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Canadian Bank Regulatory Capital Requirements: Are They Tougher?

Posted by John Kiff*

A recent article in Central Banking (“lessons for banking reform: a Canadian perspective”) took a close look at the role of Canada’s banking regulatory framework in relatively strong performance of Canada’s banks so far through this crisis. One of the key reasons is that the OSFI (Office of the Superintendent of Financial Institutions) imposes a leverage cap on Canadian banks.

Among the G7, only Canadian and U.S. bank regulators impose leverage caps. Elsewhere, two large Swiss banks, UBS and Credit Suisse, will be subject to leverage caps in 2013 (Table 1). (As part of their financial stabilization measures adopted in fall 2008, the Swiss financial market supervisor (FINMA) introduced a minimum leverage ratio that adjusts to downturns—while acknowledging the need to avoid enhancing the current downturn by tightening capital and other rules too early.)

The Canadian leverage cap is calculated on total (Tier 1 and 2) capital, and the U.S. cap on Tier 1 capital. OSFI includes some off-balance sheet exposures in its definition of assets, whereas the U.S. leverage calculation does not. (These off-balance sheet exposures include credit derivatives, financial standby letters of credit, guarantees, and surety arrangements.)

Regulatory Leverage Ratio Limits

Canada’s minimum capital requirements are tougher than called for by Basel II, and all other G7 bank regulators (Table 2). Canadian banks have to hold Tier 1 capital of at least 7 percent (versus 6 percent in the United States) of risk-weighted (RWA) assets, and 10 percent (versus 8 percent in most other G7 countries) of RWA as total capital.

Tier 1 and 2 Capital Requirments

Although these comparisons do not account for potential differences in Tier 1 and 2 capital definitions from country to country, these are believed to be immaterial. However, supervisors may impose undocumented higher capital requirements on some banks (e.g., systemically important and/or large complex institutions).


* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management. This post is based on a box he wrote in the recently-published IMF Staff Report for the Canada Article IV Consultation.



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U.S. Foreclosure Mitigation: Too Little, Too Late? (Part 3)

In the first post in this series, I gave a very broad brush overview of the three government foreclosure mitigation programs that have been introduced since 2007. In the second post, we did a deep dive into the Home Affordable Modification Program (HAMP). In this post I’ll get into the Hope for Homeowners (H4H) program.

Although the point of both programs is to reduce the borrower’s payment-to-income (PTI) ratio, they get there in different ways. Whereas HAMP aims to reduce borrower monthly payments, H4H also aims to write down outstanding loan balances through the home’s current assessed value to extinguish any negative equity and give borrowers more “skin in the game”.

As I mentioned earlier, although HAMP has a lot of good things going for it, it falls short of a real solution to the foreclosure crisis because it only defers the affordability problem, and it leaves most distressed borrowers owing more than their homes are worth (i.e., “underwater”), and not very motivated to stay current.

However, in the short run, real solutions don’t come cheap, and for securitized loan holders, long-term solutions may not help if values decline so far so as to negate any interest in solving the problem? count for much. In the first post, I made a case for government coverage of the short-run costs, but dealing with the short-run interests of mortgage-backed securities (MBS) holders is a much thornier issue.

However, the HAMP has put forward some useful measures to try to ram through modifications (e.g., incentive payments to servicers and the legal safe harbor provisions introduced by Congress). These modifications must be potentially effective when MBS holders gripe about the program “allocating losses to some place that isn’t expecting it” and damage to the “sanctity of contract law” according to a recent Bloomberg article.

Anyway, the H4H program requires the lender to write distressed underwater loans down to 96.5 percent or less of the current appraised value until the 31 percent DTI is reached (see below for the exception to the 31 percent target). The lender also has to waive all prepayment penalties and late payment fees. These “short refinancings” are funded by new 30- or 40-year fixed-rate FHA-insured loans.

In addition to the DTI reduction requirement, H4H also requires that all debt payments (home and non-home) be at or below 43 percent of borrower gross income. (The 43 percent criterion is called a “backend” DTI, as opposed to the 31 percent “frontend” DTI.) For borrowers with higher debt loads, the frontend and backend DTIs can be expanded to 38 (and 50) percent, but, in such cases, the loan must be written down to 90 percent or less of current appraised value.

