Capital Market Funding in Emerging Economies

1. Capital Market Funding in Emerging Economies Conference: Housing Finance in Emerging Markets: Policy and Regulatory Challenges The World Bank, Washington D.C. 11 March, 2003 Presented by: Dr. Michael Lea President of Countrywide International Consulting Services Material developed in conjunction with Dr. Jack Guttentag, Wharton International Housing Finance Program

2. Outline of Presentation • Why Is Capital Market Funding Important? • How Can Lenders Access the Capital Markets? • Instruments • Institutions • What Are the Prerequisites for Accessing the Capital Markets? • What Role Can Government Play in Developing Capital Market Funding? • What Has Been the Experience in Emerging Markets? • What Is the Outlook for the Future?

3. Rationales

4. Improving the Affordability of and Accessibility to Funds • Tapping new funds: particularly institutional investors (pension, insurance funds) with long term liabilities • Increasing the liquidity of mortgages (reducing risk for originators and reduce risk premia) • Increasing competition in primary markets (reduce spreads) • Increasing efficiency in the housing finance system (reduce spreads) • Lengthening the maturity of loans (improve affordability)

5. Improving the Allocation of Risk and Developing Deeper Capital Markets • Improving Allocation of Risk • Investors with long liabilities can better manage liquidity risk • Institutional investors are better able to manage interest rate risk (can facilitate offering fixed rate mortgages) • Potential diversification of credit risk (reduce spreads) • General Capital Market Development • Mortgages a good asset class for securitization, bonds • Gives investors more choice of assets • Expands monetary policy options for central banks

6. Instruments & Institutions

7. Whole Loan Sales • Can Be the Easiest Way to Start, Particularly in Small Markets • Rationale: balance sheet mgt., ALM, geographic diversification • Broker Markets • Brokers bring together buyers and sellers of loans (typically both mortgage lenders for seasoned loans) – investment bankers may act as brokers • Relationship Markets • Participations among depositories • New loan sales by mortgage companies • Wholesaler markets • Wholesalers buy loans from “correspondents”

8. High Due Diligence Costs Reduce the Likelihood of Whole Loan Sales • Cost of Information to Buyer is High • Each transaction is different • Documentation may vary lender by lender • Underwriting standards also vary by lender • Instrument itself may be complex • Loan amount is small, so costs are high per dollar of loan • Information Asymmetry: Potential Buyer Knows Less Than Seller • Can sell on recourse or participation basis • Mortgage insurance can reduce due diligence costs • Loss Insurance: the Insurer Reimburses the Lender in the Event of Default • Cash Flow Insurance: Insurer Guarantees Timely Receipt of the Mortgage Payment

9. Mortgage Bonds: General Characteristics • Issued Against Mortgage Collateral Pool • Long term funding source • Investors Have Priority Claim on Collateral • Bond is Liability of Issuer • Typically specialized mortgage bank • Heavily regulated • Cannot issue deposits; monopoly on mortgage bond issuance • Provide residential and commercial real estate loans • Universal banks may also issue • Long term funding; funding diversification • Credit enhancement from issuer’s balance sheet • Bonds May Be Over-collateralized

10. Mortgage Bonds: Pfandbrief Model • Mortgage Bank Issuer Has One Permanent Collateral Pool • New Loans Are Funded by New Bond Issues • The loan becomes part of the collateral pool • As loans are repaid and defaulted, the pool shrinks • Duration of Bond Almost Matches That of Loan • Loans have fixed-rate period of 1-10 years • Matching bond is interest-only for same period • Borrowers can prepay at end of period, or pay a yield maintenance penalty • Loans amortize, bonds do not • Major Funding Source in Germany; Introduced Throughout Europe and CEE Markets • Rigid Structure: Issuance limited to mortgage banks • Variants to model in Spain (universal bank issuers) and France (virtual issuers) • Introduced in a number of CEE Markets • Main success in Czech Republic; Interest on bonds tax exempt

11. Mortgage Bonds: Danish Model • Multiple Pools Per Lender, Each Pool Contains Loans Made Over 2-3 Year Period • Mortgage Bank Sells Bonds on Behalf of Individual Borrowers in Amounts Equal to Loans • Investors Buy Shares of Large Pools • Bonds Are Pass-throughs That Amortize • Principal and prepayments passed through to bond holders • No overcollateralization necessary • Borrowers Can Prepay Loans at Par or Buy-Back Bonds and Return to Lender • Very Successful Historically – Benefited from somewhat of a captive investor base until recently • Similar model exists in Chile; Banks as issuers

