Balanced Mortgage Bonds: Complements to Basel

Transcription

1 Balanced Mortgage Bonds: Complements to Basel 28 February, 2012 Kathleen Tyson Quah, Absalon Project Jesper Berg, Nykredit-Totalkredit 1

2 Agenda Institutional structure and market structure matter because capital is never enough if incentives create moral hazard UK market failures Balanced Mortgage Model Macro-economic benefits of structural and market mortgage finance reform Absalon Project globalising the Danish solution 2

3 The Importance of Institutional Scope and Market Structure 3

4 Credit, Liquidity and Maturity Transformation The business of banking is the intermediation of credit, liquidity and duration risks between the providers of capital (savers) and those who require funding (borrowers) Transformation risks are priced as interest rate differentials Transformation risks make banks inherently unstable Incumbent bank managers always have an incentive to distort transformation to secure short term profits at the risk of long term (socialised) losses 4

5 Balance sheet of a simple bank Maturity mismatch because bank holds loans to term while depositor can demand return of funds (refinancing risk, or in the extreme, bank runs) Liquid deposits transformed to illiquid mortgage loan (liquidity risk) Cost of funding can exceed return on loans (interest rate risk) Result: Banks are inherently unstable, illiquid and prone to crisis! 5

6 Mutuality Model Depositors claims on assets are proportional and variable in value Instability is still a problem, but contained by the structural allocation of losses to equity holders Result: Losses are absorbed, but instability remains and confidence erodes under stress 6

7 Balance sheet of a modern bank with securitisation Credit risk transfers to RMBS investors (unless there are put back provisions) Result: RMBS prone to diminishing quality and liquidity as disintermediation promotes conflicts of interest, mispricing, information asymmetries, credit laxity, etc. 7

8 Balance sheet of a modern bank with covered bonds Term of covered bonds does not match term of loans (refinancing risk) Over-collateralisation subordinates creditors of the Bank (credit risk) Over-collateralisation encumbers balance sheet liquid assets (liquidity risk) Result: Covered bonds are a fairly stable financing structure, but banks may be more unstable under liquidity and interest rate stress, and more prone to mora hazard as depositors claims are subordinated 8

9 Complex Mortgage Lending Asset-Liability Management Assets Long duration property loan (asset) Real property mortgage (collateral) Liabilities Demand and term deposits Wholesale term debt RMBS Term Bonds Covered Bonds ALM Risks Credit risk Maturity mismatch Interest rate mismatch Currency mismatch Hedging/CDO/insurance mismatch & counterparty risk Refinancing risk Prepayment risk Legal risk 9

10 Danish Mortgage Credit Institution (narrow bank) No deposits or unsecured creditors so no subordination Matched funding - bonds match loans as to rate, maturity and amount Pass through payments on loan origination and repayment of principal and interest no warehousing risk and transparent ALM performance monitoring MCI holds credit risk to maturity Strict credit scoring and property valuation methodology Delinquent loans must be bought out from cover pools, creating management discipline/skin in the game Result: Stability and liquidity under all conditions, even extreme financial system stress 10

11 Simple Danish MCI Asset Liability Management Assets Long duration property loan (asset) Real property mortgage (collateral) Liabilities Balanced Mortgage Bonds ALM Risks Credit risk Maturity mismatch Interest rate mismatch Currency mismatch Hedging/CDO/insurance mismatch & counterparty risk Refinancing risk Prepayment risk Legal risk 11

12 Basel Accord evolution Basel I rated credit risk with (flawed) riskweighting of asset classes Basel II introduced (flawed) market risk with modelling of portfolio risk weights based on historic market activity (Basic, IRB, Advanced IRB) Basel III will introduce Net Stable Funding Ratio, Liquidity Coverage Ratio and SIFI surcharges Complements to Basel? Institutional scope limitations and market reforms can improve risk allocation and transparency, and contain moral hazard and systemic risks 12

13 UK Mortgage Market Funding volatility, pro-cyclical capital assets, monetary transmission failure, complex ALM 13

14 The UK boom-bust cycle Mortgage lending is more than 70% of UK private debt Residential and commercial real estate secures most SME/business lending Securitisation broke the banking model of mortgage finance Conflicts of interest Credit laxity Disintermediation Mis-pricing Illiquidity Ill-transparency Information asymmetries Capital asset deflation Contagion and systemic risk Strong, pro-cyclical impact of mortgage lending on non-financial credit, investment and employment 14

15 Unstable mortgage lending capacity - UK UK mortgage lending has fallen severely since the collapse of RMBS markets RMBS remains illiquid and covered bonds risk depositor subordination and impaired bank liquidity. Source: Bank of England 15

16 Monetary Transmission Failure - UK UK Base Rate Tightening? Easing? 16

17 Encumbrance and Subordination Bank depositors, unsecured creditors, bondholders, deposit insurance and taxpayers are all at greater risk of impaired recovery when banks encumber their assets through secured borrowing ( subordination ) The financial crisis has led to record levels of bank asset encumbrance and credit subordination Subordination implies higher liquidity risk and vulnerability to credit shocks and systemic shocks 17

