MBS Project Report

8/8/2019 MBS Project Report

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Submitted to:

Mr. Alok Kumar

Submitted by:

09IB-019: Garvita Bajpai

09IB-031: Manmohan Sharma

09IB-040: Rachit Kaul

09IB-056: Sooraj Menon

Mortgage-Backed Securities in India

Fixed Income Securities


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FIS_2009-10 IMT Ghaziabad Page 3

Benefits to mortgage industry .......................................................................................................... 24

Analysis of the problems ....................................................................................................................... 25

Indian RMBS Market Recommendations .............................................................................................. 25

Development of specialized servicers: not an immediate need ....................................................... 25

NHB in a new role, or a new specialized agency for secondary market in mortgages ..................... 25

Specialized securitization agency for RMBS.................................................................................. 27

Development of other agencies leave it to the market ................................................................. 28

Private label securitization service providers: .............................................................................. 28

Mortgage insurers ......................................................................................................................... 28

Permitting and encouraging banks to invest in Mortgage-backed securities .................................. 29

Risk Assessment of Investing in MBS: ................................................................................................... 30

Credit Risk ......................................................................................................................................... 30

Prepayment Risk ............................................................................................................................... 31

The Securitization Act a futile exercise .......................................................................................... 32

Problems of the existing legal system: ............................................................................................. 32

Mortgage debt regarded as immovable property: ....................................................................... 33

Stamp duty issue: .......................................................................................................................... 33

Mortgage foreclosure laws: .......................................................................................................... 33

Clarity on taxation: ........................................................................................................................ 34


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MBS An Introduction:

Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from

pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased

from banks, mortgage companies, and other originators and then assembled into pools by a

governmental, quasi-governmental, or private entity. The entity then issues securities that represent

claims on the principal and interest payments made by borrowers on the loans in the pool, a process

known as securitization.

Most MBSs are issued by the Government Agencies, or the Federal National Mortgage Association

(Fannie Mae) and the Federal Home Loan Mortgage Corporation houses. Some private institutions,

such as brokerage firms, banks, and homebuilders, also securitize mortgages, known as "private-

label" mortgage securities.

Mortgage-backed securities exhibit a variety of structures. The most basic types are pass-through

participation certificates, which entitle the holder to a pro-rata share of all principal and interest

payments made on the pool of loan assets.


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More complicated MBSs, known as collaterized mortgage obligations or mortgage derivatives, may

be designed to protect investors from or expose investors to various types of risk. An important risk

with regard to residential mortgages involves prepayments, typically because homeowners refinance

when interest rates fall. Absent protection, such prepayments would return principal to investors

precisely when their options for reinvesting those funds may be relatively unattractive.

RESIDENTIAL MORTGAGE-BACKED SECURITY:

Residential mortgage-backed securities (RMBS) are a type of bond commonly issued in American

security markets. They are a type of Mortgage-backed security which are backed by mortgages on

residential rather than commercial real estate.

COMMERCIAL MORTGAGE-BACKED SECURITY:

Commercial mortgage-backed securities (CMBS) are a type of mortgage-backed security backed by

mortgages on commercial rather than residential real estate.

CMBS issues are usually structured as multiple tranches, similar to CMOs, rather than typical

residential "pass through". The typical structure for the securitization of commercial real estate

loans is a Real Estate Mortgage Investment Conduit (REMIC), a creation of the tax law that allows the

trust to be a pass-through entity which is not subject to tax at the trust level.

Many American CMBSs carry less prepayment risk than other MBS types, thanks to the structure of

commercial mortgages. Commercial mortgages often contain lockout provisions after which they can

be subject to defeasance, yield maintenance and prepayment penalties to protect bondholders.

European CMBS issues typically have less prepayment protection. Interest on the bonds is usually

floating, i.e. based on a benchmark (like LIBOR/EURIBOR).

Collateralized mortgage obligation:

A collateralized mortgage obligation (CMO) is a type of financial debt vehicle that was first created in

1983 by the investment banks Salomon Brothers and First Boston for U.S. mortgage lender Freddie

Mac. (The Salomon Brothers team was led by Gordon Taylor. The First Boston team was led by

Dexter Senft[1]).

Legally, a CMO is a special purpose entity that is wholly separate from the institution(s) that create

it. The entity is the legal owner of a set of mortgages, called a pool. Investors in a CMO buy bonds


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issued by the CMO, and they receive payments according to a defined set of rules. With regard to

terminology, the mortgages themselves are termed collateral, the bonds are tranches (also called

classes), while the structure is the set of rules that dictates how money received from the collateral

will be distributed. The legal entity, collateral, and structure are collectively referred to as the deal.

Investors in CMOs include banks, hedge funds, insurance companies, pension funds, mutual funds,

government agencies, and most recently central banks. This article focuses primarily on CMO bonds

as traded in the United States of America. The term collateralized mortgage obligation refers to a

specific type of legal entity, but investors also frequently refer to deals issued using other types of

entities such as REMICs as CMOs.

Housing Finance in India:Mortgage penetration increased significantly till 2007, but has slowed since then The Indian housing

finance sector reported a compounded annual growth rate (CAGR) of 56% during the period 2003 to

2007, aided by benign interest rates, rising property prices, and increasing income levels.

Thereafter, the growth rate slowed down, with steep real estate prices, high interest rates, exit of

investors from the market, and a weak operating environment making their impact felt. In the

current financial year (2009-10), there has been some revival in buyer sentiment with interest rates

declining and property prices witnessing some correction.

Mortgage penetration levels (mortgage loans 1 as percentage of GDP) in India, which had risen from

around 2% as in March 2002 to a little over 7% as in March 2007, have remained at the 7% levels till

date. This being significantly lower than the penetration rates in developed countries; it appears


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there is room for further growth. Going forward, some factors that may contribute positively to

growth in mortgage penetration in the domestic market are as follows:

Decline in rates of interest to 8% - 9% from 12% over the past one year; this amounts to a15% - 25% reduction in the equated monthly instalment (EMI) per Rs. 2 Lakh of loan

Increase in supply of affordable homes and price correction in the residential real estatemarket

Increase in economic activity Large inventory of unleveraged homes (which could be pledged by borrowers to raise loans) Increase in income of Government employees following implementation of the Sixth Pay

COMMISSIONS RECOMMENDATIONS:

However, it is also likely that a further correction or even stagnation in real estate prices may lead to

borrowers deferring home purchase decisions on the expectations of another round of correction.

With the tenure of most HFC borrowings being shorter (because of the lack of availability of long-

term funds at competitive rates) than that of housing loans, asset-liability-mismatch (ALM) risks are

inherent in the housing finance business. While prepayments (typically in excess of 10% of the

opening loan book in a year) and unutilised bank lines do help the HFCs maintain a comfortable

liquidity profile, such lines may not be available (or may be available at high interest rates) in a stress

scenario. This issue could be addressed by making long-term funding sources available at

competitive rates through further development of the capital markets and a mortgage backed

securitisation market.

REAL ESTATE:

So far, property financing in India has been largely implemented through conventional funding

methods, meaning mostly domestic bank loans and private equity. Real Estate Investment Trusts

(REITs) have not yet emerged, and only a few property companies are listed.

Lease Rental Discounting (LRD) structures have been used, mostly by public sector banks, to secure

their debt exposures to the real estate sector. Sale Proceeds Escrow structures -- backed by sales

proceeds from projects -- have also gained popularity among developers seeking project finance.


