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1
Mortgage Credit Risks and Public Policy
Robert M. BuckleyReal Estate Advisor
Housing Finance in Emerging Markets
The World Bank
Washington, DC
March, 2003
2
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?
3
Mortgage Credit Risk: What is It?
The Borrower does not fully honor the terms of the mortgage loan agreement for:
EconomicPolitical
FraudulentMotives
4
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
5
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.
6
Vo
V
H(V)
H(V)1
to t1
M
Mo
time
Some simple charts to consider the Different Roles
Valu
e
7
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.
8
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.
9
time
B
A
E(M)
Rm
Rd
Interest Rate Risk: Fixed Rate Loans
0
Rate
10
A
E(M)
Rm
Rd
A
time
A
Fixed Rates Loans and A Wrong Guess on the Course of Short Term rates: Losses Realized: The amount
by which B>A
B
Rate
0
11
A
E(M)
Rm
Rd
A
E(V)
Prepayment Risk can add to problems
A
BC
time
Rate
0
12
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.
13
What affects the pattern of M?
V
M M1t1 time
Vo
H(V)
H(V)1
Valu
e
t0
14
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.
15
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.
Examples of Insurance Company Terms and Implied Risks
Insurance in force-to capital ratio
Premium as an upfront fee
Premium as annual interest payment
Claim coverage
Maximum loan to value ratio
Implied volatility
Rank
Canada 57 3.75% 0% 100% 95% 2.3% 9
Estonia 10 3 – 3.5% 0% 24% 90% 4% 3
France 28 2% 0.15% 100% 100%> 3.4% 6
Kazakhstan 20 4% 0% 20% 85% 2.6% 8
Latvia 2 0% 1% 22% 90% 18.8% 1
Lithuania (old program)
12 7.78% 0% 100% 95% 5.8% 2
Netherlands 227 0.3% 0% 100% 100%> 1.4% 11
Sweden (old stock)
0% 0.5% 30% 100%> 0% 12
Sweden (new stock)
62.5 0% 0.5% 30% 100%> 1.66% 10
USA(FIs)
33 0% 0.07% 100% 80% 3.1% 7
USA (Private
Insurance)
11.2 0% 0.5% 20 – 30%
95% 3.8% 4
USA (Public Insurance)
25 1.5% 0.5% 100% 97% 3.5% 5
17
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.
18
Geographical Diversification:Default Probability vs. House-Price Appreciation for
the US
NV 1985
HI 1994
AZ 1985
CA 1989
CA 1990
DC 1995
AK 1986
0%
5%
10%
15%
20%
25%
-30% 20% 70% 120%
5-Year Cumulative House-Price Appreciation
Cum
ula
tive
Def
ault
Rat
e
Individual States National
*State/Origination Year and National/Origination Year Cohorts (1985-1995) 80% Loan-to-Value, 30-Year Fixed Rate Home-Purchase Mortgage
19
Summary
Dealing with mortgage risk effectively is important because:
1. It is the biggest financial risk most households ever take; under-diversified borrowers;
2. It is the most effective way for families to smooth life time consumption cycles because R is relatively low; relatively
3. When correctly done, it adds value to financial sectors balance sheets. Mortgages are good assets; and
4. When done incorrectly- including doing nothing at all -it can be very expensive policy.