Structured Finance. German Residential Mortgage Default Model RMBS/Germany Criteria Report

Transcription

1 RMBS/Germany Criteria Report Analysts Asina Ajwani Stefan Bund Markus Morlok Lara Patrignani Contents Introduction...1 German Mortgage Market...2 German Legal Regime...8 RMBS Rating Analysis...10 Model Approach...10 Default Probability...10 Base Default Probability...11 Recoveries/Losses...15 Property Valuations...16 Loss Severity...18 Synthetic Securitisation...18 Operations Review...19 Cash Flow Modelling...19 Performance Analytics...20 Appendix...21 German Residential Mortgage Default Model 2004 Introduction This report introduces Fitch Ratings enhanced criteria for analysing the credit risk in securities backed by German residential mortgages. This report is the third version of the default criteria and updates the version that was published in September Fitch s mortgage default model uses a loan-by-loan analysis to calculate credit enhancement (expected losses for the relevant rating level) for a portfolio of residential mortgages. The analysis takes into account the characteristics of each individual borrower, loan, lender and property that most influence default probability, loss severity and recoveries. The agency calculates the weighted average cumulative default probability (otherwise referred to as the weighted average frequency of foreclosure ( WAFF ), the weighted average loss severity ( WALS ) and the weighted average recovery rate ( WARR ). While the updated methodology is similar to the previous version, Fitch has revised its assumptions to reflect notable changes in the German residential mortgage market. Based on data obtained through the ongoing surveillance of German RMBS portfolios, as well as additional information available from originators, Fitch has undertaken a series of revisions to its criteria, thereby enhancing the default and loss determinations for a portfolio of German residential mortgage loans. The table set out below shows the key revisions that have been made since the release of the German Residential Mortgage Default Model Revised Assumptions Market value declines ( MVDs ) Foreclosure timing Enforcement costs Interest accrued on senior-ranking loan parts/liens Credit for seasoning Treatment of loans secured on Multi-Family Houses ( MFHs ) Treatment of interest-only loans Treatment of loans granted to self-employed borrowers Introduction of Fitch s servicer rating programme Market Value Decline ( MVDs ) Fitch s MVD factors have been revised to reflect current trends in property prices up to end While property prices in Germany s western states have steadily increased in nominal terms, property prices in the eastern region (the neue Bundesländer ) have continued their downward trend. However, the nominal prices of apartments and single-family houses have not changed substantially since 2000, and the revised MVDs are therefore very similar to the previous ones. 1 December

2 Seasoning Fitch has revised the credit it gives for seasoning assumptions. Whereas the agency previously, gave credit for seasoning to all loans older than 10 years, it will now adjust the base default probability only if the underlying property has also benefited from a nominal increase in value since the last property valuation date. Multi-Family Houses ( MFHs ) The agency has observed that MFHs not only carry higher risk because they are investment properties, but may also prove more difficult to liquidate in an event of default. Fitch has therefore revised the stress it applies to loans financing this type of housing, adjusting both loss severity and default probability. Interest-Only ( IO ) Loans Fitch has revised its analysis to account for the fact that IO loans in Germany are usually repaid through an alternative savings scheme, typically under a life insurance or mortgage savings contract. The agency will apply a default stress to these loans, depending on the quality of the annuity substitute. This is not as substantial as for a pure IO without a repayment vehicle, since these loan will benefit from either full or partial redemption through the alternative savings scheme at maturity. Self-Employed Borrowers The agency has revised its stress assumption for selfemployed borrowers. Reviews of German originators lending practices have shown that the increased default risk of this borrower category is partially offset by applying more stringent underwriting guidelines than for employed borrowers. For instance, detailed proof of sustainable income, in the form of certified tax statements and income statements must be presented to the lenders. Accordingly, Fitch will apply a default probability adjustment tailored to the lender s underwriting criteria instead of applying a uniform hit as was previously the case. Foreclosure Timing, Enforcement Costs and Accrued Interest on Senior-Ranking Claims Following a review of the legal processes surrounding foreclosure proceedings in Germany, the agency has reviewed its: time to foreclosure assumptions; enforcement cost assumptions; accrued interest rate assumptions for seniorranking loan claims. The report is structured into two main sections. The first provides an overview of the German mortgage market, focusing on the aspects that are relevant to the agency s analysis of RMBS portfolios. The second outlines Fitch s methodology for determining expected losses and the resulting credit enhancement levels for a portfolio of residential mortgaged backed loans. German Mortgage Market Overview Approximately EUR1.083 trillion of residential mortgage loans are currently outstanding in Germany as of end-2003 of which, as illustrated by the chart below, EUR750 billion comprise lending to private individuals only. This makes Germany the second-largest residential mortgage market in Europe after the UK. As illustrated in the chart below, new lending hit record levels in 1998 and 1999, largely owing to the favourable interest rate environment at the time. Since 1999, however, residential mortgage lending has been on the decline, both in terms of lending for Quarterly Volume of Outstanding Mortgage Loans (EURbn) Amount (LHS) % Change to Previous Year (RHS) (%) 25 Change in Definition* Dec 80 Dec 81 Dec 82 Dec 83 Dec 84 Dec 85 Dec 86 Dec 87 Dec 88 Dec 89 Dec 90 Dec 91 Dec 92 Dec 93 Dec 94 Dec 95 Dec 96 Dec 97 Dec 98 Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 * Change in definition of the outstanding volume by the German Bundesbank (Dt. Bundesbank) Source: Dt. Bundesbank 2

