Academic journal article The George Washington International Law Review

En Ruta Hacia El Desarrollo: The Emerging Secondary Mortgage Market in Latin America

Academic journal article The George Washington International Law Review

En Ruta Hacia El Desarrollo: The Emerging Secondary Mortgage Market in Latin America

Article excerpt

Securitization' of financial assets has spread throughout the world, from established economies to developing ones. In Latin America, securitization became the new financial instrument and financing alternative during the 1990s. Assets that have been securitized in the region include oil, future flow receivables, electronic remittances, credit card merchant vouchers, and medical equipment leases.2 During the past few years the region has become increasingly focused on developing a market for residential mortgage-backed securitiess (RMBS) due to a number of demographic and economic factors. Latin America, however, has been noticeably absent in one of the most successful segments of the IMAGE FORMULA13

international securitization market-the securitization of commercial mortgages.

The issuance of commercial mortgage backed-securities (CMBS) has exploded in the last ten years. Globally, analysts predict that CMBS issuance will rise twenty percent to approximately $72 billion in 2001 compared to 2000's $60 billion. The U.S. component is expected to grow to $52 billion from $48 billion in 2000. Canada, Europe, and Asia are anticipated to issue as much as $20 billion, up from 2000's $12 billion. These 2001 projections indicate that international deals will account for almost thirty percent of the global CMBS market.4

The focus of this Article will be an analysis of the legislative reforms that impact key legal issues associated with the securitization of mortgages and the emerging secondary mortgage market in Latin America. The goal is to review the changing legal landscape to assess whether these countries are primed to move from the securitization of residential mortgages to the securitization of commercial mortgages.

Two key factors must be in place to make this transition. First, laws governing issues such as the transfer of assets and the perfection of rights to those assets must be enacted. Second, investors must have confidence that the laws will function as enacted. Laws regulating issues such as foreclosure, the ability to transfer or assign rights in mortgages, and the creation of special purpose vehicles (SPVs) will be scrutinized.5 In Latin American jurisdictions, where securitization is still a relatively new process, the courts have not tested many of the existing and newly enacted laws. Both legal foundation and interpretation, therefore, play a significant role in assessing the growth of the CMBS market.

First, this Article will explore the reasons for Latin America's recent emphasis on developing an RMBS market, including the historical constrictions on the capital markets and the expansion of the investor base in the region. Second, this Article will provide a general overview of the securitization process and the legal considerations within this process. Third, the article will review the legislative reforms that have changed entity structure and foreclosure laws. The analysis focuses on Argentina, Brazil, Chile, and Mexico, IMAGE FORMULA15

as these are the markets that present the greatest potential for a substantial volume of mortgage securitizations.6 The Article then examines the impact and future consequences of these legal changes on the mortgage capital markets in the region. The last section of the Article assesses the viability of a CMBS market in Latin America.

I. THE HOUSING MARKET IN LATIN AMERICA AND THE PUSH TOWARDS AN RMBS MARKET

Latin American countries are currently focused on developing an RMBS market. The driving force behind this emphasis on securitization is the severe housing shortage in the region.7

A. Constrictions on Capital Markets

Housing finance traditionally has been unavailable throughout Latin America because of the region's historic experience with inflation, social instability, and currency weakness; these causes IMAGE FORMULA19

have a negative impact on interest rates.8 Borrowers, thus, could not rely on domestic capital markets or other local sources for medium to long-term funding. Because of high inflation, commercial banks avoided the risk of underwriting loans with maturities beyond three years.9 Many banks also refused to lend money as they faced term mismatches that discouraged them from committing their funds to long-term lending. The financial costs of mortgage loans were prohibitively high because of the banks' high cost of raising short-term funds for long-term lending.10 In addition, few banks and lenders wanted to give mortgage loans in local currencies, as they did not want the exposure of having to reimburse a loan in dollars if there was a devaluation of the local currency.11

Lenders tapped the public and private placement markets in the United States and Europe hoping to attract investors by offering them high yields; they raised, however, only limited amounts of capital.12 Foreign investors were unwilling to take on the risks of investing in a region with a reputation for instability. Housing needs, thus, were financed mostly with government funds.13 IMAGE FORMULA21

The Mexican devaluation crisis in 1994 and the "tequila" effect14 also had a devastating impact on mortgage lending as commercial banks severely restrained their operations because of their liquidity and capitalization problems. The few available credit lines for longterm financing quickly dried up. In Mexico, for example, banks stopped their mortgage operations despite a fivefold increase in mortgage lending from 1990 to 1994.15 In 2000 Mexican banks again started to offer new mortgages to the consumer sector. Because of the banks' relative weakness, however, a systemwide tightening of credit policies has reduced the number of people who can qualify for a mortgage.16 The greatest impediment to resuming mortgage lending by banks is a lack of capital to make loans as their funds were largely depleted during the crisis. Many of the largest banks also have a very high share of their assets in mortgages. They, thus, cannot increase lending any faster than the growth in their overall assets. If banks are to greatly increase their housing lending, they will require greater access to the capital markets.17 IMAGE FORMULA23

Ineffective foreclosure laws hindered private market finance.18 In Argentina, foreclosures often took up to two years.19 In Brazil, liquidation of foreclosed properties could be delayed up to seven years.20 In Mexico the average foreclosure process lasted approximately two years.21 In Chile, lenders still need about eighteen months to foreclose on a property.22 The ineffectiveness of the existing laws meant that lenders could spend years tied up in litigation, often in pro-borrower judiciary systems.

