«by MICHAEL GUDGER FAO AGRICULTURAL SERVICES BULLETIN 129 The designations employed and the presentation of material in this publication do not imply ...»
• Finally, and most importantly, most mortgages and other securities do not stay intact with both the principle and the interest stream owned by the same investor. In secondary markets, mortgages and corporate debt (and less frequently municipal bonds) securitized and broken into various components. For example, one may purchase the income stream on a pool of mortgages and not the underlying debt. Or one may buy a discounted “zero” Prof. Gonzalez Vega has stressed the problem of “opportunism” on the part of lenders. He noted that guarantors know less about borrowers than do lenders, thus offering lenders an opportunity to act opportunistically by guaranteeing the poorest loans. In the U.S. context, it is precisely this behavior that causes credit markets to demand a third party guarantee that the loan is of acceptable quality. In other words, without this vetting and backing the vetting with a guarantee based on the guarantors’ capital and credit rating, the credit markets would not likely buy the loans for fear of opportunistic behavior. From this point of view, what the income pool that will return a specified amount on a given date. Thus, there is no ongoing relationship between the borrower and the lender. In fact, they are often in different parts of the country and the holder of the mortgage may not even know the names and addresses of the underlying loans on the mortgage and structured corporate debt based products that he holds.
Thus guarantees change the relationship between a banker and a borrower in some fundamental ways. Bankers have a larger credit market for the loans that they originate.
They cannot prudently keep all the loans that they can originate. and would not want to, given the lower credit quality. In the larger credit markets there are willing buyers. Thus, banks in effect become the marketing agents for the credit markets
DO GUARANTEES PRODUCE ADDITIONALITY?
One school of thought led by Prof. Dale Adams holds that guarantees are largely irrelevant to development finance unless and until they are shown to produce additionality. An exact definition of additionality is quite complex, as the term is understood in various ways. For present purposes, additionality will be defined as additional volumes of credit and/or credit on more favourable terms to a target group which has confronted difficulties in accessing credit markets or has been charged a high “risk premium” for access to credit markets.
The U.S. experience clearly demonstrates that guarantees, if they have not produced additionality in and of themselves, certainly were part of the process of extending additional credit on significantly better terms to “low end” borrowers, a process which has resulted in additionality. There is also in the case studies a fairly consistent pattern of guarantee companies creating new guarantee products to support innovative forms of structured corporate finance and securitization of large pools of small individual transactions.
This latter development of securitizing small transactions is particularly important and interesting to those working in the field of development finance. Banks would not usually be prepared to lend amounts as small as most credit card transactions or most individual receivables nor would guarantee companies be interested in issuing a guarantee for a transaction this small. When they can be bundled (securitized), they can be guaranteed and placed in credit markets.
guarantee companies are selling is credit surveillance.
In the home mortgage arena, the development of the PMI (Private Mortgage Insurance) industry enabled people with less than a 20% down payment to buy a home. In time, the threshold was pushed down to 10% and most recently to 3-5%. This process has made home ownership, and consequently access to an important tax reduction strategy and a source of capital appreciation, accessible to millions of families that previously could not aspire to home ownership because of the collateral constraint.30 Most recently, some bond insurers (treading in the area of the mortgage insurers for the first time) have guarantee securitized secondary mortgage pools and even issued guarantees on home equity loans when the LTV reached 100%.31.
Home equity is the American family’s single largest asset class. As such, it is far more often accessed for cash to start or grow a SME than any other source, almost certainly more often government guaranteed small business loans. The PMI industry has enabled many borrowers to utilize the equity in their homes as a source of funds.
Why is this so? The principle reason is that it is far easier. Secondarily, there are no requirements to meet any other ethnic, age, income, or gender criteria. It is purely a financial transaction not affected by external factors. “Taking cash out of the home” is a decision made by the borrower and not subject to underwriting criteria and feasibility analysis. To qualify for a traditional guarantee, a borrower would be required to submit volumes of documentation and a detailed business plan that set out the projected finances of the business. Many of these applications are rejected after a long wait. Many people prefer to refinance their homes with a “cash out” mortgage and use the money to start or expand their business or for other purposes.
In the municipal and agency bond arena, lower rated municipalities and agencies with no credit histories were able to access credit markets on more favourable terms via the purchase of guarantees. The upgrading of the credit ratings on these lower rated bonds via guarantees and the sheer volume of these insured instruments seems abundant evidence that the terms and conditions on which poorer municipalities are able to sell debt has been significantly Home ownership is a politically popular policy in the U.S. The tax code provides for the deduction of mortgage interest and in some cases for an untaxed capital gain on the sale of the principle residence after a specified age. There are no such incentives for renters and therefore most families actively seek ownership both for its tax advantages and for what historically have been substantial capital gains from home ownership. Thus, in this sense the PMI buys both the tax deduction which partially or perhaps even fully offsets the cost of the insurance, and gives the mortgagee the opportunity to enjoy the capital appreciation typical of single family housing over the last half century in the U.S.
