LEGCO PANEL ON FINANCIAL AFFAIRS
The Hong Kong Mortgage Corporation Limited

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INTRODUCTION
Memorandum and Articles of Association

Memorandum
Articles
Master Mortgage Purchase and Sale Agreement and Master Mortgage Servicing Agreement

Mortgage Purchasing Criteria
WAY FORWARD
Summary of discussion --Hong Kong Mortgage Corporation- Mortgage Purchasing Criteria*-

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INTRODUCTION

Following the approval by the Exchange Fund Advisory Committee (EFAC) in July 1996, the Hong Kong Monetary Authority (HKMA) is proceeding with the preparatory work to set up the mortgage corporation, which is to be named as the Hong Kong Mortgage Corporation Limited (HKMC).

2. Good progress has been made so far in the preparatory work. The Memorandum and Articles of Association (Memarts) of the HKMC have been prepared following endorsement by EFAC and consultation with the Hong Kong Association of Banks (HKAB), the Hong Kong Association of Restricted Licence Banks and Deposit-taking Companies (DTCA) and the Hong Kong Capital Markets Association (HKCMA). We have also prepared working drafts of the Master Mortgage Purchase and Sale Agreement and the Master Mortgage Servicing Agreement which have been circulated to the three industry Associations for comments. Separately, the HKMA has informally consulted a number of banks active in the mortgage lending business on the mortgage purchase criteria of the HKMC. This paper briefs Panel Members on the key provisions of the Memarts and the working drafts of the two Master Agreements, as well as the views obtained from the informal consultation with banks on the mortgage purchasing criteria.

Memorandum and Articles of Association

3. The Memorandum sets out the company’s objects and the parameters of its business and regulates its dealings with outsiders. The Articles, which are subordinate to the Memorandum, contain the internal regulations for the management of the affairs of the company and the conduct of its business. The Memorandum and Articles of the HKMC are attached at Annex A and Annex B respectively. The provisions in the Memarts are consistent with the proposed framework of the mortgage corporation outlined in the consultation paper issued by HKMA in April 1996.

Memorandum

4. It is common practice in Hong Kong for companies incorporated under the Companies Ordinance to adopt a form of memorandum with objects that are drafted to allow them the flexibility to conduct a wide range of commercial business. Such memoranda are in practice largely standardised with only the principal objects being tailored to the needs of the individual company. The draft Memorandum of the HKMC includes a number of clauses which are unique to the mortgage corporation, whereas standard clauses which are applicable generally to limited companies are retained as far as possible.

5. The salient features of the Memorandum are summarised below:

1. Name of the Company : the Company name is to be "The Hong Kong Mortgage Corporation Limited".
2. Status of the Company : HKMC’s status will be that of a public company limited by shares. It will not be a listed corporation. A "public" company can issue debentures to the public. This will be a core activity of the mortgage corporation. As a "public" company, HKMC will have to publish its annual accounts. That is consistent with our objective that its affairs will be transparent.
3. Business scope : the Company’s business scope is defined in Object 1 as the acquisition of a portfolio or portfolios of mortgage loans on residential properties in Hong Kong and to hold and dispose of the same. This will prevent the HKMC from buying mortgages on commercial properties or properties outside Hong Kong, which may entail much greater risk. This object also provides for the Company to publish criteria for the acquisition of its residential mortgage portfolios, including a criterion relating to the owner occupancy of the relevant residential properties. It is intended that the HKMC will stipulate owner occupation, an important requirement for risk management purposes, as one of the purchasing criteria. The reason for not specifying this in the Memorandum is to avoid technical breaches of this criterion jeopardising a purchase of a portfolio on the grounds that the Company has acted ultra vires. Verification of owner occupancy in all cases presents considerable practical problems. It is unrealistic to expect the authorised institutions and the HKMC to conduct a 100% due diligence to check compliance with this criterion. Nor is this a standard feature of previous securitisations in Hong Kong. In line with market practice, we expect the seller would provide, as part of the contract, a warranty to the HKMC which would, among others, require the seller to swap the non-conforming mortgages with conforming mortgages to rectify any breach of the owner occupation criterion.

   Object 1 also specifies that the HKMC shall not originate loans for the purchase of residential properties in Hong Kong. This makes it clear that the HKMC will not compete with authorised institutions in the mortgage origination business.

