Housing Finance in Emerging Markets: Functions, Instruments and Risks

1. Housing Finance in Emerging Markets: Functions, Instruments and Risks Conference: Housing Finance in Emerging Markets: Policy and Regulatory Challenges The World Bank, Washington D.C. 10 March, 2003 Presented by: Dr. Michael Lea President of Countrywide International Consulting Services

2. Outline of Presentation • Discussion of the Organization and Economics of the Housing Finance Business • Overview of the Key Functions of Housing Finance • Brief Review of Mortgage Instruments and Mechanisms for Funding • Identification of Basic Risks, How They Can Be Managed, and How Policies Can Reduce Risk for Housing Finance Providers

3. Economics of Mortgage Lending

4. Goals of the Mortgage Lending Business • Maximize Value of Franchise (ROE) • All Other Goals Contribute to the First • Customer satisfaction • Employee motivation • Investor confidence • Regulator and policy maker confidence • Constraints • Market (competitive product, input markets) • Risk (tolerance for variation in ROE) • In particular, the ability to manage interest rate risk

5. Bundled Mortgage Finance Model Originate Portfolio Lender Service Borrowers Manage Risk Deposits Bonds Fund

6. Portfolio Lending Perspective • Mortgage As a Core Portfolio Asset • Focus on Spread Between Mortgage and Funding Yields • Must be sufficient to cover costs of origination and servicing, compensate for expected losses and provide a sufficient return on equity • Spreads Vary Widely in Relation to Risk, Competitive Environment, Costs of Doing Business, Inflation • Mortgage As a Key Customer Relationship Product • Creates long term relationship that can facilitate cross-selling of other financial products • May lead to loss-leader pricing

7. Strengths Personalized service Same entity is originator and servicer Ability to cross-sell other financial services Permanent funding source (depositories) Incentive compatibility in controlling credit risk Originator takes default risk Weaknesses Liquidity and interest rate risk mgt. difficult Borrowers want long, depositors seek short duration Operating Efficiency May Be Low One entity does wide variety of diverse functions Less incentives for quality control Competition May Be Weak Lenders limited to those with permanent funding Strengths and Weaknesses of the Portfolio Model

8. Functional Perspective • Mortgage Lending Functions Viewed As Separate Businesses • Goal Within Each Business Is Maximization of Shareholder Wealth • Integrated Lenders Can Treat Each Function As a Stand Alone Business • Allocate risk capital to each business line and require separate reporting of results • Eliminate hidden cross-subsidies

9. Unbundled Mortgage Finance Investor (Final or Conduit) Retail Mortgage Bank Correspondent Lender Servicer Borrower Wholesale Mortgage Bank Mortgage Insurer Borrower Mortgage Broker Portfolio Lender Functions: Marketing Financial Risk Mgt. Servicing Underwriting Packaging Warehousing, Pooling Credit Risk Management

10. Strengths Specialization Creates Incentives for Cost Minimization, Innovation Funding Through Sale of Assets Exerts Market Discipline Can’t bury “mistakes” in the portfolio Incentives for higher quality underwriting, servicing Better Interest Rate Risk Management Mortgage securities with different durations sold to investors best equipped Weaknesses Agency Problems From Having Many Entities Involved in Lending Process Investors must monitor originators & servicers, increasing cost Conduits May Have Excessive Market Power Risks May Be Overly Concentrated As Well Need to Maintain Higher Quality Standards Increases Cost and Technology Spend Strengths and Weaknesses of the Unbundled System

11. Key Drivers of Profitability • Competitive Environment • Does mortgage pricing cover cost, risk? Do lenders have pricing power in the market? Are there barriers to entry to new lenders? • Volume • Can lenders generate sufficient scale to cover fixed costs? • Is there an ability to manage volume variability • Cut costs in slow downs, raise margins in up turns • Funding • Access to competitive funding source (e.g., can wholesale-funded lenders compete with retail-funded lenders?)

