1. 1 Mortgage Credit Risks and Public Policy Robert M. Buckley Real Estate Advisor Housing Finance in Emerging Markets The World Bank Washington, DC March, 2003

2. 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. 3 Mortgage Credit Risk: What is It? The Borrower does not fully honor the terms of the mortgage loan agreement for: Economic Political Fraudulent Motives

4. 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. 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. 6 VoVo V H(V) H(V) 1 toto t1t1 M MoMo time Some simple charts to consider the Different Roles Value

7. 7 Points of interest in the Chart Distance between V and M; Intersections of V and M; distance t o and t 1 ; and pattern of M over time.

8. 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. 9 time B A E(M) RmRm RdRd Interest Rate Risk: Fixed Rate Loans 0 Rate

10. 10 A E(M) RmRm RdRd 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. 11 A E(M) RmRm RdRd A E(V) Prepayment Risk can add to problems A B C time Rate 0

12. 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. 13 What affects the pattern of M? V MM1M1 t1t1 time VoVo H(V) H(V) 1 Value t0t0

14. 14 With Macro shocks … The credit risk in an unstable environment is intensified. When price falls and loan balances increase, the t 0 the t 1 area is much longer. In such cases economic risk can become political risk.

15. 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.

16. Table 1. Mortgage Insurance Terms and Implied Risk. Table 1. Mortgage Insurance Terms and Implied Risk. 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 Canada573.75%0%100%95%2.3%9 Estonia103 – 3.5%0%24%90%4%3 France282%0.15%100%100%>3.4%6 Kazakhstan204%0%20%85%2.6%8 Latvia20%1%22%90%18.8%1 Lithuania (old program) 127.78%0%100%95%5.8%2 Netherlands2270.3%0%100%100%>1.4%11 Sweden (old stock) 0%0.5%30%100%>0%12 Sweden (new stock) 62.50%0.5%30%100%>1.66%10 USA (FIs) 330%0.07%100%80%3.1%7 USA (Private Insurance) 11.20%0.5%20 – 30% 95%3.8%4 USA (Public Insurance) 251.5%0.5%100%97%3.5%5

17. 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. 18 Geographical Diversification: Default Probability vs. House-Price Appreciation for the US *State/Origination Year and National/Origination Year Cohorts (1985-1995) 80% Loan-to-Value, 30-Year Fixed Rate Home-Purchase Mortgage

19. 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.