South African Home Loans Case Study


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South African Home Loans Case Study

  1. 1. Wits Business School WBS-2004-6 SA Home Loans: Bank Bashing is Good for Business! It is easier to make money by lending than by borrowing – Simon Stockley 1 Simon Stockley, CEO of SA Home Loans (SAHL), was a lawyer by education but an entrepreneur by nature; his colourful, nonconformist socks epitomised his character. In five years he had successfully broken into South Africa’s capital market, taken on South Africa’s major banking institutions, gained approximately 11% 2 market share for new bonds (estimated at ±500 million p/m), gained 3% of South Africa’s estimated R258 billion total mortgage market and forced the banking institutions to change their home loan finance modus operandi in response to his competition. Despite these achievements, he was dreading the upcoming board meeting, as he could predict the question that would be asked – the question for which he, as yet, had no sure answer. At the end of the board meeting, Laurence Rapp, Standard Bank’s director of strategic investments and alliances, would ask: “So Simon, what is your next BHAG?”3 South African Home Loan Industry Banking establishments are more dangerous than standing armies – Thomas Jefferson4 High real costs of borrowing and excessive bank margins in this country created a need to re-examine traditional methods of home financing with the view to developing more efficient funding for private residential properties – Simon Stockley 5 Pre-1994, the development of South Africa’s mortgage origination market was extremely polarised. Whites, who formed the middle and upper classes, had always had the right to own land and could easily access mortgage finance. Blacks, on the other hand, only received the right to own property outside the traditional “homelands” in the early 1980s.6 The lending 1 Interview with Simon Stockley, 11 December 2003. 2 Source: South African Reserve Bank, average for September, October and November 2003. 3 BHAG – Big Hairy Audacious Goal. 4 Circa 1799. 5 Drive to Educate Consumers, Sowetan, 27 March 2001, author unknown. 6 Group Areas Act 1956 This case was prepared by research associate Steven Cole, with lecturer Professor Mike Ward. The case is not intended to demonstrate effective or ineffective handling of an administrative situation. It is intended for classroom discussion only. Copyright ©2004 Graduate School of Business Administration, University of the Witwatersrand. No part of this publication may be reproduced in any format - electronic, photocopied, or otherwise - without consent from Wits Business School. To request permission, apply to: The Case Centre, Wits Business School, PO Box 98, Wits 2050, South Africa, or e-mail
  2. 2. SA Home Loans: Bank Bashing is Good for Business! institutions of the time seized upon the opportunity and provided mortgage finance indiscriminately. This strategy resulted in large financial losses for several institutions, and even the ruin of some, as a result of the mass debtor defaults in the late 1980s. The defaulting was caused by a lack of debtor awareness, poor education, an interest rate spike and an over- heating political environment that propagated the boycotting of rates and taxes and, eventually, bond repayments. By the time the New South Africa came into being, the banks had incurred great losses in the townships and were reluctant to return. However, the priorities of the newly elected democratic government were explicitly directing them there. Furthermore, township residents were antagonistic towards the banks, as many felt that they had previously been mistreated and exploited by them. Therefore, in 1995, in an effort to encourage banks to re-enter the townships, the government established the Mortgage Indemnity Fund (MIF).7 The MIF insured the banks against all non-commercial risk (i.e. the inability to evict and sell-off a repossessed property due to community action, etc.). The MIF was specifically designed to have only a three-year horizon to incentivise the private sector to continue looking for solutions to the low-income property market risks. Although the MIF had some success in getting banks back into the township private residential mortgage market, bank lending practice tended to segregate as the MIF was phased out. More affluent individuals in the newer, better areas of the townships had little difficulty in accessing bank mortgage finance based on their credit profiles, but those on the fringes were “red-lined” by the banks. In 1998, home loan financing to the black and white middle and upper classes was provided almost exclusively by the five major financia l institutions (see Exhibit 1 for market share percentages). These banks secured funds from the money market and lent this, in the form of mortgages, to the homeowners at the “prime” rate. Prime was, on average, 4% above the rate at which the banks had b orrowed the money – high by international standards. Security for the lending was provided by a first mortgage bond registered against the title deeds of the property, thus making first mortgages one of the highest forms of secure lending available. The banks defended their large margins by pointing out that their internal operating costs were very high. In order to be in the home loan market, they had made significant investments in fixed property, infrastructure, computer systems and personnel. Further overheads were added by the management of bad debts; profits from “good” loans were used to cross-subsidise the losses made from “bad” loans. In addition, the banks cross-subsidised their different business units, rather than allow them to fail. For example, if a bank’s home loan business was running at a loss, the bank’s board would redirect profit from another business unit and ensure the home loans unit had sufficient capital to remain in business. All semblance of competition had been lost from the home loan market. To a large extent, the home loan market was an oligopoly catering to the middle and upper classes. The banks, in essence, operated as a cartel; they were content with their market shares and had reached a tacit agreement not to “rock the boat” by competing on the issue of rates. Consumers therefore had very little choice. What is more, because each bank was “assured” of market share, service levels and customer orientation were low. 7 D Porteous & K Naicker, ‘SA Housing Finance: The Old is Dead; is the New Ready to be Born?’, F Khan & P Thring (eds), Housing Policy and Practice in Post-Apartheid South Africa, Heinemann, Johannesburg, 2003. 2
