toronto new york chicago london paris frankfurt Methodology U.K. Residential Mortgage Loan Analysis Criteria: Credit, Prepayment and Loan Aggregation

Transcription

1 toronto new york chicago london paris frankfurt Methodology U.K. Residential Mortgage Loan Analysis Criteria: Credit, Prepayment and Loan Aggregation november 2007

2 contact information Elisa Malavasi Vice President Structured Finance Quantitative Group Tel. +44 (0) Victoria Johnstone Senior Vice President Structured Finance Quantitative Group Tel. +44 (0) Kai Gilkes Managing Director Structured Finance Quantitative Group Tel. +44 (0) Apea Koranteng Managing Director Structured Finance EMEA Tel. +44 (0) DBRS is a full-service credit rating agency established in Privately owned and operated without affiliation to any financial institution, DBRS is respected for its independent, third-party evaluations of corporate and government issues, spanning North America, Europe and Asia. DBRS s extensive coverage of securitizations and structured finance transactions solidifies our standing as a leading provider of comprehensive, in-depth credit analysis. All DBRS ratings and research are available in hard-copy format and electronically on Bloomberg and at DBRS.com, our lead delivery tool for organized, Web-based, up-to-the-minute information. We remain committed to continuously refining our expertise in the analysis of credit quality and are dedicated to maintaining objective and credible opinions within the global financial marketplace.

3 U.K. Residential Mortgage Loan Analysis Criteria: Credit, Prepayment and Loan Aggregation TABLE OF CONTENTS Introduction 5 Credit Analysis 5 Prepayment Analysis 5 Loan Aggregation Analysis 5 Advantages of Approach 6 Part 1: U.K. Residential Mortgage Default Criteria 8 The Benchmark Two-Year PD Estimate 9 The Base Case Two-Year PD Estimate 9 Credit Risk Band 11 CCJs and/or Bankruptcies or IVAs 11 Loan-to-Value (LTV) 12 Employment and Other Income-Related Variables 13 Right-to-Buy (RTB) 15 Loan Purpose 15 Repayment Type 16 Loan Term 17 Loan Size 17 Second Lien 17 Loan Product 17 Buy-to-Let (BTL) 18 Credit Risk Layering 22 The Base Case Lifetime PD Estimate 22 Portfolio Default Rate Distribution 24 Rating-Specific Portfolio Default Rates 27 Part 2: U.K. Residential Mortgage Loss Criteria 28 LGD Overview 28 Components of LGD 28 Principal Amount Owed (Exposure at Default, or EAD) 28 Current Property Value 28 Sale Price of the Foreclosed Property 31 Costs 35 Prior Ranking Loans 36 LGD per Rating Level 36 Foreclosure MVDs per Rating Level 36 Loan-Level and Portfolio-Level LGD Calculations 36 Part 3: U.K. Residential Mortgage Prepayment Criteria 38 Part 4: U.K. Residential Mortgage Loan Aggregation Criteria 42 Concluding Remarks 43 Appendix A: The DBRS U.K. Residential Mortgage Loan Analysis Model 44 Appendix B: The DBRS U.K. Mortgage Loan Analysis Model Example Tear Sheet 45 Appendix C: Loan-level Example Computations of Lifetime PD, LGD and EL 48 Appendix D: The DBRS U.K. Mortgage Loan Analysis Model Example Rep Lines 50 3

4

5 Introduction This report describes the DBRS loan analysis methodology for U.K. residential mortgage portfolios and forms part of the DBRS criteria for rating U.K. residential mortgage-backed securities (RMBS) and other transactions linked to residential mortgage assets denominated in the United Kingdom. This methodology describes the approach to three main areas that DBRS considers to require a loan-level analysis: credit, prepayment and loan aggregation. CREDIT ANALYSIS The DBRS mortgage credit quality assessment addresses the principal amount of a portfolio that could be potentially lost in different rating scenarios. As such, it forms an integral part of the analysis used to assess the credit enhancement required to maintain a rating on a RMBS tranche. Principal loss on a mortgage loan occurs when the borrower fails to pay back the full balance of the outstanding loan amount. There are two key components to this analysis. First, DBRS estimates a loan s probability of default (PD); that is, how likely it is that the borrower will stop paying the mortgage loan and the lender will be forced to foreclose and sell the property. Second, the analysis assesses how much the lender will lose if the property is subject to foreclosure and a forced sale (the loss given default, or LGD), as the lender may not be able to re-coup the full outstanding loan balance from the sale proceeds. The product of the PD and LGD for a loan gives the expected principal loss (EL) for that loan. As such, the DBRS credit analysis establishes PD and LGD estimates (and therefore EL) on a loan-by-loan basis and for the portfolio as a whole over different rating scenarios. DBRS assumes that a B rating corresponds to a benign economic environment and is representative of the status of the U.K. housing market economy over the last two to five years. A detailed analysis of the behaviour of U.K mortgage loans over this time therefore forms the basis of the DBRS base case, or B rating scenario. The impact of deterioration in the economy on portfolio PD and LGD levels is then assessed to obtain these estimates at higher rating levels, which are representative of more stressful economic scenarios. For non-synthetic mortgage-backed transactions, the portfolio PD and LGD then become inputs for the subsequent cash flow analysis. Cash flow simulations overlay the assumed portfolio PDs and LGDs (along with other economic stresses such as interest rates and prepayments) within the transaction structure to assess the ability of the rated notes to withstand economic stress and, as such, maintain a rating. PREPAYMENT ANALYSIS The DBRS mortgage prepayment analysis assesses the loan characteristics known to influence prepayment rates. The outputs of a loan-level assessment are aggregated to create a base case prepayment assumption for the portfolio. The prepayment assessment addresses the amount of unscheduled principal received over time, and as such, is an important consideration within a cash flow analysis, both from note life, and tranche rating strength perspectives. The assumed prepayment rate has a large influence on the amount of excess spread (typically used to cover principal losses in most U.K. transactions), and therefore is a key factor in the assessment of the ability of a tranche to withstand a rating stress. Given its importance, DBRS considers a loan-level prepayment model as crucial in understanding the dynamics of the transaction through time, and accurately assign a rating. LOAN AGGREGATION ANALYSIS DBRS produces standardised loan aggregation rep lines for each transaction, with aggregation based on characteristics that influence the repayment profile of the loans (e.g., interest-only periods, interest rate types, remaining term). As such, the rep lines act as a transparent overview of the asset cash flow profile, and also allow for efficient and accurate cash flow modelling. 5

