1

International Conference on Affordable Housing & Mortgage Financing

28 – 29 May 2015

Organised by Infrastructure, Housing & SME

FinanceDepartment, State Bank of

Pakistan, Karachi

Sources of Long-Term Funding for Financial Institutions for

Mortgage Financing

By: N. Kokularupan

2

Table of Contents

• Introduction

• Mortgage finance in emerging markets

• Capital markets in emerging markets

• Ingredients for sustainable housing finance

• Funding models for mortgage financing

• Liquidity Facility

• Pre-conditions for establishing a Liquidity Facility

• Objectives of Liquidity Facility

• Benefits of Liquidity Facility

• Mode of operations of Liquidity Facility

3

Table of Contents (Contd)

• Ownership structure

• Rationale for Central Bank taking an equity stake

• Success factors for Liquidity Facility

• Covered Bonds

• Core features of Covered Bonds

• Eligibility Criteria for Mortgage Loans backing

Covered Bonds

• Legal basis and quality of Covered Bonds

• Rating of Covered Bonds

• Covered Bond Issuers

• Robust Covered Bond Framework

4

Table of Contents (Contd)

• United Kingdom Regulated Covered Bond Regime

• Dutch Covered Bonds

• Danish Covered Bonds

• Differences between Covered Bonds and Mortgage

Backed

Securities

• Securitisation

• Pre-requisites for Securitisation

• True sale criteria

• Activities entailed in Securitisation

• Major challenges in Securitisation

• Conclusion

5

Introduction

• Numerous benefits of mortgage lending to primary

lenders Amongst them are:

Very low credit risk as loan is secured against the

property with a reasonable LTV.

Credit risks mitigated further by lending to

properties with good resale value.

Very low capital charge – 50% under Basel 1 and

35% - 100% depending on LTV under Basel 2, (35% if

LTV is ≤80%, 50% if LTV is 80% - 90%, and 100% if

LTV exceeds 90%).

Housing loans usually have low default rates.

• Yet banks in developing countries reluctant to provide

housing loans.

6

Introduction (Contd)

• Question – WHY?

Lack of expertise in mortgage lending

Issue of maturity mismatch

Shortage of long-term funds at reasonable rates

7

Mortgage Finance in Emerging Markets

• Generally under-developed

• Deposit based

• Expensive

• Typically small and poorly accessible

• Lenders faced with credit, liquidity and interest rate

risks

• Borrowers subject to interest rate risk

• Population growth coupled with urbanisation

warrants development of long-term sustainable

housing finance.

• Governments are committed to developing robust

finance systems to cater for increasing young

population, rapid urbanisation and rising

expectations from a growing middle class.

8

Capital Markets in Emerging Markets

• Under-developed with few instruments.

• Capital markets – attractive and significant amounts of

long-term funding for housing (e.g. insurance

companies and pension funds).

• Provide an important source of long-term funding.

9

Ingredients for Sustainable Housing Finance

• Good underwriting standards and diligent follow-up

on delinquent and default cases.

• Low default rates.

• Efficient mortgage market regulated by the Central

Bank.

• Existence of a Liquidity Facility to provide sustainable

long-term funding at reasonable cost.

10

Funding Models for Mortgage Financing

• Deposit base

• Liquidity Facility (LF)

• Covered Bonds

• Securitisation

• Deposits, in particular, core deposits will remain an

important source of funding especially if mortgage

rates are variable rates

• In most cases, the cost of wholesale funding is more

expensive than retail funding e.g. deposits

11

Funding Models for Mortgage Financing

• If lenders are not constrained by liquidity or capital,

they are not motivated to seek for capital market

funding.

• Although Governments are active in the development

of secondary mortgage markets, success is not

guaranteed by Government’s participation alone, but

by ensuring there is a market need for capital market

funding and demand from investors for instruments

used in the secondary mortgage market.

12

Liquidity Facility

Liquidity Facility (LF)

• Institution that provides medium/long-term funding to mortgage

lenders.

• Acts as intermediary between mortgage lenders and capital

markets.

• Issues plain vanilla bonds to raise medium/long-term funds.

• Purchases or refinances mortgage loans with recourse.

