PROVIDING LONG-TERM FINANCING FOR HOUSING: THE ROLE OF SECONDARY MARKETS by MICHAEL LEA DIRECTOR OF RESEARCH INTERNATIONAL UNION FOR HOUSING FINANCE CARDIFF, CALIFORNIA and LOIC CHIQUIER MORTGAGE FINANCE PRACTICE GROUP CAPITAL MARKETS DEVELOPMENT THE WORLD BANK Office of Development Studies Bureau for Development Policy United Nations Development Programme ___________________________ The views and findings in this report are the sole responsibility of the authors. Mr. Chiquier’s contribution is based on a detailed case study of Cagamas. This study is being published as a World Bank Working Paper, written by Mr. Chiquier and supervised by Mr. Bertrand Renaud, which does not represent any official position of the World Bank Group. Mr. Chiquier is grateful to Mr. Huang Sin Cheng, Ms. Noor Ashikin Ismail and the whole team of Cagamas for their high-quality assistance and hospitality. DRAFT NOT FOR QUOTATION NOT FOR CIRCULATION
Transcript
PROVIDING LONG-TERM FINANCING FOR HOUSING:THE ROLE OF SECONDARY MARKETS
by
MICHAEL LEADIRECTOR OF RESEARCH
INTERNATIONAL UNION FOR HOUSING FINANCECARDIFF, CALIFORNIA
and
LOIC CHIQUIERMORTGAGE FINANCE PRACTICE GROUP
CAPITAL MARKETS DEVELOPMENTTHE WORLD BANK
Office of Development StudiesBureau for Development Policy
United Nations Development Programme
___________________________The views and findings in this report are the sole responsibility of the authors. Mr. Chiquier’s contribution is based on a detailed case study of Cagamas. This study is being published as a World Bank Working Paper, written by Mr. Chiquier and supervised by Mr. Bertrand Renaud, which does not represent any official position of the World Bank Group. Mr. Chiquier is grateful to Mr. Huang Sin Cheng, Ms. Noor Ashikin Ismail and the whole team of Cagamas for their high-quality assistance and hospitality.
DRAFTNOT FOR QUOTATION
NOT FOR CIRCULATION
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Housing is a major aspect of human development. As noted by the World Bank (1992), housing investment typically accounts for 2% to 8% of GNP, and the flow of housing services for an additional 5% to 10% of GNP. Residential real estate represents around 30% of world wealth, greater than both bonds (27%) and equities (19%). Residential construction is a major employer often accounting for more than 5% of total employment. Housing is an important economic sector with linkages to the real and financial parts of the economy.
Housing is a major good. Households typically spend between 20% and 50% of their income on housing, with a typical ratio of around 30%. In many countries and cultures, homeownership represents the ultimate dream – control over one’s existence. Housing is the major portfolio asset of most households and thus a major component of wealth. However, housing is quite expensive: The price of a house is typically two to four times the annual income of the household. The expense, along with the fact that housing is a durable good providing a flow of services over time, means that most households seek long term loans to build or buy their own home. This also applies to landlords who seek finance for rental housing.
Housing is a highly visible, key indicator of social welfare. Access to decent housing has important environmental, health, and employment effects. The property tax, which is mainly a wealth tax on housing, accounts for 25% of all local government revenues.
In developing countries, housing is a major economic, political and social issue. As populations continue to grow and urbanization accelerates, the necessity of providing adequate housing mounts. Renaud (1998) has captured the relationship between urbanization, housing investment and national wealth (figure 1). He points out that the world’s rate of urbanization is reaching a peak, in particular in China and India, and as a consequence the need for additional resources for this sector is increasing. This raises the logical question: where will these resources for housing come from?
Trends in Housing Finance
Graph 3 of figure 1 suggests an answer. As per capita income rises, so does the share of urban real estate assets in national wealth. This suggests why mortgage finance is so important to the development of housing and national economies. If real estate assets can be effectively used as collateral for household borrowing, households can benefit from both a reduced cost of funds (relative to borrowing on an unsecured basis) and from an improved availability of funds. As discussed below, access to real estate as collateral greatly enhances the attractiveness of housing loans to investors and thus the potential development of secondary markets.
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Figure 1
100 %
50 %
Industrialization and Urbanization
Housing Investment and Urbanization Level
Urban Real Estate Assets in National Wealth
Peak Rate of Housing Investment
2-3 % of GNP3-4 % of GNP
Peak Rate of Urbanization 75-80 %
Per Capita Income
Per Capita Income
Per Capita Income
35-40 %
1
2
3Growth of Real Estate Assets
7-9 % of GNP
15%
THE WORLD’S RATE OF URBANIZATION IS REACHING ITS PEAK
Source: Renaud (1998)
Historically, many governments have thought of housing, particularly for low- to moderate-income households, as a government responsibility. They have created programs and institutions to funnel public (taxpayer) resources or forced savings of households into subsidized housing production or housing finance programs. In almost all cases, governments have found that such programs provide insufficient resources and poorly targeted benefits. And in many cases, they have found that poorly designed housing finance systems have created serious budget and financial sector stability problems.
Over the past 15 years, there has been a pronounced trend towards increasing the private sector role in financing housing, with governments adopting an enabling role. This trend is manifest in financial liberalization that has broken down artificial barriers between market segments and encouraged increased competition in the provision of housing finance. As a result, housing finance is no longer the province only of special schemes or entities supported by tax and regulatory preferences but is increasingly a product offered by mainstream financial institutions (Diamond and Lea, 1992). Financial innovation has also played a role through the introduction of cheaper financial instruments and increased functional specialization with greater efficiency and improved risk management (Lea, 1996). Finally, the reform of pension plans and the growth in long-term funds for investment is opening up new opportunities for housing finance.
A relatively new development in housing finance is the secondary mortgage market. A secondary market involves pooling and sale of mortgage loans. Although this activity has been around for a long time, it has greatly expanded in recent years, reflecting the creation of new and specialized institutions and innovations in technology and security design. And secondary
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markets are not exclusive to developed countries. There are several examples of successful secondary markets in developing countries with prospects for many more.