  3. 3. SA Home Loans: Bank Bashing is Good for Business! Securitisation Securitisation is a fancy word for discounting cash flows – Simon Stockley 8 Securitisation is an efficient way of spreading risk across parties… [according] to the appetite of funders – David Porteous9 After graduating as a lawyer and completing his articles, Stockley gained experience as a managing director of an independently owned developer and marketer of residential property, the Townhouse Group. It was here that he acquired his knowledge of the South African real estate market. During this time, he received several prestigious awards and succeeded in transforming the organisation into the largest enterprise of its sort in KwaZulu Natal. In 1998, Stockley found himself unemployed due to a spike in South African interest rates that caused the business to make a loss. It was at this time that Stockley realised that it was easier to make money by lending than by borrowing. He ordered $5 000 worth of business books from an online bookstore, read voraciously and happened upon the concept of securitisation. 10 Securitisation is a process by which assets, rather than companies, are brought to the market, i.e. sold on a Bond Exchange.11 It is the process whereby, after accumulating a large number of the same type of cash-flow generating assets, one sells the assets to a Special Purpose Vehicle (SPV), a company created for the sole purpose of holding the assets. The SPV obtains the capital required to buy the assets directly from the capital markets, at a risk-related price (the risk being determined by specialist assessment agencies such as Moodys).12 The SPV therefore raises a lump sum amount with which it is able to purchase the cash-generating assets and pays the interest on the borrowed capital from the income stream produced by the assets (see Exhibit 2 for a graphical explanation). Internationally , the concept of securitisation had been used for decades with varying asset types. During 2002, Europe securitised €158 billion 13 worth of assets and the present value of all US securitisation issues amounted to approximately $4.7 trillion14 (Exhibit 3). Even the rock star David Bowie exploited the benefits of securitisation when he turned 50. He knew his songs would continue selling at an average of one million units a year for some time, and he wanted to benefit from the fruits of the cash flows whilst he was still young enough to enjoy them. After securitising the expected future cash flow from the songs on the capital markets, he received a once-off $50 million and investors received a near-guaranteed cash flow return of 8% on their investment.15 Similarly, lawyers who successfully sued the US tobacco giants in 1998 securitised their multibillion-dollar damage awards, which were to be paid out over 20 years, and were paid out the full net present value in one lump sum. 16 8 Interview with Simon Stockley, 11 December 2003. 9 Interview with David Porteous, 26 January 2004. 10 Interview with Simon Stockley, op cit. 11 G Scott, Rand Merchant Bank, in H Joffe, ‘Milestone in Emergence of Securitisation in SA’, Business Day, 27 Dec 2001. 12 Includes institutional investors from pension funds, insurance companies, banks and commercial enterprises. 13, research link (accessed 8 February 2004). 14, statistics link (accessed 8 February 2004). 15 N Hopkins, ‘Bum note for 'Bowie bonds’, 28 May 2003, available,,5- 694703,00.html (accessed 5 January 2004). 16 A Templeton, ‘Securitisation Offers Major Tom for Bowie’, Business Report, 30 November 1999. 3
  4. 4. SA Home Loans: Bank Bashing is Good for Business! SA Home Loans (Pty) Ltd: The Concept There was no brilliance in it; we just copied what we had seen internationally. The trick was in the execution! – Simon Stockley 17 As Stockley researched and studied other markets, he realised that securitisation could work in South Africa and was astounded that it had not yet taken root. The United Building Society had attempted securitisation in 1989, but it had achieved limited success because there was little interest from banks, which did not feel the need to securitise their mortgage loans because they did not face capital constraints and had little pressure from shareholders to improve returns. The development of the asset-backed securities market had been hampered further by a weak regulatory environment, significant issuance of government debt and a generally illiquid and undeveloped corporate debt market.18 Stockley saw an opportunity for a management company to use securitisation to bypass the large banks and simply link institutional lenders to the public. He could then offer capital to the public at a considerably lower margin than the banks because the new company’s infrastructure investment would be considerably lower. This model was primarily inspired by the US, European and Australian mortgage markets, where non-banks had acquired significant market share by undercutting the banks’ large margins. The activities of these new entrants revitalised the whole mortgage market and drove many of the Australian banks into securitisation themselves.19,20 Australian consumers were able to obtain cheaper finance as the Australian capital markets became more sophisticated in measuring and apportioning debt risk and as liquidity increased in the secondary market for securitised “paper”. Stockley realised that the basic elements of what made the process work elsewhere could be replicated in South Africa. He therefore took the best of what he saw internationally and adapted it to suit the local environment. 