49052 Edited by Loïc Chiquier and Michael Lea Housing Finance Policy in Emerging Markets Housing Finance Policy in Emerging Markets Edited by Loïc Chiquier and Michael Lea non-bank financial institutions group global capital markets development department financial and private sector development vice presidency iv housing finance policy in emerging markets © 2009 e International Bank for Reconstruction and Development/ e World Bank 1818 H Street, NW Washington, DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org E-mail: feedback@worldbank.org All rights reserved First printing June 2009 1 2 3 4 5 13 12 11 10 09 is volume is a product of the sta of the International Bank for Reconstruction and Development/ e World Bank. e ndings, interpretations, and conclusions expressed in this paper do not necessarily re ect the views of the Executive Directors of e World Bank or the governments they represent. e World Bank does not guarantee the accuracy of the data included in this work. e boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgement on the part of e World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. 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ISBN: 978-0-8213-7750-5 eISBN: 978-0-8213-7751-2 DOI: 10.1596/978-0-8213-7750-5 Cover and publication design: James E. Quigley Cover photo: Photos.com Contents Foreword................................................................................... xix Acknowledgments .................................................................... xxi Abbreviations.......................................................................... xxiii Introduction............................................................................ xxix Introduction ........................................................................................... xxix Objectives ................................................................................................xxix Evolution of Housing Finance Systems............................................... xxxi Policy Recommendations................................................................... xxxiv Impact and Lessons of the U.S. Subprime Crisis............................xxxvii Housing Finance Is Interrelated with the Broader Economy.......xxxviii Structure of the Book..........................................................................xxxix Summary Conclusions............................................................................xliv chapter 1 Housing Finance and the Economy............................................ 1 Developed Economies.................................................................................1 Emerging Economies ..................................................................................3 e Importance of Housing Finance.........................................................5 e Demand for Housing Finance..........................................................11 Macroeconomic Factors.......................................................................11 Financial Liberalization........................................................................13 v vi housing finance policy in emerging markets Technological Change...........................................................................13 Concerns and Opportunities....................................................................14 e E ect of Mortgage Finance on Savings.......................................14 e E ect of Mortgage Finance on Investment.................................15 Mortgage Finance and Growth............................................................15 Housing Finance, Business Cycles, and Economic Fragility............17 Mortgage Finance and the Distribution of Risk................................20 House Prices, Housing Finance, and Economic Activity.....................22 Lessons for Emerging Markets.................................................................24 chapter 2 Structure and Evolution of Housing Finance Systems ............29 Mortgage Lending Models........................................................................30 Building Societies/Savings & Loans....................................................30 Commercial Banks................................................................................33 Contract Saving Schemes.....................................................................35 Specialist Mortgage Banks....................................................................36 Combining Di erent Systems..............................................................37 Secondary Mortgage Markets..............................................................39 Introducing New Lending Models: Mexico and India..........................40 Unbundling of Mortgage Value Chain....................................................42 State-owned Lenders.................................................................................46 Conclusions ................................................................................................47 chapter 3 Mortgage Instruments ..............................................................49 Fixed-Rate Mortgages ...............................................................................50 Adjustable-Rate Mortgages.......................................................................52 Indexed Mortgages....................................................................................56 Interest-Only Mortgages...........................................................................60 Reverse Mortgages.....................................................................................62 Lessons for Emerging Markets.................................................................63 chapter 4 Primary Mortgage Market Infrastructure .................................65 Appraisal .....................................................................................................68 e Importance of Sound Appraisal...................................................68 Developing an Appraisal Industry ......................................................69 contents vii International Standardization of Appraisal Methodology...............69 Appraiser Quali cations, Appraisal Associations, Independence, and Ethics .................................................................72 Quantitative Appraisal Models and Real Estate Data.......................73 e Challenges of Establishing an Appraisal Industry in Emerging Markets .............................................................................74 Mortgage-Related Insurance Products....................................................76 Property Insurance................................................................................76 Mortgage Life Insurance.......................................................................78 Catastrophic Insurance.........................................................................80 Title Insurance ......................................................................................83 Credit Information Bureaus.....................................................................85 e Importance of Credit Information in Mortgage Finance.........85 Credit Bureaus in Developed Markets................................................86 Credit Bureaus in Emerging Markets.................................................88 Membership ...........................................................................................90 Ownership ..............................................................................................91 Management and Development ..........................................................91 Data .........................................................................................................91 Consumer Protection............................................................................92 chapter 5 Enforcement of Mortgage Rights..............................................93 Does Mortgage Collateral Matter?...........................................................95 Di erences between Legal Systems.........................................................97 Forms of Mortgage and Mortgage Documentation............................100 Alternative Security Devices..............................................................100 e Land Charge ................................................................................102 e Mortgage Certi cate....................................................................102 Mortgage Documentation..................................................................102 Secondary Mortgage Markets............................................................103 Procedural Issues in Mortgage Enforcement.......................................104 Non-judicial Enforcement..................................................................106 Negotiated versus Auction Sale.........................................................112 Responsibility for Sale.........................................................................112 Auction Sale Prices..............................................................................113 Creditor's Right to Acquire the Mortgaged Property.....................113 Notice, Cure, Rights of Redemption, and Stays of Execution........114 Bankruptcy and Other Preferences...................................................116 viii housing finance policy in emerging markets Appeals ..................................................................................................116 Eviction .................................................................................................117 Distributions ........................................................................................118 Alternatives to Mortgage Enforcement.................................................118 Forbearance ..........................................................................................119 Alternatives to Mortgage Collateral..................................................120 Common Property Mortgage ............................................................122 Minimizing Enforcement Actions.....................................................123 chapter 6 Consumer Information and Protection....................................125 De ning the Consumer...........................................................................127 Developed Markets..............................................................................127 Emerging Markets...............................................................................127 Consumer Protection Objectives ...........................................................128 Information Asymmetry between Lenders and Consumers.........129 Consumer Heterogeneity ...................................................................130 Transaction Cost Asymmetries during the Going Concern..........131 Vulnerability of the Consumer to Market Risks..............................131 Protecting the Consumer through the Loan Life Cycle .....................133 Before Borrowing................................................................................133 e Loan O er and Closing...............................................................137 e Ongoing Concern........................................................................139 e Back End: Default........................................................................147 e Costs of Consumer Protection.......................................................150 Opportunity Costs of Regulation......................................................150 Alternative Implementation Forms, Costs.......................................151 Enforcement Costs..............................................................................152 Is Consumer Protection a Luxury Good for Emerging Markets?.....153 Emerging Markets Are Part of the Global Consumer Protection Trend...............................................................................153 Appropriate Regulations May Support FinancialSector Development .....................................................................................153 Conclusions ..............................................................................................156 chapter 7 Construction Finance in Emerging Economies ...................... 159 Real Estate Development Process and Risks........................................162 contents ix Financing by Buyers................................................................................163 Financing by Banks..................................................................................167 Funding from Capital Markets...............................................................170 Financing of Buyers.................................................................................171 Other Regulatory Aspects.......................................................................173 chapter 8 Risk Management and Regulation...........................................175 e Risks of Housing Finance................................................................176 Credit Risk................................................................................................178 Other Risks...............................................................................................182 Liquidity Risk.......................................................................................182 Market Risk..........................................................................................183 Agency Risk..........................................................................................186 Operational Risk..................................................................................187 Systemic Credit Risk ...........................................................................188 Political Risk.........................................................................................189 e Role and Tools of Regulation..........................................................189 International Standards for Reporting and Capital ............................192 Provisions ..................................................................................................193 Capital Requirements for Primary Lenders.........................................196 Basel II Capital Standards and Mortgage Lending..............................197 Capital Requirements--Supervisory Standards...................................200 Credit Concentration Risk.................................................................201 Market and Liquidity Risk..................................................................201 Mortgage Loan Design........................................................................203 Other Regulator Actions.........................................................................203 Real Estate Market Information........................................................204 Management and Reporting Standards............................................204 Taking Corrective Actions..................................................................205 Financial Reporting and Disclosures by Primary Lenders.................206 Regulation of Secondary Mortgage Institutions..................................207 Case Study: e U.S. Subprime Crisis...................................................207 e Property Boom and Loose Credit Underwriting.....................208 Reduced Reliance on Credit Enhancements....................................209 Risky Loan Design...............................................................................209 Lack of Consumer Information.........................................................210 Breakdowns in the Behavior of Participants in the Securitization Value Chain..............................................................210 x housing finance policy in emerging markets e In uence of Trends in International Capital Markets.............211 Reduced Transparency Resulting from Complex Security Structures and Incomplete Information on Exposures...............211 Regulatory Failures in the United States Contributed to the Growth of Risky Subprime Lending Practices..............................212 e Risks of Subprime Practices and ose of Lending to Moderate- and Low-income Households Should Not Be Confused............................................................................................212 e Subprime Crisis Was Avoidable.................................................213 chapter 9 Contractual Savings for Housing.............................................215 Key Features of a Contractual Savings Scheme for Housing .............216 General Character ..............................................................................216 Basic Structure of a CSH Contract....................................................216 Open and Closed CSH Schemes........................................................217 Financing Function of CSH ..............................................................219 CSH and Other Housing Finance Products ....................................219 Historical Development of CSH Schemes............................................220 Developed Mortgage Markets............................................................220 CSH in Emerging Markets.................................................................222 Managing Risk under a CSH Scheme ..................................................223 Risk Pro le of CSH Contracts ...........................................................223 Demand Fluctuations..........................................................................225 In ation Risk........................................................................................227 Contract Design Flaws .......................................................................228 Misallocation of Excess Liquidity .....................................................230 CSHs as a Policy Choice in Emerging Markets....................................232 Mobilization of Savings ......................................................................233 Lack of Long-Term Funding .............................................................234 Credit Risk Mitigation and Financial Stability................................235 Stimulation of Modernization and Small Transactions Lending Market ...............................................................................238 Institutional Requirements for CSH Lenders ......................................239 Regulation of CSH Schemes ..............................................................239 Subsidies for CSHs ..................................................................................241 CSH Subsidies in Emerging Markets................................................241 Guiding Principles ..............................................................................244 Conclusions for Emerging Markets ......................................................244 contents xi chapter 10 State Housing Banks...............................................................247 A Brief Overview of State Housing Banks............................................248 De nition and Classi cation .............................................................248 Types of State Housing Banks............................................................249 e Rationale for Creating a State Housing Bank...........................250 e Model Failed in Many Countries ...................................................251 State Housing Bank Failings...................................................................254 Weak Corporate Governance.............................................................254 Lax Management of Credit Risk........................................................255 Assets/Liability Mismatches...............................................................256 Misallocation of Subsidies and Rent-Seeking Policies....................257 SHB as Obstacles to the Growth of Housing Finance Markets? ...258 Available Safeguards and Alternative Options.....................................258 Good Governance...............................................................................259 Autonomy of Funding.........................................................................260 Alignment of Corporate Interest with Market Development........260 Examples of SHBs Meeting es e Conditions.................................261 Policy Alternatives...................................................................................263 Regulatory or Contractual Credit Orientation................................264 Second-Tier Institutions.....................................................................264 Public-Private Partnerships................................................................265 "Double Bottom Line"--Social and Commercial-- Private-Sector Lenders.....................................................................266 Exit Strategies...........................................................................................267 Enable a "Corporatization Process" to Create a Commercially Run Institution..................................................................................267 Partial or Full Privatization................................................................269 Conversion of an SHB into a Second-Tier Re nance Institution.271 State Support to Private Sector..........................................................271 Conclusion: A Decision Tree for Policy Makers..................................274 chapter 11 Housing Provident Funds ....................................................... 277 Description of HPF..................................................................................277 Subsidies ...............................................................................................278 Governance ..........................................................................................280 Development of an HPF.....................................................................281 xii housing finance policy in emerging markets International Experience.........................................................................282 China .....................................................................................................282 Singapore ..............................................................................................284 Mexico ...................................................................................................285 Brazil .....................................................................................................287 Philippines ............................................................................................289 Nigeria National Housing Fund........................................................290 chapter 12 Mortgage Securities in Emerging Markets.............................293 Why Are Mortgage Securities Important?............................................295 What Are the Prerequisites for Issuing Mortgage Securities?............297 What Has Been the Experience in Emerging Markets?......................301 Covered Bond Issuers.........................................................................302 MBS Issuers..........................................................................................304 Liquidity Facilities...............................................................................306 Safety and Soundness Regulation in Mortgage Capital Markets.......308 Mortgage-Backed Securities...............................................................308 Mortgage Bonds...................................................................................310 Reporting for Secondary Market Instruments................................312 e Role of the Credit Rating Agencies............................................315 Lessons Learned.......................................................................................317 e Basics..................................................................................................317 Market Demand.......................................................................................319 Simplicity ..................................................................................................319 Role of Government................................................................................321 chapter 13 Mortgage Insurance .................................................................325 De nition and Unique Features of MI..................................................326 Purposes of MI.........................................................................................326 Countries that Have MI Today...............................................................327 Prerequisite Conditions for MI Success................................................327 Key Program Characteristics..................................................................330 Individual Loan Coverage..................................................................331 Premium Rates.....................................................................................332 Eligible Loans.......................................................................................334 Underwriting Method ........................................................................335 contents xiii Meeting Social Objectives .......................................................................338 Special MI Products for Mortgage-Backed Securities (MBS)/ Structured Finance...............................................................................339 Mortgage Pool Insurance....................................................................340 Timely Payment and Cash- ow Protection.....................................340 Credit Risk Management........................................................................341 Regulatory Issues .....................................................................................341 Bank Risk-Based Capital Rules..............................................................345 Consumer Issues......................................................................................347 Information Technology.........................................................................349 Public-Private MI Partnerships..............................................................350 Public MI Provider Supported by Private Reinsurer(s)..................351 Government Backup for Private MI Provider.................................352 Government-Sponsored Enterprises (GSEs), Privately Insured...354 Public-Private MI Competition.............................................................355 Lessons Learned.......................................................................................358 Conclusion ................................................................................................360 chapter 14 Residential Rental Housing Finance....................................... 363 Introduction .............................................................................................363 e Rental Sector in Housing Policy.....................................................364 e Importance of Enabling a Vibrant Rental Sector.....................364 Imbalance between Rental and Homeownership............................366 Rental Housing as an Investment......................................................367 e Challenges of Developing Rental Housing in Emerging Economies .............................................................................................369 Rights of Landlords and Tenants.......................................................371 Rent Control.........................................................................................372 Unfavorable Tax Regimes...................................................................374 Social Rental Housing ........................................................................375 Some Market Financing Models for Rental Housing..........................377 All-Equity Based..................................................................................377 Real Estate Investment Trusts (REIT)...............................................378 Bank-Supplied Credit for Residential Rental Investment .............380 Capital Market Financing ..................................................................382 Credit Enhancements and Insurance Products...............................385 Country Examples...................................................................................387 xiv housing finance policy in emerging markets e Low-Income Housing Tax Credit (LIHTC) in the United States .....................................................................................388 Brazil: the Residential Leasing Program (PAR)...............................389 Poland: the TBS Experience...............................................................391 Conclusions ..............................................................................................393 chapter 15 Housing Microfinance............................................................. 395 e Rise of Housing Micro nance........................................................395 An Overview of Housing Micro nance................................................398 Potential Size of HMF Markets: e Cases of Peru and Guatemala..............................................................................................399 Financial Performance of HMF.............................................................402 Other Opportunities for Housing Micro nance.................................404 Limited Potential for Linking HMF and Housing Subsidies.........404 Linkages between Commercial Banks and Housing Micro nance.....................................................................................407 e Limitations of Housing Micro nance............................................409 Market Size...........................................................................................409 Pricing and Access...............................................................................410 Re nancing and Other Micro nance Limitations..........................412 Potential to Contribute to Entrenchment of Informality...............414 Conclusion ................................................................................................414 chapter 16 Housing Finance Subsidies .................................................... 417 Where to Start? Linking Housing Problems to Subsidy Policy..........420 Analyzing the Causes of the Housing Problems .............................420 Subsidies and Other Types of Government Intervention..............426 Why Subsidize Housing?....................................................................428 Subsidies and the Expansion of Housing Finance Systems ...............429 Housing Finance Sector Problems, Causes, and Subsidies ...........429 Housing Finance Subsidies, Market Structure, andVested Interests ..............................................................................................432 Housing Finance Subsidies to Alleviate Funding Constraints......434 Subsidies to Address Lending Risks and High Transaction Costs ...................................................................................................436 Problems with Subsiding a Housing Finance System.....................439 contents xv Subsidies for the Financing of Rental Housing....................................440 e Rental Market...............................................................................440 Rental Sector Regulations, Taxation, and Subsidies .......................441 Subsidies to the Rental Sector............................................................443 Project Finance for Ownership Housing..........................................447 Public-Private Partnerships for the Provision of A ordable Rental Housing.................................................................................447 Making Rental Subsidies Work..........................................................448 Housing Finance Subsidies to Households...........................................449 Household Problems and Subsidies..................................................449 Lower-Middle Income Households..................................................453 Low-Income Households: Subsidies When Housing Supply Markets Do Not Work.....................................................................458 Conclusions ..............................................................................................460 Bibliography.............................................................................463 Contributors.............................................................................485 Figures 1. Selected Housing Loan to GDP Ratios .........................................xxxii 2. Share of Urban Slum Dwellers and Housing Loan to GDP Ratio, Asia and Latin America, 2001...............................................xxxv 1.1. Mortgage Debt/GDP--Developed Markets......................................2 1.2. Mortgage Debt/GDP--Emerging Markets........................................3 1.3. Correlation of Private Consumption Growth with Real House Price Changes............................................................................................7 1.4. Marginal Propensities to Consume Out-of-Housing Wealth and Mortgage Market Indicators............................................................8 1.5. Mortgage Rates in Developed Countries.........................................12 1.6. Mortgage Rates in Emerging Markets..............................................12 2.1. Depository and Direct Lending........................................................31 2.2. Mortgage Bank System.......................................................................36 2.3. Mortgage Lenders by Type................................................................37 2.4. Emerging Market Mortgage Funding..............................................38 2.5. Housing Finance with a Secondary Mortgage Market..................39 2.6. e Bundled Home Mortgage Delivery...........................................43 2.7. Unbundled Mortgage Delivery.........................................................43 xvi housing finance policy in emerging markets 2.8. Mortgage Distribution Channels......................................................44 3.1. Instrument Alternatives ....................................................................50 3.2. Cost of the Danish Prepayment Option..........................................52 3.3. Mortgage Products: Percentage of Adjustable Rate Loans............53 3.4. Mexican Mortgage Instrument Payment Performance.................56 3.5. Mexican Mortgage Instrument Balance Performance...................57 3.6. Amortization by Interest Rate Type in the United States (U.S. H1 2006).........................................................................................61 3.7. Method of Repayment United Kingdom ........................................61 7.1. Basic Construction Finance Model................................................168 9.1. Basic Structure of a CSH Contract.................................................217 9.2. Origins of Building Societies, Savings & Loans, and Bausparkassen .......................................................................................221 9.3. Closed System CSH Contract Demand and Capital Market Rates, Germany, 1973­2007................................................................226 9.4. Role of CSH Deposits for the Financing Structure of Monetary Financial Institutions, Czech Republic, 2002­07...........233 15.1. Government and Banking Association Charter Target Group in South Africa......................................................................................397 15.2. E ective Interest Rates (inclusive of fees) for MFIs in 2004.....410 Tables 1.1. Real Estate and Banking Crises--Selected Cases...........................23 5.1. Enforcing Mortgage Collateral..........................................................94 9.1. Main Di erences between Open and Closed CSH Schemes......218 9.2. CSH Subsidies in Central and Eastern Europe Compared.........241 12.1. Capital Market Finance of Housing in Emerging Economies..302 12.2. Basel II Standardized Risk Weights for Long-Term Bonds.......314 13.1. Selected Countries with MI Programs, 2008..............................328 13.2. MI Prerequisite Conditions for Success.......................................329 13.3. LTV Correlates Strongly with Default Risk and Losses.............330 13.4. Insurable Loans, Selected Countries............................................335 13.5. Credit Risk Management Tools ....................................................342 13.6. Advantages and Disadvantages of Public and Private MI Schemes .................................................................................................350 13.7. MI Program Reversals and Resolutions--Selected Cases.........357 15.1. HMF Performance Indicators for Six MFIs in Latin America .403 16.1. Potential Access to Housing Finance in Mexico, 2006..............423 16.2. A ordable Loan/House Price Scenario.......................................424 contents xvii 16.3. Examples of System Subsidies.......................................................431 16.4. Examples of Housing Finance Subsidies to Households...........452 Boxes 1.1. Real Estate and Financial Crises: a iland......................................19 1.2. Mexican Past Crises and the Role of Housing Finance.................21 2.1. SOFOLs--Mexican Mortgage Companies......................................41 2.2. HDFC--Creating a Market...............................................................42 3.1. e Limits of Adjustable-Rate Mortgages (ARMs)........................55 3.2. Colombia: Di culties with Indexed Mortgages.............................58 4.1. Developing the Appraisal Industry..................................................75 4.2. Examples of Property and Disaster Insurance................................82 4.3. Croatian Credit Bureau Development: HROK...............................89 5.1. e Crisis of Mortgage Markets in Colombia.................................96 5.2. Judicial Enforcement of Mortgages in West Africa......................105 5.3. Judicial Enforcement in Mexico.....................................................106 5.4. Non-judicial Enforcement of Mortgage Rights in Croatia..........107 5.5. Non-judicial Enforcement of Mortgage Rights in Sri Lanka......108 5.6. Time in Foreclosure in Power of Sale and Judicial Procedure States in the United States...................................................................109 5.7. Non-judicial Enforcement of Mortgage Rights in India..............109 5.8. Reforms of Mortgage Rights in Pakistan.......................................110 5.9. France: Guarantees as a Substitute for Mortgages........................121 5.10. Housing Lending in Indonesia.....................................................122 6.1. "High" and "Low" Levels of Consumer Protection-- e Clash of Approaches in Europe...................................................132 6.2. De ning the Annual Percentage Rate of Charge..........................135 6.3. Prepayment Indemnities--How Much is Too Much?.................139 6.4. Foreign Currency Mortgages--Low Rates, High Risk.................142 6.5. Consumer Protection in the United States and the Subprime Market ....................................................................................................144 6.6. e Legacy of Brazil's Old Housing Finance System ...................146 6.7. A New Consumer Protection Framework for Mexico.................155 8.1. Innovative Underwriting in a iland............................................181 8.2. Proactive Servicing in Mexico........................................................182 8.3. Managing Market Risk.....................................................................184 8.4. Polish Foreign Exchange Lending Requirements.........................185 8.5. Keystone Bank...................................................................................190 8.6. Spain's Statistical Provision..............................................................195 xviii housing finance policy in emerging markets 8.7. Colombia Crisis................................................................................198 9.1. CSH--an Islamic Finance Product in Iran....................................223 9.2. Prepayment Risk in the Austrian Market......................................227 9.3. Illiquidity of the Iranian Housing Savings Scheme......................229 9.4. Liquidity Fluctuations and Disconnect from the Housing Finance System in Tunisia...................................................................231 9.5. CSH System Choice in Transition Countries in the 1990s..........236 9.6. Attempts to Introduce CSH in India .............................................238 9.7. CSH Subsidies in Hungary..............................................................242 9.8. Planned CSH Law and Subsidies in Russia...................................242 10.1. e Fiscal Cost of Bailing Out State Housing Banks.................252 10.2. e Case of BancoEstado (Chile).................................................261 10.3. e Case of the Government Housing Bank (GHB) of a iland.................................................................................................262 10.4. e Case of the Federal Mortgage Bank of Nigeria...................272 11.1. e Reforms of INFONAVIT in Mexico.....................................286 14.1. Returns on Formal Rental Housing in São Paulo, Brazil ..........371 14.2. Underwriting Criteria for Multifamily Rental Loans................381 14.3. Securitization of Multifamily Rental Loans and Social Housing Loans......................................................................................383 14.4. Bond Enhancement Products for Multifamily Rental Housing ..................................................................................................387 16.1. Example of Income and Finance A ordability...........................425 16.2. De ning Subsidies..........................................................................426 Foreword is book is a magni cent e ort to pull together both knowledge and expe- riences from advanced and emerging markets to help policy makers in all markets establish sound housing nance policies. e book covers all t he important aspects of housing nance. Having been actively involved in t his topic as a p olicy maker in t he past, I ca n say this book would have made our options more clear, our thinking more focused, and our decision-making faster, if we could have had this publica- tion at that time. It will be a very valuable tool for policy makers going forward. is volume could not be more timely. e debacle of the U.S. subprime mortgage market is dist orting the discussion around housing nance in emerging markets. To c ut t hrough t he maze , t his b ook o ers insights around all t he building blocks of a ho using nance system--including mortgage s ecuritization--and guides t he r eader t hrough t he di erent policy o ptions a vailable in e ach cas e a nd t he most co mmon mist akes policy makers must avoid. e vastness of the experiences related from around the globe, and the cross-cutting perspective of the World Bank technical experts, will surely enable the reader to relate the topics discussed with the situation faced in his or her co untry. While reading it, I under stood that the problems we face in the Mexican housing market are strikingly similar to those of other xix xx housing finance policy in emerging markets emerging economies. ere is a lot we may learn from each other, and this book just made that so much easier. Guillermo Babatz President Comisión Nacional Bancaria y de Valores, Mexico Acknowledgments We would like to express our immense gratitude to the authors and co- authors of the chapters in t his book. eir contributions have been of the upmost professional quality, and re ect decades o f international exposure and experience as well as a capacity to synthesize their unbiased and in-depth knowledge. We take also this opportunity to thank them for their incred- ible support and patience. A special thanks is given to Roger Blood, Robert Buckley, Steve Butler, Franck Daphnis, Hans-Joachim Dübel, Richard Green, Britt G winner, Oli vier H assler, M arja H oek-Smit, D avid L e B lanc, Sall y Merrill, Bertrand Renaud, Claude Ta n, and Simon Walley. Many more in developed and emerging economies should be thanked for their direct and indirect contributions. As the list would simply be too long, we can only sin- cerely and collectively thank all of those we have had the privilege to work with throughout these past years. is book represents a pioneering e ort to ll a very large knowledge gap in this important but poorly understood area of housing nance in emerging economies. is publication should be improved through subsequent ver- sions. As markets and policies keep changing rapidly, we can only encourage all contributors to keep updating the collective knowledge and wisdom by taking further initiatives to share their experiences. A fantastic e ort was deployed by the GCMNB Department of the World Bank, spearheaded by Olivier Hassler, Colleen Mascenik and Simon Walley xxi xxii housing finance policy in emerging markets in order to update, adjust, edit and assemble the various part of this book, including updates related to the crisis. Without their tenacious and profes- sional involvement, this book would have not become a r eality. A sp ecial thanks as well to Patricia Braxton and Megan Gerrard of the World Bank, and Mellen Candage of Grammarians for their superb editorial contribution. James Quigley has done a highly professional job designing and laying out the book. As authors and editors of the book, we are also especially thankful to our great peer reviewers, Guillermo Babatz and Mila Freire, who made the time to provide us with detailed and constructive comments, which have been critical to improve the quality of the book. Last but not the least, we would like to thank Rodney Lester and Bertrand Renaud f or t heir in spirational, intellectual a nd ma nagerial support. is book is also largely theirs. Loïc Chiquier and Michael Lea Abbreviations absasset backed securities aidsacquired immune de ciency syndrome anilL'Agence Nationale pour Information sur Logement (National Agency for Housing Information, France) aprannual percentage rate araHousing Finance and Development Centre of Finland arm adjustable (or variable) rate mortgages avm automated valuation model bafinBundesanstalt für Finanzdienstleistungsaufsicht (Federal Financial Supervisory Authority, Germany) bhsaBanco Hipotecario SA (Argentina) bhu Banco Hipotecario del Uruguay bisBank for International Settlements bkn Statens bostadskreditnämnd (National Housing Credit Guarantee Board, Sweden) camelcapital, assets, management, earnings, liquidity ceeCentral and Eastern Europe cefCaixa Econômica Federal (Federal Housing Bank, Brazil) cfrCode of Federal Regulations cmbs Commercial Mortgage-Backed Securities cmhc Canada Mortgage and Housing Corporation xxiii xxiv housing finance policy in emerging markets cnep Caisse Nationale d'Epargne et de Prévoyance cpf Central Provident Fund (Singapore) csh Contractual Saving Schemes for Housing dim dual index mortgage ebrd European Bank for Reconstruction and Development eca Europe and Central Asia emf European Mortgage Federation eu E uropean Union fama Fundación para el Apoyo a la Microempresa, Acción Investments (Nicaragua) fghm Fonds de Garantie Hypothécaire du Mali (Mortgage Guarantee Fund of Mali) fgts Fundo de Garantia do Tempo de Serviço (Peru) fha U.S. Federal Housing Administration; Instituto de Fomento de Hipotecas Aseguradas (Guatemala) fico Fair, Isaac and Company fmbn Federal Mortgage Bank of Nigeria fmo Financierings-Maatschappij voor Ontwikkelingsladen (Netherlands Development Finance Company) fovi Fondo de Operación y Financiamiento Bancario a la Vivienda (Mexico) fovisste Fondo de Vivienda para los Trabajadores al Servicio del Estado (Mexico) frm xed-rate mortgages fsa Financial Services Authority ftt duciary transfer of title fx f oreign exchange gbp United Kingdom Pound Sterling gdp gross domestic product ghb Government Housing Bank ( ai land) ghlc Government Housing Loan Corporation gnma Government National Mortgage Association gnp gross national product abbreviations xxv gse go vernment-sponsored enterprise hbfc House Building Finance Corporation hdb Housing Development Board hdfc Housing Development Finance Corporation hew housing equity withdrawal hfcs Housing Finance Companies hkmc Hong Kong, China Mortgage Corporation hlgc Home Loan Guarantee Company (South Africa) hgc Home Guaranty Corporation (Philippines) hmf H ousing Micro nance hpf Housing Provident Fund hpi House Price Index hrok Croatian Registry of Credit Obligations hud U.S. Housing and Urban Development Department huf H ungarian Forint iadb Inter-American Development Bank ias International Accounting Standards icici Industrial Credit and Investment Corporation of India ifc International Finance Corporation imf International Monetary Fund infonavit Instituto del Fondo Nacional de Vivienda para los Trabajadores (Mexico) irb in ternal-ratings-based (approach) it inf ormation technology iuhf International Union for Housing Finance ivsc International Valuation Standards Committee jmrc Jordan Mortgage Re nance Corporation kfm National Housing Fund (Poland) kh&cb Korea Housing and Commercial Bank khb Korea Housing Bank kmgf Kazakhstan Mortgage Guarantee Fund lac Latin America and the Caribbean lihtc low-income housing tax credit xxvi housing finance policy in emerging markets lmi lenders mortgage insurance ltv loa n-to-value mba Mortgage Bankers Association (United States) mbs mo rtgage-backed security mdg Millennium Development Goal mena Middle East and North Africa mfi micr o nance institution mi mortgage default insurance mif Mortgage Insurance Fund mls multiple listing service mlv mortgage lLending value mmif Mutual Mortgage Insurance Fund mpc marginal propensity to consume mv ma rket value ngo no n-government organization nhf National Housing Fund npl no n-performing loan oecd Organisation for Economic Co-operation and Development pag-ibig Filipino Development Housing Fund (Philippines) par Programa de Arrendamento Residencial (Residential Leasing Program, Brazil) pboc People's Bank of China plam price-level adjusted mortgage pln Polish Zloty New pmi Primary Mortgage Institution pt pass-t hrough rba Reserve Bank of Australia reit Real Estate Investment Trust roa return on assets roe return on equity rsl registered social landlord s&l savings & loan abbreviations xxvii schufa S chutzgemeinscha für Allgemeine Kreditsicherung (German Credit Protection Association) scpi Société Civile de Placement Immobilier (Real Estate Investment Trust, France) sec Securities and Exchange Commission sgci Système de Gestion Centralisée des Impressions shb State Housing Banks shf Sociedad Hipotecaria Federal (Mexico) sida Swedish International Development Cooperation Agency sofol Sociedad Financiera de Objecto Limitado (Mexico) spv special purpose vehicle tbs No npro t Landlord Associations (Poland) tc Titularizadora Colombiana (Colombia) thfc e Housing Finance Corporation Limited upac Unidad de Poder Adquisitivo Constante (Constant Purchasing Power Unit of Exchange, Colombia) uvr Unidad de Valor Real (Colombia) vat value added tax wew Homeownership Guarantee Fund (Netherlands) Note: All dollar amounts are U.S. dollars unless otherwise indicated. Introduction Loïc Chiquier and Michael Lea Objectives In 1993, the World Bank published an in uential report on housing policy, "Housing: Enabling Markets to Work." is report documented the impor- tance of housing in the economy while at the same time providing govern- ments with guidelines on how best to design policy to createe cienthousing markets. A section of that report already focused on housing nance and its importance in the e ective operation of housing markets. ere have b een numerous publications f ocusing on t he e volution of housing nance systems, but most f ocus on developed economies where large markets have been built over several decades. Few publications describe the features and challenges of developing housing nance in emerging econ- omies. ere are some common features between developed and emerging markets, but the overall environment, in particular for housing and nancial services, presents greater