This paper reviews the role secondary markets can play in expanding the availability of funds for housing in developing countries. Several different secondary market models are introduced and their experience in developing countries reviewed. The benefits of secondary markets for developing countries and the obstacles that exist to their creation are explored. The experience of Cagamas, the National Mortgage Corporation of Malaysia, is discussed. Cagamas is one of the most successful examples of a secondary market institution in a developing country. In the conclusion, the future role and limitations of the secondary market model are summarized.
Traditional Mortgage Lending
To understand secondary mortgage markets it is important to understand the functional components of the mortgage lending process.1 As shown in figure 2, the traditional model is based on portfolio lending in which one institution performs all the major functions: originating a mortgage to a homebuyer, servicing it (primarily collecting and processing payments from borrowers and record-keeping) and performing all the risk and portfolio management functions, including funding. (The portfolio lender may purchase a few services from third-party vendors, such as appraisal and credit reporting). Portfolio lenders may be depository institutions such as commercial banks, savings banks, savings and loan associations, building societies; contract savings institutions; or European-style mortgage banks.
Figure 2: The Traditional Home Mortgage Delivery System
Traditional Mortgage Model
PortfolioLender
PortfolioLender
Borrowers
Originate
Service
ManageRisk
Fund
The advantages of the traditional model are institutional simplicity (one institution performs all of the functions), and the ability to provide multiple services to clients (achieving economies of scope). The disadvantages of the traditional model, particularly when depository 1 For an in-depth discussion, see Lea (1998).
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institutions are lenders, are relative inefficiency because depositories typically have higher cost ratios than capital market funded lenders and inherent mismatches that generate liquidity risk and interest rate risk.
Commercial banks have traditionally shunned mortgage lending because of these risks. Liquidity risks can arise because mortgage loans are long term and deposit liabilities are short term. Interest rate risk arises when there is a mismatch in the maturities and interest rate characteristics of assets and liabilities. Specialized depository institutions like building societies and savings and loan associations are faced with much the same risk.2 The failure of many US savings and loans in the 1980s was due to excessive interest rate risk associated with using short-term deposits to fund 30-year fixed rate loans.
Mortgage bond markets are common in a number of European countries including Denmark, France, Germany, Greece and Sweden, and they constitute a major funding source for housing in Chile. They are being developed in Hungary, Slovakia, the Czech Republic, and Poland. In Europe, mortgage banks are portfolio lenders that raise funds through the issuance of bonds backed indirectly by the mortgage loan assets of the lender. Bond investors are secured against the issuer’s bankruptcy by a privileged access to the cash flows generated by a quantity and quality of mortgage loan assets sufficient to service their bonds. Mortgage bonds can also be issued by banks and other depository institutions that use their loans as collateral for the securities.
In many countries, a form of secondary market institution exists that can help portfolio lenders manage these risks. These institutions, referred to as liquidity, rediscounting or secondary mortgage facilities, issue general obligation bonds in the capital markets and use the proceeds to refinance the portfolios of primary market lenders (figure 3). They provide funds to primary market or retail lenders through collateralized loans or recourse purchases. In the US, the Federal Home Loan Banks have been making collateralized loans to mortgage lenders since the 1930s. In France, the Caisse de Refinancement de Hypothecaire (CRH) performs a similar function. Other examples of liquidity facilities include the Swiss Pfandbriefbank der Schweizerischen Hypothekarinstitute, the Jordan Mortgage Refinance Company, Cagamas in Malaysia, the National Bank of India and the Home Mortgage Bank in Trinidad and Tobago.
2 Current accounts typically make up a high percentage of bank liabilities, increasing the liquidity and interest rate risk.
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Figure 3: Liquidity Facility
HouseholdsHouseholds
Banks &Savings
Institutions
Banks &Savings
Institutions
InstitutionalInvestors
InstitutionalInvestors
Secondary Mortgageor
Liquidity Facility
Secondary Mortgageor
Liquidity Facility
Savings
SavingsRetailLoans
Loans
Securities Funding
Liquidity facilities provide both short-term funds and capital market access to depository institutions. As such they can be viewed as either adjuncts to the portfolio lending model, or as an intermediate step before an actual securitization through secondary markets. They operate with very low credit risk, purchasing loans on recourse or lending on an overcollateralized basis.3
The mortgage collateral is a form of credit enhancement to be tapped only if the borrowing institution becomes insolvent and unable to repay the liquidity facility. Their borrowers are typically also their owners, either partially or totally. As centralized bond issuers, they can often obtain better access on more favorable terms than their owners/members. With a greater volume of assets they can access the markets more frequently, creating greater liquidity in their debt and negotiating better terms with underwriters. By lending to a number of institutions they can achieve greater diversification in their asset base. They apply strict and transparent standards to mortgage loans and to primary mortgage lenders, which can help to develop prudential norms and standardization in emerging mortgage markets. Liquidity facilities can reduce liquidity risk for primary market lenders by providing them access to the capital market based on the quality of their asset portfolios. In addition, these facilities may reduce interest rate risk by giving lenders access to longer term funds with rate structures different from those they can raise on a retail basis (e.g., fixed rates). They can provide institutional investors with attractive trade-offs among profitability, liquidity, simplicity and security (Pollock, 1994).
Liquidity facilities can facilitate participation in the mortgage market and an increased volume of lending by re-allocating liquidity and interest rate risk. However, they do not address other problems that can constrain the flow of funds and/or increase the relative cost of mortgage credit. For example, lenders may believe that the credit risk associated with mortgage lending is too high. This can be due to a number of factors including weak title and lien registration systems or non-existent or unenforceable foreclosure laws that deny lenders access to collateral in the event of default. Another credit risk problem some lenders may have is excessive
3 An overcollateralized loan in this context has a balance outstanding that exceeds its market value. Market value, in general, represents a discounted present value adjusted for expected prepayment, volatility in property values, uncertainty regarding ability to pay, and credit enhancement.
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geographic concentration. Finally, lenders may not have sufficient capital to expand their lending.
Secondary markets cannot develop unless the legal system is favorable. A strong legal framework is a prerequisite for both primary and secondary market development. However, a market in which mortgages can be bought and sold can address the other credit risk factors that inhibit mortgage lending. If a lender can sell mortgages it originates and perhaps buy those made by other lending institutions in different geographic areas, it can diversify and thus, in general, reduce its credit risk exposure. If it can sell the mortgages outright, without recourse, it can achieve capital relief: It no longer requires capital to support the loans it has sold, which are no longer on its books.
