The Mortgage Insurance Trade Association (MITA) recently submitted its commentary concerning the Financial Services Authority (FSA) Consultation Paper 189 (CP 189), which was released last year. CP189 outlines the FSA's plans for implementation of Basle II and EU Capital Adequacy Standards. MITA endorses the FSA's consultative approach in facilitating the implementation of new capital standards and has identified a number of concerns set forth in this response.
"[CP189] basically outlines the FSA's view on how they would implement the accord to other segments of the industry and its approach to risk weighting for mortgage holdings," said one source at MITA. "We've encouraged the FSA to look at LTVs as a key determinant to risk, but we feel that Basle has been fairly vague as to how it should be applied."
MITA does not believe FSA's recommendation for weighting against LTVs sufficiently covers the risks.
The FSA proposes that a 35% risk weight be applied against portions of mortgages up to 75% loan-to-value (LTV), with a marginal risk weight of 75% applied to loan portions in excess of 75% LTV. When considering the risk weight upon the entire loan, this approach has the effect of applying a constant 35% risk weight on mortgages up to 75% LTV, followed by a gradually sloped linear function up to 45% on mortgages up to 100% LTV, explained one market source.
According to MITA, market evidence strongly indicates that as the LTV increases, the probability of default and loss given default both increase. "Mortgage lenders purchase mortgage indemnity guaranty insurance that covers principal exposure above 75% LTV to provide protection against the greater risks involved with such lending," explained one source. "The application of the 45% incremental risk weight only on the loan portion over 75% LTV does not recognize the degree to which the risk actually increases."
MITA suggests that the scaling of these weights could be determined so that the capital required for mortgages by LTV band is proportionate to the expected losses of mortgages within each LTV band. They suggest that this approach would add accuracy to the measurement of mortgage risk, as opposed to a two-tiered approach. Furthermore, the two-tiered approach could motivate lenders to concentrate at the upper risk segment of each bucket (those lending close to but not greater than 75%).
MITA also responded to the suggestions that the LTV measurement be calculated using a house price index (HPI), but suggested that these indexes can mask specific trends and can lack the precision.
"An HPI can be a useful tool to provide a general or average indication of market movements," said MITA. "However, an HPI can mask appreciation variations by geography, home price segment, property type or other significant cohorts. Defaults and loss are not driven by averages. Rather, a distribution of factors, including house price appreciation, drives mortgage defaults and losses. Therefore, allowing the use of indexed LTV for risk measurement introduces a significant margin of error to capital adequacy standards."
"MITA believes that LTV based upon the original house valuation is the most reliable market data point for each individual mortgage as it is based upon the actual market-clearing purchase price, or a proper valuation in the case of a re-mortgage," MITA added.
MITA, which was founded more than two years ago in 2001, represents the interest of European providers of mortgage insurance and includes specialty insurance providers such as PMI Group who have initiated a claims certainty pledge the group hopes will pave the way for greater creativity in the markets going forward.
FSA also addressed the reduction of expected losses with the use of a credit risk mitigant such as mortgage insurance. MITA believes that a clarification is in order from the FSA that would encourage the dispersion of mortgage risk beyond the banking system and into the insurance sector, thereby improving banking system stability.
"The U.K. has in the past suffered from a fallout of claims certainty and, as a result, some creativity for the use of mortgage insurance has been lost," explained one market source.
PMI, for example, recently acquired the mortgage insurance portfolio of U.K. multi-line Royal Sun Alliance. Sources at PMI said that this positions them with favorable footing - all past RSA clients have signed on to continue with the specialty provider and plans are to beef up the potential clientele. "Building societies used to carry this type of coverage out but stopped using it about a decade ago because of issues regarding coverage," one source at PMI said. "One of the things we are dedicated to is presenting ourselves as a specialty insurer - we pledge to be very responsive."
PMI already counts three top U.K. lenders as clients and provides them with risk management through their synthetic transactions technology. There is more room to explore once the market becomes comfortable with its product. At PMI, sources expect to see more business by way of synthetic transactions as well as the growing use of structured covered bonds in the U.K. market and throughout the European continent.
"HBOs opens up a whole new world for all issuers but by following the German model for LTV that only allows for 60%; it's following a very conservative approach, and it leaves a lot of mortgages out of the potential pot for eligibility," explained the PMI source. PMI believes the use of mortgage insurance allows banks and lenders to protect the collateral at a higher LTV margin: "Based on the interest we have seen so far, we think there is a large pool of assets that can be included under future covered bond structures."
Although many of the U.K. institutions have risk distributed across a good variety of product lines, they generally are limited to consulting this business within the U.K. market. A specialty lender might also be in the position to provide diversification throughout the global markets. PMI, for example, offers diversification possibilities through the Australian and Asian markets as well as continental Europe.
"The last 10 years have been phenomenally good in the U.K. business cycle, but you still have to think about shifting risk outside of the institution on the probability that the cycle may shift the other way," said one market source. U.K. lenders have to start to look at different possibilities, the source added, because, while no one is predicting a crash in the cycle, signs exist of a deteriorating environment with debt ratios moving up, housing appreciation slowing and consumer debt levels rising.