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HOUSING FINANCE INTERNATIONAL – March 2005

Housing Finance in the United Arab

Emirates

By Mark Boleat, President, Boleat Consulting

www.boleat.com

HOUSING FINANCE IN THE UNITED ARAB EMIRATES

3

Introduction

The United Arab Emirates was formed in1971 by seven formerly independentsheikdoms.

Population 2003

Abu Dhabi 1,591,000Dubai 1,204,000Sharjar 636,000Ajman 255,000Ras Al-Khaimah 195,000Fajairah 118,000Umm-Al-Quiwan 62,000

The country is a true federation with theindividual Emirates having a great deal ofautonomy. Indeed, they are generallyviewed as “City States”. They compete witheach other to attract business and in anumber of respects have quite differentcharacteristics.

Each of the Emirates is run by its rulingfamily with no parliamentary system. Theresult, however, has been a very stablepolitical structure combined with well rungovernment services, both of which havebeen essential to attract internationalbusiness.

The key feature of the Emirates is that thepopulation is predominantly non-nationals.Emirate nationals comprise just 20% of thetotal population. The population has beengrowing rapidly at around 6% a year, almostentirely as a result of immigration. Foreignnationals are recruited to work in all parts of

the economy, from construction to transportto financial services.

The UAE is a very wealthy country, largelythanks to oil. The economy has grownrapidly, if erratically, and inflation has beenunder 3% for the last five years. Thegeneral level of interest rates is low. Thethree-month interbank rate has been under2% since 2002 and bank lending rates havefallen to under 6%.

Housing and housing finance forUAE nationals

The UAE has plenty of money to look afterits residents. In practice, most nationalshave been housed by the State andnationals have little need to borrow largeamounts to fund their housing. The Statehas built housing directly and given it tonationals. However, the circumstances inwhich the properties can be resold areseverely restricted and they cannot bemortgaged.

Low and middle income people are entitledto a 15,000 sq ft plot of “granted land”.Those earning under AED120,000 ($33,000)a year are also entitled to a grant ofAED500,000 ($136,000) to pay for thedesign and construction of a home. Peoplewith incomes in excess of AED120,000 areentitled to an interest free loan over 25 yearsof between AED500,000 and AED750,000.They can top up this loan with personalloans from commercial banks.

The opening of the market in Dubai

Until recently, it was not possible for non-nationals of the UAE (and with somerestrictions nationals of Gulf Co-operationCouncil countries) to own property. In 2002,the government of Dubai announced thatnon-nationals and non-residents would beallowed to own housing on a freehold basis.The announcement has been followed by adramatic take off in the housing market withboth demand and supply rising very rapidly.The way that this has happened and theway that house purchase has been financedis probably unique in the industrialisedworld.

This initiative by Dubai needs to be seen inthe context of the Dubai economy generally.The Government is planning a massiveexpansion of the economy including newfacilities in trading, tourism and financialservices. There is a liberal businessenvironment and low taxes, all designed toencourage entrepreneurial activity. Thepopulation is planned to increase from 1.2million to over 2 million by 2010.

There is no doubt that in 2002 there was ahuge pent up demand among long termnon-national residents in Dubai to purchasetheir properties. Many had been living inDubai for years and fully intended to make ittheir home for life. They had been payingrents at a very high level which would havepaid for the cost of their housing perhapsseveral times over. To these people theopportunity to own was gratefully receivedand many were among the initial purchasersof properties.


At the same time, a number of other factorscontributed to make Dubai an attractiveplace in which to own a property and tohave residency. As a direct consequence of9/11 much money owned from within theMiddle East was repatriated from the UnitedStates and other foreign markets and waslooking for a home. The Dubai propertymarket has provided such a home. Dubaihas also been attractive to nationals fromthe Middle East, particularly Iran, and theIndian Sub-Continent, as a result of itsstrength as a business and financial centre,low tax regime, good quality of life andphysical location.

The government did not confine itself tostimulating demand. It also took positivesteps to provide a supply of housing tomeet the demand. The tactic has been todesignate large zones as being available forhousing to be owned by non-nationals.Three developers, all effectively backed bythe State, Emaar Properties, Nakheel andEstithmaar, have led the developments onthe designated zones. They have had thebenefit of land being “gifted” to them by theState.

The developments are not of single units butrather of massive estates comprising bothapartments (particularly in the coastal areas)and villas, together with all the supportinginfrastructure and facilities such as golfcourses, marinas, shopping malls andrestaurants.

It is helpful to note some of the majordevelopments and also the pricing of them.

Emaar’s projects include –

• Dubai Marina, described as a “city withina city”, comprising 1,026 apartmentsand 64 luxury villas. The apartments’prices range from AED488,000($133,000) to AED1,050,000 ($286,000).Eventually there will be 19,000 units atthe Marina.

• A number of developments under thegeneral heading of “Emirates Living”.These include the prestigious EmiratesHills development comprising 640 singlefamily detached villas, together with a

golf course, and four otherdevelopments. These developments willhave a total of 9,000 units.

• Burj Dubai, which will be the tallest towerin the world. The apartments will be insix towers and provisionally prices rangefrom AED600,000 ($163,000) for onebedroom apartments to up to AED2million ($545,000) for the largestapartments.

Estithmaar has just one development,Jumeirah Beach Residence, whichcomprises 36 residential towers with 6,400apartments and four hotel towers with 4,000rooms. Prices range from AED315,000($86,000) up to AED1,200,000 ($327,000)for four bedroom apartments.

Nakheel Properties is best known for itsprojects that are offshore, built on reclaimedland. The Palm Jebal Ali has already beencompleted, villas and town houses havingbeen sold at prices ranging from aboutAED2 million ($545,000) to AED5 million($1,360,000). The Palm Jumeirah is asimilar development. The Palm Deira wasannounced in November 2004 and isalready being marketed in the UK. Theindividual islands will be for sale and thepurchasers can then do what they like onthem. Nakheel is also building JumeirahVillage, comprising 7,000 villas.

Almost all of the developments are sold outalmost immediately they go on sale andgenerally well before construction hasstarted let alone been completed. In 24hours in September 2004, Nakheel sold all7,000 villas in Jumeirah Village. Thedevelopers differ to some extent on theirrequirements for deposits and stagepayments. Nakheel requires a 15% depositand then regular payments duringconstruction. Emaar requires most of thepurchase price to be paid on completion.Estithmaar has required four payments of25% at various stages of the process.

However, as yet, no land law has beenenacted in Dubai and purchasers are notable to register title to their property andcannot raise finance to purchase theproperty by means of a conventional

mortgage loan. It is therefore a veryinteresting question as to why the markethas taken off.

The developers clearly trust that the marketwill continue booming as they are stillinvolved in massive developments. On thewhole, house buyers trust the majordevelopers as they are in effect part of theState. The developers give a “certificate ofbeneficial ownership” and in effect run theirown title registration services, in co-operation with the official LandsDepartment. There is total confidence thatthe developers will not go bust and that theywill not treat purchasers badly.

There is a further element of trust in thatthere is a general belief that the law will bechanged so that the purchasers of propertywill have full legal title and not just thesecurity of a sale and purchase agreementwith a developer.

Finally, and perhaps most importantly,purchasers have confidence that the marketwill continue its rapid rise and that they arebound to make a profit. This confidence inthe market, combined with trust in thedevelopers, has been more than sufficientto outweigh what are regarded as legaltechnicalities which will soon be put right.

The normal pattern is for developments tobe sold off plan with the purchaser puttingdown just a 10% deposit. With theexpectation that prices will continue rising,this has resulted in many speculatorscoming into the market, buying blocks ofproperties and then reselling them at asignificant profit. Some of the developersare sufficiently concerned about this thatthey have taken steps to prevent it, forexample by increasing the deposit or byrequiring more prompt payment of the fullpurchase price.

Financing house purchase

In an advanced industrialised economysuch as Dubai it would be normal to expectthat commercial banks would finance housepurchase as part of their mainstreambusiness. However, banks, particularly


HOUSING FINANCE INTERNATIONAL – March 2005 5

international banks, have a particularmindset when it comes to financing housepurchase. The basic requirement is that thebank should have a mortgage on theproperty such that if the borrower defaultsthen the bank has the property as securityand can recover its loan. Banks also seekother reassurance, for example that if thedeveloper defaults during construction theborrower is protected, that there areaccepted appraisal standards and also thatthe necessary legal processes andprocedures are in place to ensure that thepurchaser has good title to the property andthat the bank’s rights as mortgagee areprotected.

None of these conditions were fulfilled andtherefore the commercial banks wereunwilling to finance house purchase otherthan through a limited amount of personalloans which in any event can be for no morethan AED250,000 ($68,000).

In practice, there has not been a hugedemand for loan finance. Many of thedevelopments have yet to be completedand accordingly in some cases only theinitial deposit has been paid. Most of theproperties have been bought by speculatorswho have not needed to borrow. Wherepeople have bought for their ownoccupation, they have often done soprecisely because they have surplus funds.It is probably the case that for propertiesbought for occupation fewer than 20% haverequired loan finance and where loanfinance has been needed this is for less than60% of the purchase price.

Because Dubai is an entrepreneurialeconomy the reluctance of the banks toprovide loans to finance house purchasequickly resulted in alternative mechanisms,mainly in the form of specialist financecompanies established by the developers.

Recognising the need for loan finance,Emaar took the initiative to establish its ownmortgage lending company, Amlak in 2002.The company has obtained all of its fundingfrom its parent, Emaar Properties, althoughit plans to raise funds from other sources aswell. In 2004, the company floated throughan initial public offering in which 55% of the

shares were offered to the public, theremaining 45% being retained by Emaar.This increased its issued share capital toAED750 million ($204 million). In October2004 the company was capitalised atAED2,295 million ($625 million).

Purchasers of houses built by EmaarProperties are directed towards Amlakalthough they are free to borrow from othersources. It is estimated that Amlak financesabout 10-20% of all Emaar sales butprobably about 90% of those which requireloan finance. Amlak’s outstanding loans atthe end of 2003 were AED128 million ($35million). By the end of 2003 the figure hadincreased to AED531 million ($145 million).

Amlak has provided fairly conventionalloans for house purchase, its average loanto price ratio being around 60-65%. Amlakis in the process of transferring its entiremortgage business to a shari’a basis. Thatis, instead of the borrower being chargedinterest, Amlak technically owns theproperty, leasing it to the “purchaser” andtransferring the property to the purchaser atthe end of the lease period. In practice, theeffect is the same as a conventionalmortgage loan. The lender has moresecurity in the event of default because itowns the property.

Amlak were first in the market and probablyaccounted for well over half of loans tofinance house purchase in 2003. Its marketshare can be expected to fall over time asother financial institutions enter the market.It is seeking to diversify its mortgagebusiness and will now lend to purchasers ofdevelopers other than Emaar.

Tamweel is similar to Amlak in many waysand was set up by Nakheel which has a50% shareholding. The remaining 50% isowned by the Dubai Islamic Bank. Nakheelwas established in 1997 and currently hasAED270 million ($74 million) capital. Thecompany is intending to make a publicoffering of its shares. Although it wasestablished by Nakheel, it will lend onproperties built by any of the developers.Tamweel is operated entirely on an Islamicprinciple.

How the market will develop

The housing finance market in Dubai can beexpected to go through a period ofevolution that can probably be predictedwith reasonable accuracy. Because therewas a huge demand for housing financethat the banks were unwilling to meet, otherinstitutions, notably Amlak and Tamweel,have come into the market. They havedemonstrated that there is a big market andthat the lending, so far at least, is safe andsecure, notwithstanding the unsatisfactorylegal framework. The mainstream banksrecognise that this is a market they cannotafford not to be in and that they might risklosing their customers to banks that providehousing finance services, particularly giventhat it is a common practice for banks torequire that salaries are paid into an accountwith the bank as a condition of making ahousing loan.

Not surprisingly, the mainstream banks arenow looking at entering the market and anumber of banks, particularly HSBC, havetaken positive steps. It is to be expectedthat the banks will continue to take a marketshare, particularly if the issues on propertylaw and residency are resolvedsatisfactorily. Amlak, in particular, hasalready demonstrated its desire to diversifyboth internationally and domestically andcan be expected to become more like amainstream bank. Both Amlak andTamweel will move away from their closelinks with particular developers. It ispossible that the mainstream banks willconsider an alliance of some form witheither Amlak or Tamweel.

Assuming there are no great shocks in themarket, it is reasonable to predict that withinfive years or so the bulk of new funding forhome loans will come from mainstreambanks with specialist lenders having nichepositions in the market.

As the market expands, and if the legalissues are satisfactorily resolved, then themortgage rate can be expected to decline.At present the 6.5% variable rate formortgage loans looks high in relation to thecost of funds. It should fall if bad debtexperience is minimal and as unit



administrative costs decline with the risingvolume of business. Shuaa Capital isforecasting that Amlak’s cost income ratiowill fall from 32% in 2003 to 10% in 2007, agood indication of how a rising volume ofbusiness reduces costs.

This article is an abbreviated version of a

report commissioned by Barclays Bank and

endorsed by the Central Bank of the UAE. A

copy of the full report is available on the

author’s website www.boleat.com. The

views expressed in the report are those of

the author alone and not those of Barclays

bank or the Central Bank of UAE.

References

Amlak, The prospectus, 2004.

Dubai Property investment guide, CrossBorder legal Publishing, 2004.

IMF, United Arab Emirates: Financial System

Stability Assessment, IMF Country reportNo 03/20, 2003.

Shuaa Capital, Amlak Finance, EquityResearch 2004.

Shuaa Capital, Emaar Properties, 2004.



Building Sustainable Housing Finance

Markets: Proceedings of The Housing

Finance Roundtable in the Andean Region1

By Gerardo M. Gonzalez2

1. Introduction

There is a remarkable need to support thedesign and the implementation of soundhousing finance policies in Latin Americaand the Caribbean intended to enhanceaccess to housing and, as a result, animproved living standard for a greater shareof population. The World Bank and itsaffiliate, the International FinanceCorporation (IFC), have been greatlyinvolved in many housing finance activitiesin the region providing with both fundingand expertise. As far as the Andean regioncountries are concerned, both the WorldBank and the IFC maintain an increasedinterest in providing support for the housingpolicies and identifying and structuringviable housing finance transactions. Theinitiative of holding the Housing Finance

Roundtable in the Andean Region waslaunched by the World Bank and the IFC asa way to achieve a better understanding oflessons in housing finance and policy issuesrelevant for the region and to present theWorld Bank Group´s experience in this area.The Roundtable was also conceived as atimely opportunity to establish the groundsfor upcoming projects in the Andean regionthat require financial and technicalcooperation.

In the implementation of the Roundtable,the World Bank Group worked closely withtwo major institutions, also greatly involved

in the development of mortgage marketsthrough funding and other incentives in onecase, and through technical co-operationand expertise in the other: FondoMivivienda, the leading publicly-owned,second-tier mortgage bank in Peru; and theInter American Housing Union (UNIAPRAVI),an international organization headquarteredin Lima which performs as a tradeassociation for housing finance and othersectoral institutions in the Americas. TheRoundtable, held in Lima, in April 2004, wasattended by 172 participants (includingsenior governmental officers, top privatesector executives, and experts) from 17countries and four internationalorganizations.

Building sustainable housing finance

markets was the central topic of theRoundtable which was aimed at being aforum of discussions on a wide range ofissues relevant to both primary andsecondary mortgage markets, housingfinance policies, and the infrastructurerequired to support housing financesystems. The Roundtable focused onexploring constraints on the development ofhousing finance markets in the Andeanregion and on reviewing successfulpractices to increase access to housing.The Roundtable included a private sectorworkshop which dealt with practical lessonsin order to stimulate private sectorinvolvement in housing finance.

Discussions emphasized the overall ideathat the creation of sustainable housingfinance markets must be supported by apublic-private partnership and a stablemacroeconomic scenario. Two majorchallenges were identified: on one hand, theneed to enhance affordability of housingfinance alternatives for lower-incomesegments; and on the other hand, the needto foster long-term funding for housingfinance. In order to overcome thesechallenges, the Roundtable highlightedpolicy practices intended to enlarge primarymortgage markets making them accessibleto a previously underserved population.Also, the Roundtable focused on principlesand practices to stimulate linkages betweenmortgage markets and capital markets and,particularly, to develop secondary mortgagemarkets. The Roundtable put a specialemphasis in experiences seeking to achievean improved risk management as a pillar tomake mortgage lenders less vulnerable tocredit and market risks. Being a longlasting process, it is necessary to be patientand persevering as well as to be careful andthoughtful with the implementation ofsubsidies. There is a lot of experience, bothin the region and globally, so that it is criticalto establish a robust networking ofknowledge and expertise in this area.

The primary objective of this paper is tocollate the main ideas that were presentedat the above-mentioned Roundtable. As a

1 Jointly sponsored by the World Bank and the International Finance Corporation (IFC) with the cooperation of the Inter American Housing Union (UNIAPRAVI)and Peru´s Fondo Mivivienda, and held in Lima, Peru, on April 27-28, 2004.

2 Peruvian economist graduated at the Pontificia Universidad Católica del Perú with a master´s degree in economics from the University of Toronto, Canada.The usual disclaimer applies. The author was formerly Resident Representative of UNIAPRAVI.

HOUSING FINANCE MARKETS IN THE ANDEAN REGION


result, this paper should be useful both torecord the main findings andrecommendations of the Roundtable forfurther dissemination, and to serve as aguide for subsequent policy analysis on thebasis of a number of critical lessons learnt.

2. Housing policy and housingfinance experiences in LatinAmerica

There is no dispute regarding thetremendous impact that housing financeexerts on development globally. From theviewpoint of households, housing financeenables them to purchase an asset whichwill represent their largest single investment.As Pamela Lamoreaux pointed out,3 it isestimated that personal residences accountfor 75-90% of household wealth worldwide,which amounts to three to six times theirannual income, and housing represents40% of the monthly expenditure ofhouseholds worldwide. From an economicdevelopment standpoint, investment inhousing accounts for 15-35% of aggregateinvestment worldwide, and residentialconstruction accounts for 5% of the labourforce worldwide, while real estate services(including finance) constitutes 4% of thelabour force worldwide.

However, to a greater or a lesser extent, allLatin American and Caribbean countriesface huge housing deficits as shown inTable 1 for a number of selected Andeancountries. In Colombia, the quantitativedeficit in the urban sector affects 15.4% oftotal urban households and, if existingdwelling units which need any kind ofimprovement are added, total deficitimpacts on 28.7% of total urbanhouseholds. In Peru, 26% of total housingdeficit is explained by lacking dwelling unitsand, in addition, there is a new demand forhousing of about 90,000 units yearly. InVenezuela, the housing deficit is heavilyexplained by the qualitative deficit whichaccounts for 89% of the total deficit.

