Reverse Mortgage Programme

Our Ref :B1/15C
17 June 2011
The Chief Executive
All Authorized Institutions
Dear Sir/Madam,
Reverse Mortgage Programme
In the light of the coming launch of the Reverse Mortgage Programme (RMP) by the Hong Kong Mortgage Corporation Limited (HKMC), I am writing to set out the relevant supervisory treatments for the reverse mortgage loans under the programme (RMP loans). Underwriting standards The HKMA considers that the existing prudential guidelines on loan-to-value ratio (LTV) and debt servicing ratio (DSR) are not applicable to RMP loans, given that the repayment for these loans is basically based on the realisation of the underlying mortgaged residential property rather than on the income sources of borrowers, and that any shortfall in realising the mortgaged property would be safeguarded by the insurance protection of the HKMC. While the requirements in relation to LTV and DSR are not directly relevant, authorized institutions (AIs) should still exercise due diligence in underwriting RMP loans with a view to ensuring that the associated risks, such as legal risk, operational risk and reputational risk, are adequately addressed. In particular, an AI participating in the RMP should put in place proper control procedures to ensuring the validity of its legal title to the underlying residential property and effective repossession of the property when a maturity event arises. Contribution of mortgage data to credit reference agency In the light of the unique features of the RMP loans and the HKMC’s insurance protection to safeguard the relevant risks, AIs are not required to contribute the mortgage data of RMP loans to the credit reference agency for the time being. Capital adequacy RMP loans would fall within the definition of “residential mortgage loan” under
section 2(1) of the Banking (Capital) Rules (BCR). AIs that are using the

Standardized (credit risk) approach (STC approach) or the Basic approach (BSC approach) to calculate the credit risk for non-securitization exposures should use their respective approach to calculate the credit risk for RMP loans. AIs may regard the HKMC’s insurance protection as recognized guarantee. The IRB approach is not considered an appropriate approach for capturing the capital charge for RMP loans because the concept of default of obligor is not applicable. As such, AIs using the IRB approach should seek the Monetary Authority (MA)’s exemption approval under section 12(1) of the BCR and apply the STC approach for RMP loans. Detailed guidance relating to the above and other relevant issues, such as loan classification and accounting and impairment treatment, can be found in Annex 1 of this letter. Statutory return and survey reporting AIs are required to report their positions in respect of their RMP loans in the various statutory returns. The relevant reporting arrangements are elaborated in Annex 2. In addition, AIs participating in the HKMA’s monthly RML survey will be requested to provide additional information pertaining to RMP loans in the survey. The HKMA will advise these AIs separately on the reporting arrangements in due course. If your institution has any questions about this letter, please feel free to contact Mr Eric Kan at 2878-1096 or Mr David Yip at 2878-1588.

Yours faithfully,
Arthur Yuen
Deputy Chief Executive
Encl.

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Annex 1
Detailed Guidance relating to Reverse Mortgage Programme Underwriting Standards

1. Evaluation of borrower’s indebtedness and validation of charged
   property’s legal title and effectiveness of repossession arrangements The existing prudential guidelines on LTV and DSR are not applicable to RMP loans. However, AIs should still exercise due diligence in underwriting RMP loans with a view to ensuring that the associated risks, such as legal risk, operational risk and reputational risk, are adequately managed. In particular, an AI participating in the RMP should put in place proper control procedures to ensuring the validity of its legal title to the underlying residential property and effective repossession of the property when a maturity event arises (e.g. when the last surviving borrower of an RMP loan has passed away). In this regard, AIs should ascertain whether there is any other charge on the underlying residential property for any loan facility when assessing the application and, if so, the implication for their eventual repossession of the property.
2. Use of monthly payouts under RMP loans as regular income sources for
   repaying another conventional residential mortgage loan (RML) The HKMA has no objection for AIs to taking into account the monthly payouts received by a borrower under an RMP loan in assessing the borrower’s ability to repay another conventional RML. In this case, however, AIs are expected to adhere to the existing prudential guidelines on LTV, DSR and net worth-based lending and adopt at least the same internal prudent standards (e.g. maximum loan tenor plus borrower’s age) in underwriting the conventional RML. Capital Adequacy
3. Treatment of RMP loans under the Standardized and Basic approaches
   For capital adequacy ratio calculation purposes, RMP loans granted by AIs fall within the definition of “residential mortgage loan” under section 2(1) of the BCR. AIs that are using the STC approach or the Basic approach to calculate the credit risk for non-securitization exposures should use their respective

