Eager to dig homeowners out from under a $374 billion mortgage mountain, South Korea is moving to let its banks start selling securities similar to those at the centre of the 2007 U.S. housing crisis.
The Financial Services Commission, South Korea's financial regulator, plans to submit a bill to parliament as early as this month that would allow banks to sell "covered bonds," or bonds backed by a bank's mortgage loans. The commission's hope is that covered bonds will let banks lend more money to homeowners for longer periods and so keep them from defaulting and triggering a debt crisis. If the bill passes before June, Korean lenders could start selling the debt by the end of the year.
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"For banks to issue the longer-term, fixed-rate mortgages that the FSC wants in order to deal with household debt, there needs to be stronger long-term funding methods for the lenders," said Kim Pyung-seb, general manager of credit services and foreign exchange at the Korea Federation of Banks. "The FSC and the banks believe covered bonds will meet that need."
Covered bonds bear many similarities to the mortgage-backed securities that were made notorious in 2007 when the U.S. housing bubble burst, but with an important difference: the mortgages backing the bonds stay on the issuing bank's balance sheet. That means the bank takes a loss if a homeowner defaults. And if the bank defaults on its bonds, the bondholders get the mortgages and can sue the bank for damages.
Instead of being able to make risky subprime loans and pass them on to investors like the U.S. mortgage industry did, therefore, Korean banks selling covered bonds would in theory have to make sure their borrowers remained healthy.
And South Korea has something of a mortgage debt problem. A boom in home-buying in the past decade has left South Korean banks and other financial companies with roughly 394.9 trillion Korean won ($374.42 billion). Those mortgages represent just two-fifths of what the government estimates is an even more dangerous, 937.5 trillion won household debt burden equivalent in size to three-quarters of gross domestic product.
South Korean household debt was equivalent to 150.8 percent of gross disposable income in 2010, according to the Organisation for Economic Co-operation and Development, the seventh-highest among the 25 countries for which it reports data, higher than Portugal, Spain or the United States.
And while most mortgages in other major economies get paid down gradually with interest over 15-30 years, such long-term loans are rare in South Korea because the financial markets are not as developed and banks still rely heavily on funding of three years or less.
Precise data isn't available, but government officials and bankers say a big chunk of Korean mortgages are three-year loans with variable rates, many of which require the entire principal be paid in a lump sum when they mature.
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Such a structure wasn't an issue when South Korea was still posting high growth rates and the property market was booming. But now growth has weakened sharply, property prices are falling and South Korea's Financial Supervisory Service estimates that Korean households will either have to pay off or refinance roughly 42 trillion Korean won ($39.82 billion) of mortgages maturing this year.
While most borrowers will likely roll over their loans, late payments on mortgages held by Korea's 18 commercial banks rose in October to a six-year high. And if growth picks back up and the central bank starts raising interest rates, higher loan payments could push many homeowners under water.
"Nobody knows how external conditions will change or what will happen if home prices continue to fall; if people are asked to repay their debt in its entirety, they have no means to do so," said Youngil Choi, an analyst for Moody's Investors Service based in Hong Kong.
To be sure, neither policymakers nor analysts think South Korea is due for a housing crash. The average Korean household still has net assets worth six times their debt and the central bank has been cutting interest rates to offset slowing growth.
Still, 68 percent of households surveyed this year said they were worried about looming mortgage repayments. Many have cut spending as a precaution, placing a drag on already weakening economic growth.
That's where covered bonds come in. Already popular in Europe, covered bonds are catching on elsewhere in other parts of Asia, such as Australia: $44.37 billion worth of covered bonds were sold by Asian issuers in 2012, according to Thomson Reuters data, nearly eight times the amount sold in 2011.
Having the banks that sell covered bonds tend the mortgages underlying them ostensibly makes them less risky to investors who buy them. The latest guidelines from the Basel Committee on Banking Supervision, for example, allow banks that buy other banks' covered bonds rated double-A or higher to count them as part of their own liquidity reserve.
That makes it likely Korea's covered bonds would find a ready reception among investors overseas.
"Discussions with Asian investors indicate that the security, diversification and higher rating offered by covered bonds will be increasingly of interest to them," said Robert Londrigan, head of debt capital markets for Commerzbank in Asia Pacific.
Covered bonds would give Korean banks' a new source of longer-term, lower-cost funding at a fixed interest rate. Regulators hope that will make it cost-effective for them to let more homeowners refinance into longer-term, fixed rate, amortizing loans that reduce monthly payments, eliminate the need to come up with piles of cash when the loan matures and insulate households from the inevitable rise in interest rates when the economy picks back up.
The FSC estimates that up to 80 trillion won worth of Korean covered bonds could be issued by 2016 once the legislation is approved. It's not clear yet just how much that will ease household mortgage servicing costs.
Banks wouldn't be required to use the proceeds of covered bonds to extend new mortgages. But because the FSC has given them until 2016 to boost the proportion of fixed-rate, amortizing mortgages to 30 percent from just 5 percent in 2011, analysts believe banks would use the money they raise selling covered bonds for little else.
"So long as current market conditions hold, covered bonds will be an affordable long-term funding method needed to make the loans that regulators want," a mortgage official at a Korean bank said.