PROPOSED CHANGES TO THE RISK-WEIGHTING OF RESIDENTIAL MORTGAGE LENDING DISCUSSION PAPER

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1 PROPOSED CHANGES TO THE RISK-WEIGHTING OF RESIDENTIAL MORTGAGE LENDING DISCUSSION PAPER November 2003

2 TABLE OF CONTENTS Summary. 2 Background 3 Treatment of Low Doc Loans The use of brokers and other channels 5 Proposed approach... 6 Non Conforming Lending 7 Changes to Prudential Standards.. 7 Implementation Timetable. 8 1

3 Summary For capital adequacy purposes, most loans made by an Authorised Deposit-taking Institution (ADI) are assigned a risk-weight of 100 per cent. However, loans to an individual borrower for housing or other purposes which are fully secured by registered mortgage over a residential property are assigned a concessional riskweight of 50 per cent, provided certain criteria are satisfied. These criteria are set out in Attachment C of AGN Risk-Weighted On-Balance Sheet Credit Exposures. This concession is based upon the very low loss rates historically associated with mortgage lending in Australia. These low losses reflect the fact that conventional mortgage lending by ADIs has involved them undertaking a comprehensive assessment of the ability of the borrower to service the loan as well as ensuring that the property is appropriately valued. In the past two years, lenders outside the ADI sector have begun to offer loans written with considerably less than the normally required documentation and checking of income and serviceability. These products are usually referred to as Low Doc loans. As this market has expanded, ADIs have responded by offering similar products. There has also been an increasing tendency for ADIs to offer loans originated via mortgage brokers and other third-party channels. In some cases, ADIs are accepting the assessments done by those referring the borrower to them (and not verifying the borrower information itself) and are placing greater focus on the security underlying the loan rather than the ability of the borrower to repay the loan. While it is too early to assess the risk of loss on these non-conventional loans, it should be remembered that the market for these loans has expanded at a time when housing prices have risen significantly and interest rates have been very low. Many of the loans are also at relatively high loan-to-valuation ratios. Experience overseas indicates that these loans have a higher default rate than conventional home loans and ratings agencies have factored this into their assessments of mortgage-backed securities which include Low Doc loans in the securitised portfolio. 2

4 APRA is concerned that the current risk-weightings on loans for which the borrowers servicing ability is not verified do not adequately reflect the likelihood of increased risk. The current prudential standard on the capital treatment of residential mortgage lending gives little guidance on the criteria necessary for lending to qualify for the concessional risk-weighting. Given its concerns about the potential risk involved in Low Doc lending and the increased use of brokers and other channels, APRA considers it necessary to specify more fully the lending criteria that need to be met in order to qualify for the 50 per cent risk-weighting. This will provide an overarching framework for assessing the appropriate risk-weighting to be applied to mortgage lending. APRA does not intend to examine specific products on an individual basis other than in exceptional cases. Background The current guidance on the lending criteria required to qualify for the 50 per cent risk-weighting states that an ADI must have been involved directly in making credit assessments of individual borrowers, including the valuations of the associated residential properties secured by mortgage 1. Over the last two years, ADIs and non-regulated lenders have introduced low documentation (Low Doc) loans to cater for customers who are unable or unwilling to fulfil the normal income verification procedures required under conventional lending practices. The latter usually involves ADI s obtaining income information (such as salary slips and tax return information). In the case of Low Doc loans, however, borrowers are only required to self-declare their income levels and/or servicing ability and the lender does not seek to verify the information. Lenders view the Low Doc product as an opportunity to fill a perceived gap in their product range that would be attractive to self-employed and other borrowers with 1 Paragraph 2 of Attachment C of AGN

5 residential property as security. These loans also earn a higher margin than conventional home loans. Earlier this year, APRA surveyed a number of ADIs, lenders mortgage insurers and non-regulated loan providers regarding their experience with Low Doc lending. The survey indicated that: in the majority of cases, Low Doc loans are allowed for investment properties as well as owner-occupation; while Low Doc loans are used largely for the purchase or refinancing of residential property, most lenders do not necessarily exclude lending for business purposes; the maximum loan-to-valuation ratio (LVR) is 80 per cent for most lenders; while a number of lenders require lenders mortgage insurance on all Low Doc loans, others require this only beyond a given LVR; the majority of lenders require full valuations of the property; the loan limit is generally $750,000 or less; and the margins over the standard interest rate on mortgage lending range up to one percentage point. Treatment of Low Doc Loans APRA s view on Low Doc loans is that, since the potential borrower does not provide income details, and the lender does not verify the borrower s self-declared income levels and/or self-declared servicing ability, these loans do not comply with the intent of paragraph 2 of Attachment C of AGN At the time this prudential standard was introduced, it was intended to apply only to conventional home loans. As a result, Low Doc loans should not in APRA s view automatically qualify for the concessional 50 per cent risk-weight on lending for housing. 4

