DEVELOPING MORTGAGE DEVELOPING MORTGAGE DEFAULT INSURANCE IN A DEFAULT INSURANCE IN A

TRANSITION NATIONTRANSITION NATIONTHE CASE OF KAZAKHSTANTHE CASE OF KAZAKHSTAN

Sally MerrillSally Merrill

Douglas WhiteleyDouglas WhiteleyPrepared for the World Bank Prepared for the World Bank Housing Finance ConferenceHousing Finance Conference

March 2003March 2003

Why Focus on Why Focus on Kazakhstan?Kazakhstan?

Positive economic environment, falling Positive economic environment, falling inflation, urban growth, legal reformsinflation, urban growth, legal reforms

Competitive, private banking sectorCompetitive, private banking sector Mortgage market small but growingMortgage market small but growing A “policy champion”: Governor of A “policy champion”: Governor of

National Bank of Kazakhstan champions National Bank of Kazakhstan champions financial sector developmentfinancial sector development

NBK funds back reform agenda NBK funds back reform agenda

Mortgage Lending Mortgage Lending EnvironmentEnvironment

Legal infrastructure appears adequateLegal infrastructure appears adequate Foreclosure is non-judicial with set Foreclosure is non-judicial with set

time limits; however, it is basically time limits; however, it is basically untesteduntested

Property registration adequate, at Property registration adequate, at least in urban areasleast in urban areas

Valuation process appears inadequateValuation process appears inadequate Banks are privatized & CARs adequateBanks are privatized & CARs adequate Lending environment competitiveLending environment competitive

Mortgage Market ContextMortgage Market Context

Residential mortgage portfolio = $54 Residential mortgage portfolio = $54 million (12/2002); 8 major bank lendersmillion (12/2002); 8 major bank lenders

Average loan size is $7000; LTV 70%Average loan size is $7000; LTV 70% Loan terms are increasing from 3-5 Loan terms are increasing from 3-5

years to 7-10 years; interest rates have years to 7-10 years; interest rates have fallen from over 20% to 15% - 18% fallen from over 20% to 15% - 18%

Loans are variable rate in $ or tenge Loans are variable rate in $ or tenge pegged to $; rules for change arbitrarypegged to $; rules for change arbitrary

Structure of Market Structure of Market DemandDemand

Mortgage market largely urbanMortgage market largely urban Incomes are low; distributions quite Incomes are low; distributions quite

skewed; equity for 70% LTV limitedskewed; equity for 70% LTV limited Net out-migration, especially rural Net out-migration, especially rural Homeownership rate > 90%Homeownership rate > 90% Banks not willing to underwrite self-Banks not willing to underwrite self-

employed & informal income groupsemployed & informal income groups Long-term potential large as oil and gas Long-term potential large as oil and gas

resources boost GDPresources boost GDP

Corporate Structure of MI Corporate Structure of MI in Kazakhstan: FGICin Kazakhstan: FGIC

Capitalized by National Bank of Capitalized by National Bank of Kazkhstan ($5 million adequate under Kazkhstan ($5 million adequate under most 10-year market scenarios)most 10-year market scenarios)

USAID contributing operating funds for 2 USAID contributing operating funds for 2 to 3 start-up yearsto 3 start-up years

FGIC: Guarantee Fund for Mortgage FGIC: Guarantee Fund for Mortgage Credit; regulated by NBKCredit; regulated by NBK

Private MI-type structure: self-Private MI-type structure: self-supporting post start-up; premium supporting post start-up; premium actuarially sound actuarially sound

HOW WOULD MI WORK IN HOW WOULD MI WORK IN KAZAKHSTAN?KAZAKHSTAN?

Insurance contract between FGIC and Insurance contract between FGIC and approved lenderapproved lender

““General (Master) Policy” details termsGeneral (Master) Policy” details terms Borrower pays the premium to the bankBorrower pays the premium to the bank FGIC insures only the “top slice” FGIC insures only the “top slice” ““Reference” loan is 7 years & 70% LTVReference” loan is 7 years & 70% LTV ““Reference MI Program takes LTV to Reference MI Program takes LTV to

85% with 30% top tier coverage 85% with 30% top tier coverage

MI with 30% Coverage MI with 30% Coverage

Why not Develop Private Why not Develop Private Mortgage Insurance?Mortgage Insurance?

