Key Policy and Regulatory Issues for Credit Insurance and Guarantee Schemes

1. Housing Finance in Emerging Markets Key Policy and Regulatory Issuesfor Credit Insurance and Guarantee Schemes The World BankWashington, D.C.March 12, 2003

2. Mortgage default insurance for emerging markets • Definition and purpose • Types of risk assumed • Preconditions for success • Regulatory framework • Sponsorship and implementation

3. Definition Mortgage default insurance (MI) is a specialized form of credit insurance that protects home mortgage lenders and investors against loss by reason of borrower default Distinguishing characteristics • Unique insurance hazard • Longer exposure period • Longer loss cycle • Dominant influence of government/economic policies

4. Purpose and benefits • Expand affordability – increase homeownership • Increase home construction/economic activity • Induce liberalized loan underwriting/stimulate direct lending • Expedite flow of funds from secondary/capital markets • Boost investor confidence • Increase market liquidity • Improve market efficiency/credit risk management • Upgrade physical housing standards MI is not a subsidy, does not reduce directly cost of homeownership

5. Types of risk assumed • Borrower inability to repay • Borrower unwillingness to repay • Substandard property valuation • Loss of individual home market value • Real estate market risk • Mortgage instrument risk • Agent risk / adverse risk selection • Local/regional recession • Economic catastrophe

6. Default risks that may be excluded • Failure to recover property after default • Failure to establish clear property title • Physical damage to property • Fraud • Loan administrator performance failure • Natural disaster* • Environmental risk* • Political risk* *Uninsurable risks may be covered by a backup government guaranty

7. Preconditions for success • Functional primary mortgage market • Reasonable, economic, and political stability • Contract enforceability (“rule of law”) • Data availability (mortgage, credit, and property) • Functional system for transferring, recording real property titlesand liens (reliability, cost) • Lender competence in loan underwriting and administration • Effective banking supervision • Credit and homeownership “culture”

8. Preconditions for success • Functional home resale and rental housing markets • If condominium lending, functional condo governance regulations • Functional insurance regulation • Competent regulator • Specialized mortgage default insurance regulation • Market justification and need • Lender motivation/borrower acceptance • Threshold business volume

9. Regulatory framework • Specialized insurance regulation needed • Risk-based capital/catastrophic loss reserve • Segregation of capital reserves – “monoline” charter • “Conflict of interest” provisions to assure underwriting independence • Premium rebates prohibited • Underwriting, coverage, and risk concentration limits • “Case basis” loss reserves for insured NPAs • Approval of rates and contract forms • Banking regulator recognition of MI • Risk-based capital credit (incentive) • Deter “adverse risk selection” (mandate)

10. Sponsorship and implementation • Government versus private sponsorship • Many governments unprepared to become MIs • Problems with government guaranty program versus actuarially-based insurance • “Moral hazard”/political interference • Government support roles short of outright sponsorship • Compatible direct/targeted subsidies • Regulatory incentives/mandates • Tax breaks • Reinsurance/risk sharing • Catastrophic risk backup • Shared government sponsorship with sunset provision

11. Sponsorship and implementation • Domestic versus foreign sponsorship • Must consider secondary investor requirements • Type of investment rating needed (claims-paying capacity) • Ability to attract adequate risk capital (see prerequisite conditions) • Possible-shared sponsorship (including international development bank?) • Domestic sponsorship with foreign reinsurance • Lenders as possible co-sponsors

12. What type of MI program? • Critical features • Shared risk with originating lenders • Full coverage to secondary investors • Clear LTV, mortgage instrument, owner-occupancy standards • Built-in features to avoid adverse risk selection, moral hazard • Actuarially-based premiums • Clear definition of default, collateral recovery as precondition to claims • Investment grade rating for claims-paying capacity

13. Sponsorship and implementation • Role of regulator • Insurance regulator should assume lead role • Work with market participants, elected officials, possible applicant, to establish monoline MI regulations • Manage initial charter approval, including review of business plan • Establish method and ability to assure that proposed rates are adequate, not excessive • Banking regulation should play secondary role governing lender use of qualified MI programs Risk-based capital rules for mortgage lenders and insurers should be rationalized to avoid “regulatory arbitrage”