6 ADVANTAGES OF APPROACH The DBRS U.K. residential mortgage loan analysis methodology provides an enhanced method of assessing credit and prepayment risk, along with the production of standardised rep lines. The criteria used to calculate these components are described in full in the following methodology. There are a number of key benefits to the approach, highlighted below. The DBRS U.K. Residential Mortgage Loan Analysis Model is a Microsoft Excel-based tool used by DBRS to analyse the credit quality of U.K. loan portfolios using the methodology described in this report. In addition, the model also outputs a DBRS base case prepayment vector, and rep lines that are subsequently used in any cash flow modelling. The model is available in open format and free of charge as part of DBRS s aim to increase transparency in the rating process and allow market participants to fully understand how risk is assessed. For information on how to gain access to the model, please see Appendix A. An illustration of some key outputs of the model is given in Appendix B. The DBRS credit and prepayment assumptions stem from a comprehensive review and assessment of several data sources that covered the specifics of the U.K. residential mortgage market. Outputs from loan-level analyses, where available, have been integrated with results from portfolio-level breakdowns of existing transactions. Particular attention has been given to observed historical performance in order to estimate base case performance and provide a benchmark to estimate mortgage behaviour under more stressful economic conditions. The approach allows for predictive base case PDs and LGDs to be estimated at the loan and portfolio levels over both a two-year period and lifetime horizon. This base case performance is assumed to represent a specific rating scenario; namely, B. DBRS considers that accurate base case performance estimates are extremely important for a number of reasons. (1) Within the Basel II framework, more lenders may be motivated to move lower rated and equity tranches off their balance sheets. As such, the ability of investors to access a detailed risk assessment of the EL under base case conditions over a range of time periods is crucial. (2) DBRS believes that deal surveillance can be significantly enhanced by being able to measure and track deal performance over time with respect to an initial base case expectation identified to represent a specific rating level. This means that DBRS can easily match actual deal performance with rating expectations and provide accurate and timely rating implications. DBRS strongly believes that the behaviour of foreclosed property values is dramatically different from the average values obtained from a generic house price index. There is strong evidence both on the portfolio and loan levels that despite dramatic house price increases in recent times, foreclosed properties suffer significant market value declines, which may have been underestimated in alternative approaches. The methodology has been created so that it can easily incorporate external credit bureau scores should they become accessible to third parties. DBRS considers that the inclusion of such scores within a default model can add considerable predictive power and hence allow for better differentiation of risk across mortgage portfolios. Therefore, a methodology that can easily integrate these scores is crucial to making full and timely use of their added value. There are meaningful default adjustments to loans that are seasoned or in arrears that can facilitate more accurate portfolio default estimates through time. This ensures that the methodology can be reliably used not only at the pre-bond issuance stage (or for the initial assessment of portfolio purchases), but also integrated into the surveillance process. 6

7 Portfolio modelling techniques are used to create a distribution of potential portfolio default rates. There are two main benefits to such an approach: (1) Rating-specific default rates can be directly determined from the portfolio default distribution by holding the distribution to a rating standard implied by the DBRS Corporate Default Table. This is quite different from an methodology that multiplies base case estimates by rating multiples. The portfolio approach also allows for a consistent quantitative approach across different asset classes. For example, collateralised debt obligation (CDO) asset portfolios are also held to the same standard. (2) A distribution of portfolio default rates will allow users to test transactions over a wide range of PDs (and matched LGDs) in a stochastic framework, which may complement the usual deterministic approach (where tranches are tested with discrete rating-specific default scenarios). Although DBRS intends to initially use a deterministic approach to test U.K. RMBS tranches, a stochastic approach in creating more insights into RMBS tranche performance is a key area of ongoing research. The DBRS methodology maximizes the advantages of obtaining loan-level information, and extends its use to enhance other assumptions within the rating approach. (1) Prepayments given the large impact prepayment assumptions have on note life and excess spread, accurate and refined estimates of prepayments are crucial for transaction transparency, efficiency and robustness. DBRS is the first rating agency in Europe to create (and make available on a transparent basis) a loan-level approach to prepayment modelling. (2) Loan Aggregation the creation of standardised rep lines allows rating analysts to quickly and easily identify key cash flow risks within the asset pool (such as unhedged positions and discount reserve sizings). This rep line creation also allows efficient cash flow modelling, without any compromises in performance. In the present report, the computation of the two credit estimates (PD and LGD) are addressed separately in the first two sections. The third section covers the DBRS approach to the loan-level prepayment estimations, and the fourth section describes the loan aggregation methodology. 7

