Regulatory Framework for Secondary Mortgage Markets

Britt GwinnerBritt Gwinner

The World BankThe World Bank

March 10-13, 2003March 10-13, 2003

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Outline Motivations to regulateMotivations to regulate Areas of regulationAreas of regulation Which regulatorWhich regulator Basel II as a framework, its impact on Basel II as a framework, its impact on

capital requirementscapital requirements International accounting standardsInternational accounting standards

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Why Regulate? Establish trust in the mortgage finance marketEstablish trust in the mortgage finance market Protect consumers – good disclosures, fair loan Protect consumers – good disclosures, fair loan

termsterms Protect & inform investors – against issuer Protect & inform investors – against issuer

bankruptcy, conflict of interest, fraudbankruptcy, conflict of interest, fraud Facilitate transactions and pricing with informationFacilitate transactions and pricing with information Preserve integrity of the financial systemPreserve integrity of the financial system Reduce transaction costs by establishing standards, Reduce transaction costs by establishing standards,

disclosuresdisclosures

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Clear, Detailed Disclosures

Consistent format – Consistent format – facilitate comparisonsfacilitate comparisons To borrowersTo borrowers – to understand the loan – to understand the loan

commitment, closing costs, prepayment feescommitment, closing costs, prepayment fees To investorsTo investors – Distinctions from traditional bonds – Distinctions from traditional bonds

– uncertainties of collateral cash flows – expected – uncertainties of collateral cash flows – expected default and prepayment ratesdefault and prepayment rates

About the issuerAbout the issuer – Complete financial statements, – Complete financial statements, loan & bond servicing capacityloan & bond servicing capacity

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Financial Regulations

Capital, liquidity, insider lending, underwriting Capital, liquidity, insider lending, underwriting quality, financial controls, servicing operationquality, financial controls, servicing operation

Trade-offs Trade-offs Between simple capital rules and adequate Between simple capital rules and adequate

reflection of riskreflection of risk Between simple and complex stress testingBetween simple and complex stress testing Simple and complex accounting disclosuresSimple and complex accounting disclosures

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Which Regulator?

Banking regulator, central bank, securities Banking regulator, central bank, securities regulatorregulator

Prevent regulatory arbitrage – i.e., tailoring charter Prevent regulatory arbitrage – i.e., tailoring charter or activities to seek looser rulesor activities to seek looser rules

Regardless of whether institution takes depositsRegardless of whether institution takes deposits Consistent rules for capital, liquidity, Consistent rules for capital, liquidity,

disclosures, insider lending disclosures, insider lending Focus on integrity of financial system, not just Focus on integrity of financial system, not just

safety of deposit holderssafety of deposit holders

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Basel Accord as a Framework

Internationally-agreed guidance for bank Internationally-agreed guidance for bank supervisors:supervisors: Capital adequacy, supervision, financial Capital adequacy, supervision, financial

disclosuresdisclosures Focus primarily on internationally active Focus primarily on internationally active

banksbanks Provide a standard for all credit Provide a standard for all credit

institutions institutions

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Basel II - Three Pillars

Minimum capital requirementMinimum capital requirement Improved link to specific risks Improved link to specific risks

Supervisory review processSupervisory review process Sound internal processes, risk Sound internal processes, risk

assessmentsassessments Market disciplineMarket discipline

Enhanced disclosures by banksEnhanced disclosures by banks

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Basel II Minimum Capital Approaches – Credit Risk StandardizedStandardized – Percentage risk weights, more – Percentage risk weights, more

categories than Basel I, may refer to external categories than Basel I, may refer to external ratings – easiest to apply in new mortgage marketsratings – easiest to apply in new mortgage markets

Internal Ratings Based (IRB)Internal Ratings Based (IRB) – Banks may use – Banks may use own credit assessments, subject to methodological own credit assessments, subject to methodological and disclosure standardsand disclosure standards Requires substantial data and analytic Requires substantial data and analytic

capabilitiescapabilities

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Standardized Approach-Retained Mortgages Retained residential mortgages carry a 40 Retained residential mortgages carry a 40

percent risk weightpercent risk weight For example,For example,

30 million mortgage portfolio30 million mortgage portfolio Capital Required = Capital Required =

0.96m = 30m * 0.40 * 0.080.96m = 30m * 0.40 * 0.08

Or, 3.2 percent of total portfolioOr, 3.2 percent of total portfolio

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Internal Ratings Based (IRB) Approach - Retained Mortgages Originator estimates Probability of Default (PD), Originator estimates Probability of Default (PD),

Loss Given Default (LGD), Exposure at Default Loss Given Default (LGD), Exposure at Default (EAD)(EAD)

Minimum standards for data history, system Minimum standards for data history, system quality, estimation models – non-existent in new quality, estimation models – non-existent in new mortgage marketsmortgage markets

An incentive to develop risk management - can An incentive to develop risk management - can substantially reduce capital requirement vis-à-vis substantially reduce capital requirement vis-à-vis standardized approachstandardized approach

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IRB Risk Weights-Retained Mortgages

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%

Probability of Default

Ris

k W

eig

ht

LGD 25%

LGD 80%

LGD 35%

LGD 50%

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Securitization SimplifiedIndividual Mortgages

AAA

A

Unrated

Credit Allocation

Sold to Pension Funds, Insurance Companies

Retained by Issuer

Pooled, Sold to SPV

(Also vertical slicing for maturity)

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Perennial Questions -Securitization

How does issuer produce earnings?How does issuer produce earnings?

