International Experience in Establishing Liquidity Facilities

1. International Experience in Establishing Liquidity Facilities Workshop on Housing Finance June 26-29, 2011 Ulaanbaatar, Mongolia N. Kokularupan Views expressed in this paper are that of the authors and do not represent the views of IFC/World Bank

2. Housing Finance in Emerging Markets • Housing finance generally underdeveloped in emerging economies • Housing finance is deposit based • Housing loans not widely accessible • Housing finance is expensive • Lenders subject to interest rate, liquidity and credit risks • Population growth and urbanization calls for development of long-term sustainable housing finance systems

3. Capital Markets in Emerging Economies • Capital markets are underdeveloped with few capital market instruments • However, they provide an important source of long-term funding • Pension and provident funds and insurance companies can play an important role in providing long-term funds to primary lenders

4. Funding Models for Mortgage Financing • Deposit base • Securitization • Covered bonds • Liquidity Facility • Deposits, in particular core deposits will remain an important source of funding mortgages especially if the mortgage rates are variable • No one model is the best. All models should be considered in the context of the macroeconomic environment, capital market and needs of the mortgage originators

5. What is a Mortgage/Refinance Liquidity Facility • A specialized second tier institution which provides short term liquidity, long term funding or guarantees to housing finance lenders. • Acts as intermediary between lenders and capital markets • Issues bonds to raise long-term finance • Purchases loans with recourse or refinances mortgage loans • Low risk, simple institution

6. Objectives and Benefits of Liquidity Facilities • Develop the Primary Mortgage Market • Provide financial resources to enable primary lenders to grant more loans at fixed rates and for longer tenures • Help primary lenders to narrow the gaps between the maturity structure of the housing loans and the source of funds • Promote sound lending norms (eligibility criteria) • Allow smaller lenders to access long-term funding, and foster competition • Lower the cost of long-term funding (liquidity, prime standing, limited intermediation cost)

7. Objectives and Benefits of Liquidity Facilities (Contd) • Develop the Capital Market • Provide more private debt securities (Bonds) with different maturities and rates • Issues secured and simple instruments • Creates a Yield Curve to serve as a benchmark for other private sector issuers

8. Preconditions for establishing a Liquidity Facility • Some motivation for financial institutions to refinance/sell their loans, for e.g.: • Tight liquidity and capital constraints • Absence of long-term funding to meet demand for mortgages • Central Bank regulations/limits/caps on mortgage exposure of banks • Sufficient demand for and supply of housing and housing finance, e.g.: • Primary lenders willingness/ability to lend • Borrowers willingness/ability to afford mortgage payments

9. Preconditions for establishing a Liquidity Facility (Contd) • A functioning primary mortgage market, for e.g. • Legal framework for property ownership and transfer • Legal/statutory framework for extending a mortgage loan • Registration/cadastre facilities • Property appraisal facilities • Lenders’ ability to effectively enforce foreclosure • Critical mass (will vary from market to market) of eligible mortgage loans, for e.g. • Sufficient portfolio of local currency (vs. foreign currency) mortgages

10. Preconditions for establishing a Liquidity Facility (Contd) • Ability to effectively assign/transfer mortgage loans • Existence of a capital market and an investor base, for e.g.: • Existing fixed income/Government bond market • Presence of legal and regulatory infrastructure for bonds e.g. issuance rules/law, trading platform, depository, reporting, registering authority, etc. • Local currency/plain vanilla debt appetite among current and potential local investors • Existence of traditional local institutional investors, e.g. pension funds, insurers, banks • Commitment by the Central Bank and/or Government to initially take a minority ownership in the Liquidity Facility to lend credibility to the Liquidity Facility in its operations

11. Conditions for Success • Support from the Central Bank • To encourage mortgage originators to obtain refinance from the LF • To encourage banks and insurance companies to invest in the bonds/securities issued by the LF • Support from the Capital Market Authority • To encourage issuance of bonds/securities by the LF • To encourage investment in the bonds/securities of the LF • Support from the Revenue/Tax Authority • Good governance • Excellent rating Concessions to kick start operations

12. Business Model • Short-Term • Refinance/Purchase mortgages loans with recourse to primary lenders • Refinance/Purchase based on interest review periods • Issue unsecured debt securities (bonds) • Medium-Long Term (timing dependent on Board decisions) • Help establish the foundations of a sound securitization market (standardization, transparency, etc.) • Issue secured mortgage-backed securities (MBS) and Sukuks

