed houses.
Guarantees house against major structural defects for 10 years Guarantees house against smoke and water penetration for 2 years Guarantees against loss of ‘phased payments’ before the house is completed.
The 10 year and 2 year guarantees are self-evident. Lets look at the phased payment guarantee. This works on two levels:
Level 1: This is to protect the purchaser (and lender) in a situation where the builder declares bankruptcy or goes into liquidation during the building period.. The scheme will protect the purchaser’s deposit or contract payments up to a specified maximum. Level 2: This comes into effect usually after the final inspection when the house is ready to be handed over. The financial indemnity for the remainder of the contract period now increases to a higher specified maximum.
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WHAT INVESTORS AND RATING AGENCIES MAY REQUIRE
Rating agencies will require building insurance for reinstatement value and life What Investors assurance is a requirement in benchmark pools. and Rating Agencies may require.
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7 CREDIT AND RISK MANAGEMENT
OVERVIEW OF EBRD MINIMUM STANDARDS AND SUGGESTED BEST PRACTICES
MS/07
i. Credit Policy: The lender must have a defined Credit Policy and in Minimum this Credit Policy it must refer to the parameters on which the lender Standards carries out its mortgage lending activities. Primarily the Credit Policy must state that: • The policy is reviewed regularly to reflect business objectives and market conditions. • Mortgage lending is based on ‘ability to repay’. • There is adequate risk/reward ratio. However, irrespective of the reward, the loan will not be considered if it carries an unacceptable level of risk. The interest rate charged might vary to reflect the risks applying in a particular case that may include higher LTV ratios, Higher PTIs, (Payment to Income) smaller loans or construction loans as opposed to purchase loans. But for each risk factor, the lender should set a ceiling above which it will not lend. Each bank in their policy documents should set out what the risk/reward ratio will be. • The Interest rate charged to customers should be adequate to cover the bank’s cost of funds plus a suitable margin. • Where the interest rate charged to the customer is variable, it should be linked to the relevant reference rate for the loan currency (e.g. Libor, Euribor etc.) • A policy not to deal with known risky (sub-pime) /fraudulent customers • Explicit lending criteria in accordance with Minimum Standards as outlined in chapter 9 is adhered to. • All lending decisions to be made on the basis of verifiable information and documentation provided rather than subjective judgement. • It must set standards, which ensure that underwriters and account managers apply the policy initially at credit assessment stage and subsequently throughout the life of the mortgage. • It includes the approach to ‘Exception’ applications, the declines and appeals procedures. • It must include expected lending skills standards, lending authorities, tiered discretions, training requirements and succession planning. • It will put an obligation on lenders to explain to clients the risk undertaken by the client in the case of mortgage loans denominated in a foreign currency. • It sets out policy on Arrears management, Repossessions, Loan Loss Provisions and Write-offs. • It covers and includes Environmental Factors. (see EBRD’s Environmental Procedures, as amended from time to time (www.ebrd.com))
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ii. Loan Assessment: The lender should employ the following basic steps in critically assessing a loan application. Assess if: Minimum • Required information/documentation is in place. Standards • Application matches the standard criteria. • Customer has the ability to repay. • Customer has clean credit history. • Property is suitable for mortgage. • No legal or other impediments (age/bankruptcy etc). • Costs and funds available match.
iii An approach to Credit Risk Management which will include the following: • Detailed data capture/verifying procedures. • Detailed analysis/lending decisions. • Realisable security. • Proactive account management. • General/Specific provisions in place.
iv. Lenders must have an Arrears Management Policy for Mortgage Lending Risk Framework. This should be part of the overall Credit Policy and include specific provision for: • Well trained team/familiar with laws • Clearly documented Process. • Overall approach to arrears / face to face contact / analysis of reasons/ outline solutions. • Follow up procedure / action is always specific /measurable / achievable.
: BP/ 07
i. Turnaround time in the credit process is customer responsive,
Best Practices efficient and consistent with quality assessment. This depends on individual banks but could range from 24 hours to 7 days.
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REASONS FOR BEST PRACTICES/MINIMUM STANDARDS
Financial institutions need to demonstrate that capital and shareholder funds are being managed prudently and that adequate risk management controls are in place.
Reasons for Minimum Standards Loan Assessment: Loans are underwritten in accordance with clearly defined standards. Risk is taken in line with published policy
Credit Risk Management: Prudent business management.
Arrears Management and Repossession: Good Business Practice
POINTS TO NOTE
1. Credit Policy: The purpose of a Credit Policy in Mortgage lending is to facilitate the taking of acceptable risk by setting parameters within which we structure, approve and manage credit facilities and lending relationships. The credit policy sets out: Types of customer to whom loans may be granted (i.e. Customers of legal age with adequate repayment capacity.) Types of customers to whom loans will not be granted (e.g. minors, undischarged bankrupts etc) Income Criteria (e.g. sufficient net family income to meet banks affordability requirements) Types of property which are and are not acceptable Lending parameters Lending discretions at different levels of management Other underwriting rules (e.g. corroboration of income/outgoings) Pricing –rates of interest/fees/charges Standards in relation to property valuations/legal work etc. Commitment to operate to highest ethical standard and within all legislation.
Credit policy is always under review. It is amended regularly to cater for changing market conditions. By learning the lessons of previous lending experiences it is possible to modify the criteria to ensure a proper balance between risk and reward.
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Staff and Credit Training Credit policy should be implemented by setting out clearly each of the factors to be considered in reaching a credit decision, how each is to be taken into account and how they are to be combined to reach an overall conclusion. Objective credit assessment and prudent credit decisions are made by ensuring that all loan requests are managed by experienced staff with a minimum of 12 months mentored training. Competence is to be judged by Head of Credit or delegated experienced lender before a lending authority is authorized. A significant commitment should be made to the training and development of skilled lenders.
Credit Authority Levels Credit authority in a centralised operation is delegated to the mortgage centre who will in turn delegate discretion to the mortgage centre head of credit. Further downward delegated authorities will be put in place based on the experience and competence of the credit team. In a decentralised system individual credit authorities are delegated to Branch Managers. Consistency with bank policy and procedures will be monitored by independent checks carried out by the credit quality or compliance and Audit departments of the bank. Lending authorities to be tiered and in some cases joint. The loans should be divided into a number of size categories and setting out who can approve loans in each category. At least two members of staff should have to approve each loan, one more senior than the other. Each category should require approval by more senior people than the previous category.
Underwriting Applications are assessed in accordance with clearly defined Underwriting Criteria (see chapter 8 for specifics). These may be incorporated into a computer-based model.
In addition to the specifics outlined earlier the following should be included: Repayment Capacity model Exceptions to Credit Policy. Contract employment. HomeLoan and Commercial Loan mix. Credit declines. Appeals procedure. Customer service Commitments
Portfolio Management The Mortgage book should be managed on a portfolio basis. Diversification is achieved by maintaining an acceptable risk spread of geographical locations, product concentrations, employer concentrations, LTV’s MIG and business sources. Limits or guidelines may be set for certain concentrations.
A comprehensive suite of Management Information reports needs to be in place to monitor business progress (see Chapter 10 for detail). In relation to Credit a range of reports/analysis need to be in place on – new business, arrears, grade profile. In addition a formal half yearly review should be carried out.
Credit Loss/ Loan Loss Provisions Prudent management, in discussion with the Central Bank, would institute a range of loan loss provisions. These would be; a) General provision b) Specific provision c) Write offs. a) A General Provision Agreed with the Central Bank is a % of total mortgage lending and is instituted as a hedge against possible future losses. b) Specific Provisions Are set against individual mortgages, which are in arrears and where potential loss is identified. Potential loss arises where analysis indicates an inability to service the debt and where the net realisable value of security held is less than the debt. It is the responsibility of the Collections Manager to downgrade the account and recommend an appropriate level of specific provision.
July 2007 Part 1 25 The Minimum Standards and Best Practices Mortgage Loan Minimum Standards Manual c) Write offs Will only be approved by duly authorised officers.
2. Loan Assessment
In conjunction with the application of the Credit Policies and the Underwriting Criteria the following 7 Loan assessment steps should be undertaken before arriving at a decision. Measure/ Establish each of the following:
• Step 1: Basic Criteria • Step 2: Application matches standard criteria • Step 3: Ability to Repay • Step 4: Credit History • Step 5: Property Suitability • Step 6: The Person • Step 7: Cost/funding
Step 1: Basic Criteria Is the application properly/fully completed? Are all the supporting/corroborating documents provided?
Step 2: Application matches standard criteria Does the loan application meet standard criteria in the loan assessment and underwriting procedures?
Step 3: Ability to Repay Establish: Employment/Length of service. Permanency. Basic salary/additional earnings. Verification of : Certificate of Income/Employer contact Audited Accounts/tax position confirmed. Meets requirements of “affordability model”.
Step 4: Credit History: Establish : Savings record/previous loans/payments of rent etc. Verification of : Savings/loan statements/rent book. Credit bureau/court judgements.
Step 5: The Property Establish: Valuation/condition/location/type/suitability for mortgage. Verification of: Valuation report/structural report Local knowledge. (E.g. local staff to provide personal knowledge of property)
Step 6: The Person Establish: Legal standing/status Verification of: Marital Status/Separation/divorce agreement/Age.
Step 7: Cost/Funding Ensure all ‘hidden’ costs are factored in. As well as the property cost there will be a range of other costs e.g.: legal, property tax, utilities costs, moving costs, furniture, redecoration etc. Ensure the available equity cash together with the loan amount can meet the total costs.
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3. Arrears Management and Repossession
Full details of arrears management best practice are contained in the annex and credit policy should always include specific procedures in writing on arrears management. The objective is to minimise loss by encouraging customers to bring payments up to date and make future payments in a timely manner. Restructure of debt may be agreed in certain situations. An authorised officer can only approve proposed property repossessions and detailed operations procedures must be in place.
4. Credit and Market Risk Management:
The key risks, which financial institutions must guard against, are: Liquidity Risk, Interest Rate Risk, Currency Risk, Market Risk, Credit Risk and Operational Risk. We focus here on Market and Credit Risk in relation to Mortgages, as the other risks are general banking risks.
Credit and Market Risks arise in areas such as: Competitive pressures - competitors may introduce lower credit standards or aggressive pricing to gain business. Refinancing - taking on vulnerable customers from other lenders Economic downturn - leading to a fall in employment/fall in property values Price/income multiple – spiralling movement in property prices/income multiple. Portfolio Concentrations – over exposure (e.g. geographical, employer, LTV) Fraudulent Activity – fraud by applicant, intermediary, lawyer, and valuer results in approval, which in the ordinary course would be declined. Customer Risk Profile – customer’s position subsequently worsens. Changing Attitudes – Volatility in markets/changes in social/political attitudes which make it difficult to repossess and sell a family home.
The following approaches are adopted to manage these risks.
Maintain consistent credit standards through all phases of the economic cycle. Specifically avoid lowering credit standards in response to competitive pressure. Investigate the integrity of the applicant at the outset and maintain a focus on ‘repayment capacity’ lending. Stress test ‘repayment capacity’ by increasing the interest rate in the repayment capacity model. Maintain and develop comprehensive and effective systems for managing credit exposure. Monitor and manage Portfolio concentrations to avoid over exposure Ensure a team of experienced, well trained and professional lenders are in place Immediately cease to deal with fraudulent parties and implement corrective actions to guard against similar occurrences Credit Grading the customers – Credit Grading is an automated system that measures risk based on payment performance and automatically downgrades on default. An automated collections system to follow up on arrears. The use of General loan loss provisions The use of specific loan loss provisions Pricing lending at margins which provides a satisfactory return on equity (ROE) and reflects the level of credit risk and related management costs involved Managing the ‘credit’ elements of new products to ensure balanced risk v reward Regular reviews with Group Credit (if Mortgage Centre is stand alone) Full compliance with all relevant Legislation and Internal codes of Conduct
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WHAT INVESTORS AND RATING AGENCIES MAY REQUIRE
A financial organisation must have a documented credit policy to establish the risk parameters under which it operates. It gives clear
What Investors guidance and direction to staff and demonstrates to potential Investors and Rating and Rating Agencies the type and style of risk management in place. Agencies may require. It is evident to all external parties that prudent, structured risk management practices are in place
Refer to Chapter 7 in Part 2 for further information on Arrears Management and Repossession.
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8 IMPACT OF BASEL II
1. Introduction
2. Modelling Credit Risk in Mortgages
3. Documentation of grading system design
4. Integrity of grading process
5. Overrides
6. Data Maintenance
7. Risk Management Process and Controls
8. Validation and Documentation
9. Corporate Governance
10. Credit Risk Control
11. Internal Audit
12. Loan Loss Provisions
13. Use of Mortgage Property as Collateral
14. Accounting Standards
15. Requirements of Rating Agencies and Investors
1. OVERRIDES
2. DATA MAINTENANCE
3. RISK MANAGEMENT PROCESS AND CONTROLS
4. VALIDATION AND DOCUMENTATION
5. CORPORATE GOVERNANCE
10 CREDIT RISK CONTROL
11 INTERNAL AUDIT
12 LOAN LOSS PROVISIONS
13 USE OF MORTGAGE PROPERTY AS COLLATERAL
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1. Introduction
Basel II or its EU equivalent, known as the Capital Requirements Directive (CRD), has been developed as a framework that will further strengthen the soundness and stability of the international banking system while maintaining sufficient consistency that capital adequacy regulation will not be a significant source of competitive inequality among internationally active banks. The CRD will promote the adoption of stronger risk management practices by the banking industry. The CRD does not fundamentally change minimum standards in relation to the mortgage business, which are set out throughout this manual. The CRD does however strengthen governance arrangements and, where Credit Institutions are authorised to use internal risk models to manage their mortgage portfolios, it outlines minimum standards regarding the use and operation of these models. As and when countries adopt CRD standards, subject to individual sovereign state discretions, Credit Institutions are strongly encouraged to adopt these CRD standards also.
Depending on the level of risk management sophistication in a Credit Institution, the CRD offers two approaches regarding residential mortgages - a standardised approach and an internal ratings-based (IRB) approach.
• Under the standardised approach lending fully secured by mortgages on residential property that is or will be occupied by the borrower, or that is rented, will be risk weighted at 35%1 if the supervisory authorities are satisfied according that this concessionary weight (50% under Basel I) is applied restrictively for residential purposes and in accordance with strict prudential criteria, such as the existence of substantial margin of additional security over the amount of the loan based on strict valuation rules. Supervisors should increase the standard risk weight where they judge the criteria are not met. • Under the IRB approach Credit Institutions are required to meet certain minimum qualitative and quantitative standards, and provided these are met, Credit Institutions will be able to use internal data to calculate the capital required to underpin their mortgage business.
Thus the CRD strongly supports the residential mortgage business provided strict criteria are met.
This chapter of the manual contains thirteen sub-sections (excluding this introduction). IRB credit institutions are expected to apply the standards outlined in all thirteen subsections while standardised credit institutions are expected to adhere to the last six subsections only and to progressively adopt the remaining standards if and when they move to the IRB approach.
