MORTGAGE BONDS : BEST USAGE AND BEST PRACTICES

1
MORTGAGE BONDS BEST USAGE AND BEST
PRACTICES

• HOUSING FINANCE IN EMERGING MARKETS POLICY AND
  REGULATORY CHALLENGES
• THE WORLD BANK, MARCH 10 13, 2003
• Olivier Hassler
  The World Bank
• Financial Sector Operations and Policy Department
  

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MORTGAGE BONDS

• DEFINITION AND FUNCTIONS
• THE FOUR COMPONENTS OF A MB SYSTEM
• BEST USAGE / BEST PRACTICES

3
MORTGAGE BONDS DEFINITION

• AN INSTRUMENT DESIGNED
• TO RAISE LONG TERM FUNDS
• WITHOUT ASSETS SALE
• WITHOUT EXTERNAL CREDIT ENHANCEMENT

• CHARATERISTICS
• LIABILITY OF INDIVIDUAL LENDERS (ON
  BALANCE-SHEET)
• WITH A SAFETY NET
• A PLEDGE
• ON PRIME QUALITY MORTAGE LOANS
• THAT INVOLVES SPECIFIC REGULATION AND
  SUPERVISION
• ( QUALITY NORMS FOR DECENTRALIZED ISSUERS AND
  BANKRUPTCY PROTECTION)

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MORTGAGE BOND MARKETS

• EUROPE EURO-ZONE, EASTERN EUROPE, NORDIC
  COUNTRIES
• LATIN AMERICA CHILE, PERU, COLOMBIA
• OLD INSTRUMENT IN A FEW COUNTRIES (CHILE, DK, FR,
  GER..). A RECENT INNOVATION IN MANY MARKETS

• EURO-ZONE 300 Bln (GERMANY 230 Bln )
• OTHER EUROPEAN MKETS 250 Bln (DK 150Bln )
• RELATIVE WEIGHT
• / MORTGAGE LOANS / GDP
• DK 97
  100
• CHILE 72
  12
• GER 19
  12
• (2001 figures . European Mortgage Federation for
  European countries)

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THE BENEFITS OF MBs

• IMPROVE AFFORDABILITY
• BRING SECURITY. HENCE
• - HIGHER RATING (BOND GRADE CAN BE gt ISSUERS
  GRADE 1-3 NOTCHES TYPICALLY)
• - LONGER MATURITY
• FOSTER LIQUIDITY
• SIMPLE, STANDARDIZED INSTRUMENT
• a) b) LOWER COST OF FUNDS
• SPREADS (EUROPE) /- 5-10 BP OVER
  SWAP YIELD CURVE
• PROMOTE LOW INTERMEDIATION COST
• - DK /- 50 BP
• - CHILE 100 150 BP (VS 300
  BP 1988-1993)

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THE BENEFITS OF MBs,continued

• LEVER FOR THE DEVELOPMENT OF A BOND MARKET
• INSTITUTIONAL INVESTORS COMPARTMENT NEEDS
  DIVERSIFICATION OF VEHICLES TO GROW
• ALTERNATIVE TO GOVERNMENT PAPER
• Ex CHILE MBs SHARES IN INSTITUTIONAL
  PORTFOLIOS
• - PENSION FUNDS 16
• - INSURANCE COMPANIES 24
• ASSET-LIABILITY MANAGEMENT TOOL
• DOES NOT REQUIRE SELLING BEST ASSETS, thus
  lowering global performance ratios
• DECENTRALIZED INSTRUMENT (name recognition)
• BUT A CHALLENGE relative rigidity towards
  interest rate strategies

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INVESTORS EXPOSURE
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THE FOUR COMPONENTS OF MB

1. QUALITY OF PLEDGED PORTFOLIOS
2. COLLATERALIZATION MECHANISM
3. PROTECTION AGAINST LENDER/SERVICER S INSOLVENCY
4. FINANCIAL MATCHING

