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Establishment of a Mortgage Corporation in Hong Kong

by Joseph Yam, Chief Executive, Hong Kong Monetary Authority

(Speech to the Hong Kong Economic Association, reprinted in the HKMA Quarterly Bulletin Issue No. 10)

12 November 1996


I feel very honoured to have been given this opportunity to address the Hong Kong Economic Association, particularly when I, as someone having some responsibility over money and banking in Hong Kong, have been invited to do so by the person who taught me money and banking at university - Dr. Jao. One must, of course, be a little modest in front of his teacher for some 28 years. This is why I have chosen a topic which is unlikely to be of great controversy in the academic sphere - the establishment of a Mortgage Corporation in Hong Kong. It is nevertheless a highly important and practical topic at the present stage of development of money and banking in Hong Kong. I hope you will find this of interest.


  1. Since the Hong Kong Monetary Authority (HKMA) started conducting public consultations on the proposal to establish a Mortgage Corporation in Hong Kong earlier this year, we have received quite a lot of comments on the proposal. They are on the whole very supportive. But, understandably, as in all new policy initiatives, some concerns and worries have also been raised. Among these concerns, I sense the constructive conservatism of some people in favour of maintaining the status quo and minimizing change as Hong Kong is going through unusual times. Some also expressed the rather legitimate concern from their own points of view, about the Mortgage Corporation becoming a new competitive force which may undermine the interest of some of the long established financial businesses. I quite understand these concerns. Indeed, creating a new avenue for financial intermediation can be likened to the building of a canal around the more established channels through which water traditionally flows. The canal would reduce the volume of water flowing through these established channels, with implications for the interested parties. But the implications need not be adverse as the canal, built in time, could well avoid impending floods and therefore casualties, and enable smooth traffic over the water, in whatever direction. Surely this would be in the overall interest of a community with increasing aspirations.
  2. In the area of home financing, I am quite convinced that doing nothing is not a risk-free approach. There is a structural issue in financing home purchase in a safe and efficient manner. Our study has identified a potential gap in the supply and demand for residential mortgage loans, as the banking system is constrained by the need to avoid excessive concentration and liquidity risks in meeting the strong increase in demand. In other words, we foresee the possibility of damaging floods and so the need for a canal. The establishment of the Mortgage Corporation addresses this issue as the Corporation can play an important complementary role in intermediating between long-term funding sources and long-term borrowers for home finance. The Mortgage Corporation will also have significant contributions towards promoting banking and monetary stability, local debt market development as well as home ownership. Indeed, Fannie Mae our consultants said that: "Hong Kong is in an enviable position compared to many other economies, as its desire to expand its current housing finance mechanism is driven by a long-term vision, not in reaction to a crisis in the housing market or credit system."

Mortgage Corporation and Banking Stability

  1. Hong Kong has come a long way from the time when the majority of the population were longing for a shelter in a public rental housing estate. The last two decades saw an impressive increase in the home ownership ratio, from 27% in 1980 to around 45% at present. This has naturally been accompanied by an increasing demand for home finance. From 1980 to 1995, the outstanding amount of mortgage loans increased by almost 30 times, from $11.7 billion to $348 billion, representing an annual compound growth rate of 25%, which of course was a lot faster than the growth rate of the economy in money terms.
  2. I do not have a crystal ball to gaze into what is in store for the future. Nevertheless, if you agree that Hong Kong will continue to prosper in the years to come, spurred by the continued reform and liberalization of the economy of China and playing the important role as a leading financial centre in the region, then it is obvious that the aspiration for home ownership and the demand for mortgage finance will continue to grow rapidly. Yet we are already seeing clear signs that the banking system may be constrained in meeting this continued rapid increase. The share of mortgage loans in the total domestic loan portfolio of the banking sector has increased from less than 10% to well over 20% in the past 15 years. If lending for property development and investment is included as well, then property-related loans now account for about 40% of total domestic loans. This is by no means a low level. It is probably amongst the highest, if not the highest, in the world. You do not need to be a banking supervisor to be concerned about the risk of concentration in a particular type of lending business. Quite apart from the possible volatility in the value of the underlying assets, there is also the business risk. If banks become too reliant on income from one line of business, they will be vulnerable to adverse changes in competitive conditions and therefore lending margins in that line of business.
  3. Furthermore, banks incur a liquidity risk in mortgage lending because of the significant maturity mismatch between the funding sources and the mortgage loans. The two main funding sources for banks are interbank borrowings and customers' deposits. Over 80% of these have a maturity of less than or equal to one month. The tenor of residential mortgage loans, on the other hand, is significantly longer, even taking into account the possibility of prepayment. It is obviously not easy to liquidate long-term mortgage loans to meet withdrawals of deposits from customers and from other banks, particularly when, for one reason or another, there are unusually large withdrawals. All the seven banks that have been rescued directly or indirectly by government in the eighties suffered from this problem. It would obviously be desirable if there is an avenue by which banks can unload illiquid assets at times of need and to redress the structural maturity mismatch that is so common to banks in Hong Kong. The Mortgage Corporation proposal will provide such an avenue and would also enable the concentration risk I mentioned earlier to be reduced or contained. It will therefore significantly enhance the stability of our banking system.