3 Economic Cycle in Germany Change in GDP Germany (GDP % change) 12% Average GDP 10% 8% 6% 4% 2% 0% -2% * from 1992: East and West Germany Source: Deutsche Bundesbank, BMGS new construction, and lending for the purchase of existing real estate. New construction lending has been falling steadily, changing the ratio of lending on existing real estate to lending for new construction from 44%/56% in 1994 to 28%/72% in 2003, as illustrated below. The reduced lending level is attributable to weak economic conditions and uncertainty regarding the scaling back of tax benefits for investment properties and subsidies for owner-occupied properties. Residential Mortgage Lending Value (EUR m) Existing Real Estate 1996 Source: VDH-Statistics New Construction Economic Cycle Since 1960, Germany has experienced four major recessions as illustrated by chart above. The latest recession was caused by the bust following the boom that resulted from the reunification of Germany. Growth in GDP following the last recession was relatively low, between 1% and 3% per annum. Growth rates declined from 2000 through 2002, dropping close to zero. Although growth rates slightly increased in 2003, the economic situation prevailing in the eastern regions of Germany has left the country to face an adverse economic environment. The direct correlation between the general economic environment and the property market appears to be rather limited for western Germany, where a drop in property prices tends to lag behind a recession and does not reflect the extent of the decline in overall GDP. In eastern Germany, however, the continual decline in house prices from 1994 to 2002 was in line with the weak economic conditions prevailing in this region, and can be seen as a direct consequence of a number of economic factors that contributed to the current stagnation in the real estate market. Mortgage Rates at Month End (%) Yr 5 Yr 10 Yr FLT Source: Dt. Bundesbank Home Ownership and Tax Incentives Despite incentives granted by the government to promote home ownership in Germany, the 42% share of owner-occupied housing remains low by comparison with other European countries such as the UK (68%) or Italy (75%). The government has promoted home ownership under various schemes: interest paid on loans secured on owner-occupied housing was tax 3

4 House Prices in West Germany (EUR) 260, , , , , , , ,000 House Prices East House Prices West House Prices East Trendline House Price West Trendline Source: Dt. Bundesbank deductible until 1996, when this system was replaced by an annual homeowner subsidy. However, although home-ownership rates have increased over the past decade as a result of these measures, that growth has been limited by the combination of a strong rental culture, economic policy, the German tax regime, building quality and property development laws. An economic policy that promotes low rent levels, in conjunction with tenant-friendly laws regulating rental increases and the protection of tenants rights, have outweighed the effects of the homeowner subsidy and restrained growth in home-ownership rates. Rents are low by comparison with the cost of owner-occupied housing. Owners of rental property benefit from tax incentives, whereby interest paid on loans for investment properties is fully deductible against the borrower s taxable income. Owner Occupancy 2002 Italy Belgium Uk Luxemburg Austria France Denmark Netherlands W-Germany Switzerland (%) Source: Euroconstruct/ifo Institut (December 2002) Stringent building regulations mean that the average quality of new buildings is comparatively high, but also make German property expensive by international standards. There is virtually no cheap housing segment targeted at young first-time buyers. Various building regulations effectively limit the creation of a lower-cost, entry-level housing market. Average land prices are high owing to the dense population in most regions of Germany and restrictions on land development. As an increasing segment of the population consists of single people or childless couples, the incentive to achieve stability by purchasing a home is largely compromised. This, coupled with the higher mobility required by the current employment market, has also contributed to the low home-ownership rate in Germany. Most individuals buying property for their own use do so more for personal preference (the desire to live in their own home) than for purely economic considerations. Given the mechanics of the German mortgage market outlined above, first-time buyers in Germany are fairly old. The average age of a first-time buyer in Germany is 36 years. Property Prices One of the difficulties of calculating property price trends is the lack of long-term quantitative data on a regional level. Germany has no database of official national property price statistics. Fitch has therefore reviewed data provided by broker associations and private research firms, relying, in particular, on property price data for 60 cities in Germany (see Property Prices in Germany chart below). Available property price data goes back to 1975 for the former West Germany and to 1990 for the former East Germany. The prices provided generally cover the upper segment of the residential real estate market (average to above-average quality housing in average to above-average locations). Fitch did not find any conclusive property price statistics that cover rural areas in Germany. 4