8 Part 1: U.K. Residential Mortgage Default Criteria This section describes the DBRS methodology used to calculate loan-level PDs and portfolio-level default rates for U.K. residential mortgage portfolios. One important component of this methodology is an approach to calculate base case two-year and lifetime PD estimates for individual mortgage loans. The approach also includes the creation of a portfolio default distribution, which allows for the extension to rating-specific portfolio default rates. A summary of the methodology used to calculate loan-level PDs and portfolio default rates is given below and described in detail in the following pages. The same benchmark two-year PD estimate is assigned to each loan. A base case two-year PD estimate is calculated for each loan by adjusting the benchmark two-year PD to account for individual risk characteristics associated with each loan. A base case lifetime PD estimate is calculated for each loan by extending the base case two-year PD to account for individual loan seasoning. A portfolio default rate distribution is calculated by means of a single factor model that requires the weighted average of the base case lifetime PDs and an asset correlation estimate. Rating-specific portfolio default rates are calculated by holding the portfolio default distribution to a rating standard, as implied by the DBRS Corporate Default Table. 8

9 THE BENCHMARK TWO-YEAR PD ESTIMATE Each loan in the mortgage portfolio is initially assigned the same benchmark two-year PD. Benchmark performance has been calibrated from U.K. loan-level and portfolio-level mortgage credit behaviour over the past four to five years, from approximately 2002 to This period represents a benign economic environment for mortgage performance (e.g., low interest rates, low levels of unemployment, strong house price growth), and consequently this period has been associated with low arrears and mortgage default rates (see Figure 1.1). The benchmark PD assigned to all loans is 0.125%. 1 This is aligned with the two-year estimate from repossession data shown in Figure 1.1 and will be adjusted upward or downward on a loan-by-loan basis depending on the individual loan characteristics (see the following section). Figure 1.1: Mortgage Arrears and Repossession Rates in the United Kingdom 2.25% % of mortgage loans outstanding 2.00% 1.75% 1.50% 1.25% 1.00% 0.75% 0.50% 0.25% 0.00% Time Source: CML statistics. Repossessions 6-12m arrears 12m+ arrears The benchmark loan PD was calculated over a two-year time period for a number of reasons. Firstly, this time period allowed for an increased number of analysis points over a range of loan seasonings, across the four- to five-year horizon chosen to represent benchmark performance. Secondly, DBRS intends to include credit bureau scores (in the event they become available for third-party use 2 ) to help assess the credit risk of mortgage loans. Generic credit scores created by the bureaus active in the United Kingdom (e.g., Experian, Equifax and Call Credit) are highly predictive measures of default and are extensively used by a range of mortgage and other lenders. The scores (e.g., Delphi, Risk Navigator and CallScore) summarize borrower credit history and condense many relevant performance factors (e.g., borrower behaviour on all credit lines, level of indebtedness, geographic default data) into a single numeric value. Since credit bureau scores are commonly calibrated to reflect performance over a one- or two-year period, DBRS has developed a methodology that can easily incorporate the scores if they are made available. DBRS is a strong supporter of use of any measures that aid in predicting adverse trends at a granular level, especially where there is a prospect of a deteriorating credit cycle. THE BASE CASE TWO-YEAR PD ESTIMATE The benchmark two-year PD of 0.125% is then adjusted on a loan-by-loan basis to create the base case two-year PD estimate per loan. These adjustments are to account for borrower, property and loan product factors that increase or decrease the credit risk associated with a particular loan. An overview of the risk-adjustment factors used is provided in this section. 1. For other jurisdictions, DBRS will look to local market conditions to derive benchmark loan performance. In addition, adjustments to the benchmark to create loan-level PDs will also be jurisdiction-dependent. 2. At the time of publication, the use of bureau information by third parties is prevented by the Principles of Reciprocity developed by the Steering Committee on Reciprocity (SCOR), the governing body of the bureau databases. Changes to the Principles of Reciprocity to allow for third-party use of the data and scores under certain circumstances is, however, currently under consideration by SCOR. 9