challenges. ese include less fa vorable nancial and economic conditions; greater range and quantum risks to manage; lim- ited scal space, which can constrain government policy; and, importantly, xxix xxx housing finance policy in emerging markets emerging markets, which o en su er from shortages of housing in terms of both quantity and quality. e purpose of this book is to provide fact-based information and guid- ance to policy makers concerned with housing nance in emerging markets. An overarching goal is to improve the understanding of the importance of housing nance to the economy. is includes covering the prerequisites for an e ective housing nance system together with the main characteris- tics of such a system. e book continues by laying out some of the policy alternatives and models of housing nance (products, infrastructure, risk management, regulations, funding). In line with the priorities of many gov- ernments, the book is focused on solutions; in particular the role of gov- ernment in contributing to the growth of housing nance and in increasing access t o ho using nance f or lo wer a nd inf ormal inco me ho useholds. e way taken to achieve these objectives is o f the essence: they cannot be achieved, at least in a sustainable manner, by involving the creation of undue additional risks for the nancial sector or eventually unbearable scal liabilities. Housing nance brings together complex and multi-sector issues that are driven by constantly changing local features, such as a country's legal envi- ronment or culture, economic makeup, regulatory environment, or political system. is examination of housing nance policy highlights some general lessons for policy makers and regulators. It does not, however, provide an exhaustive review of all developments across the housing nance world. It is worth stating at the outset that there is no "b est" model set out in t his book. e aim is to provide a developmental roadmap that can be tailored and sequenced to each country's situation and timing. e book is focused on housing nance policy and takes into account only broader housing-policy considerations where it directly relates to housing nance. For instance, the book does not discuss many other fundamental aspects of a comprehensive housing policy, such as title registration, urban development rules, management of public land, access to land for develop- ment, slum upgrading tools, non- nance subsidies, the relationship between national and local authorities, and so forth. Neither would the book represent a t echnical guide o r a ha ndbook for lenders. Many in-depth publications can provide the reader with detailed accounts of developing mortgage markets at a country level or of di erent introduction xxxi products, funding models, or types of reform. ere is a det ailed bibliog- raphy with this book that interested readers are invited to consult. is publication seeks to stimulate a debate among the public- and pri- vate-sector players in this rapidly evolving industry. It should be seen as a rst edition, which can be greatly enhanced by adding experiences, case studies, and corrections in subs equent editions. is book also represents the starting point of a dialogue with readers who are welcome to contribute their input for future editions. e book is based on the experience accumulated by the Housing Finance Team of the World Bank (composed of L. Chiquier, O. Hassler, B. Gwinner, and S. Walley), which has been in the privileged position of working in more than 30 countries. e team also follows closely developments in the housing nance syst ems o f o ther co untries, inc luding de veloped eco nomies. e book was co-edited by Dr. Michael Lea, who is one of the most active inter- national experts in housing nance. Several chapters were dra ed by recog- nized experts in their eld who also worked in many emerging economies. Evolution of Housing Finance Systems Since 1993, the penetration of housing nance has increased dramatically in developed economies. In the United States, in European countries, Australia, or Japan, residential mortgage markets represent between 50 and 100 percent of the gross domestic product (GDP). Housing nance has als o been developing in mo re emerging markets, albeit at a di erent pace a nd with di erent outcomes and impacts across countries ( gure 1). Over the last 20 years, housing nance has also reached signi cant levels in a few middle-income countries (the Republic of Korea, South Africa, Malaysia, Chile, Baltic countries), with residential mortgage debt amounting to 20­35 percent of GDP. Over the past ve years, housing nance has also made inroads in several other "latecomer" countries (China, India, ailand, Mexico, most of the new European Union [EU] countries, Morocco, Jordan, and even more recently in many more countries, including Brazil, Turkey, Peru, Kazakhstan, and Ukraine) where mortgage markets stand at 6­17 percent of GDP. is expansion is impressive and seen by most as irreversible (" e housing nance genie is o ut of the bottle," Buckley, xxxii housing finance policy in emerging markets Figure 1. Selected Housing Loan to GDP Ratios World Bank 2006). Progress is also observed in a few lower­income econo- mies, including Indonesia, Egypt, Ghana, Pakistan, Senegal, Uganda, Mali, Mongolia, and Bangladesh, but not on a large-enough scale to address some of the chronic housing issues they face. is b ook f ocuses most ly o n r esidential mo rtgage nance (f or ho me acquisition). ere is recognition of other relevant forms of housing nance, such as developer nance, rental nance, or micro nance applied to housing. Developer nance is o en in t he form of unregulated advance payments by buyers, and developers sometimes provide long-term nance to buyers through installment sales when mortgage markets are not accessible. Micro- nance for housing is typically used for home improvement or progressive housing purposes. Loans are typically granted without pledging properties. Although the overall impact of micro nance in ho using remains limited, this activity can represent an important source of funding for those in the informal sector. introduction xxxiii In the last decade, a few far-reaching trends have been signi cant drivers for the expansion of housing nance in emerging economies. es e include the following: · Favorable macro conditions, notably in terms of falling in ation and mortgage rates (both in n ominal and real t erms). Many emer ging economies have experienced GDP growth, which is partly converted into rising incomes of households. ese conditions have favored the expansion of mortgage markets. Conversely, many of the historical failures of housing nance are linked to macroeconomic instability, o en combined with an inadequate regulatory and risk-management environment. is is particularly the case in Latin America, where the model of savings and loans was devastated by hyperin ation. Macro instability increases the risk and cost of providing long-term loans. While indexed mortgage instruments can facilitate housing nance in in ationary environments, they require advanced risk manage- ment skills and prudential regulations that o en remain amiss. · Increasing h ousing dem and l inked t o lo ng-term u rbanization a nd demographic forces. A t otal of 91 p ercent of the net incr ease of the world population between 2000 and 2030 will be located in cities of emerging economies (Population Division of the Department of Eco- nomic and Social A airs of the United Nations Secretariat, 2005). Africa and Asia in particular are likely to face increasing urbanization pressure over the next decade. Similar trends are observed in many countries in other regions (Turkey, Mexico, Iran, and so on). Demand is also fueled by strong aspirations for better housing conditions. In addition, housing increasingly forms part of a ho usehold's savings strategy for investment and as security for old age. In many cases, real estate is one of the asset classes available when nancial investment instruments and government debt markets are underdeveloped. · Financial l iberalization, with t he endin g of c losed public housing nance cir cuits (e armarked ho using f unds, st ate-owned ho using banks, a nd s o f orth) ca n b e a n im portant stim ulant f or ho using nance. e housing sector is too large for any government to nance it alone. Liberalization is a universal trend that mobilizes savings from the public through banks and, in later stages of development, through xxxiv housing finance policy in emerging markets capital markets, as long as housing loans can o er an attractive risk- adjusted rate of return for investors. Housing nance has become an area of increasing importance for many institutions (linked to retail nance and construction nance), including liquid banks and nance and specialist mortgage companies. eir access to private bond mar- kets is a key ingredient, inextricably linked to other reforms (public debt management, development of capital markets, pension funds, and insurance). e growth of the nancial sector has led t o lower operational costs, improved information technology, and better risk- management tools. e role of the state has e volved from direct lending and housing con- struction to regulation, policy development, building market infrastructure, and more e cient assistance for low-income groups. Policy Recommendations Although the importance of the housing sector in social and economic devel- opment is widely accepted, the role of housing nance has gained prominence in the last decade. is shi has mirrored the rise in importance accorded to the development of the nancial sector. e 2002 World Bank Development report emphasized the importance of growing the nancial sector as part of a development strategy. Housing nance is o en seen as critical both to the housing sector and to the development of the nancial sector (banks, non- banking nancial institutions, and bond markets). Housing has risen up the policy and political agendas with many govern- ments. is is in part because of the signi cant contribution that housing and housing construction can make to GDP growth. ere is also an impor- tant human dimension, where the need for public shelter programs is also increasingly recognized. is was made explicit in the Millennium Devel- opment Goals (MDG), where a reduction in the number of people forced to live in sl ums was o ne of the key targets under MD G 7, w hich covers environmental sustainability. is point is c learly illustrated in gure 2, which shows the correlation between developing a housing nance system and the number of slum dwellers. Lastly, the importance of housing and introduction xxxv Figure 2. Share of Urban Slum Dwellers and Housing Loan to GDP Ratio, Asia and Latin America, 2001 its associated nance as a de velopment catalyst for the broader nancial sector should not be underestimated despite the subprime market debacle. A number of countries have successfully developed capital markets with signi cant volumes coming from the re nancing of mortgage debt. Sound regulation and infrastructure are needed t o build a sust ainable housing nance system. e imperatives for developing a ho using nance system can be set out as 12 Herculean tasks for policy makers: 1. Enforceable property rights and e ective registration system. 2. Enforceable foreclosure for mortgage lenders (collateralized lending is superior to uncollateralized lending in cost and availability). 3. Access f or all lender s t o di versi ed f unding (inc luding mortgage securities). 4. Comprehensive credit information systems. xxxvi housing finance policy in emerging markets 5. Strong prudential regulations that encourage responsible lending and adequate consumer information (avoid abusive or unfair lending). 6. Level playing eld among lenders to encourage competition. 7. Credit products adjusted to economic and nancial realities,di erent consumer needs, and sound risk-management practices. 8. Accessible and reliable information on house transactions and prices. 9. Professional real estate intermediaries, including developers, appraisers, insurers, and realtors. 10. Urban de velopment r egulations ada pted t o eco nomic r ealities t o encourage the production of formal a ordable housing. 11. Comprehensive national housing policy, including socially and eco- nomicallye cient subsidies, slum upgrading, and title regularization programs. 12. Access to titled land for developers. Many studies demonstrate the correlation between implementing these policy recommendations and a subsequent growth in housing nance mar- kets. Rapid and sustainable expansion has been observed in countries that have managed to get high marks on most of these factors (as in Chile, Mexico, and Malaysia). In most emer ging economies, housing nance remains available only to the middle and upper echelons of the salaried income-distribution structure of households. With a few important exceptions (like Malaysia or Mexico), other low and informal income households have yet to see any mass-scale development of housing nance. In addition to formidable urbanization and demographic forces, this situation favors the proliferation of slums. On one hand, lenders already face di culties in managing their additional risks and extend smaller loans in a cost-e ective way. On the other hand, households may be confronted by expensive formal housing markets resulting from an inadequate housing policy. Key factors relate to obtaining ownership titles, adequate urban planning and development regulations, infrastructure for real estate intermediaries, resale procedures, rental laws, access to land for devel- opers, and the way subsidies are designed and implemented. e adequacy of government policy is critical to expand the outreach of housing nance. introduction xxxvii Impact and Lessons of the U.S. Subprime Crisis As this book goes to print, world attention is focused on the U.S. subprime crisis. Although subprime adjustable rate mortgages (ARMs) only make up 8 percent of U.S. mortgage debt, a large amount of credit risks is now held by global investors through the debt leverage of securitization and complex nancial structures. e fall in the quality of these securities, and thedi culty to value them, have precipitated large losses, as well as distr ust throughout nancial markets and a liquidity squeeze. e magnitude of the global crisis has been a surprise for most experts. Some nancial investors havesu ered from direct losses, but most housing nance markets in emer ging economies have not been contaminated. e structure and performance of mortgage markets in emerging economies are di erent, smaller, and more conservative. e mortgage markets are typi- cally funded by domestic deposits that reduce the global contagion via capital market ows. Emerging mortgage markets that have made he aviest use of global securitization look likely to be most a ected (the Russian Federation, Kazakhstan, Korea). In non-contaminated and high-quality mortgage mar- kets, domestic residential mortgage-backed security markets remain active, albeit with slightly higher spreads (by 20­40 basis points in Mexico). Whereas the leverage e ect on global nancial markets is a new element, this crisis displays many of the conventional features seen during other real estate nance crises, as analyzed in greater detail in several chapters of the book, including: · poor cr edit under writing co upled wi th hig her-risk p roducts f or riskier borrowers, where lenders have used continuing house-price appreciation as a safety net; · poor levels of disclosure and consumer protection; · unregulated originators having no incentive to preserve the portfolio quality; · inadequate incentives to manage credit risks; · funding models that have proved too complex and too heavily reliant on short-term debt t o s atisfy t he appetite of investors for hig her yields; and xxxviii housing finance policy in emerging markets · inadequate and weak regulatory response from a multitude of frag- mented regulators. e subprime market crisis does not contradict the goal of expanding the access to housing nance, but shows what happens when this expansion is done with no consideration for the speci cities of this market segment. e purpose of the book is to provide guidelines for emerging markets on how they might avoid such issues through setting up a sound regulatory regime supported by the necessary risk-management infrastructure. Housing Finance Is Interrelated with the Broader Economy Wider access t o housing nance has a signi cant impact on construction, economic growth, and urban development (see Renaud 1999). In countries with underdeveloped housing nance syst ems, households incrementally self-build their house over long periods of time, or settle for a low-quality structure t hat do es no t co mply wi th p lanning a nd b uilding r egulations, which contributes to the proliferation of slums. Under these circumstances, formal construction may not develop and a vicious circle is created, leading to further housing shortages. Also, the lack of housing nance for resale markets prevents the recovery of costs of housing assets and hinders labor mobility. is is particularly true for a ordable housing markets, which pre- vents investment to improve the quality of housing, reduces labor mobility, and reduces net tax receipts raised from real estate transactions. A well-functioning housing nance system contributes to the expansion of home ownership with key externalities for growth, job creation, neighbor- hood development, scal returns, and last, but not least, social and political stability. A well-functioning housing nance system is an important contrib- utor to household wealth accumulation and retirement strategy, with spillover e ects on the broader economy. For example, a large portion of the capital for start-up businesses in the United States comes from housing nance. e work by de Soto on housing wealth in emerging economies con rms the true cost of informality (economically "dead" housing assets) to emerging econo- mies. He sets out the formidable value of these unsecured housing assets, introduction xxxix which provide very little return given that they cannot be used as collateral for economic investments. Excessive emphasis on asset-based lending can prove destabilizing, however. e subprime crisis in t he United States is a clear example of this, where home ownership was pushed to groups that did not have the required loan repayment capacity. Structure of the Book Chapter 1 reviews the macroeconomic signi cance of housing nance, noting possible bene ts but alsocosts. ere are key links between housing nance,the nancial sector, economic growth, and, ultimately, poverty alleviation. Housing has always played a r ole in la rger business cycles because it is a n interest- sensitive ass et, as s een d uring cr ises b oth in de veloped ma rkets (U nited Kingdom, Japan, S candinavia) a nd emer ging ma rkets (Mexico, Ar gentina, Brazil). e r ecent exp erience o f Australia, t he United K ingdom a nd t he United States suggests that equity extracted from housing assets can nancean excessive level of consumption debt and engender macroeconomic instability. Likewise, the U.S. subprime crisis is interlinked with an adverse cycle of real estate markets that now a ects both the U.S. and world economy. Chapter 2 discusses the di erent ways in which housing nance can be delivered. Historically, in de veloped economies, specialist lenders such as building societies or mortgage banks provided housing nance. es e insti- tutions were o en part of special circuits of nance that were dismantled or lost market share to commercial banks. In some developed markets, some functions associated with mortgage lending have been unbundled through various sp ecialists (f or exa mple, in termediaries, t hird-party s ervicers, insurers). So far, this has been less the case in emerging economies, except for mortgage brokers (Poland) and mortgage insurers (Mexico, South Africa). In most countries, housing nance is mostly provided by banks, but competi- tion may come from specialized nance companies (Mexico, Egypt, UAE, India), housing provident funds (Mexico, China, Colombia), credit coopera- tives (Burkina Faso, Rwanda), and micro-lenders (Peru). Chapter 3 f ocuses on how proper credit design is a k ey ingredient for a successf ul housing nance system to allo cate r isk b etween consumers, lenders, and investors. In most emer ging markets, variable or adjustable xl housing finance policy in emerging markets rate mortgages remain the prevailing and sole products available, o ered by depository-based lenders to manage their interest-rate risk. Unfortunately, borrowers then bear most of the interest-rate risk passed through additional credit risks.1 Most of the U.S. subprime defaults relate to adjustable rate loans with lower initial "teaser" rates that can show signi cant increases once past the initial period and in a r ising interest rate environment. It is possible to protect the consumer by o ering long-term xed-rate mortgages (FRMs) that grant the borrower the right of early repayment. ese, however, require lenders to access ad vanced capital markets or derivative-market products in order to manage their cash- ow risks. Hence, in most emer ging mar- kets FRMs remain inappropriate for lenders or too expensive for borrowers. Indexed credits developed for in ationary economies have had some success (Chile) but also problems (Colombia, Brazil, Mexico). Any e ective housing nance system requires a s ound primary market infrastructure. Chapter 4 describes some of the essential building blocks, with particular emphasis placed on home appraisal practices, insurance products related to mortgage lending, and credit information systems. Many countries have improved the judicial enforcement procedures for creditors or developed non-judicial mechanisms to foreclose on a property. Chapter 5 sets out some of the key elements required for the creation of a sound legal basis for mortgage lending. A complementary pillar would be an e ective system of enforceable and registered property rights, but this vast theme is beyond the scope of this book. Chapter 6 dis cusses the importance of adequate consumer information to help households take and re nance a mortgage loan. Households should compare loan o ers and make an educated decision when taking and repaying a loan. e issue exists in both developed countries and emerging countries. In emerging markets, mortgage consumer information rarely exists (Mexico and South Africa represent exceptions). When loans go bad, the judiciary and political systems are o en less inclined to defend the rights of lenders and investors, where the consumer has been inadequately informed. is can be detrimental to future lending activities. Another cr itical, y et o en o verlooked, element in t he ho using c hain consists of providing nance to real estate developers. Without adequate 1. Remedies include a proper selection of the index used to periodically adjust the rates and caps on these rate adjustments provided at least during the rst years of the loan. introduction xli nancing in place, it falls to the households to provide larger amounts of unsecured deposits during the construction phase. is practice reduces a household's ability to leverage and exposes it to a high level of risk associ- ated with fraud or problems during the construction phase. Construction nance remains constrained in some countries, where lenders do not have su cient expertise to manage such types of risky project nance. It is also important to develop systems that better protect consumers against con- struction risks. Chapter 7 provides an overview of these issues together with some policy solutions. As housing nance markets expand, a larger range of players, including non-banks, may get involved and be exposed to various risks that may be spread quite di erently. Chapter 8 provides a review of the risks and of the regulatory frameworks in place to deal with these risks. Risks come in many forms, and regulators face many new challenges arising from nancial inno- vation, complex instruments to spread risks, the cyclical nature of real estate markets, and the long-term nature of housing debt. Most crises in real estate nance correspond to failures in both market discipline and regulation.2 Chapter 9 r eviews co ntractual ho using s avings s chemes. Under t hese schemes, households lock in a future housing loan at a predetermined interest rate, but only a er they have completed a period of savings. e credit con- ditions are contractually correlated to the accrued savings in order to limit liquidity risks. A key attribute is reduced credit risk, notably for lower-income households that need to build a down payment and their credit score before accessing home ownership. is model was exported from Germany to sev- eral countries in Eastern and Central Europe, where contracts have become very popular through subsidized saving rates. e aggregate impact on the housing nance system is delayed, and scal costs aresigni cant, but if prop- erly implemented, this system can play an important complementary role to the main mortgage markets. Special public circuits for housing nance still exist in so me emerging economies, no tably w here p rivate lender s ha ve no t y et en tered ho using nance. Housing banks are common examples of such circuits. Unfortu- 2. e subprime crisis has been worsened by the unregulated nature of intermediaries, the global leverage of debt through complex securitization, and balkanized U.S. regulatory agencies (if measures had been taken in 2005 when the toxicity of these loans was apparent, the magnitude of the crisis would have been reduced). xlii housing finance policy in emerging markets nately, the experience with them has been mostly unsatisfactory. Most have been plagued with high levels of defaults, non-targeted lending crowding out private sector competitors, ine ective and regressive subsidies, ine ciency, and p olitically mo tivated lendin g. M any ha ve dis appeared, o thers w ere restructured. e few thriving ones went through changes to comply with private banking standards, as presented in chapter 10. Housing p rovident f unds (HPFs) ma y als o b e signi cant p roviders o f nance in a number of countries. While they mobilize large sums of money for housing through recurrent wage taxes, they share many of the problems of housing banks. Furthermore, their dual responsibilities of providing a ord- able mortgage nance and providing an acceptable return for retirees present con icting objectives. In countries like Mexico, Brazil, Singapore, or China, they play an important role that needs to be better understood. Chapter 11 provides an assessment of their role in the provision of housing nance. e use of mortgage-related securities to fund housing has a long history in developed countries, and mortgage securities are second only to govern- ment securities in importance in the United States and Europe. Chapter 12 shows how they have been introduced in a growing number of emerging mar- kets, in order for lenders to diversify their funding strategy, raise longer-term resources, and manage their cash- ow risks. Housing nance can also help to develop long-term private debt markets (Chile, Malaysia, or Mexico). So far, results have been mixed, as only in about a dozen countries mortgage- related securities nance 5­20 percent of the mortgage debt (including Chile, Malaysia, Colombia, Czech Republic, South Africa, Jordan, Mexico, Hungary, and India), but remain underdeveloped or absent in most o ther countries. e regulatory infrastructure may not be developed to support such products, or banks may nd core deposits to be a cheaper funding. Investor demand may be lacking, particularly if institutional investors are not yet in place or reluctant to take prepayment risks. Covered bonds and liquidity facilities can also represent e ective alternative or transition models to securitization. It is important to diversify funding instruments for lenders; keep them exposed to part of the credit risk; and design simple, secure, and transparent bond prod- ucts for domestic investors. Mortgage loss insurance is a growing business worldwide. Such products were instituted in the United States at the beginning of the 20th century and are now available in more than 30 countries worldwide, o ered by both pri- introduction xliii vately and publicly owned companies. Chapter 13 points out how mortgage default insurance (MI) can improve the a ordability of housing nance by lowering the down payment. MI facili tates the transfer of mortgage credit risk from the banking sector to companies specializing in risk management. MI provides tools for and encourages responsible lending practices, thus supplementing supervisory resources and reducing overall risk exposures. For MI to be successful, however, there must be a relatively strong legal and regulatory framework, as well as a history of mortgage lending. e chapter analyzes key success and failure factors. Rental housing is o en overlooked, although it represents a critical part of any housing market. Finance can expand the supply of a ordable rental stock and facilitate greater mobility on the part of the population, as dis- cussed in chapter 14. e risks, underwriting and institutional mechanisms for providing rental nance di er from owner-occupied nance. While the nance of a ordable rental housing is well established in developed markets, it is more scarce and problematic in de veloping countries because of legal di culties (for example, rent control), instability, and a ordability problems for tenants. Chapter 15 co nsiders t he de velopment o f t he micr o nance industry, which has gained credibility and scale in recent years. It has achieved this by demonstrating its nancial sustainability, and by accessing a large number of low and informal income households. One of its key advantages is that it provides a wider range of nancial services than traditional lenders are able to provide. is chapter reviews the main features and challenges of housing micro nance, as w ell as p roviding an assessment of the limits of this new class of lending. Countries intervene in housing markets through an array of policies and subsidies in tended t o stim ulate ho using p roduction o r co nsumption b y various groups. Chapter 16 details the myriad of housing nance subsidies o ered on the demand side (f or example, interest-rate subsidies, ho using- savings subsidies, mo rtgage-interest tax deduction) and supply side (sub- sidized f unding f or lender s, st ate gua rantees f or in surance, s ecurities o r secondary market institutions). ere is a r ich experience on the e ective- ness of subsidies, some of it positive and some negative. In general, subsidies should be transparent, targeted, ande cient in terms of providing incentives xliv housing finance policy in emerging markets for market forces to deliver and nance a ordable housing, but also in terms of cost of delivery and minimized distortions. Summary Conclusions What are the lessons to be learned from the development of housing nance in di erent markets? ere is no magic c ure that can create an e ective housing nance system overnight. e basics ha ve to be in p lace before a market can grow and ourish. is means achieving relative macroeconomic stability, creating the necessary legal a nd regulatory infrastructure to back collateralized lendin g, enco uraging co mpetition a mong ho using nance institutions, and ensuring that the appropriate risk-management frameworks are in place. e speci c model implemented does not matter as long as the infrastructure is in place and competition between lenders is not distorted. e secondary mortgage market depends on a he althy and developed pri- mary market. Securitization is a powerful tool for lenders but is not the way to build the market, nor is it the only bond-market instrument available to mortgage lenders. Simpler, low-risk, and transparent bond products may be more attractive for domestic investors. What should be the role of government in developing an e ective housing nance system? Its primary role should be to enable the development of mortgage markets through the creation of the lending infrastructure and elimination of barriers to lending. Historical experience suggests that the development of mortgage lending follows a sequence starting with nancial liberalization and sector development, followed by the expansion of the pri- mary market and then the creation of mortgage capital markets. e state can accelerate this development by improving the liquidity of mortgage assets and reducing the costs of credit-risk underwriting for investors. Government also has a role to play in helping lower-income households obtain adequate- quality housing. Experience has shown that targeted demand-side subsidies such as housing allowances and interest-rate buy-downs can o er ane ective way to reach lower-income groups and help them meet their housing needs. Chapter 1 Housing Finance and the Economy Robert Buckley, Loïc Chiquier, and Michael Lea On a worldwide basis, housing nance is growing at an unprecedented rate. In the last decade, outstanding mortgage debt has increased by more than $7 trillion. Figure 1.1 suggests that the majority of developed economies have experienced a str ong surge in deb t levels used to nance housing. is is also the case for a signi cant number of emerging markets, such as China, India, and Mexico, although housing nance remains underdeveloped in many parts of the developing world. is chapter provides an overview of this experience and shows the various linkages between housing nance and the broader economy, in o rder to identify some of the opportunities and challenges when developing a housing nance system. Developed Economies Housing nance was once an underdeveloped segment of domestic nancial markets. It now occupies a very signi cant place, not only in the nancial system of individual economies, but as part of the global nancial system as 1 2 housing finance policy in emerging markets Figure 1.1. Mortgage Debt/GDP-- Developed Markets well. For example, U.S. mortgages are now nanced through securitization on a signi cant scale by Chinese and Indian savers, among others.1 e size of residential mortgage markets has been growing in developed economies relative to the overall economy (at least one-third of their GDP, and o en considerably more). For example, as recently as 1984, r esidential mortgage debt was one-third of U.S. GDP, but this ratio increased to 74 per- cent by 2005. In recent years, Australia, Netherlands, Ireland, and Spain have seen annual growth rates in excess of 20 percent per year, fueled by strong economic growth and lower market interest rates. Improved macroeconomic circumstances have played a b ig role in t he emergence of housing nance. Over a longer historical perspective, however, another crucial factor has been the ongoing and seemingly relentless liberaliza- tion of nancial markets, including of housing nance.2 Instead of specialized, 1. e U.S. Treasury estimates that nearly 15 percent of U.S.-agency securities were held by over- seas investors in 2005. 2. Abiad and Mody (2005) measured the nancial liberalization of 35 countries between 1972 and 1996. Until 1982, liberalization in developed countries was modest and, in emerging mar- kets, almost nonexistent. Over the next 14 years, liberalization increased rapidly and continu- ously in all developed markets. A similar pattern characterizes liberalization in less-developed housing finance and the economy 3 frequently p ublicly o wned lender s p roviding limi ted a mounts o f o en- subsidized credit to a simila rly limited number of borrowers, new lenders using new kinds of instruments coupled with new ways of accessing nance and managing risks have emerged in both developed and emerging markets. Emerging Economies In contrast to the situation in developed countries, the size of the mortgage market in most emerging markets is still small, o en accounting for less than 10 percent of GDP, as shown in gure 1.2. Despite starting from such a low base, the pace of growth has o en been considerably faster. For example, the Chinese mortgage market, which only started in the early 1990s, has b een growing at an annual pace o f more than 40 p ercent since 2000, r eaching 11 percent of GDP in less t han 10 y ears. Similarly, the Indian market has Figure 1.2. Mortgage Debt/GDP--Emerging Markets countries. By 1996, however, despite signi cant improvements, low-income developing coun- tries had not yet reached the level of liberalization achieved by developed economies in the early 1970s. 4 housing finance policy in emerging markets been growing at 30 percent per year, and some transition countries such as Hungary, the Baltic countries, and Kazakhstan have seen growth of more than 20 percent per year. Once again, the common factors in these countries are a growing economy, low in ation, interest rates, and most importantly, liberalizing nancial sectors. is has permitted a growing number of house- holds in these countries to invest in better housing. ere are a n umber of reasons for the relatively small size o f housing nance systems in de veloping countries. ey include a hist ory of macro- economic instability with high and volatile in ation and interest rates, low growth rates, weak legal systems that do not adequately protect the interests of lenders, and, more broadly, an underdeveloped infrastructure for housing and housing nance markets, as w ell as s ome underdeveloped and poorly regulated banking and capital markets. A signi cant reason for the lack of development in housing nance was the widespread reliance on the directed credit systems and public banks to nance development policy. is view of the public role in allocating credit toward strategic sectors was not unusual and was held by many leading scholars. is view was p redominant despite the empirically documented weaknesses of the public role in generating either nancial sector development or growth. is approach continued to be a commonly used approach, particularly in low-income countries, up to themid-1990s. e "market failure" argument is more appealing for some policy makers than the inability of this approach to mobilize su cient resources and manage risks related to housing lending. While the drivers of growth in institutional mortgage nance are clear, questions remain about how and why housing nance ts into the economy and the nancial system. For example, how does growth (or lack thereof) in the housing nance system relate to the performance of the economy and to housing market and nancial system policies? What are the costs and consequences of a poorly performing housing nance system in exac- erbating economic instability or misallocating resources? is chapter will explore these issues in o rder to create a co ntext for the broader housing nance book. housing finance and the economy 5 The Importance of Housing Finance One of the main reasons why housing nance is important is that the asset it nances, housing, is such a signi cant part of wealth and the xed capital stock, as documented in Goldsmith's seminal works onComparative National Balance Sheets (1984), for example. When a good accounts for 50 percent of national wealth, a majority of the xed capital stock, and for more than 80 percent of the wealth of most households in almost all eco nomies, the way that it is nanced clearly has signi cant e ects on the economy.3 Housing also represents a large proportion of most households' consump- tion. In the United States, for example, housing rent and utility expenses account for 25­30 percent of personal expenditures Residential investment is a major component of GDP, typically amounting to 4­8 percent of GDP and 20­30 p ercent of total investment. In rapidly growing countries, the share going to housing can be much higher (for example, Spain and Ireland in recent years). erefore, the ability toe ciently nance such an important component of the economic system will have a signi cant e ect on overall levels of investment and growth. Despite i ts im portance, t he us e o f in stitutional mo rtgage nance for housing is a ra ther recent phenomenon. Until well into the 20th century, such nance was the exception rather than the rule. e use of mortgage debt was limited. Up to the 1920s, the majority of U.S. homes were self- nanced (out of savings accumulations) or nanced outside of formal nancial-sector channels.4 At that time, the urban population of the world only accounted for about 15 percent of world population, around 250 million people, with the resulting lower demand for mortgage credit.5 3. Real estate represents the great majority of the tangible capital stock, and housing is the great majority of the stock of real estate. Real estate accounts for approximately 50 percent of world wealth, of which one-quarter is commercial and three-quarters residential (Source: 1993 study by Ibbotson and Associates). 4. Including construction companies, real estate bond companies, fraternal organizations, devel- opers, or previous owners of properties (see Ratcli 1949). In 1925, these non-institutional sources were nearly as important as savings and loan associations and mutual savings banks, from which the majority of institutional mortgage borrowing occurred. 5. e U.S. experience is by no means unusual, as Boleat (1985) relates. e U.S. savings and loans followed a similar development path as the U.K. building societies as did the Swedish co-ops and non-bank institutions in a number of other European countries. Neither, however, was it universal. Many of the housing nance systems in place today in developed economies bear the hallmark of path-dependent reactions to shocks. For example, the destruction of Copenhagen by re in 1795 was in strumental in de veloping the Danish mortgage bond system, as was 6 housing finance policy in emerging markets In much the same way, housing remains mostly self- nanced by house- holds' equity in ma ny emerging economies. is limits access t o home ownership and leads to expanding incremental construction and informal housing. Frequently, t he only alternative is nance provided by de vel- opers through deferred installment sales. e major di erence, however, from the historical experience comes from today's increased urbanization, which requires extraordinary levels of housing investment. Urban popu- lation growth between 2000 a nd 2030 will ex ceed 2 b illion people; that is more than eight times t he total urban population at the beginning of the 20th century. In 1950, there was one city, New York, with a popula- tion in excess of 10 million. By 2015, there will be 21 of these cities, 17 of which will b e in de veloping countries. By 2030, A sia alone will ha ve to house 2.7 billion people in cities. is inexorable demographic trend means housing demand must be met through signi cant improvements in housing nance systems. Mortgage nance improves the operation of the housing market and the economy in a number of ways, both directly by facilitating transactions and indirectly by improving the environments in which transactions take place. Consider rst the direct e ects. e use of debt allows households to better match the timing of their housing expenditures with the ow of services they receive. Housing is a long-lived, durable asset that provides a ow of services over a long period (frequently outliving its occupants). A household can purchase more housing at an earlier stage in the life cycle using debt, as opposed to paying for it all at once through accumulated savings. Furthermore, because housing provides such good collateral, mortgages are usually the lowest-cost way for house- holds to nance general borrowing for consumption, non-housing invest- ment, o r b usiness f ormation. Housing in vestors (f or exa mple, f or r ental housing) use leverage to increase the returns on investment, as w ell as t o expand and diversify their investment opportunities. In sum, for a number of reasons, housing nance can help smooth consumption expenditures and help households exibly adjust their wealth. the e ect of destruction of the Seven Years' War on the German system. Baron Haussmann's redevelopment of Paris in t he mid-19th century created the French system, and the Great Depression created many of the housing nance institutions observed in the United States. housing finance and the economy 7 Figure 1.3. Correlation of Private Consumption Growth with Real House Price Changes Housing nance also a ects the economy in indirect ways that go beyond the speci c transaction. For instance, a n umber of studies have suggested that housing wealth has a stronger e ect on consumption expenditures than do other forms of savings. If this is so, then house-price increases can lead to stronger increases in consumer demand than do rising stock markets, with the result that housing market trends may be more closely related to overall macroeconomic c ycles. A s mo rtgage ma rkets deep en, t here a re gr eater opportunities for households to access this wealth. In particular, the ability to 8 housing finance policy in emerging markets Figure 1.4. Marginal Propensities to Consume Out-of-Housing Wealth and Mortgage Market Indicators housing finance and the economy 9 re nance allows families to spend the capital gains realized on rapid house- price increases.6 Organisation f or Eco nomic C o-ordination a nd D evelopment (O ECD) research con rms the existence of signi cant housing wealth e ects on con- sumption in the United States, United Kingdom, Canada, Netherlands, and Australia, as shown in gure 1.3. In France, Germany, and Italy, however, the association has b een weaker. e estimated long-run marginal propensity to consume out-of-housing wealth is in the range of 0.05 to 0.08 for the rst group of countries. e size and direction of the consumption e ect appears to be positively correlated with mortgage-debt ratios across countries, suggesting that the mortgage market is pivotal in translating house-price changes into spending responses ( gure 1.4). is e ect depends on the extent to which housing wealth can be accessed; in particular, through the ability of homeowners to borrow against housing wealth through mortgage equity withdrawal. e OECD nds that the size of housing equity withdrawal is correlated with the impact of housing wealth on consumption. In turn, the degree of mortgage market completeness plays an important role in housing-equity withdrawal through the ability to serve a b roader range of borrowers, o er a gr eater variety of mortgage products and higher loan-to-value (LTV) loans, and pass on lower mortgage interest-rate spreads (Mercer Oliver Wyman 2003). Two important constraints emerged f rom t he OECD analysis. Higher administrative costs and greater amounts of time required to realize collateral in the event of default signi cantly reduced the completeness of the market and the house-price consumption nexus. Additionally, regulatory constraints on LTV ratios also reduced this e ect. A number of factors are likely to have contributed to this trend. e shi to a low-interest-rate environment over the past decade o r so gave house- holds an enhanced capacity to service any given level of debt, allowing the 6. A number of studies have highlighted the role of equity withdrawal in consumption. While this ability undoubtedly provides households with considerably more exibility in arranging their expenditures over time, there are also problems that can arise with widespread equity withdrawals. is concern has led the European Central Bank (2003) to examine the impli- cations of this phenomenon for the development of the single currency market. In Australia, housing equity went f rom p ositive (acc umulation) to negative (withdrawal) during the late 1990s a nd early 2000s. M ortgage debt rose sharply; however, residential investment recorded only a modest gain. Rather, the increase in indebtedness went to consumption that fueled growth in the macro economy. Similar results were recorded in the United States and United Kingdom. 10 housing finance policy in emerging markets household sector in aggregate to carry a higher level of debt in relation to income. In addition, most countries where equity withdrawal took place had experienced an increase in the relative price of housing, sometimes of a sub- stantial amount. A period of equity withdrawal might be viewed as part of the process of shi ing from relatively low to higher levels of debt over time, or a rearranging of a household's portfolio in line with increased wealth. While there are a n umber of undesirable features of such increases in indebtedness, including higher default rates, there are also a number of sig- ni cant advantages as well. For example, in the wake of the 9/11 attack, e Economist described the U.S. housing market as t he vehicle that saved the world from depression in 2001 and 2002. Similarly, in a review of the 2005 Economic Report of the Pr esident, Martin Feldstein (2006) a rgues that the household expenditures, which were enabled by mortgage re nancing, kept the U.S. economy going strongly in 2005. erefore, in many ways, the acces- sibility of mortgage nance adds exibility to consumer choices. Whether or not that increased exibility is or (as we will discuss) can be used e ectively is an important issue that the chapters in this book address. A broadened access to housing nance can also have a strong impact on urban development, as suggested by Renaud's (1990) aphorism that "cities are built the way they are nanced." In countries with underdeveloped housing nance systems, most households either build their house individually over long periods or settle for a low-quality structure that does not comply with planning and building regulations. is leads to poorly planned and serviced urban areas.Moreover, the lack of housing nance for resale markets pre- vents the recovery of costs of housing assets; hinders mobility, particularly in low- and moderate-income housing markets; and negatively a ects the quality of urban neighborhoods, hence the scal situation of cities. Conse- quently, the lack of e ective housing nance hinders both local-government service provision and labor markets. Housing nance can also have desirable spillovere ects on both the nan- cial system and social cohesion. With respect to the latter, it has been shown that ownership, which is made more accessible by housing nance, has posi- tive externalities for neighborhood development, empowerment of house- holds through communities, and children's educational achievements. As for the nancial sector, because housing is s o durable and provides good collateral for developed countries and for developing countries, it can housing finance and the economy 11 be important in promoting long-term bond markets. And it is also important as a source of innovation for di erent nancing techniques. In the United States, for instance, housing nance began the move toward securitization and improved e ciency of bond markets. It was instrumental in developing some nancial derivative markets. Financial innovations, however, are not always unequivocal gains. e ability to move money into a country or a sector is matched by the ability to move it out quickly; hence, if not done prudently, mortgage market development, like other nancial development, may fuel instability. Before discussing the potentially destabilizing role of housing nance, we rst provide a perspective on the prospects for housing nance development. The Demand for Housing Finance Macroeconomic Factors What is b ehind the signi cant growth in ho using nance in r ecent years? Clearly, the growth in overall income and wealth has been a major contrib- uting factor. It is perhaps not surprising that countries such as Germany and Japan, which have exhibited slower growth and, in t he latter case, consid- erably slower nancial liberalization, have also experienced reduced expan- sions of housing nance. Once again, stable and low interest rates and stable growth appear to be the key factors in mortgage market expansion. Over the past decade , interest rates in most co untries have fallen sig- ni cantly with a parallel increase in mortgage debt outstanding ( gure 1.5 and gure 1.6) a lo nger trend would show greater change. Mortgage rates, although falling, remain high in a n umber of emerging markets, thereby accounting for the relatively slower growth in their mortgage markets (for example, Brazil and Colombia). In such countries, the combined e ect of lower market rates, liquid banks, and an improved regulatory environment for lenders can result in an e ective kick-start of residential mortgage mar- kets, as has b een seen in India. A st able, benign macroeconomic environ- ment is a prerequisite for the expansion of sustainable housing nance, but other conditions are also required. Two other factors that come into play are nancial liberalization and technological innovation. 