IMGC

Lenders

BENEFITS OF MORTGAGE GUARANTEE

MG offers mortgage lenders the following benefits

  • Expands customer product offering
  • Improves risk management
  • Improves cash flows
  • Reduces capital requirements
  • Release of economic capital
  • Reduces credit enhancement on securitization
  • Improves ROEs

Improves lender product offering 

Credit protection available to mortgage lenders through MG could facilitate an enhancement of lender product offering, benefitting customers through the following:

  • Higher Loan to Value (LTV) ratio on the underlying property (for example, a lender may be willing to offer an LTV of 90% on a contract with MG cover as opposed to 80% LTV on a standalone basis)
  • Loans with longer repayment period than otherwise have been offered without a MG. Extension of loan repayment tenures, could lower borrower EMI or increase their eligibility for a higher loan amount
  • Credit protection available through a MG could also help lenders expand the breadth of customers they could target

Furthermore India’s mortgage credit market is expected to register a healthy growth supported by the emergence of the new customers segments given the GoI’s push for ‘housing for all’ by 2022. Access to MG product could be an enabling factor for lenders to increase their presence in under-tapped customer segments, such as the affordable housing segment, given the credit risk protection available to them with a MG.

Improves risk management for lenders 

MG provides Lenders with a tool to manage their credit risk given that a proportion of risk would stand transferred to the MGC. Engagement with a MGC could also improve the underwriting quality for Lenders, as each loan guaranteed by a MGC would pass through its internal credit screens. Furthermore, post the MG deal, insights from the analytics and performance trends of contracts guaranteed by a MGC could help lenders better understand the portfolio performance and improve risk monitoring. Additionally Lenders could achieve greater operational efficiency through the additional layer of checks and balances required under the MGC’s due diligence process. Over time this will lead to standardization of practices and processes across the industry if lenders want to use MG as a CRM.

Improves lender cash flows 

MG coverage enables a lender to receive cash flows on delinquent contracts once classified as NPA (90+ day overdue). After a claim is filed and approved, the MGC would clear all overdues (principal and interest) and makes repayment of EMIs of the housing loan until the earlier of (i) borrower becomes current on EMIs, (ii) settlement of incurred loss following disposal of the collateral, or (iii) total claim payments equal the max amount of coverage. A MG thus helps a lender to manage its cash flow during the period in which a customer has defaulted or until a settlement / foreclosure is concluded. Besides helping a lender to manage its cash flow during the period in which a customer is in the default presence of a MG can also help lender and the borrower arrive at a settlement, with any shortfall (either principal or interest) being recoverable from the MGC, subject to the maximum amount of coverage. Settlement however would require the consent of the MGC.

Lower Capital requirements 

A Mortgage Guarantee has been recognised by the Reserve Bank of India as a valid Credit Risk Mitigant (CRM) under para 7.5 of the Master Circular – Prudential Guidelines on Capital Adequacy and Market Discipline Implementation of New Capital Adequacy Framework (NACF). This means that from a lender and regulatory perspective, there is an element of risk transfer from the lending ecosystem to the balance sheet of the MGC. This risk transfer enables the lender to release capital as per the Basel rules, resulting in more efficient use of capital and enhanced Return on Equity (ROE) for shareholders from the same capital base. Capital adequacy requirement of various lenders is given in the table below.

Regulatory capital requirement & risk weights

Entity
Overall Capital Adequacy
Tier I capital Requirement
Risk weights
Banks (Basel III) 11.50% 7%,9.5% (by Mar-19) 35% and 50%
HFCs 12% 6% 35% and 50%

Source: RBI

Mortgage loans attract risk weights depending on the loan amount as given in the table below.

Risk weights and minimum Tier 1 capital requirements for mortgage loans

Loan amount
LTV
Risk Weight
Banks
HFCs
      Mar-17 Mar-19 Mar-17
      7% 9.50% 6%
Up to Rs. 3.0 million <=80% 35% 2.5% 3.3% 2.1%
  > 80% and =90% 50% 3.5% 4.8% 3.0%
Rs. 3.0 – 7.5 million <=80% 35% 2.5% 3.3% 2.1%
More than Rs. 7.5 million <=75% 50% 3.5% 4.8% 3.0%

Source: RBI

 

Therefore, minimum Tier 1 capital in relation to the loan extended by a Housing Finance Company (HFC), without a mortgage guarantee could vary from as low as 2.10% to 3%, while for a bank it would be 3.3% to 4.8% by Mar-19 respectively.

Lenders however can reduce their capital requirements by taking MG on the underlying loans. Based on RBI regulation, risk weight on the lenders balance sheet for the MG covered portion of a loan would be based on the credit rating of the MGC. The risk weight for a ‘AA’ rated MGC would thus translate to 30%, as against 35%/50% required on home loans not covered by MG.

