via e-mail
MORTGAGE BANKERS
ASSOCIATION
November 3, 2003
Regs.comments@occ.treas.gov Attn: Docket
No. 03-14
Regs.comments@federalreserve.gov Attn: Docket No. R-1154
Comments@fdic.gov Attn: Comments, Federal Deposit Insurance Corporation
Regs.comments@ots.treas.gov Attn: No. 2003-27
SUBJECT: Comments on the Risk-Based
Capital Guidelines
Implementation of the New Basel Capital Accord
Ladies and Gentlemen:
The Mortgage Bankers Association (MBA)
welcomes the opportunity to comment on the August 4, 2003 Advance Notice
of Proposed Rulemaking (ANPR) concerning the risk-based capital
guidelines for the proposed New Basel Capital Accord (Basel II).
MBA commends the Office of the
Comptroller of the Currency, the Board of Governors of the Federal
Reserve System, the Federal Deposit Insurance Corporation and the Office
of Thrift Supervision for their efforts to promote the safety and
soundness of real estate investments and mortgage-backed securities
under the Basel II framework. Sound financial institutions boost
investor confidence and encourage prudent capital flow. Because MBA
actively encourages both market liquidity and judicious underwriting
practices, our comments will focus on balancing the proposed capital
treatment of various categories of loans and mortgage-backed securities
with the need to meet real estate industry liquidity and underwriting
goals, recognizing that inappropriate weights could adversely affect
investment in communities and economic vitality, both in the United
States and elsewhere. Our comments also address specific questions posed
in the August 4, 2003 ANPR.
Background on MBA and the U.S. Real
Estate Finance Industry
MBA is the national association
representing the U.S. real estate finance industry. Headquartered in
Washington, D.C., the association works to ensure the continued strength
of the nation’s real estate markets; to expand homeownership prospects
through increased affordability; and to extend access to affordable
housing to all Americans. MBA’s membership of 2,700 companies includes
all elements of residential real estate finance: mortgage companies,
mortgage brokers, commercial banks, thrifts, the issuers of private
residential mortgage-backed securities (RMBS) and others in the home
mortgage lending field.
MBA is also the leading representative of
America’s $1.8 trillion commercial real estate finance industry. MBA’s
constituency includes the commercial banks and thrift institutions which
represent the single largest source of capital for U.S. commercial real
estate, as well as the issuers, servicers, bondholders and
administrators of commercial mortgage-backed securities (CMBS), which
provide secondary market liquidity to America’s commercial real estate
sector. MBA and its members are committed to the vibrancy of U.S.
commercial real estate finance industry and wish to see the final Basel
II guidelines support the health of this sector.
The savings of most Americans are
invested in deposit accounts at American banks, including commercial
banks and thrift institutions, who in turn invest those funds in
mortgages, mortgage-backed securities and other lending vehicles. In
addition, life insurance companies and pension funds are key investors
in the $332 billion CMBS market, which is backed by commercial real
estate loans. Therefore, the financial security of average Americans,
including small depositors, the policyholders of life insurance
companies, pensioners and other small investors, is broadly affected by
the security and liquidity of the real estate debt market. MBA is
committed to representing these consumers by promoting the safety and
vitality of real estate lending, on both the commercial and residential
fronts.
MBA members have raised the following
concerns about Basel II, including its proposed implementation in this
country, for the commercial/multifamily real estate sector and for the
single-family sector as discussed in detail below.
Implications of Basel II and the ANPR
to Commercial and Multifamily Lending
MBA supports the use of international
guidelines that can be flexibly interpreted by national banking
authorities. MBA believes that the risk rating system proposed under the
draft Basel II standard assigns excessive risk weights to certain loan
categories based on historic performance data. In this context, MBA
observes that the capital set-aside requirement for life insurance
companies with respect to commercial real estate loans in good standing
averages approximately 1.92% according to staff at the National
Association of Insurance Commissioners -- considerably below the 4%-6%
standard anticipated for the highest quality commercial real estate
loans under the proposed Basel II framework. Life insurance companies
and commercial banks compete for mortgage transactions. The heavier
capital reserve requirements for commercial real estate lending proposed
under Basel II may therefore erode the competitive position of
commercial banks relative to life insurance companies in the commercial
real estate finance realm.
