17 February 1999 www.fitchibca.com Structured Finance International Special Report Australian Residential Mortgage Default Model 1999 Analysts Kevin Stephenson 612 9375 2171 [email protected]Ben McCarthy 612 9375 2300 [email protected]Polly Kolotas 612 9375 2182 [email protected]Q Summary In 1997, Fitch IBCA developed a model to evaluate credit loss levels on Australian residential mortgage-backed securities (MBS). The model, using the Australian housing recession of the early 1990s as a benchmark, calculates credit enhancement requirements to support ratings on investment-grade classes of MBS. It incorporates a loan-by-loan analysis that takes into account the characteristics of each property, borrower, and loan. To determine rating guidelines that reflect the unique characteristics of mortgages and lending practices in the Australian market, Fitch IBCA conducted a study of the residential mortgage industry. The study included an examination of residential mortgage portfolios from several mortgage lenders. In addition, Fitch IBCA analysed data and research from several Australian mortgage insurers, the Australian Bureau of Statistics, and the Real Estate Institute of Australia. Fitch IBCA’s Australian mortgage default model calculates credit losses for MBS based on the probability of borrower default and loss severity. The model focuses on the interaction of the three primary determinants of default. These three factors are: borrower’s equity in their home (or loan-to-value ratio [LVR]); borrower’s financial resilience; and potential effect of an unexpected downturn in borrower’s financial standing, such as unemployment or divorce. Loss severity is determined by considering regional market value trends; the costs involved once a borrower has defaulted, such as carrying costs and legal expenses; and LVR. Fitch IBCA’s market value assumptions are based not only on traditional determinants such as regional economic stability but also on historical home price volatility by state and projected steady state sustainable growth. Residential MBS ratings are based on three fundamental aspects of the transaction: the credit quality of the collateral; the financial structure of the security; and the legal separateness of the issuer. This report focuses on Fitch IBCA’s approach to determining the credit quality of the collateral. The report describes some of the unique features of the Australian mortgage market, sets out Fitch IBCA’s guidelines and methodologies for rating Australian residential mortgage loans, and includes Fitch IBCA’s checklists for reviewing the origination and administration of the loans. This report updates Fitch IBCA’s report from September 1997. The primary changes are the inclusion of income coverage and other factors in calculating default probability, additional historical home price data, and a discussion of credit reporting in Australia. Collateral Information Checklist A. Loan Attributes • Loan balances (current, original, and scheduled) • Appraised value • Loan-to-value ratio • Loan term (original, remaining, and seasoning) • Origination date • Mortgage rate and description (i.e. variable) • Mortgage attributes (i.e. rate adjustment frequency) • Loan type • Loan purpose • Loan status (if in arrears, number of months and balance) • Mortgage insurance B. Borrower Attributes • Profile (i.e. first-time home buyer) • Status (i.e. self-employed) • Debt-to-income ratio • Credit reporting information C. Housing Attributes • Home type • Owner-occupied vs. investment property • Regional dispersion D. Pool Concentration • Geographic location by state and region • Post code
Q SummaryIn 1997, Fitch IBCA developed a model to evaluate credit loss levels onAustralian residential mortgage-backed securities (MBS). The model, usingthe Australian housing recession of the early 1990s as a benchmark,calculates credit enhancement requirements to support ratings oninvestment-grade classes of MBS. It incorporates a loan-by-loan analysisthat takes into account the characteristics of each property, borrower,and loan.
To determine rating guidelines that reflect the unique characteristics ofmortgages and lending practices in the Australian market, Fitch IBCAconducted a study of the residential mortgage industry. The studyincluded an examination of residential mortgage portfolios fromseveral mortgage lenders. In addition, Fitch IBCA analysed data andresearch from several Australian mortgage insurers, the AustralianBureau of Statistics, and the Real Estate Institute of Australia.
Fitch IBCA’s Australian mortgage default model calculates creditlosses for MBS based on the probability of borrower default and lossseverity. The model focuses on the interaction of the three primarydeterminants of default. These three factors are: borrower’s equity intheir home (or loan-to-value ratio [LVR]); borrower’s financialresilience; and potential effect of an unexpected downturn inborrower’s financial standing, such as unemployment or divorce.
Loss severity is determined by considering regional market valuetrends; the costs involved once a borrower has defaulted, such ascarrying costs and legal expenses; and LVR. Fitch IBCA’s marketvalue assumptions are based not only on traditional determinants suchas regional economic stability but also on historical home pricevolatility by state and projected steady state sustainable growth.
Residential MBS ratings are based on three fundamental aspects of thetransaction: the credit quality of the collateral; the financial structure ofthe security; and the legal separateness of the issuer. This reportfocuses on Fitch IBCA’s approach to determining the credit quality ofthe collateral.
