6 Pakistan

Pakistan
Chapter 6
The Mortgage-Backed Securities Market in Pakistan

by Naz Chohan
The Fixed-Income Securities Market

STRUCTURE OF THE FINANCIAL SECTOR
The financial sector in Pakistan comprises financial institutions, the capital markets, and regulatory bodies. The financial institutions can be broadly divided into scheduled banks1 and nonbank financial institutions (NBFIs). As of 31 March 19982 there were 46 scheduled banks (private, nationalized, and foreign) operating in Pakistan. Most of the other financial institutions, including development finance institutions, or DFIs (of which there are ten), investment banking companies (15), leasing companies (33), modarabas3 (48), and housing finance companies (2), are referred to as NBFIs.4 Corporate brokerage houses do not fall in either the scheduled bank or the NBFI category. Scheduled banks and the NBFIs (excluding modaraba and leasing companies) are both subject to the prudential regulations of the central bank, the State Bank of Pakistan (SBP), but are regulated by different wings of the SBP and must comply with different capital, liquidity reserve, and other requirements. While commercial banks provide mostly short-term working capital, NBFIs cater to the medium- to long-term financing needs of clients, and are barred from such commercial banking activities as trade business
1Commercial
banks operating in the country. of Pakistan, Economic Survey, 19971998. 3Trust financing arrangements. 4Khadim Ali Shah Bukhari & Co. Limited (Research).
2Government
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and check issuance. Commercial banks, on the other hand, were allowed by the SBP in September 1997 to undertake long-term project lending. Among the scheduled banks, only Pakistani commercial banks are listed. There are three stock exchanges in Pakistan, one each in Karachi, Lahore, and Islamabad. The Karachi Stock Exchange (KSE) is the oldest as well as the largest in terms of trading activity and number of listed companies. The KSE had 777 listed companies on 30 June 1998; the Lahore Stock Exchange (LSE) had 631; and the Islamabad Stock Exchange (ISE) had 285.5 The KSE and the LSE are computerized while the ISE uses the open outcry system. To facilitate the transfer of shares traded on the stock exchanges a Central Depository Company (CDC) was established in 1995 and officially inaugurated in September 1997.6 Most of the trading in the money and bond markets is in government securities and bonds issued by government authorities. Corporate bonds in the form of term finance certificates (TFCs) were first introduced in 1985. Two main regulatory bodies govern the financial sector: the SBP and the Corporate Law Authority (CLA). The SBP regulates the financial markets and has full autonomy in formulating and implementing monetary policy by virtue of an amendment to the State Bank of Pakistan Act of 1956. The CLA, under the Securities and Exchange Ordinance of 1969, has the task of promoting the development of the capital markets in Pakistan. It regulates all aspects of corporate activity, including the operations of the stock exchanges, company registrations, and share and debt issuance by companies. Like the SBP, the CLA reports to the Ministry of Finance (MOF), which thus plays an important role in both monetary and fiscal policies and capital market development. The CLA will eventually be replaced by a Securities and Exchange Commission (SEC) as part of the US$500-million Capital Market Development Program (CMDP) being financed by the Asian Development Bank (ADB) and the Exim Bank of Japan. The Parliament has already approved the SEC Act, which authorizes the SEC to regulate the capital markets. The SEC will have seven members: four from the public sector and three from the private sector. Except for the inclusion of the private sector in policymaking, the SEC Act does not seem to change the functioning of the stock markets.
5Ibid. 6Institute
of Business Administration, Report on the Central Depository Company.
THE MBSs MARKET IN PAKISTAN
401
FINANCIAL SECTOR REFORMS
The economic development of Pakistan is based on five-year rolling macro plans. Financial reforms began under the 19881993 plan, which focused on the privatization and deregulation of major sectors of the economy, including banking, communications, and manufacturing, which had been nationalized in 1972. This plan also included measures to attract foreign investment into Pakistan and to develop the local corporate debt market. A critical part of the financial reform program was the SBPs issuance of separate prudential guidelines for commercial banks and for NBFIs. The guidelines governed lending, exposure limits, and other issues, and were meant to imbue banks with the discipline of financial management. The financial sector in Pakistan has long suffered from the inefficiencies of large state-owned banks. Three ordinances were issued by the government in 1997 and later passed by Parliament to institute wideranging reforms in the banking sector. These laws were related to the Bank Nationalization Act of 1974, the Banking Companies Ordinance of 1962, and the State Bank of Pakistan Act of 1956. The SBP has been given sole authority to formulate and monitor monetary and credit policies as recommended by the Monetary and Fiscal Policies Coordination Board, and to keep a close eye on the limits set by the board on federal and provincial government borrowing. The abolition of the Pakistan Banking Council has made the SBP the only regulatory body for banks in Pakistan. It nominates the presidents and boards of directors of nationalized banks, and approves the chief executive officer nominees of all private banks. This move appears to run counter to the spirit of the banking sector reforms, but in effect nullifies the governments leverage in the operations of nationalized banks. The massive loan defaults in the country were caused by the imprudent credit policies of the political appointees who used to head the nationalized banks. However, requiring foreign banks to seek SBP approval can be viewed as overregulation of the banking sector and could lead the markets to question the governments sincerity in liberalizing the banking industry in Pakistan. The SBP has taken a number of steps to make bank operations more transparent and to deal with the problem of defaults on loans granted by nationalized banks. New, professional management has been appointed and given the task of improving the quality of new loans of these banks and tackling the problem of nonperforming loans. To facilitate loan recovery the government has also announced new foreclosure laws. Bank
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disclosure laws have been revamped and a highly informative new format for presenting annual accounts has been introduced. On the capital markets side, the CLA introduced the Employees Provident Fund (Investment in Listed Securities) Rules in 1996, allowing provident funds to invest in listed securities. Amendments to these rules in June 1997 increased the investment limit in listed securities from 10 percent to 20 percent of the provident fund size. The investment in each scrip is limited to 5 percent of the paid-up capital of the issuing company. Since 1994, the government has made significant progress in addressing constraints on the development of the fixed-income market, as follows: The company law was amended, permitting companies to raise debt directly from the public by issuing TFCs. Stamp duty was reduced from 4.5 percent to 0.15 percent at issuance, and 0.1 percent on subsequent transfer (in line with the stamp duty on equity securities). Rating agencies were established. TFCs could be listed on the exchanges, provided that they were rated. Foreign investors, as well as provident funds, were allowed to invest in listed securities. Foreign investors were allowed forward exchange cover for up to one year against the listed securities. Listed securities were made eligible for the statutory liquidity requirement of NBFIs. In the last quarter of 1997, the KSE formed a debt listing committee to simplify and facilitate the listing process, allow shelf registration, reduce listing expenses, and speed up listing. The committee has met regularly since then and is expected to streamline the listing process for debt securities significantly.
MARKET INFRASTRUCTURE
Regulatory Framework All securities generally classified as bonds are regulated by the SBP and the CLA. Bonds listed on the stock exchanges must also comply with their listing requirements. The SBP regulates the issuance of all government securities including Treasury bills (T-bills) and federal investment bonds (FIBs). The CLA is the apex regulatory body that administers all laws for the corporate sector and the securities market. It administers
403
the Securities and Exchange Ordinance of 1969 and the Companies Ordinance of 1984. Until the 1995 Finance Bill (Annual Budget) abolished the Capital Issues (Continuance of Control) Act of 1947, as part of the economic deregulation measures, this statute was also administered by the CLA. The abolition of the Capital Issues Act transferred the regulation of public issues (both debt and equity) to the Companies Ordinance of 1984, which also provides the legal framework for the corporate sector. The Securities and Exchange Ordinance of 1969 was enacted to regulate the securities market and the working of the stock exchanges. Over the years, the ordinance has been under continuous review, and the focus has shifted toward encouraging self-regulation by the stock exchanges. The Companies Ordinance of 1984 gives the name term finance certificates to what are essentially debt securities, whose important feature is that the return promised by the issuer to the investor is built into the repurchase price at maturity. The difference between the original price and the repurchase price is not referred to as a fixed return but as expected profit. The labels, particularly expected profit, are chosen to confer an Islamic character on the instrument, since interest in the form of a fixed return (riba) on capital is deemed un-Islamic by most religious scholars. Thus, while both the issuer and the potential investor share the perception that the return on a TFC, in purely legal terms, is a fixed return, there is no certainty of a fixed obligation on the part of the issuer. This appears to be an unavoidable and unrectifiable anomaly which casts doubt on the character of the TFC as a fixed-income security. Interestingly enough, the government itself promises a fixed and specified return to investors in its federal investment bonds. Various other interesting solutions have been devised to deal with the riba issue and to promote Islamic banking in the country. Trade-related L/Cs are discounted by first being purchased from the exporter and then resold back. The difference between the purchase and the resale price is treated as profit. Funding sources for business activities have been given Islamic names like modaraba (trust financing), murabaha (cost-plus financing), musharaka (venture capital), and ijara (leasing). Modaraba is an arrangement between two parties in which one agrees to provide 100 percent financing for a project while the second party agrees to run the operation, and they share the profits on a predetermined basis. Murabaha
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is an agreement under which a bank buys equipment on behalf of a client and sells it to him at a profit. Musharaka is a partnership agreement between two parties who agree to finance a project and jointly manage it, and then share the profits on a preagreed basis. Ijara is an agreement under which a bank purchases equipment for a client and leases it to him for a rental fee. The lease is an operating one, and the bank still owns the equipment. TFC issues are regulated under Section 120 of the Companies Ordinance of 1984. The CLAs interpretationand current practicerequires issuers to obtain CLA approval only for public TFC issues. The approval is contingent on several factors: security for the TFC holders, as specified; a fully underwritten issue (the KSE no longer requires this); the creation of a redemption reserve; the appointment of trustees; and mandatory credit rating (for public issues). These guidelines are not binding but are applied on a case-by-case basis. Credit-Rating Agencies There are two credit-rating agencies in Pakistan, the Pakistan Credit Rating Agency (PACRA) and DCR-VIS. PACRA was established in August 1994, and is a joint venture among IFC, Fitch IBCA, and the LSE. DCR-VIS was established in 1997 and is a joint venture between Duff & Phelps Credit Rating Co. and Vital Information Services (a local company). The companies are registered with the CLA under the Credit Rating Companies Rules of 1995 which were issued under Section 33 of the Securities and Exchange Ordinance of 1969. These rules require all credit-rating companies operating in the country to register with the CLA. To qualify for registration, a company must be affiliated with an internationally recognized rating agency, among other eligibility criteria. Registration remains in force for one year and may be renewed yearly. All NBFIs, whether or not they are mobilizing or intend to mobilize public deposits, are now required by the SBP to obtain ratings.
THE FIXED-INCOME MARKET
The fixed-income market in Pakistan can be divided into the government, semigovernment, and corporate debt markets. Statutory corporations issue semigovernment debt in the corporate debt market. As of 30 June 1998, the
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volume of outstanding bonds was relatively high, at 42.1 percent of GDP,7 but this figure is misleading since the size of the actively traded bond market as of that date was about Rs 314.19 billion, or only about 11.39 percent of GDP.8 The bond market is dominated by the government. T-bills and federal investment bonds accounted for Rs 287.33 billion, or 91.45 percent of the bonds outstanding as of 30 June 1998. Statutory corporations contributed Rs 24.60 billion (7.83 percent) and corporate entities, Rs 2.26 billion (.72 percent). Issuers Government The government has consistently run large fiscal deficits over the last two decades. At the end of June 1998, it had an accumulated debt of Rs 2,518.3 billion, or 91.2 percent of GDP.9 To finance these deficits, the government has been borrowing from the banking sector through government bills (T-bills) and bonds (federal investment bonds, or FIBs). Aside from the banking sector, the government has also borrowed from the public, through the national savings schemes. Initially the government borrowed from state-owned institutions, including financial institutions, at below-market rates through moral suasion and mandatory reserve requirements. Table 1 shows the mandatory reserve requirements for financial institutions in Pakistan.
Table 1 Mandatory Reserve Requirements for Financial Institutions
Commercial Banks
NBFIs
Statutory reserve requirement (SRR) Statutory liquidity requirement (SLR)
Cash reserve of 5% of demand and time liabilities 15% of demand and time liabilities in FIBs/T-bills/ national investment trust (NIT) units 20%
Cash reserve of 1% of demand and time liabilities 14% of demand and time liabilities in FIBs/T-bills/ NIT units/listed securities 15%
Total
Sources: Khadim Ali Shah Bukhari & Co. Limited, Fixed-Income Monthly, August 1998; State Bank of Pakistan, Annual Report 19961997
7State 8Ibid. 9Ibid.
Bank of Pakistan, Annual Report 19971998.
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National investment trust (NIT) units are units issued by the stateowned open-ended mutual fund, which is the larger of the two openended funds in Pakistan. At first, Treasury bills were issued on tap basis for six months at 6 percent per year, while bonds were issued irregularly. The following changes in T-bill issuance were introduced in April 1991, when the government moved to a market-based system as part of the process of economic deregulation, disinvestment, and decentralization: The American-style auction-based system was introduced. The primary market was limited to fortnightly auctions, instead of on tap, allowing for the development of a secondary market. The market was allowed to determine yields. Primary dealers were appointed. The government stopped issuing T-bills on 4 July 1996 and instead issued short-term federal bonds (STFBs), but reversed that decision on 24 June 1998, when it decided to stop issuing STFBs and reintroduced Tbills. While T-bills are short-term instruments, federal investment bonds (FIBs) are medium to long term. FIBs, with a fixed coupon rate for a particular tenor, were introduced in 1991. Auctions were held monthly. As of 30 June 1998, the government had domestic debt outstanding of Rs 1,151.4 billion (41.72 percent of GDP). 10 Of this amount, permanent debt11 accounted for Rs 289.70 billion (10.50 percent), floating debt12 for Rs 473.85 billion (17.17 percent), and unfunded debt13 for Rs 387.90 billion (14.05 percent). As shown in Figure 1, T-bills (through auctions) represented 21.65 percent of the floating debt, and FIBs, 50.49 percent of permanent debt. Besides the auction system, the SBP held the first formal open-market operation (OMO) sale of government securities in 1995. Although OMOs were meant to support interest-rate policy, the MOF first used them only as a borrowing vehicle. The introduction of OMOs was a severe blow to the secondary market: now the SBP would enter the market at least seven times a month (three auctions and four OMOs). The move was
10State
Bank of Pakistan, Annual Report 19961997. and long-term debt. 12Short- term debt, normally T-bills. 13Completely nonbank debt, normally national savings schemes.
11Medium-
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Figure 1
Breakdown of Domestic Debt, as of 30 June 1998 (Rs million)
FIBs as % of Permanent Debt = 52.85%
Permanent Debt 296,172
Unfunded Debt 311,783
Floating Debt 433,83
STFBs as % of Floating Debt = 21.37%
Source: State Bank of Pakistan, Annual Report 19971998
criticized by market participants as a reversion to the on tap system, with a change in rates. Characteristics of T-bills and FIBs. The T-bill is a debt instrument with a maturity of three, six, or twelve months and a face value of Rs 100, and is issued at a discount. The government guarantees the face value and the profit. As in the US, T-bills are auctioned by the central bank and all authorized primary dealers may participate. Figure 2 below presents the auction cut-off yields and amounts accepted for T-bills/STFBs since 1991.
Figure 2 Auction Cut-off Yields for T-Bills/STFBs, 1991 to present
n
19 18 17 16 15 14 13 12 11 10 9 8 7 6 5
4 4,0 00 3 8,5 00 3 3,0 00 2 7,5 00 2 2,0 00 1 6,5 00 1 1,0 00 5,5 00 0
Accepted Amount Cut-Off Yields
T-bills replace STFBs STFBs replace T-bills
19 91
199 2
1 993
199 4
1 995
19 96
199 7
1 998
Source: Khadim Ali Shah Bukhari & Co. Limited (Money Markets)
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FIBs, part of the governments permanent debt, have three different maturities with a fixed coupon rate that varies with maturity. The coupon rate is currently 13 percent per year for three years, 14 percent per year for five years, and 15 percent per year for ten years, payable semiannually. FIB auctions follow the same procedure as for T-bills and are held monthly. The actual yield to the investor depends on the accepted bid price at each auction. Each bidder at an auction gets the amount at his bid price (if accepted), as opposed to a single price for all the accepted bids. Figure 3 shows the amounts accepted in billions of rupees through FIB auctions from February 1991 to May 1998.
Figure 3 Amounts Accepted in FIB Auctions, February 1991 to May 1998 (Rs billion)
16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 1991 1992 1993 1994 1995 1996 1997 1998
The decreasing amount of accepted FIBs reflects the decreasing bid amounts in the auctions. It is evident from Figure 2 that the yield on sixmonth T-bills currently hovers around 14.00 percent per year, higher than the yield on three-year FIBs and equal to the yield on five-year FIBs. Given the current interest-rate structure, it is no surprise that most institutional investors have shifted from longer tenors to shorter ones. The main participants in the primary market are banks and other financial institutions (regardless of their resident status), which are required to hold these securities as part of their statutory liquidity requirement (SLR). Individuals and corporate entities also participate in the market, but nonresident persons or corporations may invest only with foreign exchange remitted through official banking channels. The principal and returns on such investments may be repatriated, and exchange risk cover for up to one year can be obtained from commercial banks.
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Primary dealers. Only primary dealers may participate in the auctions and OMOs. There are 77 primary dealers, including all the commercial banks and the NBFIs, as well as a few other institutions. Settlement. Settlement is normally through book entry, but physical delivery can be made if necessary. Primary dealers must maintain a current account (for cash settlement) and a subsidiary general ledger account, or SGLA (for book-entry settlement) with the SBP. The positions of primary dealers are maintained by the SBP in these accounts. Tax liability. Investors in T-bills and FIBs are subject to a withholding tax, which is adjusted against their final tax rate. The tax rates are given in Table 2.
Table 2 Tax Rate of Investors in T-Bills and FIBs
n
Final Tax Rate
Category of Investor
Withholding Tax
Foreign commercial bank Local commercial bank Local (nonexempt) institution Individual
58% 30% 10% 10%
58% 58% 33% depending on income bracket
The yield curves established by the STFBs/T-bills and FIBs were expected to provide a benchmark for corporate debt. However, the STFBs/ T-bills are used more regularly to price corporate debt, since they are used to price floating-rate loans. Secondary market. Both T-bills and FIBs are freely tradable in the secondary market through over-the-counter transactions. Transactions in each of these instruments amount to around Rs 45 billion daily with a bid/offer spread of 2550 basis points (bps), depending on the size of the transaction, and are carried out through adjustment entries in the SGLA with the SBP. The average transaction size is around Rs 100 million. Now operated manually, this system will eventually be computerized. Repo (repurchase agreement) market. This is the most common transaction in the interbank market, with a daily turnover normally in excess of Rs 10 billion. The underlying securities are T-bills and FIBs. The tenor normally varies from overnight to six months, but could be longer. Yield curve. The current yield curve in the interbank market is given in Figure 4.
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Figure 4
Yield Curve in the Secondary Market, as of 31 December 1998
17 15 13 11 9 7 5 3 1 O /N 7day 15day 13m o n th m o n th 6m o n th 1year 2year 3ye a r 10year
Discount rate. The SBP has a discounting facility that gives commercial banks access to a one- to three-day repo window at 16.50 percent per year in a liquidity crunch.
Statutory corporations This section covers the issuance of debt securities by corporations that were not incorporated under the Companies Ordinance of 1984 and are therefore not regulated by the CLA. The main entity that has relied on bond financing is the Water and Power Development Authority (WAPDA), the national power utility company, which has had a large and growing need for long-term funds. These needs used to be met from government budgetary allocations, supplemented with governmentguaranteed bank loans. But after the government stopped guaranteeing bond issues in 1994, WAPDA was forced to raise funds directly from the market. Since 1988, it has raised Rs 23.699 billion through a series of issues, as shown in Table 3. The bonds were issued in Rs 5,000500,000 denominations with returns payable every six months, and are discountable after six months from the date of sale (except for the sixth issue). They are quoted on the Karachi and Lahore Stock Exchanges. The Civil Aviation Authority (CAA) is another public-sector organization that has relied on bond financing for its capital expenditures. It has issued one series, valued at Rs 900 million and with an annual return of 12.5 percent, in 1991. These government-guaranteed bonds were redeemable after five years.
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Table 3
Salient Features of WAPDA Bond Issues