12. Key Drivers of Profitability • Understanding and Managing Risk • A function of the volatility of the economy, legal and regulatory infrastructure, adequacy of consumer information • Management expertise a critical ingredient • Access to data, markets for re-distributing risk • Understanding the Customer • Are they driven by price, service, product • Identifying profitable customers • Ability to cross sell • Understanding the Business • Do managers and employees have access to the right information, at the right time, to do their jobs effectively

13. Origination

14. Origination Functions • Marketing • Counseling • Taking Application • Locking Prices • Processing • Underwriting • Funding and Closing

15. Important Steps in Origination • Take the application in branch, via the internet, telemarketing or remote loan officer applications • Point of sale emphasis in developed systems • Collect data on employment, deposits, income, credit, assets and liabilities • Centralized credit bureau an important component of modern mortgage markets • Electronic credit information facilitates automated underwriting • Order property valuation to determine market value and condition of collateral • Importance of professional, independent appraisers • Necessity of property value and characteristic databases • Facilitates Automated (Statistical) Property Valuation • Provide proper disclosures (cost and terms of credit, conditions for providing loan etc.) • Consumer regulation a major issue in developed markets

16. Underwriting • Principles • Character: Credit history, regard to obligations, debt use, employment stability • Capacity: Ability to make payment, cash for the purchase and reserves, other assets • Collateral: Value and condition of property, LTV • Compensating Factors: mortgage insurance, counseling, co-signers, large down payment, rental history • Procedures • Verify accuracy of application information • Confirm the loan meets specific lender or investor guidelines • Lock in interest rate and loan terms

17. Automated Underwriting and Credit Scoring • Credit Reports and Credit Scoring are used to determine credit stability and allow instant feedback on credit quality • Credit scoring is a statistical modeling technique that evaluates the degree of risk posed by a prospective borrower or existing customer • Automated Underwriting combines credit reports and scoring, loan program and pricing information to approve loan at point of sale or refer to underwriter • Assumes past performance of like borrowers profile can predict future performance

18. Closing • Major Contributor to Time and Risk in Origination • Functions • Verify clear title, occupancy permits, etc. • Confirm final terms of the loan and remaining conditions; List all fees and cash required for final payment • Verify insurance policies are active • Prepare all necessary legal documents and obtain signatures (notary) • Transfer cash to appropriate parties • Ensure that property transfer and liens are properly recorded • Delivery of documents and file to servicer

19. Risks in Origination Process • Credit Risk: Non-verification of borrower ability and willingness to pay can contribute to higher default rates • Fraud: Misleading or inaccurate information provided by appraiser, guarantor, credit information provider • Agency Risk: Third party does not follow guidelines of principal (e.g. broker, appraiser, attorney) • Commitment Risk: The risk that an interest rate commitment (“rate lock”) is offered on a loan but the lender cannot earn an adequate sales price to cover the costs of providing the commitment. • Pipeline Risk: The risk that a closed loan will change in value between the time of closing and shipment to an investor. • Documentation Risk: The risk that a closed loan is underwritten improperly and does not conform to the investor’s requirements. • Cost Control: Managing loan volume variability and fixed costs of production (branches, permanent staff)

20. Managing Risk in Origination • Automating the Process • Electronic Applications • Reduces processing time/one time entry • Improves accuracy • Creates data base for later use • Facilitates flow of information through the various processing steps • Electronic Credit reports and Automated Underwriting • Increase accuracy • More objective underwriting • Improve the Flow of Information to Decision Makers • Activity-based reporting and costs • Quality control policies and procedures • Real time information on pipeline for funding, hedging • Convert Fixed Cost to Variable Cost • In US wholesale channel and commissioned loan officers are variable costs • Funding Through the Secondary Markets • Creates discipline for underwriting, documentation, quality control • Rating agency and investor review can lead to quality improvement

