12.4.2.1 Types of Mortgage Securities and Mortgage Debt Issuers

A variety of securities can be issued by primary mortgage lenders, by special purpose vehicles often called “conduits,” or by secondary mortgage companies purchasing mortgage loans with or without recourse from originators. For a housing finance industry in its infancy, a centralized liquidity facility issuing conventional bonds or enhancing mortgage securities appears fitting for many developing countries. Given an appropriate legal and regulatory environment, universal or specialized banks can also issue simple mortgage bonds as shown by the U.S. and European experience. Box 12.1. summarizes the range and variety of mortgage-backed securities in different regions of the world.

Debt issuers for housing finance can be grouped into three main types. First, there are bank and housing finance companies that originate housing loans. They can finance these loans by issuing long-term bonds rather than relying exclusively on short-term deposits and other short-term funding. Second, a centralized liquidity facility can purchase housing loans with recourse from the originators of these loans and finance the purchase by issuing general obligation bonds. Third, housing loan originators, or more typically a mortgage finance company, can buy housing loans from originators, securitize these mortgage loans, and sell mortgage-backed securities to institutional investors interested in quality paper that offer better yields than Treasury securities.

12.4.2.2 Development Path of Mortgage Markets

Mortgage markets usually evolve gradually toward the more advanced securitization stage. Securitization refers to the pooling of normally illiquid assets and the issuing of new securities backed by cash flows from those assets. Such securities can take the form of bonds, shares, and unit trust certificates. Bonds are the most popular form, which is exemplified by the increasing popularity of mortgage-backed securities in developed countries. Of particular interest to governments is that securitization facilitates development of a secondary mortgage market through mortgage-backed securities issuance and at the same time helps improve the capital adequacy ratios of banks through the sale of otherwise illiquid mortgage loan portfolios. This assists and encourages banks to manage their balance sheets in a more sound and efficient manner.

Securitization helps to further reduce intermediation costs in a more competitive mortgage industry, allows for better management of balance sheets, and improves capital adequacy through the sale of otherwise illiquid portfolios. Reaching this advanced stage of market evolution, however, is demanding and requires having the appropriate legal and regulatory infrastructure prerequisites in place. The potential benefits of mortgage securitization, however, also carry the financial costs of new technology and information systems.

Mortgage debt markets benefit from the development of the market infrastructure built up for government securities, but they have their specific legal and regulatory needs. A sound retail (or primary) mortgage market is the cornerstone of housing finance. Basic requisites for mortgage markets include a land registry system, an effective bankruptcy law, efficient foreclosure procedures, reliable property valuation, proper mortgage loan underwriting, and modern technology in loan processing and servicing. Well-rated mortgage-related securities also require a comprehensive regulatory treatment for banks and institutional investors (pension funds, mutual funds, and insurance companies).

The development of government and mortgage securities markets is interlinked. As fixed-income securities markets expand in general, the supply of mortgage-related securities of various forms grows to represent one of the largest fixed-income markets. They offer quality securities with low spreads over Treasuries. As countries run sound fiscal policies with balanced budgets or budget surpluses, they will experience a relative shortage of government securities, making it more difficult to maintain bond benchmarks. (See Chapter 4, Developing Benchmark Issues.) In certain circumstances, mortgage bonds could assume this function. (See Section 12.5.1.1 below.)

12.5.1.1 Government as Benchmark Issuer

The government is by far the most likely issuer of debt securities that could serve as benchmarks. (See Chapter 4, Developing Benchmark Issues.) The benchmark yield curve is a basic benchmark for pricing other government or nongovernment bond issues of comparable maturities across the yield curve on the primary market as well as the secondary market. Other debt securities are priced by taking the corresponding maturity on the yield curve and adjusting for the (greater) credit risk of the nongovernment issuer. The government benchmark is an important tool for price discovery in other fixed-income securities markets, including the private sector debt market. Without that benchmark, it is difficult to price fixed-income securities, including private sector debt securities, in a rational manner.

The short end of the yield curve is important in the development of efficient money markets. The short end of the yield curve is a linkage to interest rates under the banking system. It is also where the monetary authorities can influence the general interest level of the economy through open market operations. The short end of the yield curve is, thus, the anchor to the entire yield curve. (See Chapter 2, Money Markets and Monetary Policy Operations.)