5 The chart above shows the annual index for houses up to end 2002, with separate data for western and eastern Germany. Although the chart does not include figures for apartments, there is a high correlation between the prices of apartments and houses. The property market in western Germany has shown relatively stable growth, closely following the longterm trend. Since 1975, there have been four phases of price development in western Germany. The first was characterised by a significant increase in (nominal) property prices in the late 1970s to early 1980s. This was followed by a second phase in which prices started to consolidate, but without any dramatic price decline. The third phase started in approximately 1987, when a healthy economy and a widening gap between housing supply and demand caused prices to increase again. In the early 1990s, the re-unification of West Germany and the former East Germany further boosted the economy and pushed up property prices. The fourth phase, which started in , brought another consolidation of property prices, caused by a recessionary environment, higher unemployment and economic difficulties in eastern Germany, as well as increased housing supply. On average, prices in western Germany increased during 2002, but remain below the long-term trend. Price decreases have been more pronounced in eastern than in western Germany. Post-reunification price rises in eastern Germany were inflated by tax incentives and optimistic rental expectations, which proved too aggressive. Property prices in eastern Germany have experienced a steady decline since 1994 and have been stagnating since Mortgage Lending Institutions Germany has the largest and most diversified banking market in Europe. This is reflected in the highly fragmented mortgage market as illustrated below. Market Share of Mortgage Lenders 1H03 Mortgage Banks 14.14% Cooperative Cooperative Sector Banks Sector 15.37% Banks 15.37% 15.37% Buildings Societies 9.91% Source: Dt. Bundesbank Others 3.35% Universal Banks 22.16% Savings Sector Banks 35.08% Products The German mortgage market is a purely prime market with fairly standardised mortgage products. There is little variation in the loan products offered by the different lenders. Generally, mortgage loans will have a fixed rate of interest with re-set periods ranging between five and 15 years. Mortgage loans tend to involve an annuity repayment method, with loan maturities of years. Pure IO loans are rare, although loans linked to capital life insurance policies or building savings contracts are a fairly common substitute for direct loan amortisation. The specific product types that Fitch accounts for differently in its analysis of a mortgage-backed loan portfolio are addressed below. Life Insurance Policies Capital life insurance policies are a popular alternative to direct loan amortisation; in these cases, the loan will be repaid using the amounts saved under such a policy on loan maturity. This may be attractive for loans financing an investment property, as the outstanding loan amount and hence the deductible interest on the loan will remain constant over the term of the loan. The borrower will make payments into their life insurance contract, and should also achieve a certain yield on their savings. However, life insurance policies are subject to a minimum yield provision, whereby the insurance provider is only obliged to pay a pre-defined guaranteed yield if investment targets are unrealised. Although this offers more security than similar policies in other jurisdictions, which may not be subject to any minimum yield, the return on a life insurance policy with a minimum yield may not match the principal repayment due under a loan at maturity. This implies a balloon risk for the policyholder, who would, in such an event, be responsible for paying the difference between the amount yielded by the policy and the outstanding loan balance at maturity from their own savings. Please refer to page 12 for a description of how Fitch analyses loans linked to this type of policy. Building Savings Contracts German Building Savings Societies ( Bausparkassen ) are specialised mutual savings/mortgage banks regulated by law ( Bausparkassengesetz und Bausparkassenverordnung ), which were originally founded to facilitate collective saving ( Bausparen ) schemes. The incentive for taking up a building savings contract is to secure access to a preferential mortgage interest rate on a loan taken out at a later date. Under a building savings contract in Germany, an individual establishes a claim on a mortgage loan by saving under the contract s initial 5

6 Bridge Finance Phase I Monthly Rate + Interest in the Total Loan Amount Phase II Annuity for the Building Savings Contract Bridge Finance Total Savings Contract Amount Building Savings Amount Building Savings Contract Fixed Rate Time saving phase. When, inter alia, minimum equity (40%-50%) has been built up under the building society contract, the full contractual amount is paid out, part in equity and part in a building savings loan. A building savings loan has the advantage that, by pooling the amounts saved under the initial savings phase of all the building savings accounts, an individual borrower can establish their claim to a low interest rate loan that is effectively subsidised by the collective savings of all the building society s customers. Borrowers become eligible for a building savings loan once they have completed the initial savings phase; in most cases, therefore, they will have a long-term relationship with the Building Savings Society. The mechanics of a building savings loan effectively mirror those of an annuity loan. Bridge Financings As an alternative to a standard building savings loan contract, most building societies offer bridge financing, which effectively enables the borrower to draw on the full financing amount before saving the minimum equity, as outlined above. Here, the entire financing amount is paid out as an interest-only loan (bridge financing) and, in addition, the borrower signs a building savings contract. The borrower pays the interest on the full outstanding loan amount, while simultaneously paying regular savings instalments into a building savings account. When the borrower has saved the minimum required equity he becomes eligible for disbursement of a building savings loan, which will be the difference between the savings standing to the credit of the savings account and the original amount for which the building savings contract was concluded. The bridge financing loan is therefore fully redeemed by a building savings loan and the equity saved by the borrower. The new loan amortises according the conditions that apply under a building savings contract. Please refer to page 12 for a description of how Fitch analyses loans linked to building savings contracts. Origination Practices Origination practices in Germany follow fairly uniform underwriting standards and do not vary significantly from one lender to another. Key lending practices specific to Germany are highlighted below: Affordability Measures Free Available Income Unlike their counterparts in other jurisdictions in Europe, German lenders will assess a borrower s ability to pay by determining their free available income. This is calculated as the net monthly household income remaining after deducting all debts (such as other loan obligations), assuming fixed amounts for living expenses and costs as well as applying a stressed annuity rate for the loan to be granted. The amounts deducted as part of the free available income calculation will vary by lender according to their respective underwriting criteria. Lenders will generally require a minimum free available income between 40%-45% and will predefine a minimum income threshold that cannot be breached for the lower-income households. 6