The report describes some of the unique features of the Australianmortgage market, sets out Fitch IBCA’s guidelines and methodologies forrating Australian residential mortgage loans, and includes Fitch IBCA’schecklists for reviewing the origination and administration of the loans.
This report updates Fitch IBCA’s report from September 1997. Theprimary changes are the inclusion of income coverage and otherfactors in calculating default probability, additional historical homeprice data, and a discussion of credit reporting in Australia.
Collateral InformationChecklist
A. Loan Attributes
• Loan balances (current, original, andscheduled)
• Appraised value• Loan-to-value ratio• Loan term (original, remaining, and
seasoning)• Origination date• Mortgage rate and description (i.e.
frequency)• Loan type• Loan purpose• Loan status (if in arrears, number of
months and balance)• Mortgage insurance
B. Borrower Attributes
• Profile (i.e. first-time home buyer)• Status (i.e. self-employed)• Debt-to-income ratio• Credit reporting information
C. Housing Attributes
• Home type• Owner-occupied vs. investment property• Regional dispersion
D. Pool Concentration
• Geographic location by state andregion
• Post code
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Q Australian Home OwnershipThere is a significant social status to home ownershipin Australia. Approximately 70% of Australianhouseholds live in dwellings that they own or arepurchasing. For most Australians, the purchase of ahome for owner-occupation is one of the most importantand largest purchases made during their lifetime.
The high rate of home ownership in Australia canlargely be attributed to government policyencouraging ownership, both directly and indirectly,over a long period. Before World War II, thegovernment promoted home ownership to address theproblems of housing shortages, homelessness, andsubstandard rental accommodations. Thesegovernmental policies continued in the post-war era,as the government provided more than 100,000 loansto soldiers returning from the war. This significantinitiative provided a major impetus to the homeconstruction activity and increase in housing stockfor 10 years after the war.
The government continued its promotional policies inthe 1960s and 1970s, providing various measures toassist first-time home purchasers and establishingregulations affecting housing finance. Furthermore,in the 1980s, the deregulation of the financial marketand floating of the Australian dollar affected housepurchases.
In April 1986, a significant policy change occurred:The Australian government lifted the control onhousing loan interest rates. Before this, housing loaninterest rates were capped at 13.5%. This changeresulted in an unlimited supply of financing for homelending and caused rates to increase rapidly in thelate 1980s, peaking in 1989 at approximately 17%(see chart below). The rapid increase in ratesadversely affected home purchasers, and mortgage
defaults increased markedly in the years thatfollowed.
More recently, the 1990s has seen the increase ofnon-bank home mortgage lending. These non-bankoriginators often fund themselves throughsecuritising their mortgage pools. The emergence ofthe non-bank originators has led to increasedcompetition in the mortgage market, as the bank andnon-bank originators compete for customers based oninterest rates and loan amenities.
Q Fitch IBCA Residential Default Model
Model ApproachFitch IBCA considered unique social, economic, andcultural features in developing its Australianmortgage default model. Based on historical analysis,Fitch IBCA has determined that the probability ofdefault for an Australian home loan borrower islower than for similar US or UK home loanborrowers. Fitch IBCA has reflected the slightlylower likelihood of borrower default in its defaultprobability matrix on page 4.
Fitch IBCA’s market value decline (MVD)assumptions also reflect the historically low levels ofvolatility in Australian house prices; nevertheless,because Australia has not experienced a severehousing recession in recent history, Fitch IBCA hasbeen conservative in formulating its MVDassumptions to allow for the effects of a recessionsevere enough to affect investment-grade entities.
To determine loss coverage for residential MBS,Fitch IBCA’s Australian default model employs aloan-by-loan review, examining several loan-,borrower-, and property-specific factors that mostinfluence default probability and loss severity. FitchIBCA’s base default probability analysis focusesprimarily on a loan’s LVR. These expected defaultrates are then adjusted further by loan, borrower, andproperty attributes, as described later in this report.
A large component of Fitch IBCA’s recovery valueanalysis is market value trends. (Recovery value isthe inverse of loss severity.) Fitch IBCA marketvalue assumptions focus on historical regionalvolatility and sustainable growth, while alsoincluding traditional measures of MVD. The marketvalue projections are then adjusted by loan andproperty attributes, including property size andownership.
Housing Finance Interest Rates
0
2
4
6
8
10
12
14
16
18
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
(%)
Source: Reserve Bank of Australia.
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Fitch IBCA’s Australian mortgage default model can becharacterised as a worst-case, loss-driven model, whichcalculates investment-grade credit enhancementrequirements for residential mortgage securitisations.
