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					                                            THE MORTGAGE HOLDING SUBSIDIARY CONCEPT

      The Mortgage Holding Subsidiary Concept:
      A Structure for Efficient Fixed-Rate Housing
                                                                       By Bert Ely1

INTRODUCTION                                              term deposits. This article will first explain         Because MHS would fund themselves in
                                                          the MHS concept and then discusses the                 this manner, they should not be subject to
Although housing finance systems vary                     types of cost savings MHS can deliver.                 capital regulation or other forms of bank-like
greatly across countries, reflecting                                                                             safety-and-soundness supervision. In
differences in how these systems have                     This is an especially appropriate time to              effect, MHS would strictly be passive
evolved over the decades, recent initiatives              consider the MHS concept since housing                 financing vehicles with no broad public
to modernize housing finance have three                   finance is undergoing enormous change in               interaction.
underlying objectives: greater efficiency,                much of the world, and particularly in
increased choice in the mortgage products                 Europe.3 In particular, market forces are              Figure 1 illustrates the relationship of an
offered to homeowners, and greater safety                 being unleashed to reduce housing finance              MHS to its parent bank or thrift, showing the
and stability within a country’s financial                costs while broadening the range of                    parent-subsidiary relationship. Figure 2
system.                                                   mortgage products made available to                    illustrates the likely balance-sheet
                                                          homeowners. The MHS concept fits                       composition of an MHS. Assets would
The “mortgage holding subsidiary” (MHS)                   squarely in the middle of what is emerging in          consist almost entirely of residential
concept represents an organizational                      housing finance.                                       mortgages while funding would consist of
structure      for      achieving       those                                                                    various forms of debt, issued in whatever
characteristics, specifically in providing                                                                       form made economic sense at the time.
long-term, fixed-rate mortgages to                        THE MORTGAGE HOLDING                                   The MHS would be capitalized with
homeowners. The MHS concept initially                     SUBSIDIARY CONCEPT                                     sufficient equity capital to permit it to obtain
was developed to complement a proposal                                                                           a high debt rating (at least AA) on a
to privatize three government-sponsored                   The MHS concept is quite simple, which is              freestanding basis. That is, the MHS would
housing finance enterprises in the United                 the essence of its efficiency — banks,                 not look to its parent for back-up capital
States – Fannie Mae, Freddie Mac, and the                 savings institutions, and other financial              support. The MHS’s capital level would be
Federal Home Loan Banks.2 However, the                    intermediaries subject to capital regulation           entirely marketplace-determined. While
MHS concept is easily universalized so that               would form MHS to own long-term, fixed-                Basel II is intended to reduce the amount of
it can be applied in any country which                    rate residential mortgages originated by the           capital backing banks must hold for the
already has a well-developed credit market                parent institution. Shortly after a mortgage           residential mortgages they own, the capital
for financing owner-occupied housing.                     is originated, the parent would sell it to its         markets can be much more precise in
Properly implemented, the MHS concept                     MHS.       MHS would be barred from                    determining the amount of capital backing a
should safely deliver more efficient housing              accepting deposits or deposit-like funds               particularly MHS should have since that
finance than mortgage securitization or                   from the general public. Instead, they                 capital level would depend upon the
covered bond arrangements while                           would fund themselves entirely in the capital          amount of credit and interest-rate risk that
producing longer-term, fixed-rate housing                 markets through the sale of mortgage                   the MHS had assumed.
finance than is feasible with bank-like short-            bonds and other types of debt instruments.

    Mr. Ely, the principal in Ely & Company, Inc., Alexandria, Virginia, is an independent financial institutions and monetary policy consultant.
 Wallison, Peter; Stanton, Thomas H.; and Ely, Bert (2004) Privatizing Fannie Mae, Freddie Mac, and the Federal Home Loan Banks: Why and How, American
Enterprise Institute, Washington, D.C.
    Kemmish, Richard, Are you in?, The Banker, 04 November, 2004, page 9.