Several guarantee companies are considering or experimenting with 105-110% home mortgage guarantee products by which they will guarantee a loan for more than the appraised value of the home.
modified by the existence of guarantees. Additionally, the purchase of a guarantee has enabled issuers of bonds to secure complete placement of the bond, which might not have been fully placed had it been lower rated.
Structured corporate debt and asset backed securities are the newest area for guarantees.
Already there is evidence that many securitizations have found better market conditions and better placement with a guarantee than without a guarantee. It is also clear that guarantees have supported the access to credit markets of non-traditional forms of corporate debt and asset backed securities.
One could certainly view this as more a function of the securitizations arising from a deep and very liquid debt market and very active debt markets for municipals and corporate debt rather than the effects of guarantees. It is almost impossible empirically to separate the effects of a large, deep, and very liquid mortgage, municipal and corporate debt market able to absorb large volumes of securitized mortgages, municipal bonds and corporate debt from the effect of guarantees. In fact, even if possible, it would not be a useful exercise. The guarantee industry must have the debt markets just as the debt markets use the guarantees of the insurers to price and market securities that either would not have been sold or would have been sold on less advantageous terms to the borrowers. It is an interdependent and symbiotic relationship that has pushed financial markets to reach groups formerly excluded or included on far less favourable terms.
Perhaps the most striking testament to the additionality of guarantees in the U.S. context that the market for guarantees is open and highly competitive. The guarantees are sold on a completely voluntary basis. Under these conditions the premium income of these guarantee companies has grown quite rapidly. One may reasonably infer that the purchasers of the guarantees have found that the guarantees are providing a valuable credit enhancement and are prepared to pay time and again the price for better access and more favourable terms and conditions in credit and debt markets.
IS THE U.S. EXPERIENCE RELEVANT TO DEVELOPING COUNTRIES?
At first glance, the U.S. mortgage and bond guarantee market would appear to be of little relevance to the issues of financing SME and micro lending in the developing world. More careful consideration should modify that judgement. First, and most importantly, many American families would not be able to buy a home without the PMI (Private Mortgage Insurance). This is particularly true in the “affordable” housing sector where with the PMI;
families can purchase housing with 3-5% down payments. There are few, if any remaining banks and Savings and Loans (financial institutions very like British building societies) in the U.S. prepared to make a mortgage for their own net account with only 3-5% collateral.
However, the guarantee companies are willing to assume that risk for a price. In fact, some are beginning to issue guarantees on uncollateralized LTV in excess of 100%. And, it is in this sector which the guarantee companies through their controlled risk taking and innovation have produced the strongest argument can be made for massive additionality.
Does this exploration of how guarantees work in the American home mortgage market have any relevance to the developing world? I would like to suggest that for SME it does;
doubtfully and perhaps sadly it does not appear to be relevant for most micro enterprise borrowers, who are too few, too scattered and too poorly collateralized.32 However, even its application to the SME market is probably severely restricted by the potential market size in most developing countries and weak credit markets. This in turn focuses our attention on the vital importance of credit markets in the development of the largest guarantee industry in the world. From this point of view, the development of large scale guarantee programmes need to be seen as a part of an overall capital markets development strategy. U.S. banks got into the business of making large numbers of loans that
they previously would have rejected only when two conditions were met:
Prof. Claudio Gonzalez Vega in a posting on the Development Finance Network observed that the obstacles to reaching the micro borrower market with guarantees “where credit markets are thin and largely localized (which introduces huge risks from covariances), where the distribution of the probability of repayment across individual borrowers is highly dispersed, and where the guarantor knows little about the very few lenders that it is serving and their microborrower clients" is difficult in the extreme.
Additionally, in character based lending, mortgages are not available as the “first line of defense.” While the first observations are on target, mortgage guarantee companies depend not on lenders but on detailed credit information on borrowers. In fact, much of the high LTV business is character-based. These borrowers have a history of repayment. In this business segment, collateral is unimportant and disappears completely in some 100%-110% LTV products.
First, the government sponsored secondary market places, which were later privatized33, • and
• Second, credit markets were able to absorb the product of these local level home mortgage originations and municipal debt, then later corporate debt.
No developing country currently has a market size comparable to the U.S. market for home mortgages and home equity loans. We have seen that the economies of scale are very large indeed in the financial services sector. Most countries could not support even a single guarantee company, let alone a competitive industry. It is therefore likely that the development of national guarantee industries will be slow and hesitant and will parallel the development of debt markets. On the other hand, a multinational approach may have more potential both of expanding the debt markets’ depth and liquidity and in providing economies of scale for credit guarantee companies, although it must overcome some severe obstacles such as currency and political risk.
CREDIT GUARANTEE COMPANIES IN DEVELOPING MARKETS
Some countries have already begun to place securitizations in their debt markets, although not of home mortgages. They have a workable, if far from perfected, legal basis for such transactions. Several developing countries have developed specialized private sector guarantee insurers to provide credit enhancements. However the volume of credit guarantees remains quite small.