• Low risk, simple monoline institution.

Grant housing loans

CustomersMortgage lenders

(banks)Liquidity Facility Investors

Sell / refinance housing loans to LF

Issues plain vanilla debt securities

13

Pre-conditions for Establishing a Liquidity Facility

• Motivation for financial institutions to refinance/sell

their loans.

• Sufficient demand for housing finance.

• Sufficient supply of affordable housing.

• Functioning primary mortgage market.

• Ability to assign/transfer mortgage loans.

• Critical mass of eligible mortgages.

• Existence of capital market and an investor base.

• Support from the Government/Central Bank and

other regulatory authorities such as the Securities

Commission.

14

Objectives of Liquidity Facility

• Develop the primary mortgage market

Provide long-term funds to enable primary lenders

to grant loans at fixed rates and for longer

tenures.

Help lenders alleviate the gap between maturity

of housing loans and sources of funds.

Allow smaller lenders to access long-term funding

and foster competition.

Promote sound lending norms (eligibility criteria).

Lower the cost of long-term funding.

15

Objectives of Liquidity Facility (Contd)

• Develop the capital market

Provide variety of private debt securities with

various maturities and rates.

Create a yield curve for PDS.

Avenue for insurance companies and pension

funds to invest their surplus long-term funds.

16

Benefits of Liquidity Facility

• Mortgage lenders able to secure long-term funding

at attractive rates.

• Provides a mechanism for primary lenders to manage

their liquidity position in the long-term.

• Contributes to stability of liability structure of

primary lenders offering an alternative source of

funding.

• Allows lenders to provide fixed rate mortgage loans

at least over the medium term.

• Contributes to development of local bond market by

offering a new class of investment asset.

• Improves affordability for mortgage borrowers by

lengthening maturity of loans and thus lowering the

monthly instalments.

17

Mode of Operations of Liquidity Facility

a) Refinance mortgage loans from primary lenders

collateralised by the mortgage portfolio e.g. JMRC,

EMRC, TMRC.

b) Buy mortgage loans with recourse from the primary

lenders e.g. Cagamas.

18

Ownership Structure

• Can be 100% privately owned or joint ownership by

private sector and the Government (Central Bank)

with majority shareholding by private sector.

• Initially, Central Bank’s participation as equity holder

is important to kick-start the operations by instilling

confidence to investors and granting special

privileges to the Liquidity Facility.

• Important that Central Bank or Government should

divest their shares to the private sector once the

Liquidity Facility reaches self-sufficiency (sunset

provision e.g. France).

• Equally important is that the privileges granted to

kick-start its operations should cease once it reaches

self-sufficiency.

19

Rationale for Central Bank taking an Equity Stake

• Hence, Central Bank’s participation becomes

important for the following reasons:

LF new entity fulfilling a public private mission.

Initially, Liquidity Facility no track record.

Participation of Central Bank lends credibility to

the institution.

Usually mortgage market and capital market

nascent stage of development.

20

Rationale for Central Bank taking an Equity Stake (Contd)

Though the Central Bank will not provide explicit

guarantees, investors “perceive” that Central

Bank will not allow LF to default in its obligations.

Provides confidence to investors of LF’s bonds and

lowers cost of issuance.

Central Bank’s shareholding will also provide some

degree of confidence to rating agencies to look at

LF as stable and on-going institution. Rating

important to lower cost of issuance.

LF will also play a role in standardising mortgage

lending practices and introducing good risk

management practices. Central Bank’s

shareholding will facilitate the above.

21

Success Factors for Liquidity Facility

• Initial support from the Central Bank:

Shareholding

Concessions

• Credible Board of Directors and competent CEO.

• Shareholding structure.

• Support of Government/Securities Commission.

• Good Governance.

• Willingness of banks to participate actively.

• Presence of institutional investors with appetite for

medium and long-term high quality corporate

bonds.

22

Covered Bonds

• Debt securities backed by cash flows from

mortgages or public sector loans.

• Similar in many ways to asset backed securities

created in securitisation, but covered bonds remain

on the issuers’ balance sheet (with an appropriate

capital charge).