Land acquisition, construction and
development loans for single-family housing are included in the high
volatility commercial real estate (HVCRE) category (in which “Good” to
“Satisfactory” loans carry risk weights of 125% to 175%), despite the
fact that the historical default rates on such loans are well-below
commercial real estate averages and are more similar to those associated
with mortgages for owner-occupied one- to four-family housing (to which
the draft Basel standards assign a 35% risk weight). Similar evidence is
presented in a June 2003 white paper authored by the U.S. Board of
Governors of the Federal Reserve System, which notes that asset default
correlations for single-family land acquisition and construction loans
are substantially below those for other types of commercial properties.
MBA therefore recommends that one- to four-family land acquisition,
construction and development loans be moved to the income-producing real
estate (IPRE) category, which uses slightly lower risk weights (100% to
150% for “Good” to “Satisfactory” loans).
On balance, MBA believes that the
proposed risk weights for core commercial property types—that is,
multifamily, office, industrial and retail—are too high, especially for
IPRE loans. MBA’s members note that a disproportionate number of
commercial real estate loan defaults come from the hotel and health care
sectors, and that loss severity for hotel and health care credits is
also higher than for multifamily, office, industrial and retail loans.
Accordingly, MBA recommends that the Bank for International Settlements
(at the international level) and/or U.S. banking authorities (with
respect to American requirements) refine the Basel II risk weights to
reduce requirements for multifamily, office, industrial and retail
loans.
As proposed under the draft Basel
framework, MBA concurs that national banking authorities should be
permitted to reclassify land acquisition, construction and development
loans that are significantly pre-sold or pre-leased to tenants with
satisfactory credit profiles. MBA’s members have suggested that a
significant pre-leasing standard be linked, for newly-originated loans
in good standing, to that level of pre-leasing needed to achieve a 1.0x
debt service coverage ratio (DSCR). [The DCSR is the ratio of net
operating income to annual debt service.] Similarly, loans could be
moved from the HVCRE class to the IPRE class upon the attainment of a
leasing level sufficient to produce a 1.0x DSCR. Typically, properties
achieve a 1.0x DSCR when they are approximately 70% to 75% leased,
although the leasing percentage can vary according to property type,
rents and expenses, as well as the credit’s loan-to-value ratio.
An alternative, slightly more
conservative approach that is particularly relevant in situations when
the construction lender is not offering permanent financing or mini-perm
financing, might be to link the pre-leasing standard needed to achieve
the DSCR required by the property’s permanent lender. The required DSCR
is typically specified in the take-out agreement (which typically
precedes the construction loan), and is set by market conditions. When
market conditions are less robust, the takeout DSCR for multi-family
properties is typically in the 1.20x for multifamily credits and 1.25%
for office, retail and industrial credits. When market conditions are
stronger and competition among permanent lenders is keen, the required
DSCR may decline to the 1.05x to 1.15x range.
MBA suggests that DSCR tests be applied
using the higher of a loan’s (a) fixed or maximum hedged interest rate,
or (b)such other debt service constant used by the lender in its
underwriting.
MBA believes that commercial real estate
ADC loans that are pre-sold should be moved to the IPRE class. As noted
previously, we recommend that single-family ADC loans be categorized as
IPRE. MBA does not recommend any further adjustment of single-family ADC
risk weights based on the sales progress of the project. Most
single-family ADC loans are made on a recourse basis that is not linked
to the sales progress of the project. Lenders for non-recourse
single-family ADC credits often require earnest money deposits or, less
frequently, contractual commitments from homebuyers, before construction
funds are advanced to the builder. These credit practices do not lend
themselves to further risk weight adjustment based on the sales progress
of a particular project.
It is uncertain whether the Basel II
framework sufficiently considers the customary practice of employing
credit enhancements to bolster the credit quality of commercial real
estate loans when assigning risk weights. MBA suggests that banking
regulators be required to consider credit enhancement vehicles that have
proven to be effective in decreasing risk when assigning risk weights.