21 His original securitisation plan was to form a management company that would securitise cash- flow generating assets such as credit cards, vehicle financing or home loans. He intended to securitise existing assets that had been accumulated by other organisations and take a small margin, or management fee, as the basis for his return. However, because of the South African market’s naiveté to securitisation and his lack of a track record, no company would provide Stockley with assets to securitise. Undaunted, Stockley began to create the asset base himself – a full supply chain, from asset creation and administration to securitisation. 22 (See Exhibit 4). Several factors were in Stockley’s favour, and the time was ripe for securitisation in the South African market. On the one hand, the 1998 Asian Crisis (ironically, the factor that had originally caused Stockley to be unemployed) had sent South African interest rates streaking to very high levels and consumers were therefore desperate for cheaper debt (Exhibit 5). On the other hand, the financial landscape of South Africa was changing. The government’s fiscal policies were reducing the budget deficit, making the government less reliant on public debt, and thereby creating a more receptive investor base for asset-backed securities. Furthermore, the government was also close to changing the legislation governing securitisation, making it more accessible and easier to use.23,24 17 Interview with Simon Stockley, op cit. 18 Edward B Marrinan, J.P. Morgan Securities Ltd. Credit Research, South African Home Loans Limited, South Africa’s Leader in Mortgage Securitisation, 6 November 2001 19 SA Home Loans to Carve Path for South African RMBS, Structured Finance International, 9 November 2001, author unknown. 20 SA Home Loans ‘Leap Of Faith’, Structured Finance International, Nov/Dec 2001, author unknown. 21 Interview with Simon Stockley, op cit. 22 Ibid. 23 SA Home Loans to Carve Path for South African RMBS, op cit. 24 The Evolving Role of Accountants in Securitisation, Business Report, 12 September 2002, author unknown. 4
  5. 5. SA Home Loans: Bank Bashing is Good for Business! Regulatory Hurdle We had to get a “Silk”25 to confirm the stupid opinion [that SAHL was not a bank], and it cost R150 000, although it was pretty obvious to me! – Simon Stockley 26 With the basic idea to provide consumers with a significantly cheaper alternative to their existing home loan rate, Stockley surrounded himself with dedicated specialists and established SA Home Loans (Pty) Ltd. SAHL was launched on 15 January 1999 and offered home loans to the public that effectively undercut the banks’ lending rates by approximately 2%. Within its first week, SAHL had received enquiries on property to the value of R350 million. Even so, the banks were dismissive of SAHL. Peter Southworth, general manager of Nedcor’s home loans division, said that Nedcor had known someone would come along with this concept but was not concerned about the competition. He said that Nedcor would not overact.27 Alan Bennetts, Standard Bank’s divisional general manager, said that he believed banks were offering a better product because “There are no bells and whistles with these [SAHL] loans”.28 He added that “on its own, SA Home Loans’s aim to capture 3% of the market would not make much difference to the market”. One of the first hurdles faced was the nature of business of SAHL. It may have appeared that SAHL would be receiving deposits from the general public and from investors who deposited cash into the SPVs. Therefore, by definition, SAHL would be a “deposit-taking institution”, i.e. a bank. Banking, and securitisation by banks, was heavily regulated, necessitating capital reserves and high overheads. From Stockley’s perspective, it would have been better if SAHL fell outside the ambit of “a bank”, not only because it would h ave been unlikely that SAHL could have raised the capital to acquire a banking license (R250 million), but, more importantly, he wanted SAHL to be seen to be “anti-bank”. Stockley commissioned advocates Nigel Willis 29 and Malcolm Wallis, both experts in banking law, to confirm that his scheme did not constitute the business of a bank and was therefore not subject to the regulations governing banks.30 This was an important hurdle for Stockley and consumed disproportionate amounts of time and money to overcome, but it was vital. Reducing the Risk of Debtors Defaulting The entrepreneurial management team wrote some incredible systems – part of [SAHL’s] secret is the quality of the systems, the information, the database and the way they can tweak it! – James Donaldson, Standard Bank, senior manager: strategic investments and joint alliances 31 The ultimate criterion for SAHL to lend money to a potential client was that of minimised risk of default – the higher the probability of bad debt, the lower would be the credit rating of the SPV and the greater the reserving capital (and cost) that the SPV would have to pay on the capital market. To do this, SAHL ensured that all mortgage bonds were registered against the title deeds of the property. Furthermore, the bond agreement ensured that the property bonded could not be altered in any way without the cancellation of the bond or the consent of SAHL. 25 Lawyer. 26 Interview with Simon Stockley, op cit. 27 L van Duffelen & S Jones, ‘Banks Dismiss New Kid on the Home Loans Block’, Business Report on Sunday, 17 January 1999. 28 Ibid. 29 Author of ‘Banking in South African Law’, Juta, 1981, ASIN 0702112593. 30 Regulations that may have impacted on the SAHL model included: the Banks Act; Government Notice 153 as published in Government Gazette no. 13723 – 03 January 1990, Government Notice 2172 as published in Government Gazette no. 16167 – 14 December 1994; new regulations/January 2002 Basle Accord; and tacit approval/endorsement/cooperation. 31 Interview with James Donaldson, 30 January 2004. 5