12. Mortgage Pass-through Securities • Issued Against Mortgage Collateral Pool • Involves Cash Flow Matching • Balance of Pass-Through = Balance of mortgages in pool • Repayments of principal “passed through” to investor • Preset Delay in Monthly Payment • Rate on Pass-Through - Rate on Mortgage = Servicing Fee + Guarantee Fee • Usually Not a Liability of the Issuer • Sale of assets for balance sheet mgt. • Shifts cash flow risk to investor • Requires credit enhancement

13. Credit Enhancement • Mortgage Securities That Are Not Liabilities of the Issuer Require Credit Enhancement • Credit Enhancement Offers Cash Flow Insurance to Investor Provided By: • Guarantee of highly-rated third party • Bond insurers, government (e.g., Ginnie Mae) • Pool insurance from high-rated insurer • Senior-subordinate security structure • Reserve fund/spread account

14. Structured Finance • Multiple Securities Issued Against a Single Pool of Passthroughs or Loans • Purposes: • Avoid monthly pmts and highly variable life • Derivatives have quarterly or semi-annual pmts • Meet diverse cash flow needs of investors • Short vs. long expected duration • Floating vs. fixed rate • Protection against increases or decreases in rates • Examples: • CMOs: A number of separate securities repaying principal sequentially. Pre-determined collateral pool, all securities issued at the outset • Master Trusts: Dynamic collateral pool, securities issued over time

15. Institutions to Facilitate Mortgage Capital Market Development • Conduits • Purchase loans from multiple lenders; pool and issue securities • Rationales: Reduce information costs and asymmetries for investors; develop standardization and economies of scale in securities issuance; diversification • Liquidity Facilities • Issue bonds; finance lenders • Rationales: Liquefy mortgages; develop standardization and economies of scale in securities issuance • Insurers • Provide loan loss and/or cash flow insurance • Reduce information costs and asymmetries for investors; provide diversification benefits

16. Prerequisites

17. Infrastructure Prerequisites • Primary Market Infrastructure • Mortgages offer attractive risk-adjusted yields • Some standardization of documents and underwriting practices • High quality servicing and collection • Professional standards of property appraisal • Legal and Regulatory Infrastructure (can be developed simultaneously) • Legal, tax and accounting framework for securitization and bond issuance • Facilities for lien registration • Ability to enforce liens • Ability to transfer (assign) security interest • Protection of investors against bankruptcy of originator or servicer

18. Lender Prerequisites • Market Demand for Capital Market Funding • Do lenders need capital relief? • Low risk weight of residential mortgages reduces need for off-balance sheet finance • Do lenders need liquidity? • Liquid depositories may view capital market finance as too expensive • What are lender risk management needs? • Interest rate risk of ARMs often minimal • Main successes in developed markets have been in countries where consumers demand medium/long term FRMs • Liquidity risk can be managed at portfolio level until mortgages become a significant portion of assets

19. Investor Prerequisites • Investor Demand for Securities • Presence of long term investors • Not crowded out by government • Sufficient information to price and manage risk • Appropriate regulatory treatment • Strong regulation enhances credibility of securities, issuers • But inappropriate regulation can stifle market development • Credible credit enhancement • To offset high costs of due diligence • Benchmark for pricing • Particularly for longer term securities • Mortgage securities can create long end of yield curve • Market-maker • Liquidity for investors

20. Role of Government

21. Role of Government: Theoretical Considerations • Facilitator • Remove onerous laws, taxes & regulations • Provide legal framework for title registrations, title transfers, lien enforcement, uniform docs • Encouraging competition; getting banks to lend and reducing need for housing bank • Stabilizer • Maintain economic stability (low inflation and volatility) • Provide Liquidity: Deposit insurance, central bank • Remove political risk • Reduce systemic risk by encouraging re-allocation of risks outside banking system • Address Market Imperfections • High transaction cost of due diligence for investors • Information asymmetries • Institutional segmentation • Geographic segmentation • But Not Distributional • Affordability issues can be better addressed through mortgage design and direct borrower income or downpayment support.

