Financial Markets & Institutions; solution to the case study "Mortgage Securitization in Hong Kong and Asia"

Executive Summary:

In this case, the author is talking about John Lee, who is a retail banker in Hong Kong. Lee wasn’t satisfied with his bank’s MBS strategy because they didn’t participate in any MBS programme initiated by the HKMC, which was set up by the Hong Kong government in 1997. He was worried why his bank didn’t participate. So he decided to meet with his supervisor to discuss the issues involved.  They thus had a meeting with all concerned parties next week and for that, John was asked to review the securitization experience in Asia and to explore the issues involved in developing an MBS market in Hong Kong.

Later In the case author discusses major developments and hurdles involved in the concerned market in different countries of Asia including Philippines, Thailand, Malaysia, India, Taiwan, Indonesia, Singapore, Korea, Japan and mainland China. Then they talked about the MBS in Hong Kong, where Hong Kong government established the Hong Kong mortgage corporation limited (HKMC) under the companies ordinance. HKMC was expected to facilitate the debt market and the secondary mortgage market, also to help promote ownership and improve banking and monetary stability in Hong Kong.

HKMC purchased conformed mortgages according to its predetermined purchasing criteria under which they take only two weeks to conclude a sale of mortgages from an approved seller to the HKMC. HKMC accepted both floating-rate (interest rate charged on the prime rate plus or minus a spread) and fixed-rate (fixed interest rate for the entire term of the loan) mortgages.

With HKMC programme banks can benefit in many ways including: (1) the minimizing of credit risk exposure (2) banks could maintain the cash flow on mortgages for as long as they held the notes (less the guarantee fee) (3) banks could maintain relationships with customers for cross-selling opportunities.

HKMC launched two Hong Kong dollar debt issuance programmes-- the Hong Kong dollar note issuance programme (NIP) and the Hong Kong dollar debt issuance programme (DIP). HKMC launched the inaugural issues of MBS tan sold to the two banks on a back to back basis in 1999. To create a liquid market HKMC appointed four banks as market makers for these issues and these banks would help to establish a secondary market for MBS.

John reviewed the recent development of the MBS markets and found out that the HKMC and his bank had very different business risks and concerns regarding the development of MBS. There were some macroeconomic environment factors and the conditions in the property and debt markets that needed to be considered. And conclusively, John realized that in future there would be plenty of supply of mortgages in order to build a liquid secondary MBS market.

Question 1:

What are the preconditions for developing a mortgage backed securitization market? Was the Hong Kong mortgage corporation’s venturing into MBS products a timely one?

Answer:  Mortgage backed securitization was common in Europe and USA but it was not very popular in Asian countries because of some complexity associated with it. This unpopularity in Asian countries was not due to its inapplicability in those countries. Evidence suggests that necessary conditions for MBS were present in some Asian countries.

Some of the conditions which are required for the success of mortgage backed securitization are as follows:

Ø  It is necessary that sufficient amount of commercial and residential mortgage loans are available in the market.

Ø  Regulatory and supervisory arrangements should be present.

Ø  Bond markets should be present in that country because in the absence of bond market MBS cannot work properly.

Ø  When there is a need of secondary market, MBS venture can contribute towards its development. As we observed in the case that banks were used to create secondary markets or in other words banks became market makers.

Ø  When there is unknown default risk in the market. This risk can be reduced by the development of mortgage backed securitization markets.

Ø  When there is no homogeneity in mortgage loan offerings. When mortgages of different maturities are available in the market. Then the need of MBS market arises.

Ø  Mortgage loans are costly as compared to bonds. Then a central body is needed which can create a pool of mortgages and then uses that pool as a security for mortgage loans.

Ans (b): After thorough study of the case we believe that HKMC’s venture of MBS was a good decision because of the circumstances that prevailed at that time.

Ø  According to estimates demand for mortgages will increase. And there will be a gap of 5788 billion HK $.It means that if supply of mortgage loans in increased, there is huge potential in MBS market. ( Exhibit 11)

Ø  Interest rates offered by banks on commercial loans are reduced in 1999. It shows that there is saturation in that segment of debt market. So we can say with some conviction that business will be shifted towards mortgage market due to lesser risk in it. It should be noted that risk will be minimized in the MBS market after the creation of HKMC which acts as a guarantee in case of default. 