Q Credit Information AvailabilityCredit information on borrowers is an importantpredictor of borrower behaviour. Borrowers whohave poor credit histories are far more likely todefault on their home mortgages than borrowers whohave clean credit histories. In the US, credit reportingbureaus maintain accurate and detailed positive andnegative credit information for all borrowers. Thisdetailed credit history is an important indicator ofdefault probability. In Australia, as in the UK, creditreporting has not developed to the same extent as inthe US. In addition, privacy laws forbid the collectionor dissemination of some data. The table aboveoutlines some of the differences between creditreporting in the US and Australia.
The lack of available credit data in Australia reducesthe effectiveness of credit reporting as a predictor offuture defaults. Because the Australian creditreporting agencies typically only receive negativedata after a loan has defaulted (120 or more dayslate), a borrower who is habitually 30 to 90 days latein making payments will likely not appear on anynegative credit report. This high threshold ofreporting does separate out borrowers with very poorcredit histories (referred to in the US as “C” and “D”borrowers); however, it is difficult to distinguishbetween a borrower with an average credit historyand a borrower with a spotless credit history. As aresult, Fitch IBCA finds that most performing loanpools will contain “A,” “A–,” and “B” borrowers.Without the ability to distinguish among these classesof borrowers, Fitch IBCA must conservativelyassume that a performing loan pool will have equalconcentrations of all three classes.
Q Default Probability
Determinants of Default
The primary indicators of delinquency and default area combination of the following factors:
1. The amount of equity invested in the home (LVR).2. The financial resilience of the borrower.3. The effect of unexpected financial stress on the borrower, such as unemployment or divorce.
Fitch IBCA incorporates the two basic theories ofmortgage default in its model, namely the borrower’swillingness and ability to make monthly payments.
The equity or willingness-to-pay theory states that theborrower’s perceived equity in the property dominatesthe decision to default if the borrower is in financialdistress. The borrower’s incentive to avoid foreclosureis, therefore, affected by home price fluctuations overtime. The equity theory also assumes that a large initialdownpayment reflects a borrower of higher financialmeans. Fitch IBCA believes that a borrower is morewilling to pay if he has made a substantialdownpayment at origination, regardless of declines inhome prices that might erode equity over time.
In Australia, accumulated equity in housing providessignificant benefits to homeowners, including: use ascollateral against loans for cars, holidays, orinvestment purposes; and an additional degree ofsecurity against unemployment or retirement.Consequently, low LVR loans (less than 60%) areexpected to have very low default rates.
Most home mortgages in Australia are fully recourseto the borrower. The recourse provisions allow alender to pursue other assets of the borrower in theevent that the mortgage collateral is insufficient tosatisfy the loan upon a borrower default. The
Reported Credit Events
US Australia
Late Payments 30 Days Not Reported
Defaults Reported Usually Reported
Bankruptcies Reported Reported
Current Outstanding
Balances Reported Not Reported
Judgments Reported Reported
Credit Applications Reported Reported
Credit Granted Reported Not Reported
Credit Availability Reported Not Reported
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recourse provision will provide an incentive to theborrower to expend all assets to avoid a mortgagedefault. In countries with predominantly non-recourse mortgages, during periods of sharp MVDs,solvent borrowers who find their loans “under water”may choose to hand back the keys to the lender toprotect their other assets. This option is not viableunder a recourse mortgage.
A borrower’s ability to pay is largely dictated by hisincome in relation to all monthly necessaryobligations. The larger the income surplus or cushion,after paying monthly debts, the more financiallyresilient is the borrower. In addition, larger surplusesallow for greater absorption by the borrower offinancial shocks, such as divorce, unemployment, ora rise in interest rates. This is particularly importantbecause the two most common reasons for borrowerdefault are unemployment and divorce.
When Fitch IBCA analyses pools of Australianmortgage loans, it will review the lender’sunderwriting guidelines, as well as a sample of loanfiles. Fitch IBCA views a lender favourably if itlimits loan amounts based on borrower income anddebt and if a thorough borrower evaluation isperformed, including checks for negative creditinformation with the Credit Reference Association ofAustralia Ltd. Fitch IBCA’s review and analysis ofthe lender determines whether Fitch IBCA decreasesor increases the base default rates.
Fitch IBCA uses these factors in the Australianmortgage default model to determine base defaultrates, which are then modified to reflect the riskassociated with specific loan, borrower, and propertyattributes. The base default probability matrix forinvestment-grade rating levels is set out above.