approach to calculate the credit risk for RMP loans.
AIs may regard exposures to RMP loans (both on- and off-balance sheet), as fully covered by the insurance provided by the HKMC under the Master Reverse Mortgage Insurance Policy (the “Policy”) of the RMP (HKMC insurance) and treat the insurance protection as recognized guarantee for capital adequacy purposes, provided that the AIs have not breached any of their obligations under the Policy.
4. IRB approach not appropriate for RMP loans
The IRB approach is considered not an appropriate approach for capturing the inherent risks and calculating the credit risk capital charge for RMP loans. This is because the concept of default of obligor, which is central to the IRB approach, is not applicable to these loans. The existence of the HKMC insurance further protects AIs from credit losses in the event that the sales proceeds from the underlying mortgaged residential property are not sufficient to cover the amounts owed to the AIs under the loans. As such, AIs using the IRB approach for credit risk are expected to adopt the STC approach for credit risk in respect of their exposures to RMP loans. These AIs should seek the MA’s approval under section 12(1) of the BCR for exempting their RMP loans from using the IRB approach, and for applying the STC approach for credit risk, to calculate the capital requirements. Loan Classification
5. Assessment of repayment ability and collectability of the principal and
interest remain relevant for loan classification purposes In general, the principle that classification of loans should be largely judgemental based on the assessment of the borrower’s capacity to repay and the degree of doubt about the collectability of the principal and interest of a loan remain relevant for RMP loans. For RMP loans against which the HKMC insurance is in force, the AI relies on the collateral value of the underlying residential property as the primary source of repayment and on the HKMC as the ultimate source of repayment. AIs could assess the collectability of the principal and interest of a fully covered RMP loan by taking into account the financial strength and repayment ability of the HKMC as if it were the borrower of the loan, in addition to assessing the net realisable value of the underlying mortgaged residential property.

Where the HKMC insurance is no longer enforceable (e.g. due to the Exclusions provisions of the Policy), in whole or in part, in respect of the amounts owed to the AI, the AI should apply the HKMA’s loan classification guidelines in respect of the uncovered portion of the RMP loans as asset-based lending, with particular focus on the collectability of the principal and/or interest of the loan and the estimated net realisable value of the underlying mortgaged residential property. Accounting and impairment treatment
6. Measure RMP loans at amortised cost less any impairment loss and
determine impairment allowance according to applicable accounting standards for financial reporting purposes Consistent with applicable accounting standards, AIs may measure RMP loans at amortised cost (less impairment loss) and classify them as “Residential Mortgage Loans” or “Other Loans” under “Loans and Receivables” for financial reporting purposes. In addition, any undrawn credit commitment under these loans is expected to be disclosed as contingent liability in accordance with the applicable accounting standards. AIs and their external auditors should take into account the HKMC’s credit profile and financial strength for determination of any impairment allowance for RMP loans.

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Annex 2
Return Reporting relating to Reverse Mortgage Programme Item HKMA Return Elaboration on the Reporting Arrangement 1 MA(BS)1 – Return of Assets and Liabilities of an Authorized Institution The outstanding balance of RMP loan should be reported under item 15.3 “Other loans for use in Hong Kong” and item 15.7 “Total loans and advances to customer” according to its residual maturity in accordance with the Completion Instructions. Given that the residual maturity for a lifetime RMP loan is uncertain and would usually be more than 1 year, AI should report the outstanding balance of such loan under item 15.7(f) “Later than 1 year” unless the loan is to be early repaid. In such case, the residual maturity of the loan would be the time until the repayment date. 2 MA(BS)1D – Large Exposures Both the outstanding balance and undrawn commitment of a RMP loan should be reported as “direct exposure” to the borrower as well as an “indirect exposure” to the HKMC. The aggregate amount of the outstanding balance and undrawn commitment of all RMP loans granted by an AI should be included as an “indirect exposure” to the HKMC. 3 MS(BS)1E – Liquidity Ratio A RMP loan commitment with a known date of drawdown within 1 month, or any expenses payable for a RMP loan customer within 1 month, should be reported as “qualifying liabilities”. A RMP loan (including principal and accrued interest and expenses), which falls due within 1 month and meets the definition of “eligible loan repayment” and the associated eligibility criteria in the Fourth Schedule to the Banking Ordinance, can be regarded as “liquefiable assets”.

