New Mortgage Products to gain an edge

A Presentation by

Sanjay Shukla

Business Head

Tata Capital Housing Finance Limited

Views expressed in this paper are that of the author and do not represent the views of Tata Capital

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Presentation Flow

Mortgage Finance Market Overview 1

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Product Variants 3

Managing Risks 4

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Developing Innovative Mortgage Products

Conclusion

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India - Business Environment High volatility in interest rates

Supply side regulations (Regulations like CRZ Act and ULCRA restricting supply of land)

High Stamp Duties on property transactions across different states

Emerging middle class in Tier II and Tier III cities, while increasing business potential,

are impeded by poor infrastructure (connectivity, availability of quality vendors etc.)Property prices in Tier I cities amongst the highest in the world

Lack of credit risk mitigating products like Guarantee & Securitisation

Secondary market is impeded with difficult accounting regulations and high incidence of stamp duty other

than a few states Mortgage guarantee regulations do not provide any major incentives

Mortgage Finance: An Overview

• Mortgage Finance is an integral part of Housing Industry

• Mortgage Finance typically facilitates access to funds essential for owner occupation and enables the owner / borrower to match his income with expenditures over his lifetime

• Multiple Tax benefits over the tenor of the loan

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Developing Revolutionary Mortgage Products: Issues

• Product diversification and innovation is not focused

• Determining market trends on new products offering longer repayment terms, shared equity mortgages and so on

• No expansion of the mortgage product portfolio or upgrading existing products

• Managing risk of product development

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Mortgage Finance: Opportunities• Interestingly, mortgages in India are only 7% of GDP vis-à-vis 12% in

China, 29% in Malaysia, 39% in Taiwan and 80% in US

• Asia has a relatively lower mortgage penetration rate as compared to the US and Europe

• Housing Shortage, Demographic Divide, Improved Affordability and Government Incentives are strong growth drivers for Mortgage Finance Industry

• This requires continuous product innovation and has resulted in a variety of mortgage products

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Mortgage Finance: Challenges• Highly competitive market

• Constant product innovation is required

• Multiple options leads to greater reliance on expert opinion and financial intermediaries

• The traditional risk modeling has given way to riskier products and may affect adversely in a recessionary real estate market

• Luxury segment has grown, focus needs to be on Low Income segment and affordable housing

• However, growth story of Indian Real Estate Sector remains intact despite global economy slowdown

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Mortgage Products in Asia Pacific: An Overview

• The most prevalent mortgage products are listed here

• Based on

– Purpose of loan

– Loan tenure

– Interest rate type – fixed, semi-fixed & floating

– Type of borrower/ nature of entity – Individuals & Company

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Mortgage Products: Purpose of Loan• Core Business Products• Under construction (Builder/ Society)• Self construction• Ready Property• Plot plus self construction• Home Improvement• Home loan take over and enhancements

• Non Core Business Products• Loan for personal / educational / business needs against existing immoveable

property• Loan for acquisition of commercial property• Loan against future rental receivables• Loans against liquid securities like Fixed Deposits, Insurance policies, Post Office

Instruments etc.

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Mortgage Products: Other Purpose Mortgage Loans

• Debt Consolidation of other loans

• Reverse Mortgage Loans

• Shared Equity Mortgage Loans

• Mortgage Saving Account / Home Equity Line of Credit

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Mortgage Products: Repayment method

• Equated Monthly Installments

• Equated Principal Installments / Step Down Installments

• Step Up EMI

• Balloon Mortgage

• Biweekly mortgage payments

• Repayment through Escrow Mechanism

• Insurance Policy Linked Products

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Mortgage Products: Term Based

• Open Mortgage / Closed Mortgage Products w.r.t. facility to prepay loans without any levy charges or no such facility in fixed term loans which attract levy charges on pre closure/ part prepayment

