SECURITISATION: RESIDENTIAL MORTGAGES 9 September 2009 AUHF
BACKGROUND INFORMATION 2 World wealth $44 trillion of which: 50% property (residential, agricultural, C&I) 30% residential properties Bonds 27% Equities 19% Cash 3% Fundamental premise: Widespread property ownership is a desirable goal of every society Thomas Jefferson: The small landowners are the most precious part of a state (1785) This is achieved by an effective and economically efficient link between residential mortgages and the long term financial markets Widespread home ownership cannot be achieved without a robust financial system Fundamentally there are two Archetypes of long term financial markets: Banks and bonds: Banks originate loans, hold them on their books and fund them through: Issuing long term deposits or bonds (attract funds through over collateralization e.g 125%) General liabilities of a bank Government support can be in the form of a guarantee on the bonds e.g. liquidity facility
BACKGROUND INFORMATION (CONTINUED) 3 SPVs and Securitisation Bank sets up a SPV and sells loans into this (off balance sheet) Bank sets up senior/subordinated structure (bank part), with bond market buying the senior part Government support could guarantee a portion of the senior part, thus capping bond holder losses. Similarities in both structures: Government at back of queue and its role protects against systemic risk or promotes the credibility of the SPV Added advantage of securitization is that it guarantees the investors access to the mortgages where on balance sheet collateralization might not Institution that originates and manages the loans takes on the initial credit risk and passes on the interest rate risk to bond market investors No need to guarantee individual loans Risk controlled by capital and stress tests Which structure to choose: Depends on regulatory and tax issues. Banks and bonds favored in emerging economies as it is less likely to require new laws, banks are best at managing credit risk and so can manage the principle/agent problem better (past 20 years has seen the unbundling of the 4 major aspects of mortgage lending: origination, servicing, funding and credit risk but this has created principle/agent problems)
BACKGROUND INFORMATION (CONTINUED) 4 Outcomes Improved efficiencies Require strong legal and regulatory framework as secondary market exposed to risks which the primary market doesn t have Secondary market merely a vehicle for allocating capital Depository based systems can do the same thing as secondary markets do (connect mortgage borrowers with people with money) without having to sell mortgages, but require stable interest rates Guarantees can cause moral hazard (excessive risk taking, leading to poor capital allocation and taxpayer bailouts) First best economic solution Proper legal system if you want people to have good housing, you have to be able to take it away from them Property rights Good disclosure Good information Competitive markets Second best economic solution Asymmetric information Poor disclosure Poor foreclosure laws (justification for Government providing support guarantees, long term funding support)
BACHGROUND INFORMATION (CONTINUED) Secondary market funding Securitisation (package into pools), Debt or combination thereof Standardisation promotes Government agencies e.g. Fannie Mae Pass through security payment from pool to investors (Ginnie Mae) Market evolved to include private market pools, derivative securities (CMOs with up to 50 payment tranches, with a pool of 30 year callable securities being broken up into short, medium, long term bonds), futures, hedges against interest/prepayment risk, mortgage insurers etc Unbundling takes advantage of scale economics, division of labor, promotes competition between suppliers of the various bundles BUT it comes at a cost: Each player that focus on one part of the bundle is dependent upon the other players performing their role Principal/agent problems Transparency/moral hazard Understanding of risk by investors (removed/complex)? Important Lessons It is the function rather than institutional mechanism of connecting mortgage and capital markets that is important (several models available) The front end creates a good mortgage market (proper registration, foreclosure and eviction procedures ) as opposed the back end - doing deals/getting mortgages off balance sheet etc Controlling soundness and safety requires serious consideration of risk based capital (stress based tests, regular audits, risk based standards etc) Don t take interest rate risk Conflict between GSEs and demands for social housing Diversification and insurance LTVs and area/borrower demographics 5
SHAPING THE FUTURE 6 Opening up securitization again/shaping the Future Regulation (Basel 2, consumer protection and information disclosure) Technology (distribution channels) Principal/agent and moral hazard Simplicity Investor liquidity Housing as an wealth creator (long term investor confidence) Economic recovery? Consumer demand US, China vulnerability Our next engine of growth? US to move its focus from stealing their future generations money to getting the market to open up again US Fed to convince investors to move away from MBSs? Recent SA experiences In ICU (mortgages no longer sexy quality, capital intensive, margins, property illiquid asset) Investor liquidity an issue SA Home Loans Standard bank Absa By its very nature property is a bubble commodity it has and will continue to boom and bust. The trick is to get the cycles right.
