There are two types of mortgage loans: adjustable-rate mortgage and fixed-rate mortgage (Green, 2013). The interest rate of a fixed-rate mortgage remains unchanged for the whole term of a loan; therefore, it is not influenced by fluctuations in the market. An adjustable-rate mortgage, on the other hand, is associated with the change of the interest rate over time. Taking into consideration the fact that a fixed-rate mortgage does not transfer risk from a lender to a borrower, it is more expensive. In the countries like the United States, fixed-rate mortgages have existed for a long time. However, in Hong Kong the development of a fixed-rate market has started only after the establishment of the Hong Kong Mortgage Corporation Limited (HKMC) in 1997 (Ho, 2001). HKMC facilitated the backing of fixed-rate mortgages by fixed-rate debts. Therefore, it could be argued that existence of a fixed-rate debt market was one of the preconditions for the creation of a fixed-rate market (Ho, 2001).
A government agency called Fannie Mae started purchasing mortgages from commercial banks in the 1930s (Ho, 2001). Immediately after the purchase, the agency pooled all mortgages and issued debt-based securities which were later sold to new security holders. The receivables of the securities were “the interest and repayment of principal on the loans” (Ho, 2001, p. 2). The establishment of the government agency helped to transform asset-backed securities (ABS) market into the one that covered not only residential mortgages but all types of assets.
Unlike the United States, Hong Kong started securitization only in the late 1980s (Ho, 2001). Mortgages were secured by private agencies such as Manhattan Card Company, Bank of America, Citibank, and Standard Chartered Bank (Ho, 2001). Due to the fact that separate entities could not create homogeneous issues, the MBS market in Hong Kong could not attract a sufficient number of investors. Active government participation in the development of mortgage capital market started in 1997 with the establishment of HKMC (Ho, 2001). It allowed developing secondary mortgage market as well as introduce a new type of loan—the Fixed Adjustable Mortgage (FARM) (Ho, 2001).
The development of the MBS market in Asian countries was significantly hindered by the lack of foreign and local investors. Mortgage-backed securitization in the Philippines was slowed down because of the low level of investor confidence. Moreover, the country had numerous regulatory and tax impediments to the development of the market. India experienced similar tax problems (Ho, 2001). Furthermore, the lack of strict foreclosure laws and excessively high stamp duties prevented the rapid development of MBS market in the country.
Thailand also had problems with the development of mortgage-backed securitization due to the devaluation of the national currency, lack of foreclosure laws and secondary markets. Unlike India, Malaysia created comprehensive taxation framework that allowed to remove stamp duty and other similar taxes on MBS transactions (Ho, 2001). MBS market in Singapore did not experience significant problems and was promoted by the country’s government. Mainland China seized the opportunity of developing its MBS market in 2000 and saw a yearly growth of mortgage securitization at 69 percent rate (Ho, 2001). The main issue that stopped the development of asset-backed securitization in Hong Kong was the deficiency of homogeneity in the country’s pool of mortgages that was caused by the lack of government involvement.
Before the residential mortgages became a core of the asset-backed security market, “virtually any income-producing asset with an adequate performance” (Ho, 2001, p. 2) could have been securitized. Unlike corporate loans, mortgage securities have comparatively good credit ratings and could also provide capital appreciation in case of falling interests which makes them more effective as a class of asset-backed securities. Cash-flow lending is a predecessor in the use of assets as credit and income enhancement of debt instruments of corporate, state, and municipal debt markets (Green, 2013). Cash-flow lending allowed a borrower to back a loan by their cash flows from either personal or business sources. Unlike asset-backed loans, cash-flow lending does not require an appraisal of collateral because of the lack of involvement of any physical property or assets into the transaction (Green, 2013).
The Government of Hong Kong expected to promote home ownership, further develop banking, and improve monetary stability (Ho, 2001). MBS are believed to be a sufficiently safe investment that has credit worthiness of treasuries its returns are higher. Moreover, the creation of a mortgage market promotes the development of a sophisticated investor base. Consumers benefit from mortgage securitization because it could prevent banks from overcharging for loans. Transfer of risk, high efficiency, and liquidity are other benefits of MBS (Green, 2013).
Commercial banks did not want to participate in providing the assets for the mortgage market; however, HKMC offered them lucrative conditions of cooperation that changed their position on the issue. The participating banks were “entitled to an annual servicing fee of 0.5 % on the outstanding balance of the mortgage loan” (Ho, 2001, p. 6). Another benefit of the participation in HKMC’s mortgage securitization program was the reduction of risk because the government agency guaranteed the MBS. Moreover, the commercial banks could convert “the 50% risk-weighting mortgage loans into the 20% risk-weighting HKMC’s guaranteed MBS” (Ho, 2001, p. 6).