• Length of Loan Term

• Shorter repayment terms: 5 to 7 years

• Longer repayment terms: up to 40 years

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Mortgage Products: Type of interest rate

• Fixed Rate Mortgage

• Variable/ Floating Interest Rate Mortgage

• Adjustable Rate Mortgage

• Interest Only Mortgage (full term/ set period)

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Mortgage Products: Charge on the secured asset

Most common in this category are:

• Equitable Mortgage

• Registered Mortgage

• Second Charge with the lender while the first charge with Government or Employer

• Pari-Passu Charge with other lenders

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Why Product Diversification and Innovation

• Enhancing consumer choice

• Offering flexibility of payment options

• Enabling people’s affordability to acquire a real estate asset as effectively as possible

• Enabling to capitalize the existing asset for accomplishing other important goals (such as debt consolidation, reverse mortgaging, upgrading the existing asset or acquiring new assets)

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Placing Priority and Focus on Product Diversification and Innovation

• Informal Sector: The majority of mortgage lenders are reluctant to serve customers in informal sector, because of uncertainty of their risk profile (Informal sector comprises those who earn in cash, have no formal income documents, no formal residence or identity proofs)

• Products for Credit Impaired Profile

• Products for Self Employed

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Market Trends affecting new products offerings

• Interest Rate movements, Income levels and Property prices play a crucial role in Mortgage Finance Market

• Increased Mortgage debt and rising property prices has affected affordability adversely for the new buyers

• The credit norms and underwriting standards employed by Mortgage lenders impact the market

• Growth in Population, Increased Urbanization, Preference for Nuclear families

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Longer Repayment Mortgage Products: Borrower’s perspective

• Opportunities• Aim to reduce monthly repayment burden on the borrower• Help borrower enjoy the house ownership and an option to decide

on their expenditure pattern

• Risks• Leads to higher financial burden in the long run on the borrower

due to increased financial charges• The borrower is exposed to higher risks in terms of interest rates

and economic downturns• The borrower acquires full equity in the asset much later than in a

shorter term loan

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Longer Repayment Mortgage Products: Lender’s perspective

• Opportunities• Better Interest yield• Better Disbursals due to higher loan eligibility

• Risks • The uncertainty risk of the borrower’s ability to repay is very high• Loans with longer repayment term coupled with higher Loan to Value

Ratio lead to a situation of Negative equity where the loan outstanding becomes greater than market value of the property at some point of time

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Shared Equity Mortgage

• The properties are offered by Housing agencies (Public or Private Bodies) for sale to the prospective home buyers to buy as percentage equity in the property duly supported by debt facilities

• The buyer occupies the property and pays a nominal rent to the agency for the remaining share owned by the agency

• Some nominal deposit (say 10%) of the buyer’s share is required to be paid by the borrower

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Shared Equity Mortgage• Opportunities• Low to middle income earners to have a real opportunity to purchase their own

home• Is a good, effective way of property ownership particularly in volatile financial

climate where mortgages are difficult to come by and repayments and margin requirements are high

• As rents continue to rise, shared property ownership becomes a more attractive option

• Risks • Available only for new builds, and not for resale in open market• Capital infusion required to buy additional shares of the property since the

property is not entirely owned by the borrower• The lender has to deal with other parties than borrower alone for sorting out the

issues in case of delinquencies

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Interest only Mortgage/ Balloon Repayment Mortgage• Opportunities• Such mortgages are useful where the borrower has some definite plan of

having lump sum for loan closure at the end of the term, say from maturity claim of life insurance policy

• The lender earns better interest income

• Risks• The borrower may favor balloon repayment mortgage in a high interest rate

period where he would expect to get his debt refinanced in a low interest period

• These mortgages have a high risk of default in case of failure of borrower’s planning to pay back full loan as lump sum

• The interest cost to the borrower is also high

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Step Up EMI Mortgage• Opportunities• Step up Mortgage repayment plan enables the borrowers to match their

increasing income levels with loan repayments. Here, EMI amounts increase over the years, assuming that the borrower’s income will also increase over the tenure