Private MI was first choicePrivate MI was first choice Some Insurance Co. already offering Some Insurance Co. already offering

MI MI Insurance companies lack adequate Insurance companies lack adequate

funds for investment; most are bank funds for investment; most are bank subsidiaries or affiliates & capital subsidiaries or affiliates & capital structures not adequately independentstructures not adequately independent

IFC interested in theory but 51% IFC interested in theory but 51% private funds are not now availableprivate funds are not now available

Advantages of Public Advantages of Public SponsorshipSponsorship

Available capital from NBKAvailable capital from NBK Policy champion with long-term viewPolicy champion with long-term view Integration with regulatory policy & risk Integration with regulatory policy & risk

considerations under Basle IIconsiderations under Basle II Insurance companies: at present, lack Insurance companies: at present, lack

necessary capital; bank subsidiariesnecessary capital; bank subsidiaries Monoline structureMonoline structure Pave way for further Private MI Pave way for further Private MI

developmentdevelopment

Process of Implementing Process of Implementing MIMI

Policy Dialogue: National Bank (NBK)Policy Dialogue: National Bank (NBK) Policy discussions: lenders, insurance, Policy discussions: lenders, insurance,

and KMC (secondary market)and KMC (secondary market) Formal submission of proposal to NBKFormal submission of proposal to NBK

– Corporate structureCorporate structure– Business PlanBusiness Plan– Market scenarios for mortgage finance Market scenarios for mortgage finance – Master Policy Master Policy – Premium ModelPremium Model

MI Provides Major BenefitsMI Provides Major Benefits

Risk Sharing for LendersRisk Sharing for Lenders Affordability for BorrowersAffordability for Borrowers Improved Standardization & Risk Improved Standardization & Risk

Management for Financial Sector Management for Financial Sector DevelopmentDevelopment

Supervisory Benefits to Regulators, Supervisory Benefits to Regulators, especially in context of Basle IIespecially in context of Basle II

MI Benefits to Borrowers MI Benefits to Borrowers

Interest rate “spreads” are too highInterest rate “spreads” are too high Banks still very risk averseBanks still very risk averse But…competitive environment goodBut…competitive environment good Thus, MI expected to lead to:Thus, MI expected to lead to:

– higher LTV lending, and/or higher LTV lending, and/or – decreased interest rates, and/ordecreased interest rates, and/or– increased loan terms, and/orincreased loan terms, and/or– higher risk profile borrowers (informal higher risk profile borrowers (informal

income, etc.)income, etc.)

0

1000

2000

3000

4000

5000

6000

7000

8000

Loan Size

5 years 7 years 10 years

Loan Term

Loan Size by Term and Interest Rate

14%

15%

16%

17%

MI Benefits to LendersMI Benefits to Lenders

Improves efficiency & standardization Improves efficiency & standardization Promotes better risk management, Promotes better risk management,

underwriting and delinquency managementunderwriting and delinquency management Standardizes underwriting & documentation Standardizes underwriting & documentation Supports better delinquency management Supports better delinquency management

and loan “workouts”and loan “workouts” Encourages streamlined foreclosure practicesEncourages streamlined foreclosure practices Promotes credit bureau developmentPromotes credit bureau development Encourages improved property appraisalEncourages improved property appraisal

LTV & Bank Risk Position LTV & Bank Risk Position 20% Coverage 20% Coverage

LTV & Bank Risk Positon at 20% coverage

9085 80

75 7065

72.0 68.0 64.0 60.0 56.0 52.0

LTV: 90% to 65%

LTV

& Ba

nk R

isk

Posi

tion LTV

Bank Risk Position

LTV & Bank Risk Position LTV & Bank Risk Position 30% Coverage30% Coverage

LTV & Bank Risk Position at 30% Coverage

90 85 80 75 70 6563.0 59.5 56.0 52.5 49.0 45.5

0

20

40

60

80

100

1 2 3 4 5 6

LTV: 90% to 65%

LTV

& B

ank

Risk

Po

sitio

n LTV

Bank Risk Position

MI, Risk Management & MI, Risk Management & RegulationRegulation

Basle II introduces LTV-based risk Basle II introduces LTV-based risk weight approach for consideration by weight approach for consideration by National Supervisory AuthoritiesNational Supervisory Authorities

MI important risk management partner MI important risk management partner for lendersfor lenders

MI provides means to higher LTV MI provides means to higher LTV lending via sharing of credit risklending via sharing of credit risk

Favorable supervisory treatment via MI Favorable supervisory treatment via MI for high LTV lendingfor high LTV lending

MI Provides Supervisory MI Provides Supervisory BenefitsBenefits

MI transfers a portion of the credit risk MI transfers a portion of the credit risk outside the banking systemoutside the banking system

Partner in implementing risk-based Partner in implementing risk-based supervisory regime based on LTVsupervisory regime based on LTV

Mandate MI on all loans with LTV Mandate MI on all loans with LTV exceeding a certain risk levelexceeding a certain risk level

Reduce the regulatory capital - lenders Reduce the regulatory capital - lenders & - investors for loans carrying MI& - investors for loans carrying MI

LTV and Relative RiskLTV and Relative RiskInsurer/LTV Relative Risk: 80% LTV = 1.0

80% LTV 85% LTV 90% LTV 95% LTV U.S. Mortgage Information Corp.