18 Pro-cyclical capital assets RMBS proved pro-cyclical Illiquid under stress Mis-priced on balance sheets Loss of investor confidence led to freezing of interbank and commercial credit Forced central banks to become market makers of last resort The world economy faces a shortage of super-safe financial assets, bonds for which there is almost no risk of default and for which the market is so big that investors can buy and sell them readily. - David Wessel, Fewer Ports in a Storm, Wall Street Journal, 22 Dec

19 The Balanced Mortgage Model Stable, Liquid and Resilient 19

20 Danish mortgage bonds crisis and credit cycles MORTGAGE BONDS 28 February 2012 Complements to Basel 20

21 Key Elements of the Danish model Legal certainty legislation provides clear roles, rights and responsibilities Structural segregation of Mortgage Credit Institutions (MCIs) Only allowed to make mortgage loans Only allowed to borrow through listed bond series Cover pools secure performance on bond liabilities Principle of Balance loans match bonds as to amount, rate and tenor Tap Issuance as needed finance for lenders Pass through payments - protect investors Standardised credit scoring and property valuation prevents competition on credit laxity reduces fraud and loss on default Prepayment options protect borrowers and promote efficient monetary transmission Exchange trading efficient, transparent market pricing for a large, liquid asset class 21

22 Principle of Balance Matched Funding The amount and rate of the bond and loan always match Rates are set in the market Bonds issue simultaneous with loan origination Bonds are redeemed by calling when principal is repaid according to a fully disclosed algorithm Callable loans must be funded by callable bonds Variable rate index linked loans must be funded by index linked bonds 22

23 Pass-Through Payments Fair, market interest rates Prepayment options Transparent ALM Good long term, risk-adjusted, capital-weighted returns Safe, robust investment Long duration Deep liquidity Excellent repo asset 23

24 Responsible Lending Competition is on service and rates not credit laxity Borrowers have better information and make better decisions Capital is assessed dynamically to ensure continued responsiveness of mortgage lenders to credit risk and loan quality 24

25 Prepayment Options Borrowers have a right to prepay embedded in one or two prepayment options: Callable loans have an embedded call option and a delivery option Non-callable loans have an embedded delivery option only Under the Principle of Balance, callable mortgage loans must be financed by callable mortgage bonds, and non-callable mortgage loans must be financed by non-callable mortgage bonds. Since the value of homes and the associated mortgage bonds tend to move in the same direction, the borrower is protected against negative equity as he can often offset a loss on the sale price of the house with a lower cost mortgage loan redemption with market-priced bonds. 25

26 Market price discovery Primary and secondary market prices are the same Prices are transparent to investors, borrowers, banks and supervisors Less cost, risk and complexity from synthetic or derivative products Sustained investor confidence and demand 26

27 Stronger Competition Totalkredit Model Totalkredit founded 1990 as a multi-issuer platform for residential and holiday home mortgage finance 90+ small, local lenders participate Funding costs are comparable to top 3 lenders Sold to Nykredit in 2003 at significant profit to stakeholders Improved local competition and service quality Shared services platform reduces origination and administration costs, operations risk Lending totalled DKK 456 billion (EUR 61 billion) at end-2010 Totalkredit model can be adapted to other countries 27

28 Macro-Economic benefits Proven out-performance under stress 28

29 Stable lending capacity in Denmark Commercial lending has fallen since the crisis as global credit markets tighten Mortgage lending has remained robust as investors continue to fund Danish mortgage bonds Mia. kr M M M M M M M M M M M M M M M M M M M M M M M M M M12 Pengeinstitutters Commercial Lending udlån Mortgage Lending Realkreditinstitutters udlån 29 29

30 Capital efficiency Danish covered bonds average just 4-5 per cent over collateralisation (OC) on cover pools much lower than all other covered bonds Denmark OC about half of Canada s OC! 30

31 Lowest cost financing Tap issuance write once, issue many! Incremental issue of new bonds into listed, open bond series Lower costs for underwriting and investor due diligence Never a day when the mortgage finance is illiquid Deep liquidity promotes investor demand and confidence in market pricing As of May 2010 US RMBS UK Covered Bonds Danish Mortgage Bonds All-In Annual Issuance Costs 176 bp 112 bp 29 bp 31

32 Broad financing scope Distribution of Danish mortgage loans, November 2011 Commercial 12% Agriculture 58% 12% 10% 2% Social Housing Rental Housing Subsidized building 6% Residential With the number of new homes being built at a record low, David Orr, chief executive of the National Housing Federation, which represents housing associations in England, said: 'The housing crisis should be treated as a top political priority to prevent an already desperate situation becoming even more grim for the millions of people in need of a home. 32

33 Broad investor appeal Ownership distribution of the Danish covered bond holdings, November 2011 Corporates 4% 13% 5% MFI's 3% 18% 42% Other Financial Institutions Life Insurance and Pension Funds Public Funds 15% Households The typical default [UK pension] fund invests approximately 60 per cent in equities and 40 per cent in bonds. This is a high-risk strategy that lacks diversification and represents a poor match for members retirement income needs. Morten Nilssen, chief executive Now:Pensions 33