2. Modelling Credit Risk in Mortgages
• Over the last decade, a number of Credit Institutions have invested resources in modeling the credit risk arising from their mortgage business. Such models are intended to assist Credit Institutions in quantifying, aggregating and managing credit risk. The models are not intended to supplement, but rather complement human judgment and oversight which is necessary to ensure that all relevant and material information, including that which is outside the scope of the model, is also taken into consideration, and that the model is used appropriately. • If models are used for the mortgage business they must be capable of producing robust and verifiable risk components2 that are used as inputs to a formula, which calculates the required capital under the IRB, approach. Models must have good predictive power with no known material biases. The underlying data must be representative of the population of the Credit Institution’s actual borrowers or facilities. Credit Institutions must have written guidance
1 When such loans are past due for more than 90 days they will be risk weighted at 100%, net of specific provisions. If such loans are past due but specific provisions are no less than 20% of their outstanding amount, the risk weight applicable to the remainder of the loan can be reduced to 50% at national discretion. 2 Risk components are defined in the CRD and are (a) Probability of Default – PD (b) Loss Given Default – LGD, (c) Exposure at Default – EAD and (d) Maturity - M
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describing how human judgement and model results are to be combined. Credit Institutions must have a regular cycle of model validation. • Once the risk components are calculated the supervisory formula3 is used to calculate the risk weights.
3. Documentation of Grading System Design
Credit Institutions must document in writing their grading systems’ design and operational details - documentation must cover:- • Grading criteria and rationale for its choice of internal grading criteria • Responsibilities of parties that rate borrowers and facilities, • Definition of what constitutes a grading exception, • Parties that have authority to approve exceptions, • Frequency of grading reviews, • Management oversight of the grading process. • History of major changes in the risk grading process. • The organisation of grading assignment, including the internal control structure.
If the Credit Institution employs statistical models in the grading process, the Credit Institution must document their methodologies. This material must: • Provide a detailed outline of the theory, assumptions and/or mathematical and empirical basis of the assignment of estimates to grades, individual borrowers, exposures, or pools4, and the data source(s) used to estimate the model; • Establish a rigorous statistical process (including out-of-time and out-of-sample performance tests) for validating the model; and • Indicate any circumstances under which the model does not work effectively.
Use of a model obtained from a third-party vendor that claims proprietary technology is not a justification for exemption from documentation or any other of the requirements for internal grading systems. The burden is on the model’s vendor and the Credit Institution to satisfy supervisors.
4. Integrity of Grading Process
A Credit Institution must review the loss characteristics and delinquency status of each identified mortgage pool on at least an annual basis. It must also review the status of individual borrowers within each mortgage pool. This requirement may be satisfied by review of a representative sample of exposures in the pool.
5. Overrides
• For grading assignments based on expert judgment, Credit Institutions must clearly articulate the situations in which Credit Institution’s officers may override the outputs of the grading process, including how and to what extent such overrides can be used and by whom. • For model-based gradings, the Credit Institution must have guidelines and processes for monitoring cases where human judgment has overridden the model’s grading, variables were excluded or inputs were altered.
These guidelines must include identifying personnel that are responsible for approving these overrides. Credit Institutions must identify overrides and separately track their performance
3 Correlation (R) = 0.15; Capital requirement (K) = LGD × N[(1 – R)^-0.5 × G(PD) + (R / (1 – R))^0.5 × G(0.999)] – PD x LGD ;Risk-weighted assets = K x 12.5 x EAD
4 In this context pools can be taken to mean the retail mortgage book
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6. Data maintenance
A Credit Institution must collect and store data on:- • Key borrower and facility characteristics to provide effective support to its internal credit risk measurement. Data should be sufficiently detailed to allow retrospective reallocation of borrowers and facilities to grades. • Borrower and transaction risk characteristics used either directly or through use of a model, as well as data on delinquency. • Estimated PDs, LGDs and EADs, associated with pools of exposures. • For defaulted exposures, Credit Institutions must retain the data on the pools to which the exposure was assigned over the year prior to default and the realised outcomes on LGD and EAD.
7. Risk management process and controls
With regard to the development and use of internal models credit institutions should establish policies, procedures, and controls to ensure the integrity of the model and modelling process. These policies, procedures, and controls should include the following: • Full integration of the internal model into the overall management information systems of the credit institution. • Established management systems, procedures, and control functions for ensuring the periodic and independent review of all elements of the internal modelling process, including approval of model revisions, vetting of model inputs, and review of model results, such as direct verification of risk computations. These reviews should assess the accuracy, completeness, and appropriateness of model inputs and results and focus on both finding and limiting potential errors associated with known weaknesses and identifying unknown model weaknesses. • Such reviews may be conducted by an internal independent unit, or by an independent external third party.
8. Validation and Documentation
• Credit institutions should have a robust system in place to validate the accuracy and consistency of their internal models and modelling processes. All material elements of the internal models and the modelling process and validation should be documented. • Credit institutions should use the internal validation process to assess the performance of its internal models and processes in a consistent and meaningful way. • The methods and data used for quantitative validation should be consistent through time. Changes in estimation and validation methods and data (both data sources and periods covered) should be documented. • The internal model and the modelling process should be documented, including the responsibilities of parties involved in the modelling, and the model approval and model review processes. • Credit institutions must have well-articulated internal standards for situations where deviations in realised PDs, LGDs and EADs from expectations become significant enough to call the validity of the estimates into question. These standards must take account of business cycles and similar systematic variability in default experiences. Where realised values continue to be higher than expected values, Credit Institutions must revise estimates upward to reflect their default and loss experience. • An independent review of the risk measurement system should be carried out regularly in the Credit Institution’s own internal auditing process. A review of the overall risk management process should take place at regular intervals (ideally not less than once a year) and should specifically address, at a minimum: (a) The validation of any significant change in the risk measurement process;
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(b) The verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources; (c) A credit institution must have a regular cycle of model validation that includes monitoring of model performance and stability; review of model relationships; and testing of model outputs against outcomes.
Note: The above standards apply to IRB credit institutions only. Some Credit institutions will have credit grading systems which have not yet reached the IRB standards, yet they are used in the credit institution in conjunction with their standardised approach. Where this is the case, the remaining subsections of this chapter should be adopted as best practice. Standardised credit institutions can ignore any references to risk components (PD, LGD, EAD and M)
9. Corporate Governance
• All material aspects of the grading and estimation processes should be approved by the credit institution’s Board of Directors or a designated committee thereof and senior management should possess a general understanding of the credit institution’s grading systems and detailed comprehension of its associated management reports. • Senior management should provide notice to the Board or a designated committee thereof of material changes or exceptions from established policies that will materially impact the operations of the credit institution’s grading systems. • Senior management should have a good understanding of the grading systems designs and operations. Senior management should ensure, on an ongoing basis that the grading systems are operating properly. Senior management should be regularly informed by the credit risk control units about the performance of the grading process, needing improvement, and the status of efforts to improve previously identified deficiencies. • Internal gradings-based analysis of the credit institution's credit risk profile should be an essential part of the management reporting to these parties. • Reporting should include at least risk profile by grade, migration across grades, estimation of the relevant parameters per grade, and comparison of realised default rates and own estimates of LGDs and conversion factors against expectations and stress-test results. Until 31 December 2010 the exposure weighted average LGD for all retail exposures secured by residential properties and not benefiting from guarantees from central governments should not be lower than 10%. • Reporting frequencies should depend on the significance and type of information and the level of the recipient.
10. Credit risk control
The credit risk control unit should be independent from the personal and management functions responsible for originating or renewing exposures and that reports directly to senior management. The unit should be responsible for the design or selection, implementation, oversight and performance of the grading systems. It should regularly produce and analyse reports on the output of the grading systems. The areas of responsibility for the credit risk control unit(s) should include: • Testing and monitoring grades and pools; • Production and analysis of summary reports from the credit institution’s grading systems; • Implementing procedures to verify that grade and pool definitions are consistently applied across departments and geographic areas; • Reviewing and documenting any changes to the grading process, including the reason for the changes; • Reviewing the grading criteria to evaluate if they remain predictive of risk. Changes to the grading process, criteria or individual grading parameters should be documented and retained; • Active participation in the design or selection, implementation and validation of models used in the grading process; • Oversight and supervision of models used in the grading process; • Ongoing review and alterations to models used in the grading process
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11. Internal Audit
Internal audit or another comparable independent auditing unit should review at least annually the credit institution’s grading systems and its operations, including the operations of the credit function and the estimation of the risk components.
12. Loan Loss Provisions
Under the standardised approach to credit risk, general provisions, can be included in Tier 2 capital subject to the limit of 1.25% of risk-weighted assets.
Under the IRB approach, the treatment of the 1988 Accord to include general provisions (or general loan-loss reserves) in Tier 2 capital is withdrawn.
Credit Institutions using the IRB approach for mortgages must compare • the amount of total eligible provisions (5 below) with • the total expected losses amount as calculated within the IRB approach
Where the total expected loss amount exceeds total eligible provisions, Credit Institutions must deduct the difference. Deduction must be on the basis of 50% from Tier 1 and 50% from Tier 2. Where the total expected loss amount is less than total eligible provisions, Credit Institutions may recognise the difference in Tier 2 capital up to a maximum of 0.6% of credit risk-weighted assets. At national discretion, a limit lower than 0.6% may be applied.
General provisions or general loan-loss reserves are created against the possibility of losses not yet identified. Where they do not reflect a known deterioration in the valuation of particular assets, these reserves qualify for inclusion in Tier 2 capital. Where, however, provisions or reserves have been created against identified losses or in respect of an identified deterioration in the value of any asset or group of subsets of assets, they are not freely available to meet unidentified losses which may subsequently arise elsewhere in the portfolio and do not possess an essential characteristic of capital. Such provisions or reserves should therefore not be included in the capital base.
13. Use of Mortgage Property as Collateral
Residential real estate property which is or will be occupied or let by the owner may be recognised as eligible collateral where the following conditions are met:- • The value of the property does not materially depend upon the credit quality of the borrower. • The risk of the borrower does not materially depend upon the performance of the underlying property, but rather on the underlying capacity of the borrower to repay the debt from other sources. • The value of the property should be monitored on a frequent basis and at a minimum once every three years for residential real estate. More frequent monitoring should be carried out where the market is subject to significant changes in conditions. • The property valuation should be reviewed by an independent valuer when information indicates that the value of the property may have declined materially relative to general market prices. • For loans exceeding EUR 3 million or 5% of the own funds of the credit institution, the property valuation should be reviewed by an independent valuer at least every three years. Independent valuer’ should mean a person who possesses the necessary qualifications, ability and experience to execute a valuation and who is independent from the credit decision process.
5 Total eligible provisions are defined as the sum of all provisions (e.g. specific provisions, partial write-offs, portfolio-specific general provisions such as country risk provisions or general provisions) that are attributed to exposures treated under the IRB approach. In addition, total eligible provisions may include any discounts on defaulted assets.
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The competent authorities of a Sovereign State may authorise credit institutions to apply a 50% risk weighting to the part of the exposure fully collateralised by residential real estate property or commercial real estate property situated within the territory of the Sovereign State if they have evidence that the relevant markets are well-developed and long-established with relevant loss-rates that do not exceed the following limits: • Relevant losses up to 50 % of the market value (or where applicable and if lower, 60 % of the mortgage-lending-value) do not exceed 0.3 % of the outstanding loans collateralised by that form of real estate property in any given year. • Overall relevant losses do not exceed 0.5 % of the outstanding loans collateralised by that form of real estate property in any given year.
14. Accounting Standards
• The Basel Committee recognises the need for a Pillar 3 disclosure framework that does not conflict with requirements under accounting standards, which are broader in scope. • Management should use its discretion in determining the appropriate medium and location of the disclosure. In situations where the disclosures are made under accounting requirements or are made to satisfy listing requirements promulgated by securities regulators, Credit Institutions may rely on them to fulfill the applicable Pillar 3 expectations. In these situations, Credit Institutions should explain material differences between the accounting or other disclosure and the supervisory basis of disclosure. This explanation does not have to take the form of a line-by-line reconciliation. • For those disclosures that are not mandatory under accounting or other requirements, management may choose to provide the Pillar 3 information through other means (such as on a publicly accessible internet website or in public regulatory reports filed with Credit Institution supervisors), consistent with requirements of national supervisory authorities. • However, institutions are encouraged to provide all related information in one location to the degree feasible. In addition, if information is not provided with the accounting disclosure, institutions should indicate where the additional information can be found. • The recognition of accounting or other mandated disclosure in this manner is also expected to help clarify the requirements for validation of disclosures. For example, information in the annual financial statements would generally be audited and additional material published with such statements must be consistent with the audited statements. In addition, supplementary material (such as Management’s Discussion and Analysis) that is published to satisfy other disclosure regimes (e.g. listing requirements promulgated by securities regulators) is generally subject to sufficient scrutiny (e.g. internal control assessments, etc.) to satisfy the validation issue. If material is not published under a validation regime, for instance in a stand alone report or as a section on a website, then management should ensure that appropriate verification of the information takes place, in accordance with the general disclosure principle set out below. Accordingly, Pillar 3 disclosures will not be required to be audited by an external auditor, unless otherwise required by accounting standards setters, securities regulators or other authorities.
15. Requirements of Rating Agencies and Investors
• Declaration of which approach the credit institution has adopted i.e standardised or IRB. • For standardised Credit Institutions the rating agencies will expect credit institutions to be in a position to demonstrate that they meet the best practice relating to Corporate Governance, Credit risk control, Internal Audit, Loan Loss Provisions, Use of Mortgage Property as Collateral and Accounting Standards. • For IRB Credit Institutions Rating agencies (and regulators) will expect compliance with all standards outlined in this chapter.
