The new Prudential treatment for residential real estate

Transcription

1 The new Prudential treatment for residential real estate 04/09/2009 Pag. 1 di 7

2 The new Prudential treatment for residential real estate This paper describes the CRIF position about a specific question included in the Consultation on the CRD launched by the European Commission regarding further possible changes to the Capital Requirements Directive. The specific point treated is the question 17, Section 3 of the Consultation Document: Is the suggested prudential treatment for both residential and commercial real estate sufficiently sound?. The experience of CRIF in international market analysis and the availability of a large credit data about the Italian credit market stored in the Eurisc, the Italian Credit Reference Agency for Retail Credit (consumer and Small Business credit lines), could yield an interesting and unordinary point of view for the Regulator about the Capital Adequacy review. The paper is divided into 4 main points: Short history and Profile of CRIF The characteristics of Italian mortgage market The characteristics of US mortgage market The impact on Capital Requirement of the treatment for residential real estate Conclusions History and Profile of CRIF CRIF is an international Group, specializing in the design, development and management of solutions for credit risk control and financial marketing for the Retail Credit Portfolios (Consumer and SME s). Established in Bologna Italy in 1988, CRIF is now leader in credit reporting services and decision support systems due to its integrated offer of information, scoring models and analytics, internal rating systems, outsourcing services, software and consultancy. CRIF helps organisations such as Credit lenders, financial institutions, retailers, insurance companies, utilities and telecoms to manage their customer base along the whole lifecycle, from strategic planning, to acquisition and portfolio management, to debt collection. The main business areas of CRIF Group are: information solutions decision support systems outsourcing services in order to provide clients with global solutions in managing of credit risk and build successful and lasting customer relationships. More than 1,400 banks and financial institutions all over the world use CRIF services on a daily basis. From 1997 CRIF has experienced an exceptional international growth and operates with subsidiary and joint venture companies in the United Kingdom, Russia, Czech Republic, Slovak Republic, Poland, the United States, Mexico and China. Pag. 2 di 7

3 CRIF S.P.A., partially owned by all major Italian Organizations, manages Eurisc, the Italian Credit Reference Agency for Retail Credit (consumer and Small Business credit lines). Empirical evidences on the mortgage market Graph1: Italy - Default rate 1 - mortgages dic-06 mar-07 giu-07 set-07 dic-07 mar-08 giu-08 set-08 dic-08 mar-09 % Source: CRIF The default rate trend of Italian mortgage market has been increasing in the last 12/18 months, as a consequence of: The economic downturn that has impacted on the financial balance of households via a slight decrease in real available income and increase in the unemployment rate. Such dynamics have an impact on credit quality resulting in slight but progressive deterioration. Interest rate dynamics: an important role was played by high interest rates for almost the entire 2008 which had a negative impact on the amount of the variable-rate mortgages instalment, and more often than in the past, resulting in repayment difficulties. Vintage effect: after nearly a decade of sustained growth, the Italian mortgage market has slowed down the growth. As a consequence, new defaults coming from mortgages granted during the past 5 years are related to a decreasing denominator. The diffusion of financial products, in recent years, toward new customer groups (immigrants, young people) have brought both innovation elements (such as longer maturity and higher amount financed) and new elements of risk. Pag. 3 di 7

