Importance of underwriting standards to healthy real estate finance markets
Underwriting standards refer to guidelines established for ensuring that secure and safe loans are maintained and issued. The standards are crucial in setting the benchmarks on how much the debts can be issued, the loans’ terms, how much a company is ready and willing or can afford to issue as well as what rate of interest is to be charged.
The standards complement the Banks’ Acts, Loan and Trust Acts, Cooperate Credit Association Acts, Insurance Companies Acts’ relevant provisions and the governments’ mortgage insurance frameworks that are guaranteed and which establishes rules for the insured mortgages that are government-backed (Government of Canada, 2014).
Typically, underwriting comprises several terms, criteria, and conditions. The first underwriting component is the interest spread over the relevant rate benchmark. The spread is raised by the lenders to control the returns expected given their risks while taking advantage of market power which they may have. The basis of the underwritings’ second component is the balance of the mortgage (M) relative to financed property’s value (V). With that, high V/M means more collateral for every dollar of the mortgage balances and willingness by the lender to supply more. Also, the higher the V/M is on new mortgages, the lower their lending risks. Other key components include cross-property and personal guarantees, ratios of debt coverage that seek to manage risks in the market.
Changes to mortgage standards before real estate boom
Before the boom, the underwriting was a response to past recent prices. That implied that the markets were amplified by underwriting: There was faster property price growth, which led to raising of the mortgage prices and lending, in turn, loosening underwriting further.
An article published by Jacob and Manzi (2005) claimed the standards of underwriting had eased in the 2000s. The article indicated that for typical deals, debt-service-coverage ratios were unchanged from the year 1998 to the year 2004; some other underwriting components had loosened apparently. The authors also indicated that the two common default risks and underwriting standards’ indicators; DSCRs and LTVs, were prone to being flawed. However, not all the observers have concluded the standards of underwriting for the commercial mortgages became loosened in 2000s. Among most prominent naysayers are the Stanton & Wallace (2011). The two made an empirical case that was convincing that the criteria of underwriting and particularly subordination levels, required by rating agencies for the tranches of CMBS to be AAA rated considerably declined before the crises.
Further, there was a hypothesis by Jacob & Manzi (2005) that the eased standards were as a result of investors being a compliment about the risk, and as a result of a significant defaults’ drop. Also, they contend that eased standards resulting from reduced defaults and environmental allowed leaders that were a conduit to either weaken some conditions and terms of the mortgage or reduce the spread of interest rate. With that, some studies have been focusing on the explanation of why the rate of the cap; a component that is important in underwriting, changed with time, generally tightening during the 1990s; later easing in 2000s.
Changes to mortgage standards after the real estate collapse
Apparently the crisis changed how the underwriting of the commercial mortgages was being done. While the past prices do not affect it directly, underwriting became highly affected by future developments’ prediction of the real estate prices. Further Arsenault et al. (2012) provided econometric evidence supporting commercial real estate prices’ positive feedback to supply commercial mortgages. Based on the data from the period between 1991 and 2011, it was shown that lower volatility and faster growth of the prices of the real estate increased the commercial mortgage supply. It was also identified that supply of mortgages further raised the prices of commercial real estate. Thus, the market for commercial real estate apparently had feedbacks on financing that was same to the one that supposedly contributed to the downward spirals of other sectors during the crises.
Example of current underwriting standards
The sound underwriting practices for residential mortgage FSB Principles are published by Financial Stability Board which call all the jurisdictions to make sure that the mortgage originating entity owns the risks that result from it, including any involved entity in mortgage underwriting outsourcing.
In that view, there are five principles that are fundamental to underwriting of residential mortgages. The first one relates to the governance of FRFI and the business objective overarching development, oversight, and strategy mechanism in the underwriting of the residential mortgage for residential properties’ acquisition.
The other three principles mainly focus on credit decision as well as the process of underwriting in residential mortgage. They specifically relate to assessment of the following:
The identity of the borrower, their background as well as willingness to service the obligation (The 2nd Principle).
The capacity of the borrower to service the obligation (The 3rd Principle).
Value/collateral of the property in consideration and the process of management (4th Principle).
The three principals have to be assesed by the leader using the holistic approach that is risk-based unless it’s specified otherwise in the guidance. Further, the demonstrated willingness of the borrower and the capacity to pay the debt on time should be the basis for the credit decision by the lender. That is because undue collateral reliance can pose great challenges; given the process of obtaining the title to the security of the property in consideration can be costly to lenders and difficult for borrowers.
Finally, addressed by the 5th principle is for the need to underwrite the mortgage and the purchase to be under the support of effective counterparty and risk management, including, mortgage insurance where appropriate (The Government of Canada, 2014).
References
Arsenault, M., Clayton, J., & Peng, L. (2011). Mortgage Fund Flows, Capital Appreciation, and Real Estate Cycles. Journal of Real Estate Finance and Economics. 1-44.
Jacob, D. P., & Manzi, J.M. (2005). CMBS Credit Protection and Underwriting Standards: Have they declined too far? The Journal of Portfolio Management, 80-90.
Stanton, R., & Wallace, N. (2011). CMBS Subordination, Ratings Inflation, and Regulatory-Capital Arbitrage. Mimeograph. Berkeley: University of California.
The government of Canada. (2014). Residential Mortgage Underwriting Practices and Procedures. Office of Superintendent of financial institutions. Retrieved 29 May 2016 from, http://www.osfi-bsif.gc.ca/eng/fi-if/rg-ro/gdn-ort/gl-ld/pages/b20.aspx