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However, neither LRD nor Sale Proceeds Escrow structures are bankruptcy-remote from the

developers. Interestingly, construction projects have already been implemented through joint

ventures, and some banks are involved in project finance for real estate SPVs.

Deploying real estate SPVs in a CMBS may not represent so big a leap. However, based on our

analysis of key success factors for CMBS, Indias regulatory environment is still challenging. Title due

diligence can be lengthy, and mortgage enforcement is still an issue for non-banker lenders.

Stamp duties are another major obstacle. In terms of the environment, a broader investor base and

more transparency are also needed for issuance to take off. The existence of a favourable code for

REITs Real Estate Investment Trusts is among the critical factors which could significantly boost

CMBS issuance. This is because REIT could potentially optimize their funding strategies with CMBS

and drive issuance, as they have done in Singapore.

Among other Asian countries we have reviewed in this report -- Singapore, Taiwan, Hong Kong, and

China Singapore indeed has emerged as the most exemplary. In this market, REIT-originated

transactions represent 96% of the USD3.2 billion CMBS issuance rated by Moodys since 2003.

Though presently there are various constraints to the growth in CMBS in India, some positive trends

have emerged In particular, the creation of real estate SPVs a trend which has already begun

would remove many issues related to property transfers. In addition, the central government is

encouraging a reduction in stamp duties.

And the investor base could be broadened by the creation of REITs and Real Estate Mutual Funds.

Finally, the new Basel II regulations place CMBS on a favourable footing vis--vis plain loans. Should

these trends continue in the coming months, CMBS could emerge in India as another funding

alternative for achieving bankruptcy remoteness and access to better rated debt.

In addition and over the longer term, subject to the opening of Indian real estate debt to foreign

investors, CMBS cross-border issuance could become an attractive option for real estate originators.

In Singapore, 91% of the issuance rated by Moodys has been cross-border.

FACTOR FAVOURING CMBS IN PAN ASIA:

Efficient processes for title and mortgage registration, enforcement of mortgages as well as

favourable REIT codes are 3 factors in the regulatory environment, and which could help the

development of a CMBS market in ex-Japan Asia.


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OTHER CMBS/REAT MARKETS IN EX-JAPAN ASIA:

Since 1999, Moodys has publicly rated 21 CMBS or REAT transactions in ex-Japan Asia. Included in

this report are four ex-Japan Asian markets. Singapore has been the most active recently: 96% of

Moodys rated issuance in Singapore was REIT-originated, and 91% cross-border.

A: Singapore Leading the Way

The CMBS market in Singapore has been robust. The majority of its transactions were originated by

REITs. As of 2007, 17 REITs were listed in Singapore and worth USD18 billion in market

capitalization. The success of the CMBS market has been mainly due to Singapores favourable

macro-economic conditions, government policies to promote the city as a financial hub, the upward

trend in the property cycle, and Singapores favourable REIT code in particular its gearing limit.

Among measures to promote transparency and efficiency, the Urban Redevelopment Authority

(URA) acts as the official government database on property values. It provides searches for and

access to a diversity of property-related information.


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Since the first REIT was launched in Singapore in 2002, Moodys has publicly rated 13 CMBS,

included 12 sponsored by 7 REITs15. Investors have become familiar with these transactions, which

have also contributed to their success. There have been a wide variety of commercial properties

securitized, from retail and office buildings to industrial and business parks, logistics buildings and

warehouses.

In addition to traditional CMBS, which rely more on going-on rental collections and the value of

mortgaged properties, another prominent asset class in Singapore is securitization of

progressive/deferred payments from the purchasers of yet-to-be completed residential projects.

Through such a securitization exercise, developers recoup the initial project investment costs and

fund the remaining construction costs.

B: Hong Kong: Dominated by Conventional Funding

Four CMBS in Hong Kong were rated by Moodys in 1999 and 2000. At that time, developers lacked

funding sources. But with abundant liquidity, CMBS issuance ground to a halt in 2001. In 2005, the

first REIT was launched by the Hong Kong Housing Authority on behalf of the government. As of

December 2007, there have been 7 REIT listings. Their properties are in Hong Kong and China. The

types range from car parks, retail, and commercial to office buildings.

The most recent IPOs were Regal REIT and RREEF China Commercial Trust in March and June 2007.

The securitization market in Hong Kong is equipped with a clear legal framework, seasoned

intermediaries and records in CMBS issuance. However, ample liquidity in the capital market --

coupled with lower cost funding alternatives -- has made CMBS less attractive for potential

originators.

As a result, unlike Singapore, Hong Kong REITs have not driven CMBS issuance. In addition to

abundant local liquidity, this could also be due to certain restrictions under current regulations,

including a prohibition on real estate development activities by such entities, a 2-year minimum real

estate holding period, and a maximum 45% gearing ratio.

C: Taiwan: Sporadic Issuance Expected

The Real Estate Securitization Law (RESL) was enacted in July 2003 and provides a sound legal

foundation for the development on REIT and REAT in Taiwan. Other than the absence of a mortgage,

all the essential elements in a REAT deal are the same as those in any CMBS. 16 As of 31 December,


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2007, a total of 8 REITs and 9 REATs have come to the market (chart 3 in appendix A). The average

REAT size16, close to USD75 million as of 31 December, 2007, is typical of domestic transactions in

Asia, while average CMBS issuance in Singapore was USD236 million over the last two years and

mostly cross-border.

The underlying properties of Taiwan real estate securitization deals are office buildings, and only a

few are retail, logistics and serviced apartments. In addition, these properties are highly

concentrated in Taipei.

Unlike REITs and CMBS in Singapore, Taiwanese REITs are not driving REAT deals. REAT cannot be

used by Taiwanese REITs as an optimized funding source. Although it has a well-structured legal

framework, Taiwans real estate securitization market is constrained by the lack of growth in the

commercial real estate market and abundant liquidity.

In addition, there are restrictions on the type of properties in which the trusts can invest. REIT and

REAT are only permitted to invest in properties generating steady income. Investments in developing

or undeveloped real estate are not allowed. To further assure the asset quality of a REIT, regulators

posted stringent standards in July 2006 on asset diversification and quality. Such guidance provides

better protection to investors. But, on the other hand, it may also suppress supply of new REITs.

Since the announcement of these standards, only one new REIT has come to the market.

D: China: Developing Framework, Huge Potential for CMBS

The first CMBS debuted in China in 2006. The USD145million Dynasty transaction was cross-border

and backed by 9 retail properties in various capital cities of China. The transaction was successfully

launched in spite of complications associated with its multi-jurisdictional structure and the security

package needed to address legal and administrative issues.

The Chinese government has introduced measures to curb excessive growth in the real estate

market and to reduce speculative activities. These measures govern the property holding structure,

the level of registered capital of a real estate Foreign Investment Enterprise (FIE), and the use of

shareholder loans for capital injections and distributions. As a result, the structure used in the first

CMBS is of very limited application. As such, future China CMBS may need to incorporate

adjustments to property holding structures and changes in relevant security packages.

The PRC Property Right Law (Property Law) was promulgated and approved by the National People's

Congress (NPC) on 16 March 2007 and effective 1 October 2007. One section involves the grant of


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security interests over property in various forms, including mortgages, pledges and lien. With

regards to CMBS, the most notable changes concern the expedited enforcement procedures.