Term (Years)
n
Year Issued Rate (%) Amount Sold (Rs billion)
Issue
1 2 3 4 5 6 Special Total
5 5 10 10 10 10 5
1988 1989 1990 1992 1993 1994 1995
13.50 13.50 12.50 15.00 16.00 19.00 16.50
3.102 (redeemed) 5.631 (redeemed) 6.844 1.431 1.250 2.991 2.450 23.699
Corporate entities The corporate bond market in Pakistan was established only in 1994, although corporate bonds, known as TFCs, have been around since 1985. TFCs are privately placed and hence illiquid, and are, in fact, term loans provided by banks and DFIs under a different name. The creation of a corporate bond market has given corporations access to the capital market and allowed them to diversify their sources of borrowing. They have thus been able to reduce their dependency on the banking system for funds at a time of lending restrictions: SBP prudential regulations have set single-customer lending limits for each bank and restricted public-sector organizations from borrowing from banks. In September 1997, as part of the CMDP, all investors in rated corporate debt were made tax exempt. Primary yields for corporate debt dropped by 200 bps to take account of the tax advantage, and corporations and publicsector enterprises rushed to issue TFCs to lock in the low fixed rates. On 17 March 1998, SRO 171(1)/98 issued by the Central Board of Revenue (CBR) rescinded the tax-exempt status of all institutions, including corporate entities. All companies are now taxed at their normal tax rates, and only individuals, associations, and provident/pension funds are still tax exempt. The apparent reason for the measure is to prevent banks from converting their taxable loan portfolios into tax-exempt TFCs and earning abnormal profits. The authorities feared a possible misuse of the facility, which they felt should not have been given in the first place to the banking sector, the highest tax-paying category in Pakistan.
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The publicly listed issues to date are given in Table 4 below.

