Capital Market Funding in Emerging Economies

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Capital Market Funding in Emerging Economies

• Conference
• Housing Finance in Emerging Markets Policy and
  Regulatory Challenges
• The World Bank, Washington D.C.
• 11 March, 2003
• Presented by
• Dr. Michael Lea
• President of Countrywide International Consulting
  Services
• Material developed in conjunction with Dr. Jack
  Guttentag, Wharton International Housing Finance
  Program

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Outline of Presentation

• Why Is Capital Market Funding Important?
• How Can Lenders Access the Capital Markets?
• Instruments
• Institutions
• What Are the Prerequisites for Accessing the
  Capital Markets?
• What Role Can Government Play in Developing
  Capital Market Funding?
• What Has Been the Experience in Emerging Markets?
• What Is the Outlook for the Future?

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Rationales
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Improving the Affordability of and Accessibility
to Funds

• Tapping new funds particularly institutional
  investors (pension, insurance funds) with long
  term liabilities
• Increasing the liquidity of mortgages (reducing
  risk for originators and reduce risk premia)
• Increasing competition in primary markets (reduce
  spreads)
• Increasing efficiency in the housing finance
  system (reduce spreads)
• Lengthening the maturity of loans (improve
  affordability)

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Improving the Allocation of Risk and Developing
Deeper Capital Markets

• Improving Allocation of Risk
• Investors with long liabilities can better manage
  liquidity risk
• Institutional investors are better able to manage
  interest rate risk (can facilitate offering fixed
  rate mortgages)
• Potential diversification of credit risk (reduce
  spreads)
• General Capital Market Development
• Mortgages a good asset class for securitization,
  bonds
• Gives investors more choice of assets
• Expands monetary policy options for central banks

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Instruments Institutions
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Whole Loan Sales

• Can Be the Easiest Way to Start, Particularly in
  Small Markets
• Rationale balance sheet mgt., ALM, geographic
  diversification
• Broker Markets
• Brokers bring together buyers and sellers of
  loans (typically both mortgage lenders for
  seasoned loans) investment bankers may act as
  brokers
• Relationship Markets
• Participations among depositories
• New loan sales by mortgage companies
• Wholesaler markets
• Wholesalers buy loans from correspondents

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High Due Diligence Costs Reduce the Likelihood of
Whole Loan Sales

• Cost of Information to Buyer is High
• Each transaction is different
• Documentation may vary lender by lender
• Underwriting standards also vary by lender
• Instrument itself may be complex
• Loan amount is small, so costs are high per
  dollar of loan
• Information Asymmetry Potential Buyer Knows Less
  Than Seller
• Can sell on recourse or participation basis
• Mortgage insurance can reduce due diligence costs
  
• Loss Insurance the Insurer Reimburses the
  Lender in the Event of Default
• Cash Flow Insurance Insurer Guarantees Timely
  Receipt of the Mortgage Payment

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Mortgage Bonds General Characteristics

• Issued Against Mortgage Collateral Pool
• Long term funding source
• Investors Have Priority Claim on Collateral
• Bond is Liability of Issuer
• Typically specialized mortgage bank
• Heavily regulated
• Cannot issue deposits monopoly on mortgage
  bond issuance
• Provide residential and commercial real estate
  loans
• Universal banks may also issue
• Long term funding funding diversification
• Credit enhancement from issuers balance sheet
• Bonds May Be Over-collateralized

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Mortgage Bonds Pfandbrief Model

• Mortgage Bank Issuer Has One Permanent Collateral
  Pool
• New Loans Are Funded by New Bond Issues
• The loan becomes part of the collateral pool
• As loans are repaid and defaulted, the pool
  shrinks
• Duration of Bond Almost Matches That of Loan
• Loans have fixed-rate period of 1-10 years
• Matching bond is interest-only for same period
• Borrowers can prepay at end of period, or pay a
  yield maintenance penalty
• Loans amortize, bonds do not
• Major Funding Source in Germany Introduced
  Throughout Europe and CEE Markets
• Rigid Structure Issuance limited to mortgage
  banks
• Variants to model in Spain (universal bank
  issuers) and France (virtual issuers)
• Introduced in a number of CEE Markets
• Main success in Czech Republic Interest on
  bonds tax exempt

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Mortgage Bonds Danish Model

• Multiple Pools Per Lender, Each Pool Contains
  Loans Made Over 2-3 Year Period
• Mortgage Bank Sells Bonds on Behalf of Individual
  Borrowers in Amounts Equal to Loans
• Investors Buy Shares of Large Pools
• Bonds Are Pass-throughs That Amortize
• Principal and prepayments passed through to bond
  holders
• No overcollateralization necessary
• Borrowers Can Prepay Loans at Par or Buy-Back
  Bonds and Return to Lender
• Very Successful Historically Benefited from
  somewhat of a captive investor base until
  recently
• Similar model exists in Chile Banks as issuers

