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Mortgage Securitization in Hong Kong & Asia

Presented by Rohit LN Satish

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STRUCTURE OF THE PRESENTATION

•What is securitisation & what is the structure of securitisation followed by HKMC• How it benefits the parties involved (HKMC, Banks, Investors )•What are the necessary conditions for securitisation market to thrive•We would then answer the questions raised in the case.•Risk Allocation to different parties•Recommendations•-

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Securitization

“Securitisation" in its widest sense implies every such process which converts a financial relation into a transaction.

Securitisation is the process of commoditisation

Securitisation is the process of integration and differentiation

Securitisation is the process of de-construction of an entity

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Securitization Jargon

Originator Future Flows Securitization Asset backed securitization Mortgage backed securitization True Sale SPV(issuer) Pass through certificates Pay through certificates Bankruptcy remote transfer Credit Enhancement Servicer Guarantor

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Asset Pool(Mortgages, Loans etc)

Originator

SPVCredit

Enhancement

Note Structuring

Class “A” Notes (AAA)

Class “B” Notes (A)

Class “C” Notes (C)

Class “D” Notes (Equity

tranch)

Investors

Credit Tranching

Proceeds from sale of NotesIssue Securities

Proceeds from sale of Assets

True Sale

THE SECURITISATION PROCESS

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Asset Pool(Mortgages, Loans etc)

Originator

Sell Loans to HKMC

MORTGAGE BACKED SECURITIES (Structure As Followed by HKMC)

Sell Loans to SPC

Issues MBS with HKMC guarantee to Bank A

Bank can hold MBS of sell to investors

Originator Originator

Hold

Sell

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Overview of Securitization in Asia

Lack of Credit Enhancements Lack of investor confidence(lack of sophisticated foreign

investors) Lack of Regulatory framework and other structural

problems Lack of Rationalization of Taxation Structure Lack of Domestic long term bond market Lack of Liquidity For Hong Kong along with some issues listed above, lack

of homogeneity of the MBS issues before HKMC resulted in an illiquid market.

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Benefit to HKMC

Mandate for HKMC is to create a liquid debt Market and a liquid secondary market for MBS in Hong Kong .

Why a liquid debt market is important in a region?

• Alternate source of funding for companies especially during time of crisis would

release pressure of the Interbank market when they most need it .

• During the time of crisis when there is a capital flight an active debt market gives

some avenues for banks to tap in to the local investors through raising local debt

and issuing MBS in the local market .

• It helps in addressing the issue of asset liability mis match .

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Benefit to HKMC

How securitization helps in creating an active debt market ?

It acts as the second leg to the bond market in the region . In US the treasury market size is 3.1 Trillion and the MBS size is 1.7 Trillion .

Why liquid debt market is important for creating thriving MBS market ?

If corporate debt market is active banks can focus on Mortgages .

Benchmarking and attracting sophisticated foreign investor base

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Benefit to Investors

diversify sectors of interest (access sectors that are otherwise not open to them.)

access different (and sometimes superior) risk-reward profiles.

Tailor risk-return profiles

Better risk return pay off as the originator holds the first loss tranche.

Lower event risk

Pooled assets have lowered concentration risk

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Benefit to Banks

Reduce cost of funding (Bankruptcy free structure ,credit rating, credit enhancement)

To reduce capital requirements

Diversification of funding source (compare the all in cost in both the bond market and ABS market to see which is cheaper, in our case compute the cost of funding for bank from the two sources)

Diversification is beneficial in the time of crisis or difficult market condition as you have alternatives .

Banks aim to optimize their funding among a mix of retail, interbank, and wholesale sources. Securitization has a key role to play in this mix .

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Benefits to Banks

Generation of Fee income

To increase ROA

balance sheet capital management

• (reduce maturity mismatches)• Release regulatory capital

Risk management and credit risk transfer. (First loss tranche , transferring of NPAs)

Accelerating earning for financial reporting purposes.

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What do credit rating organisations see in ABS

(1) Credit quality of the collateral – market value of the loan VS the collateral

(2) The quality of the seller/servicer- default rate , recovery rate , concentration of the risk

Servicer might needed to make short term payments if there are short term liquidity issue.

(3) Cash flow stress and payment structure.

Loan to Value Ratio – Higher the LTV higher the probability of default . LTV>1 implies borrowers equity is negative.

Payment to income ratio- front and back ratio

DSCR -

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What do credit rating organisations see in ABS

Credit enhancement – external and internal

External credit enhancement

third-party guarantees such as insurance or a letter of credit.

Internal credit enhancement

includes overcollateralization, senior-subordinate structures and reserves.

Deals often have more than one form of credit enhancement. The rating agencies specify the amount of credit enhancement required to obtain a specific credit rating.