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QUALITY OF THE COLLATERAL

• LENDING CRITERIA
• LIEN FIRST MORTGAGE SOMETIMES PUBLIC GUARANTEE
  (DK, FR)
• PURPOSE RESIDENTIAL COMMERCIAL WITH
  RESTRICTIONS
• LTV TYPICALLY RESIDENTIALlt 80 COMMERCIAL lt
  60
• VALUATION RULE TYPICALLY PERMANENT VALUE
• DEBT-TO-INCOME ONLY CHILE

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QUALITY OF THE COLLATERAL continued

• EXISTING PORTFOLIO
• EXPEDIENT FORECLOSURES
  Mortgage rights efficiency critical
• Specific regime, at least originally
  CHI, POL.
• REPLACEMENT OF LOANS IF FALL OF PROPERTY VALUES
  CHILE
• IF OPEN-ENDED COVER POOL NPL AVERAGING EFFECT
• SPECIFIC SUPERVISION
• TYPICALLY
• BONDS /LOANS REGISTER
• SPECIAL AUDITOR / TRUSTEE (FR ,GER,POL, RUS, SLK)
  OR SUPERVISOR (CZ) for checking the compliance
  of quality standards and cover requirements

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COLLATERALIZATION PRINCIPLES

• COVER PRINCIPLE
• Bonds to be backed at any time by an at
  least equivalent amount of eligible loans in the
  same currency
• Issues - Nominal amount or fair
  value?
• - Overcollateralization
  ?
• INSOLVENCY INSULATION
• The assets cover is excluded from the general
  bankruptcy estate (ringfencing)
• MB holders have a priority claim on the cover
• Bankruptcy does not trigger acceleration of MB
  repayment

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COLLATERALIZATION STRUCTURE

• TWO PRELIMINARY ISSUES
• MB ISSUER SPECIALIZED OR DIVERSIFIED
  INSTITUTION?
• Most frequent case business legally restricted
  to mortgage lending and ancillary activities for
  safety reason (DK, FIN, FR, GER, HUN, POL..).
• Diversified issuer LATIN AMERICA, CZ, LATV ,SLK,
  SP
• THE BONDS Pass-through securities backed by
  segregated pools of loans (CHI, DK),
• or
• fungible debt secured by a whole, dynamic
  portfolio ?

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COLLATERALIZATION STRUCTURE SPECIALIZED PATTERN

• Priority rank of MB holders of little use if no
  other creditors
• Little room for overcollateralization (New DK
  system 4)
• Some lending diversification often allowed, but
  can be dangerous (correlated risks)

• DIVERSIFIED FINANCIAL INSTITUTION

• Trend Mortgage banks specialized subsidiaries
  of diversified groups. A way of ringfencing the
  assets cover
• Issue remoteness from parents bankruptcy
• But otherwise institutional support

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COLLATERALIZATION STRUCTURE PASS - THROUGH
SERIES

• No financial risk for the issuer
• Customer technical constraints
• Investor perfect financial cover, but closed
  pools.
• Strong reliance on the issuers guarantee

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COLLATERALIZATION STRUCTURE DIVERSIFIED
INSTITUTION PATTERN

• Global cover
• Opened pool. Issues against seasoned loans
• Substitute collateral necessary (within limits
  typically 20 of the portfolio)
• Possible present value coverage
• (alternatively) Overcollateralization possible
  (ex. BUL, LAT 10)
• Flexible and secured model

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OPTIONS IN SEEKING INSOLVENCY PROTECTION

• CONTINUATION of PORTFOLIO
• If taking over cash-flows without selling
  best protection of the bonds. Little
  overcollateralization or other enhancement
  devices needed. Prerequisite ability of primary
  market to ensure taking over . Conditions
• Legal/operational
• Back-up servicer/ lender
• LIQUIDATION OF PORTFOLIO
• May occur if no assignment or breach of
  covenants/ requirements. The severity of loss
  will then depend on
• Fair value cover
• Sufficient collateralization (major issue for
  former US MBs)
• Priority claim on non-eligible assets if
  shortfall
• Extent of privilege on cover pool (Before
  taxes, wages ?)