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Mortgage Pass-through Securities

• Issued Against Mortgage Collateral Pool
• Involves Cash Flow Matching
• Balance of Pass-Through Balance of mortgages in
  pool
• Repayments of principal passed through to
  investor
• Preset Delay in Monthly Payment
• Rate on Pass-Through - Rate on Mortgage
  Servicing Fee Guarantee Fee
• Usually Not a Liability of the Issuer
• Sale of assets for balance sheet mgt.
• Shifts cash flow risk to investor
• Requires credit enhancement

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Credit Enhancement

• Mortgage Securities That Are Not Liabilities of
  the Issuer Require Credit Enhancement
• Credit Enhancement Offers Cash Flow Insurance to
  Investor Provided By
• Guarantee of highly-rated third party
• Bond insurers, government (e.g., Ginnie Mae)
• Pool insurance from high-rated insurer
• Senior-subordinate security structure
• Reserve fund/spread account

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Structured Finance

• Multiple Securities Issued Against a Single Pool
  of Passthroughs or Loans
• Purposes
• Avoid monthly pmts and highly variable life
• Derivatives have quarterly or semi-annual pmts
• Meet diverse cash flow needs of investors
• Short vs. long expected duration
• Floating vs. fixed rate
• Protection against increases or decreases in
  rates
• Examples
• CMOs A number of separate securities repaying
  principal sequentially. Pre-determined collateral
  pool, all securities issued at the outset
• Master Trusts Dynamic collateral pool,
  securities issued over time

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Institutions to Facilitate Mortgage Capital
Market Development

• Conduits
• Purchase loans from multiple lenders pool and
  issue securities
• Rationales Reduce information costs and
  asymmetries for investors develop
  standardization and economies of scale in
  securities issuance diversification
• Liquidity Facilities
• Issue bonds finance lenders
• Rationales Liquefy mortgages develop
  standardization and economies of scale in
  securities issuance
• Insurers
• Provide loan loss and/or cash flow insurance
• Reduce information costs and asymmetries for
  investors provide diversification benefits

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Prerequisites
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Infrastructure Prerequisites

• Primary Market Infrastructure
• Mortgages offer attractive risk-adjusted yields
• Some standardization of documents and
  underwriting practices
• High quality servicing and collection
• Professional standards of property appraisal
• Legal and Regulatory Infrastructure (can be
  developed simultaneously)
• Legal, tax and accounting framework for
  securitization and bond issuance
• Facilities for lien registration
• Ability to enforce liens
• Ability to transfer (assign) security interest
• Protection of investors against bankruptcy of
  originator or servicer

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Lender Prerequisites

• Market Demand for Capital Market Funding
• Do lenders need capital relief?
• Low risk weight of residential mortgages reduces
  need for off-balance sheet finance
• Do lenders need liquidity?
• Liquid depositories may view capital market
  finance as too expensive
• What are lender risk management needs?
• Interest rate risk of ARMs often minimal
• Main successes in developed markets have been in
  countries where consumers demand medium/long term
  FRMs
• Liquidity risk can be managed at portfolio level
  until mortgages become a significant portion of
  assets

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Investor Prerequisites

• Investor Demand for Securities
• Presence of long term investors
• Not crowded out by government
• Sufficient information to price and manage risk
• Appropriate regulatory treatment
• Strong regulation enhances credibility of
  securities, issuers
• But inappropriate regulation can stifle market
  development
• Credible credit enhancement
• To offset high costs of due diligence
• Benchmark for pricing
• Particularly for longer term securities
• Mortgage securities can create long end of
  yield curve
• Market-maker
• Liquidity for investors

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Role of Government
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Role of Government Theoretical Considerations

• Facilitator
• Remove onerous laws, taxes regulations
• Provide legal framework for title registrations,
  title transfers, lien enforcement, uniform docs
• Encouraging competition getting banks to lend
  and reducing need for housing bank
• Stabilizer
• Maintain economic stability (low inflation and
  volatility)
• Provide Liquidity Deposit insurance, central
  bank
• Remove political risk
• Reduce systemic risk by encouraging re-allocation
  of risks outside banking system
• Address Market Imperfections
• High transaction cost of due diligence for
  investors
• Information asymmetries
• Institutional segmentation
• Geographic segmentation
• But Not Distributional
• Affordability issues can be better addressed
  through mortgage design and direct borrower
  income or downpayment support.