• The borrower’s loan eligibility is higher

• Risks• The increase is EMI is structured at constant intervals and the borrower might not

be in a position to afford the increase.• The increase is usually permanent (until the next renewal date)• Such mortgages are more susceptible to default in the event of borrower’s un-

affordability and increasing interest rate scenario

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Mortgage Saving Account/ Home Equity Line of Credit• Opportunities• A favorable mortgage product with modest repayment requirements and

relaxed structures• Interest only• Limited documentation relating to borrower’s assets, income & employment

• Risks• Lender’s risk is high as the end use of funds is not very specific• Usually fixed period loans after which the borrower is required to either renew

the line or repay the debt. In the event of non payment, the borrower loses equity in the house

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• Considering experience in other developed Nations, these alternative models to enable matching, such as shared ownership or interest only mortgages have proved cumbersome and subject to market failure. Nonetheless, there is a large scope and products like shared equity may be welcome, particularly for middle income group segment

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Determining Market Trends on New Products:

Opinion

Developing Revolutionary Mortgage products: • Expanding and Reinforcing the Mortgage Product Portfolio and Upgrading

Existing Products

• While mortgage finance is fundament to house ownership in almost all the cases, the main objective of mortgage lender remains to have suitable product offerings for the different users

• While mortgage products are typically secured loans, the diversified product offerings are necessary to cater to the needs of other borrower class who may not qualify for conventional mortgage products

• Different types of mortgage products generate different types of benefits to the borrower in terms of ease of mortgage access and efficient financing costs

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Developing Revolutionary Mortgage products: Risks

• In the similar manner, the different mortgage products carry different types and extent of risks and benefits for the lender

• The objective should be to understand the trade offs between benefits and risks

• Hence the mortgage lending has to be conducted with appropriate risk management structure that address marketing, underwriting standards, collateral valuation, individual account portfolio management and servicing

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Managing the risk factors in new product development• Changes in the product features like rate of interest structure, permissible LTV

ratios, margin money requirements and arrangement fees, according to market conditions

• Diversion of funds raised: (While the mortgages are formally secured against the property value, the finance raised can be employed for diversified uses)

• Better Monitoring Issues with respect to correct end use of funds, better portfolio management with respect to portfolio’s vulnerability to changes in borrower’s credit profile and value of collaterals

• Mortgage Guarantee Companies work as a risk mitigation tool for mortgage lenders since the guarantee company will serve as a back-up institution to handle the risk more efficiently

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Managing the risk factors in new product development• In order to remain competitive, the mortgage lenders are offering

Innovative products such as teaser rates that attract the customers from pricing point of view

• The new and innovative products need to be tested as the products which have not seen at least full house price cycle may be more risky on facing the downturn

• The mortgage lenders face challenges in respect of revolutionary mortgage products

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Managing the risk factors in new product development

• Volatility in Interest Rates

• High Competition demands reducing profit

• Efficient Fund raising to reduce the cost of operations

• Regulatory Hindrances

• Legal Risks relation imperfect land records, title issues etc.

• Valuation of Real Estate is challenge with huge variance of laws affecting valuations

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Managing the risk factors in new product development• Timely and efficient foreclosure laws in the event of default

• Government Incentives to the Housing Finance Industry

• Efficient Software Support for new product offerings

• Impact of global economy on the business

• The Mortgage Finance Business requires ongoing management of risk from origination stage to loan closure

• This requires better credit selection of borrower and the asset being financed

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Conclusion• Efficient products to be made available, the real challenge lies in

effective assessment of risk

• Better understanding of the relationship between different product offerings and consumer expectations with capabilities will always be required to assess the risk factors

• The Mortgage Lenders must ensure that the risk management practices keep pace with the growth and changing risk profile of mortgage portfolios

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Thank You