7 Self-Employment Self-employed borrowers are generally subject to more stringent underwriting criteria whereby lenders may impose more conservative LTV limits or higher free available income requirements on this borrower segment. Generally, self-employed borrowers must provide the following additional information to prove their ability to pay: at least two years worth of tax statements (Einkommenssteuerbescheid); a minimum of three financial statements SCHUFA Check As part of the underwriting process, it is market practice in Germany to perform a Schutzgemeinschaft für allgemeine Kreditsicherung ( SCHUFA ) check to assess the applicant s credit standing. Generally, borrowers with a negative SCHUFA entry will not be considered for a loan application or will face considerable constraints in obtaining a loan. SCHUFA is a type of credit bureau based on the concept of information exchange. SCHUFA has a number of cooperating partners which are predominantly credit institutions such as banks, credit card firms, leasing companies or telecoms companies which have all contracted to provide details on credit delinquencies or defaults to the credit bureau and are thereby eligible to receive such information in return. The SCHUFA pools all the credit information received and will provide the cooperating partners with the relevant details of a loan applicant s credit history. Data from public registries and public proclamations (e.g. launch of bankruptcy proceedings) are also collated. The cooperative partners provide the SCHUFA with data on the application, origination date, maturity date, early termination event and current performance of a credit engagement. They also provide SCHUFA with non-contractual data, such as arrears on current accounts, which may be provided without the client s consent. Creditworthiness Check Marital Status Employment Status Size of Household Occupation Married Employed 4 Persons Police Officer Credit-relevant information is generally stored for a period of three years following the resolution of a negative entry. SCHUFA will also record how it was resolved i.e. whether through repayment by the delinquent borrower or foreclosure proceedings. Valuation Practices Investment Property No Enhanced Risk for Lending Above 80% of the Value No Monthly Income (EUR): - Net Income 2,500 - Spouse Income 2,000 - Child Support 308 Total Net Household Income 4,808 Additional Monthly Expenditures - Other Banks Lendings Other Loans (from SCHUFA) 584 Sum of Other Expenditures 1,320 New Financing - New Loan 466 Sum of New Financing 466 Left for Living Expenses 3,022 Minimum Free Available Income Requirement * 1,963 Free Available Income (%) 63 Net Monthly Household Income - Total Debt Service Net Monthly Household Income Valuation Methods Valuation methods in Germany can be divided into three main types: 1. Cost Approach (Sachwertermittlung) for owner-occupied properties 2. Income Approach (Ertragwertermittlung) for investment properties 3. Sales Comparison Approach (Vergleichswertverfahren) predominantly suitable for flats/apartments/condominiums. Mortgage banks will calculate a sustainable resale value for the mortgaged property using one of the above valuation methods. According to the Mortgage Banking Act, mortgage banks are required to apply a further discount of between 10% and 20% to the sustainable resale value. This practice has its origin in the regulations designed to protect the interests of Pfandbrief investors. The valuation practices of mortgage banks that conduct Pfandbrief issuance are additionally subject to the approval of BaFin (Bundesamt für Finanzdienstleistungsaufsicht), the German Financial supervisory Authority, which will also undertake routine checks carried out through a public trustee. * Calculated based on the size of the household 7

