If you’re the King of Saudi Arabia, and you’ve just watched longstanding allies in Egypt and Tunisia being toppled by a popular uprising, you get frightened.
If you’re the King of Saudi Arabia, and you see television images of cars being set alight in Oman and an armed rebellion gathering momentum just across the Causeway, in Bahrain, you get very frightened.
Since the Tunisian revolution began in January, embattled Arab leaders have cast around with increased urgency for ways to ensure that they don’t go the same way as ex-presidents Ben Ali or Mubarak. It is no surprise that King Abdullah of Saudi Arabia has identified the housing market as a relatively painless way of helping to safeguard his future.
When, at the end of February, he pledged to pump $15bn into the Kingdom’s housing market, he did so not out of the goodness of his heart. He was aware that if Saudi Arabia did not address its economic imbalances, it could face an insurrection far more serious, for the world as well as the region, than Egypt’s.
Housing is a good place to start. Jones LangLaSalle (JLL) put the kingdom’s total stock of residential housing units at 3.95m in 2008, projecting a total flow of new units between 2008-2012 of 380,000, according to Samba research in December. With demand expected to increase by 1m units over the same period, this points to a shortfall of around 1.1m units in 2012 in a country with a population of below 26m. Samba warns, however, that even 1.1m may be an underestimate.
Throwing money at the problem is likely to have a limited and short term effect in a society in which mortgage lending is undeveloped by Middle Eastern standards and microscopic by international ones. Samba says bank mortgage lending in Saudi Arabia is about 3% of GDP, compared with 6% in Kuwait, 7% in the UAE and "well over 50% in many developed countries". If it is serious about addressing the social imbalances caused by its feeble housing market, it should expedite the passage of the mortgage law which has gathered dust since 2009.
That would create the groundwork for securitisation in Saudi Arabia and also — potentially — for covered bonds, which are regarded as broadly shariah compliant.
Some believe that if a covered sukuk mechanism could be developed in the Middle East, its potential from a supply and demand perspective could be considerable.
However, as Moyn Uddin, executive director of Al Waha Capital, pointed out in a presentation in Dubai last December, "while a covered sukuk can be structured without difficulty, a successful first issuance will need to be issued in a jurisdiction with a comprehensive and well defined law addressing such structures."
Once that template is in place, said Uddin, "target investors will come primarily from the traditional Islamic investor base, with special attention to the more conservative investors, who will be attracted by the additional layer of security provided by the covered bond structure."
The next step, he added, would be for the legal framework to be put in place for a covered sukuk to originate in the Gulf. That will take time — a luxury Saudi Arabia may not be able to afford.
Elsewhere in the developing world, democratically-appointed governments may have more time to play with, but not much. "In many emerging markets, presidential elections are often won and lost around housing policy," says Ben Colice, head of covered bonds at RBC Capital Markets in New York.
Brazil’s obvious choice
Look at Brazil, where skyrocketing demand for homes among the emerging middle class has created a housing shortage estimated at 7m. Arjan Verbeek, head of flow ABS and covered bond structuring at BNP Paribas in London, says the surge in demand for housing finance is not an immediate cause for concern there.
"Brazil believes that for the next two years there will be enough liquidity in the banking market to fund the demand for mortgages," he says. "After then, banks will need to find a funding tool to meet this rise in demand, which is why they are looking at covered bonds."
Others agree that covered bonds would be an obvious funding mechanism for Brazilian banks to explore as demand for mortgage finance grows, especially in light of the limitations of the local RMBS market. "There is a regulatory impediment to RMBS in Brazil," explains Maria Muller, senior vice president and team leader of Latin American structured finance at Moody’s in New York. "Brazilian banks are required to keep the equivalent of 65% of their savings deposits in real estate-related assets. Mortgages that are taken off banks’ balance sheets don’t count towards this ratio, which is a big disincentive for banks to securitise. Covered bonds, which allowed banks to keep these assets on their balance sheets, comply with this requirement and generate funding, would therefore be very appealing to the banks."
That may be. But Brazil is not being rushed into passing covered bond legislation. Juan de Mollein, managing director at Standard & Poor’s in New York, says that he and a number of other market participants have discussed alternatives for a covered bond framework with the central bank, with the discussion yet to reach Congress.
Verbeek at BNP Paribas welcomes this cautious approach. "There are several covered bond structures in the market, and Brazil needs to create the framework that works best for the country," he says. "It is therefore important that all stakeholders agree on a structure before legislation is passed."