  6. 6. SA Home Loans: Bank Bashing is Good for Business! The mortgage bond also gave SAHL first option to the proceeds of a property should a court sell it due to the insolvency or liquidation of the individual 32 . To further minimise the risk of acquiring defaulting debtors, SAHL “cherry-picked” the home loan market and selected only clients who measured up to specific criteria. Stockley and his team produced several internal and external systems and controls to indicate accurately the ability of borrowers to repay their liability. At its most basic level, the vetting system needed an IT base from which to function. No generic software was available, so SAHL commissioned the creation of sophisticated, customised software that facilitated efficient operations and provided a robust control structure. The system monitored the progress of each and every bond and also had the ability to produce all the conveyance documents, guarantees and correspondence associated with the registration of a bond. 33 Built into the design of the software, and forming part of the vetting criteria, was that SAHL would only consider debt to equity ratios of less than 80%. This meant that potential clients would already have to have equity of at least 20% of the property value at risk. SAHL believed that this would act as an incentive not to default. SAHL also ensured that a household’s home loan repayments did not consume more than 25% of its total income, i.e. that clients could actually afford the loan. In addition, a credit bureau’s scoring system, designed for consumer credit, was used to supplement the customised mortgage loan matrix. This gave SAHL real- time access to adverse credit reports, civil judgements and credit histories. The system was also able to verify ID numbers so as to minimise the possibility of fraud, as well as access Deeds Offices to verify property details . SAHL’s data were therefore of the highest quality and this, together with specially designed systems and procedures, aided in the recovery of bad debt. Defaulters could be identified easily and timeously and were encouraged to recommence payments before there were any serious consequences for SAHL. On the property side, the software took into account the location of the proposed property and (initially) only the premium residential suburbs of South Africa, such as Sandton, Durban North and Constantia in Cape Town (Exhibit 6), were accepted. Perceived high-risk areas, such as townships, and areas of political unrest were excluded. SAHL further ensured that the stated value of the property was correct. To do this, SAHL outsourced the valuation of premises to independent, sworn appraisers. In addition, and to validate the data received from the valuators, SAHL used careful internal audit procedures and maintained an extensive database of residential property values. Finally, at the highest level of control, a credit committee, consisting of executive directors and a non-executive director, approved all loans that fell outside the parameters of the credit policy. Cost Minimisation South African Banks, protected from true competition by years of international isolation, had grown fat and lazy. I saw an opportunity for a low cost servicer to challenge their margins on price and customer experience. – Simon Stockley 34 To make itself even more competitive, SAHL ensured that its costs would be significantly lower than that of its competitors. SAHL ensured that most business could be done online or via the telecentre, thereby avoiding the need to open an extensive branch network. In instances where personal contact was required, such as the signing of legal documentation, SAHL arranged for the documents to be signed at the offices of selected attorneys with whom they had negotiated lower conveyance fees. Furthermore, instead of looking for expensive new business (although they did not avoid new business), and to further reduce costs, SAHL enticed home owners to 32 SAHL Loan Agreement. 33 SAHL Proposal Document. 34 E-mail correspondence from Simon Stockley, 1 March 2004. 6
  7. 7. SA Home Loans: Bank Bashing is Good for Business! move their current bonds from banks to SAHL. This strategy, besides being more cost effective than writing new bonds, provided SAHL with a full payment history of the potential client’s mortgage, aiding in the assessment of that person’s creditworthiness. Marketing Bank Bashing is Good for Business – SAHL advertisement Although there were other appealing factors involved35 , the main appeal of the SAHL product was the significant discount at which the new loans could be offered. SAHL conducted research to ascertain whether this should be by way of a monthly saving, an annual saving or the value of the saving over the (typical) 20-year period of the loan (Exhibit 7). These savings were communicated to a target market that had been segmented using the Living Standards Measure (LSM)36 , with the marketing and lending activity being confined to the upper three LSM categories.37 The product was positioned in line with international trends, and was characterised by decentralisation, offering the consumer a “better deal” and advertising that was essentially anti-establishment (Exhibit 8). Stockley had originally determined that, to be successful, SAHL needed to capture between 2% and 5% of the existing market, which he estimated might take five years. After five years had elapsed, SAHL had captured over 3% of the total home loans market (a 20-year market), had 30 000 mortgages worth R8 billion on their books and were writing a three-month average of 11.4% of all new loans in the market (Exhibit 9).38 Furthermore, SAHL had only litigated five times and in these cases had made a shortfall of only R35 000.39 Shareholding You want shareholders to keep their nerve because you’re