The lender also has to extinguish any junior liens. However, as I mentioned in the first post, in some cases, junior lien holders may try to abuse their position and hold things up, plus it may be difficult to track down and negotiate with the junior lien holder. In this regard, the Second Lien Program (2MP) announced on April 28 will be helpful. The 2MP pays [first lien?] servicers that extinguish second liens 3 to 12 percent (depending on various risk factors) of the loan balance.

The lender also has to pay a 300 basis point FHA up-front mortgage insurance premium (UFMIP), while the homeowner pays a 150 basis point annual premium. This is higher than the 225/55 basis point premia that the FHA usually charges on 95 loan-to-value (LTV) mortgages, presumably to cover the heightened riskiness of these particular new mortgages. (However, the “Helping Families Save Their Homes Act of 2009” (S.896), which the Senate passed on May 6, caps the premia at 200 basis points upfront and 100 basis points annually.)

In addition, if the homeowner sells the house or refinances the new mortgage, the government claws back some of the “instant” equity (100 percent in the first year, declining to 50 percent after five years), plus, if the property is sold, 50 percent of any net property value appreciation. (S.896 will allow for reductions in this clawback, but as far as I know, it’s still 50 percent.) Also, borrowers are prohibited from taking out new junior liens during the first five years, except when necessary to ensure maintenance of property standards.

In order to make this all more concrete, I’m going to run some numbers on the same hypothetical mortgage that I ran the HAMP through in the last post. It’s a seriously delinquent $200,000 10 percent 30-year loan on a property that was worth $250,000 at origination (an 80 percent LTV). The monthly payment is $2,380, including $625 of insurance and property taxes. The borrower’s gross annual income is assumed to be $57,120, to imply a current PTI of 50 percent.

The amount of writedown needed to get the PTI down to 31 percent will depend on the interest rates being offered on the FHA-insured refinancing, and the amount of home price depreciation (HPD) since origination (because the loan must be written down below the assessed value). Current 30-year FHA-insured mortgages are going for about five percent, so that a principal writedown to at least $158,468 would be required to obtain the needed DTI ratio.

However, an additional writedown may be necessary to get the balance down to 96.5 percent of current assessed value. The table below shows that in scenarios where home price depreciation (HPD) is zero and 25 percent, the writedown to $158,468 meets all H4H criteria. However, when HPD is 50 percent, a more extreme writedown is needed – to $120,625 at which the borrower DTI drops all the way to 26.7 percent. This suggests that the requirement to write the loan all of the way down to 96.5 percent of assessed value could be usefully dropped.

Figure3-1The next table compares these H4H refinancings to the expected net present values (NPVs) calculated in the last post for HAMP modifications and for doing nothing (“status quo”). It shows that the appropriate action/inaction is very dependent on the scenario – do nothing when HPD is zero, an H4H refinancing in the 25 percent HPD scenario, and a HAMP modification when HPD is 50 percent.

Figure 3-2

You might expect that business would be booming for both refinancing/modification programs, given the widespread negative HPDs. However, although the jury’s still out on HAMP because it just started up, H4H has generated very little business. Part of the problem with H4H is that it left implementation to under-resourced servicers, and placed the entire writedown burden on lenders. Hence, the $2,500 servicers will be getting for every completed H4H refinancing since April 28 may give the program a bit of a kick start.

Nevertheless, H4H will still be held back by a process that is quite convoluted from the borrower viewpoint. H4H requires the borrower to negotiate new deals with both original lender and the new FHA-approved lender. (Somewhat helpful in this regard may be the “pay-for-success” payments to the new lenders – up to $1,000 per year for up to three years while the new loan stays current, also introduced on April 28.) In addition, the future appreciation clawback and the rather high mortgage insurance rates could be putting borrowers off. Also, some homeowners are so deeply in debt, that no reasonable modifications can get the backend DTI below 43 or 50 percent.

It is possible that in some cases, the “pooling and servicing agreements” (PSAs) that govern the relationship between servicers and lenders block the most meaningful modifications, but very few actually do (e.g., see “what do subprime securitization contracts actually say about loan modification?”). Some say that servicer incentives tilt them towards foreclosures (“deleveraging the American homeowner”). Servicers have to keep advancing monthly principal and interest payments to lenders, even when the borrower is delinquent. They recover these advances only if the loan becomes current or when a foreclosure sale is completed. In the case of modifications, however, it could take a while to recover the advances, so servicers may prefer to foreclose.