While government bonds work well as benchmark issues, countries with a small or no fiscal deficit, and those running budget surpluses after having run deficits in the past face, difficulties in supplying the government issues needed to constitute a benchmark yield curve.²⁶⁷ (See Chapter 4, Developing Benchmark Issues.) If government securities are not able to serve as a benchmark, it may sometimes be possible to use other bonds from major issuers, such as development banks, subnationals, or the major private sector issuers (such as mortgage bond issuers) as de facto benchmark issues. (See Chapter 11, Development of Subnational Bond Markets.)

With mortgage markets growing faster than government securities markets, consideration could be given to substitute mortgage debt benchmarks for government bond benchmarks. (See Section 12.4.2.2 above.) However, mortgage-backed securities other than bonds are not sufficiently homogeneous and free from various embedded risks for that purpose. In addition, the emergence of mortgage securities as benchmarks is difficult without a high degree of financial intermediation through a mortgage bank or a secondary market agency.

12.5.1.2 Dealer Community and Investor Base for Government and Private Sector Bonds

An efficient government bond market encourages, and even requires, the development of highly skilled fixed-income securities intermediaries. These intermediaries, in turn, can support the development of the private sector bond market. The government bond market can provide the experience needed to build skills in the fixed-income business, because it is more liquid than the private sector bond market and involves more issuance and trading—both of which also provide a strong profit base. Dealers need these skills and profits to support private sector bond transactions, which are riskier than government bonds because of the greater credit risk of private sector issuers and the lower liquidity of private sector issues (market risk). Two types of intermediaries where the government role is especially important are market makers and interdealer brokers (IDBs). (See Chapter 7, Developing Secondary Market Structures for Government Securities.)

Government securities also provide dealers with mechanisms to hedge their private sector securities market exposures. This could be done through repurchase agreements that are typically based on government securities, through government securities themselves that are lower risk and more liquid than private sector debt securities, or through interest rate derivatives that are often based on government securities.

12.5.2.1 Disclosure System and Information

In order to attract and maintain investor interest, all bond issuers—whether government, subnational, or private sector—need to disclose objective, relevant, and timely information about themselves and about the securities being offered to the public. Disclosure issues relating to private sector bond development have some special aspects.

In contrast to a disclosure system, which depends on building investor awareness, regulators in developing countries sometimes use a merit system to oversee and guide private sector capital market issues. A merit system is one in which the regulatory authorities review the substantive merits of a proposed capital market issue in order to ensure that investors are protected and that the issue is compatible with national development objectives. Pursuant to laws, decrees, or directives, the authorities determine the participants that may enter the market and the terms of their involvement, including but not limited to the type of instrument that may be used and the substantive terms of the instrument (e.g., timing and pricing of the issuance). This gives regulators the ability to exercise considerable power over market outcomes.²⁶⁸

A merit system does not make regulators accountable for their decisions and can induce moral hazard among market participants and investors. A merit system will protract and even crush the development of a sustainable and efficient market mechanism. In private sector bond markets in developing countries, a merit system is exemplified by a queuing system, a coupon-rate control, eligibility criteria for issuers, restrictions on bond term, and the like. Use of a merit system is understandable in developing countries with major shortcomings in such essential market infrastructures as law enforcement and court systems, sophistication of investors, strong intermediaries, adequate credit-rating systems, proper accounting standards and auditing systems, and effective corporate governance. Even under such conditions, the use of a merit system should be considered as a temporary expedient, and it should be discontinued as soon as the market infrastructure is sufficiently strong to allow the private sector market to rely on conventional disclosure system procedures.

The extent of regulatory disclosure requirements for private sector debt instruments may vary by the issuing history of the issuer and the scope of targeted investors. The existence of an equity market is practically a prerequisite for private sector bond market development, as it often sets an example for disclosure practice. International accounting standards are a good model to follow to avoid accounting ambiguities in financial statement disclosure. Disclosure on private sector bonds should focus on the issuer’s creditworthiness and the issuer’s product information.

