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MORTGAGE BONDS : BEST USAGE AND BEST PRACTICES. HOUSING FINANCE IN EMERGING MARKETS: POLICY AND REGULATORY CHALLENGES THE WORLD BANK, MARCH 10 – 13, 2003 Olivier Hassler The World Bank Financial Sector Operations and Policy Department . MORTGAGE BONDS.

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mortgage bonds best usage and best practices

MORTGAGE BONDS : BEST USAGE AND BEST PRACTICES

HOUSING FINANCE IN EMERGING MARKETS: POLICY AND REGULATORY CHALLENGES

THE WORLD BANK, MARCH 10 – 13, 2003

Olivier Hassler The World Bank

Financial Sector Operations and Policy Department

mortgage bonds
MORTGAGE BONDS
  • DEFINITION AND FUNCTIONS
  • THE FOUR COMPONENTS OF A MB SYSTEM
  • BEST USAGE / BEST PRACTICES
mortgage bonds definition
MORTGAGE BONDS : DEFINITION

AN INSTRUMENT DESIGNED

  • TO RAISE LONG TERM FUNDS…
  • WITHOUT ASSETS SALE
  • WITHOUT EXTERNAL CREDIT ENHANCEMENT

CHARATERISTICS

  • LIABILITY OF INDIVIDUAL LENDERS(ON BALANCE-SHEET) …
  • WITH A SAFETY NET:
    • A PLEDGE…
    • ON PRIME QUALITY MORTAGE LOANS
  • THAT INVOLVES SPECIFIC REGULATION AND SUPERVISION

( QUALITY NORMS FOR DECENTRALIZED ISSUERS AND BANKRUPTCY PROTECTION)

mortgage bond markets
MORTGAGE BOND MARKETS
  • EUROPE: EURO-ZONE, EASTERN EUROPE, NORDIC COUNTRIES
  • LATIN AMERICA: CHILE, PERU, COLOMBIA…
  • OLD INSTRUMENT IN A FEW COUNTRIES (CHILE, DK, FR, GER..). A RECENT INNOVATION IN MANY MARKETS
  • EURO-ZONE: 300 Bln $ (GERMANY : 230 Bln $)
  • OTHER EUROPEAN MKETS: 250 Bln $ (DK : 150Bln $)
  • RELATIVE WEIGHT:

/ MORTGAGELOANS/ GDP

DK 97 % 100 %

CHILE 72 % 12 %

GER 19 % 12 %

(2001 figures . European Mortgage Federation for European countries)

the benefits of mbs
THE BENEFITS OF MBs
  • IMPROVE AFFORDABILITY:
    • BRING SECURITY. HENCE:

- HIGHER RATING (BOND GRADE CAN BE > ISSUER’SGRADE : 1-3 NOTCHES TYPICALLY)

- LONGERMATURITY

    • FOSTER LIQUIDITY

SIMPLE, STANDARDIZED INSTRUMENT

    • a) + b) = LOWER COST OF FUNDS

SPREADS (EUROPE) : +/- 5-10 BP OVER SWAP YIELD CURVE

    • PROMOTE LOW INTERMEDIATION COST

- DK : +/- 50 BP

- CHILE : 100 – 150 BP (VS 300 BP 1988-1993)

the benefits of mbs continued
THE BENEFITS OF MBs,continued
  • LEVER FOR THE DEVELOPMENT OF A BOND MARKET
  • INSTITUTIONAL INVESTORS COMPARTMENT NEEDS DIVERSIFICATION OF VEHICLES TO GROW
  • ALTERNATIVE TO GOVERNMENT PAPER

Ex CHILE MBs SHARES IN INSTITUTIONAL PORTFOLIOS:

