Mortgage Securitization in Hong Kong

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- Suitability – asset-backed securities have become a major element of the capital markets in the U.S. and elsewhere. What were the predecessors in the use of assets as credit and income enhancements of debt instruments – in the corporate debt market? – in the state and municipal markets? What are the characteristics of mortgage securities which make them effective as a class of asset backed securities?

An early prototype of the ABS model kicked off in Prussia, after the seven years’ war destroyed farmland in the mid-18 th century. The war had left landowners in desperate need of capital. In response to the crisis, the government organized landholding pools and issued Pfandbriefe(an early form of mortgage bond) worth up to half of a property’s value. Borrowers paid interest and principal to the pool, which in turn paid the bondholders.[2]

Characteristics: housing is a kind of long-term assets, so mortgage securities are a kind of long-term investment, which makes it stable (especially at a fixed rate). mortgage securities have low default risk, borrowers typically have a good credit rating. In addition, borrowers can make interest and principal payments separately.

- The Government of Hong Kong was very motivated to develop the mortgage market. Explain its interest in terms of the advantages for the economy of Hong Kong; the requirements of consumers; the status and sophistication of the capital markets; and the stability of the banking system.

(1) Diversify funding sources and promote the liquidity of cash flow. Since the housing assets are illiquidity, mortgage markets can help promote the liquidity of cash flows and increase current cash flows, which benefits both real estate markets and banks, further facilitates the development of the local debt market and the secondary mortgage market in Hong Kong.

(2) For borrowers, they need a great amount money to buy house or do other investments, mortage enable them to do so by providing free cash flows. For investors who invest in MBS, the MBS market itself is generally less risky than other markets, this should be a good alternative for individual as well as institution investors.

(3) The MBS market itself is generally less risky than other markets. Mortgage market increases liquidity and bring high growth potentials to capital markets. There would be more confidence in capital markets, since government inject money into market and increase liquidity.

(4) Real estate industries need the money and circulation through the financial markets to finance a lot of money. While traditional financing system cannot meet the new needs, too large size of the loan would affect the bank's capital structure, which would triggered the financial crisis. Long-term loans by MBS to pack and issue securities sold to social investors can not only reduce stress but also can transfer Banks from simple business to the intermediary business, as well as keeps liabilities off books.

- Commercial Bank Participation – commercial banks and specialized housing banks were the major potential participants in providing the assets for the mortgage market. Explain the potential advantages of participation for the Hong Kong institutions. Outline the actual advantages which were provided to the institutions by the structure provided by the Hong Kong Mortgage Corporation.

The mortgage securitization would benefit both the servicing bank and the HKMC Since a servicing bank was entitled to purchase back the MBS securitized by mortgages, its cashflow position would not change much before or after the securitization. Moreover, a servicing bank was entitled to an annual servicing fee of 0.5% on the outstanding balance of the mortgage loan. Thus, a servicing bank was essentially paying the HKMC a fee for credit enhancement (guaranteed timely payments) and for securitizing mortgages for them. Other attractions of the scheme for the participating banks had been identified as follows:

• The minimising of credit risk exposure, since the MBS were guaranteed by the HKMC.

• The release of capital by converting the 50% risk-weighting mortgage loans into the 20% risk-weighting HKMC’s guaranteed MBS under the capital adequacy regime.

• MBS issued under the program qualified as liquefiable assets under the Banking Ordinance. The arrangement therefore provided a useful balance sheet management tool for banks in Hong Kong.

• Banks could maintain relationships with customers for cross-selling opportunities

• In comparison with the issuance of MBS on their own, joining the MBS program organized by the HKMC seemed to be quicker and less costly.[2]

As the following chart shows that banks and HKMC can earn fee from this process.

[pic 2]

- Alternatives – How would the Hong Kong Government system compare to one in which banks remained in control of direct sale of mortgages to investors? How would it compare to a privately organized system in which securities companies packaged mortgages for sale to investors?

HKMC intended to include two common products in the program, at least initially:

(a) single-class MBS with HKMC’s guarantee on repayment of principal and interest; and

(b) multi-class MBS with credit-enhancement provided through segmentation of the issue into senior and junior tranches, or reserve fund/over-collateralization program. [2]

Therefore, compare to direct sale of mortgages to investors, Hong Kong government system bring more guarantee and credit, so investors may be more confident to invest in. In addition, government invest money into this program, which promote liquidity as well as confidence in investors. Although there is extra fee passed on to investors, the system could facilitate the development of the mortgage market.

- Capital Markets functions – the HKMC appointed four banks as market makers for mortgage securities. Explain the importance of market trading for the success and expansion of the mortgage activity in Hong Kong’s capital markets.

To create a liquid market, the HKMC appointed four banks as market-makers for these issues. The quoting of bid and offer prices by these market-makers would help to establish a secondary market for MBS. The buyers of the first two issues had agreed to support the HKMC’s move by selling all or part of their portfolios to help generate liquidity.

If lacking market trading, no investors buy MBS in