Despite numerous attempts, there have been limited successes in introducing mortgage securities in emerging markets on a significant scale. There are two major reasons for this result. First, the infrastructure requirements for mortgage security issuance are demanding, time consuming and costly. As discussed below, there are complex legal and regulatory pre-requisites for mortgage security issuance. It takes time and significant government support to develop the proper legal and regulatory infrastructure. This infrastructure also adds to the cost of funding through securities issuance, often making it uneconomic.
There are also challenging primary market requirements. Although not inconceivable, it is highly unlikely that mortgage securities can be successfully issued in countries with weak and under-developed primary mortgage markets. There must be a modicum of standardization in mortgage instruments, documents and underwriting, reasonable standards of servicing on the part of lenders and issuers and professional standards of property appraisal. Capital market funding can provide a strong incentive to improve primary market standards in these areas, but there can be no substitute for a certain degree of market development preceding introduction of new funding vehicles.
Even in countries with reasonably well-developed primary markets there has been spotty success introducing mortgage securities. A major reason has been a lack of issuer need for capital market funding. Lenders seeking to access the capital markets through mortgage securities do so in order to better manage capital and risk and to lower cost and diversify funding sources. In most circumstances, the cost of wholesale funding through mortgage securities is higher than retail funding, at least in terms of the relative cost of the debt. If lenders are not capital or liquidity constrained, they may view mortgage securities as excessively costly and complex. Alternatively, some lenders confronted with serious financial constraints and therefore strongly motivated have managed to overcome the obstacles against the development of securitization.
In some cases, the mortgage security design has perhaps been overly complex for the environment. Mortgage securities can be complex or simple products or structures (mortgage bonds, agency bonds, securitization, structured finance etc.), differently stripping and pricing the related credit and/or market risks. The use of particular instruments needs to be in line with the standards and prerequisites of investors and the underlying legal infrastructure, as well as the funding and residual risk exposure needs of primary lenders. Institutional models should be adjusted to the development stage of financial and mortgage markets. Multiple legal and regulatory challenges must to be addressed, in particular in civil code countries.
Governments have been active in trying to stimulate issuance of mortgage securities in emerging markets. One lesson learned is that government involvement is not a guarantee of success. There must be an underlying market need for capital market funding and investor demand for mortgage securities. Government’s most important role is as a facilitator, removing obstacles to issuance and investment, and strengthening the legal and regulatory environment surrounding housing finance. In a number of countries, institutions with characteristics similar to the government-sponsored enterprises in the US have been created. Although the jury is still out as to their potential role and importance, in most cases they have had at best a modest impact. Policy makers must be aware of the potential risks and distortions to the system that such institutions present. A level playing field and sunset clauses for such government support are important considerations.
Does the limited success to date mean that mortgage securities are not relevant for emerging markets? By no means do we ascribe to this conclusion. Mortgage securities are the vehicle to tap capital markets for funds for housing and can improve the accessibility and affordability of housing and allow lenders to better manage the complex risks of housing finance. In markets with demonstrable need with appropriate instruments and institutions, mortgage securities can make a real contribution to housing finance. We believe that the use of such instruments will grow over time as housing demand increases, as lenders become more capital and liquidity constrained and as investors become more familiar with their risks.
It is important to note that in many emerging economies, interest rate risk associated with housing finance is mostly if not entirely borne by the borrower. In volatile economies it is likely that this restrains housing demand and poses a systemic risk to the system. Institutional investors are often better able to manage such risk, reflecting their ability to invest in proper models and expertise and access markets to diversify and manage the risk. Thus we believe mortgage security issuance in emerging economies will to some degree parallel the introduction of more fixed rate lending options.
