Brick by brick

Mortgage risk


The Mexican government has a problem. Faced with a population explosion – the number of households is set to double by 2020 to 42 million – and only the most basic mortgage market, the government has set about building a system capable of handling the huge demand for mortgages.

Funding this huge growth required some quick thinking considering that banks ceased mortgage lending activities after the 1994 financial crisis, which effectively wiped out mortgages as an asset class. Following the crisis, the only funding available to the newly created sofoles – mortgage banks established in 1994 – came from the federal government and development banks. The government quickly made the mortgage market a priority. In 2001, Fondo de Operación y Financiamiento Bancario a la Vivienda, the government entity charged with funding the housing market, was taken over by a new organisation, Sociedad Hipotecaria Federal (SHF), which was mandated to develop the primary and secondary mortgage market in preparation for the housing market boom.

"Housing has been a very hot topic in this country over the past four or five years. Our current government has been very keen to develop and promote housing," says Jaime Cortina, chief financial officer at SHF in Mexico City.

Interestingly, instead of copying its influential northern neighbour's mortgage agency model, SHF is taking a radically different approach to the US. After methodically studying best practices in the mortgage industry, it is fostering the development of a securitisation market for mortgages. It's still early days, but the market is being supported by issuers and investment banks alike. This year, the market is expected to grow to $650 million.

Most recently, SHF has teamed up with Absalon, which is a joint venture between George Soros, chairman of Soros Fund Management, and VP, a Danish company that provides the technology powering the country's securities and mortgage market. Denmark has one of Europe's oldest and most efficient mortgage markets and the idea is to replicate that system in Mexico. But while proponents of the Danish system view it as the best solution for Mexico's growing mortgage market, not everyone is convinced it can be adapted to the scope and eventual size of the Mexican market.

These developments are coming just in the nick of time, because the Mexican housing market is set to skyrocket. By 2014, there will be nearly 1 million new households created in Mexico annually, which will swell the nation's mortgage portfolio from roughly $70 billion today to $311 billion in 2020.

SHF has come a long way since its establishment in 2001 and it has aggressive plans for the future. Today, the entity acts as a wholesale market mortgage bank. It provides guarantees, mortgage insurance, and long-term funding to financial intermediaries on a matched basis, so that the intermediaries, such as the sofoles, do not take on any market or prepayment risk. SHF hedges those risks through the debt and derivatives markets. But by 2013, SHF will lose its government support and aims to become an AAA-rated institution.

"Our long-term funding should disappear and we will look more like an insurance company and a trading desk," says Cortina. "We want to switch the funding from long-term direct funding to funding where sofoles can access the market through securitisation."

To date, there have been eight securitisations in Mexico, the first hitting the market in late 2003. General Motors Acceptance Corporation (GMAC) has been the market's most active issuer, having completed half the total transactions. GMAC gives sofoles warehousing lines and then buys the mortgages and securitises them; or it buys the mortgages without necessarily having given the warehouse lines, packages and securitises them. SHF wholeheartedly supports this activity, and in turn provides GMAC and all lenders with mortgage insurance that acts as a credit enhancement.

"On the securitisation side, for us it's very important that securitisation vehicles develop. We do not want to copy the US agencies. We do not want to buy the mortgages, structure and sell them. We want the private market to do that," emphasises Cortina.

Mexico's first residential mortgage-backed security (RMBS) came to market in December 2003. That deal was a $53 million combined offering from Su Casita, Mexico's second largest sofole, and GMAC.

"We came to market in a very academic manner," says Mark Zaltzman, finance director at Su Casita in Mexico City. "We did research and interviewed quite a few investors to determine the longest tenor they could handle and the desired duration. After gauging what the investor appetite was, we designed a product that would meet that."

The issuers and their investment bank, Credit Suisse First Boston (CSFB), found that, much as they expected, investors wouldn't take any paper much longer than five years. The solution to funding 25 to 30-year mortgages in five years was to introduce a so-called turbo feature, whereby all the excess interest (or excess spread) that came into the deal was used to pay down the principal and shorten the average life.

"Since the first deal, investors have become more comfortable with the credit and the structure. Now they are investing in bonds that are double the average-weighted life of the first issue; as much as 10.5 years," says Sue Romo, director in Latin American capital markets at CSFB in New York.

The deal was placed with 12 investors and since then the investor base has grown, with the most recent deals attracting interest from outside Mexico. However, the Mexican RMBS market has been slow to take off. After the first deal from Su Casita and GMAC, only three deals were priced in 2004.

"We didn't see many mortgage issues in 2004, largely because many sofoles were weighing merger and acquisition offers," notes CSFB's Romo. "But this year, people have been focusing on coming to the market, standardising structures and trying to boost liquidity."

Slow growth

There have been four RMBS deals so far this year, with potentially two or three more to come. Market players aren't discouraged and predict the market will grow, if slowly. In addition, some believe deals may begin to be priced in US dollars or euros as international investors become more interested in Mexican mortgage paper.

"It's important to recognise securitisation has been an industry-wide effort over the past 10 years," says Mauricio Jannet, a director at GMAC in Mexico City. "Since the sofoles started accumulating assets, there has been an industry-wide push to get this to be a reality. It's still in the development stages, but every year we're seeing more and more transactions coming to market."

The structure of RMBS deals has also developed. Now, instead of having the turbo feature, the latest bonds are pass-throughs, which is the simplest form of mortgage bond. In a pass-through, all principal and interest payments from the mortgage pool go directly to the RMBS investors and any excess spread flows to the subordinated piece of the deal. In the pass-through structure, investors assume market, prepayment and some credit risk.

"We want securities to be homogeneous," says SHF's Cortina. "If we complicate the market too much, we're going to segment even more and it's going to be even more difficult to develop."