Table 4 Listed TFC Issues, as of 30 June 1998
Packages SSGC
n
ICI Gatron
Nishat Tek
Total outstanding Rs 232 million Rs 500 million Rs 250 million Rs 1,000 million Rs 274 million Issue date Maturity date Tenor Issue price Denomination Issue yield Profit payable Rating (PACRA) 19 Feb. 1995 19 Feb. 2000 5 yrs Rs 100 Rs 5,000 18.50% Feb/Aug A+ 19 Oct. 1995 19 Oct. 2000 5 yrs Rs 100 Rs 5,000 18.25% Oct/Apr AA 16 Jan. 1996 16 Jan. 1999 3 yrs Rs 100 Rs 5,000 18.00% Jan/Jul A 30 Sept. 1996 30 Sept. 2001 5 yrs Rs 100 Rs 5,000 18.70% Sept/Mar AA17 June 1998 17 June 2003 5 yrs Rs 100 Rs 5,000 18.00% Jun/Dec A+
Source: Khadim Ali Shah Bukhari & Co. Limited
Trading and settlement. TFCs are tradable on the stock exchanges as well as over the counter. Since the market players are normally financial institutions, more than 90 percent of trading takes place over the counter; the stock exchange is dominated by equity brokers. Over-thecounter settlement takes place on mutually agreed dates between buyer and seller, and can also be carried out on the same day. Trades on the stock exchanges are settled on T+1. Money and Bond Market Instruments The main types of instruments available in the money and bond markets are as follows: those issued by the government and statutory corporations (Treasury bills, federal investment bonds, special US-dollar bonds, foreign-exchange bearer certificates, WAPDA bonds, defense savings certificates, and special savings certificates) and those issued by the corporate and financial sectors (certificates of investment, term finance certificates). Treasury bills and federal investment bonds are interbank instruments normally invested in by banking institutions. Foreign-exchange bearer certificates, WAPDA bonds, certificates of investment, and term finance certificates are held by institutions as well as individuals. Provident and pension funds and individuals may invest in defense savings certificates and special savings certificates, but banks are not allowed to do so.
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Instruments issued by the government and statutory corporations Treasury bills (T-bills). A T-bill is a debt instrument with a maturity of three, six, or twelve months. Its short maturity makes it the most liquid government security in the money market. It is also freely traded and transferable. T-bills are issued at a discount to their face value of Rs 100 through auctions and OMOs organized by the SBP. The bidder must indicate the total bid amount and the price at which he is willing to buy the Tbill. The face value is guaranteed by the government and repaid at maturity. T-bills are treated as liquid assets for financial institutions Federal investment bonds (FIBs). FIBs are issued in maturities of three years (with a coupon of 13 percent per year), five years (14 percent), and ten years (15 percent). The coupon is paid every six months. Coupon payments and redemption of principal are guaranteed by the government. Issues are made through closed-bid auctions held monthly by the SBP. Bids are placed through primary dealers at discount, at par, or at a premium to the face value of Rs 100. FIBs are freely traded in the secondary market and are treated as liquid assets for financial institutions. Special US-dollar bonds. These are registered bonds denominated in US dollars and issued at par with maturities of five, seven, and ten years. They were introduced in 1998 to induce foreign-currency account (FCA) holders to convert their holdings into these bonds. Profits, at a rate that varies between LIBOR and LIBOR + 2 percent, are paid semiannually. Resident Pakistani FCA holders who purchase these bonds are paid their profits in rupees at the official exchange rate on the date of accrual of profits. Nonresident buyers are paid in US dollars. The face value may be cashed in at maturity in US dollars or rupees. Bonds and proceeds are exempted from wealth tax for six years, as well as from income tax and zakat.14 Foreign-exchange bearer certificates (FEBCs). First introduced in 1985, these rupee-denominated certificates are issued at par with a maturity of three years. FEBCs can be exchanged for cash from the issuing institution at any time after issue, but with a penalty in terms of interest payments. FEBCs may be purchased without limit by Pakistanis and foreigners, against payment in foreign exchange. The par value of the certificates is
14
Islamic tax on wealth, charged at 2.5 percent only on the principal amount at the time of cashing in, except where a statutory declaration of exemption is filed, and in the case of trusts, funds, and other noncorporate entities.
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paid either in rupees or in foreign currency at the holders discretion, at the spot rate as of the day of purchase. The holder bears the entire foreign-exchange rate risk. Water and Power Development Authority (WAPDA) bonds. There have been six issues of WAPDA bonds. The first four issues are guaranteed by the government, while the others are not. WAPDA bonds are issued in bearer and registered form in denominations of Rs 5,000, Rs 10,000, Rs 50,000, Rs 100,000, and Rs 500,000, with a semiannual coupon. Except for the third issue, the bonds are subject to withholding and income tax. WAPDA bonds are quoted on the Karachi and Lahore Stock Exchanges, and are accepted as prime collateral for obtaining bank advances. They are discountable six months after the date of sale. Defense savings certificates (DSCs). DSCs are issued with a maturity of ten years. They have a guaranteed rate of return of 42.50 percent at maturity, on the average, based on an internal rate of return of 18.04 percent per year. The profit is entirely tax free. Zakat is payable only once, at the time the certificates are cashed in. If the principal is not withdrawn at maturity, it is automatically reinvested. Special savings certificates (SSCs). SSCs have a three-year maturity and are registered. Their yield is 16 percent per year for the first 2.5 years and 18 percent per year for the last coupon. The profit is tax-free for individuals and local authorities, but zakat is payable at the time the certificates are cashed in. DSCs and SSCs are the most popular of the national savings schemes and are operated by the Central Directorate of National Savings under the Ministry of Finance.
Instruments issued by the corporate and financial sectors Certificates of investment (COIs). COIs are issued by DFIs, investment banks, leasing companies, and housing finance companies to raise deposits from the general public. Their tenor varies from three months to five years, and determines their rates, which also vary depending on market conditions, the credit of the borrowing institution, and deposit size. COIs cannot be recalled at the option of the issuer, and the investor is penalized for cashing them in early. There is no secondary market in COIs. Term finance certificates (TFCs). TFCs are corporate bonds normally with a tenor of three to five years. They can be listed or unlisted,
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and can be issued by listed or unlisted companies. Rating is mandatory for listing. The structure of the TFC is similar to that of a zero-coupon bond: the issuer and the investor agree on its sale and repurchase. The issuer must create a redemption reserve to repay the TFC and appoint a trustee for each issue. Individuals, associations, and pension/provident funds enjoy complete tax exemption on rated TFCs. All other institutions, including corporate entities, must pay tax on TFCs, based on their normal tax rates. Listed TFCs are exempt from capital gains tax. Interest Rate Structure Table 5 shows the structure of interest rates in Pakistan.
Table 5 Interest Rate Structure, as of 4 January 1999
Annual Yield (%)
n
Annual Yield (%)
Instrument
Instrument
Federal Government 3-month T-bill 6-month T-bill 12-month T-bill 3-year FIB 5-year FIB 10-year FIB WAPDA Bonds Sixth issue (10 years) Fifth issue (10 years) Fourth issue (10 years) Third issue (10 years) Second issue (5 years) National Savings Schemes Defense savings certificates Special savings certificates FEBCs
9.50 11.94 12.99 13.00 14.00 15.00 19.00 16.00 15.00 12.50 13.50 18.04 16.27 14.60
Financial Institution COIs 1 year 3 years 5 years
12.5017.00 13.5018.00 15.0019.50
TFCs: Primary Issues Packages Limited (5 years) Sui Southern Gas Co. Ltd. (5 years) Nishat Tek Limited (3 years) ICI (5 years) Gatron (5 years) TFCs: Secondary Market Packages Limited Sui Southern Gas Co. Ltd. Nishat Tek Limited ICI Gatron
18.50 18.25 18.00 18.70 18.00 16.34 17.68 16.92 16.26 17.82
Annual Yield (%)
Banking Sector Assets
Annual Yield (%)
Banking Sector Liabilities
Bank Advances Running finance Term loans (35 years)
16.0020.00 T-bill + 2.00 to T-bill + 5.00
Bank Deposits 1 month 3 months 6 months 1 year 3 years 5 years
9.2012.68 9.5013.91 10.7014.59 11.3015.00 12.4017.00 14.0019.00
Sources: Khadim Ali Shah Bukhari & Co. Limited (Money Markets); Pakistan and Gulf Economist
Investors Table 6 shows the various categories of investors in Pakistan.
Table 6
Number Comments
Investor Categories in Pakistan
Category of Investor
Commercial Banks
46
Largest pool of investable funds, which should be used in normal banking operations but have been diverted to T-bills because of relatively high yields on short-term government paper and scarcity of good credit. Total assets of banking system: Rs 1,587.59 billion (30 June 1998).a
NBFIs Investment banks 15 10 33
Normally invest in FIBs. Can use listed debt to satisfy SLR. Normally invest in FIBs. Can use listed debt to satisfy SLR. Earning a high gross return of over 24% from core leasing activities. Have little incentive to participate in debt securities yielding lower returns, unless used to satisfy SLR.
DFIs
Leasing companies
Institutional Investors Insurance companies 62
Potentially large source of funds. Fixed-income investments ideal for this category. Largest player is State Life Insurance Corporation (SLIC), whose total investment portfolio as of 30 June 1998 was Rs 52 billion.b
Mutual funds
39 closed-end 2 open-end
26 of 39 closed-end funds were floated by Investment Corporation of Pakistan (ICP), a government-controlled organization. As of 30 June 1998,c market capitalization of these funds was Rs 2.89 billion as against paid-up capital of Rs 4.12 billion. Among the openend funds, National Investment Trust (NIT) is a government institution; the other is private-sector. NITs investment portfolio as of 30 June 1998 was Rs 25.00 billion.d Mutual funds could become large players in fixed-income market. Fixed income investments of mutual funds are tax exempt if at least 90% of funds income is distributed.
Employees Old Age Benefit Institution (EOBI)
Government institution with large investment portfolio worth Rs 23.10 billion.e EOBI invests mainly in government securities but also has small investments in corporate debt. Provident funds of corporations and government-sector organizations potentially form huge pool of investable funds. Previously, only option available was government securities. But amended rules allow investment in listed debt securities, and some funds have invested. Largely untapped sector.
Employees provident funds (private)
Federal Employees Benevolent and Group Insurance Fund (FEBGIF)
Estimated investment portfolio of FEBGIF: Rs 2.77 billionf (net asset value). Bulk of portfolio (80%) is in government securities, but investment in other debt securities not prohibited by investment guidelines. State-owned corporations used to invest excess liquidity in government securities but have been divesting of late, because of severe liquidity crunch on most state-owned institutions. Size of market can be estimated by the size of the national savings schemes which is currently at Rs 458.95 billion as of June 1998g (provisional). Another class of potential retail investors: individuals with savings and fixed deposit accounts in commercial banks. Total amount of such accounts about Rs. 727.01 billion as of 31 December 1997.h Returns are 310% lower than on corporate debt instruments. Largely untapped market, but requires investor education, especially if individuals are to switch from government to nongovernment paper.
Corporations
Retail Investors
aState Bank of Pakistan, Annual Report 19961997 bState Life Insurance Corporation cKhadim Ali Shah Bukhari & Co. Limited (Research) dNational Investment Trust eEmployees Old Age Benefit Institution fFederal Employees Benevolent and Group Insurance Fund gState Bank of Pakistan, Annual Report 19961997 hIbid.
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Obstacles to the Development of the Fixed-Income Securities Market

INTRODUCTION
Pakistans large fiscal deficits in the past decade and a widening savingsinvestment gap have added to the countrys external debt burden, and have forced the government to borrow heavily from domestic sources. At the expense of crowding out the private sector, it has borrowed from domestic institutional investors through T-bills and FIBs, and from retail investors through its national savings schemes. The private-sector bond market, specifically the TFC market, began in 1994 when the government allowed the private sector to issue redeemable capital to the public. The government then dealt with anomalies on the supply and demand side to stimulate this market; reduced stamp duties and brought these in line with stamp duties on equities; initiated the formation of credit-rating agencies; allowed provident funds and foreigners to invest; and, most recently, granted tax exemptions to individuals. On the demand side, the investor base broadened, as provident funds were allowed to invest up to 20 percent of their fund size (from the previous limit of 10 percent), foreign investors could obtain forward risk cover of up to one year on currency, NBFIs could use TFCs for their statutory liquidity requirement, and foreign commercial banks could invest. However, the government, with its high rates of return on government borrowings from the institutional and retail sector, continues to crowd out the private sector. Because of the scarcity of good credit in the market, most banking sector funds flow into high-yielding, short-dated government paper. Retail investors, on the other hand, are generally wary of private-sector investments, and their participation has been constrained by low awareness of the relatively new market, inconsistent government policies, and lack of liquidity. Whereas a formal exchange exists to provide liquidity in the equity market, the nominated discount houses have failed to provide liquidity for the larger investors in TFCs and especially semigovernment bonds. On the regulatory front, little if anything needs to be done for government securities other than the possible lengthening of tenor and the introduction of innovative structures and instruments. Since government securities already have high acceptability, the responsibility for developing fixedincome instruments should rest with the government rather than the pri-
419
vate sector. The corporate debt market, however, needs regulatory incentives to develop further. The tax exemption granted to rated corporate debt in September 1997 stirred up hectic activity in the corporate debt market, as issuers clamored to issue and investors stood in line to invest. Six months later, in March 1998, the exemption was revoked (only provident funds and individuals remained tax-exempt), ostensibly to prevent banks (the highest tax-paying category) from converting their taxable loan portfolio into tax-exempt TFCs. The banking sector holds most of the assets in Pakistan, and investment by commercial banks in the TFC market not only provides depth but also lends credibility to the issues and reassures small investors who are fearful of investing in private debt. Several measures are suggested in this section to forestall the conversion of bank loan portfolios while retaining the tax exemption for institutions. Among the suggested measures is a time-bound tax exemption for debt of at least five years tenor. With respect to mortgage-backed securities (MBSs), their issuance through specially created special-purpose vehicles (SPVs) is not feasible in Pakistan, which has unclear laws relating to asset securitization. However, housing finance companies (HFCs) can raise funds from the capital markets by issuing debt securities backed by mortgages they hold on the fixed assets of borrowers. This matter is discussed in more detail in this section. The MBSs market, too, would be hampered by competition from the government securities market and lack of investor awareness, especially since the corporate debt market is relatively new. Most MBSs would have a longer tenor than government bonds, whose longest tenor is only ten years. Investors poor perception of the performance of HFCs as well as their lack of rating sensitivity are other concerns that must be addressed. The most important legal issue surrounding MBSs is enforceability of foreclosure laws. Unless the laws are enforced more effectively, the investor confidence required to develop this market would not exist.
INSTITUTIONAL OBSTACLES, TAXES, AND TRANSACTION COSTS
Pakistan has been facing large fiscal deficits for more than a decade and has financed these deficits by borrowing from both institutional and retail investors through the interbank market (T-bills and FIBs) and national savings schemes (NSSs). The already scarce domestic resources
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available for investment in the capital market, including investment in TFCs, have thus been further depleted. From 1976 to 1995, gross investment in Pakistan averaged 17.9 percent of GNP, 15 lower than in most other Asian countries except Bangladesh. But even this low level of capital formation could not be financed solely with domestic savings, which averaged 11 percent of GNP over the same period. Sizeable increases in savings from abroad, as well as substantial inflows of workers remittances, were also needed. The government has introduced several measures since 1994 to boost the TFC market. Government Incentives for the TFC Market The measures announced by the government to stimulate the market for TFCs deal with anomalies and problems on both the supply and the demand side.
Supply-side measures Issuance of redeemable capital by the private sector. Before 1994, bank loans were the main source of funds for the private sector. The build-up of bad debts by the banking sector and the resultant credit crunch, however, forced the private sector to look for other funding sources. The most important obstacle to the development of the private-sector bond market was removed when the government allowed companies to access the capital markets by issuing TFCs. Lower stamp duties. The government in 1994 reduced the stamp duty from 4.5 percent to 0.15 percent on issuance and 0.1 percent on subsequent transfer of TFCs, in line with the stamp duties on equities. The drastic reduction in issue cost made TFCs a viable financing option for companies looking for long-term sources of finance. Formation of credit-rating agencies. The establishment in 1994 of PACRA, the first credit-rating agency, gave companies with good credit histories an incentive to use rated TFC issues as a funding source. Good credit ratings gave these companies a better chance of attracting a wider range of investors. Permission granted to provident funds to invest in TFCs. In 1995, provident funds were finally allowed to invest in listed TFCs. Po15Andrew
T. Hook, Savings in Pakistan, Practice and Policy (1981-1996).
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tential issuers were drawn to TFCs, as an alternative to bank financing, because of their increasing and diverse investor base. Permission granted to foreign investors to invest in TFCs. Foreign investors were given permission to invest in listed TFCs in 1995, through the Special Convertible Rupee Account (SCRA). They may also invest in listed shares and government securities through this account. All these investments are tax exempt for foreign investors. Tax exemption for individuals from September 1997 onward. Investments by individuals and provident/pension funds in future TFC issues were made tax exempt in September 1997. This exemption made TFCs much more attractive to potential issuers, who could now market their instruments to nontraditional funding sources and become less dependent on bank lending.
Demand-side measures Wider investor base. The permission granted to provident funds and foreigners to invest in TFCs broadened the investor base for these securities. Provident funds were allowed to invest up to 20 percent of their portfolios in TFCs. Foreign investors could obtain forward cover for up to one year from the open market on their investments through the SCRA. NBFIs could now treat TFCs as liquid assets for their SLR requirements, and foreign commercial banks could also invest in listed securities.
Remaining Obstacles for the TFC Market Inconsistent government policies. On 17 March 1998, the government reversed its decision made six months earlier to grant total tax exemption to all investors in rated corporate debt. Only pension and provident funds and individuals remained exempt. As a result, demand from institutional investors has been adversely affected and a severe blow has been dealt to the budding TFC market in the country. This lack of consistency causes loss of credibility, and will hamper response to future reforms. Government dominance of the fixed-income market. The market for fixed-income securities in Pakistan is still dominated by the government, at both the retail and the institutional level. At the retail level, national savings schemes (NSSs) offer guaranteed rates of return to investors, as well as exemptions from taxes and zakat. The yield on NSSs, net of tax and zakat, varies between 15.66 percent and 17.79 percent yearly, as shown in Table 7. The table gives a comparison of the net yields on NSSs and issued TFCs.
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Table 7
Net Yields to Individual Investors in National Savings Schemes and TFCs