In each securitization, how has issuer added In each securitization, how has issuer added value, where does the value appear?value, where does the value appear?

Should not see undue gains on sale of ‘A’ Should not see undue gains on sale of ‘A’ class, nor on retained tranches class, nor on retained tranches

Value can be accurately reflected in Value can be accurately reflected in accounting, capital requirementsaccounting, capital requirements

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Securitization Risks

Credit, Liquidity, Operational, Legal, Credit, Liquidity, Operational, Legal, Reputational; more leverage than Reputational; more leverage than appearances might implyappearances might imply

Complex issues – recently revised capital Complex issues – recently revised capital treatment under Basel II, IAS rules for treatment under Basel II, IAS rules for disclosuresdisclosures

Transparency is critical to credibilityTransparency is critical to credibility

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Issuer Responsibilities

Identify, measure, monitor, control the risks of the Identify, measure, monitor, control the risks of the business – disclose clearly to outsidersbusiness – disclose clearly to outsiders

Minimum capital requirements assume that Minimum capital requirements assume that management does their job correctlymanagement does their job correctly

Examinations and disclosures prove that Examinations and disclosures prove that management is soundmanagement is sound

Problem circumstances lead to supervisory Problem circumstances lead to supervisory actions, additional capitalactions, additional capital

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Taxation

Ensure that SPV is not taxable, not Ensure that SPV is not taxable, not considered to earn income – the true owners considered to earn income – the true owners of the assets are the investors, assure that of the assets are the investors, assure that interest is taxed no more than onceinterest is taxed no more than once

Eliminate fees/stamp duties on Eliminate fees/stamp duties on securitization process, documentssecuritization process, documents

Treat mortgage securities on even footing Treat mortgage securities on even footing with other fixed income securitieswith other fixed income securities

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Basel II on Securitization - Standardized Approach Investment grade securitized exposures Investment grade securitized exposures

receive risk weight by rating receive risk weight by rating Requires trusted, independent rating Requires trusted, independent rating

agencies agencies Another regulatory issueAnother regulatory issue

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Risk Weights Under Standardized ApproachRating

Originating Banks

Investing Banks

AAA ~ AA- 20%

A+ ~ AA- 50%

BBB+ ~ BBB- 100%

BB+ ~ BB- Deduction 350%

Below BB- Deduction

Long-term

rating

Unrated* Deduction

A1/P1 20%

A2/P2 50%

A3/P3 100%

Other ratings Deduction

Short-term

rating

Unrated Deduction Source: BIS

* Excepted for deduction is look-through treatment for unrated most senior securitization exposure.

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Standardized Approach Example

AssetsLiabilities & Capital

Liquid Inv 30 80 DebtMortgages 30Class B 20Sub Tranche 10I/O 5 15 Capital

95 95Nominal capital ratio 0.16

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Standardized Approach Example

Standardized Approach

Required Capital / Assets

Liquid Inv - Mtgs 0.96 0.03 Class B-rated AA 0.32 0.02 Subord. Tr. - Unrated 10.00 1.00 I/O -Unrated 5.00 1.00 Total Required Capital 16.28 0.17

Capital Requirements

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Internal Ratings Based (IRB) Approach IRB incorporates more information on IRB incorporates more information on

nature of collateral pool and security nature of collateral pool and security structurestructure

Highly granular collateral requires less Highly granular collateral requires less capital – highly granular means a relatively capital – highly granular means a relatively large number of small loans – N > 100large number of small loans – N > 100

Thick exposures require less capital – Thick exposures require less capital – thickness means relatively large and seniorthickness means relatively large and senior

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Risk Weights – IRB Approach

RatingRating Thick tranches – Thick tranches – highly granular poolshighly granular pools Base risk weightBase risk weight

Non granular Non granular collateralcollateral

AAAAAA 7%7% 12%12% 20%20%

AAAA 10%10% 15%15% 25%25%

AA 20%20% 35%35%

BBB+BBB+ 50%50%

BBBBBB 75%75%

BBB-BBB- 100%100%

BB+BB+ 250%250%

BBBB 425%425%

BB-BB- 650%650%Below & unratedBelow & unrated DeductionDeduction

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IRB Approach Example

Standardized Approach

Req Cap / Assets

Ratings Based Approach

Req Cap / Assets

Liquid Inv - - Mortgages 0.96 0.032 0.12 0.004 Class B-rated AA 0.32 0.016 0.16 0.008 Subord. Tr. - Unrated 10.00 1.000 10.00 1.000 I/O -Unrated 5.00 1.000 5.00 1.000 Total Req. Capital 16.28 0.171 15.28 0.161

