The Impact of the Subprime Mortgage Crisis in Indonesia
Minister of Finance Sri Mulyani Indrawati expressed her concern regarding the strength of Indonesia’s population which is predicted to find it increasingly difficult to own housing amid the trend of rising interest rates. In order to overcome this, the former Managing Director of the World Bank said that a breakthrough was needed to support housing purchases. One of them is by securitizing Residential Ownership Credit (KPR) installments.
The securitization is then used as the underlying asset or basis for transactions in the issuance of securities that are traded in the secondary market.
In a statement from the Ministry of Finance, Sri Mulyani gave an example of how KPR capital can be used as an underlying asset for the issuance of securities which are then marketed on the secondary market called Impact Backed Stock in the form of Participation Letters (EBA-SP).
Stock-backed risk (EBA) or in English is known as asset-backed security, namely risk (certificate of value) that is ensured by the underlying capital such as a collection of provisions such as credit card bills, credit grants and so on, including mortgages that are known outside the country as mortgage-backed securities (MBS).
KIK-EBA and EBA-SP itself are basically MBS where BTN as the initial creditor (originator) transfers its financial capital to EBA holders. MBS is made from a combination of a collection of mortgage bills which on average have the same tenor and interest and are then marketed to various parties including investment banks, hedge funds or fund managers.
Then the investment bank can collect the capital and become an entity and then split it into smaller fractions to be offered to other investors. MBS can be purchased and marketed through brokers and the minimum investment varies between issuers.
Basically, EBA from mortgage bills turns banks into intermediaries between residential consumers and the investment industry. Banks can provide mortgages to residential consumers and then sell them at discounted prices to be included in the MBS.
How Does Securitization Make Residential Prices Lower?
With the current mortgage system, the bank where you borrow can buy your dream house and then market it to you in installments, some of which have a tenor of up to 30 years. This means that it will take a long time for the bank to recover its investment, even if you have paid a relative amount of up front and interest.
Relatively long returns, making the ability of banks to finance other residents who want to buy housing becomes increasingly limited. This in a way indirectly helps to boost housing prices due to limited availability, but the demand continues to increase sharply.
The initial idea for MBS was to solve this problem, where the bank is not another who is financing but only acts as an intermediary. This means that the purchase of housing is financed by the investor and you can pay installments to the investor through the bank.
Banks can benefit from various budgets or commissions paid, then a collection of mortgage bills can be marketed to interested investment banks. For example, if 1,000 houses each costing Rp. 1 billion have been provided in the form of mortgages to residents, meaning that the bank has invested Rp. 1 trillion and must wait several years before it can be reinvested. Under the MBS scheme, banks can sell directly to investment banks or hedge funds at a price of IDR 1 trillion and get their investment back quickly and profit from other fees paid by homeowners.
The result of this fast return can provide flexibility for banks to finance new mortgages and in the end can indirectly reduce housing prices because banks are able to provide more supply than before. Additional supply that is not accompanied by a higher increase in demand can put pressure on house prices.
Investment banks or hedge funds can hold these instruments until the end of maturity and get a fix income from mortgage installments. Not only that, they can also create new entities that combine the capital and market it in a smaller fraction to other investors, including retail.
For example, the Rp. 1 trillion investment mentioned at the outset each has a 10-year mortgage interest and a tenor of 10 years. Investment banks can break it down into 10 million securities (MBS), each worth IDR 100,000.
To make a profit, these instruments can be sold at a premium price, for example IDR 105,000 per share, which means that the investment bank will gain 5% or IDR 50 billion from the sale of the MBS. Then investors who order MBS will benefit from paying mortgage installments plus 10% interest, which means that if one buys MBS for IDR 105,000 in ten years the instrument will cost a total of IDR 200,000.
Threat of the 2008 Crisis Repeated?
Even though it has noble intentions that can provide benefits to many parties, MBS can become problematic if it fails to pay off a significant amount and causes investors to suffer losses.
Sri Mulyani herself is aware of the risks of securitizing KPR stock and because of that, she emphasized that the underlying assets must remain sound, risk management must remain sound and transparent.
The State Treasurer wants a number of parties to participate in reducing housing finance. He said, Bank Indonesia can help through macroprudential policies, namely by reducing the risk of Risk-Based Provisions or RWA for the housing sector and loosening loan to value.
Even though it is strictly regulated, the issuance of MBS in large numbers can cause a housing bubble, especially if the MBS issuer and the excessively greedy mortgage provider bank are followed by a dishonest rating agency. This is what happened in the US during the 2008 global crisis.
High demand by investors who perceive MBS as a safe investment and affirmed by a high rating has made mortgage banks and investment banks issuing MBS greedier by providing more mortgages to those who cannot afford to pay.
Not only that, the bank, which at that time thought that the housing market could not be destroyed, also offered ‘insurance’ for those who wanted to feel safe, should a failure occur. The large premium from the sale of the credit default swap (CDS) has also complacent the bank.
The more mortgages that do not meet the target, the higher the problem mortgages (subprime mortgages). Because they were not marketable enough, these troubled mortgages began to be combined with cool mortgages in order to get a better rating and with the hope that if they fail to pay off, at least investors can still make a profit and the bank doesn’t need to pay CDS claims.
In fact, the combination of these things turned into a disaster where the subprime mortgage became the main fuel for the collapse of the US housing market.
The crisis got faster and wilder when the Fed tightened policy by raising the benchmark interest rate in 2007. Many borrowers were unable to pay because of high interest rates, so banks had to pay large amounts of claims to CDS holders and in a short period of time, MBS became worthless.
Losses grew even greater as institutional investors and banks tried and failed to remove MBS investments that had become ‘junk’ from their portfolios. The tightening of policies caused many banks and financial institutions to teeter on the brink of bankruptcy. The spread of the crisis to the banking sector and financial institutions has also dragged down popular names like Lehman Brothers which are now history.
Not only that, the disruption in the lending sector due to limited liquidity is widespread and threatens to collapse the entire economy.
These conditions forced the US Treasury Department to intervene with Congress to authorize a US$ 700 billion financial system bailout to ease the credit crisis. The Federal Reserve also bought MBS trillions of dollars over the years while the Troubled Asset Relief Program (TARP) injected assets directly into banks.
Currently MBS is still being traded in the US this is because there really is a market for it because if it had been managed and issued properly, the average person would have paid off their mortgage when they could afford it. The Fed currently still holds most of MBS’s ownership, but is gradually selling its holdings. Quoting Federal Reserve Economic Data (FRED) data, until July 6, the US central bank had capital in the form of MBS worth US$ 2.71 trillion. This figure has increased significantly after the pandemic, where in early 2020 MBS’ written capital ownership was at US$ 1.6 trillion.