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9 LENDING CRITERIA
OVERVIEW OF EBRD MINIMUM STANDARDS
AND SUGGESTED BEST PRACTICES
MS/09: The Lender must adopt the following criteria for mortgage loans:
Purpose: Purchase, remortgage, build or improve Principal Minimum Standards Private Dwelling (including the relevant land) or “Buy-to-Let” houses or apartments. Product Type: Repayment/Annuity Mortgage Property location: Within the State To Whom: Citizens and expatriates resident in the state. Citizens and non-nationals/resident outside the state purchasing within the state. Loan Term: Min 5 years/Max 25 years (subject to funding). Age: Min – age of legal contract Max – in principle 70 years, unless demonstrable evidence of sufficient pension and/or other incomes to support mortgage payment to the end of the mortgage. Amount: Minimum /Maximum Amount Stated Affordability Test: Use of Net Disposable Income (NDI), Debt Service Ratio (DSR) model or Payment to Income (PTI). [This model should stress test the customer’s ability to repay by adjusting the interest rate upwards by 3%. The model should have a floor limit of funds available for living expenses.] Loan to Value: Dependent on Policy – max 80% LTV unless supported by a Mortgage Indemnity Guarantee. Local Regulations by the Central Bank to be also considered. PTI: Use 50% (for mortgages with higher incomes the commercial banks can use higher rates within the limits of their procedures and prudential requirements of the Central Banks) Property Valuation Carried out by independent professional with adequate Professional Indemnity Insurance. The purchase price may not always agree with the valuer’s estimation of current value. Lenders should always lend on the lesser of these two figures. Tenure of Property: Freehold or Leasehold with min 75 years unexpired term or legal maximum, if lower (see MS/05) Security Required: First legal charge over the property. Assigned life assurance for the amount and Term of the Mortgage: Buildings insurance in the joint names of the lender and customer to cover the reinstatement cost of the property. This policy to be index linked . Verification: Supporting documents as listed in the Chapter 2. July 2007 Part 1 36 The Minimum Standards and Best Practices Mortgage Loan Minimum Standards Manual
BP/09
Best Practices i. Lenders should also consider introducing Geographic and Employer spread parameters to avoid concentration of the risks. Meaning setting limits on the percentage of the portfolio that can be in a particular location or employees of a particular employer. Level of geographic diversification will depend on city size and population. ii. Max 80% LTV unless supported by a Mortgage Indemnity Guarantee. iii. PTI: Prudential regulations should be applied
REASONS FOR BEST PRACTICES/MINIMUM STANDARDS
Underwriting Criteria is the practical application of the Credit Policy and a key Reasons for aspect is to establish the applicants ‘Ability to Repay’. Minimum Standards
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10 SECURITY REQUIREMENTS
OVERVIEW OF EBRD MINIMUM STANDARDS AND SUGGESTED BEST PRACTICES
MS/10 i. First Legal Charge registered over the property for the amount of the mortgage plus interest. This charge is to be assignable to a Minimum third party based only on the consent obtained at the signing of Standards the offer letter/mortgage loan agreement
ii. Life Assurance*: A Life Assurance policy on the life/lives of the borrower(s) to cover the outstanding principal for the term of the loan as and when available in the local market The insurance policy is to be assigned to the lender and its value will decrease in line with outstanding balance of the loan.
iii. Buildings Insurance*: An index linked property policy to cover the replacement/reinstatement value of the property. The initial cover to be in line with the replacement/reinstatement cost in the Valuer’s Report. This cover to be adjusted in line with a suitable index of construction costs. The policy is to be in the joint names of the customer and the lender
* as outlined in MS/06
BP/10 i. Mortgage Indemnity Guarantee (MIG)*: This would become a minimum standard if the lender decides to lend outside of
Best Practices published LTV policy.
ii. Lender should rely on the ability of the borrower to repay and the security provided by the property and only in exceptional circumstances require further support such as liens or guarantees.
* as outlined in BP/06
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REASONS FOR BEST PRACTICES/MINIMUM
STANDARDS
Prudent banking practice. Remember the loan would not be approved at the outset unless the lender is satisfied that the customer has the ‘ability to repay’.
Reasons for Security is a fall - back position. Minimum Standards
POINTS TO NOTE
As stated previously the main activity in deciding if the loan is to be approved is measuring the customer’s ‘ability to repay’. If the customer cannot meet the repayments or indeed there is reasonable doubt in the mind of the credit assessor(s) then the application should be declined.
Irrespective of how strong the security is the Bank should never lend on the basis that the security can be realised to repay the debt. It causes misery for the customer and substantial and costly administration for the lender.
That said, the Bank always take security for a mortgage – for two reasons: 1. It is the Banks fallback if anything goes wrong 2. The customer knows that if payments are not made the property will be repossessed.
The taking of security is a critical task in the mortgage process. Lenders must ensure that quality security is taken and there are no loopholes that might be challenged at a later stage. Remember that the Bank only realises/calls in security when ‘things go wrong’ and by then it is most likely that the relationship with the customer has broken down.
WHAT INVESTORS OR RATING AGENCIES MAY REQUIRE
In the event of a Mortgage Bond or Securitisation issue, a full review will be
What Investors or undertaken of the security and documentation supporting the proposed pool of Rating Agencies mortgages. may require.
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11 MANAGEMENT INFORMATION, IT & ACCOUNT MANAGEMENT
OVERVIEW OF EBRD MINIMUM STANDARDS AND SUGGESTED BEST PRACTICES
MS/11
i. Mortgage Accounting System: Comprehensive mortgage accounting Minimum system which would include the following functions within guidelines Standards of Credit Policy: • Ability to “tag” mortgages as belonging to a particular cover pool or as having been transferred to a particular SPV. • Facility to use internal own bank Standing Orders/Direct Debits, if available. • Facility to amend payments/notify customers when rates change. • Facility to switch from variable to fixed rate and vice a versa. • Facility to accept lump sum reductions/repay early. • Facility to remove/add names to accounts. • Management of account on death of a borrower. • Facility to monitor/follow up arrears. • Facility to carry out regular/annual reviews. • Facility to provide statements to the customer. • Systems must also have an adequate disaster recovery plan.
ii Reporting: Good reporting information which is accurate, timely and relevant. Monthly/Quarterly/Annual reports to be available by Branch/Area/Total Bank for: • Mortgage Book size/split by products (total value, total volume, average term, average interest rate, average LTV, average PTI) • Share of National Mortgages (where available) • Market Segments (see chapter 4 in Part Two) • Portfolio share by sales channel (See chapter 3 in Part Two) • Growth Profile • Performance v Targets • Applications v Approvals v Declines v Drawdowns • Application Pipeline • Arrears Profile (Split into 30, 60, 90 and 120 days) • Maturity Profile • Geographic Profile/Employer Profile • Profitability • Historic Data Retention • Ability to produce reports as required by rating agencies and investors* (see Appendix 6)
iii Monitoring Mortgage Account: The following should be adhered to in order to ensure efficient monitoring of accounts: • Approvals are converted into drawdowns. • Security is in order before drawdown. • Repayments are up- to- date. • Premiums on Life Assurance policies are up to date • Premiums on Buildings Insurance policies are up to date. • Buildings Insurance Policies are index linked • Insurers report incidents of cancelled Life/Buildings Insurance policies.
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REASONS FOR BEST PRACTICES/MINIMUM STANDARDS
Reporting and Monitoring:
Reasons for The business cannot be successful unless there is regular analysis of Minimum current state vs target. Standards Remedial action may be required and, if we don’t know where we are now, it will be very difficult to get to where we want to be.
Rating Agencies and Investors will require detailed reports on the lenders mortgage portfolio in order to rate/buy mortgage bonds or mortgage backed securities. (see section below on what rating agencies think)
POINTS TO NOTE
1. Mortgage Account Management: The requirements for Mortgage Account Management are fundamentally similar to all other lending products. The objective is to manage and monitor the operation of the account and the relationship from drawdown to redemption.
The accounting system will have a capability to –accept debits/credits/permissions/judge accounts to be in arrears/issue arrears letters/calculate interest/ calculate penalty interest/provide a review facility/issue review letters etc
Repayments can be by cash, standing order or direct debit. Repayments to be made by the monthly/weekly/fortnightly due date. This date to be agreed with the customer ideally to fit with salary/wages payments. For efficiency standing orders and direct debits should be encouraged ideally with inter bank arrangements in place.
Changes in interest rates to be accommodated with the facility to switch between variable and fixed rates, to amend repayments and to notify customers.
Lump sum repayments/early repayments to be accepted. Depending on policy/legislation the facility to calculate and charge penalty/early payment charges to be in place. Penalty charges would be the norm for breaking a fixed rate contract but legislation in many of the developed markets disallows this for variable rates.
The system and procedures will be able to add/remove names, rule off account at death/bankruptcy and provide regular statements of account to customers. The accounting system will also have the capability to identify or “tag” accounts, which are in a particular mortgage pool or have been transferred to a specific SPV.
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2. IT Requirements: Both Securitisation and Mortgage Bonds place obligations on an entity for the provision of performance metrics and analysis for both underlying structures in the form of regular reporting. These can be onerous if IT systems have not been developed to take account of these requirements and can be difficult and expensive to amend later on.
Segregation of mortgage assets between those either securitised, in a mortgage bond structure, used as collateral for Central Bank liquidity or not in any of these structures means at a very minimum being able to identify which assets are in which structure.
Securitisation requires the cash flows of the underlying assets to be moved to a specific account and this has a material affect on the underlying accounting arrangements and is problematic if not understood and built into systems.
The ability to generate meaningful historic analysis may mean tracking the history of different mortgages over -time and for example being able to explain redemption patterns; arrears; write offs and the like. In addition, integrated customer records are now more of a requirement than before. Some jurisdictions allow for an implied set off of deposit accounts against borrowings and these matters may require analysis.
Backup and business continuity planning are high on the agenda for rating agencies. In addition how technology is employed in an organisation can be the difference between effective and efficient processing.
One view of a modern bank is that information processing is now a required competency. It is clear that modern IT investment facilitates the gathering of large volumes of data that can allow it to be analysed in a structured manner. The more integrated the IT systems are the lower costs an organisation can have in its dealings with customers to make them effective and profitable.
It is difficult to see how an entity could prevent credit losses without an effective IT system. Credit losses would still be the largest risk of a bank.
When assets are being placed in bond structures, investors will have demands on the information that they require when they decide to buy bonds. It is hard to imagine that they would settle for poorer standards.
Rating agencies would be aware of trends in IT, and whilst these might not always be appropriate in every circumstance, rating agencies would be well aware of the importance of IT in any structure.
3. Reporting and Monitoring Good, accurate, timely and relevant information is a critical enabler to success in any business. Mortgages are no different – it lets you know what is going well and not so well.
Reports will be available at summary level for the Board, CEO and Senior Management Team with the facility to ‘drill down’ into more detailed levels. The reporting schedule (depending on the specific need) will be issued Monthly, Quarterly, Half Yearly and Annually. Depending on organisation structure the reports will be available by Branch, region, Area and Total Bank.
It is important that historic information is retained at all levels including individual account performance, as Rating Agencies will wish to examine ‘track record’.
Business Performance Reports will cover: Share of New Business - volume/% Share of National Mortgage Book – volume /% Growth v National Mortgage Book - % Split by Market Segments – volumes % Split by Sales Channels – volumes %
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Performance v Budget + forecasts % and Volume of Drawdowns v Applications and Approvals Number + % declines v applications Leakage to Competitors Pipeline Analysis Profitability – total/by product/by segment. Maturity/Employer and Geographic Profiles
Monitoring Reports will cover: Performance/Review of individual accounts (discussed earlier) Arrears/Bad Debt reports and Profile Premiums on Life/Buildings policies – up to date Buildings policies indexed Incidents of cancelled policies reported by insurers.
Rating Agency and reporting requirements would include the following information: Payment under Notes Transaction Balances Details of Arrears Pool Indicators % LTV Rations Mortgage Principal Analysis Mortgage Size Geographic Split Arrears Multiple Seasoning Interest Rates (Please see Appendix 6 for a sample report)
4. Accounting Methods
There is a basic principle that a fair presentation is achieved if financial statements are prepared in compliance with International Accounting Standards (IAS). An entity whose financial statements comply with IASs should disclose that fact. However, where management concludes that compliance with the requirements of a standard would be misleading and, therefore, departure from the requirement is necessary to achieve a fair presentation, then the entity is required to depart from the specific provisions of the standard. This manual has not considered the detailed implications of either adopting IAS or the likely changes that are currently being debated particularly surrounding derivatives and financial instruments.
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WHAT INVESTORS AND RATING AGENCIES MAY REQUIRE
In terms of IT systems for Mortgage Account Management, we look at what Fitch IBCA specifically review when they assess mortgage
originators and servicers it would include: • What Investors and Core systems functionality. • Rating Agencies may Systems integration and interfaces. • require System security/backup/retention. • Disaster recovery and business resumption plans/testing; • Data integrity. • Use of automated underwriting systems. • Web-based applications. • Credit scoring. • Risk management modelling. • Automated valuation models. • Integration of these systems as well as other business lines.
Some examples of IT information Requirements:
• Accurate geographic location. • Customer history on mortgage, and for example, additional equity withdrawal. • Accurate recording of the customers financial position. • Details on property usage such as owner occupied; rented out. • Type of mortgage product. • Loan to value ratio. • Original valuation and most up- to- date valuation.
Refer to Chapters 7, 8 and 9 in Part 2 for more information. Refer to Appendix 6 for Rating Agency/ Investor Sample Report.
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Part 2 Overview of Primary & Secondary Markets
Mortgage Loan Minimum Standards Manual
1 GENERAL OVERVIEW
Mortgage Lending not only enables the banks to expand their capital but also benefits their economic development by making housing more affordable to all income levels and thus reducing poverty
Furthermore, by creating funds for the purchase of homes a housing market is created impacting on many industries (construction, insurance etc), which will in turn help boost a country’s GDP. The housing market is of huge importance in today’s economy and some economists even believe that is the “one single factor that has saved the world from a deep recession”1 as homes generally make up the biggest component of people’s wealth.
Throughout Europe the mortgage business continues to expand each year at a rate of 8% per annum2 and the mortgage market now accounts for 40% of GDP3. Home ownership rates are at a record high in some counties with Ireland top of the table with a rate of 82%4 (please see Appendix 7 for a cross section of a selection of mortgage markets in Europe) Although a lot of funding still comes from banking institution’s deposit base it has to be said that the secondary mortgage market is of crucial relevance to the flourishing mortgage market throughout Europe.
Mortgages in fully developed markets are the most high profile products available from financial institutions. There is regular media comment about the price of mortgages and what impact interest rate changes have on the customer’s monthly repayments and living standards. Indeed it could be argued that customers are more in tune with the cost and features of mortgages than any other financial product. So as a result mortgages are very competitive and financial institutions invest heavily in marketing their products.
______
1 “Going Through The Roof”: pg 65 The Economist” March 30th 2002. 2 European Mortgage Federation, 2003 3 European Mortgage Federation, 2003 4European Mortgage Federation, 2003 5Urban Institute: “Assessment of Mortgage Markets in Croatia” 6Urban Institute: “Assessment of Mortgage Markets in Romania” 7Urban Institute: “Assessment of Mortgage Markets in Bulgaria”
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The benefits for the customer of borrowing mortgage funds are:
Their initial capital investment is quite low but nevertheless they will eventually own the property provided they make repayments when due.
Most properties increase in value over a long period of time so the home is an investment.
The main benefits of issuing mortgages for financial institutions are:
Depending on the term of the mortgage the return on investment can be up to 100%
Compared to other types of lending – mortgages are seen as safer. Experience shows that customers will pay the mortgage before other loans to keep the roof over their heads.
Builds long-term relationship and emotional attachment. Customers tend to take other products from their mortgage provider. It also opens up opportunities to build relationships with the next generation.
Having outlined the Mortgage Loan Minimum Standards in Part One which should eventually enable lenders to participate in Secondary Mortgage Market activity, this section will explain in further detail securitisation while also elaborating further on certain aspects of the primary mortgage market such as Mortgage Market Sales Channels, Mortgage Market Segments and Mortgage Products. It will also provide additional information for the lender on topics such as lending for self-build projects, arrears management, IT requirements and interest rates.
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2 UNDERSTANDING SECURITISATION
2.1 Introduction
This chapter is included to provide information and background on the secondary markets for those who may not be familiar with those markets.