Remaining Tenor
Instrument/Issuer
Net Yield (%)
Nishat Tek Packages SSGC SSC ICI Gatron DSC

3 months 1.5 years 2 years 3 years 3 years 5 years 10 years
11.51 14.81 17.57 15.59 14.87 18.35 17.79
Even though the net yield on SSCs is 1.98 percentage points lower than the net yield on the TFCs issued by Sui Southern Gas Company Limited (SSGC), for instance, investors still prefer SSCs. Investors in general seem to be extremely wary about any investment scheme linked to the private sector, partly because of recent bitter experiences with cooperative scams in which millions of rupees worth of life savings were embezzled by unscrupulous individuals. The co-ops promised returns in excess of 18 percent per year, which in the 80s was too good an opportunity to pass up. But after raking in the investments, the co-op owners simply closed down their offices and disappeared. The true identity of the culprits is still unknown. At the institutional level, T-bills and FIBs with their attractive rates of return and highly liquid secondary markets attract the lions share of institutional funds. Recent yields on 12-month T-bills, for instance, were around 13.00 percent per year. The fact that the government guarantees their face value also makes T-bills more viable investments than TFCs for institutions, including commercial banks and NBFIs. TFCs may offer a premium of 12 percent over T-bills, but bear no government guarantee and are three to four years longer in tenor. TFCs also use per-party corporate limits which are regulated by the SBP. Lack of investor awareness. Lack of education and awareness also partly explains the lukewarm response of retail investors to TFCs. Since TFC issues are relatively new in the market, investors need to be informed about their nature and structure, and the benefits of investing in them. Seminars and conferences on fixed-income securities for retail investors can be sponsored by prospective issuers of TFCs or by brokerage houses that
423
trade in them. Khadim Ali Shah Bukhari & Co. Limited (KASB), a brokerage house, has held several such programs for the general public, drawing participants through invitations and newspaper advertisements. Lack of investor sensitivity to credit ratings. Investors also do not appreciate the value of ratings and often invest on the basis of perceptions or preconceived notions about certain companies. They need to be acquainted with the objectives and usefulness of credit-rating agencies and the effect of ratings on corporate fund-raising schemes. The yields-to-maturity and credit ratings of the TFCs issued as of 30 June 1998 are compared in Table 8.
Table 8
Issue
Yields-to-Maturity and Credit Ratings of Listed TFCs

Rating
n
Yield-to-Maturity (%)
Remaining Tenor
ICI SSGC Packages Nishat Tek Gatron

Source: Khadim Ali Shah Bukhari & Co. Limited
AAAA A+ A A+
3 years 2 years 1.5 years 4 months 4.75 years
16.94 18.02 17.48 Closed 17.82
As shown in the table, ICI and SSGC have similar ratings. But the yield-to-maturity on ICIs TFC is 0.57 percent lower than that on SSGCs, which is shorter in tenor by a year, mostly because of negative investor perceptions of public-sector companies. Lack of depth and liquidity. The TFC market lacks depth and liquidity. Despite the offer of tax exemptions, retail investors have not been attracted in droves to purchase TFCs. Commercial banks and other institutional investors, on the other hand, were enticed by the prospect of higher tax exemptions (than those for retail investors), and showed relatively more interest in TFCs before the government rescinded the tax exemption on 17 March 1998. Undercapitalized market-makers and discount houses. Brokerage houses that have been assigned market-making roles do not have enough capital to be effective market-makers. Table 9 shows the paid-up capital of listed brokerage houses in Pakistan as of June 30 1998. These brokerage houses handle millions of rupees worth of transactions in the equity market everyday, and therefore need additional credit lines and repo facilities to operate in the TFC market. One suggestion is
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that brokerage houses should be allowed to issue short-term COIs to raise funds for market making. All these funding sources might not have any effect on the market-making abilities of brokerage houses, however, if their cost of funding remains at the present level of around 18.50 percent. Since the yield on TFCs is typically around 17 percent, brokerage houses have little incentive to purchase TFCs and hold them for sale in the future.
Table 9 Paid-up Capital of Listed Brokerage Houses
n
Paid-up Capital (Rs million)
Brokerage House (Listed)
Al-Mal Securities and Services Ltd. First Capital Securities Corporation JOV and Company Jehangir Siddiqui and Company Ltd. KASB and Company Ltd. Trust Securities and Brokerage
Source: Khadim Ali Shah Bukhari & Co. Limited (Research)
50.00 213.40 40.00 120.00 111.19 40.00
The situation is not helped by the fact that the two discount houses for TFCs, National Discounting Services Limited (NDSL) and Prudential Discount House Limited, have performed well below expectations. They have either limited themselves to investing in COIs or been hindered by lack of capital from effectively performing their discounting function. Moreover, efforts to tap the capital market for extra funds have not borne fruit. Absence of a trading floor for TFCs. The absence of a separate exchange or trading floor has also adversely affected the secondary market for TFCs. All listed TFC issues are listed on the stock exchanges, whose listing requirements are geared solely to the needs of the equity market and are not applicable to fixed-income securities. This listing procedure is cumbersome and time consuming. The OTC Exchange that is being developed under the ADB-sponsored CMDP should help improve liquidity in the TFC market. Scarcity of good credit. The lack of good credit on the issue side continues to hinder the development of the TFC market. The situation is worsened by the fact that many companies operating in the country have been declared in default by the SBP. Latest estimates put the total amount of defaulted loans at between Rs 140 billion and Rs 210 billion, of which only Rs 10 billion has been pledged back by the defaulters. Unless a
425
solution is found, many companies will be excluded from the capital markets for lack of investor interest. The top-tier companies, on the other hand, can easily obtain cheaper funds from the banking system, which has the funds but is starved for good credit. Obstacles Relating to the Market for Statutory Corporation Bonds Investor wariness. Investor wariness is also a major problem in the market for WAPDA and Civil Aviation Authority (CAA) bonds. The financial malaise afflicting these organizations, especially WAPDA, and the negative publicity in the media are major disincentives to investment. The problem has been compounded by the removal of government guarantees on the fifth and future issues of WAPDA bonds. Negative investor perceptions of these corporations show in their investment decisions. Problems in the secondary market. The Federal Credit and Discount Corporation (FCDC) was established in 1989 as a discount house for WAPDA bonds, but has been hampered throughout its life by lack of capital. For the four bond issues for which the FCDC was formally assigned discounting responsibility, WAPDA committed to provide funds to FCDC equal to 10 percent of each bond issue. The committed amount was never made available in full. The two private-sector discount houses have also been allowed to discount WAPDA bonds. However, for the reasons mentioned above in the case of TFCs, these houses have failed to perform their discounting roles. The ineffectiveness of discount houses is one of the main obstacles to the creation of an active secondary market for WAPDA bonds. The Market for Mortgage-Backed Securities (MBSs) Uncertainty about laws applicable to asset securitization makes it unfeasible to issue mortgage-backed securities (MBSs) in the traditional way, that is, through a specially formed special-purpose vehicle (SPV). (This issue will be dealt with in more detail in later sections.) Housing finance companies (HFCs) can, however, raise funds from the capital market by issuing debt securities (TFCs), backed by the mortgages that they hold on the fixed assets of borrowers. According to current practice, a security (mortgage) is created in favor of a trustee to be governed by the terms and conditions of a security trust deed executed by the issuer of the debt security and the trustee. The trustee agrees to hold the mortgage for the
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benefit of the holders of the debt security, which is usually issued in the form of TFCs. The benefit of the mortgage created in favor of the trustee is transferred when the debt security is transferred. The difficulties and implications applicable to the sale or transfer of mortgage loans do not apply to these securities, if structured in the usual manner in Pakistan. Institutional Obstacles Hindering the Development of the MBSs Market There are a few obstacles to the development of a market for MBSs issued in the traditional way. Competition from government securities and TFCs. Government securities and TFCs would provide competition for MBSs and crowd them out of the market. Also, most MBSs would be longer term, whereas the longest government security is for ten years only. Investor perception. As with TFCs and statutory company bonds, investor perception is also likely to be an obstacle to the development of an MBSs market. The general view of the performance of HFCs, especially in the public sector, and the quality of their assets is not very encouraging. This perception is likely to be reflected in investment decisions regarding MBSs. Lack of rating sensitivity among MBSs investors. Potential investors in MBSs are also likely to lack sensitivity to credit ratings and to rely instead on their preconceived notions about the riskiness of investing in the housing finance market. In fact, the problem is expected to be more serious than in the case of TFCs. Lack of investor awareness of MBSs. The lack of rating sensitivity is likely to follow from a lack of awareness among investors about the nature and structure of MBSs and about the concept of securitization itself. Concepts such as assigning mortgage loans to an SPV and issuing securities backed by those loans are new to Pakistan. There is thus a considerable need for an investor education and awareness campaign. Otherwise, investors may perceive the security to be too complex to invest in.
LEGAL AND REGULATORY OBSTACLES AFFECTING THE FIXED-INCOME SECURITIES MARKET
There is little need to develop the government securities market further. If anything, the government should try to lengthen the maturity of its debt profile by offering 15- and 20-year bonds, which would encourage corpo-
427
rations to follow suit. At the same time, the government should offer differently structured securities, given the accessibility and high acceptance level of government debt. The corporate debt market, however, needs regulatory changes to develop. Unless it develops, all other types of fixed-income securities will find it difficult to gain acceptance with the general public. The TFC market should therefore be given the requisite incentives. As mentioned earlier, a major catalyst for the development of this market was the tax exemption provided in September last year. In the three years up to that time, there were only four listed issues in the market. After September, there were over 15 listed issues, mostly underwritten, reflecting the increase in demand and supply. Yields on the TFCs had fallen by over 200 bps. In March 1998, the exemption was removed to forestall the conversion by commercial banks (the highest tax-paying category) of their taxable loan portfolio into tax-exempt TFCs. Since the corporate debt market is still in its infancy, and the banking sector holds most of the assets in Pakistan, investment by commercial banks in TFCs would have lent credibility to the issues and provided comfort to small-time investors fearful of shifting their money away from government programs. To prevent banks from converting their loan portfolio while at the same time allowing them tax exemption, it has been variously suggested that the exemption be limited to: Rated and listed debt. The difference between the coupon rate and the funding rate. Debt of more than five years. Over 80 percent of bank loans in Pakistan are under one year, while less than 2 percent are over five years. Giving banks a tax incentive for long-term lending in the form of corporate debt will not only jump-start the corporate debt market but also encourage longer-term lending, the lack of which has been a constant complaint of the central bank. A predefined period, to be withdrawn once there is investor depth in the market. On the legal front, an issue that must be addressed is the absence of a master repo agreement. This agreement has to do with the ownership of securities used as collateral when raising money in the repo market. The absence of such an agreement creates uncertainties regarding ownership which can have legal as well as tax implications for both the lender and the borrower.
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Legal Obstacles Affecting the MBSs Market MBSs, in the traditional sense of the word, are a special case because they represent the secondary market for residential mortgage loans. As such, demand for them would depend on the quality of the mortgage loans and on the confidence of investors. One of the most important factors determining mortgage loan quality is the default ratio of HFCs and ease of foreclosure. Although foreclosure laws have been in place ever since the country was created, enforcement has been a problem. Section 67 of the Transfer of Property Act of 1882 entitles the mortgagee to file a suit for foreclosure or a suit for sale at any time after the mortgage falls due and before a decree for redemption of the mortgaged property is issued or the mortgage money is paid or deposited. Foreclosure enforcement has, however, been a problem because of corruption and inefficiency in the judicial system in Pakistan. Many of those who default on their loans are influential people who do not hesitate to use their influence to stop foreclosure proceedings. Unless foreclosure laws are enforced more effectively, the development of the MBSs market would be hampered by lack of investor confidence. A noteworthy development in this regard is the inclusion of a new set of foreclosure rules in the Banking Companies (Recovery of Loans, Advances, Credits and Finances) Act of 1997, with which the government hopes to remove or at least reduce bottlenecks in the enforcement of foreclosure procedures. Other legal problems that could affect the MBSs market in Pakistan will be discussed in later sections after a detailed description of the concept of asset securitization.
State of Residential Mortgage Financing