10 A more qualitative evaluation of underwriting standards, credit policies and servicing practices is then overlaid on the estimated loan-level PDs to adjust for servicer- or originator-specific influences on loan credit performance. Further adjustments may also be necessary in the case of significant concentration risks. The following section focuses on the loan, borrower and property characteristics that DBRS considers to be influential on a borrower s propensity to default. The default behaviour of each mortgage loan in the pool is forecast by integrating past credit performance information with additional characteristics that may influence a borrower s likelihood of default. Each characteristic is associated with a multiplicative factor that adjusts the 0.125% benchmark PD up or down. Table 1.1 summarizes each characteristic and gives the associated multiple used to adjust the benchmark PD. The influence of each characteristic on default is then discussed on the following pages. A worked example of this analysis for a single loan is given in Appendix C. Table 1.1: Loan-level Risk Adjustments Risk Characteristic Characteristic Value Base Multiple Credit Risk Band A B C D E Adverse Credit History CCJs <= GBP 100 GBP 100 < CCJs <= GBP 2,000 GBP 2,000 < CCJs <= GBP 5,000 CCJs > GBP 5,000 Prior Bankruptcy/IVA Loan-to-Value (LTV) <= Employment/Income Buy-to-Let (Stabilised ICR) <= Self-Certified (Employed) Self-Certified (Self-Employed) Fast Track Loan-To-Income (LTI) >3.5 Single Income Self Employed n/a Right to Buy Yes 1.10 Purpose Debt/Equity Re-mortgage 1.25 Repayment Type IO 1.35 Term Repayment Loan >25 yrs 1.20 Loan Size Jumbo (Region Specific) nd Lien 2nd Ranking Loan 1.50 Loan Product Risk Layers Tracker (For Life with Teaser) Tracker (Short Term) Discount (Short Term) Fixed (Short Term) LTV >= 95% & Self Cert/High LTI LTV >= 90% & Past CCJs/Bankrupt LTV >= 90% & Past CCJs/Bankrupt & Self Cert/High LTI

11 Credit Risk Band In order to differentiate between the credit quality of borrowers, each loan is assigned to a credit risk band, based on past credit performance information. Credit risk bands range from A to E, with A borrowers considered to be the least risky and E borrowers having severe current or past credit problems. As discussed, the best summary of past credit performance information is contained within external credit bureau scores such as those provided by Experian, Equifax and Call Credit, which use a variety of information sources to identify credit risk (e.g., payment behaviour across all borrower credit lines, credit-to-debt measures, length of history, etc.). It is DBRS s preference to determine credit risk bands from external bureau scores. In the absence of such scores being available, DBRS uses the existing credit information provided to assign credit risk bands. This information is a much reduced subset of that contained within a bureau score, and as such DBRS will not assign an A grade to any loan on the basis of this information. The available information currently used by DBRS to determine the credit risk band is the following: Combined amount (and age) of past County Court Judgments (CCJs). Any prior bankruptcy or individual voluntary arrangement (IVA). Current arrears on mortgage. Credit risk bands are assigned according to the matrix shown in Table 1.2. In addition, the credit risk band is adjusted downward by a category if the borrower has at least one CCJ that is less than one year old. Table 1.2: Cedit Risk Band Assignment Months in Arrears Amount of CCJs CCJs <= GBP 100 B C D E GBP 100 < CCJs <= GBP 2,000 C D E E GBP 2,000 < CCJs <= GBP 5,000 D E E E CCJs > GBP 5,000 and/or Prior Bankruptcy/IVA E E E E CCJs and/or Bankruptcies or IVAs Adverse credit history is a key differentiator for default risk because individuals who have suffered debt problems in the past have a higher propensity for arrears and defaults on future debt repayment. Significant previous financial difficulties are indicated by arrears or defaults on loans, CCJs or insolvency. The range of mortgage products targeting this specific segment of the residential mortgage market is generally referred to as sub-prime. Growth in the number of people with credit problems, as well as an increased demand for debt consolidation products, has boosted the U.K. sub-prime mortgage market. Lending to borrowers with adverse credit history implies higher default risk compared with mainstream lending and is evidenced by significantly higher mortgage arrears and default performance of the subprime compared with the prime mortgage market. A recent study by the Council of Mortgage Lenders (CML) 3 concludes that the more severe the level of credit adversity, the worse the performance. In the United Kingdom, CCJs are legal decisions deliberated by the County Courts with regards to monetary sums. A CCJ is recorded on a borrower s credit report every time a loan repayment is not made within specified times and/or conditions, and the creditor of the balance due brings the case to court. Unless the CCJ is paid off within 30 days of being registered, it is likely it will remain on the credit file for six years, thus significantly affecting a borrower s credit status. More severe instances of CCJs are associated with repeated patterns of credit difficulties by a borrower, hence the DBRS multiple relating to the CCJ characteristic increases as the amount of CCJs rises. 3. Council of Mortgage Lenders (CML). Adverse Credit Mortgages, November

