Olivier Hassler The World Bank

1. Securitizing Affordable Housing Loans: the Role of GovernmentsAffordable Housing and Housing Finance South Asia Housing Finance ForumDelhi, January 27-28, 2010 Olivier Hassler The World Bank Housing Finance ProgramCoordinatorFinancial and Private Sector Development ohassler@worldbank.org GCMNB

2. Securitization started as a government intervention tool (Freddy Mac, 1970s, to help Savings& Loans dire A/L mismatches) • Explosion of structured finance in the last 10years • Crisis and collapse of the market in the US, resulting in a worldwide disruption of securitization • Still, an instrument needed to back long term maturities and fixed rate loans, critical for the soundness of housing finance and its affordability • But the crisis • was ignited in the subprime segment, often equated with low income • Unfolded in the country where government related entities had remained major players, with a mandate to deepen the market (Fannie Mae and Freddy Mac, FHA/ GNMA). •  Lessons from the crisis and challenges to use securitization for low income housing finance

3. THE CRISIS

4. AAA AAA AA/A BBB BBB BB-B BB-B Securitization – Basic Structure Individual MortgagesMBS Originator SPV Investors • Portfolio sold to a Special Purpose Vehicle • Bankruptcy remoteness • Condition: “True Sale” (independent SPV, originators relinquish control over assets) • Investors’ direct exposure on the portfolio  various degrees of protection (credit enhancement) • Restructuration of cash flows • Issuance of bonds with different profiles (tranches) AA/A

5. Securitization structures did not withstand the subprime debacle • Multiple tranches/bonds (CUSIP) with different characteristics and behaviors • Normally, credit enhancement increases over time since AAA bonds are repaid first • Sub-prime/ Alt A 2005-2007: losses quickly exceeded credit enhancement (20% typical for subprime), overflowing on senior tranches

6. Re-securitization : a major contagion vehicle • Second, or third level structures, based on leverage and rating arbitrage • Credit enhancement created an illusion of safety : • Either internal and overwhelmed by actual losses • Or external (“bond wraps”) by monoline financial guarantors. Incurred large losses, leading to drastic downgrades and weakening of the support • Leverage mostly short term (credit, ABCP), based on another illusion among investors - banks, money market funds- : a AAA paper would always be liquid

7. Uncontrolled surge of financial transactions • Huge Transaction Volumes leading to Operational Deficiencies (USA and other developed markets) • Explosion of claims within the financial system . Growth of MBS disconnected of the real economy (*4, or +27% p.a. 2000-07) • Millions of mortgages , millions of bond tranches, re-securitization, illegible trustee reports • Inability of rating Agencies to adequately assess and monitor all the bonds • Lags and weaknesses of valuation models(e.g.use of CDS to price credit risk) • Extreme Complexity of unregulated Capital Markets Products • Sophistication of products – e.g. multiple tranches with specific behavior • Intensive use of leverage to fund loans = quasi banking activity (“shadow banking systems) • …Without regulation • Sudden awareness of opacity  deep confidence crisis, especially towards LI mortgage lending, equated with subprime

8. THE GOVERNMENT SPONSORED ENTERPRISES CRISIS

9. The US GSE Model : Causes of F&F Demise • Mission: • Ensure and regularize the flow of resources towards mortgage finance • Promote the access of underserved categories to housing finance (goal of +/- 50% set annuallysince 1992) • Structure: Special legislative charter, private capital, HUD + OFHEO oversight • Abyssal losses  negative equity  placed in conservatorship (Sept 08), 80% of capital held by the government • Immediate factors: • Support to Alt A loans • Investments in MBS collateralized by subprime mortgages Although about 20% of MBS guaranteed or held, source of the majority of losses ; 60% of AAA MBS bought by F&F downgraded to junk (House Committee on Financial Services Report, June 2009)

10. F&F Model Structural Flaws • Assumption of whole credit risk (shared only for high LTV loans)  Huge risk concentration • PPP model: misalignment corporate incentives / public mandate • Capture of the implicit subsidy allocated to the entities: • development of own portfolios ($1.8 Tln in 2004) to maximize its impact on profits • Small share of the subsidy value passed on to end users (est. between 0 and 35 bp) • FHA/GNMA crowded out (overall impact of the 3 agencies stationary) • Reaction to fall of market share (72% of all MBS in 2004, 57% in 2006) due to the growth of private label MBS: • investments in private MBS • relaxation of underwriting criteria and support of Alt A segment (# FHA) • Weak regulation and oversight • Low capital adequacy requirement • Relaxation of some accounting standards (NPL) • Weak supervision (close ties with the specialized supervisor)