Ø  Capital flow from China is also expected which indicated the potential of growth in this market.

Ø  In the year 1997 the unemployment rate in Hong Kong is 2.2%. It indicates that defaults will be small.

Ø  Favorable returns versus other debt sources.

Ø  Vacancy rate of private domestic units is 73% in 1997, which is a healthy signal.

Ø  Exhibit 10 shows that amount of debt instrument issues has been increasing since 1997. It is also a favorable condition for MBS market.

Question 2:

Do you think it was good opportunity for banks to partner with HKMC in developing MBS? What were the risks? Do the benefits outweigh costs?

Answer: It was a good opportunity for banks to partner with HKMC, because:

Ø  Firstly, the banks had a good opportunity to enter into a new market of securitization which can serve in increasing profit margin of the banks as currently there is intense price war between different banks in Hong Kong due to deregulation status of banks. Banks have the pressure of decreasing interest charged for different loans by the customers as many banks were charging interest of about 1.5% below BLR in 2001 which is minimal and so they need to invest in more profitable ventures in free market. The banks which intend to not enter in this corporation are losing the short run (floating rate) as well in the long run (Fixed rate loans) advantages of profit sharing.

Ø  The strategy adopted in the venture i.e. securitization was mutually beneficial for the banks as well as HKMC. The banks had the right to hold back the security was an advantage for the bank to decide which mortgage security they need to invest in the long run and on which they can earn good credit ratings.

Ø  HKMC was giving easy and guaranteed returns on securities in their back to back structure.

Ø  HKMC deals were a good opportunity for Banks because HKMC ensured in the contract that they will only accept mortgage with current loan to value ratio of greater than 90% without warranty. Also they limited the loan to value ratio of property no more than 120%.So the purchasing criteria was relaxed for the banks.

Ø  The development of HKMC will increase confidence by the public to invest in MBS market and so the volume of transactions will increase and the market for MBS will expand overtime.

Ø  Another purchasing criteria benefit for the banks was that the 50% risk weighing loans were converted into 20% risks weighting loans. So risk for investment was reduced significantly.

Ø  Securitization was considered as a liquid asset so banks had balance sheet advantages in showing more assets as well as in their financial performance

Ø  Banks can maintain the cash flow on mortgages for as long as they hold the notes(less the guarantee fee).

Ø  Banks can maintain good relationship with customers for cross selling opportunities.

Ø  HKMC guaranteed timely payments of all scheduled interest and principal.

Ø  Banks can reduce their risk of starting MBS market on their own.

Ø  Risks:

Ø  The biggest risk was big investments as banks have to give big loans for various properties. This will pose as huge outflow of money for the banks. They can face some difficulty in maintaining cash balance.

Ø  Banks have opportunity cost of investing this money on other more profitable opportunities for example in leasing with high interest rates comparatively.

Ø  MBS market is not much developed in Asian countries so risk is that this segment might not perform so well.

“In a nutshell, the benefits outweigh costs because the market potential is rising for MBS because of its liquidity as well they can easily be traded into secondary markets. In 1998, the purchases increased to HK $11.4 billion of which $10.3billion was floating rate mortgages and HK$1.1 billion were fixed rte mortgages. Also the demand for mortgages increased by 50% from 30% from year 1995 to 2005.All these factors makes benefits outweigh costs and risks.”

Question 3:

Would you advise banks in Hong Kong to issue MBS products on their own? What factors have you considered in arriving at your recommendation?

Answer: Hong Kong needed a strong and liquid debt market during its financial crisis. Depositors’ started to withdraw money from their accounts and currency devaluation led to sever shortage of funds for banks. An active debt market would have certainly addressed the asset-liabilities mismatch of many Asian banks, who were predominantly selling long-term (mortgage assets) and receiving short term deposits.

