DEVELOPING MORTGAGE DEFAULT INSURANCE IN A TRANSITION NATION THE CASE OF KAZAKHSTAN Sally Merrill Douglas Whiteley Prepared for the World Bank Housing Finance Conference March 2003

Why Focus on Kazakhstan? n Positive economic environment, falling inflation, urban growth, legal reforms n Competitive, private banking sector n Mortgage market small but growing n A “policy champion”: Governor of National Bank of Kazakhstan champions financial sector development n NBK funds back reform agenda

Mortgage Lending Environment n Legal infrastructure appears adequate n Foreclosure is non-judicial with set time limits; however, it is basically untested n Property registration adequate, at least in urban areas n Valuation process appears inadequate n Banks are privatized & CARs adequate n Lending environment competitive

Mortgage Market Context n Residential mortgage portfolio = $54 million (12/2002); 8 major bank lenders n Average loan size is $7000; LTV 70% n Loan terms are increasing from 3-5 years to 7-10 years; interest rates have fallen from over 20% to 15% - 18% n Loans are variable rate in $ or tenge pegged to $; rules for change arbitrary

Structure of Market Demand n Mortgage market largely urban n Incomes are low; distributions quite skewed; equity for 70% LTV limited n Net out-migration, especially rural n Homeownership rate > 90% n Banks not willing to underwrite self- employed & informal income groups n Long-term potential large as oil and gas resources boost GDP

Corporate Structure of MI in Kazakhstan: FGIC n Capitalized by National Bank of Kazkhstan ($5 million adequate under most 10-year market scenarios) n USAID contributing operating funds for 2 to 3 start-up years n FGIC: Guarantee Fund for Mortgage Credit; regulated by NBK n Private MI-type structure: self-supporting post start-up; premium actuarially sound

HOW WOULD MI WORK IN KAZAKHSTAN? n Insurance contract between FGIC and approved lender n “General (Master) Policy” details terms n Borrower pays the premium to the bank n FGIC insures only the “top slice” n “Reference” loan is 7 years & 70% LTV n “Reference MI Program takes LTV to 85% with 30% top tier coverage

MI with 30% Coverage

Why not Develop Private Mortgage Insurance? n Private MI was first choice n Some Insurance Co. already offering MI n Insurance companies lack adequate funds for investment; most are bank subsidiaries or affiliates & capital structures not adequately independent n IFC interested in theory but 51% private funds are not now available

Advantages of Public Sponsorship n Available capital from NBK n Policy champion with long-term view n Integration with regulatory policy & risk considerations under Basle II n Insurance companies: at present, lack necessary capital; bank subsidiaries n Monoline structure n Pave way for further Private MI development

Process of Implementing MI n Policy Dialogue: National Bank (NBK) n Policy discussions: lenders, insurance, and KMC (secondary market) n Formal submission of proposal to NBK –Corporate structure –Business Plan –Market scenarios for mortgage finance –Master Policy –Premium Model

MI Provides Major Benefits n Risk Sharing for Lenders n Affordability for Borrowers n Improved Standardization & Risk Management for Financial Sector Development n Supervisory Benefits to Regulators, especially in context of Basle II

MI Benefits to Borrowers n Interest rate “spreads” are too high n Banks still very risk averse n But…competitive environment good n Thus, MI expected to lead to: –higher LTV lending, and/or –decreased interest rates, and/or –increased loan terms, and/or –higher risk profile borrowers (informal income, etc.)

MI Benefits to Lenders n Improves efficiency & standardization n Promotes better risk management, underwriting and delinquency management n Standardizes underwriting & documentation n Supports better delinquency management and loan “workouts” n Encourages streamlined foreclosure practices n Promotes credit bureau development n Encourages improved property appraisal

LTV & Bank Risk Position 20% Coverage

LTV & Bank Risk Position 30% Coverage

MI, Risk Management & Regulation n Basle II introduces LTV-based risk weight approach for consideration by National Supervisory Authorities n MI important risk management partner for lenders n MI provides means to higher LTV lending via sharing of credit risk n Favorable supervisory treatment via MI for high LTV lending

