The Counsel

Real Estate
by Kamran A. Kazim
Head, Corporate and FI Origination, Royal Bank of Scotland

One of the many problems a developing economy confronts and is unable to resolve without structural, economic and financial reforms is its inability to create market conditions that lead to the easy provision of housing finance for its citizens. That coupled with low income and savings levels explains the much lower levels of home ownership in developing nations relative to developed ones.

Acknowledging that this as an important political and economic issue, several developing states including Malaysia, Jordan and even Palestine have instituted lending, refinancing and capital market take-out programs geared to increasing the incidence of home ownership by providing their citizens easier access to credit. These programs have had enviable levels of success and have created greater home ownership than would otherwise have been achieved. None of these programs gives away money without verifying the obligor’s repayment ability nor do they require providing loans at below market interest rates.

Instead, they have focused on developing the right conditions by institutionalizing intelligent financial market reforms and providing the right capital market conditions for the development of indigenous mortgage market conditions in their economies. The same model can easily be replicated in Pakistan. In fact it is, at this point in time, actually possible to develop an even more efficient model given that we currently have the financial market equivalent of a blank slate.

The model discussed in this paper addresses the need for creating different mortgage products, carving out and managing risks in order to adequately protect financial investors and, most importantly, defines a capital market exit strategy. Its over-arching objective is to create a wider base of home ownership in Pakistan by bringing together borrowers and lenders in an orderly fashion through a public-private partnership which draws on proven and simple financial technology. Last, but certainly not least, the model ensures a sub-prime debacle of the kind currently plaguing global financial markets does not occur in Pakistan.

Kick starting the housing finance market in Pakistan will require establishing a mortgage conduit funded by equity participation from the public and the private sector. The total amount of equity funding required to get the mortgage conduit off the ground is relatively small. Moreover, unlike other business ventures where equity investors are exposed to the entire spectrum of business risks, equity investors in a Mortgage Conduit Corporation (MCC) are exposed only to inventory risk. They, therefore, ought to be willing to accept lower equity returns given the lower risks of the enterprise.

Once established, the MCC will, as a first order of business, obtain fixed and floating rate funding from commercial banks and other providers of market based funding. Should this not be forthcoming due to market failure or some similar reasons the MCC would have the ability, as a last resort, to fund itself from the State Bank of Pakistan. However, in order to ensure the MCC does not, in the normal course of its business become dependent on funding from the SBP, the SBP funding rate should be set higher, say 50 bps, than the MCC funding rate from banks and commercial funding sources. Such a disincentive on recourse to public funds will encourage the MCC to establish lines with commercial banks and to issue bonds (TFC’s) to investors. Failure to do so will result in lower returns for its equity investors.

Two critical aspects of the MCC funding are (i) the tenure of the funding and (ii) the total leverage it may assume. The MCC should, by its charter, only be allowed to borrow short term money from its lenders i.e. loans with a duration of between six to twelve months. This offers two distinct advantages. First, it allows the MCC to take advantage of the lower interest rates typically prevalent in the short term (under one year) funding market and secondly, it places a necessary impetus on ensuring the MCC develops a viable exit strategy and which, is discussed in greater detail in the following paragraphs. Equally important is the degree of total leverage the MCC may assume at any given point in time. Again, through restrictions placed on it by its charter, the MCC will never be allowed to borrow more than twice its capital base. Such a level of leverage is adequate to provide equity investors sufficient compensation whilst, at the same time, providing an additional incentive to the firm to pursue its all important exit strategy.

Once the MCC has obtained funding it moves forward to the next step in its business process; sourcing and purchasing mortgages. Since the MCC is a conduit and not an originator or underwriter of mortgage loans it needs to source the mortgage loans, from the primary providers of these assets, i.e. the commercial banks and mortgage finance companies that underwrite and originate these loans. In order to ensure the mortgages sourced by the MCC are of the highest credit quality and are underwritten to the highest credit standards the MCC will purchase only those loans that meet pre-established underwriting guidelines. By agreeing to purchase certain types of mortgages only the MCC will ensure mortgages are issued only to those borrowers who have acceptable levels of debt coverage as measured by debt-to-income ratios (DTI), and sufficient credit protection built into the mortgage asset through acceptable levels of loan-to-value ratios (LTV). The MCC will, for instance, not purchase loans with a DTI greater than 40% (debt servicing does not exceed 40% of a borrower’s monthly income) or an LTV greater than 80% (no more than 80% of a property may be financed. The borrower/mortgage obligor invests at least 20% of their funds alongside the mortgage lender). By establishing stringent credit standards for the mortgages it purchases, the MCC ensures tight credit standards are the norm at mortgage origination and a sub-prime debacle never occurs in Pakistan.

Once the right mortgage collateral has been identified the MCC will use the proceeds it has obtained from its funding sources to purchase mortgages from banks and other mortgage originators. Since the MCC has obtained fixed and floating rate funding it can purchase, both, fixed and floating rate mortgages from the sellers of mortgage loans. Purchasing mortgages from banks and mortgage companies is an absolutely essential part of the process of developing a robust mortgage market as it provides banks and mortgage companies an opportunity to create balance sheet capacity for their mortgage lending and prevents concentration risks from developing on their books. Each time the banks and mortgage companies achieve a critical mass in terms of the total number of mortgages originated, they can sell these in tandem to the MCC at par. Each sale provides them with, both, cash which can be lent to new mortgage borrowers and, equally importantly, balance sheet capacity that allows them to do so without concentrating all the eggs in one basket. Since the MCC will operate on a continuous cycle basis and regularly purchase mortgages from the banks, it will create continuous capacity to fund new mortgages, which will create a robust mortgage market in the country and lead to the provision of greater housing finance than is currently the case.