                                                HOUSING FINANCE INTERNATIONAL – March 2005                                                                   35
                                      THE MORTGAGE HOLDING SUBSIDIARY CONCEPT

                                        Figure 1: The Mortgage Holding Subsidiary Concept

                                                    Bank, savings institution,
                                                  or other type of financial firm
                                                  subject to capital regulation

        Bank originates and sells home                                                              Bank invests sufficient equity capital
     mortgages to its MHS and services                                                              to enable its MHS to achieve a target
                       those mortgages                                                              debt rating

                                                           Mortgage Holding
                                                           Subsidiary (MHS):
                                                           A wholly owned or
                                                       majority-owned subsidiary
                                                     not subject to capital regulation

                                                 Non-insured, non-government-guaranteed
                                                 debt funding raised in the capital markets.

The following are key features of the MHS             residential mortgages, the tradeoff               Office of the Comptroller of the
concept:                                              between the cost of an MHS’s equity               Currency.
                                                      capital and the cost of its debt would tilt
•    MHS would be funded in the wholesale             MHS towards capital levels that               •   The parent’s investment in an MHS
     capital markets with medium- and long-           produce at least AA debt ratings, if not          would be fully deducted from the assets
     term debt, reflecting the relatively long        AAA. To strengthen the credit rating of           and equity capital of the parent for the
     life of fixed-rate residential mortgages.        unsecured MHS debt, MHS debt might                purpose of calculating the parent’s
     This approach parallels the widespread           be given a liquidation priority over other        compliance      with    bank     capital
     practice in Europe of pfandbriefe                general unsecured creditors of the MHS            requirements. Hence, the parent could
     financing, or funding long-term, fixed-          should it become insolvent.                       not finance its investment in an MHS
     rate mortgages with mortgage bonds or                                                              with deposits or borrowed funds.
     covered bonds sold in the capital           •    There should be no limit on the number
     markets, largely to institutional                of MHS which can be chartered nor             •   The parent would be barred from
     investors.                                       should they be chartered as banks –               injecting equity capital into an MHS if
                                                      any bank or savings institution which             that capital injection would drop the
•    MHS would not be subject to any                  wished to charter an MHS should be                parent to an undercapitalized status. If
     regulatory capital requirements, either          permitted to do so. However, the                  a parent made such a capital injection,
     simple leverage ratios or the Basel risk-        relationship between an MHS and its               its supervisor could direct the
     based capital standards. Instead,                parent should be overseen by the                  immediate return of the capital to the
     marketplace forces would determine               parent’s         safety-and-soundness             parent. An illegal capital injection into
     the capitalization of an MHS. MHS                supervisor, strictly for the solvency             an MHS should be treated on the books
     owning higher risk mortgages or                  protection of the parent institution. For         of the MHS as a secured loan superior
     retaining substantial interest rate risk         example, in the United States, the                to all unsecured claims on the assets of
     would have to carry more capital than            relationship between an MHS and a                 the MHS so that the capital can quickly
     MHS with low-risk mortgages and no               parent which had been chartered as a              be returned to the parent.
     retained interest-rate risk. Because of          national bank would be monitored by
     the high credit quality of most                  the U.S. Department of the Treasury’s

36                                       HOUSING FINANCE INTERNATIONAL – March 2005
                                       THE MORTGAGE HOLDING SUBSIDIARY CONCEPT

                                            Figure 2: Composition of an MHS balance sheet
                                                                    (not to scale)

                                Assets                                    =                         Liabilities + equity capital

                      Residential mortgages                                                                ISS debt
                        securitized “in situ”                                                          (debt incurred by
                     (in-situ securitization, or                                                          mortgages
                                ISS)                                                                  securitized “in-situ”)

                      Residential mortgages                                                       Callable, noncallable debt
                                                                                                  secured by the mortgages

