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Regulatory Framework for Secondary Mortgage Markets
Britt GwinnerBritt Gwinner
The World BankThe World Bank
March 10-13, 2003March 10-13, 2003
2
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
3
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
4
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
5
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
6
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
7
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
9
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
10
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.
20
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
21
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
22
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
23
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
24
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
26
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
27
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
30
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