INTRODUCTION
After 50 years of existence Pakistan still faces the problem of rising shortage of housing. The cumulative shortfall in supply equals 7 million units according to current estimates and is expected to reach the 10 million figure by the year 2020. This alarming state of affairs basically stems from a widening gap between the demand for housing and the ability of the formal or regulated housing finance market to meet this demand. The
429
formal market has so far met only 20 percent of the needs of the national housing finance market; the informal sector takes care of the rest. The government has always struggled to keep its budget deficit down and its problems have become even more acute as a result of the sanctions imposed on the country because of its nuclear stance. Its ability to provide funds for the housing finance market is therefore extremely limited. The government has, however, encouraged and facilitated the construction of houses in the lower and lower-middle income groups. Until the early 1990s it assigned this task to the House Building Finance Corporation (HBFC), the lone public-sector housing finance company in Pakistan and also the largest, with cumulative loans totaling Rs 27.6 billion as of 30 June 1998. HBFCs operations used to be financed by the SBP. Since 1994, however, it has had to rely on its own loan recoveries to finance additional lending. Its excessively high default ratio of 2530 percent is not helping things. The corporation has recently launched a new loan recovery drive and has warned defaulters to repay before HBFC is forced to use other legal options. But this latest campaign is not expected to be any more successful than previous ones, which failed to recover substantial amounts from defaulters for reasons given later in this section. The International Housing Finance Company (IHFC), the only private housing finance company, is facing funding shortages of its own. It has recently increased the maximum mark-up on its loans from 22 percent to 24 percent yearly and is trying to bring their tenor down from the current average of nine years, to comply with its asset-liability ratio. The increased conservatism of IHFC does not augur well for the countrys housing market. IHFC has so far issued loans worth Rs 396 million, at an average mark-up of 22 percent per year. The quality of IHFCs loan portfolio, with a default ratio of just 1 percent, is much better than that of HBFC, making IHFC a very suitable candidate for any securitization issue, provided that the right legal and regulatory environment for asset securitization exists. This is the subject of the next section. Although commercial banks are required to invest 1 percent of their loan portfolio in the housing finance market, they have always been reluctant to lend for housing finance mainly because of the higher, safer, and more attractive returns on shorter-term instruments issued by the government. It is therefore clear that the gap between housing demand and supply will continue to widen unless the government takes concrete steps to remove the major funding obstacles faced by housing finance companies
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and devises a rational strategy for involving other financial institutions, such as commercial banks, in housing finance schemes. Moreover, any new strategy, law, or policy will have be implemented properly and in its complete spirit for it to succeed.
THE HOUSING MARKET
According to the provisional results of the latest population and housing census carried out by the government in March 1998, the total population of Pakistan is 130.58 million and is growing at 2.61 percent yearly. This puts Pakistan among the ten most populous countries in the world. Its large population and high population growth rate have saddled Pakistan with a severe housing shortage throughout its brief history. The problem is more acute in urban areas because of constant migration from villages and the influx of illegal immigrants into the country. The informal (unregulated) sector has taken over the task of providing for the housing needs of these migrants, the vast majority of whom are housed in slum dwellings or shanty towns called kutchi abadis. The housing shortfall in Karachi alone is estimated at more than 580,000 units. For the entire country, the shortfall is over 7 million units, despite the fact that in real terms the housing stock has grown at an average rate of about 4.8 percent yearly for the last 15 years.16 By the year 2020 the shortfall is expected to reach 10 million units.17 Table 10 gives a comparison of the household patterns in Pakistan from 1980 to 1998. Details of the breakdown of house ownership patterns in the country are expected to become available once the full results of the 1998 population and housing census are published in 1999.
Table 10 Household Patterns, 19801998
1980
n
1989 1998
Urban Rural Total Urban Rural Total Urban Rural Total
No. of households (millions) No. of house-owners (millions) Ratio of house-owners to households (%)
3.55 2.41
9.03 12.59 7.46 9.87
5.24 4.14
11.14 16.38 10.15 14.29 91.10 87.00
6.25
13.45 19.70
67.70 82.60 78.38 79.00
Sources: Population and Housing Census, 1998 (provisional results); 21st Century Consultancy and Management Services (Pvt.) Ltd., Draft Final Report of Study on Housing Finance, 1997
1621st Century Consultancy and Management Services (Pvt.) Ltd., Draft Final Report of Study on Housing Finance, (1997). 17Eighth Five-Year Plan (19931998).
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The total number of housing units increased by about 57 percent over the 18-year period. From 1981 to 1989, the number of house-owners as a percentage of the total units went up by 8.62 percent. To meet the demand for housing, an estimated 600,000 units would have to be built every year for the next 20 years. The government cannot possibly achieve this target on its own because of its ballooning budget deficit and its debt service and defense commitments. Privatesector housing finance companies will have to play a major role in meeting this shortfall. Table 11 shows the floor area of urban and rural houses. Urban dwellings are larger on the average than village dwellings. However, for the vast number of city dwellers living in semi-pucca or kutcha (shanty) houses, the covered area is smaller than that in the villages.
Table 11
Domain
Floor Area of Urban and Rural Houses
n
Average Room Size (square meters)
Average Dwelling Size (square meters)
Pakistan Urban Pucca (brick house) Semi-pucca Kutcha (shanty) Rural Pucca Semi-pucca Kutcha
37.98 41.04 45.00 31.68 29.07 36.63 41.49 36.00 34.83
15.30 16.47 18.09 12.69 11.70 14.76 16.74 14.49 14.04
Source: 21st Century Consultancy and Management Services (Pvt.) Ltd., Draft Final Report of Study on Housing Finance, 1997
HOUSING POLICY OF THE GOVERNMENT
Background To reduce the gap between housing demand and supply, the government has always stressed the provision of houses to the lower and lower-middle income groups.18 However, the lone public-sector housing finance company, HBFC, has not had a very encouraging record in this respect. According to a study made by a local consulting firm, almost 77 percent of HBFCs housing loans have gone to influential people in the upper or
18This study assumes the following income ranges: lower (up to Rs 2,750); lower-middle (Rs 2,7514,000); upper-middle (Rs 4,0017,000); and upper (over Rs 7,000).
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upper-middle income groups, and only 23 percent have gone to the lower and lower-middle income groups.19 Experience has also shown that the lower and lower-middle income groups have received little housing assistance from other concerned government agencies such as development authorities in major cities of the country. National Housing Policy In 1992, the government approved a National Housing Policy as part of the eighth five-year economic development plan (19881993). The aim of the policy was to encourage the active participation of the private sector in developing a market-based housing finance system and increasing the number of primary market lenders in the country. The role of the public sector was restricted to providing a facilitating environment for the system. Under the new policy the SBP allowed the establishment of private housing finance companies to add breadth and depth to the financial structure of the housing market and to improve the capacity of the market to mobilize resources for its long-term financial development. These companies face the challenge of running viable financial institutions while trying to manage the mismatch between their relatively short-term funds and long-term loans.
REGULATORY SET-UP
Housing finance companies in the country are defined as nonbanking financial institutions for regulatory purposes, and are therefore supervised by the SBP. The SBP in turn reports to the Internal Wing of the Ministry of Finance as the ultimate regulatory authority for housing finance companies in the country. Only two HFCs now operate in the market. HBFC was created by a separate act of Parliament called the House Building Finance Corporation Act of 1952. IHFC was incorporated in 1990 as a public limited company (unlisted) under the Companies Act 1984 and started operations after obtaining its license from the Ministry of Finance. Its statutory monitoring authorities are the CLA and SBP. It reports to the latter by submitting periodic returns.
1921st Century Consultancy and Management Services (Pvt.) Ltd., Draft Final Report of Study on Housing Finance, 1997.
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PRIMARY MARKET LENDERS
HBFC was the only primary market lender in the formal (regulated) housing finance market until the early 1990s, when three private-sector housing finance companies were set up. Citibank Housing Finance Company (CHFC) began its operations in the early 1990s but later suspended them, in accordance with its global strategy. A housing finance company was also established by the LTV Group of Companies in 19931994, but has since closed. IHFC is the only private housing finance company still operating as a primary market lender. It is owned jointly by the International Finance Corporation, Commonwealth Development Corporation, Pakistan Industrial Credit and Investment Corporation, and Cresbank. Its share of the outstanding loan portfolio of private-sector housing finance companies is around 45 percent. However, it accounts for only 1.5 percent of the total formal sector lending to datevery small compared with HBFCs share of over 95 percent. Together, IHFC and HBFC have a mere 20 percent of the housing finance market. Table 12 shows mortgage loans as a percentage of bank loans, assets, and GDP from 1994 to 1997.
Table 12 Size of the Mortgage Loan Market, 19941997 (%)
Ratio of Mortgage Financing to Bank Loans
n
Ratio of Mortgage Financing to GDP
Year
Ratio of Mortgage Financing to Assets
1994 1995 1996 1997
6.30 5.61 5.31 4.85
1.59 1.45 1.33 1.26
1.45 1.27 1.17 1.07
Sources: SBP, Annual Report 199697; HBFC; IHFC
The ratios of mortgage financing to GDP and to total commercial bank assets are extremely low considering the high demand for housing in the country and the importance that the housing sector should enjoy in any economy. The informal sector supplies the remaining 80 percent of financing in the housing sector. Personal savings, including remittances from abroad, reportedly account for over 73 percent of total house financing. Lowerincome groups obtain around 80 percent of their financing from savings, liquidated assets, and loans from relatives.
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FUNDING SOURCES OF PRIMARY MARKET LENDERS
From 1953, when it began its operations, until 1979, HBFC received funds from the SBP at market lending rates. After 1979 the funding arrangement became a profit/loss-sharing agreement between HBFC and the SBP, in accordance with the Islamic mode of financing.20 Funding from the SBP started dwindling in 19901991, however, and was completely closed down at the end of fiscal year 1994. Henceforth, HBFC was expected to become self-sustaining. It now derives its funding solely from a revolving fund replenished with the loan repayments of borrowers. IHFC, on the other hand, has derived its funding, in the form of equity and debt capital, predominantly from sponsors. The company has subscribed and paid-up capital of Rs 125 million. In addition, it has received seven-year foreign-currency loans from two of its sponsors, the International Finance Corporation (690 million) and the Commonwealth Development Corporation (2 million). IHFC raised about Rs 6 million, much less than expected, from its first COI issue in May 1998.21 Bad timing explained the lukewarm response: investor confidence and morale had been severely dented by the nuclear tests carried out by India and Pakistan. Housing finance institutions have five main funding sources. Equity capital Debt capital. Housing finance companies usually borrow at commercial lending rates of up to 1718 percent per year, which they cannot pass on to most borrowers, as mortgage loans appear to dry up at a mark-up of around 1718 percent per year. HFCs can also issue TFCs, but the yields on these instruments are likely to be even higher than their borrowing rates. Another alternative, to issue 30day to 10-year COIs, cannot be a primary funding source for HFCs because of the resulting asset-liability mismatch (most investors prefer shorter investments). Repayments by borrowers. This happens to be HBFCs sole funding source at the moment. Local-currency savings accounts. In addition to equity and debt capital, HFCs are also allowed to accept local-currency savings accounts. However, depositor mistrust of private-sector savings cum
20HBFC
21International
reports that it has so far paid the SBP Rs 6.5 billion in profits under the arrangement. Housing Finance Corporation.
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investment companies (following the earlier cooperative scams) have made it impossible for HFCs to raise funds in this manner. Housing refinance facility. To provide short-term liquidity to private-sector housing finance companies, USAID, in December 1994, granted a US$15-million housing guarantee loan to the SBP, which later opened a housing refinance window for the companies.22 But the refinancing facility has never been used in all the three years that it has been open, mainly because of the high interest rate that would have to be paid to the SBP. Although the funds have been provided to the government of Pakistan at a mark-up of 7.75 percent per year, the proposed cost of these funds to HFCs is 19.63 percent per year (as of April 1997).23 This total cost is broken up as follows:
Mark-up rate SBP service charge Foreign exchange cover Total 7.75% p.a. 1.50% p.a. 10.38% p.a. 19.63% p.a.
Of late, the cost of funding under this facility has risen even further to 22 percent per year. Borrowing funds at this rate would make the cost unaffordable to end-users and is therefore not feasible for HFCs.
OPERATIONS OF PRIMARY MARKET LENDERS
As of 30 June 1998, HBFC housing loans amounting to Rs 27.6 billion had assisted in the construction of over 450,000 housing units throughout the country. The total loan amount includes loans for the reconstruction of over 310,000 units in the flood-affected areas of Punjab and Sind, and Rs 750 million lent to public-sector organizations including Pakistan Steel and the Lahore and Karachi Development Authorities.24 IHFC, on the other hand, had lent a total of Rs 396 million by the end of fiscal year 1998.25
22Under the facility, an HFC that issues at least Rs 10 million in mortgage loans can package these loans and present them to the SBPs Non Banking Financial Institutions Division. Assuming compliance with SBP regulations, the refinance window would pay the equivalent of 80 percent of the face value of the package. The HFC would still have to service all the mortgage loans held in SBPs custody, including collecting monthly payments, and would have to pay the SBP for the 80 percentfinanced loan. The SBP has recourse to HFC assets in case of default, and may also take title to the mortgages in the HFCs possession. 23House Building Finance Corporation. 24House Building Finance Corporation. 25International Housing Finance Company Limited.
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HFCs are not allowed to provide loans specifically for the purchase of land. But a prospective borrower who intends to buy land with the money and to build a house on the land may be granted a loan. The government, in the interest of promoting housing construction in the country, wants to make sure that the loans will be used for that purpose and not for land price speculation. Loans for house building are generally long termnine years for IHFC loans and 2021 years for HBFC loans. IHFC, with its new focus on increased conservatism and prudence, is, however, reportedly working to shorten the average tenor of its loans. HBFC loans are offered at a mark-up of 12.5019.00 percent per year depending on the amount borrowed and the creditworthiness of the borrower. The rates dropped by about 1 percent per year from 1997 to 1998 in line with the governments policy to encourage housing construction. More than 85 percent of HBFCs loans have been made at a mark-up of 18.45 percent per year or below. HBFC and IHFC lending rates differ by 3.55 percent per year on the average. Table 13 shows the cost of funding and lending rates of HBFC and IHFC.
Table 13 Funding Cost and Yearly Lending Rates of Primary Market Lenders
Mark-Up Institution Average Maximum Cost of Funds
HBFC IHFC
Sources: HBFC; IHFC
18.45% 22.00%
19.00% 24.00%
Variable (P/L sharing) 17.00-17.50%
The mark-up is fixed in the case of IHFC but variable in the case of HBFC. Monthly installment payments to HBFC comprise principal repayments, insurance installments, and a portion that depends on HBFCs assessment of the typical house rent for that particular unit. This assessment is automatically increased by 10 percent every three years. Table 14 shows the average size, maturity, and types of mortgage loans along with their maximum amounts.
Table 14
Institution
Mortgage Loan Characteristics