2.2 Residential Mortgage Backed Securities (RMBS)
Securitisation is a process whereby assets with a series of cash flows can be sold either by a true sale or a synthetic structure by the owner of the assets to a special purpose vehicle whereby a bond can be issued backed specifically by those assets. The bonds are often rated by rating agencies and are priced relative to their risk. In effect they differ from corporate bonds as they are backed by specific assets that are bankruptcy remote from the originator. Once the bond interest and the capital get repaid, the excess economic benefits get transferred back to the original owner or ‘originator’ by way of profit extraction techniques. For the purposes of this manual we are interested in only one asset class, namely residential mortgages. What is meant by residential mortgages is any lending to somebody where the security is their principal private residence. It includes lending to acquire, develop, repair the residence or other lending secured on the residence.
In the case of residential mortgages the asset is the borrowing outstanding. The borrower is contractually committed to a series of regular payments which include capital and interest. The borrowing is secured on the residence, and may be acquired by the lender if the borrower defaults. When these loans are ‘on balance sheet’ then the lender is carrying all the risks and (rewards) of ownership. Some of the risks would be credit risk, interest rate risk and the mismatch in funding long term lending with short term resources creating a possible liquidity risk.
Residential Backed Mortgage Securitisation is a funding tool where the bank sells the mortgage with the underlying security to a “special purpose vehicle” (SPV), which is not owned by the Bank. The mortgages are usually – but not always – sold at par. The SPV then only has mortgage assets. A bond is created, backed specifically by these mortgages called “residential mortgage backed securities” (RMBS) and is capable of being sold to investors. The sale of these mortgages allows the Bank to transfer a series of risks such as credit and interest rate risk to third party investors. These assets are attractive to investors because defaults on residential mortgages are very low. As such these assets are less risky than the general risk of the originator itself and therefore can command a much higher rating – often AAA – in most jurisdictions.
Often these bonds are rated by a combination of Moodys, Standard & Poors and Fitch IBCA and on the basis of the rating and subsequent demand by investors they are “priced” in the market. As there are many of these transactions they are now well understood by many specialist investors, but individual securitisations are priced depending on a number of factors. Let us assume that the price was 3M euribor + 50 basis points.
When the prospective investors buy the bonds the net proceeds are paid back to the bank that originated the mortgages. The cash flows of the mortgages are then paid into the SPV and these include interest and principal. Basically the bondholders are paid interest on the basis of Euribor +50 basis points including any capital paid back on the mortgages. Securitisation transactions are “off-balance sheet” which means that the origination bank has no further responsibility for the performance of the mortgage once it is sold into the SPV.
The bond amounts start to redeem in line with the capital payments on the underlying mortgages. The rates charged to customers might have been euribor + 120 basis points. The difference between the two is 70 basis points and this excess liquidity is returned from the SPV to the originator usually in terms of
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Overview of Primary & Secondary Markets Mortgage Loan Minimum Standards Manual extraction for servicing the mortgages and other extraction techniques. The bond holders are not entitled to any larger amounts except as described above.
Extensive legislation is not often needed to facilitate securitisation structures. The most important capabilities for an originator would be: the ability to create a ‘special purpose vehicle’ which is bankruptcy remote from the originator and is not a subsidiary; the ability to transfer assets usually in a tax neutral way to the originator;
In essence RMBS are generally regarded as bonds that can command a high rating. For example most RMBS in Europe have a significant amount of the deal rated “AAA” which from an investors standpoint is a top grade security. This type of rating is often many levels above the rating the originator itself could have. When there is lower risk, there is usually a lower return, which is why an organisation might securitise rather than issue its own corporate bond.
RMBS are the most common form of secondary market refinancing tool used in the US and in 2002 the volume of mortgage related securities was $2.27 trillion. (European Mortgage Federation; “Mortgage Banks and The Mortgage Bond in Europe”- 4th Edition) The market is dominated by 3 agencies; Federal National Mortgage Association (Fannie Mae), Federal Home Loan Association (Freddie Mac) and Government National Mortgage Association (Ginnie Mae). Each of the agencies was established by Federal Law to help combat shortfalls in the US housing Market although they do not have explicit federal guarantees.
Mortgage customers in the US would be used to being granted a long term fixed rate with an option to refinance without any – or a low – penalty during the life of the mortgage. In general, when interest rates fall, huge levels of refinancing takes place.
In addition, investors take the view that while there may not be ‘explicit’ guarantees behind the structure, these structures are now too big to fail.
The main benefits of RMBS as a tool in a banks armoury are:
Diversifying the sources of financing. RMBS is an effective method of financing mortgage growth as against a single traditional source such as core deposits. Reducing risk. RMBS transfers credit, interest and maturity risk from the originator to the investor. To help capital adequacy ratios. Certain financing tools such as securitisation can remove assets from a banks balance sheet and thus free up capital if it was inadequate.
Exhibit 1 below maps the processes involved in Mortgage Backed Securities.
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Exhibit 1: Mortgage Backed Securities Process 1
Mortgage Bank Borrowers Loans (“originator”) Special Investors Purpose Vehicle
Mortgage Sale of MBS
Pool Borrower's Obligation
Sale of Mortgage Loans 1 source: European Mortgage Federation: “Mortgage Banks & Mortgage Bond in Europe" Figure 3
2.3 Mortgage Bonds Mortgage Bonds are generally an ‘on balance sheet’ method of financing mortgages. The security for the bond holders is the collective pool of qualifying mortgage assets. For example if there were two bond issues, specific mortgages would not be identified with a specific bond issue. In effect the bond issues share the pool. To make them distinct from mere corporate bonds, specific legislation is needed in a jurisdiction permitting them to be issued. The reason for this is that the security for the bonds is part of the entities assets that will not be available to general creditors in a ‘bankruptcy’ or wind up situation. They are also called ‘covered bonds’ for that reason. They are more commonly called ‘Pfandbriefe’ and have a long track record without defaults. Often jurisdictions that want to introduce ‘mortgage bonds’ need to have similar structures to that applying in the German market if they want to attract these investors.
Often the legal structure might be a ‘mortgage bank’ which could be a subsidiary of the main bank. Typically the qualifying assets are broader than residential mortgages and can include commercial mortgages; they can include obligations by public institutions; and assets of other jurisdictions. In other words the legislation is an ‘enabling’ framework that needs to be wide rather than restrictive.
The legislative requirements can vary, but generally if the structures are perceived weaker than the German model, there could be difficulties in attracting those investors.
Mortgage bonds are the most important funding instruments for mortgage lenders in Europe after retail deposits. Currently, they fund 15% of the European capital market (European Mortgage Federation). In 2002, the total volume of Mortgage Bonds amounted to $1.5 trillion representing 17% of the entire Bond Market in Europe. (European Mortgage Federation; “Mortgage Banks and The Mortgage Bond in Europe”- 4th Edition)
Basically the mortgage bonds are issued on the strength of the mortgages issued by the originator. Therefore there is a collective pool of mortgages supporting the bonds. Mortgage Bonds are “on-
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Overview of Primary & Secondary Markets Mortgage Loan Minimum Standards Manual balance sheet” which means the originating bank continues to have responsibility for the performance of the mortgage even though it is now in the mortgage pool.
The bondholder receives interest usually on a fixed rate basis – though this is not always the case – and the bonds are redeemed on the basis of the bond agreement, which is not saying that they redeem in line with pool of mortgages. For example ‘bullet redemptions’ on these structures is not unusual. This contrasts with RMBS where the redemption of the bonds paralleled the repayment of the mortgages. Consequently there is a view that mortgage bonds once issued need to be seen as a repeat structure.
Again the protected structure means that the bonds can be priced lower than any corporate bond issued by the organisation.
On first examination, it would appear that Mortgage Bonds seem to price lower than RMBS. A significant reason for this is the level of over collateralisation that typically exists in a mortgage bond structure. For example the typical ‘loan to value’ is defined more precisely and usually involves a substantial reduction from ‘market value’. Also most of the mortgage bonds issues have been largely German Pfandbriefe and there is a considerable track record on issuance and understanding of this asset class.
The main benefits of Mortgage Bonds as a tool in a banks armoury are:
Diversifying the sources of financing. Mortgage Bonds is an effective method of financing mortgage growth as against a single traditional source such as core deposits; Closer matching of maturity profiles of the underlying assets with the liabilities financing them; To help capital adequacy ratios. Certain financing tools such as mortgage bonds can have attractive regulatory treatment.
Exhibit 2 below charts the process of Mortgage Bonds. See also Appendix 8 for a comparison between Secured Mortgage Bonds in Europe.
Exhibit 2 Mortgage Bonds Process 1
Supervisory Office, Trustee
Borrower Extends Loan Issues Issues Mortgage Investor Bond
Private Mortgage
Credit Institutional Commercial Institution Investor
Public & Semi- First-ranking Grants Funds Private Investor Public Sector Mortgage or Public Sector guarantee
1 Source: European Mortgage Federation: “Mortgage Banks & Mortgage Bond in Europe" Figure 1
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To further understand the two processes a comparative chart is shown in Table I in below.
Table I – Mortgage Bonds –v- Mortgage Back Securities 1
Criteria Mortgage Bonds Mortgage Backed Securities
Mortgage Loan Production Bundled Process Unbundled Process Type of Securitisation Assets remain on the balance Generally, assets are removed (Balance Sheet Treatment) sheet of the origination from the balance sheet of the institution originating institution (“off- (on-balance sheet balance sheet securitisation”) securitisation) Source of principal and interest payments Issuer Cashflow Collateral Cashflow Risk Exposure: - Credit Risk -Issuer -Investor - Prepayment Risk -Issuer -Investor - Market Risk -Investor -Investor Investor protection in the event Bankruptcy privilege: The bond Bankruptcy remoteness is built of issuer bankruptcy holder has a priority claim on into the structure of the MBS. assets in case the issuer goes (The bankruptcy of the bankrupt (quasi-bankruptcy originating institution does not remoteness). affect the servicing of the MBS) Credit Quality In addition to the asset quality, In addition to the asset quality, depends mainly on the strength depends mainly on the strength of the originating institution and of the structure created. the legal framework Over-collateralisation Defined by Law Usually required for a high credit rating Tiered Capital Structure Subordination is inherent in the A structure distinguishing system (e.g. requirement to between senior and respect certain LTV ratios) subordinated securities needs to be created. Guaranty A guaranty (if given) will be Guaranty provided by a third provided by the originating party such as insurance mortgage credit institution company or a bank (“credit enhancement”) Collateral Pool Structure 1. Individual Components of 1. Individual components of the asset pool are the asset pool are (in substitutable general) not substitutable. 2. Mainly heterogeneous 2. Mainly homogenous assets. assets 3. Eligible assets are not 3. Eligible assets defined by necessarily defined by law. law (e.g. requirement to respect certain LTV ratios and sound property valuation methods) Interest Payment Typically yearly Typically monthly
Principle Redemption Bullet form Amortisation and prepayment
1 Source: European Mortgage Federation: “Mortgage Banks & Mortgage Bond in Europe" Table 11
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2.4 Why do either?
Both these structures will require considerable time and effort in putting either or both in place. If the existing cost of funds is expensive and there is a desire to get a lower cost of funding then either of these structures might help.
If an entity cannot raise core deposits for some reason then potentially securitisation could allow you to approach the market regularly for funding. As all these deals are individually structured an organisation could establish important links with the European market over a period of time that would allow it to further diversify funding as your reputation develops, as sound originator.
It could facilitate the development of specialised mortgage lending without having to deal with the liability side of the balance sheet; it could enable a low cost centralised mortgage operation to emerge that could be essentially electronic and efficient.
2.5 The Building Blocks for Securitisation
The ESF (European Securitisation Forum) in a document entitled “A Framework for European Securitisation” identified 12 building blocks as a guideline for European best practices. While we will use the 12 headings, the commentary is based on experiences in developing the first securitisation for Bank of Ireland in Ireland in 2000. The building blocks are as outlined:
2.5.1 2.5.2 2.5.3 2.5.4 Origination of Sales, Transfer, Ownership of Data Protection Assets Isolation of Assets and and Banking Assets Servicing Secrecy
2.5.5 2.5.6 2.5.7 2.5.8 Securitisation Insolvency/ Methods of Taxation Vehicles Bankruptcy Enhancement Treatment Laws
2.5.9 2.5.10 2.5.1 1 2.5.1 2 Accounting Regulatory Listing, Rights of Treatment Treatment Disclosure and Investors Reporting
2.5.1 Origination of Assets
Residential Mortgage Backed Securitisations are highly regarded by investors. To achieve an ‘AAA’ rating means that any practice by an originator that is outside what a ‘prudent lender’ would do will either affect the price of the issue or the enhancement that needs to be put into the structure. On the other hand, a conservative lender will find that beyond a certain level of prudence, the market will not price the structure down further. Therefore if an originator was to use securitisation to a significant degree it raises the matter of higher pricing for individual loans where the risk characteristics tend to increase the enhancement required e.g. loan-to-value in excess of say 70%.
2.5.2 Sale, Transfer, Isolation of Assets Securitisation in effect meant the legal transfer or the assets (mortgages) together with the underlying cashflows to a vehicle that is bankruptcy remote from the originator. This usually requires a heavy involvement from IT/IS in the organisation. Due to the potential complexity of securitisation, particularly for a first issuer, early involvement by IT/IS is very important.
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2.5.3 Ownership of Assets and Servicing Whilst the ownership of the assets is with the SPV, the servicing of the assets often remains with the originator subject to certain safeguards for the investor. Depending on the particular deal – and they can all be slightly different – the need for continuing IT/IS involvement needs to be understood as there are time deadlines imposed on either a monthly or quarterly basis that need to be smooth and need to be thoroughly understood.
2.5.4 Data Protection and Banking Secrecy These matters usually involve ‘consents’ from borrowers and should be tackled in advance of starting a securitisation. The servicer, investors and rating agencies should be able to access information regarding the securitised assets, as the information is generic and non-sensitive.
2.5.5 Securitisation Vehicles The expense in initial transactions usually means that the creation of structures should be aimed towards facilitating an ongoing securitisation programme (in order to spread legal costs). Early attention to these matters in a legal context particularly is important.
2.5.6 Insolvency / Bankruptcy Laws These matters need to be clear in advance of a securitisation because if these are inadequate they will prevent a deal for being executed in the first place.
2.5.7 Methods of Enhancement As RMBS need to acquire a high rating, any weaknesses in the pool may require additional strengthening. This is often by way of either a subordinated loan to the structure by the Originator, a minimum level of ‘first loss’ by the originator or a combination of both. This is where the notion of a ‘benchmark’ pool or an ‘ideal’ pool is established and calculations are performed on a loan-by-loan basis by the rating agencies involving the ultimate risk of default. Unusual products or rights for borrowers can have a material affect on the ultimate pricing or credit enhancement level of a particular deal. Simple examples would be the right of the borrower to redraw certain amounts or interest only products. Securitisation in effect prices the additional risk for these loans.
2.5.8 Taxation Treatment The structure should be tax neutral for the originator. The excess income over and above the interest due to the investors means there needs to be profit extraction techniques to give the economic benefits back to the originator. Some methods may not be as tax effective potentially as others. In general the interest paid to bond holders is gross without deduction of withholding taxes.