Furthermore, servicers can find themselves caught between the sometimes competing interests of the different MBS tranche holders (“tranche warfare”). (For more on MBS mechanics, see Box 1 in “money for nothing”.) Basically an MBS slices and dices the performance of a pool of mortgages into “tranches”. As principal and interest payments come in on the underlying loans, the “senior” tranches get paid off first, and so on down the line to the “junior” tranches that effectively take the main brunt of any losses.

When a loan is foreclosed, the net proceeds flow immediately towards the early redemptions of some senior tranches, and a higher share of future principal and interest flows may be redirected to those tranches as well. All of this is effectively funded by the junior tranches.  On the other hand, modifications usually spread the pain across all of the tranches – cash flows to the junior tranches are reduced, and the senior tranches possibly downgraded. In the extreme case of principal writedowns, many of the junior tranches would likely have to be written off.

In any case, servicers caught in the middle of this “tranche warfare” and fearing lawsuits from aggrieved investors may not necessarily stick strictly to their NPV models. Regardless of the reasons, a recent research paper (“securitization and distressed loan renegotiations”) found that “securitization imposes significant renegotiation costs and a failure to renegotiate may have substantially contributed to the recent surge in foreclosures”.

This is where the aforementioned servicer subsidies are supposed to come in. It was also where the ill-fated bankruptcy “cramdown” legislation was supposed to come in. The idea was that, if bankruptcy judges were to be given the legal authority to write down principal balances on residential mortgage loans, servicers and lenders would be more eager to reduce principal balances voluntarily. However, S.896 includes a legal safe harbor provision for servicers that participate in the HAMP and H4H programs.

Time will tell if the servicer incentives, safe harbor, reduced FHA insurance premia and second lien subsidies will be effective in getting H4H refinancings off the ground. In the next and final post in this series, I’ll sum up these two programs and try to identify some possibly better ways forward.


* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management.


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The Yuan Takes Another Step

By Ranjan X. Roy

Another week passes…and another quiet, yet strategic announcement by China regarding the future of the Yuan. It was announced early this week that HSBC and the Bank of East Asia in Hong Kong would be the first foreign banks given the authority to issue debt denominated in Chinese Yuan.  After their numerous announcements regarding bilateral currency swaps, Chinese officials have taken an even greater step towards pushing the Yuan towards eventual reserve currency status.

However Michelle Bachmann shouldn’t be panicking just yet, and remain focused on connecting swine flu to the Democratic Party, as we still have a ways to go before the Yuan can function as a reserve currency in any tangible manner. What China appears to be doing is simply increasing the liquidity of the Yuan in a very focused, regional manner. The usage of Yuan has been increasing at the level of the ‘man on the street’ as it’s slowly becoming more common that stores in Hong Kong are accepting Yuan for purchases. This is still limited by local residents only being able to purchase 20,000 Yuan per day with their Hong Kong dollars (yes, that’s nearly $3,000, but they do love their luxury goods). The announcement of offshore debt being issued in Yuan will now allow for the transacting of Yuan by the multibillion dollar pension fund. The end goal is whether its a local buying a $10 shirt or Bill Gross buying a billion dollar bond issuance, the purchase will take place in Chinese Yuan.

Why do they want this? As the frequency of Yuan Bonds circulating increases, so does the acceptance of the currency as a basis for business. The government of China will slowly be able to issue domestic debt in its own currency and sell it to foreigners. This is a major facet of economic power. One of the greatest benefits of being the issuer of a reserve currency, is the ability to have foreigners buy up debt denominated in your currency. The US is benefiting tremendously from the amount of debt around the world that is denominated in US dollars. The entire reason China is so delicately approaching the issue of reserve currency status, is all of the US dollars they accumulated over the past years were funneled into mostly USD-denominated debt. Now, they have just as much of an interest in preventing a sudden USD collapse as Obama & Co.

The flip side of this issue is the vulnerability of nations that do not issue debt in their own currency, an example being Argentina earlier this decade. After a period of hyperinflation in the 1980s, the government pegged its currency to the USD and issued billions of dollars of debt throughout the 90s. As their economy began to deteriorate rapidly from a combination of factors in 2001, investors began fleeing from the country’s assets. Government revenues and local trade were still executed in Argentine Peso, but the government needed to make interest payments on their debt in US Dollars.  You now had a situation where the ability of the nation to pay out the interest on their debt is destroyed by the double-edged sword of a collapsing currency and collapsing revenue. That interest payment that was coming due was suddenly costing the government way more in Pesos than originally forecast, (note: the ARS was technically pegged to the USD so this pain is experienced through a variety of mechanisms) leading to Argentina eventually having to default on over 90bn USD of debt in 2001.

