European AVM Alliance (EAA)

At this stage the European AVM Alliance (EAA) does not have any particular reservations regarding the three main categories of conditions specified in Article 1 of the draft regulatory standards on the conditions that competent authorities shall take into account when determining higher risk-weights, in particular the term of “financial stability considerations” under Article 124(4)(b) CRR and the conditions that competent authorities shall take into account when determining higher minimum LGD values, for the setting of higher risk weights ( in paragraph 1) and the setting of higher minimum LGD values (in paragraph 2).

In particular the EAA supports and welcomes the EBA’s recommendation on the main category of condition (i), relating to the assessment of the appropriateness of the risk weights or LGD floors: ‘Competent authorities should frequently and at least annually assess whether the risk weights and minimum LGD values of (retail) exposures secured by mortgages on residential or commercial property are appropriate for the actual risks of these portfolios’ (CP, p.4).

The EAA, though, is concerned that the methodology of this assessment of the appropriateness of the risk weights for the purpose of Article 1(1)(a), or LGD floors for the purpose of Article 1(2)(a), proposed in Article 2 for risk weights (in particular in paragraph 2 (d) and (f)) and in Article 5 for LGD floors (in particular in paragraph 2 (d) and (f)) as it currently stands would not achieve to produce the desired results. For this reason the EAA proposes a number of amendments and clarifications to the proposed methodology (see the EAA responses to Question 2 and Question 6).
1. Conditions for specification of the loss experience and the loss expectations

The EAA has no particular reservations at this stage regarding the general conditions for specification of the loss experience and the loss expectation as set out in Article 2(1) for the purpose of Article 1(1)(a).

2. Proposed adjustments allowed to be made to the loss experience on the basis of the forward-looking immovable property market developments

With regard to the proposed adjustments allowed to be made to the loss experience on the basis of the forward-looking immovable property market developments the EAA proposes two modifications to the six conditions set out in Article 2(2)(a)-(f) on which these adjustments can be based. From the EAA’s point of view the modifications are vital and necessary in order to achieve the required result regarding the assessment of the appropriateness of the risk weights for the purpose of Article 1(1)(a).

2.1. Amendment to Article 2(2)(d)

In its proposed form Article 2(2)(d) states:

(d) the fundamental drivers of demand and supply in the immovable property market, and more in particular, the loan-to-value ratio and the debt service-to-income ratio, evidenced by the relevant data indicators;

The EAA fully agrees that the loan-to-value ratio (LTV) is the best indicator for risk weight in general and for determination of loss expectation in particular. However, it is of fundamental importance that the LTV ratio is not based on the original value of a residential or commercial property at origination, but always on the current value.

Over time LTV ratios evolve, due to loan repayments and primarily due to house price movements. The setting and annual monitoring of risk weights and minimum LGD floors should be based on the current loan to values as they reflect the current ‘risk’ in the housing market. For instance if house prices go down, a borrower is more likely to default as he or she has got less equity in the property (or even negative equity) and loss at default will be greater.

Basing the setting and annual monitoring of risk weights and minimum LGD floors on the original LTV would be a major flaw to the reliability of the LTV valuation as it does not capture any house price rises or falls.

The EAA would therefore suggest the following amendment:

(d) the fundamental drivers of demand and supply in the immovable property market, and more in particular, the loan-to-value ratio, where the value is the current value of a residential or commercial property, and the debt service-to-income ratio, evidenced by the relevant data indicators;

In fact, the entire adjustment process as described in Article 2(2)(a)-(f) should be based on the current value of a residential or commercial property, since it would always yield more accurate results with regard to the risk weight.

2.2. Amendment to Article 208(3) of Regulation (EU) No 575/2013 as referred to on Article 2(2)(f)

In its proposed form Article 2(2)(f) states:

(f) the overall increase of total risk-weighted exposure amounts for exposures secured by immovable properties across institutions that would result from increasing the risk weights for exposures secured by immovable property market has already been achieved by the smaller fully and completely secured parts of these exposures resulting from reductions to the collateral values of immovable property which the institutions have made in order to reflect forward-looking developments in the immovable property market or to meet the requirements on monitoring of property values and of property valuation as referred to in Article 208(3) of Regulation (EU) No 575/2013.

Because of the fundamental importance of LTV ratios regarding higher risk weights, and the fact that this ratio should be based on the current value, regular monitoring of the value of residential and commercial property is necessary.

The EAA thus strongly recommends, that the frequency of the valuation of residential and commercial properties should at the very least be annual. This would also be in line with the EBA’s statement in this CP: ‘Competent authorities should frequently and at least annually assess whether the risk weights and minimum LGD values of (retail) exposures secured by mortgages on residential or commercial property are appropriate for the actual risks of these portfolios’ (CP, p.4).