The capital release for lenders at a given credit rating of a MGC is driven by a combination of the extent of MG coverage taken and the factors in Tables 4 and 5.

The following illustrates the possible release of capital for a lender taking a top cover MG on home loans which attract a 50% risk weight.

Minimum tier1 capital release on home loan with 50% risk weight guaranteed by a ‘AA’ rated MGC

  
  
Extent of MG cover
Banks
HFC
HFC
      At minimum regulatory Tier 1 capital Maintaining Tier 1 capital of 12%
      Mar-15 Mar-19    
A Tier 1 capital in relation to risk weighted assets   7.00% 9.50% 6.00% 12%
B Risk weight on home loan, ticket size > Rs. 7.5 million   50% 50% 50% 50%
C=A*B Tier 1 capital requirement on loan with 50% risk weight of the lender without MG 0% 3.50% 4.75% 3.00% 6.00%
D Tier 1 capital requirement of the lender with MG 10% 3.36% 4.56% 2.88% 5.76%
E=C-D Regulatory capital release 10% 0.14% 0.19% 0.12% 0.24%
    20% 0.28% 0.38% 0.24% 0.48%
    30% 0.42% 0.57% 0.36% 0.72%

Refer to the annexure 2 for the detailed computation for the 30% MG coverage

As seen in the table above:

  • Lenders can save significant Tier 1 capital by opting for a mortgage guarantee cover. As illustrated above, at the minimum Tier 1 capital requirement and assuming all assets carry a 50% risk weight, a bank could save 0.19% - 0.57% , while HFCs 0.12% to 0.36% of Tier 1 capital depending on the extent of MG cover taken.
  • Lenders typically maintain excess Tier 1 capital, in which case capital relief would be higher. Based on the above assumptions an HFC with a Tier 1 capital of 12% could enjoy a Tier 1 capital relief of 0.24% to 0.72% by taking a MG cover.
  • Core Tier 1 capital requirement under Basel III for banks will increase to 9.5% by Mar-19 against 7.0% in Mar-15, and thus capital savings will increase (0.57% for 30% MG cover by Mar-19 against 0.42% in Mar-15). Thus, banks can take MG cover on their portfolio to meet a part of their large Tier 1 capital requirement under Basel III.

Release of economic capital

Regulatory capital requirement is a uniform prescription across all lenders. However, the assessment of economic capital requirement for any Lender is based on various qualitative and quantitative factors, including the following:

Economic Capital requirement for AA rated HFCs usually varies between 8% and 12%, depending on the factors mentioned above (as opposed to uniform regulatory Tier 1 capital requirement of 6% for all HFCs). This capital acts as a mitigant against unexpected losses that may be borne by the Lender under stress (say, prolonged slowdown witnessed in the operating environment, resulting in job losses and crash in property prices).

 

The economic capital requirement for any Lender would be lower in case it takes a guarantee cover on its portfolio, as some degree of credit risk in the portfolio is transferred to the MGC. Such a release of economic capital can allow a lender to maintain its credit profile while achieving higher business volumes against a given capital base. Alternatively a lender could improve its credit profile by lowering its economic capital requirement by taking a MG against a given level of business volumes. The extent of economic capital release (from the initial level required) would be determined by the following additional factors (other than factors mentioned earlier):

In ICRA’s assessment, for a typical AA category rated Lender, the extent of reduction in economic capital requirement, on the portion of the portfolio covered by a MG (provided by a ‘AA’ rated MGC) may broadly be as per the table given below.

Possible* Reduction in Economic Capital Requirement

Nature / Extent of MG Cover
10%
20%
30%
Extent of reduction in economic capital required 20% -30% 40% -50% 65%-75%

*The quantum of capital release actually possible can only be determined after ICRA carries out a detailed evaluation of the Lender’s portfolio guaranteed by a MGC


Based on the table above, for an ‘AA’ rated Lender, the reduction in economic capital requirement may be 65% - 75% for 30% Top Cover MG product. However, the benefit for a AAA rated Lender would be lower than illustrated above. For instance, the reduction possible in economic capital may be 45% - 50% for 30% Top Cover MG product.

The benefit of MG cover on a Lender’s portfolio would change in case of a change in the credit rating of the MGC. Also, the capital release, illustrated above, is applicable on the portion of the capital required on account of credit risk (and not pertaining to market risk or operations risk). However, the capital required for credit risk is likely to dominate the overall capital requirement, for instance credit risk weighted assets constituted around 86% of total risk weighted assets for Indian Banks as on March 31, 2015. Further, ICRA acknowledges that MG cover can also bring down the lender’s operational risk, with the portfolio undergoing an additional round of review and due diligence by the MGC.