The tax concerning property transfer is a significant issue for CMBS issuance. However, potential

domestic transactions could transfer just the mortgage rights, instead of the property, to a Special

Purpose Trust (SPT). As such, stamp duty would not apply.

To date, 3 REITs focusing on Chinese assets have listed offshore: one in Singapore, Capita Retail

China Trust and two in Hong Kong, GZI REIT and RREEF China Commercial Trust which listed in June

2007. But China lacks a framework for domestic REITs.

Moodys still believes that China has the potential for sustainable CMBS growth. Some of the

positive economic factors include continuous growth of the Chinese economy; increasing numbers

of foreign enterprises; the 2008 Olympic Games, and the 2010 Shanghai World Exposition.

INDIA:

REVIEW OF ENVIRONMENT FOR CMBS

A:SIGNIFICANT ISSUES IN THE REGULATORY ENVIRONMENT

Some issues in the Indian environment are not specific to CMBS transactions. Despite a long

tradition of private ownership, the presence of heavy regulation does not facilitate development of

the real estate sector. The Indian legal framework provides for transfer of property and recognition

of title. The applicable legislation dates back to the 19th century. The Transfer of Property Act, 1882

is the legislation that regulates transfers of property. Hence, there is a long tradition of private

ownership of property as well as land.

However, there are numerous caveats. Real estate in India is heavily regulated at several levels. Land

is a responsibility of the state, and each state has regulations governing its use. Any residential or

commercial real estate development in India has to secure numerous regulatory clearances9.

In India, land can be either freehold or leasehold. Lease tenures and terms vary. In some places, like

Mumbai, the government does not sell its land; it instead leases it on long- terms renewable for a

marginal fee. The lessee is allowed virtually all the rights of an owner, including the power to

mortgage (through a registered mortgage) and develop it.


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The title alone remains with the government. There is a title deed registration system. Registration

authorities are required to verify the genuineness of the property and its title while registering a

document. But, although they may verify it, the registration authorities in India do not guarantee the

title ownership. Mere registration of a document of title does not assure perfect title. Title insurance

is not commercially available in India.

Title to property is generally presumptive rather than conclusive. Title chains often are long and

buyers are well advised to undertake a title check, a process involving visits to government

registration offices and placing of advertisements calling for challenges to title. This has meant that

local lawyers are often hired to do title checks, but even then, there are chances that past

conveyances may not be legally perfect -- say, not stamped, or registered, or lacking the consent of

all those with a veto.

Adverse possession is yet another peculiarity, wherein if a person is in hostile (vis--vis the real

owner) occupation of a property beyond 12 years, he/she can claim ownership rights. Mortgages can

be created on property in India merely by the deposit of title deeds. Although it is not required by

law, if the mortgagor is a company, the fact of mortgage can be recorded with public registries for

achieving additional protection.

Non-corporate owners too can create a mortgage merely by depositing title deeds. Unless suchmortgages are registered with the registration office (by law, they are not bound to), it may thus be

difficult to assess the encumbrances on a given property. Registration authorities in India do verify

the genuineness of documents, but they do not guarantee the goodness of title. The possibility of

multiple/forged title documents also exists. These issues highlight the importance of due diligence,

legal and technical, into the title and suitability of the land before commencing a project.

Enforcement of mortgages through the conventional judicial system is typically lengthy, often

running into years. The situation changed after the SRFAESI Act, 2002, which provides for fast track

enforcement procedures. This Act, however, is available only for banks, housing finance companies,

some financial institutions and designated asset reconstruction companies. Mutual funds and most

of the non-banking finance companies and insurers, for instance, are not covered by this act.

To the extent banks invest in CMBS, the benefits of this Act may be available. Mutual funds, the

biggest investors in the Indian debt capital markets, do not have access to these procedures. The

India capital markets regulator, SEBI, issued draft guidelines on REITs in December 2007. Highlights

included a cap on leverage at 20% of total assets, a prohibition on investments by REITs in vacant


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land/property developments, and a dividend distribution requirement of 90% of annual net income

post tax. Taxation of REITs and the applicability of stamp duties are issues which remain un-clarified.

Nevertheless, the potential for REITs based on Indian assets has already been explored offshore. In

August 2007, Ascendas India Trust listed in Singapore with the objective of setting up four business

parks and three information technology centres in India. It is possible that the issuance cost of off-

shore CMBS would outweigh onshore transactions, especially when the underlying assets are in

India. Should the Indian environment become more favourable for CMBS, Ascendas India Trust and

any future REIT with Indian assets - would become potential originators of CMBS in India.

B:STAMP DUTIES STILL AN OBSTACLE

Transfer of property requires execution of appropriate conveyance documents which need to be

stamped after payment of duty and registered with the government registration offices. The

transfer of immovable property is taxed at the state level.

In Karnataka, a south-western state, conveyance of immovable commercial property attracts stamp

duty of 8.5% of the agreement value or guideline value, whichever is higher. Registration duty is 1%

of the market value. Other states have duty rates in the neighbourhood of these levels. Individual

states have capped duty payable in some cases. For instance, in Maharashtra, stamp duty payable

on certain kinds of commercial real estate is capped at INR1 million (regardless of the duty payable

at the ad valorem rates mentioned above).

The registered mortgage of immovable property attracts duty (Karnataka levies 1% on the loan

amount as stamp plus registration duty), thus making registered mortgages an unattractive option

for lenders.

High stamp duties, registration charges and capital gains tax (applicable on profits made on the

transfer of property) leads to a high incidence of cash transactions. These are typically routed

through various shell companies within a group.

C:NEED FOR BROADER INVESTOR BASE AND INCREASED TRANSPARENCY

Traditionally, real estate development in India was highly fragmented. The state also played a large

role. During Indias socialist period, state agencies -- such as development authorities exercised

monopoly development rights in addition to regulatory duties. The last few decades (especially post

1991) have seen a substantial shift with the emergence of large private players looking at scale and


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world class construction standards. This shift has been accompanied by the entry of internationally

renowned players in both the developer as well as intermediaries segments.

A variety of factors discussed above have led to corporate governance issues within real estate

companies in India, including inadequate transparency and disclosure. The typical areas where there

is lack of clarity are the size and number of projects executed by a property group, the exact extent

of land ownership, end-use of customer advances, and the consolidated indebtedness and cash

flows of the group.

To a degree, the complexity in land holding structures is attributed to regulations, such as the Urban

Land Ceiling (Regulation) Act, 1976 which placed a cap on land ownership. There is no central land

registry, although such registries, where records of property trades can be accessed, do exist at the

state/city level. State governments maintain their guideline values (also used by local authorities to

levy property tax), but these are often dated and may not reflect market conditions.

Transactions values are often understated in order to suppress the incidence of capital gains and

transfer taxes on property sales. The absence of a reliable official / government database of property

values make it difficult to establish the value of property held by a company.

This problem is greater in the smaller cities, namely, the Tier II and Tier III cities. Hence, the property

trade in India is not very transparent and valuation remains an art. However, India has a large

community of third-party valours, who offer perhaps the only rigorous way of assessing value in the

absence of a transparent and accurate record of trades. The property market is fairly liquid,

especially in the cities where substantial projects are present. Hence, the availability of valuation

estimates is not an issue and this mitigates the risk to some extent.