This adverse situation highlights not onlythe magnitude of the housing deficit butalso the ineffectiveness of housing andhousing finance policies implemented in thepast. The review of a number of LatinAmerican experiences in this respect leadsto the overall conclusion that these hugeand growing housing deficits are acombined result of wrong policies and anumber of barriers. On one hand, the Statehas traditionally been seen as having anactive role both as a direct housing builderand lender. The instruments used toperform this role have prevented the private

sector from being an active participant inthe housing sector. For instance, the use ofsubsidized interest rates or ceilings to theinterest rates in the mortgage market haveimpeded the expansion of a sustainablehousing finance market. Within inflationarycontexts, the real value of mortgages hastended to vanish, thereby heavilyconstraining the long-term sustainability ofthe housing finance market. When the Statehas performed a role as a direct lender forhousing, this lending has been heavilyassociated with hidden subsidies and highrates of arrears, even after governmentalintervention with repeated debt reliefmechanisms. For example, in Chile the roleof the State as a low-income housing lenderhas been rated quite unsatisfactory bysome authors who, in turn, assert that thispolicy practice has enlarged an alreadylarge moral hazard.4

In addition to wrong policies, the poorrecord in meeting housing needs can alsobe explained by the impact of a number ofbarriers. One of these is the low purchasingpower of an important share of populationwhich has become a limiting factor foraccessibility to market-oriented mortgagesand housing. The typical response hasbeen to set administrative controls over thecost of housing finance which, as has been

Table 1. Housing deficits in selected Andean countries (number of dwelling units)

3 See Pamela Lamoreaux (2004), “The IFC´s Role in Developing Housing Finance,” unpublished presentation.

4 See Claudio Pardo (1998), “Housing financing in Chile: the experience in primary and secondary mortgage financing,” paper presented at the IDB Conference“The development of mortgage securitization in Latin America and the Caribbean,” Washington, DC, November; and Eduardo Rojas (1999), “The long roadto housing reform: lessons from the Chilean experience,” in Sustainable Development Department Best Practices Series, Inter American Development Bank(IDB), Washington, DC, July. Also see Sergio Almarza (2004), “Creación de mercados financieros de vivienda sostenibles,” unpublished presentation.

Country Quantitative deficit Qualitative deficit Total deficit

Colombia 1 1,132,433 975,859 2,108,292

Peru 325,998 907,001 1,232,999

Venezuela 176,000-264,000 1,424,000-2,136,000 1,600,000-2,400,000

1 Data comprise the urban sector only.

Source: Beatriz Uribe (2004), “Experiencia en políticas y financiamiento de vivienda: el caso de Colombia,”; Cecilia Esteves (2004), “Atención

de las necesidades de vivienda en el Perú: el papel de Mivivienda,” y Jacobo Rubinstein (2004), “Política y financiamiento de vivienda en

Venezuela,” unpublished presentations.


noted, did not favour mortgage marketdevelopment. Another barrier emerges fromthe macroeconomic arena and it is relatedto inflation – and some times, hyperinflation– as well as domestic currency depreciationwhich have posed serious difficulties to theavailability of long-term finance as requiredfor housing acquisition purposes. Thetypical response has been the creation of awide range of alternatives – from floating-rate to single- or double-indexed mortgages– seeking to protect the profitability andviability of mortgage lenders. While thismight be true to a limited extent, within thecontext of highly volatile economies –because of high inflation and devaluationrates and growing interest rates – thesemortgage schemes have adversely affectedthe capacity of borrowers to pay. In fact,there are cases in which market risks – i.e.,macroeconomic shocks – have given rise tocredit risks in the housing finance systems,leading them – in the extreme case – to theircollapse. For example, the default rate ofmortgages soared, banks abandonedmortgage lending, and costly governmentalintervention took place as a consequence ofthe so-called Tequila crisis in Mexico in1994-95.

The limited growth of formal mortgagemarkets and the unsuitable terms ofaccessibility for lower-income families of theexisting housing finance alternatives haveresulted not only in huge unmet housingneeds but also in the search for housingsolutions beyond the formal channels. As aresult, land invasions and informalsettlements are remarkable features of theurban growth path in many Latin Americancities. In turn, these informal settlementshave evolved over a long period of time onthe basis of self-construction, a processwhich has been inefficient and explains thebulk of the current so-called qualitativehousing deficit.

Currently many countries have replacedformer housing policies with a heavyintervention of the State as a direct builderand lender with more market-orientedpolicies. In the Andean region, Colombia,Peru and, to a lesser extent, Bolivia areexamples of this kind of efforts, as weredocumented;5 but there are other relevantexamples in the rest of Latin America as arethe cases of Chile, Costa Rica, El Salvador,Mexico, among others. In the market-oriented approach, the State is basically to

have a role as a facilitator of the privateinvestment in the housing sector and asubsidiary role designed to ensure equity sothat all families, whatever their economiccondition, will have the possibility of findinga housing solution commensurate with theirefforts and economic capacity. Within theframework of these revised policies, theintervention of the State is aimed atsupporting the conditions for an enhancedaccessibility to housing for lower-incomegroups (including those with very limiteddebt capacity). For instance, demand-sidedirect subsidies are an integral part ofhousing policies in most Latin Americancountries today as a way to transformpotential demand into actual demand forhousing. This instrument is expected toremain as one of the key roles underresponsibility of the State. (See Diagram 1.)

As a part of these revised housing policies,the responsibility of housing lending,including options for lower-income families,is basically transferred to the private sectoragents. However, the State can play anactive role in enhancing the expansion ofmortgage credit availability by inducing adecrease in credit costs. This can be done

9HOUSING FINANCE INTERNATIONAL – March 2005

5 See Beatriz Uribe (2004), op. cit.; Cecilia Esteves (2004), op. cit.; and Walter Kreidler (2004), “Programa de financiamiento de vivienda en Bolivia,” unpublishedpresentations.

Diagram 1. Key elements and concurrent agents in revised housing policies

STATE

FINANCIALINSTITUTIONS

HOUSINGSOLUTION

HOME BUYERS

HOUSINGBUILDERS

Facilitator policy(funding, guarantees, etc.)

Housing demand(capacity to pay)

Subsidiary role(demand-side subsidies)

Previous savings

Mortgage credit Housing supply



by mitigating market risks and credit risksfrom a position in which a publicly-ownedinstitution performs a role of second-tierbank.6 As market risks are concerned,swaps can be implemented so as tosimultaneously avoid that both mortgagelenders and borrowers can be adverselyaffected by macroeconomic shocks whicheventually may give rise to credit risksituations, as is the case of Mexico (see Box1). Regarding credit risk management, therole of the State should focus on providinginsurances – e.g., mortgage insurance – aswell as on stimulating good practices inmortgage origination and servicing as apillar of a sustainable housing financesystem. For instance, two publicly-ownedsecond-tier institutions such as Mexico´sSHF and Peru´s Fondo Mivivienda arereshaping their functions and productstowards this direction rather than keepingtheir primary role of funding private financialintermediaries for mortgage origination.

In seeking the expansion of mortgage creditavailability, it should be noted that there is asignificant room to enhance the penetrationof mortgage activity in all countries. Table 2shows that the mortgage portfolio/GDPratios in Latin American countries lie wellbelow the ratios in developed economiessuch as the United States and theEuropean Union, thereby indicating thatonly a small share of existing dwelling unitshas been acquired with a mortgage. Thesame effectiveness of demand-side directsubsidies heavily depends on the availabilityof suitable mortgage credit opportunities forthose beneficiaries who have some debtcapacity. In fact, as Beatriz Uribe reports,more than 20% out of the total approvedsubsidies in Colombia has not beendisbursed because of lack of access tomortgage credit for beneficiaries.7 On theother hand, since there is a significant needfor home improvement as a way to mitigateexisting housing deficits, housingmicrofinance is another product that isdeserving a growing attention within therevised housing policy agendas. The needto enhance housing finance alternatives forlower-income families – both mortgage and

microfinance – poses important challengesto financial intermediaries given therelatively high administrative costs of small-sized loans, the unsuitable funding sources,and the difficulty of family earningverification, among other constraints. Anumber of innovative products – such ashousehold contract savings programs as away to demonstrate loan eligibility – arebeing implemented to overcome theseconstraints.

Table 2. Mortgage portfolio/GDPratios in selected countries(percentages)

Country(ies) Ratio

United States 53

European Union 36

Chile 14

Colombia 4.5

Source. Beatriz Uribe (2004), “Experiencia

en políticas y financiamiento de vivienda: el

caso de Colombia,” unpublishedpresentation.

In order to enhance long-term funding, amajor lack of most Latin American housingfinance systems, it may be useful to foster

linkages between housing finance marketsand capital markets. The existence of asecondary mortgage market may serve thispurpose, while publicly-owned institutionsmay concentrate their efforts in providingguarantees not only on mortgageoriginations but also on mortgage-backedbonds and securities and other kinds ofissues. In this respect, there are alreadyconcrete initiatives underway such as inColombia with several securitization dealscompleted and, to a lesser extent, in Mexicoand in Peru, where the agenda for publicly-owned second-tier institutions is markedlyset towards replacing their typical fundingrole for an innovative guarantor role.

The eventual success in managing bothmarket risks and credit risks, therebystrengthening the primary mortgage market,will positively influence the creation and thedevelopment of a secondary mortgagemarket. Currently this is not only favouredbecause many Latin American countrieshave seen the surge of domesticinstitutional investors that manage growingtypically long-term domestic savings as aresult of privatization of pension funds, butalso because these agents are in a betterposition to absorb and disseminate marketrisks impacting on mortgages, taking intoaccount the long-term oriented structure of

Box 1. Mexico: the case of a wage-inflation swap in the mortgage market

Since 1999 in Mexico mortgages have been originated with a market risk hedge that isintended to cope with extraordinary or permanent decreases in real minimum wages soas to allow borrowers to pay minimum wage-indexed mortgages while lenders canextend inflation-indexed mortgages. To this purpose, a swap is implemented under thecurrent administration of Sociedad Hipotecaria Federal-SHF (at the beginning, it wasadministered by its predecessor FOVI) through the financial intermediaries. The cost ofthe swap is shared by the borrower and the Federal Government: the former currentlypays a 71 basis points prime, which, in conjunction with a credit line backed by theFederal Government, is giving rise to a fund intended to meet either a temporary lackof payment flows or to face severe crises situations. This fund is arranged so as to beable to support a 25% deterioration in real wages over a 30-year period. If the fall ishigher (lower), SHF would incur (obtain) losses (profits). Thus, this is a case in whicha public sector participation is combined with a commitment of borrowers so as toshare the cost of a hedge useful to mitigate macroeconomic shocks impacting on themortgage activity.

6 See Guillermo Babatz (2004), “El papel de Sociedad Hipotecaria Federal en el desarrollo del programa de vivienda en México,” unpublished presentation.

7 See Beatriz Uribe (2004), op. cit.



their liabilities. As is the case in severalLatin American countries, there is a growingdemand for debt instruments in thedomestic capital markets which canpartially be met by mortgage-related debtinstruments.

3. Policies for social housing

As has been argued, informal humansettlements have proliferated in most LatinAmerican cities, producing huge social andeconomic costs in terms of lack of publicspace, deficient public services, exposureto natural disasters, environmentalpollution, etc.8 It is estimated that costs ofregularizing existing infrastructure in theseinformal settlements are from twice to threetimes higher than costs associated withdeveloping planned settlements.9 This taskcreates a fiscal contingency which putspressure on governmental finance. Therecommendation is straightforward: it isnecessary to shape sound policies for socialhousing (i.e., housing that can be affordedby the poor) that allow cities to growefficiently and the poor to have access toopportunities for developing progressive

housing. Within this framework, a numberof key components of any program forsocial housing were identified, namely: landproduction, property rights, subsidies, andmicrofinance.

In order to enhance accessibility to housingfor lower-income families, there is a need tocreate an institutional framework whichexerts pressure on permanently decreasinghousing prices. One way to accomplish thisis to reform the grounds of land production.Typically urban regulations influence theminimum housing price in each city and, asa result, determine which share of thepopulation can afford a formally-producedhousing unit. In order to overcome theseconstraints, and based on the experience ofMetrovivienda in Bogota, Colombia (seeBox 2), the role of the State as a landproducer can mitigate costs and risksassociated with social housing production,thereby exerting a downward pressure onprivately-produced social housing pricing.Furthermore, there is a multiplier effect inrelation to the role of the State. Based onthe above-mentioned Colombian case,10

fiscal investment for producing a socialhousing unit is one fifth of that needed in the

traditional role of direct construction by theState, the time elapsed in recovering fiscalinvestment is reduced to 25% of the timeassociated with the traditional model, andthe amount of portfolio recovery isincreased up to 2.5 times the amountallowed by the traditional model. This casealso shows that a new formal low-costhouse building industry has emerged whichhas been able both to increase the averagesize of a social housing unit and to decreaseits minimum price as a result of cost andrisk mitigation associated with landurbanization and technological innovationby the private sector.

A second major component of any programfor social housing refers to property rightson land and housing. Given the importantinformal settlements which lack formaltitles, it may be necessary to launch anurban property formalization program. Aprogram of this sort is expected to providetenancy safety and, consequently, anincentive to improve the quality of thehousing occupied as well as a betterposition for credit eligibility. A formalizationprogram comprises a number ofcomponents, namely legal and institutionalreforms, a physical and legal inventory ofinformal housing units and lots, aregularization of the housing unit or lot itself(e.g., tenancy background, plan drawing,etc.), and a regularization of individualproperties and their registry. In 1998 aformalization program was launched in Peruintended to establish clear-cut informationon the physical location and the legalproperty of urban lots in informalsettlements for a proper registration. Thisprogram is being conducted by a publicly-owned agency – COFOPRI – with thesupport of a financial co-operation of theWorld Bank. As Felipe Morris states,11 anumber of research studies show a positivesocio-economic impact of this program interms of an improved life quality standard.For instance, there is empirical evidencethat access to credit has increased in

Box 2. Metrovivienda: the case of a land bank in Bogota, Colombia

Metrovivienda is a publicly-owned (local government), second-tier land bankestablished in Bogota, the capital city of Colombia, in 1998. It is aimed at producingurbanized land – i.e., with public services, roads, and equipment – for its sale to privatesector builders who compete within the market in producing low-cost housing unitswhich, in turn, are sold at their own risk. This firm and its working model respond to afacilitator approach, based on the market functioning but contravening its failures. Theworking scheme of Metrovivienda comprises three stages. The first consists ofobtaining non-developed land in the periphery of the city. The second refers to theurbanization of land, including designs and works; as a result, land will be ready to buildhousing and other types of buildings (e.g., schools, markets, etc.). The third is the saleof urbanized lots (manzanas) to developers specialized in producing and selling low-cost housing under regulation and control of Metrovivienda as far as maximum pricingand mimimum specifications are concerned. Revenues that accrue from the sale ofurbanized lots are used by Metrovivienda to undertake new projects on a sustainablebasis.

8 See Andrés Escobar (2004), “Prevenir la marginalidad: el papel de los niveles del Estado y el caso de Bogotá,” unpublished presentation.

9 See again Andrés Escobar (2004), op. cit., and Bruce Ferguson (2004), “Hacia ciudades sin barrios: nuevas políticas y programas de vivienda social,”unpublished presentation.

10 See again Andrés Escobar (2004), op. cit.

11 See Felipe Morris (2004), “El rol de los derechos de propiedad en la política social para vivienda: la experiencia peruana,” unpublished presentation.



formalized areas though it is a process thattakes time. Furthermore, the newly-formalized housing tenant is a goodborrower as ratios of portfolio qualityindicate. There is also evidence showingthat a housing tenancy with a property titleis associated with a higher investment inupgrading the housing unit. This researchalso provides an estimate of US$925 beingthe impact of titling on the increase ofproperty value, which is equal to 25% ofaverage value of non-titled properties.Taking into account that the above-mentioned program has titled more than565,000 properties, the gross economicbenefit of this formalization program equalsUS$523 million.

The third component of any program forsocial housing is related to subsidies. AsMarja Hoek-Smit maintains,12 there is a widerange of subsidies in Latin America, most ofthem linked to housing finance: at thefunding system level (e.g., non-marketspecial tax funds), at the borrower level(e.g., interest rate subsidies by special taxfunds), at the production level (e.g., landsubsidies), and crisis-related borrowersubsidies (e.g., loan or paymentforgiveness). Taking into account that thereare many disastrous examples of finance-linked subsidies – e.g., because of theprevalence of high hidden costs andinefficiencies or macroeconomic volatileconditions that make subsidies too costly –a strong recommendation emerged to revisethe type and scope of subsidies accordingto the targeted sectors. In revising thesubsidy regimes, the first question to betackled is why subsidies are needed. Thereare two major reasons. The first is morestraightforward and relates to social equity.The second is to enhance market efficiency.Accordingly, a number of key principles fordesigning subsidy regimes is taking place(see Box 3).

In designing housing subsidies, authoritiesmust consider the appropriate types ofsubsidies depending on the different marketsegments since their needs and capabilities

differ from each other. For the low-incomemarket segment, subsidies should focus onimproving living conditions and increasingnew suitable housing options. Sizable,long-term, mortgage-guaranteed credits arenot suitable for a low-income populationwith very limited indebtedness capacity.Since mortgage finance markets do notwork for this segment, subsidies should beintended to provide grants for homeimprovements and to the strengthening ofthe microfinance industry. For the (lower)middle-income segment, subsidies shouldbe aimed at increasing affordability toformal housing options. These may includeup-front demand-side subsidies but alsosome housing finance-linked subsidieswhich may address various risks and costsfaced by private mortgage lenders (e.g.,origination subsidies to meet theadministrative costs of originating small-sized credits as is the case of Chile).13

Finally, for the (upper) middle-incomesegment, which typically comprises thelargest recipients of subsidies, the mainproblem to be addressed is the efficiency ofthe housing finance system in order to makehousing less expensive. To reach thissegment, subsidies should focus onreducing risks and costs in housing financewhich are reflected in the interest rates,thereby widening accessibility to housingfinance, rather than providing grants tobeneficiaries. Subsidies which provideincentives to originators in terms of interestrate risk- or prepayment risk-guaranteed

funding are some examples in line with thisfocus.

The fourth component of any program forsocial housing concerns housingmicrofinance which consists essentially ofsmall short-term credits for financing aprogressive home building andimprovement process. As Bruce Fergusonargues,14 only a small share of householdscan qualify for a traditional mortgage topurchase the least expensive commerciallybuilt unit. Thus, a significant segment ofhouseholds builds over a long period of timewith no or little institutional support. Forthis segment of the population, small creditscould be useful, and desirable, to buildhomes progressively (e.g., to expand andimprove the core unit). Housingmicrofinance can address the typically largeeffective demand for housing improvementlending. On the other side, since housingmicrofinance has typically short-termmaturities, microfinance institutions canbetter fit the terms of their assets andliabilities, thereby overcoming the typicalmismatch involved in traditional mortgagelending when funded with short-termliabilities.

Perhaps more importantly, housingmicrofinance is characterized byunderwriting requirements which fit betterthe conditions of lower-income householdsthan traditional mortgage lending does. Asis well known, for eligibility, mortgage

Box 3. Shifts in perception of subsidies in the housing sector

The key principles in designing subsidy regimes in the housing sector are as follows:

a) Subsidies are being intended to enhance the functioning of markets, and not tocrowding them out.

b) Subsidies are being oriented to foster access to credit markets.

c) Subsidies are performing as an incentive, rather than a hand-out, so thatbeneficiaries must contribute to the solution of their housing problem depending ontheir economic possibilities.

d) The provision of subsidies is giving priority to transparency in substitution of hiddensubsidies.