1.0 2.53 2.3 4.38

Canada: GE Mortgage Insurance

1.0 n.a. 4.08 10.63

Australia: GE Mortgage Insurance

1.0 1.92 2.34 10.63

UK: GE Mortgage Insurance

1.0 1.30 2.02 10.07

Canada: Mortgage Insurance Corp

1.0 1.99 3.45 7.69

Possible Regulatory Possible Regulatory Changes?Changes?

Now - no regulatory “recognition” of Now - no regulatory “recognition” of features of mortgage lendingfeatures of mortgage lending

No regulatory differentiation by LTVNo regulatory differentiation by LTV R/S Analysis needed as portfolios growR/S Analysis needed as portfolios grow Future regulatory considerations:Future regulatory considerations:

– MI mandatory for all LTV > 70%MI mandatory for all LTV > 70%– Risk weight reduced for loans carrying MI Risk weight reduced for loans carrying MI – LTV-based risk analysis will be initiatedLTV-based risk analysis will be initiated– Separate supervisory oversight, A/L matchSeparate supervisory oversight, A/L match

Risks of Public Risks of Public SponsorshipSponsorship

Future regulatory environment risk - Future regulatory environment risk - Not operating as “Private MI”, monoline, Not operating as “Private MI”, monoline, and non-subsidized and non-subsidized

Slips into role of “social” agencySlips into role of “social” agency Moral hazard: adverse selection Moral hazard: adverse selection Failure to consider sunset clause for Failure to consider sunset clause for

future privatizationfuture privatization Non-level playing field with private MI Non-level playing field with private MI

plans offered by insurance companiesplans offered by insurance companies

Minimizing Risks of Public Minimizing Risks of Public SponsorshipSponsorship

Charter solidifies “Private MI’ operating Charter solidifies “Private MI’ operating naturenature

Partial MI coverage (30%) limits adverse Partial MI coverage (30%) limits adverse selectionselection

Solid underwriting guidelines already put Solid underwriting guidelines already put forth by KMC (secondary market)forth by KMC (secondary market)

Banks & capital market stand to loseBanks & capital market stand to lose No additional capital from NBK - after No additional capital from NBK - after

initial capital allocationinitial capital allocation Private and IFI capital to be sought Private and IFI capital to be sought

GOK has a lot to lose: MI GOK has a lot to lose: MI Helps Capital & Secondary Helps Capital & Secondary

MarketsMarkets

GOK counting on mortgage-backed debt GOK counting on mortgage-backed debt as key alternative to Govt. paperas key alternative to Govt. paper

Institutional investors want new productInstitutional investors want new product MI expected to increase market growthMI expected to increase market growth Credit enhancement will augment loans Credit enhancement will augment loans

eligible for purchase by KMCeligible for purchase by KMC MI “softens” bank arguments against MI “softens” bank arguments against

KMC policy of purchase with recourseKMC policy of purchase with recourse

MI Development TeamMI Development Team

Kazak champion: Governor of NBKKazak champion: Governor of NBK USAID support and resident consultant USAID support and resident consultant

project (FSI); Kazak & U.S. expertsproject (FSI); Kazak & U.S. experts U.S. experts: policy development, U.S. experts: policy development,

business pro forma, premium & risk business pro forma, premium & risk management modeling, IT/operations management modeling, IT/operations

Kazak experts: financial & legal analysis, Kazak experts: financial & legal analysis, underwriting, mortgage & regulatory underwriting, mortgage & regulatory policiespolicies

Plans, Models, & Scenarios Plans, Models, & Scenarios

Market growth and MI utilizationMarket growth and MI utilization Business Plan & Pro FormaBusiness Plan & Pro Forma Premium Model simulationsPremium Model simulations Market profile & risk scenarios: Market profile & risk scenarios:

expected, optimistic, & adverseexpected, optimistic, & adverse Costs: operating costs & claim costsCosts: operating costs & claim costs Financial return assumptionsFinancial return assumptions

