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

2 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)

4 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)

5 THE BENEFITS OF MBs 1.IMPROVE AFFORDABILITY: a)BRING SECURITY. HENCE : - HIGHER RATING ( BOND GRADE CAN BE > ISSUER’S GRADE : 1-3 NOTCHES TYPICALLY) - LONGER MATURITY b)FOSTER LIQUIDITY SIMPLE, STANDARDIZED INSTRUMENT c)a) + b) = LOWER COST OF FUNDS SPREADS (EUROPE) : +/ BP OVER SWAP YIELD CURVE d)PROMOTE LOW INTERMEDIATION COST - DK : +/- 50 BP - CHILE : 100 – 150 BP (VS 300 BP )

6 THE BENEFITS OF MBs, continued 2) 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% 3)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

7 INVESTORS’ EXPOSURE

8 THE FOUR COMPONENTS OF MB 1.QUALITY OF PLEDGED PORTFOLIOS 2.COLLATERALIZATION MECHANISM 3.PROTECTION AGAINST LENDER/SERVICER ‘S INSOLVENCY 4.FINANCIAL MATCHING

9 QUALITY OF THE COLLATERAL 1.LENDING CRITERIA LIEN: FIRST MORTGAGE SOMETIMES PUBLIC GUARANTEE (DK, FR) PURPOSE: RESIDENTIAL + COMMERCIAL WITH RESTRICTIONS LTV: TYPICALLY RESIDENTIAL< = 80% COMMERCIAL < = 60% VALUATION RULE: TYPICALLY = “PERMANENT” VALUE DEBT-TO-INCOME = ONLY CHILE

10 QUALITY OF THE COLLATERAL continued 2.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 3.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

11 COLLATERALIZATION PRINCIPLES 1.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 ? 2.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

12 COLLATERALIZATION STRUCTURE TWO PRELIMINARY ISSUES : 1.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 2.THE BONDS = Pass-through securities backed by segregated pools of loans (CHI, DK), or fungible debt secured by a whole, dynamic portfolio ?

13 COLLATERALIZATION STRUCTURE : SPECIALIZED PATTERN DIVERSIFIED FINANCIAL INSTITUTION 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) Trend: Mortgage banks = specialized subsidiaries of diversified groups. A way of ringfencing the assets cover Issue: remoteness from parent’s bankruptcy But otherwise institutional support

14 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 issuer’s guarantee

15 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

16 OPTIONS IN SEEKING INSOLVENCY PROTECTION 1. 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 2. 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 ?)

17 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 lender’s level. 1.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

18 INTEREST RATE RISK, continued 2.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

19 BEST USAGE / BEST PRACTICES 1.MBs VS MBS Less legal complexity (incl. tax, accounting, prudential rules) Different issuing strategy: more liquidity, less investor’s 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

20 BEST USAGE / BEST PRACTICES 2.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

21 BEST USAGE / BEST PRACTICES LESSONS FOM SLOW TAKE-OFFS 1.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 2.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) 3.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

22 BEST USAGE / BEST PRACTICES LESSONS FOM SLOW TAKE-OFFS 4.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