Introduction to Mortgages
In most countries of the world, when someone wants to purchase a house or apartment, he can easily do that if he has a job or a regular income. Such a person does not usually have the wealth to afford the home, but he certainly can get the funds. The funds will be provided by financial institutions, usually housing banks that will in return hold the estate under mortgage until the last fee is paid, usually on a period of ten to twenty years. Such an operation is related to as mortgage. Mortgages and housing loans are among the most important financial services that help in the development of societies and economies. In this research study, we shed light on house loans and mortgages in Lebanon.
The formal definition of mortgages is that they are securities used to finance housing purchases, originated by various financial institutions such as savings institutions and mortgage companies. A secondary mortgage market accommodates originators of mortgages that desire to sell their mortgages prior to maturity (Kronner, p. 311). Both the origination process and the secondary market activities for mortgages have become more complex in recent years, but they are still non-existent in Lebanon, although the International Finance Corporation (IFC) is now hoping that such a facility will be available in Lebanon very soon.
Financial institutions that hold mortgages in their asset portfolio are exposed to two types of risk. First, they incur interest rate risk, or the sensitivity of earnings (and net worth) to interest rate fluctuations. Because mortgages are long-term in nature and deposits are commonly short-term, this interest rate risk is a primary concern. Of course, institutions with this type of balance sheet structure are not just adversely affected by rising interest rates; they also benefit from declining rates. Yet, the favorable impact is somehow dampened, as a large proportion of mortgages are refinanced when interest rates decrease.
The second risk of mortgages relates to potential late payments or even default, referred to as credit or default risk. The default rate on mortgages has generally increased over the past 25 years. The most pronounced increases in default rates occur when the economy is in a recession (Kronner, p. 312). In Lebanon, launching a mortgage securities market is considered difficult at present because the economy is already in a recession. Moreover, borrowers may be unable to make mortgage payments during period of increasing interest rates. Yet, lending financial institutions can obtain insurance to cover against default risk if they are willing to pay the insurance premiums. In Lebanon, the Loan Insurance Corporation was finally established in 1999, but it is not yet clear what role it might be able to play, given its small size and limited resources and functions, in the mortgage securities market (Abu Habib, p.37).
Financial institutions that originate mortgages sometimes sell these mortgages if they are short of cash. In addition, they may prefer to reduce their holdings of fixed-rate mortgages if interest rates are expected to increase. Some financial institutions such as mortgage companies may simply desire to service mortgages (originate them, process payments, etc), but not finance them. They periodically pool their recently originated mortgages together and sell them but commonly continue to service them. For all these reasons, a secondary market for mortgages is desirable. It is not, however, as active as the secondary markets for other capital market instruments (such as stocks and bonds), because differing mortgage characteristics cannot be standardized as easily. In addition, the amount of each mortgage is small when contrasted to bonds, stocks or other financial instruments (Kronner, p. 313).
The financial institutions that ultimately finance mortgages may differ from the institutions that service them. The borrowers continue to send their monthly mortgage payments to the lender, even though the lender no longer holds claim to the mortgage. The original lender processes the payments and charges the new holder of the mortgage a fee for processing. It deducts this fee from the mortgage payments received and sends the remainder to the new holder of claim.
The secondary market for mortgages has been enhanced as a result of securitization, which involves the pooling and repackaging of loans into securities. The securities are then sold to investors, who become the owners of the loans represented by those securities. This process allows for the sale of smaller mortgage loans that could not be easily sold in the secondary market on an individual basis. When several small mortgage loans are packaged together, they become more attractive to the large institutional investors that focus on large transactions. Securitization removes the loans from the balance sheet of the financial institution that provided them. Consequently, securitization can reduce a financial institution’s exposure to default risk or interest rate risk (Kronner, pp. 314-315).
As an alternative to selling their mortgages outright in the secondary market, financial institutions can issue mortgage-backed securities, a method whereby a security is created that is backed by mortgage loans.
Mortgage-backed securities come in various forms; the more common are mortgage-pass-through securities. A group of mortgages held by a trustee of the issuing institution serves as collateral for these securities. The interest and principal payments on the mortgages are sent to the financial institution, which then transfers (passes through) the payments to the owners of the mortgage-backed securities after deducting fees for servicing and for guaranteeing payments to the owners. This process allows the savings institutions and banks that originate mortgages to adjust their balance sheets. Thus, they can earn fees from servicing the mortgages while avoiding exposure to interest rate risk and credit risk.