At the moment, however, there is no requirement for the valuation of residential properties to be monitored annually. Property valuation in Article 2(2)(f) refers to Article 208(3) of Regulation (EU) No 575/2013, which in turn only foresees a valuation of residential property every three years:

Article 208

3. The following requirements on monitoring of property values and on property valuation shall be met:

(a) institutions monitor the value of the property on a frequent basis and at a minimum once every year for commercial immovable property and once every three years for residential property. Institutions carry out more frequent monitoring where the market is subject to significant changes in conditions;

(b) the property valuation is reviewed when information available to institutions indicates that the value of the property may have declined materially relative to general market prices and that review is carried out by a valuer who possesses the necessary qualifications, ability and experience to execute a valuation and who is independent from the credit decision process. For loans exceeding EUR 3 million or 5% of the own funds of an institution, the property valuation shall be reviewed by such valuer at least every three years.

Institutions may use statistical methods to monitor the value of the immovable property and to identify immovable property that needs revaluation.

The EAA therefore suggests amending Article 208(3)(a) in the following way:

(a) institutions monitor the value of the property on a frequent basis and at a minimum once every year for commercial immovable property and for residential property. Institutions carry out more frequent monitoring where the market is subject to significant changes in conditions;

The EAA is aware that this change would not just affect the proposed Article 2(2)(f) of this CP; it would affect the valuation of residential property and the monitoring of residential property as collateral in general. In EAA’s view, however, monitoring of property values and on property valuation needs to be more frequent and more precise than the current regulation sets out in all areas of the CRR and CRD IV, not just with reference to Article 2(2)(f) of this CP.

Under the current regime institutions are required to monitor the value of a residential property only at a minimum of every three years. More frequent monitoring is only expected if the market is subject to significant changes, whereby these significant changes are not further defined.

3. EAA Recommendation on Quality and Method of Valuations

In addition to the frequency of valuations of residential property as collateral the EAA is also concerned about the actual quality and method of these valuations.

Under the current regime no specific methods are prescribed on which the valuation of immovable property should be based. The aim of valuation is to get as precise an idea as possible about the value of collateral at that particular point in time in order to assess the financial risk or assets, including situations in which the competent authorities determine whether the risk weights and minimum LGD values of (retail) exposures secured by mortgages on residential or commercial property are appropriate for the actual risks of these portfolios.

The more accurate and reliable this valuation is the greater is not only the transparency and thus the resilience required by the regulator as set out in the single rulebook in general, but also the certainty for competent authorities when determining higher risk weights, in particular regarding financial stability considerations, and higher minimum LGD values.

Traditionally the vast majority of revaluations of residential properties is carried out by using national indices available in each of the EU 28 jurisdictions such as those provided by the respective national offices of statistics. There are, however, indisputable and demonstrable disadvantages in an index-based revaluation (please see the attached document for further information).

As a result index based valuations at origination or at any point of revaluation of residential properties or entire property portfolios are prone to carry a high degree of uncertainty and bias. Thus the resulting valuations of collateral and thus the results of the required assessment by competent authorities when determining higher risk-weights and higher minimum LGD values may in many cases not give the accurate picture intended by this CP.

In recent years the use of Automated Valuation Models (AVMs) in the valuation process of residential property as collateral has emerged in a number of European countries and has led to accurate, transparent, unbiased and independent valuation process, which in the EAA’s view vastly improves the data quality and the determination of the actual value of collateral, thus leading to a better functioning and efficiency of markets. These AVMs are now increasingly used by banks and other stakeholders within the mortgage and real estate industries, especially for valuing entire property portfolios.

The EAA holds thus that the use of AVMs for the valuation of the collateral of residential properties should be recommended or even made compulsory as an alternative to the current index-based approach. AVMs provide a value estimate for any given property using sophisticated mathematical modelling techniques in an automated and, hence, entirely objective manner. An AVM is a uniquely valuable tool for risk managers who need to accurately monitor and update the market value of residential property portfolios for credit risk mitigation and regulatory compliance, and to provide an indication of value for investors and consumers or to update the market value of the underlying collateral within structured finance products such as RMBS and Covered Bonds.

For further details on the comparison between the results of index-based valuations vis-á-vis AVM valuations, please see the attached document.
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1. Conditions for specification of the exposure weighted average LGD and the LGD expectation

The EAA has no particular reservations at this stage regarding the general conditions for specification of the exposure weighted average LGD and the LGD expectation as set out in Article 5(1) for the purpose of Article 1(2)(a).

2. Proposed adjustments allowed to be made to the average exposure weighted LGD on the basis of the forward-looking immovable property market developments

With regard to the proposed adjustments allowed to be made to the average exposure weighted LGD on the basis of the forward-looking immovable property market developments the EAA proposes two modifications to the six conditions set out in Article 5(2)(a)-(f) on which these adjustments can be based. From the EAA’s point of view the modifications are vital and necessary in order to achieve the required result regarding the assessment of the appropriateness of the minimum LGD values for the purpose of Article 1(2)(a).