Default Probability AdjustmentsFitch IBCA adjusts the base default rates on a loan-by-loan basis to account for individual loan characteristics
of the collateral across all rating levels. Default ratesmay be adjusted to reflect product type, loan purpose,second home/investment property, borrower profile,seasoning, and arrears status.
Product Type: The most common type of home loanin Australia is the variable-rate, 20- to 30-yearamortising residential mortgage loan. While variable-rate mortgages can experience payment shock due tounderlying index volatility, this risk is alreadyincorporated into the baseline default analysis. Manymortgages offer a variety of other features, such asredraw facilities; the ability to lock in a fixed rate forall or a portion of the mortgage for a set period, tooffset interest payments with earned interest from adeposit account; or the ability to receive advances forprincipal payments made in excess of scheduledamortisation. These features will be discussed inmore detail later. Fitch IBCA assumes that allresidential mortgage loans are fully amortising. FitchIBCA will increase the probability of default 100%or more for any mortgage that is not fully amortising.
Amortising Variable-Rate Mortgages: These mortgagespay principal and interest until maturity. The interestrates for these mortgages typically vary at the discretionof the trustee, fund manager, or servicer. No defaultprobability adjustments are made for these loans.
Amortising Fixed-Rate Mortgages: These types ofmortgages pay principal and interest until maturity.The interest rate is fixed for a specified period, atwhich point it will convert to a variable rate. FitchIBCA will increase the probability of default by 20%if the fixed rate is a below-market “teaser” rate. Forloans fixed five or more years, Fitch IBCA will notincrease the probability of default because it believesthat the fixed rate will protect the borrower fromincreases in interest rates during the peak defaultperiod, which occurs in years two through five formost loans. For loans fixed less than five years, FitchIBCA will increase the probability of default by up to
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10% to reflect the inability to prepay the loan and thepossibility of a shock to the borrower if paymentssuddenly increase at the expiration of the fixed term.
Some mortgage products will allow the borrower toconvert all or some of the mortgage to a fixed rate atany time during the life of the mortgage. Fitch IBCAdoes not increase the probability of default for theseloan types.
Interest-Only Mortgages: These types of mortgagesconvert to amortising principal and interestmortgages after a specified date. The interest rateunder the mortgage may be a variable or fixed rate.Fitch IBCA increases default probability for interest-only loans that convert to amortising loans due to thepayment shock caused to the borrower as a result ofhigher monthly payments required to amortise theloan by its maturity date.
Amortising Split Variable-Rate/Fixed-Rate Mortgages:Under these mortgages, the interest rate for a certainspecified dollar proportion of the mortgage is fixed fora specified time period, while the interest rate for theremaining dollar proportion of the mortgage isvariable. In these loans, the borrower may freelyprepay the variable-rate portion of the loan withoutpenalty or break charges. Fitch IBCA believes thatthe ability to prepay the mortgage and build up equitybalances the risk of a potential payment shock at theexpiration of the fixed-rate term. Therefore, FitchIBCA does not increase the probability of default forfixed/floating loans.
Redraw Facilities: Some loans will allow a borrowerto redraw principal that has been paid ahead ofschedule. The borrower may only redraw an amountup to the scheduled balance of the loan. For instance,a borrower prepays $50,000 of a $100,000 loan andtwo years later needs cash for home improvements.Had the borrower not prepaid the $50,000, thescheduled balance on the loan after two years mighthave been $95,000. Therefore, the borrower couldredraw up to $45,000 of the $50,000 that had beenrepaid to bring the balance back to the scheduledamount of $95,000. Fitch IBCA does not increase theprobability of default for the presence of redrawfacilities so long as the redraw is at the discretion ofthe lender. For loans with redraw facilities, FitchIBCA will determine default probability and lossesbased on the scheduled loan balance and not thecurrent loan balance.
“Top-Up” Facilities: These facilities will allow theborrower to receive additional funds such that thenew loan balance exceeds the original loan balance.
Fitch IBCA will increase the probability of defaultand the projected losses for loans that allow “top-ups.” To avoid the additional credit enhancementrequirements of top-up loans, the lender can agree toremove such loans from a pool before providing anyadditional advances. However, rather than removethese loans from a securitised pool, some lenders mayopt to provide a deed of priority, which willsubordinate the top-up portion to the original loanamount to insulate bondholders. Fitch IBCA believesthat while a deed of priority may protect bondholdersfrom increased losses, the top-up will still increasethe probability of default. Therefore, unless the loanis completely removed from the pool, a top-upfacility will require additional credit enhancement.
Reduced Documentation Programs: Fitch IBCAbelieves that loans made with reduced documentationare more likely to default than fully documentedloans. Loans made with no borrower incomeverification and no asset verification are much morelikely to default. Loans with little or nodocumentation perform particularly poorly whencombined with other high-risk characteristics, such aspoor credit history or high LVRs. Fitch IBCA willsubstantially increase the probability of default forlimited or no documentation loans.
