Moody’s – Page 16 – Digital Finance Analytics (DFA) Blog

Norway Tightens Mortgage Underwriting Standards

Moody’s says Norway’s Proposed Tighter Mortgage Underwriting Standards Are Credit Positive for Banks and Covered Bonds.

On 8 September, Norway’s Financial Supervisory Authority (FSA) published a proposal for tighter mortgage underwriting limits. The proposed regulation, made to the Ministry of Finance, includes a limit of 5x loan value to the borrower’s gross income; requiring loans to amortise down to a 60% loan-to-value (LTV) ratio, down from 70%; a maximum home-equity LTV of 60%, down from 70%; and the reduction or complete elimination of banks’ ability to deviate by 10% from the regulatory limits, including the 85% maximum LTV requirement.

The new measures would reduce borrowers’ ability to take on excessive debt amid still-increasing house prices, particularly in the urban areas concentrated around the capital city of Oslo. These more restrictive proposals are credit positive and would strengthen the credit quality of mortgage loans on banks’ balance sheets and in covered bond cover pools.

Norway has experienced strong house price growth since 2008 and the proposal for tighter regulations seeks to dampen excessive house price growth and credit expansion. Despite house price contraction in oilreliant areas such as Stavanger, prices in Oslo remain on a strong upward trajectory and increased more than 12% per year to the end of June. During the same period, banks and mortgage companies’ residential mortgage lending grew nationally by around 6%, according to Statistics Norway. Although Norwegian banks and covered bonds performed strongly even after the decline in oil prices, a mortgage market cool down would reduce the risk of asset price bubbles and excessive lending to vulnerable households.

Capping the loan-to-income ratio limits the overall size of loan a borrower can take, regardless of affordability. In the present low interest rate environment, loan affordability is good, but large loans can easily become burdensome if interest rates rise. Lower LTV ratios decrease the loan’s probability of default and increase recoveries of loans that do default.

Increased amortization and limits on home-equity withdrawal reduce or constrain LTVs and limit potential payment shocks, benefiting mortgage loans’ credit quality. Currently, banks must factor amortisation into affordability testing, but a material proportion of loans are still interest-only. Interest-only loans can be vulnerable in a falling house price environment. Unlike an amortising loan, an interest-only loan’s LTV only declines over time as a result of house price appreciation, resulting in a potentially lower equity buffer against declining house prices and leaving the borrower exposed if selling the property is the only method of repaying the loan at maturity. Similarly, restricting home-equity withdrawals limits increases in LTVs and discourages borrowers from taking on high debt burdens.

Removing or reducing banks’ ability to have up to 10% of loans breach the maximum 85% LTV requirement or other requirements would be prudent. The FSA considers the 10% limit substantial in light of debt and house price developments. If the government does not completely remove the 10% waiver from the regulations, the FSA suggests reducing it to 4%.

An advantage of having the regulator set underwriting restrictions is that it prevents competition from eroding prudent practices, while also allowing the rules to be changed when conditions warrant such changes. However, nationally applicable restrictions do not differentiate between Norway’s regions, and regional economic developments vary. The FSA emphasized that the tighter regulation may be temporary and could be lifted if market conditions changed, which would give banks the opportunity to recover some flexibility in their lending practices. Nevertheless, Norway’s underwriting standards and prudential regulation of mortgage loans are among the strongest in Europe, particularly the country’s conservative approach to LTVs and its affordability stress of five percentage points on loan interest rates.

Does VIX Suggest a Lower Default Rate?

According to Moody’s, the US equity market can help divine the path to be taken by the high-yield default rate. However, changes in the market value of US common stock are not the equity market’s primary channel of
prediction. Rather, the VIX index, which estimates the implied volatility of the S&P 500 stock price index over the next 30-day span, offers the more reliable guide to where defaults may be headed.

The VIX index estimates the equity market’s expectation of stock price volatility. As the market becomes more worried over a possible deep sell-off of equities, the VIX index rises. By itself, such fear may reduce financial market liquidity, including the willingness to lend to high-yield credits.