Average Loan Maturity
n
Type Maximum Loan Default Ratio
HBFC IHFC
Sources: HBFC; IHFC
Rs 200,000 Rs 800,000
2021 years 9 years
Variable-rate Fixed-rate
Rs 1,000,000 Rs 10,000,000
2530% 1%
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HBFC management has made it a policy never to write off any loans as bad debts and euphemistically refers to the companys default ratio as its nonperforming loans ratio. Because property prices have been on the rise, the management tends to believe that the money can and will eventually be recovered, and that HBFC is not likely to lose much. Credit Analysis by Primary Market Lenders IHFC owes its low default ratio to its thorough credit analysis system whose chief elements are as follows: A required debt/equity ratio of 50:50 for all loan applicants. A required income solvency ratio of 2.5 for all loan applicants, that is, the applicants net income should be at least 2.5 times the monthly installments to the finance company. An average loan-to-value ratio of 35:65, a conservative figure compared with the 60:40 ratio allowed by prudential regulations. Mortgage loans fully secured against the properties purchased. The company has exclusive equitable and legal rights over the properties and holds the original documents for the properties throughout the tenor of the loans. HBFCs high default ratio, on the other hand, is due partly to its relatively lax credit analysis procedure and partly to its being wholly government owned. It requires loan applicants to present the following: Proof of ownership, as evidenced by documents of legal title. Proof of repayment capacity, based on the applicants monthly income. Repayment capacity is 30 percent of income for applicants earning less than Rs 2,500 per month; 40 percent for those earning up to Rs 15,000; and 50 percent for those earning more than Rs 15,000. A construction plan approved by local building authorities. For applicants over 55 years of age, a guarantee by a younger family member, such as a wife or a son or daughter that the loan will be repaid. Once the application is approved, the amount of the loan is determined according to the type of dwelling and the floor area. The loan amount is currently Rs 250300 per square foot for flats and apartments, and Rs 300400 per square foot for bungalows. These amounts were revised upward after the last board meeting in view of the rising cost of land and construction materials.
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CONSTRAINTS ON THE DEVELOPMENT OF HOUSING FINANCE
The lackluster performance of the housing finance system in Pakistan is due mainly to the reluctance of traditional lending institutions such as commercial banks to extend housing finance loans to their clients. This is despite the governments guideline that housing finance loans should compose at least 1 percent of the loan portfolio of commercial banks. Commercial banks lack interest in residential mortgage financing for the following reasons: Attractive returns on risk-free government bonds; Better-quality collateral on government bonds; Small size of housing loans, which therefore cost more in terms of time and effort to process and administer; and Legal bottlenecks in foreclosures and eviction of tenants and the confirmation of legal title to land/property, as well as the high cost of registration of property transaction. The legal problems are discussed below. Absence of a clear legal title to land and property. This has been a major obstacle to the development of a vibrant housing finance system in Pakistan. Possession of land title is a prerequisite to debt recovery and foreclosure proceedings. The West Pakistan Land Revenue Act of 1967 and the Transfer of Property Act of 1982 do not provide for such a clear title, making housing loans a risky proposition for lending institutions. High stamp duties, land transfer and registration fees, and collateral wealth tax liabilities. Municipal authorities generally charge stamp duty of 10 percent of the value of land and corporation tax of 2.5 percent of the value. A capital value tax of 5 percent is also levied on all nonincome tax payers. People contrive ways of bypassing the land registration process to avoid these excessive charges, but in the process they also make it risky for housing finance institutions to lend money to them. Problems of foreclosure. The development of housing finance in Pakistan has been slowed down by the difficulty of enforcing foreclosure laws in the event of default. The private sector has stayed out of housing finance activities, daunted by the procedural complications that have hampered financial institutions in liquidating collateral, particularly fixed assets. The Banking Companies (Recovery of Loans, Advances, Credits and Finances) Act of 1997 was passed by the government in an attempt to remove the bottlenecks in the foreclosure procedure and to speed up the process.
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Foreclosure Procedure HBFC now has four options for the recovery of defaulted loans (as stated in the Act of 1952). Contacting the defaulter. This is the usually the first step in HBFCs loan recovery process. An HBFC collection officer visits the defaulter at home and asks him to settle his accounts; otherwise, the corporation will be forced to explore other options such as serving a legal notice to the defaulter and having his name published in leading newspapers. Selling or forcibly occupying the property. If option 1 above does not work, Section 28 of the HBFC Act 1952 empowers the corporation to sell the defaulters property. The problem with this option is that many defaulters are influential people who are easily able to obtain a stay order from the court. They can also apply pressure through high-ranking officials or politicians to stop the sale. The same problems keep HBFC from forcibly occupying the defaulters property in case of continued nonpayment. Approaching the civil or high courts. HBFC can also lodge a case against the defaulter in the civil courts or the High Court. But this route usually takes a long time (two years, on the average), given the thousands of cases normally pending in the judicial system, and even then, enforcement can be extremely difficult. Approaching the banking tribunal courts. This a relatively quicker method of cashing in the mortgaged property. It normally takes six months from the time the foreclosure application is submitted to the time the property is auctioned. However, corruption prevalent in the system can make this option as time consuming and unreliable as the court option. Loan recovery has not been a big problem for IHFC. It has had a default ratio of only around 0.5 percent, although this ratio has deteriorated a bit of late and has gone up to 1 percent. The introduction of the new Banking Companies Act is expected to cut the foreclosure proceedings to no more than three to six months, if initiated and implemented properly. Section 14 of the act provides a forum for a banking company to file a claim before the banking tribunal courts to enforce a mortgage of fixed assets. The courts are then supposed to pass a final decree for the foreclosure or sale of mortgaged property. The recent experiences of IHFC with the new banking act have not been very encouraging, however. Defaulters can easily lodge appeals against any decrees, which are moreover difficult to enforce. But this has more to do with corruption, nepotism, and a lack of political will than with anything legal.
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IMPORTANT DEVELOPMENTS
At a businessmens convention held by the government of Prime Minister Nawaz Sharif in Lahore in February 1997, 11 committees on different sectors of the economy were formed to recommend measures to stimulate these sectors. The proposals submitted by the committee on the construction sector to the Ministry of Housing and Works included specific recommendations on housing finance and land acquisition.26 Recommendations on Housing Finance The committee recommended that commercial banks be given an incentive to finance the housing sector and that foreclosure laws be implemented more effectively to protect the lending institutions. (Efforts have been made on this front, but without much success.) The recommendations included the following: Allow commercial banks and the HBFC to grant loans for the purchase of land. Increase the amount of HBFC loans for construction from Rs 200 to Rs 400 per square foot for flats, and from Rs 250 to Rs 500 per square foot for houses. Increase the loan amounts periodically, to allow for increases in the prices of construction materials. (This recommendation has been adopted.) Develop a methodology for bulk/bridge financing of house projects. The recommendations were intended to remove a major obstacle to the development of a private-sector housing finance systemthe difficulty in initiating and executing foreclosure proceedings against defaultersand thereby reduce the risk to HFCs in giving out loans. But the housing finance market in Pakistan continues to be underdeveloped despite the governments efforts. By allowing commercial banks to grant housing and land purchase loans the committee also hoped to deepen the funding base for housing finance. The continuing prohibition against bank and HFC lending for land acquisition is nonetheless a major shortcoming of the formal housing finance system.
26Ministry
of Housing and Works.
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Recommendation on Land Acquisition Act The committee on the construction sector recommended that land acquisition procedures be made more realistic, transparent, and market oriented, and that the National Housing Policy be implemented in letter and in spirit. These recommendations are being reviewed and implemented. However, the housing finance sector in Pakistan is still plagued by inadequate funding, foreclosure problems, and the unwillingness of major financial institutions to enter the housing finance market in any significant way.
Legal and Institutional Framework for Asset Securitization