Secondary Mortgage Markets
A strict definition of a secondary mortgage market is a market in which mortgages trade; i.e., one that involves the sale and purchase of the mortgage asset. Secondary markets can exist for both whole loans and mortgage-backed securities. The simplest and oldest version of a secondary market is the purchase and sale of whole loans among portfolio lenders. Although whole loan sales exist in many countries, they are typically not large or widespread for two reasons: credit risk assessment is costly and the heterogeneous nature of mortgage loans makes it difficult to develop liquidity (i.e., low bid-ask spreads) in the market.
Due diligence is costly in whole loan sales because loan structure, documentation and underwriting are typically not standardized across lenders. In addition, sellers need to generate portfolio performance data, which requires a certain level of system integration and sophistication. The due diligence costs and the risks of whole loan purchase can be reduced if the seller agrees to recourse (i.e., agrees to buy back some or all of the loans in the event of default). While recourse makes whole loan purchases more attractive to buyers it makes it less attractive to sellers which retain substantial risk against which they must continue to hold capital.
Mortgage-backed securities (MBS) are instruments backed by pools of mortgages. The simplest MBS is the pass-through security in which investors receive pro-rata shares of the cash flows (scheduled principal, prepayments and interest) from the mortgage pool. More complex derivative securities are frequently created from the pass-throughs. The cash flows of the loans and securities are thus matched, with the balance of the security equaling the outstanding loan balance.
A mortgage pass-through security represents a sale of the underlying loan. The issuer may sell the mortgage assets to a special purpose vehicle or trust which then issues the securities, or to a conduit institution which purchases mortgage loans from a number of lenders, pools the loans and issues the securities.
An example of the direct sale of MBS is the Ginnie Mae (the Government National Mortgage Association or GNMA) market in the US. In this model the retail loan originators are
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the security issuers. Ginnie Mae provides credit enhancement of the security through cash flow insurance.
Mortgage companies in the US with small balance sheets and capital primarily originate FHA (Federal Housing Administration) and VA (Veterans Administration) loans. They pool the loans, obtain a Ginnie Mae insurance certificate and then sell the pools as Ginnie Mae securities (Figure 4). The collateral behind Ginnie Mae securities is FHA and VA insured mortgage loans. Although these loans carry 100% default risk insurance on the principal, the timing of receipt of the principal and interest is uncertain because houses are frequently bought and sold: a sale usually results in repayment of the mortgage in full. The main risks to an investor in pass-through securities issued by a mortgage company are the failure of the company that services the loans and the delay in collecting the mortgage insurance. Ginnie Mae provides cash flow insurance, a guarantee of timely payment of interest and principal to the investor. The risk it takes is the delay in receiving mortgage insurance proceeds and the failure of the servicer. Ginnie Mae insurance enables mortgage companies to sell portfolios of FHA/VA loans directly in the capital markets.
Figure 4: Direct Sale Secondary Market
HouseholdsHouseholds
LendersLenders
Guarantor/Insurer
Guarantor/Insurer
InstitutionalInvestors
InstitutionalInvestors
Savings Loans
Savings
Securities
CreditEnhancement
Funding
Ginnie Mae has insured over $500 billion in securities. The principal advantages of this model are its simplicity and low cost (Ginnie Mae has a staff of fewer than 60), ability to liquify mortgages, and enhanced competition in the primary market by giving small, thinly capitalized lenders direct access to the capital markets. Its principal disadvantages are the dependence on 100% default risk insurance and small pools which are less liquid and more costly to issue.
The alternative model of MBS issuance is the conduit. Conduits purchase mortgages and issue MBS (figure 5). The best known conduits in the US are Fannie Mae and Freddie Mac, both of which are government sponsored enterprises (GSEs). There are also more than 20 private conduits with a rapidly growing share of the market.
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Figure 5: Secondary Market With a Conduit
Households
Households
Banks&Savings
Institutions
Banks &Savings
Institutions
MortgageCompanie
s
Mortgage
Companies
SecondaryMarke
tConduit
Secondary
Market
Conduit
Institutional Investor
s
Institutional
Investors
Savings Loans
Loans
Loan Sales
Savings
SecuritiesSecurities
Loan SalesFunding
The pass-through securities issued by Fannie Mae and Freddie Mac differ in several significant ways from those guaranteed by Ginnie Mae. First they are backed by non-government-insured mortgages. By charter they are required to have some form of credit enhancement on loans they purchase with loan-to-value ratios (LTVs) of 80% or more which is typically in the form of private mortgage insurance. Second, because they purchase a large volume of loans from a large number of lenders, they can issue larger securities with more diversified loan collateral and greater liquidity. As purchasers of the loans they receive the cash flows and repackage them for payment to investors. Thus, they are much larger organizations with over 3,000 employees per company. Third, they provide their corporate guarantee on their securities whereas Ginnie Mae provides a full faith and credit of the US government guarantee. Although they are private corporations, their unique status as GSEs allows them to issue debt at yields lower than comparable issues of AAA-rated corporations but higher than comparable maturity US Treasury bonds.
An active private secondary mortgage market has emerged in recent years in the US. During the 1990s, between 16% and 21% of MBS issued have been private label (other than Ginnie Mae, Fannie Mae, Freddie Mac) and the share of mortgage debt outstanding in private securitized form grew from 2% in 1990 to nearly 8% by the end of 1997.
The securities issued by private conduits are similar to those of Fannie Mae and Freddie Mac with the exception of loan size. (Fannie Mae and Freddie Mac are subject to loan limits which were US$227,150 in 1998.) In this market, investors rely on information supplied by rating agencies and enhancement from either the collateral (i.e., over-collateralization), priority claims on cash flow (e.g., senior-subordinated securities and reserve funds) or third parties (e.g., pool insurance provided by mortgage insurers or bond insurers) to protect them from the credit and agency risk inherent in third party origination and servicing.