8 German Legal Regime Enforcement Process A property can be disposed of either through an open market sale (for which the consent of the borrower is required) or a public auction. In general, a higher price is obtained in an open-market sale, while a public auction is more expensive and time consuming. The foreclosure and bankruptcy procedures used to recover on a defaulted loan in Germany are always subject to German court proceedings. A lender seeking recovery in a default situation can request the court to sell the underlying collateral via legal proceedings (Verwertung) or may, alternatively, enter a claim against the borrower via various types of insolvency proceedings, i.e. the liquidation of cash deposits. Public Auction The auction process is regulated by German law and requires a new appraisal of the property value by an independent valuer appointed by the regional courts. The law regulates the bidding process whereby, at the first auction, the only offers that can be accepted must cover at least all claims ranking higher than those of the initiating secured creditor, including any senior claims (the so-called minimum offer or geringstes Gebot). Furthermore, the court must reject the sale if the highest offer is not at least 50% of the appraised value of the mortgaged property based on the most recent valuation report; it may also be rejected upon the request of a lower-ranking creditor if the highest bid is not at least 70% of that value. The reserve price of 50% of the appraised value applies only to the first auction and not to any subsequent auctions. Relative to other jurisdictions, legal enforcement procedures may be lengthy and troublesome depending on the region, the court s ability to handle an increase in legal proceedings, and the financial and social situation of the borrower. The speed of the process varies from one court to another in Germany owing to differences in staffing levels, work load, the existence or not of computerised records and the work ethic. On average, mortgage-related court proceedings in Germany take two years; however, for the reasons outlined above, the time can increase to as much as five years and, in some isolated cases, even beyond. Insolvency Law A revised insolvency law became effective in Germany on 1 January One of its new features was that it allowed private individuals to declare bankruptcy, which was not possible before. Previously, an overindebted borrower could try to settle their outstanding financial obligations out of court, potentially with the help of a non-profit debt counselling service (Schuldnerberatungsstelle). Under the revised law, if an out-ofcourt settlement has failed, a borrower who has defaulted on his debt can apply for a court settlement. After all assets have been foreclosed upon (within certain limits defined by law), the borrower must meet certain obligations for a period of seven years they must, for example, hand over all their earnings (subject to certain limits) to a trustee, who will distribute the income to the various creditors. Any debt obligations remaining after seven years can be waived. For obligations due under mortgage loans, the consequences of a borrower s personal bankruptcy may compromise the lender s recourse to any amounts outstanding after recovery from the underlying property. Although Fitch does not give any credit to additional recoveries post-enforcement, the enactment of such a law may have an impact on the borrower s incentive to keep a loan current in times of economic stress. Although there has been a general increase in personal bankruptcies on a yearly basis, this may simply be the result of the poor economic climate; no direct correlation has been detected between increased defaults and personal bankruptcies in the securitised RMBS portfolios. It is standard for German lender to carry out desk-top valuations for properties that secure loans up to a threshold of EUR300,000 ( Kleindarlehensgrenze ). The valuation will generally be carried out by the respective credit officer. However, an on-site visit of the property involving a drive-by inspection occurs in most cases. Full valuations are only carried out for properties with special characteristics, or where the loan amount exceeds the EUR300,000 threshold Most of the real estate valuations will be carried out by a specialised in-house valuation team. Only when the property valuation requirements exceed the bank s internal resources or expertise will external valuations be requested. That said, it is very uncommon for German lenders to draw on thirdparty valuations, since most have a well-qualified inhouse appraisal department and sufficient resources to cope with underwriting volumes. To qualify as a 8

9 standard lender, Fitch expects the originator to employ experienced professional real estate valuers with local knowledge. It will review this aspect of the bank s operations as part of the origination/servicing review carried out for each transaction. Actions on Borrower Default Restructuring Enforcement is a costly and time consuming process while property sold via public auction will usually be sold at below market value. Servicers in Germany therefore tend to focus their efforts on reaching an agreement with the borrower and restructuring a loan before initiating foreclosure proceedings. Restructuring measures will depend on the internal guidelines defined by the respective lenders; however, it is common practice to: grant forbearance periods of up to 12 months; arrange for a debt rescheduling by extending the maturity of the loan; reduce the annuity rate on a loan for a flexible period; restructure the interest rate on the loan; in certain instances, agree to a discounted payoff with the borrower, i.e. forgo a given amount of principal. Only if restructuring proves unsuccessful and the borrower is unable to maintain the payments agreed with the lender will foreclosure proceedings be initiated. The impact of restructuring is less critical for synthetic securitisations, since ongoing note payments do not depend upon cash flows from the underlying mortgage portfolio; however, in the context of a true sale, this may have a significant impact on a portfolio s liquidity. Loans that default but do not go through to foreclosure may bring additional stress to the interest income generated by the mortgage portfolio, which are needed to service the outstanding rated debt. Enforcement Where effective restructuring using the measures outlined above has failed, the lender will terminate the loan and proceed to enforce into the mortgage. Enforcement is carried out by the lending institution s specialist workout units, and the process is managed by experienced and trained staff. 9