Mortgage Corporation and Monetary Stability

  1. Let me turn to the implications of establishing the Mortgage Corporation for our monetary system. Home mortgages in Hong Kong are predominantly on floating interest rates as banks are keen to pass on funding costs, which again are predominantly on floating interest rates, to customers. But this is not the case in many other economies. In the USA, for instance, over 70% of home mortgages have been arranged on fixed interest rate terms, reflecting quite a strong preference on the part of mortgage payers to lock in and immunize their mortgage payments from fluctuations in interest rates. But desirable as it may be, this is not a choice for home mortgage payers in Hong Kong, at least not to a significant degree. We cannot of course blame the banks for acting prudently to avoid incurring large interest rate risks. When there is a lack of long term fixed interest rate funding, the banks would naturally be reluctant to hold fixed interest rate assets. Ironically, there should be strong investment demand for fixed income securities in Hong Kong arising from long- term savings which are becoming increasingly institutionalized. The proposal to have mandatory provident funds, when implemented, is likely to give this demand quite a boost. The fact that borrowing and lending in Hong Kong generally, and in the mortgage sector particularly, operate predominantly on floating rates of interest is, in my opinion, not entirely satisfactory from the point of view of monetary stability.
  2. With interest payments being subject to short-term fluctuations in interest rates, borrowers, including the majority of home mortgage payers, are vulnerable. As you all know, under a fixed exchange rate system, short-term interest rates may have to be adjusted upwards or downwards rather sharply to defend the exchange rate, particularly when there is any sign of speculative forces at work. When high interest rates are used to inflict pain on the speculators, I would of course choose as far as possible to be selective, and indeed when our interbank payment system goes onto a Real Time Gross Settlement basis on 9 December this year it will be possible for us to do so more effectively. But there is always the possibility under whatever system that similar pain might also be inflicted on the innocent parties as well, for example, the home mortgage payers on floating interest rates. Thus, the popularity of fixed versus floating interest rates in borrowing and lending does have a bearing on the pain tolerance level of the economy towards fluctuations in short- term interest rates brought about, when required, to defend the exchange rate. The corollary of this argument is that the robustness of a fixed exchange rate system depends not only on the familiar factors such as the basic economic fundamentals, the credibility of the policy, the determination of the authorities, etc., but also depends, to some extent, on the ability of important sectors of the economy and the community to withstand the interest rate pain. This therefore argues for promoting the fixed interest rate element in the economy generally and in home mortgages in particular, as this is indeed a most important sector of our community.
  3. This is where the Mortgage Corporation comes in. A credit-worthy Mortgage Corporation should be well placed to tap long term savings through the issue of fixed rate debt. And when the fixed rate funds so borrowed are in turn used to acquire fixed rate mortgage loans, there will hopefully be greater encouragement for banks to offer and market fixed rate mortgage loans to home buyers. To the extent that this would in time result in a higher proportion of mortgages being on fixed interest rates, there will be a greater degree of insulation of mortgage payers from interest rate fluctuations. And to the extent that fixed interest rate borrowings become more readily available and popular, there will also be a greater degree of insulation for the economy as a whole from interest rate fluctuations. The resilience of our monetary system against interest rate shocks will thus be enhanced. The Mortgage Corporation will therefore contribute to monetary stability. Some of you may query: the interest rate risk must have been shifted to some other parties. This is indeed very true. The holders of the fixed interest rate debt paper will be adversely affected by an interest rate hike. But by virtue of the fact that many of these are long-term institutional investors managing long-term savings of the community, they should be in a much better position to weather short-term volatility in interest rates. The exposure to interest rate risks would in effect be shifted from those who are less able to those who are better able to bear them.