14. Sponsorship and implementation • “Franchise value” • A private sponsor – domestic or foreign – that sinks substantial long-term MI risk capital into an emerging national market will look for some comfort that the “franchise value” of its investment will be reasonably secure during its startup years • In a small national market that will support just one MI provider (public or private), need to avoid monopolistic behavior

15. Thailand • Macroeconomic conditions • Recovery strengthening in 2002-03 after post-1997 crisis period of weaknesses, uncertainty • Continued high NPA rates overhang banking and housing sectors • Housing and mortgage markets • Relatively small: Estimated annual demand = about 128,000 units • Annual residential originations: about $US3 billion • Housing and homeownership • Stock is plentiful, diverse, moderately priced relative to incomes • Active urban rental market; home resale market developing • Homeownership rate >50% in greater Bangkok; >75% nationwide

16. Thailand • Mortgage financing system • Serving existing needs rather well • Capable lenders with competitive loan products serving wide range of homeowners • Home mortgage origination, including cost of title transfers, lien registration, working well • Abundant funds available from primary lenders at modest rates • Prevailing mortgage instruments volatile, risky • Homeownership impediments • Cash down payment accumulation • Many lenders reluctant to serve lower income borrowers • Relative to other countries, homeownership is quite accessible

17. Thailand • Secondary market • Secondary Market Corporation (SMC) poised to become active • Excess bank liquidity (temporary?) means little demand for secondary sources of capital • Market acceptance of MI • Lenders, other market participants see MI as useful, say borrowers will pay reasonable MI premium for access to homeownership • Banks are already making many high LTV (90%+) loans uninsured • MI market penetration may depend on: • End of excess bank liquidity/need for secondary market access • Rising losses on recent uninsured loan portfolios • Regulatory action creating incentives and/or mandates for use of MI on high LTV loans

18. Thailand • Low-income lending • MI can do little to induce bank “down market” • Some cooperative lenders already serving lower income borrowers may serve more with use of MI • Mortgage credit quality: Many “positives”; a few “doubtfuls” • Many lenders originate and administer home loan competently • New Thai Credit Bureau moving toward high level of credit reporting capability, driven by consumer lending • Non-housing debt levels appear rather high; concept of “back ratio” (total debt burden) not well established in home loan underwriting • Property valuations are improving; full confidence not yet warranted

19. Thailand • Data availability, including historical loan level data, is remarkably rich, at least for Government Housing Bank (GHB) portfolio • Standardized documentation not yet achieved, but Thai Housing Finance Association has begun to address • “Borrower culture”: Financial obligations – especially car and home loans – are taken seriously. Some “stretching the truth” on loan applications. • Borrower equity, essential to establishing true LTV and related risk, needs better documentation. Same is true for owner occupancy. • “Restructured” NPAs: A large, though declining share of portfolios. To avoid recognition of default and final write-off, too many NPAs are restructured as “current,” only to re-default later.

20. Thailand • Legal and regulatory issues • Non-Life Insurance Act does not recognize any form of credit insurance. A new section is needed to cover credit insurance, financial guaranty, and mortgage default insurance, with special MI provisions as noted above • Banking regulation needs regulatory incentive (risk-based capital credit) and/or mandate for use of MI on high LTV ratio loans to assure threshold volume and financial solidity • Foreclosure laws and procedures entail excessive costs and time delays. Reforms are needed that will enable most home loan foreclosures to bypass full judicial procedures, while retaining essential consumer protections.

21. Without regulatory support: Market penetration 5-10% Annual MI $volume $150-$350MM • With regulatory support: Market penetration 25-33% Annual MI $volume $750MM-$1.2BB Thailand • Estimated potential MI market penetration/volume

22. Thailand • Implementing MI • Thai government not inclined to be a direct sponsor • Legislative and regulatory action to expedite creation of MI entity is needed • Hybrid sponsorship (e.g., public-private, domestic-foreign)a possibility • Enlisting foreign expertise can accelerate implementation • Conclusion • MI is close to full feasibility in Thailand • Market functions reasonably well without MI • MI is key component to developing secondary market • Achieving threshold MI volume, even with regulatory support, could be a challenge