Item HKMA Return Elaboration on the Reporting Arrangement 4 MA(BS)1G – Maturity Profile Return RMP loan commitments with known dates of drawdown should be reported in item 6(a) “Firm commitments” in the relevant time bands according to the expected drawdown dates. Other payments arising from the RMP should be reported under item 4 “Other liabilities” if they have been accrued, or in item 6(c) “Other payables” if they have not been accrued, in the relevant time bands according to the expected payment dates. RMP loan repayments (including principal and accrued interest and expenses) should be reported under item 11(b) “Other loans and advances to customers” in the relevant time bands according to the expected repayment dates. Receivables from RMP loan customers not included in the loan accounts can be reported under item 12 “Other assets” if they have been accrued, or in item 14(b) “Other receivables” if they have not been accrued, in the relevant time bands according to the expected receipt dates. 5 MA(BS)2A – Quarterly Analysis of Loans and Advances and Provisions The outstanding balance of RMP loans should be reported under item H5(e) “Professional & private individuals for other private purpose”. 6 MA(BS)3 – Capital Adequacy Ratio of an Authorized Institution Incorporated in Hong Kong The outstanding balance and undrawn commitment of RMP loans should be reported as follows:
STC approach

Item HKMA Return Elaboration on the Reporting Arrangement z (On-balance sheet exposures under Part IIIb Division A) the outstanding loan balance should be reported in Class X Residential Mortgage Loans. The outstanding loan balance after CRM should be reported in Class II 4 Domestic PSEs in the row for the risk-weight applicable to the HKMC (currently 20%). z (Off-balance sheet exposures under Part IIIb Division B) the undrawn commitment should be reported under item 9c “Other commitments (CCF at 50%)”. BSC approach z (On-balance sheet exposures under Part IIIa Division A) the outstanding loan balance should be reported in Class II 13 “Exposures to PSEs of Tier 1 countries”. z (Off-balance sheet exposures under Part IIIa Division B) the undrawn commitment should be reported under item 9c “Other commitments (CCF at 50%)”. 7 MA(BS)12 – Interest Rate Risk Exposures (IRR) On-balance sheet exposures :
Since RMP loans are priced at prime, AIs should report the outstanding loan balance of a RMP loan under item 4, managed rate assets, of the IRR Return in accordance with paragraph 21 of the Completion Instructions. Off-balance sheet exposures:
An AI is obliged under the RMP to pay to the borrower a specified sum on a specified date every month over an agreed period of time. These obligations of the AI (i.e. undrawn

Item HKMA Return Elaboration on the Reporting Arrangement commitments) can therefore be regarded as a series of forward loans committed by the AI in favour of the borrower, and reported as off-balance sheet positions under item 15 of the IRR Return in accordance with paragraph 38 of the Completion Instructions. More specifically, (a) the individual monthly payouts should be reported as short positions, slotted into the appropriate time bands in which the AI makes the monthly payouts; and (b) the aggregate repayable amount of such “forward loans” should be reported as one long position, and slotted into the time band in which the reverse mortgage is due and repayable, with the residual maturity of the RMP loan adjusted for the occurrence of a Suspension Event, Maturity Event or Early Termination as set out in the documentation of the RMP, where applicable. Embedded option Under the RMP documentation, a RMP loan is subject to Early Termination, which includes the borrower’s right to early redeem the loan in full at any time during the term of the loan. AIs should refer to paragraph 14 of the Completion Instructions for the treatment of embedded options arising from Early Termination as provided for in the RMP documentation.