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The development of the senior-subordination structure has been a key factor in the growth of the private MBS market. In this structure, the senior security has priority claim on the pool cash flows. All defaults and cash flow shortfalls will be borne by the subordinate tranches until (in a worst case scenario) they are depleted. The rating agencies have developed models that predict the default rates on pools of mortgages based on loan characteristics (underwriting ratios, loan type), servicer performance, geographic location etc. Based on their estimate of default rates over the life of a pool they determine the size of the subordinate tranch(es) necessary to get the desired rating.
Outside the US, secondary markets based on securitization have been started in a number of developed countries, including Australia, Canada, Hong Kong and eight European countries, particularly in the UK and more slowly in other EU countries (Thompson, 1995; Lea, 1998). Mortgage securitization has been implemented in several developing countries including Argentina and Colombia. Mortgage-backed securities were first issued in Colombia in early 1995 by savings and loan corporations, known in Spanish as CAVs (Gomez, 1996). The securities were backed by inflation adjusted loans using the UPAC indexing system and issued directly through vehicles created solely to issue the securities. Several MBS have been issued but they still refinance only 3% of mortgage loans. In Argentina, the National Mortgage Bank (BHN) issued its first mortgage-backed securities in October 1996 (Cerolini, 1996). BHN functions as a conduit, purchasing mortgages on a recourse basis from commercial banks and issuing securities backed by these loans. In both Argentina and Colombia credit enhancement was achieved through senior-subordination combined with pool-specific credit enhancement (e.g., a reserve fund created from the excess spread between the mortgage note rate and security coupon rate). Recent experience in emerging economies has highlighted a rather slow development of MBS in part due to the relatively high costs for the selling institution and difficulties in establishing the legal and regulatory framework for issuance.
Pre-requisites for Secondary Market Development
There are three major pre-requisites for the development of a secondary market: an adequate primary market infrastructure, an adequate legal and regulatory infrastructure and an adequate capital market infrastructure (Lea, 1994).
Primary Market: The starting place for the discussion of the requirements for a successful secondary market is the primary mortgage market and within that the mortgage instrument itself. First and foremost, mortgages must be attractive investments. The interest rates on mortgages must be market determined and provide investors with a positive, real, risk-adjusted rate of return. Thus, the mortgage rate must be sufficient to cover the investor’s marginal funding cost (both debt and equity), the risks of mortgage investment and the administrative cost of servicing mortgages and MBS. In addition, the mortgage market must be sufficiently developed to produce a significant volume of loans to justify the up-front costs of secondary market infrastructure.
A second key primary market characteristic is standardization of the mortgage instrument. There can be many types of mortgages, but only those with sufficient volume are candidates for sale and securitization. In order to reduce the transaction costs of evaluating
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mortgage loans and the processing costs of issuing and administering MBS, the characteristics (e.g., rate adjustment features on variable-rate loans, amortization schedule, term) of the mortgages should be uniform. In addition, standardized documentation must be available for all loans. Typical documentation includes the mortgage note describing the mortgage obligation, the deed conveying ownership to the lender as security for the repayment of the mortgage, the application, the property appraisal and the borrower credit report.
Along with standardization of mortgage instrument and design, the underwriting of mortgages should be comprehensive and consistent. The underwriting process establishes guidelines ensuring that a borrower has the ability and the willingness to repay the debt and that the property provides sufficient security for the mortgage. Assessment of the ability to pay generally consists of relating borrower income, assets, liabilities and net worth to proposed mortgage payments and overall housing expenses. Debt-to-income guidelines help to standardize underwriting. Willingness to pay is based on the downpayment, which is the borrower’s investment in the property, and credit history. The appraisal determines the value of the property through examination of the sales prices of similar properties, construction costs of new properties and market conditions and trends. Relying exclusively on the mortgage collateral value without screening the borrower’s ability to repay can prove hazardous particularly in countries where foreclosure and eviction procedures are difficult.
The servicing of mortgages is a critical component of a viable secondary mortgage market. The collection of mortgage payments and the periodic remittance of these payments to the investor or to the conduit is the major task of servicers, whether they are originators or third parties. In addition, servicers are the primary repository of information on the mortgage loans. They must maintain accurate and up-to-date information on mortgage balances, status and history and provide timely reports to investors.
Ultimately, the attractiveness of mortgages and MBS depends on the ability of investors to understand the instruments and quantify their risk and return potential. Standardization of mortgage instruments is an important step in reducing the information costs to investors. In addition, historical performance data on mortgage payments (e.g., default and prepayment) is important in risk assessment. Because of the importance of data in the assessment of risk, the demands on servicers and conduits are potentially great. These institutions must be able to process and disseminate large amounts of information. Thus, they must develop effective, automated management information systems.
An important part of servicing is the establishment of clear guidelines for the collection of mortgage payments. The documents must spell out payment obligations (dates, amounts, terms of interest rate adjustments on variable-rate loans, obligations for taxes and insurance) and procedures to be followed in the event of default. Lender discretion in working with borrowers is an important part of the collection process. However, to assess the degree of default risk third party investors must know what those procedures are before making their investment and what latitude exists in dealing with the borrower (e.g., forbearance or restructuring). Servicers also must make decisions about and implement procedures leading to foreclosure and repossession of defaulted loans.
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Legal and Regulatory Framework: A successful housing finance system is premised on a well developed legal and regulatory structure. The primary concern for investors is the security interest. In other words, how enforceable is the claim the investor has on the collateral in the event of default? The answer depends on the clarity of land title, the ability to establish the priority of liens on the collateral, which requires an effective title and lien registration system, and the ability to enforce foreclosure and repossession within a reasonable time period.
Enforceable security interest is a necessary but not sufficient condition for a successful housing finance system. For transactions involving asset sale or pledging (i.e., as collateral), security interests must be transferable and investors must have the ability to perfect their security interest, by seizing collateral, after transfer. Furthermore, the transfer of interest must be at relatively low cost. Thus, transfer and recording fees should be nominal and borrowers should not have to approve the transfer.4
An additional legal concern for investors is the solvency of the seller, servicers or other third parties such as credit enhancers or trustees. In the event of insolvency, payments to investors may be delayed while a court reviews the merits of various claimants. Thus, the rights of investors to the cash being collected on their behalf are important. Also, investors should be able to monitor the financial condition of servicers. Investors may demand the right to “pull” or transfer servicing if the solvency of a servicer becomes impaired, avoiding the hazards of the servicer’s diverting cash flow, delaying payments or inadequately collecting loan payments.