going to burn a whole bunch of cash before you become profitable – Simon Stockley 40 At its launch, SAHL was provided with R30 million of working capital by management and Peregrine.41 SAHL had also acquired a R300 million line of credit through the International Bank of South Africa (IBSA).42 Stockley maintained that obtaining the R300 million line of credit was one of his greatest challenges. Firstly, he found it difficult to convince investors to lend him money when he did not have a balance sheet. Secondly, potential funders were suspicious of the repayment mechanism because they were not familiar with securitisation. Finally, it was not possible to approach the traditional lenders (banks) because he meant to go into competition with them. Jacko Maree, Standard Bank Group’s CEO, had told Stockley after a business breakfast weeks after SAHL’s launch that, if SAHL was still in business after four years, Stockley could contact 35 Appeal of the SAHL product: twenty-year, variable rate, reducing term mortgage; no pre-payment or redemption penalties; discounted legal and administrative fees; no ongoing administrative charges; re-advance facility; fixed margin above cost of money; and transparent pricing. 36 Consumer groups are characterised into eight groups depending on their usage and access to amenities and their degree of urbanisation. 37 LSM 6 – Emerging Markets; LSM 7 – Established Affluence; LSM 8 – Progressive Affluence. 38 Source: South African Reserve Bank, average for September, October and November 2003. 39 Statistics provided by SAHL. 40 Interview with Simon Stockley, op cit. 41 Peregrine was a listed financial services company operating in the Venture Capital market and, at the time, a 24% shareholder in SAHL. 42 IBSA is now deregistered. 7
  8. 8. SA Home Loans: Bank Bashing is Good for Business! him again.43 Stockley eventually persuaded the IBSA to invest in SAHL, but IBSA only had an appetite for a R300 million credit line. Stockley’s original securitisation plan was therefore to acquire R100 million in mortgages, place them into an SPV, securitise the SPV from the capital market and thereby replenish the credit line. He therefore believed that the R300 million credit line would be an ample provision. JP Morgan, an investment bank, was appointed as advisor to the securitisation programme.44 The investment bank advised that R100 million was too small an amount to securitise. Not only were the transaction costs too high, but there would also be a lack of liquidity in the secondary market. In other words, a critical mass was required to facilitate the buying and selling of the securitised “paper”. JP Morgan therefore extended the ambit of its involvement to identify an equity partner that could make up the capital shortfall for SAHL. As Stockley put it: “It’s all about timing”; JP Morgan had recently aided Standard Bank in defending a hostile take- over bid by Nedcor and was on very good terms with the Standard Bank executive.45 Although not an easy process, JP Morgan eventually persuaded Standard Bank to become a 40% equity partner in SAHL. Seeing an interesting private equity investment opportunity itself, and wanting to assist in developing the capital markets and exploit their international knowledge and expertise locally, JP Morgan bought 25% of SAHL shares. On the back of the Standard Bank equity transaction came a R1 billion credit-line warehouse.46 Standard Bank saw its investment as an opportunity to establish securitisation in South Africa and to acquire in-house skills in securitisation for other deals. It was also agreed that Standard Bank would provide the standby service for all the securitised entities, i.e. if anything went wrong with SAHL as a service provider, Standard Bank could take over the servicing of the home loan book and therefore ensure control of the home loans. Stockley was cynical about Standard Bank’s intentions in buying into the company, particularly in the light of his previous conversation with the CEO. He did not know if it was to gain a foothold in a bright, new venture, or to crush potential competitio n. As such, although he knew that he had to make Standard Bank a shareholder for the survival of the business, he was determined not to let it control the company. Therefore, to balance the weight of the bank, Stockley approached the International Finance Corporation (IFC), the commercial arm of the World Bank, to join as a shareholder in SAHL by buying out Peregrine. The IFC had a mandate to uplift developing markets, but not at the expense of profits. Stockley convinced the IFC that securitisation was the ideal model for packaging risk and therefore suited to funding the low end of the housing finance business. The IFC liked the idea of a non-bank lender and saw an investment in SAHL as an opportunity to help further develop the capital markets in South Africa, and one that would also turn a profit. The IFC thus became a 20% shareholder in SAHL. Therefore, although Standard Bank was the major shareholder, JP Morgan, the IFC and management (with the remaining ±15%) had the controlling interest in SAHL if they worked together. Although Stockley saw the accumulation of shareholders as necessary for the success of SAHL, he was concerned that it would lead to further complications. Securitisation, the building of a mortgage portfolio (heavily dependent on annuity income with expenses being incurred up front) and the establishment of a national retail brand take an enormous amount of start-up capital. It was originally calculated that shareholders would only begin seeing returns on their investment after five years. Stockley therefore needed shareholders who would have the nerve to stay for the long run. Furthermore, he was determined to maintain the entrepreneurial spirit and flair of SAHL, even though a large bureaucratic organisation like Standard Bank was the major shareholder. In addition, he was worried about the very different objectives of the 43 Interview with Simon Stockley, op cit. 44 JP Morgan was known as JP Morgan Chase at the time of writing. 45 Interview with Simon Stockley, op cit. 46 Now R8 billion. 8