10 RMBS Rating Analysis The following section discusses the characteristics and Fitch-relevant adjustments for a standard German RMBS portfolio. For any characteristics that may diverge from those addressed in the section below, Fitch will undertake individual adjustments on case-by-case basis. This is especially relevant when referring to the RMBS criteria for assessing the credit quality of a mixed residential portfolio i.e. where the mortgage loans are secured on residential properties with partial commercial use, which have a larger-than-average exposure to MFHs with more than four units or where borrowers may are not all private individuals. When rating a residential mortgage securitisation, Fitch builds its analysis on three fundamental aspects of the transaction: 1. The Credit Quality of the Collateral: This is determined by calculating the expected probability of a default and the loss severity upon default on a loan-by-loan basis. Fitch also assesses the quality of the underwriting and servicing applied to a portfolio of residential mortgage loans. The resulting weighted average expected loss will provide the credit enhancement for each of the rating levels. 2. Financial Structure of the Transaction: In a true sale transaction, the financial structure may further affect credit enhancement levels. For example, further credit protection may be available through excess spread, which may reduce hard credit enhancement levels. For a discussion of the financial structure, please refer to the separate criteria report A Guide to Cash Flow Analysis of European RMBS dated 20 December 2002 and available at 3. The Legal Framework: A review of the transaction s documentation is undertaken to ensure that the legal structure of the deal is fully reflected in the financial analysis, and that no legal risks threaten the claims for payment of interest and principal. This report does not address specific legal issues involving the rating of German RMBS transactions. Model Approach To determine credit enhancement levels for German RMBS, Fitch s default model employs a loan-byloan review. This examines a number of the loan-, borrower-, lender- and property-specific factors that most influence default probability, loss severity and recoveries. Fitch s credit enhancement for each loan in the portfolio is a measure of its expected loss under the associated stress scenario that is, the product of its default probability and exposure to loss given default. On a portfolio basis, credit enhancement is expressed as the product of the weighted average cumulative default probability, otherwise referred to as the WAFF, and the WALS. Fitch s default model also calculates recoveries that is, the principal and interest recovered on foreclosure of the loan as a percentage of the current principal balance. Recovery is also expressed as a weighted average, referred to as the WARR. An example of the calculation of default probability, loss severity and recovery rate is set out in Appendix 3. Default Probability Fitch s base default probability analysis focuses primarily on the debt-to-income ( DTI ) and loanto-value ( LTV ) ratios. The agency believes these two measures are interdependent and should therefore be examined in conjunction. The resultant base default rates are then adjusted further to account for individual borrower, loan and portfolio characteristics. Determinants of Defaults Fitch believes the primary indicator of a borrower s propensity to default is a combination of their ability to pay and willingness to pay. A borrower s ability to pay is evidenced by their DTI ratio. A borrower s willingness to pay is expressed through the amount of equity invested in the home, as determined by the LTV. Ability to Pay German lenders measure a borrower s ability to pay by calculating the free available income as outlined on page 7. Generally, lenders will require a minimum of 40%-45% of the free available income to be available to the borrower/household. It should, however, be stressed that the definition of free available income may vary from one lending institution to the next. The main threats to a borrower s ability to pay are personal financial stresses in the form of either increased outgoings or reduced income. Both situations result in a reduction of the free available income that can be used to service their debt. Unemployment and divorce are identified by most lenders as the principal causes of borrower delinquency and default. Fitch incorporates these 10

11 Foreclosures/Unemployment The following chart illustrates the number of foreclosures per year on residential and commercial loans compared with the number of divorces and the rate of unemployment. Although both factors are clearly correlated with the number of foreclosures, the rate of unemployment, in particular, matches foreclosures very closely. Foreclosures vs Unemployment and Divorces No. of Foreclosures (LHS) Unemployment (RHS) Divorce (RHS) No. of Foreclosures 100,000 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10, Index (1976 = 1) Source: Dt. Bundesbank socio-economic factors indirectly through the borrower s employment status and income. Lower DTI ratios increase the borrower s ability to absorb such financial shocks. Willingness to Pay The equity, or willingness-to-pay, theory contends that perceived equity in the property will influence whether a borrower defaults during times of financial stress. The incentive to avoid foreclosure is, therefore, affected by house price fluctuations over time. However, regardless of declines in property prices that might cause the erosion of equity over time, Fitch believes that borrowers who have initially made a substantial down payment show a stronger commitment to their debt servicing obligations than borrowers who have built equity only through property price increases or amortisation. A larger initial down payment is also likely to reflect a borrower of greater financial means. Consequently, Fitch believes the original LTV ratio is one of the most important indicators of the potential to default and that a borrower is more willing to pay if a substantial down payment is made at origination. Hence lower-ltv loans are expected to have lower default rates. This theory does not necessarily hold true for loans secured on investment properties, as the interest payment on such loans is fully tax deductible in Germany. Such tax incentives may drive borrowers to take up higher-ltv loans even if they are able to make a large down payment. For this type of loan, exceptions to the rule may therefore apply, since the default probability may not be linked directly to the LTV. However, the agency will only lower a loan s default probability if it can be shown that the borrower has available savings or investments that, for the reasons stated above, they have chosen not to use as a down payment for their mortgage. Base Default Probability Fitch s model assigns each loan a base default probability that is derived from a matrix, whose variables are ability to pay (DTI) and willingness to pay (LTV). The base default probabilities for a AAA rating scenario are shown on the subsequent page. The matrix splits affordability into five classes, the lowest of which (Class 1) encompasses loans with a DTI of less than 20% and the highest of which (Class 5) encompasses all loans with a DTI exceeding 50% as shown in the table below: Fitch DTI Classes (%) Class 1 < Class Class Class Class Debt to Income Where DTI information is not available on a loanby-loan basis, the agency will assume an income class based on the lender s underwriting standards, particularly focusing on the calculation of free 11