In general, the regulatory environment also must be supportive. Capital requirements on mortgages and MBS must reflect the relative risks and ensure a “level playing field”, one that does not favor certain institutions or instruments. Proper accounting standards including the requirements for off-balance sheet or sale treatment should exist to provide institutions, investors and regulators with accurate and consistently defined information. The ability to sell assets in a tax-efficient manner, avoiding double taxation at both the trust and investor level for example, is an important consideration. In many countries, withholding taxes on asset transfer have proved to be a formidable impediment to the development of a secondary mortgage market.
Capital Market: Mortgage pass-through securities are complex instruments relative to government bonds. They pay principal and interest on a monthly basis and can be subject to uncertain amounts of prepayment and default. The more sophisticated the investors and the more developed the government bond market, the greater likelihood of success in developing a mortgage securities market. Key questions include: Are there benchmark yields particularly on long term government securities that define a “market rate” against which yields on other instruments can be compared? Are there market makers to provide liquidity? Is there a regulatory body providing oversight of security issues? Are there rating agencies that can help investors understand the characteristics of the instruments and their relative creditworthiness? In countries where bond markets are not well developed, particularly for long maturities, issuance of simple bonds by a centralized entity may be necessary to create the market. Issuance of more complex mortgage pass-through securities could come at a later stage.
4As long as borrowers receive adequate service on their loans (e.g., get their questions answered and have access to accurate information on payment changes and balances outstanding) they should not care who the ultimate investor is. Consumer information issues may arise when loan servicing is transferred.
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Secondary Mortgage Market Development in an Emerging Market: The Case of Malaysia
Background
Cagamas Berhad, the National Mortgage Corporation of Malaysia, is perhaps the most successful example of a secondary mortgage facility in a developing country (Cheng, 1997 and 1998). It functions as a liquidity facility providing short and medium term finance and capital market access to mortgage lenders. Cagamas purchases mortgage loans from mortgage originators, with full recourse, at a fixed or floating rate for three to seven years. This is in effect a secured financing with Cagamas looking first to the credit of the financial institutions when mortgage loans default. Cagamas issues unsecured debt securities to investors, in the form of fixed or floating rate bonds, short-term notes, or Cagamas Mudharabah (Islamic) Bonds. Cagamas is the largest non-government issuer of debt in Malaysia.
Although Cagamas is the beneficial owner of purchased mortgage loans, it is best characterized as a liquidity facility. This is because it takes very little credit risk (all loans are purchased on recourse so the main credit risk is bank failure) and primarily serves as a centralized funding source for mortgage lenders.
A mortgage seller is assigned a maximum purchase ceiling by Cagamas reflecting its recourse exposure. Mortgage loans are subject to eligibility rules, including a first-ranked mortgage on the residential property title, in an amount less than or equal to Ringgit (RM) 150,000 (US$40,000 as of late 1998) which excludes high-cost units, and no arrears of more than three months. There is no over-collateralization requirement. All mortgage payments including scheduled principal and prepayments are passed through to Cagamas. The seller remains the custodian, trustee of the loans and services the loans on behalf of Cagamas. The seller passes through principal and interest to Cagamas at pre-determined rates, retaining the difference between the loan coupon rate and Cagamas’s required yield as its servicing and recourse fee. Loans that become fully amortized or that are ineligible are replaced by the seller, which must report the performance of the pool to Cagamas quarterly. Controls are limited to the seller’s auditor’s yearly review, as Cagamas does not conduct on-site inspections.
Cagamas obtains funds by issuing bonds. The bonds are not backed by specific mortgage loan pools but are guaranteed by the company. Cagamas refers to its bonds as mortgage-backed securities but the refinancing function is independent from the mortgage pool. To date all of its bonds have been single-bullet structures, which expose Cagamas to cash flow risk arising from the different payment characteristics of its assets and liabilities.
Cagamas was created in 1986 and commenced business in 1987. The corporation was set up to alleviate the liquidity problems of primary market lenders by allowing them to use their mortgage loan portfolios as collateral to obtain additional funds. In addition, it allows them to reduce interest rate risk by making available longer term fixed rate funds, narrowing the difference between the maturities of their assets and liabilities. An additional objective of the company was to deepen of the financial sector by creating a new source of fixed-income securities and to widen the range of low-risk placement alternatives for banks’ liquidity reserves.
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Cagamas was created in response to a financial crisis. A collapse in commodity prices and a sharp rise in interest rates caused liquidity problems for banks, building societies and finance companies which were forced to make a large volume of loans to priority sectors including housing. Selling their loans to an intermediate institution that could raise funds from the capital markets allowed these lenders to obtain additional funds to meet their mandates. Also, through refinancing with Cagamas an originating bank could significantly reduce the maturity mismatch of funding 15 year housing loans with deposits having maturities of one year or less.
In several respects, Malaysia was a good candidate for creating a secondary market institution. It has a well developed legal and regulatory system based on the British model which underlies the successful mortgage markets in Australia, Canada, the UK and US. In particular, the Torrens system of land registration was put in place in 1966 and security of tenure has been a major emphasis of post war governments (Cagamas, 1997). A substantial body of case law has established the right of property owners to mortgage their holdings and the right of lenders to foreclose and repossess in the event of default. The banking system was relatively well developed and through past government mandates was already significantly involved in housing finance.5 A relatively well developed government bond market also existed at the time of Cagamas’ creation.6
Performance
The Malaysian mortgage market has grown substantially in absolute and relative terms since the creation of Cagamas (figure 6). From 1986 to 1996, the stock of outstanding housing loans grew at a 13% annual rate, significantly higher than GDP growth or inflation. Part of this growth reflected the sustained high economic growth rate and improved standard of living in Malaysia, fueling housing demand. Cagamas has undoubtedly had a catalytic impact. Its market share grew significantly, up from 9% in 1991 to 31% in 1997 (figure 7). Its presence may have also encouraged increased commercial bank participation in the market: Their market share rose from 38% in 1986 to 52% in 1997. Cagamas has also played an important role in developing fixed income debt markets for finance companies: their market share rose from 11% to 18%. As of the end of 1997, Cagamas’ outstanding balances were RM21.4 billion (US$6.5 billion) or 31% of the total volume of housing loans granted in Malaysia. Their total purchases for the year was RM8.4 billion.