There are currently many examples of companies issuing debt in currencies other than their own. Corporations, especially of the multinational variety, often want to avoid fluctuations in their native countries local currency and instead look to base the issuance on a major currency. Some fairly hilarious names are borne of this practice, ranging from the fairly common Samurai bonds (non-Japanese entities issuing debt in Japanese Yen), to the Kangaroo Bond (Aussie Dollar denominated by non-Australian issuer in Australia), to the ubiquitous but less creatively named Eurodollar Bond (USD denominated by a non-US entity outside the US).

As the USD is still the world’s leading reserve currency and USD-denominated debt constitutes the vast majority of debt circulating (Eurodollar bonds are estimated to be nearly 80% of the international bond market), the announcement from China should be applauded. Moving away from the economic order where China’s consumption of USD and related assets allowed for excessive borrowing (concisely referred to as ‘Chimerica’ by Niall Fergson) in a careful manner should be the goal of economic policymakers globally. China’s effort to increase their currency’s presence in the world of debt is one key element of this healthy rebalancing.

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Mitigating Counterparty Risk in the Credit Default Swap Markets with Central Counterparties: The Whys and Wherefores

Guest post by Jodi Scarlata*

This post discusses key features of a well-designed central counterparty (CCP), aspects particular to a credit default swap (CDS) CCP, and the factors for choosing between multiple CCPs versus a single CCP. For broader discussions of CCP issues, see the 2004 and 2007 reports published by the Bank for International Settlements Committee on Payment and Settlement Systems.

A CCP facilitates standardization and multilateral netting, increases liquidity, and can improve the availability of price information, increasing the ability to value CDS products, and ultimately serves to mitigate risk. A CCP for standardized CDS contracts can reduce operational risks, especially those inherent in over-the-counter trades, such as backlogs of outstanding confirmations and unwinding positions in case of default that can spread across multiple counterparties. In addition, the mutualization of risk among clearing members provided by a CCP reduces hedging costs by eliminating the need for hedging bilateral exposure.

The lack of transparency about the net counterparty exposure in the CDS market can inflate the public perception of counterparty risk. For example, if the market had known in advance that the settlement of Lehman swaps would amount to only $5.2 billion of net funding obligations in the CDS market, according to the Depository Trust and Clearing Corporation, instead of the hundreds of billions in notional that were speculated, the financial markets might not have seen the same degree of turmoil in the fall of 2008. Thus, greater insight into CDS trading activity could reduce the uncertainties characteristic of the recent crisis.

Risk Management: Margining, Collateral, and Membership Requirements

While a CCP mitigates counterparty risk, it also concentrates risk and requires extensive risk management systems. Consequently, a CCP’s risk management processes, internal controls and operational risk procedures, and the adequacy of its back-up financial resources are key to ensuring that risks are contained. In addition, a CCP that clears CDS contracts should conduct stress tests with relevant shocks to its members.

A CCP typically uses margining as an instrument to reduce counterparty credit risk. Initial margin, the amount required to initiate a position, and variation margin, payments for the daily losses and payoffs for daily gains, are required to keep a position open. This allows payment flows to account for intra-day price movements and variation margin changes to account for end-of-day settling up, since variation margin is based on daily mark-to-market pricing; positions are liquidated if variation margin cannot be met. Riskier instruments should incorporate larger margins to account for the greater risk to which the CCP is exposed.

Margin requirements for less liquid instruments should incorporate the potential losses that might occur over a longer liquidation period following a default. Margining requirements should therefore account for risks of a particular product and elements such as sector risk and liquidity risk. The accurate calculation of margin requirements, or even an appropriate range of margin requirements, will be a key challenge to the new CDS CCPs due to the complexities in the pricing of these particular products.

Cash Settlement versus Physical Settlement in a CDS CCP

A CCP can facilitate settlement of contracts after an event of default. For credit derivatives contracts, there has been a decline of physical settlement in favor of cash settlement, and the use of ISDA auction protocols have become standard practice in credit events for the reasons cited below.

