Development of rmbs market in India: Issues and Concerns



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1Introduction

The housing finance sector in India has undergone unprecedented change over the past five years. The importance of the housing sector in India can be judged by the estimate that for every Indian rupee (INR) invested in the construction of houses, INR 0.78 is added to the gross domestic product of the country2. The housing sector is also subservient to the development of 269 other industries3. Also the development of robust housing finance is important to cope with population growth and rapid urbanization in the country.

Despite its recognized economic and social importance, housing finance has remained under-developed in India. The role of efficient housing finance system in the provision of housing cannot be over-emphasized, and is too obvious a need to demand an explanation.
The dismal state of the Indian housing finance can be gauged from the fact that the mortgage to GDP ratio stood at an abysmal 3% in India in 2001 when compared to 57% in UK, 54% in USA, 40% in EU, 7% in China, 17% in Thailand and 34% in Malaysia4.

2Housing finance systems

Broadly speaking, housing finance is delivered, at the house-owner level, by housing finance companies or banks (say, mortgage financiers). This is by and large common in every country. The secondary market in residential mortgages refers to the manner in which these mortgage financiers raise their own funding. On this front, there are several models, which may broadly be classed into (a) depository banking model; (b) refinancing body model; or (c) capital market model.

No country in the world works exclusively on any one of the models – there are combinations in various proportions. In the first system, the mortgage financiers are depository institutions who are allowed access to public savings – for example, banks typically raise public deposits; building societies in the UK having been depending on public savings in form of deposits. The second system has some form of refinancing body, say, National Housing Bank in India, that raises resources at a central level on its own balance sheet, and then provides refinance to the mortgage financiers. In the third model, the mortgage financiers have their mortgage originations funded by capital market. Here again, there are two possible models – the covered bond or pfandbriefe model as it prevails in Germany, and the mortgage pass through model or securitisation model that originated in the USA and then spread all over the World.

Each model has its own merits and demerits. The first model has existed through centuries, and its biggest advantage is its simplicity. The public needs some saving option -mortgage financiers provide an easy mode of pooling public savings. However, the first model has shown grave potential for problems over time. The biggest problem is the huge asset liability mismatch (ALM) problem that it necessarily implies – the retail deposits are either contractually or behaviorally short-term, while mortgage finance is long term. In addition, retail delivery requirements necessitate presence of a large number of mortgage financiers in every country, and if they are allowed access to public deposits, there is a huge requirement of regulatory surveillance on a large number of depository entities. Not only their capital adequacy needs to be monitored, there is a need to ensure there are no unfair or unhealthy practices in place – a goal which is more often observed in breach than in compliance. The debacle of savings and loans associations in the USA proves the point that a large number of entities with depository access can pose a threat to the system.
The refinancing model is cost and inefficiency-ridden. More intermediaries imply more costs, and if the apex refinancing body is a publicly-owned entity, it may also carry sloth which percolates down. That apart, such larger apex bodies are not immune from financial problems - on the contrary, their large size only means any probability of demise of the institution may too strong a shock for the system to tolerate. Alan Greenspan was recently critical of the behemoth-sized Fannie Mae and Ginnie Mae.5

The capital market model has one notable difficulty – it is not easy, particularly for regular requirements of small amounts of funding. On the other hand, it has several merits. Eventually, in either model, the funding comes from the capital market – so the capital market model only integrates the primary mortgage market with the ultimate provider of funding. It is a sort of a disintermediation model, as the role of the mortgage financier is reduced to mortgage originator and servicer. If the integration is efficient, the capital market model brings down the cost of funding6, and resolves several problems such as ALM, interest rate mismatch, etc. The capital market model cannot replace the other models, but to the extent it can be exploited, it brings efficiency and makes housing finance both cheaper as also more easily accessible.

We later revert to the example of the US government-supported entities (GSEs) in promoting house finance, but it is clear from history that in both the capital market models – the European covered bonds or pfandbriefe model7 and the US mortgage pass-through model - the mortgage-backed capital market securities have proved to be extremely safe and sound means of investment for the investing public. In the European covered bonds case, for example, there is reportedly no default over the last 200 years. In the US mortgage pass throughs, to the extent they are backed by the GSEs, there is no question of a default as the GSEs bear the implicit support of the US government, and even in the non-agency or private label market, defaults have been very scanty, with very high recovery rates8. In addition, the level of secondary market activity in the GSE securities is only next to government treasuries – as reflected by the graphics below.


The Size of the US MBS market is huge – as the graphic below shows







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