12 See Marja Hoek-Smit (2004), “Designing effective housing subsidy systems,” unpublished presentation.

13 See again Sergio Almarza (2004), op. cit.

14 See Bruce Ferguson (2004), op. cit.



lending typically requires that borrowers candemonstrate a permanent, sufficient andverifiable source of income as well as a legaltenancy of the property, but lower-incomefamilies can seldom meet all of theserequirements. In turn, short-term maturitiesand small-sized amounts associated withhousing microfinance, together withadditional instruments such as non-traditional collateral and innovative criteriato determine credit eligibility, can ease theaccessibility to this sort of housing financefor lower-income families. The feasibility ofhousing microfinance in addressing thedemand for housing improvement lendingfor lower-income families can bedemonstrated by an increasing number ofsuccessful experiences: Mibanco´s one inPeru is remarkable. Housing microfinancecan also be useful in providing the creditcomponent, usually missing for lower-income households, thereby supporting theeffectiveness of increasingly widespreadup-front demand-side subsidy regimes asan integral part of revised housing policies.

4. Fundamentals for expandingprimary mortgage markets

As was stressed, throughout Latin America,and particularly the Andean region,mortgage markets are far from beingdeveloped and mature financial markets.Not only there is a huge room to increasepenetration in primary mortgage marketsbut also the scarce credit available is hardlyaffordable for the lower-income population.In addition, there is a strong lack of long-term funding and mortgage lending typicallyfaces significant credit and market risks.The expansion of primary mortgagemarkets is also important given therelevance of a well-developed primarymarket to support the creation of asecondary mortgage market which allowsthe establishment of linkages with thecapital market. The latter, in turn, issupposed to provide the mortgage marketwith two necessary components: (a) long-term funding; and (b) risk atomization, butthe creation of secondary mortgagemarkets cannot substitute for primary

market development. In fact, there arenumerous examples of publicly-supportedsecondary market institutions that do littleor no business due to a non-existent orweak primary mortgage market.

To expedite the expansion of primarymortgage markets, some recommendationscan be made based on a number ofexperiences. First, as far as the role of theState is concerned, a direct performance ofthe State as a builder and as a lender hastypically proven to be harmful with respectto the efficiency of the housing financemarket. Publicly-owned mortgage lendersusually have poor quality underwriting,politically motivated lending, inappropriateinstruments, and weak or non-existent riskmanagement; in the end, they tend to crowdout private sector lending. Instead, theprimary role of the State should be to enablethe development of mortgage marketsthrough the creation of the properinfrastructure for, and the elimination ofbarriers to, lending. The State canaccelerate the development of mortgagemarkets by improving the legal andregulatory framework – e.g., an efficient andinexpensive title and lien registrationprocess. Also, it may be quite relevant forthe State to perform a second-tier bankingrole, to foster, from this position, thedevelopment of the mortgage market byproviding either funding or guarantees, andby enhancing better practices such asstandardization.

As explained above, subsidies are neededbut hidden subsidies do not help markets towork. For instance, interest rate subsidiesare clearly inefficient since they often lastbeyond the needs of the borrowers andseldom reach the most needy; also theiropportunity cost is difficult to track.Moreover, interest rate subsidies do notfavour a secondary market developmentbecause the asset yield does notcompensate for risk. Experiencedemonstrates that in order to reach lower-income households, it may be necessary toestablish some incentives for the privatelenders to provide these groups withaffordable housing finance options. This is

the case – for instance – of mortgageorigination subsidies recently implementedin Chile.

On the other side, incentives must also be inplace to allow available funding, particularlylong-term funding, to flow towards housingfinance. In this respect, the design ofmortgage products is important not only toprovide, or maintain, affordability toborrowers but also to meet the needs ofinvestors. A good example of this is theimplementation of the above-explainedinflation-indexed mortgage, along with aswap, providing borrowers with coverage inthe Mexican mortgage market following theso-called Tequila crisis in 1994-95.Responding to market conditions, mortgagelenders are to play a crucial role in balancingthe diverse interests of borrowers andinvestors.

A major challenge for any primary mortgagemarket is to offer affordable loans to lower-income families with market-drivenmechanisms. To this purpose, programsand products offered by mortgage lenders,supported by sound governmental policies,must be capable of addressing typicalborrower constraints. Taking into accountthat there is a wide range of customers withdiverse needs, there is a significant room foraddressing housing finance market niches.For instance, in Mexico one of the leadingsofols manages, via a mutual entity, asavings program that has been designed toallow informal economy customers thatcannot prove complete incomerequirements and those with no credithistory, to establish payment capacity andcreditworthiness, and to save for the downpayment.15 More recently, similar programshave been implemented in Peru: they areessentially contractual savings programsthat, upon a period of time, are prerequisiteto apply for a demand-side direct subsidyand/or a mortgage loan. In Chile andMexico innovation has considered theavailability of mortgage loans to purchaseused dwelling units; in doing so, asecondary market of used dwelling units isbeing fostered.

15 See Manuel Campos (2004), “Improving mortgage product design for low income housing and underserved markets,” unpublished presentation.



There are also examples in which someinterest rate reduction – either explicit orimplicit – is offered when payments aremade on time, thereby increasingaffordability of these loan programs, as isthe case of Fondo Mivivienda in Peru withthe so-called Premio al Buen Pagador, orpremium to good payer (see Box 4). As wasalso argued, the effectiveness of all of theseproducts also relies on a good servicingpractice. For instance, in Panama, there isa legalized practice of charging the monthlymortgage installments directly from thepayroll of borrowers,16 while in Mexicomortgage lenders (sofols) make use ofspecialized collection systems, namely on-site booths, hand delivery of accountstatements, etc. To the extent that theseprograms and products contribute toenhance affordability, thereby wideningmortgage markets, to improve theperformance of mortgage lending, to attractavailable funding, and to increase profits forlenders, solid pillars will develop on whichsustainable primary mortgage markets willbe able to expand.

Liquidity risk and credit risk are majordeterrents to expanding primary mortgagemarkets. On the former side, mortgages arelong-term and illiquid assets, while, as willbe emphasized later on, depositaryinstitution lenders usually have short-termfunds and this mismatch often inducesthem to limit or avoid mortgage lending. Onthe credit risk side, there are hightransaction costs in underwriting mortgageassets which may preclude sale andsecuritization and individual lenders maynot be able to adequately diversifymortgage credit risk. In order to manageliquidity risk, liquidity facilities may be usefulas long as they may provide lenders withloans or purchase on recourse from lenders.With the purpose of deterring credit risk,mortgage insurance may be relevant as longas it can spread risk across lenders andareas, as well as reduce risk by requiringimproved documentation and underwriting

– enforcing standardization – andmonitoring lender performance. In bothcases, the State can play a direct role – e.g.,owning a liquidity facility or investing in amortgage insurer – or a catalyst role – e.g.,performing as a bond market-maker orproviding co-insurance for privateproviders.17

As was noted earlier, the agenda of anumber of publicly-owned, second-tiermortgage institutions is giving considerableroom for developing guarantee schemes,including mortgage insurance. To thisrespect, the well-developed experience ofthe Canada Mortgage and HousingCorporation was thoroughly reported.18 InCanada, mortgage insurance is mandatoryin mortgage lending with loan-to-valueratios higher than 75%. This practicefacilitates protection for lenders against aportion of the costs related to homeownermortgage defaults or foreclosures and, in sodoing, has benefited the financial system byenhancing access to affordable housing,promoting standardization and transparentlending practices, and acting as a creditenhancement and audit verification tosupport securitization. In this country,mortgage insurance has been a powerfulinstrument to achieve an improved riskmanagement by disseminating credit risk

and reducing systemic risk. Sincemortgage insurers share the risk, they aremotivated to demand quality creditinformation, property valuations, andunderwriting standards.

Additionally, the application of technologymay perform as a key factor to attain asuccessful expansion of mortgage lending.19

In this respect, the U.S. mortgage marketexperience may be a relevant reference foremerging markets. First, technology maycontribute to faster, more responsive andcheaper loan applications since automatedprocessing reduces time, improvesaccuracy and facilitates the creation ofdatabases. Second, automatedunderwriting can reduce cost and improvefairness in mortgage lending by allowingnearly instantaneous decisions and astandardized and more objective originationprocess. As was reported by Lea, based ontechnology, today a credit approval maytake in the United States as short as 20minutes, while in 1994 the same task tookno less than two days. Third, automatedproperty valuation speeds originationbecause of on-line availability of informationon recent sales data of comparableproperties, which eases property priceanalysis, as well as reduces possibilities offraud. Fourth, technology also facilitates

Box 4. Peru: Premio al Buen Pagador in Mivivienda mortgage loans

Fondo Mivivienda´s mortgage loans comprise, from 2000, the so-called Premio al Buen

Pagador, an incentive to increase affordability by lowering the monthly payment or,which is the same, the implicit interest rate of the loan. This is divided into two parts,one being a concessionary share equivalent to 20% of total loan, to be paid semi-annually. If the borrower fulfills all the monthly payments for the non-concessionaryshare (equivalent to 80% of the total loan) within a semester, he/she is exempted frompaying the concessionary installment for that semester. In those semesters in whichthe borrower does not benefit from the Premio al Buen Pagador, the concessionaryinstallment for that semester is prorated in the following semester in six parts; thus, theborrower must pay timely the installments corresponding to both shares of the loan, inorder to be elegible for the benefit in the following semester. Though Miviviendamortgage loans allow prepayments, in order to access to the Premio al Buen Pagador

benefit they can only be made 10 years after origination.

16 See John Rauschkolb, “Developing regional and specialized mortgages companies in small economies,” unpublished presentation.

17 See Britt Gwinner, “The role of the State in developing and funding mortgage markets: lessons and best practices,” unpublished presentation.

18 See Jay Thakar (2004), “Developing mortgage insurance products in emerging markets,” unpublished presentation.

19 See Michael Lea (2004), “Expanding primary markets: programs, processes and technology,” unpublished presentation.



improved risk management by providing on-line access to portfolio data whichconstitute a useful input for a better productdesign, pricing, and funding. Fifth, servicingtechnologies – such as electronic paymentoptions and automated account information– improve customer service, reduce risk andincrease profits. Finally, technology alsocontributes to improved delinquencymanagement because available data maybe used to identify potentially weakborrowers and, as a response, to deal withthem on the basis of pro-active counsellingstrategies. As can easily be recognized, allof these contributions of technology toimproving origination and servicingprocesses in the primary mortgage marketprovide better grounds for a successfuldevelopment of a secondary mortgagemarket.

5. Funding strategies to supportsound primary mortgage markets

Many argue that appropriate funding – i.e.,stable, long-term, lower cost, low riskfunding sources – is the most difficultingredient needed to sustain a housingfinance system. From the viewpoint offunding, market-oriented housing financehas typically relied on a financialintermediation process in which long-termmortgage origination has been supportedby deposit-taking instruments. This hasbeen the case whether mortgage originationhas been undertaken by specializedhousing finance institutions (e.g., savingsand loan associations or housing banks) ornon-specialized housing finance institutions(e.g., commercial banks with mortgageportfolios). As long as liabilities are basedon (predominantly) short-term deposits, thisfinancial intermediation process involves apotential maturity mismatch. In fact, thereare numerous examples where thisapproach to funding has resulted in financialmarket instability and limited capability togrow soundly or, even worse, eventualcollapse. A deposit-based housing financesystem may face another limitation when

deposits are raised on a variable-interestrate basis which prevents the intermediariesfrom originating fixed-rate mortgages.Other problems include currency mismatch.

The genuine objective of housing financeinstitutions to seek an appropriateasset/liability maturity matching may posean important barrier for mortgage lending toexpand when this is predominantly fundedon the basis of a deposit-raising model. Aswas noted,20 the case of Peru is a goodexample of this issue. Over the last fiveyears, mortgage credit has been growingmore rapidly than any other type of creditwhile recording, at the same time, a lowerdefault rate. Based on reasonableassumptions, it is estimated that mortgagecredit could increase by US$1.4 billion overthe next 10 years; this would double thecurrent balance of mortgage credit in thePeruvian banking system. But this growthwould be difficult to realize if it weresupported only by medium-term deposits(the so-called CTS deposits), together withother minor instruments (e.g., mortgagebonds and other bonds), which allowfinancial intermediaries to matchasset/liability maturities.

Furthermore, the Peruvian mortgage marketpresents another striking feature. Given theprevalence of a highly-dollarized economyand financial system, a currency mismatchexists, not for financial intermediaries -theirassets (i.e., mortgages) and liabilities (i.e.,CTS deposits) are both predominantlydenominated in foreign currency-, but formortgage borrowers, whose income isdenominated in domestic currency but theirmortgage borrowing is held in foreigncurrency. In the event of a devaluation, thissituation could impair borrowers´ ability topay and, consequently, create a potentialcredit risk for mortgage lenders. Thus, amajor challenge is to generate medium-term, fixed-income, domestic currency-denominated resource-raising instrumentsto fund the expansion of the mortgagemarket in Peru.

The traditional deposit-based model forfunding housing finance poses not only amaturity mismatch constraint but alsoheavily depends on the credit quality of themortgage lender. In addition, as long as allthe functions in the mortgage business areconcentrated in the same institution – i.e,origination, fund raising, servicing, etc – allthe subsequent risks remain concentratedon the balance sheet of that institution. Inseeking to overcome this kind ofconstraints, a model based on specializedparticipant agents has been analysed whichis useful to raise funds from the capitalmarkets. This alternative model has anumber of advantages but one particularlyimportant is its ability to allow riskatomization, particularly when it isassociated with the issuance of mortgage-backed securities: risk is no longerassociated with the lender or issuer but withthe underlying assets (mortgages). Thisdistinctive feature, for success, demandsspecialization, information availability,transparency and, remarkably,appropriateness of the mortgage product inmeeting the needs of the purchaser ofhome. As a result, it can facilitate a moreappropriate funding, in both volume andterms, for housing finance, therebybenefiting the end borrower with a moredynamic and less costly mortgage lending.

There are a number of initiatives towardssetting legal and institutional frameworksnecessary to implement this alternativemodel in Latin America. For instance, in thecase of Colombia,21 the currently prevalentHousing Law enacted in 1999 comprises anumber of provisions to allow and enhancea significant shift in funding mortgagelending. To this end, two instruments –mortgage-backed bonds (bonos

hipotecarios) and mortgage-backedsecurities (titularización hipotecaria) – areregulated in order to enable long-termresource mobilization from capital marketstowards mortgage markets.

On the other side, financing residentialconstruction has also led to a search for

20 See Walter Bayly (2004), “Estrategias de captación de recursos para el sostenimiento del mercado de hipotecas: el modelo basado en a captación de

depósitos en el Perú,” unpublished presentation.

21 See Alberto Gutiérrez (2004), “Desarrollo de la titularización hipotecaria en Colombia,” unpublished presentation.



alternative funding sources as in the case ofsofols (mortgage banks) in Mexico. In 2003the Sociedad Hipotecaria Federal (SHF), thepredominant funding source of sofols,stopped funding new bridge loans forresidential construction and is insteadproviding guarantees. Following thischange, sofols have developed marketfunding through the domestic debt capitalmarket, through domestic and internationalcommercial banks and throughsecuritization (including construction-related bridge loans). It is worthwhilenoting that the proceeds fromsecuritizations will be used to fund housingconstruction loans as long as financing isavailable for the individualization of theloans. As a result, these new fundingsources have contributed to decreaseddependency on SHF funding, have alloweda greater flexibility in the development andimplementation of new products fordevelopers with better conditions, and havefostered strict controls in loan origination,administration and loan individualization,thereby mitigating risks.22

Within this model, a number of agents orinstruments may be particularly relevant toboost funding from the capital market andto provide the mortgage market withefficiency.23 On one side, based on a highfinancial capacity, warehouse lending canprovide intermediaries with shorter-term,revolving lines of credit. One way toenhance efficiency in the market is byestablishing origination criteria that fosterstandardization. On the other side, theexistence of conduits, whether they arerelated to the warehouse lender or not, mayplay a relevant role by providing a significantcapacity to store mortgages and to assumeinterest rate and liquidity risks associatedwith this task. The role of conduits may alsobe important at the time of needinginvestment capacity to purchasesubordinated bonds. In addition,management risk may also be supported by

the implementation of a wide range ofhedging alternatives to mitigate market risksin funding mortgage activity, for instance, tocope with interest rate risks or, as explainedabove, exchange risks which eventuallygive rise to credit risks adversely affectinglenders. As has been the case of oneoutstanding experience – Fannie Mae´s onein the United States – the widespreadavailability of numerous derivatives for riskmanagement has allowed financialinstitutions to meet effectively the hugedemands of mortgage borrowers for long-term, fixed-rate loans.

6. Fundamentals and options fordeveloping secondary mortgagemarkets

The development of a secondary mortgagemarket can play a significant role in creatingsustainable housing finance activity.Basically, two major benefits can behighlighted. On one side, the existence of asecondary mortgage market shouldcontribute to provide liquidity and todiversify funding sources by creating alinkage with the capital market. By usingsecondary market mechanisms, it ispossible to recycle funds before originalmaturities, thereby providing mortgagelenders with liquidity for new originationsand lessening the need for new capital. Byaccessing the capital markets, mortgagelenders have additional, and moreappropriate in terms of maturity, funding. Asecondary market is more crucial forspecialized non-banking financialinstitutions (e.g., sofols in Mexico) but, fordepository institutions, can also serve as astabilizer taking into account that theirdeposit bases can become volatile and canallow fixed-rate lending when no derivativeoptions are available. On the other side, asecondary mortgage market should allowan improved risk management bytransferring market risks to capital market

participants who have a better capacity todeal with them. Risk atomization shouldgive rise to efficiency earnings in resourcemobilization, thereby making mortgagefinance less costly to borrowers and moreprofitable to lenders.

A number of pre-conditions necessary forestablishing a secondary mortgage marketwere noted. The four most critical factorsare the following: (a) a sufficient legal, tax,and regulatory framework; (b) a robustprimary mortgage market; (c) capital marketpreparedness and appetite for mortgage-backed debt instruments; and (d) economicincentives for secondary marketparticipation.24

Laws and regulations applicable must allowan easy and cost-reduced true transfer ofassets to secondary market and capitalmarket investors, cost-reduced and time-saving foreclosure procedures, and tax andaccounting rules which do not rendersecuritization uneconomical vis-à-vis otherfunding sources. One key aspect is, as wasremarkably noted, the need to insulatemortgages to be securitized, or backingbonds, from any insolvency and remotebankruptcy of the originator or the issuer. Ineffect, laws and regulations must be shapedto ensure a true sale of mortgages which areto be securitized, thereby enabling investorsto access the benefits of the collateral in theevent that the originator enters insolvency.The need to previously notify, and/or to geta consent from, the borrower in order tocomplete a legal transfer of property of thecollateral may also deter a more expeditiousprocess. As was maintained, this factorcontributed to the delay in theimplementation of mortgage securitizationin Mexico.25

Laws and regulations should also constrainthe probability of an issuer enteringinsolvency or bankruptcy by establishing,for instance, provisions that limit the

22 See Kathleen Towle (2004), “Financing residential construction in emerging economies,” unpublished presentation.

23 See José Landa (2004), “Diseño de facilidades de liquidez eficaces para el sostenimiento del financiamiento hipotecario para vivienda,” y Gonzalo Ortiz de

Zevallos, “Developing hedging mechanisms to mitigage market risks in funding mortgage facilities,” unpublished presentations.