A feature of the CDS market is the settlement method in case of default, or credit event. With the occurrence of a credit event, there are two options for the settlement of CDS contracts— physical settlement or cash settlement. A CDS credit event is a default event that results in payments by the protection seller to the protection buyer, concurrent with delivery requirements by the protection buyer. Typical credit events include bankruptcy of the reference entity or its failure to pay with respect to its bond or debt and, for some reference entities, restructuring.

In the case of physical settlement, the protection buyer delivers the debt obligation (the cash instrument) of the reference entity and in return is paid the par value by the protection seller. In cash settlement, the protection seller pays the protection buyer the difference between par value and the market value of the debt obligation of the reference entity. However, the growth of the CDS market has resulted in a much larger notional value of CDS contracts than the outstanding value of the debt obligations. Cash settlement avoids possible failure in physical delivery due to a shortage in deliverable cash instruments.

Keep in mind that the notional amount of single-name CDS far exceeds notional of physical cash bonds and can be potentially distorting. Bank for International Settlements data show CDS notional outstanding of around $57 trillion at end-June 2008 versus a gross market value of underlying securities of only $3.2 trillion for the same period. Further, a physical settlement could result in a short squeeze, as protection buyers purchase bonds to deliver for settlement, bidding up the bond price and thereby offsetting the gains on the CDS protection.

In any case, in light of the concentration of risk in a CCP, a smoothly operating settlement system is crucial for reducing any potential systemic consequences. Central counterparties’ use of cash settlement for CDS contracts would deter market manipulation and help avoid disruption in the settlement process. In March 2009, ISDA initiated its Auction Settlement Supplement and Protocol incorporating cash auctions into standard documentation for settling CDS contracts, i.e., “hardwiring” the ISDA settlement protocol into the contracts. While the ISDA defined protocol provides for both auction and physical settlement, cash settlement can benefit by minimizing price distortions. However, maximizing participation in the industry standard settlement mechanism for all CDS contracts is crucial.

Multiple CCPs versus a Single Central Counterparty

The CDS CCP ventures based in the United States and Europe have engendered some debate as to the optimal number of central counterparties. These currently include CME Clearing, Eurex Clearing, ICE Trust/ICE Clear Europe, and NYSE Liffe/LCH.Clearnet. A single CCP would accomplish the largest reduction in systemic counterparty risk, benefit from economies of scale and a larger pool of counterparties and resource base, and limit opportunities for regulatory arbitrage and competitive distortions. See the recent paper by Duffie and Zhu (“Does a Central Clearing Party Reduce Counterparty Risk?”) for discussion of these points.

The resulting concentration of operational risk would necessitate strong risk management processes and oversight. The U.S. approach is to allow for multiple CCPs, allowing market forces to determine the optimal number of CCPs in order to assure clearing services are provided efficiently. However, there are concerns that such an approach will be a “race to the bottom,” as each CCP fights for market share by economizing on risk management procedures, and lowering margining requirements and contributions to a guarantee fund. (A guarantee fund compensates nondefaulting participants from losses suffered in the event of another participant’s failure to meet its obligations to the CCP.)

From a cross-border perspective, the systemic importance of a single CDS central counterparty for a domestic economy might lead authorities toward retaining the CCP under national regulatory and supervisory oversight for the ability to control or mitigate the impact on domestic financial stability. National authorities might be reluctant to oversee a global entity where jurisdictional disputes may arise. Nevertheless, a global CDS CCP would mitigate the most overall counterparty risk. Thus, if a global CDS CCP is not established, then the development of separate CCPs should provide for the crossborder coordination of regulatory and supervisory frameworks to avoid regulatory arbitrage. These frameworks should ensure that linkages and clearing mechanisms are established across CCPs, without constraining the use of multiple-currency transactions. At present, there are various legislative, regulatory, and market proposals outstanding to deal with counterparty clearing organizations, which may affect issues such as the standardization and documentation of credit default swaps, and the responsibilities of counterparties and clearinghouse members, amongst others.


* Jodi Scarlata is a Senior Economist at the IMF. These are her personal views, and should not be attributed to the IMF, its Executive Board, or its management.

