SECURITISATION: RESIDENTIAL MORTGAGES 9 September 2009 AUHF - PowerPoint PPT Presentation

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) 5 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

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 10 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  