The uncertainty that drives the VIX index higher often stems from signs of an extended stay by weaker corporate earnings. Significantly lower earnings, if not outright losses, will increase defaults among more marginal business credits. Downwardly revised earnings prospects, more frequent defaults, and heightened equity market volatility can only boost risk aversion and, thereby, diminish systemic liquidity.

These adverse developments will add to the difficulty of raising cash via asset sales and will lessen the willingness of healthy companies to purchase financially stressed businesses.

Since year-end 2003, the high-yield default rate has generated a very strong correlation of 0.91 with the moving yearlong average of the VIX index from three months earlier. As opposed to an average measured over a shorter span, the VIX index’s moving yearlong average helps to explain the default rate partly because the default rate is measured over a yearlong span.

As derived from a regression model, the VIX index’s latest moving yearlong average of 17.2 predicts a midpoint of 2.9% for the high-yield default rate of three months hence. Though few, if any, expect the default rate to sink from its recent 5.5% to 2.9% three months from now, the VIX index’s recent trend weighs against an extended climb by the default rate that might distend the already above-trend yield spreads of medium- and speculative-grade corporate bonds.

Nevertheless, the VIX index’s predictive power might now be criticized on the grounds that it has been skewed lower by expectations of a prolonged stay by a very accommodative monetary policy. The equity market may have concluded that the FOMC will not dare risk a deep slide by share prices that could slash confidence and diminish liquidity by enough to bring a quick end to the current business cycle upturn. A recent ultra-low VIX index of 12.1 points suggests that the equity market is supremely confident of monetary policy’s willingness and ability to quickly remedy a potentially disruptive slowdown by business activity.

Default Risk On The Up, Moody’s

Moody’s says that markets are now relatively sanguine about default risk, effectively concurring with the baseline forecast of Moody’s Default Study. However, compared to baseline default forecast, more can go wrong than right.

After rising from September 2014’s current cycle low of 1.6% to July 2016’s 5.5%, the baseline forecast sees the US high-yield default rate peaking in early 2017 at roughly 6.5%. Thereafter, the baseline prediction has the default rate receding to 4.9% by July 2017.

The baseline forecast is bordered by considerable downside risk. In addition to the baseline view, Moody’s Investors Service supplies optimistic and pessimistic projections for the default rate. The optimistic scenario projects a 5.3% average default rate for January-July 2017 that hardly differs from the 5.6% projected average of the baseline view. In stark contrast, January-July 2017’s 13.7% average expected default rate of the pessimistic scenario towers over the baseline forecast.

On balance, the default forecast suggests that the best days of the current credit cycle have passed. Even if the optimistic backdrop holds true, the default rate is likely to remain above-trend given the presence of an economic recovery. That is: The optimistic scenario predicts a range of default rates that exceeds both the average and median default rates of economic recoveries. Even if the optimistic view is correct, the default rate may still exceed its average, or trend, of an economic upturn.

Since the 1981-1982 recession, whenever the US lagging 12-month high-yield default rate either mostly or entirely overlapped an economic recovery, the default rate revealed a median of 3.4% and an average of 4.1%. By contrast, the default rate generated a median of 10.7% and an average of 9.6% whenever the yearlong observation period either mostly or entirely overlapped a recession.

Recessions joined three of the four prior climbs by the default rate to 6.5%. Following each of the three previous episodes showing a climb by the default rate up to 6.5%, the default rate continued its ascent. After first reaching 6.5% in February 2009, April 2000, and February 1990, the default rate eventually crested at 14.7% in November 2009, 11.1% in January 2002, and 12.4% in June 1991. Coincidentally, a recession overlapped each of the default rate’s last three peaks. In addition, the equity market suffered deep setbacks at some point during the 12 months prior to the peaking of the default rate.

Only once has an ascent by the default rate to 6.5% not been followed by a recession within 12 months. The lone exception occurred during the mid-1980s, or when the default rate first approached 6.5% in July 1986. Thereafter, the default rate formed a localized peak at the 7.0% of April 1987.

