Bill Stacey argues that as the market has changed the original policy rational of the Hong Kong Mortgage Corporation has disappeared

The Hong Kong Mortgage Corporation (HKMC) has reached its use-by date. It has sought to survive through a strategy of diversification that takes on higher risk with public funds. The organization now does little more than exploit credit and regulatory arbitrage opportunities. The government should dramatically reform HKMC by either listing the company or selling its stake to private institutions.

Rationale for HKMC

Hong Kong Mortgage Corporation (HKMC) was established in 1997. The original rationale stated in the 1997 Annual Report was to:

1. Purchase portfolios of mortgages or other loans secured by residential properties situated in Hong Kong from Hong Kong “authorized institutions,”
2. T o raise financing for purchase of mortgages through the issuance of debt securities in the capital markets, and
3. T o securitize mortgage portfolios.

At founding the idea was to provide an outlet for banks to manage total mortgage exposures and the Hong Kong Monetary Authority (HKMA) was particularly interesting in building Hong Kong fixed income markets.

The original rationale was weak. Hong Kong hadnot developed deep fixed income markets because thestrong fiscal position of the government, relativelyconservative gearing of corporations, as well as easyaccess to Eurodollar markets saw limited supply of termcredit. Investor demand was also weaker when in a linkedexchange rate regime USD securities provided manyinvestment alternatives.

The original rationale was weak. Hong Kong hadnot developed deep fixed income markets because thestrong fiscal position of the government, relativelyconservative gearing of corporations, as well as easyaccess to Eurodollar markets saw limited supply of termcredit. Investor demand was also weaker when in a linkedexchange rate regime USD securities provided manyinvestment alternatives.

The HKMC has strayed far from its original rationale. Mortgage Insurance is now an important line of business (from 1999). In October 2006 the Board of HKMC approved a diversification strategy. Non mortgage assets are growing (from 2006) and since late 2007, HKMC has expanded the strategy by growing Asia mortgages assets, with 24% of loan exposure now outside Hong Kong.

This diversification has not been driven by opportunity and market demand, but by a drive for institutional survival as the original business rationale disappeared.

It is not a harsh assessment. The HKMC in its 2008 annual report states that:

“The Board accepted the assessment [by a consultant] that without substantial asset acquisition by the Corporation, there would be little room for the corporation to remain a viable entity.”

For a private business, changing corporate strategy with changing markets is a necessity. There is always the sanction that a shrinking business or unsuccessful diversification will see closure of the business, merger or other restructuring.

However for a public institution using public funds, divergence from the original purpose needs a strong policy justification. Given the actual role and performance of HKMC, it is not at all clear that it any longer serves its original policy purpose.

Performance of HKMC – less than it seems

HKMC operates three main lines of business: 1. a domestic mortgage business, 2. domestic mortgage insurance, and 3. international mortgage and mortgage insurance. Non mortgage assets are small.

Hong Kong Mortgages

The core business of HKMC is the purchase of mortgage loans from Hong Kong banks and funding these purchases either through securitization or HKMC debt facilities. HKMC does not originate or service mortgages. Its customers are the banks and debt markets.

This basic role is very similar to Freddie Mac and Fannie Mae (Government Sponsored Enterprises or GSEs) in the United States, although both of those institutions ultimately diversified considerably from their original function. A key difference between Hong Kong and U.S. markets is that typical Hong Kong mortgages are variable rate, compared to the fixed rates that are common in the U.S. Therefore, HKMC does not have the interest rate risk intermediation function of the GSEs. It also operates on much less leverage and as a much smaller player in the market.

The role of the HKMC is more akin to the historic role of competing money centre banks in the U.S. providing smaller regional banks with funding and liquidity. Closer to Hong Kong, it can play a role as an alternative to the major deposit taking banks in Hong Kong providing liquidity to the money market which funds the balance sheets of smaller banks.

Despite initial promise during the period from 2001- 03 when banks themselves faced pressures, HKMC has for the past five years been a declining business. Irrespective of mortgage credit growth, which in Hong Kong has been subdued compared to many markets globally, HKMC has been losing market share and its portfolios contracting.

