SECURITISATION: RESIDENTIAL MORTGAGES

1. SECURITISATION: RESIDENTIAL MORTGAGES 9 September 2009 AUHF

2. BACKGROUND INFORMATION • World wealth $44 trillion of which: • 50% property (residential, agricultural, C&I) • 30% residential properties • Bonds 27% • Equities 19% • Cash 3% • Fundamental premise: • Widespread property ownership is a desirable goal of every society Thomas Jefferson: “The small landowners are the most precious part of a state (1785)” • This is achieved by an effective and economically efficient link between residential mortgages and the long term financial markets • Widespread home ownership cannot be achieved without a robust financial system • Fundamentally there are two Archetypes of long term financial markets: • Banks and bonds: • Banks originate loans, hold them on their books and fund them through: • Issuing long term deposits or bonds (attract funds through over collateralization e.g 125%) • General liabilities of a bank • Government support can be in the form of a guarantee on the bonds e.g. liquidity facility

3. BACKGROUND INFORMATION (CONTINUED) • SPVs and Securitisation • Bank sets up a SPV and sells loans into this (off balance sheet) • Bank sets up senior/subordinated structure (bank part), with bond market buying the senior part • Government support could guarantee a portion of the senior part, thus capping bond holder losses. • Similarities in both structures: • Government at back of queue and its role protects against systemic risk or promotes the credibility of the SPV • Added advantage of securitization is that it guarantees the investors access to the mortgages where on balance sheet collateralization might not • Institution that originates and manages the loans takes on the initial credit risk and passes on the interest rate risk to bond market investors • No need to guarantee individual loans • Risk controlled by capital and stress tests • Which structure to choose: • Depends on regulatory and tax issues. • Banks and bonds favored in emerging economies as it is less likely to require new laws, banks are best at managing credit risk and so can manage the principle/agent problem better (past 20 years has seen the unbundling of the 4 major aspects of mortgage lending: origination, servicing, funding and credit risk but this has created principle/agent problems)

4. BACKGROUND INFORMATION (CONTINUED) • Outcomes • Improved efficiencies • Require strong legal and regulatory framework as secondary market exposed to risks which the primary market doesn’t have • Secondary market merely a vehicle for allocating capital • Depository based systems can do the same thing as secondary markets do (connect mortgage borrowers with people with money) without having to sell mortgages, but require stable interest rates • Guarantees can cause “moral hazard” (excessive risk taking, leading to poor capital allocation and taxpayer bailouts) • First best economic solution • Proper legal system “if you want people to have good housing, you have to be able to take it away from them” • Property rights • Good disclosure • Good information • Competitive markets • Second best economic solution • Asymmetric information • Poor disclosure • Poor foreclosure laws (justification for Government providing support – guarantees, long term funding support)

5. BACHGROUND INFORMATION (CONTINUED) • Secondary market funding • Securitisation (package into pools), Debt or combination thereof • Standardisation promotes Government agencies e.g. Fannie Mae • Pass through security – payment from pool to investors (Ginnie Mae) • Market evolved to include private market pools, derivative securities (CMOs with up to 50 payment tranches, with a pool of 30 year callable securities being broken up into short, medium, long term bonds), futures, hedges against interest/prepayment risk, mortgage insurers etc • Unbundling takes advantage of scale economics, division of labor, promotes competition between suppliers of the various bundles BUT it comes at a cost: • Each player that focus on one part of the bundle is dependent upon the other players performing their role • Principal/agent problems • Transparency/moral hazard • Understanding of risk by investors (removed/complex) ? • Important Lessons • It is the function rather than institutional mechanism of connecting mortgage and capital markets that is important (several models available) • The “front end” creates a good mortgage market (proper registration, foreclosure and eviction procedures ) as opposed the “back end” - doing deals/getting mortgages off balance sheet etc • Controlling soundness and safety requires serious consideration of risk based capital (stress based tests, regular audits, risk based standards etc) • Don’t take interest rate risk • Conflict between GSEs and demands for social housing • Diversification and insurance • LTVs and area/borrower demographics

6. SHAPING THE FUTURE • Opening up securitization again/Shaping the Future • Regulation (Basel 2, consumer protection and information disclosure) • Technology (distribution channels) • Principal/agent and moral hazard • Simplicity • Investor liquidity • Housing as an wealth creator (long term investor confidence) • Economic recovery ? • Consumer demand • US, China vulnerability • Our next engine of growth ? • US to move its focus from “stealing their future generations money” to getting the market to open up again • US Fed to convince investors to move away from MBSs ? • Recent SA experiences • In ICU (mortgages no longer sexy – quality, capital intensive, margins, property illiquid asset) • Investor liquidity an issue • SA Home Loans • Standard bank • Absa By its very nature property is a bubble commodity – it has and will continue to boom and bust. The trick is to get the cycles right.

