Lecture Legal and regulatory aspects of banking supervision – Chapter 3

The following will be discussed in this chapter: Credit rating agencies, mortgage brokers, secondary mortgage markets, the mess, evolution of home mortgage, new model of mortgage lending, private sub prime mortgage process, reasons for forming of subprime mess.

MBF-705 LEGAL AND REGULATORY ASPECTS OF BANKING

SUPERVISION

OSMAN BIN SAIF

Session: Three

Summary of Previous Session

• General principles of banking regulation

– Central Bank US Example

– Government Securities / Bonds

2

Agenda of this session

– Credit rating agencies

– Mortgage Brokers

– Secondary Mortgage Markets

– Evolution of Home Mortgage

– New model of Mortgage lending

– Private sub prime mortgage process

– Reasons for forming of subprime mess

Credit Rating Agency (CRA)

ratings for issuers of certain types of debt obligations as well as the debt instruments themselves

consideration the issuer's credit

worthiness (i.e., its ability to pay back

a loan), and affects the interest

rate applied to the particular security being issued

4

Credit Rating Agency (Contd.)

Poor's (U.S.)

by investors, issuers, investment

banks, broker-dealers, and governments

– For investors, credit rating agencies increase the range of investment alternatives and provide independent, easy-to-use measurements of relative credit risk

Mortgage Broker

• Mainly found in developed economies like US, Western Europe

• Professionals who are paid a fee to bring

together lenders and borrowers

• Sells mortgage loans on behalf of businesses (ex Banks)

6

Mortgage Broker (Contd.)

• Tasks undertaken:

– Marketing to attract clients

– Assessment of the borrowers circumstances

(Mortgage fact find forms interview) This may include assessment of credit history (normally obtained via a credit report) and affordability (verified by income

documentation)

– Assessing the market to find a mortgage product that fits the clients needs (Mortgage

presentation/recommendations)

Mortgage Broker (Contd.)

– Applying for a lenders agreement in principle (pre-approval)

– Gathering all needed documents (paystubs / payslips, bank statements, etc.),

– Completing a lender application form

– Explaining the legal disclosures

– Submitting all material to the lender

8

Sub-prime mortgage – What’s

that?

credit ratings — a group generally defined

ranges from 300 to 850

Sub-prime mortgage (Contd.)

statistical analysis of a person's credit

report, and is used to represent the

(FICO is the acronym for Fair Isaac Corporation, a publicly-traded corporation (under the symbol

"FIC") that created the best-known and most widely used credit score model in the US.)

person will pay his or her debts

Calculated by credit reporting agencies

Ex Equifax, Experian, and TransUnion in

Secondary Mortgage markets

banks to sell mortgages, giving them new funds to offer more mortgages to new

borrowers

full 15 or 30 years, they would soon use

up all their funds, and potential

homebuyers would have a more difficult time to find mortgage lenders

Secondary Mortgage markets

(Contd.)

market are bought by Fannie Mae

securities, and sold to investors

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Now we are ready to look into

the mess !

Evolution of home mortgage

1930s

Lender-Banks Borrower-Individuals

Home loan funding

Principal + interest payable over long term

• Owning a house was not affordable to many

• Great Depression brought industry to a halt Large scale defaulters and lenders could not recover by reselling

14

Evolution of home mortgage

(Contd.)

• To simulate the industry again Government as part of New Deal policy created the Federal National Mortgage Association (Fannie Mae) in 1938 This created a secondary market for mortgages

Lender-Banks Borrower-Individuals

Home loan funding

Principal + interest payable over long term

Bought loan Cash

Transfer of credit risk, market risk

Had Access to long term borrowing

Bought only those which conformed to certain

underwriting standard ( called Prime Mortgages)

Evolution continued…

• Fannie Mae proved very successful But by 1960s ,

borrowing done by it constituted a significant share of the debt owed by US government.

• 1968- Government National Mortgage Association

(Ginnie Mae) was created to handle government

guaranteed mortgages.

• Fannie Mae became federally chartered, privately held

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– To securitize conventional mortgages

– Provide competition to Fannie Mae

Evolution Continued

together provided enormous amount of

funding for US mortgage

guaranteed loans, much of credit risk

stayed with them Size and diversification allowed them to handle it

18

New Model of mortgage lending

Lender-Banks

Home loan funding

Principal + interest payable over long term

Bought loan Cash

Transfer of credit & market risk

New Model of mortgage lending

(Contd.)

• More liquidity in market

• Risk spread out

• Long term funding for mortgage lending

• MBS- allows originators to earn fee income from underwriting activities without exposure

to credit, market or liquidity risks as they see the loans they make

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Further evolution

first done by BOA and Salomon Brothers

were resolved in same

securitization has 10 or more different

parties playing independent role

Details : Private Sub-prime

mortgage process

borrower after looking at his credit rating

subsidiary of an investment banking firm ( Seller)

of loans and call it as SPV Off balance

sheet instrument

23

Details : Private Sub-prime

mortgage process (Contd.)

or limited liability company Most often a

Trust It has nothing else except mortgage loans

(derivative income streams)

underwriter works with credit rating

agencies

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Details : Private Sub-prime mortgage process (Contd.)

the investors

guaranteed by a 3rd party insurance

company

to service the loan pool to a company or sometimes Originator takes these rights

Company to keep track of mountains of paper work on loans in the pool At

National level

25

Reasons for forming of Subprime

mess

• Giant pool of money available for investment

through savings of Oil exporters , economic

development in BRIC countries

• Private share in mortgage market growth in large part through origination and securitization of high risk sub-prime and Alt-A mortgages.

• Building up of the housing bubble

• Private Banks made use of CDOs to sell to

investors

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Reasons for forming of Subprime mess (Contd.)

with the innovations happening in financial engineering

in post dotcom bust period

instructional investors found lower

tranches in MBS and CDO attractive

which were highly risky

500%

dean: Leverage(high), Transparency (low) and Liquidity (abundant)

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Summary of this Session

– Credit rating agencies

– Mortgage Brokers

– Secondary Mortgage Markets

– Evolution of Home Mortgage

– New model of Mortgage lending

– Private sub prime mortgage process

– Reasons for forming of subprime mess

28

THANK YOU