Specifically, residential and nursing home loans backed by FHA
guarantees (which guarantee the lender against 99% of loss) should be
associated with reduced capital set-asides. MBA concurs with the
suggestion in the current ANPR that private mortgage insurance be
considered fully as a factor associated with lower loss reserve
requirements. With respect to commercial properties, reduced capital
set-asides should accompany loans backed by borrower guarantees or
tenant rental guarantees sufficient to ensure loan repayment or, in the
case of tenant guarantees, a 1.0x or better DSCR. Borrower guarantees or
tenant rental guarantees can include pledged assets, lines of credit or
letters of credit.
Finally, the Basel II standards should
require capital set-asides only for at-risk capital, rather than for the
full loan amount. This principal should extend to all credits for which
the lender is responsible for only a portion of principal risk. For
example, the Fannie Mae Delegated Underwriting and Servicing (DUS)
program requires the lender to absorb only a small portion of any loss
on multifamily loans originated, and Basel II capital reserves should be
required only against the DUS lender’s actual exposure.
Implications of Basel II and ANPR to
Single-Family Residential Mortgage Lending:
Generally, MBA believes the 35% risk
weight assigned to qualifying residential mortgage loans under the
Standardized Approach in Basel II acknowledges that the 50% risk weight
assigned to such loans under Basel I is excessive. MBA believes that
this is particularly true in the U.S. where credit losses from
qualifying residential mortgage loans are often covered entirely by
mortgage insurance. We therefore strongly recommend that the banking
regulators follow the lead of the Basel II architects by amending the
existing capital regulations to ensure that “general banks” in the US
(i.e. those banks that would continue to be subject to Basel I and
existing regulations) will be able to assign a risk weight of 35% or
lower to their qualifying residential mortgage loans. We believe this
change will help to ensure that “general banks” in this country are not
placed at a disadvantage with respect to their residential lending
activities vis a vis A-IRB banks and foreign banks that adopt the
Standardized Approach.
More generally, we support the Agencies’
approach in furthering the Basel II effort to more closely align
economic and regulatory capital. We perceive our member institutions to
be driven to a greater extent by economic capital considerations as
opposed to regulatory capital. Having said this, a significant disparity
between the two creates intraorganizational stress and potential for
“capital arbitrage” that is wasteful and counterproductive. The efforts
by the agencies to reduce this disparity will help institutions of all
sizes. With regard to competitive considerations between large and small
institutions, we believe preserving the option for smaller banks to
opt-in to the A-IRB approach is critical. If any competitive disparities
between large and small institutions were inadvertently created through
the new capital regime, we would expect the marketplace to address these
disparities by selling the appropriate expertise and potentially the
operational implementation to smaller institutions, allowing them to
correct any such disparity. We see no reason why this “entry cost” into
the A-IRB approach should be prohibitive.
MBA also believes that the proposed 10%
Loss Given Default (LGD) floor and 15% Asset Value Correlation (AVC)
factor for residential loans are not empirically-based and are therefore
excessive, resulting in regulatory capital charges significantly in
excess of A-IRB bank’s economic capital requirements. As a result, the
proposed implementation of Basel II will on a relative basis discourage
residential lending among A-IRB institutions.
The MBA further believes that, as noted
in a recent study conducted by the Risk Management Association (RMA),
the AVC values remain too high relative to industry practice for
mortgage assets. Implementation of this AVC would also unfairly
discourage the holding of mortgage assets relative to other assets. We
believe a lower mortgage AVC consistent with the RMA study is
appropriate.
Our responses to several specific
questions posed by the Agencies in the ANPR for comment are provided
below:
With regard to the recognition of PMI for
LGD, a data-driven approach to LGD estimation should capture the impact
of PMI and, for that matter, government mortgage insurance or
guarantees. Imposition of an arbitrary 10% floor on mortgage LGD is
unnecessary and contrary to empirical risk determination. This would
unduly and inappropriately discourage institutions from holding
mortgages; consequently, we do not believe a floor should be imposed,
irrespective of PMI considerations. Having said this, any exclusion from
such a floor would be a positive development and PMI protection would
seem to provide the most appropriate exclusion. Again, we believe that a
data-driven approach is the most sound, robust and stable means for
appropriate capital regulation.