22. Possible Functions for Government • Regulator: Lenders, insurers, security issuers • Mortgage (Loss) Insurer • Can liberalize loan terms for low-income borrowers • Reduce information costs for investors • Provide diversification benefits • Can burden taxpayers: politically may be difficult to price for risk, raise premiums or maintain reasonable underwriting guidelines • Cash Flow Insurer (Guarantor) of Private Security Issuers • Can create highly efficient secondary market (e.g., GNMA in US) • Guarantee reduces information costs for investors (about collateral and issuers); can offset potential weaknesses in legal system (e.g., long time to foreclose) • High agency costs; vulnerable to fraud • Need strong incentives for issuers to perform (in US large servicing fee), ability to transfer servicing, good information for guarantor

23. Functions for Government (cont’d) • Conduit/Cash Flow Insurer • Can create highly efficient secondary market • Reduces information costs for investors • Creates economies of scale in securities issuance • Provides diversification for security investors • May also create economic behemoth • Reinsurer (catastrophic and/or political risk) • Provides incentive for government to provide conducive macro-economic and legal environment • Provides incentive to private insurers to cover default loss with government protecting against uninsurable risks • Difficult to draw line between insurable and uninsurable risks • Liquidity Facility • Liquefies mortgages; Provides economies of scale in securities issuance • Smaller efficiency benefits than conduits (doesn’t facilitate off-balance sheet finance, finance new entrants) • Less legal and institutional infrastructure required

24. Experience in Emerging Markets

25. What Has Been Tried?

26. Are There Successes? • What Constitutes Success? • Sustainable volume of activity; significant portion of housing loans funded through instrument/institution • Ability to create products that meet the needs of private sector lenders and investors • Where Are the Successes? • Chile: Mortgage bond introduction benefited from strong legal system, sound macro-economy and coincident privatization of pensions • Malaysia: Government created incentives for borrowers and investors; used as instrument of policy and functioned effectively in crisis • Trinidad: Same starting conditions as Malaysia; has transitioned from liquidity facility to conduit • Argentina: Successful tapping of international markets using structured finance. Recent downgrades demonstrate the difficulties associated with hard currency lending and finance

27. Why So Limited Success? • There Has Not Been a Perceived Need for or Acceptance by Lenders • Capital ratios have been improving in most countries • With global slowdown, most depositories liquid and not in need of significant new sources of funds • In most markets, deposit funding significantly cheaper than capital market funding • If main mortgage instrument an ARM, can match fund with deposits • If spike in demand, capital markets cheaper than repricing deposits • In many emerging markets, it is still difficult to lay off cash flow risk • Reluctance of investors to buy longer term debt • Lack of systems, capabilities to manage amortization, prepayment • Infrastructure Problems Can Be Difficult to Solve • Concept of trust or SPV unknown in many countries • Inefficient or costly title and lien registration discourage use • Taxes may make securitization uneconomic

28. Lessons Learned: Role of Government • Government Involvement Not a Guarantee of Success • There must be an underlying demand for products • Facilitating Role Still the Strongest Rationale • Must remove obstacles, strengthen legal/regulatory system • Is There Too Much of an Institutional Focus? • Would regulatory incentives or partial guarantees accomplish the objectives in an easier to implement/control manner? • Are We Putting the Cart Before the Horse? • Can capital market funding reasonably take place in markets with weak legal, primary mortgage market infrastructure?

29. Moving Forward • As Economies Improve and Demand for Funds Picks Up, Banks Will Become More Capital/Liquidity Constrained and Look to the Capital Markets for Funding => Continue building capital market infrastructure • ARMs Transfer Most if Not All Interest Rate Risk to Borrowers • Introduction of FRMs important for financial system stability • FRMs need to be funded in the capital markets => Efforts to create mortgage capital markets should include a product development component focusing on FRMs • Development Efforts in Many Countries Has Focused on Institution Development, Particularly Conduits With Government Involvement => Weak results to date suggest that more emphasis could be given to instrument development (both bonds and MBS), use of mortgage insurance and guarantees to facilitate investor acceptance

30. Upcoming publication:“Mortgage Securities in Emerging Markets”Published by: The World Bank