In previous article, we saw how regulators across the globe are engaged in developing principle of sound mortgage lending, post the global financial crisis of 2007-2008. In this part, we will take a look at guidelines issued by several authorities for sound mortgage lending.
European Banking Authority (EBA) Guidelines
To ensure that potential risks associated with mortgage lending are managed adequately by credit institutions, and to contribute to the development of consistent practices in this area, the European Banking Authority (EBA) opined on good practices for mortgage lending. However, wording of the good practices laid down by EBA closely follows the FSB Principles.
The guidelines apply to loans to consumers that are: secured either by residential mortgage or by another comparable security commonly used in some EU markets on immovable residential property; secured by a right related to immovable residential property; and loans, the purpose of which is to acquire or retain rights in immovable residential property.
In addition to FSB’s criteria concerning verification of information, EBA also suggests specifying the minimum period for which consumers should be asked to provide income information by creditors, using a specified minimum amount for living expenses for each household member as part of the creditworthiness assessment, requiring the calculation of a reasonable loan load or debt-to-income maximum for each consumer, the need for the creditor to consider documenting that the consumer is financially able to bear the risks attached to a foreign currency mortgage (which would include considering the impact of a severe depreciation of the local currency and an increase in foreign interest rates); the creditor having to provide numerical examples to illustrate the impact of increases in variable interest rates, or of currency fluctuations where the loan is a foreign currency mortgage.
Further, practice identified by EBA in relation to Loan to Value ratio involves the consumer needing to certify that any down payment is from their own funds rather than from other borrowing; that in the event of repayment being based on the sale of the asset, the assessment should consider changes in market value and liquidity rating.
Office of the Superintendent of Financial Institutions (OSFI) Guidelines
The Office of the Superintendent of Financial Institutions (OSFI) is an independent agency of the government of Canada established in 1987 to contribute to public confidence in, and the safety and soundness of, the Canadian financial system. OSFI supervises and regulates federally registered banks and insurers, trust and loan companies, cooperative credit associations, and fraternal benefit societies, as well as private pension plans subject to federal oversight, and ensures that they are complying with their governing legislation.
The supervision of Federally Regulated Mortgage Insurers(FRMI) is principles-based. It requires the application of sound judgment in identifying and assessing risks, and determining, from a wide variety of supervisory and regulatory options available, the most appropriate method to ensure that the risks that an FRMI faces are adequately managed.
This Guideline sets out the Office of the Superintendent of Financial Institutions’ (OSFI’s) expectations for prudent residential mortgage insurance underwriting and related activities. This Guideline is applicable to all federally-regulated mortgage insurers (FRMIs) to which the Insurance Companies Act
applies and that provide mortgage insurance for residential mortgage loans in Canada, and/or reinsurance for such insured loans.
Section II of this Guideline articulates six fundamental principles for sound residential mortgage insurance underwriting that has been illustrated in the table below:
The final section of the Guideline outlines disclosure and supervisory requirements. However, our focus would be confined to Principle 2 to 4
A FRMI should ensure that a lender applying for mortgage insurance coverage is adequately qualified to offer and service mortgage loans and that it has adequate processes in place to comply with the FRMI’s mortgage insurance coverage requirements, before providing mortgage insurance coverage to that lender.
To carry out an initial assessment of a mortgage lender, a FRMI should establish sound qualification standards. Factors that should be considered include, but are not limited to:
The mortgage loan parameters shown below are central to FRMI central to its sound mortgage lending practices.
The purpose of the loan;
Maximum mortgage loan size and, if applicable, maximum exposure to any one borrower and/or related parties;
Maximum loan-to-value (“LTV”) ratio; and
Maximum allowable loan term and amortization length.
Besides establishing mortgage loan parameters, borrower’s background and willingness and capacity to service debt are also significant to ensure prudent mortgage lending. As part of its criteria for mortgage loans, a FRMI should establish and outline prudent underwriting criteria for the assessment of the borrower, which should include, but is not limited to:
Background and Credit History: An FRMI should outline acceptable methods for lenders to assess the financial background of prospective borrowers, including the use of credit history checks and credit bureau reports. The mortgage loan criteria should outline the FRMI’s minimum credit bureau score requirements.
Down Payment: An FRMI should establish minimum down payments, as well as acceptable sources of down payment in its criteria. In particular, the FRMI should specify where traditional sources of down payment (e.g., borrower’s own equity) are required and cases where non-traditional sources for the down payment (e.g., borrowed funds) may be used. Where non-traditional sources of down payment are being used, further consideration should be given to establishing greater risk mitigation and/or additional premiums to compensate for increased risk. Incentive and rebate payments (i.e., “cash back”) should not be considered part of the down payment.
Income and Employment Verification: An FRMI should specify for lenders, processes for verifying a borrower’s underlying income and sources of income. This includes substantiation of employment status and the income history of the borrower. For borrowers who are self-employed, an FRMI should outline reasonable steps for lenders to obtain income verification (e.g., Notice of Assessment) and relevant business documentation.
Debt Service Coverage: An FRMI should outline quantitative limits on debt service coverage ratios, using measures such as the total debt service (TDS) and gross debt service (GDS) ratios, as a means to assess affordability. To reduce ambiguity, an FRMI should clearly outline the formulae to be used by lenders to calculate debt service coverage and describe how key inputs (e.g., income, mortgage loan interest and principal repayment, other debt obligations, etc.) should be treated.
Loan Recourse and Additional Assessment Criteria: An FRMI’s decision to insure a mortgage loan (or require higher risk mitigation) should consider the effectiveness of recourse against the borrower in the event of borrower default. To the extent possible, an FRMI should also consider factors that would not ordinarily be captured by income and debt serviceability metrics, such as the borrower’s assets (e.g., savings).
Furthermore, conducting a thorough assessment of the underlying property, prior to insurance approval, helps to reduce risk in the residential mortgage insurance business. As part of the FRMI’s criteria for mortgage loans, an FRMI should outline clear and transparent policies in respect of the property acting as collateral, including insurable property types, responsibility for property valuation and property valuation assessment.
In assessing the value of a property (or requiring a third party to carry out the assessment), an FRMI should take a risk-based approach, and consider a combination of valuation tools and appraisal processes appropriate to the underlying risk being undertaken (e.g., automated valuation model, review of comparable properties, on-site inspections, drive-by appraisals, progress inspection reports, and/or a full appraisal). In general, an FRMI should not rely exclusively on any single method for property valuation. An FRMI should undertake a more comprehensive and prudent approach to collateral valuation for applications with higher overall risk (e.g., less liquid properties, higher risk borrowers).
OSFI expects FRMI to undertake reasonable inquiries and reviews, on a risk-based and periodic basis, into lenders’ underwriting practices as well as to exercise a relatively higher level of examination and scrutiny in respect of underperforming lenders (e.g., those with proportionately higher levels of delinquencies and claims, on a risk-adjusted basis) or whose practices have been found unsatisfactory or inconsistent with the insurer’s criteria or conditions established in the mortgage insurance policies (e.g., poor loan documentation, inconsistent reporting, evidence of misrepresentation, forms of negligence, etc.)
(Rajeev Jhawar is Executive at Vinod Kothari Consultants Pvt Ltd)