We do not see or believe there are any
significant competitive implications to PMI recognition. This assessment
flows from the broad application of PMI by all firms originating
mortgages, the universal PMI requirements imposed by market-making
institutions, and the competitive nature of PMI pricing in the
marketplace.
With regard to risks associated with
residential mortgage exposures generally, we believe the credit risks
associated with holding prime first mortgages are well understood. The
data history on this product is long-standing and robust, making
Probability of Default (PD) and LGD predictable within a very small
margin of error by utilizing ever more advanced statistical techniques
and technology.
Although the data is somewhat less broad
and deep for home equity loans and lines, this small disadvantage is
offset in the nature of home equity lending, which is based more on
ability to repay (cash-flow lending) than on collateral (equity
lending). The robust nature of credit history analysis as applied in the
credit card industry greatly assists firms in estimating home equity PD,
which is of greater significance than LGD in this type of lending.
Non-prime mortgages constitute a much
smaller market than either of the above. Credit risk is significantly
more operative, given the lack of consistent historical credit standards
and the resultant relative lack of data for building predictive models.
These aspects are reflected in both the securitization structures common
to this asset and the more direct risk management role of non-prime
mortgage underwriters. Securitization agreements and trustees require
close monitoring of delinquencies and defaults, along with the related
cash or collateral funding of the sub-structures required to protect
bondholders. Credit risk management is further aided by the relatively
short life of non-prime mortgages, driven by the strong pricing
incentives for the mortgagor to reduce cost by improving his credit
grade at the first opportunity.
With regard to any housing price bubble
or mortgage credit shortage, we see no real evidence of either
phenomenon. Given the predictability of mortgage defaults as discussed
above, capital requirements for prime mortgage and home equity lending
of less than one percent appear appropriate. This predictability
emphasizes EL and thereby minimizes UL, indicating appropriately low
credit risk capital levels for these assets. We believe such a level
would be accurate and would not, therefore, have any significant
negative competitive implications. On a relative basis at least, the
regulatory oversight of the GSEs and the dramatic expansion of their
mortgage holdings in recent years would seem significantly more
problematic with regard to any extension of the federal safety net than
this alignment of economic and regulatory capital. Given the significant
expansion of mortgage risks taken on by the GSEs, we have seen and would
expect no evidence of a mortgage credit shortage.
We believe mortgage assets and MBS are
arguably the safest possible assets for regulated institutions to hold
from a credit risk standpoint, relative to minimizing the federal
government's exposure. Mortgage loans as a whole have a very long and
robust data history, providing the raw material for creation of accurate
default predictive models with an outstanding record of accuracy over a
long period of time. This has resulted in very low delinquency and
default rates for mortgages as against other assets. It also drives the
vast majority of losses, such as they are, into EL as opposed to
Unexpected Loss (UL). Given that capital is designed to compensate for
UL, which we strongly support, this further appropriately assesses
credit risk and reduces government exposure. Residential MBS are even
safer in that they have, unlike any other asset, as many as six sources
of repayment: the mortgagor, government guarantee or PMI, the house
itself, the seller/servicer, the GSE and any pool insurance. To best
protect the government's interest, regulatory capital requirements
should encourage to the extent possible regulated institutions towards
holding the safest and most credit-manageable assets: in our view,
mortgages and MBS.
Real Estate Securitization Issues
Suggested by Basel II
MBA’s members are pleased that the
proposed Basel II framework allows lenders a variety of approaches,
including reliance on external or internal ratings, to calculate capital
set-asides for commercial and residential mortgage-backed securities.
MBA’s members eligible for the use of the proposed A-IRB standards value
the opportunity to use flexible methods to determine appropriate capital
set-asides and agree that institutions should be able to rely either on
external ratings-- the foundation on which mortgage-backed securities
are evaluated, priced and traded—loan mapping, or internally-generated
inferred ratings.
