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Basel Committee on Banking
Supervision, The Joint Forum
Review of the Differentiated
Nature and Scope of Financial Regulation
Key Issues and
Recommendations (January 2010)
Chapter 3
Mortgage Origination
I. Introduction
The Joint Forum believes that sound, consistent and
effective underwriting practices should apply to financial
products, regardless of the originating institution.
Problems arising from poorly underwritten residential mortgages
contributed significantly to the financial crisis.
Credit
was extended to consumers who did not have the ability to repay
under the loan terms, eg subprime mortgages in the United
States.
Although this was not a cross-sectoral problem
that is typical of the issues taken up by the Joint Forum, the
related securitisation of these mortgage loans did affect the
banking, securities, and insurance sectors globally.
Additionally, given that the majority of problem mortgage loan
products were originated by lightly regulated mortgage
companies, this issue is related to the review of the perimeter
of regulation, which is within the scope of this report.
Many of the issues emanating from the financial crisis, and more
specifically relating to mortgage-related structured products,
are being or have been addressed in other Joint Forum
initiatives as well as initiatives of other international fora,
including by the parent committees of the Joint Forum.
For example, IOSCO has undertaken several initiatives relating
to credit rating agencies,41 securitisation,42 and transparency
of structured products.
The Joint Forum does not,
therefore, focus on securitisation of mortgage loans or the sale
of securitisations.
Rather, the focus is on the
origination of mortgage loans, with the goal of providing
recommendations to promote safe and sound lending practices
appropriate for each country, thereby contributing to enhanced
residential mortgage quality and stability on a global basis.
II. Background
Until 2007, this decade was characterised by relatively
strong economic growth, low interest rates in many
jurisdictions, an abundance of liquidity, and increased lending
to consumers.
In a number of countries, housing and
mortgage markets expanded dramatically.
Additionally,
there was rapid expansion in the variety and number of mortgage
products and in related securitisation.
Lack of
discipline by market participants in several jurisdictions was
notable during this boom period.
As a result, growth in
mortgage loans, both relative to GDP and as a share of total
credit outstanding, rose significantly. In addition, home prices
increased substantially; and new, nontraditional mortgage
products designed to lower initial monthly payments increased as
a share of total mortgage loans.
When housing price
bubbles were suspected, it was not clear at what point a
system-wide response would be needed, especially given the
positive macroeconomic effect of increasing home values and
homeownership.
This evaluation was further complicated
by rising home values masking a number of poor underwriting
practices, particularly those designed to lower initial monthly
payments.
In several countries that experienced a surge
in mortgage lending and housing growth, most notably the United
States and the United Kingdom, lenders developed new, riskier
products that made use of relaxed product terms, liberal
underwriting, and increased lending to highrisk populations.
These developments eventually resulted in signifcant losses
for consumers and financial institutions alike.
However,
many other countries with sophisticated mortgage markets have
not experienced a significant degree of distress and some
countries did not experience such growth, for example, Germany
and Canada.
To better understand the differences, the
Joint Forum reviewed several countries.
A. United Kingdom
In the United Kingdom, total mortgage debt to GDP jumped
from 50 percent in 1997 to over 80 percent in 2007.
Measures of leverage relative to income (loan-to-income and
debt-to-income) rose.
Mortgage credit was extended to
borrowers with higher risk characteristics.
Those
borrowers previously would not have enjoyed access to such
credit, and an ever increasing number of mortgages was sold on
an “income non-verified” basis.
For example, in 2006 and
2007, 45 percent of loans were advanced on an “income
non-verified” basis.
Meanwhile, residential mortgage
lending shifted away from house purchase.
The buy-to-let
sector grew from small to significant proportions.
In
2007, the buy-to-let segment accounted for 26 percent of
mortgage lending.
That same year, mortgage equity
withdrawal, such as through home equity loans or lines of
credit, accounted for 39 percent of mortgage lending.
The
rapid extension of mortgage credit contributed to the expansion
of the UK property market.
This in turn further fueled
the demand for mortgages and homeownership as property
appreciated quickly in value.
