The EMFA says a EU-sponsored entity – like the US’s Fannie Mae or Freddie Mac – would help to create a continent-wide, liquid, mortgage-backed securities (MBS) market. This, its proponents say, would give homeowners cheap fixed rate loans, remove credit risk from banks’ balance sheets and provide standardised instruments for investors.
But the proposal has brought a storm of criticism that European government-sponsored entities (GSEs) would damage the development of existing covered bond and mortgage-backed securities markets. Critics have been almost universal in criticising a dirigiste American model that would choke a successfully developing freewheeling European system.
In this latest game of skittles, say critics, policy makers should “strike out” Fannie Mae and turn their attentions to smoothing the way for European innovation.
GSEs stifle innovation
The trade association, European Mortgage Federation (EMF), is scathing about the GSE system and its detrimental effect on competition and innovation. “If the EMFA did not support a mortgage provider’s new product, they would not be able to securitise it and therefore they would not be able to offer it at a competitive price because non-securitised products would not receive the subsidy implicit in the state guarantee. As a result, there will be fewer products around and these products will become more standardised,” says Judith Hardt, secretary general of the EMF, in Brussels.
Berlin-based financial services consultant, Hans-Joachim Dübel, is equally dismissive. He says that at the same time as stimulating excessive product standardisation, there is a widespread notion in the US that Fannie and Freddie “overcharge” for the services they perform and thus form a “price setting duopoly” in the mortgage market.
“Loans carrying any form of prepayment indemnity are not purchased by them. Flexible mortgages are not supported. Due to the fringe benefits that originators obtain from dealing with the duopoly, alternative credit guarantee products have little success or are limited to niche markets,” says Mr Dübel.
Framework from US agencies
The proposed model rests on the creation of a new European institution, the EMFA, a private entity “sponsored” by an implicit guarantee from the EU. It is framed largely on the US system – although Rob Thomas, general manager of the EMFA project team, is careful to point out that the US is not unique in this approach, which is shared by Canada, Hong Kong, Japan, Malaysia and Korea.
The US agencies, Fannie Mae and Freddie Mac, which began life as GSEs (but which were privatised in 1989 and now operate with an implicit government guarantee), were created with the mandate to increase home ownership. They have done this by creating a national mortgage market: buying mortgages from originating banks, packaging them as mortgage-backed securities and selling them to the capital markets. In the process, they take the mortgages off lenders’ balance sheets, provide them with further funding and pass on the prepayment risk to investors. Standing in-between lender and investor, the agencies take on the credit risk by guaranteeing all payments to investors.
Rob Thomas, general manager of the EMFA project team, says the fundamental strength of the US system, and of the EMFA proposal, is the link between the capital markets and mortgage rates: risk is taken by investors who choose to do so rather than homeowners who have little choice. In Europe, he says, almost 70% of mortgages are funded by retail deposits, which skews the lending model towards short-term, variable rates.
“Retail depositors are not willing to commit money for 30 years but institutional investors are. And, when you create a large liquid, standardised secondary market of this nature, it allows the risks to become tradable in their own right. It creates a more transparent market in which participants are able to price risk more accurately,” says Mr Thomas.
Larry Dyer, director and head of agency strategy at Credit Suisse First Boston in New York, agrees about the case for homeowners: “Homeowners should not be expected to hedge the interest rate risk on their mortgages. If they had the inclination to do that, they would be bond traders.”
But a question remains about the assumption that the US GSEs are the primary force behind the liquidity of the secondary market or the country’s 30-year fixed rate mortgages. Alan Brazil, managing director and global head of mortgage research at Goldman Sachs in New York, believes that, while the GSEs may have enhanced liquidity, its existence is a function of the sheer size of the US market – in 2003 about $3000bn of mortgages were originated and the ultimate size of the market is estimated to be up to $7000bn. Similarly, he says, the tradition of long-term fixed rates is simply a legacy of the US market’s evolution.
“Historically, due to the steepness in the US yield curve, US mortgage institutions, such as the thrifts and the banks, have based their earnings on the spread between the asset yield and the liability yield. Banks in Great Britain, for example, have never really looked at the yield curve as a stable way to generate earnings, and instead build their business models on the spread between the floating rate mortgage assets less their floating rate liabilities,” says Mr Brazil.
Is KfW stepping into the gap?
While the EMFA has been writing its business plan and courting supporters, Kreditanstalt fur Wiederaufbau (KfW), a German bank that is 80% owned by the German government and 20% by the Bundeslander, has made a move on its territory. KfW is already securitising retail mortgages via its Provide platform, based in Dublin, and is backed by a government guarantee. The structure, however, is different: it takes the credit risk of a mortgage portfolio via credit default swaps and hedges the risk in the capital markets by selling credit-linked notes.