Refinancing: Fitch IBCA views mortgage loansadvanced to release equity in the home (equityrefinance mortgages) as risky because thehomeowner is essentially borrowing back equitybased on the home’s price appreciation. Fitch IBCAbelieves that a cash-out refinance is more likely todefault than a rate and term refinance. First, given theborrower’s desire to obtain a certain amount of cash,pressure to reach the corresponding propertyvaluation may result in understated LVRs. Therefore,such loans would be more risky than accuratelyvalued loans with apparently identical LVRs.
Because the loan is advanced on the basis of thehome’s appreciated value, appraisals for a refinanceare critical to the underwriting process. Fitch IBCAreviews the issuer’s appraisal process, as well as allunderwriting guidelines, when meeting with theoriginator’s management. Second, a common purposefor cash-out refinancing is debt consolidation. Whiledebt consolidation may result in a lower aggregatemonthly payment for the borrower, the need for debtconsolidation can be an indicator of financial stress.Should the borrower “reload” on other credit linesafter the consolidation, the debt burden may becomeintolerable. For these reasons, Fitch IBCA increasesthe probability of default for a cash-out refinance.Conversely, Fitch IBCA will reduce the probability
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of default on a rate and term refinance if the borrowercan demonstrate a clean mortgage payment history.
Purchase Money Mortgages: Fitch IBCA believesthat the safest purchase money mortgages are toborrowers who have had prior mortgages and whoare not pushing maximum LVR limits. Fitch IBCAwill reduce the probability of default and potential forloss upon a default for these types of loans. For loansthat are seeking the maximum available LVR, FitchIBCA believes that there may be pressure on theappraisal to arrive at the appropriate value and theborrower may have used all available resources toobtain the mortgage. Therefore, Fitch IBCA willincrease the loss upon a default for these loans. Inaddition, Fitch IBCA will increase the probability ofdefault for first-time borrowers because they are agreater risk than seasoned borrowers.
Construction Loans: For loans advanced toconstruct homes, Fitch IBCA expects construction tobe completed before the loan being included in thepool for securitisation.
Mortgages Up to 90 Days in Arrears: When ratinga portfolio combining current and arrears mortgages,Fitch IBCA increases base default rates formortgages in arrears up to 90 days by 25%–75%.
Credit Report Histories: Fitch IBCA will decreasethe probability of default for borrowers with nodefaults, bankruptcies, or other blemishes on theircredit report. A borrower with any defaults, no matterhow small or despite any explanation, will notreceive this credit.
Second Homes and Investment Properties: Whileinformation about mortgage performance for secondhomes is limited, Fitch IBCA assumes that secondhomes are considerably more susceptible to default.A financially distressed borrower is more likely todefault on a second home than on a primary
residence. A borrower is even more likely to defaulton an investment property than on a second home.Investment properties in Australia tend to have lowyields and generate little or no positive cash flow.Borrowers typically acquire investment properties fortax benefits and appreciation. If interest rates rise,investment property borrowers will see their cashflow positions rapidly deteriorate, thus increasing theprobability of default. Accordingly, Fitch IBCAincreases base default rates up to 25% for investmentproperties.
Borrower Profile: Self-employed borrowers have agreater probability of default than borrowers who arepaid a salary, depending on the nature of theirbusiness. More importantly, as mentioned earlier, aborrower in Australia is required to guarantee hismortgage with all his assets, including moveableassets and wages, as well as the real estate againstwhich the loan has been advanced. If the entire loan isnot repaid by foreclosing on and selling the mortgagedproperty, the borrower’s wages and other income can beseized according to limits set by Australian law.
Given this legislation, Fitch IBCA believes that aborrower who earns a fixed annual salary is morelikely to make monthly mortgage payments than aself-employed borrower who generates income fromhis own business. For these reasons, Fitch IBCAincreases default probability on loans to self-employed borrowers by up to 30%.
Q Income Ratios/Excess IncomeThe ability of a borrower to repay a loan has a directlink to the size to the mortgage payment relative tothe borrower’s income. Naturally, a borrower with alow mortgage payment to income ratio will havemore ability to survive stress situations, such as anincrease in interest rates, a reduction in income, or anunexpected major expense. Fitch IBCA’s defaultratios on page 4 assume a borrower with a debtservice-to-income ratio of 35%–40%. If a borrower’sratio exceeds 40%, Fitch IBCA will increase theprobability of default. Conversely, if the borrower’sratio falls below 35%, Fitch IBCA will decrease theprobability of default.