In much of Latin America, consumers need a fifty percent down payment to purchase a home. They fund the balance with shortterm personal loans.23 High interest rates between fifteen to twenty percent force most homebuyers to fund with cash.24 As of 1998 only one to fifteen percent of the houses in Latin America had mortgages.25 More specifically, in Mexico only "one in five homes ... carries mortgage financing."26 In Argentina only five to ten percent of homeowners have mortgages.27 Another indicator of the penetration of mortgage financing in a country is the ratio of outstanding mortgage loans to GDP. In the United States, outstanding mortgage loans as a percentage of GDP is almost fifty percent.28 In contrast the percentages for Argentina, Brazil, and Chile IMAGE FORMULA25

are 2.1%, 2.4%, and 9.5% respectively.29 In Mexico, mortgage debt amounts to eight percent of GDP.30

B. Expansion of Investor Base

The second main factor pushing the development of the RMBS market has been the creation and privatization of pension funds throughout Latin America. These funds, combined with mutual funds and life insurance companies, have greatly expanded the investor base in mortgage capital markets in the region.31 These financial institutions are excellent matches for mortgage-backed securities as they have a relatively long-term investment horizon that coincides with the long maturities of most mortgage loans.32

Mexico created a private pension fund system in 1997 to foster domestic savings, generate capital for local investments, and provide retirees with other options when investing their funds. At the end of 2000, it was estimated that the system had approximately US$25 billion in assets and is expected to reach US$94 billion in the next fifteen years.33 Brazilian pension and mutual funds, together with insurance companies, currently manage more than US$150 billion in assets.34 In Argentina a growing workforce is expected to add US$400 million per month to the US$18.3 billion currently under management by these funds.35 Chile's private fund pension system holds more than $30 billion in assets.36

The need for funds and the expansion of the investor base made securitization more attractive to Latin America, thus triggering substantial legislative reforms in the region. To fully analyze the nature and effect of any legal reforms impacting the secondary IMAGE FORMULA28

market, a general overview of the mortgage securitization process is in order.

II. THE SECURITIZATION PROCESS

The first step involves the origination of mortgages to be used as collateral for the securities. The mortgages are then pooled and sold to an SPV (also known as a special purpose entity). At this stage, a rating agency evaluates the investment risk of the pool. Then, the mortgage pool is tranched (i.e., divided into classes) with various combinations of mortgages and subordination levels. The issuer takes into account the capital market forces at that moment and considers if there is a need for credit enhancement, and if so, what form it will take. Once this is done, the SPV sells an interest in the pool to third party investors. The securities are then traded in the secondary market.

Other parties in the transaction include the trustee, the master, and special servicers. The trustee represents the trust or SPV that holds the legal title to the collateral for the benefit of the investors. The trustee's duties include holding the mortgage collateral, passing the funds gathered by the loan servicers to investors, and supervising the loan servicers, including the appointment of a new servicer if the terms between the parties are violated. The master servicer must service the mortgages that collateralize the securities on behalf of and for the benefit of the investors. Duties include collecting the mortgage payments, passing the funds to the trustee, and providing mortgage performance reports to investors. Some transactions also make use of a special servicer, who assumes servicing responsibilities when a loan goes into default and carries out the workout or foreclosure process.37

The following diagram illustrates the relationships between these parties.

B. Legal Considerations

Through growth and maturity, the secondary mortgage market in the United States has confronted and defined several key legal issues including (a) the structure of the SPV, which impacts the bankruptcy remoteness requirement of a true sale and the transfer IMAGE FORMULA32

and perfection of assets; and (b) the efficacy of the foreclosure process. Successfully transporting the securitization structure outside the United States will require that local law treat these matters in such as a way as to insure the economic objectives of the transaction.

The SPV (whether a trust or another entity created according to local law) must be structured to insure complete isolation of the assets from the originator. The creation of a special vehicle (the SPV) to bold the assets minimizes the possibility of a voluntary bankruptcy for reasons unrelated to the performance of the assets. To insure this result, the transfer of the assets from the Originator to the SPV must be a "true sale" with the Originator (and, more importantly, with the creditors of the Originator) having no remaining interest in the assets. A true sale of an asset is effective against the transferor, its creditors, its regulator, or receiver. The true sale can be enforced against the borrower, and more importandy, this true sale also results in the separation of the credit risk of the mortgages from that of the transferor.