  9. 9. SA Home Loans: Bank Bashing is Good for Business! various shareholder groupings, as he found that he was spending 25% of his time mediating between them.47 Would the pursuit of their different vested interests ultimately lead to conflicting relationships? To the Capital Markets [The SAHL] transaction creates a true benchmark. It is a first not just for South Africa, but ranks among the first mortgage-backed securitisations outside Europe, Australia and the United States. For South African domestic homeowners the transaction opens up a new era of competition in the mortgage market. For investors, it provides an opportunity to diversify their bond portfolios away from the traditional investment instruments such as government gilts – John Coulter, JP Morgan CEO 48 Stockley, JP Morgan and Standard Bank purposely modelled the initial R1 billion loan facility provided to SAHL by Standard Bank as a replica of what the post-securitisation investment would look like. This was done to demonstrate to investors the way the actual securitisation would work. The asset security of the loan was rated by the rating agencies (not usually done 49) and offered Standard Bank the same income streams that were eventually extended to investors in the later securitisation issue. The loan was priced in relation to the Johannesburg Interbank Agreed Rate (“JIBAR”).50 On 29 November 2001, a year after the Standard Bank deal and almost three years since its launch, SAHL took the first SPV, The Thekwini Fund 1 Limited (Thekwini 1) , with a value of R1.25 billion, to the market.51 As was common with securitisation deals, a series of measures were undertaken to enhance the creditworthiness of the SPV, thereby ensuring a higher rating from the rating agencies. Thekwini 1 was rated by Fitch and Moodys and divided into a R1.15 billion domestic AAA-rated tranche (the highest rating issued and equivalent to the rating of a government bond) and a R100 million BBB-rated mezzanine portion (Exhibit 11). SAHL itself provided capital, securing an even greater credit enhancement for the debt, as it would take the first loss if something were to go wrong with the cash flow of Thekwini 1. The buyers of the junior bonds (BBB-rated tranche) would rank second in default and only after that would the senior bondholders (AAA-rated tranche) be affected. Senior bondholders were therefore protected from loss on their investments by the credit enhancement features. JIBAR was the rate at which banks borrowed money (see footnote 50 and Exhibit 10) and, for that reason, JIBAR was also the rate an investor earned on a money market account. Any rate above JIBAR was an attractive investment, especially if the investment was AAA-rated. As Thekwini 1 was the first securitisation deal in South Africa, investors were uncertain as to how tradable securitised issues were likely to be. This uncertainty was priced into the rate by the market and the bonds were offered at a wide premium to other equivalent, highly-traded, investment-grade paper, such as government debt or parastatal bonds. The AAA-rated bonds were offered to investors at a spread of 70 basis points (bp) over JIBAR and the BBB-rated bonds at 230 bp above JIBAR. 52 Interest on the relevant bonds was paid quarterly in arrears at the rate determined on the first day of each quarter. 47 Interview with Simon Stockley, op cit. 48 [Author] ‘Inaugural Bond Issue’, African Connection, First Quarter 2002. 49 Traditionally, the bank carried all the credit risk itself and therefore there was no need to obtain an external rating. With securitisation, this risk was being passed to investing institutions, which required an external risk rating. 50 JIBAR was the rate at which banks borrowed money and was therefore several percentage points below Prime (Exhibit 10). The JIBAR rate was a South African money market rate indicated by a number of local and international banks and was updated daily. Each day the banks were asked for their mid-point (between bid and offer) three-month deposit Bankers’ Acceptance rate, which was quoted as a discount rate. The highest two and lowest two rates were eliminated and the remaining rates were averaged and rounded to three decimal places (SAHL Revolutionises Home-Owning, Business & Finance, 28 May 2001). 51 Thekwini is the Zulu name for the city of Durban. 52 One percent is equivalent to 100 basis points (bp). 9
  10. 10. SA Home Loans: Bank Bashing is Good for Business! By the time the R1.1 billion Thekwini 2 securitisation was launched on 21 November 2002, investors had become more comfortable with the instruments and the AAA-rated notes were placed at a spread of 65 basis points above the benchmark JIBAR. Thekwini 3 did even better on its debut less than 12 months later, with the AAA-rated notes being priced 46 bp above JIBAR. Thekwini 3 also included several other efficiencies (Exhibit 11). The increased efficiencies of the Thekwinis were a great advantage to SAHL, as this reduced funding costs and thus increased the lending margin and made SAHL more profitable . SAHL charged home loan clients at a rate of 210 bp above JIBAR. Of this, 50 bp went directly to SAHL as a management fee and, in the case of Thekwini 3, 45 bp were transferred to AAA-investors as interest on loans, leaving approximately 115 bp to cover the costs of the Thekwini companies. Any remaining cash would profit SAHL. So Simon, what’s the next BHAG? By the end of 2003, only five years after launching SAHL, Stockley had created an efficient mortgage processing and selling machine, pioneered the securitisation of home loans, achieved critical mass in the capital market and was beginning to show profits. However, he, and the SAHL shareholders, had different views about the future. Where should he take the business now? In order to stay below the competitive radar’s of the