Regulatory Framework for Secondary Mortgage Markets Britt Gwinner The World Bank March 10-13, 2003

2 Outline Motivations to regulate Motivations to regulate Areas of regulation Areas of regulation Which regulator Which regulator Basel II as a framework, its impact on capital requirements Basel II as a framework, its impact on capital requirements International accounting standards International accounting standards

3 Why Regulate? Establish trust in the mortgage finance market Establish trust in the mortgage finance market Protect consumers – good disclosures, fair loan terms Protect consumers – good disclosures, fair loan terms Protect & inform investors – against issuer bankruptcy, conflict of interest, fraud Protect & inform investors – against issuer bankruptcy, conflict of interest, fraud Facilitate transactions and pricing with information Facilitate transactions and pricing with information Preserve integrity of the financial system Preserve integrity of the financial system Reduce transaction costs by establishing standards, disclosures Reduce transaction costs by establishing standards, disclosures

4 Clear, Detailed Disclosures Consistent format – facilitate comparisons Consistent format – facilitate comparisons To borrowers – to understand the loan commitment, closing costs, prepayment fees To borrowers – to understand the loan commitment, closing costs, prepayment fees To investors – Distinctions from traditional bonds – uncertainties of collateral cash flows – expected default and prepayment rates To investors – Distinctions from traditional bonds – uncertainties of collateral cash flows – expected default and prepayment rates About the issuer – Complete financial statements, loan & bond servicing capacity About the issuer – Complete financial statements, loan & bond servicing capacity

5 Financial Regulations Capital, liquidity, insider lending, underwriting quality, financial controls, servicing operation Capital, liquidity, insider lending, underwriting quality, financial controls, servicing operation Trade-offs Trade-offs  Between simple capital rules and adequate reflection of risk  Between simple and complex stress testing  Simple and complex accounting disclosures

6 Which Regulator? Banking regulator, central bank, securities regulator Banking regulator, central bank, securities regulator Prevent regulatory arbitrage – i.e., tailoring charter or activities to seek looser rules Prevent regulatory arbitrage – i.e., tailoring charter or activities to seek looser rules Regardless of whether institution takes deposits Regardless of whether institution takes deposits  Consistent rules for capital, liquidity, disclosures, insider lending  Focus on integrity of financial system, not just safety of deposit holders

7 Basel Accord as a Framework Internationally-agreed guidance for bank supervisors: Internationally-agreed guidance for bank supervisors:  Capital adequacy, supervision, financial disclosures  Focus primarily on internationally active banks  Provide a standard for all credit institutions

8 Basel II - Three Pillars Minimum capital requirement Minimum capital requirement  Improved link to specific risks Supervisory review process Supervisory review process  Sound internal processes, risk assessments Market discipline Market discipline  Enhanced disclosures by banks

9 Basel II Minimum Capital Approaches – Credit Risk Standardized – Percentage risk weights, more categories than Basel I, may refer to external ratings – easiest to apply in new mortgage markets Standardized – Percentage risk weights, more categories than Basel I, may refer to external ratings – easiest to apply in new mortgage markets Internal Ratings Based (IRB) – Banks may use own credit assessments, subject to methodological and disclosure standards Internal Ratings Based (IRB) – Banks may use own credit assessments, subject to methodological and disclosure standards  Requires substantial data and analytic capabilities

10 Standardized Approach-Retained Mortgages Retained residential mortgages carry a 40 percent risk weight Retained residential mortgages carry a 40 percent risk weight For example, For example,  30 million mortgage portfolio  Capital Required = 0.96m = 30m * 0.40 * 0.08 Or, 3.2 percent of total portfolio

11 Internal Ratings Based (IRB) Approach - Retained Mortgages Originator estimates Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) Originator estimates Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) Minimum standards for data history, system quality, estimation models – non-existent in new mortgage markets Minimum standards for data history, system quality, estimation models – non-existent in new mortgage markets An incentive to develop risk management - can substantially reduce capital requirement vis-à-vis standardized approach An incentive to develop risk management - can substantially reduce capital requirement vis-à-vis standardized approach

12 IRB Risk Weights-Retained Mortgages

13 Securitization Simplified Individual Mortgages AAA A Unrated Credit Allocation Sold to Pension Funds, Insurance Companies Retained by Issuer Pooled, Sold to SPV (Also vertical slicing for maturity)

14 Perennial Questions - Securitization How does issuer produce earnings? In each securitization, how has issuer added value, where does the value appear? Should not see undue gains on sale of ‘A’ class, nor on retained tranches Value can be accurately reflected in accounting, capital requirements

15 Securitization Risks Credit, Liquidity, Operational, Legal, Reputational; more leverage than appearances might imply Credit, Liquidity, Operational, Legal, Reputational; more leverage than appearances might imply Complex issues – recently revised capital treatment under Basel II, IAS rules for disclosures Complex issues – recently revised capital treatment under Basel II, IAS rules for disclosures Transparency is critical to credibility Transparency is critical to credibility