In addition to meeting regulatory disclosure requirements, the development of private sector bond markets could be aided by voluntary disclosure. Policymakers in developing countries should be aware of the important role that voluntary disclosure activities play in the functioning of developed-country capital markets, and should promote and facilitate proactive information dissemination by private sector entities. If not already mandatory, the voluntary public release of a credit-rating agency’s rating of a private sector bond issuer could form an important element of a voluntary disclosure system. Voluntary disclosure is also achieved by improvements in corporate governance that focus on transparency of the issuer’s activities and management,²⁶⁹ public relations through the media, and investor relations.

12.5.2.2 Credit-Rating System

Credit-rating agencies perform a catalytic role in developing capital markets. The purpose of credit ratings is to provide objective and independent summary opinions of relative credit risk. Ratings give an indication of relative risk for a bond issuer’s ability and willingness to make full and timely payments of principal and interest over the lifetime of the rated instrument.²⁷⁰ Investors will demand a higher interest rate to compensate for investing in bond issues with a lower rating, which reflects higher credit risk. The differentiation of interest rates on the basis of risk has two beneficial effects—the efficient allocation of resources by investors and encouragement of companies to improve their financial structure and operations. Regulators can also use credit ratings when assessing fulfillment of capital adequacy requirements, with debt of a higher credit rating carrying more weight. More generally, credit-rating agencies encourage greater transparency, increased information flow, and improved accounting and auditing. For credit-rating agencies to be successful, they must be seen to be independent, and investors must understand and value the role of ratings.

While credit-rating agencies help in the development of capital markets, they also need a minimal degree of capital market development in order to be commercially sustainable. It is doubtful whether most developing countries have the minimal degree of capital market development to sustain a credit-rating agency under normal conditions. One alternative has been for credit-rating agencies to expand into other business lines such as providing general financial information services.

Some rating agencies have dropped the link between ratings and specific issues of debt. Instead, they have rated institutions that issue the debt. In the Philippines and Turkey, for example, domestic banks obtain ratings in order to establish relationships with foreign banks and even to raise funding on international markets.

Another, and more controversial, method to make credit-rating agencies willing to rate entities in developing countries has been to aid these agencies by public policy actions. In most developing countries with credit rating agencies, mandatory ratings by accredited credit-rating agencies have been introduced, and, often, a system is set up to license approved rating agencies. Mandatory ratings usually require private sector bond issues to be rated, and certain institutional investors may be restricted to purchase securities that have received a certain rating classification. For example, pension funds may be required to purchase only rated securities.

International credit-rating agencies, such as Standard & Poor’s and Moody’s, have advantages over domestic agencies in their greater expertise and credibility. They at times may lack, however, the qualitative understanding of local conditions, which is particularly important in developing countries where access to, and availability of, quantitative data is often lacking. A common approach has been for a domestic credit agency to form a joint venture with an international rating agency, with the latter providing technical assistance to the domestic rating agency. Fitch-IBCA Duff & Phelps,²⁷¹ a leading international credit-rating agency, has expanded its activities to lesser-developed capital markets through joint ventures. Often this has been with the International Finance Corporation of the World Bank Group helping to establish the new rating agency and taking a small equity share. Most of these projects are yet to be completed, and it is too early to assess the success of the local joint venture rating agencies that have begun operations. Their supposed catalytic impact on capital market development is far from demonstrated, especially as they almost all rely upon mandatory ratings.

Another issue is the optimal number of credit-rating agencies in a market. Too much competition in an undeveloped market may cause an inflation of ratings or lower quality of the rating process in an attempt to cut costs. Too little competition, on the other hand, raises concerns about slackening of standards and performance.

12.5.2.3 Bankruptcy Laws

Bankruptcy laws are another essential element for developing private sector securities markets. Nongovernment bonds, typically private sector bonds, may default, whereas government bonds denominated in the local currency do not default, at least in theory.

