International Conference on Affordable Housing & Mortgage Financing 28 – 29 May 2015 Organised by Infrastructure, Housing & SME Finance Department, State Bank of Pakistan, Karachi Sources of Long-Term Funding for Financial Institutions for Mortgage Financing By: N. Kokularupan

Table of Contents Introduction Mortgage finance in emerging markets Capital markets in emerging markets Ingredients for sustainable housing finance Funding models for mortgage financing Liquidity Facility Pre-conditions for establishing a Liquidity Facility Objectives of Liquidity Facility Benefits of Liquidity Facility Mode of operations of Liquidity Facility

Table of Contents (Contd) Ownership structure Rationale for Central Bank taking an equity stake Success factors for Liquidity Facility Covered Bonds Core features of Covered Bonds Eligibility Criteria for Mortgage Loans backing Covered Bonds Legal basis and quality of Covered Bonds Rating of Covered Bonds Covered Bond Issuers Robust Covered Bond Framework

Table of Contents (Contd) United Kingdom Regulated Covered Bond Regime Dutch Covered Bonds Danish Covered Bonds Differences between Covered Bonds and Mortgage Backed Securities Securitisation Pre-requisites for Securitisation True sale criteria Activities entailed in Securitisation Major challenges in Securitisation Conclusion

Introduction Numerous benefits of mortgage lending to primary lenders Amongst them are: Very low credit risk as loan is secured against the property with a reasonable LTV. Credit risks mitigated further by lending to properties with good resale value. Very low capital charge – 50% under Basel 1 and 35% - 100% depending on LTV under Basel 2, (35% if LTV is ≤80%, 50% if LTV is 80% - 90%, and 100% if LTV exceeds 90%). Housing loans usually have low default rates. Yet banks in developing countries reluctant to provide housing loans.

Introduction (Contd) Question – WHY? Lack of expertise in mortgage lending Issue of maturity mismatch Shortage of long-term funds at reasonable rates

Mortgage Finance in Emerging Markets Generally under-developed Deposit based Expensive Typically small and poorly accessible Lenders faced with credit, liquidity and interest rate risks Borrowers subject to interest rate risk Population growth coupled with urbanisation warrants development of long-term sustainable housing finance. Governments are committed to developing robust finance systems to cater for increasing young population, rapid urbanisation and rising expectations from a growing middle class.

Capital Markets in Emerging Markets Under-developed with few instruments. Capital markets – attractive and significant amounts of long-term funding for housing (e.g. insurance companies and pension funds). Provide an important source of long-term funding.

Ingredients for Sustainable Housing Finance Good underwriting standards and diligent follow-up on delinquent and default cases. Low default rates. Efficient mortgage market regulated by the Central Bank. Existence of a Liquidity Facility to provide sustainable long-term funding at reasonable cost.

Funding Models for Mortgage Financing Deposit base Liquidity Facility (LF) Covered Bonds Securitisation Deposits, in particular, core deposits will remain an important source of funding especially if mortgage rates are variable rates In most cases, the cost of wholesale funding is more expensive than retail funding e.g. deposits

Funding Models for Mortgage Financing If lenders are not constrained by liquidity or capital, they are not motivated to seek for capital market funding. Although Governments are active in the development of secondary mortgage markets, success is not guaranteed by Government’s participation alone, but by ensuring there is a market need for capital market funding and demand from investors for instruments used in the secondary mortgage market.

Liquidity Facility Liquidity Facility (LF) Institution that provides medium/long-term funding to mortgage lenders. Acts as intermediary between mortgage lenders and capital markets. Issues plain vanilla bonds to raise medium/long-term funds. Purchases or refinances mortgage loans with recourse. Low risk, simple monoline institution. Sell / refinance housing loans to LF Grant housing loans Customers Mortgage lenders (banks) Liquidity Facility Investors Issues plain vanilla debt securities

Pre-conditions for Establishing a Liquidity Facility Motivation for financial institutions to refinance/sell their loans. Sufficient demand for housing finance. Sufficient supply of affordable housing. Functioning primary mortgage market. Ability to assign/transfer mortgage loans. Critical mass of eligible mortgages. Existence of capital market and an investor base. Support from the Government/Central Bank and other regulatory authorities such as the Securities Commission.

Objectives of Liquidity Facility Develop the primary mortgage market Provide long-term funds to enable primary lenders to grant loans at fixed rates and for longer tenures. Help lenders alleviate the gap between maturity of housing loans and sources of funds. Allow smaller lenders to access long-term funding and foster competition. Promote sound lending norms (eligibility criteria). Lower the cost of long-term funding.