12 housing finance policy in emerging markets Figure 1.5. Mortgage Rates in Developed Countries Figure 1.6. Mortgage Rates in Emerging Markets housing finance and the economy 13 Financial Liberalization Financial liberalization is the most fundamental factor in housing nance's growth. As noted earlier, throughout the developed world, the 1980s was a period of substantial liberalization of the nancial markets, including (and o en speci cally focused on) housing nance. e nancial architecture of the postwar period was one of nancial control, interest rates ceilings, and limited competition. But this paradigm broke down and has been increas- ingly replaced by a more competitive and integrated world nancial system. In their study of the provision of mortgage nance in ve major developed markets in 1993, Diamond and Lea chronicled the breakdown of special cir- cuits for housing nance and the resultant integration of housing nanceinto the broader nancial markets in ve major developed markets. Technological Change At the same time that the world was innovating in its nancial delivery sys- tems, the innovations in t echnology were driving down the costs of inter- mediation a nd, pa rticularly, mo rtgage in termediation. N o lo nger was i t necessary to have a depository institution to be able to underwrite and mon- itor mortgage loans. It has been documented that some of thesigni cantcost savings have been realized through automated underwriting and servicing. ese changes mean that mortgage lending no longer has to rely simply on the costly collection of small dep osits for repackaging in la rger mortgage loans. Now, small mortgage loans can be repackaged in large and diversi ed mortgage-backed securities (MBSs), w hich can access la rge investors with appetites for non-recourse, long-term investments (such as pension funds) and life insurance companies. In sum, nancial liberalization and technology improvements have had an important e ect on the growth of the demand for housing nance. Fur- thermore, if o ne argues t hat t he underlying nancial-sector institutional development and macroeconomic stability are increasingly being achieved in emerging economies--as suggested by the growth rate of more than 7 percent for developing countries (the highest in more than 30 years) and a median in ation rate of less than 7 percent (less than half that of a decade 14 housing finance policy in emerging markets earlier)--then one can expect a rapid growth rate in the supply of housing nance going forward. Indeed, with housing nance in China a nd India, which together account for more than one-third of the world's population, growing at compound annual rates in excess of 35 percent per year; and in Europe, where it has been growing at more than 8 percent a year, it is clear that the growth of housing nance still has substantial momentum. Concerns and Opportunities Even under co nservative assum ptions, i t is r easonable t o exp ect t hat in emerging economies, housing nance should grow rapidly in t he coming years. What risks and opportunities are associated with such a trend? What steps can be taken so that the bene ts realized by the 20 or so rapidly growing emerging systems can be not only sustained, but also prudently extended to the far larger number of countries where growth remains stagnant? The Effect of Mortgage Finance on Savings Jappeli argues that increased access to housing nance can have a negative e ect on saving and investment. Financial repression in t he form of bor- rowing constraints on young borrowers can force them to borrow less than they would otherwise. is clearly has a nega tive e ect in t erms of inter- temporal ma nagement o f co nsumption, ind ucing sub optimal timin g o f consumption. But it also increases saving, which may be welcome in some markets where there is t oo little saving and investment. Furthermore, an argument can be made that improved housing nance can actually increase rather than decrease savings. For instance, new nancial instruments, such as mortgage securities (safe, but also providing better returns than government bonds), that provide a relatively attractive nancial instrument can stimu- late saving, contributing to the development of a sustainable pension and life insurance industry. housing finance and the economy 15 The Effect of Mortgage Finance on Investment Mortgage nance could also have an e ect on the structure of capital forma- tion, moving it toward housing and away from other investments. e e ects of a change in portfolio composition, however, are di cult to infer. Among other things, the degree to which the shi occurs ultimately depends on the extent to which mortgage markets are integrated with the broader capital markets, as well as, importantly, on factors such as the elasticity of savings with respect to interest rates.7 In a highly developed nancial system such as in the United States, it has been argued that increases in the supply of mort- gage funds have little to no e ect on the amount of housing investment. In other words, in their view, mortgage debt is simply the lowest-cost way for households to issue the fungible debt that is used to nance relatively con- stant investment demands. On the other hand, one study of the welfare costs attributable to the exis- tence of an inadequate mortgage nancing system has been undertaken by Kim (1990) for Seoul, Korea. Using a long-run equilibrium model that com- pares returns to housing and non-housing capital, Kim found that Korea's housing nance system--or lack t hereof--skewed investment away f rom housing su ciently to engender signi cant welfare losses. Point estimates varied with assumptions, but his estima tes of the equivalent variation of losses because of this inadequacy could be 10 percent of household income or more. Mortgage Finance and Growth As has been shown by Levine and Demirguç-Kunt (2003) and others, nan- cial systems promote economic growth by channeling capital to its most pro- ductive use. at is, deeper nancial systems lead to higher levels of growth. As nancial systems grow and become deeper, housing nance emerges as an 7. For example, Van Order (2006) shows that with a positive elasticity of savings with respect to interest rates, tax subsidies for housing may increase, rather than decrease, total savings, as the increase in total savings more than o sets the portfolio shi s toward housing. e point is not that we know the e ects of such policies; rather, it is to suggest how di cult it is to infer such impacts and how closely such results are linked to quite speci c and o en intractable assump- tions about behavior. 16 housing finance policy in emerging markets increasingly important part of the nancial system. In other words, housing nance tends to account for an increasing share of the nancial system as it matures and provides a broader range of nancial services. From this per- spective, the process of maturation of nancial systems appears to lead to the development of housing nance, and this deeper, more extensive nancial system, in turn, contributes to higher rates of growth. While di cult to quantify, as are sources of growth generally, this result has a good deal of intuitive appeal for two reasons: · First, the provision of nance only allows, not mandates, speci c investments. As a result, the growth in the supply of housing nance should la rgely b e s elf-limiting b y t he val ue co nsumers p lace o n housing investments relative to other assets. In urbanizing coun- tries where the development process generates sharp increases in the demands for mobility and relocation, empirical evidence shows that housing investment increases as a share of GDP until middle-income status is achieved. In these countries, it is reasonable to expect that the demand for mortgage credit would therefore also rise. · Second, denying small businesses and households access to the lowest- cost source of funds through liquefying savings they have accumu- lated in housing--by restricting their access to market-rate mortgage nance--seems t o b e a r emarkably ine ective lo cus f or g overn- ment policy. In many ways, it mimes an intellectual vein developed by Hernando de S oto (2002), w ho has em phasized the importance of unlocking wealth through mortgages. He argues that in this way low-income borrowers, who have few prospects for borrowing in the formal nancial sector, can raise money for businesses by pledging their property as collateral. In sum, it is conceivable that the increased ability of households to become indebted can have some undesirable side macr oeconomic e ects. But it is also important to keep in mind t hat the instruments used to o set or dis- courage this sort of behavior have usually had much worsee ects on savings, investment, and economic growth. housing finance and the economy 17 Housing Finance, Business Cycles, and Economic Fragility e experience of the 1990s suggests that increased attention should be given to helping countries avoid some of the precipitous drops in income that were experienced during that period.8 e achievement of higher growth by itself is no longer the unambiguous target of macroeconomic management, as the welfare costs of macroeconomic instability are far higher than was thought to be the case. e e ects that the provision of housing nance can have on contributing to or exacerbating macro volatility is an important dimension of housing nance's broader e ects on the economy. Housing has al ways played a r ole in b usiness cycles, as sug gested long ago by Keynes (1937) in his Great Depression advice to President Roosevelt, and subs equently b y H arberger (1974), w ho la beled t he ho using s ector "the handmaiden of monetary policy."9 is is primarily because it is a very interest-sensitive asset, so that changes in interest rates have big e ects on housing demand and production. ese kinds ofshi s can either help or hurt in terms of stabilizing. ey can hurt because increases in interest rates lower housing production. is might not be such a bad thing.10 If business cycles come from the "real side" (for example, uctuations in demand for capital goods), then housing can be an "automatic stabilizer," falling in expansions and rising in co ntractions. is seems to have been the case recently. For example, in the United States, declining interest rates resulting from a com- bination of central bank policy and lower demand for funds by businesses caused the housing demand to increase, partially o setting output declines in other sectors. On the other hand, if a decline comes from the nancial side, such as a loss o f con dence in the nancial sector and a "liquidity crunch," leading to higher rates and/or less availability of funds, then housing contrac- tions will exacerbate the contraction. is process may be under way in the United States today (mid-2008). 8. e IMF's increased emphasis on nancial-sector assessments for all de veloping countries re ects the increased policy interest in the costs of macro volatility. 9. Keynes' recommendation to Roosevelt was in a n open letter to him in w hich he called f or Roosevelt's focus on housing as a means of stimulating the Depression-constrained economy. 10.We are explicitly not considering the role of housing as a p rovider of jobs. In the long run, there is nothing special about construction as a f orm of employment, and markets tend to clear. Instead, we focus on cyclical elements where housing is important, and on the role of housing in resource allocation. 18 housing finance policy in emerging markets Improving the housing nance system may or may not make much dif- ference in v olatility. In t he United States, removing dep osit-rate ceilin gs probably diminished the e ects of interest rate increases on housing. Nev- ertheless, housing is likely to be cyclical in any system simply because it is so durable. e durability implies that annual housing production is typically on the order of 4 percent of the housing stock. Hence, if there is a 1 percent change in housing demand and adjustment to this lower demand is made in one year, then housing production will fall by 25 percent (from 4 percent to 3 percent of the stock). is change suggests that under any circumstances, housing output will be more volatile than that of other goods. Regular business cycles, however, are not the only cyclical problem. A major part of the relationship between housing and the macro economy has been its negative role in a ecting macro stability through major nan- cial instability (for example, through bubbles in ass et prices a ecting col- lateral value and inducing rapid changes in nancial structure and interest rates). In many emerging economies, housing nance systems remain too underdeveloped to fuel the creation of any real estate bubble. Yet, the real estate sector has been an important part of the nancial fragility seen in Asia and other places in the past few decades. e instability related to real estate lending has b een greater in s ome emerging markets relative to the size o f their economies. In ailand, real estate lending was a ma jor contributing factor in the 1997 "Asian crisis." Quigley (2001) and Mera and Renaud (2004) trace the channels by which housing nance problems helped to propagate the nancial crises. China's central bank has instituted controls on mortgage lending (maximum LTV ratios, restrictions on lending against speculative investment) in order to slow the pace of house-price increase and reduce the likelihood of a destabilizing bursting of any possible bubble. us, precautions are essential, but a case can also be made f or local- currency residential mortgage markets--to the extent that they attract longer- term funds and mitigate the risk of nancial fragility. For instance, bond or secondary markets might be a particularly good way of tapping international capital markets for long-term loans, because the collateral is, with the right legal structure, both good and long-lived. is can be a signi cant contribu- tion to emerging markets. Mortgage-backed securities have been developed in many countries not only to improve the housing nance system, but also to help develop resilient private bond markets for institutional investors, as housing finance and the economy 19 Box 1.1. Real Estate and Financial Crises: Thailand The performance of Thailand's economy was remarkable during the 1965­95 period; however, the economy suffered a major setback with the currency devalu- ation in 1997. Poor credit risk management and excessive lending to the real estate sector played a major role in the financial sector crisis in the late 1990s. The property boom started in the late 1980s, when Thailand was enjoying double-digit growth. With that kind of growth rate, there was indeed a shortage of office and residential space, particularly in Bangkok. The resulting construction spree was only to be expected and, in the beginning, justified by demand, at least until about 1992­93 (Renaud, Zhang, and Koeberle 1998). By 1994, it was becoming obvious that supply was overshooting requirements. By the mid-1990s, the level of oversupply and vacancy rates in Bangkok became among the highest on record. Lenders collaborated closely in fueling the property boom. Bank of Thailand data indicate that the bank's share of real estate lending in their overall portfolio went up from 6.3 percent at the end of 1988 to 14.8 percent at the end of 1996. Over the same period, the share of real estate in the portfolios of the finance companies went up from 9.1 percent to 24.3 percent (cited in Renaud, Zhang, and Koeberle 1998). These figures actually underestimate the role of property in the Thai financial system. The majority of Thai bank loans were based on collateral with property as the asset of choice. With rapidly rising prices, even to non-property companies, the property placed as collateral could be used to raise more loans, whose pro- ceeds could in turn be used to purchase yet more property, fueling asset price rises even further. Rising interest rates associated with attempts to defend the baht, combined with restrictions on lending, sent the property markets into a downward spiral. When the inevitable currency devaluation came, unhedged foreign currency borrowers went bankrupt, further destabilizing the system. seen in Malaysia, for example. One of the things that has characterized nan- cial breakdowns such as the one in Asia in the late 1990s has been reliance on short-term international borrowing, which can be cut o rapidly if there is a loss o f con dence in the country in question. Foreign investors want a 20 housing finance policy in emerging markets chance to get out fast (which is not possible if they all try to do so at once). Because mortgages are potentially good collateral--at least where foreclosure can be enforced--and can be expected to be a way of getting more long-term foreign money, they can decrease the dependence on hot money. Because of its multiple interfaces with the broader economy and nancial sector, housing nance (more broadly, real estate nance) plays a signi cant lever role, either positively or negatively. Under some circumstances aggra- vated by the adoption of an improper model, housing nance can be a major contributor to macroeconomic instability in both developed and emerging markets. For example, both the United Kingdom and United States mortgage markets were substantially liberalized during the 1980s and su ered signi - cant stress on their housing nance systems, housing markets, and broader economies by the end of the decade. In the former case, an exogenous event turned a b oom into a b ust--in the United Kingdom, short-term interest rates increased from 7 percent to 15 percent in conjunction with the deci- sion to bring the pound into the European exchange-rate mechanism. e shock resulted in a record level of arrears and repossessions, a sharp decline in lending, and a decline in nominal house prices. In the United States, the long-delayed resolution of the savings and loan (S&L) crisis coincided with an economic downturn--the real damage had been done during the preceding decade because of lax oversight and aggressive lending by bankrupt thri s. Recent concerns relate to the impact of any potential burst of the larger and riskier subprime markets. Mortgage Finance and the Distribution of Risk Another core issue is t he nature of the mortgage instrument promoted by the system and the way the political system deals with its implications. Miles (2004) discusses the U.K. system, which is bank-based with almost exclusive use of variable rate mortgages linked to short-term deposit rates. is system places a lot of interest-rate risk on borrowers who are not always able to hedge it. In the long run, this situation may lower the housing demand relative to what it could be with a wider ra nge of instrument choice, or expose house- holds to the sorts of macroeconomic risks that could wipe out their housing equity. In many emerging economies, long-term xed-ratemortgages(FRMs) housing finance and the economy 21 Box 1.2. Mexican Past Crises and the Role of Housing Finance In Mexico, there have been several episodes of currency devaluation leading to sharp increases in inflation and interest rates. In the early 1980s, Mexican banks were required to make fixed-rate loans at administered rates. A sharp spike in inflation and interest rates because of the 1982 devaluation left the banking system undercapitalized and led to nationalization. In 1995, the cycle repeated. There was a sharp spike in inflation and interest rates because of devaluation leading to cessation of bank lending, eventual sale of most banks to foreign competitors, and a burden to the economy in the form of bailout subsidies to banks and consumers. The downturn in the economy precipitated a banking crisis in which the share of nonperforming assets grew to over 40 percent. Individual residential mortgages comprised a large portion of the delinquent portfolio, and were a major focus of government intervention. Banks had 30 percent of portfolios in housing loans, mostly price-level adjusted. In 1995, when the government began aiding banks to restructure loans, half of the total funds available--an amount over $7 billion--were directed to restructuring mortgage credits. Government aid to the mortgage sector grew to nearly $18 billion by the end of 1996. Since this experience, the Mexican housing finance system has been restructured. It has been expanding rapidly and soundly thanks to better macro conditions, private market competition, new funding and risk management tools, and more efficient housing-policy authorities. remain a r elative luxury good, and oating or indexed loans still prevail, exposing households to interest-rate risk and banks to credit risk. Another perspective was discussed by Laidler (1974), who argues that in a system where everyone's housing costs are tied to short-term rates it is more di cult to control in ation. is is because controlling in ation will require, from time to time, increases in interest rates that can be politically di cult to realize if they raise mortgage rates and the cost of housing for most hom- eowners. Hence, a bene t of a more bond- or capital-market-oriented system (whether done via banks or secondary-market facilities) is that it will allow borrowers to take less interest-rate risk, placing it in capital markets where it is e asier to handle, and making the political costs o f e ective monetary 22 housing finance policy in emerging markets policy less costly and more likely to be realized.11 e scal costs of an under- developed or poorly designed housing nance system can be signi cant, as evidenced by the bailout of insolvent housing lenders and many borrowers in Argentina, Brazil, and Mexico. House Prices, Housing Finance, and Economic Activity ere has recently been a great deal of interest in the evolution of house prices and their economic e ects. Most OECD countries have experienced a sub- stantial run-up in real house prices in recent years. An important question is whether these house-price booms will inevitably be followed by a house- price bust with reverse e ects on consumption and output. An International Monetary Fund (IMF) analysis of asset-price booms and busts in the postwar period suggests a signi cant likelihood of a reversal.12 eir analysis found that housing-price busts on average occurred about once every 20 years, lasted about four years, and involved price declines of about 30 percent. While only about one-quarter of equity-price booms were followed by busts, about 40 percent of housing-price booms ended in busts. Both types of busts were highly synchronized across countries. Both equity- and housing-price busts were associated with output losses (relative to the simple extrapolation of the pre-bust growth rate), re ecting declines in t he growth rates of all t he main components of private nal domestic demand: consumption, investment in machinery and equipment, and investment in construction. e output loss associated with the typical housing-price bust (about 8 percent of GDP) was twice as large as that asso- ciated with a typ ical equity-price bust (about 4 p ercent of GDP). Output started to recover about nine quarters a er the start of either an equity- or a housing-price bust. Bank-based nancial systems tended to su er larger output losses than capital market-based nancial systems during housing-price busts, w hile capital market-based systems tended tosu er larger output losses than bank- 11. e recent experience with the U.S. subprime market suggests that the dispersal of risk in the capital markets led to imprudent lending, leaving many borrowers with excessive interest- rate risk. 12.IMF 2004, Chapter 2. housing finance and the economy 23 Table 1.1. Real Estate and Banking Crises--Selected Cases Financial crisis/stress Consequences Contributory factors 1973­75 U.K. secondary Rash of failures and weakness among Preceding planning restrictions on banks. secondary banks. Bailout by group of supply. Extreme credit boom. Financial Speculative development clearing banks at a total cost of GBP intermediaries. boom, largely in London 1.2 billion, equivalent to half their offices. shareholder's equity, or 1.5% of GDP. 1984­91 U.S. savings and 1,400 savings and loans. 1,300 banks Inexperienced lenders through loans. failed. Cleanup costs estimated at US$180 deregulation of savings and loans. Moral Speculative development billion, 3.2% of GDP. hazard through deposit insurance. boom in Southwest. 1987­93 Norway. State took control of three largest banks Combined oil boom and problem real Bank crisis. with 85% of banking system assets. estate loans. Recapitalization costs estimated at 5­8% of GDP. 1991 Swedish banks. Two of six major banks, 22% of banking Deregulation of domestic and Lending boom for system assets, insolvent. Three further international investment. Credit boom. domestic and overseas banks in difficulty. Nonperforming Financial intermediaries. investment/development. real estate in special vehicles. State recapitalization costs estimated at 4­6% of GDP. 1991­94 Finland savings State took control of three banks As in Sweden. bank crises. accounting for 31% of bank deposits. Nonperforming real estate in special vehicles. Recapitalization costs estimated at 11­15% of GDP. 1990s­ongoing Japan. Nonperforming loans estimated at up Long preceding land-price boom. Special Systemic banking crisis. to 25% of GDP. Bank nationalizations, real estate financial intermediaries closures, mergers. Cleanup costs by late (Jusen). Moral hazard through state 1990s around 12% of GDP. Liquidation of support for large banks. intermediaries (Jusen) at a cost of US$6.3 billion. Mid-1990s France. Stress bordering on insolvency in several Unreliable valuations. Bank exposure Bank crisis. major banks. Range of government- to real estate through shareholdings support measures; final costs estimated in development and construction at the equivalent of 1% of GDP. subsidiaries. 1997­2000 Asian crisis. Malaysia: two banks insolvent, Long preceding land-price booms. Malaysia, Thailand, nonperforming loans 25­35% of banking Extreme credit booms and deregulation Korea... Systemic banking system assets. of international capital flows. Financial crises linking asset price intermediaries (especially Thailand). and real estate bubbles Thailand: State intervention in 70 finance with foreign capital flows. companies and six banks. Nonperforming loans 46% of total loans. Net losses equivalent to 42% of GDP. Korea: Two banks nationalized, five closed, seven under special supervision. Nonperforming loans 30­40% of total. Fiscal costs estimated at 34% of GDP. Sources: Barth, Caprio and Levine 2001; author's calculations. 24 housing finance policy in emerging markets based systems during equity-price busts. is is co nsistent with the high exposure of banks to real estate lending, and the importance of equities in household assets in capital market-based systems. As shown in table 1.1, crises have resulted in major reductions in GDP and damage to banking systems. While house-price volatility is a n important factor in macr oeconomic instability, the experience of the last 20 y ears has not been lost on regula- tors or innovators. Information systems, monitoring capabilities, and under- standing are much better today in most co untries. In addition, a f orward market in housing prices is being established, following the work of Robert Shiller, which would, if it develops, allow homeowners to hedge the risks of house-price declines. e volatility of house prices and the potential for a boom-bust is higher if the housing supply is severely constrained by land access and urban regulation problems, which drive housing prices up to una ordable levels (see Glaeser and Gyourko 2003 for the United States and Malpezzi and Mayo 1997 for a number of developing countries). Creating a more elastic supply of housing can reduce the probability of adverse real estate cycles and sharp run-ups in house prices. In addition, the potential for destabilization is hig her in less mature nancial systems (for example, Russia, Ukraine). Under tight supply conditions, the expansion of housing nance--o en through middle- a nd higher-income groups--may even worsen the overall housing a ordability problem instead of providing the expected remedies. Lessons for Emerging Markets e rst and perhaps the clearest lesson is that the performance of the macro economy, the legal system, and housing market regulations are inextricably linked to the development of housing nance. A st able, growing economy will encourage the growth of the housing nance system through lowerin a- tion, lower interest rates, and lower systemic risk. In this evolutionary per- spective, beyond a cer tain level of per capita income, housing nance will emerge with household demand for it; that is, as long as the macro, legal, and housing-market regulation environments are conducive to its emergence. In such cases, a vir tuous circle can emerge as gr owth if t he nancial system housing finance and the economy 25 promotes overall economic growth, and this higher growth, in t urn, will encourage both further nancial-sector and housing- nance development. An important corollary of this rst lesson is t hat housing nance does not work in un stable, volatile economies. Instability inevitability leads to less credit availability, less f ormal housing built, a ordability problems for housing consumers, and greater risk for all concerned. In a word, macroeco- nomic instability creates a negative circle where less housing nance leads to less residential investment and slower growth in t he economy. Attempting to break the vicious circle by promoting housing nance will almost cer - tainly fail. Macroeconomic stability and a strong legal environment have to be present for housing nance to develop. Macroeconomic stability and legal clarity alone are not enough though. Indeed, the evidence of the past decade suggests that housing nance policy is of fundamental importance in determining the resilience and vibrancy of the sector. A er years of stagnation, across many countries, a thriving and buoyant su pply o f ho using nance has emer ged wi th r emarkable sp eed. is sudden de velopment is mo re than just the unintended consequence of im provements in t he macr oeconomic a nd legal en vironments. e world nancial system, as Calomaris described it, is entering a new, liberal- ized nancial paradigm at a time w hen liquid banks actively develop retail activities. In this regime, policy will no lo nger systematically deny house- holds access t o credit through direct or indirect restrictions. In the places where these restrictions are reduced, housing nance systems can and have emerged very rapidly. us, the second lesson is that in the many countries with nascent supplies of housing nance, the development of coherent, sustained e orts to develop a more transparent, competitive supply of housing nance, be it bank-based or bond-based, is likely to have high economic and social returns. A strong housing nance system cannot only contribute to a b roader, more resil- ient nancial sector, it can also promote housing development, particularly of informal settlements, and improve labor mobility and the construction industry. In so doing, it can contribute to growth and stability in the economy. e growth and increased availability of mortgage credit can also be in uen- tial in creating better-planned urban environments with lower congestion, improved services, and less crowding. ese positive e ects of system devel- opment, however, will only come about with an appropriate policy frame- 26 housing finance policy in emerging markets work. Indeed, in the wrong policy environment, unfettered private-housing nance development can be a causal factor in macro instability. e use of the wrong instrument, excessively risky lending, and unsustainable, badly targeted subsidies can lead to the collapse of housing nance institutions and markets, with large costs b oth to government (bailouts) and the economy (lost productivity, lower growth). Hence, the third lesson is the need for a strong but nimble and delimited public role in sector development. Without a clear and focused public role, it is all too easy for nancial liberalization and development of the housing nance system to be incomplete, with consequent adverse e ects on the housing market and economy. Of course, greater competition leads to lower interest rate spreads, greater product variety, and more a ordability. Further, the increased ability to borrow against housing wealth can increase consump- tion and investment, producing economic growth. On the other hand if the newly supplied credit carries implicit interest rate subsidies, or is nanced through the taxation system together with the use of regulatory directives, as continues to be the case in many countries, it can lead to very costly nancial sector problems. Similarly, the international experience has demo nstrated that caution is warranted whenever there is rapid growth in lending of any sort. For mortgage lending, a concern with rapid growth may be even more pronounced, as mortgage borrowing typically involves a moderate-income family nancing its largest purchase ever in a transaction with a nancially sophisticated lender. Once again, experience has shown that in such environ- ments consumer information and protection are necessary. Hence, while the private sector must be the chief risk bearer in any sustainable system, a strong and transparent public role is essential. e nal lesson relates to the importance of making sure that expanded access to nance does not simply nance sharp asset price increases. Recent years have witnessed extremely large and, as o f yet, not well-understood house price increases in many countries (as seen in some Russian or Ukrai- nian major cities, for example). While talk of housing bubbles may be pre- mature, it is certainly a valid concern when house prices increase as rapidly as they have in s o many major cities both in de veloped and developing countries. While the full dimensions of this process are not yet understood, one important aspect of the phenomenon is c lear: the important role that housing market conditions play in whether increases in demand are accom- housing finance and the economy 27 modated by increases in ho using supply or housing prices. On t his score, the evidence is unambiguous. Without a responsive housing delivery mecha- nism, including both new housing and the existing stock, improving access to housing nance will largely fuel price increases. us, the lesson is that attempts to improve access to housing nance must be deeply cognizant of underlying housing market conditions and policies. Chapter 2 Structure and Evolution of Housing Finance Systems Michael Lea A characteristic feature of a housing investment is its relative size and long investment horizon, requiring large amounts of long-term nance. e aim of a housing nance system is to provide these funds to the producers and pur- chasers of housing, both rental and owner-occupied.1 is simple description has spawned a broad array of institutional arrangements, ranging from con- tractual savings schemes; to depository institutions specializing in mortgage nance; to the issuance, sale, and trading of mortgage bonds and securities. All of these arrangements have been created with the same purpose in mind, to mobilize and channel funds from savers to borrowers in an e ective way. In an economy without a well-developed formal nancial system, housing is either self- nanced (that is, by equity accrued through many years of prior savings or through incremental construction; in most countries the majority of r eal est ate tra nsactions r emain nanced b y cash) o r directly nanced between individuals (such arrangements are o en referred to as inf ormal nance). Direct nance can b e provided by f riends, relatives, small s av- 1. For comparative reviews of housing nance development, see Boleat 1985 a nd Diamond and Lea 1992. is taxonomy was originally developed by Boleat and expanded in Lea and Bernstein 2001. 29 30 housing finance policy in emerging markets ings and lending clubs (for example, consórcios in Brazil), or housing coop- eratives or landlords (for example, the chonsei system in Korea). Although o en the only alternative for households seeking to better their housing cir- cumstances, informal arrangements are o en ine cient and costly because the requirements of savers and borrowers are di erent, information is not equally shared, it isdi cult to achieve scale, and lending is hampered by lim- ited funding and risk-management capacities. Dependence on direct nance results in cities that are built as they are nanced, with a considerable and visible proportion of self-construction and slum proliferation. An alternative to direct nance are installment s ales contracts, w here developers nance purchase through deferred payments. istypeof nance is seen in most emerging economies (for example, Egypt, Brazil, and Turkey). While more scalable than direct nance, it is also quiteine cient, as it ties up developer capital, making it more di cult to start new projects. Developers may also nance projects through presales, with or without mortgages. is can be quite problematic for buyers as they may bear both completion and quality of construction risk. istypeof nance has been plagued with prob- lems in some countries (China, Turkey, Russia, and Ukraine). A sign of nancial-sector development is the funding of housing by formal nancial institutions. ese institutions can be private-sector entities, which can be shareholder-owned or mutual organizations, or government-sponsored or -owned institutions (for example, state housing banks). Historically, a char- acteristic of many housing nance systems was the existence of a special circuit in which particular types of lenders enjoyed preferential nancing,o en oper- ating apart from the broader nancial markets (Diamond and Lea 1993). As economies develop and nancial systems are liberalized, provision of housing nance o en moves away from extensive reliance on special circuits toward integration of housing nance into the broader nancial markets. Mortgage Lending Models Building Societies/Savings & Loans In many countries, the traditional and still predominant mechanism for formal nancial-sector nance of housing is the retail depository institution. structure and evolution of housing finance systems 31 Figure 2.1. Depository and Direct Lending In this system, an institution gathers savings from households and enterprises and makes loans to homebuyers ( gure 2.1). By taking in savings from non- homebuyers, depository institutions can access a much larger pool of funds than through dedicated savings, including a stable mass of core deposits at a relatively cheap funding cost. ere are several types of deposit-taking insti- tutions, including commercial banks that o er a complete range of banking services, savings banks that deal largely with the household sector, and spe- cialist housing- nance institutions (building societies or savings and loan associations) that focus their lending primarily on housing. A key feature of a depository system is that the institution originates, services, and funds the loan. Funding is primarily through retail deposits, but these institutions may also issue bonds and mortgage securities. Another important feature is the short-term, variable rate nature of the funding, compared to the longer-term housing loans. Specialist-deposit-funded institutions have traditionally dominated the provision of housing nance in Anglo-Saxon countries (for example, Aus- tralia, Canada, South Africa, and United States) as well as in Commonwealth countries. e initial model for housing nance was the terminating building societies founded in England in 1775, later introduced in the United States in the 19th century (Mason 2004). e early building societies were formed to mobilize savings of lower- and middle-income households for the sole purpose of home construction. Members would agree to contribute regu- larly to the society, build houses together, and allocate houses by lottery until each member was housed. Once thede ned group of members was provided housing and had r epaid the loans, surplus assets, if a ny, would be distrib- 32 housing finance policy in emerging markets uted among members and the society would be terminated. Credit risk was lowered by the shared information about the groups' members. Variants can still be found in many lower-income countries particularly when commercial banks are absent from the market. During the mid-19th century, societies developed into permanent institu- tions, attracting funds not just from borrowers but also from other savers, and lending for purchase of existing houses as well as for building new ones. is development loosened the bond that had p reviously existed between savers and borrowers. e permanent form had the advantage, however, of widening the investor base and o ering a stable and relatively risk-free form of saving, greatly increasing the supply of funds for housing. Increased scale facilitated the hiring of permanent management. Building societies are mutual institutions owned by their investors and borrowers. Savers purchased "shares" in the society that allowed them to par- ticipate in the surplus, if any, that existed a er all of the group had received and repaid their loans. In this sense, members were risk takers, as their return depended on the performance of the institution and was not guaranteed. In later versions, savers received periodic dividends. As the permanent society developed, shares became interest-bearing deposits that could be withdrawn at par upon reasonable notice. rough most of the 20th century, the building society/savings and loan (S&L) mo del dominated housing nance in t he English-speaking world. ese institutions were the cornerstone of a special circuit for housing nance supported by regulation (for example, in t he United Kingdom, banks had high reserve requirements on housing loans as a f orm of credit control; in the United States, S&Ls had funding and tax advantages vis-à-vis commercial banks). Starting in the 1980s, this model began to lose in uence and market share to commercial banks. e main drivers of change were deregulation (removing preferences and constraints, allowing broader asset and liability powers), demutualization, and institution failure (United States).2 e failure of many U.S. S&Ls was a result of their inability to manage the market risks of providing long-term xed-rate loans vs. shorter-term variable rate liabili- ties. Regulatory failure, initially by requiring xed-rate lending and later 2. e reasons for demutualization included diversi cation of assets and funding sources, the desire to raise new equity capital, and the possibility of large payouts for members and man- agement. structure and evolution of housing finance systems 33 through regulatory and capital forbearance, contributed to the collapse. e remaining institutions have evolved into broader-based depository institu- tions but retained their focus on housing nance(o ering variable rate mort- gages). e mutual, specialized housing- nance model continues to exist in the United Kingdom, where the remaining societies compete on bene ts pro- vided to members in the form of lower mortgage rates and higher savings rates in lieu of dividends paid to shareholders. Today, however, building soci- eties account for less than 25 percent of the U.K. mortgage market and S&Ls a smaller share of the U.S. market. In many emerging economies, where variants of this model were intro- duced (for example, S&Ls in L atin America; building societies in N igeria, Kenya, or Malaysia), these deposit-based specialized institutions either grad- ually lost gr ound against other models (for example, banks and mortgage companies in Malaysia) or were wiped out by losses related to excessive risks during phases of macro instability (hyperin ation, asset-liability mismatches, deposit r uns, and s o forth, particularly in L atin Amer ica). Nevertheless, there are advantages to the building society model for lower-income coun- tries. e group nature and informational advantages of mutual organiza- tions provide an advantage over other lenders in credit-risk management, an attribute shared with other mutual organizations such as credit cooperatives and credit unions (for example, Paraguay, Mali) and housing micro-lenders (for example, Peru or Bolivia, as discussed in a later chapter). While a mar- ginal source of funding in developed markets today, mutual housing- nance specialists may still have a role to play in lower-income emerging markets with weak or government-run commercial banking systems. e danger (as evident from developed markets) is providing government support that cre- ates a special circuit that delays the inevitable entry of commercial banks or non-depository lenders. Commercial Banks Commercial banks historically did not have a major involvement in housing nance. eir tradi tional p urposes o f nancing b usiness a nd p roviding means of payment lead them to a commercial, not a consumer, orientation. Prior to nancial liberalization, this tendency was o en supported by regula- 34 housing finance policy in emerging markets tion that constrained banks from o ering mortgage nance. Banks have con- cerns about the risks of providing long-term loans as well, if much of their funding comes from short-term deposits that can be withdrawn on demand. In many countries, regulators concerned about the volatility of real estate markets have also further constrained bank presence, although confusion has o en existed between riskier construction loans to developers and safer individual mortgage loans. Financial liberalization in de veloped countries has c hanged the role of banks in the mortgage market.3 Central banks provide liquidity and deposit insurance, discouraging runs and reducing the concern over liquidity.4 In stable economies, a proportion of core deposits can be safely used for long- term nance. Banks are turning to retail clients across the world in pa rt because of a loss of their business lending to the capital markets. Long-term mortgage loans are attractive to banks that hope to cross-sell other services and develop long-term customer relationships. In most countries, banks have substantial brand, distribution, and funding advantages over other lenders, and have emerged as market leaders. Banks can be portfolio lenders, o ering ARMs to reduce interest-rate risk; providers of short-term construction and warehousing loans; and sellers of loans in the secondary market. Despite the growing attractiveness of mortgage lending for banks, there are m any lo wer-income co untries wh ere ba nks s till r efuse t o en ter th e market. eir ambivalence may re ect deep-seated concerns about the ability to manage risk, particularly credit risk in markets with weak legal founda- tions for collateralized lending, the relatively high cost o f making smaller loans, and potential political risk over raising rates and enforcing liens. While improving the infrastructure and environment for mortgage lending is the long-run solution for obtaining bank entry, in t he short to medium term, 3. Savings banks are major mortgage lenders in several European countries (France, Germany, Spain). ey are o en owned by state or municipal governments and can bene t from gov- ernment backing. C ooperative banks have signi cant market share in G ermany and t he Netherlands. ey operate as mutual organizations. Such institutions are not housing- nance specialists. 4. e ability of central banks to provide su cient liquidity to keep banks lending is being tested in the credit crunch that started in 2007. Banks' concern over the quality of their portfolios has severely impacted the interbank and swap markets. e reluctance on the part of banks to lend to each other has been re ected in lower volumes and higher rates on interbank loans (for example, London Interbank O ered Rate). Central banks in Canada, Europe, and the United States have injected liquidity into the system and set up a term auction facility that will make loans available to banks at a non-penalty rate backed by a broader range of collateral than open market operations. structure and evolution of housing finance systems 35 most lending may be done by specialized lenders. If well-run in a st able environment, the specialists may show that mortgage lending can be a safe and pro table business. is has been the case in Mexico, where successful Sociedad Financiera de Objeto Limitado (SOFOL) lending has led the banks to reenter the market. Contract Saving Schemes Contract savings institutions can be viewed as specialized depository institu- tion circuits. Contract savings are major components of the housing nance systems of Austria, France, and G ermany. ey have b een de veloped in Central and Eastern Europe (Slovakia, Czech Republic, and Hungary) as well as in a f ew French-speaking African countries (for example, Cameroon). ey generate funds through loan-linked savings contracts, generally at a below-market xed rate of interest. ere are two variants to the system, the so-called closed system in which specialized institutions make loans funded by the contractual savings attracted from potential home buyers (for example, the Bausparkassen in A ustria and Germany), and open systems in w hich banks o er the loans funded by the contractual savings held wi thin their overall deposit base (for example, l'Epargne Logement in France). Contract savings are generally supported by government through savings bonuses and favorable tax treatment.5 In France and Germany, the contract savings system provides supplementary credit (that is, second mortgages), while in Austria it provides primary mortgages. In the Czech Republic and Hungary, the system has generated considerable savings aided bysigni cant savings subsidies, but produced comparatively few and small housing loans (mostly for renovation purposes). Unsubsidized contract savings programs have been introduced in India (unsuccessfully) and more recently in China, with limited success.6 is model, its impacts, and limits are discussed in chapter 9. 5. Recently, France has reduced its support of the epargne logement system and Germany has eliminated the savings bonus. 6. A n umber o f ci ties in China ha ve ho using p rovident f unds (HPFs), p rimarily f or st ate employees. While they have accumulated signi cant funds, their housing lending perfor- mance has b een modest and a number of funds have been plagued with fraud. HPF loa ns account for approximately 20 percent of total Chinese housing nance lending. 36 housing finance policy in emerging markets Specialist Mortgage Banks An alternative to depository institution lenders are mortgage banks ( gure 2.2). In such systems, specialized institutions (mortgage banks) originate and service portfolios of mortgage loans that are funded by securities they issue. e securities (mortgage, or covered, bonds) are general obligations of the mortgage bank and are typically purchased by institutions with long-term sources of funds (for example, pension funds and insurance companies). e mortgage bank system dates back to the late 1700s and has been extensively used in continental Europe (particularly in Germany and Scandinavia) (EMF 2001). Mortgage banks o er both residential and commercial mortgages. A major feature of mortgage banking systems is the predominance of long-term, xed-rate mortgages that are match-funded with corporate debt. e bonds are considered very high quality as a r esult of conservative underwriting, strong regulation, priority rights of investors in the event of bankruptcy, and transparent operations (mortgage, or covered, bonds are described in more detail in chapter 12). Mortgage banks are transparent, e cient producers of mortgage assets; however, as with other specialist systems in developed countries, mortgage banks are in decline. eir reach is limited by their specialization, as their funding source constrains their product selection (that is, the need to pro- duce standardized assets in high volume to achieve liquidity and low xed Figure 2.2. Mortgage Bank System structure and evolution of housing finance systems 37 cost of funding) and their inability to provide other types of nancial ser- vices (although they do function as brokers of other nancial services). e e cient funding mechanism of covered bonds has been extended to com- mercial banks in most countries (Chile, both Western and Eastern Europe, and the United States). Also, many mortgage banks have been purchased by commercial banks. In Germany and, more recently, Denmark, mortgage banks have lost their monopoly on covered bond issuance. us, they are likely to be folded into the general operations of their commercial bank par- ents over time. Combining Different Systems Figure 2.3 shows the market shares of di erent lenders in major developed markets. Commercial and savings banks have more than a 70 percent market share in all countries except Germany. Non-depositories (mortgage banks or Figure 2.3: Mortgage Lenders by Type 38 housing finance policy in emerging markets Figure 2.4. Emerging Market Mortgage Funding mortgage companies) have signi cant market share in Australia, Germany and the United Kingdom.7 Figure 2.4 shows the market shares ofdi erent types of lenders in a number of major emerging markets. In most countries, commercial banks and sav- ings institutions dominate the provision of housing nance. Two notable exceptions are Brazil and Mexico, which have large housing provident fund (HPF) special circuits. ese circuits are described in a later chapter. China and Korea also have sizeable special circuits. Note that gure 2.4 refers to funding share rather than lending share. 