In a rising property
market, lenders had reduced incentives to assess borrowers’
ability to repay their mortgage obligations.
And
mortgages with multiple high-risk features increased, such as
loans with greater than 95 percent loan-tovalue ratios, in
combination with terms exceeding 25 years or in combination with
greater than three times income multiples.
Another
feature in the UK mortgage market in the run-up to the crisis
was the rapid growth of a number of banks that, instead of
funding themselves with deposits or other stable sources of
funding, were increasingly reliant on the permanent availability
of large-scale interbank funding and/or on their continuous
ability to securitise and sell down credit assets, particularly
in the mortgage market.
B. United States
Concurrently, in the United States, multiple factors drove
the change to less traditional mortgages and less rigorous but
more expedient methods of closing loans.
As home prices
continued to appreciate, competition among lenders intensified,
and investors clamoured for higher yields, lenders responded by
offering nontraditional mortgage loan products to
address
affordability and made such loans available to a much wider and
often higher risk spectrum of borrowers.
Until reined in
by the regulatory community, lenders qualified borrowers based
on the low initial payments without considering their capacity
to perform on the higher payments necessary to amortise the
debt.
This significant weakness was further exacerbated
by excessive “risk layering,” which combined two or more liberal
underwriting characteristics.
Other common un-mitigated
risk factors included low/no documentation of income or assets,
low/no down-payments, and high debt-to-income levels.
In
addition, these more liberal underwriting practices were also
employed for investor loans, which typically warrant more
conservative standards.
The bulk of non-prime business
activity in the United States was conducted by state licensed
mortgage originators, who were not subject to stringent
supervisory oversight.
The practice of
securitisation,
notwithstanding its well documented benefits, appears to have
contributed to the weakening in underwriting practices as
mortgage originators were able to pass on to
investors much
of the risk from these loans.
Investors drove part of
this in their quest for yield and reliance on steady house price
appreciation, high credit ratings, and low historic losses on
mortgage credit.
During the boom period, underwriting
practices were increasingly loosened in pursuit of market share
and income, at the expense of prudent risk management and
controls.
The increased complexity of mortgage products
sometimes interacted with weakened incentives for sound
underwriting, to the detriment of the borrower.
C. Spain
The period from 2000 to 2007 was marked by the introduction
of the euro, low interest rates, and high demand for housing (eg
the monthly payment of a mortgage in late 90’s early 2000’s
could be below or shortly over the monthly payment of a rent).
Both home prices and construction volumes increased
dramatically over this period.
The mortgage market was
characterised by increasing competition, and there was some
relaxation of traditional underwriting practices.
Some
mortgage products that were new to the Spanish market were
introduced in this period, such as greater-than-80 percent
loan-to-value mortgages, along with a general use of additional
guarantees and/or mortgage insurance.
These products
provided easier access to credit for first-time home buyers.
Also becoming available were extended loan maturities, which
reduced borrowers’ monthly payments, but that would also be much
more sensitive to future increases of interest rate.
However, lenders in Spain have recourse to all the borrower’s
other assets and income if their mortgage loan goes to
foreclosure. Lenders primarily target prime borrowers, while
buyto- let mortgages represent a small portion of lending
volumes.
Loans without proper verification of income and
total debt of the borrower are extremely rare and only may be
granted for low loan-to-value loans, in very specific
circumstances.
Additionally, a number of legal procedures
prevent mortgages from being originated by a different type of
originator other than a registered credit institution.
D. Canada
Mortgage underwriting practices in Canada are generally
considered to be conservative relative to practices in other
countries. Deposit-taking financial institutions hold the bulk
of outstanding residential mortgage debt and securitisation
plays a relatively small role.
Loans with greater than
80
percent loan-to-value must have insurance, while all mortgages
that back the National Housing Act Mortgage-Backed Securities
Program also must be insured.
Mortgage insurance covers
the full amount of a loan, and the borrower pays the entire
insurance premium up front. If a mortgage loan goes to
foreclosure, the lender has full recourse to all the borrower’s
other assets and income.
E. Germany
Germany offers another contrast to the recent experience of
the United Kingdom and United States.