INTRODUCTION
Securitization is the use of financial assets of banks, leasing companies, utilities, and corporations to issue securities. Mortgage loans, auto loans, credit card and cellular phone receivables, leases, and utility payments are among the assets that can be securitized. In ideal circumstances, asset securitization confers certain advantages on the originator or the company whose assets are securitized. Securitization, among other things: Gives access to new sources of funds, particularly long- and medium-term funds. Gives access to lower-cost funding than is currently available to the originator. (Securitized debt is accorded a higher credit rating than the originators own debt, partly because of credit enhancement and partly because it is removed from the originators balance sheet and rated on its own merits. It is therefore not influenced by the overall credit exposure of the originator.) Opens up the capital markets to subinvestment grade and unrated originators. Frees existing capital resources to finance new business. Improves liquidity. Increases return on assets and equity. For investors, securitization: Gives the opportunity to invest in a discrete pool of assets rather then in a corporate entity, so that the risk is limited to the nonperformance of assets rather than general corporate risk.
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Makes risk analysis easier to conduct. Securitized assets are usually enhanced with credit and liquidity facilities to protect the investors. Gives access to assets and markets previously unavailable to investors, such as aircraft finance. Securitization therefore allows investors to diversify their return and risk profiles. Asset securitization is, however, not without risk. The two most important risks associated with investment in asset-backed securities are: Credit risk. It arises from the possibility that debtors of the originator (those from whom the receivables are due) might default on their payments and that investors might not get their return on time, if at all. Prepayment risk. This is the risk that debtors might want to settle their obligations before time, thereby leaving the originator with surplus cash, which might not be channeled to any efficient and productive use, particularly in the short term. Asset securitization techniques are being adopted by Asian countries seeking to promote home ownership, to finance infrastructure growth, and to develop their domestic capital markets. Pakistan has laws and regulations for different aspects of asset securitization, including the transfer of assets from the originator to the special-purpose vehicle (SPV), the structure and bankruptcy remoteness of the SPV, and investments by financial institutions in asset-backed securities. However, these laws and regulations are not cohesive or coordinated with regard to securitization issues. The laws and regulations need to be revamped and updated to answer the particular requirements of asset securitization. Asset securitization demands a clear-cut legal and regulatory framework, one that protects the SPV from the implications of the originators bankruptcy and also guarantees the undivided interests of the investors in asset-backed securities on the cash flows from the securitized assets. The prudential regulations should also be amended to allow financial institutions to invest in securities issued by thinly capitalized SPVs. The number of potential originators and investors in asset-backed securities in Pakistan is very large. But an enabling legal and regulatory framework must be in place before securitization can take root in Pakistan. Things seem to be moving in the right direction, though. There has been a concerted effort among some private-sector organizations to draft clear-cut and comprehensive rules for asset securitization and to
443
formulate a suitable accounting and taxation framework for securitization transactions in Pakistan. This effort involves the credit-rating agency DCRVIS; Ford, Rhodes, Robson, Morrow, Chartered Accountants; and Mandviwalla and Zafar, Legal Advocates and Consultants. The amendments recommended by these parties have not yet been approved by the CLA but are under consideration by the regulatory body. Figure 5 illustrates the usual securitization process and identifies the market players.
Figure 5 Securitization Flowchart
SECURITIZATION PROCESS
True asset securitization involves the pooling of assets by the originator and their sale to a third party. The assets must have the same or similar characteristics, particularly interest rates and maturities. The third party, which is set up specifically for securitization, is called an SPV. The originator sells its present and/or future receivables to the SPV in return for the immediate payment of the purchase price. The SPV finances the purchase price by issuing fixed-income securities or through bank-syndicated purchase facilities. The choice of which funding instrument to use (commercial paper, bonds, or bank syndication) is determined by the maturity of the assets being securitized, the costs of arranging the transaction, and the legal and regulatory framework of the country where the securitization is taking place. A trustee is appointed to look after the investors interests. Ideally, the SPV should act as a pass-through structure, whereby cash flows from debtors can be channeled straight through to investors with the least possible distortion or leakage.
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The originator continues to service the receivables. It collects repayments on behalf of the SPV. In return, the SPV pays a servicing fee to the originator. Any surplus income of the SPV, after all principal payments have been made, the securities have matured, and all dues have been cleared, is returned to the originator, either as a service fee or through other methods of profit extraction. Securitization usually involves credit enhancement to ensure that the receivables are sufficient to pay the investors on time. There are different ways of providing credit enhancement. Reputable banks or companies specializing as guarantors can provide guarantees. This method can be used to guarantee both the principal and the interest on the securities. Reputable banks can also provide first-loss cover on securities issued by the SPV. In developing a market for asset-backed securities, it is important that the instrument should be of standard quality and specifications. To achieve this standardization, credit enhancement could provide for varying levels of first-loss cover. Overcollateralization is another way of providing credit enhancement. The extent of collateralization depends on the past recovery record of the originator and the quality of the asset portfolio.
ASSET SECURITIZATION LAW
Given its numerous advantages for both originators and investors, is asset securitization possible in Pakistan? Is the legal and regulatory framework conducive to asset securitization? Although Pakistan does not yet have a codified asset securitization law, it has laws relating to various aspects of securitization, such as assignment, structuring of SPVs, and recourse for investors. From a legal point of view, the most important requirement for any successful asset securitization is the presence of a clear-cut criterion for determining a true sale. If a true sale can be clearly identified from a legal perspective, then it would be possible to make the SPV bankruptcy remote, that is, if the originator goes bankrupt, its general creditors would have no claims on the assets that have been sold to the SPV. Bankruptcy remoteness is an important reason why properly structured asset-backed securities are accorded a higher credit rating than ordinary securities.
445
However, before a true sale can be identified, the assets/receivables must first be transferred from the originator to the SPV. Transfer of Receivables from the Originator to the SPV Novation One way of transferring receivables from the originator to the SPV is through novation. Novation is a process whereby existing rights and obligations under a receivables contract are discharged and substituted with a new contract between the debtors and a new creditor (the SPV). Novation is rarely used where a large pool of receivables is to be vested in the issuer (SPV), because it requires the consent of the originator and all the debtors.
Assignment Another way of transferring receivables from the originator to the SPV is through assignment. In Pakistan, assignment can be done without the debtors consent. But they should be notified of the transfer. This provision makes the assignment a legal one. The assignment is subject to the payment of stamp duty, under the Stamp Act of 1899. The duty is 7 percent in the case of receivables arising under loan agreements, lease agreements, credit-card use, etc. In the case of mortgage loan receivables related to property, the duty can vary between 7 percent and 9 percent. There are case laws under the Transfer of Property Act of 188227 to suggest that if notice of assignment is given to the debtor, then his obligation can be discharged only if he pays the assignee, which is the SPV. In other words, if the debtor pays the originator after the notice of assignment has been given, his obligations to the SPV would not be discharged. Subparticipation Subparticipation is best defined as an assignment of the proceeds of underlying financial assets. Subparticipants do not acquire a direct claim against the borrowers. They are only the creditors of the lender (the originator). In essence, they run a double credit risk: the risk that the borrowers may not pay or that, even if they pay, the originator might not transfer the proceeds to the subparticipants.
27Khozem A. Haidermota (of Haidermota and Co., Barristers-at-Law and Advocates), Prospects of Securitization in Pakistan, 1996.
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Subparticipation is used only where there are restrictions on transfer, or stamp duty or tax considerations make assignment or novation unattractive.
True sale If the assignment is a true sale, then the receivables can effectively be taken off the balance sheet of the originator. Determining whether or not an assignment is a true sale is a complex question, and various factors need to be considered. The most important one is determining whether the SPV has any recourse to the originator if it cannot meet its obligations to the investors. If recourse exists, the assignment will not be characterized as a true sale. In such an event, in all likelihood, the transaction would be recharacterized as a loan from the SPV to the originator secured with the receivables. Under Section 121 of the Companies Ordinance of 1984, certain charges created by registered companies are, so far as they confer security on the companys property or undertaking, void against a liquidator, administrator, and any other creditor of that company. This provision holds unless prescribed particulars of the charge, together with the instrument by which the charge is created or evidenced, are delivered to or received by the Registrar of Companies for registration within 21 days after the date of creation of that charge. In securitization, if the sale is reclassified as a secured loan, the charge arising from the reclassification would be one to which Section 121 applied.
Bankruptcy Remoteness In case the assignment of receivables is characterized as a true sale, then the SPV can safely stand outside the bankruptcy of the originator. In other words, it will be shielded from the fallout resulting from the originators bankruptcy. Under Pakistani law, it is well established that a secured creditor can effectively stand outside bankruptcy if it so desires or may submit to bankruptcy to prove its debt. The Supreme Court of Pakistan has held that a secured creditor is at liberty to realize his security in any manner he likes. However, there may be a problem in the context of security interests over certain receivables that have not become due at the time a liquidator is appointed. The security may not catch receivables if the liquidator of
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the bankrupt must earn the receivables to bring them into existence by rendering services. The rationale for this is that upon bankruptcy it would not be fair to unsecured creditors to deplete the assets of the bankrupt to the advantage of a secured creditor. Take, for example, a case where the originator is a utility company that has securitized its present and future receivables. When a liquidator is appointed for the utility company, the receivables that have not been generated at the point of liquidation may not form part of the security belonging to the creditor if the company in liquidation has to render the services to generate the future receivables. Laws Relating to the Structure of an SPV An SPV in Pakistan can be structured either as a trust or a company. However, redeemable capital in the form of TFCs, which can be issued only by companies, enjoys certain protections that are not available to investment certificates issued by a trust. If, therefore, the chosen structure for an SPV is that of a company, then ideally it should have as little equity as possible since any substantial equity investment by the originator in the SPV would defeat the purpose of using asset securitization as a relatively low-cost fund-raising technique. Nothing in the Companies Ordinance of 1984 prohibits a very thinly capitalized structure for an SPV. An SPV can also be used for a series of securitizations. In other words, after the investors are paid off, there would be no need to constitute a new SPV for further securitization. The effect would be analogous to master trusts prevalent in the US. The final part of the securitization process is the offering by the SPV of redeemable capital such as TFCs. The SPV may grant a security interest in the receivables to the trustee who will hold the security for the benefit of the TFC holders.
MARKET PLAYERS IN SECURITIZATION
Asset securitization is a new concept in Pakistan. The few securitization or securitization-like transactions that have been carried out were structured in such a way as to avoid altogether the payment of stamp duty on the assignment of receivables. One of the true asset securitizations involved PTCL, a semiprivatized company with a monopoly position in the local telephone market. As such, all international calls to and from Pakistan have to use its lines. The deal involved the securitization of the international telephone toll receivables
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of PTCL, which were due from AT&T, BT, Deutsche Telecom, Mercury Telecommunications, and other carriers. Net receivables worth about US$250 million were securitized in the deal. To conclude the transaction, the international carriers had to sign consent forms that acknowledged the sale of net settlement payments to an SPV, which in this case happened to be a New York trust. The transaction had a six-year expected tenor, with a legal maturity of seven years and was placed at a spread of 225 bps over the relevant US Treasury rate in the US private placement market. The whole deal was arranged and executed outside Pakistan, thereby avoiding legal complications and payment of stamp duty on assignment to an SPV. A securitization-like transaction was carried out on the receivables of SNGPL, which were due from KAPCO, one of the largest power companies in Pakistan. SNGPL is a government-owned gas utility. The receivables were securitized into bills of exchange and sold to local investors via a trust transaction account. The use of the account avoided the payment of stamp duty on assignment to another entity, the SPV. The asset-backed bills of exchange had a tenor of 7.5 months and were bought by commercial banks operating in the country. Askari Leasing Limited (ALL) also had a securitization-like issue. The issue was backed by ALLs leased assets and its future lease rentals. The receivables were assigned to an escrow account at a foreign bank operating in the country. Once again, stamp duty was avoided. The bank acted as an adviser and trustee/security agent in the deal. TFCs backed by the assets and rentals were privately placed with institutional investors, which mostly included commercial banks. Originators The origination side has so far been dominated by utility companies and financial institutions. The potential number of originators in the country is substantial, as shown in Table 15. However, simply having receivables on the balance sheet of the companies is no guarantee for a successful securitization. The receivables must be amenable to rigorous credit and statistical analysis. For example, do the originators have annual statistics on the composition of their receivables, their aging, defaults, loss, and dilution? Do the accounts receivable statistics show stable, consistent trends? Are the assets unencumbered and transferable?
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Table 15
Potential Originators of Asset-Backed Securities

Potential Originators
n
Number
Commercial banks Housing finance companies Leasing companies Cellular phone companies Utility companies Manufacturing companies
an.a. = not available
46 2 33 3 7 n.a.a
Sources: State Bank of Pakistan, Annual Report 19961997; Khadim Ali Shah Bukhari & Co. Limited
All these questions have to be answered before securitization can proceed. Given the high percentage of defaults in NCBs and HBFC, the prospects of securitization for some of the institutions listed above are likely to be bleak, unless some sort of guarantee is provided on the principal and interest amounts of the securities. This guarantee could be provided by commercial banks, specialized guarantor companies, or even the government. Investors Securitizations that have been carried out in Pakistan were dominated on the investor side, by institutions, including commercial banks. Table 16 shows the potential number of investors in asset-backed securities in Pakistan.
Table 16 Potential Investors in Asset-Backed Securities
Potential Investors
n
Number
Commercial banks Insurance companies Mutual funds Closed-end Open-end EOBI FBF Provident funds Foreign investors
an.a. = not available
46 62
39 2 1 1 n.a.a n.a.
Sources: State Bank of Pakistan, Annual Report 19961997; Khadim Ali Shah Bukhari & Co. Limited
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On the support side of the securitization process, the countrys two credit-rating agencies, PACRA and DCR-VIS, have been involved in rating the asset-backed securities. Missing on the securitization front in Pakistan are institutions providing guarantees for the securities issued. Although commercial banks are potential guarantors, they have been reluctant to provide guarantees, mainly for credit reasons.
REGULATORY BODY
Asset securitizations in Pakistan have involved corporations on the origination side and financial institutions on the investor side. Among the instruments issued were TFCs and bills of exchange. Since no law specifically governs asset securitization, there is no specific regulatory body for such transactions. They fall under the purview of the CLA, which is in turn supervised by the MOF.
Feasibility of Launching Special-Purpose Vehicles and MBSs