Fitch IBCA recognises that debt service-to-incomeratios are not as applicable to wealthy borrowers,who will have a greater amount of disposableincome, even at higher debt service-to-income ratios.For this reason, Fitch IBCA will allow wealthyborrowers a debt service-to-income ratio of up to45% before increasing the probability of default.
Housing Price Indicies
100
120
140
160
180
200
220
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
(%) Home Prices* Consumer Price Index
*Weighted average of eight capital cities.
Source: Housing Australia, Australian Bureau of Statistics.
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Some lenders will use excess income as a measure ofloan affordability as opposed to debt service-to-income ratios. Fitch IBCA will look at theseunderwriting guidelines individually to determinetheir appropriateness. Excess income required by afamily will vary greatly depending on the number ofchildren, whether one or both parents work, and thelocation of the borrowers. In addition, changes infamily status and interest rates can quickly reduceexcess income. Fitch IBCA may increase or decreasethe probability of default depending on the lender’sguidelines for determining excess income.
Q Loss Severity
Components of Loss SeverityIt has long been recognised that economic changesaffect mortgage performance. The risks created byserious economic downturns can be severe: homeprices and repossession rates can fluctuatedramatically, with bank losses escalating, if a surgein foreclosure rates coincides with a downturn inhome prices. Fitch IBCA’s Australian default modelquantifies loss severity (or, conversely, recoveryvalue) by utilising several factors, including marketvalue trends, foreclosure and carrying costs,mortgage insurance, and LVR.
Q House Prices in AustraliaBetween 1986–1989, house prices in Australiaincreased more rapidly than the Consumer PriceIndex (CPI) (see chart, page 6). Since then, priceshave moved more in line with the CPI, although morerecently they are diverging again. This divergencefrom the CPI in 1986–1989, as well as recently,reflects the volatility of the housing market, whichhas historically worked on boom/bust cycles. The lastboom was between 1987–1989, when house pricesincreased almost 50%.
The increase in prices in 1987 was caused by growthin demand for real estate. There are several reasonsfor this growth: pent-up demand following a periodof relatively high prices in 1985; children of “babyboomers” started to form households of their own;increased interest in real estate following the 1987stock market corrections; Australia experienced highlevels of net overseas migration through the last halfof the 1980s (net migration for the five years endedJune 1990 was 48% higher than the previous fiveyears); and housing demand fueled by thegovernment lifting the control on housing loaninterest rates in 1986.
Since 1989, house price growth has slowed due to acombination of high interest rates, greater homeprices, a decline in overseas migration, and lowereconomic growth. However, in 1997 and 1998, realestate prices in Sydney and Melbourne increased
Market Value TrendsTo capture true market value movements for eachregion, Fitch IBCA’s methodology focuses ontraditional determinants, such as regional economicstability, as well as historical regional changes inhome prices and projected steady state sustainablegrowth.
Many variables influence home price movements,such as sudden, volatile changes in housing demandbrought about by government policy and speculationor population migration, variations in disposableincome induced by fluctuations in interest rates andwages, and changes in lending practices. While thesevariations are sometimes measurable, they generallyare not predictable and, as a result, do not lendthemselves to the traditional methods of assessingfuture decreases in market values. For this reason, FitchIBCA’s model focuses on home price movements ratherthan the events that influence them.
Fitch IBCA divided Australia into eight regions tocarry out its house price analysis, as shown in thetable on page 8. Fitch IBCA analysed house pricemovements in each region since 1978 on the basis ofdata compiled by the Real Estate Institute ofAustralia and found that house prices had increasedyear-over-year in the country as a whole since 1978,despite the minor recession in the early 1990s.Although home prices have been increasing overall inAustralia, as in the UK and the US, each region hasdifferent patterns of growth and declines (seeAppendix 1, page 11). To determine worst-case homeprice movements and volatility for each region, FitchIBCA focused on each region individually andassessed worst-case home price declines andvolatility. The results were then increasingly stressedto determine base MVDs ranging from ‘BBB’ to‘AAA’ for each region in Australia.
Adjustment Factors for High-Value Properties
Property Sydney/ Other CapitalValue (A$) Melbourne (x) Cities (x) Other (x)
400,000�600,000
N.A. 1.10 1.25
600,001�900,000
1.10 1.25 1.50
> 900,000 1.25 1.40 2.00
N.A. � Not applicable.
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Market Value Adjustments: Fitch IBCA adjusts itsprojected MVDs depending on the property type.Fitch IBCA believes that single-family detachedhomes are the least volatile of all residential propertytypes. Therefore, Fitch IBCA will reduce theprojected MVDs for this property type. Otherproperty types, such as apartments, attachedtownhouses, units with fewer than two bedrooms, anddowntown residential, have historically shown greaterprice volatility. As a result, Fitch IBCA will increase theMVDs for these more volatile property types.
