From Main Street to King Abdullah Financial District: Lessons Learned in International Mortgage Finance
In December 2016, I was asked to consult on a start-up real estate refinance company located in the Saudi Arabia. I wasn’t sure I understood what he was saying. As someone who has worked in the U.S. mortgage business since college, the word “refinance” has very strong connotations, but its use seemed wrong in this context. As it turned out in overseas mortgage markets, the phrase real estate refinance refers to “providing funding” or “purchasing mortgage assets.” And that started my quick introduction into the world of international mortgage finance where, “everything is different but in the end it’s all the same.”
By early January 2017 I found myself in Riyadh, Saudi Arabia, working as an adviser to a consulting firm contracted to manage the start-up of the new enterprise. Riyadh in January is nice—cool temperatures and low humidity. In the summer it’s another story. Our client was the Ministry of Housing and the Saudi Sovereign Wealth fund. One of the goals of Saudi Arabia’s ambitious Vision 2030 is the creation of its own secondary mortgage company. Saudi Arabia has 18 banks and finance companies originating Islamic mortgages, but the future growth of the economy and population is expected to create demand for mortgages that far exceeds the current financial system’s capacity. The travel and hotel accommodations were delightful. The jet lag and working hours were not.
My foremost motivation for taking the project was to check off “worked overseas” from my career bucket list. Having spent my entire career in the U.S. mortgage business, this had always seemed too distant an opportunity. The project was supposed to last three months, but seventeen months later I’m writing this article in a hotel room overlooking downtown Riyadh. The cultural experience living and working in Saudi Arabia is something I have spent hours discussing with family and friends.
But the goal of this article is not to describe my cultural experiences but to write about the lessons I’ve learned about the U.S. mortgage business sitting 7,000 miles away. Below, I’ve laid out some of my observations.
Underwriting is underwriting
As simple as that. Facts, practices and circumstances may be local, but the principles of sound mortgage underwriting are universal: 1) develop your risk criteria, 2) validate and verify the supporting documentation, 3) underwrite the file and 4) capture performance data to confirm your risk criteria. Although mortgage lending is only 10 years old in Saudi Arabia, underwriting criteria and methodologies here strongly resemble those in the USA. Loan-to-value ratios, use of appraisals, asset verification, and debt-to-income (DTI) determination—it’s basically the same. All mortgages are fully documented.
But it is different. In Saudi Arabia, where macro-economic issues—i.e., oil prices and lack of economic diversification—dominate the economy, lenders need to find alternatives in underwriting. For example, the use of credit scores takes a second seat to employment stability. To lenders, a borrower’s employer—i.e., government or the military—is more important than a high credit score. Why? Lower oil prices can crush economic growth, leading to higher unemployment with little opportunity for displaced workers to find new jobs. The lack of a diversified economy makes lenders wary of lending to employees of private-sector companies, hence their focus on lending to government employees. This impact leads to whole segments of potential borrowers being left out of the mortgage market.
The cold reality in emerging economic countries like Saudi Arabia is that only the best borrowers can get loans. Even then, lenders may require a “salary assignment,” in which a borrower’s employer pays the lender directly. The lesson is that the primary credit risk strategy in Saudi Arabia is to avoid credit losses by all means—the best way to manage credit risk is to avoid it.
Finance is finance
Finance is the same everywhere and concepts of cash flow and return analysis are universal, whether the transaction is Islamic or conventional. There’s lots of confusion about what Islamic finance is and how it works. Many people misunderstand shariah law and its rules on paying interest. Not all banks in Saudi Arabia are Islamic, and although many are, while paying interest on debt is non-sharia, leases and equity returns are sharia compliant. The key to Islamic finance is selecting appropriate finance products that comply with shariah but also meet the needs of lenders.
In Saudi Arabia, most lenders originate Islamic mortgages called Ijarah. With an Ijarah mortgage the borrower selects a property to purchase and then goes to the lender. At closing the lender accepts a down payment from the borrower and the lender purchases the property directly from the seller. The lender then executes an agreement to lease the property to the borrower for the life of the mortgage. This looks a lot like a long-term lease. Instead of paying an interest rate, the borrower pays an APR on a stated equity return or “profit rate” to the lender on the lease arrangement.
Similarly, Islamic warehouse lending on mortgage collateral resembles a traditional repo transaction—an agreed upon sale price and repurchase price and a bunch of commodity trades linked to the transaction. In Islamic finance, the art relies on a sound understanding of the cash flows, the collateral limitations, the needs of all parties, and Islamic law. Over the past decade, the needs of the lenders, investors and intermediaries has evolved into set of standardized transactions that meet the financing needs of the market.