12 Individuals in severe financial difficulties may declare an insolvency status in order to settle and clear outstanding debts. In the United Kingdom, this is typically achieved by either bankruptcy or IVA. A bankruptcy is ordered by a court and results in a public legal declaration stating the inability of an individual to repay his or her creditors. Any debt that is unable to be covered by available (or, sometimes, future) assets is then discharged. A bankruptcy order can restrict borrowers on their future employment possibilities (e.g., prevent an individual from holding public office). As an alternative to bankruptcy, an IVA is a privately arranged plan for the repayment of debts to creditors and as such is not presided over by a court. An IVA is generally associated with a lower cost than a bankruptcy, is confidential and has no restrictions in terms of future employment. As such, consumer debtors are increasingly turning to IVAs in order to avoid bankruptcy (see Figure 1.2). Figure 1.2: Number of Individual Insolvencies in the United Kingdom 20,000 18,000 16,000 14,000 Number 12,000 10,000 8,000 6,000 4,000 2,000 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 P P = Provisional. Source: The Insolvency Service statistics. Time Bankruptcies IVAs DBRS does not discriminate between bankruptcies and IVAs in terms of risk adjustments because they are both viewed as an indicator of severe financial distress. Loan-to-Value (LTV) LTV is the ratio between the principal balance on the mortgage and the appraised value of the property serving as security for the loan itself. The input used by DBRS in the default model is the current LTV at the time of securitization. This is calculated by summing all of the outstanding balances from every loan secured by the same property (e.g., first-lien and second-ranking mortgages) and dividing the total by an estimate of the current market value of the property. The current market value is calculated by taking the given valuation and adjusting, if necessary. Adjustments are made on the basis of the property valuation method and the last valuation. Details of these adjustments are given in the LGD part of the methodology. In the case of flexible loans, the maximum drawable amount is taken into account instead of the outstanding loan balance. Higher LTV ratios are associated with increases in the likelihood of default, attributable to the progressively smaller portion of equity that the borrower has in the property. Equity is the difference between the value of the property and the amount of all loans secured against it. The smaller the equity, the smaller the potential financial benefit the borrower can retain from the property, and the lower the incentive to maintain loan repayments. 12

13 DBRS has approximated the relationship between LTV and the likelihood of default by the function shown in Figure 1.3. Here, the multiple applied to the benchmark loan PD rate increases as LTV increases. Note that for LTVs below 60%, this multiple is less than 1.0, indicating a decrease in overall PD compared with the benchmark. The highest multiple is 3.0 once the LTV reaches 105%. Also note that static values reported in Table 1.1 on page 9 show examples of this function at various LTV levels. Figure 1.3: Multiple to Benchmark PD by Current LTV Base Multiple % 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% 105% 110% 115% Current LTV Employment and Other Income-Related Variables Borrower propensity to default is clearly related to the ability to make timely mortgage repayments on an ongoing basis. DBRS regards affordability and other income- and employment-related aspects as very important, particularly at a time when numerous affordability product innovations have taken place in the U.K. market. In addition to this, U.K. consumer indebtedness levels have grown substantially in recent years, raising serious concerns as to the ability of people to repay their debts should the current favourable economic and housing conditions deteriorate. The following sections outline employment and other income-related features that DBRS considers to affect performance behaviour. These features are for owner-occupied properties only and do not apply to buy-to-let (BTL) products, which are discussed separately in a following section. Self-Certification Self-certification is used by borrowers who want to obtain a mortgage without having to demonstrate their earnings to a standard required by conventional mortgage underwriting criteria. Here, applicants simply declare their own income, without having to provide the lender with any underlying documentation (e.g., pay slips, audited accounts). Typically, borrowers who seek to self-certify are self-employed, commission-based or contract workers. Self-employed borrowers may choose to self-certify for a number of reasons. Firstly, most lenders require self-employed workers to provide two to three years of audited financial accounts, meaning that more recent self-employed borrowers would be unable to satisfy this request. Secondly, audited accounts and/or current tax returns are often time lagged and may not show the latest figures of a borrower s income. Thirdly, self-employed borrowers may also perceive that supplying the necessary documentation would be too onerous and time-consuming. Commissionbased workers may also choose to self-certify, as they receive a salary with a high proportion of bonus payments and hence show a large degree of variability in income over time. Contract workers and those with incomes from a variety of sources choose to self-certify because their total earnings may not otherwise be considered under a traditional mortgage. 13

14 There are additional risks with self-certified mortgages, and the concept that a self-certified borrower could not afford the loan under normal lending criteria is a common one. Recent Financial Services Authority (FSA) research 4 has highlighted that lenders generally have a higher level of material arrears for their self-certified business compared to mainstream lending. Lenders endeavor to offset this risk by a variety of ways, the most common being: Most self-certified mortgage providers pass the applicant s stated income through a plausibility check to ensure their stated job type fits within a reasonable salary range. More conservative credit scoring cuts are taken into account when assessing self-certified mortgage applications, as well as lower LTV ratios so as to deter borrowers from taking out a mortgage that they cannot afford. Fraud detection systems across U.K. lenders also discourage systematic fraud in the self-certified market (e.g., CIFAS the U.K. s Fraud Prevention Service, which pools information on financial crime). Despite these additional safeguards, the higher level of arrears experienced with this product type means that DBRS considers self-certified loans to be more risky than benchmark loans. Note that DBRS considers self-certification products to employed borrowers more risky than those to self-employed borrowers, given that a self-employed borrower may have a more legitimate reason for self-certification (such as the burden of supplying audited financial accounts). Fast Track Some lenders are currently providing an accelerated approval process for low-risk borrowers that speeds up the time they take to finalise a mortgage offer. This process, known as Fast Track, enables lenders to have the right to seek full income verification for a loan application, even if they eventually choose not to do so in practice. Lenders generally offset the risk involved in offering Fast Track loans by making these products available only to LTVs lower than a certain limit, typically 85%. Given that the lender can seek to fully verify a borrower s income in the approval process, the likelihood of borrowers overenhancing their stated earnings is lower compared with self-certificated incomes. This is reflected in a significant differentiation of the base multiples for the Fast Track versus the Self-Certification product types. Self-Employed Self-employed borrowers who do not self-certify their income need to provide the mortgage lender with documentary evidence of their earnings (e.g., latest tax payments). However, compared with borrowers who are employees, self-employed borrowers tend to have lower stability in terms of monthly income. In addition, self-employed borrowers often need to undertake large financial investments in order to set up their own business, which may make then more vulnerable in an increasingly stressful financial environment. Loan-to-Income (LTI) LTI is a measure of loan affordability and is commonly used by lenders to determine how much they are prepared to advance on a mortgage. LTI is calculated by dividing the loan balance by the total income for the household (e.g., the sum of incomes in the case of multiple borrowers). Many lenders also use more sophisticated affordability measures to take into account other financial commitments (e.g., council tax, unsecured loan repayments, childcare costs, utility bills, etc.), but usually in conjunction with LTI measures. In a recent report, the CML indicated that approximately 85% of U.K. lenders continue to use LTI measures (either as a sole determinant of the maximum loan amount or as a crosscheck to the affordability measure). 5 Although it is likely that more complex affordability measures are better indicators of risk than a simple LTI, the components of these measures are not consistent across lenders. As such, DBRS considers LTI a simple but effective means of assessing affordability Financial Services Authority (FSA). FSA Finds Improvements from Lenders but Mixed Results for Brokers in Self- Certified Mortgages, 14 November Council of Mortgage Lenders (CML). U.K. Mortgage Underwriting, April 2006.