Hong Kong banks need to look at the advantages of Mortgage based securitize (MBS).Here are some of the advantages of MBS:-

Ø  Transformation of ill-liquid assets- individual financial mortgage assets into liquid into more liquid tradable capital market instrument.

Ø  Allow banks (mortgage originators) to replenish their funds, which would increase their current assets and can use the freed capital for additional origination activities.

Ø  Is usually considered a more efficient and less costly source of financing than other bank and capital market financing alternatives.

Ø  Hong Kong banks can use MBS to monetize their credit spread by issuing such securities.

Ø  As MBS offers alternatives to more traditional forms of debt and equity financing, issuers can help themselves by diversifying their financing source.

Ø  Mortgage originators can remove long-term held up capital from their Non-current assets section by selling mortgage as MBS .This would help Hong Kong banks to improve its financial ratios utilize capital more efficiently.

Ø  Banks could save itself from prepayment risk on mortgage loans from the borrowers.

Past History

John and other banks that operate in Hong Kong need to analyze the last time private institutes like banks decided to issue mortgage based securities (MBS).In 1994, there were four issues of MBS. These MBS issues were originated from Standard Chartered Bank, Citibank, Bank of America and a subsidiary of Cheug Kong holdings. Only two MBS issues got rating from international rating agencies.

However, these attempts were not too successful because of the following reasons-

Ø  Lack of conformity and standardization in the mortgage pool combined with heterogeneity of the issues.

Ø  Evident technical problems resulted in inaccurate assumption of prepayment and credit risk.

Ø  A feeling of exploitation from the issuer, as market sentiments were undermined by the unfamiliarity of MBS in the Hong Kong market from the institutional investors.

Ø  Lack of guarantee of default payments.

Ø  Lack of diversification of the underlying mortgage pool geographically.

Efforts by individual Institution in the past have failed to bore fruit, which should warn individual institutes from repeating the same mistakes in future. Although all these issues were accompanied by credit enhancement (paying over-collateral on default from borrower) still they failed to built a secondary debt market in Hong Kong.

Residential Property market-

Starting from 1980’s, Hong Kong experienced a booming residential market. The percentage of owner occupied household increased tremendously. The vacancy rate fell to as low as 31% in 1988 (Exhibit 7).Since home buyers needed funding from banks ,the rapid increase in home ownership increased mortgage financing demand from 1980’s to 1990’s.

In 1990’s,in mid 1990’s the funding of mortgage loan suffered in the banking sector as Hong Kong’s GDP couldn’t catch up with the mortgage loan growth. The average growth rate fell to 3.8% (Exhibit 6A).

Certainly, individual banks would have faced difficultly as percentage of borrowers defaulting increased .More capital got held up.

Unemployment

Exhibit 6B shows that unemployment in Hong Kong grew to 6.2% in 1999 due to slow performance of economy. These figures pushed more pressure on Return’s of mortgage loan and increased default risk on individual banks.

Recommendations:

After considering factors like past experiences, unemployment, GDP growth and residential property market patterns .I have come to the conclusion that Individual banks like John’s should not issue MBS of their own. They are better off joining hands with HKMC and become its approved seller and service provider .I propose this alternative due to the following reasons-

Ø  HKMC programme is to generate a secondary debt market, which up till know is not existent in Hong Kong. A secondary market for mortgages with a standardized structure which carries guarantee of HKMC. Investor’s especially institutional investors might favor MBS backed by a government fund than a banks guarantee.

Ø  HKMC is there to enhance the stability of the whole system backed by government agencies. Its long-term channeling of funds would reduce the dependency in mortgage lending of the banking sector and diversify the risk.

Ø  HKMC market is already more liquid and supportive of a more active MBS market in Hong Kong.

Ø  HKMC securities are rated by international rating agencies .Something that individual bank MBS issues might not get instantly.

Ø  HKMC has a vast mortgage pool already .Its mortgage pool have mortgages that have low loan/value ratio , 70-90% of floating rate mortgages and 90% in fixed rate mortgages (Exhibit 2).This means that investors would receive a considerable investment return and their default risk is minimized but the guarantee provided my HKMC.