Premium Model User Premium Model User VariablesVariables

3 mortgage market risk scenarios3 mortgage market risk scenarios Book year default rate Book year default rate Interest rates & loan payoff rateInterest rates & loan payoff rate Operating costs: underwriting, taxesOperating costs: underwriting, taxes Claim costs: salvage value at default, Claim costs: salvage value at default,

delinquent interest, legal & foreclosure delinquent interest, legal & foreclosure costs, taxes, maintenance costscosts, taxes, maintenance costs

Financial costs and expectations: risk-Financial costs and expectations: risk-to-capital, investment return, ROE to-capital, investment return, ROE

Premium Model Premium Model Calculations & Output Calculations & Output

Variables Variables Present value calculations for losses, Present value calculations for losses,

expenses, and profitexpenses, and profit Premium rates: annual & singlePremium rates: annual & single Premium rate determined for: Premium rate determined for:

– LTV ratio: 70%, 75%, 80%, 85%, 90%LTV ratio: 70%, 75%, 80%, 85%, 90%– MI coverage: 15%, 20%, 25%, 30%, 40% and MI coverage: 15%, 20%, 25%, 30%, 40% and

50%50%– Loan term: 3, 5, 7, and 10 yearsLoan term: 3, 5, 7, and 10 years

Premium = weighted average of 3 loss Premium = weighted average of 3 loss scenarios: 50% expected + 25% high & scenarios: 50% expected + 25% high & lowlow

0

0.5

1

1.5

2

2.5

Premium Rate

50% 60% 70% 80% 90%

Salvage Value

Premium Rate by Salvage Value

5 years

7 years

10 years

0

0.5

1

1.5

2

2.5

3

Premium Rate

90 85 80 75 70

LTV

Premium Rate by LTV and Loan Term for 30% MI Coverage

5 year loans

7 year loans

10 year loans

0

0.5

1

1.5

2

2.5

3

Premium Rate

1.5 2 2.5 3 3.5 4 5

Default Rate

Premium Rate by Default Rate and Loan Term

7 years

10 years

Serious Information Serious Information Problems!Problems!

Mortgage Market, & its IT, are youngMortgage Market, & its IT, are young Loan terms short, few seasoned loansLoan terms short, few seasoned loans Default rate low; little experience with Default rate low; little experience with

foreclosureforeclosure No “book year” data (default/pay-offs)No “book year” data (default/pay-offs) Result: use of U.S. LTV default Result: use of U.S. LTV default

probability curves in Premium Model - probability curves in Premium Model - a good news/bad news situation a good news/bad news situation

Recommendations for Recommendations for Start-up MI Plans for FGICStart-up MI Plans for FGIC

Coverage: Coverage: – 30%; perhaps 20% also30%; perhaps 20% also

LTVs: LTVs: – 75%, 80%, & 85%75%, 80%, & 85%– (norm is now 70%)(norm is now 70%)

Single payment plan to assist early Single payment plan to assist early cash flow for FGICcash flow for FGIC

Start with a manageable # of plansStart with a manageable # of plans

Ongoing RequirementsOngoing Requirements

Revise Premium Model with Kazak data: Revise Premium Model with Kazak data: LTV default rate curves; prepaymentsLTV default rate curves; prepayments

Establish system to provide book year Establish system to provide book year data for Premium Model data for Premium Model

Revise Premium Model input variables:Revise Premium Model input variables:– market conditionsmarket conditions– operating and capital costsoperating and capital costs– financial requirements and returnsfinancial requirements and returns

Long-term Horizon in Long-term Horizon in Kazakhstan?Kazakhstan?

Privatization: investment by local Privatization: investment by local or international insurance or international insurance companies?companies?

IFC or other IFI participation? IFC or other IFI participation? Sunset clause?Sunset clause? Establish co-existing monoline Establish co-existing monoline

Private MI?Private MI?

Recommendations for Recommendations for Transition Nations Transition Nations

Promote Private MI if possiblePromote Private MI if possible If not possible, develop a Private MI structure If not possible, develop a Private MI structure Include long-term plan for privatizationInclude long-term plan for privatization Insure only “top slice”: Insure only “top slice”:

– risk sharing crucial; banks can’t rely on risk sharing crucial; banks can’t rely on Government for risk management Government for risk management

– Government. must minimize moral hazard riskGovernment. must minimize moral hazard risk Coordinate with regulatory, capital market, Coordinate with regulatory, capital market,

and mortgage-backed debt developmentand mortgage-backed debt development