The 1986-1987 climb by the default rate was linked to a profound deceleration by the annual increase of corporate gross-value-added — a proxy for corporate net revenues — from 1984’s patently unsustainable 12.1% surge to the 3.8% of the year-ended March 1987. Partly because of a less pronounced slowing of employment costs to the 6.4% annual increase of the year-ended March 1987, operating profits went from soaring higher by 20.8% annually in 1984 to contracting by -9.1% annually for the 12-months-ended March 1987.

However, during the ensuing two years, corporate credit quality benefited from an 8.2% average annual advance by corporate gross-value-added that stoked an accompanying 14.9% average annual increase by operating profits.

Thus, the market’s current expectation of a limited rise and subsequent fall by the high-yield default rate implicitly assumes a major rejuvenation of net revenues. As derived from the US National Income Product Accounts (NIPA), corporate gross-value-added slowed from the 5.4% annual increase of the year-ended June 2015 to the 2.1% of the year-ended June 2016. Partly because the deceleration by net revenues was more pronounced than the comparably measured ebbing of employment cost growth from 5.4% to 4.7%, the annual percent change of operating profits switched direction from the 4.7% increase of the year-ended June 2015 to the -6.8% contraction of the year-ended June 2016.

New Application Form Will Lead to Stronger Conforming Loan Originations

According to Moody’s Last Tuesday, US government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac released a new joint loan application for residential mortgage loans that requires additional information fields from borrowers and provides standardized definitions for various data fields.

The new form takes effect on 1 January 2018. The additions to the form will increase the granularity and accuracy of the data that the GSEs collect, which will allow them to refine their automated underwriting models to better differentiate credit risk. This likely will lead to stronger loans originated using the GSEs’ automated underwriting systems and will be credit positive for future residential mortgage-backed securities (RMBS) backed by conforming loans.

The new application form provides the GSEs with more detailed information electronically and allows them to improve credit analysis by linking various borrower characteristics to loan performance. Additionally, standardized definitions of data fields will reduce the GSEs’ reliance on lenders to ensure that the data are correctly defined. The form also will help ensure accuracy in areas where borrowers were previously likely to make assumptions that were inconsistent with the GSEs’ definitions.

Examples of some significant new fields, and fields that now have standardized choices include the following:

Total gifts and grants: The new form requires borrowers to identify the source of gifts or grant funds and provides nine sources from which to choose, including a relative, unmarried partner, employer or federalagency. The previous form did not provide such categories and only asked prospective borrowers to identify the amount of gifts and grants.

Income type: The new form requires borrowers to itemize income under 20 specific sources, such as automobile allowance, foster care and royalty payments. The previous form only asked prospective borrowers to list types of income, without providing any categories.

Borrower assets: The new form provides 13 categories of assets from which to choose, such as checking, savings, bridge loan proceeds and mutual funds. The previous form had fewer categories.

Self-employment/business ownership: The new form asks borrowers if they are self-employed or business owners, defines upfront that the prospective borrower must own at least 25% of the business to qualify as a business owner, and asks whether the borrower is employed by a family member. The previous form lacked that kind of detail, merely asking prospective borrowers to check a box denoting whether or not they were self-employed.

Moody’s “more challenging operating environment for the banks”

ANZ today confirmed Moody’s decision to revise Australia’s macro profile has resulted in a change in the outlook for the major Australian banks, including ANZ, from stable to negative.

Moody’s reaffirmed ANZ’s Aa2 rating moving from Aa2 (Outlook Stable) to Aa2 (Outlook Negative) saying it expected a more challenging operating environment for the banks for the remainder of 2016 and beyond.

The ratings outlook change has not impacted Moody’s rating of ANZ’s baseline credit or counterparty risk assessment.

Moody said that bank profits are likely to be squeezed thanks to low interest and strong competition between lenders, as well as moderately rising credit costs. That said they comment on the strong profitability in the sector, and higher capital ratios.