Properly structuring the SPV is not the only legal consideration. Local law regarding transfer and perfection of interest will likewise impact upon the complete divesture of the assets from the Originator. One of the more common problems is that the transfer of assets can be time-consuming, costly, and complicated.39 In many foreign jurisdictions, the transfer requires consent or notification to the borrower, which potentially threatens to constrain the use of securitization as a financing technique.40

Local default and foreclosure laws have direct economic effect on a securitized transaction. A major factor in the pricing of any mortgage-backed security is derived from the loss expectations in the collateral pool supporting the securities. In this context, loss is a function of the following: (1) the percentage of the pool balance that experiences delinquency; (2) the percentage of the delinquent loans that go into default; and (3) the loss severity associated with those defaulted loans. Overall portfolio loss is the delinquency percentage multiplied by the default ratio multiplied by the loss severity.41 Foreclosure laws impact on this percentage as jurisdictions with effective and timely foreclosure laws have a greater possibility of reducing the loss severity and consequently the loss percentage of the portfolio. Issuers in these jurisdictions will be in a better position to ensure the continued servicing of the debt.

Fortunately, as will be discussed in the next section, the new securitization laws in Latin America have explicitly addressed the above-mentioned concerns.

III. LEGISLATIVE REFORMS IN LATIN AMERICA

Latin American governments realized that traditional financing techniques would not be effective to increase both the availability and affordability of housing. Their focus therefore shifted to the liquidity possibilities offered by the securitization of mortgages. As these countries began to explore the issue, it became apparent that IMAGE FORMULA37

the legal frameworks had to be revised to better meet the requirements of securitized transactions and the demands of investors.

The approach to securitizations in civil law jurisdictions differs from that in common law jurisdictions. Jurisdictions that follow civil law enacted detailed securitization laws to ameliorate uncertainties that stem from the formality of civil codes, the inability to rely on equitable principles, and the scarcity of precedent to define the law.42 As a result, since 1994 many of the countries in the region have modified or created new laws to encourage and simplify the securitization of financial assets, including mortgages.43

A. Changes in Entity Structure

Chile took an early initiative to create a permissive framework for securitization by enacting Law 18,405 in 1994.44 The law permitted the creation of securitization companies (securitizadoras), which are essentially SPVs, and set forth the requirements for their incorporation as public corporations. The sole purpose of the SPV must be to acquire credits from an originator and in turn to issue long-term or short-term debt securities. In addition, the law contains certain measures to ensure that the sale of assets to the trust is a true sale, thus protecting the mortgages from the possible bankruptcy of the originator.45

Argentina adopted its comprehensive securitization law, Law 24,441 (Trust Law), in January 1995. More specifically, this law sets forth the requirements to form trusts. All trust property must be registered and separated from the balance sheet of the originator IMAGE FORMULA40

and the trustee, thus preventing creditors of the originator or trustee from pursuing such property for credit collection purposes. Particularly relevant was the creation of financial trusts, which get preferential tax treatment not applicable to corporations or `regular' trusts. Financial trusts have to follow the basic rules of general trusts, but trustees must be financial institutions or companies specially authorized by the National Securities Commission and must meet certain financial requirements.46 The financial trusts can issue a wide-ranging variety of securities, including registered or bearer securities and securities of different classes and series.47 The law also allows the creation of two different types of securitization structures.48 In the first type, an SPV holds a pool of assets and then issues certificates of participation backed by the underlying receivable. In the second form, a third party buys the entire pool of receivables and places them in a trust, which can be used as collateral for debt securities issued and guaranteed by the buying party.49

Brazil passed Law 9514, its major securitization law, in November 1997. This law created a new real estate finance system, Sistema de Financiamento Imobiliario (SFI), and set forth substantial reforms.50 These reforms included the formation of securitization companies and a new type of security backed by mortgages acquired from financial institutions, the certificado de recebiveis imobilidiios (CRIs).51 In addition, this legislation also established that debtors do not have to be notified of any assignment of their loans. Law 9514, which applies to both residential and commercial real estate, effectively overturned the legal obstacles that had impeded the creation of a favorable economic environment for mortgage lending in Brazil.52 IMAGE FORMULA42

Law 9514 authorized the formation of securitization companies" to issue securities (CRIs) backed by mortgages acquired from financial institutions. The SPV must be a corporation whose business objective is limited to the acquisition of assets and to the issuance and placement of debt. During the period in which any of its obligations to third parties are outstanding, the SPV may not assign its corporate control, reduce its share capital by issuing additional equity, merging, reorganizing or liquidating, or assign the assets purchased by it to its controlling shareholders.54 There are two types of CRIs, simples and com regime fiduciario. With CRIs simples, the securitization company remains as the issuer and thus keeps the risk on the balance sheet. With CRIs com regime fiducid?io, the transaction is secured by the mortgage pool and thus is not an obligation of the securitization company and does not have the company's credit support.55