12 Base Default Probability (%) LTV (%) Class 1 Class 2 Class 3 Class 4 Class 5 < >100 Analysed on an Individual Basis DTI available income (as outlined on page 7) in terms of the deductions made to calculate this amount as well as the minimum income threshold requirements. Loan to Value Valuations for German mortgages are generally based on the lending value, which is typically 10%- 20% below the market value (as regulated through the Mortgage Banking Act for mortgage banks). In most cases, Fitch is provided only with the lending value, which it may increase by upto10% to calculate the market value if the lender provides the agency with sufficient comfort that its valuations are below the market value. The agency may adjust this factor in times of high housing market volatility or as a result of differences in the appraisal process. Default Probability Adjustments Fitch adjusts the base default rates on a loan-by-loan basis to account for individual loan, borrower, property or lending/servicing characteristics. Underwriting Quality The base default probabilities shown in the table above assume standard origination and servicing abilities for German mortgage lenders. Fitch reviews and analysis the lender s origination processes and its historical performance information when rating a residential mortgaged-backed portfolio to determine whether it will need to adjust these base default rates. If a given originator or servicer has specific features that differ from standard market practice for example, servicing procedures or technology (systems in place) an adjustment will be applied accordingly. This can reduce default rates by up to 5% or increase them by up to 100%, depending on whether these features are viewed as having a positive or negative influence on the potential default of a loan. The areas of focus for the agency s review of an originator and servicer are summarised in Appendix 6. A strong or weak servicer rating will also be a factor that could specifically lead to positive or negative adjustments in the agency s default assumptions. Servicer ratings for the German market were recently launched and the Germany-specific addendum to Fitch s European Servicer Rating criteria was published concurrently with this report. Rating European Residential and Commercial Mortgage Loan Servicers, published on 14 May 2001 and Rating European Mortgage Loan Servicers - the German Market Addendum dated September 2004 are available at Product Characteristics Fixed Rate Mortgage Approximately 80% of outstanding German mortgage loans carry a fixed interest rate the most typical fixed periods being in the range of five to 10 years (70%). Borrowers with fixed-rate loans may be more susceptible to payment shocks after the reset date; however, Fitch believes this does not warrant a supplementary default factor as the base default probability matrix is based on an analysis of typical lending profiles. Variable-Rate Mortgage Borrowers with variable-rate mortgages can experience payment shocks as a result of underlying index volatility; mortgage lenders usually factor in this risk when determining the free available income, although Fitch may apply a 5%-10% adjustment to variable-rate mortgages to address this additional risk. IO Loans Bullet mortgage loans where the whole loan amount is due at maturity are usually subject to refinancing risk in the event that the borrower cannot source funds to repay their obligation at maturity (termed balloon risk ). Given this increased risk, Fitch will 12

13 increase default probability by up to 20% for loans where the borrower repays principal in one lump sum at loan maturity. However, pure IO loans are fairly uncommon in Germany, and most, in fact, use an alternative repayment scheme as a substitute for direct loan amortisation. The most common alternative payment schemes in Germany are: Building Savings Contracts Capital Life Insurance Policies Fitch may also adjust default probabilities for loans that have an alternative repayment scheme. The magnitude of the adjustment will be determined on the basis of: the type of policy/savings contract the coverage of the outstanding loan amount at maturity the policy/savings provider Fitch will review the type of alternative repayment scheme to assess the extent to which it is a credible substitute for a direct loan amortisation and the extent to which the repayment scheme mitigates a borrower s exposure to balloon risk. If the policy covers only a percentage of the loan amount due at maturity, the borrower may be exposed to a balloon risk, since the remaining loan amount will have to be covered by additional savings. Fitch, therefore views the type of policy backing the principal loan repayment and the expected return or yield on the policy as critical when determining whether or not a borrower is likely to face such a balloon risk. The agency will carefully review the basis for calculating returns under the respective policy to determine the appropriate default adjustments. Finally, for an alternative repayment schemes to mitigate a borrower s exposure to balloon risk and to serve as a credible substitute for direct loan amortisation, it must be set up by a provider that will be able to meet its obligations up to its respective rating level. In this context, Fitch will also consider the extent to which a portfolio s principal balance is concentrated in a single insurance provider. If a disproportionate amount of IO loans are linked to life insurance policies issued by the same provider, Fitch may adjust the default probability of these loans to account for the joint probability of default. Generally, Fitch will reduce the IO default adjustment by the percentage of the principal loan balance covered by the alternative repayment scheme as shown in the example below: Example Revised IO Adjustment Pure IO Adjustment (%) 20 Alternative Repayment Life Insurance Policy Loan Principal Coverage at Maturity (%) 40 Revised DP Adjustment (%) 12 20%-(20%*40%) Source: Fitch Payment Frequency Fitch will stress the default probability for loans where repayments occurs other than on a monthly basis. Borrowers usually receive monthly salary payments therefore larger, less frequent payments could cause payment shocks for borrowers who are unable to manage their personal finances effectively. Depending on the frequency of payment, default adjustments may range between 5% and 15% as shown below: Fitch Payment Frequency Stresses Payment Frequency Default Adjustment Monthly 1 Quarterly 1.05 Semi-Annual 1.1 Annual 1.15 Loan Purpose Fitch views mortgage loans for the construction of new houses and for home improvements (construction deposits) as riskier than loans to purchase an existing home. The amount of the construction loans advanced is usually based on the home s appreciation value after the construction or improvement, and therefore involves additional risks, since the property has yet to be completed. Fitch increases the default probability for construction loans by 10%. The agency does not differentiate between mortgage loans advanced to purchase a home and those advanced to refinance existing mortgage loans. It does not penalise for first-time buyers on the grounds that the base default probability assumptions will include a broad borrower mix. Property Use Fitch assumes that loans secured by properties that are not the primary residence of a borrower are more susceptible to default. These include investment properties (flats or houses purchased for investment purpose and let to third parties), multi-family properties (residential dwellings with several detached condominiums for letting purposes), and second or holiday homes (summer houses, secondary residences). 13