The issuer’s obligation to pay interest and repay the principal in a timely manner should not be a matter for issuer discretion. The investor is able to assess meaningfully the risk of investing in bonds only if the limit of the investor’s legal ability to force the bankrupt issuer to service its obligations and the procedures for going to that limit are clearly defined. Bankruptcy laws define the limit and the procedures. A mechanism for efficient reorganization is vital to a smooth functioning of private sector bond markets in that it establishes the investor’s right to recover investments and establishes the priority (seniority) or subordination of one investor’s right to that of other creditors.²⁷²

The investor’s ability to force a bankrupt issuer to repay its obligations under bankruptcy laws can be generally classified into three classes according to its security type—secured or collateralized bonds, senior bonds, and subordinated bonds.

12.5.3.1 Crowding Out by Public Sector Borrowing

Given the credit standing of government bonds, such securities, especially if priced competitively, will be the preferred investment choice for many market participants. Persistent large government budget deficits, financed by issuance of new government bonds, could absorb national savings, thereby crowding out the private sector from the bond market. Under such circumstances, the private sector will find it impossible to obtain investors for its bonds or will do so only at prohibitively high interest rates.

There are other ways in which the government may be crowding out the private sector. The government may be tempted to finance its fiscal deficit at the lowest possible cost before any nongovernment issuers tap the market. This could be achieved by offering special-issue bonds with a low yield but with other attractive features (e.g., tax exemptions, backing by proceeds of gold or oil, distinctive maturities) that other issuers are not able to provide. A variant is for the government to require financial institutions to purchase government securities to meet regulatory requirements (captive sources of government funding). (See Chapter 6, Developing the Investor Base for Government Securities.) There is not much that the private sector can do to contend with such government actions except to engage government officials and enlighten them of the undesirable consequences of their conduct and policies.

12.5.3.2 Statutory Restrictions

The primary private sector bond market is more subject to governmental interference than the secondary market because it is the entry point of securities into the market and thus the very first checkpoint for investor protection. Statutory restrictions are usually imposed around either the market participants’ eligibility or product features, or both. Such government interference often ends up with a merit system. (See Section 12.5.2.1.)

Table 12.6 summarizes typical restrictions that the government in a developing country often imposes on the primary market for private sector bonds, possible motives behind the restrictions, and possible negative impacts of the restrictions on private sector bond market development. These statutory restrictions usually have plausible but ostensible policy objectives that often disguise their true intentions and/or negative effects. Possible motives behind those statutory restrictions can be categorized as:

Table 12.6.

Statutory Restrictions and Requirements Impeding Primary Corporate Bond Market Development in Developing Countries

Source: Endo 2000.

Table 12.6.

Statutory Restrictions and Requirements Impeding Primary Corporate Bond Market Development in Developing Countries

Restrictive Areas	Restrictions and Requirements	Possible Motives	Possible Negative Impacts on Debt Market Development
Product features	No short term	To avoid conflicts with banking products	No reliable anchor for yield curve; will distort yield curve
	Cap on coupon rates	To keep general level of interest rates artificially low	Will hamper formation of yield curve; will dampen supply of, and demand for, long-term bonds
	No floating rate	To limit competition with bank deposits	Will limit hedging tools against interest-rate risks
	No/restrictive unsecured bonds	Unsecured bonds may undermine banks’ demand for collateral to their loans	Will be disadvantageous to new, fast growing companies and noncapital-intensive companies
	Bank guarantee	To keep bond issuance under a bank’s control	Will limit free risk/return trade-off
	No forex-linked bonds	Capital control	Will limit hedging tools against currency risks
Issuer’s eligibility	Credit-rating-linked eligibility for bond issuance	To avoid conflict with banks in lucrative mid-market	Will limit free risk/return trade-off; disadvantageous to low-rated companies
	Cap on debt issue amount	To keep bond issuance supplementary to bank loans	Will limit free risk/return trade-off
	Queuing system	To keep room for government bond issuance	Will dysfunction demand/supply relationship
Underwriter’s eligibility	Strict requirements or no license for new entrants	To protect vested interests of existing underwriters	Will limit competition and innovation
Taxation	Withholding tax and stamp duties	To compensate for weak tax collection system	Will fragment market and limit liquidity
Other	Ban on swap Ban on futures and options	Bureaucratic investor protection in absence of financial expertise and well-organized risk management systems at regulatory and corporate levels	Will limit hedging tools against interest rate risks; will limit arbitrage activities
	Vetting period of securities registration	Cumbersome and time-consuming; bureaucratic inefficiency. Banks may benefit from this inefficiency	Will reduce optimal financing opportunities; may raise financing costs to issuers

Source: Endo 2000.

