Birth of the HKMC (March 1997)
Late summer 1996: it was red hot in Hong Kong, and not just because of the weather. The whole town was in a frenetic, if not feverish, mood on the housing market. It was a time when any one of your neighbours could wake up in the morning several hundred thousand dollars richer than the night before solely by virtue of the continued rise in the value of local properties he/she happened to own. It was a time when middle income office workers could turn speculators and borrow to buy two, three, four or even five properties at a time. This could happen because, whilst bank mortgages had a 70% loan-to-value (LTV) ratio ceiling, some local property developers were very eager to “help” buyers by offering top-up loans of 20% or more without questioning their repayment ability. There was no credit database for banks to cross check, and so property speculators could obtain mortgages easily by going to a different bank for each purchase, claiming that they did not have any other outstanding mortgages. It was a time when over 15,500 property transactions were recorded in a month (equivalent to a turnover rate of about 15% per annum of the private housing stock).1 In other words, one in every seven housing units changed hands in a year.
The super bull market was aided in no small way by analysts and real estate agents arguing that the seemingly exaggerated upswing of the housing market was fully justified for three reasons: (i) Hong Kong did not have sufficient land supply to meet the rising demand from its growing population, (ii) the return of Hong Kong to the Mainland in 1997 was now expected to be a smooth process with many Hong Kong people who had earlier migrated overseas wanting to return to the city, and (iii) the economy of Mainland China was growing rapidly and the rising appetite and purchasing power of our neighbours from the north would structurally support the property demand in Hong Kong. So basically many of the participants in this market boom predicated their activity on the belief that “This time is different” or “We are different”. The irony is that, while these three factors did not ultimately prove to be wrong, property prices did collapse, as we now know, falling by a staggering 66% from the peak in the autumn of 1997 to the trough in 2003.
Back in the 1990s, the notion of countercyclical macro-prudential measures was a relative novelty and banks sought to maintain what was generally considered at the time to be a prudent maximum LTV ratio of 70% when granting mortgages. This, as we now more readily appreciate, was pro-cyclical indeed. This fixed lending ratio meant that the rise in property prices would increase the value of properties used as collateral for new mortgage loans, enabling yet more lending and helping to inflate a credit-fuelled property bubble. The speed at which mortgage loans increased was quite alarming, at an annual rate of about 25% in 1996-97. It was apparent that the banking system could not sustain this rate of credit expansion and that, if and when the bubble burst, there would likely be a severe liquidity squeeze. It was against this background that we in the HKMA saw the potential need for, and ultimately decided to set up, a mortgage corporation, along the lines of Fannie Mae and Freddie Mac in the US.
The HKMA issued a consultation paper in 1996 pointing out that, if the banks continued with the prevailing pace of mortgage finance, there would likely be a huge funding gap in the next few years. To assist banks in managing their balance sheets, and thereby promote banking sector stability, it was proposed that the HKMA should set up a mortgage corporation to facilitate the securitisation of banks’ mortgage loans, in order to release and recycle liquidity back to the banking system. As this was a brand new idea in Hong Kong, we commissioned Fannie Mae to provide technical assistance in the establishment of the new entity, which came to be known as The Hong Kong Mortgage Corporation Limited (HKMC). The goal of setting up the HKMC was to develop securitisation and other financial products that, in addition to contributing financial stability in Hong Kong, could also facilitate the development of the local financial markets. One of the preconditions for the attainment of the mission was that the HKMC should operate on a commercial and financially sustainable basis. The purpose and mission, as well as the operating principles of the HKMC, which was formally set up in March 1997, have remained unchanged ever since.
Naturally the very first product of the HKMC was mortgage securitisation. Having worked with the banking industry to standardise the documentation for residential mortgages, the HKMC began to purchase mortgage loans from banks, many of which were initially keen to unload at least part of their mortgage loan portfolios. When the Asian Financial Crisis first hit Hong Kong in the summer of 1997, the banking sector became even keener to sell mortgages for cash in order to counteract the effects of the liquidity squeeze provoked by the crisis. The HKMC bought HK$11.44 billion of banks’ mortgage loans in 1998, injecting the same amount of liquidity into the banking system. In this way, the HKMC had not only supported the development of a new financial product, but also contributed to banking stability during this very difficult period of our financial history.
It is worth noting that, since the property market has recuperated from its trough in 2003, banks in Hong Kong have generally not experienced any significant periods of liquidity squeeze, other than a short spell during the Global Financial Crisis. In fact, thanks to the extremely loose global monetary conditions since 2009, there has been abundant liquidity in the banking system and therefore banks’ appetite to sell their mortgages to the HKMC has remained lukewarm, to say the least. So the volume of mortgage loan purchase by the HKMC has been rather low in recent years.