On the investor front, mutual fundswhich form the key investor base for the domestic debt capital

marketmostly have appetite for debt maturing within three years, as opposed to CMBS, whichcould have tenures of 3-9 years or more. The illiquidity in long-term structured debt means CMBS

are not favoured by mutual funds. Of course, CMBS could be structured as short-term instruments,

but developer/originator community appetite may be limited. While insurance companies and

retirement funds could be suited for investing in such paper, the investment guidelines for these

institutions leave little room for such paper.

While a broader investor base and more transparency are required, the Indian macro-economics and

real estate outlooks are extremely favourable for CMBS. The Indian real estate industry has seen


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unprecedented growth in recent years. Demand for commercial space has been driven by strong

growth in the software sector, Business Process Outsourcing (BPO) and organised retail.

On the other hand, rapid population growth, growing urbanisation, decreasing household sizes and

rising income levels together with easier access to finance have pushed up demand for residential

property. These growth trends are set to continue with some participants forecasting that real

estate development in India will grow from USD12 billion in 2005 to USD90 billion by 2015.

Case for CMBS to Flourish In India:

A:SOME MITIGANTS TO REGULATORY ISSUES

First, title due diligence, although lengthy, could be worth implementing for commercial mortgages

involving a limited number of properties. Concerning mortgage enforcement, the SRFAESI Act

provides for fast track enforcement procedures. This Act, however, is available only for banks and

designated asset reconstruction companies.

Mutual funds, the biggest investors in the Indian debt capital markets, do not have access to these

procedures. A way-out would be for domestic ratings to address eventual payment of principal and

interest (as opposed to timely payment of both interest & principal), but acceptance of such a rating

promise in the Indian context could prove elusive.

A solution could involve including a reserve fund and liquidity facility from a highly rated bank, and

which could plug the cash flow gap between default and realisation of money from the security. The

availability of title insurance on a commercial scale also would help. An extension of SRFAESI Act

provisions to mutual funds and NBFCs11 is another possibility.

The introduction of Real Estate Mutual Funds (REMFs), entry of private equity investors, repeal of

socialist-era legislation, such as the Urban Land Ceiling (Regulation) Act, 1976, and listing norms

would raise transparency for accounting norms and disclosure. These steps would bring much

needed liquidity to the property market.

In addition to REMFs, SEBI has initiated a process to introduce REITs. Once regulations are finalized,

there could be solutions to issues such as taxation of SPVs and high stamp duties.


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B:CENTRAL GOVERNMENT ENCOURAGING REDUCTION IN STAMP DUTIES

The creation of SPVs from the outset -- to house projects/properties, a trend which has begun,

would minimise transfer taxes and provide bankruptcy remoteness. We can also expect greater

alignment of interest across developers and investors through the provision of credit enhancement

in CMBS. If the credit enhancements come from the developers themselves, they would retain a

stake in the project, even post securitisation.

A reduction in transfer taxes, such as stamp duties, would help reduce the incentive for evasion and

encourage creation of bankruptcy remote SPVs. Stamp duty is the prerogative of state governments,

but the central government has been urging the states to reduce them to 5% as part of its urban

land reform efforts.

The central government is also encouraging states to move to a more transparent system of

property tax, whereby updated property values form the basis of the levy. Many local bodies have

made this migration. Many cities are also undertaking surveys, using geographical information

systems to plug revenue leakage from untaxed properties. These steps should help bolster property

tax collections and, hopefully, help state governments reduce transfer taxes. This would in the long

run simplify the valuation conundrum.

C:POTENTIAL FOR NEW INVESTORS

The introduction of REMFs/REITs12 will go a long way towards institutionalizing the real estate

sector and bringing in a larger number of investors. Changes in investment guidelines for insurance

companies and retirement funds could broaden the potential CMBS-investor base. Insurance

companies and retirement funds are ideally suited for investing in CMBS. But currently, their

investment guidelines leave only a little room for securities other than government securities. But it

is possible that these rules may evolve. Indeed, the same rules have also restricted appetite forother types of paper, including RMBS, which are seen as important by policy makers.

The new Basel II regulations governing bank capital also place CMBS on a favourable footing vis--vis

plain loans. While all bank exposures to the commercial real estate sector is risk weighted at 150%

(regardless of the credit rating), exposure to CMBS will be risk weighted as per their ratings.

Securities rated the equivalent of AAA to A on the national scale will rank for risk weighted purposes

from 50-100%, lower than the 150% prescribed for direct exposure to commercial real estate. The

RBIs concerns regarding overheating in some pockets of the real estate sector, which may translate


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into an increase in risk weighting for exposures to commercial real estate, sectorial caps and appeals

to commercial banks to curtail lending to the real estate market, could limit the sectors access to

bank funding, thereby encouraging participants to consider alternative funding.

Hence, the pricing advantages for CMBS could become even more significant for those smaller

developers, which do not get access to the bank pricing available to the larger entities.

Mortgage Backed Securities in India

The beginning of Mortgage Backed Securities (MBS) in India was made in August 2000, when

National Housing Board (NHB) issued the first MBS with issue size of INR 59.7 crores, originated by

HDFC Ltd. Till October 2004, NHB has made 10 MBS issues in the secondary market with total issue

size of INR 512.27 crores and comprising of 35,116 housing loans.

While the number of housing loans has increased, the number of MBS issued so far has remained

more or less constant for all the years since 2000, on the basis of total issue size. Also, while the

volumes of securitisation in general have continued to zoom, the RMBS activity remains limited. The

MBS issued so far has been for an aggregate outstanding principal of INR 663.91 crores. The

aggregate principal outstanding against the MBS issued till 2003 was just 0.5% of the total

disbursements made over these years. On an annual basis the percentage of loans converted into

MBS of the total disbursements made in that year has declined from 0.96% in 2003 to 0.34% in 2003.

While 2004 has seen comparatively better performance with MBS of issue size INR 144.75 crores

already issued, the performance of India with regard to developing the secondary market for home

mortgages is far from satisfactory.

One possible explanation for the declining interest in issuing mortgage backed securities is the fact

that the spreads in mortgage lending have come down drastically over time. Interest rates have

declined, and there is stiffening competition. Housing finance has suddenly become the coveted

asset class for a bank to house on its balance sheet which has been responsible for squeezing the

spreads. If the spreads are thin, will mortgage originators securitize? Essentially, the question is one

of mind-set.

There is a notion that securitisation transactions were driven by a gain-on-sale motive1. If gain-on-

sale is the driving motivation, it is understandable that where spreads have dwindled, the extent of


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gain-on-sale will become less significant. However, the gain-on-sale is one of the many motivations

in securitisation.

The most predominant motive is the reduced cost of funding in any mature securitisation market,

a securitisation transaction must result into lower weighted average cost of funding. If it does not, it

is a clear signal that either the rating agencies are dictating too high credit enhancements, or that

the investors are demanding too high premiums possibly due to lack of understanding of the

inherent risks in RMBS.