HKMC mortgage loans

This is mainly because the mortgage market in Hong Kong has changed. Deregulation of interest rates and the entrance of new competitors, as well as the more recent impact on the market of China banks, have significantly reduced net interest margins in the mortgage market from the levels seen in the 1990s. Subdued corporate lending growth as capital markets intermediate more credit has reduced balance sheet growth for banks and made mortgages more attractive. Lower capital requirements and favourable treatment under Basle 2 further encourage banks in Hong Kong to focus on retention and growth of their mortgage portfolios.

Market share of mortgages and mortgage growth

As a result of these changes, the market share of mortgages held by HKMC has declined from a peak of 9.3% to 4.6% today.

Further, the average life of a mortgage varies with interest rates and expected incomes, but around six years is relatively low by international standards and is a declining trend. Hong Kong consumers have, since the experience of negative equity in 1999-2004, had a cautious appetite for leverage.

This portfolio shrinkage creates challenges for funding programmes and the demand for HKMC paper in the market. It makes it difficult to sustain securitization vehicles.

It is evident from this data that whilst the HKMC might have a desired function, its core business rationale does not look sustainable. As a result, the focus of the HKMC has shifted from a purported business rationale towards a policy role “providing liquidity” to the Hong Kong banking sector and helping them manage their balance sheets.

Even that rationale would have looked flimsy if not for the financial crisis. Yet even here the role of HKMC was slight. A single local bank had a small “run” driven by rumor rather than actual balance sheet stress. Amongst measures taken to ensure liquidity for that bank, a substantial portfolio of mortgages was sold to HKMC. This measure was not essential to the bank concerned. Other established liquidity measures would have been sufficient for the bank to work through the short-term challenge. Indeed, other banks may well have been willing to acquire the portfolio or other assets. The bank has since intimated that it might have preferred not to have sold those mortgages.

In retrospect, the minor and arguably unnecessary role of HKMC during an extreme crisis of the financial system underlines that the institution has reached its use-by date. We examine below the financial performance of this part of the business.

Despite initial promise during the period from 2001-03 when banks themselves faced pressures, HKMC has for the past five years been a declining business.

Hong Kong Mortgage Insurance

HKMC is also the major provider of mortgage insurance in Hong Kong. It began the business in 1999. Mortgage insurance provides lenders guarantees that in the event of mortgage default they will not suffer losses or that those losses will be capped. Typically mortgage margins are fine and insurance is only used for higher risk mortgages.

In the case of Hong Kong, the HKMA imposes stringent constraints on mortgage origination. Amongst other limits, banks are not allowed to offer mortgages with a loan to valuation ratio (LVR) over 80% unless those mortgages have mortgage insurance. In other markets, an LVR up to 90% might commonly be underwritten without mortgage insurance and LVR limits are usually bank practice rather than regulatory rules. As a result, penetration of mortgage insurance is growing quickly and now stands at 16% and 84% of approvals are for secondary market transactions.

These rules have underpinned rapid growth in HKMC mortgage insurance premium. This growth has been further boosted by policy changes designed to support the market during the financial crisis. HKMC sharply expanded its mandate, offering mortgage insurance for mortgages with an LVR of above just 60%. Previous extensions offered premium discounts for lower risk loans and extended insurance to cover non-owner occupied property.

Gross premium growth

There are a number of private sector mortgage insurance providers internationally. Given the strong underwriting track record in Hong Kong despite stressed markets, it could be an attractive niche market for some of these underwriters.

These attractions of the business for private providers are underlined by the financial performance of this business for HKMC. The expense ratio for an insurer is a measure of efficiency that compares costs to net premium written. This ratio has continued to decline and is currently 8%, an extremely low number by industry standards.

The claims performance has also been extremely strong, consistent with the good credit quality experience in Hong Kong. At the peak of the negative equity experience, claims were just 6% of net premium. Note that the high claims ratio in 2008 reflects a growth in “claims incurred but not reported” simply reflecting very prudent provision for economic changes and the rapid portfolio growth rather than any actual losses.

This results in a combined ratio on an underlying basis of under 10%, where insurers are typically happy with any number under 100%.