large banks and remain a mere annoyance, he estimated he would have to keep SAHL’s market share below 10%. However, an all-out price war was certainly one possibility open to him. On paper he had calculated that he could win a price war, given his low operating and capital costs, but he was concerned about the banks’ ability to cross-subsidise their mortgage products and thereby their ability to outspend him. How rational would these behemoths be? Furthermore, what would be the view of Standard Bank? Surely they would not be in a hurry to ignite a price war through SAHL! Alternatively, he reflected, SAHL could innovate its product further. With the better-controlled macroeconomic policies of the government and stable interest rates, SAHL could, for example, offer clients a fixed interest rate bond or a capped rate bond. These were the norm in the US and other economies but, apart from short-term fixed mortgage options made available by the banks, South African mortgages were on a floating rate, a significant risk to the holders. Salary- linked mortgages, where debtors would pay a fixed percentage of their salaries for the life of the bond, were another possible product. Further alternatives included stabilising at about 8% of the mortgage market and using his efficient machine to branch into the securitisation of different assets: credit card debts, car loans, consumer loans, etc. Having Standard Bank as a shareholder and as an originator of these types of assets would then be a distinct advantage. Another interesting possibility would be to enter the low-income housing sector, an area where the banks still feared to tread. This was a virtually untapped market, ripe for plucking. In other parts of the world, the original US securitisation models had successfully been used for this sector. In the US, Ginnie Mae stipulated that 50% of securitised home loan issues needed to be to the lowest income quartile, with the rest being made up from the middle -income class.53 Since the marke t was now comfortable with securitisation and pricing it efficiently, SAHL would no longer have to convince investors of the concept of securitisation, only of the higher risk asset class. Entering the low cost housing mass market would have the added benefit of earning SAHL huge political credos in the New South Africa. Furthermore, the recent introduction of empowerment charters in the mining and financial industries was likely to spur interest in the provision of housing to lower income individua ls. Listed companies requiring empowerment credits would be able to piggyback on their low-income investments. All of this could be channelled through SAHL. 53 Ginnie Mae, the US government-backed equivalent of Fannie Mae and Freddie Mac (both private mortgage funders), was granting an average of US$10m per month in 2003. 10
  11. 11. SA Home Loans: Bank Bashing is Good for Business! Entering the mass market would require a large amount of restructuring and possibly rebranding. SAHL’s core competency was its servicing operation, but it also had a retail brand (discounted home loans to the public) and a wholesale brand (extremely safe investments for institutional investors). SAHL would risk tarnishing either b rand with more risky debt and might therefore need to enter the low-income market with different brands, very similar to what Standard Bank had done when it became an equity partner of SAHL. Furthermore, even if the same servicing operation was used, the current operation was run on a virtual platform without the costs of an extensive branch network. It was improbable that the existing SAHL operation could successfully enter the low-income, mass market without Stockley having to establish some kind of walk-in branch network. Different credit enhancement techniques would also have to be used to ensure the highest rating of the SPVs. Not only would SAHL have to diversify the low-income mortgage risk geographically through employment sectors, as well as ensure that abnormal risk was properly covered, but more capital would be required. Furthermore, distressed debtor management would also be very different in this market and this too would have to be addressed. A further dilemma facing Stockley was that of his shareholders. Standard Bank possessed 40% of SAHL shares and was in for as long as either company played in the mortgage field. However, JP Morgan in particular and the IFC were short-term investors and had accomplished their mission of developing the capital markets – they would probably sell their shares as soon as SAHL showed a profit (therefore getting the best price for the shares). Management, JP Morgan and the IFC had been an efficient counterbalance to Standard Bank; what would happen if JP Morgan and the IFC sold their shares – would they sell them to Standard Bank, giving Standard Bank the controlling interest in SAHL? Who else might be interested? A management buyout? A listing of SAHL on the stock exchange? Would one of the international banks entering South Africa want to buy into SAHL? Furthermore, and more of a concern to Standard Bank, what would be the market reaction if Standard Bank became the controlling shareholder, since SAHL was being marketed on the image of a non-bank mortgage lender. Would Standard Bank’s increased shareholding destroy SAHL’s value? 11
  12. 12. SA Home Loans: Bank Bashing is Good for Business! Exhibit 1 Mortgage market share of the major banking institutions in 1998 Other 9.1% First Rand 10.2% ABSA 33.0% BOE Limited 12.4% SBIC Nedcor Group 17.3% 18.0% Source: South African Reserve Bank 12