Law 9514 was followed by resolutions in 1998 and 1999 that revised the housing finance system and further defined the legal framework for securitization.56 Resolution 2493, passed in May 1998, authorizes financial institutions to assign loans without the consent of the Brazilian Central Bank, provided that the assignee is a SPV that will act as issuer and own the receivables. The assignment will then constitute a true sale and the assigned assets will not constitute property or rights of the assignor.57 In July 1999, Resolution 2623 allowed financial institutions to use ten percent of their savings deposits to buy CRIs.58 Resolution 2675, adopted in December 1999, made it possible for banks to use CRIs as collateral in repurchase agreement transactions.59

Although at a much slower pace, Mexico also has updated its legal framework in the past few years.co A key revision to the FedIMAGE FORMULA44

eral District Civil Code dealt with the assignment of mortgages. Mortgages in Mexico must generally be formalized before a Notary Public and then recorded with the Public Registry of Property within the jurisdiction where the property is located. Under prior law, assignment of the collection of rights under the mortgage had to satisfy the same formal requirement. A notary had to be employed and the assignment had to be re-registered. Under the new laws, financial institutions can assign mortgages without notice to the debtor, without the use of a Notary Public, and without recording in the Public Registry as long as the assignor continues to administer the credits. If the assignor stops the administration of the credits, it only needs to notify the debtor in writing. The recording of the mortgage in favor of the original mortgagee is deemed to be in favor of the assignee, who has all the rights and causes of action derived therefrom.61

In 2000 the Mexican government enacted a new law that permitted the creation of SPVs to issue debt.62 Before the express permission to form SPVs, securitization deals made use of a trust (fideicomiso), which was the most flexible vehicle that the Mexican legal system allowed. Unlike many Latin American countries, Mexico had allowed the formation of trusts for many decades, and the concept of the business trust arrangement was well developed.63 Under these trusts, legal title of the assets was transferred to the trustee who then issued special types of securities called Ordinary Participation Certificates (Certificados de Participation Ordinaria, CPOs).64 The trustee then had to evaluate the assets backing the CPO and certify that the value of the assets was equal to the mortgage-backed security.65 These trusts were not allowed to issue debt, however, thus necessitating the new law.665 IMAGE FORMULA46

B. Changes in Foreclosure Process

Another key issue in ensuring the continued and timely servicing of the debt is the ability to foreclose promptly on mortgages in default. Realizing the importance of this issue to investors, many countries in the region updated their foreclosure procedures when they adopted the new securitization laws.67 Argentina was the first country to substantially reform its foreclosure procedures in 1995 under Title V of the Trust Law.68 Under the old Argentine law, the courts were in charge of the entire foreclosure process. Foreclosures averaged fifteen months and often took more than two years.69

The Trust Law introduced two major reforms: a non-judicial foreclosure procedure and a summary eviction proceeding to be applied when using the old foreclosure method. The non-judicial foreclosure procedure is included in the mortgage as long as both parties agree to its application. This new procedure limits court activity in order to expedite the final auction of the property. If the debtor is in default for a sixty-day period, the creditor may demand payment after fifteen days and give notice stating that the property will be auctioned in a non-judicial proceeding in the case of default. The debtor then must provide the name and addresses of any privileged creditors. If the default is not cured within fifteen days, the lender may present the mortgage title to obtain a court order. The court will use the mortgage title and a notary public appointed by such party to verify the status of the property and eventually to obtain possession of the property. The debtor has five days to file a response and to raise the following defenses: (1) that no default has been verified; (2) that no payment notice was given; or (3) that the parties had not agreed to the non-judicial procedure. Once the status of the property is verified and a list of all debts on the property is obtained, the creditor may proceed to appoint an auctioneer without court intervention. After publicaIMAGE FORMULA49

tion in the Official Gazette and in a newspaper in the relevant jurisdiction, an auction may be held.70

In Mexico twenty-three out of the thirty-two estates have modified their foreclosure laws.71 The process, unlike that of Argentina, is still dependent on the judiciary and is accomplished through either a judicial mortgage trial or a commercial executive trial, depending on the location of the property.72 A bank may legally initiate a foreclosure proceeding in one of these venues two months after a borrower has been found delinquent or at any time after a borrower has been found to have reported fradulent information.73 Additionally, the bank will have to provide the Notary testimony, the agreement, the appraisal, and the certification. Once a court renders in favor of the lender, sale of the property is carried out through a public auction.74 These new foreclosure procedures aim to reduce the process from an average of five years to a time frame of six to twelve months.75