2.1. Amendment to Article 5(2)(d)

In its proposed form Article 5(2)(d) states:

(d) the fundamental drivers of demand and supply in the immovable property market, and more in particular, the loan-to-value ratio and the debt service-to-income ratio, evidenced by the relevant data indicators;

The EAA fully agrees that the loan-to-value ratio (LTV) is the best indicator for minimum LDG values in general and for determination of loss expectation in particular. However, it is of fundamental importance that the LTV ratio is not based on the original value of a residential or commercial property at origination, but always on the current value.

Over time LTV ratios evolve, due to loan repayments and primarily due to house price movements. The setting and annual monitoring of risk weights and minimum LGD floors should be based on the current loan to values as they reflect the current ‘risk’ in the housing market. For instance if house prices go down, a borrower is more likely to default as he or she has less equity in the property (or even negative equity) and loss at default will be greater.

Basing setting and annual monitoring of risk weights and minimum LGD floors on the original LTV would be a major flaw to the reliability of the LTV valuation as it does not capture any house price rises or falls.

The EAA would therefore suggest the following amendment:

(d) the fundamental drivers of demand and supply in the immovable property market, and more in particular, the loan-to-value ratio, where the value is the current value of a residential or commercial property, and the debt service-to-income ratio, evidenced by the relevant data indicators;

In fact, the entire adjustment process as described in Article 5(2)(a)-(f) should be based on the current value of a residential or commercial property, since it would always yield more accurate results with regard to the minimum LGC values.

2.2. Amendment to Article 208(3) of Regulation (EU) No 575/2013 as referred to on Article 5(2)(f)

In its proposed form Article 5(2)(f) states:

(f) the increase in capital requirements for exposures secured by immovable properties across institutions that would result from increasing the minimum LGD value for exposures secured by immovable property as referred to in in Article 164(4) of Regulation (EU) No 575/2013 has already been achieved by the reductions to the collateral values of immovable property which the institutions have made in order to reflect forward-looking developments in the immovable property market or to meet the requirements on monitoring of property values and of property valuation as referred to in Article 208(3) of Regulation (EU) No 575/2013.

Because of the fundamental importance of LTV ratios regarding higher minimum LGD values, and the fact that this ratio should be based on the current value, regular monitoring of the value of residential and commercial property is necessary.

The EAA thus strongly recommends, that the frequency of the valuation of residential and commercial properties should at the very least be annual. This would also be in line with the EBA’s statement in this CP: ‘Competent authorities should frequently and at least annually assess whether the risk weights and minimum LGD values of (retail) exposures secured by mortgages on residential or commercial property are appropriate for the actual risks of these portfolios’ (CP, p.4).

At the moment, however, there is no requirement for the valuation of residential properties to be monitored annually. Property valuation in Article 5(2)(f) refers to Article 208(3) of Regulation (EU) No 575/2013, which in turn only foresees a valuation of residential property every three years:

Article 208

3. The following requirements on monitoring of property values and on property valuation shall be met:

(a) institutions monitor the value of the property on a frequent basis and at a minimum once every year for commercial immovable property and once every three years for residential property. Institutions carry out more frequent monitoring where the market is subject to significant changes in conditions;

(b) the property valuation is reviewed when information available to institutions indicates that the value of the property may have declined materially relative to general market prices and that review is carried out by a valuer who possesses the necessary qualifications, ability and experience to execute a valuation and who is independent from the credit decision process. For loans exceeding EUR 3 million or 5% of the own funds of an institution, the property valuation shall be reviewed by such valuer at least every three years.

Institutions may use statistical methods to monitor the value of the immovable property and to identify immovable property that needs revaluation.

The EAA therefore suggests amending Article 208(3)(a) in the following way:

(a) institutions monitor the value of the property on a frequent basis and at a minimum once every year for commercial immovable property and for residential property. Institutions carry out more frequent monitoring where the market is subject to significant changes in conditions;

The EAA is aware that this change would not just affect the proposed Article 5(2)(f) of this CP; it would affect the valuation of residential property and the monitoring of residential property as collateral in general. In EAA’s view, however, monitoring of property values and on property valuation needs to be more frequent and more precise than the current regulation sets out in all areas of the CRR and CRD IV, not just with reference to Article 5(2)(f) of this CP.

Under the current regime institutions are required to monitor the value of a residential property only at a minimum of every three years. More frequent monitoring is only expected if the market is subject to significant changes, whereby these significant changes are not further defined.

As far as the quality and method of valuations are concerned the EAA refers to section ‘3. EAA Recommendation on Quality and Method of Valuations’ as part of the EAA response to Question 2 of this consultation as well as to the document attached to the EAA response, comparing AVM-based and index-based valuations.
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Arjen Wink
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