11. A more resilient mixed economy model : the Canadian MBS market • MBS =29% market share (2007) • Standards set since the 1990s by the Office of the Superintendent of Financial Institutions and the Deposit Insurance Corp.- emphasis on creditworthiness • Financial Consumer Agency of Canada, est. 2001: a protection against reckless lending • Bank Act: MI compulsory for mortgages > 80% LTV (75% before 07) • In practice, 0% down-payment existed until 2008 (5% mandatory now) • Government guarantee for MI, public (CMHC) or private (2 insurers), for a premium • National Housing Act: CMHC guarantee of MBS (90% of MBS) All underlying mortgages must be insured • Prevalence of portfolio lenders also an important factor

12. RESTORING THE MARKET - THE ROLE OF GOVERNMENTS

13. General Orientations to restart securitization Numerous on-going initiatives industry/regulators, national/international to restore markets and investors’ confidence: 1) Lending norms and origination practices • Quality standards • Due diligence and post-issuance verification by third parties • Exposure retention by originators to align incentives • Enhance transparency : data, qualitative information standardized definition (LTV, DTI, etc.), accessibility • Regulate securitization structure: capital charges as a deterrent to re-securitization, leverage limitations • Enhance investors’ capacities: better education, valuation tools and accounting rules (problem of marked- to-market as well as marked-to-model)  Value of a specialized agency to set standards, check and certify compliance

14. A possible model: Colombia • Titularizadora Colombiana: Central private sector securitization agency • Select originators and servicers • Define lending standards and loan eligibility criteria, e.g. scoring • Provides valuation model • Acts as a master servicer • Provides regularly market information  Ensures transparency and allows investors’ confidence • But government support critical for the success of securitization (30% market) : • Conservative prudential framework • Income tax relief for investors (not a sustainable factor)

15. Application to Low Income Housing Finance • Lending norms: the assessment of repayment capacity of special importance: • budget analysis maybe more important than DTI ratios • Informal sector: Verification, or adequate estimation of income • Assessment to be based on full interest/amortization rates if lowered initial payment phase • Avoid excessive reliance on LTV, and on price appreciation expectation • Importance of responsible lending and access to indebtedness information • The recovery performance of servicers of the essence. Should be an eligibility criteria and a public information - Ex.(primary level credit enhancement); US FHA, Colombia Guarantee Fund • Importance of supporting alternative lenders that finance underserved categories - Mexico: SHF’s new strategic orientation

16. A promising experience? Micro Credit Securitization in Bangladesh Successful securitizations of BRAC micro-credits, incl. housing loans ($ 15Mln ) High performance history/credibility/information system of the originator Large credit enhancement: 50% Overcollateralization, 16% cash reserve, replacement of NPL, Importance of a rating agency (CRAB) with proportionate operational capacities Public support: FMO/KFW guarantee for Subordinated tranche

17. Credit Risk Sharing Arrangements • Securitization is about transferring risks. Even if quality standards are warranted, investors reluctance to be exposed to LI credit risk will not recede easily given the subprime crisis • External guarantees probably necessary beside internal credit enhancement. Unlikely to be developed without government support • Danger: moral hazard resulting in uncontrollable fiscal contingent liabilities. Need of safeguards: • Appropriated risk sharing with originators/servicers • Premiums charged for the coverage • Guarantees on portfolios, not to an institution • Clear eligibility criteria and surveillance to ensure the desired targeting

18. Reconciling affordable loan profiles with investors demand • Features of special importance for LI segments: slow amortization rate, prepayment option, stable payments, no exchange risk • Investors may want short term instrument, – particularly if market liquidity is low-, predictable cash flows, a protection against capital depreciation (floating rate, indexation, hard currencies, etc.) •  Need of a buffer • In the absence of hedging instrument, the government can sponsor reconciliation mechanisms. Ex.: • Mexico: swap between different indices • Colombia: equalization fund between short term rates and fixed real rate loans