7. Note that the United States does not keep gures on lending by institution type. Most of the top 25 lenders that had a 87 percent market share in 2006 were commercial banks but all major lenders in the United States source mortgages through multiple channels including loans pur- chased from correspondents. e largest mortgage companies have acquired bank charters to add retail deposits to their nancing options. structure and evolution of housing finance systems 39 Secondary Mortgage Markets Another approach that has ga ined popularity in de veloped and emerging markets is a s econdary mortgage market ( gure 2.5). A s econdary market involves the sale of mortgage loans or mortgage securities backed by speci c pools of mortgages. As such, it involves the transfer of the risks and owner- ship of mortgage loans to a third party. e loans are originated by a variety of primary lenders, including banks and specialized mortgage companies. Although portfolio lenders occasionally securitize pools of seasoned loans, a hallmark of secondary market-based systems is the widespread securitiza- tion of newly originated loans. ey may be sold to specialized institutions called conduits or through special purpose vehicles (SPVs). es e entities raise funds through issuance of securities backed (or collateralized) by the loans. e majority of residential mortgage loans in t he United States are funded through the secondary market. Mortgage security issuance, while on Figure 2.5. Housing Finance with a Secondary Mortgage Market 40 housing finance policy in emerging markets the rise, represents a small f raction of funding for emerging markets (for more detail, see the mortgage securities chapter). Mortgage or housing nance companies are specialized non-depository institutions that obtain funds either through sale of loans or special circuit funding. In the United States, mortgage companies developed with the sec- ondary market. ey pioneered the unbundling of mortgage functions (below) as specialists in origination and servicing. During the 1980s and 1990s, inde- pendent mortgage companies were the largest lender class in the United States. More recently, many U.S. mortgage companies have been absorbed by the com- mercial banking system. Specialized mortgage companies were an important component of the recent subprime lending boom in the United States, but a number failed in the collapse of the market in late 2006 and2007. e existence of secondary markets facilitates the easy entry (and exit) of such lenders.8 Introducing New Lending Models: Mexico and India In Mexico, the Sociedades Financieras de Objecto Limitado (SOFOLs) were created to provide mortgage nancea er the collapse and withdrawal of com- mercial banks. ey focus on the low- to moderate-income sector and initially obtained their funds from the Central Bank and World Bank. e SOFOLs showed that lending to low- to moderate-income households can be pro t- able with manageable credit risk. In recent years, the SOFOLs have issued mortgage securities and moved more upmarket. As of 2006, a majority of their funds were coming from the capital markets. At the same time, the commer- cial banks have reentered the market and have purchased several SOFOLs. Until recently, the Housing Finance Companies (HFCs) were the major providers of housing nance in I ndia. e Housing Development Finance Corporation (HDFC), a p rivate-public partnership, was t he rst special- ized housing lender in India. It initially received funding from its investors 8. A major cause of failure was t he inability to obtain short-term funding for their inventory (loans held for sale) and loans subject to repurchase. Mortgage companies obtained such funds through warehouse lines of credit with commercial banks and through issuance of commer- cial paper. e commercial paper market dried up in fall 2007, a nd banks refused to extend or roll over the warehouse lines because of concerns about the quality of the loans pledged as collateral. structure and evolution of housing finance systems 41 Box 2.1. SOFOLs--Mexican Mortgage Companies The SOFOLs (Sociedad Financiera de Objecto Limitado) were born in 1993 as a result of the North American Free Trade Agreement, with a limited scope. They were created just before Mexico entered the worst economic crisis in its history, which devastated the banking industry, resulting in their withdrawal from the mortgage market. Along with two housing pension programs described later, the SOFOLs have been the major mortgage lenders in Mexico until recently. In 2006, they provided over $5 billion in mortgage funding, representing 24% of the market. In the previous years, they had a much higher market share, but it was reduced by the sale of the largest SOFOL, Hipotecaria Nacional (National Mortgage), to the largest bank, BBVA Bancomer, in 2005). SOFOLs are spe- cialized financial institutions that grant mortgage (both construction and per- manent loans), consumer, automotive, agricultural, and other kind of loans (that is, working capital). For the past few years, they have successfully competed with commercial banks that have returned to the market. They serve the middle and lower market with more than 50 percent of clients with incomes below eight minimum wages. They specialize in the origination and servicing of loans and have low default rates (less than 3.5 percent). Initially funded through a state- owned liquidity facility (passing on refinancing loans from the public sector and the World Bank), 70 percent of funds now come from the financial markets, including 38 percent from mortgage-backed security issuances in the bond markets (domestic and international). and through the issuance of bonds. Subsequently, HDFC and other HFCs were funded by the National Housing Bank, which was created as a regulator and liquidity facility for the sector. HDFC showed that housing nance is pro table even in a ma rket where foreclosure and repossession are nearly impossible. e HFCs t hrived during the time t hat state banks were not allowed to provide housing nance. Financial sector liberalization has led to strong entry by banks, which now have a dominant market share (HDFC has formed its own bank). HFC market share has fallen from 61 percent in 2001­2 to 34 percent in 2004­5. Inevitably, all but the largest HFCs are likely to be absorbed by banks. 42 housing finance policy in emerging markets Box 2.2. HDFC--Creating a Market The Housing Development Finance Corporation (HDFC) was incorporated in 1977 with the primary objective of promoting home ownership by providing long-term finance to households for their housing needs in India. At that time, there was very little housing finance provided in the country as the state-owned banking sector was prohibited from lending and only government lending pro- grams existed. HDFC was promoted as a private-sector institution with an initial share capital of Rs. 100 million. HDFC was primarily funded wholesale in its first decade, with loans from international donors. HDFC launched a retail deposit program in 1991 and created a bank subsidiary in 1995. HDFC was declared India's best-managed company by Asia Money in 1995. It has promoted private- sector housing-finance companies in Bangladesh (Delta Brac) and Sri Lanka. HDFC was a pioneer in instruments (first ARM in 1999), securitization (2000), Internet loan approval (2001), and business process outsourcing (2001) in India and is an acknowledged leader in corporate governance and financial institution efficiency. As of 2005, HDFC had about $3.1 billion in mortgage loans out- standing, representing a 28 percent market share. Unbundling of Mortgage Value Chain A major emerging characteristic of mortgage markets is f unctional sepa- ration (or unbundling) in w hich specialists perform the various functions underlying a mortgage loan (Jacobides 2001). As shown in gure 2.6, in t he bundled model of mortgage lending a nancial institution performs the major functions of origination, servicing, funding, and portfolio risk management. ese intermediaries may utilize the services of third-party vendors, such as mo rtgage insurers, appraisers, and credit agencies. A single rm, however, accomplishes the primary func- tions. e portfolio lender originates a mortgage to a home buyer, services it, and performs the pipeline risk management and portfolio management functions, including funding. Portfolio lenders may be specialized institu- tions such as savings and loans, building societies, or European-style mort- gage banks, or general-purpose depository institutions (commercial banks, savings banks). structure and evolution of housing finance systems 43 Figure 2.6. The Bundled Home Mortgage Delivery Figure 2.7. Unbundled Mortgage Delivery Figure 2.7 shows the unbundled mortgage delivery system. In this system, the functions of origination, servicing, risk management, and funding are unbundled and provided by di erent specialized entities. For example, mortgage origination is no longer con ned to retail branches of nancial institutions, although they remain important distribution chan- 44 housing finance policy in emerging markets Figure 2.8. Mortgage Distribution Channels nels. Mortgage intermediaries (introducers, brokers) are increasingly impor- tant in de veloped markets ( gure 2.8). ese entities may be specialists in mortgage o rigination o r o riginate mortgages in co njunction wi th o ther activities such as real estate brokerage, providing nancial advisory services, or building homes. Mortgage brokers are becoming a more important distri- bution channel in the new EU member countries (more than 50 percent of new originations in the Czech Republic and Poland) and recently in India. ey remain underdeveloped in most emerging economies, but should take more importance as mo rtgage markets grow in size a nd competitiveness. Correspondent lenders close loans in t heir own name (but under written to the speci cations of the ultimate investor) and immediately sell them to larger, wholesale lenders that can get better execution upon sale in the sec- ondary market. e Internet is r ising in im portance in mo rtgage lending, but primarily as an adjunct to existing distribution channels. "Pure" Internet origination has not yet proven itself as a stand-alone channel, as it depends on other channels for ful llment. structure and evolution of housing finance systems 45 e institution that originates the loan may or may not be the one that services it. In recent years, mortgage servicing has become much more con- solidated in the United States, with the top 10 servicers administering over 70 (2007) percent of the market. Various aspects of servicing, such as arrears management, have become even more specialized, as the importance of this function has risen with the advent of the subprime mortgage market in devel- oped markets such as Australia, the United Kingdom, and the United States. Outsourcing of administrative and information technology (IT) f unctions for both origination and servicing, whether by commercial banks or spe- cialist lenders, is also becoming more commonplace, but there again mostly in developed markets rather than emerging ones. In the unbundled system, there are a wide variety of investors in housing loans, ranging from depositories to mutual funds. Investors provide funds to the housing market by funding whole loans or investing in mortgage bonds or mortgage-backed securities. In the global market, they may be either domestic or foreign. Credit risk management is o en specialized as well, pro- vided by third parties such as mortgage insurance or bond insurance compa- nies (public or private) for the bene t of investors. ree ma jor fac tors dr iving un bundling a re co mpetition, t echnology, and the development of mortgage securities. Housing nance is becoming a more competitive business on a daily basis, creating spread compression and incentives to cut cost. Administrative activities such as s ervicing lend themselves to automation and scale economies that can be achieved through consolidation and outsourcing. Improved and more timely access to infor- mation facilitates monitoring of agent behavior, reducing both cost and risk associated with unbundling. e subprime debacle of 2007 exposed a fundamental aw in the disag- gregate model of mortgage lending. With the rise of the secondary market and sale of loans, most players in the market became fee driven. Loan bro- kers receive fees to originate loans. Lenders receive fees to sell ("gains on sale") and service loans. Investment banks and rating agencies receive fees to create, rate, and sell securities. Each of these players is more volume oriented than quality oriented. is unbundling creates agency problems resulting from a divergence in incentives between the agents to the transaction and the ultimate risk takers (investors). While brokers, mortgage companies and investment banks will continue to play an important role in the market, the 46 housing finance policy in emerging markets secondary market share will shr ink substantially and new models of com- pensation and risk management will need to be developed. Yet, in most emerging economies, fees and margins of the lenders--net of assessed or perceived costs and risks--remain too large to create incentives for unbundling and outsourcing. In addition, many banks remain culturally reluctant to transfer to any third party any information of commercial and nancial value about their loans and clients. erefore, unbundling remains limited to a f ew functions such as ho using appraisal, and in f ewer cases, mortgage origination and, to some extent, mortgage default insurance (more as a credit-risk management tool than as actual unbundling). A higher scale of competitiveness would be needed to create the incentives to realize the net gains of unbundling. Secondary market development is a necess ary major catalyst for unbundling, as i t creates incentives for specialized origination and servicing as well as third-party credit enhancement. State-owned Lenders In many countries, government-supported or -controlled institutions have a prominent role in t he provision of housing nance. e largest housing nance in stitutions in t he United S tates, t he F ederal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac), are government-sponsored enterprises operating in the sec- ondary mortgage markets, with --until the 2008 rescue by the federal gov- ernment--private shareholders but a government charter and both funding and tax advantages. Until recently, the largest housing nance institution in Japan was t he Government Housing Loan Corporation, a g overnment entity.9 ere is an emerging privatization trend, with former government- supported lending institutions in Ar gentina, Australia, France, Korea, and Spain being partially or totally sold to the private sector. e nature of state intervention has takendi erent forms (for example, support to securitization conduits or to mortgage insurance products, smarter subsidies, preferential 9. e Government Housing Loan Corporation has b een converted from an originator and matched funder of mortgages to a secondary market institution that both guarantees securi- ties issues by private lenders and purchases closed loans, and issues mortgage-backed securi- ties. It has been renamed the Japan Housing Finance Agency. structure and evolution of housing finance systems 47 regulatory treatment of mortgage loans) but the trend has been away from state-owned institutions, notably state housing banks, because of their poor performance as ine cient lenders, failure to meet housing policy objectives, and crowding out of private market participants (chapter 10). Conclusions e use of one or more of these systems depends on the stage of development of a country's markets as well as government policies. Housing nance usu- ally emerges as a retail activity. Wholesale funds mobilization develops if the banking system is constrained from supplying su cient mortgage credit to meet demand or if capital market sources of funding are more cost e ective. e issuance of mortgage securities, however, is premised on the existence of several conditions, including a supportive legal and regulatory framework, sizeable and standardized primary mortgage markets, and well-developed bond markets. Specialized lenders can create e ciencies; however, they need an external funding source such as a g overnment lending window or sec- ondary market. Experience suggests that specialized lenders can thrive in a market for a period as long as their funding can incorporate bond markets and be competitive with retail (deposit) sources. eir viability will ultimately depend on the willingness of investors to buy mortgage-backed securities and provide short-term funding, which in turn depends on their con dence in the credit quality of the underlying assets. Eventually, however, banks are likely to take the dominant market share re ecting their inherent distribu- tion, brand, and funding advantages (including central bank support). Chapter 3 Mortgage Instruments Michael Lea A wide variety of mortgage instrument designs have been created to meet the varying needs of borrowers and lenders. In general, there is no one ideal mort- gage instrument for a market, although as explained below there are clearly instruments that are not appropriate for some markets or types of lenders and borrowers. A robust mortgage market will have a variety of instruments that can be tailored to the varying needs of borrowers and lenders. What are the desirable attributes of a mortgage instrument from a bor- rower's and a lender 's perspective? A b orrower is in terested in t he a ord- ability of the loan, both at inception and over its life. e lender is interested in getting an acceptable risk-adjusted rate of return over the life of the loan. is presents a conundrum--o en an attempt to improve the attractiveness of the loan for the borrower or lender creates a problem for the other party. For example, an interest-rate cap on an adjustable-rate mortgage (ARM) reduces the potential payment shock and default risk for borrowers but can reduce the yield of the loan for lenders. 49 50 housing finance policy in emerging markets Fixed-Rate Mortgages Perhaps the most important parameter in mortgage-instrument design is the determination of the periodic interest rate. e critical factor is the level of in ation in the economy. In ation creates problems for housing nance as it increases the level of interest rates (to compensate for expected future price increases) and their variability. As shown in gure 3.1, the appropriate class of instruments for a ma rket will dep end on the in ationary environment (both the level and the volatility of prices and interest rates). Fixed-rate mortgages (FRMs) are most suitable for low to moderate and stable in ation and interest-rate environments. In such environments, the premiums for expected in ation and its variability are relatively low and stable. In higher and more volatile in ation environments, FRMs b ecome either prohibitively expensive or too risky for lenders to o er. er earesome notable examples of spectacular failures for lenders o ering FRMs in high- in ation environments. In the early 1980s, Mexican banks were required to use FRMs at rates set by the government. An in ation spike following cur- rency devaluation bankrupted the banks and led to their nationalization. Long-term FRMs p resent formidable r isk-management challenges for lenders, which is why they can be safely o ered only in countries with devel- Figure 3.1. Instrument Alternatives mortgage instruments 51 oped capital markets. ere are two sources of risk for lenders--interest-rate risk arising from a misma tch between the durations of lender ass ets and liabilities and prepayment risk arising from the interest-rate sensitivity of borrower repayment.1 Interest-rate risk led to the bankruptcy of a majority of the savings and loan (S&L) industry in t he United States in t he 1980s. It is very di cult to manage in t he absence of developed capital markets and investors with long-term liabilities (for example, pension and insurance companies). As such, these products are a luxury good una ordable in most emerging markets. In most countries o ering long-term FRMs, borrowers are charged a pre- payment penalty for the option to repay their loan early; however, a p re- payment penalty limits the term over which the rate can be xed--typically from 5 years (for example, Canada, Netherlands) up to 10 years (Germany). e magnitude and term over which a prepayment penalty can be charged is a matter of controversy. For example, in France the penalty is limited to 3 percent of the outstanding balance, which lenders claim does not adequately compensate them for the risk. In Germany, the lender ca n charge a yield- maintenance prepayment penalty--but the term over which the penalty can be applied is 10 years (for a 25­30 year amortization period). ere has been considerable debate in Germany over whether borrowers can prepay when they move and how the penalty is calculated (for example, whether lender pro ts are an acceptable component in the penalty). Signi cantly, there are only two countries that have long-term FRMs with unlimited prepayment options for borrowers--Denmark and the United States. In those countries, almost all of the FRMs are nanced in the capital markets, where sophisti- cated investors can price and manage the prepayment risk. e cost of the option is embedded in the interest rate and can vary substantially over time, as shown in gure 3.2. In Canada and a number of European countries, the dominant instrument is a rollover or short-termFRM. e rate of these instruments is initially xedand adjusts periodically (for example, every one to ve years) with a longer amorti- zation period. e borrower is subject to a prepayment penalty for repayment during the xed-rate term, but can typically make partial prepayments without 1. For example, if interest rates fall, borrowers will re nance their loans, shortening the maturity and exposing the lender to reinvestment risk. If rates rise, borrowers may keep their loans longer, creating extension risk for lenders. 52 housing finance policy in emerging markets Figure 3.2. Cost of the Danish Prepayment Option penalty. ese in struments w ork w ell in ma rkets w here lender s ca n issue matching term debt or use swap markets to lengthen their liability maturities. As such, they may be useful in more mature emerging markets where lenders have access to medium-term funds. Borrowers bene t froma xed rate during a limited period, and can typically choose the term over which their rate is xed; however, they can be exposed to unlimited rate change at the end of their xed-rate period, as the rate is market determined at adjustment. Adjustable-Rate Mortgages e most prevalent instrument class in the world is undoubtedly the adjust- able- or variable-rate mortgage(ARM). ese loans perform well in moderate in ation scenarios, as t he rate can be adjusted to changes in in ation and real interest rates. eir popularity derives from two characteristics: deposi- tory lenders lessen their interest-rate risk by o ering ARMs and borrowers improve initial a ordability with ARMs because of the relatively low starting rate.2 For borrowers it is somewhat of a gamble that their income will keep 2. Lenders seeking to originate ARMs o en o er starting rates below the natural (for example, index + margin) rate to enhance initial a ordability. ese "teaser" rates can create payment problems for borrowers as the loans adjust to market. mortgage instruments 53 pace with payment changes--this characteristic means that ARMs a re not suitable for all borrowers (that is, borrowers with unstable or xed incomes) or high-in ation economies. ARMs are well suited to moderatelyin ationary environments where interest rates, prices, and incomes move together with modest changes. ey are more problematic in high-in ation environments characterized by large interest rate changes and sluggish income change. e ability to change the interest rate makes ARMs appealing to lenders, as they allow lenders to better manage interest-rate risk (particularly for banks with short-term deposit funding). In turn, ARMs allow lenders to o er lower margins (reduced exposure to interest-rate risks) and extend their loan maturity (potential immediate and signi cant a ordability gains). Figure 3.3 shows the proportion of ARMs in developed markets. ere are two important ARM characteristics that deserve mention. First is the index used (if any) to determine rate adjustments. At one extreme there may be no index--t he lender ma y adjust the rate at its discretion. is is Figure 3.3. Mortgage Products: Percentage of Adjustable Rate Loans 54 housing finance policy in emerging markets the standard instrument used in t he United Kingdom and other countries that adopted the building society model. In most cases, the lender changes the rate according to changes in its cost of funds. is can be advantageous to borrowers if t he lender p rimarily raises funds through retail deposits. ese liabilities adjust less rapidly than money-market rates and shield bor- rowers somewhat from interest rate uctuations; however, in less competitive or developed markets this instrument can create problems for borrowers if lenders abuse their privilege by manipulating rates. In many countries, lenders are obliged to use a published index which is beyond their control and transparent to borrowers and the market. While these characteristics are useful to borrowers, they can create complexity for borrowers and may lead to greater payment volatility if the indices are more volatile than retail funds. Spain has the most developed regulations on ARM indices, allowing a mix of indices as determined by the Bank of Spain.3 Amend- ments to the mortgage law in Turkey in 2007 allowed variable rate mortgages but required the use of indices as determined by the Central Bank.4 e other important characteristics of ARMs are caps on the periodic rate or payment increase and the maximum (minimum) rate for the life of the loan. Caps represent an important consumer safeguard, but they come at a cost, as they potentially reduce the return on the loan to the lender and the attractiveness of the product and are expensive to hedge--which is anyway not possible in most emerging markets due to a lack of derivative instruments. Caps are more common in countries that require indexation of ARMs (United States, Spain, France) and less common in countries with discretionary ARMs (Australia, United Kingdom). e recent mortgage law in Turkey requires a life-of-loan cap but leaves it to the lender t o determine the parameters. In some countries (Malaysia), caps are limited to social housing loans. ARMs have become more heterogeneous over time. In Australia and the United Kingdom, the most common instrument is the standard variable-rate mortgage (a r eviewable instrument), which is o en preceded by a o ne-to two-year initial xed-rate period. In the United States, hybrid ARMs a re common. In a hybrid ARM, the rate is xed for one to ve years, a er which 3. See http://www.bde.es/tipos/tipos.htm as well as the legal database on the Bank of Spain Web site. 4. Capital Markets Board of Turkey, mortgage law amendments, March 2007 http://www.cmb. gov.tr/. mortgage instruments 55 Box 3.1. The Limits of Adjustable-Rate Mortgages (ARMs) Excessively risky ARMs are at the heart of the subprime crisis in the United States. As underwriting standards were relaxed beginning in 2004 (in anticipation of con- tinued house-price inflation), lenders began offering loans with fixed rates for two to three years, after which the loan rate became adjustable (so-called 2/28 and 3/27 loans). The initial fixed rate was below market and the margin to which the loan adjusted was large, guaranteeing a payment shock upon adjustment. The loans were made with the assumption that they would be refinanced at the end of the fixed rate period. The combination of funding problems for non-prime lenders and falling house prices invalidated this assumption. Another potential problem loan is the pay-option ARM.* Many borrowers that take this loan are qualified and make their initial payments based on a deeply discounted rate (1 percent). The unpaid interest is capitalized and the loan negatively amortizes. Although this loan was typically provided to borrowers with a good credit history, the combination of high initial loan-to-value, negative amortization, and potential payment shock makes it exceedingly risky in a falling house-price environment. The differential experience of these instruments is shown in the figure below. * A typical pay-option ARM gives the borrower four amortization choices: minimum (typically, the first month below market rate), interest only, 15- or 30-year amortizing). Most pay-option ARMs have a very low initial rate used to qualify the borrower. The rate adjusts after one month to one year, subject to a payment cap. These features generate negative amortization. The loans will recast to full amortization either at the end of five years or when a negative amortization cap is applied (110%­125% of the original balance), which can generate significant payment shock. 56 housing finance policy in emerging markets the loan becomes an indexed adjustable rate instrument. ARMs in ai land can be of exible term. e payment remains constant and the term adjusts with interest rates. A disadvantage of this instrument is the requirement for the initial term to be less than the maximum to allow exibility to increase the term if rates rise.5 Indexed Mortgages A nal class of products is instruments designed for high and volatile in a- tion environments. ese instruments attempt to reduce the impact of in a- tion on nominal interest rates to make loans initially more a ordable. ey also index payments toin ation or income in an attempt to make loans more a ordable over time. e most popular are the price-level adjusted mortgage (PLAM) and the dual index mortgage (DIM). e PLAM is an FRM in real terms--the rate is set at the beginning of the contract and xed for the life of the loan, and principal balance and payment are adjusted periodically for changes in a price index. Typically, the balance Figure 3.4. Mexican Mortgage Instrument Payment Performance 5. e shorter initial term increases the initial monthly payment, reducing a ordability. mortgage instruments 57 Figure 3.5. Mexican Mortgage Instrument Balance Performance is adjusted frequently (monthly) and the payment less frequently (annually), leading to negative amortization on the loans. PLAMs have been used suc- cessfully in Chile since the early 1980s. ey are primarily nanced through the issuance of matching mortgage bonds purchased by institutional inves- tors (particularly pension funds that nd that the real rate bonds are a very good match for the real rate pension liabilities). Chile has f ortunately ben- e ted from a st able and declining in ation environment since widesp read use of the instrument began. e experience with PLAMs in o ther markets has no t been as s atisfac- tory. Commercial banks in M exico were using PLAMs in t he early 1990s. e sharp devaluation of 1994 (the "Tequila crisis") led to a rapid increase in in ation (from 10 percent to 50 percent and higher within a year). e resulting payment shock was unbearable for borrowers and led to massive defaults (over 50 percent of mortgages went into default). Figures 3.4 and 3.5 show the relative performance of PLAM and DIM mortgages before and a er 58 housing finance policy in emerging markets Box 3.2. Colombia: Difficulties with Indexed Mortgages Colombian savings and loans, the Corporaciones de Ahorro y Vivienda, had a relatively long and successful experience with PLAMs until the late 1990s. A sharp deterioration in the economy, however, along with a Supreme Court ruling that required a change in the index, led to high levels of default and a serious asset- liability mismatch for lenders. By the late 1990s, the Corporaciones de Ahorro y. Vivienda had developed a sizeable interest rate imbalance between their deposit liabilities that paid a nominal peso rate of interest and their mortgage loans that were indexed to the inflation rate through the Unidad de Poder Adquisitivo Con- stante (Constant Purchasing Power Unit of Exchange; UPAC) price index. The dra- matic increase in deposit interest rates in 1998 led the government to modify the UPAC formula to incorporate both changes in interest rates and inflation in the determination of the value of the UPAC index applied to mortgage loans. Colom- bia's Constitutional Court subsequently ruled against the change in the indexation mechanism and instructed banks to restate the value of mortgage loans back to the time when the original change to the UPAC index was made, applying only the inflation index to the newly named Unidad de Valor Real (Real Value Unit; UVR) index. The downward adjustment to the value of the banks' mortgage loans that this caused further exacerbated loan portfolio problems that were already severe after debtor defaults resulted from rising indexed interest rates. the devaluation (Lea and Bernstein 1996). While the DIM had more modest payment increases, the negative amortization was considerably greater. e DIM attempts to address the a ordability problem by indexing the pay- ments to wages but allowing the accrual rate on the loan to vary with in ation or a nominal interest rate. Once again, the basic mortgage design dilemma arises--in an attempt to maintain a ordability for the borrower over time, a new problem is created: if the wage and rate indices diverge for a period of time the loan may not amortize. is happened to several vintages of DIMs in Mexico during the 1990s because of the Tequila crisis and aggressive initial terms (although these loans performed better than the PLAMs).6 DIMs were 6. A particular issue in Mexico is the use of the administratively determined minimum wage for payment indexing. mortgage instruments 59 also used in Brazil. Another problem occurred there, however--the govern- ment manipulated the payment index for political reasons, bankrupting the mortgage nance system. DIMs were introduced in Poland with more conser- vative parameters but never achieved consumer acceptance because of their inherent complexity (Chiquier 1998). DIMs cr eate ass et-liability ma nagement p roblems f or b orrowers a nd lenders. ey can experience large negative amortization, which can result in negative equity and greater default risk if house prices are not rising as fast as the balance on the loan. Additionally, DIMs may have extended dura- tions (the term can lengthen to accommodate the negative amortization, but typically up to a limit), potentially creating a positive remaining balance at nal maturity. e Mexican government has a ttempted to deal with both of these problems. In the early years of DIM usage, the government under- wrote the risk of a p ositive balance at maturity for (government-owned) lenders. More recently, the national mortgage bank (Sociedad Hipotecaria Federal; SHF) developed a novel scheme to reduce the funding risk of DIMs, allowing them to be nanced through the issuance of price-level adjusted securities. SHF o ers a wage-price swap for DIMs. e borrower pays an up-front premium of 60 basis points to a fund that balances the di erences between the cash ows from a pool of DIM mortgages and those of price- level adjusted securities. If wages lag prices, the fund contributes additional cash to the security pool to make up the shortfall. If wages rise faster than prices, the fund balance increases, in e ect providing a gr eat insurance against future real-wage decreases. Several lessons can be drawn in examining the experience with high in a- tion mortgages. First, although they can ameliorate the impact of in ation on mortgage payments, improving a ordability and reducing the risk of default, they can only do so within a range ofin ationary outcomes. Severe shocks like those seen in Colombia and Mexico will overwhelm the instrument, leading to adverse results. Second, there must be a matched funding source for the instruments. Lenders without a matching liability will not be able to manage the cash- ow risk they generate. Finally, these instruments are very complex, presenting challenges to both lenders and borrowers. It is lik ely that many borrowers with these loans do no t really understand their dynamics--past experience has suggested the lender's sta may not understand them as well. 60 housing finance policy in emerging markets Another indexed instrument gaining popularity in relatively high interest rate environments are loans indexed by foreign exchange (FX). es e loans adjust balances and payments to changes in the exchange rate or are denomi- nated in foreign currency. FX-indexed loans have been especially popular in transition economies (over 50 percent of loans in Poland, Romania). es e loans carry great risks for borrowers and lenders. A sharp devaluation can lead to a payment shock for borrowers whose incomes are in the domestic currency. Similarly, a devaluation can lead to signi cant losses for unhedged lenders. e potential for this occurrence was demonstrated in Turkey, with a 24 percent devaluation of the Turkish lira in 2006. Fortunately, there were relatively few Euro-denominated mortgages in Turkey at the time. Several central banks, including Poland and Romania, have attempted to get banks to reduce their FX lending through imposition of higher reserve or capital requirements on FX-indexed loans (see chapter 8 on consumer protec- tion, which deals with this subject in greater depth). Interest-Only Mortgages Another key characteristic of mortgage design is t he amortization formula. e standard mortgage instrument is a level-payment, fully amortizing loan.7 is rather rigid design calls for equal monthly payments over the life of the loan.8 e dominance of the level payment loan has been dictated by the ser- vicing systems available to lenders and the desire to keep borrowers on a steady payment schedule. is design, ho wever, is no t suitable for borrowers with uneven incomes or who are su ering from a temporary income shortfall. In recent years, there has b een a r ise in in terest-only mortgages in t he United Kingdom, the United States, and several other developed markets. A 7. ere are variants to this design, including the constant amortization mortgage, which has a level principal payment and declining total payment over time, and the graduated payment mortgage, which has a rising payment over the rst few years (and resultant negative amor- tization) before leveling out at a constant payment higher than a standard mortgage loan for the remaining life. e constant amortization mortgage has the disadvantage of higher initial monthly payment, reducing a ordability. e graduated payment mortgage enhances a ord- ability at the beginning of the loan--with the disadvantages of possible payment shock, nega- tive amortization potentially de ating borrower equity, and longer duration. 8. For ARMs, the payment is recalculated at the new rate upon adjustment based on amortiza- tion of the loan in equal payments over the remaining term. mortgage instruments 61 Figure 3.6. Amortization by Interest Rate Type in the United States (U.S. H1 2006) Figure 3.7. Method of Repayment United Kingdom 62 housing finance policy in emerging markets primary motivation has been to enhance a ordability. e structures di er ( gures 3.6 and 3.7). In the United States, the loans are interest only for a number of years (for example, ve to ten), a er which they revert to amor- tizing (with concomitant increase in payments to re ect amortization over the remaining term). e loans can be xed or variable rate. In the United Kingdom, interest-only mortgages are variable rate, but the majority do not have an identi ed repayment vehicle (perhaps a legac y of the endowment mortgage, w hich was a n interest-only loan with a co mpanion insurance policy designed to repay the principal upon maturity--but which o en did not during the 1990s). In recent years, the exible mortgage has been introduced in a number of developed countries. e exible mortgage allows borrowers to take payment holidays (typically limited) without penalty. is feature is attractive to bor- rowers with uneven income (for example, teachers and commissioned salesper- sons, or those subject to short-term unemployment). More advanced versions (for example, the pay-option ARM) in t he United States allow borrowers to choose from a menu of payment options, including negative amortization, to accelerated amortization. While providing a ordabilitybene ts, exiblemort- gages may carry more risk for borrowers and lenders. As they have not yet gone through an interest rate cycle, it is too early to judge their performance. Default rates on pay-option ARMs have been strongly increasing in the United States. Reverse Mortgages Another class of mortgage, the reverse-annuity mortgage or shared equity loan, is targeted at aging populations. ese loans allow homeowners to con- sume some or all of their housing equity to support their retirement income needs. e borrower can take a lifetime annuity, term annuity, or lump-sum payment at funding and the lender gets a portion of the property value (or appreciation) upon sale or death. e amount of the payment depends on the equity in the home and whether the payments are for a xed term or for the life of the borrower. In the United States, the borrower can remain in the home until they die, and the loans are insured by the government mortgage insurer (U.S. Federal Housing Administration [FHA]). Such loans are likely to gain in popularity as the population ages. mortgage instruments 63 Lessons for Emerging Markets e choice of mortgage instrument should be consistent with the macro- economic environment. FRMs will no t work for lenders in v olatile mac- roeconomic environments. e risks are too great for lenders to manage and their mandated use will greatly restrict the ow of mortgage credit or lead to large losses for lenders. ARMs can work with moderate in ation, but the potential for payment shock is great in volatile environments. Indices increase transparency but also complexity. Interest rate and payment caps can reduce payment shock but at the cost o f reduced expected yields f or lenders, particularly if no hedgin g instruments are available. Loans have been designed for high-in ation environments with limited success. er e is no free lunch--PLAMs, DIMs, and FX-linked mortgages carry many risks and will not substitute for the bene ts of a low-in ation environment. With macroeconomic stability and nancial deepening, a wider variety of instru- ments can be made available, including xed-rate and non-constant amor- tization mortgages. Capital market funding, however, should be available before long-term FRMs are o ered. Chapter 4 Primary Mortgage Market Infrastructure Sally Merrill is c hapter addr esses t he k ey f unctions needed t o su pport a n e cient primary mortgage market: property appraisal; mortgage-related insurance products, including catastrophic insurance against earthquake and ood; and assistance with credit risk assessment via cr edit bureau information. e successful development of these support functions and of a sound mort- gage market is m utually supportive. For example, the increasing sophisti- cation of the appraisal industry both responds to, and supports, a growing primary market. Similarly, the demand for property insurance is a function of a growing mortgage market that enables insurers to achieve diversi ca- tion and scale economies and o er reasonably priced products. As these sup- port functions help to measure and share the risks, they shape the evolution of primary mortgage markets (needed b efore developing secondary mort- gage markets) and they facilitate the penetration of housing nance markets through lower-income groups. Yet, these support functions do no t represent absolute prerequisites for would-be candidate lenders, as demonstrated by the Housing Development Finance Corporation (HDFC)--pioneer and now leader of housing nance 65 66 housing finance policy in emerging markets in India--which went forward without any of these supports in place (plus the critical lack of long-term funding, and of any enforceable foreclosure). An e ective appraisal process is a rguably the most im portant of these functions. e accuracy of the valuation, through its impact on loan-to-value (LTV); the level of property insurance; and the validity of higher- or lower- risk weight assignments ultimately impacts credit risk, collateral risk, capital charges for banks, and improved a ordability for the borrower. Building a credible appraisal industry, however, is demanding and takes time. Credit bureau reports on borrower debt and loan repayment history are crucial inputs to determining credit risk through both the debt-to-income ratios and knowledge of past repayment behavior. Many emerging markets have trouble convincing leading market lenders and other suppliers of credit that information sharing is bene cial to all. Moreover, of course, newly estab- lished markets require time to develop credit histories and other information that ultimately o ers the bene ts of a full-service credit bureau. Finally, mo rtgage-related in surance p roducts a re a n im portant me ans of sharing collateral and credit risk and avoiding default and repossession. ese include property insurance and mortgage life insurance, and, in a few countries, disaster insurance. Property insurance should clearly be manda- tory, and fortunately, this is g enerally not a di cult insurance product to develop. Similarly, various approaches exist for mortgage life insurance prod- ucts. In contrast, developing catastrophic risk insurance in countries prone to natural disasters such as hurricanes, oods, or earthquakes has proved to be a very daunting task, even in de veloped markets. A few higher-income emerging markets are paving the way, however. ese products di er from mortgage default insurance (which shares credit risk with lenders [chapter 13]) developed in some emerging markets. Worldwide trends, especially in appraisal, but also in credit information and disaster insurance, will assist emerging markets in developing e ective support functions. ese trends include the following: · international e orts to standardize and improve appraisal method- ology and certi cation of appraisers; primary mortgage market infrastructure 67 · development of more complete databases and IT platforms, leading to use of quantitative methods and modeling in both appraisal and credit s coring (m any co untries s till lac k a ny u seful da tabase o n housing markets and prices); · establishment of credit bureaus in ma ny emerging and transition markets; and · slow but steady progress in de veloping viable approaches to cata- strophic risk insurance, combined with increased access to interna- tional reinsurance for emerging markets. ere has been worldwide movement toward standardization and confor- mity in appraisal methodology and appraiser quali cations. Also, although less widespread to date, credit scoring has become more prevalent with the use of consistent, quantitative estimates of credit risk. e reasons for this push are compelling. As funding of mortgage loans in both local and inter- national capital markets becomes widespread, rating agencies and investors alike demand consistent underwriting information in valuing the portfolios. Similarly, as im plementation of Basel II p roceeds, lenders' capital require- ments on residential mortgages will b e in uenced by obtaining the lower- risk weights on qualifying loans; this, in t urn, demands consistency and conformity to accepted standards of valuation and underwriting. Finally, although numerous emerging and transitioning nations are in the process of developing secondary markets based on mortgage-backed debt p roducts o ered in lo cal o r international capital ma rkets, t here is increasing realization that the primary market must exhibit e ective stan- dards before a secondary market can thrive. is implies sound and trans- parent approaches to controlling credit and collateral risk via good appraisal methodologies, credit information, and support from insurance products o ered by appropriately capitalized and regulated insurers. In sum, a sound primary market and prudent underwriting depend on a solid infrastructure able to value and protect collateral and to determine the relative worthiness of would-be borrowers. 68 housing finance policy in emerging markets Appraisal The Importance of Sound Appraisal An accurate assessment of the value of residential real estate may be the most crucial support function in mo rtgage lending. First, without consis- tent and accurate appraisal to guide LTV decisions, lenders cannot achieve their desired distribution of risk and portfolio size. e level of LTV has been shown to be the single-most-important predictor of default, and thus the accuracy of the valuation is key to knowing "true" LTV levels. Without this assurance, "real" LTV levels in emerging markets are likely to be lower than what might be expected, because risk-averse lenders reduce the appraised value by a signi cant percentage (the so-called "haircut") or rely on their cli- ents to pay a higher price than what is o cially declared to the seller or devel- oper. Second, capital market funding, especially if internationally accepted ratings are sought, will be much more di cult without acceptable appraisal practices among the underwriting standards. Finally, the valuation is again linked to collateral risk, as it may form the basis for the level of a homeown- er's property insurance coverage. In the last 15 y ears, appraisal quality and methodologies have received a great deal of attention in t he United States and throughout Europe. A number of real estate crises have reemphasized the importance of competent appraisal practices: the U.S. savings and loan crisis of the 1980s, real estate asset bubbles in various OECD countries and the Asian collapse in the 1990s. As a result, the U.S. and European appraisal industries have developed more stringent standards for methodology, certi cation, and ethics, which are now contributing to improvements in appraisal practices worldwide. e strong push to standardize appraisal has spread to numerous emerging markets. As noted, the "internationalization" of capital market funding of mortgage lending requires standardized and transparent underwriting cri- teria, especially if rating agencies are involved. In addition, under Basel II, regulators are looking to standardize the risk-weight treatment of various categories of mortgage lending, and receiving the lower recommended risk- weight assignment will r equire adequate valuation processes. Finally, the appraisal standardization e ort joins a broader e ort to standardize nan- cial-sector functions, such as international accounting and regulation. primary mortgage market infrastructure 69 Developing an Appraisal Industry A number of important elements are required in de veloping an e ective, transparent, and professional appraisal industry. ese include the following: · adherence to internationally accepted norms of appraisal method- ology; · adequate accreditation standards and educational and professional training o pportunities under w hich a gr oup o f a ppraisal p rofes- sionals ca n emer ge, a nd als o pa rticipate, in o ngoing ed ucational opportunities; · independence from parties to real estate transactions and acceptance of an accepted code of ethical conduct; · appropriate fee structure · appropriate le vels o f g overnment r egulation a nd de velopment o f a structure of taxes and fees in real estate transactions that support transparency and honesty; and · a p rofessional ass ociation o f a ppraisers r esponsible f or enf orcing these requirements. International Standardization of Appraisal Methodology For the last two decades, appraisal methodologies and valuer quali cations have become more standardized and codi ed, providing an important ben- e t to development of appraisal competency in emerging markets. Several major gr oups ha ve p layed im portant r oles: t he I nternational V aluation Standards Committee (IVSC),1 the Royal Institute of Chartered Surveyors, the U.S. Appraisal Institute, the U.S. Appraisal Foundation, and e European Group of Valuers Associations' development of the International Valuation Standards has been guided by three main principles: 1. An IVSC publication, International Valuation Standards, Sixth Edition, 2003 (I nternational Valuation Standards Committee 2003), is an important international documentation of valu- ation concepts and valuation codes of conduct. e latest edition also contains a white paper, "Valuation in Emerging Markets," which is intended to assist valuers in emerging markets and guide development assistance e orts by national institutions, IFIs, and other donors. 