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Irish mortgages analysed in new rating agency model Back  
Fitch IBCA, the international rating agency, released a new model in August for calculating credit enhancements for Irish residential mortgage-backed securities. It offers insights into the special characteristics of the Irish market and rating agency’s approach to default and loss severity adjustments for Ireland. The following is an edited extract from the report introducing the model.
Fitch IBCA’s new model, calculates credit enhancement requirements for Irish residential mortgage securitisations for investment-grade and supporting classes via default probability and loss severity calculations.

To determine rating guidelines that reflect the unique characteristics of mortgage loans and lending practices in Ireland, Fitch IBCA conducted a study of the residential mortgage industry and analysed historical home price data.

In addition to generalised default and loss matrices, individual loan characteristics, such as borrower profile, loan type, and property type, among others, are factored into the model.
Fitch IBCA’s market value assumptions are based on traditional determinants, such as regional economic stability, and historical home price volatility by region. Foreclosure costs, which include carrying costs for the duration of the foreclosure period and legal expenses associated with the default process, are based on actual cost data supplied Fitch IBCA by Irish mortgage lenders.
Generally, residential mortgage ratings are based on the credit quality of the collateral, the financial structure of the security, and the legal separateness of the issuer.

Model Development

To determine an adequate level of credit enhancement for Irish Residential Mortgage Backed Securities, Fitch IBCA’s model calculates default probability and loss severity of the collateral. As such, the model employs a loan-by-loan review, examining loan, borrower, and property-specific factors that influence default probability and loss severity.

Income multiples of loans are put into five classes, ranging in steps from Class 1 reflecting an income multiple of less than two times, to Class 5 for income multiples of three times and over.
The severity of a given loss is determined by an analysis of market value trends to determine house price volatilities. Once market trends have been determined, individual loan losses are calculated by adjusting the figures by loan characteristics, such as loan size and ownership status.

Fitch IBCA’s base default probability is determined largely by the affordability factor as well as the loans to value ratio of each loan. Since these factors do not operate independently, Fitch IBCA accounts for their interaction in the model. A matrix is then constructed showing (see table 1)) shows the percentage of default probability given a loan’s LTV and its affordability factor, which is the income multiple.

The main factors used in assessing default are the amount of equity invested in the home (original LTV) and the financial resilience of the borrower. Fitch IBCA used a study by Threshold on the causes of default which found that “wilful” default was the most common, others being “failure to cope” with decreased income and “marital problems”, which are largely under-reported. Unemployment was not found to be a primary cause of default due to the social welfare compensation system.

These factors are used to determine a base default rate, which is then adjusted on a loan-by-loan basis to account for individual loan characteristics. Traditional methods for assessing the likelihood of default are based primarily on LTV but tend to minimise the complex relationship of circumstances that force an Irish borrower to default. In Ireland, as in most markets, LTVs alone fail to fully explain a borrower’s ability and willingness to pay.

Default Probability Adjustments for Ireland

The Fitch IBCA default matrix is applied to a pool of mortgages and then on a loan-by-loan basis, adjusted for property type, borrower profile, affordability, product type, repayment type, loan purpose, mortgages in arrears, seasoning, and underwriting quality.

Property Type: In Fitch IBCA’s model, mortgages associated with second homes and investment properties are assumed to be more susceptible to default than owner-occupied properties. The model increase the default rate 10%-35% in such cases.

Borrower Profile: Fitch IBCA assumes that self-employed borrowers, depending on the nature of their business, are more likely to default than borrowers who are paid a salary. Making a monthly mortgage payment from a regular monthly salary is presumed to be easier than for a self-employed borrower who may receive remuneration on a more intermittent basis. For this reason, Fitch IBCA generally increases the default probability on loans to self-employed borrowers 33%-50%.

Product Type:

Although mortgage lenders offer a fixed-rate product, the interest rate is only fixed for a certain period (one, five, or as much as ten years) and then it resets to current interest rates or converts to a variable rate. The model does not give any benefit to fixed-rate loans since they are only fixed for a relatively short period.