Overall, as the economic capital requirement for a high investment grade rating (AA to AAA) is significantly higher than regulatory requirement, sometimes lack of an adequate level of economic capital becomes a constraining factor for growth for the credit profile. In this situation, a lender could release significant economic capital by taking a mortgage guarantee cover, capital thus released could be further leveraged to increase the business volumes or to meet economic capital deficit or to reduce its cost of funds with an improved credit rating.

Lowering of credit enhancements on securitization transactions

The benefit of MG cover in an Originator’s portfolio being securitized can also get reflected in the form of lower credit enhancement requirement, than what would have been required in the absence of MG cover for a similar target rating. The actual reduction in credit enhancement would depend on the underlying transaction structure, target rating of the transaction and a detailed analysis of the Originator’s portfolio and pool to be rated by ICRA. Lower credit enhancements in turn would release capital for the originator.

As a broad benchmark, for a target rating of AAA, and assuming a “par” securitisation transaction in which residual excess collections (after meeting scheduled investor payouts) are paid out to the Originator on each payout date, the extent of reduction in credit enhancement may broadly be in the region of 45% - 50% for 30% Top Cover MG product.

The corresponding reduction in regulatory Tier 1 capital requirement for Banks (assuming 75% Risk Weight for assets being securitised) for a typical AAA rated mortgage loan securitisation transaction can be as per the Table given below.

Nonetheless, it must be highlighted that the extent of reduction in credit enhancement could be lower if the credit enhancement is low in absolute terms, to cover the liquidity risk in the transaction (i.e. to mitigate against interim delinquencies in the pool until the money is received from MGC against these delinquent contracts).

Impact of MG Cover on Tier 1 capital requirement for Banks post securitisation with increased capital requirements under BASEL III

  
Without MG cover
With 30 % MG (Top Cover)
Mar-15 Mar-19 Mar-15 Mar-19
Principal amount securitised/ assigned 100 100 100 100
Credit enhancement stipulated1 10 10 5.5 5.5
Capital required by Originator prior to securitisation 5.25 7.13 4.31 5.84
Capital required by originator post securitisation 5.00 5.00 2.75 2.75
Extent of regulatory capital release for Originator on account of MG cover alone (prior to securitisation) 0.95 1.28
Extent of additional regulatory capital release for the Originator on account of securitisation 0.25 2.13 1.56 3.09
Extent of total regulatory capital release on account of both MG cover and securitisation 0.25 2.13 2.50 4.38

As can be seen in the table above, there is a significant amount of regulatory Tier 1 capital release for the banks on account of MG cover on the underlying loans post securitization, especially given the increase in Tier 1 capital requirements under BASEL III by March 2019

Impact on Return on net worth

Using the MG product could result in an improvement in ROE for the lender. The impact of mortgage guarantee standalone and MG as credit enhancement for securitization transactions would be a function of:

  • Capital relief
  • Reduction in credit cost
  • Guarantee fee

In addition to the above, the economics of a MG transaction for a mortgage lender would also depend upon the whether the lender or borrower is servicing the guarantee fee. In case of bulk transactions the guarantee fee is paid by the lender, which being an up-front payment, would have to be amortised over the tenure of the mortgage loan to assess the impact on the lender’s ROE. However incise of a flow product, the guarantee fee could be paid by either the lender or by the borrower depending upon arrangement and product offered. Lenders typically can incentivize a borrower to pay the premium by offering:

  • Lower down payments on a loan, or conversely a higher loan amount for a given level of down payment
  • Elongation of loan repayment tenures, which could bring down the EMI or increase the loan amount eligibility of the borrower

Return on Equity for a typical HFC required to maintain 10% Economic Capital

Source: ICRA Research

As shown in figure 9, the size and type of MG cover have a key bearing on capital relief; the higher the MG cover, the higher the capital relief, and the larger the improvement in the ROE.

Impact on the ROE for Securitisation transactions

MG could provide greater impetus to the securitization market as the requirement of credit enhancement to be provided by the Lender would come down if the underlying loans included in the securitized pool had MG cover. The actual reduction in credit enhancement would depend on the underlying transaction structure, target rating of the transaction and characteristics of the Lender’s portfolio and specific pool to be rated, in addition to the nature of the MG product (Quota or Top Cover), extent of MG coverage, and rating of the MGC.

Return on Equity for a typical HFC required to maintain 10% Economic Capital

Source: ICRA Research

As figure 10 shows, the impact on the return on equity for an HFC improves with securitization done with a mortgage guarantee with a 30% top cover.