Objectives of Liquidity Facility (Contd) Develop the capital market Provide variety of private debt securities with various maturities and rates. Create a yield curve for PDS. Avenue for insurance companies and pension funds to invest their surplus long-term funds.

Benefits of Liquidity Facility Mortgage lenders able to secure long-term funding at attractive rates. Provides a mechanism for primary lenders to manage their liquidity position in the long-term. Contributes to stability of liability structure of primary lenders offering an alternative source of funding. Allows lenders to provide fixed rate mortgage loans at least over the medium term. Contributes to development of local bond market by offering a new class of investment asset. Improves affordability for mortgage borrowers by lengthening maturity of loans and thus lowering the monthly instalments.

Mode of Operations of Liquidity Facility a) Refinance mortgage loans from primary lenders collateralised by the mortgage portfolio e.g. JMRC, EMRC, TMRC. b) Buy mortgage loans with recourse from the primary lenders e.g. Cagamas.

Ownership Structure Can be 100% privately owned or joint ownership by private sector and the Government (Central Bank) with majority shareholding by private sector. Initially, Central Bank’s participation as equity holder is important to kick-start the operations by instilling confidence to investors and granting special privileges to the Liquidity Facility. Important that Central Bank or Government should divest their shares to the private sector once the Liquidity Facility reaches self-sufficiency (sunset provision e.g. France). Equally important is that the privileges granted to kick-start its operations should cease once it reaches self-sufficiency.

Rationale for Central Bank taking an Equity Stake Hence, Central Bank’s participation becomes important for the following reasons: LF new entity fulfilling a public private mission. Initially, Liquidity Facility no track record. Participation of Central Bank lends credibility to the institution. Usually mortgage market and capital market nascent stage of development.

Rationale for Central Bank taking an Equity Stake (Contd) Though the Central Bank will not provide explicit guarantees, investors “perceive” that Central Bank will not allow LF to default in its obligations. Provides confidence to investors of LF’s bonds and lowers cost of issuance. Central Bank’s shareholding will also provide some degree of confidence to rating agencies to look at LF as stable and on-going institution. Rating important to lower cost of issuance. LF will also play a role in standardising mortgage lending practices and introducing good risk management practices. Central Bank’s shareholding will facilitate the above.

Success Factors for Liquidity Facility Initial support from the Central Bank: Shareholding Concessions Credible Board of Directors and competent CEO. Shareholding structure. Support of Government/Securities Commission. Good Governance. Willingness of banks to participate actively. Presence of institutional investors with appetite for medium and long-term high quality corporate bonds.

Covered Bonds Debt securities backed by cash flows from mortgages or public sector loans. Similar in many ways to asset backed securities created in securitisation, but covered bonds remain on the issuers’ balance sheet (with an appropriate capital charge). Covered bonds continue as obligations of the issuer; in essence the investors have recourse against the issuer and the collateral, often referred to as “dual recourse”. Covered bonds have been in existent since 1769. First created in Prussia in 1769 and in Denmark in 1795.

Core Features of Covered Bonds Issuance of covered bonds usually regulated by a specific legal framework or on a contractual basis, supervised by a national financial supervisory authority. Covered bonds issued by banks with a dynamic pool of earmarked assets on the balance sheet of the issuer collateralising the bonds. Covered bonds are bankruptcy remote, i.e. segregated from the bankruptcy procedure of the issuer once it is insolvent or bankrupt. Covered bondholders have a preferential claim on the proceeds of the collateral in case of insolvency or the issuer.

Eligibility Criteria for Mortgage Loans backing covered bonds Maximum LTV 80%. Value of the property underlying the mortgages used as collateral shall be monitored on a regular basis by an independent valuer. Mortgages used as collateral shall be adequately insured against damage. Should be legally enforceable in the relevant jurisdications and be properly filed.

Legal basis and quality of Covered Bonds Specific legislative framework or contractual agreements define rules on management of cover asset pools such as minimum over-collateralisation and maximum LTV for mortgages. Common legal basis supports the transparency and homogenity of one market as the minimum standard for all issuers are the same. This also keeps analysis efforts by the investors at an acceptable level, especially when compared with MBS. Quality of covered bonds is determined by the quality of the collateral, asset liability matching requirements, potential over-collateralisation and the degree of bankruptcy remoteness.

Rating of Covered Bonds Unwritten law that covered bonds need to be highly rated, at least double A. Rating agencies have expressed their requirements with regard to bondholders’ protection to apply such high rating. Rating agencies have made it clear that in order to meet their requirements, covered bonds do not need to be issued on the back of a specific legal framework. A bond property structured on a contractual basis and meeting the four core features above will be able to qualify as a high quality covered bond.