15 In the past, loans were generally restricted to 3.0 times a single income or 2.5 times joint incomes. Recently, lenders have generally started to increase income multiples, sometimes up to 4.0 or even 5.0 times their earnings, for borrowers with low LTVs or good credit history. Higher LTI ratios are a sign of greater financial commitment and make a borrower more susceptible to default in case of life changes such as divorce and unemployment. As a consequence, DBRS applies a risk adjustment to LTIs that exceed 3.5. Single Income When mortgage repayments are serviced by two separate incomes, if one income becomes unavailable (e.g., as a result of unemployment), being able to rely on a co-borrower s income mitigates the likelihood of default. As such, the repayments on a mortgage serviced by a single income attract a multiple to the benchmark PD rate. Right-to-Buy (RTB) The RTB scheme was originally introduced in the United Kingdom in Under the scheme, council tenants and tenants of registered social landlords or housing associations can buy their own homes at a low price, because part of the rent paid over the previous years of tenancy is discounted from the full market value. Borrowers who exercise their RTB typically have more fragile economic backgrounds and are likely to have relied on some form of financial support in the past. As owner-occupiers, however, these borrowers do not receive any additional housing benefit to assist them with their mortgage repayment. For this reason, DBRS considers loans granted on the basis of this scheme as riskier compared with standard mortgage loans. Loan Purpose Borrowers apply for mortgages primarily for two reasons: home purchase or re-mortgage. As seen in Figure 1.4, re-mortgage activity in the United Kingdom has boomed over the last years. Figure 1.4: Distribution of Gross Mortgage Lending by Loan Purpose % of mortgage originations 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Time Home Purchase Re-mortgage Other* Source: CML statistics. * Includes lifetime mortgages, further advances and buy-to-let. Typically, when borrowers re-mortgage, they use the proceeds from the re-mortgage to pay down an already existing mortgage, with the same property being used as security. The main motivation for this type of re-mortgage, also referred to as refinancing, is usually to take advantage of a more favourable interest rate offered by an alternative mortgage provider. Over the last years, strong house price appreciation persuaded many borrowers to re-mortgage in order to release equity from their property. As such, a growing proportion of borrowers are raising capital from their properties, hence taking on more debt. Debt consolidation is a particular form of equity release re-mortgaging, where one loan (e.g., the re-mortgage) is taken to pay off other debts already existing (e.g., unsecured loans, credit lines, etc.). 15

16 DBRS considers only raising capital and debt consolidation to be associated with a higher likelihood of default compared with traditional mortgages. Being a form for increasing credit exposure, they contribute to stretch borrowers finances, potentially compromising their ability to repay their debts. Repayment Type There are currently two main mortgage repayment methods in the United Kingdom: repayment and interest-only (IO), although there are many variations of each of these two types (e.g., a mixture of the two, where an IO reverts to repayment after a certain time period, investment backed, etc.). In a standard repayment mortgage, both interest and some of the capital borrowed is paid back over time to ensure the mortgage is totally paid off by the end of the term. In contrast, IO mortgages only require the repayment of the interest on the initial principal balance until maturity, when the borrower repays the principal balance. There is a general trend toward the growing use of IO or mixed mortgage products that allow borrowers to defer the payment of principal (see Figure 1.5). There are a number of possible reasons for this. Firstly, mortgage originators recognize that IO mortgages can service borrowers who require more flexibility in the way they repay their mortgages. For example, those who have fairly low earnings but expectations for extra financial income (e.g., bonuses) can benefit from smaller regular payments of interest and a more flexible approach to repaying the principal. Secondly, IO mortgages may be becoming more popular as they require a smaller short-term monthly commitment than a regular repayment. With growing levels of unsecured consumer indebtedness, combined with high house prices, borrowers may consider IO loans as a way to afford property that they may not be able to afford with a regular repayment scheme. Figure 1.5: Distribution of Mortgage Originations by Repayment Method % of mortgage originations 79.0% 16.0% 5.0% 71.5% 64.8% 67.0% 28.5% 28.2% 22.2% 6.3% 6.7% 4.8% Time Capital And Interest Interest-Only Mixed Source: CML statistics. As such, DBRS has some concern that IO borrowers are more likely to have stretched financial circumstances (although certainly this is not necessarily the case). In addition, there are further concerns around borrowers ability to pay back the entire balance due on the mortgage at the maturity date. In the past, IO loans were usually combined with regular payments to some sort of vehicle to ensure the repayment of principal at loan maturity. The Financial Services Authority (FSA) recently highlighted, however, that many IO borrowers did not have a strategy in place for repaying the capital. Although borrowers can refinance at maturity, the market environment at that future date is unknown and, as such, exposes borrowers to refinance risk. 16