High-Value Properties: Homes with relatively highmarket values are generally subject to greater MVDsin a deteriorating market than homes with average orbelow-average market values due to limited demandfor such properties. Imprecise pricing information,caused by the lack of comparable benchmark homes,also influences the amount of price volatility during amarket downturn. Additionally, Fitch IBCA recognisesthat relative and absolute home price movements canvary by region. Fitch IBCA will increase base MVDassumptions to account for this increased risk, asdetailed in the table on page 7.
Property Ownership: In Australia, a borrower canpossess his/her home freehold or leasehold. If theregistered legal mortgage is over freehold land, thehomeowner owns the land on which the house isbuilt. If the property is possessed leasehold, creditrisk can be higher. As the lease approachestermination, the value of the leasehold propertyrapidly declines. This depreciating effect increases inseverity toward the end of the lease’s life. In somerare cases, the lease may not be renewed, and theowner of the property can take possession of thestructure. For this reason, Fitch IBCA imposes aminimum lease life of approximately 20 years beyondthe life of the loan. In the event this condition cannotbe met, Fitch IBCA will depreciate the value of thehome based on the duration of the lease’s life.
Foreclosure and Carrying CostsWhen calculating recovery value, Fitch IBCA’smodel reduces the property valuation by foreclosurecosts and the cost to the administrator of “carrying”the loan from delinquency through to default. FitchIBCA assumes foreclosure costs amount to 8% of the
loan balance at the time of possession. This estimateis based on actual cost data supplied to Fitch IBCAand may be adjusted as cost structures change in theindustry.
To calculate carrying costs, Fitch IBCA assumes theborrower does not pay interest for 12 months and thatthe interest rate on all loans during this time is theweighted average rate in the mortgage pool for fixed-rate product and at 17% for variable-rate mortgages.The 12-month time frame is based on worst-caseestimates obtained from Australian mortgage lenders.The 17% interest rate is based on worst-casehistorical interest rate data.
Q Mortgage InsuranceMortgage insurance in the form of primary mortgageinsurance (PMI) and pool policies (as creditenhancement) is commonly provided on all mortgageloans securitised in Australia. Typically, there is100% loss coverage by mortgage insurance againstthe loan balance plus costs. Mortgage insurance alsooften provides liquidity to the securitisations,ensuring that timely interest is paid to the securityholders even upon the default of a large percentage ofborrowers in a securitisation.
Participants: Five participants dominate the mortgageinsurance market in Australia: CGU Lenders MortgageInsurance Ltd. (formerly Commercial Union); HousingLoans Insurance Corporation Ltd. (rated ‘AAA’ byFitch IBCA); GE Capital Mortgage Insurance(Australia) Pty Ltd. (rated ‘AA’ by Fitch IBCA);MGICA Ltd.; and Royal and Sun Alliance LendersMortgage Insurance Ltd.
Primary Mortgage Insurance: Typically, theinsurance provided under a PMI policy covers lossesand costs after enforcement against a defaultedmortgage. The losses and costs covered includeprincipal losses, interest losses, and any amount ofcosts of sale and enforcement reasonably andnecessarily incurred.
Cash Flow Coverage: Many PMI and pool policiesinclude cash flow coverage (liquidity) in an amountequal to defaulted interest installments. This coverage
Market Value Declines(%)
AustralianNew South Western Capital Northern
South Wales Victoria Queensland Australia Australia Tasmania Territory Territory
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typically starts after one missed payment andcontinues until the default in payment is remedied oruntil enforcement of the mortgage is complete,subject to a maximum period, usually between 12 and24 months, specified in each PMI policy. Theinsurers are typically required to pay cash flowclaims within 14 days of having received a properclaim. Cash flow coverage does not provide creditenhancement to the transaction, rather, it decreasesthe amount of liquidity that Fitch IBCA wouldotherwise require for the securitisation.
Exclusions: PMI policies will not cover lossesresulting from: the liability of the trustee asmortgagee under any environmental legislation; thepayment of any further penalty or liability to paydamages; war, invasion, insurrection, or like events;government or local authority confiscation,nationalisation, requisition, or damage to any propertysecuring a mortgage; refusal or failure to complywith reasonable directions of the mortgage insurer;material breach by the trustee as the insured; themortgage becoming invalid, unenforceable, or losingpriority; losses due to the lender’s systems failing tomeet Year 2000 compliance; or material or physicaldamage to a security property (however, in thisregard, mortgagors are obliged to effect full fire andgeneral insurance, and there is often a mortgageprotection policy purchased for the benefit of thetrustee that provides coverage in the event of physicaldamage loss arising from the failure of the originalinsurance policy).