“While Moody’s expects further capital improvements over time, the timing of such improvements will depend on the global and domestic regulatory agenda.”

Australia’s AAA rating affirmed by Moody’s

From The Conversation.

Moody’s has reaffirmed Australia’s AAA credit rating, as Malcolm Turnbull seeks to put pressure on Labor and crossbenchers to pass measures to help repair the budget.

Moody’s Investor Services said in a statement on Wednesday that reasons for maintaining the status quo were the expectation that Australia’s “demonstrated economic resilience will endure in an uncertain global environment”; its very strong institutional framework; and stronger “fiscal metrics” than many of its similarly rated peers.

The agency’s assessment notes that moderate nominal GDP growth will continue to dampen revenue and “the government faces political hurdles to the implementation of fiscal tightening measures, as it rules with a very thin majority in the House of Representatives and a splintered Senate. The effectiveness of fiscal policy may be undermined somewhat.”

Moody’s points to two factors that could push the rating down. One was if there was evidence that the economy’s resilience to negative shock was reducing, especially “if it led to severe challenges to the government’s or the banks’ financing from international investors”. The other was if there were “indications that the hurdles to fiscal consolidation are higher than we currently expect”.

In a speech to be delivered on Wednesday, Turnbull warns of the uncertain economic times and says if “we falter in our plan to transition the economy, there is a real risk of Australia falling off the back of the pack of leading economies”.

When parliament resumes the government will present an omnibus bill for multiple savings totalling about A$6.5 billion. It says these are savings Labor built into its pre-election figures.

Treasurer Scott Morrison said the Moody’s affirmation was a “welcome boost” as well as a timely reminder on the need for policies to keep the economy strong.

“Our AAA credit rating helps to keep borrowing costs low for businesses and consumers across the economy, as well as ensuring Australia is in a much stronger position in the event of any external shocks,” he said.

He said the agencies were sending a very consistent message about the government’s budget trajectory.

“The challenge is to see that budget supported by the parliament. We are having very constructive discussions with new crossbench senators,” Morrison told a news conference.

“As welcome as this result is today, and it is, we cannot take these things for granted.”

Morrison used the Moody’s point about the strength of the institutional framework to counter the Labor push for a royal commission into the bank.

“Our banking and financial system is one of the core pillars of our economy that underlie our prosperity into the future. You don’t go play politics with that. You don’t go messing around with the banking and financial system to make cheap political points,” he said.

Author: Michelle Grattan, Professorial Fellow, University of Canberra

European Union Banks To Have 3% Leverage Ratio

According to Moody’s, last Wednesday, the European Banking Authority (EBA) formally recommended the introduction of a minimum 3% leverage ratio for banks in the European Union (EU) by 1 January 2018.

The 3% leverage ratio would be credit positive for banks because it would become a complementary capital requirement to a bank’s risk-weighted capitalisation. As a non-risk sensitive measure, it would act as a backstop to risk-sensitive capital approaches and excessive internal model calibration of risk weights.

Before the introduction of the leverage ratio as a regulatory tool in the Basel III framework, banks used leverage as a means to increase profits by earning the premium between the expenses of the additionally raised funds and the yield of risky, often illiquid, investments. Banks that are highly leveraged are considerably more vulnerable than others to unexpected losses.

The EBA finds that among the 246 entities in its study’s sample, the aggregate capital shortfall for banks that do not yet comply with a 3% level would amount to €6.4 billion, based on a Basel III fully loaded Tier 1 definition over total exposure (including on- and off-balance sheet items). This amount is derived from shortfalls at 21 banks. However, as shown, the high sensitivity of shortfalls above this target ratio reflects the EU banking sector’s challenges in terms of deleveraging and adjusting business models (a 3.5% leverage ratio equates to a €25.4 billion capital shortfall; 4% = €84.9 billion; 4.5% = €166.7 billion; and 5% = €281.6 billion).

