The population of the UAE (as in the GCC and Mena) is demographically young and fast-growing, putting pressure on the housing market.
In addition, there is a large and continuous influx of expatriates attracted by the current economic boom, with strong job growth and remuneration. Population in the UAE has been growing steadily in recent years at a compound annual rate of 7.4 per cent.
In the GCC, the reforms of property laws allowing foreigners to own property has also fuelled investment in real estate, and higher income and wealth have increased the demand on mortgages from both locals and expatriates.
However, low- and middle-income groups have limited access to housing finance facilities, while the availability, sources and instruments of housing and property finance have been lagging in the GCC countries. Traditional lending institutions, such as commercial banks and finance firms, remain the only source for finance facilities.
In the booming UAE real estate market, for example, such institutions have become increasingly exposed to the real estate market, or are facing maturity mismatching between the short-term sources of funds available, such as deposits, and the long-term funding of real estate and housing.
The creation of a liquid mortgage market, through securitisation, would reduce the risk and exposure of real estate developers and lending institutions, provide additional funding to the housing finance market and give strong impetus to the financial markets as an engine of economic growth and its sustainability.
In theory, a saleable debt instrument should be standardised, have large denominations to appeal to institutional buyers, a low-cost method of assessing credit risk and good collateral. By contrast, individual mortgages have non-standard, relatively small denominations, unique size, with high and costly credit risk assessment. Further, though they may have good collateral, standard length maturities and interest rates, they are still generally difficult to sell in a secondary market.
In order to improve marketability and create a mortgage market, several structural steps need to be taken.
First, to be able to market an issue to buyers, the mortgage security has to have standard terms (maturity, size, and interest or Sharia-compliant equivalent) familiar to the investor.
Second, the small and variable denomination of individual mortgages needs to be addressed. One way is to pool mortgages (with similar characteristics) together to create a standard large denomination.
Third, is to overcome the high cost of assessing the credit risk of the individual mortgages. This is not inherently complicated; however the credit risk analysis of the individual borrowers in the pool would be costly and would limit the usefulness of the pooling process if not alleviated. To cut transaction costs, the issuer can seek third-party insurance for the whole pool, or limit the mortgage pool to mortgages that are privately insured, or increase the loan-to-value ratio.
All these steps are feasible. However, implementing them would lower the expected economic return and attractiveness of the issue. We will discuss later how this hurdle is overcome in developed markets, and the recommendations for developing a UAE mortgage market.
Securitisation brings many benefits to financial institutions, mainly lending institutions.
First, the sale of mortgages and removal from the financial institution's balance sheet hedges the credit risk and eliminates the direct exposure to the housing and real estate market.
Second, the ability to sell loans improves the liquidity of the bank's loan portfolio. The cash generated from the sale of the mortgages would be available for immediate spending or investment, such as issuing more mortgages.
Third, considering regulatory capital needs under Basel II, loans carry a substantial risk weight in calculating capital requirements. If the loans are sold without recourse, the amount of capital the financial institution must hold can be cut and additional growth in assets may be possible.
Fourth, once the financial institution sells the pool of mortgages, the level of profits can be locked in and can be realised immediately.
Fifth, by tapping the financial market, banks can achieve more efficient funding terms than through traditional direct borrowing. This is especially true when the gap between the rating of the bank and its receivable is wide.
Finally, in most instances, securitising mortgages continues to generate fee income for the financial institution; it usually retains the servicing contract for which it receives a fee from the mortgage holder.
(to be concluded next week)
The author is Chief Economist, Dubai International Financial Centre.