2.5.9 Accounting Treatment Generally if the mortgage assets are sold at their balance outstanding, there is neither a profit nor loss on sale. The underlying accounting treatment in the SPV should therefore that when the excess income is extracted that the Originator pays tax on either this ‘servicing income’ or ‘interest income’ or whatever extraction methods are used.
2.5.10 Regulatory Treatment The capital treatment of the SPV should not be inconsistent with any general regulatory treatment and not regarded as a specific risk asset warranting harsher regulatory treatment if the mortgages were never sold.
2.5.11 Listing, Disclosure and Reporting The ongoing requirements of reporting and disclosure are usually time defined and need to be adhered to. If they are well understood at the outset, they should be efficiently executed by a well-designed IT/IS system.
2.5.12 Rights of Investors Ultimately the investors want their income and investment returned. Good regular reporting – as agreed – on the performance of the underlying pool is important.
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Securitisation is still a deal-by-deal transaction, and it will take a considerable effort by any financial institution to structure their first deal. Most importantly the costs associated with a first deal are considerable, and careful consideration of the matter of further issuing needs to be upper most in the strategy of the organisation.
Given that Securitisation of Mortgages in Europe started with the first deal being in the United Kingdom – there is now considerable investor understanding of the asset class. Any new originator will face a steep learning curve in order to meet investor expectations.
Please refer to: Appendix 5: Mortgage Bank and Mortgage Bond Laws in Europe Appendix 8: Comparison between Secured Mortgage Bonds in Europe
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3 MORTGAGE SALES CHANNELS
The principal sales channel for Mortgages is the Branch network.
A number of other channels can be considered – these are:
Specialist Mortgage stores Intermediaries Mortgages by Telephone Direct Sales Force Internet
1. Branches
The greatest sales opportunity is within the existing customer base.
The branch should have good information on the income, savings, assets, debt, spending habits and track record of the customer.
If the business potential is considered high then the appointment of Full TimeMortgage advisers/consultants in large branches and part –time advisers in smaller branches should be explored. Full time advisers would become experts in all aspects of house purchase, improvements, house finance and what’s happening in the economy and the housing market.
2. Specialist Mortgage Stores The development of specialist mortgage stores in areas of high population and high potential can be explored.
The concept behind a mortgage store is to provide a dedicated outlet, more in the ambience of a sitting room at home or a retail store than a bank branch. Most customers do not like going into a bank branch to borrow money. The idea is to take the stress out of the transaction for the customer. Coffee available for the parents and a play area for children!
Like their ‘full time’ colleagues in branches The Mortgage Store staff would be highly trained and provide continuous service to the customer until the mortgage is drawn down.
3. Others: Recruitment and appointment of 3rd party Intermediaries such as Estate Agents, Accountants, Specialist Brokers and Lawyers can be considered. In addition some financial institutions also appoint a Direct Sales Force who would call directly to customers’ homes. Many institutions now provide mortgage information and an application process on the Internet.
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4 MORTGAGE MARKET SEGMENTS
Is our approach and offering going to be identical for all customers? Does one suit fit all? The concept behind ‘market segmentation’ is to have a specific offering for individual segments of the market. It does not mean different products more the approach to individual segments is different. Customers are not all the same. Their needs are not all the same.
The market segments for mortgages are: First Time Buyer Trading up Buyer. Equity Release and Home Related Investor Switcher.
1 First Time Buyer Customer Characteristics Customer Needs • Buying a first home • friendlynot-intimidating environment. • Typically aged between 25-35 • A simple explanation of the mortgage • Tends to be in a relationship process • Currently renting • A quick answer to whether they qualify • Tends to finance a higher % of the for a mortgage and how much will it value of their new home. cost. • Tends to buy newly built homes. • A mortgage rate quoted in terms of • Tends to shop around. repayment. • Price Conscious • Clear and simple explanations of mortgage rates and APRs • A clear understanding of all costs including itemized details of each. • Flexibility when lifestyle changes occur.
2 Trading up buyer Customer Characteristics Customer Needs • Selling one home and buying another. • Fast approval • Typically aged between 35-50 • Need to match buying and selling at the • Tends to be married. same time • Tends to have one or more children • A good deal in terms of interest rates, • Tends to be a two salary household fees and service. • Timely and efficient processing of their mortgage • Flexible repayment options.
3 Equity Release Customer Characteristics Customer Needs • Topping up existing mortgage to • A quick response typically facilitate: • Minimum fuss in terms of procedures - Extensions and administration - Home improvements • A competitive interest rate. - Buying a second property • Advise regarding effects on their - Payment of wedding expenses. mortgage. - Payment of education, medical fees. • Typically aged between 35-50 • Tends to be married with children.
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4. Investor
Customer Characteristics Customer Needs • Purchasing a residential property for • Competitive interest rates and costs investment purposes for both rental and • Fast, efficient service price appreciation. • Financial advise on managing their • Typically aged between 40-55 investment portfolio. • Has a higher than average annual income • Flexible repayment options. • Average mortgage size is higher than that for first time buyers and those buyers trading up. • Tends to be price conscious
5 Switcher
Customer Characteristics Customer Needs • Moving an existing mortgage from one • Better service than their previous lender lender to another • Attractive rates in order to switch their • Typically aged between 30-45 mortgage. • Tends to be married • Flexibility to meet their specific needs • Tends to be price conscious • Flexible repayment options
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5 MORTGAGE PRODUCTS
While there are many variations and add-ons fundamentally there are just two basic mortgage products. These are:
1) Repayment/Annuity Mortgage 2) Endowment/Interest only Mortgage.
In this section we will also deal briefly with: 3) Variations and Add-Ons
Repayment mortgages are also known as Annuity or Redemption or Capital and Interest mortgages.
Here is how it works:
• Portion of capital and interest included in each repayment • Repayments generally monthly (but fortnightly/quarterly also) • Standing order/direct debit from operating account to mortgage • Total repaid in equal amounts over term of mortgage. • Repayments adjusted to reflect interest rate changes (if necessary) • Life assurance required to cover amount/term of mortgage • Buildings insurance for the reinstatement value of the property.
In some instances when rates reduce customers may opt to continue making the higher repayment and this will accelerate the repayment term and reduce the total interest. The opposite of this is if rates increase the customer may want to retain the existing repayment. This will obviously increase the term and would only be put in place after renegotiations with the lender.
As stated above there are standard repayments throughout the life of the mortgage (assuming no interest rate changes). The accounting model used works on the basis that in the early years repayments are mostly interest while in the later years repayments are mostly capital.
The following examples illustrate this. Tables 1 and 2 below show the repayment profile on €100k over 20 years @5% whereas Table 3 and 4 show the repayment profile at 10%. At the 5% rate the balance drops below 50% of the total after year 12 while at 10% it does not drop below 50% until after year 13. Nevertheless both mortgages will be repaid in full (assuming no arrears) after 20 years.
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Table 1: Annuity Repayment calculations for a Repayment Mortgage @ 5% Amount in €: 100,000.00 Rate: 5.00% Term in years: 20% Repayment Schedule No. of Year Monthly Year/end Annual Annual Annual % Months repayment balance repayments capital Interest Balance Repayment Repaid 12 0 659.96 -96992 7919 3008 4991 3% 24 1 659.96 -93930 7919 3161 4758 6% 36 2 659.96 -90508 7919 3322 4597 9% 48 3 659.96 -87016 7919 3491 4428 13% 60 4 659.96 -83346 7919 3669 4250 17% 72 5 659.96 -79489 7919 3856 4063 21% 84 6 659.96 -75436 7919 4053 3866 25% 96 7 659.96 -71176 7919 4259 3660 29% 108 8 659.96 -66699 7919 4476 3443 33% 120 9 659.96 -61995 7919 4704 3215 38% 132 10 659.96 -57050 7919 4944 2975 43% 144 11 659.96 -51854 7919 5196 2723 48% 156 12 659.96 -46393 7919 5461 2458 54% 168 13 659.96 -40653 7919 5739 2180 59% 180 14 659.96 -34622 7919 6031 1888 65% 192 15 659.96 -28283 7919 6339 1580 72% 204 16 659.96 -21621 7919 6661 1258 78% 216 17 659.96 -14619 7919 7001 918 85% 228 18 659.96 -7261 7919 7359 561 93% 240 19 659.96 0 7919 7261 187 100%
TOTALS 157,918 100,000 57,918
Table 2: Capital and Interest Repayment @ 5%
Capital & Interest Annual Repayment
8000
6000 Capital 4000 Interest 2000 Repayments (€) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Years
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Table 3: Annuity Repayments Calculations for a Repayment Mortgage @ 10% Amount in €: 100,000.00 Rate: 10.00% Term in years: 20% Repayment Schedule No. of Year Monthly Year/end Annual Annual Annual % Months repayment balance repayments capital Interest Balance Repayment Repaid 12 0 965.02 -98259 11580 1740 9840 2% 24 1 965.02 -96338 11580 1921 9659 4% 36 2 965.02 -94217 11580 2121 9459 6% 48 3 965.02 -91876 11580 2341 9239 8% 60 4 965.02 -89292 11580 2584 8996 11% 72 5 965.02 -86440 11580 2852 8728 14% 84 6 965.02 -83291 11580 3148 8432 17% 96 7 965.02 -79816 11580 3475 8105 20% 108 8 965.02 -75980 11580 3836 7744 24% 120 9 965.02 -71745 11580 4234 7346 28% 132 10 965.02 -67072 11580 4674 6906 33% 144 11 965.02 -61913 11580 5159 6421 38% 156 12 965.02 -56218 11580 5694 5886 44% 168 13 965.02 -49932 11580 6286 5294 50% 180 14 965.02 -42994 11580 6938 4642 57% 192 15 965.02 -35335 11580 7658 3922 65% 204 16 965.02 -26881 11580 8454 3126 73% 216 17 965.02 -17550 11580 9331 2249 82% 228 18 965.02 -7250 11580 10300 1280 93% 240 19 965.02 0 11580 7250 266 100%
TOTALS 227,541 100,000 127,541
Table 4: Capital & Interest Repayment @ 10% Capital & Interest Repayment @ 10%
12000 10000 8000 Capital 6000 Interest 4000
Repayments 2000 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Years
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Repayments will still be required should the principal earner die during the term of the mortgage. In a family situation this could cause difficulties for the surviving spouse especially if there are young children. This is why a Mortgage Protection policy (or similar) is taken out on the life/lives of the borrower(s) and assigned to the lender. The proceeds would go to the lender to repay the mortgage and no further repayments would be required.
2. Endowment Mortgage
The endowment mortgage is also known as an ‘Interest only’ mortgage.
Here is how it works: Customer pays only interest to the Lender Capital not reduced Customer takes out an endowment/investment policy with an insurer and pays premiums. Objective is that maturity value of policy will repay the mortgage * Life assurance to cover the loan is incorporated into the policy
The Exhibit below illustrates how the endowment mortgage works:
Capital Not Reduced
50 Surplus Value
40
30 Value of Endowment Policy 20 (Depending on Performance
10
5 10 15 20
*Repayment of the mortgage is linked to the performance of the endowment/investment policy. The customer remains fully liable to repay the mortgage even if the policy does not perform. Unless a ‘guaranteed’ policy is affected there can be no certainty that the policy will perform. Insurers have instituted regular (5 year) reviews to ensure that premiums are adequate to ensure repayment. But due to the sustained poor performance of international investment markets over the past few years Endowment/Interest only mortgages are not popular at present.
Even guaranteed policies cannot be fully relied on because if the insurance company has given the guarantee imprudently it could become insolvent. (See also Endowment assurance in the Chapter 6 on Insurances in Part One)
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Rating Agencies and Investors consider both product types suitable for inclusion in a pool for the issue of Mortgage Bonds or Mortgage Backed
What the Ratings Securities.
Agencies may require? In recent years customers are favouring repayment mortgages over endowment mortgages mainly because of uncertainty in international investment markets to which the repayment of endowment mortgages is linked.
There are also many variations and add-ons (see section below). However it should be noted that the more “bells and whistles” which are added to the basic product the less attractive they become for inclusion in the mortgage pool. Rating agencies and investors favour uncomplicated products
3. Variations and Add-Ons:
The most popular and attractive mortgage add-on options are a) Pension Mortgage b) Deferred Start c) Skipped month d) Index linked e) Level payment f) Mortgage break g) Lump sum payments h) Equity release i) Stage/Phased payments*
(*See “Self Build” projects in following section) a) Pension Mortgage A pension mortgage is broadly similar to an Endowment mortgage in that interest is paid to the lender, the capital does not reduce and an insurance product pays off the capital at the end of the term.
The Pension Mortgage is a ‘niche’ product suitable for wealthy self -employed people who have a Personal Pension Plan. These are successful professional or business people who are funding a large pension policy, which will be adequate on maturity not alone to provide them with a pension on retirement but also to repay their mortgage. In general lenders will provide a mortgage not greater than 25% of the total pension plan i.e.: for a mortgage of €100k the pension plan must be a minimum of €400k.
In addition because pension plans are not assignable (in some jurisdictions) separate life insurance is required. The max loan to Value (LTV) is normally less than that for a standard mortgage.
b) Deferred Start This is also called a ‘Moratorium’ and is generally only available to First Time buyers. Repayments are deferred for a number of months after moving into the new house when cash flow is tight. The premiums on the life insurance are not deferred.
In effect using this option the customer is borrowing extra funds as the capital payments and interest are ‘rolled up’. Repayments are calculated so as to ensure the mortgage is repaid within the original agreed term. Because of the ‘moratorium’ the mortgage may be outside the normal credit policy for a period of time and would not be included in a pool of mortgages until it is back in line.
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c) Skipped month Customers can decide to skip payments for 1 or 2 months during the year. It is particularly useful for people who would like more cash flow at expensive times e.g. Summer holidays. So if a customer opts for say 2 skipped months – the total annual repayments are divided by 10 instead of 12 and the mortgage repayments are fully up to date by year-end. d) Index Linked This is an option to increase repayments annually in line with either the Consumer Price Index (CPI) or increases in salary. This is in effect an ‘overpayment’ and as an example if this overpayment amounted to €64 per month it would have the effect, on a 20 year €127k mortgage, of reducing the term by 27 months and the total interest paid by €9194. The customer would have the option to revert to normal payments at any time. e) Level Payment This option is of particular benefit to both the financial institution and the customer during a time of interest rate fluctuations. Here is how it works. It’s available on variable rate repayment mortgages. The monthly payment is set at the beginning of the year based on the current interest rate and the term remaining. No change to the monthly repayment is made during the year even though interest rates have moved. At the end of the year repayments are recalculated to reflect interest rate changes during the year. Repayments for the following year will either be increased or decreased depending on how interest rates moved. If rates fell during the year then the customer has overpaid and the following year’s payments can be reduced. If rates increased the converse applies. The mortgage will be repaid over the original term (assuming no arrears) The customer benefits by having a variable rate mortgage and still having fixed monthly repayments for each year. This creates certainty and helps with cash flow. The financial institution benefits in that repayments do not have to be recalculated at each interest rate change thus reducing workload and saving on postage costs etc. f) Mortgage Break Mortgage break is a ‘repayment holiday’ for existing customers with a good track record. Here is how it works: During the life of a mortgage (approx 20 years) the customers circumstances and lifestyle needs will almost certainly change – for example a customer might become ill, or want to take a career break or take time off work for maternity/paternity reasons. In such circumstances they might wish to suspend payments on the mortgage for a period of time. To qualify the customer will need to have met monthly repayments for the previous 3 years. Qualifying customers can suspend payments for 3 consecutive months during a 12-month period. This facility is available for up to 4 periods of 3 months during the life of the mortgage. The payments are rescheduled at the end of each ‘holiday’ so as the mortgage is repaid within the original term.
g) Lump Sum payments: Customers can be in a position from time to time to make ‘out of course’ lump sum repayments. They can either then decide to continue with the existing monthly payments (which means the mortgage is paid off early) or renegotiate the payments to repay over the original term. This option will usually apply, without penalty, to variable rate mortgages. Lump sum repayments can also be made to fixed rate mortgages but lenders would, in general, impose a penalty in this situation to compensate for the loss incurred on the funds as the price the lender initially paid for the funds assumes that the borrower will continue with the fixed rate to the end of the contract. h) Equity Release Equity Release is a key market segment as stated above and is also a key mortgage sub product. Equity Release is also known as Remortgaging as in many instances it will be additional borrowing. Of course Equity Release is available as a first mortgage also. Many people decide they want to remain in their current home and improve it.