24 See, for example, Soula Proxenos (2004), “Essentials for secondary market development,” unpublished presentation.

25 See Brigitte Posch (2004), “Consideraciones legales y regulatorias en las securitizaciones,” unpublished presentation.



purpose of the issuer only to the issuance ofsecurities, or provisions that restrict thecapacity of the issuer to get indebted. Onthe other side, effective and efficientforeclosure laws and enforceable liens onproperty are required to minimize lossseverity in the case of defaults. Judicialforeclosure regimes often take too long and,if time usually devoted to enforce liens andto sell the property is added, the wholeprocess turns out to be even longer andmore costly. As was asserted, whenexisting laws and regulations do notembrace these fundamentals, legal reformswill be necessary to foster financialinstitutions to intervene in the mortgagemarkets and in the capital markets. Fromthe viewpoint of taxation, a tax-neutralspecial purpose vehicle could help todevelop secondary mortgage markets;otherwise, if the assets are taxed whenmortgages are passed to the specialpurpose vehicle and also when the securityis sold to investors, double taxation mightrender the securitization deal unprofitable.

A secondary mortgage market requires arobust primary market to develop, for whicha number of critical elements is required:macroeconomic stability, marketability andliquidity of the housing market, a sufficientnetwork of quality primary market lenders,product standardization across the industry,and alternative credit enhancement optionsto overcome insufficient credit quality orlack of data. On this basis, each functionperformed in the primary mortgage market –such as loan origination, underwriting,funding and loan closing, loan servicing andloss mitigation, and criteria, timing, andmanagement of loan default – shouldcontribute to develop a product appropriatefor secondary market operations. In otherwords, underlying mortgages forsecuritization should be high-quality assetswith a long-term profitability, low defaultand foreclosure rates, predictable andsteady loan performance, and standardized.Uncertainty or unpredictability of loanperformance will cause investors to demandhigher returns on the mortgage-backedsecurities and rating agencies to requiregreater credit enhancement.

The existence of reasonably deep capitalmarkets is crucial for the development of asecondary mortgage market. A fairly solidinstitutional development for the capitalmarket includes an investor understandingof the investment vehicle, an interested andactive investor base, an efficient andregulated clearing-house infrastructure, andinformation service providers. For instance,independent, credible rating agencies arerequired to assess the relative risk ofmortgage-backed securities issues;otherwise, investors must rely on their ownability to conduct this task making it a morecostly and time-consuming process. Thesize of the capital market matters: adomestic capital market with a well-endowed resource base is expected toprovide mortgage-backed debt instrumentswith liquidity, while the international capitalmarket should provide, whenever possible,a complementary demand-side support forsuch debt instruments.

Finally, the development of a secondarymortgage market requires a number ofeconomic incentives in order to helpovercome barriers that make this progressmore difficult. These barriers may berelated to funding as expressed in terms ofa liquidity crunch for lenders; to credit risk,for which an enhanced credit guaranteeissued by a third party may be useful; tointerest rate risk; to risk-based capital andtaxation, for which a capital relief for holdinga security and a favourable taxation ofsecurities may be implemented; amongothers.

In developing a secondary mortgagemarket, particular market conditions shouldbe accurately assessed in order to make achoice between mortgage-backed bonds(MBB) or mortgage-backed securities(MBS). While both of them commonly sharesome prerequisites such as the existence ofefficient mortgage collaterals and soundmacro-economic scenarios, they differ fromeach other.26 As is well known, basicallyMBB remains to be a debt obligation of theoriginator (and, at the same time, the issuer)which is collateralized by pools of mortgageloans that stay on the originator´s balance

sheet; for them, some regulatory eligibilitycriteria – e.g., first mortgage, limited LTV ordebt-servicing-to income ratios – areapplied in order to ensure a special qualityof the underlying portfolio. MBB feature acontingent transfer of credit risk just in caseof insolvency of the issuer, and theoriginator assumes the market risks on thebasis of asset/liabilities managementtechniques. On the other hand, MBS arefundamentally based on the true sale andbankruptcy remoteness principles; as aresult, MBS are issued by a special purposevehicle as off-balance-sheet instruments,while payments associated with securitiesare based on the direct allocation ofmortgages cash-flows without recourse tothe originator. The issuance of MBS, usinghomogeneous pools of mortgage loans,involves a transfer of market risks toinvestors, and a transfer of credit risk tocredit enhancers (e.g. guarantors) or toinvestors.

When both instruments are compared, theyboth need robust legal frameworks to beimplemented, but MBS are a somewhatmore complex instrument requiring perhapsmore time to develop. In this regard, alarger critical mass may be very important:large volumes ease periodical, sizeableissues, while sporadic, small issues arecostly – first-time issues face high costs –and do not provide the market with enoughliquidity. In turn, MBB may be less costly aslong as neither external credit enhancementnor large overcollateralization is required,and they involve simple, standardizedfinancial instruments easy to value and totrade. A major challenge for MBB is tomitigate prepayment risk taking intoaccount that the capital market may notaccept call options, while a major challengefor MBS is the availability of a market forcredit risk because, in the absence ofexternal credit enhancement, securitizationrequires either costly cushions (e.g.,overcollateralization) or credit risk retentionby the originator. The typical candidates forMBS are specialized, non-deposit takinginstitutions in a market with no or fewderivatives available, while the typicalcandidates for MBB are commercial banks

26 See discussion by Olivier Hassler (2004), “Mortgage bonds or mortgage-backed securities,” unpublished presentation.



with “natural hedges” (i.e., diversified assetsand liabilities with different durations) and/orexternal hedging instruments.

The development of secondary mortgagemarkets in Latin America, and particularly inthe Andean region, remains a relativelyincipient process. Within this context, thepromising case of TitularizadoraColombiana (TC) was thoroughlydocumented (see Box 5).27 Since itsestablishment in 2001, TC has run over asignificant share of the above-mentionedrelevant elements. The work of TC is basedon a well-established legal framework with aremote bankruptcy-typed special purposevehicle called universalidad. In addition tothe currently performed functions by TC,such as appointing originators andservicers, selecting loan portfolio,structuring issues, purchasing portfolio andissuing securities, following up securitizedloan portfolio, and administering the specialpurpose vehicle, it is anticipated that TCcan provide issuers with guarantees andhedges (coberturas) in the future. In termsof future developments, TC is planning touse for a next issuance a performancescoring which will allow a methodology forselecting the loan portfolio to be securitized;and an origination scoring which isexpected to allow a more expeditiousprocess for purchasing and storingmortgage loans. TC is also working on theestablishment of a database with mortgageloan performance information – i.e.,payments, pre-payments, and defaults –which is to be useful to implement astatistical portfolio management.

The experience of TC shows a number ofbenefits derived from securitization,including generating additional funding formortgage lending, controlling maturity andinterest rate risks for mortgage originators,increasing return rate for originators,lessening new capital requirements,improving mortgage standardization acrossthe industry, fostering the development ofcapital markets, and diversifying investmentportfolios, all of them with a minimalintervention of the State. The achievementof other benefits – an increased competitionin the mortgage industry, lower interestrates, more stability in the mortgage activity,and an increased specialization – isexpected in the future. Some majorchallenges to be faced by TC include toaccomplish securitization deals equivalentto 40% of outstanding mortgage loans inthe next five years; to make further progress

in non-performing mortgage-backedsecuritization; to make securitizationprofitable enough with no need of taxprivileges which are only temporal; and tosecuritize social housing-oriented mortgageportfolios for informal sectors. Broadlyspeaking, the experience of TC indeveloping a secondary mortgage market isquite illustrative as regards the importanceof the fundamentals previously explained: arobust primary mortgage market, anappropriate legal and regulatory framework,a fairly developed capital market,standardization (of mortgages andsecurities) across the industry, and an initialcommitment and support by the State.

27 See again Alberto Gutiérrez (2004), op. cit.

Box 5. Titularizadora Colombiana: a leading secondary mortgagemarket institution

Titularizadora Colombiana (TC) is a specialized secondary market institutionestablished in July 2001 within the framework of the 1999 Housing Law in Colombia.Its shareholders are five mortgage banks in Colombia with the partial partnership of theInternational Finance Corporation (IFC). As of 2003 year end, TC had completed foursecuritization deals totaling US$720 million, having securitized about 15% of theoutstanding mortgage portfolio in Colombia. By the time of the Roundtable, TC wasabout to complete a non-performing mortgage-backed securitization deal, which wassuccessfully marketed in May 2004, totaling about US$150 million. Yield at the time ofissuance was lower from one deal to the following, showing a growing confidence andacceptance by investors. TC is currently the biggest private debt-instrument issuer inColombia and the biggest mortgage-backed securities issuer in Latin America.



Housing Finance Practices and Developmentof a Secondary Mortgage Market in Turkey

By Onur Özsan, Director, Oyak Konut1 and

Cem Karakas, EVP, Oyak Konut2

1. INTRODUCTION

Turkey, being one of the largest economiesof the World, still lacks an appropriatelyfunctioning housing finance system. In thelast couple of years there has beenincreased awareness in the public andprivate circles for the urgent need ofcultivating a system that would alleviate theshortfalls in the Turkish economy in thehousing finance front. Nonetheless, Turkeyhas to act swiftly to reverse the opportunitycosts it has incurred to date due to the lackof such a system.

Inadequate urban planning, illegalurbanization, and chronic shortage ofmetropolitan residential units haveproduced the dominant conundrum in theTurkish real estate market. The policychoices adapted to date have been illadvised; consequently more than half of thedwelling stock in Turkey is not properlylicensed. A chronic shortage of fundschanneled to the housing finance marketleft about 40% of the existing housing stockin need of renovation. These are allinhibiting factors for an appropriatelyfunctioning housing finance system, yetthey also create an immense demand forsuch. Given the market characteristics andexisting infrastructure, Turkey is set to beone of the largest housing finance marketsamong the emerging economies.

Recent developments in the Turkisheconomy have created a better environmentfor longer-term debt and investment tools.As the government’s domestic debtrequirement diminishes, investors areseeking alternative tools with reasonablerisk grades. Mortgage backed investmentinstruments have gained significantpopularity in Turkey within the last 10months. These instruments will also fosterhome ownership rates among the less-served households. In order to create the

appropriate regulatory environment for sucha market, the government has drafted a billwhich would amend certain laws in order tominimize the regulatory impedimentsagainst a robust mortgage market in Turkey.Although regulatory developments are veryimportant, they should be coupled with lowinflation and interest rates and a stablemacroeconomic environment.

This paper discusses the existing primaryhome loan market practices, the regulatory

1 Mr. Onur Ozsan is the Director of Housing Finance of Oyak Konut Insaat A.S., a fully owned real estate project development subsidiary ofOYAK (Armed Forces Pension Fund). Mr. Ozsan holds a B.Sc. Degree in Engineering from Middle East Technical University and an MBAdegree from University of Illinois at Springfield.

2 Mr. Cem Karakas is the Executive Vice President of Oyak Konut Insaat A.S., a fully owned real estate project development subsidiary ofOYAK (Armed Forces Pension Fund). Mr. Karakas holds a B.A. Degree in Management from Middle East Technical University and an MBAdegree from Massachusetts Institute of Technology.

Population Distribution by Age, 2003(Source SIS)

0-29;59%30-49;

26%

50-69;12%

70+; 3%

HOUSING FINANCE PRACTICES IN TURKEY


infrastructure, the need for a secondarymarket and the impediments, and thedevelopments in housing finance market inTurkey.

2. DEMOGRAPHICS

a. Population CharacteristicsAs per 2003, the population of Turkeyamounts to 72 million with an annual growthrate of 1.8%. The age distribution of thepopulation signals a significant future needfor new housing that would vastly surpassthe levels required in the past.Approximately 60% of the population isbelow the age of 30. The trend towardsdiminishing household sizes is yet anotherfactor that further imbalances the supply-demand equilibrium.

b. Household Income and Affordabilityof Housing

Income is distributed relatively unequally inTurkey where the wealthiest 20% ofhouseholds receive over 50% of the incomegenerated in Turkey. Urban householdsconstitute only about half of the population,but earn nearly 75% of the income. Thisuneven income distribution signifies the factthat Turkey, being a large country in terms ofpopulation, is inhabited by a segment that isas wealthy and as large as many developedcountries around the world. Annualhousehold incomes per quintiles are givenbelow in Table 1.

c. Dwelling StockDue to the earthquake in 1999 andeconomic crises in 2000 and 2001, housing

production has significantly declined. Therewere two main reasons for the sharp drop inhousing production figures; first of all thegovernment temporarily ceased issuingconstruction and occupancy permits andsecondly purchasing power of nearly 80%of the population diminished significantly.

The total number of housing units as of2004 June is estimated to be above 17million. This number, however, includessummer homes, second homes, andshantytowns. Hence, when analyzed inconjunction with the demographic data,there appears to be growing demand forquality housing units at an affordable pricethat will continue well into the future. Thiswould add up to the existing metropolitanhousing shortage of approximately 1.5million units.

d. Home OwnershipIn 2003, there were 16,070,093 householdsin Turkey. The most updated statistic (2000census data) suggests that 68.2% of thetotal households are homeowners(10,959,803 households). 23.9% of themare leaseholders, 2.1% of them live ingovernment housing and 4.9% of them areneither leaseholders nor own their houses.Culturally, home ownership is the mostadopted means of investment. Socially,Turkish families tend to be homeownersrather than being tenants. Sinceinstitutional housing finance mechanismsdo not exist, home ownership is financedmainly through family resources. Boththese similar longitudinal data and otherdemographic analyses indicate that thetypical tendency towards home ownership

is disturbed towards tenancy mainly due tothe lack of adequate financial structures tofoster homeownership.

3. PRIMARY MARKET PRACTICES

Mortgage lending in Turkey has been mainlylimited through a chronically high inflationrate and resulting high real interest rates.The high domestic debt requirement of theTurkish Treasury and adversely high interestrates offered by domestic debt instrumentscauses a crowding out effect in thesecondary bond market. This phenomenonindirectly affects the cost of funds availablefor mortgage lending and inhibits growth ofretail banking in general.

There is a need to provide predictable take-out financing to help spur housingproduction. An unintended effect of aninadequately functioning primary mortgagemarket is that it affects the willingness ofdevelopers to construct homeownershipunits, which over time, can lead to ashortage of housing units, particularly at themore affordable price points. Constructioncompanies and developers build housingunits that they know they can sell. Having apredictable source of mortgage finance,which potential homebuyers can access topurchase new units from homebuilders,helps homebuilders to construct housing.

Most homeowners in Turkey had to procuretheir home without resorting to mortgagelending. Less than 1% of the householdshad an outstanding mortgage balance.Mortgage debt outstanding was a mere

20

Quintiles Turkey Urban Rural

2002 2003 2002 2003 2002 2003

Total 100.0 100.0 100.0 100.0 100.0 100.01st 5.3 6.0 5.5 6.1 5.2 6.42nd 9.8 10.3 9.7 10.3 10.3 11.03rd 14.0 14.5 13.9 14.5 14.7 15.04th 20.8 20.9 20.5 20.8 21.7 21.25th 50.1 48.3 50.4 48.3 48.0 46.3GINI Coefficient 0.44 0.42 0.44 0.42 0.42 0.39

Table 1 Annual Household Income by Quintiles, 2002/03 (Source: SIS)



0.224% of the GDP in 2003, a record for theTurkish mortgage lending industry. Thiscompares to 71% in the US and 45.7% inEU.1

A McKinsey and Company study claims thatthe mortgage market in Turkey could reachUSD $20-$30 billion over time: based on atop down comparison, if Turkey’smortgages/GDP reaches 4 to 5 percentsimilar to other emerging countries, themortgage market could reach US $20 -$25billion, or alternatively based on a bottom-up estimation, if the private rental ratiodrops to European levels through mortgagefinancing, the size of the market could reachUS $25-$30 billion.”2

The mortgage lending activity through theretail banks is illustrated in Table 2 below.

Although the target market for mortgagelending activities is assumed to be middleincome families, outstanding mortgage loanamount per person suggests that these

persons are mainly upper level incomefamilies. In other words, families with someamount of wealth accumulated fordownpayment can receive adequate fundstowards home ownership. The families inneed of funds for home ownership are notable to participate in the demand side of themarket as they are seldomly capable ofgetting involved in housing transactions. Asmentioned above, such families are eithertenants, live in a family-financed dwelling orin illegal dwellings.

Since lenders have to bear high riskscaused by duration mismatch and do nothave the means of hedging it properly, theytarget families with lower risk profiles. Thisbehaviour leaves a wide segment of familiesunderserved. This group is targeted bygovernmental agencies to a very limitedextent but this approach is far from beingadequate.

Lenders, mainly commercial banks,disburse loans at branch level. Branches

take the application, conduct the real estateappraisal, check for borrower risk andunderwrite the loan. Servicing could bedone by any other branch of the same bankregardless of having done the origination orunderwriting.

a. ProductsLenders extend loans to borrowers whowish to purchase a single-familydetached/semi-detached/apartment stylehome. The lenders generally rely on theappraisal company’s determination of theeligibility of the property subject totransaction. Some lenders have their ownstaff to do the appraisal.

The lenders offer a combination of TurkishLira (TL) – denominated, and either dollar, or,Euro denominated home loans. The mostpopular products are fully-amortizing 36-month and 60-month loan products,although lenders will utilize pricing as a wayto discourage the use of the 60-months.The average life of a typical mortgage loan

21

Years Currency Denomination Number of Home Loans Extended Loans (US$) Outstanding Loans (US$)

1998 TL 16,591 166,008,071 107,652,583FX 2,001 97,833,177 88,185,452

Total 18,592 263,841,249 195,838,035

1999 TL 9,941 70,375,791 67,687,305FX 645 40,668,731 73,100,092

Total 10,586 111,044,522 140,787,397

2000 TL 55,859 828,907,297 737,521,548FX 2,756 245,605,886 172,589,861

Total 58,615 1,074,513,184 910,111,409

2001 TL 2,457 12,231,509 190,936,807FX 454 21,015,410 53,080,172

Total 2,911 33,246,918 244,016,979

2002 TL 9,767 80,697,328 104,490,789FX 1,148 76,402,961 82,309,618

Total 10,915 157,100,288 186,800,407

2003 TL 23,305 371,117,673 384,126,263FX 2,694 200,710,287 188,287,412

Total 25,999 571,827,960 572,413,675

2004 TL 96,678 1,658,601,341 1,477,227,273FX 3,771 362,733,234 340,280,924

Total 100,449 2,021,334,575 1,817,508,197

1 European Mortgage Federation, 2003

2 “Residential Construction Report-2002.” McKinsey Global Institute

Table 2 Mortgage Lending Through Retail Banks (Source TBA)



◆

◆

◆

◆◆

◆

◆

◆

1998

264

1999

111

2000

1,074

2001

33

2002

157

2003

572

2004

2,021mio USD

Amount of Home Loans Extended

2500

2000

1500

1000

500

0

mill

ion

s o

f U

SD

FX

TL

1998

2,001

16,591

1999

645

9,941

2000

2,756

55,859

2001

454

2,457

years

2002

1,148

9,767

2003

2,694

23,305

2004

3,771

96,678

FX TL

Number of Loans Extended

120000

100000

80000

60000

40000

20000

0



is as short as 24-36 months due toprepayments.

Mortgage lending has been limited for anumber of reasons. First, lenders arelimited to providing only fixed-ratemortgages under the Consumer Law, whichrequires a lender to provide a borrower withthe exact amount of monthly loaninstallments through the life of themortgage. This requirement, in effect,prohibits the origination of adjustable-ratemortgages (ARMs). While such loans can

contribute to a high default rate when ratesrise, particularly with lower-incomeborrowers who cannot absorb the paymentshock, ARMs are often used in economieslike Turkey, which have had high-inflationrates. In an effort to meet market demandfor ARMs, Turkish banks have beenextending foreign exchange denominatedloans with longer terms and better interestrates, simply because they are not allowedto extend ARMs in TL; however, this resultsin sizable foreign exchange liabilities beingcarried on their balance sheets. Foreign

exchange denominated loans are quitewelcome by upper level families, given agenerally higher level of financialsophistication, but are not ideal for those oflower income who may not be as financiallysophisticated.

