Lecture 10 Foreign Investment, Securitisation and Financial Crisis

Session Outline
Portfolio Lending Types of Risks Associated with Mortgage Finance Risk Measurement and implications Managing Mortgage Related Risks Mortgage securitisation and recent global financial crises

Portfolio lenders

What are portfolio lenders?

Loan originated by lenders who retain them in their portfolio Usually deposit institutions e.g. banks May include finance companies, insurance companies or other lenders Lenders have access to central liquidity facility as supplementary source of funds Sell low risk bonds, finance mortgages lenders

Perform financial intermediation

Home Buyer

Loan

Bankssavings institutions
savings

Saver

Direct lending

Activities of portfolio lenders

Originate loans Service loan Manage risk Fund through deposits and bonds

Model of Portfolio lending

Originate

Service

Borrower

Portfolio Lender

Manage Risk
Deposits

Fund
Bonds

Strengths of portfolio system

May provide personalised service to borrowers because the same entity originates and service loan Lenders can cross serve other services Originator take delinquency/default risk and therefore incentivised to control risk Originator has access to permanent funding source

Weaknesses of portfolio system

Interest rate management is difficult because borrowers want long, depositors seek short duration Default risk may be highly concentrated especially if loans cover small geographical area Operating efficiency may be low because one entity does wide variety of functions Competition may be weak because lending limited to those with permanent funding

Risks Associated with Mortgage Finance

Legal risks (possible violation of rights) Loan agreement Enforceability Property rights Consumer protection Business fraud Borrower credit risks Default Prepayment Collateral

Risks Associated with Mortgage Finance Contd

Interest rate risks
Prepayment risk Pipeline risks

Operations risk
Failure of performance of mortgage market institution Institutional bankruptcy Mismanagement

Liquidity risks
Ability to buy and sell asset in a timely manner

Dealing with Mortgage Risks

Hedging mortgage origination risk Indexation Credit evaluation Managing Securitisation and secondary market activities

Risk Measurement & Policy Implications

Assessing credit risk

Use underwriting principles of 5Cs
Character, capacity, Collateral, Capital & Conditions

Credit scoring
A statistical technology that calculates the risk of default and translates default probability into a useful standard score (measure)

Mortgage score factors

LTV ratios, property type, borrower attributes, local real estate price changes

Default Management Process

Borrower Defaults Evaluate Options Begin foreclosure Obtain Title Market property

Work out plan (forbearance) >Bring account current (wave late fees) >Recast rate or term >Forgive or capitalise interest in arrears >Refinance Deed in lieu of foreclosure Foreclose

Continue negotiation

Mortgage Securitisation
Definition: It is a device of structured financing whereby an entity seeks to pool together its interest in identifiable cash flow over time, transfer the same to investors either with or without the support of further collateral, and thereby achieve the purpose of financing.

Mortgage Securitisation structure

Rating agency

Insurer

Loan

Sale of assets

Sells secured notes

Borrowers Borrowers Borrowers

Cash flow from assets

Originaor/ Seller of asset

Notes proceed

S P V
Cash

Note Holders

Key functions within structure

Design of the mortgage product Selling or marketing of the loan Packaging the loan Administration Funding Assumption of risk Delinquency/default management

Lenders
Banks and depository institutions receive savings etc from customers in the form of deposits Banks lend money to customers to buy a house, i.e.- mortgage lender makes loans to individuals. This may involve in-house staff or mortgage brokers.

Special Purpose Vehicles (SPV)

SPVs are companies that are set up for the purpose of holding assets on which Mortgage Backed Securities (MBS) are secured, and for issuance of the securities. SPV are legal entities
Can be owned by the lender Or can be independent company Can be partly state owned

The lender does this to achieve

Better cost of funding Avoid potentially having to maintain capital against the assets

SPV issues securities and sell to investors

Rating Agencies
Potential investors depend on independent assessment of quality of the underlying pool of assets by rating agency before purchasing notes, e.g. S&P.

Insurer
The quality of the asset may not be high enough on its own so credit enhancement (insurance) is usually necessary to lower the credit risk on the notes which are sold by the SPV Insurance may be provided
By public sector institutions as by the US government through Fannie Mae and Freddie Mac Privately provided e.g. AIG

Note Holders
These are investors who participate in purchasing the investment assets and taking on the risk and receiving the benefits in returns

Potential Benefits of securitisation

Specialisation and efficiency Increase in liquidity Balance sheet management Investor flexibility (able to reassess assets held) Range of products available to borrower

Moral Hazards
Mortgage broker receives immediate payment between 0.5 to 3% on origination Lender paid 0.5 to 2.5 on sale Bank or Bond issuer paid 0.2 to 1.5% on issuance Rating agency paid fee by Bond issuer immediately on issuance No incentive for participants to exercise due diligence

What can be done?

Providing better incentives to participants? Mortgage broker bonded or licensed Lender responsible for mortgage originated and purchased Rating agency paid in shares of securities

Concluding remarks: Important lessons

Effects of mortgage innovations Sub prime lending benefits ownership rate Beware of moral hazards Use manageable options available