INTRODUCTION
Mortgage-backed securities can be a viable funding option for HFCs in Pakistan, provided the government and regulatory authorities create an enabling environment and a level playing field for the instruments. The present laws and regulations do not encourage asset securitization, let alone mortgage securitization. The main culprit is the absence of a watertight legal framework, which would make the issuance of mortgage-backed securities a feasible, cost-effective, and attractive funding option for originators. Issues like the identification of a true sale, bankruptcy remoteness, and prudential regulations that have a bearing on asset securitization all have to be sorted out and addressed in a logical and coherent manner. Other nonlegal issues are involved as well, such as the suitability of the accounting and tax framework of the country. Accounting Framework There is a definite need to set forth detailed criteria for determining a true sale. Without such criteria, securitization cannot achieve the main objective of removing assets from the originators balance sheet, thereby
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improving its capital adequacy ratio and making the SPV bankruptcy remote. Tax Framework Taxation of SPV income is also a major impediment to securitization in Pakistan. At present the Income Tax Ordinance does not grant tax exemption to an SPV. Such a provision would have to be introduced if securitization is to be a viable fund-raising vehicle. Once an enabling framework is in place, then the nitty-gritty of structuring MBSs can be sorted out. Investor demand for MBSs, although likely to be low at the start, is sure to pick up given time and a reliable record of prompt repayment of interest and principal. However, in mortgage loan securitization, as with any other type of securitization, the presence of third-party guarantors and other forms of credit enhancement would greatly increase the chances of a successful issue. For MBSs, credit enhancement in the form of guarantees can be provided by an Apex Housing Bank (AHB). The proposal for the creation of such an institution has been floating around for a few years now. The idea is to create an AHB with an initial capital of around Rs 1.5 billion and with sponsors that would include the government, HFCs, insurance companies, and commercial banks. All these institutions have a stake in the successful development of the housing finance market in the country. The government should give serious consideration to this proposal, because it is imperative for the formal housing finance market in Pakistan to explore new ways of raising funds. It is also important from an investor point of view that the mortgage loans be of better quality and that their documentation and credit terms be standardized, so that a liquid market for MBSs can develop. Given the widening gap between housing demand and supply in Pakistan and the governments inability to meet this demand on its own, new and viable funding options for housing finance will have to be explored. MBSs can be a solution to this problem. However, their efficacy would depend in part on the continuing development of the corporate fixedincome market itself. Inconsistencies and sudden turnarounds in government policy regarding fixed-income instruments would have to be removed. Investors would need to be educated much more about the fixedincome investment avenues available to them in the country, especially in the private sector.
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Once a liquid and efficient fixed-income market is operative in the country and investors, both retail and institutional, are willing to invest in corporate fixed-income issues, then there is no reason why a market for MBSs cannot take root in Pakistan
ADEQUACY OF THE LEGAL AND REGULATORY FRAMEWORK
Two major obstacles to issuing MBSs in Pakistan, if done in the true sense of the word, lie in the determination of a true sale and, on the regulatory side, in the form of prudential regulations for financial institutions. Framework for the Transfer of Mortgage Loans from the Originator to the SPV The problems arise at the start when mortgage loans are transferred to the SPV. As mentioned in the previous section, there are three ways of doing this: novation, assignment, and subparticipation. However, all three methods have their drawbacks.
Problems with novation The problem with novation is that it requires specific approvals from the originator and all the debtors. Getting approval from debtors for any reasonably sized pool of borrowers is very difficult, if not impossible. It is therefore unlikely that potential originators (HFCs) would go for novation as a feasible option. Problems with assignment The biggest obstacle facing the HFCs in assigning loans to the SPV is the extremely high stamp duty on the transaction (79 percent in Sind). The duty makes it economically unfeasible for any originator to securitize its mortgage loans, since the cost to the originator would be unaffordable. Issues resulting from true sale Even if stamp duty is somehow avoided and loans are cost-effectively transferred to the SPV, the question then arises as to whether the transfer can be legally perceived as a true sale. The concept of a true sale is not dealt with adequately in Pakistani law. Its importance cannot be overstated though, since it has implications for both the originator and the investor.
453
The problem occurs in identifying when and under what circumstances an assignment can be considered a true sale. In theory, a true sale takes place if all the risks and benefits associated with owning a particular asset are transferred to the SPV. In other words, in the case of default, the SPV should have no recourse to the originator. If this happens to be the case, then the question arises, how will the investors get their money back? In the case of MBSs, the mortgages on immovable property are transferred to a trust. What if the default happens to be the result of a few borrowers not paying on time? Should the SPV liquidate the entire pool of mortgages or just those in default? Strictly speaking, the default would be on the part of the pool of mortgages taken as a whole and not the individual borrowers. However, the legal position in this regard is not clear. Even if foreclosure proceedings were initiated against a group of defaulters, executing foreclosure would not be an easy task, given the problems mentioned earlier.
Possibility of reassigning and reclassifying mortgage loans If the SPV does have recourse to the originator in the event of default, then it is very likely that the assignment will not be classed as a true sale from a legal standpoint. If so, then the mortgage loans will be reassigned to the originator and stamp duty would again become payable. Potential originators have to keep this outcome in mind when evaluating the costs of raising funds through securitization. In addition to the stamp duty, the investment could also be reclassified as a secured loan. In the case of MBSs, the security would include the mortgaged property as well. If that happens and the originator has not registered the security under Section 121 of the Companies Ordinance of 1984, the security will not hold if the originator goes bankrupt. The investment would simply be treated as an unsecured loan, thereby increasing the risk for investors in MBSs. Problems with subparticipation Subparticipation increases the risk that investors will not receive a return on their investment. This is due to the double credit risk that they have to bear, by virtue of being subparticipants in the securitization deal. The double risk is likely to increase the cost of funding to the originator, to compensate for the added risk. This makes subparticipation a more expensive form of transferring loans than assignment.
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CHAPTER 6
Adequacy of the Legal and Regulatory Framework for Structuring an SPV A thinly capitalized SPV can be created under Pakistani law, but financial institutions would not be able to purchase MBSs issued by it. Prudential Regulation No. 5, which applies to financial institutions, prohibits new long-term debt in cases where the debt-to-equity ratio is already greater than 60:40. If the originator decided to create an adequately capitalized structure for the SPV, so that financial institutions could invest in it, the effectiveness of the SPV as a low-cost pass-through medium for mortgage loan installments would be severely reduced. The reason is that any substantial equity investment by the originating HFC would run contrary to its objective of using the SPV as a minimal investment funding vehicle. Another problem with overcapitalization of an SPV is that if the investment is reclassified as a loan, the originator could be subject to restrictions on borrowing from a subsidiary. This could further complicate matters. The legal and regulatory framework regarding securitization needs to be reformulated to remove these anomalies and complications. Until that happens, securitizations in the true sense are likely to be rare in Pakistan. Therefore, given the difficulty of creating the right legal and capital structure for an SPV and problems with the assignment of loans, it becomes highly unfeasible for HFCs to raise funds through securitization. Ways of Avoiding Legal Complications The stamp law applicable to Pakistan comes under the Stamp Act of 1899, which is the same one that is being used in the UK, one of Europes biggest securitization markets. This shows that there are ways around the issue of the stamp duty on the assignment of loans to the SPV. These could include executing the transfer documents outside Pakistan, or documenting only the offer for sale from the originator and not the acceptance by the SPV. The acceptance could instead come through actual payment for these assets. Since the legally defined criteria for a sale would not be documented, the issue of paying stamp duty would not arise. However, both these options and others that can be used to avoid payment of stamp duty have not been tried in Pakistan, with particular reference to securitization. Therefore, one cannot be certain as to whether these forms of sale would protect the undivided rights of investors on the future cash flows from the securitized loans in a court of law.
455
MARKET DEMAND FOR MBSs
The demand for MBSs is likely to be low. This would hold true for both originators and investors. Factors Affecting MBSs Issuance Adequate liquidity for HFCs. The biggest problem on the origination side is that the largest HFC, HBFC, feels that it has enough liquidity to meet the demands of borrowers. HBFC contends that it has never had to refuse a loan to a good credit risk and therefore needs no additional funding sources at present. In the case of IHFC, there is a need for additional capital of about Rs 250 million, since it has entered the commercial mortgage lending market and plans to diversify its loan portfolio substantially over the coming year. However, the bottlenecks facing securitization in the country do not make it feasible for IHFC to issue MBSs. It would be much easier for it to issue TFCs backed by mortgaged property, in the manner described in the section entitled Obstacles to the Development of the Fixed-Income Securities Market. Therefore, the demand for MBSs on the origination side is likely to be low. MBSs as an expensive funding source. Another factor reducing the supply of MBSs in the case of local execution of transfer documents is the high stamp duty that would have to be paid on assignment to the SPV. Added to this is the fact that the originator would also have to allow for prepayment risk, credit enhancement, operating expenses, etc. Therefore, the final cost for the originator, including both issuing costs and the return to investors, is likely to be very high, especially when compared with other methods of raising finance, such as by issuing TFCs using mortgages on property as a security. Ability to raise deposits through COIs. Since HFCs are classified as NBFIs by the SBP, they can raise deposits from the general public and institutions by issuing COIs. This option can potentially raise large sums of money for these institutions. Issuing MBSs would definitely be a more complex and less attractive route than the alternative already available to them. Investor Demand for MBSs There are many problems on the investor side as well. SPV capital structure. The most important factor determining investor demand for MBSs is the capital structure of the SPV and the implications of prudential regulations for potential investors. Present regulations
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CHAPTER 6
do not allow investment in companies with a debt-to-equity ratio greater than 60:40. However, in the case of a traditional SPV the debt-to-equity ratio is most likely to be higher than 60:40, given that the only items on the balance sheet are the assigned assets from the originator (the HFC) and the securities issued by the SPV itself. In fact, an efficiently functioning SPV can be created with a nominal equity of Rs 1. Prudential regulations also require financial institutions to ensure that the total investment in any particular company or entity is not more than ten times the capital and reserves (free of losses) of that entity as disclosed in its unaudited accounts. Since an ideal SPV can be created with a nominal equity of Rs 1, this regulation is again likely to be violated by any financial institution buying MBSs issued by it. Since most of the demand is from the financial sector, investor interest for MBSs issued by an SPV would therefore be severely restricted and negligible. Tenor of MBSs. MBSs are likely to have a long tenor, given the long repayment schedule of mortgage loans. The long tenor would rule out many investors such as commercial banks, which prefer investing in shorter-term securities, such as T-bills. Thus, the demand for MBSs is likely to be restricted to institutional investors such as insurance companies and pension and provident funds. Under current prudential regulations, however, investment from pension and provident funds would also depend on whether the MBSs are listed or not. If they are not listed, then these institutions cannot invest in them. Unstandardized mortgage loans. The lack of standardization of the lending terms, documentation procedures, and credit appraisal techniques is also likely to adversely affect demand for MBSs. Only when these procedures are standardized will investors understand the risk and return profiles of MBSs and not base investment decisions purely on their perceptions of HFCs. Investor perception and high default ratio of HBFC. HBFCs high default ratio of 2530 percent would worsen investor perception regarding investment in MBSs. However, this problem could be rectified to a large extent if banks and/or the government were to guarantee the interest and principal repayments on MBSs. The guarantee could also come from an Apex Housing Bank, which could be set up with the sponsorship of the government, the HFCs, and commercial banks operating in the country. The guarantee provided by the AHB would increase investor confidence in the quality of their investment and allay fears of default by the MBSs originators (HFCs). The AHB could also act as a principal agency for promoting HFCs at the regional and local levels. The AHBs
457
work would focus on developing a healthy and self-sustaining housing finance system and integrating it with the countrys general financial system. Problems in getting information about the performance of HFCs. A related problem is the difficulty investors would face in getting accurate information about the loan portfolios of HFCs, especially HBFC. Investors would need this information to understand the nature and structure of MBSs. If this information is not available, investors would be encouraged to rely on their preconceived notions about HFCs when deciding whether or not to invest in MBSs. All these problems would affect investor demand for MBSs.
GROWTH OF THE RESIDENTIAL MORTGAGE LOAN MARKET
Assumptions Estimates of the growth of the residential mortgage market are based on the following assumptions and reflected in Table 17:
Table 17 Estimates of Mortgage Loans to be Disbursed by HBFC and IHFC, 19992008 (Rs billion)
n
HBFC IHFC Total Loans Disbursed Loans Disbursed During the Year Loans Disbursed During the Year
Year
Total Loans Disbursed
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
29.60 31.60 33.60 35.60 37.60 39.60 41.60 43.60 45.60 47.60
2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00
.455 .523 .601 .691 .795 .914 1.051 1.209 1.339 1.599
.059 .068 .078 .090 .104 .119 .137 .158 .181 .209
HBFC will grant an average of Rs 2 billion in mortgage loans yearly over the next ten years.28 IHFC mortgage loans will grow at an average rate of 15 percent yearly over the next ten years, provided IHFCs funding requirements are met.29
28Estimates 29Estimates
provided by the House Building Finance Corporation. provided by the International Housing Finance Corporation Limited.
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Selected References
Fabozzi, Frank J. and Irving M. Pollack. The Handbook of Fixed Income Securities. Second Edition. Finance Division, Economic Advisors Wing, Government of Pakistan. Economic Survey 1997-1998. Garg, Yogendra Kumar, and Vastu Nirman. India Case Study. Paper presented at the IFC Conference on New Directions in Asian Housing Finance, Bali, Indonesia, 56 February 1998. Giddy, Ian H. Asset Securitization in Asia: An Overview. Haidermota, Khozem (of A. Haidermota and Co., Barrister-at-Law and Advocates). Prospects of Securitization in Pakistan. 24 September 1996. Hassan, Waheed. Pakistan Banking Sector: Banking on Firm Foundations. Report prepared for Merrill Lynch. Hook, Dr. Andrew T. Savings in Pakistan: Practice and Policy (19811996). IBA. Report on CDC. Lea, Michael J. (Cardiff Consulting Services). Models of Secondary Mortgage Market Development. Paper presented at the IFC Conference on New Directions in Asian Housing Finance, Bali, Indonesia, 56 February 1998. Mandviwalla, Mehmood Y. Securitization in Pakistan: Legal Aspects. State Bank of Pakistan. Annual Reports, 19901997. Stone, Charles, Anne Zissu, and Jess Lederman. Asset Securitization: Theory and Practice in Europe. Tayebaly, Irfan (Mohsin Tayebaly and Co.). Review of Mortgage-Backed Securities in Pakistan: Draft Commentary. February 1998. Twenty-First Century Consultancy and Management Services (Pvt.) Ltd. Study on Housing Finance: Draft Final Report. 30 April 1997. Washington Asset Management, Inc. Pakistan Bond Market Study. Washington, DC, 19 June 1996. Zahid, Rummana Yazdanie. Housing Finance in Pakistan. Business Recorder, 2 February 1998.
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Pakistan

The Mortgage-Backed Securities Market in Pakistan

The Fixed-Income Securities Market

of Business Administration, Report on the Central Depository Company.

THE MBSs MARKET IN PAKISTAN

FINANCIAL SECTOR REFORMS

THE MBSs MARKET IN PAKISTAN

THE MBSs MARKET IN PAKISTAN

Statutory reserve requirement (SRR) Statutory liquidity requirement (SLR)

7State 8Ibid. 9Ibid.

Bank of Pakistan, Annual Report 19971998.

THE MBSs MARKET IN PAKISTAN

Breakdown of Domestic Debt, as of 30 June 1998 (Rs million)

FIBs as % of Permanent Debt = 52.85%

Permanent Debt 296,172

Unfunded Debt 311,783

Floating Debt 433,83

STFBs as % of Floating Debt = 21.37%

Source: State Bank of Pakistan, Annual Report 19971998

4 4,0 00 3 8,5 00 3 3,0 00 2 7,5 00 2 2,0 00 1 6,5 00 1 1,0 00 5,5 00 0

Accepted Amount Cut-Off Yields

T-bills replace STFBs STFBs replace T-bills

THE MBSs MARKET IN PAKISTAN

58% 30% 10% 10%

58% 58% 33% depending on income bracket

Yield Curve in the Secondary Market, as of 31 December 1998

17 15 13 11 9 7 5 3 1 O /N 7day 15day 13m o n th m o n th 6m o n th 1year 2year 3ye a r 10year

THE MBSs MARKET IN PAKISTAN

Salient Features of WAPDA Bond Issues

1988 1989 1990 1992 1993 1994 1995

13.50 13.50 12.50 15.00 16.00 19.00 16.50

The publicly listed issues to date are given in Table 4 below.

Source: Khadim Ali Shah Bukhari & Co. Limited

THE MBSs MARKET IN PAKISTAN

THE MBSs MARKET IN PAKISTAN

Financial Institution COIs 1 year 3 years 5 years

12.5017.00 13.5018.00 15.0019.50

Banking Sector Assets

Annual Yield (%)

Banking Sector Liabilities

Bank Advances Running finance Term loans (35 years)

16.0020.00 T-bill + 2.00 to T-bill + 5.00

Bank Deposits 1 month 3 months 6 months 1 year 3 years 5 years

9.2012.68 9.5013.91 10.7014.59 11.3015.00 12.4017.00 14.0019.00

Investors Table 6 shows the various categories of investors in Pakistan.

Investor Categories in Pakistan

NBFIs Investment banks 15 10 33

Institutional Investors Insurance companies 62

Employees Old Age Benefit Institution (EOBI)

Employees provident funds (private)

Federal Employees Benevolent and Group Insurance Fund (FEBGIF)

Obstacles to the Development of the Fixed-Income Securities Market

THE MBSs MARKET IN PAKISTAN

T. Hook, Savings in Pakistan, Practice and Policy (1981-1996).

THE MBSs MARKET IN PAKISTAN

Net Yields to Individual Investors in National Savings Schemes and TFCs

Net Yield (%)

Nishat Tek Packages SSGC SSC ICI Gatron DSC

3 months 1.5 years 2 years 3 years 3 years 5 years 10 years

11.51 14.81 17.57 15.59 14.87 18.35 17.79

THE MBSs MARKET IN PAKISTAN

Yields-to-Maturity and Credit Ratings of Listed TFCs

ICI SSGC Packages Nishat Tek Gatron