Macroeconomic conditions, such as thoseresulting from the 2000 and 2001 crises,have had a limiting effect on mortgageoriginations, as can be seen in Table 3below. High inflation rates during thosecrises resulted in the purchasing power of

23

◆◆

◆

◆

◆

◆

◆

◆

1998

196

1999

141

2000

910

2001

244

2002

187

2003

572

2004

1,818mio USD

Outstanding Home Loans

2000

1800

1600

1400

1200

1000

800

600

400

200

0

mill

ion

s o

f U

SD

Table 3 Current Monthly Mortgage Interest Rates (Source: Akbank, Oyakbank, HSBC, Garanti, Isbank)

Akbank Oyakbank HSBC Garanti Isbank

Term FX TL FX TL FX* TL FX TL FX TL

(years)

1 0.70 1.60 0.70 1.55 0.74 1.95 0.70 1.65 0.70 1.552 0.70 1.60 0.70 1.70 0.74 1.85 0.70 1.65 0.75 1.553 0.70 1.60 0.75 1.70 0.74 1.65 0.70 1.65 0.75 1.554 0.75 1.60 0.75 1.70 0.74 1.65 0.75 1.65 0.80 1.555 0.75 1.60 0.75 1.70 0.74 1.59 0.75 1.65 0.80 1.555+ 0.75 1.60 0.80 1.65 0.74 1.59-1.55-1.49 0.75 1.60 0.80 1.55

* There is no constant data for FX loans disbursed by HSBC. It is stated that the rate varies according to the loan amount. 0.74 is the average.



nearly 80% of the population beingdiminished significantly. And, becauselenders are limited to originating fixed ratemortgages, they will only originate short-term mortgages only. Terms have veryrecently extended to 8-10 years (table 3).Lenders still seem to be serving themortgage needs of upper incomehouseholds, as families of lower incomeneed longer repayment periods to make amortgage affordable.

Mortgage lending has also been limitedbecause there is no source of liquidity.Lenders are funding mortgage loans fromtheir deposit base, and have a fundamentalmis-match between assets and liabilities.Without a functioning secondary mortgagemarket, mortgage lenders limit theirmortgage lending.

Although the maturities promoted bylenders are quite similar, there is asignificant difference in interest rates. Theinterest rates on home loans of the largestmortgage lenders at the time of writing areprovided in Table 3. Mortgage loan rates inTurkey are quoted on a monthly basis.

b. ServicingThere are multiple ways that homemortgage borrowers may repay theirmortgages: via a branch, via a direct debitto their bank account, or other electronicmeans. At time of closing, the borrowerreceives a repayment schedule from thelender. It is important to note that thedefault history throughout many lenders isminimal, i.e. less than 1%. They sustainminimal losses to date on their mortgagelending operations, even during the crises.

c. Auxiliary ElementsFor an effective mortgage market, theremust be well-developed supportprofessions that provide reliable third-partyinformation and services to the lenders andpotential homebuyers, as well as well-formed information networks, such asassociations.

i. Consumer Risk

There are two main external sources ofcredit risk information in Turkey: The Central

Bank of Turkey and Consumer CreditBureau (KKB). Independent of the dataacquired from these institutions, most of thelenders utilize their internal credit scoringsystems.

Lenders also utilize certain ratios to ensurethat a loan applicant’s income is enough topay the mortgage.

If the Consumer Credit Bureau/Central Bankreports are negative, the borrower hasinsufficient income or insufficient funds fordown payment, the applicant may bedenied. The Central Bank is a provider ofbad credit information, where KKB offers arange of products including good and baddata of the consumer.

According to the KKB, all major bankinginstitutions are members of the KKB. Theproof of this is the fact that 95% of allconsumer lending in Turkey is originatedusing the KKB’s services. Currently, thereare approximately 45 million records in theKKB’s database

ii. Real Estate Appraisal Services

The real estate appraisal industry withinTurkey is growing. There are currently morethan 100 licensed appraisers in Turkey. Therole of an appraiser is to provide a reliableestimate of the value of a property thatserves as the loan’s collateral. However,there is not much available data for anappraiser in Turkey to work with, as there iscurrently no computerized database of realestate sales prices. An appraiser inspectsand investigates the subject property (forexample, outstanding liens; other debtowed, such as water, sewer, or real estatetaxes; and zoning issues), as well as derivesvaluation information from a wide variety ofsources, including their own data files,property listings, and brokers or agents whoare specialized in specific areas, districts, orneighbourhoods. Historical data isgenerally not reliable - depending upon theneighbourhood and the economic climate,(e.g. three month old data may beconsidered to be “old”). As a result,approximately 80% of an appraiser’s workis “done on the street” because there are nocomputerized records.

Loan to value ratios (LTVs) are applied to theappraised value of the real estate property.Some lenders have their in-house appraisalstaff and some outsource this service. Inthe case of in-house appraisal services, thevaluation is done quite conservatively.However, LTVs in these cases go as high as85-90%, where the in-house appraisal valueis lower than the market levels. On theother hand, the majority of lendersoutsource this service to certified real estateappraisal companies. In these cases, LTVsare around 60-75% depending on thelender.

iii. Insurance Services

Hazard and Earthquake Insurance isrequired by all lenders. This has been arequirement since 1999 and is provided byTurkish Catastrophe Insurance Pool (TCIP).TCIP takes the first loss position and privateinsurers take the second loss position. Theannual premiums due to TCIP are collectedby private insurance companies from thehome owners and then forwarded to TCIP.Earthquake insurance rates are not fixed.They are determined according to the typeof dwelling and the earthquake zone it is in.

Most of the lenders require that theborrower have in place a life insurancepolicy that would remain in effect over theterm of the mortgage. Such a policy wouldhelp to cover the full repayment of the loanin the event of borrower’s death. Suchpolicies seem to be available for only one-year time horizons, even though mostmortgages terms exceed one year. Hence,borrowers must renew their policy annually(at least during the term of the loan).

Private mortgage insurance services are notprevalent in Turkey. Extensive studiesalready conducted suggest that there is nourgent need for mortgage insurance as thiswill increase the cost of funds for borrowers.

Title registry offices are by far the mostrobust governmental institutions in Turkey.Studies conducted by banks suggest thatover the last thirty years there had been onlya few cases of faulty registrations, andthose were due to fraud. In addition, mostof the lenders re-check the building andland registries before closing on a mortgage

24



loan. Therefore, there is no need for titleinsurance.

d. Key Government Participants inHousing Finance

In Turkey, there are a number ofgovernmental agencies that have roles inthe housing finance system. The keyagencies are the Housing DevelopmentAdministration (“HDA”) and the CapitalMarkets Board (“CMB”). Additionalregulatory agencies that have also animpact on the housing finance systeminclude the Banking Regulation andSupervision Agency (“BRSA”), the Ministryof Finance, the Treasury, and the CentralBank.

Currently there is a draft being discussed atthe parliament about establishing asecondary market institution that would buyoutstanding mortgage portfolios whichconform to standards of this institution,from the lenders in order to provide liquidityto the market. This act also suggestscertain tax incentives and provisions fromsome laws such as foreclosure law. Ill-functioning foreclosure law is one of thebiggest impediments towards a robustmortgage-lending program. In Turkey,foreclosure on properties of defaultedborrowers can take as long as four to fiveyears. With the envisaged implementationof a foreclosure law coupled with a newconsumer protection act, the governmenthopes to eliminate certain impediments anddefine the standards of “conforming”mortgage loans These acts are expected toprovide the long expected standardizationof the primary mortgage market besidesliquidity.

3. Legal and RegulatoryInfrastructure

a. Title and Lien RegistrationWell-established property registration andforeclosure laws are essential for successfulimplementation of a mortgage lendingsystem and these exist in Turkey. Currently,lien records are kept locally, at the TitleRegistry Office that covers the area wherethe property is located. In most cases,entries are made by hand.

The real estate transaction is first recordedin the log journal, which keeps records ofthe date of the transaction. In this context,the Title Registry Office directory is theofficial file of the transaction. Since thetransfer of the ownership and recording ofthe lien is done simultaneously at the titleregistration office, there is very little roomleft for human error. If any, the state is liablefor mistakes made – it is responsible forrecovery of losses of an owner that haveresulted from mistakes made by the State.

b. Loss Mitigation and Foreclosure“Loss mitigation” is the process a lenderundertakes to work with a borrower to findalternative payment solutions to cure adelinquency.

According to Consumer Law, for amortgage to be in default, the borrowermust have missed two consecutivepayments and not responded within 7 daysto the written notice sent by the lender.Banking Law requires that the bankestablish a loan loss reserve for all of theborrower’s outstanding consumer loansafter two consecutive missed payments onany consumer loan that it has originated tothat borrower. This implies that if aborrower has missed two consecutivepayments on a car loan, then the bank hasto establish a loan loss reserve for that loan,as well as any additional credit that the bankhas extended to that borrower, for example,on the home loan, even if it has been paidon-time. This regulation creates a burdenon the commercial bank by causing it tokeep more reserves than are necessary forperforming mortgage loans. Suchregulations force banks to adopt moreconservative lending guidelines.

c. Bonds and SecuritiesThe banking system in Turkey is quitedeveloped. Although some of the bankshave extensive cross border assetsecuritization, none has been involved insecuritization of mortgage assets primarilybecause of limited volume of outstandingloans. In spite of adequate laws andregulations for domestic asset backedsecuritization, due to poor marketconfidence and crowding-out caused by theTurkish Treasury, these banks choose off

shore placement practices. If theconditions were in favour of such domesticplacements, there would still be certainrestrictions on the sale or transfer ofmortgage loans from one bank to another.This situation tends to favour the use ofmortgage bonds over off-balance sheetmethods such as mortgage-backedsecurities. At present the stock market ismore developed than bond and fixed-income markets.

4. EVOLUTION OF A SECONDARYMORTGAGE MARKET INTURKEY

There are a number of reasons why asecondary mortgage market has not yetdeveloped in Turkey. Macroeconomicconditions, paired with an inadequatelydevelopment capital market, seem to bethe greatest inhibitors. For example, highdomestic debt requirement of the TurkishTreasury and adversely high interest ratesoffered by domestic debt instrumentscauses a crowding out effect in thesecondary bond market. Hence, mortgagebanks have only limited access to capitalmarket funding for their mortgages. Thisphenomenon indirectly affects the cost offunds available for mortgage lending anddilutes growth of retail banking in general.

As has been previously discussed,mortgage lending in Turkey has been limitedby high inflation and high interest rates –two conditions requiring the design andimplementation of alternative mortgageinstruments. The development ofappropriate primary and secondarymortgage market financing will increase theliquidity and lending capacity of mortgagelenders, increase housing affordability, andfacilitate the wealth accumulation byindividual households.

Mortgage lenders in Turkey are mainlycommercial banks. Funding for mortgageloans is done through savings deposits.The average term of savings deposits is lessthen two months. Therefore, evenmortgages with 5-8 years maturity create anenormous amount of risk load on banks’balance sheets. Secondary markets will

25



provide the long-term funds required todisburse longer-term mortgage loans at theprimary market level.

Currently there is a draft being discussed atthe parliament about establishing asecondary market institution that would buyoutstanding mortgage portfolios, whichconform to their standards, from the lendersin order to provide liquidity to the market.The suggested secondary market entity willassume some conduit (Fannie Mae-like)functions and some other functions ofFHLB, VA and German mortgage banks.This institution is expected to providestandardization to the primary market.

This act also suggests certain tax incentivesand provisions from some laws such asforeclosure law. Foreclosure law is one ofthe biggest impediments towards a robustmortgage lending program as with thecurrent implementation of this law coupledwith the new consumer protection act,foreclosure on properties of defaultedborrowers can take as long as four to fiveyears. By eliminating certain impedimentsand defining the standards of “conforming”mortgage loans, this act is expected toprovide the long expected standardizationto the primary mortgage market besidesliquidity.

Tax exemptions, faster foreclosureprocedures, exemptions from consumer

protection law and some other incentivesand exemptions are also defined in thisdraft.

Most important of all, the new draft willenable the lenders to extend ARMs despitethe consumer protection act.

5. CONCLUSION

There is a tremendous expectation for arobust mortgage market to be up andrunning in Turkey. All the players are puttinga lot of resources into this development.However, for a mortgage lending system tobe as effective as it is in westerneconomies, first of all, macroeconomicstability should be achieved. Secondly, untilall the elements of a robust mortgagesystem is adequately in place, “mortgagelending” practices should be implementedon housing development projects as “pilotprograms”. This approach would enablethe lenders to create homogeneous pools ofmortgages. On the other hand, minimizingthe cost of land for housing developmentpurposes through proper regulation andutilization of state owned lands would play acrucial role in making housing moreaffordable, at least until a robust domesticmortgage market is in place. Thirdly, a localinvestor appetite towards mortgage-backedbonds should increase. This appetite isexpected to increase as the crowding out

effect in the domestic bond marketdiminishes in the short run. Finally,regulatory infrastructure should be in place.In other words, in order to eliminate certainlegal impediments, certain laws, such as thetax laws, consumer protection law,foreclosure law, etc have to be amended.These amendments are expected to be ineffect within 2005.

Until the above-mentioned prerequisites aremet and a domestic secondary market isevolved, lenders may choose to utilizefunding their mortgages through crossborder placements.

Buyer’s equity (down payment) plays acrucial role for affordable monthlypayments. Housing savings fund systemsis one of the methods to help the buyersraise equity shares. There is a law ofincorporation for a housing savings fundissued by Housing DevelopmentAdministration in 1995 in place withoutsecondary regulations necessary forimplementation. Housing finance throughsavings funds support the primary market inreaching a volume where secondary markettransactions would fit the economies ofscale.

26



I. INTRODUCTION

Mortgage securitization2 is new in the

mortgage markets in Korea. The Korean

Mortgage Backed Securities (MBS) market

has grown both domestically and abroad as

a result of the expansion of the Asset

Backed Securities (ABS)3 market since the

establishment of the legal framework for

mortgage securitization in 1998 and 1999.

The Korean government enacted new

legislation to (1) further the development of

the secondary mortgage market and (2)

reduce financial risks in the primary

mortgage market by promoting long-term

mortgages. A fully government-supported

Secondary Mortgage Market Enterprise

(SMME) was launched, and it issued KRW4

3 trillion MBS in 2004. After the kick-off of

offshore Residential Mortgage Backed

Securities (RMBS) transactions in late 2002,

three cross-border RMBS deals were

successfully completed in 2004 to probe a

new funding source. Moreover, the size of

the Commercial Mortgage Backed

Securities (CMBS) market has been

increasing, and CMBS notes are being

backed by cash flows from various types of

real estate.

This article provides updated information on

the mortgage markets and discusses the

latest development in mortgage

securitization in Korea. It begins with the

evolution of the ABS market and recent

developments in the RMBS and CMBS

markets. Second, it explains the conditions

of the primary mortgage market, reviews the

accomplishments of the new Government

Sponsored Enterprise (GSE), and provides

detailed information on cross-border RMBS

transactions. Third, it covers the recent

development in the CMBS market and key

features of CMBS, and then concludes.

II. TRENDS IN SECURITIZATION

MARKETS

Legal Framework

Three acts govern the securitization

business in Korea: the Asset-Backed

Securitization Act (ABS Act), the Korea

Housing Finance Corporation Act (KHFC

Act), and the Mortgage-Backed

Securitization Company Act (MBS

Company Act). Under the provisions of the

ABS Act, all assets including residential

mortgages that create cash flows are

securitized; the other Acts5 permit

securitization of only residential mortgages.

Evolution of the ABS Market

The ABS market has steadily been evolving

since its establishment under the financial

corporate restructuring promotion plan

initiated in 1998. The demand for

Collateralized Bond Obligations (CBOs) and

Collateralized Loan Obligations (CLOs) was

high immediately after the enactment of the

ABS Act for the purpose of disposing of the

enormous burden of Non Performing Loans

(NPLs) at banks; from 1999 to 2001, KRW

17.7 trillion in primary CBOs and CLOs were

issued, and KRW 23.4 trillion in NPLs were

securitized. Credit card ABS was the

predecessor of CBOs and CLOs and

accounted for nearly half of the volume in

the ABS market; in 2001 and 2002, credit

card ABS accounted for 47% of the KRW

90.7 trillion in ABS issued. However, the

sudden increase in ABS issuance has given

rise to side effects such as a deterioration in

asset quality. Thankfully, a new product,

auto loan ABS, held up well amidst the

turmoil in the credit card sector (Hani and

Batchvarov 2004 p. 31), and the real estate

backed securities notes have emerged in

27

Korean Mortgage Markets: Transition to

Securitizations

By Seung Dong You1

1 Seung-Dong You is an instructor of the Graduate School of Housing at Seoul National University of Technology. Email: [email protected]

2 Securitization is the process of pooling and repackaging residential or commercial mortgage loans originated in the primary mortgage market into securities

that are sold to investors in the secondary mortgage market.

3 According to S&P, in 2003 Korea accounted for 82% of the overall Asian securitization market, excluding Japan and Australia. Meanwhile, according to the

database of Merrill Lynch, Korean ABS accounts for nearly 60% of offshore Asian ABS issuance volume. (Hani and Batchvarov (2004. p.3)

4 KRW 1,008 = USD 1 as of March 3, 2005.

5 The MBS Company Act was enacted in January 1999, and the KHFC Act passed the National Assembly on December 23, 2003. The KHFC Act states that

the mission of KHFC is to contribute to the development of the national economy and to promote the housing welfare through the long-term and stable supply

of housing funds through securitization in such forms as mortgage-backed securities and the credit guarantee business. The ABS Act was enacted in

September 1998.

MORTGAGE MARKETS IN KOREA


the market as well. Although the ABS

market has contracted since 2002, new

types of assets such as receivables of

airfares, steel, oil, and internet service fees

are slated to be securitized. Table 1 shows

the outstanding volume of newly issued

ABS from 1999 to 2004.

Recent Developments in the RMBS

Market

The RMBS market has experienced two

major changes since its inception in 2000.

First, the Korea Housing Finance

Corporation (KHFC) was established in

March 2004 and wholly owned by the

Korean government. It was created through

a merger with the first government and

private MBS joint venture, Korea Mortgage

Corporation (KoMoCo), which completed

nine MBS transactions totaling KRW 2,877

billion. Second, the first offshore securities

backed by Korean residential mortgages

were issued in December 2002, and three

transactions followed in 2004.

After introducing long-term fixed-rate

mortgages with maturities up to 20 years,

KHFC issued KRW 3 trillion RMBS in 2004

as shown in Table 2. It also assumed

KoMoCo’s business including the right to

manage KoMoCo’s trust accounts in March

2004.6 Factoring companies such as New

State Capital and Woori Capital failed to

issue additional RMBS after 2002 because

of fierce competition with commercial

banks. In a low interest rate environment,

they could not accumulate an adequate

volume of underlying assets for

securitization because of high funding costs

to originate mortgages. For the offshore

RMBS transactions, Samsung Life

Insurance and Korea First Bank completed

four deals to explore a new funding source.