Cagamas was also instrumental in developing fixed income debt markets in Malaysia. Its outstanding debt securities exceeded RM21.3 billion (including RM14.1 billion of bonds), representing 45% of the private debt securities market and 12.5% of all debt securities with terms over one year by the end of 1997. Its market share has risen considerably from 1996 when Cagamas securities represented 35% of private debt securities. Cagamas remained the only non-state regular issuer of securities during the financial crisis which erupted in Malaysia in 1997.
5 Building societies were set up in Malaysia in the early 1950s. Commercial banks entered the market in the early 1970s and became the dominant lenders by the middle of the decade. The government provided subsidies directly through the Treasury Home Loans Division, but its relative share fell significantly in the 1990s. 6 Financing through the capital market accounted for 10% of funds raised in Malaysia between 1980 and 1985. This share rose to 35% in the 1990-1996 period.
Cagamas has been and continues to function as an instrument of government housing policy. Financial institutions are still subject to multi-sector mandatory lending. Although the overall level of such directed credit has fallen from 20% of resources in 1985 to 5% in 1995, housing mortgage quotas have not been reduced. Quotas are assigned every two years by the Central Bank according to the type and size of each individual institution. The assignment renewed in 1998 corresponds to 100,000 units for commercial banks and 40,000 units for finance companies. For housing, the quota is for low to medium cost units defined as costing less than RM100,000. Interest rates on mandated lending are set at the base lending rate plus 1.75% but capped by a 9% ceiling. Thus when market rates are greater than the capped rate, as they were particularly during the financial crisis in 1998, the mandate means that lending institutions must provide subsidized funding for these sectors. However, prior to the financial market crisis in mid-1997, these loans were not loss-makers due to a relatively low interest rate environment. Cagamas has attempted to maintain the lower rates for lower-income housing through cross-subsidization. Since February 1998 it has purchased loans on lower-cost houses at lower
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“preferred” rates than loans on higher cost houses.7 As all of the loans are funded by the same coupon debt this results in a cross-subsidy (as Cagamas’ margin has remained roughly constant).
The government backs Cagamas in many different ways. Perhaps the most important is through ownership and board representation. Twenty percent of its shares are owned by the Central Bank, and commercial banks, merchant banks and finance companies hold the remaining shares. The chairman of the Central Bank chairs the Cagamas board. The Central Bank can also offer last resort liquidity to Cagamas.
To promote the secondary mortgage market in Malaysia, the government provided a number of incentives to institutions selling loans to or investing in bonds issued by Cagamas:
• Funds received by the financial institutions from the sale of housing loans to Cagamas are exempted from statutory and liquidity reserves requirements (fully for housing mortgages, half of statutory reserves for industrial property loans), thus lowering the cost of these funds to the seller. The required level of these reserves was 13.5% until January 1998, gradually reduced to 4% by September 1998. These reserves are held as noninterest-bearing cash, making Cagamas refinance quite attractive. Reduction in the required level of reserves freed up additional liquidity and reduced the appetite for Cagamas refinance.
• Cagamas securities are recognized as liquid assets by the Central Bank. Those refinancing housing loans of RM150,000 and below are classified as Tier-1. Securites are then risk-weighted at 10%, compared with 50% for housing loans, making them attractive to banks. They are eligible as low-risk technical reserves for insurance companies on the same basis as government securities. This has the effect of lowering the required yield for Cagamas securities, as it creates strong demand from financial institutions.
• Housing and industrial property loan transactions are exempt from stamp duties. The exemption has been given by the government for transactions with Cagamas and dealings in Cagamas debt securities. This lowers the transaction cost of issuing debt.
• Cagamas does not have to obtain approvals from the Securities Commission or the Central Bank to issue debt securities, which expedites issuance. Cagamas is also exempt from having to provide a prospectus for its debt securities, lowering its cost of funding. Cagamas securities were traded under particularly favorable conditions like government securities through the 16 appointed dealers.
These privileges make loan sales to Cagamas more attractive to banks and finance companies facing low-cost mortgage quotas. It also makes these securities more attractive for institutional investors. Its securities are rated AAA by Rating Agency Malaysia and the Malaysian Rating Corporation. One purpose of these privileges is to offset some of the cost of the mandated below-market rate housing loans. This is achieved by increasing the effective
7 Preferred rates are set as Cagamas’ 3-year bond rate plus 30 basis points as compared to the usual spread of 70 to 80 basis points. A basis point is 1/100 of a percent.
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yields on Cagamas securities and reducing the costs of selling these subsidized loans relative to holding them. This offset, however, works only within a narrow range. The maximum gain from reserve deductions was estimated at 1.2% in early 1998 before reserve requirements were lowered.
The merits of using Cagamas to subsidize mortgages for low income home buyers are dubious. Mandated loans at below market interest rates are a tax on lending institutions. Most if not all of this tax is likely to be shifted away from the owners of the institutions to other suppliers of funds, such as through lower yields to savers. As discussed by Thillainathan (1997), the ability to finance these loans through Cagamas represents a small reduction in the tax, a portion of which is borne by the government through lower stamp duties and a portion of which offsets the burden of the high reserve and liquidity requirements, the costs of which are also borne by savers. The efficacy of these mechanisms is also affected by variations in market interest rates and reserve regulations.
The preferences enjoyed by Cagamas may be better viewed as instruments to encourage development of a secondary market which creates benefits for the housing and financial markets. These benefits are probably much larger than the small cost savings of the subsidized mortgage rates. These benefits come in the form of increased availability of funds from primary market lenders as well as a slightly lower average mortgage rate, reflecting a better allocation of risk in the housing finance system. These privileges were key to the successful development of Cagamas, but after 12 years they may now represent entry barriers to others that could make secondary markets for mortgages.
