Prior to the global financial crisis (GFC) of 2007-2008, concerns about sound mortgage lending were largely lender-based. However, the GFC demonstrated how exuberance on the part of lenders in trying to achieve ambitious loans booked may push the entire world into a crisis. Since the GFC, regulators all over the world have been engaged in developing principles of sound mortgage lending.
A connected word is “responsible lending”. If lending is done without concern about whether mortgage loan is inherently sound, and the borrower has the ability to perform, the lender acts irresponsibly. There are even suggestions that if the loan goes into default within a certain number of months after its origination, the onus will lie on the lender to prove that the lender had acted responsibly. Thus, sound mortgage lending is no more the lender’s prudence; it goes further into the concept of responsible lending.
This article collates major global regulations relating to sound mortgage lending, also known as responsible lending.
Additionally, it covers some of the best practices laid down by mortgage regulatory authorities of major economies which are in line with international bodies such as the Financial Stability Board (FSB), European Banking Association (EBA), and so on.
While the article does not delve into the details of specific underwriting practices, it does suggest a targeted approach to imposing stricter requirements.
Financial Stability Board (FSB) Guidelines
The FSB, based in Basel, Switzerland, was established after the 2009 G-20 London summit as a successor to the Financial Stability Forum (FSF). The FSB includes all G-20 major economies, four prior FSF members, and the European Commission. On 18 April 2012, the FSB issued its Principles, expressly seeking to develop “an international principles-based framework for sound underwriting practices.”
The FSB Principles suggest best practices to be implemented in some fashion by member jurisdictions. However, as the FSB itself is not a regulatory body, the Principles do not attempt to establish specific rules that must be implemented or enforced. For example, the Principles do not mandate international loan-to-value ratios or down payment requirements, nor do they prohibit specific loan features. Indeed, the FSB acknowledges that the Principles are not meant to be a one size-fits-all approach to international underwriting standards.
The FSB states that the Principles “should be implemented according to national circumstances, and as appropriate to national institutional arrangements, whether through legislative, regulatory, or supervisory measures, or through industry practices.” While deferring to local implementation, the Principles emphasise that the consequences of weak residential mortgage underwriting practices in one country can be transferred globally through securitisation of mortgages underwritten to weak standards.
The Principles are predicated on safety and soundness considerations—to improve institutions’ (and markets’) financial stability. They focus only on the credit-granting decision itself, and do not delve into other responsible practices, such as those related to post-origination loan servicing or administration, or overall credit risk management. Most notably, the
principles are not predicated on consumer protection (although strict underwriting, to the extent it lowers default and foreclosure rates, benefits consumers in general).
The Principles will assist FSB members in their efforts to improve financial stability and prudential standards.
- Jurisdictions should ensure that lenders make reasonable inquiries and take reasonable steps to verify a borrower’s underlying income capacity;
- Jurisdictions should ensure that lenders maintain complete documentation of the information that leads to mortgage approval;
- Jurisdictions should ensure that incentives are aligned with accurate representation of borrowers’ income and other financial information.
Rationale: A borrower’s underlying income verification is crucial to effective mortgage underwriting. Jurisdictions should ensure that lenders verify and document each applicant’s current employment status, relevant income history, and other financial information (e.g., credit scores, credit registers) submitted for mortgage qualification. While other financial information can help to measure or to infer a borrower’s historical 'propensity to repay', income verification can help to measure a borrower’s 'ability to repay.'
Reasonable Debt Service Coverage
- Jurisdictions should ensure that lenders, while taking into account data protection rules in their jurisdiction, appropriately assess borrowers’ ability to service and fully repay their loans without causing the borrower undue hardship and over-indebtedness.
- Jurisdictions should ensure that lenders make reasonable allowances for committed and other non-discretionary expenditures in the assessment of repayment capacity.
- Jurisdictions should ensure that lenders provide borrowers with sufficient information to clearly understand the main elements which are taken into account in order to determine a borrower’s repayment capacity, the main characteristics of the loan including the costs, and risks associated with the loan in order to enable borrowers to assess whether the loan is appropriate to their needs and financial circumstances.
Rationale: The debt service coverage could assist institutions to minimise defaults and losses, and thus, promote stability of the financial system. Furthermore, it is an important factor in reducing the likelihood of consumer over-indebtedness and the negative social and economic impact of forced sales.
Appropriate Loan-to-value (LTV) Ratios
- Jurisdictions should ensure that their regulatory and supervisory frameworks appropriately incentivise prudent approaches to the collateralisation of mortgage loans. However, the LTV ratio should not be relied upon as an alternative to assessing repayment capacity.
- Jurisdictions should ensure that lenders adopt prudent LTV ratios with an appropriate level of down payment that is substantially drawn from the borrower’s own resources, not from, for example another provider of finance, to ensure the borrower has an appropriate financial interest in the collateral.
- Jurisdictions should ensure that lenders refrain from relaxing LTV ratios at the time of a boom in the property market.
Rationale: The LTV ratio is the ratio of loan amount to the value of the asset. While computing LTV we take into consideration the real market value of the property and not the depreciated value for tax or accounting purposes. While it is common for individual lenders to apply a cap on LTV ratios, it is not necessary for regulators and supervisers to mandate such a cap if they satisfy themselves that the underwriting standards are sufficiently prudent and are unlikely to be eroded under competitive pressure. However, jurisdictions may consider imposing or incentivising limits on LTV ratios according to specific national circumstances.
Effective Collateral Management
- Jurisdictions should ensure that lenders adopt and adhere to adequate internal risk management and collateral management processes.
- Jurisdictions should ensure that lenders adopt appraisal standards and methods that lead to realistic and substantiated property appraisals.
- Jurisdictions should ensure that lenders require all appraisal reports to be prepared with appropriate professional skill and diligence, and that appraisers (whether internal or external) meet certain qualification requirements.
- Jurisdictions should recognise the importance of sound regulation and oversight of appraisers, either through self-regulation or statutory means.
- Jurisdictions should ensure that lenders maintain adequate appraisal documentation for collateral that is comprehensive and plausible.
- Jurisdictions should ensure that lenders satisfy themselves that the claim on collateral is legally enforceable and can be realised in a reasonable period of time.
- Jurisdictions should ensure that lenders deduct significant incentives or benefits offered in the context of buying the property (e.g., vendor financing of down payments, sales and financing concessions) that may inflate the price of the property in the course of the appraisal process.
Rationale: Collateral management and sound appraisal processes are cornerstone of the mortgage business. Periodic property appraisal would manifest the true value of the property which in turn would help the lenders to fathom whether the property has been appreciated or depreciated.
Prudent Use of Mortgage Insurance
- Jurisdictions should ensure that where mortgage insurance is used, it does not substitute for sound underwriting practices by lenders.
- Jurisdictions should ensure that lenders carry out prudent and independent assessments of the risks related to the use of mortgage insurance, such as counterparty risk and the extent and details of the coverage of the mortgage insurance policies.
- Jurisdictions should ensure that all mortgage insurers be subject to appropriate prudential and regulatory oversight and, where used, represent an effective transfer of risks from lenders to insurers.
Rationale: Mortgage insurance is an insurance policy that protects a mortgage lender or title holder in the event that the borrower defaults on payments, dies or is otherwise unable to meet the contractual obligations of the mortgage. Mortgage insurance lowers the risk of the lender thereby ensuring financial stability in case of any disruption or default by the borrower.
(Rajeev Jhawar is Executive at Vinod Kothari Consultants Pvt Ltd)