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There are two possible scenarios; 1) First Mortgage for home improvements or 2) Remortgaging a property – existing mortgage with the lender
1) First Mortgage – for Home Improvements This application will be treated by the lender from an application and credit assessment perspective as if the applicant is a First Time buyer.
The steps in summary are:
Assume no borrowing track record – so all credit checks to be carried out. Customer provides estimates of work to be completed. ** (see below section on Structural and Refurbishment works) Customer completes mortgage application/with full supporting documents Lender assesses the application Lend/Defer/decline decision Offer issued (lend decision) Copy to Lawyer Offer accepted Legal requirements completed Mortgage Drawn down.
2) Re-mortgaging a property As payments are made on the original mortgage the balance is gradually reducing. At the same time the value of the property is probably increasing (depends on market conditions and demand). The gap between the two is known as the customers Equity. Example: House purchased in 1998 for €50k and the borrowing then was €35k (70% LTV) – customers’ equity was €15k+ costs. House now valued at €70k while the mortgage is reduced to €32k. (45.7% LTV) – customers equity now €38k. So assuming that the customer continues to meet your underwriting requirements and repayments are up to date on the existing mortgage then this is an opportunity to lend more money to your existing good customer. When people look at both the financial and emotional costs of moving, staying put and doing up their existing home is a good option. Equity release is generally used for ‘home’ related purposes such as: extensions, refurbishment, holiday homes, educational or medical needs. The steps outlined above for ‘new customers’ will apply to existing customers with the exception of the ‘credit check’ requirement. However the lender will also need to obtain an up to date: - Income certificate - Property Valuation - Mortgage Indemnity Bond - Increased Life assurance - Increased Property Insurance.
Additional legal costs will also be incurred. Equity Release/Remortgage is an attractive funding option for customer as funds can be borrowed at mortgage rates instead of commercial rates.
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Investors and rating agencies do not concern themselves with the ‘purpose’ of
What Investors the loan – their key requirement is a first legal mortgage over the property and
and Rating no arrears on repayments Agencies may require
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6 SELF BUILD PROJECTS
When a customer owns the land and wishes to construct a property, houses will be built by either ‘registered builder’ or by ‘direct labour’. In many countries the Construction industry, with Government approval/support, has set up a scheme which provides guarantees on the quality of construction of houses. We have examined this scheme in more detail under Insurances in Chapter 6 of Part One. What happens in reality is that once the scheme is set up builders are anxious to join because buyers naturally try to purchase properties where the standard of construction is guaranteed.
Registered Builder/Fixed Price contract In all instances where a builder is employed the customer should ensure (and the lender should insist) that only a Fixed price Contract is entered into.
Where the builder is registered lenders will release Phased drawdowns on production of ‘stage completion certificate’ (part of the scheme) which is provided by the customers Lawyer (see the Insurance chapter for the detail). An initial property valuation is required (site value) together with ‘stage’ valuations’
In course of construction’ buildings insurance is required to be increased in line with the increasing value of the property. Life cover for the full amount of the mortgage is required before any drawdowns are approved. Usually the final 5% of the mortgage is retained until a final valuation is completed.
Direct Labour Direct labour means that the customer is either building the house himself/herself or is employing all the various skills – bricklayers, plumber, electrician etc. Most lenders are slow to release stage payments in this type of situation as there is no fixed price contract in place and there is a tendency for price overruns.
However suitable situations and opportunities will arise – e.g. customer is a building professional/has previous experience. Undoubtedly a well-managed ‘self-build’ project will come in cheaper than employing a builder and the quality of construction will probably be better.
Phased Payments: People ‘building’ homes require a mortgage in the same way as people ‘buying’ homes do. The difference is that the need the money in ‘phases’ We will now examine the Phased concept and how it works in relation to the various types of building arrangement:
Customers will use their own funds first. From a lenders perspective this ensures commitment/buy-in. The more of their own funds they use the less likely they are to default/abandon the project. For example if the total cost is €100k and the mortgage is€70k then the customers contribution is €30k – these funds will be used before the lender will release the phased payments.
The facility offers gradual drawdown of funds typically in four tranches as the construction progresses. These are clearly defined completion points in the project and are: stage 1 : ‘wall plate’ - walls in place but roof not yet constructed stage 2 : ‘basic shell’ – roof etc complete stage 3: ‘interior’ – all interior fittings, connections, finishes have been applied stage 4: ‘architect’ sign off – final certificate from architect.
At each stage the lender requires inspection and certification by an architect or other suitably qualified professional (engineer/quantity surveyor) that the work has been completed satisfactorily prior to drawdown of the funds.
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When advising a customer on financing a self- build project, it’s critical to stress the importance of thorough preparation especially in relation to costs and cash flows. The self-builder has not only to take account of design and construction costs but items like: Professional fees Planning/bye-law approvals Connections to services (e.g. water/electricity etc) Possibly sinking a well etc
To a lending institution a self-build project is more risky than lending on ready- built properties. The lender needs to be confident that the customer will see the project through and there will be no cost overruns. The worst-case scenario for a lender is that the project is abandoned half way through which leaves the lender with a partially constructed property that is difficult to sell.
Before agreeing to lend on a self- build project the lender must be satisfied that:
The borrower owns the land unencumbered with appropriate access The plans meet local authority planning and bye-law conditions In course of construction property valuations will be carried out. In course of construction insurance will be in place. The site will be fully serviced with all utilities The customer has funds available (i.e. their equity) These funds will be used before the phased drawdowns commence The builder is professional/registered and/or a qualified architect will supervise the construction. The property will be readily marketable in the event of a forced sale. The completed house will be adequate security to cover the mortgage.
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7 ARREARS MANAGEMENT AND REPOSSESSION
The account is now in arrears and the customer is not making or will not make repayments. It’s important that before we go into the reasons for and action steps around arrears management that we revisit the initial decision to lend. A comprehensive analysis was undertaken including measuring the customers ‘ability to repay’ before a ‘yes’ decision was made. Based on the information available at the time this was a good decision. Something has gone wrong.
Most lenders use system generated letters to follow up initial arrears situations. Lenders do not get particularly upset about ‘late’ payments provided it is not a regular feature of the account operation. However it may be an indication of pressure on cash flow and should be monitored.
If the arrears becomes habitual (ie1 month or more) then the arrears management team become actively involved in the case. They need to establish the reasons for the arrears ideally by meeting the customer. There is a different approach to someone who ‘can’t pay’ v someone who ‘won’t pay’. Staff who work in the arrears unit need a particular skill and training. They deal with the problem customers – they are counsellors. Their objective is to ‘work out’ with the customer rather than ‘fall out’ with the customer. There are specific action steps to follow: Identify customers in arrears Identify the reasons Contact initially by letter followed by telephone followed by meeting (if necessary) Agree an action plan with the customer which is specific,measurable and achievable. Advise customer of consequences of non payment (reference warnings in letter of offer etc) Monitor progress.
If the arrangement falls down (and sadly some do) then Legal Action for Repossession is commenced. Legal processes vary considerably between countries. The following is a summary template for the Irish/UK model: Formal repayment demand issued by Lawyer giving 14 days notice to pay. Ejectment Civil Bill issued – outlining reasons. Court order – judge orders property to be surrendered under the powers in the mortgage deed. If Customer disobeys – Contempt of Court – Eviction – Jail. The Court attitude in most western economies would be to favour the customer if the customer is making any effort to repay. The Court would be conscious of the consequences of repossession of a Family Home. The Lender needs also to be aware of the social issues.
For Lenders this is a very fraught situation. It is probable that the relationship has totally broken down. If the business decision is to repossess the home then it is critical that the security is absolutely 100% in order. The day the security is taken is in reality the day it is realised.
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8 INTEREST RATES
Interest rates charged to residential mortgage customers are generally either fixed or variable. In the case of fixed interest rates this is for an agreed period, usually in years, with the interest rate usually being higher the longer the period that is fixed and when the period expires, the underlying interest rate reverts to a variable interest rate. These interest rates include the margin for the lender, and sometimes individual interest rates reflect a risk premium for the specific loan.
Variable interest rates are usually referenced to some a market benchmark such as an inter-bank offered rate (IBOR). The customers rate changes in line with changes in the market benchmark. The precise mechanics can vary by lender or country. For example a ‘tracker mortgage’ usually defines the precise time response for upward and downward movements to the IBOR rate and may guarantee a maximum deviation from this rate.
With regard to RMBS, these deals are usually structured so that the interest to bond holders is struck at IBOR plus a premium expressed in basis points. This might be 1 month or 3 month IBOR plus 50 basis points. Clearly if the underlying mortgages that are securitised are all variable interest rates it makes sense to have these rates adjustable in similar fashion. Some of the structures might have a fixed interest rate at the outset.
Often with Mortgage Bonds, the interest rate on the underlying bonds may be fixed for a specified duration or they might be variable.
Some countries have preferences for fixed rates – such as Germany – whereas the UK and Ireland see many customers with variable rate mortgages.
Both RMBS and Mortgage Bonds therefore require considerable care and attention as to how underlying mortgages are priced and then how the underlying interest rates can be changed. This potentially can affect the ability for product flexibility.
The mechanics of dealing with duration risk and interest rate risk are beyond the scope of this Mortgage Manual.
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9 INFORMATION TECHNOLOGY
“From a traditional perspective, banks act as intermediaries in the allocation of financial resources; a modern perspective treats them as factories engaged in information processing and deal making. Innovations in banking have paved the way for electronic banking, electronic money and electronic commerce. Technological innovation presents banks with opportunities to gain competitive advantage.” Commercial Bank Financial Management” Joseph Sinkey, 6th Edition Prentice Hall 2002.
Banks were early adaptors of transaction processing systems and many of these investments deliver continuing benefits and the systems have lived on far longer than was originally envisaged. Integration of systems was merely a dream, and the investment required now by many Banks often fails “return on investment” criteria as Banks still try to assess IT investment in terms of cost savings when in effect IT is now a critical piece of infrastructure.
A well thought out IT architecture can lead to substantial added benefits to an organisation. Focusing on integration with the customer relationship as the centre will become essential from profitability, risk, efficiency and flexibility stand points.
Simple designs could lead to the accurate collection of customer data that can be accessed and kept up to date when customers develop their relationship with a bank through additional product offerings that a bank may sell or be purchased by a customer.
Specifically as regards mortgages there is likelihood that additional products may be required by the customer such as life assurance, fire insurance or home equity withdrawal. Accurate and up to date information about the customer, their track record, their financial position linked with external databases such as credit reference agencies allows a bank to act on more complete information which allows for more informed decisions as to the granting of credit or the decline of facilities.
At the end of the day the biggest risk that a bank will have is credit risk and the possibility of write offs.
Furthermore when organisations want to be in a position to securitise their mortgage book, Moody’s look for what they term “static pool analysis” meaning that they like to be able to review historically what has happened to a pool or mortgages originated many years previously. Many banks often struggle when it comes to the IT information requirements that they need to be able to produce to demonstrate the track records of their mortgage clients.
If the organisation is considering securitisation, we noted earlier that there is a “true sale” of the mortgages involved. This typically requires structures to ensure that cash flows now properly belonging to the SPV need to be accounted for and placed in proper structures. Many organisations had great difficulty in facilitating securitisation. Those that regard it as an important source of funding have amended their core systems to facilitate these transactions. Similarly where there are other forms of funding such as mortgage bonds or collateralisation there is a need for extensive IT functionality to support these diversifications of liquidity without shifting everything to other systems.
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Appendices
Mortgage Loan Minimum Standards Manual
Appendix 1: The Mortgage Process The Mortgage Process
Property Selection Customer Application Credit Assessment
Mortgage Account Management
Loan Offer
Loan Security Loan Accounting Loan Completion
Appendices Appendix 2: Sample Mortgage Application
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Appendix 3: EUROPEAN AGREEMENT ON A VOLUNTARY CODE OF CONDUCTON PRE-CONTRACTUAL INFORMATION FOR HOME LOANS (“AGREEMENT”)
This Agreement has been negotiated and adopted by European associations of consumers and the European Credit Sector Associations offering home loans (see below). The Agreement provides backing for a voluntary code of conduct (“Code”) to be implemented by any institution offering home loans to the consumer. A list of signatories to the Agreement is annexed to the Agreement. The Agreement is divided in two parts: • Part I: The terms of implementation and monitoring of the voluntary Code; • Part II: the contents of the voluntary Code regarding pre-contractual information to be provided to consumers: - as general information about home loans on offer; - as personalised information at a pre-contractual stage to be presented in a “European Standardised Information Sheet”. The aim of the Code is to ensure transparency of information and comparability.
Coverage of the voluntary Code The Code covers consumer information for domestic and cross-border home loans.
Definition of a “home loan” for the purposes of the Code A “home loan” is a credit to a consumer for the purchase or transformation of the private immovable property he owns or aims to acquire, secured either by a mortgage on immovable property or by a surety commonly used in a Member State for that purpose. Home loans covered by the Consumer Credit Directive(87/102) are excluded from the scope of the Code
PART I: TERMS OF IMPLEMENTATION The voluntary Code will be implemented by means of the following procedure: 1. The European Credit Sector Associations subscribing to the Code will make an official public announcement of their commitment to it. 2. Each of the European Credit Sector Associations will send an official recommendation to its national members inviting them to: 2.1. make an official public announcement that they subscribe to the Code; 2.2. take all necessary measures with a view to the effective implementation of the Code, which means, inter alia, inviting those individual institutions that opt to adhere to the Code to: 2.2.1. within 6 months of the ratification of the Agreement, announce their commitment to the Code; and 2.2.2. publicise their subscription to the Code; and 2.2.3. notify their commitment to apply the Code together with the date of implementation to the central register (see 7.2). The date of implementation of the Code should be within 12 months from the date of notification of the commitment to apply the Code. 3. The Code will be publicised and copies made available in each branch of the individual institutions subscribing to the Code.