Another point of interest is that, while Fannie Mae (which had had a very good track record in the US since 1960s) provided very valuable advice on the establishment of the HKMC, we were mindful of the need to operate this new business in Hong Kong on a very prudent basis. From the outset, the HKMC adopted stricter underwriting standards in two main respects: (i) the maximum permissible leverage of the HKMC was only 50% of that of Fannie Mae. The HKMC then later switched to a more stringent benchmark in line with Basel II, even though it was not a bank; and (ii) the HKMC would scrutinise each and every mortgage loan in a transaction to ensure that they are all conforming mortgages (i.e. they meet all of the HKMC’s underwriting criteria) whereas Fannie (and Freddie) would delegate the underwriting of mortgages to external agents, some of whom it subsequently transpired could be somewhat lax in enforcing the underwriting standards. As we now know, both Fannie and Freddie ran into such deep financial difficulty during the Global Financial Crisis that they needed to be rescued by the US Government using billions of dollars of public funds. In contrast, the quality of the mortgage loan portfolios purchased by the HKMC and the mortgage backed securities (MBS) it has issued have not to date presented any problem, with the highest delinquency rate of 0.42% observed in 2000 so far.
Mortgage Insurance Programme (MIP)
Mortgage insurance was not new in Hong Kong. Prior to the launch of the Mortgage Insurance Programme (MIP) by the HKMC in 1999, several insurers were operating in the Hong Kong mortgage market, offering insurance to banks such that they could offer higher LTV mortgages to those homebuyers without sufficient down payment. However, most of these insurers lost their commercial appetite and their business volume significantly declined after the onset of the Global Financial Crisis. Under the HKMA’s prudential guidelines for banks, a standard LTV ratio ceiling was set at 70% during the 1990s and this remained in place up until October 2009 when the first round of countercyclical macro-prudential measures was introduced. The MIP is an insurance product that allows qualified homebuyers, without a sufficient down payment, to borrow beyond the permissible LTV ceilings, upon the payment of an insurance premium. The lender banks are protected in that if the borrower defaults and the value of the collateral (i.e. the property) realised in the market is not sufficient to repay the outstanding loan, any shortfall above the permissible ratio would be paid for under the MIP policy. As the MIP is a market-based financial product, the HKMC needs to assess, price and manage the relevant risks prudently in order to achieve long term financial sustainability. So far the HKMC has assisted more than 143,000 homebuyers in owning their homes. The MIP has become even more important for prospective homebuyers in recent years due to the increase in down payment requirements as a result of the significant tightening of the prudential guidelines for mortgage loans by the HKMA in response to increased risk in an exuberant property market.
One of the key challenges for many Hong Kong people, having worked hard all their lives, is how to plan for their financial needs in retirement. For many people, their homes are the most valuable assets that they have. Without a pension or any steady regular income, many can be squeezed of cash in their later years. I was attracted by the idea behind the reverse mortgage products available in some Western countries and initiated an internal study by the HKMC in 2004. The conclusion then was that this kind of product would not work in Hong Kong because, quite apart from the traditional Chinese thinking of leaving behind as much as possible to the next generation, there would be significant PR risk (which had been the experience in countries such as the UK) if the HKMC were to benefit from the full value of the pledged property in the event that, unfortunately, a borrower were to pass away relatively early. So the idea was shelved until I returned to the HKMA in 2009. After further research and studies in 2010, we reckoned that the HKMC could learn from others’ experience and introduce a reverse mortgage programme in Hong Kong that would overcome the main problem mentioned above. This would entail the return to the borrower’s children or estate of any residual value of the pledged property after the lending bank has received repayment of all outstanding principal plus interest under the reverse mortgage. This would be more acceptable to potential local borrowers. However, as a result, the risk pooling component would disappear and the lending banks might be exposed to a shortfall risk due to: (i) a fall in the property value; (ii) a rise in interest rates; and (iii) borrowers living longer than expected. Clearly no banks would be willing to take on these risks without being adequately protected. So in 2011, the HKMC stepped in by offering banks the necessary protection through the taking out of insurance by the borrowers with the HKMC. Again this is a market-based financial product that requires prudent risk management and pricing by the HKMC. So far more than 3,000 households have joined the programme, which has resulted in material improvement in their cash flows and thus living standards. The Reverse Mortgage Programme is gradually gaining awareness and interest in the community but obviously the HKMC will need more time to develop the customer base, as news of the product’s benefits spreads through word of mouth.
Having introduced the Reverse Mortgage Programme, I believed that the HKMC was in a good position to launch another financial product to help retirees in generating steady cash flows. As most retirees in Hong Kong do not enjoy the privilege of a pension, they face a significant challenge in managing their life savings. Whilst a few may be investment savvy, many people do not have the expertise, appetite or time to undertake active investment in the often volatile equity markets. In the current low yield environment, bank deposits or bonds generate rather low and unattractive returns. There is also the deeper problem of longevity risk, stemming from uncertainty on life expectancy and on the adequacy of financial means to support a long retirement. So the HKMC launched a life annuity scheme, now known as the HKMC Annuity Plan (the Plan), in June 2018. Basically the Plan enables a retiree to convert a lump sum from their savings into an immediate and steady stream of monthly cash flows, at an amount that is fixed and guaranteed for life, regardless of the volatility in asset markets or interest rates. This should relieve a Plan buyer from the difficulty of actively managing his or her investments or worrying about longevity risk. So far, more than 6,500 have joined the Plan. Again, life annuity is a relatively new and unfamiliar financial product in Hong Kong, but the launch of the Plan has greatly enhanced public awareness of such products and stimulated significant interest in the market, which has responded by launching many related but different products, mostly deferred schemes, which have received a generally favourable reception from potential customers. Again it will take time for the HKMC to promote public awareness, as well as appreciation, of the relative merits of the Plan versus other annuity/financial products that might suit the needs of retirees.
