Mortgage Credit Risks and Public Policy Robert M. Buckley Real Estate Advisor Housing Finance in Emerging Markets The World Bank Washington, DC March, 2003
Topics that will be discussed • What is involved with Mortgage Credit Risk? • Why Governments around the world care about it? • What Government and Financial Institutions do to deal with these Risks?
Mortgage Credit Risk: What is It? The Borrower does not fully honor the terms of the mortgage loan agreement for: Economic Political Fraudulent Motives
Why does the Government Care? While in many ways mortgages are simple contracts, in other ways they are quite complicated: • Long term transaction; and • One between a sophisticated or public Financial Institution (FI) and a family, often of modest means
What do Governments and FIs do about mortgage credit risk? They intervene in a number of ways: • They subsidize borrowers and lenders; • They insure them; and • They regulate the transactions.
Some simple charts to consider the Different Roles Vo Value V Mo H(V) H(V)1 M to t1 time
Points of interest in the Chart • Distance between V and M; • Intersections of V and M; • distance to and t1; and • pattern of M over time.
The Pattern of M: The most important Issue is Interest Rate Risk The M pattern drawn is for a full amortizing, fixed rate loan which for a borrower is often the best of all possible worlds.
Interest Rate Risk: Fixed Rate Loans B Rate Rm A Rd time 0 E(M)
Fixed Rates Loans and A Wrong Guess on the Course of Short Term rates: Losses Realized: The amount by which B>A B Rate Rm A A A Rd time 0 E(M)
Prepayment Risk can add to problems C B Rate Rm A A A Rd time 0 E(M) E(V)
The result is that: • Lenders vary interest rates over the course of loan; • Borrowers are subjected to other risks – which affect their willingness to pay and as a result the credit risk exposure; and • In unstable environments everyone can get “hit” at one time.
What affects the pattern of M? V Vo Value H(V) H(V)1 t0 t1 M M1 time
With Macro shocks… The credit risk in an unstable environment is intensified. When price falls and loan balances increase, the t0 the t1 area is much longer. In such cases economic risk can become political risk.
What, then, do lenders and borrowers do? • Lenders increase VM distance – i.e. ration credit • Borrowers (and lenders) receive subsidies to offset rationing; or • Insurance companies develop to address credit risks.
Table 1. Mortgage Insurance Terms and Implied Risk. Table 1. Mortgage Insurance Terms and Implied Risk. Examples of Insurance Company Terms and Implied Risks
Why do the terms vary so much across Countries? • Geographical risk; • Differences in legal recourse to house or borrower’s income; and • Some appear to have prices set at implicitly subsidized fees.
Geographical Diversification:Default Probability vs. House-Price Appreciationfor the US *State/Origination Year and National/Origination Year Cohorts (1985-1995) 80% Loan-to-Value, 30-Year Fixed Rate Home-Purchase Mortgage
Summary Dealing with mortgage risk effectively is important because: • It is the biggest financial risk most households ever take; under-diversified borrowers; • It is the most effective way for families to smooth life time consumption cycles because R is relatively low; relatively • When correctly done, it adds value to financial sectors balance sheets. Mortgages are good assets; and • When done incorrectly- including doing nothing at all -it can be very expensive policy.