7. SHAPING THE FUTURE (CONTINUED) • Limited direct effects • Insignificant exposure to sub-prime • Limited use of structured finance • Markets remain “prime” (smaller, more conservative) • Intensified indirect effects • Slow down in growth (affects demand) • Return of inflation • Liquidity squeeze and market distrust (increase cost of funds) • Credit contraction • Additional credit risks (variable/adjustable rate loans) • Higher energy/food costs • Bank decapititalization • Foreign banks withdraw/downsize from Africa • Depressed capital markets • Africa perceived as potential “sub prime” market by investors

8. HOUSING FINANCE IN AFRICA (CONTINUED) • Steady demand (urbanization) • Access to finance remains a policy priority • Continuance of undeveloped mortgage markets • Easy expansion over for many countries • Vulnerable countries: liquidity, high LTV variable loans, weak lending standards etc • Liquidity crisis: securitization, roll-over refinancing • Cost of funds to increase • Diversity tools: covered bonds, liquidity facilities • Non-bank lenders require secure access to bond markets • State support: liquidity, systemic risk, sunset clauses

9. CHALLENGES FOR AFRICA • Improve land and housing policy (supply constraints) • Build market infrastructure (title, foreclosure, appraisal etc) • Smart subsidies (not linked to bailout packages) • Support for rental market (not just ownership) • Improve ways to finance low/informal income households (risk sharing tools, housing microfinance, savings schemes etc) • Diversify domestic funding models • Tighter securitization framework (lenders first loss, simplistic/transparent models, legal/regulatory framework) • Lethargic markets (how to deepen penetration and sound lending) • Risk based pricing, capital retention in property cycles • Improve borrower education • Information (data) improvement • Limit/identify property bubbles

10. Alternative Model • Investors • Want to commit capital to long term uses • Fixed return • Diversified portfolios • Safety which mortgages offer • Borrowers • Certainty which fixed rates offer • Availability of full amortisation tarm • Various refinancing options • Financial Institutions • Balance risk/profit • Whilst deposit base can fund a substantive portion of mortgage assets, there is a need for this to be supplemented by access to the bond market: • Liquidity backup and funding alternatives • Long term fixed rate liabilities often not available in deposit markets • Ability to hedge the options embedded in mortgage contracts • Home Loan Bank Model/Mortgage Liquidity facilities(premise: assets of high quality) • Home Loan Bank pools the mortgage loan portfolios of numerous banks • Provides large scale financing to banks • Issues simple, classical debentures with short to long term maturities at favorable interest rates (AAA/Aaa) • Banks get attractive rates • Mortgages are pledged as collateral with wide collateral margins • May contain prepayment options • Promotes greater competition

11. ALTERNATIVE MODEL (CONTINUED) • Promotes product standardization/transparency • Lenders adhere to best practice • Increases market information systems which in turn promotes better risk management • Deepens the financial market • Can be effectively used to promote delivery of policy objectives e.g. affordable housing • Must adhere to market based pricing (market distortion issue) • Don’t need critical mass and can issue debentures anytime (NB: It must stay away from regulation and politics and focus on banking) • Creating a model • Step 1: Create primary market mortgages • Step 2: Bond market (the base market of traded securities) • Step 3: Link private credit institutions to the bond market through the Home Loan Bank organization model • Becomes more sophisticated over time as market develops and can co-exist with other market instruments – could even be viewed as an in-between leading up to a full secondary market • Successful models Cagamas (Malaysia), France, Jordan, Algeria,West Africa ? • Preconditions • Effective mortgage legislation, including repossession upon default • Fixed income market • Credit bureau • Efficient mortgage/land registration systems • Efficient judiciary • Appraisers • Functional securities market