The EBA’s findings suggest that introducing the leverage ratio will have profound effects on business models, as reflected by the range of actual leverage ratios it found from 2.8% for public development banks up to 8.7% for automotive & consumer credit banks. In addition, its empirical findings from the benchmarking study show that small and medium-sized entities (The EBA defines small banks as entities with a total leverage ratio exposure below €10 billion and medium banks with an equivalent volume of €10 billion to €100 billion) are already in compliance with the suggested 3% leverage ratio. In this context, the EBA mentions that there is no need to deviate from this baseline requirement for smaller banks.

For our rated banks in the European Union, we find that the average leverage ratios (as measured by Tier 1 capital divided by total assets) for different countries is sufficiently above the minimum threshold of 3% as of 31 December 2015, as shown in Exhibit 2. However, the results vary considerably by country. Here is the EBA’s median and average leverage ratio from its benchmarking study.

The EBA’s recommendation is in line with the oversight body of the Basel Committee on Banking Supervision (BCBS) agreement in its January 2016 meeting, which also recommended a minimum level of 3% and in addition,
stricter requirements for global systemically important institutions.

Likewise, the BCBS will finalize its calibration this year and the EBA intends take up further work along the committee’s findings. Additionally, it will also consider higher leverage ratio requirements for domestic systemically important institutions.

New Zealand Banks Will Benefit from Tighter Rules on High-LTV Mortgage Loans – Moody’s

According to Moody’s, New Zealand banks will benefit from tighter rules on high-LTV mortgage loans.It is also worth noting how the market responded to earlier less aggressive macroprudential measures.

On 19 July, the Reserve Bank of New Zealand (RBNZ) released a consultation paper outlining a proposal to limit bank lending to home investors at loan-to-value ratios (LTVs) above 60% to 5% of new originations and lending to owner-occupiers at LTVs above 80% to 10% of new lending. These restrictions are credit positive for New Zealand banks and their covered bond programs because they reduce their exposures to higher-risk lending at a time when house prices are at historic highs.

The proposal will be particularly beneficial to New Zealand’s four major banks, ANZ Bank New Zealand Limited, ASB Bank Limited, Bank of New Zealand and Westpac New Zealand Limited. These four banks hold approximately 86% of all New Zealand residential loans.

The tighter restrictions on LTV limits will benefit banks and their cover pools by providing a buffer against declining house prices before the size of the loan exceeds the value of the property. In the longer run, banks will have fewer high LTV loans to sell into their cover pools, which will strengthen the pools’ credit quality.

The new rules would replace existing limits that restrict new lending to investors in Auckland at LTVs greater than 70% to 5%, lending to owner-occupiers in Auckland at LTVs above 80% to 10%, and all other housing lending outside of Auckland at LTVs above 80% to 15%. The proposal is in response to the boom in New Zealand house prices, which are at historical highs, creating a sensitivity to a sharp reversal in home prices.

Although LTV restrictions protect banks against a sharp correction in house prices, it remains to be seen how effective these measures will be in moderating house price appreciation if interest rates decline further. In March 2016, the Reserve Bank of New Zealand reduced its policy rate by 25 basis points to 2.25%, the fifth reduction since June 2015, while also stating that further policy easing may be required. Furthermore, strong immigration and supply shortages continue to support house prices, particularly in Auckland.

The first of New Zealand’s macro-prudential measures, introduced in October 2013, had a sharp but temporary effect on house price growth. Further measures were introduced in 2015 that also immediately reduced house price growth in fourth quarter of 2015. However, prices rebounded and have appreciated in 2016.

The Reserve Bank of New Zealand is inviting market feedback on its proposal until 10 August, after which, a final policy will be released to take effect from 1 September 2016.

Bank profits under pressure as loan impairments rise: Moody’s

From Australian Broker.

Skyrocketing bank profits and are set to slow as Australia’s big banks face rising loan impairments, Moody’s Investor Service has warned.