View Table

Table 12.6.

Statutory Restrictions and Requirements Impeding Primary Corporate Bond Market Development in Developing Countries

Restrictive Areas	Restrictions and Requirements	Possible Motives	Possible Negative Impacts on Debt Market Development
Product features	No short term	To avoid conflicts with banking products	No reliable anchor for yield curve; will distort yield curve
	Cap on coupon rates	To keep general level of interest rates artificially low	Will hamper formation of yield curve; will dampen supply of, and demand for, long-term bonds
	No floating rate	To limit competition with bank deposits	Will limit hedging tools against interest-rate risks
	No/restrictive unsecured bonds	Unsecured bonds may undermine banks’ demand for collateral to their loans	Will be disadvantageous to new, fast growing companies and noncapital-intensive companies
	Bank guarantee	To keep bond issuance under a bank’s control	Will limit free risk/return trade-off
	No forex-linked bonds	Capital control	Will limit hedging tools against currency risks
Issuer’s eligibility	Credit-rating-linked eligibility for bond issuance	To avoid conflict with banks in lucrative mid-market	Will limit free risk/return trade-off; disadvantageous to low-rated companies
	Cap on debt issue amount	To keep bond issuance supplementary to bank loans	Will limit free risk/return trade-off
	Queuing system	To keep room for government bond issuance	Will dysfunction demand/supply relationship
Underwriter’s eligibility	Strict requirements or no license for new entrants	To protect vested interests of existing underwriters	Will limit competition and innovation
Taxation	Withholding tax and stamp duties	To compensate for weak tax collection system	Will fragment market and limit liquidity
Other	Ban on swap Ban on futures and options	Bureaucratic investor protection in absence of financial expertise and well-organized risk management systems at regulatory and corporate levels	Will limit hedging tools against interest rate risks; will limit arbitrage activities
	Vetting period of securities registration	Cumbersome and time-consuming; bureaucratic inefficiency. Banks may benefit from this inefficiency	Will reduce optimal financing opportunities; may raise financing costs to issuers

Source: Endo 2000.

• Protection of vested interests of market participants

• Preservation of the existing tax base

• Capital control

• Bureaucratic inefficiency

The development of private sector bond markets may erode some part of the business activity of commercial banks. Banks may feel threatened by an emerging securities industry, and often will attempt to use their political influence to foil or curb the development of such private sector markets.

Opposition to the development of a primary market for private sector bonds may also be found in a country’s securities industry itself. Existing intermediaries, such as investment banks and brokerage houses, may have built up significant vested interests through a banking/brokerage business and may resist changes to existing market structures and environments. Pressure from these firms at times has effectively barred new entrants such as commercial banks and foreign investment banks from posing strong competition to them. In the process, the development of the private sector bond market is impaired.

As discussed in Chapter 10 (Development of Government Securities Market and Tax Policy), taxes on securities transactions and fees (stamp duties) are common impediments to the development of government securities markets. The same considerations apply to the development of the private sector bond market. Such taxes and fees reduce market turnover and thereby market liquidity in the secondary market for private sector bonds, and in this manner inhibit the development of the market.

Lengthy vetting of filed securities registration statements is in all likelihood not an intended restriction. It is a by-product of a statutory action to implement disclosure requirements. Nonetheless, cumbersome and excessive filing requirements can become a de facto statutory restriction in that it actually prohibits issuers from expeditiously availing themselves of timely financing opportunities.

In addition to making vetting operations at the regulatory authority efficient by periodic review of existing requirements and by staff training, a shelf-registration system may be helpful in this regard. A shelf-registration system allows for the sale of securities on a delayed or continuous basis. Once a prospective issuer registers for an amount that may reasonably be expected to be sold for a predetermined period (say, two years) after the initial date of registration, the issuer and its underwriters are allowed the flexibility to sell the registered securities when they think market conditions are most favorable during that period. The major security markets, including those in Japan, the United Kingdom, and the United States, have shelf-registration arrangements.