                                                                                                Unsecured “preferential” debt
                      Residential mortgages                                                     raised in the capital markets
                   (one-family and multi-family)
                                                                                                  Other unsecured liabilities

                 Cash + short-term investments                                                         Subordinated debt
                            Other assets                                                                   Equity capital

•   An MHS could issue stock to third                   exists in many securitization or                    from its MHS long-term, fixed-rate
    parties (including other banks and                  covered-bond arrangements and hence                 mortgages just a few years short of
    savings institutions), subordinated debt,           more efficient.                                     maturity.
    unsecured debt, preferential unsecured
    debt, covered bond arrangements, and           •    There should be no restriction on the          •    When interest-rate levels declined,
    secured debt. Secured debt could be                 size or type of residential mortgages the           triggering mortgage refinance activity,
    secured by a specified group of                     MHS could purchase from its parent or               the MHS could lower the cost of
    mortgages       under     the     “in-situ          from third parties. In addition to owning           refinancing mortgages by simply
    securitization” concept discussed                   mortgages on primary residences, MHS                adjusting the interest rate on the
    below. For financial reporting purposes,            should be permitted to hold mortgages               mortgage and recalculating the monthly
    the MHS’s financial statements should               on holiday homes, apartment buildings,              payment. It could profitably fund the
    be consolidated with its parent in                  university dormitories, nursing homes,              lower interest rate on the mortgage by
    accordance with Generally Accepted                  and other residential structures. At the            calling higher cost debt and replacing it
    Accounting Principles.                              same time, the MHS’s parent should                  with lower-cost debt.
                                                        have complete latitude in determining
•   Because the MHS would be a passive                  which mortgages to sell to its MHS and         •    In order to operate as efficiently as
    financing vehicle, with few if any                  which ones to keep on the parent’s                  possible, particularly in dealing with
    employees, it could be managed by its               balance sheet. Quite likely, the parent             mortgage refinances, the MHS could, to
    parent bank, it could share officers and            would retain adjustable rate mortgages              the extent tolerated by the financial
    directors with the parent, purchase                 and fixed-rate mortgages with short                 marketplace, operate as one giant
    mortgages from the parent (as well as               maturities, funding them with deposits,             mortgage pool financed by preferential
    from third parties), and contract with its          while selling long-term, fixed rate                 unsecured debt.       However, when
    parent to service those mortgages. This             mortgages to its MHS.4 By the same                  market conditions so demanded, the
    relationship would be closer than what              measure, the parent might buy back                  MHS could create pools of mortgages

 An October 2003 report by consultants’ Mercer Oliver Wyman, Study on the Financial Integration of European Mortgage Markets, for the European Mortgage
Federation had this to say about funding mortgages (page 63): “The mortgage bond appears to be an efficient mechanism for funding long term fixed rate
products but possibly less efficient for short-term products where the flexibility of deposits make this a more attractive option.”

                                           HOUSING FINANCE INTERNATIONAL – March 2005                                                              37
                                            THE MORTGAGE HOLDING SUBSIDIARY CONCEPT

