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Wednesday, 2 July 2014

Blowing up the Dutch “mortgage mountain”: why securitization of mortgage portfolios might not be such a bad idea after all, when the price and the risk assessment are right!

Two days ago, I wrote about the Copperfieldian illusions that retired professor Dolf van den Brink and independent advisor Peter van den Berg sketched in their Op-Ed with respect to the Dutch ‘mortgage mountain’, in Het Financieele Dagblad of last Saturday.

While their proposed solution for the Dutch mortgage problem contained a lot of smoke and mirrors and – in my humble opinion – only shifted the problem for a short while instead of solving it permanently, their analysis of the awkward Dutch situation was spot on.

Perhaps, the first part of their proposal – creating a special entity, which buys large parts of the banks’ mortgage portfolios and deploys securitized National Mortgage Paper (i.e. NHP) for funding – might not be so bad after all.

The main difference between the proposal of 'Van den Brink et al' and mine – which I will describe in the remainder of this article  is that the ownership of the mortgage would shift permanently from the bank to the new entity in my proposal: a new, specialized mortgage bank or financial institute.

Of course, this transfer should happen through an official ‘certificate of public cession’ – possibly signed at a public notary – and after explicit (!) consent of the customer, who, in exchange, could benefit from slightly better conditions.

[Read this article for the Dutch legislation with regards to cession of debt and the accompanying certification process; non-Dutch speaking readers could use]

This mortgage entity itself could be funded through the deployment of common stock and/or corporate bonds. The purchases of (bundled) mortgages could be funded through the deployment of the aforementioned securitized national mortgage paper, in the form of fixed interest bonds with a maturity period equal to the maturity period of the underlying mortgages.

Of course, this whole idea is very much akin to:
  • a.    the US entities for mortgage supply Fannie Mae and Freddie Mac.
  • b.    the Mortgage Backed Securities, which started the US credit crisis in the first place;

We tried both once and it blew up in our faces…

The difference is, however, that in the first place the Dutch entity should be a fully private entity, with no strings attached to the Dutch government. 

This in contrary to the US-based Fannie Mae and Freddie Mac, which are both (partially) public entities. This entity should be funded by the Dutch banks and insurance companies, as well as pension funds and private investors.

Besides that, the discrimination between (bundles of) mortgages should be fully based on the history and broad risk profile of the mortgage owners AND the underlying pledge. Full disclosure must be the name of the game for this new mortgage entity, in order to make it work.

This could lead to discrimination of mortgages, based upon the following mortgage trademarks:
  • Client history, including past (temporary) arrears situations;
  • Maturity date of the interest fixation period;
  • Amortization method;
  • Accompanying insurances and savings arrangements;
  • NHG (Dutch national mortgage guarantee) included or not
  • Current interest rates and risk surcharges for the customer;
  • Former and current pledge value;
  • Risk profile and ‘similar sale’ history for the domicile of the pledge.

In my opinion, this would be the only viable way to prevent moral hazard from occuring: a situation in which banks and insurance companies could sell their worst or most risky mortgages to this new mortgage entity and subsequently diminish their prudence with respect to future customers for mortgages, as ‘it does not matter anymore’.

In the United States, many corporate customers had been lured with the often unjustified, but nevertheless seemingly ‘rock-solid’ AAA-ratings on opaque bundles of mixed Prime, Alt-A or Subprime loans, which were especially dangerous. Generally, these customers hardly knew exactly what they had bought and what their risk would be eventually.

So when the collaterized mortgage based securities (CMBS) suddenly became ill-reputed – just before the collapse of Lehman Brothers bank – the market for these securities totally imploded and trade became virtually impossible.

In other words: in order for this new Dutch mortgage entity to survive and even thrive with its investments – and the buyers of its securities too – the regulation and risk mitigation must be 180 degrees different from the situation in the United States, which ultimately led to the credit crisis in 2008. 

Based on these aforementioned (and additional) trade marks, the mortgages for sale could be bundled in risk packages, each with their own kind of NHP paper: ranging from the ‘extremely low risk category‘ for the most rock-solid mortgages to the ‘very high risk category’ for challenging mortgages with current or past arrears situations.

Of course the sales price (read: the net amount of cents to be paid per €uro of mortgage value) of the securitized bonds, should contain a substantial discount for the latter category, in order to cover the risk on this particular portfolio. 

To put it simply: the lower the risk of the mortgage, the smaller the discount on the sales price. Price calculation would work in a way akin to this:

Model for calculating the price of mortgages
being sold to the new mortgage entity
Table created by Ernst's Economy for You
Click to enlarge
The creation process for the NHP securities would take place in a similar way, based on the risk rating report, emerging from the typical trademarks of the underlying mortgages.

Only when the customer knows exactly what kind of mortgage he buys and what risks he encounters while buying it, he will be willing to invest in such NHP paper. And then he can decide in what kind of NHP paper he invests (more or less risky), depending on his risk preference and time horizon.

The advantages for all parties in such a construction could be substantial, while the disadvantages are manageable in my humble opinion:

Advantages and disadvantages of this
new mortgage entity for all involved parties
Table created by Ernst's Economy for You
Click to enlarge
Summarizing, while I disagreed with the proposed implementation of the ideas of Dolf van den Brink and Peter van den Berg, I agreed with their opinion that the Dutch mortgage mountain, at the balance sheets of the Dutch banks, should be diminished.

Perhaps this proposed, new mortgage entity could work as a catalyst for enabling such process. When we use the lessons learned from the subprime crisis and avoid the errors made in the prelude to that very crisis, then this mortgage entity could help to reinforce the large Dutch banks.

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