In addition, MBA suggests the following
revisions in the risk-based capital guidelines for mortgage-backed
securities under Basel II:
Substantial reduction of the recommended
capital set-aside for mortgage-backed securities (MBS). The 56 basis
point minimum capital set-aside for CMBS and RMBS is excessive for AAA
and AA rated issues or tranches, which typically are associated with
default rates of considerably below 1%. With respect to CMBS, the
proposed Basel framework overstates the risk associated with CMBS,
relative to collateralized debt obligations (CDOs). MBA recommends that
the federal agencies rely on CMBS loss experience data that pertain
specifically to CMBS.
A-IRB originators of CMBS should not be
required to deduct from capital securitization exposures at or below
KIRB in circumstances where such exposures are rated. We believe the
disparate treatment of exposures held by originators of CMBS -- versus
investors in CMBS -- is unjustified in circumstances where the exposures
held by both banks are rated. We urge the banking authorities to conform
the treatment of originating and investing banks in these circumstances.
With respect to unrated positions above
K-IRB, the proposed deduction method is too harsh and penalizes
institutions for holding CMBS. It is our understanding that the Basel
Committee plans to revise the proposed Supervisory Formula Approach for
unrated securities. MBA believes that both A-IRB originators and
investors should be permitted to develop internal ratings approaches or
to apply external ratings, when appropriate, to determine capital
set-aside standards.
With respect to the proposed
Ratings-based Approach, MBA notes that external ratings typically
consider the granularity and tranche thickness of the underlying issues.
Thus, external ratings take into account the risks associated with
holding thin or less-granular tranches. The imposition of additional
risk criteria based on tranche thickness and granularity might therefore
overstate the risk of holding the affected securities. Because
originators more frequently hold below-investment grade pools, MBA has a
concern that such treatment might adversely affect the originators of
CMBS and market liquidity.
MBA observes that the Ratings Based
Approach need not make any adjustment for loan maturity, as all CMBS
issues are routinely re-evaluated and re-rated over the life of the
securities. Thus, external ratings remain fresh.
Treatment of CMBS originators and
investors for non-A-IRB institutions: MBA feels that originators and
investors should be treated identically, to ensure that neither group is
penalized under the Basel framework. MBA believes that both originators
and investors should be able to use a variety of approaches to determine
capital set-aside standards, and believes that financial institutions
should be permitted to choose either the Ratings Based Approach or the
Alternative Ratings Based Approach, based on the judgment of the
financial institution.
MBA concurs with the proposed risk
weighting of 0 for recoverable servicing advances, funds for which are
disbursed extremely conservatively and pose virtually no repayment risk.
Recoverable servicing advances for CMBS securitizations have first claim
on all cash flows from the underlying loan pool.
Study to Evaluate Whether Improved
Practices Have Materially Reduced Default Rates and Correlations
There is considerable evidence to suggest
that the use of enhanced underwriting standards, practices and
technologies and the growing influence of the secondary markets,
including the standards set by rating agencies and growing information
transparency, have materially reduced since the mid-1990s commercial
real estate loan default rates and the default correlations for
commercial real estate loans.
• The July 2003 Standard and Poor’s
study documents declines in U.S. commercial real estate loan default
rates that parallel a period of improvement in U.S. underwriting
practices and technologies, including the adoption of more stringent
appraisal standards, the growing use of underwriting standards
established by the secondary market rating agencies, and the
introduction of lease-based valuation software.
• The U.S. Board of Governors of the
Federal Reserve, in a June 2003 White Paper, also has reported
time-series data showing declines in asset default correlations for
commercial real estate loans since the mid-1990s, both in absolute
terms and relative to commercial and industrial credits. Industry
participants suggest that these declines mirror improvements in
underwriting practices and technology that have accompanied the growth
of secondary market securitization, the adoption of more stringent
appraisal and valuation standards, and the introduction of lease-based
valuation software. These developments appear to have improved market
transparency and the sophistication of underwriting models, with the
effect of reducing commercial real estate credit risk.