- PENSION FUNDS = 16%

- INSURANCE COMPANIES = 24%

  • ASSET-LIABILITY MANAGEMENT TOOL
  • DOES NOT REQUIRE SELLING BEST ASSETS,thus lowering global performance ratios
  • DECENTRALIZED INSTRUMENT (name recognition)
  • BUT A CHALLENGE: relative rigidity towards interest rate strategies
the four components of mb
THE FOUR COMPONENTS OF MB
  • QUALITY OF PLEDGED PORTFOLIOS
  • COLLATERALIZATION MECHANISM
  • PROTECTION AGAINST LENDER/SERVICER ‘S INSOLVENCY
  • FINANCIAL MATCHING
quality of the collateral
QUALITY OF THE COLLATERAL
  • LENDING CRITERIA
  • LIEN: FIRST MORTGAGE SOMETIMES PUBLIC GUARANTEE (DK, FR)
  • PURPOSE: RESIDENTIAL + COMMERCIAL WITH RESTRICTIONS
  • LTV: TYPICALLY RESIDENTIAL< = 80% COMMERCIAL < = 60%
  • VALUATION RULE: TYPICALLY = “PERMANENT” VALUE
  • DEBT-TO-INCOME = ONLY CHILE
quality of the collateral continued
QUALITY OF THE COLLATERAL continued
  • EXISTING PORTFOLIO
  • EXPEDIENT FORECLOSURES Mortgage rights efficiency = critical

Specific regime, at least originally: CHI, POL.

  • REPLACEMENT OF LOANS IF FALL OF PROPERTY VALUES: CHILE
  • IF OPEN-ENDED COVER POOL: NPL AVERAGING EFFECT
  • SPECIFIC SUPERVISION

TYPICALLY :

  • BONDS /LOANS REGISTER
  • SPECIAL AUDITOR / TRUSTEE (FR ,GER,POL, RUS, SLK) OR SUPERVISOR (CZ) : for checking the compliance of quality standards and cover requirements
collateralization principles
COLLATERALIZATION PRINCIPLES
  • COVER PRINCIPLE

Bonds to be backed at any time by an at least equivalent amount of eligible loans in the same currency

Issues : - Nominal amount or fair value?

- Overcollateralization?

  • INSOLVENCY INSULATION
  • The assets cover is excluded from the general bankruptcy estate (ringfencing)
  • MB holders have a priority claim on the cover
  • Bankruptcy does not trigger acceleration of MB repayment
collateralization structure
COLLATERALIZATION STRUCTURE

TWO PRELIMINARY ISSUES :

  • MB ISSUER = SPECIALIZED OR DIVERSIFIED INSTITUTION?
  • Most frequent case: business legally restricted to mortgage lending and ancillary activities for safety reason (DK, FIN, FR, GER, HUN, POL..).
  • Diversified issuer: LATIN AMERICA, CZ, LATV ,SLK, SP
  • THE BONDS = Pass-through securities backed by segregated pools of loans (CHI, DK),

or

fungible debt secured by a whole, dynamic portfolio ?

collateralization structure specialized pattern
COLLATERALIZATION STRUCTURE: SPECIALIZED PATTERN

DIVERSIFIED FINANCIAL INSTITUTION

Priority rank of MB holders of little use if no other creditors

Little room for overcollateralization (New DK system: 4%)

Some lending diversification oftenallowed, but can be dangerous (correlated risks)

Trend: Mortgage banks = specialized subsidiaries of diversified groups. A way of ringfencing the assets cover

Issue: remoteness from parent’s bankruptcy

But otherwise institutional support

collateralization structure pass through series
COLLATERALIZATION STRUCTURE:PASS - THROUGH SERIES
  • No financial risk for the issuer
  • Customer: technical constraints
  • Investor: perfect financial cover, but closed pools.

Strong reliance on the issuer’s guarantee

collateralization structure diversified institution pattern
COLLATERALIZATION STRUCTURE: DIVERSIFIED INSTITUTION PATTERN
  • Global cover
  • Opened pool. Issues against seasoned loans
  • Substitute collateral necessary (within limits: typically 20% of the portfolio)
  • Possible present value coverage
  • (alternatively): Overcollateralization possible (ex. BUL, LAT : 10%)

Flexible and secured model

options in seeking insolvency protection
OPTIONS IN SEEKING INSOLVENCY PROTECTION
  • CONTINUATION of PORTFOLIO

If taking over cash-flows without selling: best protection of the bonds. Little overcollateralization or other enhancement devices needed. Prerequisite: ability of primary market to ensure taking over . Conditions:

    • Legal/operational
    • Back-up servicer/ lender
  • LIQUIDATION OF PORTFOLIO

May occur if no assignment or breach of covenants/ requirements. The severity of loss will then depend on:

    • Fair value cover
    • Sufficient collateralization (major issue for former US MBs)
    • Priority claim on non-eligible assets if shortfall
    • Extent of privilege on cover pool (Before taxes, wages ?)
interest rate risk
INTEREST RATE RISK

The simplicity of MBs and their market can lead to maturity and cash-flow mismatches, and the impossibility to externalize prepayment risks. A significant interest rate risk may stay at the lender’s level.