4. Borrowing powers : Object 2 empowers the HKMC to borrow or raise money in Hong Kong dollars or other currencies and in such manner as the Company shall think fit. It also confers the power to issue paper through the medium of a trust or such other vehicles as the Company may require from time to time. This should give the Company maximum flexibility in managing its funding activities and is a technique often used with securitisation.
5. Use of financial derivatives : as hedging will be an important part of the risk management systems of the HKMC, Object 5 makes it clear that the Company has the power to enter into a wide range of lending and derivatives contracts for the prudent management of the Company’s financial affairs.

Articles

6. The majority of Articles proposed for the HKMC are standard provisions for a commercial corporation. The salient points are summarised as follows:

1. Board of Directors : Article 87 stipulates that the Board of Directors shall comprise not less than eight and not more than fifteen Directors. These numbers allow a fairly broad representation without creating too large a Board. Article 118 provides that the Financial Secretary (in his capacity as Financial Secretary) shall be the Chairman of the Board and Article 1 provides that he shall appoint a Deputy Chairman. The Financial Secretary shall, in his capacity as shareholder, appoint other members to the Board on an ad personum basis (Article 88). In other words, while industry associations may be invited to put forward nominations for appointment as Directors of the HKMC, the successful candidates will be appointed by the Financial Secretary as Directors in their personal capacity and will be required to perform the usual fiduciary duties of Directors in accordance with the Companies Ordinance. The Financial Secretary may appoint one or more Directors to be Executive Directors who will be responsible for the day-to-day management of the HKMC in accordance with the policies determined by the Board (Articles 88 and 99).
2. Committees and advisory groups : Article 100 provides that the Directors and the Executive Directors may form committees and advisory groups to assist in the efficient management of the HKMC. These advisory groups will enable the HKMC to tap the expertise of a wide spectrum of industry experts in areas such as loan purchase, servicing standards and procedures, and debt issuance arrangements.

Master Mortgage Purchase and Sale Agreement and Master Mortgage Servicing Agreement

7. The Master Agreements contain the general terms governing the sale of mortgages to the HKMC by the authorised institutions and the continuing servicing of these mortgages by the authorized institutions. The working draft of the Master Mortgage Purchase and Sale Agreement at Annex C covers the following broad aspects:

1. the procedures for initiating and concluding mortgage sales;
2. the circumstances in which the HKMC may serve notices on mortgagors to perfect the HKMC’s assignment from an equitable to legal assignment ;
3. the representations, warranties, undertakings and indemnity of the selling authorised institution to the HKMC;
4. the circumstances in which the selling authorised institution will be obliged to repurchase mortgages (basically in cases of non-compliance with the HKMC’s purchasing criteria as at the time of the mortgage sale).

The working draft of the Master Servicing Agreement at Annex D covers the following aspects :

1. the continuing servicing of mortgages by the selling authorised institution (including the setting of the Mortgage Rate and the redemption of mortgages);
2. the receipt of mortgage payments and cash flows;
3. the provision of information by the servicer to the HKMC;
4. the servicer’s obligations with regard to Title Deeds, Mortgage Deeds and insurance policies;
5. the servicer’s representations, warranties, covenants and indemnity to the HKMC;
6. the circumstances in which the servicing function may be terminated; and
7. the parties’ respective obligations of confidentiality.

8. Specific matters relating to individual purchases of mortgage portfolios, such as the pricing and the servicing fee payable, will be dealt with in the exchange of confirmations concluding the relevant transactions. It is also useful to note that the Master Agreements refer to two manuals, "the Purchase and Sale Manual" and "the Servicing Manual". The former will set out in detail the Purchasing Criteria required to be fulfilled by mortgages purchased by the HKMC together with standard forms of confirmation and transfer documentation. The latter will set out the continuing administrative services to be performed in respect of mortgages purchased by the HKMC, including the forms of the various reports to be delivered by the servicer to the HKMC.

Mortgage Purchasing Criteria

9. There was a strong consensus among the banks we consulted that the criteria should be set on prudent principles and with reference to the general industry practice in mortgage loan origination. The following summarises our discussions with the banks so far :

1. Original loan size : There was broad agreement that HKMC would need to set a maximum loan size to avoid exposure to the luxurious properties, the prices of which have tended to be more volatile than the other segments of the market and hence a higher risk of delinquency and default. Most banks considered a maximum loan size of $5 mn would be appropriate, subject to review from time to time with reference to prevailing conditions in the property market, although a few banks suggested a higher figure of $8 mn. With a loan to valuation ratio of 70% (see (c) below), a loan size of $5 mn means that the property is worth around $7 mn at the maximum.