People are people
People are the same everywhere—good, bad and otherwise—and it’s no different overseas. And there is a lot of great talent out there. The people I have worked with are talented, motivated and educated. I have had the opportunity to work with Saudis and people from at least 15 other countries. Fortunately for me, English is the operating business language in Saudi Arabia and no one is any wiser to whether my explanations of the U.S. mortgage market are accurate or not. The international consulting and accounting firms have done a tremendous job creating strong business models to identify, hire, train and manage employees, cultivating a rich talent pool of consultants and future employees. A rich country like Saudi Arabia is a magnet for expats—it has both the money and vision to afford talent. In addition, Saudi Arabia’s rapid population growth and strong education system has added to a homegrown pool of talented employees.
Standardization is a benefit worth fighting for
One of the primary goals of any international refinance or secondary market company is standardization. The benefits of standardization extend to all market participants—borrowers, lenders and investors. Secondary market companies thrive where transactions are cheaper, faster and better, making it an easy choice for government policymakers to support. For consumers, rates are lower, the choices of lenders and products are better, and the origination process is more transparent. For investors, the standardization of structures, cash flows and obligations improves liquidity, increases the number of active market participants and ultimately lowers the transactional bid/ask spreads and yields.
However, the benefits of standardization are less clear for the primary customer they are meant to help—the lenders. While standardization can lower operating expenses or improve business processes, it does little to increase the comparative advantages of each lender.
Saudi lenders are focused on customer service and product design, leaving price aside. This focus has led lenders to design mortgage products with unique interest rate adjustment periods, payment options and one-of-a-kind mortgage notes and customized purchase and sale agreements.[1] This degree of customization can be a recipe for disaster, leading to endless negotiations, misunderstandings of rate reset mechanisms, extended deal timelines, and differences of opinion among shariah advisers. When negotiations are culturally a zero-sum game, trying to persuade lenders of the rationale for advancing monthly payments by the 10th of each month is exhausting.
Saudi lenders see the long-term benefits of increased volume, selling credit exposure and servicing income. But they haven’t figured out that strong secondary markets lead to the development of tertiary markets like forward trading in MBS, trading of Mortgage Servicing Rights (MSRs) or better terms for warehouse lending.
Mortgages are sold, not purchased
It’s a universal tenet throughout the world: buying real estate and financing it with a mortgage is a complex transaction. It requires experienced and well-trained loan officers to aid and walk the consumers through the process. A loan officer’s skill at persuading a potential customer to submit a loan application is every bit as important as his knowledge of mortgages. It’s no different in Saudi Arabia. While building relationships with realtors is important, the Saudi market is more of a construction-to-permanent market than a resale market. Individuals builders are simply too small to be able to channel consumers to lenders.
What to do? The Saudi mortgage origination market has quickly evolved to using alternatives like social media to capture consumer traffic. Saudi citizens are some of the most active users of social media in world.[2] (How active? From my experience, 9 out of 10 drivers on the road are reading their smart phones instead on looking at the road—it’s downright scary.) Lenders have developed sophisticated media campaigns using Twitter, You Tube and other platforms to drive traffic to their call centers where loan officers can sell mortgages to potential borrowers.
Whatever the language, closing lines are the same everywhere.
Regulation – A necessary evil
Saudi Arabia’s is a highly regulated financial market. Its primary financial regulator is the Saudi Arabia Monetary Authority, better known as SAMA. Regulation and oversight is centrally controlled and has been in place for almost 70 years. SAMA has placed a premium on well-capitalized financial institutions and closely monitors transactions and the liquidity of its institutions. The approval process is detailed and time consuming, but it has resulted in well-capitalized institutions. The minimum capital of the country’s five non-bank mortgage lenders exceeds $100MM USD.
A secondary role of SAMA has been to maintain stability within the financial markets—protecting consumers against bad actors and minimizing the market’s systematic risks. Financial literacy among Saudi citizens is low and comprehensive consumer protections akin to the Real Estate Settlement Procedures Act (RESPA) in the U.S. don’t exist here. SAMA fills this role, resulting in an ad hoc mix of consumer protections with mixed enforcement actions. Sometimes the cost of the protection is greater than evil it’s ostensibly protecting against.
As examples, SAMA regulates the maximum LTVs for the mortgage market and limits the consumer’s out-of-pocket cash fees to $1,250 USD. Managing LTV limits for the market goes a long way toward preventing over-lending when the markets are speculative. This was extremely beneficial in cooling down a hot Saudi real estate market in 2013.