13. Factors contributing to Limited Success/Failure of Liquidity Facilities (LF) • Lack of understanding of purpose of a LF • LFs set up without prevalence of preconditions for a LF • Lack of commitment on part of Central Bank to promote LF • Political interference • Leadership – Management must understand the business and Board should be competent and actively involved • Failure to consult the market participants (mortgage lenders and potential investors) when drawing up guidelines for operations • Pricing of products • Staffing – to keep lean in initial years • LFs become too ambitious – take on other roles thus losing their focus on core business • Lack of support from Central Bank/Securities Commission on terms of granting concessions to kick-start operations

14. Factors contributing to limited Success/Failure of LFs (Contd) • Over-estimation of growth of mortgage market and LFs’ share of business in the Business Plan before establishing the LF • Model of LF • Only shareholders have access to facility • Shareholders access to facility proportionate to their equity in the LF • All mortgage originators, irrespective of whether they are shareholders or not can avail the facility • Significant portion of mortgage loans originated by banks versus multifinance companies

15. Jordan Mortgage Refinance Company (JMRC) • Incorporated in 1996 as a public shareholder company started operations in 1997 • Chaired and supervised by the Central Bank • 16 shareholders – 3 from public sector {contribute 38% of paid-up capital of JD5 million (USD7.05 million)} and 13 from private sector • Has a long term subordinated loan of $19.6 million from GoJ/WB • 20% over collateralization based on full recourse to primary lender • Exemptions granted: • For CAR, housing loans refinanced by JMRC have a 20% risk weight • Banks are not required to have a General Allowance for housing loans refinanced with JMRC • Bonds risk-weighted at 20% and eligible to serve as liquidity assets of banks • Bonds are exempted from ownership transfer fees and charges • Bonds are tax exempt from interest as well as capital gains • Till Dec. 31, 2010, refinanced loans of JD539 million with outstanding balance of JD150 million and issued bonds of JD628 million with outstanding balance of JD141 million

16. Egyptian Mortgage Refinance Company (EMRC) • Incorporated in 2006 as a Joint stock company with a current paid-up capital EGP214 million • 27 Shareholders: Public sector - 40%, private sector - 60% (IFC-7.9%) • Only shareholders can benefit from the refinancing facility • 20% over collateralization based on full recourse to primary lender • Primary mortgage shareholders to replace loans that are prepaid / redeemed or more than 3 months delinquent • Loans outstanding as at end December 2010 – EGP277 million • Company has done business with 6 clients – 3 banks and 3 MFCs • No bond issuance as yet

17. Palestine Mortgage & Housing Corporation (PMHC) • Started operations in 2000 as closed public shareholding company with paid-up capital of USD14.9 million • 14 shareholders including PIF 15%, PDIC 30%, IFC 15%, Consolidated Construction Co 15%, Arab Bank 10%, DEG 10% • 20-year WB loan of USD17 million • PMHC offers a maximum of 80% refinancing of appraised property value and PMIF can insure up to 70% of the loan • Declining volumes because: • Banks have introduced their own products which are better • Lenders are using their own liquidity • PMHC ties its mortgage insurance product to refinance • PMHC’s practice of seeking business directly has led to an unclear role • $15.4 million refinanced by PHFC as at end 2010

18. Lessons • Some motivation for financial institutions to refinance/sell their loans (Banks versus multi finance companies) • Sufficient demand for and supply of affordable houses  • A functioning primary mortgage market with the legal and regulatory framework in place  • Critical mass of eligible mortgage loans denominated in local currency  • Ability to assign/transfer mortgage loans  • Existence of a capital market and an investor base  • Commitment by the Central Bank and/or Government to initially take a minority ownership in the LF to lend credibility to the LF in its operations  • Shareholding Structure – Majority owned by private sector (mortgage originators with minority shares by Central Bank)

19. Lessons (Contd) • Support given by Government and Central Bank in initial stages of LFs  • Concessions given to LFs’ bonds to kick start the market  • Don’t overestimate growth of the mortgage market and LF’s share of the market in the business plan before establishment of the LF  • Recruitment of a capable CEO with well-known track record to drive the organization  • Ability of the LF to re-engineer and diversify into other products before reaching saturation point for refinancing of mortgage loans  • Organization Structure – Keep the organization “lean” in the initial years of operations until the volume of business builds up to sufficient scale  • Have good risk management practices particularly with regard to Asset Liability Management