Even during the
early 1990s boom after German reunification, the country did not
experience significant house price increases.
There are
several possible reasons, including high transaction costs,
substantial prepayment penalties, and long-term financing
structures that discourage the frequent buying and selling of
properties.
Additionally, noncredit institutions are not
permitted to provide residential mortage loans.
III. Key issues and gaps
This report focuses on two fundamental areas of concern.
• Poor mortgage underwriting
practices: Problems arising from poorly underwritten
residential mortgages in certain countries contributed
significantly to the global financial crisis; indeed, the
securitisation and other structured financing of these mortgage
loans - which were purchased by a number of international
financial firms
- spread the problems of their poor
underwriting to the banking, securities, and insurance sectors
globally.
In contrast, prudent practices and sound and
comprehensive policies may have prevented market participants in
those countries that have not experienced a significant degree
of distress from engaging in the less disciplined underwriting
behaviour that was endemic in other, more troubled mortgage
markets.
• Mortgage originators
subject to differing supervision, regulation and enforcement
regimes for similar activities/products: Like most
aspects of the mortgage industry, the prevalence, role, and
supervision of nonbank credit intermediaries varies greatly
among the various mortgage markets.
Mortgage originators
range from the smallest individual mortgage brokers to large
international lenders.
They include lenders that provide
warehousing lines to fund loans on an interim basis, those that
structure the securitisations and market the securities, and
central banks and government-sponsored enterprises that
essentially make markets in mortgage loans.
In some
cases, the government closely controls the market through
explicit guarantees for the full balance of the loan, while in
others involvement is limited. The number of participants, the
variety of roles they play, and the differences among countries
are substantial, particularly given the patchwork approach to
the regulatory framework in many countries.
Such
differences created regulatory gaps that helped erode prudent
mortgage underwriting practices.
IV. Recommendations to promote consistent and effective
underwriting standards for mortgage origination
Because each country’s mortgage industry is shaped by
distinct real estate markets, cultural influences, and
socioeconomic policies, it would be challenging to construct a
single regulatory approach to mortgage underwriting standards.
To help prevent recurrences of the market disruption and
financial instability recently experienced, however, supervisors
should address issues in their respective mortgage markets to
achieve more consistent and more effective regulation of
mortgage activities.
Sound underwriting standards53 are
integral to ensuring viable, robust mortgage markets at the
local and global levels and may improve financial stability
notably when mortgages are securitised.
Systemic risk will
be reduced if mortgages are properly underwritten, ensuring that
borrowers have the capacity and economic incentive to honour
their commitments to retire the debt in a reasonable period of
time.
Indeed, by focusing on prudent underwriting,
supervisors can help institutions and markets avoid the
broad-based issues and disruptions experienced in recent years
and potentially help restore securitisation/structured finance
markets.54 Therefore, the Joint Forum recommends that
supervisors take the following actions:
Recommendation n° 7:
Supervisors should ensure that mortgage originators adopt
minimum underwriting standards that focus on an accurate
assessment of each borrower’s capacity to repay the obligation
in a reasonable period of time.
The minimum standards
adopted should be published and maintained in a manner
accessible to all interested parties.
Measuring a borrower’s ability and
willingness to repay: Standards should incorporate
requirements consistent with the following basic principles,
with guidelines and limits adjusted to reflect the
idiosyncrasies of the supervisors’ respective markets and
regulatory framework.
Effective
verification of income and financial information.
Capacity measurements, such as debt-to-income ratios, are
only as good as the accuracy and reasonableness of the inputs.
That is, the efficacy of debt-to-income ratios and other
capacity measures is dependent on stringent guidelines for
verifying a borrower’s income and employment, debt, and other
financial qualifications for repaying a mortgage.
When
lenders allow borrowers to claim unsubstantiated financial
information, or do not require such information, they undermine
underwriting policies and introduce additional credit risk as
well as expose themselves to fraud.
Supervisors should
therefore generally require lenders to verify information
submitted for mortgage qualification.
There also should
be penalties for borrowers and other originators who
misrepresent such information.