Repayment Type: Most Irish mortgages are repaid in monthly principal and interest payments (amortising loans). However, some loans have the principal repayment tied to a pension plan or investment account, leaving the borrower to pay only the interest. Fitch IBCA’s Irish default model penalises such loans according to their “balloon risk,” or how far in the future the principal repayment takes place.

Loan Purpose: Fitch IBCA believes that mortgage loans advanced to release some of the equity in a property carry more risk than those used for the purchase or refinancing of a property. Accordingly, the model generally increases the default probability for such loans 10%-25%.
Mortgages in Arrears: When rating a portfolio of current and arrears mortgage loans, Fitch IBCA increases the default probability for mortgages in arrears 25%-100%. For arrears exceeding 90 days, Fitch IBCA uses a separate non-performing loan analysis to determine the probability of default. The model assumes that any borrower that has not made a payment on his loan in more than three months has 100% probability of default.

Seasoning: Since there is no historical information suggesting that default rates peak at any given time in the life of an Irish mortgage, Fitch IBCA does not incorporate seasoning into its Irish default model.

Underwriting Quality

There is a direct correlation between the origination and servicing functions and the performance of a mortgage pool. Therefore, as a part of the rating process for each transaction, Fitch IBCA reviews the operations of the originator and servicer to determine whether the company’s procedures, controls, and performance are acceptable. Fitch IBCA may then increase or reduce credit enhancement based on such due diligence

Loss Severity
Fitch IBCA’s Irish default model quantifies loss severity by evaluating several factors, including market value trends, mortgage insurance, costs associated with the foreclosure process, and LTV.

Market Value Decline: To capture true home price movements by region, Fitch IBCA focuses on historical regional home price volatility, steady-state sustainable growth projections, and current home price levels. This approach provides the model with better market value movements than more traditional methods.

Typically, mortgage default models determine market value decline (MVD) figures by observing a period of recession or other adverse economic conditions that caused home prices to decline. The amount of actual price decline, or a factor of it, would be applied to each loan against the property’s appraised value to arrive at a worst-case future value. However, examining home price data showed that Irish home prices have experienced only an upward trend and, thus, there is no downward home price trend to establish a benchmark MVD.

Instead, Fitch IBCA quantified the increase in prices during the recent Irish housing boom and applied a stress on this growth to account for a potential bubble. First, a long-term market trend in regional home prices from 1979-1998 was observed. The trend represented stable, moderate growth in prices from 1979-1994. However, the period from 1995-1998 saw a rapid increase in the level of home price growth. Fitch IBCA assumed a future market value decline to be a substantial portion of that observed increase.

Once market value declines are determined, they are adjusted on a loan-by-loan basis to account for loan size, property type, insurance coverage, and foreclosure costs, as detailed below.

High-Value Properties: Higher than average priced properties will experience greater price volatility in adverse economic conditions due to a limited demand for that sector of the housing market. It is also more difficult to determine the exact market value of a home without many comparable properties. To compensate for this additional risk, Fitch IBCA associates a higher market value decline to properties in the top 5% of the market in terms of price. Market value adjustments for these “jumbo” loans will be 10%-30% higher than those associated with loans secured by low- to median-priced properties (see Table). This adjustment is applied to properties by region, since a high-value property in Limerick may be considered an average value for a Dublin property.

Insurance: Many originators require some form of mortgage insurance for loans with an LTV higher than 75%-80%. Fitch IBCA gives credit for mortgage insurers according to the rating of the mortgage insurance guarantee provider and the terms of the relevant policy. For instance, an ‘AA’ insurer would be given 75% coverage credit and an ‘AAA’ would receive coverage of 100%.

Foreclosure and Carrying Costs

When calculating the recovery value of a loan, Fitch IBCA deducts the costs involved in foreclosing on a property. One of these expenses is the “carry” cost, which is the foregone interest income during the foreclosure process. The magnitude of this figure depends entirely on the length of time it takes to realise a recovery amount on the property. Fitch IBCA’s Irish default model assumes a period of 36 months for this. This time frame is a conservative estimate based on industry experience. Added on to the cost of carry is the cost of repossessing a property, which is expressed as a percentage of loan value.

Using all these data, the model then calculates a percentage credit enhancement needed, for each type of loan, based on the interaction of default risk and loss severity.

Third party references to FITCH IBCA above are original in its report.

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