Regulatory Framework for Secondary Mortgage Markets

1
Regulatory Framework for Secondary Mortgage
Markets

• Britt Gwinner
• The World Bank
• March 10-13, 2003

2
Outline

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

3
Why Regulate?

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

4
Clear, Detailed Disclosures

• Consistent format facilitate comparisons
• 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
• About the issuer Complete financial statements,
  loan bond servicing capacity

5
Financial Regulations

• Capital, liquidity, insider lending, underwriting
  quality, financial controls, servicing operation
• 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
• Prevent regulatory arbitrage i.e., tailoring
  charter or activities to seek looser rules
• 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 II - Three Pillars

• Minimum capital requirement
• Improved link to specific risks
• Supervisory review process
• Sound internal processes, risk assessments
• Market discipline
• Enhanced disclosures by banks

8
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
• Internal Ratings Based (IRB) Banks may use own
  credit assessments, subject to methodological and
  disclosure standards
• Requires substantial data and analytic
  capabilities

9
Standardized Approach-Retained Mortgages

• Retained residential mortgages carry a 40 percent
  risk weight
• For example,
• 30 million mortgage portfolio
• Capital Required
• 0.96m 30m 0.40 0.08
• Or, 3.2 percent of total portfolio

10
IRB Risk Weights-Retained Mortgages
11
Securitization Simplified
Individual Mortgages
Credit Allocation
(Also vertical slicing for maturity)
Pooled, Sold to SPV
AAA
Sold to Pension Funds, Insurance Companies
A
Retained by Issuer
Unrated
12
Standardized Approach Example
13
Standardized Approach Example
14
IRB Approach Example
15
Accounting Issues

• Reporting literature complex
• Some areas of emerging practice exist
• Key is clear disclosure of assumptions, risks to
  values and earnings as reported

16
Concluding Remarks

• 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
• Regulators have their work cut out for them to
  tailor Basel II and IAS rules to their markets