Emerging CMBS Market

The CMBS market in Korea has been

growing. As the ABS market matures,

institutional investors feel comfortable

investing in real estate-backed products,

and general contractors with low credit

ratings, to whom traditional real estate

lenders hesitate to originate commercial

mortgages, take advantage of off-balance

sheet financing. The preferential tax

treatment for Special Purpose Companies

(SPCs) or Project Financing Vehicles (PFVs)

has encouraged increased CMBS issuance.

Under the ABS Act, which governs the

issuance of most CMBS products, and the

Corporate Tax Act reformed in 2004, the

dividends of SPC, a bankruptcy remote

paper company, are deducted to estimate

its income as long as it pays out at least 90

percent of its taxable income as dividends.

Also, 50 percent of registration taxes and

28

Table 1 ABS New Issuance(Unit: KRW trillion)

Year 1999 2000 2001 2002 2003 2004

ABS (% Change) 6.8(-) 49.4(629.3) 50.9(3.1) 39.8(-21.8) 39.9(0.1) 27.0(-32.3)

(Factoring Companies) 1.7 6.1 21.5 28.1 19.2 8.5

No. of Issuance 32 154 194 181 191 170

Source: Financial Supervisory Services (FSS)

Table 2 RMBS Issuance(Unit: KRW billion)

Domestic Cross-Border Total

KHFC(KoMoCo)1) Others2)

2000 1,279 377 - 1,656

2001 743 477 - 1,220

2002 528 12 411 951

2003 327 - - 327

2004 3,016 - 2,031 5,047

total 5,893 866 2,442 9,201

Source KHFC, FSS

Note 1 KHFC manages the trust accounts that were originally established by KoMoCo.

2 New State Capital and WooRi Capital issued RMBS under the provisions of the ABS Act.

6 KoMoCo is in the process of liquidation after the transfer of its operations to KHFC.



acquisition taxes on real estate owned by

SPC are exempt in order to promote

corporate restructurings. As shown in Table

3, in 2004 the issuance volume of CMBS

backed by cash flows from real estate

development projects more than doubled,

and 37 transactions (22 per cent of the 170

ABS deals in 2004) were completed.

III. THE GROWING RMBS MARKET

1) Primary Mortgage Market

The primary mortgage market has

expanded rapidly since 1999. As shown in

Table 4, the volume of outstanding

mortgages at commercial banks nearly

doubled from 2001 to June 2004. The low

interest rates fuelled speculative demand by

home buyers, and as nearly every

commercial bank and other financial

institution has entered the mortgage market

due to the relatively lower credit risks in the

primary market compared to the corporate

loan market, competition between

originators has been hot, to say the least.

There were previously few long-term fixed-

rate mortgages available. If there were any

at all, the interest rates were too high.

Based on the figures in Table 5 released by

the Financial Supervisory Services (FSS),

more than 75 percent of mortgages have

maturities of less than three years. In 2003,

the maturities of mortgages were mainly

less than five years: just 13.1 percent of the

outstanding mortgages had maturities

greater than five years. As shown in Table 5

and Table 6, most mortgages are short-term

interest-only variable-rate mortgages.

Banks that mobilize short-term savings to

fund mortgages obviously cannot assume

the risks associated with long-term fixed-

rate mortgages, even though these are

precisely what most borrowers prefer.

According to the survey by Kookmin Bank in

2004, the average maturity of mortgages

that homebuyers would choose is 10.37

years, and 67.9 percent of respondents

prefer fixed rates to variable rates. In the

primary mortgage market, there is indeed a

great deal of unmet demand for long-term

fixed-rate mortgages among Korean

homebuyers.

Table 3 CMBS Issuance for Development and SOC projects

(Unit: KRW billion)

Year 2003 2004

No Amount No Amount

Development Projects 16 735.9 37 1,624.6

SOC Projects 1 500.5 3 638.5

Source FSS

Table 4 Outstanding Volume of Mortgages at Commercial Banks

(Unit: KRW trillion, % )

2001 2002 2003 2004.6

Outstanding Mortgage Balance 85.4 131.3 152.4 161.3

(Increase) (-) (53.74%) (16.07%) (11.67%)1)

Source FSS

Note 1 annualized figure

Table 5 Mortgage Maturities

Years M < 1yr 1 yr <= M < 3yrs 3 yrs <= M < 5yrs 5 yrs <= M Total

2001 21.2 % 52.8 % 7.6 % 18.4 % 100 %

2002 18.7 % 62.6 % 6.3 % 12.4 % 100 %

2003 27.8 % 50.0 % 9.1 % 13.1 % 100 %

Source FSS

29



2) Korea Housing Finance Corporation

Establishment of Secondary Mortgage

Market Enterprise

This new government-owned entity was

established to facilitate the provision of

mortgages on a long-term and stable basis,

thereby helping increase social welfare and

furthering the development of the national

economy. The SMME is positioned similarly

as GSEs in the US, the Canada Mortgage

Housing Corporation, or the Hong Kong

Mortgage Corporation. Table 1 summarizes

KHFC’s median-to-long-term effects on the

national economy. To raise public

confidence, the SMME is chartered by a

more favourable act than the MBS

Company Act. Perhaps most importantly,

the government and the Bank of Korea

wholly financed the capital funds of the

GSE. The main business line of this new

entity, the successor of KoMoCo, is

purchasing mortgages to securitize them up

to 50 times its equity capital under its

guaranteed MBS program. Other lines of

business are its mortgage portfolio

business, issuance of Mortgage Backed

Bonds (MBBs), and providing credit to

lenders to support mortgage origination.

Securitization Commitment Program

and Eligible Mortgages

KHFC completed seven RMBS transactions

totaling KRW 3 trillion from June to

December 2004. To issue MBS and

promote origination of eligible mortgages, it

developed a unique securitization

commitment program. Under the program,

KHFC provides participating lenders with

underwriting guidelines, including mortgage

terms and standard loan documents.

Eligible mortgages are designed to promote

home-ownership, stabilize the primary

mortgage market, and allow issuance of

long-term MBS. The standard maturity is 20

years, though 15-year or 10-year maturities

are also available. They are standard fixed-

rate mortgages with an optional one-year

grace period. Prepayment is permitted on

them with penalties of 2.0 percent of the

remaining balance if the mortgage is

prepaid within the first one-year, 1.5 percent

if repaid within the following two years, and

1.0 percent if repaid within the next two

years. No penalties apply after five years.

Based on the guidelines of the FSS, eligible

Table 6 Mortgage Portfolios of Three Major Commercial Banks as of Oct. 2004

Fixed Rate Variable Rate Total

A bank 10.8%1) 89.2% 100%

B bank 0.2% 99.8% 100%

C bank 4.6% 95.4% 100%

Note 1 73 percent of fixed rate mortgages are mixed forms of fixed and variable rate mortgages

Chart 1 Overview of KHFC and its Mid-to-Long-term Effects

■ Mitigate Short-term Borrowers’ Repayment Burdens

■ Provide Long-term Fixed-rate Mortgages

■ Discourage Residential Real Estate Speculation

Promoting

Home Ownership

■ Reduce Risks Associated with Short-term Variable Rate Mortgages

■ Absorb abundant quasi-cash assets

■ Improve Financial Institutions’ Profitability

Enhancing Stability of

Financial Markets

■ Provide Safe Investment Opportunities

■ Provide Investment Products with Range of Maturities

■ Introducing Pass-through Securities and New Products

Developing Long-term Bond

Market

KHFC

30



mortgages under the KHFC program have

an LTV of 70 percent. However, mortgage

lenders are required to cap their lending at

60 percent LTV. The mortgage rate is a

single base rate (5.95 percent as of March

2005) determined by KHFC for every

qualified borrower.

Contributions to the Korean Finance

Market

KHFC has laid the foundation to upgrade

the mortgage market by proposing

innovative fixed-rate long-term mortgages

in the primary mortgage market and by

providing long-term MBS in the secondary

mortgage market.

In the primary mortgage market, KHFC was

issuing mortgages via twenty-one

originators as of March 2005, rather than

buying mortgages already held by financial

institutions in their portfolios. It provides the

standard underwriting guidelines and asks

partner originators to review the

parameters, as some did not examine them

before. For example, KHFC considers the

borrower’s income a key factor because it

applies ratios of maximum Debt to Income

(DTI)7. Before the establishment of KHFC,

most originators did not review the

borrower’s income because mortgages

were heavily collateralized. With sound

collateral, originators did not always need to

apply very stringent underwriting criteria

because they could realize additional

income in the form of charges for defaults

on loans or late payments. Furthermore,

after working with KHFC, several originators

began to originate a fully amortization basis

mortgage product.

In 2004, KHFC sold KRW 3.3 trillion in

mortgages to 47,841 households. It is

meeting much of the unmet demand of

middle-income homebuyers, as shown in

Table 7. The average age of KHFC’s

mortgagors is 38.2, and the average

mortgagor’s income is KRW 28.9 million,

somewhat less than the average Korean

household’s income of KRW 36.68 million

based on the survey of Kookmin Bank in

2004.

In the secondary mortgage market, KHFC

issues long-term securities, helping to

develop the long-term bond market. In

2004, MBS held a 5.8 percent market share

of the market for bonds with maturities of

more than 10 years, as shown in Table 8. In

the Korean bond market, where bonds with

maturities of more than five years are

considered long-term, 82.6% of KHFC MBS

are long-term securities with maturities of

more than five years, whereas 22.5 percent

of bonds are long-term. As shown in Chart

2, most types of institutional investors put

fresh money in MBS.

3) Cross-Border RMBS Transactions

Four cross-border securitization transactions

of Korean residential mortgages were

completed from 2002 to 2004. As shown in

Table 9, Samsung Life Insurance Co., Ltd

issued the first KRW 411 billion RMBS in

December 2002, and Korea First Bank

securitized KRW 2,031 billion in residential

mortgages three times in the global market

in 2004. To enjoy the legal protection of the

ABS Act in Korea, the four securitization

plans were registered on the Financial

Supervisory Commission registration

system (http://dart.fss.or.kr).

Table 7 Characteristics of KHFC Mortgages Originated in 2004

Avg. mortgage amount 69 million Avg. House price 125 million

Avg. Mortgagee’s Age 38.2 yrs Avg. Borrower income 28.2 million (per annum)

Avg. LTV ratio 59% Seoul Metropolitan Area 64.8%

Source: KHFC

Table 8 Bond Origination by Maturity in 2004

(Unit: KRW trillion)

Maturity Total Bonds Major Bonds1) MBS

M < 5 yrs 273.0 77.5% 163.2 77.7% 0.53 17.4%

5 yrs <= M <10 yrs 57.4 16.3% 30.6 14.6% 1.23 40.8%

M>=10 yrs 21.7 6.2% 16.3 7.8% 1.26 41.8%

Total 352.1 100.0% 210.1 100.0% 3.02 100%

Note 1 Monetary Stabilization Bonds, government bonds, and municipal bonds

7 Two DTI ratios are considered for decisions on the mortgage amount.

1) DTI1 = {(Monthly Principal & Interest Payment Amortized) / (Monthly Income)}

2) DTI2 = {(Monthly Principal & Interest Payment Amortized + Estimated Interest Payment* Amortization of Other Debts) / (Monthly Income)}

* Estimated Interest Rate = Weighted Average Loan Interest Rate published by the Bank of Korea

31



Source: KHFC

Chart 2 Institutional Investors of KHFC MBS in 2004 (Unit: %)

Unknown

3.45

Securities

10.61

Pension

12.7

Insurance

30.67

Bank

42.57

Table 9 Summary of Cross-Border RMBS Transactions

(Unit: KRW billion)

Samsung Life Insurance Co., Ltd Korea First Bank

1st 2nd 3rd

Date 2002.12.10 2004.3.29 2004.7.29 2004.12.6

Senior 364.0 588.1 378.1 787.1

AmountJunior - 90.01) - -

Sub 47.0 23.1 76.8 87.5

Total 411.0 701.2 454.9 874.6

No of Mortgages 15,525 18,067 9,758 11,073

Fixed - 7.6% 2.1% -

Type of Variable 100% 43.4% 63.9% 100%

Mortgages Others - 49.0% 34.0% -

Total 100% 100% 100% 100%

Apartments 96.6% 95.7% 95.2% 92.8%

Type of Underlying Assets Others 3.4% 4.3% 4.8% 7.2%

Total 100% 100% 100% 100%

Servicer Samsung Life Insurance Co., Ltd KFB KFB KFB

Sub Servicer Korea Development Bank Kookmin Bank Kookmin Bank Kookmin Bank

Note 1: Three junior tranches with different maturities

32



The cross-border RMBS deals were pooled

by mortgage loans of high quality. The

underlying assets are first liens and

mortgages on mostly apartments that 75.7

per cent of future homebuyers hope to buy,

according to the Kookmin bank survey in

2004.

The high credit rating of structured financial

products in the international bond market

allowed the financial company to offer low

rates. Moody’s, for example, rated the

Samsung Transaction Aaa8 and the KFB

transactions Aa39, although it assigned A3

to Korea’s Sovereign rating. Four US dollar

deals of Korean RMBS were structured with

LIBOR-indexed coupons. The LIBOR has

historically been lower than any other index

rates in Korea. In addition, originators could

build good reputations for their innovative

financial products in the domestic and

foreign bond markets.

Chart 3 Cross-Border RMBS Transaction Diagram

Table 10 Issuance of CMBS backed by Equitable Mortgages and Construction Loans

(Unit: KRW Billion)

Year No Underlying Assets Senior Junior Total

1999 1 Equitable Mortgages 190.0 37.8 227.8

2000 1 Equitable Mortgages 17.9 - 17.9

2001 8 Equitable Mortgages

Construction Loans 827.0 31.6 858.6


Construction Loans 1,136.0 12.4 1,148.4


Construction Loans 1,158.9 1.5 1,160.4

Total 49 3,329.8 83.3 3,413.1

Source: Lee and Jung (2004) p. 30

Originator

Domestic SPC (purchaser)

Foreign SPC (Issuer)

Swap Counterparty

Monoline Insurance

Investors

KRW Sales of Mortgages (KRW)

USD Note

USD Guaranteed RMBS

Swap Guarantee

Note Guarantee

USD

KRW

8 S&P rated this deal AAA.

9 Moody’s rated Korea First Bank Baa3.

33



Nonetheless, as shown in Chart 3, the

financial companies must deal with several

disadvantages from structural features such

as swap costs to mitigate currency and

interest rate mismatches, guarantee fees on

interest and principal payments of notes to

international monoline insurance

companies, and several expenses incurred

through cross-border transaction structures.

Additionally, the senior notes are protected

by ample subordination as well as reserves.

IV. DEVELOPMENT OF THE CMBSMARKET

CMBS is securitization of mortgages

backed by commercial real estate

(Fabozzi(2001), p.1). The volume of the

CMBS issued by general contractors

(usually construction companies in Korea)

with low credit ratings is increasing due to

the limitations they experience issuing

corporate bonds (Lee and Jung, p. 30). As

the structure of CMBS in Korea is similar to

that of ABS and is designed for the purpose

of funding land costs or initial construction

costs during the construction period, CMBS

would be considered a sort of project-

financing vehicle. Most CMBS notes in

Korea are backed by equitable mortgages10

or construction loans. CMBS backed by

equitable mortgages is considered a

security of high quality because equitable

mortgages are expected to produce stable

cash flows. The cash flows of equitable

mortgages come from those who buy the

apartments or the buildings under

construction, whereas the general project-

financing vehicle is backed by incomes

generated after the completion of the

project. Another popular underlying asset

of CMBS is the construction loan generated

by commercial banks. After the first

equitable mortgage CMBS transaction of

Hyundai Development Company in 1999,

KRW 3.4 trillion in CMBS backed by

equitable mortgages and construction loans

was issued from 1999 to 2003, as shown in

Table 10.

As the maturities of CMBS generally do not

exceed the construction period, they are

much shorter than those of ABS;

construction projects usually are completed

within two or three years. In comparison

with other structured financial products, the

volume of CMBS transactions is small. The

average volume of CMBS transactions was

KRW 67.6 billion in 2002 and KRW 52.7

billion in 2003, whereas that of ABS

transactions was KRW 220.0 billion and

KRW 208.8 billion, respectively.

CMBS notes are issued in the domestic and

international markets, and are denominated

in US dollars as well as Japanese yen,

depending on the funding needs. New

vehicles such as Asset Backed Loans (ABL)

and Asset Backed Commercial Papers

(ABCP) and master-trust11 structured CMBS

are being introduced to maximize the

benefit of the sophisticated real estate

structured products in the CMBS market.

V. CONCLUSION

The Korean MBS markets are expected to

continue to grow. A thriving RMBS market

will greatly facilitate the continued

development of the Korean financial

markets, including especially the long-term

bond market. One of the main objectives of

establishing KHFC was to shield the primary

mortgage market from systemic risks

stemming from the increased issuance of

short-term variable-rate mortgages. Up to

the present time, commercial banks have

led the structural change in the primary

mortgage market, and banks have tried to

keep profitable mortgages in their own

portfolios rather than transfer them to the

secondary mortgage market through an

SMME such as KHFC or KoMoCo.

However, competition between commercial

banks will cause originators to sell their

mortgage assets in the secondary mortgage

market in the near future. Obtaining these

mortgages from commercial banks that

dominate loan origination will be one of the

major challenges for the success of KHFC.

The volume of offshore RMBS transactions

will increase because originators believe

that issuing RMBS in the international

financial market will raise their image and

the public’s confidence as well as afford

them lower funding costs. Nonetheless,

cross-border RMBS transactions may be

less attractive due to the swap economies

(i.e. decline in domestic interest rates vs. a

rise in interest rates in the US) (Hani and

Batchvarov (2004) p. 5) and the lack of

funding needs of financial institutions with

high deposit balances that generate wide

spreads by holding mortgage loans.

The CMBS market is also expected to

expand because contractors fund

construction costs based on cash flows

from the projects themselves. The

development of the structured financial

products market would also remove

obstacles to the evolution of the CMBS

market and reduce the risks associated with

CMBS transactions. Nevertheless,

uninterrupted preferential tax treatment is

critical for the market to flourish.

Reference

Chiatsu Hani and Alexander Batchvarov,

“Korean Securitization Update 2004”,

Merrill Lynch Global Securities and

Research Economics Group, Sep 2004.

Euisub Lee and Jaeho Jung (2004), “Current

State and Improvement Way for

Financing the Development of Real

Property (in Korean)”, Construction &

Economy Research Institute of Korea,

Dec 2004

Frank J. Fabozzi, Investing in Commercial

Mortgage-Backed Securities, Fran J.

Fabozzi Associates, 2001.

Seung-Dong You, “Investing in a Emerging

Mortgage Backed Securities Market:

the Case of Korea Housing Finance

Corporation, Cornell Real Estate Journal

Vol 3, June 2004.

10 Before the completion of the construction project, the developer pre-sells the building and finances construction costs or land costs from the buyer – the

future occupier – based on the stage of work. The buyer’s equity grows as the buyer submits installments according to the process of construction. The

future obligations of installments are called equitable mortgages.

11 In the Korean master trust scheme, a single master ABS plan was filed with the Financial Supervisory Commission at the initial closing, and an amendment

is proceeding as new assets are added to trust. (Hani and Batchvarov (2004. p.7))

34



THE MORTGAGE HOLDING SUBSIDIARY CONCEPT

INTRODUCTION

Although housing finance systems varygreatly across countries, reflectingdifferences in how these systems haveevolved over the decades, recent initiativesto modernize housing finance have threeunderlying objectives: greater efficiency,increased choice in the mortgage productsoffered to homeowners, and greater safetyand stability within a country’s financialsystem.

