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

1. 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

2. 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

3. 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

4. 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

5. 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 > 90% • Banks not willing to underwrite self-employed & informal income groups • Long-term potential large as oil and gas resources boost GDP

6. 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

7. 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

8. MI with 30% Coverage

9. 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

10. 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

11. 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

12. 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

13. MI Benefits to Borrowers • Interest rate “spreads” are too high • Banks still very risk averse • But…competitive 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.)

15. 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

16. LTV & Bank Risk Position 20% Coverage

17. LTV & Bank Risk Position 30% Coverage

18. 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

19. 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

20. LTV and Relative Risk

21. 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 > 70% • Risk weight reduced for loans carrying MI • LTV-based risk analysis will be initiated • Separate supervisory oversight, A/L match

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

32. 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

33. 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

34. 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

35. 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?

36. 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 can’t rely on Government for risk management • Government. must minimize moral hazard risk • Coordinate with regulatory, capital market, and mortgage-backed debt development