     funded by debt secured by the                       should be a highly unlikely event), that           intends to sell the mortgage to an unrelated
     mortgages,           through        in-situ         insolvency would not endanger its parent’s         party. Since origination costs vary greatly,
     securitization, or it could sell mortgages          capital position. Moreover, limiting MHS to        depending on house price, mortgage
     into a bankruptcy-remote securitization             capital market funding would eliminate any         amount, jurisdiction where the home is
     trust which would issue mortgage-                   rationale for applying bank-like regulation to     located, and how well the costs are
     based securities (MBS).                             MHS. Therefore, MHS should be highly               identified and quantified, cost savings
                                                         capital efficient, which would generate            would vary from country to country.
•    MHS could enter into interest-rate                  significant cost savings by reducing the
     swaps and other interest derivatives to             required profit spread incorporated in             Lower origination costs can reduce a
     hedge interest-rate and prepayment                  mortgage interest rates.                           homeowner’s “all-in” mortgage interest rate
     risk. They also could enter into credit-                                                               by more than a few basis points. Seldom
     derivative transactions to shift a portion          The cost argument underlying the MHS               considered by borrowers, the all-in interest
     of geographical or credit-quality                   concept begins by differentiating the two          rate includes the amortization of any
     concentrations to third parties.                    major cost components associated with a            mortgage origination costs paid by the
                                                         mortgage — mortgage transaction costs              borrower, usually when the mortgage is
                                                         (the cost of making and servicing a                originated, in addition to the mortgage
POTENTIAL MHS COST SAVINGS                               mortgage loan) and the pure cost of funding        interest rate. It is not possible to compute
                                                         the mortgage.                                      the all-in interest rate when a mortgage is
In essence, the MHS concept would make it                                                                   originated if the actual life of the mortgage is
financially feasible for mortgage originators                                                               not known because it can be paid off,
to originate long-term, fixed-rate mortgages             Mortgage transaction costs                         through a house sale or refinancing, before
that they could hold to maturity in an MHS                                                                  the mortgage is fully amortized. Origination
rather than originate them for eventual sale             The MHS concept would enable banks,                costs can add significantly to the all-in rate
or securitization.                                       savings institutions, and other mortgage           if the mortgage is outstanding for just a few
                                                         originators to reduce mortgage transaction         years.
The sound public-policy reason for                       costs – originating the mortgage and then
permitting this is that ownership of an MHS              servicing it – by originating long-term, fixed-    For example, if a borrower incurs a cost of
should not endanger the solvency of the                  rate mortgages to hold in their MHS rather         $1,500 in connection with originating a
parent bank or other type of depository                  than originating mortgages to sell in a            $100,000 mortgage, he might save up to
institution because the parent’s investment              secondary mortgage market. This would be           $500, or one-third, if the originator sells the
in an MHS should be fully deducted from                  the case because many costs in the                 mortgage to its MHS rather than selling it
the parent institution’s capital. Hence,                 origination process can be reduced or              into a secondary mortgage market. Cost
should an MHS become insolvent (which                    eliminated if the mortgage originator never        savings on refinanced mortgages should be

                  Figure 3: Lowering origination costs significantly reduces the all-in mortgage interest rate
                                                    Based on a 30-year, $100,000 6% fixed-rate mortgage
                                               Amortized cost per year of
                     Basis points

                                               $1,500 in origination costs
                                                                                                            $1,000 cost
                                                                                                              $500 cost
                                         30 years     10 years       7 years       5 years        3 years       2 years

                                                           Early pay-off mortgage at the end of

38                                             HOUSING FINANCE INTERNATIONAL – March 2005
                                         THE MORTGAGE HOLDING SUBSIDIARY CONCEPT