Description of the Housing Situation in Lebanon
During the late 1980s and early 1990s, Lebanon witnessed an upsurge in its real estate industry, and thousands of housing unites were built every year. The lack of planning, the failure to realize the nature of demand and supply forces in the market, and finally, the recession that started in the spring of 1996, all led to the stagnation of the sector. Today, it is estimated that there are between $7 billion and $10 billion worth of idle estate units in the Lebanese market. At the same time, however, there is a very strong demand on real estate in the economy, estimated at 35,000 units every year. The only reason that those on the demand side are not purchasing is that they do not have the funds needed, or at least, they do not have the funds available in hand in the form of cash. In response to this situation, a number of commercial banks started offering housing loans to the public. These loans were backed by putting the purchased asset on mortgage. This is not to mention the fact that many banks were already lending to businesses and individuals in return for mortgages on real estate property (Abdul Hadi, p. 25).
Although the housing loans were quite attractive to many, they did not witness a strong demand for a number of reasons that are worth mentioning in brief. First, the loans were made over a short period, usually not exceeding five years. Secondly, the loans were made for individuals and households with high incomes, but given the poor rate of saving in the country, not many found themselves capable of taking these loans. Thirdly, the interest rates were generally high, ranging between 9.9% and 13%, basically meaning that within a few years, the interest paid would equal or even exceed the principal owed to the lending bank. Fourthly, fees of originating the loan, registration, life insurance, underwriting risks and various others proved to be very high, hence discouraging many people from seeking such loans (Abdul Hadi, pp. 24-25).
With a huge supply of housing units faced with a strong potential but not real demand for these units, the need for a mortgage system in Lebanon is indispensable. What lacks, however, is the mechanism.
The IFC and the Mortgage Market in Lebanon
The International Finance Corporation is a subsidy of the World Bank, operating both as a development bank and as an investment bank. It has accumulated considerable expertise from previous experiences in launching and supporting mortgage markets in other developing countries, and right now, it is trying to establish a similar market in Lebanon with the objective of vitalizing the real estate market and the economy in general, in addition to enabling a larger portion of the Lebanese to possess realty (Ayoub, p. 40).
Currently, the IFC is trying to help the Lebanese government resolve the housing problems in a number of ways, mostly by focusing on the needed legislation to realize the possibility of launching a mortgage securities market. The process through which the IFC operates is very effective. As a development financial agency, the IFC links interested foreign investors with strong local partners, and finally overlooks the operations and when needed, provides funds for any development projects in an economy (Ayoub, p.41).
In 1996, the IFC made loans to a number of Lebanese local banks mounting to $120 million, all of which were dedicated to housing loans. At this point, the IFC does not believe that there is a necessity to intervene beyond this point. However, according to IFC Middle East director, André Hovaguimian, “when banks start reaching central bank limitation ceilings, they will need a secondary market to unload part of their portfolios” (Ayoub, p.41).
This simply means that in the mean time, the IFC is going to wait until the banks offering housing loans reach their limits. In that case, there will be a strong need for securitization, and with the availability of a secondary market at the same time, a strong mortgage securities market will eventually emerge.
Hovaguimian’s predictions may actually come true. Although the demand on bank loans was not as high as expectable, mainly due to the many defects in the offered plans as well as the recession, there seems to be a lot of competition among banks offering housing loans. Some of the indicators that were detected in 1999 included the reduction in interest rates. Most banks have now shifted their interest rates on housing loans from a high 13% to about 10%, with some banks even going as low as 9%. Eventually, the rates of 6% may be reached in a few years, thus resulting in a strong demand in the market, and finally pushing the banks to the limits imposed by the Central Bank. In addition to this, most banks are now becoming aware that their plans are not attractive enough, and hence, they are trying to offer more lucrative packages in the market. Considering the most recent developments, longer mortgage loans are now being issued, reaching up to fifteen years, a prospect that was not even thought of in 1997 (“Housing loans declining, pp. 31-32).
Such developments are already reflecting better prospects for a mortgage securities market in Lebanon. Common sense implies that the improved plans launched by lending banks in 1999 will lead to an upsurge of demand on the offered housing loans. This will eventually create a strong movement of moneys and funds in the economy, and at the same time, will help the real estate market pick up. To maintain the opportunity, establishing a mortgage securities market will be an optimal development.
Efforts to Establish a Mortgage Securities Market in Lebanon
Alongside the efforts made by the IFC, individual initiatives have also been active. The chairman of the Harvard Graduates in Lebanon, Dr. Habib Zogby already proposed the project to the government in 1996, and right now, the project is under serious consideration by the Minister of the Economy, and indeed, the Central Bank and the IFC are reported to have already initiated negotiations, thus possibly launching the mortgage securities market in Lebanon before the end of 2000.
