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Mortgage Credit Risks and Public Policy

Robert M. BuckleyReal Estate Advisor

Housing Finance in Emerging Markets

The World Bank

Washington, DC

March, 2003

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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?

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Mortgage Credit Risk: What is It?

The Borrower does not fully honor the terms of the mortgage loan agreement for:

EconomicPolitical

FraudulentMotives

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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

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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.

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Vo

V

H(V)

H(V)1

to t1

M

Mo

time

Some simple charts to consider the Different Roles

Valu

e

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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.

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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.

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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

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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.

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What affects the pattern of M?

V

M M1t1 time

Vo

H(V)

H(V)1

Valu

e

t0

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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.

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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

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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.

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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

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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.