Both these factors are signals of market inefficiency inefficiency is necessarily transient, if the

extraneous hurdles to development of the market are removed. So, we expound in this article that

the reduced interest in securitisation is in fact the product of inefficiencies of the system, which have

set in process a vicious cycle inefficiency breeding inefficiency

THE USSUCCESS STORY:

The US secondary mortgages market is considered to be the worlds most developed mortgage

securitisation market. Due to this reason it has always been an area of interest to people of other

countries, to see how it has worked and to learn the lessons from it. This study also incorporates this

element besides others and goes to the extent of looking how the advantages of the US secondary

mortgages can be replicated in the Indian context. The US mortgages market consists of primarily

three participants besides the mortgagor: the mortgage originators, the secondary market conduits

and the investors in the secondary market. The mortgage originators are commercial banks, thrifts,

mortgage banks, and mortgage brokers. The main secondary market conduits are Fannie Mae,

Ginnie Mae and Freddie Mae. Some private investment banks also act as conduits in the secondary

mortgages market, but to a limited extent. The investors in the secondary mortgages market are the

pension funds, the life insurance companies, the commercial banks, the thrifts, and Fannie Mae.

The total outstanding mortgage debt in US was $6.2 trillion at the end of 2003. Moreover, at 2003

end the total outstanding debt of three GSEs was more than USD 2.4 trillion, in comparison to the

publicly held debt of USD 4 trillion for the federal government. At the end of Q2 of 2004, the

outstanding mortgage related debt was USD 5357.5 billion dollars as compared to treasury (USD

3755.5 billions) and corporate debt of USD 4569.9 billion. The two-third of Americans won their

homes and over two-third of the residential mortgages are securitized. The US mortgage value chain

is significantly unbundled with different organizations specializing in different parts of the value

chain.


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Institution framework:

Secondary Mortgages Market

REGULATORY FRAMEWORK

The housing and mortgages industry in US is overseen by U.S. Department of Housing and Urban

Development (HUD). It also sets goals for government owned Ginnie Mae, and Government

Sponsored Enterprises (GSE) like Fannie Mae and Freddie Mac.

The Secretary of HUD is the mission regulator for Fannie Mae and Freddie Mac with oversight

authority to ensure that both GSEs comply with the public purposes set forth in their charters. The

secretary is charged with the general regulatory authority over GSEs in all areas other than the GSEs

financial safety and soundness. The secretarys authority includes setting and enforcing three

affordable housing goals, monitoring compliance with fair lending principles, collecting loan-level

data from the GSEs on their loan purchase activities, creating and distributing a public use data base

of non-proprietary GSE purchase data, and providing oversight for new program approval.

The financial safety and soundness of GSEs is regulated by an independent office of HUD, the Office

of Federal Housing Enterprise Oversight (OFHEO). It regulates both the GSEs for safety and

soundness, by ensuring that they are adequately capitalized and operating their businesses in a

financially sound manner.

KEY ORGANIZATIONS IN SECONDARY MORTGAGES MARKET

The three agencies form the backbone of the US secondary mortgages market. Their main objectives

are:

Providing stability to the mortgages market Responding to the changing capital markets Assisting the secondary markets including the support of these markets for affordable housing Promoting access to credit throughout the country by increasing liquidity and improving

distribution of investment capital for residential mortgages market

Secondary market investor buys mortgages within their guidelines and limits, which are revisedfrom time to time depending upon the market considerations


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Fannie Mae

It was established in 1938 to buy Federal Housing Administration (FHA) insured mortgages and to

create a secondary market for mortgages. It is the second largest corporation in US in terms of

assets. Till 1968 it was owned by the federal government, but since then it has been a privately

owned company. Its main activities are:

Pays cash for mortgages bought from lenders in the primary market and keep them in its books Issues Mortgage Backed Securities in exchange of pool of mortgages from lenders Buys MBS from the secondary marketFannie Mae funds it capital requirements by issuing debt securities like debentures, notes, bonds to

the investors. In 2003 it had Senior debt of USD 947.72 billion and Subordinated debt of USD 464.53

billion. The companys main source of earnings are the spread due to yield on mortgages and the

cost endured to buy them, and by fees earned for providing guarantees to MBS issues. The

guarantees issued by Fannie Mae assures the buyers of MBS that they will receive timely principal

and interest payments regardless of what happens to the underlying mortgages.

In 2003 the company had total Mortgage assets of USD 906.53 billion. Out of which MBS accounted

for USD 665.95 billion and loans (mortgages) accounted for USD 240.58 billion. In MBS 71.35% ofMBS were in help to maturity category and 28.65% were in available for sale category.

In the present circumstances the companys role is to provide a steady strea m of mortgage funds to

lenders across the country and introduction of new technologies that make the process of buying a

home quicker, easier, and less expensive.

Ginnie Mae

It was established on September 1, 1968 after being partitioned from Fannie Mae. It is a government

corporation within HUD. It is the only agency to offer mortgage-backed securities backed by the full

faith and credit of the United States government. It provides guarantees on timely payment of

principal and interest on MBS backed by federally insured or guaranteed loans mainly by Federal

Housing Administration (FHA), Department of Veterans Affairs (VA), Rural Housing Service (RHS) and

Office of Public and Indian Housing.

It does not buy or sell loans or issue mortgage-backed securities (MBS) and so its balance sheetdoesn't use derivatives to hedge or carry long term debt. Due to this its balance sheet size is smaller


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in comparison to the balance sheet size of Fannie Mae and Freddie Mac. Also Ginnie Mae has got no

MBS under held tillmaturity category.

Freddie Mac

It was established in 1970 as a private company. Like Fannie Mae it also purchases residential

mortgages and mortgage related securities and issues MBS, but is smaller in size as compared to

Fannie Mae. It also issued debt instruments to fund its activities. Freddie Mac is the purchaser of one

in six mortgages that is done in US. As on March 31, 2004 its mortgage assets totalled $635.6 billion,

of which a total of USD 60.3 billion was mortgage loans and USD 575.2 billion was MBS. It also had

USD 798.9 billion outstanding in guaranteed mortgage backed securities.

Support to GSEs from the US Government

The government of US provides support to GSEs through various means. Some of them are listed

below:

The government provides no direct subsidy Exemption from local and state taxation Exemption from securities registration requirement Line of credit at the US treasury Implicit protection of GSEs debt against defaultPossible problems with GSEs

Availability of fewer funds for business investment Moral hazard problem related to risk taking

Incomplete pass-through of subsidies intended for mortgage borrowers Risk shifting to the Federal Deposit Insurance Corporation Risk taking by GSEs could undermine the stability of the financial system because lot of banks

depend on them for liquidity


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MBS in USA

Mortgage related debt is the most dominant debt category in the US debt market. If we consider the

bond market in entirety and include municipal bonds, treasury securities, mortgage related

securities, corporate debt, federal agencies debt, short term debt and asset based securitization, and

compare the performance of mortgage related debt, then we see that the percentage of mortgage

related debt in the total outstanding debt has increased from 8.11% in 1985 to 23.51% in Q2 2004,

making it the most dominant debt category. At Q2 2004, total outstanding mortgage related debt

was 142.67% of the total outstanding US treasury debt and 117.23% of the total outstanding

corporate debt (Refer Exhibit 3 for details). The mortgage backed securities have clearly seen a

tremendous growth over the years, to now become the leader the debt market. The total

outstanding mortgage related debt at Q2 2004 stood at USD 5358 billion dollars. Another indication

of the dominance of MBS in the US debt market is their daily trading volume compared to other debt

securities. The average daily trading volume of MBS in April 2004 was 307.36% of the agency

securities and 1226.74% of the corporate securities. The average daily trading volume of MBS in US

debt market in 2004 has been in the range of 245% - 307% with respect to agency securities and

around 1000% with respect to corporate securities. The average daily trading volume of MBS in April

2004 stood at USD 243 billion dollars.