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INTEREST RATE RISK

• The simplicity of MBs and their market can lead
  to maturity and cash-flow mismatches, and the
  impossibility to externalize prepayment risks. A
  significant interest rate risk may stay at the
  lenders level.
• The way of mitigating /managing interest rate
  risk depends on MARKET CHARACTERISTICS
• Primary market Acceptance of
• - Prepayment partial exclusion
• - Prepayment penalties at their economic value
• - Taking over market risk on loan disbursements
  (CHI, DK bond loans)
• Capital market Acceptance of embedded call
  option
• Availability of derivatives
• In the absence of such conditions, MB (fixed
  rate) preferably be part of a funding mix. Other
  components help cushion mismatches and
  uncertainties

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INTEREST RATE RISK, continued

• THREE TYPES OF REGULATORY ANSWERS
• NO PROVISION Global Nominal cover
• No guaranteed matching
• STRICT SYMMETRY loan/loan nominal pass-through
  (CHI, DK)
• Constraints for the borrowers, funding of
  seasoned loans excluded
• GLOBAL ALM REQUIREMENTS RECENT TREND
• An easy solution banning borrower prepayments
  for a certain period GER, POL
• Net present value coverage GER, IRE
• Global limits on financial imbalances DK (new
  cover system)
• Inclusion of swaps in the cover principle FR,
  FIN,GER,IRE

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BEST USAGE / BEST PRACTICES

• MBs VS MBS
• Less legal complexity (incl. tax, accounting,
  prudential rules)
• Different issuing strategy more liquidity, less
  investors customization
• MBs do not require a market for credit risk
• A frequent impediment for actual securitization
  in an emerging market (lack of insurers,
  investors, data)
• MBs credit risk clearly located. Monitoring and
  supervision easier
• A converging trend
• New MB frameworks structured finance patterns,
  close to bankruptcy remoteness,
• On-balance sheet portfolio pass-through possible
  
• COLOMBIA interesting example

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BEST USAGE / BEST PRACTICES

• LOAN PREPAYMENTS ARE THE MAJOR ISSUE TO ADDRESS
• Callable bonds might not be
• Accepted
• Consistent with borrowers near-free options
• Efficient option priced on the capital market
  independently of actual loan prepayment
  rates
• An argument in favor of a flexible institutional
  framework compatible with diversified sources of
  funds

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BEST USAGE / BEST PRACTICES LESSONS FOM SLOW
TAKE-OFFS

• LACK OF CONFIDENCE IN REAL ESTATE LOANS AS
  COLLATERAL
• Strong creditor rights required for all
  mortgage-related securities
• Mortgage registration process can also be a
  concern
• LINKAGE MBs -SPECIALIZED INSTITUTIONS
• May be too strong a constraint in a new market
• Redundant (no other creditors), unless
  specialized arm of a group (a ringfencing method)
• Inducement to rent-seeking
• ?Trend towards a relaxation of business
  restrictions (POL) and the use of
  overcollateralization (LAT)
• FINANCIAL MISMATCHES
• Interest rate risk stays with lender MB
  regulation should include financial balance
  obligations (fair value cover)
• A good opportunity to bring in Asset/Liability
  prudential rules

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BEST USAGE / BEST PRACTICES LESSONS FOM SLOW
TAKE-OFFS

• CAPITAL MARKET ACCEPTANCE
• The label is not universally familiar,
  but the structure may be.
• Capital market rules should reflect the enhanced
  security
• - Investors adjustment of investment guidelines
  ( ex. EU relaxed risks limits art. 22(4)
  of the UCITS Directive)
• - Central Bank eligibility to repos
• - Payment systems eligible collateral
• Tax privileges are tempting incentives, but
• - Distort market
• - Counterproductive in the long run