When rating an MBS, Fitch IBCA initially reviewsthe PMI and/or pool policies to determine coverageamount and payment terms and to understand theexclusion clauses in the policy that might cause non-payment by the insurer. The insurer’s rating also is
taken into consideration when determining theamount of credit for mortgage insurance for eachloan in a pool. If a mortgage insurer is rated less thanthe rating on the MBS transaction, only partial creditis given. For example, on ‘AAA’ rated MBS, creditfor mortgage insurance from an ‘AAA’ rated entitymay be up to 100%, with up to 75% for an ‘AA’rated insurer, up to 50% for an ‘A’ rated insurer, andup to 25% for a ‘BBB’ rated insurer.
Q Credit EnhancementFitch IBCA calculates credit enhancement for eachloan in a mortgage pool by multiplying defaultprobability by loss severity. The required creditenhancement amounts for each loan is totalled andthen adjusted for any pool-wide characteristics toderive the required credit enhancement for the entiresecuritisation. An example of Fitch IBCA’s loan byloan calculation is set out above.
Q Liquidity CoverageMBS transactions require liquidity to cover short-term delinquencies and long-term shortfalls.Assumptions regarding liquidity requirements can varydramatically because the timing of delinquencies andshortfalls is difficult to predict. For this reason, FitchIBCA uses a worst-case methodology to determine thelevel of liquidity required to cover delinquencies anddefaults and takes the weighted average defaultprobability for a given pool of mortgages as the baseindicator. Because liquidity coverage is closelyrelated to the quality and efficiency of mortgageadministration as well as the quality of the collateral,Fitch IBCA tailors the calculation of liquidity to theparticular dynamics of each transaction that it rates.
For short-term delinquencies, Fitch IBCA assumesthat payment will be received within a maximum of
Loan-Level Credit Enhancement Calculation
Desired Rating 'AAA' Loss Severity Calculation (A$)Appraised Value (A$) 100,000 Loan Balance 75,000Region Melbourne Appraised Value 100,000Loan Advanced (A$) 75,000 Less: Market Value Decline (40%) 40,000Loan-to-Value Ratio (%) 75.0 Less: Repossession Costs 6,000Product Type Variable Rate Less: Carrying Costs (17% for 12 Months) 12,750
Equals: Recovery Value 41,250
Default Probability Calculation (%) Loan Balance (30 Months Seasoned) 75,000
'AAA' Base Default Probability 14.0 Less: Net Recovery 41,250 Equals: Loss Amount 33,750
Loss Severity (Loss/Original Balance) (%) 45.0
Required Credit Enhancement �AAA� Default Probability (%) 14.0 Times: Loss Severity (%) 45.0 Equals: �AAA� Credit Enhancement (%) 6.3
Note: Example assumes no mortgage insurance.
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six months and that interest will accrue during thisperiod at the weighted average interest rate for afixed-rate mortgage pool and at 20% for variable-ratepools. Short-term delinquencies also includelegitimate events of non-payment, such as formaternity/paternity leave and payment holidays.
For long-term payment shortfalls, Fitch IBCAtypically assumes that payment will be receivedwithin a maximum of 15 months from the point ofdefault and that interest will accrue at the weightedaverage interest rate for a fixed-rate mortgage pooland at 18% for variable-rate pools. Fitch IBCA thenadjusts weighted average default probability to reflectits estimation of the number of loans likely to be indefault at any one time. To the extent liquidity isprovided by an appropriately rated mortgage insurer,this liquidity calculation may be substantially reduced.
A key factor in evaluating and rating a pool of mortgageloans is the quality of the operations and procedures ofthe underlying mortgage originator/administrator. Adirect correlation exists between the origination and
servicing functions and the performance of a collateralpool. Fitch IBCA may increase or reduce creditenhancement based on the quality and experience of theoriginator and administrator. Underwriting guidelines,appraisals, and collection procedures are of particularimportance.
Operations ReviewAs part of its rating process for each transaction,Fitch IBCA reviews the operations of theoriginator/administrator, determining whether thecompany’s procedures, controls, and performance areacceptable. Interviews, procedural reviews, and loan-level analyses are performed, not only to determine ifoperations comply with industry and investorguidelines but also to ensure that the proper controlsare in place for a given transaction.
Fitch IBCA tailors its review to the requirements ofeach issuer and investor, as well as the nature of thetransaction involved. The key aspects of its approachare summarised in the checklists in Appendix 2 onpage 12.
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