• Covered bonds continue as obligations of the issuer;

in essence the investors have recourse against the

issuer and the collateral, often referred to as “dual

recourse”.

• Covered bonds have been in existent since 1769.

First created in Prussia in 1769 and in Denmark in

1795.

23

Core Features of Covered Bonds

• Issuance of covered bonds usually regulated by a

specific legal framework or on a contractual basis,

supervised by a national financial supervisory authority.

• Covered bonds issued by banks with a dynamic pool of

earmarked assets on the balance sheet of the issuer

collateralising the bonds.

• Covered bonds are bankruptcy remote, i.e. segregated

from the bankruptcy procedure of the issuer once it is

insolvent or bankrupt.

• Covered bondholders have a preferential claim on the

proceeds of the collateral in case of insolvency or the

issuer.

24

Eligibility Criteria for Mortgage Loansbacking covered bonds

• Maximum LTV 80%.

• Value of the property underlying the mortgages used as

collateral shall be monitored on a regular basis by an

independent valuer.

• Mortgages used as collateral shall be adequately

insured against damage.

• Should be legally enforceable in the relevant

jurisdications and be properly filed.

25

Legal basis and quality of Covered Bonds

• Specific legislative framework or contractual

agreements define rules on management of cover

asset pools such as minimum over-collateralisation

and maximum LTV for mortgages.

• Common legal basis supports the transparency and

homogenity of one market as the minimum standard

for all issuers are the same.

• This also keeps analysis efforts by the investors at an

acceptable level, especially when compared with

MBS.

• Quality of covered bonds is determined by the

quality of the collateral, asset liability matching

requirements, potential over-collateralisation and the

degree of bankruptcy remoteness.

26

Rating of Covered Bonds

• Unwritten law that covered bonds need to be highly

rated, at least double A.

• Rating agencies have expressed their requirements

with regard to bondholders’ protection to apply such

high rating.

• Rating agencies have made it clear that in order to

meet their requirements, covered bonds do not need

to be issued on the back of a specific legal framework.

• A bond property structured on a contractual basis and

meeting the four core features above will be able to

qualify as a high quality covered bond.

27

Covered Bond Issuers

• Traditionally covered bonds issued by special banks

and these institutions’ business activities are typically

limited to low risk activities such as mortgage loans

and public loans.

• Limited and low risk activities of special banks

enhance the quality of covered bonds since the risk of

default of special banks is lower than that of a

commercial bank.

28

Covered Bonds Issuers

• In recent years, commercial banks also issue covered

bonds and this has been widely accepted by the

market.

• Issuance of covered bonds offers indirect advantages

to depositors.

• Covered bonds enable banks to lower their funding

cost, diversify their funding source and investor base

and have access to medium and long-term funds.

• Above helps the issuer to increase flexibility,

competitiveness and profitability and this in turn

enhances security for depositors.

29

Robust Covered Bond Framework

European Banking Authority has identified the following

areas:

• Dual recourse mechanism

• Asset segregation and bankruptcy remoteness of

covered bonds

• Valuation of cover assets and LTV limits

• Asset and liability risk management : coverage

principles and over-collateralisation

• Asset and liability risk management : stress testing

• Covered Bond Monitoring

• Role of competent authority

• Disclosure to investors

30

United Kingdom Regulated Covered Bonds Regime

Introduction

• UK covered bond market established in July 2003

under UK general law. In March 2008, the Treasury

introduced dedicated covered bond legislation

(Regulated Covered Bond Regulations 2008) for the

UK market.

•  Regulated by Financial Conduct Authority.

 Key Features of Covered Bonds in UK

• Only deposit-taking institutions with headquarters in

UK can issue regulated covered bonds.

31

United Kingdom Regulated Covered Bonds Regime (Contd)

• Only eligible property as defined in legislation can

be used as collateral for regulated covered bonds

• In UK, the assets backing the bond are transferred to

a separate legal entity (Special Purpose Vehicle) and

form collateral for the bonds.

• Asset pool of the covered bonds is dynamic i.e.

replacement of non-performing loans in arrears with

new mortgages.

• Covered bonds are obligations of issuer, so investors

can expect issuer to make interest and principal

payments on due dates.