Crucially, it has expanded beyond the German issuance that it was created to foster and has completed two synthetic MBS transactions for foreign banks: first for the UK’s egg bank and then, in November 2003, for the Netherlands’ NIB Capital Bank.
Is KfW stepping niftily into the vacuum left by the lack of a pan-European MBS platform? “[That] is going a bit too far,” says Dr Dieter Glüder, head of securitisation at KfW. He says synthetic structures have always been appealing in Germany due to the legal environment, and are particularly attractive for banks that are more interested in risk transfer than funding. But recently, he says, there has been increasing interest in synthetic securitisations from other European banks.
“It is also in KfW’s interest to deliver an efficient platform for risk transfer to European banks that are active in housing finance, since that will broaden acceptance in the investor base and liquidity for Provide. This is a contribution to the European RMBS [residential MBS] market, whose strengths are derived from the diversity of originators and structures.”
KfW does not like to be called a GSE in the same vein as Fannie Mae or Freddie Mac, saying that comparison to other institutions in the US is difficult given the different institutional settings. However, the bank did admit that its platform addressed one of the major challenges facing Europe. “The platforms could contribute to compensating for the fragmentation of the European securitisation market, which has resulted from the various national legal systems,” says Dr Glüder.
Germany has another project up its sleeve, the outcome of which was still under discussion as The Banker went to press, but which some believe could also emerge as a pan-European contender. Through KfW, the German state has joined with 12 other German banks in the True Sale Initiative to set up a joint company for securitising loans, and is supporting the initiative by lightening the tax burden on securitisation by exempting transactions from local professional taxes. Its main objective is to optimise German solvency ratios and to gain better access to new investors and sources of funding. But some ask if, like Provide, it will extend beyond Germany to offer its services to foreign banks. KfW declined to comment ahead of any formal decision.
There has been no official response on what German taxpayers think about effectively guaranteeing non-German MBS transactions. “There has been no real debate about it, because banks love the [KfW] deals because of the regulatory benefits the transaction with a zero-risk-weighted institution provides. There has been no public discussion of the issues,” says Mr Dübel.
KfW will only say that it is acting in the interests of the German and the European economy, in which it is free to act within the EU or to co-operate with national and supranational institutions in the EU. “So offering our securitisation platforms to non-German, European banks is perfectly in line with this aim and is just another way to fulfil the mission given to KfW,” says Dr Glüder.
Judith Hardt: “Implicit public guarantees distort competition”
GSE has defenders
While the initial response to the EMFA proposal has been largely negative in Europe, the US GSEs do have some defenders. It is true, says Mr Dyer, that GSEs tend to impose their “view” on the market place; for example, their view of credit becomes the de facto standard because of the sheer size of their operations. This means that if a bank wants to use what it believes to be a better credit risk model, it may make mortgages originated under that model ineligible for agency purchase.
That said, he stresses that at least the market has “safety and soundness”, and, crucially, very deep liquidity. “Many believe that these attributes outweigh any disadvantages. At least the GSEs mortgage liquidity has knock-on benefits for the mortgage market that 10 different banks using 10 different credit risk models would not,” he says.
Mr Dyer believes criticism of the GSE model, including that by the US Congressional Budget Office, ignores the knock-on benefits to mortgages that fall outside of the agencies’ purview. “For example, when the US mortgage market became so big and so liquid because of the role of the GSEs, it became possible to hedge those that are not qualified for agency purchase, because they are about 98% correlated to how Freddie and Fannie mortgages trade. And, because they are able to be hedged, the risk premium drops. Liquidity cuts the cost of hedging and therefore the cost of credit.”
The EMFA’s Mr Thomas agrees, and argues that there are additional benefits to be derived by the creation of a GSE. He says their presence had the effect of “unbundling” the US market so that origination, mortgage servicing and funding are separated, and in the process has facilitated the growth of specialisations, such as mortgage insurance and large-scale servicers. He says the transparency of the US market has driven efficiency: origination stays with the relationship bank but it can choose whether or not to continue, servicing the mortgage for a fee or sell the servicing rights to a servicing factory. “In the US, the lender knows exactly how much servicing costs – or earns for – the business. The European model is largely based on internal pricing, so few providers have an accurate picture of how much it costs them to service a mortgage,” he says.
