A Saudi Fannie Mae

Saudi Arabia is proposing setting up a Fannie Mae-style company to create secondary market liquidity for mortgages (presumably using Shari'ah-compliant financial instruments like sukuk).  The institution would be at least 50% owned by the government with real estate finance companies being able to own up to 30% of the company and possibly a public listing of the shares. 

This would be a big step forward to set up a pipeline of sukuk that would create supply of new issuance to match the Malaysian housing company Cagamas, which issues similar securities (both conventional and Islamic) in Malaysia.  The plan is to broaden the share of mortgages in Saudi Arabia from the current 6% of GDP eventually, according to Arqaam Capital, to 12% of GDP (the comparable numbers in the US is 63.5% based on Federal Reserve  Flow of Funds reports [pdf, table D-3]).

The Reuters report notes several impediments to developing a secondary market for mortgages, in particular the lack of ability of mortgage holders to take possession of the property and evict the residents in case of non-payment.  This is a serious problem if a secondary market is to develop and, more importantly, if the financing is extended to middle class household where a more significant level of default is to be expected, compared to the high-income segment of the market where home financing is currently offered. 

I can't offer much advice on developing the domestic legal system for mortgages--that's outside of my ability--but I think there are a few lessons that the country should take from the US' experience with Fannie Mae during the housing crash in the US, the most severe test if faced, which left the government-sponsored enterprise in government conservatorship. 

First, the role of the government needs to be clear and laid out in advance.  Fannie Mae operated on the assumption that it would be propped up by the US government if the need ever came, which held true as the financial crisis led to the effective nationalization of both Fannie Mae and Freddie Mac.  The important point here is that the implicit government backing allowed Fannie and Freddie to borrow at lower rates in the debt markets, compared with private sector mortgage-backed securities (MBS) originators. 

With the government backing assumed, there was little role for the private sector in originating MBS backed by prime mortgages, so they turned much more heavily towards (more risky) subprime.  The difference between prime and subprime is determined by the quality of mortgage accepted by Fannie and Freddie, with prime mortgages accepted and subprime and most larger, or jumbo, mortgages not accepted. 

If the Saudi government wants to monopolize the secondary mortgage market, it should make that decision explicit and extend the full faith and credit of the Saudi government to the refinancing agency and regulate the giving and packaging of any mortgages that are not bought by the refinancing agency.  If it wants to develop a vibrant market to allow banks to issue MBS, it will need to limit the ability of the refinancing agency to some share of the market, or else it will drive the other issuers out. 

The latter point is particularly important if the government-owned refinancing agency has private ownership.  These private owners will demand that the refinancing agency maximize profits for shareholders and if there is no pre-set limit for how much of the market it can take, it will be driven to take all of the market because of its lower funding costs (from the government backing). 

Whatever the decision about whether the government refinancing agency will be the sole provider of secondary market liquidity (and that decision should be based on an analysis of whether it could become a systemically important financial institution), the role of the government in supporting that institution should be explicit.  If it is not government-backed, and particularly if the profits are privatized to give it the incentive to stretch creditworthiness, it will be tested at some point should housing prices fall and the government will be on the hook for the losses to avoid a total collapse in the market.  

And that leads to a decision for the government: should the mortgage refinancing agency be a government-backed agency or should banks in the Kingdom be responsible for issuing MBS?  Personally, I believe that there benefits to a government-backed housing agency, but it does create systemic problems if it were to run into problems when housing prices decline.  But the risks should be considered in advance, rather than ex post as the US dealt with. 

The potential for growth in Islamic mortgage-backed securities

The GCC does not have a well developed market for mortgage-backed securities, and with the exception of a number of MBS sukuk issued by Cagamas in Malaysia, Islamic finance has seen few MBS sukuk.  One notable exception was an MBS issued by Sorouh Real Estate, which I described in a blog post and which was later redeemed (which revealed a limitation for investors since the sukuk was redeemed by the issuer (scroll down to the July 18 newsletter) and not through pre-payment on the underlying assets).

However, with Tamweel considering the issue of $235 million in asset-backed MBS, there is a potential benefit for the sukuk market from more sukuk like this.  The estimated redemption date is 2046 according to Moody's who rated the MBS significantly higher than both Tamweel and its parent company, Dubai Islamic Bank. 

Before you start commenting on the post and suggesting that Islamic finance shouldn't use any of the products which played a part in the financial crisis, I want to offer a rebuttal.  The development of MBS was not at fault in the credit crisis by virtue of their structure.  In fact, they offer an asset-backed product which is demanded in the market (with potentially longer maturities for takaful and pension funds).  The role that MBS (in contrast to CDO and CDS) played in the crisis was more effect than cause: as home prices fell, many MBS lost value.  In addition, the MBS which lost the most value were those backed by bad mortgages that would not have been issued in earlier years. 

There are risks to MBS that aren't present in a sukuk.  For example, in the Sorouh MBS sukuk, the issuer could refinance and redeem the sukuk early, even before the underlying assets had paid out.  But that was more an issue of that structure that gave the issuer a call option on the portfolio but left the risk with the sukuk investors.  The structure of the Tamweel may not include a similar provision (I have not seen the documents for the Tamweel MBS sukuk). 

Apart from this redemption risk, there is also the risk that the underlying assets are redeemed earlier (introducing reinvestment risk, as the investor is paid out earlier than anticipated and may not be able to find another investment with a similar return).  

The benefit for the Islamic finance industry from more MBS issuance is that it can free up more funds for Islamic banks and mortgage lenders, while also offering additional sukuk to the market, potentially with longer maturities than most sukuk issance.  This will expand the capacity of Islamic banks to finance other projects and expand their scope, while also offering a more complete fixed income market, which has been so far dominated (particularly in the GCC in recent years) by sovereign issues.

The potential ability of MBS to attract higher credit ratings than their originators is a mixed benefit.  It is good, of course, to have a larger supply of highly rated sukuk to fill the portfolios of conservative investors like pension and takaful funds.  However, this benefit should always be carefully weighed against the potential to replicate the ills of the MBS market leading up to the crisis where ratings schemes were gamed by originators to get higher ratings so they could push out more and more issuance, the risk of which is largely transferred to investors.  

All in all, I think more MBS issuance should be a good thing for the Islamic finance industry and it can offer a way for investors to get Shari'ah-compliant fixed income investments.  There are risks to be sure and, given the recent financial crisis, there should be vigilance to ensure that the MBS markets are not flooded with MBS sukuk backed by low quality assets.  But if done correctly, it could be a boon to sukuk markets.