To promote liquidity in the secondary market, SHF started a market-making initiative whereby it, in conjunction with several investment banks, commits to making a market in RMBSs if the bonds meet SHF's criteria. Homogeneity is key to the market-making criteria. SHF wants the bonds to be AAA-rated, true sale and pass-through structures. If the bonds meet these criteria, SHF will bid for up to 100% of the bonds, guaranteeing the securities will be sold. SHF encourages the investment banks to make a market in mortgage securities by guaranteeing it will make a repo market in the securities. So in the event a dealer is allocated securities during a sale, it can turn to SHF and repo them if need be.

Issuers such as GMAC and Su Casita say there is a need for more information in the market to attract new investors and improve pricing. "We need as an industry to produce the data that's required by investors in order for them to make decisions," says GMAC's Jannet. "As the information gets better, the pricing can be better analysed, which in turn provides better and cheaper products for borrowers. That is the point of this whole industry."

Su Casita's Zaltzman is particularly concerned about the availability and depth of prepayment data: "Investors are still not aware of prepayment and that's still the biggest question mark in this market."

Improving information quality and data availability is an area SHF is addressing, says Cortina. SHF already has the best database in the market and makes it available upon request on a confidential basis. However, there are plans to publish data on SHF's website next year. SHF is also working on increasing the information available and standardising it to make it more accessible.

As part of its investigation of best practices in mortgage markets, and through an initiative started by the US and Mexican governments called Partnership for Prosperity, SHF was introduced to George Soros. Through his philanthropic programmes, Soros has been promoting the Danish mortgage system as a solution for emerging market countries seeking to develop mortgage markets.

Most recently, Soros and VP, the company that provides the system running the Danish securities industry, have joined forces to create Absalon, which will develop mortgage credit systems and securities infrastructures in emerging markets. "Our proposal was working from the idea that because you've got to have a big bond market, why don't you figure out the most standardised and efficient way to get there," says Alan Boyce, chief executive of Absalon. "It is our hope that some or all the attributes we've brought to the table will be used to create that bond market."

What Absalon is bringing to Mexico in partnership with SHF is the technology that will permit local mortgage lenders to replicate the Danish mortgage bond market. Danish mortgage bonds are pass-through securities based on the balance principle, where the bonds are backed by the same cashflows that are paid by the homeowner. So, all payments made by the borrower go directly to paying down the bond. Borrowers can prepay at any time, either by purchasing the bond in the market or prepaying at par. What the VP technology does is link the loan to the bond.

"In a joint venture with SHF, we will make those systems available to whoever wants to use them," says Boyce. "This cannot be understated. We and our partners at VP are not going to pick the companies in Mexico that can use the software. Everyone can use it."

The idea is to get a few sofoles signed up for a pilot programme, and those that participate in beta-testing of the systems will probably get a discount. Boyce says the cost for using the software will be quite low in any case. Currently, Absalon is in talks with a few sofoles interested in beta-testing and hope to have them signed up soon.

The Danish model could certainly bring some stability to the Mexican mortgage market. Prior to the 1994 financial crisis, Mexico had a functioning mortgage market, with few foreclosure issues. What killed the mortgage market and caused so many defaults was that all the mortgages were indexed to inflation. When inflation ballooned and wages remained unchanged, mortgages as an asset class were essentially wiped out. Currently, the SHF is promoting mortgages indexed to inflation with a minimum wage swap, as well as fixed-rate mortgages. These two products are unlikely to cause the homeowner to default in the event that inflation or interest rates take a sharp upward turn.


In Denmark, the balance principle links the bond to the loan in perpetuity, so if interest rates go up, the value of the bonds drop. From the homeowner's point of view, the value of their liability will also drop. "The balance principle is the part that only the Danes do and what holds that together is the software systems," says Boyce. "In a country like Mexico, having this balance principle is probably more valuable than having it in Denmark."

While Mexico has come along way economically since 1994, it is still an emerging market prone to financial shocks. "If seven years down the line there are a significant number of balanced principle mortgage loans in Mexico and foreigners run away from peso assets, homeowners will benefit because they can go and buy back their liabilities at a discount," says Boyce.

For example, if a homeowner took out a 9% fixed 15-year mortgage and rates went up by 100 basis points, using the Danish system the corresponding bond would go down to 80, giving the homeowner a number of options. He or she could try to pay off the mortgage, curtail it by buying back some if it at 80, or take out a new market rate mortgage at 80% of the balance and pay off the old one.

"I would love the Mexican market to work the way the Danish one does. It's the most efficient model there is. It's more efficient than the American model," says SHF's Cortina. "It's cheaper, because everything is done through the same vehicle. You don't need warehousing lines or derivatives."

Cortina emphasises, however, that the SHF does not want to settle on one mortgage funding system for Mexico – that RMBS and the Danish model could coexist. He also believes it could take some time for the Danish model to gain traction, perhaps up to 15 or 20 years. It is possible that other mortgage funding models could develop as well, he adds.

Johannes Luef, president and chief executive of VP, is very optimistic about his system's success: "The first Mexican mortgage bonds will be issued a year from now and in two to three years the market will reach $100 billion in size." Others have put forward lower estimates. Cortina, for one, believes the Danish model would be very successful if it reaches $10 billion in three years' time.

Of course, there are naysayers who believe the Danish model won't work in Mexico, and there are sofoles that for now say they want to stick with their own securitisation models. Banks are also getting back into mortgage lending for the first time since 1994 but, for the time being, they are opting to keep these assets on balance sheet.

The Mexican mortgage market is going to have plenty of room for competition and different ways of accessing funding. Whether one model prevails over another in the market isn't the point. Finding ways of raising $300 billion over the next 15 years means SHF must look at all the best options available.

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