DEVELOPING MORTGAGE DEFAULT INSURANCE IN A TRANSITION NATION THE CASE OF KAZAKHSTAN

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DEVELOPING MORTGAGE DEFAULT INSURANCE IN A
TRANSITION NATIONTHE CASE OF KAZAKHSTAN

• Sally Merrill
• Douglas Whiteley
• Prepared for the World Bank Housing Finance
  Conference
• March 2003

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Why Focus on Kazakhstan?

• Positive economic environment, falling inflation,
  urban growth, legal reforms
• Competitive, private banking sector
• Mortgage market small but growing
• A policy champion Governor of National Bank of
  Kazakhstan champions financial sector development
• NBK funds back reform agenda

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Mortgage Lending Environment

• Legal infrastructure appears adequate
• Foreclosure is non-judicial with set time limits
  however, it is basically untested
• Property registration adequate, at least in urban
  areas
• Valuation process appears inadequate
• Banks are privatized CARs adequate
• Lending environment competitive

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Mortgage Market Context

• Residential mortgage portfolio 54 million
  (12/2002) 8 major bank lenders
• Average loan size is 7000 LTV 70
• Loan terms are increasing from 3-5 years to 7-10
  years interest rates have fallen from over 20
  to 15 - 18
• Loans are variable rate in or tenge pegged to
  rules for change arbitrary

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Structure of Market Demand

• Mortgage market largely urban
• Incomes are low distributions quite skewed
  equity for 70 LTV limited
• Net out-migration, especially rural
• Homeownership rate gt 90
• Banks not willing to underwrite self-employed
  informal income groups
• Long-term potential large as oil and gas
  resources boost GDP

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Corporate Structure of MI in Kazakhstan FGIC

• Capitalized by National Bank of Kazkhstan (5
  million adequate under most 10-year market
  scenarios)
• USAID contributing operating funds for 2 to 3
  start-up years
• FGIC Guarantee Fund for Mortgage Credit
  regulated by NBK
• Private MI-type structure self-supporting post
  start-up premium actuarially sound

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HOW WOULD MI WORK IN KAZAKHSTAN?

• Insurance contract between FGIC and approved
  lender
• General (Master) Policy details terms
• Borrower pays the premium to the bank
• FGIC insures only the top slice
• Reference loan is 7 years 70 LTV
• Reference MI Program takes LTV to 85 with 30
  top tier coverage

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MI with 30 Coverage
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Why not Develop Private Mortgage Insurance?

• Private MI was first choice
• Some Insurance Co. already offering MI
• Insurance companies lack adequate funds for
  investment most are bank subsidiaries or
  affiliates capital structures not adequately
  independent
• IFC interested in theory but 51 private funds
  are not now available

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Advantages of Public Sponsorship

• Available capital from NBK
• Policy champion with long-term view
• Integration with regulatory policy risk
  considerations under Basle II
• Insurance companies at present, lack necessary
  capital bank subsidiaries
• Monoline structure
• Pave way for further Private MI development

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Process of Implementing MI

• Policy Dialogue National Bank (NBK)
• Policy discussions lenders, insurance, and KMC
  (secondary market)
• Formal submission of proposal to NBK
• Corporate structure
• Business Plan
• Market scenarios for mortgage finance
• Master Policy
• Premium Model

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MI Provides Major Benefits

• Risk Sharing for Lenders
• Affordability for Borrowers
• Improved Standardization Risk Management for
  Financial Sector Development
• Supervisory Benefits to Regulators, especially in
  context of Basle II

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MI Benefits to Borrowers

• Interest rate spreads are too high
• Banks still very risk averse
• Butcompetitive environment good
• Thus, MI expected to lead to
• higher LTV lending, and/or
• decreased interest rates, and/or
• increased loan terms, and/or
• higher risk profile borrowers (informal income,
  etc.)

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MI Benefits to Lenders

• Improves efficiency standardization
• Promotes better risk management, underwriting and
  delinquency management
• Standardizes underwriting documentation
• Supports better delinquency management and loan
  workouts
• Encourages streamlined foreclosure practices
• Promotes credit bureau development
• Encourages improved property appraisal

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LTV Bank Risk Position 20 Coverage
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LTV Bank Risk Position 30 Coverage
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MI, Risk Management Regulation

• Basle II introduces LTV-based risk weight
  approach for consideration by National
  Supervisory Authorities
• MI important risk management partner for lenders
• MI provides means to higher LTV lending via
  sharing of credit risk
• Favorable supervisory treatment via MI for high
  LTV lending

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MI Provides Supervisory Benefits

• MI transfers a portion of the credit risk outside
  the banking system
• Partner in implementing risk-based supervisory
  regime based on LTV
• Mandate MI on all loans with LTV exceeding a
  certain risk level
• Reduce the regulatory capital - lenders -
  investors for loans carrying MI

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LTV and Relative Risk
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Possible Regulatory Changes?