The “mortgage holding subsidiary” (MHS)concept represents an organizationalstructure for achieving thosecharacteristics, specifically in providinglong-term, fixed-rate mortgages tohomeowners. The MHS concept initiallywas developed to complement a proposalto privatize three government-sponsoredhousing finance enterprises in the UnitedStates – Fannie Mae, Freddie Mac, and theFederal Home Loan Banks.2 However, theMHS concept is easily universalized so thatit can be applied in any country whichalready has a well-developed credit marketfor financing owner-occupied housing.Properly implemented, the MHS conceptshould safely deliver more efficient housingfinance than mortgage securitization orcovered bond arrangements whileproducing longer-term, fixed-rate housingfinance than is feasible with bank-like short-

term deposits. This article will first explainthe MHS concept and then discusses thetypes of cost savings MHS can deliver.

This is an especially appropriate time toconsider the MHS concept since housingfinance is undergoing enormous change inmuch of the world, and particularly inEurope.3 In particular, market forces arebeing unleashed to reduce housing financecosts while broadening the range ofmortgage products made available tohomeowners. The MHS concept fitssquarely in the middle of what is emerging inhousing finance.

THE MORTGAGE HOLDINGSUBSIDIARY CONCEPT

The MHS concept is quite simple, which isthe essence of its efficiency — banks,savings institutions, and other financialintermediaries subject to capital regulationwould form MHS to own long-term, fixed-rate residential mortgages originated by theparent institution. Shortly after a mortgageis originated, the parent would sell it to itsMHS. MHS would be barred fromaccepting deposits or deposit-like fundsfrom the general public. Instead, theywould fund themselves entirely in the capitalmarkets through the sale of mortgagebonds and other types of debt instruments.

Because MHS would fund themselves inthis manner, they should not be subject tocapital regulation or other forms of bank-likesafety-and-soundness supervision. Ineffect, MHS would strictly be passivefinancing vehicles with no broad publicinteraction.

Figure 1 illustrates the relationship of anMHS to its parent bank or thrift, showing theparent-subsidiary relationship. Figure 2

illustrates the likely balance-sheetcomposition of an MHS. Assets wouldconsist almost entirely of residentialmortgages while funding would consist ofvarious forms of debt, issued in whateverform made economic sense at the time.The MHS would be capitalized withsufficient equity capital to permit it to obtaina high debt rating (at least AA) on afreestanding basis. That is, the MHS wouldnot look to its parent for back-up capitalsupport. The MHS’s capital level would beentirely marketplace-determined. WhileBasel II is intended to reduce the amount ofcapital backing banks must hold for theresidential mortgages they own, the capitalmarkets can be much more precise indetermining the amount of capital backing aparticularly MHS should have since thatcapital level would depend upon theamount of credit and interest-rate risk thatthe MHS had assumed.

The Mortgage Holding Subsidiary Concept:

A Structure for Efficient Fixed-Rate Housing

Finance

By Bert Ely1

1 Mr. Ely, the principal in Ely & Company, Inc., Alexandria, Virginia, is an independent financial institutions and monetary policy consultant.

2 Wallison, Peter; Stanton, Thomas H.; and Ely, Bert (2004) Privatizing Fannie Mae, Freddie Mac, and the Federal Home Loan Banks: Why and How, AmericanEnterprise Institute, Washington, D.C.

3 Kemmish, Richard, Are you in?, The Banker, 04 November, 2004, page 9.


The following are key features of the MHSconcept:

• MHS would be funded in the wholesalecapital markets with medium- and long-term debt, reflecting the relatively longlife of fixed-rate residential mortgages.This approach parallels the widespreadpractice in Europe of pfandbriefefinancing, or funding long-term, fixed-rate mortgages with mortgage bonds orcovered bonds sold in the capitalmarkets, largely to institutionalinvestors.

• MHS would not be subject to anyregulatory capital requirements, eithersimple leverage ratios or the Basel risk-based capital standards. Instead,marketplace forces would determinethe capitalization of an MHS. MHSowning higher risk mortgages orretaining substantial interest rate riskwould have to carry more capital thanMHS with low-risk mortgages and noretained interest-rate risk. Because ofthe high credit quality of most

residential mortgages, the tradeoffbetween the cost of an MHS’s equitycapital and the cost of its debt would tiltMHS towards capital levels thatproduce at least AA debt ratings, if notAAA. To strengthen the credit rating ofunsecured MHS debt, MHS debt mightbe given a liquidation priority over othergeneral unsecured creditors of the MHSshould it become insolvent.

• There should be no limit on the numberof MHS which can be chartered norshould they be chartered as banks –any bank or savings institution whichwished to charter an MHS should bepermitted to do so. However, therelationship between an MHS and itsparent should be overseen by theparent’s safety-and-soundnesssupervisor, strictly for the solvencyprotection of the parent institution. Forexample, in the United States, therelationship between an MHS and aparent which had been chartered as anational bank would be monitored bythe U.S. Department of the Treasury’s

Office of the Comptroller of theCurrency.

• The parent’s investment in an MHSwould be fully deducted from the assetsand equity capital of the parent for thepurpose of calculating the parent’scompliance with bank capitalrequirements. Hence, the parent couldnot finance its investment in an MHSwith deposits or borrowed funds.

• The parent would be barred frominjecting equity capital into an MHS ifthat capital injection would drop theparent to an undercapitalized status. Ifa parent made such a capital injection,its supervisor could direct theimmediate return of the capital to theparent. An illegal capital injection intoan MHS should be treated on the booksof the MHS as a secured loan superiorto all unsecured claims on the assets ofthe MHS so that the capital can quicklybe returned to the parent.

Figure 1: The Mortgage Holding Subsidiary Concept

Bank, savings institution,

or other type of financial firm

subject to capital regulation

Mortgage Holding

Subsidiary (MHS):

A wholly owned or

majority-owned subsidiary

not subject to capital regulation

Bank originates and sells home

mortgages to its MHS and services

those mortgages

Bank invests sufficient equity capital

to enable its MHS to achieve a target

debt rating

Non-insured, non-government-guaranteed

debt funding raised in the capital markets.



• An MHS could issue stock to thirdparties (including other banks andsavings institutions), subordinated debt,unsecured debt, preferential unsecureddebt, covered bond arrangements, andsecured debt. Secured debt could besecured by a specified group ofmortgages under the “in-situsecuritization” concept discussedbelow. For financial reporting purposes,the MHS’s financial statements shouldbe consolidated with its parent inaccordance with Generally AcceptedAccounting Principles.

• Because the MHS would be a passivefinancing vehicle, with few if anyemployees, it could be managed by itsparent bank, it could share officers anddirectors with the parent, purchasemortgages from the parent (as well asfrom third parties), and contract with itsparent to service those mortgages. Thisrelationship would be closer than what

exists in many securitization orcovered-bond arrangements and hencemore efficient.

• There should be no restriction on thesize or type of residential mortgages theMHS could purchase from its parent orfrom third parties. In addition to owningmortgages on primary residences, MHSshould be permitted to hold mortgageson holiday homes, apartment buildings,university dormitories, nursing homes,and other residential structures. At thesame time, the MHS’s parent shouldhave complete latitude in determiningwhich mortgages to sell to its MHS andwhich ones to keep on the parent’sbalance sheet. Quite likely, the parentwould retain adjustable rate mortgagesand fixed-rate mortgages with shortmaturities, funding them with deposits,while selling long-term, fixed ratemortgages to its MHS.4 By the samemeasure, the parent might buy back

from its MHS long-term, fixed-ratemortgages just a few years short ofmaturity.

• When interest-rate levels declined,triggering mortgage refinance activity,the MHS could lower the cost ofrefinancing mortgages by simplyadjusting the interest rate on themortgage and recalculating the monthlypayment. It could profitably fund thelower interest rate on the mortgage bycalling higher cost debt and replacing itwith lower-cost debt.

• In order to operate as efficiently aspossible, particularly in dealing withmortgage refinances, the MHS could, tothe extent tolerated by the financialmarketplace, operate as one giantmortgage pool financed by preferentialunsecured debt. However, whenmarket conditions so demanded, theMHS could create pools of mortgages

Figure 2: Composition of an MHS balance sheet(not to scale)

4 An October 2003 report by consultants’ Mercer Oliver Wyman, Study on the Financial Integration of European Mortgage Markets, for the European MortgageFederation had this to say about funding mortgages (page 63): “The mortgage bond appears to be an efficient mechanism for funding long term fixed rateproducts but possibly less efficient for short-term products where the flexibility of deposits make this a more attractive option.”

Residential mortgagessecuritized “in situ”

(in-situ securitization, orISS)

Residential mortgages

Residential mortgages(one-family and multi-family)

Cash + short-term investments

Other assets

ISS debt(debt incurred by

mortgagessecuritized “in-situ”)

Callable, noncallable debtsecured by the mortgages

Unsecured “preferential” debtraised in the capital markets

Subordinated debt

Equity capital

Other unsecured liabilities

=Assets Liabilities + equity capital



funded by debt secured by themortgages, through in-situsecuritization, or it could sell mortgagesinto a bankruptcy-remote securitizationtrust which would issue mortgage-based securities (MBS).

• MHS could enter into interest-rateswaps and other interest derivatives tohedge interest-rate and prepaymentrisk. They also could enter into credit-derivative transactions to shift a portionof geographical or credit-qualityconcentrations to third parties.

POTENTIAL MHS COST SAVINGS

In essence, the MHS concept would make itfinancially feasible for mortgage originatorsto originate long-term, fixed-rate mortgagesthat they could hold to maturity in an MHSrather than originate them for eventual saleor securitization.

The sound public-policy reason forpermitting this is that ownership of an MHSshould not endanger the solvency of theparent bank or other type of depositoryinstitution because the parent’s investmentin an MHS should be fully deducted fromthe parent institution’s capital. Hence,should an MHS become insolvent (which

should be a highly unlikely event), thatinsolvency would not endanger its parent’scapital position. Moreover, limiting MHS tocapital market funding would eliminate anyrationale for applying bank-like regulation toMHS. Therefore, MHS should be highlycapital efficient, which would generatesignificant cost savings by reducing therequired profit spread incorporated inmortgage interest rates.

The cost argument underlying the MHSconcept begins by differentiating the twomajor cost components associated with amortgage — mortgage transaction costs(the cost of making and servicing amortgage loan) and the pure cost of fundingthe mortgage.

Mortgage transaction costs

The MHS concept would enable banks,savings institutions, and other mortgageoriginators to reduce mortgage transactioncosts – originating the mortgage and thenservicing it – by originating long-term, fixed-rate mortgages to hold in their MHS ratherthan originating mortgages to sell in asecondary mortgage market. This would bethe case because many costs in theorigination process can be reduced oreliminated if the mortgage originator never

intends to sell the mortgage to an unrelatedparty. Since origination costs vary greatly,depending on house price, mortgageamount, jurisdiction where the home islocated, and how well the costs areidentified and quantified, cost savingswould vary from country to country.

Lower origination costs can reduce ahomeowner’s “all-in” mortgage interest rateby more than a few basis points. Seldomconsidered by borrowers, the all-in interestrate includes the amortization of anymortgage origination costs paid by theborrower, usually when the mortgage isoriginated, in addition to the mortgageinterest rate. It is not possible to computethe all-in interest rate when a mortgage isoriginated if the actual life of the mortgage isnot known because it can be paid off,through a house sale or refinancing, beforethe mortgage is fully amortized. Originationcosts can add significantly to the all-in rateif the mortgage is outstanding for just a fewyears.

For example, if a borrower incurs a cost of$1,500 in connection with originating a$100,000 mortgage, he might save up to$500, or one-third, if the originator sells themortgage to its MHS rather than selling itinto a secondary mortgage market. Costsavings on refinanced mortgages should be

Figure 3: Lowering origination costs significantly reduces the all-in mortgage interest rate

Based on a 30-year, $100,000 6% fixed-rate mortgage

90

80

70

60

50

40

30

20

10

030 years 10 years 7 years 5 years 3 years 2 years

Early pay-off mortgage at the end of

Bas

is p

oin

ts

Amortized cost per year of$1,500 in origination costs

$1,000 cost

$500 cost



much greater, perhaps by two-thirds, or$1,000, in case of the $100,000 mortgageexample. These savings can be quitesubstantial, in terms of the amountexpended and the actual, after-the-fact all-in interest rate. Figure 3 illustrates the all-ininterest-rate reduction for origination costsavings, based on actual mortgage lives.The savings are especially significant if amortgage is refinanced frequently.

An example will further illustrate thesignificant impact of reducing originationcosts. Assume an original 30-yearpurchase mortgage of $100,000, carryingan 8% interest rate, is refinanced everythree years and then the home is sold at theend of the twelfth year, triggering amortgage payoff. Further assume themortgage was refinanced at theprogressively lower rates of 7%, 6%, andfinally 5.5%. Finally, assume an initialmortgage origination cost of $1,000 and a$500 charge for each refinance. Thisreduction in origination costs, from $1,500per origination or refinance, spread over 12years, would reduce the all-in mortgageinterest rate by 31 basis points.

The cost savings, in basis points, for largermortgages is not as great - becauseorigination costs are lower in relation to thesize of the mortgage - but still significant.For example, assuming a $200,000mortgage with the same refinancingfrequency and interest rates set out above(except for a $2,000 initial origination cost),the reduction in the all-in rate of interestwould equal about 22 basis points over thelife of the loan. This second examplehighlights a key advantage of the MHSconcept - the benefits, in terms of reducingthe all-in interest-rate, would beproportionally greater for smallermortgages, which tend to be taken out bylower income families purchasinginexpensive homes. This feature shouldenhance the attractiveness of the MHSconcept for those who believe lowermortgages rates are key to making home-ownership more affordable while expandinghome ownership opportunities.

Mortgage servicing costs

Mortgage originators can trim their servicingexpenses by originating mortgages to meettheir own servicing standards, not industrystandards governing the sale of mortgages,which may require additional costs. Thus, inaddition to trimming origination costs, theMHS structure should reduce servicingcosts by a few basis points per mortgagedollar outstanding by (1) not requiring theoriginator to prepare to sell the mortgage;(2) permitting the mortgage originator tointegrate mortgage servicing more closelywith other services provided to thehomeowner; (3) reducing credit costsbecause of a broader customer relationship;and (4) increased cross-sellingopportunities, particularly for property-related services such as property insurance,home equity lines of credit, and credit lifeinsurance.

It is also more likely that homeowners wouldfinance and refinance their mortgage wherethey have their primary banking relationshipif the bank can retain the ownership of themortgage in its MHS. This would allow thebank or savings institution to capture thesynergies of an integrated customerrelationship - an element that would alsoresult in a lower mortgage interest rate. Thevalue of the other benefits of this closer,more integrated customer relationshipwould vary from country to country, but in arecent study of the European mortgagemarket the authors noted that “there isstrong evidence from interviews withmortgage lenders that the mortgageproduct is increasingly being seen as a‘gateway’ product to gain access to thecustomer and use as a basis for cross-selling other products.”5

Lowering mortgage funding costs

While MHS would fund themselves inwhatever manner makes most economicsense at the time, MHS most likely wouldfund their mortgage assets with acombination of unsecured debt andsecured debt raised through “in-situ

securitizations” (ISS). Given their largeasset size, MHS would issue debt in largetranches, which would make their debtextremely liquid.

Unsecured financing - an MHS could fundits mortgages with a combination of seniorunsecured debt and subordinated debt,plus equity capital. In so doing, an MHSwould assume full credit risk on themortgages it owned plus whatever interest-rate and prepayment risk it did not hedgethrough on-balance-sheet maturitymatching, callable debt, and off-balance-sheet interest-rate derivatives. The financialmarkets would determine the amount ofcapital backing for this portion of an MHS’sbalance sheet, based on (1) the riskiness ofthe mortgages financed in this manner, (2)the amount of interest-rate and prepaymentrisk the MHS had retained, and (3)management’s target credit rating for theMHS debt.

In-situ securitization In-situ securitization,or ISS, is functionally equivalent to fundingmortgages with MBS or covered bonds,except that with ISS financing, both themortgages financed and the ISS debtremain on the MHS’s balance sheet ratherthan being moved off-balance-sheet into asecuritization trust or sold to an unrelatedspecialized mortgage financing entityissuing covered bonds. That is, as is thecase with MBS, investors in ISS wouldassume all interest-rate and prepaymentrisk while the MHS, as issuer of the ISS,would retain all credit risk. However,mortgages financed with ISS debt wouldenjoy substantial origination cost savingsbecause they would not be originated forsale in the secondary mortgage market.Instead, ISS-financed mortgages would be“kept in the family” by being sold by amortgage originator to its captive MHS.

Structuring an ISS debt financing wouldwork as follows: The MHS would set asidea group or pool of mortgages it owned andthen grant an undivided security interest inthose mortgages to the purchasers of theISS debt financing the mortgages. In effect,just these mortgages would secure the debt

5 Mercer Oliver Wyman, “Study on the Financial Integration of European Mortgage Markets,” European Mortgage Federation, October 2003.



financing them. This financing arrangementwould be comparable to a businessfinancing a factory building with asyndicated loan secured by just thatbuilding. ISS debt could be structured as asimple pass-thru security or as a morecomplex, multi-tranche security. Eitherstructure would pass through to the debtholders principal and interest payments asthey were being made, less a profit andexpense margin for the MHS.

In order to obtain an AA or better creditrating on its ISS debt, an MHS most likelywould covenant to maintain at all times anover-collateralization of a particular ISSdebt issue by a specified multiple ofexpected credit losses projected for thepool of mortgages securing the debt issue.Over-collateralization would ensure timelypayment of principal and interest on the ISSdebt. Based on the U.S. experience, theover-collateralization multiple most likelywould fall in the range of 10 to 20 times theexpected loss rate. For example, if theexpected loss rate was two basis pointsannually, the over-collateralization wouldequal .2% to .4% of the amount of ISS debtthen outstanding. Additionally, MHS mostlikely would guarantee the timely paymentof principal and interest on ISS debt, on theslight chance that the over-collateralizationproved to be insufficient during a time ofsevere economic distress.

Hence, the credit rating assigned to aparticular ISS debt issue would reflect boththe degree of over-collateralization backingthe debt and the overall capital strength ofthe MHS. Due to the relatively low volatilityof residential mortgage loan credit losses,an MHS’s targeted pre-tax, pre-credit-lossreturn on its capital allocated to credit riskshould exceed it actual credit losses, evenin high-loss years. Consequently, it shouldbe extremely rare for an MHS to dip into itscapital to absorb credit losses.

Competition among MHS in selling their in-situ financing securities would force anoptimal level of transparency in mortgagesfinanced with in-situ securities, specificallywith regard to prepayment characteristics.In particular, greater transparency wouldreduce any cross-subsidy now flowing frommortgages that prepay slowly to mortgagesthat prepay quickly where no prepaymentpenalty is charged. This cross-subsidy,which flows from the less well off to thebetter off, arises because the prepaymentoption in fixed-rate mortgages provides abenefit only when it is exercised; those whorefinance more frequently tend to be higherincome, more sophisticated borrowers.