6 While there is insufficient Australian data at this stage to determine the loss rates on Low Doc loans, overseas evidence suggests that these loans experience a substantially higher default rate than conventional loans. Rating agencies also reflect a higher default rate in residential mortgage-backed securities programmes containing Low Doc loans. The fact that ADIs generally set lower LVR limits on Low Doc loans and use lenders mortgage insurance at lower LVRs than conventional loans, as well as charge a margin over the standard residential mortgage rate, also implies that ADIs themselves consider that a greater risk attaches to these loans. The use of brokers and other channels APRA has become aware that, with the increased use of brokers and other channels to originate loans, some ADIs are relying on broker valuations or income checking when providing a home loan. APRA considers that the ADI itself must be responsible for deciding the criteria to be used in making the decision to lend. It is extremely important that the use of third parties in the lending process does not adversely impact upon compliance with the ADI s lending criteria. APRA is of the view that any use of a third party in the credit decision should only be allowed where the ADI s credit assessment requirements are clearly specified and the relationship is managed in accordance with ADI Prudential Standard APS Outsourcing. In particular, there should be a formal agreement in place that covers: the criteria that are to be used in making the decision to lend; audit and monitoring procedures; pricing and fee structure; dispute resolution arrangements; and confidentiality, privacy and security of information. The use of brokers as a home loan distribution channel is not of itself a prudential concern. The prudential issue is the use of broker-originated information without the ADI independently verifying the data in the home loan application. 5

7 Proposed approach Currently, all ADIs risk-weight their Low Doc loans at 50 per cent based on the underlying residential property security for the loans. APRA proposes to expand the criteria set out in AGN to ensure that the 50 per cent risk-weighting is not applied to potentially higher risk lending such as Low Doc lending and brokeroriginated lending unless the ADI has independently assessed critical information in respect of the borrower. Where the ADI has not carried out an independent assessment, housing lending would only qualify for the concessional 50 per cent risk-weighting if stricter LVR criteria are met. As the risk of loss on these loans is dependent on the LVR, APRA does not believe it would be appropriate to apply a 100 per cent risk-weighting for loans for which serviceability is not independently assessed, but which have low LVRs. While there are insufficient data to determine statistically what the appropriate LVR should be to qualify for the concessional risk-weighting, APRA believes that it should be much lower than the current figure of 80 per cent applying to loans that meet the income/serviceability tests. Conventional loans with LVRs greater than 80 per cent are not eligible for the concessional risk-weighting unless they are fully mortgage insured through an acceptable lenders mortgage insurer. APRA is proposing that loans for which serviceability is not independently assessed but which have an LVR of 60 per cent or less would be eligible for the concessional risk-weight. This figure may be revised once a run of loss data on these loans becomes available. For similar reasons, loans for which serviceability is not independently assessed but which are fully mortgage insured would be eligible for the concessional risk-weight. APRA s proposed approach is to set out high-level criteria that allow each ADI to put in place a policy appropriate to its circumstances. This approach will impact on Low Doc loans as well as other potential loan products that fail to meet the criteria for a 6

8 fully assessed loan. The assessment of compliance with these criteria, and hence eligibility for the concessional 50 per cent risk-weight is, in the first instance, a matter for the ADI, with the ADI auditor having primary responsibility for reviewing compliance. Where appropriate, APRA will also check compliance in its on-site reviews. Non Conforming Lending Non conforming lending involves borrowers who could not normally qualify for a conventional home loan. APRA is unaware of any ADI engaging in non conforming lending; this is a specialist industry sector pursued by unregulated lenders. Any non conforming loans advanced by ADIs will attract a 100 per cent risk-weight. Changes to Prudential Standards APRA is proposing to substitute the existing paragraph 2 of Attachment C AGN with the revised paragraph 2 below. ADIs will need to ensure that they comply with these revised lending criteria before the loans originated by them are eligible for the concessional 50 per cent risk-weighting. 2 (a) An ADI must have procedures in place to assess the ability of potential borrowers to meet repayment obligations. These criteria must be documented as part of an ADI s Lending/ Credit Policy and Procedures Manual. (b) An ADI must have in place verification procedures to substantiate critical application data provided by the borrower. These should include verifying income documentation sufficient for an ADI to make an assessment of the repayment capacity of the borrower. All material income sources and employment details of the borrower must be assessed by the ADI prior to loan approval, and documented as part of the loan origination and approval process. (c) Where an ADI accepts the purchase price, or other means of valuation, as being an indication of value of the residential property (in lieu of a formal 7

9 valuation), it must detail the criteria used to justify this use in its Lending/ Credit Policy and Procedures Manual. (d) Where an ADI requires a formal valuation for a home loan, all residential properties securing the loan must be subjected to an independent valuation. Valuations must be carried out by an accredited valuer nominated by the ADI in respect of each residential property offered as security. (e) Loans will only be eligible for the concessional risk-weighting where they are secured against properties zoned residential or where the ADI can demonstrate the marketability of the property would be of a similar nature to properties with such zoning. (f) A 100 per cent risk-weighting will be assigned to loans that do not fulfil the criteria set out above unless (1) the LVR at origination is 60 per cent or less or (2) the loan is fully mortgage insured with a mortgage insurer rated at least A, in which case the risk-weighting will be 50 per cent. (g) Where an ADI outsources any part of the credit process to a third party, the arrangement must comply with APS Outsourcing. ADIs should undertake due diligence on the third parties they use to make any lending decisions or that undertake assessments of borrower information on their behalf. There should be a formal agreement in place with the third party that specifies the criteria that are to be used in approving the loan and audit and monitoring procedures should be in place to ensure that the lending criteria are met at all times. Implementation Timetable APRA welcomes comments on the proposed changes from ADIs and other interested parties. These comments should be submitted in writing by 30 January 2004 to: 8

10 Mr Lawrence Lim Manager, Credit Risk, Policy Research & Consulting Division Australian Prudential Regulation Authority GPO Box 9836 SYDNEY NSW 2001 Alternatively, comments may be submitted electronically to by 30 January The intended date for implementation of changes to the prudential standard is 1 July

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