Capital Requirements

Requirements drop dramatically for mortgages, AA tranche

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Accounting Issues

Reporting literature complexReporting literature complex Some areas of “emerging practice” existSome areas of “emerging practice” exist Key is clear disclosure of assumptions, Key is clear disclosure of assumptions,

risks to values and earnings as reportedrisks to values and earnings as reported

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International Accounting Standards (IAS) IAS 39IAS 39

Prescribes fair value treatment for many Prescribes fair value treatment for many financial instruments and derivatives – but still financial instruments and derivatives – but still calls for mixed attribute in some cases – calls for mixed attribute in some cases – historical cost plus fair valuehistorical cost plus fair value

Applicable for reporting periods starting 1/1/01Applicable for reporting periods starting 1/1/01 Weaker standard for sale v. financing than Weaker standard for sale v. financing than

Basel IIBasel II

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U.S. Securitization Shipwrecks – Superior Bank – August, 2001 Cost to U.S. government: estimated USD 500 Cost to U.S. government: estimated USD 500

million – big hit to deposit insurance fundmillion – big hit to deposit insurance fund Bought high credit risk mortgages, securitized, Bought high credit risk mortgages, securitized,

retained subordinated and I/O tranchesretained subordinated and I/O tranches Half of the bank’s assets were subordinated Half of the bank’s assets were subordinated

tranches or I/O stripstranches or I/O strips Defaults and prepayments rose, I/O strips Defaults and prepayments rose, I/O strips

evaporatedevaporated

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Superior Bank (continued)

Sophisticated investors, BoardSophisticated investors, Board Ignored the importance of underwritingIgnored the importance of underwriting Debate over accounting standards – an Debate over accounting standards – an

emerging practice area in U.S. GAAP & emerging practice area in U.S. GAAP & International Accounting StandardsInternational Accounting Standards

Auditors, regulator, rating agencies were all Auditors, regulator, rating agencies were all late in realizing the scope of the problemlate in realizing the scope of the problem

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Concluding Remarks

Mortgage finance requires robust requirements for Mortgage finance requires robust requirements for disclosures and risk managementdisclosures and risk management

In emerging markets, data restrictions and rating In emerging markets, data restrictions and rating agency limits likely to affect the use of more risk-agency limits likely to affect the use of more risk-sensitive capital measures such as IRBsensitive capital measures such as IRB

Regulators have their work cut out for them to Regulators have their work cut out for them to tailor Basel II and IAS rules to their marketstailor Basel II and IAS rules to their markets

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References

PapersPapers““The New Basel Capital Accord: An Explanatory Note”, Basel Committee on Banking Supervision, Bank for International The New Basel Capital Accord: An Explanatory Note”, Basel Committee on Banking Supervision, Bank for International

Settlements, January, 2001Settlements, January, 2001

““Consultative Document; The New Basel Capital Accord”, Basel Committee on Banking Supervision, Bank for Consultative Document; The New Basel Capital Accord”, Basel Committee on Banking Supervision, Bank for International Settlements, January, 2001International Settlements, January, 2001

““Second Working Paper on Securitization”, Basel Committee on Banking Supervision, Bank for International Settlements, Second Working Paper on Securitization”, Basel Committee on Banking Supervision, Bank for International Settlements, October, 2002October, 2002

““Quantitative Impact Study 3 , Technical Guidance”, Basel Committee on Banking Supervision, Bank for International Quantitative Impact Study 3 , Technical Guidance”, Basel Committee on Banking Supervision, Bank for International Settlements, October, 2002Settlements, October, 2002

““The New Basel Capital Accord – Quantitative Impact Study 3 and Working Paper 2”, comments by the European The New Basel Capital Accord – Quantitative Impact Study 3 and Working Paper 2”, comments by the European Securitisation Forum, the American Securitization Forum, The International Swaps and Derivatives Association, the Securitisation Forum, the American Securitization Forum, The International Swaps and Derivatives Association, the International Association of Credit Portfolio Managers, January 13, 2003International Association of Credit Portfolio Managers, January 13, 2003

Web SitesWeb SitesBank for International Settlements: Bank for International Settlements: www.bis.orgwww.bis.org

U.S. Federal Reserve: U.S. Federal Reserve: www.federalreserve.govwww.federalreserve.gov

British Bankers Association: British Bankers Association: www.bba.org.ukwww.bba.org.uk

European Securitisation Forum: European Securitisation Forum: www.europeansecuritisation.comwww.europeansecuritisation.com