Local lenders more risk averse, leading to a tightening of credit for housing finance.
Home loan insurance should be a priority
The global financial crisis is having a significant impact on the property sector in the UAE and the rest of the GCC. Even with proactive measures by the region's policymakers, widespread uncertainty globally has made local lenders more risk averse, leading to a tightening of credit for housing finance and stricter requirements for home loan approvals. Without a return to normal lending practices for home buyers, the strains in the property market and related sectors such as construction are destined to worsen. In this situation, one way to boost home lending could be the introduction of mortgage insurance. One of the main reasons that banks are currently reluctant to lend is the difficulty of evaluating the creditworthiness of clients in an environment characterised by uncertainty, where exaggerated rumours of layoffs and economic doom abound and where information on credit history is sketchy or absent. These problems are compounded by a lack of the tools and institutions available in many developed countries and even some emerging markets, which allow for risk mitigation and risk pooling. In particular, the UAE lacks an institution providing insurance against mortgage defaults by individuals experiencing economic hardship. Such institutions are increasingly common across the world and one might argue that the time has come for the UAE to establish a nationwide mortgage insurance company. What would be the purpose of such a company? Banks and financial institutions are exposed to a series of risks in mortgage lending. If a borrower defaults, there is a loss on the market value of their home. Local or regional recession can cause a generalised decline in property prices. Lastly, a major economic downturn will bring on a fall in the prices of all assets and also in credit quality. The first risk is reasonably manageable, as it involves repossessing the mortgaged dwelling and selling it to cover the outstanding debt. In normal times this process might be costly and time consuming for the bank, but it does not jeopardise the bank's solvency. The other two risks, however, are potentially disruptive because in deteriorating markets it becomes less likely that repossessing and selling a dwelling when the borrower has defaulted will see the full value of the mortgage loan recovered. A mortgage insurance company would provide coverage of eligible housing loans by approved banks and other financial institutions for a predetermined percentage of the value of the property at the start of the loan. Let us assume that this is 30 per cent (subject to the insurance eligibility criteria of different mortgage insurance products). This would enable banks to advance mortgage loans of up to 90 per cent to 95 per cent of the property's value, since with the protection of mortgage insurance, the downpayment required for potential homebuyers can be reduced without increasing the risk to the banks. However, to avoid moral hazard - the lack of any incentive to guard against a risk when you are protected against it - and to ensure the lender continues monitoring the borrower's performance and repayments, and the borrower has an incentive to repay, one would not want to insure 100 per cent of the loan. The mortgage insurance company would hedge the exposure of the insurance by taking out reinsurance with approved reinsurers. Part of the risk could then be offloaded to international reinsurers. In this way the bank's prudential limits on mortgage lending - typically 60 per cent to 70 per cent of the value of the property - can be overcome without exposing individual banks to undue risk. In other words, banks would be exposed for 60 to 70 per cent of the mortgage but they could earn interest on the full amount of the loan. To make mortgage insurance effective, home loan contracts should be standardised, both in conventional and Sharia-compliant finance, to allow the efficient packaging of risks and more effective risk management. Specific provision for Sharia compliance can be easily devised, as the home loan is backed by a real asset generating a stable cash flow. Underwriting rules should also be standardised in a more rigorous legal framework. The home loans, conventional and Sharia-compliant, could also be repackaged into mortgage-backed securities that could then be used to increase the liquidity of banks via "repo" (sale and repurchase) operations with the Central Bank. In this way, a secondary market for mortgage-backed securities could gradually emerge, with positive effects on the overall depth and liquidity of the domestic securities markets, both conventional and Sharia-compliant. Thus, mortgage insurance would, crucially, facilitate the transformation of illiquid assets into high-quality negotiable securities for all types of investors and financial institutions. A market in insured mortgage-backed securities would have the additional advantage of integrating financial markets in the UAE with global financial markets, providing a standardised, familiar asset class for global investors wishing to invest in the Gulf. Typically, the mortgage insurance premium is paid by the borrower, but one could envisage a scheme where banks take up at least a portion of the fee. Any mortgage insurance scheme should not be extended to large investors, whose creditworthiness can be established through a professional analysis of their net worth and their balance sheet. Instead, it should be aimed at specific - possibly disadvantaged - groups, such as first-time buyers, young professionals, newly weds, lower income families and small businesses. Each borrower should benefit from insurance only on one eligible mortgage. The insurance company that provides mortgage insurance might be founded as a private-public partnership; for example, with half the capital provided initially by public entities and the rest by private investors and non-banking financial institutions. Once the scheme is firmly established, the share of public capital could gradually decrease. It would be desirable for the company to be established by a law that would define the level of coverage - say 30 per cent, but this could vary - devise the regulatory and supervisory structure, and set the procedures to be followed when a borrower defaults. It would also be useful to specify how much money needed to be held in a catastrophic loss reserve, to be used in exceptional circumstances; to prevent conflicts of interest by establishing the mortgage insurance company's independence from banks and other entities; and to prohibit premium rebates to banks - or their brokers - or any other significant involvement by third parties. Finally, mortgage insurance is more effective when the broader legal framework is grounded on stable principles and follows established practices. In particular, ownership rights must be clearly defined and easily enforceable. In addition, bankruptcy and foreclosure processes should be transparent and swift. Mortgage renegotiation should be attempted before triggering the foreclosure process, and in general, the management by banks and financial institutions of borrowers who are in default should be made accountable. Clearly, an Emirates mortgage insurance company would help revitalise both the property market and the construction sector, and give a strong boost to housing finance. It should be high on our agenda for action. Dr Nasser Saidi is chief economist of the Dubai International Financial Centre Authority. The analysis, views and opinions in this article are those of the author and should not be interpreted or construed to represent any official policies or views. UAE banks shun repossessions, b6