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4. The copies of the Code made available will always contain the identification, address and telephone number of the competent body to which the consumers can refer if they face difficulties in relation to the application of the Code. 5. The consumers will be informed of the code’s existence and availability by a special notice in the European Standardised Information Sheet. 6. The European Credit Sector Associations will publish an annual progress report on the implementation of the Code. 7. The European Commission has indicated that it will: 7.1. monitor the uptake and effectiveness of the Code; and 7.2. ensure that a central register is established indicating which institutions are offering home loans and, if so, which have and which have not adopted the Code; 7.3. issue a Recommendation containing the voluntary Code as foreseen in COM (1999) 232, 11.05.99; 7.4. within two years of its Recommendation, review the operation of the Code on the basis of the results of its monitoring activity, annual progress reports produced by the European Credit Sector Associations and any additional information available. Immediately thereafter, and under the aegis of the European Commission, the Code will then be reviewed by all dialogue participants on the basis of the Commission’s review findings. 8. Adherence to the Code will be open to other institutions which are not members of the European Credit Sector Associations having adopted it.
PART II: VOLUNTARY CODE OF CONDUCT ON PRE-CONTRACTUAL INFORMATION FOR HOME LOANS This is a voluntary Code of conduct (“Code”) , which deals with pre-contractual information to be provided to the consumer regarding home loans. The Code is the core of the European Agreement on a voluntary Code of conduct on pre-contractual information for home loans (as defined in the Agreement) negotiated and agreed between European associations of consumers and the European Credit Sector Associations. Institutions subscribing to the Code undertake to provide to the consumer, in accordance with the agreed terms of implementation and in the form described below: - general information about home loans on offer; - personalised information at a pre-contractual stage to be presented in a “European Standardised Information Sheet”. The final decision to accept a credit offer from a lender belongs to the consumer.
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1. General Information to be provided to the consumer Initial information about home loans should include or be accompanied by the following information in the same format as that initial information is itself provided:
A – Lender: 1. Identification and address of the lender; 2. Where appropriate, identification and address of the intermediary.
B - Home Loan: 1. Purposes for which the home loan may be used; 2. Form of surety; 3. Description of the types of home loans available with short description of the differences between fixed and variable rate products, including related implications for the consumer; 4. Types of interest rate – fixed, variable, and combinations thereof; 5. An indication of the cost of a typical home loan for the consumer; 6. A list of related cost elements, such as, administrative costs, insurance costs, legal costs, intermediaries costs…; 7. The different options available for reimbursing the credit to the lender (including the number, frequency, amount of repayment instalments if any); 8. Whether there is a possibility of early repayment (if so, its conditions); 9. Whether a valuation of the property is necessary and, if so, by whom it has to be carried out; 10. General information on tax relief on home loan interest or other public subsidies prevailing, or information on where one can obtain further advice; 11. The duration of the reflection period, where relevant; 12. Confirmation that the institution subscribes to the Code, and indication that a copy of the Code is available in the institution.
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2. Information to be presented in a “European Standardised Information Sheet”
The contents of the European Standardised Information Sheet are set out below.
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Appendix 4: EBRD Environmental Guidelines for Residential Mortgages
ENVIRONMENTAL GUIDELINES FOR RESIDENTIAL MORTGAGE LENDING
Introduction
The EBRD's Environmental Mandate requires it to 'promote in the full range of its activities, environmentally sound and sustainable development'. This also applies to the financing activities of EBRD’s Financial Intermediaries, including Mortgage Lenders.
These guidelines summarise the environmental, health and safety issues that may be associated with the provision of residential mortgages to individuals, and how they should be addressed by Mortgage Lenders (MLs). Agreements between the EBRD and MLs require that MLs comply with the Guidelines in all business supported with EBRD funds.
N.B.: The provision of non-residential mortgages potentially involves higher environmental risks and therefore requires a different environmental due diligence process. Therefore, for non-residential mortgages, lenders should use the EBRD’s Environmental Procedures for Local Banks.
1) Establishing management oversight for environmental matters
The ML will appoint a member of management who has overall responsibility for the implementation of these Guidelines within the ML and is the liaison point with EBRD on environmental issues.
2) Conducting environmental due diligence on mortgage applications a) Identifying environmental and health and safety risks
Prior to granting a mortgage, MLs require a valuation survey to be carried out on the property by a qualified surveyor. In addition to other factors such as the structural integrity of the building, environmental issues could also negatively affect the value of the residential property taken as mortgage security. Therefore, MLs must ensure that the valuation surveys cover potential environmental risks. The main environmental and health and safety risks that could be associated with residential properties are outlined below and MLs need to verify that surveys include clear answers as to whether these is a potential problem in any of these areas. The surveys should also include cost estimates for correcting any problem identified.
(i) Regulatory compliance – environmental protection aspects
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Properties must comply with all applicable national laws, regulations and standards, including environmental, planning, building, and health and safety regulations. The valuer should inform the lender of any areas of non-compliance, the effect on the value of the property/properties, and the associated risks involved, if any.
Existing properties may be exempt from some current regulations. However, MLs should note that activities in contravention of national regulations on nature protection (e.g. national parks) the protection of cultural heritage, or the protection of indigenous peoples are excluded from EBRD financing, even if building permits overriding those regulations have been obtained.
(ii) Site contamination In order to determine the risk of contamination the previous use of the site must be determined. For example, if the site on which the property is built/will be built has always contained residential dwellings, or was a greenfield site, then contamination is unlikely. If the property is/will be built on, or in proximity to, a brownfield site (e.g. former industrial site or landfill), the valuer should assess the possible risk of contamination and should, if necessary, advise testing of soil samples. The results will determine the possible adverse effect on property/land values and consequently any risk to the lender. Even the proximity to a landfill/dumpsite can have a serious negative effect on house prices.
(iii) Risk of flooding / seismic activity The siting of a property in a flood plain or in an area of seismic activity may represent a high risk to the lender. The valuer should research previous incidence of flooding/seismic activity and should advise the lender of the probable risks. The relevant national authority/ research institution may be able to provide guidance and advice.
(iv) Use of / presence of hazardous materials in construction The property/properties should be checked for presence of hazardous materials i.e. materials damaging to human health, e.g. unbonded asbestos, formaldehyde, and radon. ML should note that treatment of such materials, such as their safe removal by licensed contractors, is likely to prove costly and be subject to national regulations. Properties where unbonded asbestos is present are excluded from EBRD financing.
(v) Other health and safety hazards The surveys should check properties for faulty electrical wiring or faulty gas appliances, which is not only a major health and safety hazard (e.g. emission of toxic gases from gas stoves or heaters) but could also impair the value of the property through fires or explosions. b) Feeding the survey results into the lending decision Having considered the results of the survey and any follow-up investigation, MLs will need to decide on the appropriate strategy to control any environmental risks identified. If any area of regulatory non-compliance has been identified, MLs need to require borrowers to rectify the problem as a condition of providing the mortgage. A similar
Appendices Mortgage Loan Minimum Standards Manual approach can be taken to mitigate other issues that represent risks without being a regulatory infringement. If the ML considers the risk too high and impossible (or too costly) to mitigate, the mortgage application should be rejected. If the property is excluded from EBRD financing (see sections a) (i) and (iv) above), the property may not be financed using EBRD funds.
3) Controlling environmental risk at the portfolio level
The above mentioned environmental risks may on occasion affect multiple properties, e.g. if the ML provides a number of mortgages to new properties built on the same contaminated site, or on an unprotected flood plain. In such cases the environmental risk could have a significant adverse impact on the ML’s business. The ML should therefore check that any site-related risks that affect a larger area beyond the boundaries of one single property are taken into account for all properties located in that larger area.
4) Monitoring and reporting to EBRD
The ML is required to provide EBRD with annual environmental reports. These report should be brief and should cover the following issues:
(a) Confirmation that ML’s real estate appraisal process complies with the Environmental Guidelines;
(b) Confirmation that borrowers’ properties meet applicable regulatory requirements;
(c) Information on any mortgage applications declined on environmental or health and safety grounds;
(d) Information on any environmental or health and safety issues that had a material adverse effect on the value of properties financed by a mortgage loan under the agreement with the EBRD (e.g. fires, contamination) including a description of the relevant issues and an estimate of the financial impact.
(e) Information on any financial incentive granted by the ML, governmental authority or other institution to encourage borrowers to improve the safety or the environmental efficiency of their property (e.g. energy efficiency, measures such as wall /roof insulation, installation of solar water heating systems or solar electric power, solar panels, etc).
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5) Public information on environmental issues
EBRD encourages its financial intermediaries (FIs) to disclose, to their external stakeholders, information on how the FIs address environmental issues in their business and operations. This may, for example, be in the form of a section in the ML’s Annual Report summarising the ML’s commitment to environmental risk management in its lending operations, including its mortgage lending. Further guidance on public environmental reporting for FIs is available from EBRD.
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Appendix 5: Mortgage Bank and Mortgage Bond Laws in Europe*
Ireland Spain Denmark Germany Bulgaria Romania Entered into Force 2001 1981 1850 1900 1999 2000 Specialist Bank Yes No Yes Yes Unclear No Principle Terms Protected Yes Yes Yes Yes Unclear Yes by Law (Mortgage Credit (Cedulas (Realkredit (Hypotheken (Obligatuinile Covered Security, Hiptoecarias) Obligation) -pfandbief Ipotecare) Public credit and Offentlicher Covered security) Pandbrief) Refinancable Mortgage & Mortgage & Mortgage Loans Mortgage & Public Mortgage Loans Mortgage Loans through mortgage bonds Public Sector Loans Public Sector Loans Sector Loans Cover Register Yes No Not Necessary Yes No Yes (Mortgage Banks are only allowed to do mortgage business) Legally anchored Yes Yes Yes Yes No Yes preferential right in Bankruptcy Valuation Regulations Yes Yes Yes Yes No Yes Lending Limit for 60%-75% of 70-80% of 40/60/70/80(91)% 60%of Mortgage Value 60%of Portfolio Value 60/80% of Market funding through prudent market value market value of Mortgage Value mortgage bonds Lending Value
Absolute Lending Limit Yes. 80% of the No 40/60/70/80(91)% No (100%of market No No prudent market of Mortgage Value) Limit for Yes. 10% of No Not Permitted 20% Unlimited No Lending beyond the cover Mortgage Cover (volume above the Pool relative lending limit) Trustee Yes No No Yes No Basically no Substitute Collateral Yes No No Yes No Yes Limit for Substitute 20% of the No No 10% of the mortgage No 39% Collateral Mortgage bonds in circulation Cover pool Public-Sector Bond Yes Yes, but not used No Yes No No Special ranking of Cover No Yes Yes No No No Mortgages Special Public Supervision Yes Yes Yes Yes No Unclear Art 22 (4) UCITS directive Yes Yes Yes Yes No Unclear fulfilled *Taken from Annex of “Mortgage Banks & The Mortgage bond in Europe - 4th Edition.