The appetite of private sector insurers for Hong Kong mortgage risk is illustrated by the high use of reinsurance by HKMC in the early stages of its mortgage insurance programme. Retention ratios under 50% are low and reinsurers were clearly happy to take on the risks. HKMC has been increasing retention, sharply increasing the profit contribution from insurance, albeit increasing risk exposures.

HKMC insurance combined ratio

The insurance business is a growing contributor to the HKMC bottom line, now delivering 13% of pre-tax profits. However the underlying contribution without the high reserves taken in 2008 is probably much higher and will be reflected in a rapid profit growth going forward.

Insurance % of total profit

Two criticisms can be made of the HKMC mortgage business. The first is that it is largely the result of “regulatory arbitrage.” The business comes into existence and has its current scale mainly because of the stringent HKMA prudential requirements on mortgages.

Secondly, the HKMC has displaced potential private providers in the business. They might reasonably argue that the Hong Kong market is small and would not be adequately provided with mortgage insurance if not for their role. However, the appetite of reinsurers for HKMC risk suggests this is not the case. Further, the extremely high profitability of the business since inception suggests that there should be more competition. Unfortunately although there are no formal restrictions on new entrants, the close relationship between the HKMC and the banking regulator likely makes the private sector reluctant to compete.

International Mortgages

The international business includes mortgage portfolios from Korea, a joint venture in Malaysia, and a new venture in Shenzhen China. The international operations contribute 24% of assets, but just 12% of profits for HKMC. The business started in December 2007 with the purchase of HK$ 5.5bn of mortgage-backed securities from Korea. The Korea purchase looks like little more than an investment strategy adding assets to the balance sheet with HKMC adding no value in origination.

The joint venture in Malaysia with Cagamas, the Malaysian mortgage corporation, targets mortgage guarantee business particularly in Islamic markets, though not limited to Malaysia in its scope. There is extensive over-building in parts of Malaysia and it is one of the riskier mortgage markets in Asia.

The China venture is established with an associated company of the Peoples Bank of China and will also offer mortgage guarantees.

The international business diversification has moved beyond the core businesses operated in Hong Kong. The guarantee business is not the same as mortgage insurance and arguably carries higher underwriting and operational risks. The guarantee business typically lacks the close cooperation with originators and the ability to manage underwriting criteria that is found in mortgage insurance. Loan guarantee businesses operated by domestic insurers in China had a very patchy track record, albeit that they did not target the mortgage market. China already has an extensive network of private loan guarantee providers and it is not at all clear what gap in the market is targeted by the HKMC and its partner.

These ventures may all prove to be well thought out and successful. However, they seem driven more by the necessity to diversify than by strong market opportunities. That both are also with government related partners in countries without the same discipline about governance and returns that are present in Hong Kong is also a concern. These operations are new and there is little disclosure about the strategic case for them and financial targets.

There is no question but that the international businesses are higher risk ventures than the existing business of HKMC.

Credit arbitrage is an old game. A highly rated company can easily raise cheap funds and report higher earnings by investing that money in higher risk assets. However, that strategy does not add value, unless those higher risk assets are being mispriced in the market or the acquirer can manage those assets better. The international strategy to date looks simply like an exercise in credit arbitrage.

Asset mix HKMC	Profit mix HKMC

Financial Performance of HKMC

The Hong Kong Government, the company, and HKMA tout a strong financial performance as vindication of the HKMC operations and strategy. The view seems to be that if the HKMC can support itself financially and also perform a valuable back up public policy role, then it might as well continue.

Revenues and margins

Looking at that overall financial performance in more detail, 85% of revenues for HKMC are Net Interest Income, although with the growth of the insurance business the reliance on interest income has declined over time. Interest income is generated from interest generated on loan portfolios and investment securities. The investment securities portfolio largely represents the return generated on placement of HKMC capital and is conservatively invested. However, the contribution of the investment portfolio is growing over time to 28% of interest income.

HKMC looks like it has delivered very stable net interest margins, managing interest rate volatility well. Historically, higher short-term interest rates were negative for margins, increasing funding costs before loan repricing. However, with a greater reliance on investment securities for interest income, it looks like low investment yields have recently depressed margins and offset the funding cost changes.