Brazil's Law 9514 also updated the procedures to seize and liquidate the property upon a debtor's default. The government's main goal was to make the process more timely and efficient, as the prior foreclosure laws sometimes delayed liquidation of the property for as long as seven years. With the new law, lenders expect to be able to foreclose on property within six to twelve months.76

Under the old Brazilian regime, the property was held in the name of the borrower, making it necessary to rely on the judicial system to foreclose. The process was subject to numerous delays and extensions due to the pro-borrower bias of the judiciary and the greater number of defenses available to the borrower.77 In IMAGE FORMULA51

contrast, under the new law the property is held in the name of a trustee. Law 9514 introduced the concepts of fiduciary ownership of real estate and fiduciary title of credit rights originated by the sale of real estate (alienafdo fiducidria de bens imdveis). Under these new concepts, the property is now held in the name of an independent trustee until the loan is repaid. This change increases the ability of the lender to execute a loan in the event of default. The new process takes the form of a trustee sale that allows the creditor to take possession of the property in a timely manner if the debtor defaults. Again, this procedure is now nonjudicial and therefore easier to effect.71

These legal changes dramatically simplified the securitization of mortgages. The unequivocal authorization to create and use SPVs or trusts has reduced the time and effort needed to structure a deal. Before, parties were obligated to 'comb' through the legal codes to determine if these set forth an equivalent structure. More frequently, parties were forced to be creative in creating bankruptcy remote entities within the existing legal frameworks. The importance of having a bankruptcy remote entity cannot be overstated; rating agencies (without which there would be no market interest) place tremendous importance on this factor. Any review of the literature put forth by rating agencies makes this very clear.79 For those countries that want to attract foreign investors to participate in their MBS deals, it is imperative to secure an investmentgrade rating.80

These countries also greatly streamlined the procedure to assign loans. A system, like the old system in Mexico that required debtors to approve the transfer and that required transfers to be formalized before a Notary Public and be reregistered effectively, prohibited the use of securitization. Though the new requirement to notify debtors in writing is not cost free, it is not so onerous as to preclude the securitization process. Parties now can also include provisions in the mortgage documents that allow borrowers to waive their right to receive notice. IMAGE FORMULA53

IV. EFFECT OF NEW LAWS ON MORTGAGE CAPITAL MARKETS

A review of Latin American MBS transactions to date indicates a link between the adoption of the legislative reforms and the subsequent emergence of mortgage securitization in the region. This link exists because all of the transactions have been structured only after each country has enacted or revised its securitization laws. Overall, in the year 2000, MBS issuance in Latin America rose from US$55 to US$240 million.81

Argentina launched the first RMBS transaction in 1996. Since then, the country has pooled and securitized more than $650 million of residential mortgages.82 Brazil's market has the most growth potential. It is expected that US$200 million of MBS will be issued in 2001, of which construction companies will originate US$100 million.83

In Mexico the future also looks promising. A mortgage bank, Hipotecario Su Casita, sold 70 million pesos (US$7.5 million) of 10-year mortgage backed bonds in July 2000.84 Corporacion Geo, Mexico's largest homebuilder, sold $14 million of two-year debt in March 2000.85 The number of securitizations, especially in the area of affordable home construction loans, is likely to increase significantly. It is expected that US $120 to US$200 million will be IMAGE FORMULA56

issued in the home construction sector, a 400% increase from the year 2000.86

Chile's market also is expected to grow. Conditions in the country vary somewhat from the rest of the region. Since the early 1900s, mortgage banks have been active in the country, private lending is available in maturities of fifteen to twenty years, and the more traditional thirty-year terms are available for inflationindexed instruments.87 "Mortgage loans of a certain size and targeted toward middle to upper income borrowers are ... usually sold to local pension funds and insurance companies rather than securitized."88 This is bound to change as the domestic market embraces securitization more fully. In addition, Chile has devised housing leasing contracts, which are government-subsidized loans made through private lenders. The lessee makes monthly payments to the bank or leasing company while the property belongs to the lender until the last payment is made.89 The consumer has the option of buying the property after the lease runs out, usually after fifteen or twenty years.90 Last year two lenders securitized their leasing contracts with insurance companies as the main investors.91

The new securitization laws and the subsequent pooling of residential mortgages have had positive economic effects in these countries. In Argentina, for instance, the substantial reduction in down payments, interest rates, and the time needed for approval of a loan have been identified as benefits resulting from mortgage securitizations.92 For the first time Argentine banks are offering residential mortgages with extended maturities of thirty to forty years.93 The extension in mortgage terms is made possible by the banks' ability to access capital markets for funding at longer duraIMAGE FORMULA58

tion.94 "Outstanding mortgage debt in Argentina increased from $5.2 billion in 1994 to $9.4 billion in 1998". On a per capita basis, mortgage debt grew more than ninety percent, from $137 to $264 million during the same period.95