16 Issuer Responsibilities  Identify, measure, monitor, control the risks of the business – disclose clearly to outsiders  Minimum capital requirements assume that management does their job correctly  Examinations and disclosures prove that management is sound  Problem circumstances lead to supervisory actions, additional capital

17 Taxation Ensure that SPV is not taxable, not considered to earn income – the true owners of the assets are the investors, assure that interest is taxed no more than once Ensure that SPV is not taxable, not considered to earn income – the true owners of the assets are the investors, assure that interest is taxed no more than once Eliminate fees/stamp duties on securitization process, documents Eliminate fees/stamp duties on securitization process, documents Treat mortgage securities on even footing with other fixed income securities Treat mortgage securities on even footing with other fixed income securities

18 Basel II on Securitization - Standardized Approach Investment grade securitized exposures receive risk weight by rating Investment grade securitized exposures receive risk weight by rating Requires trusted, independent rating agencies Requires trusted, independent rating agencies  Another regulatory issue

19 Risk Weights Under Standardized Approach

20 Standardized Approach Example

21 Standardized Approach Example

22 Internal Ratings Based (IRB) Approach IRB incorporates more information on nature of collateral pool and security structure IRB incorporates more information on nature of collateral pool and security structure Highly granular collateral requires less capital – highly granular means a relatively large number of small loans – N > 100 Highly granular collateral requires less capital – highly granular means a relatively large number of small loans – N > 100 Thick exposures require less capital – thickness means relatively large and senior Thick exposures require less capital – thickness means relatively large and senior

23 Risk Weights – IRB ApproachRating Thick tranches – highly granular pools Base risk weight Non granular collateral AAA7%12%20% AA10%15%25% A20%35% BBB+50% BBB75% BBB-100% BB+250% BB425% BB-650% Below & unrated Deduction

24 IRB Approach Example

25 Accounting Issues Reporting literature complex Reporting literature complex Some areas of “emerging practice” exist Some areas of “emerging practice” exist Key is clear disclosure of assumptions, risks to values and earnings as reported Key is clear disclosure of assumptions, risks to values and earnings as reported

26 International Accounting Standards (IAS) IAS 39 IAS 39  Prescribes fair value treatment for many financial instruments and derivatives – but still calls for mixed attribute in some cases – historical cost plus fair value  Applicable for reporting periods starting 1/1/01  Weaker standard for sale v. financing than Basel II

27 U.S. Securitization Shipwrecks – Superior Bank – August, 2001 Cost to U.S. government: estimated USD 500 million – big hit to deposit insurance fund Cost to U.S. government: estimated USD 500 million – big hit to deposit insurance fund Bought high credit risk mortgages, securitized, retained subordinated and I/O tranches Bought high credit risk mortgages, securitized, retained subordinated and I/O tranches Half of the bank’s assets were subordinated tranches or I/O strips Half of the bank’s assets were subordinated tranches or I/O strips Defaults and prepayments rose, I/O strips evaporated Defaults and prepayments rose, I/O strips evaporated

28 Superior Bank (continued) Sophisticated investors, Board Sophisticated investors, Board Ignored the importance of underwriting Ignored the importance of underwriting Debate over accounting standards – an emerging practice area in U.S. GAAP & International Accounting Standards Debate over accounting standards – an emerging practice area in U.S. GAAP & International Accounting Standards Auditors, regulator, rating agencies were all late in realizing the scope of the problem Auditors, regulator, rating agencies were all late in realizing the scope of the problem

29 Concluding Remarks Mortgage finance requires robust requirements for disclosures and risk management Mortgage finance requires robust requirements for disclosures and risk management In emerging markets, data restrictions and rating agency limits likely to affect the use of more risk- sensitive capital measures such as IRB In emerging markets, data restrictions and rating agency limits likely to affect the use of more risk- sensitive capital measures such as IRB Regulators have their work cut out for them to tailor Basel II and IAS rules to their markets Regulators have their work cut out for them to tailor Basel II and IAS rules to their markets

30 References Papers “The New Basel Capital Accord: An Explanatory Note”, Basel Committee on Banking Supervision, Bank for International Settlements, January, 2001 “Consultative Document; The New Basel Capital Accord”, Basel Committee on Banking Supervision, Bank for International Settlements, January, 2001 “Second Working Paper on Securitization”, Basel Committee on Banking Supervision, Bank for International Settlements, October, 2002 “Quantitative Impact Study 3, Technical Guidance”, Basel Committee on Banking Supervision, Bank for International Settlements, October, 2002 “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 International Association of Credit Portfolio Managers, January 13, 2003 Web Sites Bank for International Settlements: U.S. Federal Reserve: British Bankers Association: European Securitisation Forum: