This page updated regularly deals with securitization developments in Israel. If you have any news or development to contribute to this, please write to me.

The articles below on securitisation in Israel has been contributed by Menachem Feder – we are thankful to him for his contribution.

They Came to Help the Secondary Mortgage Market, They Left Injurious

By Menachem Feder, Adv. *

[This article first appeared in Hebrew in the Israeli newspaper Globes on December 23, 2002. ]

This year's budgetary Arrangements Law imposes rules that needlessly burden development of a secondary mortgage market in Israel. To be sure, the rules do lower some barriers to this market and this should be applauded. But, the overall impact will be to shrink the likelihood of a secondary mortgage market, in the misperceived name of borrower protection. The rules should be changed.

Typically, a mortgage bank collects principal and interest payments over the life of a mortgage loan it makes. During this time, the bank faces a number of risks. An important one of these is liquidity risk. Because banks often fund floating rate mortgage loans, which are long-term, with floating rate deposits, which are short-term, the bank must pay off expiring deposits with new deposits. This means that a mortgage bank runs the risk that deposit funding will dry up. Today, this risk looms especially large, given the credit standing of some banks and the state of the economy.

Because of liquidity risk and a number of other factors, a mortgage bank would do well to sell the loans it originates. The parties who would buy these loans, for a fair price of course, are investors that need long-term income streams to match long-term payment obligations. Provident funds, pension funds and insurance companies would be classic mortgage loan buyers. Buying and selling mortgage loans after a bank originates them are done via mortgage-backed securities and make up a "secondary mortgage market". This market promotes efficiencies, which usually lower mortgage loan interest rates.

The Arrangements Law imposes specific rules on secondary mortgage market transactions — even though these transactions do not yet exist here. The claim is that some of the rules will encourage mass sales of mortgage loans and that others will protect borrowers. Regarding the encouragement: the initiative is welcome. Regarding the claimed protection: borrowers do not need what is offered.

For example, the new rules require that mortgage loans sold by a bank be serviced by a bank only. The idea must be that banks do not collect loans too aggressively because they are regulated. If that is the case, the wise path is to license mortgage loan collectors or to strengthen consumer protection rules, to the extent necessary, not to burden transfer of particular assets. In any event, no mortgage bank wants a competitor to access its borrower database. Since a mortgage-backed security must provide for a primary servicer (commonly the originating bank) and a backup servicer (in case the primary servicer does a bad job or fails), the proposed requirement could turn into a deal killer. For another example, the rules require a mortgage seller to notify borrowers and property owners (they may not be the same person because of delays in registration) of the sale of a mortgage. The new law does not even permit waiver of the notice.

Oddly, requiring the notice implies that the government, which pushed the Arrangements Law, considers the Assignments Law and the Lands Law, which generally govern assignment of rights and transfer of land security interests respectively and do not require such notice, to be inadequate. If that is the case, the principled approach would be to review the Assignments Law wholesale, not to supplant them piecemeal with budget-linked legislation. Requiring notice adds an unnecessary expense to a mortgage-backed security, since Israeli mortgage banks do not typically send out monthly payment notices. Even if the expense is bearable, borrowers and owners do not obviously benefit from notice — notice does not give them a right to prevent either the loan or the mortgage. Moreover, most borrowers and owners probably do not care to whom the mortgage belongs, all other things being equal. On a more fundamental level, there often is no way for a bank to determine the location of a property owner, as banks track borrowers only.

If the government wants to encourage a secondary mortgage market, it can do many things. It can sell government subsidized loans. It can waive its right to prevent the sale of a loan that contains a government subsidy. It can take a secondary secured position behind the buyer of a mixed government-bank loan. It can waive the requirement that a mortgage for a loan that supplements a loan which contains a government subsidy and which the borrower drags to a new property have equal standing with the initial mortgage. It can work to ease the transfer of cautionary notes. It can arrange to enlarge the stamp tax exemption on the sale of housing loans to include the sale of construction loans. It can act to cancel fees for bulk transfer of mortgages. If any of these jeopardize borrowers — and most do not — solutions should be explored, not ignored.

The Arrangements Law has set back prospects for a secondary mortgage market. The newly imposed rules should be changed and more help should be put in place. A secondary mortgage market deserves to be promoted — to the maximum point of fairness and reason — because it enhances efficiencies and allocates risks appropriately, all to the ultimate gain of the borrower public. While an Israeli secondary mortgage market has yet to arise, its delay should result from market forces, not unnecessary rules or overlooked relief.

The Almost Brave New World of Securitization

By Menachem Feder, Adv.*

Recently, Makhteshim Agan Industries announced a program with Bank of America to securitize up to $150 million of trade receivables in the U.S. capital markets. This was exciting news because securitization is practically unknown in Israel and an Israeli securitization meaningfully expands the list of sophisticated financial techniques that Israelis have adopted in recent years. Wild celebration, however, would be premature. Reference to U.S. capital markets in the announcement only highlights the inhospitability of Israeli capital markets to something like a trade receivables securitization.

What Is Securitization

What exactly is securitization? For a start, securitization is named after its essential function: the conversion of relatively illiquid financial assets, such as receivables, into marketable securities. More technically, securitization is a process by which an "originator" of rights to future cash – receivables – sells these assets to the securities market for immediate cash. It does this by selling the receivables to a special purpose entity, whose activities are limited by design to the securitization. This entity raises the cash required for the purchase either by issuing a debt or equity security or by pledging or transferring the receivables to another entity, which in turn issues the security. In any event, payments on the security depend on actual collections from the sold receivables. The security itself is called an asset-backed security, or ABS.

In a quality securitization, bundling and isolating the assets underlying the ABS narrows the risks to the security holders. Bundling a large number of receivables diversifies the hazard of default by any one customer of the originator of the receivables. Isolating the receivables means protecting the sold receivables from any possible claims of the originators' creditors. In this way, an ABS can carry a credit rating actually higher than that of the originating company.

The Need to Securitize

The need to securitize grows out of certain market realities. First, traditional moneylenders – banks — are strictly regulated. Among other things, this means that the banking supervisor limits how much a bank can lend any one of its borrowers. In Israel, single borrower limits are particularly constraining because of prevalent group holdings and the requirement that banks aggregate borrowings of closely associated companies when calculating borrower limits. Additionally, the number of substantial lending banks in Israel is small.

Second, it costs a company a lot to borrow, sometimes in terms of interest rate charges and almost always in terms of balance sheet capacity. Regarding interest rates, bank financing in Israel is commonly inexpensive relative to Treasury rates, so non-traditional funding sources will not necessarily provide attractive rates. When considering the balance sheet, however, a company may well wish to avoid borrowing traditionally. This is because more debt could compromise an important financial ratio, such as debt-to-equity, that determines the company's creditworthiness.

These market realities create a problem for a company that originates receivables. Ordinarily, a company sells its products on terms. This means that it grants the customer credit for the period in which the related invoice is outstanding. To finance this credit, the company usually borrows from a bank. Thus, the more a company grows its receivables, the more it must borrow, until one day the company can borrow no more because of bank or balance sheet limitations.

Yet a third market reality delivers a solution to the company's problem. Today, the securities markets contend more than ever with banks to finance economic enterprises. In fact, the trend in Israel is increasingly to expose pension and provident funds to the competitive investments of the securities markets. These new players compete for capital, creating new and efficient sources of funds. It takes an issue of securities to access these alternative funds and that is just what a securitization does.

The Benefits are Many

Securitization yields a host of benefits, some obvious, others subtle. Among the most obvious is the ability of a company to sidestep debt. Indeed, assets sold in securitization will often qualify for removal from the originating company's balance sheet. This releases the securitizing company to spend its borrowed money on strategic ventures.

Slightly more subtle are the freedoms and efficiencies enabled by securitization. In a high-caliber ABS, investors expect to be paid solely from collections on the isolated receivables. In other words, they require rates of return that reflect only the risks of the receivables themselves. Thus, a securitizing company raise funds at rates that disregard its own credit risk and can access capital even when it is troubled financially.

Even subtler, securitization can reduce the risk of imbalanced assets and liabilities. The maturity of a company's debt does not commonly match the maturity of the assets that the debt finances. This creates a risk that the originator will pay more for funding than earn from related assets. Securitization, however, can match the term of funding with that of the related assets. Thus, commercial paper can fund short-term receivables, such as trade receivables, and longer term debt can fund longer term receivables, such as heavy equipment receivables.

Finally, and on the very subtle macro scale, securitization can have massive economic and social impact. It makes significant amounts of private capital available for business activities. It also marries traditional borrowers with non-traditional money providers. These non-traditional providers comprise socially critical institutional investors, such as pension and savings schemes.

Israel is Missing Out

Israeli institutional investors are deprived. Because of the absence of a commercial paper market and the infancy of the corporate debt market, the ability to sell in Israel debt backed by cash flow – the heart of most securitization – is constricted. Yes, Israeli regulators are expanding capital competition, but, no, they are not concurrently incubating new markets by easing regulatory bottlenecks or reducing government debt issues. For Israel's pension and provident funds, this imbalance limits product variety and diversification possibilities. The individual whose money constitutes these insitutions pays the price.

In recent years, Israel has embraced many aspects of structured finance. From derivatives to securitization, Israeli companies have ventured into some of the world's most challenging financial territories. Nonetheless, the full benefit of these adventures will not be realized in Israel until local capital markets participate fully. For this to happen, capital market reforms, started fifteen years ago and stalled today because of lagging social and political will, must be revitalized. Until then, honors to today's financial pioneers, who remind us that to grow you sometimes need to dare.

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* The author is a partner in the Tel Aviv law firm of Caspi & Co. and specializes in international finance and transactions. He advised Bank of America on the Makhetshim Agan securitization, but does not describe that or any other specific transaction in this article. The above article first appeared in the Israeli newspaper Haaretz on November 26, 2001