Mortgage Corporation and Debt Market Development

  1. Let me turn to the implications of the Mortgage Corporation for debt market development. We have seen quite impressive growth of the local debt market over the past few years. This is largely attributable to the efforts of the HKMA in developing that market. We have brought a substantial supply of debt paper to the market in the form of Exchange Fund Bills and Notes. We have at the same time established a benchmark yield curve for Hong Kong dollar debt up to the 10-year area. We have also put in place an efficient infrastructure for the debt market with a computerized paperless clearing and settlement system. The private sector has made use of this market framework. There has thus been a marked expansion in market size in recent years. But most of the private sector issuers are concentrated in the banking sector and there are hitherto still relatively few non-bank issuers, other than the multilateral financial organizations. As I see it, home financing is a major source of demand for long-term funds, and hence a natural base for further expanding our debt market. In the USA, mortgage-backed securities (MBS) and unsecured paper issued by mortgage corporations account for around 24% of all outstanding debt securities.
  2. Some critics have unfairly accused us of setting up the Mortgage Corporation to expand our "empire". Let me be absolutely frank on this. I would have been very happy to see the secondary mortgage market developing on private sector initiatives. In fact, this was the reason why we set up an informal group to provide market participants a forum to address technical issues of common concern. Following the rather unsatisfactory experience in developing that market, the market participants themselves have come to the view that establishing a government supported Mortgage Corporation will be the most effective way to kickstart the development of the secondary mortgage market.
  3. According to our business plan, the Mortgage Corporation will initially issue unsecured debt paper to fund the purchase of home mortgages. At a later stage when we are satisfied that the Mortgage Corporation has been operating smoothly and well established, there is intention for the Mortgage Corporation to introduce MBS. Unlike the MBS launched so far by private sector issuers, MBS issued by the Mortgage Corporation will have a standard structure and be backed by standardized loan pools. This makes them much easier for investors and traders to understand and trade. It is also useful to note that the increased supply of high quality debt securities issued by the Mortgage Corporation will nicely coincide with the commencement of the mandatory provident fund scheme next year, which will significantly increase the demand for good quality Hong Kong dollar debt securities.

Mortgage Corporation and Home Financing

  1. Let me turn to the contribution that the Mortgage Corporation can make to home financing. There was an interesting debate on whether our forecast of the big shortage in mortgage funds is reasonable or not. Some call this the HKMA's multi-billion dollar blackhole of mortgage funds. But it is reassuring that many shared our view that there is likely to be a significant shortage. Dr. Jao, for example, in the helpful comments that he sent to us, has found our estimate reasonable. And he added that economic forecasting was at best an art, and there was no such thing as a fool-proof estimate. Indeed, no one here today can claim to have an authoritative forecast of the supply of and demand for mortgage funds over the next decade. Our basic premise is that, with increasing aspiration for home ownership, home mortgage demand will continue to grow faster than bank assets. And concentration and liquidity risks will constrain the ability of banks to satisfy that demand and our prudential concerns at the same time. As economists, you can of course immediately point out that the market will adjust in the face of the shortage. True, but I believe such adjustment will come largely in the form of higher mortgage rates, which would be very unfair to those wishing to buy their own homes and those already paying mortgages at floating rates. I am aware of the advice that central bankers should not get themselves involved in social engineering. But I have to say that, in home financing in Hong Kong, it is more often that the dice is loaded against the home buyers.
  2. We should consider the Mortgage Corporation as a strategic piece of infrastructure in the home financing mechanism. If the demand for mortgage funds continues to show a strong increase as we have projected, the Mortgage Corporation will have an important role to play in channeling funds from long-term funding sources such as pension and retirement funds to home financing. These will mostly be additional funds, which are most probably now invested outside Hong Kong, and not funds diverted from the banking system. If, on the other hand, there is little growth in the demand for mortgages, which would imply an uncharacteristically depressed property market and economy, the Mortgage Corporation, with its small scale of operation initially, should not inflict any serious injury on the public purse or on the monetary and financial systems of Hong Kong. It may, nevertheless, inflict injury on the ego of those that have been promoting and supporting the project, but I am sure we are all matured enough to eat humble pie when proved wrong. So let us wait and see.