70 housing finance policy in emerging markets · facilitating cross-border transactions in international property mar- kets by promoting transparency in nancial reporting and reliability of valuations performed to secure loans and mortgages; · serving as a p rofessional benchmark for valuers around the world; and · providing standards of valuation and nancial reporting that meet the needs of emerging markets and newly industrialized countries. Market Value (MV) is t he approach recognized by IVSC, the Appraisal Institute, the Royal Institute of Chartered Surveyors, and many other EU and OECD countries.2 MV is the standard adopted by numerous emerging markets as t heir b enchmark as t hey de velop t heir a ppraisal ind ustries. Market valueisde ned as the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm's length transaction a er proper marketing wherein the parties had each acted knowledgeably, prudently, and without compensation. MV includes the cost approach, sales comparison approach, and income capital- ization approach. For residential real estate, the sales comparison approach forms the key basis of valuation, and secondarily the cost approach is a basis of valuation; for commercial real estate, in contrast, the income capitaliza- tion approach is paramount. Unlike larger and riskier loans to nance com- mercial property, single-family mortgage loans normally do not require any costly renewal of a detailed appraisal, as long as the portfolio performance is satisfactory. e move to standardize appraisal within the EU has r evealed a di er- ence in the appraisal methodology used in Germany, Austria, and Hungary, among others, which rely on a concept called mortgage lending value (MLV) to appraise the collateral of the mortgage loans that back covered mortgage bonds. Asde ned by IVSC, MLV is a "value at risk" concept: the valuer makes a "prudent assessment of the future marketability of the property by taking into account the long-term sustainable aspects of the property, the normal and local market conditions, and the current use and alternative appropriate uses of the property." 2. For detailed information on the de nition of market value, see IVSC and Appraisal Institute publications, available at www.appraisalinstitute.org, and the Royal Institute of Chartered Surveyors' "Red Book." primary mortgage market infrastructure 71 According to the German Pfandbrief Association, MLV is bas ed on the following principles: assessment of future marketability, elimination of spec- ulative elements, long-term sustainable use of the property, and consider- ations of the conditions of local real estate markets. us, MLV introduces into market value the notion of "smoothing" of market trends, rents, and yields, in order to eliminate some cyclical e ects inherent to real estate mar- kets, and to provide a more conservative estimate for the purpose of rating high-quality and long-term covered bonds. MLV is a more conservative con- cept than MV, as implicitly recognized by the Basel I Accords.3 Does this dual approach between MV a nd MLV matter for emerging economies?A country like Poland uses both methods, which simply mirrors the fact that mortgage lending is done by both universal banks (which use MV) and specialized German-style mortgage banks (which use MLV). As noted, pressures tode ne a single international standard are being driven by the global rise of mortgage-backed securities (residential mortgage-backed securities [RMBS] and covered bonds), and by the risk-based approach of Basel II, in w hich the LTV is o f paramount importance. Most emerging nations have adopted the MV approach, which had emerged as the world- wide standard, probably because of its operational simplicity in countries where no historical data records are required for MLV. On the other hand, smoothing out some conjectural short-term uctuations through collateral prices is a laudable purpose for assessing the quality of long-term mortgage securities. is point has gained visibility through the ongoing adverse cycle in the United States, where the market values of housing assets related to subprime loans are rapidly declining with adverse e ects on the value of res- idential mortgage backed securities. Yet, parties other than appraisers may be better positioned to forecast real estate cycles and determine corrective discounts (MBS arrangers, rating agencies, or regulatory authorities).4 Both MV a nd MLV have valid ad vantages and disadvantages, and it is likely that countries that have historically used MLV will continue to do so, as least so far as it is a regulatory requirement for their covered bonds. e 3. For commercial loans, the preferential risk weight treatment (50 percent) is only accorded if the loan does not exceed 50 percent of MV or 60 percent of MLV. 4. e German regulatory authorities periodically revisit the minimum discount rates applied by appraisers. 72 housing finance policy in emerging markets MV-MLV duality matters less as long as it is clear to lenders and investors of mortgage-backed debt which approach is being used. Appraiser Qualifications, Appraisal Associations, Independence, and Ethics e key international appraisal organizations strongly emphasize the impor- tance not only of establishing methodological standards, but also of ensuring more p rofessional im plementation a nd enf orcement. e issues inc lude establishment of s elf-regulating professional b odies, cer ti cation require- ments, appraiser independence, disciplinary procedures, and professional indemnity insurance. Issues of ethics and appraiser independence have received international attention. Both European (IVSC) and United States (Appraisal Institute) associations ha ve p ublished co des o f co nduct f or a ppraisers. A ppraiser independence from the control of both borrowers and lenders has b een addressed worldwide, thus requiring the proper incentives for the appraiser to perform any unbiased valuation. In general, appraisals should be a credit administration function, most appropriately controlled by the credit risk or credit policy functions of the lender, not the credit production (loan o cer) sta . Ordering and review of appraisals should be located away from the "hands, eyes, and control" of the loan sta . ese principles are imple- mented as r ules or at least as s elf-regulatory codes of conduct in s everal emerging markets (for example, Bank of ailand appraisal rules for loan provisioning purposes). e increasing importance, however, of mortgage brokers, who are not subject to the same compliance rules as banks, con- tinues to be a grey area. While meeting the above-mentioned principle of independence, many lenders fear that the collateral value may be over-appreciated by external appraisers paid by borrowers, who may shop around to obtain the highest valuation. erefore, even when contracting external certi ed appraisers, banks should keep su cient in-home expertise to review the work of outside appraisers. ey may also use statistical valuation models (see below) for pre- or post-quality control. primary mortgage market infrastructure 73 Quantitative Appraisal Models and Real Estate Data Most emerging countries are confronted by a lac k of reliable data on the evolution of housing prices and rents, thus a ecting the quality of any pro- fessional appraisal, whatever the methodology or model. Beyond the data collected from or through o cial sources (registration o ces, tax authori- ties, public housing nance institutions, and so forth), vital information must also be gathered from the market operators (appraisers, developers, realtors, banks, brokers, and so forth). In many emerging economies, market players are reluctant to share any information, although all parties would collectively gain from an e ective real estate information center. Databases actively sup- ported by market players (for example, Poland) perform better than those only supported by the public sector. In countries where quality data can be gathered on a large scale, statistical models of valuation--automated valuation models (AVMs)--are increasingly utilized in de veloped economies, where real estate databases have become more widespread and accessible and have supported the development of complex AVMs and house price indices (HPIs). e United States, Denmark, Germany, Spain, and the United Kingdom are using these methodologies, and elsewhere in Europe AVMs are in the development phase.5 ere are a number of approaches to AVMs: hedonic indices, repeat sales methods, and various hybrids of these. ese mo dels have a n umber of useful applications: mass valuation of real estate for tax purposes, valuation for development of HPIs, assessment of the error variances of conventional appraisals (quality control), loss mi tigation analysis, and, as no ted above, internal bank review and portfolio valuation. While the statistical aspects of the various models have advanced, the data quality and quantity for cali- brating and testing them--across time, location, and property details--still determine their utility. 5. See Calhoun 2001; EMF 2000b; and Bates, Johnson, and Brzeski 1999. 74 housing finance policy in emerging markets The Challenges of Establishing an Appraisal Industry in Emerging Markets e development of e ective appraisal methodology in emer ging markets faces numerous challenges and is inevitably a long-term process. Some of the many issues include the following: · Emerging markets generally lack a su cient number of adequately trained in spectors, esp ecially t hose wi th all-im portant o n-the-job experience. Appraisers are o en engineers, trained in the cost replace- ment methodology, although estimation of MV for residential prop- erties using the "comparables" MV methodology is the priority. · ere is no overview of the broader market and its trends on which to base a comparable estimation. Data are generally held by individual appraisers, realtors, and banks. Large databases, such as the Multiple Listing Service (MLS) in the United States, do not exist. us, even when appraisers are trained in the theory of market valuation, they are limited in their ability to put it into practice, especially e ective utilization of the comparables methodology and the development of computer models. Commercial databases are unlikely to come into being until realtors, lenders, and appraisers recognize the bene ts from cooperation and follow de ned "rules of the road" for exclu- sivity and cost-sharing arrangements. · Actual transaction prices may not be recorded in an e ort to reduce the taxes and fees o en levied on transactions; this renders the data less useful than would be the case if t he true relationship between market price and the characteristics of the property could be studied and ultimately used to develop hedonic models. · Appraisal associations must be established that create e ective gov- ernance conventions, including rules for independence from lenders and buyers. A fee structure must be established that is " at"; that is, does not represent a proportion of the valuation. e issue of inde- pendence from lenders, or from the banks' lending o cers, or from developers--the o cial sale price of a ne wly built unit not always re ecting t he ac tual ma rket val ue--also needs mo re a ttention. Appraisal associations in most emerging countries have not managed primary mortgage market infrastructure 75 Box 4.1. Developing the Appraisal Industry The Polish Association of Property Appraisers and the National Association of Romanian Valuers, the Romanian appraisers association, have both developed good appraisal industries in a limited time frame, having made good use of donor technical assistance and membership in international appraisal organiza- tions. U.S. and British standards were used for licensing requirements, which include a college degree, specialized education, and on-the-job training. Poland's appraisers are trained in both the MV and MLV methodologies. In contrast, although the mortgage market is growing rapidly, there is no formal association of appraisers in India. India's premier housing lender, HDFC, handles the appraisal process as an in-house function. Over the years, an extensive centralized property database has been developed that can be tapped by HDFC's entire network of offices. In certain cases, independent appraisers are consulted, but it has been a conscious decision not to outsource this critical function. yet to become credible self-regulatory bodies, capable of granting and revoking licenses, taking sanctions, providing training to their mem- bers, enforcing codes of conduct, and so forth. · Appraiser fraud is an issue in both developed and developing coun- tries. For example, " ipping" refers to the practice of buying a prop- erty at the market price, getting an appraiser to in ate the value, and reselling at the in ated price. While AVMs may be one approach to reducing such fraud, the requisite databases generally do not exist in emerging markets, as discussed. ere is no easy x to the problem. Requirements must be in place for minimum standards in training, experience, and adherence to international valuation standards, with o ending appraisers subject to civil and criminal penalties. In addi- tion, banks can use trusted, licensed appraisers to perform periodic spot checks. As noted, one result of these valuation problems is t he lender "ha ircut." us, a val uation, whether done by bank appraisal sta or an independent appraiser, is o en arbitrarily reduced by a signi cant percentage (say, 15­30 76 housing finance policy in emerging markets percent) in order to compensate for unknown appraisal error. As a result, true LTVs are o en lower than the stated value, which hinders both development of the MV a pproach and reduces a ordability for many would-be buyers. Much can be gained, however, from the substantial internationale ortsnoted above in standardizing methodologies and certi cation procedures. Mortgage-Related Insurance Products is section addresses three mortgage-related insurance products: property insurance, mortgage life insurance, and catastrophic insurance, which is most commonly utilized to assist aga inst the devastation of earthquakes, oods, a nd h urricanes. P roperty in surance is no w a vailable in ma ny emerging markets; it can generally be developed without signi cant delay as both mortgage markets and the insurance sector mature. Property insur- ance is usually the rst insurance product to become a mandatory under- writing r equirement f or mo rtgage loa ns. L ife in surance r equired f or a mortgage loan can take two forms: a general life insurance policy or a life policy speci cally geared to pay o the mortgage in case of the borrower's death or incapacitation; this latter is referred to as mortgage life insurance. is product, too, can generally be made available as a country's insurance sector matures. In contrast to these insurance products, disaster insurance is now available in o nly a ha ndful of emerging markets. Structuring and funding disaster insurance is, in fac t, a worldwide problem for developed and emerging markets alike, as it requires design of appropriate roles for government, mo re ma ture lo cal co mmercial in surers, a nd in ternational reinsurers, all in a complex context of ex ante funding strategies, risk mod- eling, and disaster mitigation planning. Property Insurance Property insurance is generally mandatory in de veloped markets, whether as a r esult of regulation, commercial practice, or both. For example, most bank regulators would cite mortgage lenders making loans without prop- erty insurance as an audit de ciency--that is, bad lending practice. Property primary mortgage market infrastructure 77 insurers are generally multi-line insurers, o ering other types of insurance such as car and commercial insurance; costs are reasonable, as a function of both scale and competition. e most co mmon, and most im portant, type of property insurance is for loss due to re. Most lenders require minimum coverage amounting to the replacement cost o f the structure, not including the value of the land. ere are several types of policies, including xed value and escalating value, the latter being adjusted with in ation or a construction-cost index. Lenders will insist that they are jointly named in the insurance contract or that their "interest" is noted. e initial amount of property insurance is highly depen- dent on the appraisal process. Homeowner pac kages a re als o p rovided, in suring t he co ntents o f t he homes aga inst t he . N atural dis asters suc h as t ornadoes, lig htning, a nd damage from internal water pipes may also be covered under some standard policies, as might structural damage under a home-builder warranty for new homes or resulting from termites, and so forth. Other types of protection, however, such as ood and earthquake, are "standard exceptions" in nearly all property insurance contracts, and are covered--if at all--in some type of disaster insurance, as discussed below.6 Whether f ormally r egulated o r no t, p roperty in surance is cr ucial in guarding against collateral risk. An increasing number of developing coun- tries now require a generic homeowner's policy, particularly for re insur- ance. e problem, however, is that market penetration is still very low, generally less than 5 percent of households, for example, in countries such as Turkey, Romania, and Mexico. In contrast, Colombia represents a "b est practice" exception, with penetration of 30 p ercent for both general prop- erty and earthquake protection, as all mortgage lenders require such insur- ance. As a counterexample, however, property insurance is not required in the Philippines, which despite having a reasonably well-developed mortgage market, does not have adequate risk management for residential and com- mercial properties. 6. e EBRD Mortgage Loan Minimum Standards Manual indicates that both property insur- ance and mortgage life insurance should be regarded as a mandatory minimum standard; best practice would also include contents insurance (and mortgage default insurance, discussed in Chapter 13). 78 housing finance policy in emerging markets e problem is due, in part, to low income. Research has shown that the incidence of coverage increases as a country's income (per capita GDP) grows: there is a 1.3 percent increase in property insurance coverage for every 1 percent increase in GDP.7 As noted in the introduction, the development of property insurance and the maturation of the mortgage market are mutually supportive. On one hand, mortgage markets require property insurance to reduce collat- eral risk, and on the other hand, a gr owing mortgage business provides the necessary incentives and scale for development of cost-e ective homeowner property-protection packages. Higher insurance costs go hand in hand with limited scale and penetration, and low per capita income. As both the mort- gage market and the insurance industry grow and become more sophisticated, competition, risk analyses, and increased scale will contribute to moree cient pricing. Regulators in emer ging markets under a "b est practice" approach should be encouraged to mandate property insurance as soon as possible. A number of issues must be addressed in the course of making property insurance an integral part of lending, especially in the early phases of mort- gage market development. ese include the following: · added exp ense f or mo derate-income b orrowers, esp ecially in t he early phases of insurance industry development of the product; · the adequacy of the appraisal function in providing an adequate mea- sure of property value and of building standards and their enforce- ment in reducing risk; · the adequacy of capitalization in t he insurance industry and other regulatory parameters, such as solvency ratios, and appropriate insur- ance regulation (particular supervision of solvency, issue of "captive" insurers owned by lenders, and geographical dispersion). Mortgage Life Insurance Mortgage life insurance, a rapidly growing product line around the world, is typically life coverage equal to the outstanding mortgage loan balance at the time of death. e family or estate is thereby able to retain ownership 7. See the discussion in Gurenko and Lester 2004. primary mortgage market infrastructure 79 of the home without the responsibility of making the mortgage loan pay- ment. Coverage is generally only for the primary borrower; joint coverage is available but not widely used. Although mortgage life insurance could be mandatory by law, it is g enerally simply dictated as co mmercial practice. When a voluntary program is in place, the premium rate is generally higher to allow the lender to earn a commission. Voluntary programs would usu- ally have higher claims experience, since healthy people may be less likely to buy coverage. Mortgage life insurance is available in a n umber of the more developed markets in Latin America, Asia, and Central and Eastern Europe. For example, Malaysia has had mo rtgage life insurance for about 10 years; although it is voluntary, more that half of the borrowers elect to buy it. Indonesian lenders also promote mortgage life insurance, with the premium included in the loan amount. Romania and Bulgaria provide other examples. A number of issues should be addressed in considering the merits of mortgage life insurance in emerging markets: · Should the product be voluntary or mandatory? · Are insurers su ciently well capitalized and prudentially regulated? · Are there supply constraints, such as a ppropriate actuarial tables? Availability of adequate medical exams? · Should the policy cover limited or temporary disability as well (how to control)? In the U.S. market, mortgage life insurance is a v oluntary product. As noted a bove, ho wever, t he EBRD Mortgage Loa n M inimum S tandards Manual(2007) for emerging markets lists mortgage life as a minimum stan- dard requirement. Clearly, mortgage life insurance needs adequately capi- talized and regulated insurers, just as for property insurance. e issue of mandatory versus voluntary coverage is more di cult. Mortgage life insur- ance can be a us eful additional tool in co ntrolling credit risk, especially in newly expanding markets, but it does not substitute for other reforms needed to manage credit risks (e ective foreclosure, credit bureaus, and so forth). 80 housing finance policy in emerging markets Catastrophic Insurance Natural disasters, by their nature, are events with a low probability of occur- rence and a high level of loss given an occurrence. Developed markets rely on the international reinsurance market to transfer and spread these risks.8 Even in developed countries, however, private disaster insurance is not com- prehensive. e potential losses can be so large or indeterminate that com- mercial insurance markets cannot provide su cient coverage at acceptable prices. is has resulted in some countries supplementing the private market with public programs. Examples include France, New Zealand, the United States, Norway, and Taiwan. In addition, not all types of disasters are insured. While ood insurance is a vailable (and mandatory in oodplain areas) in the United States, for example, earthquake and hurricane insurance may be very di cult to obtain, as r isks are both high and geographically concen- trated. us, given the limits of commercial programs, individual states have stepped in, with Florida providing hurricane insurance and California earth- quake coverage (even so, only 10 p ercent of Californians have earthquake insurance). Finally, signi cant moral-hazard problems exist with earthquake and ood insurance, stemming from insuring buildings in areas expected (or known) to have higher probabilities of disaster, and this is likely to be an issue in emerging markets as well. Catastrophic insurance coverage against natural disasters, most frequently against loss from earthquakes, ood, and hurricanes, is far less common than property insurance among developing nations. For example, whereas disaster insurance in countries such as the United States and France cover 40 to 100 percent of loss from some types of natural disasters, in developing markets less than 1 percent of losses are insured. Furthermore, emerging markets are far more vulnerable to disasters, for reasons stemming from both geography and limited nancial and real estate sector development. While the abso- lute economic costs o f natural disasters in de veloped countries are higher than in emerging markets, the relative cost of disasters is generally greater in developing markets, where infrastructure and buildings are less resilient. For example, the 1985 earthquake in El Salvador destroyed 27 percent of GDP and losses from ooding in Bangladesh have resulted in losses as high as 17 8. International reinsurers include Munich Re, Swiss Re, Lloyds, Berkshire Hathaway, and Axa Re. primary mortgage market infrastructure 81 percent of GDP.9 e 2004 tsunami in the Indian Ocean has tragically under- scored the vulnerabilities in Asia. A number of countries must deal with natural disasters relatively regu- larly, including Turkey, the Philippines, India, and Bangladesh. Yet, disaster coverage in emerging markets is limited by both low income and the rela- tively underdeveloped state of their insurance industries, which makes it dif- cult to transfer risk to the international insurers. As a result, because risks (and thus costs) cannot be spread internationally, governments in emerging markets are unlikely to engage in ex a nte risk management. ey respond to natural disasters a er the fact, relying on emergency funding and grants from donors and charitable organizations, although such Good Samaritan alternatives are not as e ective as ex ante hazard-risk management. Colombia, Turkey, and more recently Singapore provide best-practice examples of catastrophic earthquake insurance programs, while Romania, where earthquake risk is present but less serious, provides an example of insurers o ering a va riety of "package plans," including property insur- ance, mortgage life insurance (see box 4.2), a nd earthquake insurance. Other countries, such as Iran, are in the process of developing plans for disaster insurance programs, o en with the assistance of the World Bank and other donors. Emerging economies have much more work to do in developing disaster- coverage insurance products, in order to reduce long-term losses and recon- struction costs. I n countries with high vulnerability to huge catastrophic events, there is a legi timate role for government to act as in surer of last resort. Care must be taken, however, to minimize the moral hazard inherent in government insurance. e cost for commercial insurers of keeping suf- cient reserves ready and liquid would lead to huge sums in low-yield prod- ucts, the opportunity cost of which would be charged to their customers. In Turkey, disaster insurance is a ordable because of adequate scale and because capital costs a re reduced by the government's backup guarantee against catastrophe. 9. Gurenko and Lester 2004. 82 housing finance policy in emerging markets Box 4.2. Examples of Property and Disaster Insurance Turkey. Turkey provides a good case study of both the positive effects of policy development and the problems initially caused by limited mortgage and insurance markets. In 1999, only 2 percent of households in Turkey had property insurance. The Turkish Catastrophe Insurance Pool, a risk-sharing arrangement among com- mercial insurers, the government, and the World Bank, was launched in 2000, following the devastating earthquake in the Marmara Sea in 1999. As of early 2006, penetration for earthquake insurance had risen to 18 percent--and over 13 million houses are covered--making Turkey second only to Colombia in terms of penetration.* Commercial insurers in Turkey write the earthquake policies but do not cover the risk; rather, most of the risk is passed on to international rein- surers, although Turkish insurers can provide additional coverage in excess of that offered by the pool. During its development, the design of the Turkish Catastrophe Insurance Pool became a political issue: whether or not to make the insurance mandatory. The decision was taken to make coverage mandatory, but problems remain in enforcing this regulation. Turkey does not insure properties worth less than $5,000. Insurance is concentrated in Istanbul and Ankara, and the insurance markets in these cities are competitive. Penetration, however, varies widely-- from 8 percent to 26 percent in different geographic areas. In addition, the renewal rate is only 33 percent, which the Turkish Catastrophe Insurance Pool intends to improve. Colombia. Mortgage lenders in Colombia require both property and earthquake insurance; 30 percent of households are covered--a major exception to the low penetration in other emerging markets. In contrast with Turkey, Colombia's earth- quake program is entirely commercial; policies are sold to reinsurers as in Turkey but there is no government disaster pool. The law requires that lenders contract with licensed insurance companies to cover assets. (continued) * Also, see Ozay 2006 (available at http://www.ceemortgagefinance.org/). Ferhan Ozay is Executive Vice President of Garanti Sigorta A.S., the insurance company that recently won the right to manage the Turkish Catastrophe Insurance Pool via competitive bidding. primary mortgage market infrastructure 83 Box 4.2. Examples of Property and Disaster Insurance (continued) Overall risk in Colombia is covered via two types of protection. First, life cov- erage is included as part of the insurance that covers the mortgage debt. Life policies with coverage for death and permanent incapacity correspond in their value to the outstanding balance of the mortgage, which is periodically updated. Second, earthquake insurance is generally an annex to a fire insurance policy, corresponding in value to the "destructible" portion of the property, determined by the average cost of construction of similar structures in the area where the insured asset is located. At the discretion of the debtor, it is possible to take addi- tional coverage, for example, for explosion, terrorism, water damage, and flood. In practice, insured households prefer to take complete coverage. Structures are covered under fire and earthquake policies with no restriction unless their insured value exceeds the capacity of the reinsurance, which is automatically contracted (the coverage is automatic once the mortgage credit is authorized by the bank). The life insurance must comply with the terms of the reinsurance contract in terms of the maximum value insured, and considering the age, health condition, and occupation of the debtor (which also determine the premium). Romania. Several Romanian insurers offer package deals covering property and disaster insurance. The property insurance includes fire and water damage coverage (package A); package B adds supplemental earthquake coverage, and package C adds storms, floods, landslides, riots, and vandalism. Property insurance is mandatory, but the others are not. Premiums are determined by how many packages are to be in effect, and by type of housing and construction. Title Insurance Title insurance is insurance against loss from defects in title to real property and from the invalidity or unenforceability of mortgage liens, a er a title has been recorded. It is meant to protect an owner's or lender's nancial interest in real property against loss due to title defects, liens, or other matters. It will defend against a lawsuit attacking the title as it is insured, or reimburse the 84 housing finance policy in emerging markets insured for the actual loss incurred. Just as lenders require re insurance to protect their investment, nearly all institutional lenders in the United States also require title insurance to protect their interest in the collateral of loans secured by real estate. e demand for title insurance has been mostly driven by the U.S. secondary-mortgage markets, as a requirement imposed by inves- tors. As with mortgage insurance, the borrower pays the premium and the lender or investor receives the bene t in terms of cost and loss protection. e title insurance industry in the United States is quite pro table because of the accuracy of land registries in most j urisdictions and the widespread requirement for its use (even in cases of mortgage re nancing, new insurance may have to be contracted). Although now available in m any countries, it is principally a p roduct developed in the United States mainly as the result of a comparative de - ciency in U.S. land records laws. In most other developed economies, the land registration system sees the government determining in a conclusive way the title ownership and related encumbrances--any error made by the governmentalo ce can lead to monetary compensation, but that aggrieved party usually cannot recover the property. By contrast, most states in the United S tates r ecord do cuments wi thout a ny o cial determining who owns the title or whether the instruments transferring it are valid, sparing the costs o f legally skilled em ployees. But a t hird party must determine who owns the title by examining the indexes in the recorder's o ces, scru- tinizing the instruments to which they refer and making the determina- tion of how they a ect the title under applicable law. Title insurers perform these searches and make the determinations of who owns the title and to what interests it is subject. e insurance policies are fairly uniform and the insurers carry, at a minimum, the reserves required by insurance regulation to compensate their policyholders for their valid claims--notably impor- tant in large commercial real estate transactions. e policies also require the insurers to pay for the costs of defense of their insured in legal contests over what they have insured. Title insurance has b een introduced by U.S. companies in a n umber of emerging markets. Stewart Title o ers insurance in 45 co untries; however, their presence is o en restricted to resort areas catering to foreign buyers. First American o ers title policies in Asia, Europe, and Latin America. primary mortgage market infrastructure 85 In many emerging economies, title insurance is not a real prerequisite for developing residential mortgage markets, as lenders express con dence in the ability and performance of the individual attorneys they rely upon to examine title and mortgage documents prior to granting a mortgage loan. ey can also rely on the conclusive determination by a government o ce that the recorded lien cannot be alienated. e product of title insurance may then be perceived as redundant or not worth its costs. A more serious threat sometimes comes from pre-registration issues with delays, costs, and uncertainties related to the transfer of title and granting of a mortgage lien, including the possible failure to register. Title insurance products cannot cope with that risk. e cases where a title is eligible to be registered but is subject to delay in establishing legal title and lien priority protection resulting from slow procedures for completing reg- istration may correspond to an insurable risk, and gap insurance products may be developed during a tra nsition phase until registration-process improve- ments bear fruits for lenders. Such was the case, for instance, in the late 1990s in Poland, at least in major urban centers such as Warsaw. In response, several private insurance rms began to o er a short-term "gap" insurance product to lenders whereby losses from borrower defaults that might occur during the registration delay period would be covered. e price of the product reportedly has dropped as a result of minimal losses and growing competition, and now costs about 60 basis points of the loan balance annually. Credit Information Bureaus The Importance of Credit Information in Mortgage Finance Worldwide, credit information bureaus, which collect, maintain, and dis- tribute data on borrower credit activities, are a cr ucial mainstay of under- writing for both consumer and small business loans. Known by a variety of names--for example, credit bureaus in the United States, credit referencing agencies in the United Kingdom,centrale rischi in Italy, orKreditschutzverband von 1870 (Austrian Credit Bureau) in Austria--credit bureaus are universal in developed economies and well integrated into the nancial system as ser- vice bureaus for both lenders and borrowers. Increasingly, especially in the 86 housing finance policy in emerging markets last decade, credit bureaus are now operating in many emerging and transi- tion markets, ande orts are under way to develop them in many more. us, credit bureaus are now operating in many Latin American countries and in some of the higher-income countries of Asia, the Middle East, and Central and Eastern Europe. Numerous types of lending depend on credit bureau information, including credit cards, small business loans, and personal loans. Solid credit informa- tion is especially important to risk management in mortgage lending. Credit bureau information addresses two of the "three Cs" of mortgage lending-- credit and capacity (while appraisal, of course, upholds the third--collateral). Credit bureaus provide important insight into both a b orrower's ability to pay, as evidenced by their past and current indebtedness, and willingness to pay, as evidenced by their debt repayment history. In addition, credit bureaus may be able to shed light on the source of down payment. Without the ability to determine whether the down payment has come not from own savings, but is rather a loan from another bank, lenders are at much greater risk than would otherwise be the case. Credit Bureaus in Developed Markets In many OECD countries, credit bureaus are sophisticated, automated, fast, and e cient. ree la rge in ternational cr edit b ureau co mpanies--Trans- Union, Experian, and Equifax--are highly competitive and operate across numerous countries, including the United States and most of Europe. es e companies have now also opened credit bureaus in several countries in Latin America, Asia, and the Middle East. In other countries, they have established partnerships and alliances; they may manage the credit information process, but do not own the credit bureau, or may be a joint owner or developer with other private entities or government agencies. ese companies also compete for business with large nancial-sector clients to serve as database managers and credit-scoring experts. Other credit bureaus also o er international ser- vices; Schutzgemeinscha für Allgemeine Kreditsicherung (German Credit Protection Association; SCHUFA), the German credit registry system, for example, has a regional presence in assisting countries in Central and Eastern Europe (CEE). primary mortgage market infrastructure 87 Credit bureaus perform a variety of functions, generally serving as the main credit information sources in many countries, and are utilized by a large number of bank and non-bank lenders, as well as by households. ey o er their clients credit reports, credit scores, credit-score modeling, and database management and interface, among other products. In the United States, there are also credit- score modeling experts who work with lenders, credit bureaus, and borrowers. Credit scores in the United States are o en referred to as FICO scores, named a er Fair, Isaac and Company, the company that pioneered the modeling pro- cess. FICO scores are fundamental to mortgage loan origination in the United States, and Fair, Isaac is expanding services abroad to emerging and developed markets, including Brazil and Germany, for example (Palla 2000). e bene ts of e ective credit bureaus can be substantial. With regard to lenders, for example, one of the large international credit bureau com- panies claims that its credit information can decrease the proportion of bad loans in a lender's portfolio by 45 percent and credit card default by 40 percent.10Some banks are now basing servicing and delinquency strategies on credit scores. Credit bureaus also o er borrowers and potential borrowers a wide variety of services. First and foremost, of course, persons can obtain (for a fee) their credit reports and credit scores. e bureaus also o er a va riety of prod- ucts to help the customer manage risk and get the best price for his or her credit, given his or her credit pro le. Other services include "credit watch" and "score watch," a ho me valuation service for help in b uying or selling, credit management services, a credit advice column, and information on the national distribution of credit scores. Credit bureaus represent a critical part of a sound infrastructure for housing nance, but their usage should not be seen as a panacea or as a substitute for the many elements of a sound credit underwriting policy. For example, just before the crisis, the average credit score of successive generations of adjustable- rate subprime loans in the United States has been improving between 2005 and 2007, yet the resulting performance of these credit vintages as measured through non-performing loans has b een worsening because of other pre- vailing risk factors like the decline of home prices. 10.From the presentation by Experian: "How a Credit Bureau Enhances the Credit Approval and Risk Management Process," by John Hadlow. 88 housing finance policy in emerging markets Credit Bureaus in Emerging Markets Credit bureaus have now been established in many emerging markets: Peru, the Czech Republic, ailand, India, Turkey, Poland, Croatia, Mexico, and El Salvador, to name just a few. Many othere orts are under way, for example, in Kazakhstan, Slovakia, Egypt, Russia, and Indonesia. Other markets have had, or still have, a limited form of credit information, usually managed by the central bank. e central bank, serving as the regulator of the banking sector, collects information on bad debts and defaults, which it will generally share with the banking sector. is activity, in fact, has been the precursor to credit bureau formation in many cases, and central banks have o en become sup- porters or partners in credit bureau e orts. Generally, however, central bank databases have been viewed as inadequate to support e ectively an expan- sion of lending, consumer, and small- and medium-scale enterprise lending, in particular. Although the central bank approach varies from country to country, the following limitations have been repeatedly cited: · negative-only information, that is, data is gathered only when a loan fails; · information only from banks, and not from the wide range of other lenders and credit providers, including non-bank nancial institu- tions such as building societies and nance companies, micro nance lenders, utilities, and department stores; and · data recorded for "large" loans only. e cuto levels are generally larger than most mortgage and small- and medium-scale enterprise loans would be, so nothing is recorded when these loans failed. Developing a f ull-service cr edit b ureau is a lo ng-term p rocess in emerging markets. ere are numerous barriers, including the structure of t he ba nking syst em itself. Where t here are a f ew dominant p layers, they o en resist sharing information. As discussed in b ox 4.3, t he Croa- tian Credit Bureau had to overcome reluctance by the banks with domi- nant market positions to join. In addition, there may be restrictive bank secrecy laws and problems establishing unique customer IDs. ere is also the problem of cost: developing a bureau is not inexpensive, and potential members may not see that the risk-reduction bene ts will ultimately out- primary mortgage market infrastructure 89 Box 4.3. Croatian Credit Bureau Development: HROK The Croatian Registry of Credit Obligations (HROK) was championed by the Croatian Banks Association, which had to work diligently to overcome reluc- tance by banks with a major share of the market to become members. HROK, a private company owned by its member banks, was developed with assistance from TransUnion's internationally utilized systems, combined with European and CEE knowledge and support from CRIF, an international credit reporting service that operates International Institute for Risk, Security and Communi- cation, the main Italian credit bureau. HROK will collect positive and negative data and will begin with banks and with information on numerous types of installment loans, credit cards, credit lines, and factoring; it will later expand to include other credit providers. Source: Bohacek 2003. weigh the cost. e ai Credit Bureau has had t o overcome barriers of both cost and lender reluctance. e Indian credit bureau's history points to the importance of credit bureau information to mortgage lending. HDFC, India's groundbreaking mortgage lender, set up India's rst credit information bureau in 2001 in pa rtnership with State Bank of India (India's largest commercial bank), Trans-Union International, and Dun & Bradstreet. e Credit Information Bureau (India) Limited deals with both positive and negative information that is sold to its members. Currently, there are 87 credit grantors. Credit Information Bureau (India) Limited launched the operations of its consumer credit information bureau in April 2004. While the process of populating the database is still under way, the bureau will be useful for HDFC to tap into a larger customer base without compromising on credit quality. Finally, credit bureau development in emer ging markets has g enerally been taken one step at a time, o en beginning only with banks and o ering only basic information. Development plans, however, should (and generally do) contemplate expanding membership to multiple credit providers and providing additional and more sophisticated products addressing credit risk, so that a full-service structure is envisioned from the beginning. 90 housing finance policy in emerging markets What features would a comprehensive credit information service exhibit? is has been widely discussed in countries where credit bureaus have been under development. e issues include the following: · Coverage: Will there be banks only or a wide sweep of lenders? · Reciprocity: Are only t hose supplying data p ermitted t o purchase data? · Ownership: Will it be private or public or mixed? · Management and development: Do it yourself or use an international company? · Datatypes:Willboth"negative"and"positive"informationbecovered? · Borrower types: Will they be individuals, small businesses, and com- panies, with links between them? · Data format, standardization, and volume: What scope is hoped for? · Bank secrecy rules and borrower ID issues: Do they limit scope and operations? · Updating and accuracy: How frequently are the data updated? · Consumer protection: Are legal s afeguards in p lace to enable cor- recting errors? · Modeling: Will credit scoring ultimately be addressed? · Competition and e ciency: Is the bureau a monopoly and expected to remain one? Placed against these issues, cr edit information bureaus, and especially newly formed ones in emer ging markets, face o ngoing challenges. Com- ments g leaned f rom r ecent exp eriences in emer ging ma rkets (inc luding Poland, Croatia, and ailand) include the following: Membership Information should be collected from all banks, especially the major lenders, and ultimately include all alternative lenders: non-bank nancialinstitutions, retail stores, nance and leasing companies, micro-lenders, utilities, and so forth. Reciprocity is a cardinal principle: only those providing data are per- mitted to purchase it, and they must have a legitimate purpose in requesting primary mortgage market infrastructure 91 information. Staged development is im portant: begin with basic p roducts, and then expand into value-added services such as s coring and antifraud. Should participation by lenders be obligatory, and if so, which lenders? Ownership Whether a credit bureau should be state-owned or private (a mix of the two), and the extent to which it is user owned, has been one of the most widely debated issues in emerging markets. Although there is no hard-and-fast rule, the majority of credit bureau experts and users worldwide opt in favor of full or majority private ownership. As with the nancial sector overall, best prac- tice is o en not for the government to provide prudent regulation and a legal framework, but for the private sector to own and manage the credit bureau. Nearly all credit bureaus in the developed world are privately owned (with the notable exceptions of France and China). Management and Development Should a country try "do-it-yourself," or buy a black box? e issue is dif- cult: reinventing the wheel can be as costly in the long run as engaging a seasoned international rm. Another cardinal principle is eco nomic justi- cation. To be successful, the cost of establishing the credit bureau must be justi ed in t erms of reduced risk and improved e ciency. Ongoing man- agement poses similar issues, and emerging markets exhibit a wide range of solutions. As noted, the international credit bureau companies have a liates in many countries where they do not own the bureaus, and most countries seek their help; they may be under co ntract to assist in de velopment, and may or may not conduct ongoing management. Data Both negative and positive data should be collected--for example, all loan and credit types and amounts, and payment histories. Without this collec- 92 housing finance policy in emerging markets tion, lenders cannot compute capacity to pay and willingness to pay, or con- sider various "warning signs," such as obtaining many new credit cards. Other data may include public data, such as ba nkruptcies, pledges of real estate, and existing databases such as those from the central banks. Development of credit scoring capability, or providing banks with the information to do so, will go hand in hand with increased sophistication of the data and the data standardization process. Consumer Protection Consumer protection is an important issue that should be an integral part of any credit bureau development, including regulatory oversight, privacy protection, legitimate use criteria, and error corrections. Misinformation and mistakes have proved to be serious issues in the use of credit bureau informa- tion, as individuals and others may be wrongly denied loans or o ered less advantageous terms than deserved. Individuals should have the right to access their data, to correct mistakes, to know the reason for rejection, and to know who has requested their information; the information must also be secure to ght against identity fraud. is is, however, an o en-overlooked area in emerging markets. Credit bureau design sho uld incorporate technological and organizational security and con dentiality. In Croatia, for example, the credit bureau has a control committee that includes both Central Bank and user representatives.11 In sum, credit bureaus have the potential to o er signi cant bene ts to lenders, borrowers, and the government. For banks, costs should be reduced through both improved e ciency and reduced losses. Bene ts to borrowers include easier access to nancing, help in preventing over-indebtedness, and lower rates; bank spreads should fall (at least in a competitive lending envi- ronment). Regulators and the economy should bene t from more prudent lending, improved supervision potential, facilitated risk classi cation, and a reduced moral hazard of good borrowers "paying" for bad borrowers. 11. Bohacek 2003. Chapter 5 Enforcement of Mortgage Rights Loïc Chiquier, Olivier Hassler, and Stephen Butler * "Mortgage" is a legal device by which a debtor pledges his residence to secure his obligation to the creditor that provides the loan to construct or acquire it. e mortgage is typically a public, registered agreement, and its creation is subject to certain legal f ormalities. e mortgage pledge is typ ically an accessory to the credit (it exists only so long as t he debt remains unpaid). It is a non-possessory pledge, meaning that despite its existence, the debtor retains legal title to the residence. He or she is entitled to use and occupy the residence until he or she fails to perform his or her obligation, at which time the creditor has a p referred right to evict the debtor, sell the property, and recapture its investment. e development of mortgage markets depends to a signi cant extent on how e ective the procedures of mortgage enforcement are. In theory, the mortgage device should respond to everyone's interests. It provides the cred- itor with a preferred position over valuable collateral with long-term market value, while at the same time leaving the title and use of the home with the debtor and closely regulating all enf orcement procedures. In practice, in * See Butler 2003 for the report on which this chapter draws. 93 94 housing finance policy in emerging markets Table 5.1. Enforcing Mortgage Collateral Country Time (months) * 14 EU countries (except for Italy) 4­36 (most countries: less than one year) Italy 60­84 Mexico 9­30 (average 20 months) Colombia 28­48 Namibia 6­18 Thailand 12­60 United States 8.4 (average) Sources: European Mortgage Federation 2002; Moody's Investors Services 2002; Department of Housing and Urban Development 2006; Cardenas 2003; and Calhoun 2005. * From commencement of mortgage enforcement proceedings to execution of sale for typical cases, notwithstanding the additional time needed to distribute the sale proceeds. many emerging economies, there is still a strong perception that these rights remain unbalanced in favor of the debtor to the detriment of the creditor, whereas developed markets have reached a better equilibrium through long experience. is perception of a bias against creditors' rights is valid even though in practice today, lenders use mortgage foreclosure only as a last-r esort tool of debt recovery, and consumers in most emerging markets, partly for cul- tural reasons, would rather prepay their mortgage debt than risk losing their homes and the social stigma of repossession. Long delays, uncertainties, and, in some cases, a judicial bias against cred- itors' rights, weaken the collateral value versus the debt, discourage creditors from making more and larger housing loans, or make them seek alterna- tives to the mortgage that provide less legal protection to debtors. Part of the problem is the reluctance of policy makers and courts to evict citizens from their homes, which may be culturally o ensive and politically unpopular. Even though there are few cases of mortgage execution in most emer ging economies, e cient execution procedures may be needed to avoid the per- ception by citizens that repayment has no consequences and convince credi- tors that they are protected, thereby facilitating the access of housing nance to many more households. As noted by Van Order,1 "strong foreclosure laws have b een absolutely essential to the development of the U.S. secondary 1. See Van Order 2003. enforcement of mortgage rights 95 market; if you want people to have good housing, you have to be able to take it away from them." As awareness improves, there are an increasing number of countries imple- menting reforms to strengthen the e ectiveness of their mortgage collateral system. Countries may be assigned t o groups according to the amount of time needed to execute a mortgage: (i) the very expedient systems (less than a year, where most developed economies are found), (ii) the rather expedient systems (between one and two years, where many countries that undertook reforms may be found), and (iii) the ine ective systems (still more than two years in many emerging economies). Does Mortgage Collateral Matter? Shorter periods for execution and greater certainty in realization of collateral rights can reduce costs and risks, such as lost interest and principal losses from deterioration in the collateral value. Higher resale proceeds should ben- e t both the creditor and debtor. ere is a growing body of empirical evi- dence that shows that an e cient system of mortgage collateral increases the welfare of society, as lenders make housing loans more accessible (to lower- or informal-income households, and through higher LTV ratios), and credit rates may re ect a lo wer risk premium, although this e ect is no t always observed through lower spreads. e deterrence e ect of an e ective mortgage-enforcement system also improves the credit culture, as p eople are more likely to honor their debt obligations if there are signi cant consequences. On the other hand, banks are hesitant to engage in housing lending if the law says, as it did in Russia for many years following the collapse of the Soviet Union, that a defaulting borrower must be provided with substitute housing or kept as the creditor's tenant under a lease of inde nite term at a state-determined rent. e expansion of housing lending is also discouraged by any lengthy and cumbersome delays in ex ecution imposed by the courts, which encourage delaying tactics by defaulting debtors and their attorneys. Under such cir- cumstances, the lenders must require signi cant down payment (that is, lower LTVs) from the borrowers in order to protect themselves. Even once a 96 housing finance policy in emerging markets Box 5.1. The Crisis of Mortgage Markets in Colombia Mortgages markets had expanded between 1993 and 1997 through indexed loans mostly made by specialized savings and loan institutions. These credits were indexed on the UPAC (Unidad de Poder Adquisitivo Constante), whose definition has changed from an initial inflation index to a short-term market index. These products were revealed to be complex and hazardous, escalating debt balances and installments, When market rates rose in 1998, a major portfolio crisis (24 percent nonper- forming loans [NPLs] by 2002) aggravated by serious asset-liability mismatch issues was created. The Constitutional Court required the government to convert the portfolio into fixed real rates, which triggered a broader reform of the housing finance system and fiscally costly restructuring efforts (4.5 percent of the GDP). Many lessons may be drawn from this crisis, including the slowness of the judiciary system (delays of more than three years) in processing an impressive number of enforcements requested by mortgage lenders through courts (128,000 cases by mid-2002). Most lenders denounced the bias of courts against debtors, but an aggravating factor against the lenders was the high degree of hazard associated with their loans, coupled with the absence of any adequate credit infor- mation system. court has issued a judgment, the executing o cer may nd further barriers to the actual sale of the property. In ailand, the judicial foreclosure process should take about one year, but cases through courts can take as long as ve years because of complex court procedures that permit mortgagors to use legal loopholes to prolong their cases (although simpli cation has been recently gained through a more expeditious process of court hearings). In Colombia, courts were ooded by thousands of mortgage execution cases, with the process taking between two and four years. In many African countries (Nigeria, Cameroon), several years are needed to complete a forced property sale. If mortgage enforcement is uncertain, nancial regulatory authorities may be reluctant to grant banks regulatory incentives to hold mortgage loans or mortgage securities. An unsupportive legal regime for creditors could also a ect the price and marketability of mortgage securities (such as co vered enforcement of mortgage rights 97 bonds or mortgage-backed securities) and make housing nance less a ord- able. It could also prevent attractive products such as mortgage default insur- ance from expanding, with adverse impacts again on the accessibility of the housing nance system. Differences between Legal Systems e key principles of a modern mortgage system existed in the Roman law, including: · real property pledged without delivery of possession to the creditor; · the "accessorial" nature of the mortgage right; · the right of the creditor to sell pledged property to satisfy the unpaid obligation; · the right of the debtor to excess proceeds of sale; · the ranking principle of " rst in time, rst in right," and other prin- ciples to establish ranking among competing creditors; · the pledge of present and future rights, as well as corporeal and incor- poreal property; and · the continuation of the mortgage lien o n real estate regardless of transfer of the ownership right. ese features remain the foundation of any mortgage law today, in both common and civil laws countries. Di erences that are more important are observed on the cultural attitudes toward credit and indebtedness than on the substantive legal issues. Some minor di erences found today include the following: · In civil law countries, the notary can play a signi cant role in mort- gage transactions, including creation of the mortgage and enforce- ment through notarial writs of execution without court proceeding. In common law countries, various actors perform these roles, including licensed attorneys and courts. · In civil law systems, the registration of the mortgage may have "con- stitutive e ect" (the registration is necessary to give its legal e ect); 98 housing finance policy in emerging markets however, in most civil law jurisdictions, this condition is required to make the act e ective only against third parties. · Some civil law jurisdictions do not permit a present pledge of property to be acquired by the pledgor in the future, challenging the validity of a mortgage executed prior to registration of the property right. · In s ome ci vil la w j urisdictions, a mo rtgage ca nnot b e made f or unde ned debts that may arise in the future; however, debts may be de ned with precision by formula or otherwise; for example, mort- gages securing loans with adjustable interest rates or increasing prin- cipal balances may be created. · Common law and some civil law jurisdictions consider a lease of real property to be a hybrid right that entails some characteristics of both real and personal rights; however, some civil law jurisdictions do not apply the mortgage concept to leases of real property. · ere may be an emphasis among civil law jurisdictions on public auction sale of mortgaged property. Delivery of possession of prop- erty to a cr editor and alternative methods of sale, including nego- tiated or brokered sale, is mo re likely to be found in co mmon law jurisdictions and civil law jurisdictions that have modernized their laws in recent years. Even these perceived di erences have many quali cations. Most systems di er in some respects at the margins, particularly in the procedural rules governing enforcement of mortgage rights. Some research suggests a dis- tinct di erence between civil code systems within the French tradition, and common law or civil systems within the Germanic tradition, re ected in long delays to complete mortgage enforcement in the former systems. es e long delays are variously attributed to inadequate creditors' rights under laws of bankruptcy, the accumulation of small procedural delays, the slowness and ine ciency of court procedures, and lack of judicial regard for creditors' rights generally. e importance of an e ective system for registering property rights and transactions is critical. e issue of inadequate or ine cient title registration is well known and complex (di erent systems of property rights; di erent registration systems; complex technological, administrative, budgetary, and human resources issues; rapid expansion of illegal construction and informal enforcement of mortgage rights 99 housing settlements, and so forth), and beyond the scope of this inquiry. It should be stressed, however, that in many countries (for example, Egypt), the lack of an e cient and reliable title registration system has been so far the main barrier to greater mortgage lending activity, as registration of real prop- erty rights a ects secured housing nance at practically every step.2 Some key concerns with registration systems that have arisen in many emerging markets include the following: · Costs of notary certi cation and registration (notably if based on the loan amount, leading to extraordinary costs to register and transfer the liens--6­12 percentindi erent states in India--which also makes mortgage securitization infeasible). · Speed o f re gistration. In most emer ging ma rkets, lender s will no t release loan proceeds until the mortgage right has actually been regis- tered, and in some cases until the right of the mortgagor to the prop- erty title has been registered rst.3 · Maintenance of priorities. Particularly where registration is delayed, the la w sho uld p rovide metic ulous p rocedures f or ma intaining ranking priorities. · Cheap and quickaccess to title information. Creditors need t o have cheap and e cient access to data on property ownership and encum- brances. In most EU co untries, the registration system is electronic even if not always centralized. · Mortgage of future acquired property. In some jurisdictions a mort- gage cannot be registered until the debtor's title to the property is itself registered, greatly complicating transactions. In some places, lenders are forced to enter into a tripartite agreement with the buyer and seller of the property. e solution consists in assuring that future acquired property may be the subject of a mo rtgage, and allowing 2. e most im portant and essential uses of the registration system in mo rtgage lending are checking that the debtor owns the property and has the right to pledge it, identifying third- party rights to the property, and establishing the creditor's mortgage priority over other credi- tors. 3. e Russian mortgage law has made it possible for a mortgage to be established by including in the sale contract a p rovision that the residence is sub ject to a mo rtgage in a sp eci ed amount in favor of a speci ed lender, essentially creating a mortgage containing the standard provisions of the mortgage law that becomes e ective simultaneously with registration of the contract of sale. 100 housing finance policy in emerging markets simultaneous registration of a property sale and a purchase money mortgage, simple remedies that a sur prising number of emerging markets have not implemented. · Incomplete construction. Some legal systems do not recognize incom- plete construction as real property, which cannot then be registered, and t herefore a co nstruction loa n mo rtgage ca nnot b e r egistered until completion. In some cases, the creditor may register a mortgage against the land right and take a separate pledge of the building mate- rials, or ask for a third-party guarantee. · Clear provisions on indemni cation for registration errors. Assurances that creditors will beindemni ed for errors of the registry can enhance con dence in the registration system and mortgage lending. Forms of Mortgage and Mortgage Documentation Alternative Security Devices In most of the developed world, the conventional mortgage is the prevalent legal device in housing nance. Until relatively recently, foreclosure enforce- ment would require intervention of a court; however, court intervention can be avoided through mortgage by deed (sometimes known as equitable mort- gage), lease-purchase contracts, and installment sales contracts. All of these devices leave the property title with the creditor, and enforcement does not entail termination of a property right but enforcement of a simple contract. e mortgage by deed is perhaps the oldest form of mortgage, and entails delivery of a deed--o r legal ti tle--to the creditor, subject to the creditor's contractual obligation to return the title when the debt is paid. It is still in use in some emerging markets, but rarely in developed markets. It has a modern equivalent in some U.S. states in the so-called "deed of trust," under which legal title to the property is held b y independent trustees having a p ower to sell the property in t he event the borrower fails to meet his ob ligation, but that device is essentially regulated as a mortgage. An equivalent device-- the "alineacao duciaro" or trust deed by default translation--has existed in Brazil since 2001 and has proved to be a much moree ective collateral device than the conventional mortgage lien. enforcement of mortgage rights 101 Under a lease-purchase contract, the property title also remains with the creditor, as the property is leased to the debtor under an agreement, which credits his or her lease payments toward the price of the home and obligates the creditor to convey title upon full payment of the price. is system has developed in Brazil, Russia, ailand, and Chile, notably for lower-income households that cannot gather the required down payment for a mortgage loan. It is also common through Islamic nance systems (ijara contracts). In Russia, it was the main form of housing nance under earlier anti-creditor mortgage laws, but abuses were reported by lenders recapturing the property value in excess of the debt amount and denying lessee or purchasers their accumulated equity. e similarinstallment sale contract, a device used mostly by housing devel- opers, is an executory contract under which the developer holds legal title, but grants to the purchaser a right of immediate possession of the home and to delivery of the title upon completion a er a series of installment payments. is device has been observed on a large scale in most emer ging countries such as Brazil or Turkey, where mortgage markets have not been developed through banks, as developers need to commercialize their production. With each of these alternative devices, the creditor owns the title and avoids the pitfalls of ambiguous collateral laws, delayed foreclosure proceed- ings, unsympathetic courts, and debtor bankruptcy. e creditor possesses the property as w ell as a ny related incomes, without the need f or a co urt judgment. But what makes these devices e ective for the creditor re ects their weaknesses from the consumer perspective, as t he debtor frequently is deprived of rights to redeem his property or to fully recapture his equity investment, or is burdened with the challenge of taking legal action against the seller in an environment where it is di cult for low-income households to get access to courts and legal assistance. ese devices can be regulated to provide debtors with essential protections, but they usually represent a second best to improving the mortgage laws themselves.4 4. In the United States, most co urts would rule that mortgage alternative devices should be treated as mortgages and be subject to the all of the substantive and procedural rules of mort- gages. 102 housing finance policy in emerging markets The Land Charge An alternative to the mortgage--used in G ermany, Sweden, Austria, and several other EU countries--is the land charge. is is not an accessory to a particular obligation, but has a n independent existence without regard to whether a debt exists. e land charge is typically registered against the property by the owner and remains in e ect until terminated by him o r her. Designation of the amount of the charge and the secured party is le to ancillary contracts between the owner and the creditor. e security is easily transferred from creditor to creditor without registration of termination or assignment of the charge (easier re nancing). Moreover, once registered, the land charge maintains its priority regardless of substitution of creditors. The Mortgage Certificate Another de vice is t he "mortgage note" or "mortgage cer ti cate," w hich is essentially a nancial instrument transferable by endorsement of the present holder without the need for registration of an assignment of the mortgage in the land register. e mortgage certi cate is issued based on a loan agreement and registered mortgage (or a pool of them in practice). e device permits the unregistered current holder of the obligation to prove his or her right to the security under the registered mortgage by establishing a chain of endorsements from the registered holder. is is no t characterized as a list ed security, but is simply a convenient tool to transfer mortgage loans to mobilize long-term funding (for example, Chilean "mutuos endorsables") for banks and mortgage lending companies to sell their mortgage loans to institutional investors such as insurance companies, which cannot by law originate them). e transfer of the mortgage certi cate avoids the time and cost of preparation of legal docu- ments, notary certi cation, and registration of transfer. Mortgage Documentation e conventional mortgage typically entails two legal documents: the loan agreement, or evidence of indebtedness, and the mortgage, though there enforcement of mortgage rights 103 are quite a few jurisdictions that use a single document incorporating both the loan and mortgage obligations.5 e use of separate or not agreements is mostly a matter of tradition and convenience. e standardization of loan documents and ease of transferability are both extremely important in syst ems that rely on secondary mortgage markets. From the consumer perspective, reducing the legal a nd registration costs of transactions, as well as providing simple and understandable legal docu- ments, are also important objectives. Secondary Mortgage Markets Secondary mortgage markets access capital markets through mortgage bonds or mortgage securities, which are typically collateralized by large pools of individual loans and the mortgages by which the loans are secured. e legal terms of transfer of mortgages can have critical e ects on the funding costs, including not only the preparation of legal documentation and registration fees, but also the task of registering assignment documents in each local reg- istry o ce in which one of the large number of loans securing a mortgage bond or security is r egistered. e costs a nd inconvenience of registering transfer documents has induced some secondary market systems to forego registration, assuming cer tain legal r isks in do ing s o, or to exp edite t he transfer from a simple list of assigned loans, or reduce the registration fees for transferring purposes. Systems like land charges (for example, Germany) and mortgage certi cates can be very bene cial. Other approaches t o lower tra nsaction costs inc lude central re gistries, which track changes in the bene cial ownership of the loans while leaving the registered ownership unchanged, as in Sweden. Similarly, the U.S. Mort- gage Electronic Registration System registers a single entity as the nominal legal holder of the mortgage, and this registration remains constant in the local legal registry throughout the term of the loan while actual bene cial ownership is r ecorded in a cen tralized database and updated as tra nsfers are made. e Securitization and Reconstruction of Financial Assets and 5. Other jurisdictions, such as the United States, may use three separate agreements, depending on the transaction: the loan agreement, promissory note, and mortgage (promissory note is related to legal issues concerning transferability of nancial obligations). 104 housing finance policy in emerging markets Enforcement of Security Interest Ordinance (2002) of India also authorizes a national "central registry" in which mortgage loans may be registered and assigned in bulk to facilitate securitization. Procedural Issues in Mortgage Enforcement e devil is in the details as far as procedures for mortgage enforcement are concerned. Mortgage laws di er signi cantly with respect to the rules of enforcement. Several distinct phases should be considered, each of which may ha ve i ts o wn r equirements a nd time co nstraints: no tice o f defa ult, period of cure, demand for repayment (acceleration), issuance of the writ, appeal, notice and publication of sale, sale, eviction, and the distribution of proceeds. Depending upon how each of these phases is addressed by law, time and expense may begin to accumulate, and evasive delaying tactics may be facili- tated. ere is no simple solution, but each step in the process must be scru- tinized to determine whether it adds val ue, or whether it can be usefully eliminated or improved. If some incremental improvement can be made in each step, the overall reduction in time and costs can perhaps be signi cant. What may initially appear as a r elative detail may become a formidable barrier. For example, as observed in Tanzania and Uganda, the spousal con- sent required by law to be obtained by the lender o en became a loophole permitting some debtors to get court injunctions against enforcement of their mortgage loans by invoking the existence of an undisclosed spouse-- not a di cult feat in countries that recognize polygamy and informal mar- riages and lack accurate civil records. Some laws authorize the execution of the mortgage to proceed without court supervision through a "private power of sale" granted to the cred- itor over the pledged property. When private sale is not permitted, judicial enforcement of mortgage collateral through order of execution typically remains ma ndatory, a nd t he s ale ma y b e su pervised b y a st ate o cial in charge of the execution of judgments. Depending on procedures and appeal options, the court proceedings may be a mere formality or a main cause of delays. enforcement of mortgage rights 105 Box 5.2. Judicial Enforcement of Mortgages in West Africa The countries that belong to the West African Economic and Monetary Union and Communauté Économique et Monétaire de l'Afrique Centrale (Central African Economic and Monetary Community) zones in West Africa are part of the Organi- sation pour l'Harmonisation en Afrique du Droit des Affaires (Organization for the Harmonization of Business Laws in Africa) Uniform Treaties of 1997 and 1998 (on Securities, Debt Collection, and Execution Measures). These acts estab- lished a common basis for the enforcement of a mortgaged property, which must proceed only through the courts. The process is exposed to the ineffectiveness of court system, and plagued by many broader problems. The OHADA Treatise on securities and their enforcement is under way. The system permits unregistered hidden liens. Enforcement procedures, inspired by a dated system in France, are complex and long. The debtors can pursue delaying tactics (demand conciliation, or object to the process, the date, and conditions of sale by motions and pleadings). The procedures of public auction suffer from a lack of active secondary housing markets. In the case of willful obstruction, delays can easily extend to five years. Yet, although this fore- closure process is difficult and unpredictable, it is an improvement over the old laws, and mortgages work better than other available forms of security. Mortgage is used beyond housing finance, sometimes by banks with the motivation of ben- efiting from some advantages that the prudential frameworks provide for this type of secured lending. Beyond enforcement, as in so many other emerging markets, another issue is to get registered property titles that can be mortgaged (not only in rural areas where customary rights prevail, but in main cities as well) because of inadequate land use rules and institutional or operational weaknesses that affect the registration offices. 106 housing finance policy in emerging markets Box 5.3. Judicial Enforcement in Mexico Federal countries like Mexico show how enforcement procedures may vary. Foreclosure and resale had been costly and difficult for lenders until different states began to improve their civil proceedings. According to a 2002 Moody's report, the timing for enforcing a mortgage would vary between nine and 30 months across Mexico's 32 states (and even longer in a few states, like Chi- huahua). Other delays occurred in final eviction, according to the attitude of the courts and the accessibility to public bailiffs. The report stressed differences displayed by the courts in terms of impartiality between debtors and creditors, professional use of their discretionary powers, and capacity to avoid backlogs. Because of these differences, most lenders have been avoiding mortgage lending in some states. Improvements to the legal framework were passed through a legislative package in 2003, which is anticipated to eventually reduce the average expected time to foreclose to less than two years. Nevertheless, the process to register or transfer property remains expensive in many states. Non-judicial Enforcement In most countries that permit a private right of sale, the debtor has the right to bring the case before a court to assert defenses against the claim or protest defects in t he proceedings. e creditor--or an agent such as a tr ustee or a notary--may, however, take possession of the property and may be per- mitted to advertise and sell the property using its own means and methods, subject to some regulations regarding the organization and terms of the sale. In a number of civil law countries, the equivalent of the private power of sale is the writ of execution issued by a notary public, who serves an interme- diary to verify the debt and supervise the actual execution sale, including the giving of required notices to the debtor and other interested parties. Court proceedings are typically recommended by those who believe that courts would better protect the debtor, through, among other things, assuring clear and timely notices to the interested parties and adequate advertising of auction sales, reasonable sale prices, and so forth. Some unspoken prem- ises of proponents of private right of sale regimes have been that banks act enforcement of mortgage rights 107 Box 5.4. Non-judicial Enforcement of Mortgage Rights in Croatia The judicial enforcement of a conventional mortgage can take up to three to five years because of backlogs in the courts. There is, however, a mortgage-by-trust deed device (Fiduciary Transfer of Title, or FTT) that is enforceable out of court by registration of a notary act certifying the occurrence of a default sufficient to terminate the debtor's property interest. The registration of the notarial act is nec- essary to vest absolute title in the creditor. Then, the creditor can sell the property without court supervision, subject to the usual rules of public sale applicable to any other mortgage sale. At the start, in practice some courts were permitting this form of non-judicial foreclosure, while others were not (based on some ambigu- ities in the law, the Zagreb land court would not allow registration of the notarial act of execution, referring the case instead to the municipal court). This reaction is not unusual in countries in which power of sale is new, and registrars can be among the main barriers to implementation as they refuse to register titles arising from a creditor's power of sale. Most of the housing portfolio remains secured by third-party personal guarantee loans. responsibly in makin g loans and enforcing mortgage rights, that they are non-predatory and lack incentives to exploit the ignorance of borrowers, and that there are few good defenses to enforcement of a mortgage. e recent (2008­2009) events in the U.S. "sub-prime" mortgage market challenge some of those premises insofar as many borrowers may allege that they were duped into taking loans that they did not understand and could not a ord by bank agents who had a nancial interest in makin g loans without regard to the borrower's ability to repay. Whether these allegations ultimately are proven true or a ect a signi cant portion of the troubled loans still remains to be seen, but if so this crisis may be an object lesson that the fair use of private rights of sale may depend on underlying mortgage lending practices. Several countries that take the judicial approach to mortgage enforcement under their civil legal systems have managed to improve their proceedings by providing explicit and detailed guidance on each step of the process, limiting delays and possibilities of abusive appeals, eliminating arbitrary decisions, imposing nancial s anctions aga inst dela ying t actics (f or exa mple, most 108 housing finance policy in emerging markets states in Mexico since the 2002 and 2003 reforms; Namibia; Egypt, through its 2001 Mortgage Law; and soon Turkey, through its revised mortgage law), and creating courts specializing in debt recovery with better-trained judges. For example, Rwanda reactivated in 2004 a fast-track foreclosure procedure (voie parée) with severe time limits on appeals once a judge has agreed to foreclose, a nd est ablished sp ecialized c hambers wi thin t he t hree b usiest courts of the country. Nevertheless, the numerous drawbacks of the judicial approach continue to be stressed by creditors, including long case backlogs, extensive delays based on frivolous motions and continuances of proceedings, and cases of courts displaying a bias toward the interests of debtors. e principle of equi- table treatment of individual borrowers is laudable, but may produce adverse e ects when courts are incapable of handling the cases expediently, and judges are granted a discretionary power to assess the appropriateness of the proceedings and to grant relief to mortgagors based on extralegal consider- ations of social justice. Box 5.5. Non-judicial Enforcement of Mortgage Rights in Sri Lanka In Sri Lanka, most of the legal system is based on the principles of English common law for commercial matters, but areas of law such as mortgaged property remain under the influence of the Roman-Dutch law. The Mortgage Act and Debt Recovery Act were modified in 1990 so that commercial banks (com- pared to only a few state banks before) were given the "parate" execution power, to foreclose and sell the property through auction without recourse to courts (after a board decision and press publications). These rights were extended to properties provided by third parties and to syndicated lenders. New questions have related to the extension of "parate" for a securitization special purpose vehicle (SPV). The timing of enforcement has been reduced to five months, but appeals can be processed through courts, resulting in longer delays. The debate is over whether banks have abused these rights, notably in small- and medium- scale enterprise lending (unduly accelerating the liquidation) or used it only as a last-resort solution. The government has been trying to suppress the "parate" for loans below 5 million rupees, which would be a severe blow to housing finance. enforcement of mortgage rights 109 Box 5.6. Time in Foreclosure in Power of Sale and Judicial Procedure States in the United States The United States may serve as a valid laboratory to test the hypothesis that non-judicial enforcement is more efficient than judicial ones, as non-judicial pro- cedures are still not permitted in 20 states. The table below tends to confirm the theory. Average time in foreclosure in the United States System Number of jurisdictions Months in foreclosure* Power of sale 31** 5.1 Judicial enforcement 20*** 9 Source: Federal Home Loan Mortgage Corporation 1993. * Average time to actual sale of the property, without the statutory period for redemption of the property. ** AL, AK, AZ, AR, CA, CO, DC, GA, HI, ID, MA, MI, MN, MS, MO, MT, NC, NH, NV, OK, OR, RI, SD, TN, TX, VA, WA, WV, WI, WY *** CT, DE, FL, IL, IN, IA, KS, KY, LA, MA, MD, ND, NE, NJ, NM, NY, OH, PA, SC, UT, VT Box 5.7. Non-judicial Enforcement of Mortgage Rights in India Different types of mortgage exist in India: (i) the traditional mortgage that is enforceable only through a court decision; (ii) the "legal mortgage" by registered deed, which can include a non-judicial power of sale; and (iii) the "equitable mortgage" by an unregistered deposit of the debtor's certificate of title with the creditor. Through the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act of 2002, India extended the right of non- judicial enforcement to all forms of security interests and mortgages, provided that the secured creditor is in possession of the original mortgage deed. The act requires notice to the debtor demanding full repayment of the debt, and a 60-day waiting period, in which the debtor may redeem his property. If the debtor fails to meet this obligation, the creditor may possess the property, manage it directly or through an agent, or lease or sell it. Proceeds are held by the creditor in trust and continued 110 housing finance policy in emerging markets Box 5.7. Non-judicial Enforcement of Mortgage Rights in India (continued) applied first to the costs of the enforcement action, then to the debt, and finally to other creditors. This power of sale is available only to the financial institutions or their agents for their secured lending, and can be used only if the amount due exceeds 20 percent of the principal amount and interest thereon (to avoid abuses by lenders of this fast-track debt-recovery mechanism without debt mitigation efforts). The debtor has 45 days to lodge an appeal with the Debts Recovery Tribunal, but should then post a bond with the tribunal of 75 percent of the creditor's claim (dissuasive against delaying tactics) unless a lower amount is set by the tribunal. A successful appeal to the Debt Recovery Tribunal can result in return of the property to the debtor and payment of costs and damages. Four years later, lenders agree that this way is more effective and speed- ier--under six months--than the traditional way, at least for the small resi- dential mortgage loans, and that creditors may no longer hide behind a slow- paced judiciary. Box 5.8. Reforms of Mortgage Rights in Pakistan In Pakistan, nonperforming assets have been plaguing the banking system, notably because of an inefficient judicial system for recovering defaulting loans (encumbered courts). The Financial Institutions Ordinance of 2001 created a new foreclosure mechanism for the financial institutions to bypass judicial pro- ceedings for mortgage claims. New rules aim to avoid delaying tactics often used by debtors: a defendant debtor may mount a defense only with the permission of the court and only on the basis of substantive questions of law or fact; if court proceedings last for more than 90 days, the defendant can be required to furnish a security to indemnify the creditor; appeals of judgments must be made within 30 days and decided within 90 days, and execution will not be suspended unless the debtor repays; and (continued) enforcement of mortgage rights 111 Box 5.8. Reforms of Mortgage Rights in Pakistan (continued) if the court determines that objections to the sale are raised for the purpose of delay, it can charge the debtor with a penalty of up to 20 percent of the sale property price (symmetric penalty to the lender if the objections prove to be sustained). The ordinance enables lenders to directly repossess and sell the property without court intervention, provided that several conditions are met (early notices, sales through public auction, or solicitation of tenders in which the lender may also participate). The police may be called to assist if the borrower does not evacuate. The ordinance specifies the few cases when the court will intervene (if no mortgage existed, or was paid in full, or if the debtor deposits the full amount of the debt as a security). Some early decisions overrode the initial reluctance of registrars to validate such non-judicial forced sales. Problems come from cases where an ongoing tenancy contract deposits a security in the full amount of the debt. Courts have also been sensitive to debtors' contestation on grounds of insufficient prices of the forced sales. The recommendation made by the Mortgage Finance Advisory Committee has been to insert the notion of "reserve price" in the law, verifiable by independent valuers. e best choice may depend on the circumstances in each country. For example, in some low-income countries, the judicial system may be plagued by many problems that cannot be solved quickly by mere changes to the laws: limited budgetary resources, excessive backlogs and delays, insu ciently trained and paid sta , and corruption. In such cases, improvements to the laws may be ine ective and out-of-court proceedings may be the only fea- sible alternative. In some cases, the enforcement of mortgage collateral appears as mo re cost e cient, with private powers of sale, and such proceedings can also be designed to adequately protect the interests of debtors. e cases presented in Croatia, India, Sri Lanka, and the United States tend to con rm these views (also, Brazil since 2001, or Ethiopia since 1998). Yet, as noted earlier, signi - cant improvements have also been implemented in judicial proceedings, and 112 housing finance policy in emerging markets some countries, including Sri Lanka and Pakistan, have been facing issues with their attempts to develop non-judicial enforcement mechanisms. Negotiated versus Auction Sale Many judicially supervised enforcement procedures require public auction sale. ere is a p erception that public sale is a tra nsparent procedure that provides greater assurance of obtaining a market price for the property, and allows interested third parties, such as gua rantors and junior creditors, to participate and protect their interests. As the success of the auction sale depends on the level of participation, evidence in developed markets suggests that participation is mostly limited to interested parties and professional property speculators. Auction prices rarely exceed the established starting price, or the amount of the debtor's obli- gations. In some places, such sales are also viewed as culturally o ensive and the auctioned property tainted, lowering the auction value. In many small communities, it may be unacceptable for residents to bid on a neig hbor's property, and newcomers may not be welcome in the place of a displaced and publicly humiliated neighbor. Negotiated sale through the intermediation of property brokers may result in hig her prices and may be carried with the cooperation of the defaulting mortgagor, allowing him or her to avoid public attention. It should be stressed that the conditions of negotiated sale also can and should be regulated to assure protection of the borrower's interests.6 Responsibility for Sale Laws di er in assigning responsibility for conducting execution sales: by the creditor itself; licensed rms engaged by the creditor; or the court, notaries, and court executives (baili s or clerks). Each alternative o ers both bene ts and problems. Court-supervised auction or sale procedures risk entangle- ment in court schedules and case backlogs. Even use of notaries and court 6. Detailed no tices t o t he deb tor a nd o ther t hird pa rties, p referential p urchase r ights a nd rights of rst refusal to interested third parties, pricing based on independent appraisal, full accounting, and penalty for sale below reasonable market value. enforcement of mortgage rights 113 o cers can lead to delays. In some cases, a centralized executive o ce, o en related to the Ministry of Justice, may be charged with the execution of all judgments and attachments, but these o ces can be understa ed and under- funded, and become themselves a roadblock to e cient execution. Placing the responsibility on the creditor or professionals hired by the creditor cre- ates the economic incentives to accelerate proceedings, but may create con- icts of interest that require adequate regulation. Auction Sale Prices Prices for sale of mortgaged property may be set by legal formula, or may be est ablished by t he auction. Forced s ales may b e ine cient as pricing mechanisms. Starting prices may be unrealistic. A creditor may bid only the amount of its debt, which could be far below the actual value of the property, and property speculators may bid only slightly more than the debt amount. Some mortgage laws require that the starting price for auction be set as a rea- sonable proportion of independently appraised market value (for example, Egypt 2001 Mortgage Law), and approved by the court or other public o - cial. If this price is not reached, a second auction may be held at which the starting price is reduced, but not below a minimum. If all auctions fail, the creditor may be obligated to take possession of the property at a price estab- lished by legal formula. Automatic reduction of starting prices for second auctions recognizes the ine ciencies of the auction mechanism, and that the creditor needs some surplus in the property to assure payment of costs and expenses of the enforcement procedure, including the costs o f property improvement and maintenance. It creates, however, a disincentive to bid at auction sale, partic- ularly for the creditor, since the only penalty for failing to bid at the auction procedure is perhaps a delay of some period in realization of the collateral. Creditor's Right to Acquire the Mortgaged Property In most systems, the creditor has the right to acquire the mortgaged property, either directly from the debtor or as a participant in the forced sale. Direct 114 housing finance policy in emerging markets acquisition is a negotiated transaction between the creditor and debtor that results in delivery of title to the creditor in exchange for release of the debt (an e cient alternative to execution when the property value is c lose or below the debt amount) and results in a waiver of any further claims against the debtor. As a variant, the creditor may also assist the debtor in selling his or her property to a third-party purchaser.7 Direct acquisition or assisted sale can have substantial bene ts for both sides, by avoiding public exposure, reducing the time and costs for realiza- tion of the mortgage collateral, and relieving the debtor of liability for any shortfall. e sale of the property under market conditions is likely to pro- duce a higher price than a forced auction sale, to the bene t of both sides. is is usually permitted by direct negotiation and an arm's-length contract, although abusive transactions should be avoided (for example, by requiring that the debtor be fully informed about the terms of the transaction and have the right to reject it). Creditors are also typically permitted to participate in a public sale, and their bids are automatically credited with the amount of the debtor's out- standing obligation. In the absence of a starting price, the creditor's bid will equal only the amount of the obligation, and subordinate creditors will bid the sum of their own and all senior obligations. Permitting creditors to par- ticipate in sales is s ensible, as they may be the only motivated bidder, and creditor participation has no apparent prejudicial e ect. is form of acqui- sition should be distinguished from the arm's-length negotiation described above, which takes place prior to and outside of the forced sale. Notice, Cure, Rights of Redemption, and Stays of Execution Most systems of mortgage nance require that prior to enforcement of a mortgage, a demand must be made on the debtor to cure his or her default, and a reasonable period be provided to him or her to do so. is procedure is o en set by law as a p rerequisite to demanding repayment of the entire 7. Some evidence suggests that assisted sale has become the predominant form of execution in the United States. How the recent collapse of housing markets and the explosion of foreclo- sures has a ected that dynamic is not known. enforcement of mortgage rights 115 mortgage loan (acceleration of maturity). e time b etween default and commencing enforcement procedures typically varies from 30 to 120 days. Notice requirements and periods for cure are good practices to be followed by lenders. Interest and other charges should continue to accrue during the cure period, and cure of the default requires payment of all amounts due to the lender at the time, including costs and penalties. Once the time provided to cure default has been exceeded and the creditor has commenced proceedings, the debtor may still cure his or her default at any time up to actual sale of the property, but in this case only by repaying the entire loan balance and any costs, including attorneys' fees and court costs, incurred by the creditor. A rationale for limiting the debtor's right to rein- state the loan a er repayment has been demanded is essentially to prevent a repeated and costly cycle of consecutive defaults and cures. Some laws, particularly in t he United States, provide mandatory rights of redemption even a er the completion of the execution sale. During this period, the purchaser at the auction sale is p revented from taking posses- sion of the property while the debtor is given additional time to raise funds to redeem his or her property. is redemption period can range from sev- eral months to up to one year. e practice of providing long post execu- tion redemption periods has b een criticized for increasing creditor's costs and, therefore, interest rates, threatening deterioration of the property, and decreasing interest in auction sales of property, but as with most issues sur- rounding enforcement, hard empirical data is scant. Similar in e ect to statutory periods of redemption, some laws or legal systems (for example, Tanzania, Russia) place it within the discretion of the court to grant a stay of execution, so that justice may be done with least harm to both parties if the ultimate remedy is delayed for some period. For example, this step might be taken if the debtor has a realistic chance of over- coming a transitory setback for health or employment reasons. Where such discretion is ex ercised, interest on the debt continues to accrue, and the debtor remains liable for any other damages caused to the creditor for delay. In systems where there is a b ias against the rights of creditors, this type of discretion can lead to unjusti ed additional delays and should be limited, for example, to cases where the debtor can demonstrate reasonable chances of nancial rehabilitation. 116 housing finance policy in emerging markets e same type of delay can be obtained by exercise of the court's discre- tion to grant delays and continuations in the proceedings, for one or another (sometimes) d ubious r eason, suc h as t he una vailability o f t he deb tor's attorney. e frequent rescheduling of proceedings at the discretion of the court can add substantial time to the enforcement proceeding. Abuse of this sort of procedural device should be addressed by law. Bankruptcy and Other Preferences In places where modern personal bankruptcy law exists, the ling of a bank- ruptcy may result in a susp ension of proceedings to execute a mo rtgage against the debtor's property. e main questions are whether the duration of the delay and the mortgage residence is automatically included in the bank- ruptcy estate. Many modern bankruptcy laws avoid making bankruptcy a "back door" to depriving the creditor of its right to security. Bankruptcy, however, may sub- ordinate the mortgage lender's rights (from resale proceeds) to other interests like the cost of all legal p roceedings and execution of judgments, or unpaid taxes and social debts (health, pension, alimony, and so forth) to employees and family. A good bankruptcy law would include provisions that preserve the mortgage creditor's priority over unsecured creditors by, for example, speci - cally excluding a mortgaged property from the bankruptcy estate. Appeals Frivolous appeals of judgments to higher courts can signi cantly delay exe- cution on mortgage collateral. One k ey issue is w hether an execution sale may proceed pending appeal, or whether it is delayed until the appeals are completed (years of delays may accompany a suspension). If execution sale is permitted to proceed pending appeal, the rights of the purchaser of the property must be protected by, for example, assuring reimbursement for his costs and reasonable investments in the property. Various a pproaches t o co ntrol a busive a ppeals t oday inc lude t he f ol- lowing: enforcement of mortgage rights 117 · Assure that the elements of the case for collection of the debt and execution of mortgage are simple and clearly de ned in the law, and the grounds of appeal limited. is has been the case in Chile through the 1997 Banking Act, where the enforcement of a mortgage must go through a court, but where a defaulting debtor has only 10 days to comply with a payment request through the court before this latter starts the enforcement (usual publication and public auction rules). Debtor's defenses for a ve-day period is limited to only a few nar- rowly de ned cases (debt repaid, prescription, action non-applicable to this defendant) grounded by written evidence and credible founda- tion. An appeal would also not suspend the forced sale procedure. · Leave t he decisio n t o susp end ex ecution p ending co mpletion o f appeal to the discretion of the court, which should be in t he best position to judge whether appeals are unfounded (but if the judiciary system is known to have a strong pro-debtor inclination, it may be necessary to prohibit narrowly de ning the grounds for suspension of execution pending appeal). · Require the debtor to post a bond or other nancial undertaking that indemni es the creditor for any losses that may be incurred during the appeal period, and to make the debtor liable for court costs and attorneys' fees in case his or her appeal is rejected, as implemented as part of broader reforms of the mortgage enforcement in India or Pakistan. e same approach is also re ected in t he new mortgage law of Turkey, where execution can be delayed for two to three years by increasing the undertaking that an appealing borrower should deposit from 15 percent to 40 percent of the unpaid debt. Eviction Obtaining a judgment or writ of execution is sometimes only a rst step, and the actual possession of a vacant property may be another matter. e inability of the creditor to obtain possession of the property in a timely manner may delay execution, increase costs, and perhaps threaten property deterioration. In jurisdictions in which courts or notaries must issue a writ of execution, the writ should include an enforceable order for possession and eviction. Where 118 housing finance policy in emerging markets execution sale is the responsibility of a state or court entity, that entity should be responsible for delivering vacant possession of the property at the time of sale. In cases of non-judicial enforcement, eviction and possession should be carried out at the request of the creditor prior to or contemporaneously with the sale. e least desirable procedure is t o place the burden of obtaining possession on the purchaser through a separate court action following the sale. e last resort of public force should remain a feasible option, however unpopular, that any government should be ready to provide, but obtaining assistance of public o cials can be di cult in many countries. Distributions e last step in the process is the distribution of the proceeds of sale, and this can be a complex procedure. Performance can di er among countries, ranging from practically immediate in some places to up to a year in others. Much may depend upon factors such as w hether the order of distribution is subject to approval, by a court or equivalent body, or whether the deter- mination of priorities among competing creditors and other third parties is integrated into the early preparation of the execution sale. For example, in some systems requiring judicial proceedings, the order of distribution must be submitted with the request for judgment, leaving the burden of due dili- gence on the creditor, who has the greatest incentive to perform it quickly ande ciently. In contrast, where sales proceeds are collected and distributed by court executive agencies, there is o en no incentive to accelerate distribu- tion, and sometimes there is incentive to delay distribution if revenues can be earned from the interest rate oat on execution proceeds in their accounts. Alternatives to Mortgage Enforcement While all systems seek to avoid dispossession or minimize its impact in some ways, the fact remains that a creditor may not be able to recapture its invest- ment without either depriving the debtor of possession or shi ing the loan obligation to some other party. enforcement of mortgage rights 119 Forbearance e formal processes for enforcement of a mortgage against a residence are perceived by many experts to be costly and ine cient, and depending on the relationship of the loan amount to the property value (LTV ratio) and the performance of the housing market, may o en result in a loss t o the cred- itor. is is true in jurisdictions such as the United States, where LTV ratios are relatively high, as such loans leave the creditor with minimal surplus to protect against declines in housing prices, delays in enforcement, and other potential losses incurred in the mortgage enforcement process. In such cases, attempts at forbearance and active debt mitigation, including payment defer- rals and loan restructuring, may be less costly than a rush to enforcement of collateral rights. Losses may be less likely in countries where loan amounts are lower relative to property values. In the United Kingdom, the search for alternative debt mitigation solu- tions before foreclosure is treated as a mandatory responsibility of the lender, which is a fair and symmetric treatment, notably as LTVs are high and fore- closure proceedings e ective. Forbearance ca n t ake ma ny f orms, inc luding ext ension o f ma turities, lowered interest rates, and deferral and capitalization of interest payments. Whether forbearance is less cost ly than realization of collateral rights is an economic calculation that would have to be made in each system, and which may vary over time depending upon the mortgage lending practices, barriers to enforcement, and the dynamics of the housing market. At another level, however, forbearance, or at least the attempt to nd a solu- tion short of enforcement of the mortgage, is viewed in some jurisdictions as a necessary element of fairness and the procedural protections a orded to debtors who are acting in g ood faith. In the United States and the United Kingdom, for example, the obligation to attempt solutions short of mortgage enforcement is deeply embedded in the practices of the industry, and enforced indirectly by major institutions such as the secondary market agencies, the government's own mortgage insurance program, or the industry association. In no developed market, however, is there currently a legal r equirement to forbear or to modify the terms of a loa n, and ultimately the terms of any forbearance remain the discretion of the creditor. Even under t he current 120 housing finance policy in emerging markets (2008­2009) foreclosure crisis conditions in the United States, government approaches to forbearance entail nancial incentives to lenders--including subsidies covering portions of reduced interest payments and lump sum cash payments to creditors for entering into and completing restructuring discus- sions with borrowers--rather than enforced forbearance. Alternatives to Mortgage Collateral Not all housing lending is mortgage based or micro nance based. er e are alternatives to mortgage collateral and eviction as its last-resort consequence. In some societies, other tangible or intangible assets may be attached to the housing loan in an e ort either to recover the credit or to discourage default. ese approaches may avoid harsh results by shi ing the risk and burden of default to other parties that may be more willing to seek accommodation with the debtor. Yet, international experience shows that the impact of these alternative techniques is valuable, but may not be su cient to substitute for an e ective mortgage system in order for a sound housing- nance system to scale up and become accessible. For example, in most o f the formerly socialist societies, all employment was under the control of the state. us, garnishment of wages was a direct and e ective form of collateral for housing loans; given legal restrictions on foreclosure and eviction, garnishment was in fact relied upon. In other coun- tries, this system remains quitee ective for lenders toward public and private employees, at least until the employee loses or changes his or her job. Wage garnishment may be associated with payroll deduction in order to repay the loan, and should be seen as complementing the main mortgage system. Personal guarantees from related parties represent another form of alter- native to mortgage enforcement. ey have been extensively used in coun- tries such as India or Croatia, o en as a second-best alternative toine ective systems of mortgage enforcements rather than by a lender's preference. ey can be provided by one or more family members, or even by employers. e theory is that the creditor will be compensated by guarantors, who will then have the burden of working out an accommodation with the debtor. e existence of personal guarantors may also be viewed as an incentive for the debtor to repay the loan and avoid opportunistic or strategic defaults. enforcement of mortgage rights 121 Box 5.9. France: Guarantees as a Substitute for Mortgages Another way to use a guarantee as a mortgage substitute is the French prêt immo- bilier cautionné, a housing loan guarantee that takes the place of a conventional mortgage. The main issuer of the guarantee is a well-rated financial institution-- Credit Logement--which is capitalized by most mortgage lenders and operates independently with certain privileges. This system arose in response to the high costs of creating, registering, and enforcing conventional mortgage liens. Bor- rowers are charged guarantee fees and annual servicing fees, a portion of which may be returned to the borrower if the loan is repaid on time. The guarantor takes assignment of troubled loans from the insured creditors, and must then decide on the subsequent course of action with respect to the loans, including the pos- sibility of registering and executing ex post a mortgage lien. In societies such as India, where nonpayment of debt is considered a social embarrassment, communication between the borrower and the guarantors may be as e ective as a court threat in producing repayment. is is espe- cially true for loans made by small-scale mutual or cooperative organiza- tions. Of course, personal guarantees only shi risk of default, sometimes onto someone who is no b etter able to bear it than the debtor, and may have to rely on the volatile evolution of the guarantor's incomes through the many years of the housing loan rather than the more stable value of real collateral. (In most legal syst ems, the personal guarantors, a er honoring their obligations, have the right to execution of the mortgaged property.) In some countries, such as Croatia, the system may have reached its limit when lenders cannot nd enough creditworthy guarantors free of debt or other guarantees. Another remedy may come from a mortgage default insurance program (see chapter 13). Such insurers step into the shoes of the insured private cred- itor and may apply alternative debt-mitigation techniques to debtors. Again, this does not eliminate the risk butshi s the burden to all borrowers and tax- payers (if the fund is public), with the arguably bene cial e ect of spreading risk broadly over a wider population. 122 housing finance policy in emerging markets Box 5.10. Housing Lending in Indonesia The Indonesian State Savings Bank implemented a "community mortgage loan," which is used by low-income persons working in the informal sector to obtain land and construct housing. This credit is granted not to individuals, but to entire communities, which must first contribute cash or other value, including land, to a restricted fund to evidence discipline and willingness to save. In addition, the bor- rowers and community members must each make an additional contribution over and above normal loan payments to create a reserve fund against the possibility that certain members of the community may default. If there is no default, the reserve fund remains with the community. Recent reports suggest that this form of community lending has met with limited success. For example, the U.S. Federal Housing Administration (FHA) for many years has operated a large program of mortgage insurance for low- and moderate- income persons. In most respects, the program operated as any other private sector insurer, and mortgages were frequently enforced against borrowers. Under pressure from stakeholder groups, the agency implemented a program whereby debtors, under threat of forced sale, could petition to have the FHA pay o the creditor and take ownership of the loan for providing forbearance relief to debtors who experienced nancial setbacks but had a realistic pos- sibility of nancial rehabilitation. Research has suggested that this program has been costly and unsuccessful in ultimately preventing loss of the home. Common Property Mortgage Another hybrid approach is to mortgage a common property for a loan that is the joint obligation of the property owners. An example would be a mortgage loan made to nance construction of a building owned by a cooperative legal entity, in which each cooperative member holds a legal interest, as well as a personal right to occupy a speci c home or space. e individual members bene t from the mortgage loan, but do no t pledge individual property as security and may not be personally liable to the creditor for the loan. e enforcement of mortgage rights 123 individual's obligation to repay the loan is governed by the terms of member- ship in the entity. If an individual member fails to meet his or her obligations, the creditor continues to receive payment and avoids the need for enforce- ment of collateral rights. e risk, however, is shi ed again to persons who must make their own arrangements with the defaulting party. Depending upon the size and basis of the cooperative relationship, they may be more willing to seek accommodation than would a private creditor, and at the same time, individual members have greater incentive to meet their obligations. ere may be a breaking point, however, and the coopera- tive mortgage may perhaps subject all members to greater risks than some of them would bear if they had taken their own mortgage loan. Conventional mortgage techniques applied to commonly owned lands (particularly to lands held by customary property rights) are o en less e ec- tive than other housing nance techniques such as micro nance and incre- mental housing development, as it is unlikely that creditors would be willing, or able, to execute on commonly owned and customary lands, and even more unlikely that they would be able to nd purchasers for homes and lands that are traditionally occupied by relatives. Minimizing Enforcement Actions e most e ective way of avoiding mortgage enforcement is to make loans only t o g ood credit r isks--that is, cr edit rationing bas ed on sound loan underwriting criteria--and professional servicing, including preventive and active debt mitigation. Unfortunately, this is easier said than done in some emerging economies where credit information systems are underdeveloped, and lenders are dependent on the debtor's own representations (see other chapters of this book). Another critical and related aspect of mortgage enforcement is consumer information and education of mortgage borrowers (see chapter 6), including complete disclosure of the costs of the mortgage loan, and the rights, obliga- tions, and risks of the borrower. Borrowers should be provided with all perti- nent information to determine whether they are willing or able to assume the burdens. is is critical, as housing may be the most important investment of the household's life. Some jurisdictions legally require complete disclosure to 124 housing finance policy in emerging markets consumers of the costs, terms, and potential consequences of mortgage bor- rowing in a simple, transparent, and comparative manner. Good models are available in the EU (the European Standardized Information Sheet is used by most lenders on a voluntary basis). e more complex rules on mortgage- loan disclosure practices in the United States (Truth in Lending Act, Federal Reserve Regulation Z) have been the object of intense debate on their limited impact, notably for subprime mortgage markets. Chapter 6 Consumer Information and Protection Hans-Joachim Dübel with contributions from Simon Walley Protecting the consumer of housing nance products has become an increas- ingly important and debated subject in both developed and emerging mar- kets. One of the special characteristics of housing nance urging intervention is the creation of large nancial exposures for the consumer and a burden for him or her to make sizeable payments over extended periods, coupled with the risk of losing his or her primary residence posted as collateral. In addi- tion to this "credit" dimension, housing nance contracts also contain many nancial options for the consumer (for example, early repayment) and the lender (for example, assignment or sale of the loan, rate adjustment), whose values are extremely sensitive to a changing market environment and whose outcomes may impose additional risk on the consumer. For these reasons, the "why" of consumer protection is rarely debated today. e speci c goals and approaches of consumer protection are more con- tentious, however, because of inherent con icts with other developmental goals. is is already noticeable in t he traditional de nition of the goal of consumer protection, because it ensures a "fair deal" for consumers while allowing lenders to reach a su cient return on their invested capital. Seen from a b roader nancial-sector de velopment p erspective, consumer pro- 125 126 housing finance policy in emerging markets tection o en means solving con icts between market e ciency on the one hand, and market stability and social protection on the other. For instance, the right of a consumer to repay a xed-rate loan unconditionally con icts with the goal to o er the lowest-cost xed-rate loan, because of reinvest- ment risk for the lender. On the other hand, the ability to a ord by young households through credit products with low initial payments may con ict with stability goals when the same product entails a possible future payment shock. It is clear that nding the optimum here is a di cult task. Considering the varying stages of housing nance development, there can also be no one-size- ts-all strategy of consumer protection. Roles and charac- teristics of the agents--lenders, developers, courts, local governments--that have to implement any set of rules change, and new agents (for example, bro- kers) appear. With this environment, the cost-bene t balance of individual rules changes, as do their implementation requirements and the availability of supportive social and economic policies. Finally, there is the risk that rules accumulate without regular review and cutbacks, leading to overregulation or inconsistent regulation. is section starts by brie y referring to the di erent interpretations of the consumer that lead to di erent perspectives of the role of consumer pro- tection, followed by a more precise economic de nition of the objectives of consumer protection. e third subsection discusses the canon of the most common consumer protection rules in more detail: a frequently used classi - cation follows the typical loan life cycle and distinguishes between consumer information rules, enabling transparency of loan o ers and possibly advice to assist his or her choice, and "material" consumer protection rules governing limits to products and lender covenants, as well as the foreclosure process. e section then proceeds by discussing the costs of consumer protection, including the role of di erent delivery mechanisms, which can range from nancial literacy programs over industry self-regulatory mechanisms to full legislative coverage. It is then asked whether consumer protection must not be seen as a luxury good for emerging markets, and if not, what options there are for economizing the discussed costs. e section ends with conclusions. consumer information and protection 127 Defining the Consumer Developed Markets Modern consumer protection law in de veloped markets is bas ed on two competing concepts of the consumer. e rst is where the consumer is con- sidered broadly rational and able to make informed decisions and choices in their own interest based on the information available to them. In this school of thought, it is deemed su cient to protect the consumer by ensuring ade- quacy of information and antidiscrimination.1 e second approach is much more recent and contends that some negative contract outcomes, especially if related to the most vulnera ble in s ociety, matter for society as a w hole. Even if full transparency exists and contracts are negotiated fairly, the weight of negative individual outcomes may justify the costs o f intervention into contractual freedom.2 e tendency has been for Anglo-Saxon countries to adhere to the former, and for continental European and socialist countries to adhere to the latter concept. e fault lines, however, generally go through individual societies, where they traditionally fuel debate between consumer and lender gr oups and lib eral a nd co nservative p olitical ca mps. I ntervention in to co ntrac- tual f reedom--so-called "material" consumer protection--as a r esult has remained hotly contested. e consensus area is consumer information and empowerment in contract negotiations, which is seen as a necessary, although not su cient, element of consumer law by both schools. Emerging Markets From a historical perspective, the transfer of law from Western and socialist country sources to emerging markets has led t o a certain level of di usion of these competing concepts worldwide.3 For example, recipient countries 1. e Utilitarian school of thought has roots in the Age of Enlightenment and can be traced to Bentham (1789), who also wrote one of the rst critiques of usury laws. 2. See Rawls 1971. Antecedents go back to the Greeks (Aristotle), the Christian canonic interest prohibition, and Marx. 3. is economic school was de veloped inter alia a t the World Bank. See LaPorta, Lopez de Silanes, Shleifer, and Vishay 1998, and Djankov, La Porta, Lopez de Silanes, and Shleifer 2002 128 housing finance policy in emerging markets of Western law in Latin America, the Commonwealth, and parts of Asia can be shown to have adopted creditor- or borrower-friendly contract laws and judicial processes, depending on the origin of law.4 In addition, there has been increasing transfer of law between emerging markets. A prominent example is Islamic nance rules, which combine the religious and social perspectives of the consumer in their respective societies, justifying signi cant intervention into contractual freedom, including into the admissibility of charging interest. Formal Islamic nance rules, in their various forms today, span the entire Islamic world and, through the intro- duction of Islamic nance products for immigrants, have started toin uence consumer-lender relations in Western Europe. A speci c problem of many emerging markets is the multiplicity of var- ious layers of law implemented over time--for instance, today's set of con- sumer protection rules in Egypt are an amalgam of Western (French, British), Ottoman, socialist, and Islamic rules. Many countries struggle to create their own legal "identity" from their complicated legacy. Consumer Protection Objectives Two key objectives can be distinguished for an e ective framework that con- sumer protection should aim to achieve. e rst is improved e ciency of t he mo rtgage ma rket, esp ecially b y addressing the market failures that lead to reduced levels of competition, high costs of loans, or the exclusion of consumers. e most important fail- ures arise from information asymmetries between lenders and consumers; the heterogeneity of consumers with respect to their nancial education, gender, race, and other factors; and transaction-cost asymmetries, which limit the ability of consumers to react to lender ac tion; for example, to an interest rate increase. The second goal ismarket stability and social protection: stability in the sense of avoiding over-indebtedness of borrowers, with its consequences for key papers. 4. Djankov, L a P orta, L opez de S ilanes, a nd S hleifer (2002) sho w, f or exa mple, t hat L atin American courts in t heir French law tradition have been more protective of rental tenants than their Asian and African counterparts, which were inspired by English law, but less so than courts in former socialist countries. consumer information and protection 129 for t he s olvency of lenders and systemic r isk for t he f inancial s ector. Social protection is relevant in the sense of mitigating individual hard- ship caused by mortgage market outcomes; for example, a personal insol- vency or the loss of the most important pension asset of the consumer, his or her personal home, and, more broadly, the consumer's vulnerability to market shocks. Information Asymmetry between Lenders and Consumers e mortgage market is a "textbook case for market failure caused by infor- mation asymmetry. One party is in the market continuously, the other very infrequently--sometimes only once or twice in a lif etime."5 Market failure due to information asymmetry has been a consensus intervention ground, and mandating disclosure from lenders to consumers a consensus interven- tion type.6 In mortgage nance, for example, the true costs of credit, the character of interest rate adjustment mechanisms, or loan termination conditions may be hidden from the consumer prior to loan closure. e Truth in Lending Act of 1968 in the United States, as a reaction to this, focuses on such disclosures. Roman law countries address the issue in their civil codes and special laws; for example, on disclosure of credit costs and terms. Information asymmetries are even more pronounced in emerging mar- kets, given that access t o information is mo re constrained--for example, through a gr eater "digital di vide"--and co mpetition ma y b e less ac tive because smaller markets and lenders may have shorter histories. A frequent asymmetry arises if contracts are very complex because of the risk environ- ment; for example, indexed products with ballooning debts that respond to in ation risk and may lead to residual debts for the consumer (see discussion below on Mexico and Brazil). 5. G uttentag 2002. 6. Credit market failures resulting from information asymmetry has b een a k ey topic of eco- nomic research of the past 25 years. For an overview, see Stiglitz 2000. 130 housing finance policy in emerging markets Consumer Heterogeneity Transparency standards do not overcome de ciencies adherent to the con- sumer's identity that disable him o r her f rom overseeing the implications of closing a contract, limit the rationality of his or her market behavior, or render him or her a mo re likely a vic tim of abusive practices. Research in the United States shows that factors such as culture, education, and access to information matter in t his regard, and that these factors are regionally concentrated.7 To the extent that lenders systematically exploit these asym- metries, market failure may be the result. For example, so-called "predatory" lending practices to vulnerable groups may lead to predictably high default rates, ultimately leading to market breakdown because of spiraling costs. e current "subprime" lending default crisis has led to a breakdown for parts of the U.S. mortgage market, especially lending to minorities. e main approaches to addressing consumer heterogeneity are to force lenders to disregard elements of the identity of the consumer upon under- writing (antidiscrimination), to penalize detrimental advice given by lenders and brokers to consumers under co n ict of interest, and to enhance con- sumer education levels. e United States, which is characterized by both a very deep mortgage market and a great variety of consumers, has the most developed regulations in that regard. Yet, abusive practices in the subprime market show how large the regu- latory gaps still are.8 Anti-discrimination and con ict-of-interest rules are starting to take hold in Europe, but so far not systematically.9 Emerging mar- kets still usually lack such standards. Consumers tend to be less educated in nancial a airs, although in hig h-in ation environments, depending on individual education levels, the reverse has also been true.10 7. For example, Deng, Pavlov, and Yang (2004) nd that borrowers from a uent western Los Angeles both re nance and move quicker than predicted by standard estimation techniques, while those in less a uent areas tend to stay longer than expected with their properties and loans. 8. A typical abusive practice in the U.S. subprime market has been to re nance xed-rate loans into adjustable-rate loans with low initial "teaser" rates. In subprime, those teaser rates end a er one to two years, resulting in a massive payment shock for borrowers as rates adjust to the fully indexed and fully amortizing level. Such re nancings were targeted at nancially non-astute borrowers. e United States is now discussing a "suitability" standard in order to eliminate such and other practices. 9. Low, Dübel, and Sebag-Monte ore 2003. 10.For example, Argentinean consumers, hardened by decades of high in ation, are famous for their astuteness in nancial management. e country has several daily newspapers dealing consumer information and protection 131 Transaction Cost Asymmetries during the Going Concern Material consumer protection in mortgage nance largely deals with assigning rights to consumers or limiting lender rights in order to reduce the impact of transactions cost asymmetries. Examples are price discrimination against consumers with seasoned contracts (for example, if loan rates can be unilat- erally adjusted by the lender), rights to assign the loan to another lender that might impair the value for the consumer, and high charges or legal mecha- nisms that lenders may use to block early repayments. e reverse problem may arise, however, when contract law assigns consumer options that exploit lender transactions costs; for example, a consumer right of transferring the mortgage to another property, caps to indemnities on prepayments leading to a loss f or the matched-funded lender, or options to delay foreclosure in case of default. Because of the important cost e ects of material consumer protection, approaches in practice have varied greatly. In the United States, the states enforced strong material consumer protection rules until the early 1980s, when federal deregulation overruled them.11 In the EU, because of the large national di erences in co ntract law the commission until today has no t been able to expand the ambit of the Consumer Credit Directive of 1987 to mortgage lending (see box 6.1).12 Material consumer-protection issues in the area of mortgage nance are also becoming increasingly prevalent because of the surge of consumer-protection legislation in emerging econ- omies in the past decade. Vulnerability of the Consumer to Market Risks Mortgage lending overcomes the information asymmetry of a lender about the solvency of a co nsumer through collateralization, and is t herefore an inexpensive form of consumer credit. e downside for the consumer is the cost of pledging the collateral; in the extreme case, the loss of his or her primary residence and most important pension asset. High externality costs exclusively with investment and personal nance issues. 11.Saunders and Cohen 2004. 12.Dübel, Lea, and Welter 1997. 132 housing finance policy in emerging markets Box 6.1. "High" and "Low" Levels of Consumer Protection--The Clash of Approaches in Europe Within the EU, there is considerable diversity of consumer protection regulation in mortgage lending. Among the larger nations, France has traditionally regulated material consumer protection issues more in-depth and in favor of the consumer than Germany and the United Kingdom. The Consumer Credit Directive of 1987 gave the starting signal for the creation of EU­wide minimum standards, to be eventually imposed on mortgage finance. From the beginning, it was subject to strong controversy: First, even a low common minimum was not easy to find, because of strong historic differences in mortgage market practices. The most prominent examples were annual percentage rate (APR), early repayment, and rescission. A common APR definition was found to be problematic even for a majority of European products, in particular the dominating variable-rate products. German lenders objected to a universal prepayment option for fixed-rate mortgages in order to legally protect their matched-funding mechanism, Pfandbrief. Danish lenders refused to accept a rescission period because their regulation would not allow them to take pipeline risk. Secondly, the proposed EU approach of minimum harmonization left room for countries with "higher" levels of national consumer protection to adopt stricter regulations. This meant that national regulators could use, and in fact do use, consumer protection as a trade barrier against foreign entry. For example, France, which limits prepayment penalties, could block German or British mortgage products coming with higher prepayment penalties. Germany, which effectively bans indexed products, could block most Spanish or Portuguese products. The lesson from the European debate is that idiosyncratic market practices require considerable attention in law formulation and tend to lower the regulatory minimum unless they converge through competitive forces. Regional mortgage markets are also almost impossible to create without a strong political unifying force. Maximum harmonization could be a solution--that is, a positive-definition consumer law imposing deregulation on some members. The United States has historically followed such an approach by enforcing product standardization through the secondary mortgage market and federally regulating state law--so far with mixed results (see box 6.4). consumer information and protection 133 for society may be the result if economic shocks--for instance, large house- price cycles or interest rate increases--force many consumers simultaneously into default. In developed markets, public housing and pension safety nets provide such defaulting consumers with a minimum of tenure and old-age retirement income security. In emerging markets, where shocks also tend to be more frequent and severe, absent su cient safety nets, defa ulting con- sumers are o en le on their own. Material consumer-protection standards, primarily concerned with the going concern, usually assign the costs of such cyclical or catastrophic risk to lenders, consumers, or government in an unsystematic fashion. Even in the United States, with well-developed foreclosure laws and strict practices, foreclosure prevention that might lead to loss minimization for both con- sumer and lender is still nascent. is is a lso typical for many Common- wealth countries. In France, by contrast, foreclosure prevention is the focus of an elaborate piece of consumer protection legislation, the Loi Neiertz. In Latin American markets, which experienced large interest-rate and house- price shocks, the lack of foreclosure prevention, inexperienced regulators combined with insu cient housing and pension safety nets has ind uced courts to intervene systematically on behalf of consumers, o en resulting in signi cant losses for lenders. Where foreclosure was e asily possible, in contrast, ex cessive f orced s ales ra ther t han f oreclosure p revention ha ve worsened house-price declines (for example, in parts of Mexico during the Tequila crisis). Protecting the Consumer through the Loan Life Cycle Before Borrowing Disclosure e U.S. Truth in L ending Act requires lenders to disclose to consumers for closed-end loans, among other things, the nance charge, the annual percentage rate (APR), the amount nanced, and the total of all payments. Enhanced disclosure is r equired in o ther laws for "federally related mort- 134 housing finance policy in emerging markets gage loans"13 and subprime mortgage loans with very high interest rates.14 Disclosures in the United States have been criticized as cumulative and con- fusing, overreaching the information-absorption capacity of the consumer.15 e European Union Home Loan Code, adopted in 2002, remedies some of the information overload by mandating a single information sheet for con- sumers; however, national regulations in Europe o en go into much greater detail and cause similar problems as in the United States. In emerging markets, unfair marketing is still a widespread problem, as lenders in most jurisdictions are not forced to disclose loan costs systemati- cally. Recent regulations have started to address the issue. Box 6.7 reports the Mexican example. Accurate loan disclosure is a sine qua non in mortgage nance. In particular, in countries where nancial literacy is still not widespread, information given should be simple and understandable, and if possible it should be explained by independent parties to consumers (for example, consumer groups). Annual Percentage Rate of Charge e APR is central to the concept of disclosure. Box 6.2 discusses the con- ceptual problems of capturing di erent mortgage products in a single APR computation, which is impractical. Comparing APRs makes sense only for products with comparable terms and options content.16 Choosing the right APR ambit is also pivotal: the U.S. Federal Reserve, which implements the Truth in L ending Act, requires interest, fees, points, and private mortgage insurance (if required by the lender) to be included in the APR. Title insur- ance, document preparation, appraisal fees, and other mandatory fees, how- 13.Real Estate Settlement Procedure Act. Most middle-income and practically all low-income mortgage loans in t he United States are guaranteed by the federal government agencies or government-sponsored enterprises. 14.Home Ownership and Equity Protection Act; see discussion in box 6.5. 15.Guttentag (2002) a nd U.S. HUD a nd Treasury (2000) cr iticize t he dual responsibility of Federal Reserve System (Truth in Lending Act, Home Ownership and Equity Protection Act) and HUD (Real Estate Settlement Procedure Act). 16.Guttentag (2002) proposes to compute APRs over multiple terms or over loan terms as speci- ed by the borrower. consumer information and protection 135 Box 6.2. Defining the Annual Percentage Rate of Charge The APR is defined as the internal rate of return of future payment streams from consumers to lenders. Such a computation assumes a constant duration of the loan and invariability of loan terms over time. Unfortunately, since mortgages are pre-payable and often priced at variable rates or rates reset periodically, both assumptions are violated as a rule, rather than an exception. Consider a standard variable rate loan with a two-year initial period of low fixed rates ("teaser" rates). This is the most frequent loan product in the United Kingdom, and gaining in popularity in the United States ("hybrid" ARM). For such a product, taking the APR over the fixed-rate period is misleading--it is known in advance that rates will not remain constant. Even the concept of an "initial" APR--comparing the teaser rates only--is misleading, since the lender can "claw back" any discount by overcharging in the variable rate loan phase. In contrast, so-called "tracker" ARMs following an interest rate index with constant con- tractual spreads can be compared with relative ease. As a second example, compare the typical U.S. product, a 30-year pre-payable fixed-rate loan, with the typical German product, a 10-year non-pre-payable loan. Since U.S. borrowers frequently exercise the prepayment option, the effective duration of a U.S. loan is between four and seven years, after which a new loan is closed. In effect, the German loan has therefore a longer duration than the U.S. loan; closing costs will be amortized over longer periods, which leads to distorted APR results. The conclusion is that APR comparisons in mortgage finance only make sense if the option characteristics of mortgage contracts--both on lender and borrower side--are taken into consideration. ever, are excluded. In France, all third-party costs required by the lender need to be included in the APR.17 Despite the problems, an appropriately formulated APR may capture the main features of mortgage loans, which is essential to secure fair competi- 17.Guttentag (2002) suggests adopting broad de nitions of all mandatory fees. Dübel, Lea, and Welter (1997) propose for Europe to operate with both broad (all mandatory fees) and narrow (lender costs) de nitions. 136 housing finance policy in emerging markets tion. It is t herefore central to mortgage market development. In emerging markets, slow amortization patterns are very popular in order to overcome initial a ordability constraints. is invites abuse through high fee incomes spread over the life of the loan. Without an APR, very long-term loans thus appear cheap on rates, although they are in reality expensive. Consumer Literacy and Counseling According to U.S. government analysis,18 nancial illiteracy of consumers is at the core of consumer vulnerability to abusive lending practices. Some juris- dictions (for example, the United Kingdom) are therefore passing "respon- sible lending" rules forcing lenders to ask whether mortgage loans are suited for the consumer. Lenders, however, face a co n ict of interest when being explicitly man- dated to perform counseling. e U.S. Housing and Urban Development Department (HUD) has t herefore developed a Housing Counseling Assis- tance Program, under which brokers, housing agencies, charities, and con- sumer groups are certi ed and partially funded as counselors. Pre-borrowing counseling, in particular, is mandatory for loans to low-income borrowers that are eligible for Federal HousingAdministration (FHA) public loan insur- ance. Similar certi cation initiatives exist in t he broader market to secure absence of con ict of interest of brokers.19 Moreover, in ma ny developed countries, an infrastructure of consumer groups provides counseling. Funding varies from public grants and endow- ments to consumer journal sales and service charges. Financial regulators or public consumer o ces also provide online guides and references to counsel- ing.20 Consumer agencies, public commissions, and other bodies furthering literacy and counseling are quickly de veloping in emer ging markets; for example, in Mexico (see box 6.7), Poland, or Korea.21 Prior to formulating regulations, it seems advisable to clearly analyze the con ict-of-interest situation. Tight lender r egulations may be less p roduc- 18.U.S. HUD and Treasury 2000. 19.For example, the Upfront Mortgage Broker certi cation system. 20.For example, the British Financial Services Authority and the U.S. Federal Reserve System. 21.For a listing of agencies, see http://www.consumerworld.org. consumer information and protection 137 tive than strategies to develop independent counseling agents, including an endowment with su cient funding. The Loan Offer and Closing Cooling Off Regulations in developed markets generally allow for cooling-o periods of between three (United States) and 14 days (France, Germany), during which the consumer has the right to unwind the contract. e period is extended in cases where certain selling practices, for example, door-to-door, leave con- sumers little time to re ect on their decision. Cooling o may be a problem for mortgage lenders, if p ipeline risk--the market risk taken by holding a closed, but not yet re nanced, loan--is high. In emerging markets, a co n ict may arise from a gr eater need f or the consumer to re ect on his or her borrowing decision, especially if there is poor access to information and greater market risk for the lender. is would speak in favor of greater emphasis put on information and counseling, and curbing selling methods that rely on spontaneous decisions, such as door-to- door selling. Circumvention of APR and Risk of Over-indebtedness through Cross-selling Cross-selling of mortgages with other nance products, most notably insur- ance, may lead to the circumvention of APR r ules and con ict of interest of lenders between serving the consumer and adding income from a third source. e requirements for and length of mortgage insurance coverage is a highly contested issue in the United States. Kickbacks and referral fees to originators have been put under threat of criminal penalty by the Real Estate Settlement Procedure Act for "federally related mortgages." In countries that allow tax deductibility of both mortgage interest payments and insurance premia or contractual savings contributions, endowment mortgages paid 138 housing finance policy in emerging markets down by life insurance or mutual funds are popular. If nonperforming, these instruments carry the risk of leaving consumers with residual debt. Cross-selling poses a certain risk in fast-growing emerging markets that have weak or no APR frameworks and favor indebtedness through mortgage interest deductibility. Incentive structures should be set so as not to arti - cially favor indebtedness; for example, through leverage-neutral taxation. BroadAPRde nitions are needed to enable the consumer to capture the cost e ects of cross-selling. Discrimination and Predatory Lending e U.S. Equal Credit Opportunity Act bars discrimination based on age, gender, marital status, race, color, religion, and national origin. In addition, U.S. federal agencies and government-sponsored enterprises are held to pro- mote lending to underserved groups.22 Similar policy instruments exist in the United Kingdom, but are still in their infancy in the rest of Europe. e "reverse redlining" problem lending to borrowers without regard to their ability to repay at exorbitant interest rates has been related to the deregula- tion of the U.S. mortgage market. Box 6.5 describes the ongoing struggle to nd a balanced regulatory framework in this area. In many emerging markets, regional and social heterogeneity is high, and so is lender r edlining. Examples are multiethnic states (for example, South Africa and Iran) or states with high income inequality (for example, Brazil and India), or both. South Africa had pass ed antidiscrimination rules for mortgage lending in the early 1990s; however, real progress to greater down- market penetration required the gradual emergence of new lender gr oups specializing in low-income lending. Some emerging markets also operate public banks that distribute loans at highly favorable terms. Anecdotal evidence would suggest that this circum- stance has favored requests for kickbacks by bank o cials. Such situations can be resolved to the extent that the incentive for kickbacks, subsidies, is weakened, or penalties are increased. While there is no immediate predatory 22. ese policies have not always been e ective, as the recent almost-complete substitution of U.S. federally insured xed-rate lending (FHA, variable annuity) through mostly adjustable- rate private-sector subprime lending demonstrates. consumer information and protection 139 Box 6.3. Prepayment Indemnities--How Much is Too Much? Fixed-rate lending may all but disappear (Spain) or become considerably more expensive (Denmark, United States) if prepayment indemnities are not practiced, capped at marginal levels, or even banned by consumer protection rules. But even the most lender-friendly regulations (Germany) limit yield mainte- nance prepayment indemnities to a period of 10 years--a wholly arbitrary figure-- to avoid very large amounts. Moreover, should the calculation of yield mainte- nance be allowed to include the lost future income of the lender from the loan, which, if not charged, without doubt would raise the costs of future lending? What should the policy be in "hardship" cases (for example, a forced move, divorce and so forth)? Finally, should the lender be required to disburse reinvestment gains that may arise if a borrower prepays during an interest rate rise? The solution to some of these problems may be found in technology; for example, Danish non-callable mortgages can be prepaid through delivery of mortgage bonds, which means automatic disbursement of reinvestment gains and disregard of lost future lender income. In any case, solutions will require an informed economic judgment balancing the interest of lenders and consumers. lending threat for emerging markets, excessive debt service burdens o en arise with high levels ofin ation, especially if inappropriate loan instruments are used.23 The Ongoing Concern Back-book Price Discrimination Overcharging of consumers in seasoned contracts is a f requent problem in markets characterized by unilateral reviewable and short-term FRMs. es e products are still typical for most developed markets. ere is evidence that seasoned borrowers of U.K. standard variable rate loans and German reset 23.For example, as a r esult of the so-called tilt e ect of xed-rate loans under hig h in ation, typical initial debt-to-income ratios in Iran by loan closing approach 50 percent. 140 housing finance policy in emerging markets xed-rate mortgage loans are charged 50­150 basis p oints more than new borrowers upon rate adjustment.24 Absenta xed-rate market, contract terms are frequently unilaterally reviewable in emerging markets, especially in the Commonwealth countries that are dominated by the British thri tradition, and in Arab countries. Techniques to address price discrimination include the introduction of long-term xed-rate mortgages (United States, Denmark), the speci cation of pricing benchmarks for short-termFRMs( ailand, Canada), and manda- tory linkage of adjustable or short-term xed-rate contracts also to external benchmarks (France, Spain, Mexico). Benchmark provision for mortgage lending usually requires the active support of the Central Bank. Early Repayment Consumers in de veloped markets enjoy a uni versal right of prepayment.25 e value of that right, however, is frequently neutralized through indemni- ties in o rder to protect funding instruments. e United States liberalized the charging of indemnities in the 1980s; however, the purchasing practice of the federal agencies in the secondary mortgage market marginalized loans carrying them. In Europe, regulations vary between strict limits (France) and indemnities that allow the lender to recover his or her nancial damage (Germany, Sweden). In some jurisdictions, court practice has eroded their amount (United Kingdom, Netherlands). Box 6.3 describes the problems of de ning a consistent regulation. Fixed-rate lending in emer ging markets almost in variably carries legal ambiguity about early repayment, which raises the risk of lender reinvest- ment loss oncein ation and interest rates fall and prepayments occur. Exam- ples are Russia and Iran, where loan rates are xed in local currency over the long maturities (15­20 years). Because of the potential scale of losses, lenders are tempted to block prepayments in such situations, which may force con- sumers to seek court arbitration. 24.See Low, Dübel, and Sebag-Monte ore 2003. 25.An exception is Germany, which allows legal exclusion of prepayments in cases when these are primarily motivated by nancial considerations of the consumers. consumer information and protection 141 It seems advisable for emerging markets to aim at a basic, y et funda- mentally complete, set of xed-rate contracts with and without prepayment protections. In the latter case, the consumer would save the option premia while having to pay an indemnity at prepayment, for instance for loans with rates xed up to about ve years. e Danish mortgage market holds a good example for the coexistence of these products. Interest Rate and Exchange Rate Risk Mirroring the previous two issues, excessive debt service arising in interest-, in ation-index-, or exchange rate-linked mortgage contracts has been a sub- ject of interventions on behalf of consumers. Indexation schemes are fre- quently pegged to short-term market rates, which tend to be highly volatile. Exchange rate risk may render seemingly cheap xed-rate loans that are denominated in foreign currencies highly expensive a er a realization. Both issues are particular virulent in emerging markets. Recent court orders ruling in fa vor o f co nsumers, w hen la rge in terest-rate o r ex change-rate sho cks occurred, have been recorded, for example, in C olombia26 and Argentina (see box 6.4). e conclusion from those cases would be to focus on pricing benchmarks that are good measures of long-term capital costs.27 Foreign- exchange risk in mortgage contracts should ideally be avoided, unless pro- tective hedges or caps are available to the consumer or consumers receive incomes in foreign exchange. Usury r egulations a re wi thout do ubt t he o ldest ma terial co nsumer- protection instrument.28 Usury rates are not determined a p riori in most European legislations and the burden of determination of abusive practices is laid on the courts. Where rate formulations exist, theyde ne a threshold as 26.In Colombia, the default crisis of the early 2000s was linked to a large real shock on interest rates. is triggered a judgment by the Constitutional Court that ruled that the variable mort- gage rate index us ed by the housing nance institutions (the UPAC), which was bas ed on average nominal interest-rate levels, was invalid and that anin ation-based index should have been consistently used. is forced the government to refund borrowers for payments made in excess of the in ation-based index. 