4 Despite the severity of the crisis, a default rate of 1.8% in the mortgage market can be defined as significant but contained if compared to other international markets. For example, the US mortgage market showed very different performances. The delinquency trend of USA mortgage market is significantly differentiated for Fixed Rate Mortgages (FRM) and Adjustable Rate Mortgages (ARM). The FRM trend shows a relevant increase starting from Q1_2008, while dramatic increases in the ARM trend start from Q2_2007. Graph2: US - Delinquency rate mortgages Q1_2006 Q2_2006 Q3_2006 Q4_2006 Q1_2007 Q2_2007 Q3_2007 Q4_2007 Q1_2008 Q2_2008 Q3_2008 Q4_2008 Q1_2009 Q2_2009 Prime ARM Mortgages: Total Past Due: United States (SA, %) Prime FRM Mortgages: Total Past Due: United States (SA, %) Source: Mortgage Bankers Association The evidence of this analysis underlines the fact that the ARM is the real driver of the current crisis while the default rate in the FRM segment appears to be growing in a considerably less sustained fashion. On top of this, it seems likely that changing the offering might have additionally contributed to the U.S. mortgage crisis. Starting from 2000, the strategy of the U.S. financial and credit system has been the expansion of the customer base through the creation and distribution of new financial instruments for all the consumer groups (e.g., ARM, ALT-A ). The choice of offering financial products such as ARM to segments of the population that did not meet the necessary conditions for debt repayment, 1 The Default Rate is calculated as: (number of 6-month past-due credits + number of bad loans in the preceeding 12 months) / (total number of non-defaulted credits at the beginning of the reference period). Pag. 4 di 7

5 probably contained an element of risk strictly linked to the changing expectations in the housing market. Specifically, the subprime mortgage market has grown more than the average in the years before stabilizing at around 14% of the total market (20% if we include the share of mortgages issued or guaranteed by government agencies that address this category of parties.) Impact on Capital Requirement of the proposed rule The impact on capital requirement under the standardized approach for the Italian banking system can be estimated from the Eurisc database. The study was performed using more than residential mortgages (around 200 bn Euros in terms of loans originated) present at December Graph3 shows the exposures distribution of the portfolio in terms of year of origination. Given that a high percentage of the portfolio has been originated from 2005 and that the amount weighted average maturity is around 17 years, the Italian portfolio is quite young. Graph3: Distribution of the mortgages in terms of year of origination Fonte: CRIF Therefore, a big portion of the portfolio seems to have an LTV higher than 40%. A more accurate analysis of the impact of the proposed rule requires to develop the amortizing plan of those loans until December 2008, and to compare the outstanding with the house values as estimated by the bank during the application. We do not have the house values at the loan level so we estimate them at the portfolio level applying an average LTV (65% is a reasonable approximation for the Italian market) to the initial amount of the mortgage. Pag. 5 di 7

6 As a result it is possible to quantify the impact on capital requirements as a function of the initial LTV (which is subject to scenarios given that it has been estimated) and different thresholds for considering an exposure fully secured. Table 1 shows the results of the simulations. Two main conclusions can be drawn: The 40% threshold has a relevant impact on capital requirements; This effect is still present even applying LTVs between 60% and 65%; On the other hand, the effect will be significantly lower if the threshold were to be set around 50%-55%. Tab1: Impact on capital requirements (Standardized Approach) Percentage Increment in capital requirements (Standardized Approach) Initial LTV 50% 60% 65% 70% 80% Maximum LTV threshold 40% 8% 26% 33% 39% 48% 45% 0% 15% 23% 29% 40% 50% 0% 4% 12% 20% 32% 55% 0% 0% 2% 10% 23% 60% 0% 0% 0% 1% 15% Source: CRIF Conclusions As far as the question 17, Section 3 of the Consultation Document on the CRD launched by the European Commission regarding further possible changes to the Capital Requirements Directive: Is the suggested prudential treatment for both residential and commercial real estate sufficiently sound? is concerned: The current crisis is probably the consequence of a large amount of system-wide liquidity which led to excessive risk taking and leverage; however, the housing/mortgage market played an important role. As an independent observer, however, we do not believe that a unique general rule, such as an LTV threshold, could be completely sound. In fact, although a fine tuning of the rules on the mortgage market could be welcome, a 40% threshold would probably bring to generalized higher capital requirements as a buffer against housing depreciation which was not the main driver of the current crisis, and on the other hand, it might be excessively low for the level of risk of a traditional mortgage; furthermore, two important elements such as the lack of transparency in contractual conditions and neglecting debt affordability would remain uncovered since the LTV is not significantly different from traditional mortgages; Pag. 6 di 7

7 in conclusion, we believe that the new rule should focus both on reducing the LTV threshold yet to a level significantly higher than 40%, and on excluding the ARM-style mortgages from the eligibility for the 35% risk weight. Pag. 7 di 7