32

United Kingdom Regulated Covered Bonds Regime (Contd)

• If the issuer defaults on its obligations to covered

bondholders or becomes insolvent, asset pool

becomes static and SPV assumes responsibility for

administering the asset pool to continue to make

payments to bondholders.•  

• If there are insufficient assets in the pool to meet the

obligations to covered bondholders, they become

unsecured creditors of the failed issuer for the

residual amount.

33

United Kingdom Regulated CoveredBonds Regime (Contd)

What is a Regulated Covered Bond?

• Complies with the Regulated Covered Bonds

Regulations 2008 and is registered with the FCA.

• All regulated covered bonds are listed on the RCB

register.

• However, structured (unregulated) covered bonds

are not subject to these requirements.

34

United Kingdom Regulated Covered Bonds Regime (Contd)

Regulatory benefits associated with regulated covered bonds

• Increased investment limits. Undertakings for

collective investment in transferable securities

(UCITS schemes) can hold up to 25% of their assets

in RCBs issued by one issuer, but only 5% in

structured (unregulated) covered bonds issued by

one issuer. 

• Insurers can invest up to 40% of their assets in RCBs,

but only 5% in structured (unregulated) covered

bonds.

   

35

United Kingdom Regulated Covered Bonds Regime (Contd)

Criteria for banks to be eligible to issue regulated covered bonds

• Competency of the proposed oversight and governance framework in managing risks of the programme.

• Systems, controls, policies and procedures in respect of risk management, underwriting, arrears and valuation.

• Competency in cash management and servicing functions.

• Quality of eligible assets in the cover pools. 

• Ability to substitute non-performing loans. 

• Ability to make timely payments on the bond programme.

•  

• Legal structures compatibility with the Regulations.  

36

United Kingdom Regulated Covered Bonds Regime (Contd)

Stress Test by FCA to determine over-collateralisation

 

• Key variables used to stress test are: 

Default rate and timing Loss severity and timing Prepayment rate and timing Servicing cost Resilience of counterparties and hedges

• FCA conducts an annual on-site review of each

regulated covered bond programme to assess the

issuers’ continuing ability to meet the Regulations.

•  

37

Dutch Covered Bonds

General Characteristics

• Banks originating mortgage loans enter into Trust

Agreement with a Dutch security trust approved by

the Central Bank.

• Trust and Board members are independent from the

bank.

• Bank pledges the mortgages and the cashflow from

the mortgages to the Trust.

• Mortgage loans remain in books of bank as long as it

is not insolvent or bankrupt.

• Collateral pool is refreshed monthly (replacement of

non-performing loans).

 

38

Dutch Covered Bonds (Contd)

• Following the pledge, bank issues covered bonds.

• Bonds are bullet bonds and redeemed at par at

maturity.

• Collateral only consists of first ranking mortgages on

private housing.

• If banks do not have sufficient eligible mortgages for

replacement, the Trust will accept bank deposits and

listed bonds having a rating not lower than AA –

temporarily. 

• Covered bonds are supervised by the Authority for

Financial Markets.

•  

39

Dutch Covered Bonds (Contd)

 Post Bankruptcy Procedures and Preferential Claim

• If issuer faces bankruptcy or becomes insolvent

Trustee takes over management of the portfolio.

• Bondholders have exclusive claims on pledged

mortgages if issuer becomes bankrupt.

• If proceeds from the pool are insufficient to pay the

bondholders, the bondholders have a claim against

issuers’ other assets pari passu with unsecured

holders of unsecured bonds by the issuer.

•  

40

Introduction

• Danish covered bonds issued in compliance with

Danish Mortgage Loans and Mortgage Bonds Act

(DMLMBA) and the Danish Financial Services Act.

• Comply with the UCITS directive.

• 10% risk weighting in Denmark and most EU

countries. 

Danish Covered Bonds

41

Danish Covered Bonds (Contd)

Mechanism and Characteristics of Danish Covered Bonds

• Only mortgage banks are allowed to issue the bonds.

• Bonds collateralised by mortgage loans which must

be registered with the Land Registry.

• Over-collateralisation is secured by law, with

maximum LTV of 80% for residential loans.