SHAPING THE FUTURE (CONTINUED) 7 Limited direct effects Insignificant exposure to sub-prime Limited use of structured finance Markets remain prime (smaller, more conservative) Intensified indirect effects Slow down in growth (affects demand) Return of inflation Liquidity squeeze and market distrust (increase cost of funds) Credit contraction Additional credit risks (variable/adjustable rate loans) Higher energy/food costs Bank decapititalization Foreign banks withdraw/downsize from Africa Depressed capital markets Africa perceived as potential sub prime market by investors
HOUSING FINANCE IN AFRICA (CONTINUED) 8 Steady demand (urbanization) Access to finance remains a policy priority Continuance of undeveloped mortgage markets Easy expansion over for many countries Vulnerable countries: liquidity, high LTV variable loans, weak lending standards etc Liquidity crisis: securitization, roll-over refinancing Cost of funds to increase Diversity tools: covered bonds, liquidity facilities Non-bank lenders require secure access to bond markets State support: liquidity, systemic risk, sunset clauses
CHALLENGES FOR AFRICA 9 Improve land and housing policy (supply constraints) Build market infrastructure (title, foreclosure, appraisal etc) Smart subsidies (not linked to bailout packages) Support for rental market (not just ownership) Improve ways to finance low/informal income households (risk sharing tools, housing microfinance, savings schemes etc) Diversify domestic funding models Tighter securitization framework (lenders first loss, simplistic/transparent models, legal/regulatory framework) Lethargic markets (how to deepen penetration and sound lending) Risk based pricing, capital retention in property cycles Improve borrower education Information (data) improvement Limit/identify property bubbles
Alternative Model Investors Want to commit capital to long term uses Fixed return Diversified portfolios Safety which mortgages offer Borrowers Certainty which fixed rates offer Availability of full amortisation tarm Various refinancing options Financial Institutions Balance risk/profit Whilst deposit base can fund a substantive portion of mortgage assets, there is a need for this to be supplemented by access to the bond market: Liquidity backup and funding alternatives Long term fixed rate liabilities often not available in deposit markets Ability to hedge the options embedded in mortgage contracts Home Loan Bank Model/Mortgage Liquidity facilities (premise: assets of high quality) Home Loan Bank pools the mortgage loan portfolios of numerous banks Provides large scale financing to banks Issues simple, classical debentures with short to long term maturities at favorable interest rates (AAA/Aaa) Banks get attractive rates Mortgages are pledged as collateral with wide collateral margins May contain prepayment options Promotes greater competition 10
ALTERNATIVE MODEL (CONTINUED) Promotes product standardization/transparency Lenders adhere to best practice Increases market information systems which in turn promotes better risk management Deepens the financial market Can be effectively used to promote delivery of policy objectives e.g. affordable housing Must adhere to market based pricing (market distortion issue) Don t need critical mass and can issue debentures anytime (NB: It must stay away from regulation and politics and focus on banking) Creating a model Step 1: Create primary market mortgages Step 2: Bond market (the base market of traded securities) Step 3: Link private credit institutions to the bond market through the Home Loan Bank organization model Becomes more sophisticated over time as market develops and can co-exist with other market instruments could even be viewed as an in-between leading up to a full secondary market Successful models Cagamas (Malaysia), France, Jordan, Algeria,West Africa? Preconditions Effective mortgage legislation, including repossession upon default Fixed income market Credit bureau Efficient mortgage/land registration systems Efficient judiciary Appraisers Functional securities market 11