Development of a Mongolian MBS Market Workshop on Housing Finance 28th June 2011 Presented by Jim France

Development of a Mongolian MBS Market Topics covered: Requirements for the Development of an MBS Market Issues Affecting the Development of a Mongolian MBS Market

Requirements for the Development of an MBS Market

Requirements for the Development of an MBS Market Five Critical Factors for Development of a Market Supportive legal, tax and regulatory framework. Established primary market policies, procedures, and operations, and market standardization. Abilities of asset originators to satisfy the preconditions for securitization. Developed capital markets and appetite for MBS. Economic incentives for securitization market participation.

Requirements for the Development of an MBS Market Legal, Tax, and Regulatory Environment. Ability to establish special purpose vehicles (SPVs). SPVs under enabling law. Trusts or similar structures. New companies that can function as SPVs. Ability to achieve true sale or equivalent. Ability to structure a tax neutral transaction. Taxes on transfer of assets. SPV income taxes. Value Added Tax (VAT). No regulatory barriers. Well-informed and effective regulators.

Requirements for the Development of an MBS Market Primary Market Requirements Sufficient volume of homogenous loan product. Standardization Loan products. Loan documentation. Policies and procedures. Availability of historical loan data. Prepayments. Delinquencies and cure rates. Defaults and recoveries Stability of macroeconomic environment. Marketability and liquidity of the lending markets. Sufficient network of quality primary market lenders.

Requirements for the Development of an MBS Market Originator Preconditions for Securitization Loan Origination Sufficient volume of homogenous product Credit Underwriting Established and consistent credit policies and procedures Servicing Established and consistent collection procedures Established and consistent loss recovery procedures Ability to service securitized loan portfolio or to transfer servicing IT/Data Loan tracking and monitoring Investor reporting Cash and account management Availability of data related to the pool to be securitized Availability of historical data related to delinquencies, defaults, recoveries, and prepayments The credit quality of the originator will affect the optimal transaction structure

Requirements for the Development of an MBS Market Capital Markets and Appetite for MBS Essential Capital Market Elements: Existence and depth of capital markets. Interested and active investor base. Investor understanding of MBS. Supportive broker/dealer environment. Efficient and regulated clearinghouse infrastructure. Information service providers. Availability of interest rate hedging, if required Supporting Infrastructure: International standard risk-based capital rules and regulations. Counterparties to facilitate securitization (transaction execution; rating; issuance and placement; settlement). Exchange to facilitate issuance and secondary market trading. Clearinghouse and bond administration processes. Ability to satisfy investor reporting requirements

Requirements for the Development of an MBS Market Economic Incentives for Securitization Lack of liquidity for lenders. Lenders wish to diversify their funding sources. Lenders need or want to manage their interest rate risk and asset/liability mismatches. Lenders need or want to reduce their exposure to a particular asset type or counterparty.

Issues Affecting the Development of a Mongolian MBS Market

Consistent availability of funding through capital markets or loan sales. Supporting legal, tax, accounting and regulatory environment. Easy access of borrowers to finance. Standardization of loan documentation. Standardization of credit policies and operational procedures. Automation of operational processes. Market-based loan pricing. Efficient pricing for secondary loan purchases and capital market instruments. True sales of loans with no recourse. Willingness of investors to accept MBS repayments that match loan repayments and to accept quantifiable risk. Issues Affecting the Development of a Mongolian MBS Market Characteristics of Efficient Securitization Markets

Lenders fund loans from their existing funding sources, primarily deposits. Lending volumes are not consistent. Lending is primarily lending to higher income borrowers for the purchase of apartments; lenders are unsure how to lend to lower income borrowers while maintaining an acceptable risk/return profile. Absence of capital market investors as potential investors in MBS. Lack of interest on the part of lenders to securitize; potential lenders do not appreciate the benefit of securitization. Current secondary market loan sales and securitizations are with recourse to the sellers and primarily associated with swaps of loans for bonds. There is limited standardization of lending criteria, loan documentation or operational procedures among lenders. Current capital market activity is not sufficient to create efficiency. Issues Affecting the Development of a Mongolian MBS Market Current Lending Market in Mongolia

Lack of capital market investors able and willing to buy housing finance backed loans. Availability of finance is not consistent. Lending is concentrated on only one segment of the market. Standardization of lending policies, operational procedures, and risk management is still developing. Lender funding sources are unreliable. There is no systematic method to price loans. Current secondary market sales are cosmetic; there is no true risk transfer. Limited lending history makes risk estimation difficult for lenders. Lenders do not appreciate the benefits of selling or securitizing loans. Issues Affecting the Development of a Mongolian MBS Market Gaps between Current Market & Efficient Markets

Who are the likely investors? In developed MBS markets, investors normally include: Insurance companies; Pension funds; Banks; Investment funds. In Mongolia there is currently a shortage of potential investors. Any regulatory restrictions for investing in MBS in Mongolia must be loosened. Investor education is very important. MBS are different from normal bonds. Loan cash flows repay MBS; bond issuer repays normal bonds. MBS amortize - investors receive principal repayments as they are received from loan borrowers; with normal bonds issuer repays all principal at maturity. Credit quality of MBS depends on quality of underlying loans and lender policies and procedures; with normal bonds credit quality depends on the borrowers credit quality. Investors must understand the effect of prepayments and late payments on the MBS yield. Issues Affecting the Development of a Mongolian MBS Market An Investor Base Must Be Developed

Comparison of MBS funding cost to the cost of alternative funding sources: The all-in cost of MBS may be higher than the cost of alternative funding sources, but there are strategic reasons for issuing MBS: Diversification of funding sources; MBS issuance is a stable alternative to deposits and foreign loans. Asset/liability management; MBS provide matched funding; payments on MBS match payments on the securitized loans. Regulatory capital and financial accounting treatment With an MBS issuance, do the loans receive on or off balance sheet treatment? Can the lender receive capital relief for the sold loans? With new accounting and regulatory guidelines, off-balance sheet treatment and capital relief will not be possible. Transaction costs and timing Legal, structuring, placement and other issuance costs must be considered when determining the all-in cost of issuing MBS. Arrangement time can be long and the transaction costs can be high for first-time MBS issuance. Issues Affecting the Development of a Mongolian MBS Market Issuer Considerations

Deposits Normally lower cost than MBS, but availability varies. Asset/liability mismatch for mortgage and other medium to long term lending. Loans from International and Development Financial Institutions Can be lower cost than MBS. No guarantee of additional future funding or refinancing. Asset/liability mismatch for mortgage and other medium to long term lending. Domestic bond issuance Investor demand, cost, and terms and conditions for bonds are still uncertain in Mongolia. Bond quality is linked to quality of issuer; MBS quality is linked to quality of the securitized loans. International bond issuance Same issues as with domestic bond issuance. Rating issues. Currency hedging issues. Issues Affecting the Development of a Mongolian MBS Market Competing Funding Sources

Is there appetite among foreign investors? If so, where should the MBS be sold? Fixed or floating rate issuance? Investor demand Availability of interest rate hedging Currency of issuance? Investor demand Availability of currency hedging Rating issues What rating(s) will investors require? What maximum rating can be achieved for Mongolian MBS? Sovereign rating of Mongolia Transaction legal and cash flow structure Collateral quality Quality of issuer Issues Affecting the Development of a Mongolian MBS Market Is International MBS Issuance Possible?