14 Fitch holds the view that a financially distressed borrower is more likely to default on loans secured by a property that is not their primary residence. Furthermore, the debt service for loans backed by investment properties or MFHs may depend on rental income generated by these properties, which may prove more volatile than personal income in stress periods. Accordingly, Fitch increases the base default rate for these types of loans by 25%. These assumptions were confirmed in a study conducted by Fitch that identified the characteristics of delinquent or defaulted loans in Germany RMBS. For full details, refer to German Performance Bulletin 2003, dated 18 November 2003 and available at Borrower Profile Fitch believes self-employed borrowers have a greater probability of default than those who are paid a salary, depending on the nature of their business. In the agency s view, borrowers who earn a fixed monthly salary are more likely to be able to make monthly mortgage payments than self-employed borrowers who generate income from their own business and are more susceptible to economic cycles and business interruption for example, through personal illness. However, self-employment in Germany does not equate to self-certification, as is the case for some lenders in the UK, and borrowers categorised as self-employed will generally be subject to more stringent underwriting criteria than their employed counterparts. Lenders may impose harsher LTV limits and/or higher free available income requirements on this type of borrower. Furthermore, self-employed borrowers will generally have to provide sufficient evidence (in the form of income and tax statements) of their ability to service the loan debt. For these reasons, Fitch increases the default probability on loans to self-employed borrowers by 10%-20% depending on the underwriting criteria the respective lender applies to such borrowers. Fitch reduces the base default probability on loans granted to public sector employees or civil servants by 2%-5% owing to the high degree of job security that these borrowers enjoy in Germany. Additional Features Regional Exposure A weak real estate market coupled with the currently high unemployment rates in eastern Germany have led the agency to increase the default probability for loans secured by properties located in these regions by 25%. A study conducted by Fitch to assess the concentration of specific loan and property characteristics of defaulted loans in German RMBS portfolios corroborated this adjustment. The assessment showed that the non-performing part of RMBS portfolios is highly exposed to loans secured on properties in eastern Germany. For full details refer to German Performance Bulletin 2003, published on 18 November 2003 and available at Delinquencies When rating a portfolio, Fitch multiplies the base default rates for mortgages in arrears by the following adjustment factors. Fitch Arrears Stresses Arrears Bracket Adjustment (%) 0-30 Days Days Days 75 Over 91 Days Default Probability = 100* * Default probability will be set to 100% However, the agency has rarely had to use this table since the vast majority of the portfolios securitised to date have consisted solely of performing loans. For loans less than 90 days in arrears, the stresses indicated above will be applied to the base default probability on a loan-by-loan basis. For loans more than 90 days in arrears, Fitch assumes that the loan will default and consequently applies a default probability of 100%. Seasoning Mortgage default behaviour is generally linked to the length of time a mortgage loan has been performing. Well-seasoned mortgage loans are more likely to perform for their remaining life than newly originated mortgages. Based on available data for rated RMBS transactions, Fitch estimates that mortgage loan defaults in Germany peak approximately five years after origination. Based on these findings, the agency may apply a level of seasoning credit to mortgage loans originated 10 years ago or more. Credit for a shorter seasoning period can be considered on a case-bycase basis depending on the underlying default data provided by the respective originator. However, Fitch will only incorporate seasoning credit into its analysis for loans secured on properties that have benefited from house price appreciation since the last valuation date. Fitch believes it is not justifiable to apply credit for seasoning where the loans are secured on properties whose equity has eroded owing to a decline in property prices. This rules out seasoning benefits for loans located in eastern Germany. 14