More importantly, as regulators and key participants in the region have gained a deeper understanding of securitization, they have increased their efforts to improve conditions and to make more efficient the pooling and securitization of residential mortgages. To reduce the risks associated with volatile inflationary environments, many countries in the region have used inflation indexing to maintain the market value of their assets.96

Regulators across the region also have implemented new rules to improve overall credit risk management in financial institutions. For instance, the National Banking and Securities Commission in Mexico issued stricter requirements for loan classification and provisioning standards. Specifics of the new rules include classifying loans by type of portfolio (commercial, consumer, and mortgage) and factoring in the number of months that the loan payments are IMAGE FORMULA60

delinquent.97 In Brazil, Central Bank Resolution 2682 was promulgated in 1998 to provide banks with a limited time period to determine which loans have defaulted and when they have defaulted. This capital allocation scale is supposed to result in better risk management practices.98 The widespread use of credit bureaus to evaluate the creditworthiness of borrowers is another important innovation.99

In addition, there has been a push towards uniform loan documentation, origination and appraisals. In Argentina, for example, if banks fail to meet these criteria, they are required to put up additional capital against their mortgage assets.100 The Central Bank signaled its intention to standardize mortgage procedures by approving a regulation that would commit it to buying any conforming mortgages from an insolvent bank.101 In Mexico the SOFOLES have adopted standard underwriting guidelines modeled after Fannie Mae applications and are using a common servicing system.102 Standard forms for mortgage applications and actual loan documents have been introduced, and some lenders have started to use PC-based applications for their processing, closings, and loan administration.los In Brazil, Cibrasec is working closely with originators to set up standardized criteria for underwriting mortgages and to improve their underwriting standards.104 This movement towards uniformity is crucial since it is the quality of the initial underwriting that will drive in large part the rest of the securitization process. The quality of the loans dictates whether there is a need for credit enhancement and thus determines the pricing of the securities.105

V. FUTURE CONSEQUENCES OF LEGAL CHANGE

The progress made since 1996 is undisputed. It is important to keep in mind, however, that most of these new securitization laws IMAGE FORMULA63

have not yet been tested. Up to now Argentina is the only country that has faced a major test.los In 1998 the Central Bank suspended Banco Mayo after a run on its deposits. Banco Mayo had been acting as a servicer on six asset-backed deals, and there was investor concern about the continued performance of those deals. The bank was ultimately replaced as servicer the day after its suspension and the issues continued to perform as expected. This example underscores the depth of Argentina's trust law. The law assures independent roles for trustees and servicers, with no economic interest linking the two, and the Central Bank's willingness to replace the servicer shows the importance of having these independent roles. More importantly, this crisis showed that the securitization laws are useful in practice and not just a theoretical concept.107

The increase in mortgage lending in turn has spurred the secondary mortgage market. Multinational agencies have been deeply involved in this process. The International Finance Corporation (IFC), a member of the World Bank Group, has the potential to function similar to Fannie Mae in the United States.108 The World Bank also approved key loans to promote the development of secondary markets. In the year 2000, for example, a housing agency in Mexico received a US$500 million loan to reorganize the primary mortgage market, improve foreclosure laws, develop mortgage insurance, and make mortgage rates more uniform.1119 In Argentina the IFC also invested $150 million in the country's first major secondary mortgage company, Banco de Credito y Securitizacion, and provided $50 million to the Banco Hipotecario, formerly owned by the state, to help fund primary mortgages for the eventual sale to the secondary mortgage market.110 Banco de Credito y Securitizacion will purchase mortgage loans that yield an average of eleven to twelve percent and repackage them into securities with yields ranging from seven to eight percent for sale to local and foreign investors."' IMAGE FORMULA65

The local governments have been instrumental in jump-starting the secondary mortgage markets. Mexican President Vicente Fox has been the most vocal proponent of the benefits of secondary mortgage markets. Since he took office last year, he introduced a number of financial reforms, including the creation of Sociedad Hipotecaria Federal (Federal Mortgage Society), a governmentsponsored enterprise similar to Fannie Mae and Freddie Mac in the United States.' 12 His objective is to have an annual flow of $2.5 billion of securitized mortgages by the end of his six-year administration.113 The overhaul of the existing legal frameworks was itself a response by these governments to facilitate the creation of a secondary mortgage market. "It has been proven that no country on the planet has been able to generate a secondary market for mortgages without the selective, temporary intervention of the government."114

The region still faces several constraints in developing an efficient secondary market. First, in many countries there are not enough mortgages to pool together.115 For example, in Brazil only those mortgages that originated after November 1997 (thus incorporating provisions of the new securitization law) are available for securitization, so the volume of standardized mortgages is still low.116 Mexico faces the same problem, as the number of mortgages originated through the government's low-income housing programs is still low given the program's recent creation.117 Lenders need large pools of assets to achieve economies of scale, to reduce costs, and to increase liquidity.