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Possible Functions for Government

• Regulator Lenders, insurers, security issuers
• Mortgage (Loss) Insurer
• Can liberalize loan terms for low-income
  borrowers
• Reduce information costs for investors
• Provide diversification benefits
• Can burden taxpayers politically may be
  difficult to price for risk, raise premiums or
  maintain reasonable underwriting guidelines
• Cash Flow Insurer (Guarantor) of Private Security
  Issuers
• Can create highly efficient secondary market
  (e.g., GNMA in US)
• Guarantee reduces information costs for investors
  (about collateral and issuers) can offset
  potential weaknesses in legal system (e.g., long
  time to foreclose)
• High agency costs vulnerable to fraud
• Need strong incentives for issuers to perform (in
  US large servicing fee), ability to transfer
  servicing, good information for guarantor

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Functions for Government (contd)

• Conduit/Cash Flow Insurer
• Can create highly efficient secondary market
• Reduces information costs for investors
• Creates economies of scale in securities issuance
• Provides diversification for security investors
• May also create economic behemoth
• Reinsurer (catastrophic and/or political risk)
• Provides incentive for government to provide
  conducive macro-economic and legal environment
• Provides incentive to private insurers to cover
  default loss with government protecting against
  uninsurable risks
• Difficult to draw line between insurable and
  uninsurable risks
• Liquidity Facility
• Liquefies mortgages Provides economies of scale
  in securities issuance
• Smaller efficiency benefits than conduits
  (doesnt facilitate off-balance sheet finance,
  finance new entrants)
• Less legal and institutional infrastructure
  required

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Experience in Emerging Markets
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What Has Been Tried?
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Are There Successes?

• What Constitutes Success?
• Sustainable volume of activity significant
  portion of housing loans funded through
  instrument/institution
• Ability to create products that meet the needs of
  private sector lenders and investors
• Where Are the Successes?
• Chile Mortgage bond introduction benefited from
  strong legal system, sound macro-economy and
  coincident privatization of pensions
• Malaysia Government created incentives for
  borrowers and investors used as instrument of
  policy and functioned effectively in crisis
• Trinidad Same starting conditions as Malaysia
  has transitioned from liquidity facility to
  conduit
• Argentina Successful tapping of international
  markets using structured finance. Recent
  downgrades demonstrate the difficulties
  associated with hard currency lending and finance

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Why So Limited Success?

• There Has Not Been a Perceived Need for or
  Acceptance by Lenders
• Capital ratios have been improving in most
  countries
• With global slowdown, most depositories liquid
  and not in need of significant new sources of
  funds
• In most markets, deposit funding significantly
  cheaper than capital market funding
• If main mortgage instrument an ARM, can match
  fund with deposits
• If spike in demand, capital markets cheaper than
  repricing deposits
• In many emerging markets, it is still difficult
  to lay off cash flow risk
• Reluctance of investors to buy longer term debt
• Lack of systems, capabilities to manage
  amortization, prepayment
• Infrastructure Problems Can Be Difficult to Solve
• Concept of trust or SPV unknown in many countries
• Inefficient or costly title and lien registration
  discourage use
• Taxes may make securitization uneconomic

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Lessons Learned Role of Government

• Government Involvement Not a Guarantee of Success
• There must be an underlying demand for products
• Facilitating Role Still the Strongest Rationale
• Must remove obstacles, strengthen
  legal/regulatory system
• Is There Too Much of an Institutional Focus?
• Would regulatory incentives or partial guarantees
  accomplish the objectives in an easier to
  implement/control manner?
• Are We Putting the Cart Before the Horse?
• Can capital market funding reasonably take place
  in markets with weak legal, primary mortgage
  market infrastructure?

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Moving Forward

• As Economies Improve and Demand for Funds Picks
  Up, Banks Will Become More Capital/Liquidity
  Constrained and Look to the Capital Markets for
  Funding
• gt Continue building capital market
  infrastructure
• ARMs Transfer Most if Not All Interest Rate Risk
  to Borrowers
• Introduction of FRMs important for financial
  system stability
• FRMs need to be funded in the capital markets
• gt Efforts to create mortgage capital markets
  should include a product development component
  focusing on FRMs
• Development Efforts in Many Countries Has Focused
  on Institution Development, Particularly Conduits
  With Government Involvement
• gt Weak results to date suggest that more
  emphasis could be given to instrument development
  (both bonds and MBS), use of mortgage insurance
  and guarantees to facilitate investor acceptance

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Upcoming publicationMortgage Securities in
Emerging MarketsPublished by The World Bank