21. Servicing

22. File Set Up Quality Control Payment Processing Insurance and Tax Management Customer Service Document Control Collections/Loss Mitigation Processing Foreclosure/Bankruptcy Real Estate Management and Disposition Investor Accounting Functions of Servicing

23. Servicing Objectives • File Set Up: Fast, error free entry of new loan data/documents into the servicing system • Quality Control: Avoid losses by catching errors and fraud early; ensure proper documentation and adherence to investor guidelines (reduce probability of repurchase • Payment Processing: Focus on efficiency, avoid loss through error • Customer Service: Handle requests and maintain customer satisfaction and retention • Document Control: Protect lender’s security, efficient handling of documents • Collections: Avoid foreclosure and improve cure rate on delinquent loans • Foreclosure and Repossession: Minimize loss severity, liquidate property to recover as much value as possible • Taking the property is a last resort for lenders but the possibility has strong deterrent value • Investor Accounting: Ensure Accurate And Timely Disbursement Of Funds To Investor

24. Collections and Loss Mitigation • Early Stage Management Critically Important • Catching problems early may prevent defaults • Trick is to act quickly before borrower passes the point of no return • Newest approach: Take preventative action before trouble begins • Presort borrowers to identify those most likely to have payment problems using predictive scoring systems • High-risk borrowers given shorter leash, more labor-intensive servicing • Serious Arrears Costly: Timely Action Essential • Rising interest accruals • Legal fees • Property value and condition declines • Maintenance costs increase • Risk of economic downturn increase • Forbearance May Be Preferable to Foreclosure • Securitization may discourage forbearance

25. Default Management Process Evaluate Options Borrower Defaults Begin Foreclosure Obtain Title Market Property Continue Negotiations • Work out plan (forbearance) • Bring account current (waive late fees) • Recast rate or term • Forgive or capitalize interest in arrears • Refinance • Deed in lieu of foreclosure • Short sale • Foreclosure

26. Risks in Servicing • High Level Of Defaults/Delinquencies • May reflect poor underwriting, volatile economy, ineffective collection policies • Staff/Volume Imbalance - poor planning, managing loan volume variability (cost control) • Errors Made In Other Departments That “Come To Roost” In Servicing • Securitization focuses attention on servicing functions of reporting, documentation, performance • Fluctuations in Value of Servicing Asset • In secondary market system, servicing rights may be capitalized and held on the balance sheet. Value of servicing asset will vary with changes in interest rates, prepayment

27. Managing Risks in Servicing • Automation • Facilitates cost control, information flow for managers, investors; reduces incidence of errors • Data Collection and Analysis • Understanding default and prepayment based on analysis of portfolio • Pro-active collections can reduce default loss • Quality control procedures can reduce errors and improve efficiency • Cost Control • The “Loan Factory” – loan processing is a commodity business • Outsourcing

28. Loan Servicing Economics • In Secondary Market System a Profitable Business • Servicer receives fee (bp/month on outstanding balance) • Other sources of income: float, late fees, investment of escrow balances • Strong incentive to minimize costs (processing, arrears) • Portfolio lenders can turn servicing into a profit center as well • Transfer pricing and cost accounting

29. Mortgage Instruments

30. Mortgage Instruments • Two Instruments • Mortgage is pledge of property as security for an obligation • Promissory Note defines debt and makes borrower liable for obligation • Recording (Registration) of Mortgage • Not essential to validity of obligation • Protects mortgagee from subsequent acts of mortgagor

31. Mortgage Design • Design Objectives • Borrower affordability • Borrowers have diverse needs • Lender profitability • Instruments have different risk-return profiles • General Rule About Mortgage Design • Changing design to solve one problem always creates a new problem

32. Fixed Rate Mortgages • Fixed Rate Level Payment Mortgage • Works well in low inflation environment • Unanticipated inflation helps borrowers hurts lenders • Anticipated inflation leads to affordability problems (“tilt problem”) • Protects borrowers against interest rate risk • Graduated Payment Mortgages • Payments start low and rise over time • Improves affordability and partially offsets tilt • But lengthens duration and creates negative amortization • Reduces interest rate risk protection