much greater, perhaps by two-thirds, or              Mortgage servicing costs                           securitizations” (ISS). Given their large
$1,000, in case of the $100,000 mortgage                                                                asset size, MHS would issue debt in large
example. These savings can be quite                  Mortgage originators can trim their servicing      tranches, which would make their debt
substantial, in terms of the amount                  expenses by originating mortgages to meet          extremely liquid.
expended and the actual, after-the-fact all-         their own servicing standards, not industry
in interest rate. Figure 3 illustrates the all-in    standards governing the sale of mortgages,         Unsecured financing - an MHS could fund
interest-rate reduction for origination cost         which may require additional costs. Thus, in       its mortgages with a combination of senior
savings, based on actual mortgage lives.             addition to trimming origination costs, the        unsecured debt and subordinated debt,
The savings are especially significant if a          MHS structure should reduce servicing              plus equity capital. In so doing, an MHS
mortgage is refinanced frequently.                   costs by a few basis points per mortgage           would assume full credit risk on the
                                                     dollar outstanding by (1) not requiring the        mortgages it owned plus whatever interest-
An example will further illustrate the               originator to prepare to sell the mortgage;        rate and prepayment risk it did not hedge
significant impact of reducing origination           (2) permitting the mortgage originator to          through      on-balance-sheet        maturity
costs.      Assume an original 30-year               integrate mortgage servicing more closely          matching, callable debt, and off-balance-
purchase mortgage of $100,000, carrying              with other services provided to the                sheet interest-rate derivatives. The financial
an 8% interest rate, is refinanced every             homeowner; (3) reducing credit costs               markets would determine the amount of
three years and then the home is sold at the         because of a broader customer relationship;        capital backing for this portion of an MHS’s
end of the twelfth year, triggering a                and      (4)    increased      cross-selling       balance sheet, based on (1) the riskiness of
mortgage payoff. Further assume the                  opportunities, particularly for property-          the mortgages financed in this manner, (2)
mortgage was refinanced at the                       related services such as property insurance,       the amount of interest-rate and prepayment
progressively lower rates of 7%, 6%, and             home equity lines of credit, and credit life       risk the MHS had retained, and (3)
finally 5.5%. Finally, assume an initial             insurance.                                         management’s target credit rating for the
mortgage origination cost of $1,000 and a                                                               MHS debt.
$500 charge for each refinance. This                 It is also more likely that homeowners would
reduction in origination costs, from $1,500          finance and refinance their mortgage where         In-situ securitization In-situ securitization,
per origination or refinance, spread over 12         they have their primary banking relationship       or ISS, is functionally equivalent to funding
years, would reduce the all-in mortgage              if the bank can retain the ownership of the        mortgages with MBS or covered bonds,
interest rate by 31 basis points.                    mortgage in its MHS. This would allow the          except that with ISS financing, both the
                                                     bank or savings institution to capture the         mortgages financed and the ISS debt
The cost savings, in basis points, for larger        synergies of an integrated customer                remain on the MHS’s balance sheet rather
mortgages is not as great - because                  relationship - an element that would also          than being moved off-balance-sheet into a
origination costs are lower in relation to the       result in a lower mortgage interest rate. The      securitization trust or sold to an unrelated
size of the mortgage - but still significant.        value of the other benefits of this closer,        specialized mortgage financing entity
For example, assuming a $200,000                     more integrated customer relationship              issuing covered bonds. That is, as is the
mortgage with the same refinancing                   would vary from country to country, but in a       case with MBS, investors in ISS would
frequency and interest rates set out above           recent study of the European mortgage              assume all interest-rate and prepayment
(except for a $2,000 initial origination cost),      market the authors noted that “there is            risk while the MHS, as issuer of the ISS,
the reduction in the all-in rate of interest         strong evidence from interviews with               would retain all credit risk. However,
would equal about 22 basis points over the           mortgage lenders that the mortgage                 mortgages financed with ISS debt would
life of the loan. This second example                product is increasingly being seen as a            enjoy substantial origination cost savings
highlights a key advantage of the MHS                ‘gateway’ product to gain access to the            because they would not be originated for
concept - the benefits, in terms of reducing         customer and use as a basis for cross-             sale in the secondary mortgage market.
the all-in interest-rate, would be                   selling other products.”5                          Instead, ISS-financed mortgages would be
proportionally     greater      for    smaller                                                          “kept in the family” by being sold by a
mortgages, which tend to be taken out by                                                                mortgage originator to its captive MHS.
lower income families purchasing                     Lowering mortgage funding costs
inexpensive homes. This feature should                                                                  Structuring an ISS debt financing would
enhance the attractiveness of the MHS                While MHS would fund themselves in                 work as follows: The MHS would set aside
concept for those who believe lower                  whatever manner makes most economic                a group or pool of mortgages it owned and
mortgages rates are key to making home-              sense at the time, MHS most likely would           then grant an undivided security interest in
ownership more affordable while expanding            fund their mortgage assets with a                  those mortgages to the purchasers of the
home ownership opportunities.                        combination of unsecured debt and                  ISS debt financing the mortgages. In effect,
                                                     secured debt raised through “in-situ               just these mortgages would secure the debt

    Mercer Oliver Wyman, “Study on the Financial Integration of European Mortgage Markets,” European Mortgage Federation, October 2003.