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Mitigating Counterparty Credit Risk in OTC Markets: The Basics

By John Kiff*

A central counterparty (CCP) reduces systemic counterparty credit risk by applying multilateral netting. This post discusses key tools of over-the-counter (OTC) counterparty credit risk mitigation, including netting and the collateralization of residual net exposures, and explains how a CCP reduces systemic counterparty risks. A follow-up post by one of my IMF colleagues (Jodi Scarlata) will delve deeper into the particulars of CCPs for credit default swaps.

An OTC contract is exposed to counterparty default risk prior to the contract’s expiration while it has a positive replacement value. In the absence of bilateral closeout netting, the maximum loss to a defaulted counterparty is equal to the sum of the individual contracts’ positive replacement values. The figure below shows two bilateral contracts. A owes B $5 on one contract, and is owed $10 from B on the second one. A faces a $10 loss if B defaults. This all assumes that the counterparties have signed a master agreement with the appropriate closeout provisions that covers both transactions. If they had not, B could “cherry pick” A by defaulting on its obligation to pay the $10, but insisting that A still pay the $5. In this case, A loses $15.


Closeout netting aggregates all exposures between the counterparties, under a default, and contracts with negative values can be used to offset those with positive values. Hence, the total exposure associated with all contracts covered by the particular master agreement is reduced to the maximum of the sum of the replacement values of all the contracts and zero. A loses $5 if B defaults. The exposure can be further reduced by requiring counterparties to post collateral (cash and highly-rated liquid securities) against outstanding exposures, usually based on the previous day’s valuations.

For more detail on OTC derivative collateral and netting practice see Bliss and Kaufmans’ “derivatives and systemic risk” paper. For surveys of OTC derivative counterparty credit risk exposure management practices, including collateral policies, see “new developments in clearing and settlement arrangements for OTC derivatives” by the Bank for International Settlements Committee on Payment and Settlement Systems, and “counterparty credit exposure among major derivatives dealers” by the International Swaps and Derivatives Association. Best practice guides can be found in the 2005 and 2008 reports by the Counterparty Risk Management Policy Group.

The second figure shows contracts across four counterparties, all of whom have bilateral closeout netting master agreements with each other applies. The numbers on the arrows indicate the net bilateral flow (A, B, C and D, clockwise from the top left corner), and the subscripted “E” indicates the maximum counterparty exposure for the counterparty. Thus, ED = $10, because both A and B owe D $5. Each counterparty faces a maximum counterparty default-related loss of either $5 or $10. C loses $10 if both A and D fail, and D is vulnerable to the simultaneous default of A and B. Hence, A and B should each provision against $5 of potential counterparty credit losses, and C and D should each provision for $10, for a total of $30, even though the maximum potential loss among all four is only $10.



Multilateral netting, typically operationalized via “tear-up” or “compression” operations that eliminate redundant contracts, reduces both individual and system counterparty credit risk. In this case, it could eliminate four contracts, and eliminate all A’s and B’s counterparty credit risk exposure, and leave C and D with $5 of maximum potential individual losses. The third figure shows the two possible post-netting configurations. The leftmost configuration eliminates the circular BACB flow, and replaces the BDC flow with a more direct BC flow. The rightmost configuration just needs to eliminate the circular BADC flow. Using such tearup operations, TriOptima’s TriReduce service eliminated about $30 trillion notional of credit default swap contracts in 2008.


A sound CCP takes the multilateral netting principle a step further, and reduces the likelihood of knock-on failures by requiring the participants to post margin, and by loss sharing among other clearinghouse members. Other typical arrangements include capital funds comprised of clearing member contributions and accumulated profi ts and transaction fee rebates. All of this will be covered in more detail by Jodi, but see also Bliss and Steigerwalds’  “derivatives clearing and settlement: A comparison of central counterparties and alternative structures”).



* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management.

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U.S. Government Foreclosure Mitigation Policies: Too Little, Too Late? (Part 2)

By John Kiff 

In the first post in this series, I gave a very broad brush overview of the three government foreclosure mitigation programs that have been introduced since 2007. In this post, I’m going to dive a bit deeper into the details of the Home Affordable Modification Program (HMP), the more recent of the government’s two active foreclosure mitigation plans. I’ll get into the Hope for Homeowners (H4H) program in the next post.