Risk Management

  1. Some commentators have cautioned us on the risks that the Mortgage Corporation might itself be exposed to. They argue that with a 100% exposure to residential mortgages, the Corporation would be subject to a much higher level of concentration risk compared with banks. While seemingly logical, this proposition misses an important fact - the Mortgage Corporation not only transfers the risk of mortgage loans, it also transforms the risks involved. Unlike banks which mainly borrow short to lend long, the Mortgage Corporation will not incur any significant maturity mismatch in the intermediation of mortgage funds. It will tap long term funds to acquire long term mortgages.
  2. I should perhaps also reassure you that central bankers have a strong "sense and sensibility" towards risks. Risk management does not mean risk avoidance. It means proper identification, measurement and control of risks. As in all types of financial intermediation, the operation of the Mortgage Corporation will involve risks. We have studied very carefully the experience of overseas mortgage corporations and their risk management techniques. The main risks to the Mortgage Corporation are credit risk, interest rate risk, prepayment risk and operational risks. Our assessment is that these risks can be prudently managed by stipulating prudent mortgage purchasing and servicing standards, matching the interest rate and maturity structure on the asset and liability sides, as well as putting in place robust internal control, audit and computer systems.
  3. It is also useful to note that the residential mortgage loans in Hong Kong are traditionally of very high quality. The loan delinquent or default rate, defined here as loans behind payment for more than 90 days, stood at 0.13% in 1994, compared with 0.57% in the USA. The rate of 0.13% includes mortgages on properties for both self occupancy and for investment. It is our intention that the Mortgage Corporation will purchase only those mortgages on owner-occupied properties. I believe the loan delinquent or default rate of those mortgages is even much lower. But to cater for a stress situation, we have constructed various hypothetical scenarios to see how the Mortgage Corporation could cope. Assuming that the loan delinquent or default rate is 30 times of that under a normal situation, that all delinquent loans would go into default, and that this extraordinary high rate persists for three years, our analysis still suggests that, with a prudent capital-asset ratio of 5% and prudent loan origination criteria (such as a loan to valuation ratio of not more than 70%), the Mortgage Corporation would still be able to cope.
  4. To ensure that the Mortgage Corporation will be founded on a sound and prudent basis, we have been seeking, and will continue to seek, the expert advice of Fannie Mae, as well as engage local legal, financial and business advisers throughout the process leading to the establishment of the Mortgage Corporation. We will also consult the banking community, the capital market participants and other relevant parties on the loan purchase and servicing standards, debt issuance arrangements and other aspects of the operation of the Mortgage Corporation. Of course, the Mortgage Corporation will, after its establishment, also be subject to the supervision of an independent Board of Directors.

Progress in the Establishment of the Mortgage Corporation

  1. Finally, you may wish to know where we are in the preparatory work for the setting up of the Mortgage Corporation. I am pleased to tell you that we have been making good progress. We have finished drafting the Memorandum and Articles of Association, which have now been endorsed by the Exchange Fund Advisory Committee and are being circulated to the relevant industry associations for their comments. We have given the corporation the name "The Hong Kong Mortgage Corporation Limited". We are currently working on the loan purchasing and servicing standards, and the related documentation, the debt issuance arrangements, the organization and human resources strategies, as well as devising a technological platform for the Mortgage Corporation. You can see that we still have a very packed agenda. But I am confident that we will in the next few months continue to make good progress. We expect the formal establishment of the Mortgage Corporation and the appointment of its Board of Directors in the first half of 1997 and for it to commence its market operations in the second half of 1997.
Last revision date: 1 August 2011
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