Covered Bond Issuers Traditionally covered bonds issued by special banks and these institutions’ business activities are typically limited to low risk activities such as mortgage loans and public loans. Limited and low risk activities of special banks enhance the quality of covered bonds since the risk of default of special banks is lower than that of a commercial bank.

Covered Bonds Issuers In recent years, commercial banks also issue covered bonds and this has been widely accepted by the market. Issuance of covered bonds offers indirect advantages to depositors. Covered bonds enable banks to lower their funding cost, diversify their funding source and investor base and have access to medium and long-term funds. Above helps the issuer to increase flexibility, competitiveness and profitability and this in turn enhances security for depositors.

Robust Covered Bond Framework European Banking Authority has identified the following areas: Dual recourse mechanism Asset segregation and bankruptcy remoteness of covered bonds Valuation of cover assets and LTV limits Asset and liability risk management : coverage principles and over-collateralisation Asset and liability risk management : stress testing Covered Bond Monitoring Role of competent authority Disclosure to investors

United Kingdom Regulated Covered Bonds Regime Introduction UK covered bond market established in July 2003 under UK general law. In March 2008, the Treasury introduced dedicated covered bond legislation (Regulated Covered Bond Regulations 2008) for the UK market.  Regulated by Financial Conduct Authority.  Key Features of Covered Bonds in UK Only deposit-taking institutions with headquarters in UK can issue regulated covered bonds.

United Kingdom Regulated Covered Bonds Regime (Contd) Only eligible property as defined in legislation can be used as collateral for regulated covered bonds In UK, the assets backing the bond are transferred to a separate legal entity (Special Purpose Vehicle) and form collateral for the bonds. Asset pool of the covered bonds is dynamic i.e. replacement of non-performing loans in arrears with new mortgages. Covered bonds are obligations of issuer, so investors can expect issuer to make interest and principal payments on due dates.

United Kingdom Regulated Covered Bonds Regime (Contd) If the issuer defaults on its obligations to covered bondholders or becomes insolvent, asset pool becomes static and SPV assumes responsibility for administering the asset pool to continue to make payments to bondholders.   If there are insufficient assets in the pool to meet the obligations to covered bondholders, they become unsecured creditors of the failed issuer for the residual amount.

United Kingdom Regulated Covered Bonds Regime (Contd) What is a Regulated Covered Bond? Complies with the Regulated Covered Bonds Regulations 2008 and is registered with the FCA. All regulated covered bonds are listed on the RCB register. However, structured (unregulated) covered bonds are not subject to these requirements.

United Kingdom Regulated Covered Bonds Regime (Contd) Regulatory benefits associated with regulated covered bonds Increased investment limits. Undertakings for collective investment in transferable securities (UCITS schemes) can hold up to 25% of their assets in RCBs issued by one issuer, but only 5% in structured (unregulated) covered bonds issued by one issuer.   Insurers can invest up to 40% of their assets in RCBs, but only 5% in structured (unregulated) covered bonds.

United Kingdom Regulated Covered Bonds Regime (Contd) Criteria for banks to be eligible to issue regulated covered bonds Competency of the proposed oversight and governance framework in managing risks of the programme. Systems, controls, policies and procedures in respect of risk management, underwriting, arrears and valuation. Competency in cash management and servicing functions. Quality of eligible assets in the cover pools.   Ability to substitute non-performing loans. Ability to make timely payments on the bond programme. Legal structures compatibility with the Regulations.

United Kingdom Regulated Covered Bonds Regime (Contd) Stress Test by FCA to determine over-collateralisation   Key variables used to stress test are: Default rate and timing Loss severity and timing Prepayment rate and timing Servicing cost Resilience of counterparties and hedges FCA conducts an annual on-site review of each regulated covered bond programme to assess the issuers’ continuing ability to meet the Regulations.

Dutch Covered Bonds General Characteristics Banks originating mortgage loans enter into Trust Agreement with a Dutch security trust approved by the Central Bank. Trust and Board members are independent from the bank. Bank pledges the mortgages and the cashflow from the mortgages to the Trust. Mortgage loans remain in books of bank as long as it is not insolvent or bankrupt. Collateral pool is refreshed monthly (replacement of non-performing loans).  

Dutch Covered Bonds (Contd) Following the pledge, bank issues covered bonds. Bonds are bullet bonds and redeemed at par at maturity. Collateral only consists of first ranking mortgages on private housing. If banks do not have sufficient eligible mortgages for replacement, the Trust will accept bank deposits and listed bonds having a rating not lower than AA – temporarily.  Covered bonds are supervised by the Authority for Financial Markets.  

