Best Practices for Sound Mortgage Lending

Sound Principles are vital if the industry has to sustain and survive the occasional rough weather.

By Rajeev Jhawar (finserv@vinodkothari.com)

Prior to the Global Financial Crisis (GFC) of 2007-2008, the concerns about sound mortgage lending were largely lender-based. However, the GFC demonstrated how an exuberance on the part of lenders in trying to achieve ambitious loan books 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 concerns 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 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, aka 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, 4 prior FSF members, and the European Commission. On April 18, 2012, the FSB issued its Principles, expressly seeking to develop “an international principles-based framework for sound underwriting practices.” The Principles include standards regarding:

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 emphasize that the consequences of weak residential mortgage underwriting practices in one country can be transferred globally through securitization 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).[1]

The Principles will assist FSB members in their efforts to improve financial stability and prudential standards.

Effective verification of income and other financial information.[2]

  • 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 minimize 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 incentivize prudent approaches to the collateralization 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 supervisors 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 incentivizing 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 recognize 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 realized 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.

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 applies 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 a 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:

Principle(s) Objective
Principle 1 relates to a FRMI’s governance and the development of business objectives, strategies and oversight mechanisms in respect of residential mortgage insurance underwriting.
Principle 2 Focuses on FRMI’s establishment of standards, and the initial assessment of lenders against those standards, for “qualified / approved” lender status
Principle 3 relates to the FRMI’s loan underwriting criteria for lenders (i.e., the characteristics defining insurable mortgage loans), as well as requirements for lenders, for initial and continuing mortgage insurance coverage
Principle 4 focuses on  FRMI’s ongoing due diligence into lenders’ underwriting practices
Principle 5 relates to assessment and validation of the mortgage insurer’s internal underwriting systems, models, and underwriters’ processes
Principle 6 focuses on the use of effective portfolio risk management, including stress testing and risk mitigation such as reinsurance

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, borrowers 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: A 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: A 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: A 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, a FRMI should outline reasonable steps for lenders to obtain income verification (e.g., Notice of Assessment) and relevant business documentation.
  • Debt Service Coverage: A 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, a 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: A 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, a 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, a 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), a 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, a FRMI should not rely exclusively on any single method for property valuation. A 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.)

Consumer Financial Protection Bureau Guidelines (CFPB)

The Consumer Financial Protection Bureau (CFPB) is a regulatory agency in United States 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:[3]

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 per cent 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.

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 (e.g. “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.


[1] http://documents.jdsupra.com/ce2f082e-5275-4254-8e3d-e03e0d076f23.pdf

[2] http://www.fsb.org/wp-content/uploads/r_120418.pdf?page_moved=1

[3] https://www.consumerfinance.gov/about-us/newsroom/consumer-financial-protection-bureau-issues-rule-to-protect-consumers-from-irresponsible-mortgage-lending/

 

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