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Appendix 6: Investor / Rating Agency Sample Report
Dates
Report for Quarter Ending 21/06/2002 Interest Payment Date 08/07/2002 Calculation Date from 21/03/2002 To 21/06/2002 Number of Days 92 Interest Period From 08/04/2002 To 08/07/2002 Number of Days 91
Security Data
Report Date 21/06/2002 Report Currency € Class A ISIN XS011318(1) Class B ISIN XS011318(2) Trustee Citibank N.A
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Payments under Notes
Principal Interest Opening Balance Amortisation Closing Balance Pool Factor Interest Due Interest Paid A Notes 371,090,674.00 15,703,718.00 355,386,957.00 0.7450460 3,466,025.00 3,466,025.00 B Notes 23,000,000.00 - 23,000,000.00 1.0000000 240,405.00 240,405.00
Totals 394,090,674.00 15,703,718.00 378,386,957.00 0.7567740 3,706,430.00 3,706,430.00
Transaction balances
Drawings and Balance at start of Replenishments Balance at close Required Amount Quarter in Quarter of Quarter (Max)
Reserve Funds 3,750,000.00 3,750,000.00 3,750,000.00 Retained Principal Ledger 3,783,870.00 Class A Principal Definciency Ledger Class B Principal Definciency Ledger Subordinated loan (start up costs) 1,500,000.00 1,500,000.00
Arrears
At Closing End of this Quarter Total number of borrowers in pool 6,741.00 5,572.00 Total number of advances in pool 6,921.00 5,732.00 Total number in arrears (>1 month) 91.00 Principal Balance of loans in arrears € 5,987,857.00 Tital arrears Balance € 233,444.00 Incremenatla Increase/(-decrease) in over due amounts €- 59,344.00 Total Proncipal Balance of loans over 12 months in arrears € 306,189.00
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Pool Indicators
At Closing End Quarter Aggregate balance of Mortgages € 499,601,275.00 378,620,401.00 Average Mortgage Balance € 74,114.00 67,951.00 Largest Mortgage € 463,947.00 443,068.00 Weighted Average LTV % 62.35 55.19 Weighted Average Rate % 5.50991 5.172939 Weighted Average Seasoning Months 25.32 48.96 Longest Remaining Term Months 352 351
% LTV Ratios
End At Closing Quarter % by % by Number of Number of Principal and Number of Number of Principal and Borrowers Borrowers Arreas Borrowers Borrowers Arreas 0-30 948 14.06 35,912,032.00 1190 21.36 46,775,822.00 30-40 700 10.38 41,687,293.00 719 12.9 42,463,921.00 40-50 850 12.61 58,368,895.00 851 15.27 58,909,497.00 50-60 965 14.32 74,859,191.00 861 15.45 64,876,577.00 60-70 944 14 79,627,988.00 742 13.32 60,302,851.00 70-80 986 14.63 86,820,841.00 802 14.39 65,827,269.00 80-90 1348 20 122,325,036.00 406 7.29 39,296,975.00 90-100 0 0 - 1 0.02 167,488.00
Totals 6741 100 499,601,276.00 0 5572 100 378,620,400.00
Mortgage Principal Analysis
End this Qtr Since Closing Adjusted Mortgage Principal Balance end previos quarter 394,090,674.00 499,601,275.00 Principal write offs - - Substitutes mortgages - - Further advances - - Max amt of substitutions and further advances allowed 125,000,000.00 - Principal receipts 15,703,718.00 121,214,315.00 Closing mortgage system balance on calculation date 378,620,401.00 - Total arrears balance 233,444.00 - Adjusted mortgage system balance on calculation dates 378,386,957.00 - Target Note Balance 354,311,843.00 - Actual Note Balance 378,386,957.00 - Appendices Mortgage Loan Minimum Standards Manual
Mortgage Size
End At Closing Quarter % by % by Number of Number of Principal and Number of Number of Principal and (€ 000's) Borrowers Borrowers Arreas Borrowers Borrowers Arreas 0-20 259 3.84 3,699,014.00 324 5.81 4,374,985.00 20-40 972 14.42 29,813,616.00 994 17.84 30,327,618.00 40-60 1598 23.71 80,825,239.00 1418 25.45 71,411,138.00 60-80 1592 23.62 110,577,297.00 1265 22.7 87,729,204.00 80-100 1045 15.5 93,154,971.00 704 12.63 62,470,975.00 100-120 514 7.62 56,151,247.00 358 6.42 39,070,861.00 120-140 299 4.44 38,394,068.00 195 3.5 25,175,299.00 140-160 172 2.55 25,626,036.00 123 2.21 18,201,166.00 160-180 90 1.34 15,217,118.00 74 133 12,602,927.00 180-200 82 1.22 15,584,306.00 48 0.86 9,087,709.00 200-500 118 1.75 30,558,364.00 69 1.24 18,168,520.00
Totals 6741 100.01 499,601,276.00 0 5572 231.66 378,620,402.00
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Geographic Split
End At Closing Quarter By Defined % by % by Area (e.g Number of Number of Principal and Number of Number of Principal and County) Borrowers Borrowers Arreas Borrowers Borrowers Arreas County 1 128 1.9 6,646,529.00 111 1.99 5,128,173.00 County 2 62 0.92 3,256,816.00 55 0.99 2,676,589.00 County 3 182 2.7 12,015,855.00 160 2.87 9,639,762.00 County 4 265 3.93 19,556,780.00 212 3.8 14,978,344.00 County 5 506 7.51 35,290,333.00 429 7.7 27,454,564.00 County 6 101 1.5 5,441,595.00 60 1.62 4,368,396.00 County 7 1213 17.99 111,681,223.00 1031 18.5 89,127,273.00 County 8 632 9.38 60,783,996.00 459 8.24 39,681,197.00 County 9 114 1.69 9,203,502.00 99 1.78 7,296,348.00 County 10 380 5.64 24,811,422.00 332 5.96 19,632,058.00 County 11 98 1.45 5,657,578.00 79 1.42 4,143,288.00 County 12 422 6.26 34,175,423.00 351 6.3 26,023,009.00 County 13 128 1.9 9,326,554.00 108 1.94 7,127,564.00 County 14 77 1.14 4,866,931.00 67 1.2 3,952,489.00 County 15 23 0.34 1,019,387.00 20 0.36 750,122.00 County 16 207 3.07 14,937,479.00 168 3.02 11,404,057.00 County 17 229 3.4 14,076,209.00 191 3.43 10,488,518.00 County 18 29 0.43 1,766,666.00 25 0.45 1,419,134.00 County 19 169 2.51 10,872,940.00 135 2.42 8,155,748.00 County 20 161 2.39 8,991,564.00 130 2.33 6,710,800.00 County 21 280 4.15 20,958,538.00 226 4.06 14,784,755.00 County 22 62 0.92 3,306,418.00 58 1.04 2,826,629.00 County 23 39 0.58 2,632,028.00 60 0.54 1,921,497.00 County 24 52 0.77 2,653,560.00 46 0.83 2,177,686.00 County 25 113 1.68 6,492,438.00 91 1.63 4,923,519.00 County 26 165 2.45 9,580,169.00 142 2.55 7,601,973.00 County 27 98 1.45 6,902,375.00 82 1.47 5,309,653.00 County 28 103 1.53 6,634,672.00 83 1.49 5,030,672.00 County 29 131 1.94 8,216,653.00 113 2.03 6,513,742.00 County 30 264 3.92 12,227,169.00 214 3.84 8,984,504.00 County 31 308 4.56 25,618,472.00 235 4.2 18,388,338.00
Totals 6741 100 499,601,274.00 0 5572 100 378,620,401.00
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Arrears Multiple
End At Closing Quarter % by % by Number of Number of Principal and Number of Number of Principal and Borrowers Borrowers Arreas Borrowers Borrowers Arreas Less than = 1 6741 100 499,601,275.00 5481 98.37 372,632,544.00 1-2 0 - 38 0.68 2,617,542.00 2-3 0 - 12 0.22 686,426.00 3-4 0 - 16 0.29 1,090,478.00 4-5 0 - 6 0.11 324,390.00 5-6 0 - 6 0.11 368,741.00 6-7 0 - 2 0.04 120,983.00 7-8 0 - 1 0.02 43,919.00 8-9 0 - 2 0.04 183,697.00 9-10 0 - 1 0.02 37,564.00 10-11 0 - 2 0.04 119,076.00 11-12 0 - 2 0.04 88,853.00 12 + 0 3 0.05 306,189.00
Totals 6741 100 499601275 0 5572 100.03 378,620,402.00
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Seasoning (Months)
End At Closing Quarter % by % by Number of Number of Principal and Number of Number of Principal and Borrowers Borrowers Arreas Borrowers Borrowers Arreas 7-12 539 8 45,702,005.00 0 0 - 13-18 1344 19.94 113,672,848.00 0 0 - 19-24 1576 23.38 123,744,714.00 0 0 - 25-30 956 14.18 72,103,339.00 0 0 - 31-36 843 12.51 57,692,007.00 468 8.4 36,996,002.00 37-42 645 9.57 38,388,658.00 1140 20.46 89,422,056.00 43-48 570 8.46 34,143,319.00 1306 23.44 93,907,580.00 49-54 226 3.35 11,821,447.00 777 13.94 53,405,287.00 55-60 42 0.62 2,332,938.00 676 12.13 41,443,633.00 61-66 0 - 524 9.4 28,156,343.00 67-72 0 - 470 8.44 25,408,645.00 73-78 0 - 180 3.23 8,380,351.00 79-84 0 31 0.56 1,500,504.00
Totals 6741 100.01 499601275 0 5572 100 378,620,401.00
Interest Rate
End At Closing Quarter % by % by Number of Number of Principal and Number of Number of Principal and Borrowers Borrowers Arreas Borrowers Borrowers Arreas Fixed 3826 55.28 278,664,583.00 2514 43.86 166,072,850.00 Variable 3095 44.72 220,936,692.00 3218 56.14 212,547,551.00
Totals 6921 100 499,601,275.00 0 5732 100 378,620,401.00
Appendices Mortgage Loan Minimum Standards Manual
Appendix 7: Cross Section of Mortgage Market Across Europe1 Ireland Spain United Denmark Germany Kingdom Home 82% 80% 67% 60% 40% Ownership Rates Size of 34% 50% 53% 70% 53% Mortgage Market (as % GDP) Population 3.8 million 40.5million 59 million 5.3 million 81 million Housing Size: 1,300,000 19 million 25 million 36.8 million Stock permanent dwellings dwellings dwellings housing units
Dwellings Per Per Thousand: 342 469 424 468 451 Population Regional 60% housed in Owner Owner occupation Recently home owner Owner Occupation Urban areas occupation rate rate higher in ship rates higher rates differ between higher in rural rural zones than in outside capital city East (31%) and West zones than in urban ones area. Germany (43%) urban ones Rate of Ownership in big cities is below average House Prices Characteristics: Dramatic Dramatic -Average rate of -house prices are -house prices have Increases Increases inflation on house cyclical and volatile. been stable in recent between 1995- between 2000 prices since 1970 years 2000 and 2001 is approx 3.5% Regional: (15.54%) House prices in House prices in South London typically House prices in big are 30% higher than House prices Cities (e.g. 1.4 times more cities has been higher German average. higher in urban Madrid, Bilboa than UK average than country average. Also high in Munich areas and Barcelona) house price. & Stuttgart. have highest prices Coastal areas also in high demand (tourism) and so prices here are rising. Construction Level 50,000 house 366,755 house Average of Between 15,000 – 421,800 new completions in completions in between 160,000- 18,500 house dwellings in 2000. 2000 2000. 180,000 house completions per year. completions per year Mix -6.3% of -public sector -public sector has experienced accounts for an completion in decline due to average of 10% of rising prices house building 2000 built by -Private sector -private sector continuing to currently builds local increase. 150,000 properties authorities annually
-20%of new housing was apartments. Government Taxation -Mortgage -Tax relief on Tax on Purchase Ordinary taxation of 3.5% tax on real Taxation Interest Relief Mortgage of Property: properties. estate -Stamp duty of repayments - <£250,000: 1% 9% - 7% VAT on tax -Tax relief for new dwellings, - £250,000 -
Appendices Mortgage Loan Minimum Standards Manual
purchase and 6% on 2nd hand £500,000: 3% tax development in dwellings - >£500,000: 5% certain (Estate Tax) tax designated -16% VAT on - No tax on areas areas. renovations and described as improvement of deprived dwellings - No VAT on new property - 17.5% VAT on renovations and improvement of dwellings
Size & Outstanding In 2000, In 2001, 11.2 million 2000: Total volume of €1.031 billion Growth Mortgages amounted to 33 amounted to mortgages worth loans 1,926m/ billion 45,899 billion £535 billion Total Bond pesetas Debt1158.6 billion DKK Gross Lending €7.6 billion Volatile Grew robustly in 185 billion DKK in €51.432 m in 2000 Net lending €7.1 billion Btn 50%-66% later 1990’s 2000. Decreased in recent of gross lending 33% of gross 50 billion DKK in years lending 2000 Loans for 74,258 in 2000 Increase in Average of Loans for house House recent years approx 1.1 million purchase has been Purchase due to positive since mid 1990’s declining since 1994 conditions in the Economy Industry No of lenders 11 Association Council of 8 Mortgage Banks German Mortgage Structure Hipotecaria Mortgage Lenders represented by Federation has 24 Espanola has has 118 members Association of Danish members 42 members accounting for Mortgage Banks accounting for 98% of market accounting for 90% of 80% of market market Type of -Retail Banks -Banks -Building -Mortgage Banks - Mortgage Banks lenders -Building -Savings Banks Societies which are Ltd - Savings banks Societies -Co-operative -non-mutual companies -Commercial banks -domestic Banks institutions lender -Mutual institutions Regulation -mostly Main Financial Services -Mortgage Credit Act; Banking practice regulated by authorities: Authority which stipulates that regulated by Central Bank -Bank of Spain is single regulator mortgage banks are “Bundesaufsichtsamt of Ireland -Ministry of for financial subjected to fur das Kreditwesen” -Consumer Economy services. supervision from the Credit Act Lenders regulated Finanstilsynet which (19950 by this however is an independent which states intermediaries are authority under that: not. Ministry of Economic 1) Bans Responsibility Affairs consolidation redemption will include: Act. fees for -mortgage Their job is to ensure variable rate advertising that regulations of the mortgages -a standard Mortgage Credit Act 2) Information disclosure regime are met with. requirements -common must be disclosure specified -compensation 3) APR arrangements regulations must be specified 4) Rules for advertising and restrictions on contacting the consumer must be specified. Funding Mortgage -retail funds -deposits -retail funds Mortgages Funded in -wholesale -other retail -wholesale 4 types of Bonds:
Appendices Mortgage Loan Minimum Standards Manual
markets funds markets - Long Term Fixed Interested - Index - Short Term fixed- interested - Variable interested bonds Securitisation -outstanding -total number Value of issues of securitised of securitisation MBS was £13.4 assets worth worth 1.783 million (2000) approx €4.1bill billion pesetas (2001) Prospects Asset Covered -decrease in -Expected Securities Act recent times increase in sales enable issuance due to change of Mortgage by lenders of of investor’s Backed Securities mortgage views bonds Affordability Loan Ratios Average LTV Average LTV Average LTV Average LTV 80% Average LTV 70% 70-75% 70% 75% Regional High price High price Cost of entering levels in levels in cities London market Dublin have make them very most expensive caused urban unaffordable sprawl Purchase in extending tourist coastal outside Dublin zones also quite County expensive Welfare Public Scheme run by No public Assistance given State supports public (Safety Nets) government safety nets in to those on buildings (or provides Spain income support or subsidised buildings) support to unemployment by guaranteeing loans individuals in benefit extreme cases struggling to make mortgage payments Private Mortgage Some Mortgage Insurance Policy Protection institutions Payment available to cover Insurance a offer Protection against against unemployment legal unemployment illness or or accident and requirement or illness unemployment interest alterations insurance 1 Sources: European Mortgage Federation: Fact Sheets 2002, OECD Website and other sources.
Appendices Mortgage Loan Minimum Standards Manual
e: p e Bonds Euro in g a g arison Betweenarison Secured Mort p endix 8: Com endix 8: pp A
Appendices Mortgage Loan Minimum Standards Manual
) Continued ( e: p e Bonds Euro in g a g arison Betweenarison Secured Mort p endix 8: Com endix 8: pp A
Appendices
Glossary of Terms
Affordability Models. Lenders should not approve a mortgage unless they are satisfied that the customer has the ‘ability to repay’. A number of models are used to test this. The most frequently used ones are: Net Disposable Income (NDI) Debt Service Ratio (DSR) Payment to Income (PTI)
NDI: This model sets out to establish what ‘remains’ to live on each month after all taxes, social insurances, mortgage payments, other loan payments and an amount to cover each child are deducted from the gross income(s) of the customer(s). The actual interest rate is notionally increased in the model by 3% and by doing this the lender stress tests the customer’s continuing ability to repay in a rising interest rate environment. In order to qualify under this affordability measure the customer must have a minimum floor amount remaining for living expenses. This amount varies depending on whether the customer is married, single or a single parent.
Example: Gross income (per month) 4000 Deduct: taxes/social insurances 1000 other loans 300 mortgage* 600 children(2) 100 sub total 2000
net income to live on 2000
Floor limits – example - married 1200 single parent 900 single 600. In this example the net income is greater than the floor limit so the customer qualifies under the affordability test.
DSR and PTI: DSR and PTI are similar models in that they specify the maximum amount of net after tax monthly income available to meet mortgage repayment. If there are joint applicants then joint income is included. Depending on individual bank or government policies this can be in the range of 30% - 50%. A ‘residual or remainder’ amount must be available to live on. This is often = to or > than the mortgage repayment. This model also quantifies the maximum mortgage the monthly repayment will ‘buy’.
Example: Gross income (per month) 4000 Deduct: Tax 1000 Net income available 3000 Max mortgage repayment (40%) 1200 Net to live on/pay other loans/costs 1800 In this example the amount to live on is > than the mortgage payment so the customer qualifies for the mortgage.
Bibliography
Bibliography:
1. European Mortgage Federation (2002): “Mortgage Banks & The Mortgage Bond in Europe” 4th Edition 2. European Mortgage Federation (2002): “2002 Factsheets” 3. Federal National Mortgage Association (Fannie Mae) (March 2003): Annual Report 4. Sally Merril & Carol Robenhorst (Urban Instititute) (January 2003); “Developing Secondary Mortgage Markets in Southeast Europe: Assessment of the Mortgage Market in Bulgaria.” 5. Sally Merril & Carol Robenhorst (Urban Instititute) (January 2003); “Developing Secondary Mortgage Markets in Southeast Europe: Assessment of the Mortgage Market in Romania.” 6. Sally Merril & Carol Robenhorst (Urban Instititute) (January 2003); “Developing Secondary Mortgage Markets in Southeast Europe: Assessment of the Mortgage Market in Croatia 7. Deloitte Touche Tomatsu Emerging Markets Ltd (July 2003): “ Developing the Romanian Mortgage Market” 8. ESF (European Securitisation Forum) “A Framework for European Securitisation” 9. European Mortgage Federation Quarterly Review Magazine