Another constraint is that none of these countries have a comprehensive source of information on borrower credit histories or databases tracking performance of mortgage portfolios over time. In many countries, accurate methods to estimate land and property IMAGE FORMULA67

values remain underdeveloped.lla This makes it harder to estimate loan-to-value-ratios, one of the most basic elements of credit risk in mortgage lending.' 19 Property values also are often underreported to minimize tax payments.120

Across the region, though, there is a small number of experienced servicers. Servicing procedures must be updated for securitized mortgages, especially for those lenders that have traditionally enjoyed late payment penalties from delinquent borrowers.121 "A direct correlation exists between the servicing functions and the performance of the collateral pool."122

Although great progress has been made, these countries need to keep developing a standardized underwriting process for mortgages. Originators also must have incentives to securitize their assets. Currently, banks with sizable portfolios still hold excess capital relative to the regulations in force and therefore have no need to sell assets in order to improve their capital needs.123 Some lenders also do not wish to furnish sufficient information on their portfolios for competitive reasons.124

Based upon this analysis of the residential segment of the market, the next step is to ask if these countries are ready to move from the securitization of residential mortgages to the securitization of commercial mortgages. IMAGE FORMULA69

VI. VIABILITY OF A CMBS MARKET IN LATIN AMERICA

As of July 2001 only a few CMBS transactions have been structured in Latin America.125 "There has yet to be a rated CMBS transaction in... [the region], but there have been some deals composed of mortgage bonds backed by single properties and placed with Latin investors."126 The changes in the legal landscape set forth before in this article should remove significant obstacles in the growth of a CMBS market in the region. Just as the RMBS market in the United States preceded the CMBS market,127 the lessons learned from residential financings and securitizations can and should inform the Latin American CMBS market.128

Beyond the issues as to the structure of a securitized transaction (whether commercial or residential), several unique legal issues arise in a commercial setting. First is the necessity of title insurance. Insuring good tide is more important in a commercial transaction because there are fewer properties worth proportionately more in a given mortgage pool. Failure of tide in one property would naturally impact the pool severely. Although tide insurance does not exist in Latin America129 as it does in the United States, IMAGE FORMULA72

Stewart International has begun to provide tide guarantees in Argentina and Mexico.130

Another issue is the form of property ownership. Traditionally, condominium ownership structures were used to finance development. The occupants would own and finance the commercial property, while the developer built the project for a fee and profit.131 Pete Harrison, a U.S. executive who opened an office in Mexico City a decade ago for Cushman and Wakefield, says basic statistics about supply and demand didn't exist, and a building's ownership structure made calculation even more frustrating.132 "`Maintaining any kind of database was practically impossible.... You had a 10story office building that had 10 floor owners."'133 As owners of the newest buildings are becoming more receptive to lease agreements that are often negotiated in U.S. dollars to protect rents from currency devaluations, however, ownership structure in Mexico is beginning to mirror that of the United States.134

Legal impediments to market growth only tell part of the story. Economic and political factors play the major role in market development. Just as in the residential market, the Latin American commercial real estate market has catered to developers with very short-term horizons. The market disfavors long-term financing because of the region's history with currency devaluations and political and economic instability. The region still suffers from interest rate volatility and inflation rates that make it harder to price the securities and establish a rate of return. This leads invariably to a discussion of sovereign risk. Sovereign risk has been a longstanding issue for financing in emerging markets because of the currency, political, and economic uncertainties involved in cross-border transactions.135 Indirect sovereign risk is the risk of affecting the performance of bonds because sovereign actions had an unexpected impact on the structural elements of a transaction.136 The structural elements of a transaction include the financial and business environment facing the obligor.137 Direct IMAGE FORMULA74

sovereign risk is defined as the risk that certain sovereign actions will interfere directly with the terms and conditions under which a bond is issued by directly impeding the obligor's capacity to meet its financial obligations in a timely fashion. Examples include the imposition of foreign exchange controls or a moratorium on repayment of foreign debt.138

Currency risk becomes particularly relevant as sharp devaluations of local currencies make the servicing of dollar-denominated debt virtually impossible. The economic and financial crises in Latin America in recent years have led to tangible shifts in the region's currency setups. Currently, Mexico, Brazil, Colombia, and Chile let their currencies float, while Argentina, Ecuador, and Panama peg their exchange rate to the U.S. dollar.139 For this latter group, whose advantages from pegging to the U.S. dollar are small due to their relatively modest economic ties with the United States, the sole reason is the seal of credibility.140 Currency risk, however, is still high in heavy dollarized economies since adequate assets and current-dollar receipts do not balance the foreign-currency loans on the liabilities side.141

