1. MBF-705 LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION OSMAN BIN SAIF Session: Three 1

2. Summary of Previous Session General principles of banking regulation – Minimum Requirement – Supervisory review – Market Discipline Banking Crises – Banking system (Operations, potential Problems, Criticality) – Institutional investors investment banks Pension Funds Hedge funds – Central Bank. US Example – Government Securities / Bonds 2

3. Agenda of this session – Credit rating agencies – Mortgage Brokers – Secondary Mortgage Markets The Mess – Evolution of Home Mortgage – New model of Mortgage lending – Private sub prime mortgage process – Reasons for forming of subprime mess 3

4. Credit Rating Agency (CRA) Company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued 4

5. Credit Rating Agency (Contd.) Ex: Moody's (U.S.), Standard & Poor's (U.S.) Credit ratings are used by investors, issuers, investment banks, broker-dealers, and governments. – For investors, credit rating agencies increase the range of investment alternatives and provide independent, easy-to-use measurements of relative credit risk. 5

6. Mortgage Broker Mainly found in developed economies like US, Western Europe Professionals who are paid a fee to bring together lenders and borrowers Sells mortgage loans on behalf of businesses (ex. Banks) 6

7. Mortgage Broker (Contd.) Tasks undertaken: – Marketing to attract clients – Assessment of the borrowers circumstances (Mortgage fact find forms interview). This may include assessment of credit history (normally obtained via a credit report) and affordability (verified by income documentation) – Assessing the market to find a mortgage product that fits the clients needs (Mortgage presentation/recommendations) 7

8. Mortgage Broker (Contd.) – Applying for a lenders agreement in principle (pre- approval) – Gathering all needed documents (paystubs / payslips, bank statements, etc.), – Completing a lender application form – Explaining the legal disclosures – Submitting all material to the lender 8

9. Sub-prime mortgage – What’s that? Home loans made to borrowers with poor credit ratings — a group generally defined by FICO scores below 620 on a scale that ranges from 300 to 850 9

10. Sub-prime mortgage (Contd.) FICO - a number that is based on a statistical analysis of a person's credit report, and is used to represent the creditworthiness of that person. (FICO is the acronym for Fair Isaac Corporation, a publicly-traded corporation (under the symbol "FIC") that created the best-known and most widely used credit score model in the US.) Creditworthiness—the likelihood that the person will pay his or her debts. Calculated by credit reporting agencies. Ex. Equifax, Experian, and TransUnion in US 10

11. Secondary Mortgage markets The secondary mortgage market allows banks to sell mortgages, giving them new funds to offer more mortgages to new borrowers. If banks had to keep these mortgages the full 15 or 30 years, they would soon use up all their funds, and potential homebuyers would have a more difficult time to find mortgage lenders. 11

12. Secondary Mortgage markets (Contd.) Many of the mortgages on the secondary market are bought by Fannie Mae. Other are packaged into mortgage-backed securities, and sold to investors. 12

13. Now we are ready to look into the mess ! 13

14. Evolution of home mortgage 1930s Lender-Banks Borrower-Individuals Home loan funding Principal + interest payable over long term Owning a house was not affordable to many Great Depression brought industry to a halt. Large scale defaulters and lenders could not recover by reselling 14

15. Evolution of home mortgage (Contd.) To simulate the industry again Government as part of New Deal policy created the Federal National Mortgage Association (Fannie Mae) in 1938. This created a secondary market for mortgages Lender-Banks Borrower-Individuals Home loan funding Principal + interest payable over long term Bought loan Cash Transfer of credit risk, market risk Had Access to long term borrowing Bought only those which conformed to certain underwriting standard ( called Prime Mortgages) 15

16. Evolution continued… Fannie Mae proved very successful. But by 1960s, borrowing done by it constituted a significant share of the debt owed by US government. 1968- Government National Mortgage Association (Ginnie Mae) was created to handle government guaranteed mortgages. Fannie Mae became federally chartered, privately held 16

17. Evolution continued 1970- Ginnie Mae developed MBS (Mortgage backed by Securities) -- shifted the market risk to investors -- eliminated debt incurred to fund government housing programMBS 1970-Federal National Mortgage Corporation (Freddie Mac) created – To securitize conventional mortgages – Provide competition to Fannie Mae 17

18. Evolution Continued Over time Fannie Mae and Freddie Mac together provided enormous amount of funding for US mortgage Since Fannie Mae and Freddie Mac guaranteed loans, much of credit risk stayed with them. Size and diversification allowed them to handle it. 18

19. New Model of mortgage lending Lender-Banks Home loan funding Principal + interest payable over long term Bought loan Cash Transfer of credit & market risk MBS Cash Transfer of market risk SPV Securitization fees 19

20. New Model of mortgage lending (Contd.) Advantages More liquidity in market Risk spread out Long term funding for mortgage lending MBS- allows originators to earn fee income from underwriting activities without exposure to credit, market or liquidity risks as they see the loans they make 20

21. Further evolution.. 1977- Private label securitization started first done by BOA and Salomon Brothers 1980s- pricing, liquidity and tax hurdles were resolved in same Unlike 2-3 party, private label securitization has 10 or more different parties playing independent role 21

22. Further evolution Big private players in this field were – Wells Frago – Lehman Brothers – Bear Stearns – JP Morgan – Goldman Sachs – Bank Of America 22

23. Details : Private Sub-prime mortgage process 1. Brokers identify borrowers 2. Originator and broker identify a loan for borrower after looking at his credit rating 3. Formal application for loan by borrower 4. Originator transfers the loan to the subsidiary of an investment banking firm ( Seller) 5. Seller(Investment bank) collects a pool of loans and call it as SPV. Off balance sheet instrument 23

24. Details : Private Sub-prime mortgage process (Contd.) 6. SPV can be a corporation, partnership or limited liability company. Most often a Trust. It has nothing else except mortgage loans 7. Underwriter purchases all the securities (derivative income streams) 8. In designing SPV and its tranches underwriter works with credit rating agencies 24

25. Details : Private Sub-prime mortgage process (Contd.) 9. Underwriter then sells the securities to the investors 10. High rated tranches might be guaranteed by a 3rd party insurance company 11. Seller also arranges to sell the rights to service the loan pool to a company or sometimes Originator takes these rights 12. MERS – document custodian. Company to keep track of mountains of paper work on loans in the pool. At National level. 25

26. Reasons for forming of Subprime mess Giant pool of money available for investment through savings of Oil exporters, economic development in BRIC countries. Giant pool of money Private share in mortgage market growth in large part through origination and securitization of high risk sub- prime and Alt-A mortgages. Private share in mortgage market Building up of the housing bubble Private Banks made use of CDOs to sell to investorsCDOs 26

27. Reasons for forming of Subprime mess (Contd.) Lax regulations which did not keep pace with the innovations happening in financial engineering US kept interest rates too low for too long in post dotcom bust periodtoo low for too long Hedge funds, Wall street firms and instructional investors found lower tranches in MBS and CDO attractive which were highly risky Hedge funds leverage ratio of the order of 500%. To sum up in 3 words as noted by Harvard dean: Leverage(high), Transparency (low) and Liquidity (abundant) Leverage(high) 27

28. Summary of this Session – Credit rating agencies – Mortgage Brokers – Secondary Mortgage Markets The Mess – Evolution of Home Mortgage – New model of Mortgage lending – Private sub prime mortgage process – Reasons for forming of subprime mess 28

29. THANK YOU 29