Best Practices for Sound Mortgage Lending-3
Rajeev Jhawar 29 January 2019
In previous two parts, we have seen how regulators are working on sound mortgage lending practices and guidelines issued by some of the authorities. This is the concluding part of a three-part series. 
 
I feel lending standards should be applied in a coordinated way, leading to a balanced approach that can vary with the national or economic context. Such an approach aims at preventing excessive build-up of risks like risk layering, avoiding one-dimensional policies that could exclude some creditworthy categories from housing finance, and dampening cycles that could arise from neglecting important dimensions, both in overheating phases (undue relaxation) or downturns.
 
Here are some more guidelines issued by regulators…
 
Consumer Financial Protection Bureau Guidelines
 
The Consumer Financial Protection Bureau (CFPB) is a regulatory agency in the US charged with overseeing financial products and services that are offered to consumers. The Office of Fair Lending research, community affairs, consumer complaints, and the Office of Financial Opportunity are the several units into which the CFPB is actively involved. 
 
Post deterioration in underwriting standards leading to dramatic increases in mortgage delinquencies and rates of foreclosures, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act created broad-based changes to how creditors make loans and included new ability-to-repay requirements, which the CFPB is charged with implementing.
 
The CFPB expects the mortgage lenders to evaluate consumer’s financial information. A lender generally must document: a borrower’s employment status; income and assets; current debt obligations; credit history; monthly payments on the mortgage; monthly payments on any other mortgages on the same property; and monthly payments for mortgage-related obligations. Besides, lenders can’t base their evaluation of a consumer’s ability to repay on teaser rates rather they will have to determine the consumer’s ability to repay both the principal and the interest over the long term − not just during an introductory period when the rate may be lower.
 
Further, lenders will be presumed to have complied with the Ability-to-Repay rule if they issue “Qualified mortgages.” In order to be classified as qualified mortgage, certain criteria have been listed by the CFPB  which are as follows:
 
 
In order to ensure responsible mortgage lending practice CFPB updates the norms accordingly and which are in the best interest of the economy.
 
The Australian Prudential Regulation Authority (APRA) Guidelines
 
The Australian Prudential Regulation Authority (APRA) is an independent statutory authority that supervises institutions across banking, insurance and promotes financial system stability in Australia. APRA has implemented a range of supervisory measures to reinforce sound residential mortgage lending practices. This has included benchmarks on investor loan growth, prudential guidance to strengthen industry standards and targeted reviews to scrutinize lending practices.
While establishing norms for mortgage lending, APRA has had regard to the Financial Stability Board’s (FSB) Principles for Sound Residential Mortgage Underwriting Practices (FSB principles), which sets out minimum underwriting standards that the FSB encourages supervisors to implement. Although the exact details may differ somewhat to reflect local conditions, but the underlying theme remains the same.
 
In respect to the loan serviceability, APRA expects authorized deposit taking institutions (ADI) to undertake a new serviceability assessment whenever there are material changes to the current or originally approved loan conditions. Such changes would include a change of repayment basis from principal and interest to interest-only, or the extension of an existing interest-only period. A change from a fixed-rate basis to a floating-rate basis (or vice versa), or an extension in the tenor of the loan are other examples of material changes. A new serviceability assessment would be appropriate for any change that increases the total repayments over the life of the loan, even when immediate periodic repayments are lower than under the previous loan conditions. 
 
Loan serviceability policies would include a set of consistent serviceability criteria across all mortgage products. A single set of serviceability criteria would promote consistency by applying the same interest rate buffers, serviceability calculation across different products offered by an ADI. Where an ADI uses different serviceability criteria for different products or across different ‘brands’, APRA expects the ADI to be able to articulate and be aware of commercial and other reasons for these differences, and any implications for the ADI’s risk profile and risk appetite. 
 
ADIs generally uses net income surplus (NIS) model to make an assessment as to whether the borrower can service a particular loan, based on the nature of the borrower’s income and expenses. Good practice would ensure that the borrower retains a reasonable income buffer above expenses to account for unexpected changes in income or expenses as well as for savings purposes.
 
When assessing a borrower’s income, an ADI would discount or disregard temporarily high or uncertain income. Similarly, it would apply appropriate adjustments when assessing seasonal or variable income sources. For example, significant discounts are generally applied to reported bonuses, overtime, rental income on investment properties, other types of investment income and variable commissions. Good practice is to apply discounts of at least 20 per cent on most types of non-salary income; in some cases, a higher discount would be appropriate. In some circumstances, an ADI may choose to use the lowest documented value of such income over the last several years, or apply a 20 per cent discount to the average amount received over a similar period. Self-employed borrowers are generally more difficult to assess for borrowing capacity, as their income tends to be less certain. 
 
Accordingly, an ADI would make reasonable inquiries and take reasonable steps to verify a self-employed borrower’s available income. Verification of a self-employed borrower’s stated income is normally achieved through a combination of obtaining income and cash flow verification and supporting documentation, including third-party verification. This could include, for example seeking written advice from the accountant/tax advisor confirming actual or likely income levels; reviewing income tax assessment notices and returns; and so on. In the case of investment property, common industry practice is to include expected rent on a residential property as part of a borrower’s income when making a loan origination decision. In APRA’s view, good serviceability policies incorporate a minimum haircut of 20% on expected rental income, with larger haircuts appropriate for properties where there is a higher risk of non-occupancy.
 
Conclusion
 
In all instances, a robust and effective assessment of individual affordability must underpin any sustainable lending model. The policymakers should ensure that different types of mortgage providers, whether or not currently regulated, are subject to consistent mortgage underwriting standards, and consistent regulatory oversight and enforcement to implement such standards. 
 
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(Rajeev Jhawar is Executive at Vinod Kothari Consultants Pvt Ltd) 

 

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