The process is based on the establishment of a national office for mortgages (BNH) which is owned by the public and the private sector at the same time. The objectives of this office is to prepare the legal procedures necessary for the issuing of mortgage securities (among other securities related to loans made by commercial banks). BNH then offers the guarantee of the state to cover 20% of the value of the total securities issued.
The mortgage security, on the other hand, is to be divided into portions that are pooled, all having the same maturity dates and bearing the same interest rates. These securities are to be sold in the primary market in the form of chips priced at $5,000 to the public. Risks, however, will vary from one security to another, since different securities are issued to cover real estates in different areas in the country. The remaining 80% not guaranteed by the government have to be covered by insurance companies through specially devised insurance policies (Zogby, p.36).
Considering 12% as average interest rate in the market at current, BNH can play a very effective role in catalyzing the mortgage securities market. Accordingly, the borrower will have to pay 20% of the total value of the asset, and BNH can further finance 7% of the interest rate that the borrower will have to pay on the mortgage. Meanwhile, BNH rather than the lending bank will have the right to repossess the asset in case of default (Zogby, p.37).
Several financial derivatives may also ensue as a result of this project. For example, the holder of the mortgage security may choose as an option to share whatever profits may arise from the sale of the property or from reevaluation of the asset at a given future date (Zogby, p.37).
Opportunities & Threats
Although the project of launching a mortgage securities market in Lebanon is still under initial construction, it is possible to draw on some opportunities and threats that may arise.
Such a project, if it works properly, will resolve problems for two large sectors in the Lebanese economy. The first is the construction sector, whose growth will once again be triggered by the increasing demand. The second is the banking sector that has for the past few years been suffering as a result of increasing defaults on commercial loans. Many of these loans are backed up by real estate. Yet, banks are only allowed to hold these properties for a maximal period of two years, but given the low demand, selling more than $120 million worth of property acquired in return for bad debts has proven to be very difficult (Abboud, pp. 19-21). The securitization of mortgages can enable these banks to get rid of the property by offering the opportunity to the original owners to refinance their debts through mortgage securities. Thus, perhaps big portions of the bad debts owed to banks may be revived, and these may be issued in the form of mortgage securities, although at lower prices and higher risk.
Another opportunity is that the mortgage securities market will create an incentive for local and foreign investors to pour money into the economy, and eventually a growing secondary market for these securities will reflect a stronger financial image of Lebanon.
Needless to mention, the mortgage securities market will enable banks to allocate their resources to other developmental areas in the economy, and hence, their growth and profitability will also increase while offering more financial resources and benefits to the economy as a whole.
Some problems and threats may also be witnessed. No one can ignore, for example that the Lebanese economy is in a serious state of recession. Even those who enjoy high income levels are in fact unable to save or pay off housing debts. Demand on housing loans may still increase, but there are no guarantees that these debts will be paid off. This means that the banks pooling the housing loans will eventually place higher risk rates on their securities. High levels of defaults will not only affect many securities negatively, but it might also undermine both the primary and secondary markets for mortgage securities.
There many opportunities and a few risks involving the securitization of housing loans and the initiation of a mortgage securities market in Lebanon. Yet, we should also acknowledge the fact that such a step has become indispensable for stimulating several sectors in the Lebanese economy. The healthy banking sector, backed up with the guidance of the Central Bank, the IFC and professional authorities in the field can assure a smooth initiation and operation of such a market. Yet, much more than this will be needed, especially in an economy that has been suffering a recession for several years, not to mention the political instability resulting from the fluctuation of the peace process in the Middle East.
Abboud, Reine. “Bank on getting a bargain.” Lebanon Opportunities, June
1999: pp. 19-21.
Abdul Hadi, Fatima. “Counting the hidden costs.” Lebanon Opportunities,
September 1999: pp. 24-25.
Abu Habib, Khatir. “Loan Insurance Company sees light.” Al-Iktisad wal-
a’amal. September 1999: p.37.
Ayoub, Ziad. “IFC looking to develop the financial sector.” Lebanon
Opportunities, June 1997: pp. 40-41.
“Housing loans declining.” Al-Iktisad wal-a’amal. September 1999: pp. 31-35.
Kronner, Craig. Financial Markets: An Introduction. New York: McGraw Hill
Zogby, Habib. “Mortgage securities market: A third solution for housing
crisis.” Al-Iktisad wal-a’amal. September 1999: pp. 36-37.