Reasonable debt service coverage.
One of the most fundamental components of prudent underwriting
for any product that relies on income to service the debt is an
accurate assessment of the adequacy of a consumer’s income,
taking into account all debt commitments.
These
assessments and calculations should accurately capture all debt
payments, and any exclusions should be well controlled.
The assessment also should ensure sufficient discretionary
income to meet recurring obligations and living expenses.
Supervisors should adopt appropriate standards to ensure
reasonable debt-to-income coverage for mortgages.
As a
secondary capacity test, supervisors should consider appropriate
standards regarding incometo- loan amount (eg loan amount should
generally not exceed a particular multiple of annual earnings).
Realistic qualifying mortgage
payments.
At least in the United States, there
was a proliferation of mortgage products with lower monthly
payments for an initial period that were to be offset by higher
monthly payments later (eg “teaser rate” mortgages, “2/28”
adjustable rate mortgages, payment option mortgages).
In
some cases, the initial monthly payments were much lower than
the payments scheduled for later.
Many lenders determined
whether a borrower qualified for a mortgage by calculating the
debt-to-income ratio using only the reduced initial monthly
payment, without taking into account the increase in that
payment that would occur later.
When house prices
stopped appreciating, and then declined, borrowers could no
longer refinance loans and very often could not afford the
mortgage payment once it reset to a higher rate.
To
address this problem, underwriting standards should require that
the analysis of a borrower’s repayment capacity be based on a
mortgage payment amount sufficient to repay the debt by the
final maturity of the loan at the fully indexed rate, assuming a
fully amortising repayment schedule.
Any potential for
negative amortisation should be included in the total loan
amount used in the calculation.
Appropriate loan-to-value ratios.
Supervisors should adopt appropriate standards for loan-to-value
(LTV) ratios.
Equity requirements should address loan
underwriting in the form of both minimum down payments and caps
on subsequent equity extraction through cash-out refinancing and
other types of home equity borrowing.
Meaningful initial
down-payment requirements help validate borrower capacity as
well as ensure necessary commitment to the obligation. Equity
extraction limitations contribute to housing market stability,
deter irresponsible financial behaviour that puts homes at risk,
and promote savings through equity build.
They
effectively limit the fallout associated with unfettered
“monetization” of the equity gained during periods of rapid home
price appreciation, especially since that appreciation may not
prove sustainable.
However, while LTV limits help
control the lender’s loss exposure upon default, they should not
be relied on exclusively because they are not a substitute for
ensuring the paying capacity of the borrower.
Effective appraisal management.
The LTV measure relies on sound real estate values.
If lenders assign unsubstantiated values to mortgage
collateral, the effectiveness of LTV thresholds or minimum down
payments is significantly diminished.
Therefore,
supervisors should ensure the adoption of and adherence to sound
appraisal/valuation management guidelines, including the
necessary level of independence.
No
reliance on house appreciation.
Lenders should not consider future house price appreciation as a
factor in determining the ability of a borrower to repay a
mortgage.
Other factors important
to an effective underwriting program:
The
following are not substitutes for sound underwriting practices
but should be taken into consideration when determining the
soundness of an underwriting program.
Mortgage insurance.
Mortgage insurance provides additional financing flexibility for
lenders and consumers, and supervisors should consider how to
use such coverage effectively in conjunction with LTV
requirements to meet housing goals and needs in their respective
markets.
Supervisors should explore both public and
private options (including creditworthiness and reserve
requirements), and should take steps to require adequate
mortgage insurance in instances of high LTV lending (eg greater
than 80 percent LTV).
Recourse.
Individual financial responsibility is critical to ensuring the
smooth functioning of the mortgage market for all participants.
Consequently, mortgage loans should be backed by full
recourse to the borrower.
Recommendation n° 8:
Policymakers should ensure that different types of mortgage
providers, whether or not currently regulated, are subject to
consistent mortgage underwriting standards, and consistent
regulatory oversight and enforcement to implement such
standards.
The goal is to ensure that similar products
and activities are subject to consistent regulation, standards,
and examination, regardless of where conducted.