The point of both programs is to get the borrower’s payment-to-income (PTI) ratio down to 31 percent. The PTI is calculated by dividing all mortgage-related payments (including insurance and property taxes, but excluding mortgage insurance premia) by the homeowner’s gross income. HMP does it by offering to subsidize the cost to the lenders of temporarily reducing monthly payments to the 31 percent PTI ratio.

HMP gives lenders a subsidy of up to one-half the difference between the monthly payments at the 31 percent PTI ratio, and what the payment would have been at a 38 percent ratio, for up to five years. In addition, they get $1,500 for every current loan modified to encourage the offering of early intervention (rather than waiting until the borrower is seriously delinquent). Studies have shown that early intervention results in lower redefault rates (see “loan modifications and redefault risk”).

Servicers also get $1,000 for each modification, plus another $500 if the borrower was still current and $1,000 each year (for up to three years) that the borrower stays current (“pay for success”). One of the reasons cited for the H4H’s poor results has been that servicers are unincentivized and under resourced.

HMP also subsidizes lender costs of extinguishing junior liens (up to 12 percent of the unpaid balance), or subsidize junior lien holder costs of temporarily reducing interest rates to as low as one percent. Junior lien servicers who opt to reduce the interest rate will receive $500 upfront and $250 per year for up to five years. For more information see the April 28 update.

In order to make this all more concrete, I’m going to run some numbers on a hypothetical seriously delinquent $200,000 10 percent 30-year mortgage on a property that was worth $250,000 at origination (an 80 percent LTV). The monthly payment is $2,380, including $625 of insurance and property taxes. The borrower’s gross annual income is assumed to be $57,120, to imply a current PTI of 50 percent.

In order to get the PTI down to 31 percent the interest rate must be reduced from 10 to 3.125 percent (see table). Lender subsidies will amount to $326 every month that the modified loan stays current (half the difference between payments at the 38 and 31 percent DTI levels) for up to five years. Since the rate is below the current Freddie Mac Weekly Primary Mortgage Market Survey (PMMS) rate, after five years, the rate increases by one percent every year until it reaches the PMMS rate. I assume that the PMMS Rate is five percent.


The result of all of this, in net present value (NPV) terms using a 7.50 percent discount rate, is an effective write down from $200,000 to $122,530 plus $8,143 if the modified loan stays current for five years. However, before racing ahead into this modification, the servicer will compare this potential $130,673 NPV to the liquidation value in foreclosure.

The table below estimates these liquidation values in three home price depreciation (HPD) scenarios. For example, at zero, the lender will net about $148,750, making foreclosure a better alternative to an HMP modification. At 25 percent the net is $106,563, making it a close call between modification and foreclosure. At 50 percent HPD the $64,375 recovery value makes modification a possibly better choice.


The table below shows the outcomes for the HMP modifications under the three HPD scenarios, compared to the outcomes if the servicer just rides out the loans (“status quo”). The dollar numbers are the NPVs, and the assumed probabilities are in the parentheses (more about those later). It suggests that HMP modifications aren’t likely work out so well in the zero and 25 percent HPD scenarios for this particular example, because their expected NPVs are less than those in the status quo scenarios (see below for more detail). However, in the deep depreciation scenario (HPD = 50 percent), the HMP modifications have a have higher expected NPVs.


In general, the ultimate success of the HMD modifications will depend on whether the modified loan stays current (“cures”) or redefaults. The decision as to whether to modify will also depend on the likelihood of the unmodified loan becoming or staying current. The Treasury is making available to servicers an NPV calculator which embeds their suggested assumptions for the two key default probabilities, and large servicers (with books exceeding $40 billion) “may” use their own. I’m not a servicer, so for now, all I have to go on are the HMP NPV guidelines which remain vague on many key details and parameters.

In the above table I assume that the default probability on the unmodified seriously delinquent loan is 85 percent and 30 percent if it is modified. The expected NPV on the modified loan is $147,493 or less (depending on the amount of post-modification HPD), and $164,090 on the unmodified loan. In all but the 50 percent HPD scenario, for this specific example, it looks like it would be better not to modify.

Of course, as we discussed in the last post, default rates on modified loans are likely to vary according to the type of modification and the degree to which the loan balance exceeds the value of the underlying property (“negative equity”). Hence, a more sophisticated analysis would vary the probabilities according to the negative equity, which might even swing the evaluation towards the status quo in the 50 percent HPD scenario.