Most importantly, by purchasing fixed interest rate mortgages from banks and mortgage companies, the MCC creates the necessary market conditions for the provision of fixed rate mortgages. This is a hitherto missing component of the mortgage market as banks are unable to hedge the interest rate risks associated with a fixed rate asset. Asset values are inversely correlated to interest rates i.e. as rates rise, the value of fixed rate assets on a bank’s balance sheet falls. The sharper the rise in interest rates the greater the value deterioration of the fixed rate asset. As illustration of this concept, a 10 year fixed rate mortgage loses 10% of its value for every 1% rise in interest rates (1% x 10 years). Since mortgages are long duration assets with repayment periods of ten years or longer, the levels of value deterioration are also higher. Moreover, in developing economies interest rates have been increased by several percentage points in a year in order to tame high levels of inflation.

Hence, the risk of value deterioration of fixed rate assets on a bank’s balance sheet is much higher in developing economies and, a primary reason banks hesitate to provide fixed rate loans. Contrast that to the most advanced mortgage market in the world that of the US, which has traditionally provided borrowers fixed rate mortgages. That alone goes a long way in explaining why the US has the highest incidence of home ownership in the world.

Upon purchasing fixed and floating rate mortgages, the MCC embarks on the final aspect of its business plan, that of securitizing the mortgages it has purchased. Securitization involves the sale of the mortgages to a Special Purpose Vehicle (SPV) which issues bonds to finance the purchase. Investors in the bonds issued by the SPV are collateralized by and repaid from the interest and principal payments on the underlying mortgages. So long as the mortgage obligors keep up with their interest and principal payments, the bond holders continue to receive the interest and principal due to them. The terms of the bonds including interest payments and principal amortization are exactly matched to those of the underlying mortgages. All payments and cash flows from the mortgage obligors are “passed-through” to bond investors. All SPVs issuing Mortgage Backed Securitization (MBS) Bonds employ pass-through structures as all of the risks and rewards are typically just passed through. The only cash that is not passed through are the fees banks and mortgage companies charge for various services.

Unfortunately, a unique aspect of the Pakistan market is that properties often have title issues which means the lender may find the property does not really belong to the borrower or is subject to rival claims. This creates an important risk that needs to be addressed through some form of title insurance which is missing in Pakistan. In order to ensure the success of the MCC model, it is imperative that some monetary remuneration is paid to banks in order to take on the title risk. Similarly, the MCC too needs to earn returns on its equity. As all stakeholders need adequate protection from the risks involved, the model provides for adequate compensation for all participants as the following example illustrates.

The MCC borrows from the commercial market at 11.50% per annum (it can also borrow floating rate money but for purposes of illustration only the fixed rate funding example is discussed). It then turns around and purchases mortgages from the banks that have been originated with a fixed rate coupon of 16% per annum. However, the banks retain 1.50% of the coupon on the mortgage as compensation for taking title risk (1%) and for continuing to collect and remit the mortgage payments to the SPV (0.50%). The MCC, therefore, ends up owning a mortgage asset that pays 14.50% per annum. The MCC on-sells the mortgages into an SPV which raises cash for the purchase of the mortgages by issuing fixed rate bonds with an interest rate coupon of 13.50% per annum. This leaves the MCC with 1% per annum on every purchase and sale through MBS transaction it completes. This is the MCC’s return for assuming inventory risk i.e. the risk that it purchases mortgages from the banks but is unable to complete an MBS transaction and is left holding the mortgages. Since the MCC can leverage itself to twice its capital base and, assuming it can churn its books twice in a year it will return 6% to its equity holders before expenses in the first year. More importantly, every 1% it earns on a transaction is annuity income as income from the first year goes on as long as the mortgages are outstanding, say 10 years. Each new deal adds to the income stream providing additional returns to equity investors.

Investors who purchase the MBS bonds are adequately protected as the mortgage loan is never more than 80% of the property value. Since, the obligor owns significant equity in the property they will continue making their payments. Most importantly, investors in MBS bonds never assume title risk. That has been carved-out and retained by the banks for a 1% fee as discussed above. Should there be problems with a mortgaged property’s title, it is the banks and not MBS investors that will bear responsibility. These two levels of protection ensure the MBS investor will be willing to accept the lower 13.50% coupon on MBS bonds.      

The model, as we have seen, ensures each participant is paid an adequate return for the risks they assume but, there is an inherent weakness in Pakistan’s financial system that no model can address. It is the lack of long term investors who need to be brought to the table and incentivized to invest in longer maturity bonds. Globally, strict regulations govern the investment activities of insurance companies, pension and provident funds. These regulations, at their most basic level, ensure that the asset and liability maturities of these funds and companies match as closely as possible. This simply means that any insurance company, provident or pension fund which, is expected to incur pay outs ten years down the road should have sufficient ten year assets so as to ensure adequate levels of cash availability at the time of pay out. By ensuring asset-liability pay out periods are as close together as possible, the regulators ensure the probability of a failure to make timely payments by insurance companies, pension and provident funds is kept as close to zero as possible. Unless similar regulations are enacted in Pakistan, the MCC model will not work, insurance companies as well as pension and provident funds may end up being less financially stable and our financial system will end up being the loser. However, with the right regulations in place it is not difficult to ensure adequate levels of investor protection as well as a more robust and sounder financial system not to mention the ability to provide greater access to housing finance for many Pakistanis who currently have no recourse to the same.             

The author is an investment banker with 19 years of experience in New York and and is a graduate of the IBA and Columbia University. The author is currently the Head of Pakistan, Corporate and FI Origination, Global Banking and Markets at the Royal Bank of Scotland, Karachi. Comments may be directed to editors@counselpakistan.com.