  13. 13. SA Home Loans: Bank Bashing is Good for Business! Exhibit 2 Process of securitisation Asset Originating Company INSTITUTIONAL INVESTORS 2. Assets ring-fenced and placed into an Rating SPV 2 Agency 4. SPV raises money to PUBLIC Special 3. Assets in SPV rated by a rating buy assets from the 1. Group of homogeneous, cash Purpose agency and credit originating company flow generating assets e.g. by issuing a bond on Vehicle enhancements performed 3 mortgages, car loans, leases, the Capital Market 4 debtors1 (SPV) 5. Interest is paid on the borrowed money out of the cash flow generated by the assets in the SPV 5 1. Securitisation is a funding method that can be performed with any class of homogeneous, cash-flow generating assets. 2. These assets are ring-fenced and placed into a special purpose vehicle (“SPV”), a company that exists only to hold and securitise the assets. The SPV is totally separate from the company that originated the assets, therefore, if for example, the originating company went bankrupt, the SPV would remain unaffected and the cash flows from the assets would continue. Securitisation therefore improves the rating for the debt issued, and protects assets from other market forces. 3. The SPV is assessed by a reputed ratings agency, which factors out all risk except the risk that market sentiment will move in the wrong direction and the risk of default; the performance of the original company that created the assets is of no concern. Credit- enhancement measures can be identified between the arranging banker and the originating company so as to minimise risk, thereby enhancing the credit rating. 4. The SPV can then finance the purchase of the ring fenced assets from the originating company by issuing debt at an attractive yield, offering the investment-grade securities to investors, either into the market as listed bonds or directly to institutional investors. 5. Interest on the debt is serviced out of the cash flow generated by the underlying assets. 13
  14. 14. SA Home Loans: Bank Bashing is Good for Business! Exhibit 3a International expansion and product innovation of securitisation EMBEDDED VALUE EXPORT SOCIAL HOUSING RECEIVABLES LOANS STUDENT SUB-PRIME LOANS AUTO LOANS BOAT HEALTH CARE LOANS RECEIVABLES EQUIPMENT DELINQUENT LEASES TAXES INSURANCE ENTER TAINMENT PREMIA RECEIVABLES AUTO RV’s UTILITY LOANS RECEIVABLES COLLATERAL SMALL BUSINESS HOME EQUITY ROAD MORTGAGE LOANS LOANS TOLLS OBLIGATIONS RESIDENTIAL COMME RCIAL CREDIT TRADE LOTTERY MORTGAGES MORTGAGES CARDS RECEIVABLES RECEIVABLES 1970’s Early Mid Late Early Mid 1980’s 1980’s 1980’s 1990’s 1990’s USA UK FRANCE SPAIN GERMANY, ITALY, TURKEY, Canada NETHERLANDS ARGENTINA, BRAZIL, VENEZUELA INDONESIA, MALAYSIA, MEXICO THAILAND, SOUTH KOREA, PHILLIPINES, CHINA ETC. Source: The 3rd Annual Securitisation Symposium, SAHL Case Study, Establishing SA Home Loans as an issuer of asset-backed paper in South African markets, 17 September 2003. Exhibit 3b Outstanding value of US asset-backed securities 6,000 5,000 4,000 US$ billion 3,000 2,000 1,000 - 1995 1996 1997 1998 1999 2000 2001 2002 2003* Other Asset Backed Securities** Mortgage Backed Securities * Quarter 38, 2003 ** Includes vehicle, credit card, home equity, student loans, equipment leases, CBO/CDO, etc. Source: The Bond Market Association, available, statistics link (accessed 8 February 2004). 14
  15. 15. SA Home Loans: Bank Bashing is Good for Business! Exhibit 4: Stockley’s model to bring cheaper mortgage finance to the public TRADITIONAL Pension Funds, Insurance Companies, Banks, C ommercial Enterprises Banks provide capital to Public Banks loan capital from capital with margin of ±4% markets INSTITUTIONAL INVESTORS BANKS Public repays loans to banks Interest paid on investments / Loans PUBLIC SECURITISATION SAHL provides SPV acquires capital to buy Managerial assets from SAHL by issuing debt Services to SPV on Capital Markets for a 0.5% margin SPV Public repay loans to investors via SPV Exhibit 5 Prime, 1965 to 2004 30% 1998 Spike (25.5%) 25% 20% 15% 10% 5% 0% 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 Source: South African Reserve Bank. 15
  16. 16. SA Home Loans: Bank Bashing is Good for Business! Exhibit 6 Geographic locations of SAHL-approved suburbs Johannesburg Northern Suburbs Pretoria West Rand East Rand Bloemfontein North Coast Durban Pietermaritzburg South Coast Boland Cape Town Northern Suburbs Eastern Cape Cape Town Southern Suburbs Source: SAHL Business Proposal Documents. 16
  17. 17. SA Home Loans: Bank Bashing is Good for Business! Exhibit 7 The three ways in which the SAHL rate saving was advertised Source: SAHL marketing material. 17
  18. 18. SA Home Loans: Bank Bashing is Good for Business! Exhibit 8 SAHL advertisements Source: SAHL. 18
  19. 19. SA Home Loans: Bank Bashing is Good for Business! Exhibit 9a SAHL’s market share 22% 2.5% Share of Total Mortgage Market (2%) 20% 18% 2.0% 16% Share of Total Mortgage Market Share of New Bonds Written 14% Share of New Bonds Written (20%) 1.5% 12% 10% 1.0% 8% 6% 0.5% 4% Source: Reserve Bank of South Africa and SAHL 2% 0% 0.0% Jan-02 Jul-02 Jan-03 Jul-03 Exhibit 9b New loans per month 2,000 1,800 Number of New Bonds per month 1,600 1,400 1,200 1,000 800 600 400 200 Source: SAHL 0 12/98 06/99 12/99 06/00 12/00 06/01 12/01 06/02 12/02 06/03 12/03 19
  20. 20. SA Home Loans: Bank Bashing is Good for Business! Exhibit 10 Prime rate vs SAHL rate, showing difference 30% Prime Rate 25% Prime and SAHL Rate 20% 15% SAHL Rate 10% 6% 5% 5% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Prime and SAHL Rate 4% Average difference 2% 3% 2% 1% 0% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 -1% Source: I-Net Bridge. 20
  21. 21. SA Home Loans: Bank Bashing is Good for Business! Exhibit 12 Changes in structure and increased efficiencies of Thekwinis Thekwini 1 Thekwini 2 Thekwini 3 Value R 1.25 billion Value R 1.1 billion Value R 2 billion Issue Date 29 November 2001 Issue Date 21 November 2002 Issue Date 27 October 2003 Structure Price * Structure Price * Structure Price * BBB (2.5%) 2.15% BBB (1.5%) 2.10% BBB (8%) 2.30% A (5.1%) 1.20% A (5.2%) 1.15% AAA (92%) 0.70% AAA (92.4%) 0.65% AAA (68.2%) 0.46% Capital 2.1% Capital 1.5% Capital 1.2% Contribution Contribution Contribution Blended Blended Blended 0.828% 0.716% 0.519% COF** COF** COF** Percentage bars are not to scale * Percent above JIBAR ** Cost of Funds 21