• Now - no regulatory recognition of features of
  mortgage lending
• No regulatory differentiation by LTV
• R/S Analysis needed as portfolios grow
• Future regulatory considerations
• MI mandatory for all LTV gt 70
• Risk weight reduced for loans carrying MI
• LTV-based risk analysis will be initiated
• Separate supervisory oversight, A/L match

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Risks of Public Sponsorship

• Future regulatory environment risk - Not
  operating as Private MI, monoline, and
  non-subsidized
• Slips into role of social agency
• Moral hazard adverse selection
• Failure to consider sunset clause for future
  privatization
• Non-level playing field with private MI plans
  offered by insurance companies

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Minimizing Risks of Public Sponsorship

• Charter solidifies Private MI operating nature
• Partial MI coverage (30) limits adverse
  selection
• Solid underwriting guidelines already put forth
  by KMC (secondary market)
• Banks capital market stand to lose
• No additional capital from NBK - after initial
  capital allocation
• Private and IFI capital to be sought

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GOK has a lot to lose MI Helps Capital
Secondary Markets

• GOK counting on mortgage-backed debt as key
  alternative to Govt. paper
• Institutional investors want new product
• MI expected to increase market growth
• Credit enhancement will augment loans eligible
  for purchase by KMC
• MI softens bank arguments against KMC policy of
  purchase with recourse

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MI Development Team

• Kazak champion Governor of NBK
• USAID support and resident consultant project
  (FSI) Kazak U.S. experts
• U.S. experts policy development, business pro
  forma, premium risk management modeling,
  IT/operations
• Kazak experts financial legal analysis,
  underwriting, mortgage regulatory policies

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Plans, Models, Scenarios

• Market growth and MI utilization
• Business Plan Pro Forma
• Premium Model simulations
• Market profile risk scenarios expected,
  optimistic, adverse
• Costs operating costs claim costs
• Financial return assumptions

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Premium Model User Variables

• 3 mortgage market risk scenarios
• Book year default rate
• Interest rates loan payoff rate
• Operating costs underwriting, taxes
• Claim costs salvage value at default, delinquent
  interest, legal foreclosure costs, taxes,
  maintenance costs
• Financial costs and expectations
  risk-to-capital, investment return, ROE

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Premium Model Calculations Output Variables

• Present value calculations for losses, expenses,
  and profit
• Premium rates annual single
• Premium rate determined for
• LTV ratio 70, 75, 80, 85, 90
• MI coverage 15, 20, 25, 30, 40 and 50
• Loan term 3, 5, 7, and 10 years
• Premium weighted average of 3 loss scenarios
  50 expected 25 high low

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Serious Information Problems!

• Mortgage Market, its IT, are young
• Loan terms short, few seasoned loans
• Default rate low little experience with
  foreclosure
• No book year data (default/pay-offs)
• Result use of U.S. LTV default probability
  curves in Premium Model - a good news/bad news
  situation

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Recommendations for Start-up MI Plans for FGIC

• Coverage
• 30 perhaps 20 also
• LTVs
• 75, 80, 85
• (norm is now 70)
• Single payment plan to assist early cash flow for
  FGIC
• Start with a manageable of plans

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Ongoing Requirements

• Revise Premium Model with Kazak data LTV default
  rate curves prepayments
• Establish system to provide book year data for
  Premium Model
• Revise Premium Model input variables
• market conditions
• operating and capital costs
• financial requirements and returns

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Long-term Horizon in Kazakhstan?

• Privatization investment by local or
  international insurance companies?
• IFC or other IFI participation?
• Sunset clause?
• Establish co-existing monoline Private MI?

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Recommendations for Transition Nations

• Promote Private MI if possible
• If not possible, develop a Private MI structure
• Include long-term plan for privatization
• Insure only top slice
• risk sharing crucial banks cant rely on
  Government for risk management
• Government. must minimize moral hazard risk
• Coordinate with regulatory, capital market, and
  mortgage-backed debt development