17 Loan Term Traditionally, the maximum term offered by U.K. mortgage originators was 25 years. Although rare, mortgage lenders recently have extended possible mortgage terms for some products, sometimes up to 40 years. DBRS regards repayment mortgages with a final maturity greater than 25 years as riskier compared with shorter amortizing products. There is a general concern that a borrower may choose a long amortization term in order to reduce his or her monthly payments and, as with IO products, could be indicative of some financial vulnerability. Loan Size Given that mortgage providers generally limit the maximum loan size based on income multiples, larger loan amounts are only available to borrowers with higher incomes. DBRS regards larger loans (jumbo loans) as riskier than smaller loans. The rationale behind this view is that higher incomes are subject to greater volatility in the event of an economic downturn. Typically, these borrowers are more likely to rely on significant bonuses and may find it difficult to maintain their financial status when forced to move to a new job position (as the result of a changing economic environment). In order to account for the variety of economical environments across the United Kingdom, DBRS defines jumbo loan limits based on region and on the time of origination (see Table 1.3). Table 1.3: Example Jumbo Loan Limits (GBP) for Different Regions and Origination Time Periods Region Q2, 2006 Q4, 2006 Q2, 2007 Greater London 430, , ,000 South East 360, , ,000 Nth Ireland 255, , ,000 South West 320, , ,000 East Anglia 290, , ,000 West Midlands 280, , ,000 East Midlands 260, , ,000 Wales 250, , ,000 North West 250, , ,000 Yorkshire & Humberside 245, , ,000 North 230, , ,000 Scotland 215, , ,000 Second Lien A second-lien mortgage is a subordinated loan taken on a property already used as security for an existing mortgage. Lien positions differentiate levels of subordination in the rights of creditors to receive proceeds from the sale of the mortgaged property in the event of borrower default. Second-lien mortgages, although a common feature of many mortgage finance products in continental Europe, are less widespread in the United Kingdom. In the United Kingdom, second-lien mortgages are generally taken out as an equity release tool for raising capital or to finance the down payment of a purchase. Secondlien loans are potentially granted to borrowers who are unable to re-mortgage easily to release equity and, as such, may represent a more risky profile than the benchmark. Loan Product DBRS has reviewed the increasing variety of interest rate products that are currently available for residential mortgages in the United Kingdom. A brief summary of the most common product types are given below: Standard Variable Rate (SVR) is set by the individual lender and usually increases and decreases in line with the Bank of England s base rate. Hence, mortgage interest payments based on SVR are likely to rise or fall every time the Bank of England modifies the base rate. 17

18 Tracker (For Life) loans are guaranteed to track the rate set by the Bank of England plus a differential. This differential remains constant over the entire life of the loan (e.g., the Bank of England s base rate +0.55%). Mortgage interest payments will rise and fall with base rate changes. Tracker (For Life with Teaser) loan products track the rate set by the Bank of England plus or minus a differential for an initial period. This differential then increases at a point in the future and then stays constant for the remaining term of the loan (e.g., the Bank of England s base rate +0.19% for the first two years, then increasing to base rate +0.67% for the remaining life). Mortgage interest payments will rise and fall with base rate changes, but there will be a definite increase in mortgage payments once the teaser period expires. Tracker (Short Term) loan products track the rate set by the Bank of England plus or minus a differential for a short term (commonly between two and five years) and then switch to the SVR for the remaining life of the loan. Mortgage interest payments will rise and fall with base rate changes, but there will be a definite increase in mortgage payments once the Tracker period expires (SVR is typically set above the Tracker rate). Discount (Short Term) loan products pay interest on the basis of the SVR minus a discount for a short term (commonly between two and five years) and then switch to the SVR for the remaining loan term. Mortgage interest payments will rise and fall with base rate changes, but there will be a definite increase in mortgage payments once the discount period expires. Fixed-Rate (Short-Term) loan products pay interest based on a fixed interest rate (at a rate typically below the SVR) for a short term (commonly between two and five years) and then switch to the SVR for the remaining term. Here, the initial interest payments in the fixed-rate period will not rise and fall with base rate changes, and borrowers may be exposed to an increase in mortgage payments when they revert to the SVR. The relative amount of this increase is unknown at the time of loan origination. DBRS has applied risk adjustments to loan products where there is the potential risk of payment shock (a sharp increase in regular mortgage payments as a result of a change in the interest rate on the loan). Loans that track the ongoing changes in interest rates over time (e.g., SVR, Full Term Tracker) are not subject to this risk adjustment. Loans that generally track the ongoing changes in interest rates over time but are subject to an increase in payments once the mortgage product reverts to a higher rate are, however, considered to have some exposure to payment shock (e.g., Tracker (For Life with Teaser), Tracker (Short Term), Discount (Short Term) loan products). Fixed Rate (Short Term) loan products are seen to have to most potential for significant payment shock, as they do not adjust with increases in the base rate. If interest rates increase during the fixed period, the borrowers become exposed to a substantial increase in their regular mortgage payments at the time of the switch to the SVR. Buy-to-Let (BTL) A BTL mortgage is for the purchase or re-mortgage of a residential property used for investment purposes. Here, the property is let to tenants as opposed to direct occupation by the borrower. In the United Kingdom, BTL lending has experienced spectacular growth since the late 1990s, as shown in Figure 1.6, and corresponds to almost 10% of all U.K. outstanding mortgages. 18