Dutch Covered Bonds (Contd)  Post Bankruptcy Procedures and Preferential Claim If issuer faces bankruptcy or becomes insolvent Trustee takes over management of the portfolio. Bondholders have exclusive claims on pledged mortgages if issuer becomes bankrupt. If proceeds from the pool are insufficient to pay the bondholders, the bondholders have a claim against issuers’ other assets pari passu with unsecured holders of unsecured bonds by the issuer.  

Danish Covered Bonds Introduction Danish covered bonds issued in compliance with Danish Mortgage Loans and Mortgage Bonds Act (DMLMBA) and the Danish Financial Services Act. Comply with the UCITS directive. 10% risk weighting in Denmark and most EU countries.  

Danish Covered Bonds (Contd) Mechanism and Characteristics of Danish Covered Bonds Only mortgage banks are allowed to issue the bonds. Bonds collateralised by mortgage loans which must be registered with the Land Registry. Over-collateralisation is secured by law, with maximum LTV of 80% for residential loans. Mortgage loans solely funded through the issuance of bonds.

Danish Covered Bonds (Contd) Mortgage banks have no access to money market or deposits. Issuance of covered bonds by mortgage banks subject to “balance principle” i.e. can only issue bonds with same terms as the underlying loans, strictly passing through the cashflows from the borrowers to the bondholders. Mortgage banks earn revenue from a service fee.  Balance principle ensures mortgage banks do not assume interest rate or liquidity risk.

Danish Covered Bonds (Contd) Bondholders have preferential status in event there is a shortfall when the bank becomes insolvent/bankrupt. Bonds by mortgage banks are treated as highly secure investments in capital market. No bankruptcy of mortgage banks in the 200 years of history of Danish mortgage system.

Differences between Covered Bonds and Mortgage Backed Securities 1. Debt Type Direct bank debt Debt issued by SPV 2. On/Off Balance Sheet On Balance Sheet of Originator Off Balance Sheet of Originator 3. Tranches No tranching of covered bonds Senior and subordinated tranches 4. Asset Pool Dynamics “Dynamic” revolving pool of qualifying collateral Static pool of assets 5. Substitution Non-performing loans substituted by Originator No substitution of non-performing loans

Mortgage Related Securities Differences between Covered Bonds and Mortgage Related Securities (Contd) Covered Bonds Mortgage Related Securities 6. Recourse to Originator Full recourse to Originator for covered bondholders No recourse to Originator 7. Originator default In case Originator defaults segregation of cover assets MBS not affected by originator default 8. Bondholders’ Protection Preferential claim on cover assets, senior to other creditors Exclusive claim on cover assets

Securitisation Converting illiquid assets into liquid assets by creating high quality investment instruments. Advantages of securitisation: Diversifying funding sources Risks transferred from lenders to investors Capital savings Access to global capital markets

Prerequisites for Securitisation Stable Macroeconomic Environment Competitive Market Structure Standardised Mortgage Loans and Instruments Proper Origination and Servicing Techniques by primary lenders Liquidity in secondary mortgage securities market Investors’ base Adequate legal, tax and accounting framework Good title registry with accurate records Good foreclosure system Ability to transfer beneficial interest to investors at minimum cost Protection of investors against bankruptcy of originator/servicer

True Sale Criteria Securitisation should comply with true legal and accounting sale. True legal sale Bankruptcy remoteness Minimal re-characterisation risk No recourse to originator by purchaser for any losses from assets True Accounting Sale Governed by Para 20 of IAS 39 for de-recognition of financial assets. All economic benefits and risks should be transferred from the originator to purchaser/investors.

Activities entailed in Securitisation Setting up of a Special Purpose Vehicle Appointment of external parties for Securitisation e.g. Legal Adviser, Financial Adviser, Reporting Accountants, Tax Adviser etc. Kick-off meetings with Advisers Data Review and Structuring Cashflow Analysis Legal, Accounting and Operational Due Diligence Documentation Regulatory Approval Compliance and Conditions Precedent Issuance of RMBS

Major Challenges in Securitisation Data Review and Structuring Cashflow Analysis Regulatory Approval (especially in jurisdictions where securitisation is new) Getting all the Accountants/Auditors to agree on true accounting sale Pricing of RMBS

Conclusion So which is the most optimal long-term financing model? Choice of funding model depends on Needs of mortgage lenders (capital constraints versus need for liquidity) Presence of the right type of investor base Stage of development of the primary mortgage market and capital market State of supporting infrastructure for mortgage lending (e.g. title registry, foreclosure, Credit Bureau etc.) Sources: 1. Covered Bonds by Goldman Sachs 2. Covered Bonds by ABN AMRO - November 2004