Latin America has had its fair share of sovereign risk-related examples. Currently, Colombia is the country in the region suffering the most from political risk. Colombia has the only mortgage system in Latin America that has survived successfully for more than twenty-five years. The home mortgage industry, known as the UPAC system, was created in 1972 against the backdrop of a stable economy and was connected to market interest rates in 1990. UPAC was instrumental in developing the country's building and housing sector, and today the country has a mortgage portfolio worth more than US$9 billion.142 In addition, Colombia has succeeded in securitizing commercial property almost floor by IMAGE FORMULA76

floor.143 Domestic RMBS issuance, however, dropped dramatically in the year 2000 because of the growing political unrest. 144 Analysts maintain it will be a while before the country can attract foreign investors although investment opportunities abound.145 There are ways to mitigate sovereign risk. "The Overseas Private Investment Corp. (OPIC), a U.S. federal government agency, recently adapted its existing political insurance policy for capital market transactions issued from the emerging markets."146 The Multilateral Investment Guarantee Agency (MIGA), part of the World Bank Group, offers political risk insurance that can be adapted to individual transactions.147 "Insurance can be purchased ... to mitigate currency inconvertibility, expropriation, and political violence . . . Private insurance companies, such as Zurich U.S. Political Risk, are also successfully entering the market."148 The issuer purchases the insurance for the benefit of the investors, and [i]f an insured event were to occur, . . . the insurance . . . become[s] available to continue making timely payments to investors."149 Other agencies, such as the Inter-American Development Bank and the Asset Guaranty Insurance Co., have been providing full or partial guarantees for international securitizations. 150

More traditional ways of bypassing certain sovereign risks include offshore reserve funds and currency swaps. In certain crossborder transactions, SPVs are set up outside the jurisdiction, usually in the United States. In some cases, an interim vehicle is set up in a tax haven jurisdiction to avoid negative tax consequences. The originator then transfers title to the mortgages to an offshore corporation who in turn transfers title to an offshore SPV that will ultimately issue the securities.151 Subordination and overcollateralIMAGE FORMULA78

ization are other methods often used.152 For example, Banco Hipotecario in Argentina issued its fourth RMBS deal in the international capital markets in 2000. The transaction was backed by domestic, U.S. dollar-denominated residential mortgages, benefited from twenty percent subordination, and included a political risk insurance policy to mitigate convertibility and transferability risk.153 Even with the deep economic recession of 1999 in Argentina, "the collection, [ ) delinquency, and foreclosure levels" of the previously issued RMBS deals "did not follow in the same direction, and were not linked to the deterioration of the sovereign macroeconomic figures."154 These transactions demonstrated that all of the credit enhancements and guarantees included in the transactions were appropriate.155 This bodes well for the CMBS market.

Lack of investors could be the most significant problem in structuring CMBS transactions in Latin America.15s Domestic investors focus on residential MBS deals, and foreign investors are expectedly hesitant because of currency and political risk. But again, this is bound to change as the domestic investors, who do not have to worry about currency risk, shift their attention to commercial mortgages. Foreign investors can be eased into the process. For example, J.P. Morgan is originating loans in Mexico for securitization in U.S. transactions. More importantly, it already began IMAGE FORMULA80

making commercial loans in the region and accumulating them for securitization.157

With the different real estate cycles around the world, "growth in international real estate transactions is expected to accelerate over the next five to ten years."158 Global real estate investment funds continue to emerge.159 Also, foreign banks that already have reaped the benefits of securitizing their commercial mortgage portfolios in other jurisdictions are purchasing many of the local banks in Argentina.160 The legal structure will continue to be refined but should not impede the development of a Latin American CMBS market. After all, "the U.S. CMBS market developed against a regulatory scheme and complicated trust laws that initially made it difficult to fashion transactions."161

Eventually, the Latin American market could mirror what is happening in Europe, where the year 2000 was characterized by the emergence of repeat issuers. Whether it was conduit lenders, single borrowers, or issuers of nonperforming loan securitizations, a growing number of issuers came back to the public debt markets. More importantly, CMBS have now achieved credibility among borrowers, issuers, and investors in Europe.162

VII. CONCLUSION

Mortgage-backed securitization in Latin America is here to stay as local governments accept that they need international capital to fund their residential and commercial property needs. The new securitization laws serve as evidence that the region is receptive and willing to make necessary and fundamental changes to its legal and financial systems. Parties willing to make an investment now thus will reap the benefits of increased issuance in the primary mortgage markets and the further development of secondary more gage markets. IMAGE FORMULA83

[Author Affiliation]

GEORGETTE CHAPMAN POINDEXTER*

WENDY VARGAS-CARTAYA**

[Author Affiliation]

* Associate Professor of Real Estate and Legal Studies, Wharton School; Associate Professor of Law, University of Pennsylvania Law School.

** J.D. Candidate, University of Pennsylvania Law School. The authors would like to thank participants of the First World Congress of the International Real Estate Society for their valuable comments and suggestions.

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