Capping a borrower’s out-of-pocket expenses makes sense to limit unscrupulous market players from hustling borrowers. But the downside is the inability of lenders to monetize their transactions—i.e., to get cash from borrowers, sell mortgages at premium prices or sell servicing rights. This results in higher mortgage rates as lenders push up their mortgage coupons to generate cash to reimburse them for the higher costs associated with originating the mortgage. It is also a factor in the lenders’ use of prepayment penalties.
External constraints affect the design of local mortgage products
Ultimately, mortgage financing products available to consumers in any country are a function of the maturity level and the previous legacy development of its financial and capital markets. In Saudi Arabia, where large banks dominate, the deposit funding strategies determine mortgage product design. Capital markets are relatively new in the Kingdom. Only in the past several years has the Saudi government issued enough Sukuks to fill the Saudi Arabian yield curve out to ten years. While the government has plenty of buyers for its debt, the primary mortgage lenders do not. The concept of amortizing debt products is anathema to the market’s debt investors. Without access to longer-term debt buyers, the mortgage market products are primarily linked to 1-year SAIBOR (the Saudi version of LIBOR). This inability to secure long-term funding impacts amortization periods the lenders can offer, with most mortgages limited to a maximum amortization period of 20 years. The high mortgage rates, short-fixed payment tenors and short amortization periods all contribute to affordability issues for the average Saudi citizen.
Affordable Housing is an issue everywhere
Over the past 50 years Saudi Arabia’s vast oil wealth has enabled it to become an educated, middle-class society. The trillions of dollars in oil revenues have enabled the country to transform from a nomadic culture to a modern economy with growth centered in its primary cities. But its population growth rate and urban migration has created a mismatch of affordable housing in the growth centers of the country. The lack of affordable urban housing, outdated government housing policies and restrictive mortgage lending policies has stifled both the demand and supply of affordable housing units.
While well-functioning capital markets can help to lower mortgage rates and improve credit terms, it is only a small part of the solution for helping people afford and remain in housing. In this regard, Saudi Arabia looks a lot like the United States. With entities like the Real Estate Development Fund (REDF), Saudia Arabia is trying to manage the challenges of creating housing programs that solve housing issues for all, as opposed to subsidy programs that only help a small minority of people, operating with the high cost of program administration and with nominal benefits to its participants.
Concluding Thoughts
The past year and half have been both personally and professionally rewarding. The opportunity to live and work abroad and to become immersed in another culture has been gratifying. Professionally, it’s been eye-opening to see the limits of my previous experiences and need to recalibrate my core assumptions and thinking.
I maintain that the United States absolutely has the best mortgage finance system in the world. The ability of our secondary markets to provide consumers with low mortgage rates and a 30-yr fixed rate mortgage has no match in the world. The modern U.S. mortgage market, with its century of history and supportive policy decisions, has the luxury of scale, government guarantees and depth of investor classes.
Saudi Arabia’s own mortgage solutions are mostly a result of necessity. For the country, it has been more important to build a stable and well-capitalized banking system—and then to provide affordable mortgage products and terms. Think of it in terms of airline safely instructions—secure your own oxygen mask first, and then take care of your children.
Housing finance systems aren’t like building smart phone networks. You can’t just import the technology and billing systems and flip a switch. It’s a long-cycle development that requires the legal systems, regulatory framework and entities and a mature finance industry before you can start contemplating and building a secondary market.
As I reflect on my experiences in Saudi Arabia, I would describe the role I have played as that of an intermediary—applying proven “best in class” secondary market and risk management approaches I learned at home to Saudi Arabia. And then trying to understand their limits and coming up with Plan B. And sometimes Plan C…
[1] Competition has not prompted an expansion of the credit box, as lenders are generally risk averse and their regulators are hyper diligent on credit standards.
We can observe an MI Haircut Rate averaging at 19.50% for vintages 1999 to 2011 with higher haircuts for the distressed vintages 2003 to 2008 at 23.50%. Exhibit 2: Mortgage Insurance Haircut Rate by Disposition Year 
Our analysis shows the MI Haircut Rate prior to 2008 on average was 6.5% and steadily increased to an average of 25% from 2009 thru 2014. We will explain below. Exhibit 3: Mortgage Insurance Haircut Rate and Expense to Delinquent UPB Percentage by Months Non-Performing 
In this analysis, we observe the MI Haircut Rate steadily increased by the number of months between when a loan was first classified as non-performing and when a loan liquidated. This increase can be explained by increased curtailments tied to expenses that increase over time, such as expenses associated with physical damage of the property, tax penalties, delinquent interest, insurance and taxes outside the coverage period, and excessive maintenance or attorney fees. Interest, taxes, and insurance typically constitute 85% of all loss expenses. 