HKMC does not have the advantages that a bank might have of a stable source of low cost retail deposits. It has longer duration liabilities and is not in the business of “borrowing short and lending long.” With lower risk assets than a bank, HKMC delivers and should deliver consistently lower margins than large mortgage oriented banks.

HKMC NIM compared to Hang Seng Bank

However, HKMC should have significant advantages over banks in delivering a return to shareholders. As an investor rather than an originator, it can run much leaner cost structures. As a mortgage specialist it should be safely able to operate with higher gearing than a commercial bank. More importantly, as an arm of the HKMA and the Hong Kong government, HKMC has a much lower cost of funds than a bank.

That both are also with government related partners in countries without the same discipline about governance and returns that are present in Hong Kong is also a concern.

The chart below compares the average cost of liabilities for HKMC to the yield to maturity on HSBC wholesale debt. It points to a funding cost advantage in term debt over even the strongest private sector players of 100-200bp. This sovereign support is a key competitive edge of HKMC over banks or any potential commercial rival.

The structure of the Hong Kong market, with a focus on variable rate mortgages, benchmarked at prime rates or HIBOR somewhat neuters this as a competitive advantage in mortgage acquisition. However, the lower cost of funds from the government relationship does enhance HKMC returns and influences the economic incentives as HKMC looks at expansion opportunities.

HKMC comparable cost of funds

Most of the non interest income at HKMC is generated by the insurance business. However, under new Hong Kong accounting standards, more of the investment activities are reflected in non interest income via gains on disposal, dividends, and fair value adjustments.

In 2008 securities valuations and foreign exchange differences were a large, though likely non recurring drain, on income. However, the higher emphasis on international business and greater reliance on securities income than loans is likely to lead to more volatile revenues.

The lower cost of funds from the government relationship does enhance HKMC returns and influences the economic incentives as HKMC look at expansion opportunities.

Efficiency

HKMC runs a lean cost structure reflecting its low growth, wholesale or intermediary business model and a focus on productivity. However, staff costs (65% of total costs) have started to grow much more quickly with the implantation of the diversification strategy. Staff costs in 2008 were 31% higher than in 2006, whilst revenues were down 6.8% in the same period.

Staff costs growth

Asset quality

Reflecting the market, HKMC has delivered extremely good loan asset quality. In the weakest property market of a generation in 2003, delinquencies peaked at 60bp of loans. Loan loss provisions peaked at 43bp of loans and in the 3 years afterwards, there were two years of write back reflecting provisioning conservatism.

HKMC mortgage delinquencies

Gearing is conservative

HKMC has traditionally run conservative gearing, with simple equity to assets ratio of 11.5% in 2006-07. In 2008 this dipped to 8.8% with a combination of asset growth and the impact of market shifts on reserves. 1H09 has seen the capital ratio rise up at 9.6% because of fair value gains and retained earnings. By way of example, despite HKMC likely having a lower risk profile, Hang Seng bank has an equity to assets ratio of 6.8% and Bank of China (Hong Kong) of 8.4%.

Staff costs in 2008 were 31% higher than in 2006, whilst revenues were down 6.8% in the same period.

Conservative gearing contrasts HKMC with mortgage companies that had high losses and caused systemic problems in other parts of the world. However, it also suggests a lazy balance sheet struggling to deploy the financial resources at hand.

Guidelines for HKMC issued by the Financial Secretary limit the equity to assets ratio to 5%.

Returns probably understated, but flattered by low funding costs

Over its life, HKMC has delivered an average Return on Equity (ROE) of 11.5% and Return on Assets (ROA) of 1.3%. The underlying performance is probably better, shown by the 15.6% annualized ROE achieved in the first half of 2009.

It also looks like HKMC are consistently conservative in reserving for loan loss, insurance liabilities, and seems to take reserves for “contingencies” that I estimate suppress ROE by 60bp.

Combined with the conservative gearing, the “rents” being extracted from mortgage holders by HKMC are obscured by these layers of caution.

HKMC returns

That said, compared to a company operating without the sovereign backing that supports its low cost of funds, HKMC enjoys an advantage. As a rough estimate, the funding cost advantage averages something like 60bp. Returns are very sensitive to the cost of liabilities. The benefit from the government supported lower cost of funds enhances ROE by as much as 5%.

