Mortgage Securitization in Hong Kong

1. Premise – “One precondition for developing a fixed-rate mortgage market was the existence of a fixed-rate debt market.” Explain.

The HKMC accepted both floating-rate and fixed-rate mortgages from banks. One precondition for developing a fixed-rate mortgage market was the existence of a fixed-rate debt market.

A fixed-rate mortgage is a mortgage that has a fixed interest rate for the entire term of the loan. The distinguishing factor of a fixed-rate mortgage is that the interest rate over every period of the mortgage is known at the time the mortgage is originated. The benefit of a fixed-rate mortgage is that the homeowner will not have to contend with varying loan payment amounts that fluctuate with interest rate movements. [1]

The interest rate on a fixed-rate mortgage is fixed for the life of the mortgage. If the market interest rate is volatile (especially when economic turmoil occurred), the demand for fixed rate mortgage would increase since mortgager would concern to pay at very high floating rate. However, in normal economic situation and interest rate is relatively stable, mortgager would prefer floating interest rate since homeowners frequently move or will refinance their mortgages and on average, 30-year fixed-rate mortgages have a lifespan of only about seven years, so usually they do not want to pay high fixed rate to sustain the long-term debt. In this case, no one would want to borrow at fixed rate, the fixed-rate debt market would disappear as well as fixed-rate mortgage market.

1. International Models – Review the U.S. structure for government agency participation in the development and maintenance of mortgage capital markets. Explain the series of steps taken to create the U.S. system. Compare them to the structure adopted in Hong Kong.

In the 1930s, the Federal National Mortgage Association (Fannie Mae) in the United States began purchasing mortgages from commercial banks. Using the pooled mortgages as backing, Fannie Mae issued new debt-based securities. The process was described as a “pass through” arrangement since all receivables on the mortgages passed through to the new security holders. The receivables were the interest and repayment of principal on the loans, which, instead of being paid to the originating banks, passed through to the new security holders via Fannie Mae.

Since the establishment of Fannie Mae, property had become the most common asset used in an ABS deal. During the 1970s, the asset securitization market developed further to cover assets of virtually every class. But mortgage-backed securities (MBS) remained the most common form of ABS. As at the end of 1994, unsecured debt securities and MBS guaranteed by the three key mortgage corporations in the United States [i.e. Fannie Mae, Federal Home Loan Mortgage Corporation (Freddie Mae) and the Government National Mortgage Association (Ginnie Mae)] amounted to US$1,785 billion. By comparison, the outstanding amount of US Treasuries was around US$3,126 billion. In other words, the mortgage market was the second-most important debt market in the United States.[2]

Although the mortgage capital market is mature in U.S., it is not the case in Asia. In Hong Kong, the issuance of MBS began in the mid-1990s. MBS was first introduced in 1988 by Chase Manhattan in the form of a private placement. [2]

The structure adopted in Hong Kong is similar as American model. It is characterized as that commercial Banks selling mortgages to SPV (Special Purpose Vehicle), and then SPV issue securities in its own name. In this way, loans and the issuance of securities are not recorded in the bank's balance sheet. This way can improve the bond credit rating and strengthen the attractive to investors. As for Hong Kong, the SPV is the Hong Kong Mortgage Corporation Limited (“HKMC”), which is established by government in 1997, a few months before the outbreak of the Asian financial turmoil.

The main functions of the HKMC were to purchase residential mortgage loans from banks for its retained portfolio and to fund its purchases through the issue of unsecured debt securities. Eventually, the HKMC could package the mortgage loans from its own portfolio or from loan originators into mortgage-backed securities(MBS), with a guarantee on the timely payment of principal and interest on these securities.[2]

The following chart shows us the structure for Hong Kong and U.S. mortagage market. We can know that they are similar, but the In United States, Fannie Mae purchase mortgages from commercial banks and using the pooled mortgages as backing, issued new debt-based securities, while in Hong Kong HKMC played this role.

[pic 1]

1. Emerging Market Issues – developing markets may have tax, regulatory and legal impediments to the creation of new products. Review the situations in other Asian countries and indicate what were the principal problems and the necessary steps for solution. What were the issues in Hong Kong?

While ABS was mature in the United States and Europe, the development was still in its infancy and success was limited in Asia. [2]

Compared to U.S., the Mortgage Securitization is Asia has principal problems:

(1) Lack of liquidity. The absence of big and active foreign investors and a sophisticated

investor base had also hampered the development. [2]

(2) Lack of investor confidence and regulatory and tax issues were some obstacles that hindered the development.

As for Hong Kong, it also has these problems. The First individual institution to securitize mortgages had failed. The lack of conformity of the underlying pool of mortgages and the heterogeneity of issues had kept many potential investors away from the MBS market. There was little liquidity as the MBS were not listed on the Stock Exchange.

And then Hong Kong Government established the Hong Kong Mortgage Corporation Limited (“HKMC”) under the Companies Ordinance. The Government injected corporation’s initial paid-up capital of HK$1 billion through the Exchange Fund. This was later increased to HK$2 billion in September 1998, and it was planned that an additional capital of HK$1 billion would be made available to the corporation if special needs arose. The establishment of the HKMC was expected to entail significant benefits to Hong Kong in terms of facilitating the development of the local debt market and the secondary mortgage market in Hong Kong. [2]