MI Provides Supervisory Benefits n MI transfers a portion of the credit risk outside the banking system n Partner in implementing risk-based supervisory regime based on LTV n Mandate MI on all loans with LTV exceeding a certain risk level n Reduce the regulatory capital - lenders & - investors for loans carrying MI

LTV and Relative Risk

Possible Regulatory Changes? n Now - no regulatory “recognition” of features of mortgage lending n No regulatory differentiation by LTV n R/S Analysis needed as portfolios grow n Future regulatory considerations: –MI mandatory for all LTV > 70% –Risk weight reduced for loans carrying MI –LTV-based risk analysis will be initiated –Separate supervisory oversight, A/L match

Risks of Public Sponsorship n Future regulatory environment risk - Not operating as “Private MI”, monoline, and non- subsidized n Slips into role of “social” agency n Moral hazard: adverse selection n Failure to consider sunset clause for future privatization n Non-level playing field with private MI plans offered by insurance companies

Minimizing Risks of Public Sponsorship n Charter solidifies “Private MI’ operating nature n Partial MI coverage (30%) limits adverse selection n Solid underwriting guidelines already put forth by KMC (secondary market) n Banks & capital market stand to lose n No additional capital from NBK - after initial capital allocation n Private and IFI capital to be sought

GOK has a lot to lose: MI Helps Capital & Secondary Markets n GOK counting on mortgage-backed debt as key alternative to Govt. paper n Institutional investors want new product n MI expected to increase market growth n Credit enhancement will augment loans eligible for purchase by KMC n MI “softens” bank arguments against KMC policy of purchase with recourse

MI Development Team n Kazak champion: Governor of NBK n USAID support and resident consultant project (FSI); Kazak & U.S. experts n U.S. experts: policy development, business pro forma, premium & risk management modeling, IT/operations n Kazak experts: financial & legal analysis, underwriting, mortgage & regulatory policies

Plans, Models, & Scenarios n Market growth and MI utilization n Business Plan & Pro Forma n Premium Model simulations n Market profile & risk scenarios: expected, optimistic, & adverse n Costs: operating costs & claim costs n Financial return assumptions

Premium Model User Variables n 3 mortgage market risk scenarios n Book year default rate n Interest rates & loan payoff rate n Operating costs: underwriting, taxes n Claim costs: salvage value at default, delinquent interest, legal & foreclosure costs, taxes, maintenance costs n Financial costs and expectations: risk-to- capital, investment return, ROE

Premium Model Calculations & Output Variables n Present value calculations for losses, expenses, and profit n Premium rates: annual & single n Premium rate determined for: –LTV ratio: 70%, 75%, 80%, 85%, 90% –MI coverage: 15%, 20%, 25%, 30%, 40% and 50% –Loan term: 3, 5, 7, and 10 years n Premium = weighted average of 3 loss scenarios: 50% expected + 25% high & low

Serious Information Problems! n Mortgage Market, & its IT, are young n Loan terms short, few seasoned loans n Default rate low; little experience with foreclosure n No “book year” data (default/pay-offs) n Result: use of U.S. LTV default probability curves in Premium Model - a good news/bad news situation

Recommendations for Start-up MI Plans for FGIC n Coverage: –30%; perhaps 20% also n LTVs: –75%, 80%, & 85% –(norm is now 70%) n Single payment plan to assist early cash flow for FGIC n Start with a manageable # of plans

Ongoing Requirements n Revise Premium Model with Kazak data: LTV default rate curves; prepayments n Establish system to provide book year data for Premium Model n Revise Premium Model input variables: –market conditions –operating and capital costs –financial requirements and returns

Long-term Horizon in Kazakhstan? n Privatization: investment by local or international insurance companies? n IFC or other IFI participation? n Sunset clause? n Establish co-existing monoline Private MI?

Recommendations for Transition Nations n Promote Private MI if possible n If not possible, develop a Private MI structure n Include long-term plan for privatization n Insure only “top slice”: –risk sharing crucial; banks can’t rely on Government for risk management –Government. must minimize moral hazard risk n Coordinate with regulatory, capital market, and mortgage-backed debt development