• Delinquency and default data compiled
by Fitch Ratings and JP Morgan Securities also suggest that commercial
real estate delinquencies and defaults are at materially lower levels
than in previous real estate cycles.
MBA believes that a federal study is
warranted to determine whether these trends have been associated with
declines in asset default correlations and delinquency and default
rates. If this is the case, further reductions in proposed Basel II
capital set-asides for commercial real estate credits would be
warranted. MBA supports a multiple regression or other appropriate study
to shed light on this important issue and would recommend that such a
study be completed in time to influence the U.S. implementation of Basel
II by federal banking regulators.
Incentives for Non-A-IRB Lenders who
Adopt Exemplary Underwriting Standards, Practices and Technologies
The proposed A-IRB standards recognize
and reward the underwriting and credit management sophistication of the
largest financial institutions. MBA believes that the final Accord and
its regulatory implementation in the U.S. should also offer concrete
incentives for non-A-IRB real estate lenders to adopt high-quality
underwriting practices and technologies. To this end, MBA recommends
that the final Accord establish preferential risk weights—or permit
national banking authorities to do so—for all real estate credits in
good standing which utilize exemplary underwriting standards, practices
and technologies. Precedent for this approach is found in the American
mortgage-backed securities industry, in which the practices, procedures
and technologies used by loan servicing firms are evaluated when ratings
are assigned.
MBA believes that the introduction of
preferential capital standards for the use of exemplary underwriting
standards, practices and technologies would encourage non-A-IRB banking
entities across the globe to carefully underwrite, value and monitor
their commercial real estate credits through the use of state-of-the-art
underwriting standards, practices and techniques.
MBA and its member financial institutions
look forward to continuing to work with the Basel Committee, BIS, U.S.
banking regulators, and other interested parties on the development and
implementation of the Basel II standards for real estate lending. To
ensure the safety and soundness of our financial institutions, MBA
recommends that Basel II reflect the underlying risk of loans secured by
single-family and commercial real estate through refined risk weights.
Risk weights should also be refined for mortgage-backed securities,
particularly for highly-rated issues and tranches. Regulators also
should reward non-A-IRB lending institutions that utilize exemplary
underwriting standards, practices and technologies.
Please do not hesitate to contact MBA if
we may be of further assistance. Should you have any additional
questions, please contact Leanne Tobias, Director, Commercial Real
Estate Finance (tel: 202/557-2840; e-mail: LTobias@mortgagebankers.org)
on commercial and multifamily matters and Alison Utermohlen, Senior
Director, Government Affairs (tel: 202/557-2864; AUtermohlen@mortgagebankers.org)
on one- to four-family residential matters.
Most sincerely,
Jonathan L. Kempner
President & Chief Executive Officer
cc:
Honorable Robert F. Bennett
Chairman
Joint Economic Committee
U.S. Congress
G-01 Dirksen Senate Office Building
Washington, D.C. 20510
Honorable Richard C. Shelby
Chairman
Committee on Banking, Housing and Urban Affairs
U.S. Senate
SD-534 Dirksen Senate Office Building
Washington, D.C. 20510-6075
Honorable Michael G. Oxley
Chairman
Committee on Financial Services
U.S. House of Representatives
Rayburn House Office Building, Room 2157
Washington, D.C. 20515
Honorable Roger W. Ferguson, Jr.
Vice Chairman
Board of Governors of the Federal Reserve System
Mail Stop 179, 21st and C Streets, NW
Washington, D.C. 20551
Honorable James E.Gilleran
Director
Office of Thrift Supervision
U.S. Treasury Department
1700 G Street, NW
Washington, D.C. 20429-9990
Honorable John D. Hawke, Jr.
Comptroller of the Currency
Office of the Comptroller of the Currency
250 E Street S.W.
Washington, D.C. 20219-0001
Honorable Donald Powell
Chairman
Federal Deposit Insurance Corporation
550 17th Street, N.W.
Washington, D.C. 20429-9990
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