Lawrence Dyer: ‘At least the GSEs mortgage liquidity has knock-on benefits for the mortgage market’
Europe is evolving anyway
But European markets are becoming more efficient without intervention, argues John Dziadzio, head of northern European agency business at Lehman Brothers in London. As well as the evidence that mortgage providers are increasingly using covered bonds and MBS to diversify their funding strategies, he says unbundling is already beginning to happen. The UK’s Abbey National has outsourced its loan administration services to a joint venture with EDS, while GMAC-RFC and Kensington Mortgages outsource the servicing of some of their assets to Home Loan Management Ltd. “In a multi-jurisdictional environment like Europe, this kind of development must occur within one jurisdiction before it can become a cross-border phenomenon,” says Mr Dziadzio.
And many of the other so-called GSE-related benefits are achievable without the intervention of a government-backed agency, according to Matthew Sebag-Montefiore, director at consultancy Mercer Oliver Wyman. Speaking at the Eurocatalyst conference in November last year in Lisbon, he said: “The same sort of credit enhancement and risk distribution offered by Fannie Mae and Freddie Mac can be achieved in the existing secondary markets. And European secondary markets are rapidly increasing in size without the backing of a GSE.”
The EMF also believes that organic evolution is best and is well under way. It has come out strongly against implicit “public guarantees”, saying they create distortions of competition and threaten the existence of some of Europe’s more mature and stable capital markets by allowing access to cheaper funding. That is not a new stance: two years ago the EMF lobbied against Freddie Mac’s inclusion on the EuroMTS bond trading platform, accusing the agency of profiting from having access to cheaper funding at the same time as being a private enterprise.
The federation cites the evidence of already vibrant secondary markets in Europe. Since 1987, it says, the MBS market has grown by 61% per year and now accounts for more than E260bn. Similarly, the European covered bonds market now accounts for more than E1500bn of funding, representing about 17% of the continent’s overall bond market.
“These markets have not benefited from public guarantee,” says Ms Hardt. “They have grown because of the quality of the loans that they fund and the sound management of the issuing banks. A publicly-backed agency would be severely damaging for these markets because it would have access to cheaper funding. We believe fair competition is the only way for the market to evolve.”
The arguments against a European Freddie Mac are convincing. If Europe has increasingly liquid, if varied, MBS and covered bond markets, what can be gained by the introduction of a synthetically-created, government-backed entity? Europe is not facing the market failure that spawned the creation of the US agencies – they emerged in 1937 to address a reluctance by private companies to provide mortgages during the Depression and later served to end regional disparities and bail out the Thrifts during the crisis in the 1980s.
“[The GSE’s are] a throwback,” said Karen Lissakers, adviser to George Soros and US executive director on the executive board of the International Monetary Fund from 1993-2001, speaking at the Eurocatalyst conference.
Even Mr Dyer, who champions the benefits they have provided to the US, believes they are now something of an anachronism. But as long as Congress believes that the GSEs are run in a safe and sound manner, he says they will be treated like the appendix: “It is an organ you no longer need but you are not going to volunteer to have it removed.”
John Dziadzio: ‘European markets are becoming more efficient without intervention’
The Danish principle
If European financial markets reject a Fannie Mae approach and baulk at the idea of a German-sponsored, pan-European platform, there is always the Danish mortgage model. It is funded up to 98% by mortgage-backed bonds, issued on the balanced principle: mortgage loans are pooled and bonds with the same characteristics as the underlying loan are issued on a daily basis, minimising risk arising from interest rate and maturity mismatches.
Ms Lissakers is a devotee: “[The Danish market] is transparent, highly efficient [and] with costs among the lowest in Europe, without government subsidy,” she says.
Margins are tight, at about 50 basis points. Jan Knosgaard, deputy director of the Association of Danish Mortgage Banks, RealKreditraadet, says: “We achieve these kinds of economics by running the mortgage business in the same way as a wholesale business. Also, we don’t do a very detailed credit check on the borrower; the loan is based on the property, not the borrower.”
To support this approach and to protect the investor, the foreclosure process is speedy. In contrast with France, say, where it can take several years to foreclose, Danish properties can be repossessed in less than six months. This is the price that is paid for an efficient system, acknowledges Mr Knosgaard.
Ms Lissakers is such a fan of the Danish system that, in an advisory capacity to the Mexican government on how to revive a mortgage market decimated by the 1994-95 currency crisis, the Soros organisation proposed the Danish model as the framework and approached the Danish central bank and mortgage institutions for their help with the project. According to Ms Lissakers, Mexico has since abandoned its plan to adopt the US system.
Niels Třrslev, CEO of Danish mortgage bank Totalkredit, which has been involved in the process, says Mexico essentially needs foreign investors to drive housing development; in addition to a cost-efficient model, Mexico is looking for the most loan/loss efficient framework in which to present borrowers to investors. “The Danish balanced principle, and the legislative framework behind it eliminates risk from the system. Danish bonds, mostly rated triple-A, are instruments with which you can go to market with as little risk as possible and the best credit rating,” he says.