  • The way of mitigating /managing interest rate risk depends on MARKET CHARACTERISTICS
  • Primary market:Acceptance of

- Prepayment partial exclusion

- Prepayment penalties at their economic value

- Taking over market risk on loan disbursements (CHI, DK bond loans)

  • Capital market: Acceptance of embedded call option
  • Availability of derivatives
  • In the absence of such conditions, MB(fixed rate)preferably be part of a funding mix. Other components help cushion mismatches and uncertainties
interest rate risk continued
INTEREST RATE RISK, continued
  • THREE TYPES OF REGULATORY ANSWERS
  • NO PROVISION: Global Nominal cover

No guaranteed matching

  • STRICT SYMMETRY: loan/loan nominal pass-through (CHI, DK)

Constraints for the borrowers, funding of seasoned loans excluded

  • GLOBAL ALM REQUIREMENTS: RECENT TREND
    • An easy solution: banning borrower prepayments for a certain period: GER, POL
    • Net present value coverage: GER, IRE
    • Global limits on financial imbalances: DK(new cover system)
    • Inclusion of swaps in the cover principle: FR, FIN,GER,IRE
best usage best practices
BEST USAGE / BEST PRACTICES
  • MBs VS MBS
  • Less legal complexity (incl. tax, accounting, prudential rules)
  • Different issuing strategy: more liquidity, less investor’s customization
  • MBs do not require a “market” for credit risk
    • A frequent impediment for actual securitization in an emerging market (lack of insurers, investors, data…)
    • MBs: credit risk clearly located. Monitoring and supervision easier
  • A converging trend:
    • New MB frameworks = structured finance patterns, close to bankruptcy remoteness,
    • On-balance sheet portfolio pass-through possible

COLOMBIA = interesting example

best usage best practices20
BEST USAGE / BEST PRACTICES
  • LOAN PREPAYMENTS ARE THE MAJOR ISSUE TO ADDRESS
  • Callable bonds might not be
    • Accepted
    • Consistent with borrowers near-free options
    • Efficient : option priced on the capital market independently of actual loan prepayment rates
  • An argument in favor of a flexible institutional framework compatible with diversified sources of funds
best usage best practices lessons fom slow take offs
BEST USAGE / BEST PRACTICES LESSONS FOM SLOW TAKE-OFFS
  • LACK OF CONFIDENCE IN REAL ESTATE LOANS AS COLLATERAL
  • Strong creditor rights required for all mortgage-related securities
  • Mortgage registration process can also be a concern
  • LINKAGE MBs -SPECIALIZED INSTITUTIONS
  • May be too strong a constraint in a newmarket
  • Redundant (no other creditors), unless specialized arm of a group (a ringfencing method)
  • Inducement to rent-seeking

Trend towards a relaxation of business restrictions (POL) and the use of overcollateralization (LAT)

  • FINANCIAL MISMATCHES
  • Interest rate risk stays with lender: MB regulation should include financial balance obligations (fair value cover…)
  • A good opportunity to bring in Asset/Liability prudential rules
best usage best practices lessons fom slow take offs22
BEST USAGE / BEST PRACTICES LESSONS FOM SLOW TAKE-OFFS
  • CAPITAL MARKET ACCEPTANCE
  • The label is not universally familiar, …but the structure may be.
  • Capital market rules should reflect the enhanced security:

- Investors: adjustment of investment guidelines ( ex.: EU relaxed risks limits art. 22(4) of the UCITS Directive)

- Central Bank: eligibility to repos

- Payment systems : eligible collateral

  • Tax privileges are tempting incentives, but

- Distort market

- Counterproductive in the long run

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