ADVANTAGES OF HAVING ASECONDARY MARKET FOR MORTGAGES IN INDIA

A vibrant secondary mortgages market in India will benefit all the stakeholders in the mortgage

chain. This includes issuers, investors, borrowers and mortgage finance industry as a whole. It will

also improve the housing situation and socio-economic situation in the country. The introduction of

MBS can improve housing affordability, increase the flow of funds to the housing sector and better

allocate the risks inherent in housing finance. It will also benefit lot of other industries that depend

upon housing sector in one way or the other. In this paper we will identify the main benefits of

secondary market for the main stakeholders in the value chain.

BENEFITS TO ISSUERS

Reduction in cost of funding, as explained earlier. Capping of credit risk the risk in case of securitisation transactions is capped to the extent of

credit enhancements provided by the originator

Elimination of asset liability mismatches, both in terms of maturities and interest risks


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Increase in liquidity and funding appetite by creating an additional avenue With more efficient use of owned capital, the issuer is enabling to create higher effective

leverage which promotes RoE, hence market capitalization.

BENEFITS TO INVESTORS

Attractive rate of return on investment in a highly-rated instrument, with excellent track recordof rating resilience and recovery rates

Portfolio diversification both geographically and economically Socially responsible investing Ability to buy tranches that matches their appetite

Alternative to investment in government bonds and corporate bonds

BENEFITS TO BORROWERS

Reduction in cost of mortgage finance Greater availability of funds Availability of funding for lower income groups Creation of formalized credit scoring systems which ultimately result into a decentralized,

formula-driven approach to mortgage origination and makes the process extremely fast

On a higher level of development, integrating the origination process with the securitisationprocess, whereby the mortgage originator matures into a mere originator-cum-servicer, for a

much smaller agency cost, and therefore, much lower lending costs.

BENEFITS TO MORTGAGE INDUSTRY

Specialization of mortgage related service providers leading to reduction of costs andimprovements in efficiency

Lender access to alternative funding sources Improved sustainability of longer term housing funding through long term debt market with

reforms of contractual savings institutions like pension funds and insurance companies

Potentially larger investor-base Lenders able to broaden target market, through risk sharing Long term debt market funding can help smooth housing cycles

Improved standardization and supervision of real estate loans, improve transparency andsecurity for borrowers and lenders


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Analysis of the problems

Indian RMBS Market Recommendations

A vibrant secondary market can turn out as an efficient, low cost and stable way of raising money

and managing cash flows in the overall mortgages market. This can be achieved due to economies in

raising money wholesale in the capital markets, in processing the purchase and servicing of large

numbers of mortgage loans, and in managing risks, through diversification.

In this section, we analyse the factors that stifle, either by their presence or in absence, the

development of the RMBS market in India. While on our analysis, we also discount some of the

commonly-cited factors which are not really stumbling blocks and which may be allowed to bedeveloped either by the market forces or over the long run.

DEVELOPMENT OF SPECIALIZED SERVICERS: NOT AN IMMEDIATE NEED

Quite often, one of the factors cited for development of the RMBS market is the existence of

specialized servicers. The phenomenon obviously comes from the US market where securitisation

has developed to an extent where the several components of a mortgage loan are completely

unbundled the origination done by originators who are wide-spread geographically, the servicing

done by servicers who are technology and infrastructure-rich, and the funding done by the capital

markets. To an extent, the risks are sucked out by insurance companies and other credit enhancers.

While this is the wish list of any country wanting to develop securitisation, such a specialized

framework is certainly not a pre-requisite. Specialization itself is a by-product of development

putting specialized agencies as a pre-requisite for development is like putting the cart before the

horse. If securitisation market develops, the need for outsourcing of the servicing function will be

felt, and in India, there is no dearth of outsourcing potentials.

Institutional Framework

NHB IN A NEW ROLE, OR A NEW SPECIALIZED AGENCY FOR SECONDARY MARKET IN MORTGAGES

Under the present institutional framework National housing Board (NHB) is the apex level financial

institution for the housing sector in the country and performs the role of promotion and


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development, regulation and supervision, financing, development of secondary mortgages market

through securitization of housing loans, and promotion of rural housing.

While all the functions that are being carried out by NHB are essential and many more functions will

also have to be carried out, if we ever intend to provide a roof over the head of millions of Indians

who havent got a house, the prevailing institutional framework is not sufficiently equipped to meet

the challenges of the future. First of all, NHB is currently mainly engaged, apart from its regulatory

position, in the role of being a refinancing body. The perils of creating a refinancing behemoth have

already been highlighted earlier. Though NHB avowedly does not take the risks of the mortgage

pools that it refinances, it is not immune from the same. The funding of NHBs own balance sheet

comes from various sources, which include the capital market. There are some tax subsidies in

certain of the funding liabilities of the NHB for example, capital gain bonds.

This structure is surely not efficient if the objective is to provide a capital market window whereby

ultimate investments in mortgage loans can be funded (an investment in NHB is essentially an

investment in mortgage loans), the same can be achieved more efficiently by securitisation. The

current practice of NHB is to provide with-recourse funding to the mortgage institutions, whereby

there is no integration of the credit risk of the mortgage loan pool with the effective capital of the

mortgage originator. All NHB does is to lay down regulatory capital requirements which obviously

do not distinguish between the risks of different portfolios. On the other hand, securitisation will

directly link the level of credit enhancement with a scientifically estimated measure of stressed risk

of the pool, thereby ensuring more sound investment avenue for the capital market investors.

Therefore, we recommend that NHB may gradually increase its role in intermediating in the

securitisation market, rather than refinancing mortgage originators. The intermediation in the

securitisation market may also take three forms:

By simply facilitating a securitisation transaction, by providing SPV support, as it is doingcurrently;

By providing a facilitation role as above, coupled with a credit enhancing role, where NHBabsorbs credit risk above a certain first loss piece retained by the mortgage originator. There

are models, for example, from KFW in Germany that may be either emulated or modified to

suit requirements. We call this NHB-credit-enhanced approach.

By being a buyer of mortgage loans, minus the servicing function, with NHB providingwarehousing funding, as also securitising the portfolios thereafter. We call this pool-of-pools

approach.


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The first model is being pursued by NHB currently, with all the inefficiencies of the system on which

we dwell later.

The second model provides a more active role for NHB where, being a mezzanine loss absorber,

NHB inherently also provides a degree of comfort to retail investors that the pool has been analysed

by an apex institution. If the objective be to attract retail investors to invest in the mortgage market,

this kind of role (unless the third role becomes a reality) would really be commendable. In addition,

if the government considers tax incentives to be necessary to attract retail savings, the tax benefits

that today attach with NHBs bonds may be granted to the NHB-credit-enhanced securitisation

structure suggested above.

The third model should be the ultimate objective. As the supervisor of the mortgage financing

business, no one is better suited to buy mortgage loans than NHB. With or without a first loss

support, NHB may buy mortgage loans minus the servicing, leaving the servicing fees, origination

profits and a compensation for the first loss support, if any, with the originator. These commingled

pools may thereafter be securitized. In this pool-of-pools securitisation, there is far greater

diversification than ever possible in any securitisation.