The role
of mortgage participants should be clear, and they should be
subject to appropriate and consistent levels of regulatory
oversight and enforcement.
Any framework should include
provisions for ongoing and effective communication among
supervisors.
The lines of supervision must be clearly
drawn and effectively enforced for all market participants.
The Joint Forum recognizes that this recommendation presents
many challenges because it requires changes to some countries’
legal and supervisory regimes.
Nevertheless, the
importance of the goal of consistent underwriting standards
makes these changes worthwhile.
Recommendation n° 9:
National policymakers should establish appropriate public
disclosure of market-wide mortgage underwriting practices.
In addition, the Financial Stability Board should consider
establishing a process to review sound underwriting practices
and the results should be disclosed.
While there are
efforts under way in some parts of the world to harmonise
mortgage lending practices across borders, this is a longer term
challenge given the differences in mortgage markets.
However, these individual markets can be evaluated to determine
the overall adequacy of underwriting practices and mortgage
market trends.
To address this recommendation and to have
an international effect, the following should occur:
•
Countries should have adequate public disclosure that includes
dissemination of information concerning the health of their
mortgage market, including underwriting practices and market
trends, encompassing all mortgage market participants.
•
The Financial Stability Board should consider establishing a
process to periodically review countries against the sound
mortgage underwriting practices noted in recommendation 7, and
the results should be made publicly available.
The goal
is to evaluate the soundness of mortgage practices overall
rather than to evaluate individual components.
For
example, a country with high LTV limits may mitigate the risk
through more stringent debt-to-income or other capacity limits.
The review process would consider the level of risk
posed by the underwriting criteria as a whole rather than focus
solely on the high LTV limits.
The review may also
consider underwriting in light of macroeconomic conditions,
including evolution of housing prices, interest rate levels,
total mortgage debt to gross domestic product, and reliance on
various funding mechanisms.
• The Financial Stability
Board should consider monitoring the health of the mortgage
market (eg country volumes, funding needs, bond performance) to
highlight emerging trends and to consider recommending
adjustments or changes as warranted.
Basel Committee on
Banking Supervision, The Joint Forum
Review of the Differentiated
Nature and Scope of Financial Regulation
Key Issues and
Recommendations (January 2010)
Conglomerates
- Part 1:
Introduction, Mandate, Focus and guiding principles of this study,
Key issues and gaps
Conglomerates - Part 2:
Supervision and regulation of financial groups. Mortgage
origination. Hedge funds
Conglomerates - Part 3:
Recommendations and options for effective and consistent
financial regulation across sectors. Reducing key regulatory
differences across the banking, securities, and insurance sectors.
Strengthening supervision and regulation of financial groups.
Promoting consistent and effective underwriting standards for
mortgage origination. Broadening the scope of regulation to hedge
fund activities
Conglomerates - Part 4:
Strengthening regulatory oversight of credit risk transfer
products. Key differences in regulation across the banking,
securities, and insurance sectors.
Background and approach adopted by the Joint Forum. Key issues
and gaps
Conglomerates - Part 5:
Recommendations to reduce key differences in regulation across
the banking, securities, and insurance sectors. Supervision and
Regulation of Financial Groups. SPEs. Key issues and gaps.
Recommendations to strengthen supervision and regulation of
financial groups
Conglomerates - Part 6:
Mortgage Origination. United Kingdom, United States, Spain,
Canada, Germany. Key issues and gaps. Recommendations to promote
consistent and effective underwriting standards for mortgage
origination
Conglomerates - Part 7:
Hedge Funds. Key issues and gaps
Conglomerates - Part 8:
Recommendations and policy options to broaden the scope
of regulation to hedge fund activities.
Credit Risk Transfer Products.
Key issues and gaps common to both CDS and FG insurance (CDS -
Credit default swaps, FG - Financial guarantee)
Conglomerates - Part 9:
Key issues and gaps specific either to CDS or FG insurance.
Recommendations and policy options to strengthen regulatory
oversight of credit risk transfer products
Conglomerates - Part 10:
Annex 1-9
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