Lessons and Guidelines
The Cagamas model has several important lessons for other developing countries. First, the design of the purchase programs keeps mortgage credit risk with primary market lenders. One of the main difficulties in a true secondary market where the sale of loans also transfers risk is the monitoring of sellers and servicers. Secondary market institutions are subject to adverse selection, fraud and moral hazard. Lenders may sell their weak or bad credits to the facility, particularly if it is government owned, as a way of reducing their problem loans. Or servicers may divert cash flows from loans or not effectively collect on defaulted loans if they bear no risk. In the early stages of secondary market development, in almost all cases it is preferable for the originating lenders to retain most or all of the credit risk. Only when the systems and sophistication of the facility and the lenders are sufficiently well developed should true securitization and risk transfer occur. Cagamas may soon introduce purchase of mortgage loans on a non-recourse basis, depending on market conditions.
As a provider of liquidity and long-term funds Cagamas plays a positive role in standardizing loan terms, documentation and servicing. In addition, it plays a regulatory role that is useful for overall financial system supervision.
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Innovative Features
Cagamas purchases fixed rate loans from lenders, which facilitates interest rate risk management. Many lenders, particularly depository institutions, would be subject to interest rate risk by funding fixed rate mortgages with short term and thus variable rate deposits. Fixed rate loans also eliminate the risk of payment shock for borrowers. While Cagamas provides the means for lenders to offer a fixed rate alternative, the vast majority of mortgage loans in Malaysia remain variable rate. Whether this is consumer or bank preference is not clear.
During the 1997-1998 financial crisis, Cagamas continued to supply liquidity and interest rate management tools to mortgage originators. Cagamas helped to avert a residential mortgage credit crunch at a time when housing prices declined by purchasing RM8 billion of mortgage loans in 1997 and RM3.3 billion for the first semester 1998. Such figures are large even after deducting the normal refinancing of the existing portfolio. Since September 1998 and the new policy of the government, interest rates declined and the demand for banking reserves declined, dissuading banks from selling their higher-rate mortgages or locking in a refinancing rate while rates declined. Banks sought to dispose of additional liquidity, and Cagamas’ purchases fell sharply during the second semester of 1998 after having played a positive counter-cyclical role during the crisis.
A third benefit from Cagamas operations is longer-term mortgages for borrowers. Cagamas offers purchase terms of from three to seven years. Although this funding is shorter than the duration of the mortgages it is longer than that available through deposits, facilitating offering of longer term mortgages with lower periodic payment burdens. Over the past 10 years, securitization facilities provided by Cagamas lengthened the average maturity of housing loans in Malaysia from approximately 15 years to about 25 years (Thillainathan, 1997). Although the majority of Cagamas purchases are short term – mostly three years - the ability to get longer term financing and lenders’ confidence that Cagamas will be able to roll over their loans inspires them to offer longer term mortgages to their customers. However, transformation risks of mortgage originators remain quite large, as the residual term of Cagamas’ assets is about two years. The presence of Cagamas as a secondary mortgage facility has not helped to develop a fixed-rate mortgage market despite a period of moderate interest rates.
Cagamas has been an innovative force in Malaysian mortgage and capital markets. In 1992 Cagamas offered floating-rate refinancing and issued corresponding securities. In 1992 as well, Cagamas began accepting back-to-back arrangements with merchant banks, in which loans serviced by other banks are transferred to a merchant bank with a higher quality recourse guarantee. Since 1994 Cagamas has offered to purchase Islamic housing finance debts which are interest-free with a profit sharing feature.8 In turn they have sold Cagamas Mudharabah bonds structured on the same principle. Islamic finance remains a small proportion of Cagamas activities. In addition, since 1993 Cagamas has offered to purchase convertible mortgage loans that provide an option to convert a fixed rate into a variable one or vice-versa on a 12 or 18 months basis for three years at a pre-determined price. This product allows lenders to offer a 8 The debts are issued on the basis of Al-Bai Bithamin Ajil (deferred payment sale). This means at the point of granting a facility, the financier purchases a house from a developer at cost, and then sells it to a borrower at a predetermined profit. Therefore, the financier earns a profit instead of interest as the borrower pays for the house in installments over a period of time.
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more complete product selection to borrowers and a better interest rate risk hedge. In 1997 Cagamas began purchasing industrial property loans on a recourse basis supported by issues of securities classified as Tier-2 liquidity by the Central Bank. In December 1998 Cagamas started buying hire purchase and leasing debts. Cagamas can also buy mortgage loans from selected public companies and from the government’s Treasury Housing Loans Division. This originator played a large role during the critical start-up phase of Cagamas.
A fourth potential area of benefit is tapping new funding sources. Long-term savings held in pension and insurance funds are a particularly attractive source of funds for housing. Although such funds exist in Malaysia they have not been significant purchasers of Cagamas debt. Through the end of 1997, 78% of Cagamas debt was held by commercial banks, finance companies, merchant banks and discount houses, which may account for the predominance of short-term issues in its financing structure.
A final important characteristic of Cagamas is its sustained and substantial profitability. Cagamas has been profitable since it began, with pre-tax profit rising from RM4.3 million (US$1.7 million) in the Company’s first year of operation in 1987 to RM131.0 million (US$52.4 million) in 1996 and RM174 million in 1997. Consequently, its capital has risen from RM52.3 million (US$20.9 million) at the end of December 1987 to RM344.2 million (US$137.7 million) at the end of December 1996, and RM452 million by the end 1997. Cagamas demonstrates that the business can be managed in both a safe and profitable manner. Its post-tax return on equity (paid-in capital, reserves and retained earnings) was 31.4% in 1997. Most of its profits have been prudentially retained as a cushion against its operational risks including interest rate risk, pipeline risk (arising from the delay in issuing debt to cover commitments), bank counterparty risks, and residual mortgage credit risks and to cover innovative and more risky products like non-recourse purchases. However, in part its returns reflect its unique privileges as a secondary market institution, which limit or preclude competition. If its returns are viewed as excessive, its privileges could be phased-out or they could be offered to competing institutions.