With the Brasilian government taking its time, S&P’s de Mollein says two other countries in the region are likely to have enacted legislation on covered bonds before Brazil does, one of which is Peru. "The Peruvian financial system is highly concentrated among four or five large institutions that performed very well during the crisis," he says. "All of these have a good track record in the market for plain vanilla funding. But as these institutions become more aggressive in the consumer finance area they will need to expand their horizons beyond the structures and maturities that can be offered in the plain vanilla market."
Mexico on pole
It is Mexico, however, that is recognised as being in pole position to lead the way in Latin American covered bonds. It needs to be, given the country’s housing deficit is now estimated by the National Housing Chamber (Canadevi) at 8m units.
At a conference in Miami last May, José Manuel Rivero Andreu, president of the Mexican Mortgage Association, said he hoped legislation would be passed by the end of the year paving the way for the first issue of Mexican covered bonds. Mexico’s Covered Bond Regulation programme, he explained, was "intended to regulate the issuance of Bank Securities Certificates (BSC), supported by mortgage guaranteed credits fully identified and recorded in the balance sheet of multi-service banking institutions."
Passage of legislation has been slower than the Mortgage Association had hoped, and has been in Congress for two years. Long before this, however, Mexican officials had shuttled to and from Copenhagen, studying the Danish system as a template for a Mexican covered bond market.
When, rather than if, legislation is enacted allowing for what will probably be known as bonos cubiertas (as distinct from Mexican cédulas), the first issuer into the market is likely to be the Instituto del Fondo Nacional de la Vivienda para los Trabajadores (Infonavit).
It is 100% government-owned, so S&P rates it at the same level as the Mexican sovereign, and Infonavit is Mexico’s largest mortgage lender. According to the most recent S&P update, as of June 2010 Infonavit had a total on-balance sheet portfolio of Ps688.8bn ($53.2bn), and a domestic market share of loans and mortgage originations of 72% and 54% respectively.
Jerzy Skoryna, manager of capital markets at Infonavit’s Mexico City headquarters, says that 85%-90% of the lender’s funding comes from mandatory payments from private sector workers, and mortgage collections on its housing portfolio. The remaining 10%-15%, he says, comes from Infonavit’s domestic mortgage securitisation programme, which dates back to 2004.
Certainly, Infonavit does not yet appear to have hit any shortage of local demand for its local RMBS (cedevis). Its first transaction of 2011, a Ps3.67bn inflation-linked issue at the start of March, generated demand of more than P9bn from local institutions.
Infonavit has, however, also been making overtures to international investors, selling part of a Ps2.7bn mortgage-backed placement overseas for the first time in 2010. "Local investors have small buckets for structured finance and some are approaching their limits both on the instrument and the Infonavit name, so as a long term strategy it makes sense to look for alternative funding," says Muller at Moody’s.
Foremost among those, as soon as legislation permits, will be a covered bond. "All the elements are in place, so if Congress approves the law in 2011 as we expect, we may be in a position to issue our first transaction in the next few months," says Skoryna. Details, however, are sketchy, although a pilot issue is likely be no smaller than $500m, perhaps in a two-tranche offshore and local structure in dollars and pesos. As to whether the cost of funding would be demonstrably cheaper, Skoryna says this has "yet to be proved".
Other covered bonds from Mexican issuers are likely to follow a successful pilot transaction from Infonavit. Marisol Gonzalez de Cosio, emerging markets structured finance analyst at S&P, says that Infonavit would probably be followed by the other main government owned lender, Fovissste, which is smaller than Infonavit and a more recent entrant to the RMBS market. Fovissste has issued in the local securitisation market since 2009.
Beyond the government owned lenders, adds Gonzalez de Cosio, covered bonds are likely to be attractive funding sources for Mexico’s largest banks, most of which have local ratings of mxAAA or mxAA from S&P and are owned by foreign banks. Some of those foreign owners (notably BBVA and Santander) have well established covered bond issuance platforms, which would form a ready source of market expertise.
Even if and when covered bond laws are passed in Latin America, say some European bankers, enforcing them may be a different question altogether. As one points out: "Imagine trying to enforce a mortgage on a property in a favela in Sao Paolo or Rio. You’d probably have to take the army in with you."
Enforcement of mortgage laws is one of the many challenges that covered bonds will face if and when they spread their tentacles into emerging markets. However, bankers point out that covered bonds will be very different instruments in the developing world to the product familiar to investors in Europe.
"Even if emerging market issuers can pierce their local sovereign ratings, which should be possible, we’re likely not going to see $2bn triple-A rated covered bonds coming out of markets like Mexico or Brazil," says Colice at RBC. "That means that the investor base will be different, with the bonds likely to be sold to a cross-over audience of emerging market funds and existing covered bond investors looking to diversify beyond the existing jurisdictions."