At the UK’s HBOS, Phil Jenks, head of mortgages, favours the Danish model over that of the EMFA. He says it is the most efficient market worldwide. “The operating profits are so small that there is no room for intermediaries to enter the market. By comparison, the US, if you take into account the servicing fees etc, runs on margins of 125-150bp.”
The question is, says Mr Jenks, whether or not a bond market could be created that is as liquid as the Danish, without drastic regulatory changes, over which he believes there would be a long debate in the EU. That said, he believes that, as the UK market evolves, at least, “it is more likely to follow the Danish model than anything else”.
But even the Danes have their detractors. Some argue that while the Danish market performs well in terms of generating a complete set of products to match borrower needs, on the funding side, it would be much more difficult to apply the model to the rest of Europe because it would eat away at existing profit margins. “I don’t believe that other European mortgage lenders would like to be as tightly regulated or as constrained in terms of risk taking as the Danish mortgage credit institutions are. For example, the strict cover principle implies that Danish institutions have to pass on all interest rate risk to investors, a significant source of income and profit for mortgage lenders elsewhere,” says Mr Dübel.
Eurozone inconsistencies
The EMFA proposal has clearly been timed to resonate with the aims of some European governments and the EU’s aim for an integrated financial market. The UK’s Chancellor of the Exchequer, for example, recently stated that British homeowners should have access to 30-year, fixed-rate products to promote greater stability in the UK housing market, and the Treasury is looking into how this could be achieved. Equally, further European integration is hampered by inconsistencies between member countries.
Certainly, there is a disconnection between common currency countries’ financial systems – and with some of those outside the eurozone. Homeowners in Germany and France, for example, which operate predominantly on fixed rate mortgages (albeit not as flexible as the US version) benefit from far greater protection from the impact of interest rate rises than those in Ireland, Spain, Italy and the UK, where variable rate products are the norm. “This creates a disconnect between the impact of monetary policy in each country and makes the EU’s aim of economic further integration more difficult, if not impossible,” says Mr Thomas.
The US housing market has certainly been a more effective vehicle for monetary policy. According to Ms Lissakers, US homeowners refinanced about $1700bn of mortgages in the past year. Adding equity cash-outs and home equity loans, she believes this put about 7% of the country’s GDP into homeowners’ hands and has been instrumental in cushioning the world’s mightiest economy during the downturn. By comparison, fragmented European markets lead to asymmetric transmission of monetary policy and blunt any attempt at monetary easing by the European Central Bank. In this light, it is almost certain that the UK government will not take the UK into the euro at a time when consumer debt is at an all-time high, there are concerns over a housing bubble and interest rates are on the rise.
All market participants agree that the major barrier to any further integration lies in disparities in national legislative frameworks and individual tax regimes. Drew Ertman, managing director and head of agency business at Morgan Stanley, says: “There would need to be considerable legislative reform to create harmonisation around tax, property and consumer protection laws before any kind of further integration or pan-European entity could be created. Differences in foreclosure regulation, for example, are crucial in developing the MBS market, and there are variations in what is tax deductible and what isn’t across Europe. You cannot have a single MBS market if all the securities are grounded in disparate frameworks.”
European governments have in the past been accused of inaction and insularity in their failure to achieve greater integration in the EU. This charge has raised its head once more and this time Ms Lissakers includes European mortgage players in the attack. While she is a vigorous opponent of Europe adopting US-style GSEs, she does believe that a harmonised, unified, flexible and securitised pan-European mortgage model is possible. “Only inertia and parochialism stand in the way,” she says.
Lack of incentive
Mr Dziadzio agrees that narrow national interest is preventing the further integration of financial markets – whether via a pan-European entity or organic evolution. He says that vigorous local competition means that at the domestic bank level there is no incentive for the creation of a GSE or to change the existing borrowing and lending model.
“In the US, the GSEs levelled the playing field between originators,” says Mr Dziadzio. “It makes little or no commercial sense for large European incumbents to support an initiative that does so, or to challenge the status quo. If European banks can already access the capital markets to get cheaper or diversified funding, where is their incentive to change the mortgage model?”
At HBOS, which last year issued its first structured covered bond into Europe and which issues MBS into the US market, Mr Jenks denies that the existing European model gives preference to ‘larger’ players. “There are European lenders of all sizes tapping the international covered bond and MBS markets – and without the need for a GSE sitting between borrower and investor.”
And Mr Jenks is not yet persuaded by the EMFA proposal. “Add our deposits to our capital markets investor base and we already have a deep and diverse funding pool, at a very competitive cost. What the EMFA is proposing is emerging anyway,” he says.