There are important limitations on the Cagamas model as well, and the institution is addressing them. Perhaps the most significant is the 100% recourse restriction. Keeping the credit risk at the primary market level in the early stages of development was noted as a positive feature of the Cagamas model. However, as the market becomes deeper and more sophisticated a secondary mortgage facility can perform a valuable function by purchasing loans on a non-recourse basis, enabling lenders to get them off balance sheet. This can free up capital for primary market lenders, allowing them to make more loans. It also may facilitate the offering of longer fixed rate terms. Furthermore, it can stimulate the formation of specialized mortgage companies, providing a competitive alternative to banks and other established lenders.
Cagamas will move closer to becoming a true conduit through its plans to begin non-recourse or limited-recourse purchases in early 1999. Initially Cagamas will be conservative, as it will be exposed to most or all of the default risk. The maximum LTV (the ratio of the outstanding loan balance to the value of the collateral supporting the mortgage) will be 60%, and the loans will have to be at least two years old with no delinquencies in the last 12 months. The remaining terms to maturity will be between 5 and 10 years, and loan balances between RM150,000 and RM1 million, which means a segmentation of the mortgage market between the
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recourse and non-recourse products. Cagamas will purchase loans only from established lenders and require some risk sharing: primary originators will absorb the first 5% loss from default, with any additional loss shared in the ratio 90:10 between Cagamas and the seller.
Cagamas plans to fund these purchases by issuing long-term, fixed rate multi-tranche securities. Cagamas will provide its corporate guarantee to protect investors from default. Cagamas initially expected to pool loans and issue mortgage-backed securities in which the cash flows from borrower payments will be passed on to investors, but the market was perceived as not yet mature enough for this arrangement.
This approach will significantly increase Cagamas’ risk exposure. Cagamas will cover a large proportion of credit risks, plus prepayment risks and other interest rate risks associated with a possible mismatch between the expected duration of the mortgage pool and of the long-term single maturity bond (up to 12 years, which is much longer than for the recourse product). An additional significant source of risk arises from issuing bonds carrying fixed rates attractive to investors, although existing mortgage pools are variable-rate. Cagamas’ guarantee will be priced higher thank the usual 75-80 basis points, reflecting the higher risks of non-recourse, full term purchase. The exact spreads are still to be determined. Cagamas has had to reduce its pricing in order to attract sales from mortgage originators that increasingly have preferred to keep loans (with relatively high margins of 300 basis points and relatively low default risk) on their balance sheets. There are a number of intermediate steps that could be considered by Cagamas to reduce its cash flow risk, including the use of amortizing debt and callable debt. The successful introduction of these instruments or features will necessitate education of investors.
According to Huang (1998), marketing long-term, pass-through securities in Malaysia will face several obstacles: The first is the longer tenor (maturity) of the bonds. To date most bond issues have been relatively short term (three years) with the longest at seven years. The lack of a market benchmark for longer term bonds hampers their pricing and trading. Second, the mechanism by which title and liens are transferred is a concern due to delays and the requirement that the borrower must consent to the transfer (at least for existing loans). And third, there is a need for quick foreclosure, as the current process can frequently take a year or longer, raising the risk on mortgage loans.
Conclusions
A properly structured secondary market can provide significant benefits to a housing finance system, and ultimately to the entire economy. The primary benefit is an increase in the availability of funds for housing. A secondary market can overcome a geographic mismatch between the suppliers and demanders of funds in the absence of nationwide banking or of an efficient payments system. It can overcome a mismatch between institutions having different capacities or inclinations to hold and originate long-term assets. By expanding the pool of funding options available to retail or primary market lenders, there is less pressure on governments to provide direct (and often subsidized) credit to homebuyers. In turn, governments can target scarce resources to the most deserving groups.
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A secondary market also can lower the cost of mortgage credit through a more efficient allocation of risk. For example, a Secondary Mortgage Facility (SMF) may improve interest rate risk allocation by matching long term mortgages with long term sources of funds.9 A secondary market may lower credit risk through nationwide diversification. Liquidity risk may be reduced through expansion of funding opportunities for primary lenders.
A SMF can reduce the transaction costs of mortgage lending and investment through standardization of mortgage loan documentation, underwriting, servicing and creation of standardized securities. Expansion of the market and functional specialization can reduce costs through economies of scale. By expanding the funding sources for mortgages, a secondary market improves competition, which can reduce cost for participants and borrowers.
All of these factors can lead to lower relative mortgage rates. A secondary market also can improve access to finance for housing by offering longer maturity mortgages and alternative mortgage instruments such as indexed loans and graduated payment mortgages.
Finally, an active secondary market enhances the marketability of securities, reducing the risk of investment and ultimately mortgage rates. Not only will improved marketability lower the relative costs of mortgage securities, it can also be a catalyst for the development of the overall bond market.
Secondary market institutions are not appropriate vehicles for subsidizing mortgage credit. Their primary mission should be to mobilize private capital, broaden the financial markets and improve risk allocation. Subsidizing mortgage borrowers by taxing savers or private investors will not supply sufficient capital to meet demand. As a result, the institutions will have to resort to non-price rationing of mortgage credit during periods of rising demand. Their lending activities will crowd other intermediaries out the market and distort efficient capital allocation. Expanding access to mortgage credit can be better addressed through mortgage design and direct income or downpayment support for target group borrowers.
As demonstrated in Malaysia, government can be influential in the development of a secondary market. Its major role should be to develop an appropriate legal and regulatory environment. In the early stages, some involvement of government in a secondary market institution can improve the chances for success by reducing the default risk perceptions of investors. However, in order to avoid creating an inefficient or risky monopoly, government should have a plan to phase out its involvement and the privileges it offered to create the market and support it initially.
Secondary markets are not panaceas. They cannot solve the basic problems of poverty in which households have too little income to afford decent shelter. Nor can they overcome the lack of a basic legal framework that respects and protects private property rights. They cannot exist without relatively strong primary markets. A secondary market should be thought of as an
9 Interest rate risk arising from the early repayment of mortgages is called prepayment risk. Specialized securities (derivatives) have been created in the US to allocate prepayment risk more efficiently. A SMF may be exposed to significant prepayment risk if it relies on straight debt without prepayment options to purchase mortgages. However, it may be in a better position than individual lenders are to hire experts to manage this risk.
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adjunct to the primary mortgage market, allowing lenders to expand the volume of lending in a safe and sound manner.
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