Moody’s senior vice president, Ilya Serov said banks have faced increasingly difficult operating conditions over recent months, resulting in a “sharp rise – from an exceptionally low base – in large, single-name loan impairments in the banks’ corporate portfolios”.

This pressure on the banks’ asset quality will come from “multiple headwinds”, according to the report released by Moody’s Investor Service, including potential further stress in resources-related sectors and regions and a worsening outlook for residential property developments.

Moody’s conclusions in the report are based on the first-half FY2016 financial results of the major banks – ANZ, NAB, Wesptac and CBA.

Moody’s noted that in the results, the major banks reported higher loan impairments during the first half of 2016, averaging 0.19% of gross loans, up from 0.16% in the second half of 2015. CBA has also reported that its loan impairment rose to 0.25% during its third quarter 2016 reporting period.

These results suggest that further deterioration, closer towards the long-run average of 0.35-0.40%, is likely.

Additional provisioning for rising loan impairments, alongside record low interest rates, will put bank profitability under increasing pressure over the rest of 2016.

On the other hand, Moody’s noted that capital levels are likely to “remain stable or improve moderately”, as the banks position themselves in anticipation of likely further regulatory reform.

Canadian Regulators Ups The Ante On Residential Mortgage Lending

According to Moody’s last Thursday, Canada’s Office of the Superintendent of Financial Institutions (OSFI) notified the country’s regulated mortgage lenders that it will intensify its supervisory oversight of their residential mortgage underwriting practices.

In the past 10 years home prices in Canada have lifted more than in Australia, although the debt to disposable income ratio at around 155% is still lower than Australia (175%) but higher than the UK (~130%). The Canadian market is also exposed to the impact of future interest rate rises.

Moody’s says that Canadian housing prices have risen faster than most other industrialized countries, resulting in house price levels increasing substantially over the past 10 years to be among the highest in major industrialized countries (see Exhibit 2), and raising the risk of a price correction. Over the past 25 years, house prices in Canada have steadily increased, primarily in urban centres such as Toronto, Ontario, and Vancouver, British Columbia.

The regulator vowed a heightened focus on income verification, mortgages with loan-to-value ratios of less than 65% (which OSFI indicated was a category in which underwriting practices are often less rigorous), stress assumptions related to debt-service ratios and the reliability of property appraisals. OSFI’s announcement is credit positive for Canadian banks because heightened regulatory scrutiny will force them to maintain or enhance existing residential mortgage underwriting controls and practices amid growing concerns about increasing household debt and elevated housing prices.

Residential mortgage debt, including home equity lines of credit (HELOCs), has doubled over the past decade. Canadian conventional mortgage debt, excluding home equity lines of credit (HELOCs), has grown at a compound annual rate of 7% over the past decade. Almost CAD1.6 trillion in mortgage debt, including HELOCs, was outstanding as of 31 March 2016, more than double the amount outstanding for the same period 10 years ago (see Exhibit 1).

Over the past 25 years, Canadian consumer debt-to-income levels, which include mortgage debt, almost doubled and are at a record high. As a result, housing indebtedness has tracked closely to house price increases as borrowers take larger loans, while at the same time, incomes have not kept pace. These higher debt levels make Canadian consumers vulnerable to an employment or interest rate shock that would exacerbate their debt-servicing burden (see Exhibit 3).

Of note, OSFI specifically indicated its interest in debt service ratios because current underwriting requirements may not adequately capture the stress effect of refinancing a mortgage into one with a higher mortgage interest rate. This is important because of the unique characteristic of a Canadian mortgage. A Canadian mortgage is structured as a balloon loan whereby the term (typically five years) is shorter than its amortization (typically 25 years). This means borrowers must periodically refinance their mortgages (see Exhibit 4), exposing them to changes in interest rates over the life of the mortgage. This refinancing risk is greatest for recent borrowers with high loan-to-value mortgages in a rising interest rate environment. OSFI noted that a rapidly rising interest rate environment would place considerable stress on existing debt service ratios, particularly on investment properties with rental income.