19 Figure 1.6: Outstanding Buy-to-Let Mortgages in the United Kingdom ( m and % total value) m of mortgage loans outstanding 120, ,000 80,000 60,000 40,000 20,000 12% 10% 8% 6% 4% 2% % of mortgage loans outstanding % Time Mtgs outstanding at end period ( m) LHS Mtgs outstanding at end period (% total value) RHS Source: CML statistics relating to new specialist lenders (e.g., Paragon Mortgages, Mortgage Express), hence not taking into account mortgages to investors from mainstream lenders. The expansion of the BTL market is attributable to several key drivers. Residential property investors have been encouraged by strong house price appreciation and good rental demand. 6 In tandem, BTL lending has expanded significantly over the last few years, and a growing number of lenders offer bespoke BTL products at an attractive price. Growing volumes, however, have been accompanied by a growing number of BLT arrears and repossessions. DBRS considers that this increase has been potentially driven by a number of factors: A decrease in the minimum required interest coverage ratio (ICR), which is computed as the expected monthly rental income divided by the monthly mortgage interest payment (see Figure 1.7). Higher LTV ratios, mainly as a result of increases in the maximum amount lent to landlords (see Figure 1.7). Figure 1.7: Buy-to-Let Mortgage Trends 140% 0.8% 120% 0.7% 100% 0.6% 80% 60% 40% 0.5% 0.4% 0.3% 0.2% 20% 0.1% 0% % Time Maximum LTV (LHS) Minimum Interest Coverage Ratio (LHS) 90+ arrears (RHS) Source: CML statistics relating to new specialist lenders (e.g., Paragon Mortgages, Mortgage Express), hence not taking into account mortgages to investors from mainstream lenders. 6. Royal Institute of Chartered Surveyors (RICS). RICS Residential Letting Survey Great Britain, July

20 Rising interest rates. Changes in the type and experience level of borrowers accessing the residential property market; a growing proportion of new entrants are amateur landlords. An increase in the average aggregate loan ceiling for individual investors, which grew from GBP 1 million in 2006, to GBP 1.5 million in 2006, and is currently reported to be at around GBP 2.5 million. BTL mortgages are also exposed to the risk that the property may not be tenanted for part of the year, meaning the landlord may need to rely on alternative income to cover the loan repayment. Lenders try to mitigate the above exposure by requiring the rental coverage ratio to exceed 100%, but the surplus rent may not be sufficient to cover long terms without tenancy, as well as other repairs and maintenance costs. DBRS applies a risk adjustment to the benchmark two-year PD for BTL loans based on a DBRS-calculated lowest base case ICR (the stabilised ICR). This analysis calculates loan-level ICRs at six-month intervals over a four-year time period from the date of the portfolio assessment. The ICR at each time period is calculated using the following equation: ICR = updated rental income interest payable The initial step in this calculation is to update the given rental income, this is not usually updated through time, and consequently, the rental income for seasoned loans will be out-of-date. DBRS applies two adjustments to the given rental income: a rental increase and a tenant void period. Rental Increase Assumption A rental increase of 3.5% per annum on average has been assumed in order to increase the rental income from origination to a level more likely to reflect a current rental income. The 3.5% annual increase equates to the retail price index (RPI) observed over the last three to four years. This may initially seem like a relatively unsophisticated assumption, given that there will be regional variations in rental increases, and also rental increases may not track the RPI directly, but other data sources corroborate this approximate increase. An initial analysis on a survey of regional rental incomes indicates that since 2003, average rents have increased between approximately 0% and 8% per annum, depending on region. Using the proportion of BTL loans that DBRS has observed within each region, the weightedaverage annual rental increase is calculated at 3%. As such, a 3.5% increase is considered an adequate proxy for a rental increase assumption. Rental Void Assumption A rental void refers to a period in which a property is vacant, and as such, the borrower will not receive any rental income during that period. An average void period of one month per year has been assumed, on the basis of an analysis of reported void data from the Association of Residential Letting Agents (ARLA), shown in Figure