33. Adjustable Rate Mortgages • Allows Lenders to Manage Moderate Inflation • Three Major Types • Discretionary: Determined by lender • Rollover: Short term, fixed rate periods during long term amortization • Indexed: Rate change tied to external rate • Transfers Interest Rate Risk to Borrowers • Better match for depository portfolio lenders • Higher credit risk due to potential payment shock

34. Indexed Mortgages • Conventional Mortgages Do Not Perform Well With High and Volatile Inflation • Mortgage Designs Must Balance Affordability and Profitability • Two Major Designs • PLAM (Price Level Adjusted Mortgage) • DIM (Dual Indexed Mortgage)

35. Indexed Mortgages (cont’d) • PLAM • Interest rate fixed at “real” rate • Payment and balance adjusted by price index • Works well if incomes and property values rise with inflation • Can lead to payment shock or negative equity if income or property values do not rise with inflation • DIM • Separates payment and accrual rates • Solves problem that incomes may not rise with inflation • Payment rates typically indexed to wages • Dangers of minimum wage indexing • But creates new problem • DIM may not amortize

36. New Mortgage Designs • Equity Release Mortgages • Allows elderly home owners to consume some or all of their equity • Borrowers receive payments in exchange for portion of equity or capital gains • Flexible Mortgages • Allow uneven repayment patterns • Integrated Mortgages • Link mortgage with checking account, savings accounts, insurance policies etc.

37. Funding and Risk Management

38. Funding Options • Deposits • Other Corporate Liabilities • Whole Loan Sales • Mortgage Bond Sales • Mortgage Security Sales • Liquidity Facilities

39. Funding Mortgage Assets • Maximize the Value of the Earning Asset Through Selection of the Lowest Cost Funding on a Risk Adjusted Basis • Portfolio Lenders: Maximize spread through mix of retail and wholesale funding of various terms and equity in accordance with risk management guidelines • Secondary Market Lenders: Best execution on sale of mortgage (maximum price upon sale) • Pricing incorporates target profit margin • Temporary lenders need warehouse funding

40. Financial Institution Risks • Credit Risk: Loss Due to Default on Loan Obligation • Liquidity Risk: Risk That the Money Will Be Needed Before It Is Due • Interest Rate Risk: Risk That Interest Rate Changes Will Affect the Value of Assets and Liabilities • Basis Risk: Risk that margins on assets and liabilities will vary over time

41. Financial Institution Risks: II • Prepayment Risk: Risk That Mortgage Will Be Repaid Earlier Than Scheduled • Inflation Risk: Risk That Unexpected Inflation Will Affect the Value of Assets and Liabilities • Foreign Exchange Risk: Risk That Movements in Exchange Rates Will Affect the Value of Assets And/or Liabilities

42. Financial Institution Risks: III • Operations Risk: Risk That the Organization, Controls, Information Systems and Technologies Are Inadequate to Safeguard the Institution • Agency Risk: Risk That an Agent or Intermediary Will Misuse the Funds • Political Risk: the Risk That the Legal and Political Framework Within Which the Lending Takes Place Will Change

43. Cushions to Absorb Risk • Equity Capital • Basel II will more explicitly link equity requirements and risk broadly defined • Managerial Controls and Policies • Must have an understanding of how interest rates impact balance sheet and income statement • Importance of data, measures • Must have policies regarding tolerance for and management of various risks • Portfolio Structure • Inflows and outflows of funds • Maturities and interest re-setting periods of assets and liabilities • Management Judgment

44. How Policy Makers Can Reduce Risk in Housing Finance • Origination • Centralized credit bureau • Centralized house price database • Accurate, efficient and low cost title and lien registration • Encourage competition • Stable economy • Servicing • Stable economy • Effective foreclosure regime • Funding • Stable economy • Strong and flexible regulatory system for institutions, instruments • Develop capital markets and sources of long term funding