                                            HOUSING FINANCE INTERNATIONAL – March 2005                                                             39
                                     THE MORTGAGE HOLDING SUBSIDIARY CONCEPT

financing them. This financing arrangement      Hence, the credit rating assigned to a           securities quite liquid, which in turn would
would be comparable to a business               particular ISS debt issue would reflect both     further reduce interest rates on home
financing a factory building with a             the degree of over-collateralization backing     mortgages as marketplace competition
syndicated loan secured by just that            the debt and the overall capital strength of     pushed the benefits of greater liquidity
building. ISS debt could be structured as a     the MHS. Due to the relatively low volatility    through to borrowers, in the form of lower
simple pass-thru security or as a more          of residential mortgage loan credit losses,      mortgage rates. Savings of even a few
complex, multi-tranche security. Either         an MHS’s targeted pre-tax, pre-credit-loss       basis points per mortgage dollar financed
structure would pass through to the debt        return on its capital allocated to credit risk   would be significant, relative to a country’s
holders principal and interest payments as      should exceed it actual credit losses, even      GDP, given the amount of home mortgage
they were being made, less a profit and         in high-loss years. Consequently, it should      debt outstanding in most countries.
expense margin for the MHS.                     be extremely rare for an MHS to dip into its
                                                capital to absorb credit losses.
In order to obtain an AA or better credit                                                        CONCLUSION
rating on its ISS debt, an MHS most likely      Competition among MHS in selling their in-
would covenant to maintain at all times an      situ financing securities would force an         Housing finance is undergoing enormous
over-collateralization of a particular ISS      optimal level of transparency in mortgages       change in much of the world, and
debt issue by a specified multiple of           financed with in-situ securities, specifically   particularly in Europe, as covered bond
expected credit losses projected for the        with regard to prepayment characteristics.       legislation is revised and expanded and as
pool of mortgages securing the debt issue.      In particular, greater transparency would        other forms of structured finance emerge.
Over-collateralization would ensure timely      reduce any cross-subsidy now flowing from        Basel II also will impact on housing finance
payment of principal and interest on the ISS    mortgages that prepay slowly to mortgages        in ways which are not yet fully understood.
debt. Based on the U.S. experience, the         that prepay quickly where no prepayment          Further, there is strong interest in many
over-collateralization multiple most likely     penalty is charged. This cross-subsidy,          countries in shifting towards a greater
would fall in the range of 10 to 20 times the   which flows from the less well off to the        reliance upon long-term, fixed-rate home
expected loss rate. For example, if the         better off, arises because the prepayment        mortgages and away from variable rate
expected loss rate was two basis points         option in fixed-rate mortgages provides a        housing finance funded largely by bank
annually, the over-collateralization would      benefit only when it is exercised; those who     deposits. The MHS concept provides a
equal .2% to .4% of the amount of ISS debt      refinance more frequently tend to be higher      vehicle for efficiently providing long-term,
then outstanding. Additionally, MHS most        income, more sophisticated borrowers.            fixed-rate housing finance while maintaining
likely would guarantee the timely payment                                                        the role banks and savings institutions have
of principal and interest on ISS debt, on the   By using the in-situ technique to finance        traditionally, and understandably, played in
slight chance that the over-collateralization   mortgages originated by their parent banks,      housing finance, yet avoiding the
proved to be insufficient during a time of      large MHS should be able to construct            complexity and rigidity that Basel II capital
severe economic distress.                       mortgage pools with large tranches of ISS        requirements will impose on banks and
                                                securities.   This would make in-situ            other types of depository institutions.

40                                      HOUSING FINANCE INTERNATIONAL – March 2005

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