The most recent product introduced by the HKMC is the Reverse Mortgage of Life Insurance Policy. Life insurance policies are normally taken out by people who worry about financial protection for their families if they pass away prematurely. The need to protect dependents against the premature death of a breadwinner is particularly acute when someone is still young. However, such need diminishes as one grows old. While the value of the life policy can only usually be realised after the policyholder has died, the HKMC now offers a product that enables the policyholder to convert the insurance policy into a steady stream of cash, at a fixed guaranteed rate for as long as he or she lives. This product has just been launched and I am confident that it, like the Reverse Mortgage Programme for properties and the Plan, will gradually become popular amongst retirees in Hong Kong.
All in all, the HKMC is now a provider of financial solutions for retirement. If a person makes full use of all these three products, he or she can create the economic equivalent of a “self-made pension” for his/her lifetime through the HKMC.
Securitisation of Infrastructure Loans
In line with its mission to promote financial stability and market development, the HKMC has launched a new line of business in 2019: securitisation of infrastructure loans. Infrastructure investments, whether in the form of equity or debt, have become a new asset class for institutional investors. The main attraction of investing in infrastructure is that, once completed, it generates a stable stream of income over a long period of time, which suits the needs of long term investors such as pension funds, sovereign wealth funds and insurance funds. All infrastructure projects need debt financing, which is normally provided by banks at the greenfield (construction) stage. However, banks do not usually find it attractive, in terms of the deployment of capital, to retain infrastructure loans over the entire life of the project. So it makes sense for banks to sell their infrastructure-related loans at some stage in order to release capital which can then be recycled for use elsewhere (including new infrastructure lending). The sale of individual loans directly to investors is possible but difficult in practice because each infrastructure project is different and the terms of each loan may be different. Investors would prefer a simpler and easier way of investing in infrastructure loans. This problem is in many ways similar to the difficulties in investing in housing loans. The solution is the securitisation of a basket of infrastructure loans. Compared with MBS, however, the securitisation of infrastructure loans is significantly more challenging. First, infrastructure projects are quite diverse, involving complex technical, business, legal, environmental, governance and sometimes political issues. Second, each project is large in scale and it is not easy to achieve the same degree of diversification as in MBS. Third, it has rarely been done before, largely for the reasons outlined.
The HKMC is now in the process of sourcing and buying infrastructure loans from banks and warehousing them for future securitisation. The HKMC is a pioneer in this field and has been collaborating closely with the International Finance Corporation2, which is very supportive of the initiative. The success of this initiative should make a significant contribution to the debt market for infrastructure, providing an avenue for banks to manage their balance sheets and allowing more efficient flows of capital into infrastructure projects. This would also help banks to concentrate on what they are best at, i.e. originating loans at the greenfield stage and exiting at the brownfield stage instead of sitting on loans of very long tenors.
Developing Hong Kong’s Bond Market
The HKMC is the largest corporate debt issuer in Hong Kong. So far, the HKMC has issued HK$400 billion of bonds denominated in different currencies and ranging in tenor from three months to 30 years. The issuance of long tenor fixed rate bonds was originally intended to provide long term funding for HKMC’s fixed rate mortgage products to homebuyers, although the take-up rate for these products has remained low, reflecting insufficient interest amongst borrowers to hedge their long term interest rate risk. In other words, the prevalent market preference is for floating rate mortgages, which carry lower interest rates initially. In more recent years, the long tenor fixed rate bonds have found new roles in supporting the development of the HKMC’s new fixed rate products such as fixed rate reverse mortgages which are growing in popularity. As an active debt issuer in Hong Kong, the HKMC has contributed greatly to the development of Hong Kong’s bond market, which is one of its core missions.
Since inception in 1997 with an initial investment of HK$2 billion, the HKMC has generated a total profit before tax of HK$15.1 billion, which demonstrates both its financial viability and sustainability as well as its ability to provide an attractive return on equity for the Exchange Fund. In 2018, there was a further investment of HK$5 billion to support the new life annuity business which is also expected to generate a decent return in the longer term. The HKMC is therefore a good example of a successful venture that makes sound commercial sense and, more importantly, serves financial stability and market development purposes. I am confident that the HKMC will go from strength to strength to achieve its missions.
Hong Kong Monetary Authority
28 August 2019