By using the in-situ technique to financemortgages originated by their parent banks,large MHS should be able to constructmortgage pools with large tranches of ISSsecurities. This would make in-situ

securities quite liquid, which in turn wouldfurther reduce interest rates on homemortgages as marketplace competitionpushed the benefits of greater liquiditythrough to borrowers, in the form of lowermortgage rates. Savings of even a fewbasis points per mortgage dollar financedwould be significant, relative to a country’sGDP, given the amount of home mortgagedebt outstanding in most countries.

CONCLUSION

Housing finance is undergoing enormouschange in much of the world, andparticularly in Europe, as covered bondlegislation is revised and expanded and asother forms of structured finance emerge.Basel II also will impact on housing financein ways which are not yet fully understood.Further, there is strong interest in manycountries in shifting towards a greaterreliance upon long-term, fixed-rate homemortgages and away from variable ratehousing finance funded largely by bankdeposits. The MHS concept provides avehicle for efficiently providing long-term,fixed-rate housing finance while maintainingthe role banks and savings institutions havetraditionally, and understandably, played inhousing finance, yet avoiding thecomplexity and rigidity that Basel II capitalrequirements will impose on banks andother types of depository institutions.



As is well known, the American housingfinance system is notable for thepredominant role played by the “HousingGovernment-Sponsored Enterprises,”called for short the “GSEs.” These areprincipally Fannie Mae and Freddie Mac,but also include the Federal Home LoanBanks (FHLBs). All are for-profitcorporations owned by privateshareholders, but each is chartered by aspecific Act of the U.S. Congress, datingrespectively from 1938, 1970 and 1932,which grants it special privileges andadvantages. Estimates of the economicvalue of these advantages vary, but they areunquestionably worth billions of dollars ayear.

In particular, Fannie and Freddie are usually(and correctly) described as operating anextremely profitable, government-createdduopoly in the huge American secondarymortgage market. The GSEs are among thelargest issuers of debt securities in theworld, and their bonds and notes are widelyheld on a global basis. The GSEs represent

a very large financial sector: their combinedassets plus off-balance sheet guarantees ofmortgage-backed securities (MBS) totalabout US$ 5 trillion.

Past Triumphs

A good statement of the overall goal of ahousing finance system is to help create

and support a property-owning democracy.Obviously, different countries and timeschoose different ways to pursue this goal.The most fundamental choice in housingfinance structure is whether thepredominant funding for mortgage loans willbe provided by deposits or bonds – in otherwords, by financial institution balancesheets or by capital markets.

The GSEs can best be understood asrepresenting a historical “paradigm shift” inAmerican housing finance from a deposit-based to a bond-based system. The keytransition year can be considered to be1980, symbolizing the downfall of the U.S.

savings and loans and the rise of the GSEs.This shift is summarized in Exhibit 1.

American housing finance from the 1940s toabout 1980 was based primarily on savingsand loan associations, in which savingsdeposits financed long term, fixed ratemortgage loans. As many observers havepointed out, this funding mismatch was aninherently unstable structure, extremelyvulnerable to large increases in interestrates. The vulnerability was increased bygovernmental ceilings on the interest rateswhich could be paid on deposits, so thatwhen rates increased, the deposits werewithdrawn, which caused cyclical “creditcrunches” or rationing of mortgage funding.Nonetheless, during the time of the savingsand loan paradigm, the U.S.homeownership rate increased from 43% in1940 to 65% in 1980.

The ultimate collapse of the savings andloan system in the 1980s is a story too wellknown to need retelling.

American “Housing GSEs”: Past Triumphs,

Present Tensions, Possible Futures

By Alex J. Pollock

Exhibit 1: A Financial Paradigm Shift in U.S. Housing Finance

Post-War Structure■ Deposits■ Savings & Loans■ Interest Rate Ceilings■ Bretton Woods/Fixed Exchange Rates■ Domestic Capital Markets■ Housing Finance Credit Crunches

Current Structure■ Capital Markets■ GSEs■ No Interest Rate Ceilings■ Floating Exchange Rates/Fiat Currencies■ Globalized Capital Markets■ Housing Finance Robust

1980

AMERICAN HOUSING FINANCE SYSTEM

It was the insolvency and crisis of thesavings and loans which made possible therise to greatness of Fannie and Freddie, asthe two GSEs filled the competitive spaceformerly held by several thousand savingsand loans. The new GSE-based systemwas a distinct improvement in the housingfinance structure, because it meant thatlong term, fixed rate mortgages could befinanced with long term, fixed rate bondsand MBS. The GSEs thus represented a farbetter approach to the management ofinterest rate risk.

The interest rate risk of a mortgage financesystem cannot be made to disappear – itcan only be moved to one economic partyor another. Exhibit 2 considers therelationship of mortgage finance elementsto who bears the interest rate risk. Variablerate mortgage loans or fixed rate loans withheavy prepayment fees put the interest raterisk on the household borrowers—onaverage, the economic actors least wellequipped to cope with it. Bond-basedsystems, including the use of MBS, movethe interest rate risk to capital marketinvestors, who are much better able toaddress it. Finally, it must be noted that bysetting up deposit insurance or GSEs, thegovernment moves interest rate risk toitself. (This may be considered just, since itis the monetary behaviour of thegovernment in a fiat currency system whichcreates the extremes of interest rate risk.)

This capital market-funded housing financestructure blossomed in the U.S. after 1980.It never had any interest rate ceilings tocontend with. Moreover, it developed alongwith the globalization of capital markets,making GSE securities available to investorsworldwide. Mortgage finance no longerexperienced periodic “crunches,” butoperated robustly. Throughout economicand financial cycles, long term, fixed ratemortgage credit was routinely and easilyavailable to American households.

These were real achievements of the GSE-based system.

However, the achievements came at theprice of creating a non-competitive,implicitly colluding duopoly which

concentrated both economic and politicalpower. The financing advantages derivedfrom their government support allowed thetwo GSEs to amass a dominating marketshare, up to approximately 70% of the hugeAmerican market for “conforming”mortgage loans (that is, standard loans lessthan a certain amount, currently about US$360,000).

Market power or the ability to enforce highprices for their services has been evident inthe GSEs’ guaranty fees (“g-fees”). This isthe annual charge they receive forguaranteeing the credit performance ofMBS. Average g-fees are five times the longrun average credit loss rate on mortgage

loans, and in recent years have been morethan thirty times credit losses on an annualbasis, as shown in Exhibit 3. The estimatedreturn on equity for the GSEs’ guarantybusiness is about 28% after tax.

All of this is possible only because theAmerican government, by granting specialfranchises which were masterfully exploitedby Fannie and Freddie, created a non-competitive secondary mortgage market.Small banks and thrifts suffer the most fromthis situation, because they tend to deliverthe lowest risk mortgage loans, but pay thehighest guaranty fees. These smallinstitutions would benefit the most fromcreating more competition. The situation


Exhibit 2: Who Has the Interest Rate/Prepayment Risk?

■ Variable Rate Mortgages■ Mark-to-Market Prepayment Fees

■ Bond-Based Systems■ Pass-Through MBS

Also:■ Deposit Insurance■ GSE Balance Sheets

The fundamental source of interest rate risk is the money printing

behaviour of the government’s central bank.

Households

Capital Market Participants

Government

}

}

}

Exhibit 3: Pricing Power

Due to their market position, Fannie and Freddie are able to charge lenders,

particularly small banks, excessively high “guarantee fees” in relation to the

credit losses of the mortgages they originate.

2003 2002*

Fannie Mae Freddie Mac

Average G-Fee 20.2 bps 22.0 bps

Credit Losses 0.6 bps 0.7 bps

Multiple of Losses 33.7 x 31.4 x

“Loss to Premium” Ratio 3% 3%

*Figures as of 12/31/02, revised 11/21/03



was probably not the intent of Congress,but was certainly the outcome of its actions.

This leads to the political side of the story.Under the banner of homeownership, whichincreased from 65% to 69% between 1980and 2003, the exceptional profits of Fannieand Freddie have allowed them easily tofinance large political lobbying forces andactivities. This includes regularly recruitinginto their government relations departmentssignificant political figures and relevantmembers of Congressional staff. Thepolitical activity protected the economicadvantages, which enhanced the profits

and the means to carry on the politicalactivity.

This self-reinforcing historical GSE dynamicis shown in Exhibit 4.

The capital market funding relationships ofthe GSE-based system have growncomplex. An example of this, which is alsotouched with paradox, is shown in Exhibit 5,the “Circle of Value.”

Starting at the top of the circle, consider atypical small bank (a “community bank” inAmerican banking jargon), which

underwrites and originates standard fixedrate mortgage loans. In the GSE-basedsystem, these loans will be originated tostandards set by Fannie and Freddie, verylikely using underwriting software theyprovide. The bank does not (and shouldnot) keep the loans in portfolio, since thiswould be an obvious mismatch against itsdeposit-funding base. Instead it willtypically sell the loans to a larger mortgagebanking operation, known as an“aggregator.”

The aggregator in turn bundles themortgage loans into Fannie or Freddie MBS,the source of g-fees paid to Fannie orFreddie for the life of the loans.

The MBS might well be bought by a largeWall Street investment bank, which would“slice and dice” the cash flows in order tostructure Collateralized MortgageObligations (CMOs). The CMOs would bemarketed to investors through a syndicateof investment banks including regionalsecurities firms.

Such a regional firm might well sell the CMOto – guess who: the small bank whichoriginated the loans in the first place! So the

Exhibit 4: A Self-Reinforcing GSE Dynamic

GSE Charter Duopoly Power

Political Power Economic Rents

Exhibit 5: U.S. System – A “Circle of Value”

creates

finance

protects generates

GSEs are “political finance”

Regional

Securities Firm

Large

Aggregator

Midwestern

Community

Bank

Large

Investment

Bank

Fannie/

Freddieg-fees

Originates Mortgages

Buys CMO

Sale of

CMO

Sale of

Mortgages

MortgagesCMO

MBS

▲

▲

▲

▲

▲



principal asset ends up where it began, butonly after traversing a circle in which at eachpoint a slice of value is extracted by otherfinancial actors. Notably, high g-fees arepaid to Fannie and Freddie as the mortgageloans pass by to become MBS.

As the “Circle of Value” suggests, a highlycomplex infrastructure filled with highlycompensated traders, lawyers andsalesmen is required to maintain the GSE-based system.

Present Tensions

Changes very surprising to most observershave occurred in the GSE system during thelast two years. Fannie and Freddie findthemselves in a defensive posture whichwould have been considered unimaginablea few years ago. The top managements ofboth have involuntarily “retired”—that is,been forced out, along with many othersenior managers. Fannie especially isburdened by onerous regulatoryrestrictions. Freddie has spent more than $150 million revising its accounting andrestating its financial reports, although itsfinancial reports are still not current.Financial report restatements by Fannie arein process.

Two key factors appear to have triggeredthese changes. One is that the ExecutiveBranch of the U.S. government becamevery critical, one might even say hostile, toFannie and Freddie after they blocked theAdministration’s proposed GSE reformlegislation in 2004. The other is that anunexpected source of vulnerability for theGSEs was created by a new accountingrule, and this vulnerability was fullyexploited by their critics. Of course, Fannieand Freddie remain extremely large andimportant companies with a good deal ofpolitical support.

Consider the pattern of a U.S. Presidentwho is very popular in the South and West,while much resented on the East Coast,particularly in “elite” circles, leading hisAdministration against a large, elite,government-sponsored financial power.This could be Andrew Jackson 170 years

ago rejecting the rechartering of the SecondBank of the United States, the GSE of itsday. Or it could be George W. Bush and thehumbling of Fannie and Freddie. Anintriguing parallel!

In any case, Jackson’s thoughts as hevetoed the rechartering bill in 1832, asshown in Exhibit 6, are quite apt whenapplied to the problems posed by GSEstoday. We have the same problems ofprivileges for shareholders, government-sponsored profits, concentration of power,and monopolistic grants as Jacksonopposed. But the focus in the current GSEdebates has instead been accountingissues.

Owning fixed rate mortgage loans which areprepayable without penalty requiresintensive hedging and the extensive use ofderivative instruments, such as interest rateswaps and option contracts. FinancialAccounting Standard 133 (FAS 133),addressing accounting for derivatives, is thenew accounting rule which played such aprominent role in bringing down themanagements of both Fannie and Freddie.

FAS 133 was contentious from the outset,and still is. Everybody always knew it wouldbe complex and costly, but its effects on theGSEs have been much more impressivethan anyone expected, especially themanagements of Fannie and Freddie.Freddie has restated its after-tax profitssince 2001 to increase them by an

aggregate $ 5 billion. Fannie will have torestate its after-tax profits over the sameperiod to reduce them by $ 9 billion in theaggregate.

These are big numbers, to be sure! Ofcourse, the accounting result is to makeFreddie appear even more profitable thanbefore, and Fannie is still very profitableeven after the subtractions. But do the FAS133 adjustments reflect economic reality?This continues to be debated.

Neither Fannie nor Freddie strictly followedthe requirements of FAS 133. Whileeveryone agrees they should have, virtuallyeveryone also agrees that FAS 133 is overlycomplex, convoluted and difficult to apply.Along with its official interpretations, it runsto more than 800 pages.

In addition to being enormously expensiveto implement, FAS 133 tends in thejudgment of many to make financialstatements less clear, less understandablefor investors, and more divergent fromeconomic reality. In a recent survey offinancial professionals, 86% said FAS 133made financial statements less clear, 97%that it was too complex, and over 90% thatis should be significantly revised orreplaced. The managements of Fannie andFreddie clearly shared these views.

It appears that one source of Freddie’saccounting problems was its management’sconviction that FAS 133 so distorted the

Exhibit 6: Regarding the GSE of Its Day

“Admit that the bank ought to be perpetual, and as a consequence the

present stockholders will be established a privileged order, clothed both with

great political power and enjoying immense pecuniary advantages from their

connection with the government. It is easy to conceive that great evils to our

country and its institutions might flow from such a concentration of power.

If we can not at once make our government what it ought to be, we can at

least take a stand against grants of monopolies and exclusive privileges.”

Andrew Jackson

Veto Message, 1832



reported results that it made sense tostructure shell transactions to adjust them.That did not make sense (as truncatedcareers attest), but the effects of correctlyapplying FAS 133 to Freddie’s financialstatements were probably to createmisleading accounting artifacts.

FAS 133 is widely considered to be a kind of“metaphysical bookkeeping,” which isconvoluted and confusing, distortseconomics, obscures performance, and isconceptually wrong. But whatever itsmerits or lack thereof, it has proved to bethe “soft underbelly” of regulatory andpolitical vulnerability of Fannie and Freddie.Quite an ironic outcome.

An additional element of potential change inthe GSE-based system is the “other GSE”:the Federal Home Loan Banks. The FHLBshave the same government-sponsoredadvantages as the better-known GSEs,which allow them to compete equally withFannie and Freddie in the debt and hedgingmarkets. Taking advantage of this, in 1997,the FHLBs introduced a competitivesecondary mortgage finance program,“Mortgage Partnership Finance” or “MPF”as an alternative to MBS.

Over 1,000 mortgage-lending institutionsnow participate in the FHLBs’ secondarymortgage programs. An important questionin GSE sector evolution is whether thiscompetitive alternative can realize itspotential. (I confess a strong bias here,being the originator of the MPF concept.)Will the GSE sector remain duopolistic orcan it become truly competitive?

Possible Futures

In the wake of the accountingembarrassments and managementdepartures at Fannie and Freddie, the mainresponse of the Congress has been toconsider changes in regulatory structure. Inthe U.S. Senate, the “Federal HousingEnterprise Regulatory Reform” bill wasintroduced earlier this year. Senator Shelby,the Banking Committee Chairman, hascalled GSE legislation a “top priority.” TheHouse Financial Services Committee is alsoplanning to take up regulatory reform.

Virtually everyone involved agrees with theprovisions of the Senate bill which wouldabolish the Federal Housing Finance Board(the FHLB regulator) and the Office ofFederal Housing Enterprise Oversight(OFHEO – the Fannie and Freddie regulator),and replace them by a new combinedregulator. Both the Finance Board andOFHEO have regulatory domains toonarrow to make sense—they are equallyunable to see the whole picture of the GSEsector and its global issuance ofgovernment-sponsored debt securities.Creating an overall view of the entire $ 5trillion housing GSE sector is a good idea.

However, creating stronger regulation in andof itself may have an ironic unintendedconsequence: actually increasing thegeneral confidence in the government’scommitment to the GSEs, strengtheningeven further the bond market’s so farunshakeable belief in the impliedgovernment guaranty, helping sell GSE

bonds and MBS at tight spreads, andsupporting GSE profits.

In other words, the unintended result ofstrengthened regulation by itself could be toenhance the government-linked status andduopoly power of Fannie and Freddie.

To address this problem, GSE reformlegislation needs to become clearly pro-competitive, consistent with thefundamental principle that all regulatoryreforms should be designed to be explicitlypro-competitive. The U.S. experience sincethe 1970s is that greater productivity andconsumer benefits have been created inmany industries by forcing competition onhitherto comfortable oligopolies. A notablecontrast to this positive trend has been theduopoly in the huge American secondarymortgage market.

In order to achieve a competitive outcome,any GSE reform legislation might includeprovisions like the following:

• It could simply state that the goal ofCongress, in addition to safety andsoundness, is also to enhancecompetition. In the American setting,no one should be able to disagree withthis as a fundamental principle.

• It could instruct the new combined GSEregulator that the development ofregulations should include the goal ofensuring a competitive GSE sector.

• It could include a provision addingsecuritization to the explicit legalpowers of the FHLBs. (Although it canbe argued that they already have this asan implied power, such a provisionwould avoid any debate on the matter.)This provision would directly attack theduopoly power and excessive g-fees ofFannie and Freddie, give customersmore attractive pricing, and add choiceto the secondary mortgage market.

• It could mandate studies by the newGSE regulator, the Federal ReserveBoard and the Treasury Department ofwhether the secondary mortgage

Exhibit 7: GSE Legislation in 2005?

Four Possible Outcomes of Legislation:

1. Status quo.

2. Reorganize: a new regulator, which strengthens implicit guaranty and GSE

status.

3. GSEs put on the road to greater competition.

4. Possible ultimate privatization.


market is duopolistic or competitive,and since the conclusion of suchstudies is in little doubt, what could bedone to enhance its competitivenenss.

As shown in Exhibit 7, there are four basicoutcomes possible from current proposalsfor GSE reform legislation.

One is that nothing will happen in the endand the status quo will prevail, whileworking through the GSE accountingscandals.

The second is the creation of strongerregulation by itself, which may end upstrengthening GSE status and duopolypower.

The third is in addition to a new regulator, toput the GSE sector on the road to greatercompetition, with the benefits of enhancedmarket choice, innovation, pricecompetition and efficiency that would bring.

Lastly, there is the possibility ofprivatization. This is highly unlikely in anynear term, but is an idea whose time mayultimately arrive. The triggering event wouldprobably be that in the fullness of time, theGSEs themselves decide that the economicadvantages of their special charters are nolonger worth the regulatory restrictions andburdens they entail. That will be a story fora future day.

As of 2005, the GSE-based housing financeparadigm has been dominant in America fora generation. The immediate futureprovides a major opportunity which may ormay not be seized. This opportunity is tobegin the transition to a new housingfinance paradigm: one built on competitivesecondary markets instead of agovernment-sponsored duopoly.

Alex J. Pollock is a Resident Fellow at the

American Enterprise Institute in Washington,

D.C. and a Past President of the

International Union for Housing Finance.



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