The issuer decides on what mechanisms to use.

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Conditions for a successful MBS market

1) Continuous and sizable volume of Residential and Commercial Mortgages .

2) Policy & Regulatory framework-

Improvement of Corporate Governance

Regulatory and supervisory arrangements

• Taxation policy, Legal protection• Regulatory authority power

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Conditions for a successful MBS market

3) Market Infrastructure and liquidity-

Development of Long Term Bond markets• Lack of benchmark yield curve(Malaysia, Philippines)• Limited supply of quality bonds• Limited bond demand• Inadequate bond infrastructure• Market making and creation of secondary markets .

4) Incentive for investors – Comparison with other sources of investment• Favorable returns viz a viz other traditional sources .• MPF scheme authorities are looking for a quality paper to invest in . (AUM 30 B by

2011 and 60 billion HKU by 2030)• Huge capital flow from china expected ..

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Contribution of HKMC to liquidity creation -What has already been done –

Homogeneity of the product

Credit enhancement

Secondary liquid market ( Banks appointed as Market Makers)

Fixed Adjustable rate mortgages(FARM)

For creating liquidity in debt market – NIP, DIP

What is planned –

Listing of the MBS locally and over seas

Tranching

Reserve fund and over collateralization program .

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Is the MBS market in Hong Kong poised to grow?

Supply of mortgage(Exhibit 11:Refute) Low yield for investors Mandate for HKMC to create a liquid primary and secondary market by

introducing standardized products in the primary market and facilitating market making function.

Good Regulatory infrastructure and Rationalized taxation. Maintain required levels of liquidity (Min 25%) in the market .(secondary

source) Lowest Delinquency rate in the Hong Kong market If the deflation that started from 1999 continues to grow then the default

rates going forward might go up. MPF scheme authorities are looking for a quality paper to invest in . (AUM 30

B by 2011 and 60 billion HKU by 2030) Huge capital flow from china expected .

YES

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What’s in it for the bank? Would it be a good opportunity for them? Should they get in to it?

The benefits to the banks are explained in the previously, plus as established the market has a very high possibility of being successful as shown in the previous slide.

Minimization of Credit Risk exposure as the MBS is guaranteed by HKMC Release of regulatory capital by reducing risk- weightage from 50% to 20% Balance Sheet Management Tool

Duration matching Minimum Liquefiable asset management(25% as ordered by HKMA)

Regular cash flows maintained by holding on to the notes Maintain relationship with customers by the lieu of cross selling opportunities Annual Servicing fee of 0.5% on the outstanding mortgage loans MBS through HKMC quicker and cheaper( explained in the next slide)

YES

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Should the bank go to HKMC for MBS Issuance?

Credit enhancement – Implied sovereign guarantee makes the rating of MBS independent of the Credit rating of the originator .

Better Liquidity of the instrument – HKMC is providing standardized product with facilitation of market making function in the secondary market .

Risk weightage of Mortgages - If it goes through HKMC RW would decrease from 50 to 20 because of sovereign guarantee which would not be possible if it issues MBS on its own .

Qualification as liquefiable asset - HKMC issued MBS are considered liquefiable . Interest rate deregulation in July 2001

YES

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Is it the right time to enter the MBS market?

Hong Kong is in the middle of a Deflation and ongoing economic slump(not a recession though)

Increased default risk so it makes sense to transfer it to HKMC

Interest rate deregulation increased pressure on deposit rate side.

Now securitize and hold so that when interest rates start going upliquidate MBS to free capital to invest for other high yieldingopportunities.

YES

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What are the different risks of bank and HKMC ?

Risk for HKMC – Mortgage payment default Risk (Contagion Risk) – increses in deflationary

environment(Stringent covenants like LTV ratio of 70%) The fact that delinquency rates stayed below 2% even during the crisis and has

remained relatively stable in the following years goes to show the stability of HK mortgage market.

Loan Servicing Risk (Principal agent problem)

Risk for Banks – Counterparty risk – Concentration of default risk with HKMC - increses in

deflationary environment Prepayment Risk (In this structure) Interest rate risk, Credit spread risk (In this structure) Liquidity Risk(In this structure)

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Recommendation

A Fundamental understanding of securitization and its benefits is key to athriving Asian securitization market

With the return of investor confidence after the crisis , provision of alternatesource of funding becomes viable for which MBS is an instrument.

For HKMC – Convince banks to go for securitization of existing mortgages(Pitch

prepayment and default risk in a deflationary environment) Set up tranchingFor Banks – In prevailing volatile market conditions Enter into MBS to cap downsideFor Investors- Given the potential of MBS market institutional and retail investors should

consider MBS as a alternative asset class.For regulators – Asset quality checks

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Thank you


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