The scheme proposed by HKMC attracted the participation of the banks by offering them less costly conditions of issuing MBS. They could also control the cash flow on mortgages. Furthermore, MBS issued by HKMC could be qualified as liquefiable assets; therefore, the program provided the commercial banks with an effective balance sheet management tool (Ho, 2001). Another attraction of the program for the participating banks was the ability to retain relationships with their customer in order to benefit from cross-selling opportunities.
The actual advantage of the participation in the program was loosening of some purchasing criteria. Specifically, HKMC purchased loans with “a current loan-to-value ratio greater than 90 percent without warranty” (Ho, 2001, p. 7). Nonetheless, one of the conditions of participating in the program was that only 30 percent of mortgages could have had a current loan-to-value ratio exceeding 90 percent. Moreover, the ceiling for a current loan-to-value ratio was set at 120 percent. The core purchasing criteria were “70 percent loan-to-value ratio at origination, owner-occupied status, and no equitable mortgages” (Ho, 2001, p. 7).
The main difference between HKMC and a privately organized system for issuing securities is that the government agency provided MBS with a guarantee. However, HKMC program included an extra intermediary, therefore it had more steps than systems offered by either individual banks or private organizations packaging mortgages for sales to investors (Ho, 2001). HKMC system eliminated issues created by the mortgage price war between private organizations such as the Manhattan Card Company, Bank of America (Asia), Citibank, and Standard Chartered Bank (Ho, 2001). Moreover, numerous individual institutions participating in the securitization of mortgages could not have created conformity and homogeneity of the pool of mortgages. It has led to the lack of interest of potential investors. If private banks could have formed a system for packaging mortgage securities for sale, they would have been able to dispose of heterogeneity issues. Moreover, such organization could have increased the liquidity of MBS by listing them on the Stock Exchange (Ho, 2001).
HKMC created the inaugural issues of MBS that were valued at HK$1.63 billion (Ho, 2001). However, the organization wanted to develop a liquid market; therefore, it has appointed Dao Heng Bank, Deutsche Bank, JP Morgan, and Merrill Lynch as market makers (Ho, 2001). HKMC calculated that “the quoting of bid and offer prices by these market makers would help to establish a secondary market for MBS” (Ho, 2001, p. 8). It was a smart decision on the part of HKMC because higher liquidity of the market results in a reduction of transaction costs.
Moreover, if there is a possibility of quickly selling one’s assets at the current market price, the perceived risk of owning them is much lower for both investors and creditors. Therefore, in order to facilitate an expansion of the mortgage activity in Hong Kong’s capital markets it was necessary to create liquid secondary markets. They helped to decrease risk premiums thereby increasing the value of MBS. HKMC also decided to list MBS both locally and overseas (Ho, 2001). It also contributed to success and expansion of the market because retail investors were able to trade them more easily.
The Asian economic crisis in 1997 created significant changes in the country’s economic conditions (Ho, 2001). It could be argued that the lack of liquidity of regional debt market contributed to the severity of the crisis. Taking into consideration the fact that the crisis stimulated withdrawal of deposits due to the fears of currency devaluation, it is reasonable to assume that numerous banks and private institutions would experience significant pressure on their funding base if the crisis were to last much longer. Protracted crisis also could have led to the significant decline in the growth of the mortgage capital market system. However, the impact of the economic crisis was ameliorated by the establishment of the government system for mortgage securitization.
If I were a senior manager at John Lee’s Bank, I would have been worried about the lack of sophisticated investor base in Hong Kong if the bank were to participate in the government program of mortgage securitization. Moreover, taking into consideration the fact that bond market in Hong Kong was not sufficiently developed at the time, the project could have been significantly hindered. On the other hand, the experience of the United States proves that asset securitization markets hold a huge commercial potential (Ho, 2001). Therefore, I would have decided to participate in mortgage purchase program initiated by HKMC. I would have justified my position to the Board of Directors by telling them that HKMC could have homogenized the market and increased its liquidity by listing MBS on the Stock Exchange. It would have led to the reduction of risk and a higher level of investor participation.
References
Green, R. (2013). Introduction to mortgages & mortgage backed securities (1st ed.). New York, NY: Sage.
Ho, M. (2001). Mortgage Securitization in Hong Kong and Asia. Case Study.