In our suggested model, there is very little additional credit burden on NHB therefore, hardly any

need for additional capital infusion into NHB. On the contrary, it may be argued that the credit risk

of NHB will substantially come down, as also its balance sheet size NHB might even eventually

think of returning a part of its capital to the government. The credit risk with NHB in our models will

be no more, and in fact will be arguably lesser, than the risk being taken currently in its refinancing

role.

Specialized securitization agency for RMBS

We have also at length considered whether it would be preferable to have NHB get into this

securitisation promotional role, or to reserve the same for a specialized secondary market agency.

There are arguments on either side. The advantage of retaining NHB as the securitisation agency

albeit with enhanced role as suggested by us is that we are not proliferating institutions. After all,

every new institution needs capital, manpower, and above all, might lead to an overlap of roles. On

the other hand, a separate specialized body for secondary market in RMBS might have its own


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advantages primarily that of focus. NHB is currently also assigned a regulatory role it registers

and regulates housing finance institutions.

The question of separate body or NHB in an enhanced role is essentially a question that requires

more interaction and since the rest of the recommendations in our article are not affected by the

specialization question, we defer it for further thought.

DEVELOPMENT OF OTHER AGENCIES LEAVE IT TO THE MARKET

The securitisation market will also need at least two more agencies: private label securitisation

service providers, and insurance or external credit enhancement providers. Both of these are

market-related developments, and left to itself, the market will cause them to come up.

Nevertheless, we discuss below these agencies:

Private label securitization service providers:

We do not expect the entire mortgage origination market will be ruled by NHB. In fact, as

developments in most markets evince, GSEs and private label transactions co-exist. The reasons for

private label transactions are various they include securitisation of non-conforming mortgages, or

for reasons of staying outside NHBs supervision over the transaction.

Currently, in the RMBS segment, there are no private label transactions. However, there are several

private securitisation service providers in the ABS market, who, as needed, may provide support to

securitisation transactions in the MBS segment as well. The services are typically provided by

investment banks that have focused themselves on structured finance transactions. The other

ephemeral services are those of SPVs etc. which can easily be developed to accommodate market

needs.

Mortgage insurers

In many countries, insurance companies cover pool losses beyond a particular level this is common

in USA, UK, Australia, etc. Under the current refinancing model, most of the mortgage originators

have not felt the need for this external credit enhancement. Insurance companies do not provide

insurance against credit risk but mortgage pool insurance covers may be provided, as the need is

felt. We feel that this development is purely market-based, and there is no specific regulatory

intervention required to make it happen.


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PERMITTING AND ENCOURAGING BANKS TO INVEST IN MORTGAGE-BACKED SECURITIES

Much of the efforts at developing a securitisation market could be nothingness, if there is not

sufficient investor appetite. In order to develop the securitisation market, we need to develop strong

investor demand, which has to come from two broad classes institutional investors and retail

investors.

Among institutional investors, banks, insurance companies, mutual funds, employee benefit funds,

etc are major investors in senior classes of RMBS, and hedge funds, private equity funds, ABCP

conduits, structured finance CDOs etc are investors in junior classes of RMBS.

Currently in India, major buyers of securitisation paper are insurance companies and banks. Banks

have a huge treasury position. The current investments by banks in RMBS paper are driven by an RBI

circular being DBOD No. BP. BC. 106/21.01.002/2001- 02, dated 24th May 2002. The language of this

circular is far from clear. It does nothing by way of incentivising banks to invest in RMBS paper, nor

does it provide any guidance on how to assess the risks of RMBS investing. On the other hand, by

laying down several conditions that banks must monitor, some of which are impractical, it only

creates the impression of being a piece that regulates banks investments in RMBS.

Though the circular aforesaid does provide a 50% risk weight for investments in RMBS, what is

required is a comprehensive guidance to banks wanting to invest in RMBS. Not necessary that the

RBI should do it even some industry association, for example, FIMDA can do it. Bond Market

Association in the USA has easily-understandable guidance on investing in MBS paper. In absence of

a guide, it is quite easy for banks to either over-estimate or under-estimate the risks of MBS

investing. In practice, in a situation of ignorance, over-estimation of the risks is more common. We

spend below a few paras on the risks of RMBS-investing.

The other significant investor class is mutual funds. So far, there were several apprehensions as towhether mutual funds could invest in MBS, as the same was not apparently defined as securities

under sec. 2 (h) of the Securities Contracts (Regulation) Act, and under SEBIs current scheme,

mutual funds might invest only in securities. A major step in this direction has already been taken

- the Union Budget 2005 proposes an amendment of the definition of securities in sec. 2 (h) of the

aforesaid law, so as to clearly include asset-backed and mortgage-backed securities. This will open

the avenues for mutual funds and foreign institutional investors to invest in MBS paper.


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Employee benefit funds may also find investing in senior tranches of MBS paper interesting. The

governments interference here is very helpful it might recommend/permit limited MBS

investment by provident funds and pension funds.

Risk Assessment of Investing in MBS:

In any market, to encourage investors to invest in securitisation transactions, an easy-to-understand

guide from a body who carries reliability and faith would be highly helpful. We are of the view that in

absence of such guide, the risks of investing in MBS have generally not been understood, or have

been over-blown. Essentially, there are two primary risks in MBS investing:

Credit Risk Prepayment risk, which is essentially Interest rate RiskCREDIT RISK

Essentially, in MBS, like in any other default-able mode of investment, the basic risk is risk of default,

or credit risk. Mortgage-backed securities are not guaranteed by either the originator or the trustees

the credit support has to come from the credit enhancements which are put in place at the

inception of the transaction. There is no continuing credit support, and it would be foolhardy to

think that any of the parties would do anything to bail out a transaction potentially into a default.

This risk, analytically, is no different from risk of plain corporate bonds. In case of plain corporate

bonds, the bond-holders primary source of comfort is the existence of equity in the corporation. To

the extent the equity is not wiped out due to losses, the bond holder is protected. As equity is wiped

out, the bonds will get into a default.

What equity does to corporate finance, credit enhancements do to a securitisation. Credit

enhancement is the economic equity of a securitisation. Investors need to understand that in

structured finance transactions, the computation of the size of the credit enhancement is based on

the rating agencies stressed default scenarios. Each and every factor that contributes to the credit

of the portfolio excess spreads, prepayment rates, contraction of the excess spread over time,

delinquencies, are stressed, stretched, and the ability of the transaction to withstand the stress is

analysed. The size of the credit enhancement itself is a function of the desired rating. Investors need

to look at the following factors to understand the inherent credit risk:

The rating of the tranche that they are buying


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The rating rationale and the factors that the rating agency has/has not considered in givingits rating;

Was excess spread a major factor in determination of the credit enhancements? Excessspread itself is a function of the weighted average rates of return from the pool over time,

and rising prepayment rates might compress the excess spread.

Extent of concentrations in the pool Assumptions of recovery rates, delays in case of foreclosure Other assumptions made by the rating agencies.

PREPAYMENT RISK

One of the most commonly misunderstood risks in MBS investing is the risk of prepayment. Since

mortgages tend to prepay (obligors exercise a prepayment option), the prepayments are passed

over to investors. Thus, investors get a part of the principal before scheduled maturity, and hence,

lose their coupon to the extent they are prepaid.