   It was also felt that a minimum loan size might be needed to avoid the high administration costs involved in handling very small loans. Some suggested that the minimum loan size should be set at $2 mn. But others felt that the minimum limit should not be set too high to exclude mortgages on small and old properties, as this would have an adverse impact on the availability and the pricing of mortgages to first-time or lower-income home buyers. They considered a minimum loan size in the region of $0.5-0.8 mn to be more appropriate.

2. Outstanding principal : As the proposed seasoning is about one year, the maximum and minimum outstanding principal should be close to the original loan size.
3. Maximum loan to value (LTV) ratio : 70% at origination.
4. Maximum debt to household income ratio at origination : 50%, in accordance with the mortgage lending policy of most banks. Household income would cover the income of co-mortgagers and that of the guarantors of the mortgage loans.
5. Seasoning : As the majority of mortgage loans in Hong Kong are repaid within 4-5 years, it was generally felt that the minimum seasoning requirement should not be set too high. Most banks considered a seasoning of one year as appropriate. A few suggested that 6-month seasoning should be adequate.
6. Maximum original maturity : 25-30 years.
7. Remaining maturity : The maximum remaining maturity would be determined with reference to (e) and (f) above, i.e. 29 years if the maximum original maturity was pitched at 30 years. There might also be a need to set a minimum remaining maturity to avoid acquiring loans which would fully be repaid very shortly.
8. Age of property : Most banks considered that the quality of the property, rather than its age per se, would be more important in affecting the market value of the property. A possible approach would be to accept mortgages on property aged 30 years or above, subject to a satisfactory report by a qualified surveyor. An alternative would be not to specify a limit on property age, but simply rely on the sum of "original maturity" and "age of property at origination" as a control (see (i) below).
9. Sum of "original maturity" and "age of property at origination" : 40 years at maximum, in accordance with general lending practice of banks. This approach leaves some flexibility as to the property age restriction. As an illustration, mortgages on 30-year old properties may qualify for purchase if their original maturity is, say, 10 years.
10. Delinquency status : It was generally considered that a clean record in the 12 months prior to mortgage sale (defined as no single instalment behind payment for more than 30 days) would appear to be a reasonable standard.
11. Legal charge : First legal charge.
12. Avoidance of risk concentration : It was felt that the HKMC should consider setting limits on the proportion of mortgages on properties in a single development rather than requiring rigid geographical diversification between Hong Kong Island, Kowloon and New Territories.
13. Occupancy status : Owner-occupied at the time of mortgage sale.
14. Insurance : The property should be insured against fire and other calamities, in accordance with banks’ general practice in mortgage lending.

10. A summary table comparing the above criteria with the general industry practice in mortgage loan origination is at Annex E. It should be noted that these criteria pertain to floating rate mortgages on private residential mortgages. For fixed rate mortgages, some of the above criteria, such as the seasoning requirement, may need to be set differently. Furthermore, in respect of mortgages on properties in the Home Ownership Scheme and the Private Sector Participation Scheme, the credit risk involved is minimal because of the guarantee provided by the Housing Authority. It would therefore be appropriate to adopt a separate set of purchasing criteria for such loans.

WAY FORWARD

11. The HKMA has circulated the working drafts of the Master Mortgage Purchase and Sale Agreement and the Master Mortgage Servicing Agreement as well as a summary of our informal discussion with banks on loan purchase criteria to the HKAB, DTCA and the HKCMA for comments. These Master Agreements, together with the proposed mortgage purchase criteria, will be presented to the Board of Directors of the HKMC for consideration in due course.

12. In parallel, we will continue to proceed with other aspects of the preparatory work, including the development of the IT system, the risk management system and the human resources arrangements. Our present plan is to constitute the Board of Directors of HKMC in the first half of 1997. The mortgage corporation is expected to commence business in the second half of 1997.

Hong Kong Monetary Authority
December 1996

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Summary of discussion --Hong Kong Mortgage Corporation- Mortgage Purchasing Criteria*-

* For mortgages on private residential properties. Different criteria will be set for mortgages on HOS and PSPS flats.

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