However, we’re not quite done yet! The hypothetical loan we just worked over was seriously delinquent. What about current borrowers? Recall that HMP is going to pay lenders $1,000 and servicers $500 for every current loan that they modify under HMP. However, although proactive modifications can be a good thing, they can backfire if borrowers who would have otherwise stayed current come forward for modifications. HMP controls this “moral hazard” risk by requiring that the borrower give proof of a significant change in income or expenses, to the point that the current mortgage payment is no longer affordable. However, keep in mind that, despite all the nasty headlines, there are still lots of nonprime loans that are not delinquent, so this risk could be significant.

Anyways, one of the key take aways from this post should be that loan modification analysis has a lot of moving parts, many of which I’m leaving out of this example (e.g., delinquency and prepayment timing, the evaluation horizon, and discount rate). Also, there are numerous other combinations and permutations of DTIs, LTVs and HPDs. In the next post in this series, I’ll go through a similar analysis of the H4H program, and show how it fits with the HMP under different DTI/LTV/HPD scenarios.


* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management.

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Credit Default Swaps and Control Rights

By Charles Davì

Megan McArdle asks, “Do We Hate Credit Default Swaps for The Wrong Reasons?” As Megan notes, blaming credit default swaps for all kinds of things is quite fashionable these days, since simply uttering the term makes commentators feel sophisticated. While this is itself a topic worthy of discussion, the more interesting point in Megan’s article concerns how credit defaults swaps affect the incentives of bondholders in the context of restructurings.
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China Goes Continental

By Ranjan X. Roy

Asia’s answer to the yearly Davos gathering, the Boao Forum of Asia, ended last week with some choice words from Lou Jiwei, chairman of the China Investment Corporation (CIC), China’s primary sovereign wealth fund (SWF). Mr. Lou, in a tone ironic enough to satisfy even the snarkiest of us bloggers, indicated China’s intention to reexamine investment opportunities in Europe:

“I have to thank these European officials. They saved me a lot of money. Now they come to me without conditions and I am beginning to consider making investments in Europe again.”

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The Art of the Banking Controversy

By Charles Davì

Now that we are well into the depths of a recession, banker-bashing is all the rage. In addition to being fashionable, these “arguments” have an air of credibility about them, given the dire context in which they are made. As a result, the debate over regulating the financial sector is being recontextualized by portraying Wall Street as little more than a vacuous pig-pen. This view is informed by a grand equivocation, which lumps together all of finance under one roof, somewhere on Wall Street, where bankers convene and discuss how they can further redirect the world’s resources towards their pockets. And the shapeless anger that follows from this view has consumed not only the main stream media, but bloggers as well.

Brad Delong takes the view that both compensation and profits in the financial sector are wholly unjustified. Matthew Yglesias agrees. Another even more dubious theory, also espoused by Matthew Yglesias, is that those in finance are morally inept. (You can find Conor Clarke’s response to Yglesias here). Together, Delong and Yglesias employ straw men, false dichotomies, equivocation, conflate coincidence and causation, and in general treat a complex subject with glib answers that suggest the authors have no concern with getting it right, or have just finished reading Schopenhauer’s, “The Art of Controversy.”

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The Real Implications Of China’s Currency Policy

By Ranjan X. Roy

Yesterday, as Americans paid their taxes and partied like it was 1773, China took yet another action little noticed in the American media, but with major long term implications.  China finalized a deal with Argentina, arranging a $10.2bn currency swap of their respective currencies (70bn CNY/38bn ARS). While Michele Bachmann and the like were up in arms after Zhou Xiaochuan, Governor of the People’s Bank of China (PBoC), suggested that SDRs could potentially function as a new global reserve currency, this particular story appears to have garnered little attention from those paranoid of a “one world currency“. However, this development is of crucial strategic importance and should be recognized by US policymakers as a development that must be addressed, rather than proposing legislation that doesn’t even begin to make any sense.

The move will allow Argentineans to directly access Chinese Yuan for trade, rather than having to settle in US Dollars. Previously, as the USD has been the primary reserve currency for international trade, an importer would have to cross two “spreads”, first converting ARS to USD, and then the USD to CNY (just imagine having to go to the airport currency exchange twice just to buy a souvenir). The Argentine Central Bank is explaining the move as a “contingency plan to bolster liquidity amid the global financial crisis,” but this vague statement is better explained by Passport at Foreign Policy:
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