The community, banks and the regulator all have a common interest in helping homeowners in negative equity reduce their burden.
In the HKMA briefing to the Legislative Council Financial Affairs Panel on 6 May I spent some time explaining our policy in respect of mortgages in negative equity - where the outstanding borrowing is greater than the value of the property. They are an issue of continuing concern: to the community, because of the financial burden that many in such an unfortunate situation have to carry; to the banks, because of possible adverse effects on asset quality; and to the HKMA as banking supervisor, because of the associated risks to banking stability. Although these are very much different concerns, there is a common approach in the strategies adopted by all in addressing their respective concerns: this is to lessen the burden of the mortgagors in negative equity so that they will not default on their mortgage loans.
In order that they can benefit from lower mortgage interest rates, recently driven down by competition from well above to well below best lending rate, we have to address the risks the banks are exposed to. Other things being equal, a mortgage in negative equity involves greater risks than one in positive equity, and prudent banking supports the charging of a higher interest rate. But if, by whatever arrangements, the mortgage in negative equity becomes one in positive equity, the banks should be more prepared to lower the mortgage interest rate for that loan to nearer the market norm. The trick is to address the portion of the loan in negative territory, that is to say, the amount of loan in excess of the market value of the property, with a view to removing that part of the risk exposure of the bank arising from the mortgage in question. As a first move to help addressing the matter, we agreed last year to raise the loan to valuation ratio in refinancing mortgages in negative equity from 70 per cent to 100 per cent.
There are a number of ways of tackling the negative equity portion of a mortgage. The first is simply for it to be repaid by the borrower. The reduced mortgage loan then becomes fully secured and so the bank is more willing to charge the lower, prevailing market interest rate. But, obviously, those who have the financial resources to repay the negative equity portion of the mortgage are not really the cases that we are all concerned about.
So, secondly, the market has come up with the arrangement for a third party to underwrite this negative equity portion or guarantee the repayment of it, but for a fee to be incurred by the mortgagor, who stands to benefit from the lowering of the mortgage rate. The bank's exposure of, say, 140% of the value of the property to the mortgagor will then become a mortgage secured on 100% of the value of the property and an exposure to the third party equivalent to 40% of the value of the property. For the time being, the exposure to the third party (presumably much more creditworthy than the mortgagor) is virtually unsecured, but if property prices recover there will be additional security. The guarantor, as the third party, gets the guarantee fee or insurance premium up front, in return and commensurate with the risk for assuming contingent liability that diminishes with a recovery of the property market. We thus have a situation in which all the three parties win. Furthermore, the risk of default is reduced and the banking supervisor sleeps better.
This arrangement may, thirdly, involve the third party buying the negative equity portion of the mortgage off the books of the banks. This is similar to the bank extending a first mortgage at 100% loan to valuation (at market interest rate) and the third party extending a second mortgage (presumably also at market interest rate) for the rest in return for a fee that is paid up front by the mortgagor. Now the third party may need finance for such a transaction and it will be up to the financiers to assess the credit risk involved. The interesting aspect of this type of arrangement is the potential for the negative equity portion of mortgages, now being the assets of the third party, to be turned into securities and be sold to investors, most probably institutional investors, in a position to appreciate the risks involved. There is a need for a bit of financial engineering here, which if successfully organised, will help diversify the risk which has been shifted outside the banking system. It may also contribute to the further development of the capital market.
I am sure the private sector is quite up to speed on these issues. Our job is to lay down clearly our policy stance and to stand ready to assist appropriately. I am therefore pleased to see that the Hong Kong Mortgage Corporation has last week come up with a market-driven solution that will help mortgage borrowers in negative equity to refinance at a lower mortgage rate and the banks to manage the credit risk of their mortgage portfolios. We support this initiative because it should contribute towards maintaining the stability of the banking system.
Joseph Yam
20 June 2002
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