• Mortgage loans solely funded through the issuance of

bonds.

42

Danish Covered Bonds (Contd)

• Mortgage banks have no access to money market or

deposits.

• Issuance of covered bonds by mortgage banks

subject to “balance principle” i.e. can only issue

bonds with same terms as the underlying loans,

strictly passing through the cashflows from the

borrowers to the bondholders. Mortgage banks earn

revenue from a service fee.

•  Balance principle ensures mortgage banks do not

assume interest rate or liquidity risk.

43

Danish Covered Bonds (Contd)

• Bondholders have preferential status in event there

is a shortfall when the bank becomes

insolvent/bankrupt.

• Bonds by mortgage banks are treated as highly

secure investments in capital market.

• No bankruptcy of mortgage banks in the 200 years of

history of Danish mortgage system.

44

Differences between Covered Bonds and Mortgage Backed Securities

Covered Bonds Mortgage Backed Securities

1. Debt Type Direct bank debt Debt issued by SPV

2. On/Off Balance Sheet

On Balance Sheet of Originator

Off Balance Sheet of Originator

3. Tranches No tranching of covered bonds

Senior and subordinated tranches

4. Asset Pool Dynamics

“Dynamic” revolving pool of qualifying collateral

Static pool of assets

5. SubstitutionNon-performing loans substituted by Originator

No substitution of non-performing loans

45

Differences between Covered Bonds and Mortgage Related Securities

(Contd)

Covered Bonds Mortgage Related Securities

6. Recourse to Originator

Full recourse to Originator for covered bondholders

No recourse to Originator

7. Originator defaultIn case Originator defaults segregation of cover assets

MBS not affected by originator default

8. Bondholders’ Protection

Preferential claim on cover assets, senior to other creditors

Exclusive claim on cover assets

46

Securitisation

• Converting illiquid assets into liquid assets by

creating high quality investment instruments.

• Advantages of securitisation:

Diversifying funding sources

Risks transferred from lenders to investors

Capital savings

Access to global capital markets

47

Prerequisites for Securitisation

• Stable Macroeconomic Environment

• Competitive Market Structure

• Standardised Mortgage Loans and Instruments

• Proper Origination and Servicing Techniques by primary

lenders

• Liquidity in secondary mortgage securities market

• Investors’ base

• Adequate legal, tax and accounting framework

• Good title registry with accurate records

• Good foreclosure system

• Ability to transfer beneficial interest to investors at

minimum cost

• Protection of investors against bankruptcy of

originator/servicer

48

True Sale Criteria

• Securitisation should comply with true legal and

accounting sale.

• True legal sale

Bankruptcy remoteness

Minimal re-characterisation risk

No recourse to originator by purchaser for any

losses from assets

• True Accounting Sale

Governed by Para 20 of IAS 39 for de-recognition

of financial assets.

All economic benefits and risks should be

transferred from the originator to

purchaser/investors.

49

Activities entailed in Securitisation

• Setting up of a Special Purpose Vehicle

• Appointment of external parties for Securitisation

e.g. Legal Adviser, Financial Adviser, Reporting

Accountants, Tax Adviser etc.

• Kick-off meetings with Advisers

• Data Review and Structuring

• Cashflow Analysis

• Legal, Accounting and Operational Due Diligence

• Documentation

• Regulatory Approval

• Compliance and Conditions Precedent

• Issuance of RMBS

50

Major Challenges in Securitisation

• Data Review and Structuring

• Cashflow Analysis

• Regulatory Approval (especially in jurisdictions where

securitisation is new)

• Getting all the Accountants/Auditors to agree on true

accounting sale

• Pricing of RMBS

51

Conclusion

• So which is the most optimal long-term financing

model?

• Choice of funding model depends on

Needs of mortgage lenders (capital constraints

versus need for liquidity)

Presence of the right type of investor base

Stage of development of the primary mortgage

market and capital market

State of supporting infrastructure for mortgage

lending (e.g. title registry, foreclosure, Credit

Bureau etc.)Sources: 1. Covered Bonds by Goldman Sachs 2. Covered Bonds by ABN AMRO - November 2004