1 Housing Finance and the Capital Markets Douglas Diamond AIPRG Workshop 29 May 2005

2 Why Need the Capital Markets? In many countries, the bank deposit base is enough Depends on the size, term, and mostly overall stability of banking deposits Depends on demand for housing finance vs. size of banking sector Usually not a problem up to 20% of loans Depends on types of loans that are popular and rate of prepayments Depends on liabilities of institutional investors

3 1st Conclusion: Ask…. Is it likely that the capital market will develop faster than banking sector? What are prospects for exceptionally rapid growth of mortgage demand? Where is the line between enabling and distorting? Tax advantages? State-sponsored facility?

4 Modes of Access to Capital Markets Lender-based corporate bonds Lender-based covered mortgage bonds Lender-based securitizations Liquidity facility: corporate bonds Centralized mortgage bank: mortgage bonds Conduit: Securitizations

5 Covered Mortgage Bonds Standard corporate bonds +specific collateral/ overcollateralization Segregated in case of bankruptcy + special supervision Spanish vs. German/Danish Latter involves special institutions German has very conservative LTV Spanish has less need for balancing restrictions More useful tool for general ALM

6 Securitization Loans are sold to a special purpose legal entity (SPV) that holds title to the loans and manages and passes through all cash received from the loans SPV has no operating business and no tax exposure Participations are tradable, but hard to value. Can sell different classes of participation to different kinds of investors E.g., some investors bear the default losses, some get the early prepayments, others get very predictable cash flow and return

7 Securitization (2) Overall, it is not cheap or easy, so usually done only when there are special reasons In Australia, SA, and UK, done on VRMs so as to use call centers and agents for originating loans, not cheaper funds; not dominant in any of these It is big in the US because Fannie/Freddie offer both: Implicit government guarantee (reduces capital costs, created large market) Takes on the deadly prepayment risk of Fixed Rate loans Regulatory arbitrage

8 Liquidity Facility Liquidity Facilities provide temporary refinance, relying on mortgage assets for security Usually refinance is for 1-5 years (3 is favorite) As supplement to deposits, e.g., 10-30% Usually obtains funding by issuing simple bonds Banks can do this also, so LF has to be cheaper Essentially a central mortgage bond issuer Always state sponsorship, but better not state ownership or guarantee Low risk due to high safety, not state guarantee

9 Centralized Mortgage Bank Provides permanent refinance. Takes on all funding risks, looks like a German-style mortgage bank With or without recourse Kazakhstan Mortgage Company Fannie Mae More profit by keeping the funding risks and employing derivatives to manage them. Giant hedge fund Who can take on those risks better in Armenia, the banks or a centralized mortgage bank?

10 Conduit Centralized Securitizer Provides permanent refinance. Takes on all funding risks, but passes them to investors Not always state-sponsored Private entities in the US for large loans Fannie Mae from Implemented in HK, KR, MY

11 Hazards of State-sponsored Entities 1. Start off low-risk, but politicians may use for populist policies Kazakhstan, Ukraine (?), Philippines 2. If business is weak, entity may be granted more subsidies to succeed Hungary 3. Private interests may take advantage of state sponsorship Fannie Mae