Considering the offsetting impacts of a low cost of funds and reporting conservatism, the normalised return on equity for a business like HKMC would be in the 10- 12% range; a mediocre return in a mature business with no domestic growth.

HKMC funding cost normalised returns

Disclosure Slips

On the whole, HKMC should be commended for reasonable monthly disclosure that meets investor and rating agency needs. However, as the business has expanded, regular monthly disclosure has slipped. Through its 10 years of operations, the following disclosure changes have been made:

• For insurance, the actual insured amounts were dropped
• The key insurance approval data was dropped
• Charge off rates are no longer published
• Detail of LVR for insured loans has been dropped
• Volumes of Korea and international mortgages are no longer disclosed monthly
• There was a recent switch back from disclosing insurance applications received to approved

Some new disclosure has been added on debt programmes in particular. However, it seems that the data no longer disclosed is more likely to be controversial and seems to be data that would be most helpful in understanding the pattern of portfolio risks being taken.

A private firm can cite commercial confidentiality as a constraint on disclosure. Public institutions should not be in businesses that cannot be fully disclosed.

How HKMC distorts the market

The origins of the HKMC can be appreciated and arguably, management has done a reasonable job executing the original policy vision. However, the market has changed and the HKMC no longer plays a role that justifies the investment of public funds and support of the public finances strong credit rating.

The existence of the HKMC distorts the domestic mortgage market.

First, in the domestic mortgage market, its shrinking portfolio is only viable because of the low cost of funds. The role in a “crisis” does not seem essential. There is a risk that HKMC activities crowd out new entrants in securitization markets that do not have the advantage of funding costs at sovereign benchmarks. Without any portfolio growth, the HKMC cannot play its desired role deepening the fixed income market.

Second, the insurance business is reliant on regulatory arbitrage. Owned by HKMA, the HKMC is reliant on the parent’s stringent mortgage prudential rules for delivery of volume to its business. This provides a disincentive for reform of those prudential rules.

Those rules are one reason why mortgage products in Hong Kong do not have the flexibility and features that can be accessed in other mature mortgage markets. This means that banks have fewer options in terms of non price competition to differentiate themselves and contributes to very aggressive pricing in the mortgage market. The HKMA themselves have recently warned against aggressive mortgage pricing.

On top of this, the partial data available seems to suggest that HKMC are generating excessive returns from mortgage insurance and may be overcharging consumers.

Third, the diversification strategy seems reliant on the low cost of funds and under leveraged balance sheet for a rationale. There is little evidence that the investments are driven by a strong business rationale. They look more to be a tool to ensure survival of the institution.

Policy for reform

At the core of HKMC is an incentive problem. Management are public officials with an incentive to keep the institution running and grow its scale, but have weaker incentives to deliver strong financial performance. They can perform better by using bureaucratic skills to expand their brief and policy role than by winning business in more competitive markets.

This can be seen in conservative financial statements and a strategy of diversification that seems more like diplomacy and networking than leveraging strong business advantages. It is not harsh to observe that HKMC exists only to exploit credit arbitrage and regulatory arbitrage.

Given a moderately successful track record over 10 years under poor incentives and a degree of genuine expertise in mortgage and funding markets, it makes sense to look at options for reforming HKMC rather than abolition.

Moving HKMC into the private sector through listing or sale of a stake to other financial institutions could put it on a commercial footing. This would provide management with an incentive to grow returns, but also look more critically at regional markets. Support for the credit rating from the government could be progressively phased out.

For businesses to survive in dynamic markets they have to change. One of the great virtues of the capitalist system that Hong Kong’s Basic Law is committed to preserve is that institutions that no longer serve their owners or customers are closed and resources are reallocated to more productive uses. This is not failure for the system, it is a success. Hong Kong banks, HKMA, and the government have created an efficient mortgage market that no longer needs the HKMC – this should be counted as a success. Failure would be to allow the institution to linger beyond its use-by date.

Government involvement in mortgage markets has proved disastrous in the United States and other markets. Hong Kong has avoided these problems so far, but the new diversification strategy takes HKMC into markets that have had a more difficult track record.

Bill Stacey is the Chairman of The Lion Rock Institute and a partner in a boutique Hong Kong based securities company.