34 Lower delinquencies and losses on default Denmark 6% 5% 4% 200 3% 100 2% 1% % Single Family House Price Index Q1 = 100 << 3M arrears >> USA 6% 5% 4% 200 3% 2% 100 1% 0% % House Price Index Q1 = 100 << Fannie Mae Delinquencies >> 34

35 Quick, efficient foreclosure Efficient, timely enforcement of collateral Average duration is 6 months No obligation to provide new housing Loss will constitute a personal claim DK Efficiency varies Duration up to 7 years in Social considerations given more weight than legal claims Slow repossession means bigger losses EU 35 35

36 Development in bid-ask spread during the crisis I 36

37 Development in bid-ask spread during the crisis II 37

38 Covered Bonds Liquidity Beauty Contest DK * * * * * * * * SE * * * * *? * GE? * *?? * SP * *? *? FR * *? * NO *?? UK * *?? The different liquidity indicators are given by the 9 criteria given below. Criteria 1: Minimum trade volume of the assets. Criteria 2: Minimum outstanding volume of the assets Criteria 3: Transparent pricing and post-trade information Criteria 4: Credit quality steps Criteria 5: Proven record of price stability. Criteria 6: Average volume traded and average trade size Criteria 7: Maximum bid/ask spread Criteria 8: Remaining time to maturity. Criteria 9: Minimum turnover ratio * in the table indicates that data is available. 38

39 Reviews of the Danish mortgage system Moody s: (2002) Moody s believes that Danish mortgage bonds are very strong and very low-risk financial instruments Mercer Oliver Wyman: (2003) The Danish mortgage credit in a European context has high efficiency, low prices and large product offers Bank for International Settlements (BIS): (2004) However, in the Danish case the institutional structure, the regulatory approach and monetary policy together have resulted in a market which, relative to the US market, has shown little or no stress in periods with significant refinancing International Monetary Fund (IMF): (2006) Through the implementation of a strict balance principle, the system has proved very effective in providing borrowers with flexible, transparent and close-to-capital markets funding conditions. Simultaneously, as pass-through securities, mortgage bonds transfer market risk from the issuing mortgage bank to bond investors. Lastly, strict property appraisal rules and credit risk management by the mortgage banks have also historically shielded mortgage bonds from default risk. Shin: (2010) The Danish system of mortgage banks has attracted considerable attention as a resilient institutional framework... Narrow banks would be akin to Danish mortgage banks whose liabilities match the duration of assets perfectly and whose equity provides a cushion for bond holders. Hancock and Passmore (2009) We think implementing a Danish-Type system in the United States would have many benefits International Monetary Fund (IMF): (2011) Denmark has a sophisticated housing finance system with a unuique arrangement of asset liability management that has helped maintain financial stability over the last two centuries 28 February 2012 Complements to Basel 39

40 Absalon Project Services and Solutions... from concept to live operations 40

41 Global Activities USA Obama Refinance Proposal UK Initial Feasibility Study pending The Netherlands Solid Mortgages business plan Dubai/UAE Initial Feasibility Study delivered White Paper issued HiTo Mexico Solution in operation since December 2007 Peru Intial Feasibility Study pending Nigeria Feasibility Study pending Kenya Initial Feasibility Study pending 41

42 Local Stakeholders Government and regulators Local investors Central Bank Securities Commission Pension Regulator Capital Market Pension Fund Managers Insurance Companies Investors Mortgage Credit Intermediaries Banks Building Societies Co-operatives Specialist mortgage lenders Mortgage Collateral Installments Mortgage Service Provider NewCo Capital Bonds Installments Exchange Listing Authority Registrars/Notary Capital Bonds Installments Market Makers Investment Banks Broker-Dealers Other financial Other & Legal Property Register Foreign Investors Federal Mortgage Bank Mortgage Banking Ass. Law firms Trade groups Consumer lobbies = Indirect part in Mortgage Model = direct part in Mortgage Model 42

43 Stakeholder benefits BORROWER Near wholesale interest rates Good range of loan types (fixed or variable rate, callable or non-callable) Lower risk of negative equity trap Attractive prepayment options Easier product comparisons MSP AAA rated, long duration asset class Low cost low risk solution Liquid, large bond series Proven system and support Transparent price discovery and performance history Low cost due diligence and administration Repo asset for cash management BANK/MCI Stable mortgage finance Lower capital costs Transparent ALM Counter-cyclical capital and repo asset class Lower compliance cost and risk Low risk of fraud, mis-pricing or mis-selling Matched ALM for stability Central data reporting and history Low refinancing, contagion and systemic risks No subsidy, guarantees or bailouts INVESTOR SUPERVISOR 43

44 Kathleen Tyson Quah Jesper Berg Absalon Project Nykredit/Totalkredit Managing Director UK SVP Regulatory Affairs and Rating