A degree of prepayment speed is always estimated in any MBS investing, and hence, the expected

maturity is computed, but if the actual prepayment speed is higher than that estimated, it

introduces a maturity contraction risk to the investment; if the actual prepayment speed is slower

than that projected, it introduces maturity extension risk. In general, neither of the two risks affects

the yield of the investors from the given investment but they have a bearing on the reinvestment

returns.

Therefore, in a falling interest rate scenario, a contraction risk results into reinvestment risk. In a

rising interest rate scenario, extension risk becomes a loss of opportunity. Ironically, in a portfolio of

fixed rate mortgages, falling interest rates will be generally associated with increasing prepayment

speed, and rising interest rates will slow down prepayment speeds.

Much of the literature on prepayment risks comes from the USA, where mortgages carry a

contractual prepayment option. In India, as in most other markets, there is a prepayment penalty,

which serves as a demotivation to prepayments. If the prepayment penalties are worked out as a

mark-to-market differential, the prepayment penalties may be sizeable for a mortgage which is not

significantly burnt-out (that is, substantially amortized). Those are the mortgages where there is a

stronger urge to prepay based on interest rate changes.


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Besides the above difference, there is yet another significant difference between the US market and

the Indian market the predominant share of floating rate mortgages in India. If the mortgage

lending rates are periodically reset based on interest-rate changes, interest rates cease to be a

motivation for prepayments to happen. These risks have not properly been communicated to

investors. Being unaware, investors demand too high risk premiums for investing in MBS, which

implicitly includes a fat premium for their own lack of understanding.

Legal Infrastructure

By far, the most significant barrier to development of securitisation in India is the presence of certain

antiquated laws that date back to the 19th

century and are completely out of place with the present

market reality. Unfortunately, these laws are stumbling blocks to the development of securitisation

in the country. It is not that this paper brings those issues to the notice for the first time this has

been done by every single committee that went into the matter, starting from the Andhyrujina panel

to the several consulting groups of the Asian Development Bank. However, no concrete measures

have been taken by the government to resolve the issues.

THE SECURITIZATION ACT A FUTILE EXERCISE

To many, it might sound surprising that there is an enactment called the Securitisation and

Reconstruction of Financial Assets and Enforcement of Security Interests Act (SARFAESI) enacted in

2002. The long title suggests that the Act does something about securitisation in fact, the Act is

focused on enforcement of security interests, and whatever skeletal provisions it had enacted about

securitisation have been completely useless in practice. The whole scheme of the Act was flawed it

envisaged the concept of a securitisation company, supposedly a company in the business of

securitisation, which will be licensed and regulated by the RBI. No such companies have come into

existence, and therefore, the provisions of the Act on securitisations have been of no avail

whatsoever. Perhaps in realization, the Finance Minister announced as a part of the Budget Speech

presenting the Union Budget 2005 that the government will appoint a high-powered committee to

examine all aspects of securitisation transactions.

PROBLEMS OF THE EXISTING LEGAL SYSTEM:

The existing legal system, as far as it relates to mortgage backed securitisation, suffers from two

basic legal infirmities. It was easy to resolve both of these without involving any Centre-State issues

and it is only surprising as to why this has not been done.


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Mortgage debt regarded as immovable property:

The first problem is that a mortgage backed security, being an interest in a mortgage, is treated by

law as an immovable property. This may be resolved by providing, that a receivable which as the

security of a mortgage will not be deemed to be an immovable property, thus taking mortgage

receivables out of the domain of the Transfer of Property Act, a law with its foundations in the 19th

century.

Stamp duty issue:

The other issue is the issue of stamp duty. The stamp duty also originates from an archaic concept of

English law whereby a receivable (actionable claim) is treated as a specific form of property, for the

transfer of which a written instrument is required. This principle is enshrined in sec. 130 of the

Transfer of Property Act. If this provision was deleted or amended, obviating the need for a written

instrument, one would not need a conveyance to transfer a mortgage debt, and therefore, the

whole issue of stamp duty could be resolved in one stroke.

Currently, the system works under an extremely inefficient structure of stamp duty concession

notifications. Several states have issued such notifications, notably, Maharashtra, Gujarat, Tamil

Nadu, West Bengal, etc. As could be expected, the language of the notifications is different, andinterpretations are mind-boggling. It is easy to understand why securitisation pools have been

restricted to those states where these notifications exist, thus, keeping the borrowers from the rest

of the country outside the securitisation framework.

The stamp duty issue is being made to look like a Centre-State issue, but in fact it is not. None of the

States would have projected huge revenues out of securitisation stamp duties in States which have

not made the stamp duties practical enough, there are not any securitisation transactions at all. So

the options are clear either makes it practical, or the transactions do not happen at all.

Mortgage foreclosure laws:

Another difficulty commonly cited so far was the lack of mortgage foreclosure laws. Under

traditional civil law (sec. 67 of the Transfer of Property Act), mortgage foreclosure necessarily

required the decree of a civil court, which could take anywhere between years to ages. This problem

has substantially been addressed in terms of legal infrastructure - only requires institutional

structure to handle foreclosures. The SARFAESI Act made it permissible for banks (and notified


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finance companies some 23 housing finance companies have already been notified) to foreclose

mortgages (and other security interests) without approaching a Court. While the legal provision

therefore exists, all that is required is development of institutions that could carry out the law and

logistics inherent.

Clarity on taxation:

Securitisation structures are going on without any clarity whatsoever on the tax treatment of special

purpose vehicles. Securitisation SPVs are created as trusts, and it is believed, without any precedent

or basis, that they will be tax transparent and that the tax will be imposed on the ultimate investors.

Given the fact that the pass-through rules in the US taxation are quite complicated and not every

transaction qualifies for pass-through or see-through treatment, believing securitisation SPVs to be

tax transparent may be quite dare-devilish. In fact, with the kind of recycling, reconfiguration of

cash-flows and stripping of inflows, it is quite likely that the transactions are not treated as pass-

through. Lack of tax clarity promotes malpractices; the smart ones overdo things, which can be fatal.

In case of financial lease transactions, this was clear from history. Tax clarity is therefore a must.

Development:

Primary Mortgage MarketsThe following recommendations are not necessarily intended for the regulators self regulatory

bodies like the FIMDA can easily contribute. To develop effective disclosure and reporting systems

for securitisations, the following standards need to be developed. It is notable that the both the

American Securitization Forum and the European Securitisation Forum have come out with reporting

standards, which may be emulated with necessary modifications in India:

Standardization of documents and underwriting practices: The more standardized are theproducts, documents and underwriting practices, the lower the transactions cost of due

diligence and credit enhancement costs in the case of securitization. So, proper standardization

norms should be followed in the primary mortgages market.

Post-issue servicer reporting: Regular reporting by the servicers is quite important to allow theinvestors to know the state of the collateral.


35/35


References:

I. U.S. Securities and Exchange Commissionhttp://www.sec.gov/answers/mortgagesecurities.htm

II. The Mortgage-Backed Securities Market in IndiaKeki M. Mistr

III. Asian CMBS Market Review: Real Estate Securitization in India and Factors FavouringCMBS

Moodys Investors Service & ICRA Ltd

IV. The Feasibility of Creating Mortgage-Backed Securities Markets in Asian CountriesR t R id S Gh Rh d Y t k Shi t
http://www.sec.gov/answers/mortgagesecurities.htmhttp://www.sec.gov/answers/mortgagesecurities.htmhttp://www.sec.gov/answers/mortgagesecurities.htm

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