27. is would be measures of long-term interest or in ation rates, which can be derived from market signals. An exa mple would be the Brazilian TasaR eferencia (or reference rate), a forward-rate measure of future interest rates. 28. e canonic prohibition of taking interestwasli ed in Europe only in the 16th century. Until the 20th century, usury ceilings were mostly the only element of material consumer protection. 142 housing finance policy in emerging markets Box 6.4. Foreign Currency Mortgages--Low Rates, High Risk Foreign currency mortgages are an important example of loan products with high future payment-shock potential for consumers, and, by implication, high default risk for the lender. The type of risk is analogous to price-level-adjusted contracts in local currency: foreign currency mortgages imply a periodic adjustment of the outstanding balance in line with the devaluation of the currency. Yet borrower sal- aries, which are usually paid in local currency, are unlikely to rise smoothly at the pace of devaluation, and in many emerging markets there is risk of shock devalu- ation as a result of economic or balance-of-payment crisis. To the devaluation risk is often added interest-rate risk in cases where rates in foreign currency have been chosen as adjustable in order to depress initial interest payment further. Despite these risks, foreign currency mortgages have grown in popularity throughout the world, and particularly so in two regions: In Latin America, a large proportion of debt is traditionally dollarized as a result of the legacy of hyperinflation. There is considerable mismatch risk for banks, since loans are even more dollarized than deposits; Peru, for example, has around 70 percent of all its deposits and 75 percent of its loans in dollars, with over 90 percent of mortgage loans in dollars. Eastern Europe has also seen high levels of foreign currency lending, with loans being advanced in euros, Swiss francs, or Japanese yen. Although the interest rate differential has fallen in recent years, foreign currency loans remain popular. Poland, Hungary, and Ukraine have all seen high levels of foreign currency loans. In Estonia, foreign currency loans represent 88 percent of total lending. Particularly risky for lenders are large shock devaluations after long phases of fixed-exchange rate policies, which encourage indebtedness in foreign currency. In Argentina, as of 2001 the entire mortgage portfolio was denominated in U.S. dollars and financed with U.S. dollar debt. With the breakdown of the fixed-exchange rate policy and the devaluation of the peso--by 75 percent at one point--the (continued) consumer information and protection 143 Box 6.4. Foreign Currency Mortgages--Low Rates, High Risk (continued) government in early 2002 decided to "pesify" all consumer debts, rather than allow an adjustment of the credit outstanding debt due by borrowers, as contractually agreed.* Wary of high payment shocks for borrowers, regulators in Poland have responded by taking a stance against further growth in currency lending. A new regulation was put into force in July 2006 that includes a consumer education and awareness initiative. Consumers have to show that they are actively rejecting a domestic currency loan by signing a declaration to this effect. An information sheet with details of the risks of the products being purchased also must be given to the customer. The second strand in the supervisory response is to tighten the underwriting criteria by making banks review the client's creditwor- thiness based on the higher domestic-currency interest rate only. In addition, the capital requirements for foreign exchange (FX) lending are 20 percent higher, with further changes possibly in the pipeline. * The forced pesification of liabilities (at a different rate) was only carried out, leading to the downgrade of dollar denominated MBS. a multiple of or markup over the applicable mortgage rate (Germany, France, and Portugal). In Italy, the average market rate cannot be exceeded. In the United States, state usury regulations were dismantled by federal deregula- tion in the early 1980s, but in response to the tide of subprime lending at extremely high rates, are returning. In the United Kingdom, usury limits were repealed in 1818.29 Emerging markets feature the whole spectrum of usury regulations, from prohibition of interest in Islamic nance, to regulatory ceilings in French and German law descendents, to relative liberality in the Commonwealth coun- tries. While predatory lending is less of a problem as long as even middle-class households o en do not receive loans, there is potential for abusive charges once the markets deepen. Box 6.5 describes the di culties in addressing this 29.Not coincidentally, an early fundamental critique of usury regulations was la unched by a Briton, Bentham, as early as 1787. 144 housing finance policy in emerging markets Box 6.5. Consumer Protection in the United States and the Subprime Market Consumer protection in the United States has traditionally been the role of the states. In a country with widespread federal interest-rate controls originating in the New Deal of the 1930s, state legislation gave rigidly formulated usury interest-rate ceilings a prominent role. In January 1980, because of inflation, long-term U.S. Treasury rates exceeded 10 percent for the first time in history, and eventually reached 15 percent in 1981. The resulting mortgage rates of 15 percent, 20 percent, and more brought lenders into conflict with the usury laws. In a sweeping attack on state consumer-protection rules, the Reagan administration launched two federal acts (Depository Institutions Deregulation and Monetary Control Act, Alternative Mortgage Transaction Parity Act): the first overrode state usury ceilings and the second outlawed state material consumer-protection rules such as limits imposed on negative amortization clauses and prepayment penalties. The deregulation of consumer protection enabled the development of the "subprime" mortgage market, a market that since the mid-1980s at the same time provided credit to high-credit-risk households and became the main playing field for abusive lending practices. According to the joint HUD and Treasury report of 2000, in 1999, the median spread over treasuries in the subprime market was 500 basis points, with 18 percent of borrowers paying a spread higher than 700 basis points. Not surprisingly, default incidence in the subprime market in 2001­2 was on average 15 times higher than in the prime market, with one in every 15 mortgages being in default (Saunders and Cohen 2004). Nevertheless, the market grew to an astounding 20 percent of new origi- nations in 2006 (together with near-prime loans with limited documentation 35 percent of new originations). As of 2006­7, the subprime market spiraled into its second major default crisis within a decade, threatening the stability of the entire U.S. mortgage sector by adding to excess housing supply through a huge number of foreclosures. Federal efforts in the 1990s had failed to seriously address the undesired con- sequences of the Reagan deregulations. The 1994, Home Ownership and Equity Protection Act had imposed heightened disclosure requirements just for (continued) consumer information and protection 145 Box 6.5. Consumer Protection in the United States and the Subprime Market (continued) extreme loan spreads over treasuries, which applied to only 0.7 percent of loans, and also did not end abusive pricing or contract clauses. The result is that by 2007--starting with North Carolina in 1999--the majority of U.S. states have started re-regulating mortgage lending. The subprime market crisis since 2007 has even raised the likelihood of a federal re-regulation of the sector. problem in the United States. A particular problem is that loan volumes in emerging markets are o en low, while origination and servicing causes high costs, which may push up cost-covering interest rates to very high levels.30It seems therefore not advisable to rigidly control interest rates. Alternatively, lenient ceilings could be adopted, allowing for derogations if lender s can demonstrate that their costs are higher. Residual Debt upon Maturity In the interest of minimizing credit risk, mortgage loans should be repaid within their term--ideally before the consumer retires. We have seen above that e ven wi th st andard p roducts, t his co nstraint is o en no t p roperly addressed. Lenders have a pro t incentive to minimize amortization in order to retain a maximum base for charging interest. Loans with ballooning out- standings that are adequate in the presence of in ation o en entail a height- ened risk to generate residual debt. In the United States, such ballooning loans were liberalized in the 1980s. Several European countries, in turn, have put restrictions on such products. Because of in ation risk, almost all Latin American markets use indexed products th at--intentionally--lead t o ballo oning o utstandings, b ut f re- quently--unintentionally--end in situations of residual debt at the time of loan maturity. Court rulings have o en mandated government or lenders to cancel these debts. While the intended impact has been to protect retired 30. is issues is o f particular importance for micro-credits, the transaction costs of which are necessarily high relative to the loan amounts. 146 housing finance policy in emerging markets Box 6.6. The Legacy of Brazil's Old Housing Finance System Mortgage market development in Latin America has been constrained by a history of high inflation. High inflation carries the temptation to design products that may lead to large residual debts, especially when political intervention on behalf of borrowers comes into play. The main beneficiaries of such intervention have been members of the upper middle class. From 1984 to 1993, Brazil, under the Sistema Financiera Habitacional (Housing Finance System) practiced dual-indexed mortgages (DIM), a product in which borrower payments and outstandings due to banks are adjusted to inflation by wage and price indices, respectively. Even in its plain vanilla form, the DIM product is subject to delicate stability issues, since too low initial payment rates may lead to failure of the loan to amortize. In 1985, political pressure exercised by trade and professional groups in Brazil led to the application of several dozen different wage indices for the DIMs, each representing the wage trajectory of an individual profession. Mortgage pay- ments moreover became systematically under-adjusted to inflation in a mixture of attempts to protect the affordability of borrowers in times of sluggish real income growth and distribution of political favors. By the early 2000s, a typical Brazilian mortgage borrower of the 1980s--in general a high- or upper-middle-income household--had repaid only a fraction of his debt in real terms. Court interventions on behalf of these groups made sure that residual debt at maturity had to be cancelled by the lenders. To avoid lender insolvencies, a government fund--Fundo de Compensação de Variação Salarial (Wage Variation Compensation Fund)--was created, which by 2001 had pro- duced a deficit corresponding to 4 percent of the Brazilian GDP. Fundo de Com- pensação de Variação Salarial is part of a larger legacy debt of the Sistema Finan- ciera Habitacional that then totaled 10 percent of GDP and continues to rise. consumers from losing their home, in many cases such intervention ended in distributing regressive bene ts to consumers belonging to the upper middle class, who were given most of the real values of their houses for free. Box 6.6 discusses the Brazilian case, which is far from being isolated. consumer information and protection 147 ese experiences suggests that, as a r ule, those loan instruments should be given priority that safely amortize within the contracted period even if this comes at the expense of slower market penetration. Moreover, lenders should be required to present the consumer binding amortization plans and, if amor- tization is contingent on external variables, clearly signal the possible risks. The Back End: Default Avoiding Foreclosure and Pre-foreclosure Avoiding foreclosure and pre-foreclosure is frequently in the interest of both lender and consumer, because ofine ciencies of the judicial foreclosure pro- cess. Loi Neiertz of 1989 was a f ormalized attempt to address archaic, but hard to change, judicial foreclosure practices in F rance: the law de nes a formal mediation and counseling process between lender and consumer, in which government plays the role of the mediator. Approximately 90 percent of French default cases are thought to be resolved in such "amicable" solu- tions (solution amiable). Even in An glo-Saxon co untries wi th r elatively e cient foreclosure processes,31 foreclosure avoidance is rising in relevance. During the 1989/90 default crisis, U.K. lenders adopted new strategies to stem the tide of repos- sessions. Independent arrears counselors were paid by the industry in order to do debt reschedulings and restructurings with over-indebted households. In the United States, a er traumatic experiences in the industry downsizing wave of the early 1990s,32 the public insurers FHA took the lead to develop regulations prescribing loss mi tigation procedures, including mandatory debt counseling. Today, even secondary mortgage investors pay servicers premia to avoid foreclosure, for example, through f reehanded sales and trading down to smaller houses. Foreclosure a voidance i s s till n ot sys tematically dev eloped in m ost emerging markets; however, some of the new consumer legislation has intro- duced a consumer right for loan restructuring (for example, Malaysia). Con- 31.See Butler 2003. 32.Moore (1989) describes foreclosure practices in Flint, Michigan, a er the closure of a large car plant. 148 housing finance policy in emerging markets sidering the great inertia in undertaking court and bankruptcy reform, the introduction of a better-structured foreclosure process is a promising avenue in most jurisdictions for reducing credit losses for lenders while simultane- ously protecting the consumer from residual debt. Foreclosure In Europe and the United States, consumers are protected by the need for the lender to obtain court orders and the right to retrieve any residual value of the house a er a forced sale. O en, however, there is less protection against high arrears fees and legal charges that may eliminate any such residual value. More importantly, the auction process through courts is frequently illiquid, follows an antagonistic formalism, and leads to less p redictable recovery values than freehanded or lender-supported sales. Court formalism and ine ciency has unf ortunately b een a successf ul Western export product to emerging markets. Djankov et al . (2002) sho w that Latin American courts are leaders in legal f ormalism, taking up the French and Spanish traditions. ey take signi cantly longer to evict rental tenants than do courts in African or Asian countries with English law tradi- tion. Courts in former socialist countries are found to be the record holders, o en asking lenders to provide substitute housing. Clearly, inability to enforce e ciently t hrough t he courts--and parallel absence of meaningful pre-foreclosure arrangements--is a main reason behind the predominance of lease-purchase contracts in many emerging markets. In Brazil, approximately three-quarters of new housing transactions take place through lease-purchase; in E gypt, the share is a pproximately 90 p ercent. In lease-purchase schemes, the housing remains owned by the developer until the last installment. Consumer protection in this area has been notoriously weak. On the other hand, courts in s ome countries remain extremely lender friendly or even biased toward the lender. In Iran, for instance, lenders can de facto repossess the house and are forced neither to sell any time soon nor redistribute any excess of the proceeds over the loan claim to the consumer. In most emer ging markets, the absence of a me aningful social housing system that could provide housing alternatives for defaulting borrowers is likely to instill some level of court bias in favor of defaulting homeowners. consumer information and protection 149 is is the main economic point behind court delay in Poland, where a con- stitutional right of housing existed or continues to exist. e Polish govern- ment has responded with a program designed to provide emergency shelter for evicted households. Foreclosure reform is lik ely to remain an obstinate problem anywhere, because of the power of legal traditions. Governments can create emergency housing solutions to give comfort to courts. Court reform itself should be high on the legal reform agenda. Specialized courts or tribunals (see below) may constitute alternative, more e ective foreclosure mechanisms. Consumer Insolvency and Discharge Dealing with residual debt a er a f oreclosure is t he third element of con- sumer protection at the back end. A formal consumer insolvency law is now the standard in the United States and Europe. Solutions vary as to whether the lender is forced to choose between collateral and other consumer assets (United States) or can go for both (Germany). A er the German reform of 1999, consumers in t he EU a re now generally discharged of their residual debt within three to seven years; however, residual income burdens and col- laboration duties imposed on the consumers vary. In emerging markets, a urry of general consumer protection legislation has been passed since 1995, which may be expected to create similar concepts of consumer insolvency. In economic terms, residual debt discharge is a double-edged sword. On the one hand, it strengthens the collateralized nature of mortgage credit and avoids the "eternal debt tower" that treated consumers unfairly in many his- toric private law formulations. On t he other hand, it provides additional incentives for consumers to see a mortgage default as an economic option whose exercise will come at the expense of the collective of performing bor- rowers, if house prices fall, for example. Lawmakinge orts in emerging mar- kets should strike a middle ground to keep debt performance incentives for borrowers intact. 150 housing finance policy in emerging markets The Costs of Consumer Protection Opportunity Costs of Regulation ere is little doubt that disclosure requirements, consumer education, and public certi cation and counseling measures yield hig h returns in a cost- bene t analysis. As the experiences presented above show, however, some degree of material consumer protection is needed, because signi cant abu- sive practices and risks for consumers prevail. Moreover, the bene ts of inter- nationalization and globalization for all consumers cannot be reaped without a level playing eld of products across jurisdictions. Whether that eld should be wide or narrow is the subject of legitimate debate. Absolute protection of the consumer from abuse or risk is nei ther practical no r desira ble. M aterial co nsumer-protection r egulations ma y lead to the unintended disappearance of products or increases in the price of the mortgage for the consumer. In addition, the structure of the mort- gage industry may become less co mpetitive; for example, if lender gr owth strategies through product innovation become impossible to realize through excessive product standardization. As in the analogy of durable consumer products, imposing greater con- sumer options in mortgage nance will increase product costs: for instance, in the case of the universal prepayment option on a 30-year loan, the rate increase is estimated in the range of 70­100 basis points.33 e exact costs, however, of reduced product choice and growth oppor- tunities are hard to assess in quantitative terms. ey depend moreover on the amount of substitution goods available; for example, curbing the sub- prime market through rate ceilings may e ciently induce more subprime borrowers to stay renters, if there is su ciently elastic rental housing supply. Moreover, costs are o en contingent rather than current and explicit; for example, if consumers, because of restrictions imposed on xed-rate mort- gages, are encouraged to take up more adjustable-rate debt, the main cost factor is the increase in insolvency risk, which may or may not materialize in the future. 33.See Dübel and Lea 2000. consumer information and protection 151 Consumer p rotection r ules ma y als o in teract wi th ba nking r egula- tions a nd p ublic-mortgage-market in tervention in a wa y t hat r educes product c hoice a nd co mpetition. Exa mples a re t he hig h-LTV a nd sub- prime mo rtgage ma rkets, w here lender s a re b ound b y incr eased tra ns- parency, co unseling, a nd usur y p ricing r ules w hile ba nking r egulators curb r isk t aking. W here, ho wever, do es a valid ma rket end a nd w here do a busive o r ex cessively r isky p ractices st art? e exp erience o f t he U.S. sub prime ma rket sug gests t hat t he s eesaw o f der egulation a nd r e- regulation may produce more pronounced distortions than a consensus reg- ulatory approach would have. e task when formulating consumer protection rules is therefore to try to identify, quantify, and strike a balance between these current, future, and contingent costs o f regulation and the bene ts from reduced incidence o f abuse and risk for the consumer. Such a decision must be supported by suf- cient microeconomic analysis of the mortgage market, which requires a minimum of data dissemination and analytical capacity. Alternative Implementation Forms, Costs Does the form of regulation matter for its cost-bene t balance? Industry self-regulation, for example, through codes of conduct or pre-commitment approaches to certain policy goals, has been popular, in particular if agree- ment over a new law could not be obtained.34 ey may serve as a collective bargaining mechanism to build consensus between stakeholders, rst within industry and consumer groups, then between industry and consumer groups, and nally between both and government. ey also introduce an element of market testing, which is o en missing in cases of government at.35 In practice, voluntary agreements seem to end invariably in formal regu- lation, because they tend to treat disputed areas by negligence rather than enforced political compromise. In the United Kingdom, the voluntary Mort- gage Code, a lender C ode of Conduct of 1997, has b een replaced by com- pulsory Financial Service Authority (FSA) rules. e EU Home Loan Code 34.Dübel, Lea, and Welter 1997 proposed such a code of conduct to overcome the gridlock over the transposition of the Consumer Credit Directive in the EU. 35.See Guttentag 2004. 152 housing finance policy in emerging markets covers only partial aspects of consumer information and required seven years of negotiation between industry and consumer groups. It is widely held to fall far behind the consumer protection agenda and will likely make room in due course for an enlarged Consumer Credit Directive. Enforcement Costs Whatever the scope and form of regulation, consumer protection needs a clear enforcement structure. Regulations must be developed, revised, and enforced, ideally by a single public body with a clearly de ned mandate (see box 6.7 o n the Mexican case).36 Institutions providing consumer informa- tion, education, and counseling must be funded; they can be established by government itself (housing agencies, local or state housing o ces), consumer groups, charities, or independent brokers and debt counselors. To settle con- icts in the going concern or an early stage of foreclosure, special tribunals or extrajudicial mechanisms, such as third-party arbitration and ombudsmen, have proved valuable.37 Court reform itself may add to e ciency if foreclosure cannot be avoided. A clear coordination between di erent agents in incr easingly disinterme- diated nancial systems is als o important. Credit investors should provide incentives to servicers aimed at facilitating debt restructuring and resched- uling, and where private responsibility for settlement ends a nd the public safety net starts should be clearly established. 36.Guttentag 2002 notes the con icts between Federal Reserve and HUD in t he United States. Germany has st arted a co nsumer protection ministry that may rival the consumer protec- tion role of the federal nancial regulator, Bundesanstalt für Finanzdienstleistungsaufsicht (Federal Financial Supervisory Authority; BAFIN). France uses a single agency for the housing and housing nance sectors, L'Agence Nationale pour Information sur le Logement (National Agency for Housing Information). 37.Examples for tribunals are the Malysian Tribunal for Consumer Complaints, the Indian system of national and state commissions and district fora for consumer a airs, and the French system of Tribunal d'Instance dealing with over-indebtedness. Portugal has an independent national arbitration center for consumer credit. Independent ombudsmen originated in Nordic coun- tries and have been successful in the British and German banking and insurance industries. consumer information and protection 153 Is Consumer Protection a Luxury Good for Emerging Markets? Emerging Markets Are Part of the Global Consumer Protection Trend Consumers International, a global representation of consumer groups and agencies worldwide, reports that consumer protection laws have been passed since 1995 in many emerging markets, mostly in the form of general con- sumer protection acts. is follows the 1985 passage of UN Guidelines for Consumer Protection. Edwards (2003) indicates that progress is greatest in Latin America, where all countries except Guatemala, Cuba, the Dominican Republic, and Bolivia have passed laws. South and East Asian countries (for example, Indonesia and Malaysia, both in 1999) did lik ewise, while less developed South and Central Asian countries are lagging behind. In Africa, South Af rica--through t he ex cellent National Cr edit Act o f 2005--a nd some other countries such as the Seychelles and Botswana have consumer protection laws, and a number of others are preparing them. A 2000 report by the group summarizes policies and institutions in Central and Eastern Europe, w hich a re b eing tra nsformed f rom t heir s ocialist p redecessors, rather than recreated. Appropriate Regulations May Support Financial Sector Development e New Institutional Economics literature, developed among others at the World Bank, has stressed the importance of appropriate regulations for eco- nomic development. Applied to mortgage nance, the notion ofappropriate- ness implies recognition of the speci city of an emerging market with regard to the lender, product, and risk environment. e implication on expanding a housing nance system may be changes in weighting or priority; for example, between consumer information and material protection rules. For instance, improving information may be a pri- ority in markets with erce price competition on standard products, yet sees frequent acts of misstatements by some lenders to make the costs of credit 154 housing finance policy in emerging markets appear less expensive. In contrast, material protection interventions may be a priority in markets featuring products with payment shocks (for example, foreign currency lending) that may increase over-indebtedness risk. Ideally, the latter situation should be avoided altogether, and mortgage products should be initially kept simple and at low risk in the interest of all parties. In this situation, the regulatory focus will be on the front and back ends of the loan life cycle. · Concerning loan closing, emerging markets should require, in par- allel, su cient loan disclosure and minimum contract content. ey should su pport co nsumer ed ucation a nd assist ance e orts. e simplest means of disclosure should be adopted, for example, self- explanatory, single-page term sheets and the mandatory quotation of the APR for the main product classes. Consumer groups will typically provide pre-closing education and assistance on loan o ers against minimal, but ideally systematic, public nancial support. Such mea- sures will als o improve the competition environment and be wel- comed by most lenders. · Functioning pre-foreclosure, foreclosure, and consumer insolvency regimes, as w ell as a s afety net f or defaulting consumers, are also central.38 Courts (foreclosure, eviction) and local governments (re- housing the evicted) must be enabled to ful ll essential support func- tions. e servicing departments of lenders, however, should also receive training by, for example, public agencies to help avoid fore- closures that may produce lower recovery ratios than workouts and other pre-foreclosure techniques in ma ny situations. For instance, during the Tequila crisis of 1994 in Mexico, a rush by lenders to fore- close lead to a spiraling price decline that maximized losses. · An ombudsman, created by an industry group or with the regulator, can im prove co nsumer-lender co mmunications a nd a void ma ny court cases. 38.Without a s ocial s afety net in t he f orm o f al ternative, lo wer-cost ho using a vailable f or defaulting homeowners, it is likely that even the most balanced set of foreclosure regulations will meet resistance from courts. is is one of several areas where broader housing policies and consumer protection rules need synchronization. consumer information and protection 155 Box 6.7. A New Consumer Protection Framework for Mexico The Federal Law on Transparency and Promotion of Competition in the Guar- anteed Credit Market of 2002 introduced minimum consumer protection stan- dards for mortgage finance in Mexico. In the fields of disclosure and transparency, the law defines a total cost of credit concept, a disclosure standard for contract terms, a binding loan offer period of 20 days, and appraisal standards and authorization of appraisers, as well as minimum contents of contracts. The federal housing finance agency, SHF, is mandated to provide monthly comparative loan-offer information to consumers. As expected, in an economy with a history of high inflation, material con- sumer protection concentrates on setting rules for interest rate adjustment. Variable rate contracts are permitted if they follow a public reference rate. Spreads over the reference rate may vary only within contractually determined limits. Prepayment of fixed-rate loans is not generally cost free, but the Central Bank and Federal State Secretary for Economy may jointly determine pre- payment conditions and penalties to be then paid. Prepayment charges for variable rate loans, however, are limited to 1 percent. There are no usury ceilings for interest rates. While it is too early for a proper evaluation, the current framework can be expected to provide for simplification and greater efficiency of borrower- lender relations in a market historically plagued by frequent court and political interventions. At the same time, there seems to be room for consolidating the supervisory structures that the law created in combination with other consumer protection legislation. Currently, the federal consumer protection agency, Profeco; SHF; the Central Bank; the Commission Bancaria (Banking Commission); and the Federal State Secretary Ministry for Economy share responsibilities for detail formulation and enforcement of consumer protection regulations in mortgage finance. ere are situations where developing more complex products or prod- ucts with potential payment shocks is una voidable, for example, in t he presence of in ation risk. Even with full disclosure and guidance, many 156 housing finance policy in emerging markets consumers will not understand these products. Central banks or regulators here can support appropriate product regulations, for example, through providing appropriate base indices f or rate adjustment and establishing simple pricing and re-pricing rules. Public agencies can provide lenders with caps or swaps (foreign currency, interest rates, negative amortization) to protect against the downside risks of such products, which should not fall on consumers. e Mexican example reported in box 6.7 seems to be a good re ection of these speci cities. It strengthens the front end--information and disclosure-- and structures the going concern only as far as the main risks--in ationrisk-- are concerned. It should be noted that the federal housing nance agency SHF o ers swaps to lenders in order to shield both borrowers and lenders from certain price risks of the dominant mortgage product used in Mexico. Understood as a me ans of structuring the relationship between lenders, consumers, and government without introducing excessive legal formalism, consumer protection is not a luxury good for emerging mortgage markets, but rather an integral part of the overall nancial sector infrastructure. It is self-evident that emerging market countries should use their chance to avoid the mistakes of many developed markets, which have found themselves in repeating deregulation and re-regulation cycles following changes in political colors and, o en, overregulation. Conclusions Both consumer information and material protection rules are a necessity in an industry characterized by information asymmetries, consumer heteroge- neity, transactions costs, a nd complex products carrying multiple options. It is the degree of standardization of lender covenants and products, not the fact that some standardization must occur in the interest of the weakest con- sumers, that is a worthwhile subject of debate. ese economic points have been blurred in the understandable thrust to deregulate an overregulated mortgage industry in de veloped markets of the 1980s a nd the subsequent polarized policy debate. Much of that debate can be traced t o the traumatic experiences of high in ation and is increasingly obsolete. Today, the practical di culties in determining an consumer information and protection 157 appropriate level of consumer protection should have priority. es e arise because of the idiosyncrasies of mortgage lending, especially funding and risk management mechanisms. e trend in emerging markets has been to quickly develop their consumer protection frameworks. For them, in the mortgage sector, in particular, the front end--consumer information and education--and the back end--fore- closure, eviction, and insolvency, should be the central focus of a strategy to develop adequate regulations. Appropriate regulations and institutions should be created that ease the burden of courts and reduce the widespread polit- ical risks. is also requires an economic support strategy; for example, sup- porting institution building of courts, local governments, consumer groups, or, more radically, alternatives to homeownership for those completely unable to borrow safely. An initial limitation to simple, low-risk mortgage products that require less legal structure and impose less regulation costs will be in the interest of all parties, lenders, consumers, and government. Chapter 7 Construction Finance in Emerging Economies Loïc Chiquier Construction nance refers to the funding of land development and building construction. As such, it is an essential--even if o en overlooked--part of anye ective national housing nance system. New housing in most emerging economies is typically provided through informal construction (slum devel- opment or just nonconforming housing), owner-built individual housing, and developer-built housing. As the pressure of urbanization and the failure to eradicate slums drive the formidable challenge of providing modern a ordable housing in emerging economies, so does the role of professional developers capable of delivering such housing increases. Planned developments allow for the inclusion of infrastructure, such as access roads, water, sewerage, and power as part of the initial construction process. is is as opposed to the prevailing production model of incremental building or slum proliferation, where the provision of ex post infrastructure to the informal neighborhoods is all the more expen- sive. is positive evolution has been observed in countries such as Mexico or ai land. Construction nance is vi tal for nancing any housing supply system capable of meeting the challenges of increased demand for formal housing 159 160 housing finance policy in emerging markets in emerging economies. Developers can be associated with di erent forms of construction nance, each of which can play an important role: devel- oper equity, buyer deposits (including presales), developer nance to buyers (installment sales), construction loans provided by nancial intermediaries to developers, and, more recently, bond markets through the securitization of construction loans. e supply side r emains severely constrained because of di culties in leveraging su cient debt and in accessin g land and construction permits within reasonable time frames and budgets. As a result, housing prices keep rising to ever-less-a ordable levels. Without debt leverage, developers invest more of their own capital into projects, thus reducing the size and number of overall projects. is also pushes developers to orient their production toward higher-income households more likely to pay cash or to be credit- worthy for the developers own installment sales program. Construction nance can also refer to self-construction by individuals, which is the predominant form of nance for lower-income groups in many emerging economies. Financial institutions have great di culty in adminis- tering loans to self-constructed units because of their small scale and because of di culties in securing collateral prior to completion. Lenders also subject themselves to considerable construction risk through rising costs or delays, which may a ect the loan repayment. Construction nance therefore helps to increase the supply of units for occupation, boosting the level of home ownership, and improving the quality and e ciency of projects, notably for a ordable housing. In many emerging markets, nancial institutions limit their credit expo- sure to developers for legitimate reasons, which includeasigni cantlyhigher exposure to credit risk. Developers are o en vulnerable, thinly capitalized, and sometimes even relatively unprofessional in conducting their construc- tion activities or the other critical aspects of project management (notably legal, administra tive, nancial, a nd co mmercial). is si tuation is t hen re ected in high lending spreads (typically between 5 percent and 10 percent in many emerging economies), and limited levels of banking exposure to the construction sector (as observed in Poland or a iland). Inhospitable regulatory environments for developers in many emerging markets ho ld bac k productivity growth t hat w ould come a bout t hrough larger-scale a ordable units. Costly and lengthy red tape is associated with construction finance in emerging economies 161 acquiring land, developing zoning rules, registering and transferring titles, and obtaining utility and construction permits. According to De Soto 2000, the procedures in Egypt to gain access to desert land for construction pur- poses and to register these property rights takes between six a nd 14 y ears (77 steps through 31 en tities). Developers also have to cope with market- unfriendly tax and labor laws, which creates an uneven playing eld when contrasted with the informal sector. e productivity of emerging market developers may also be held bac k by ine cient organization of functions and tasks, di culties in obtaining standardized building materials, and the heavy reliance on cheap labor as opposed to modern building equipment and machinery. e construction sector is also o en subject to a lack of competi- tion and entry barriers. e low productivity in the construction sector tends to also a ect the construction materials industry. is industry is c harac- terized by small, informal suppliers who survive by avoiding taxes, evading safety standards, and paying only a fraction of their energy bills, while larger- scale suppliers look for protection from competition through import tari s and licensing restrictions. Another common symptom of a stagnating sector is the high concentra- tion of loans made by banks to a small number of developers. Only a limited number of developers are able to meet t he prudent underwriting lending standards set by banks that would include criteria on nancial strength, own- ership of the land under development, and a solidly established reputation as a developer, which is critical for presales. is nancial concentration o en limits the competitiveness of the real estate sector and the a ordability of new housing, notably toward smaller projects that may very well t the local market realities, land supply constraints, and market demand. Many countries require reforms in real estate development nancing in the following areas: (a) more e ective equity and debt instruments for devel- opers, (b) more security for the households making advance payments (in some cases for the entire amount of the project) and carrying most of the construction risk, and (c) more households pre-quali ed for mortgage loans. e main constraints observed on the supply of housing are access to titled land and access t o construction nance. Issues about land use and urban regulations are not developed further in t his chapter, which will f ocus on the nancing side of property development, coveringdi cultiesinobtaining nance and innovations taking place to overcome these obstacles. 162 housing finance policy in emerging markets Real Estate Development Process and Risks ere are many complex risks related with every phase of development proj- ects, notably related to the o en hazardous regulatory process (land infra- structure and construction permits), the construction phase (possible delays and additional costs), and the commercialization (sales) policy. Real estate developers span a spectrum of operating models, from indi- viduals to partnerships to small and large corporations. ey may specialize in land acquisition and development, ultimately selling the improved land to a builder, or they may take the project through to completion. ey need funds to obtain land, obtain the necessary permits and authorizations, pro- vide or have the local government provide basic infrastructure, construct the building(s), and sell them. is process is typically lengthy, meaning that the developer has funds tied up in the project for an extended period. e length of the development period is a k ey risk factor, as i t exposes the developer to possible cost increases and additional technical delays. By de nition, the developer is als o exposed to market risks, as t he initial assumptions made on the demand for a given product and price may have been wrongly esti- mated. Developers are exposed to real estate price cyclicality, which is dif- cult to forecast without reliable information systems on housing markets and prices. In the absence of permits and infrastructure, the land value is limi ted, which is why the land acquisition phase is mainly nanced through devel- oper equity. An incomplete structure is also worth relatively little, and value can be lost quickly if construction is slowed or stopped. During construction, value depends largely on the capability of the developer to see the project through to completion. It is als o critical to isolate developer risk from the project risk, which is a c hallenge in s ome countries where developers are used to commingling cash and proceeds from various projects. For example, in France, there is now an obligation to create a sp ecial company for each project. All t hese aspects di erentiate construction-project nance from a more standardized underwriting policy for retail mortgage lending. e initial step in the process is land acquisition. Larger developers may acquiresigni cant amounts of land in advance of development (land banking), but more frequently, it is a sp eci c parcel (which can accommodate one or several buildings). In most emerging economies, acquiring land and nancing construction finance in emerging economies 163 land infrastructure remains the toughest and most enduring challenge, and represents a f ormidable disincen tive aga inst t he de velopment o f f ormal a ordable housing units. In developed markets, developers may use options contracts to tie up the land while conducting market research and obtaining permits. e option gives the holder the right, but not the obligation, to pur- chase the land for a st ated price within a sp eci ed period of time. Options reduce the risk and the time frame over which developer equity is committed; however, such options are rarely observed in emerging economies. An inhospitable regulatory environment for real estate development in terms of authorizations and permits (administrative red tape, but also cor- ruption of local authorities and agencies) adds costs and risk to development and in many cases can preclude formal nance. In many African countries, a lack of land and property security (for example, provisory or conditional titles, which cannot be recognized by the nancial intermediaries) inhibits formal development. e main other legal di culty for the developer lies in transferring titles to buyers. Many countries do not permit any early transfer before the phys- ical completion of the building. Such provisions aim to avoid having house- holds become owners of illegally built units, but adversely a ect the project funding, as clients cannot obtain mortgage nancing during the construc- tion phase. Better solutions could impose some third-party monitoring of the construction process and protection of the advances paid by the clients to the developer. In countries where developers are exposed to adverse laws and regula- tions, creative nancial instruments for mitigating risks, as presented below, will be of limited use. Financing by Buyers In many emerging and transition countries (for example, China, P oland, Russia, Turkey, Egypt, Brazil and so forth) a large portion of developments are funded by consumers through advance deposits or presales.1 e deposits 1. Many variants exist to capture these advances; for example, through "share nancing"schemes (individuals paying a portion in advance for apartments under construction of a given project) or purchase of "targeted bonds" issued by the developer for a similar purpose. 164 housing finance policy in emerging markets may be for a portion of the price or the entire amount. Presales with deposits help lenders to verify the strength of demand for a project, but in most devel- oped markets, this advance is small, more to demonstrate the commitment of the consumer than to nance the developer. In less developed markets, it is a major source of nance, either in lieu of formal nance or in addition to it. Developers may prefer pre-sale nance, as it lessens the risk (the sales price is determined in ad vance) and cost (a voids construction period interest; developers may also earn income on unused portions of deposits). In sum, a certain level of pre-sale should be part any sound credit underwriting policy of banks to demonstrate the commercial and nancial viability of the project, but this should not become the main or sole source of construction nance, as it would transfer an excessive level of construction risks to buyers. Indeed, presale nance can be very risky for the consumer. As seen in several countries (Russia, Ukraine) problems occur when there is no co n- struction lending but large advances paid by consumers, and the developer fails to deliver the expected housing product (quality, time, price), leaving households to take the whole risk and face dir e legal stra its in tr ying to recover their advances. Consumers, especially those that earn low or mod- erate incomes, frequently commit all of their savings to make a down pay- ment. Should the project or developer fail, individual consumers rarely have the resources to pursue a case in court to recover their deposits, which is unlikely when the developer is bankrupt or has le insu cient assets. If the unit that is delivered does not meet promised standards, a consumer who pre-purchased with a mortgage has little recourse except to default on the mortgage and pass the problem on to his or her lender (the main cause of the few nonperforming mortgage loans in China). In particular, consumers are usually ill eq uipped to judge progress or quality of construction of a large development project. Several scandals of this nature have been made public (for example, Ukraine, 2005). Improved procedures are needed to better secure the buyer's rights to the unbuilt property. is could include making better use of the advances paid during construction to create an individual property title before the comple- tion of the project. An ide al con dence builder for all t he parties may be performance bonds or an insurance policy contracted by the developer from worthy third parties. Both these methods would provide greater security by enabling a new contractor to be brought in quickly to complete the project if construction finance in emerging economies 165 the original contractor should fail. ese systems have worked well in devel- oped economies, but not yet in emerging economies, as the whole profession of developers must also gain in exp erience and professionalism, which in turn will allow private markets to rate their performance and better manage this construction risk. A payment and performance bond is a nancial tool used to guarantee completion of construction in the event of a developer or contractor default. A performance bond guarantees that a commercial construction contract is upheld as agr eed between contracting parties. e payment bond guaran- tees the payment of materials and labor by the contractor to all subcontrac- tors and material suppliers. Construction lenders are the parties most likely to require a payment and performance bond in o rder to reduce construc- tion risk. e cost of the bond is borne by the borrower or developer. Such bonds are issued by surety companies, a special kind of insurance company. e surety company determines if the developer or contractor is bondable by looking at its nancial statements and performance record, but will also scrutinize the project whose completion is under guarantee. In Brazil, the legislature introduced in 2001 a legal in strument to distin- guish and preserve the equity of the households from the equity of the devel- oper, should the latter become insolvent. e developed real estate assets (patrimônio de afetação) are legally separated--and registered as such--from the overall equity of the developer. A su pervision commission, including household representatives, is responsible for verifying the development pro- cess. In case of a developer's bankruptcy, purchasers may nish the building; however, they would also be jointly liable for taxes and labor obligations of the a ected assets, thus creating possible complications. In Algeria, a m utual guarantee fund "Fonds de Ga rantie & de C aution Mutuelle de la Promotion Immobilière"--sponsored by the state--covers the advances made by clients to developers. e 1993 law on real estate develop- ment included a framework for the sale of housing units before the construc- tion is co mpleted and the possibility for the developer to require advance payments from clients. e developer is required to cover the advance pay- ments against its insolvency through a guarantee fund. e Fonds de Garantie & de Caution Mutuelle de la Promotion Immobilière was established for that purpose in 1997 and became operational in 2000. e decision to grant the guarantee and the setting of the premium is made by the fund's committee, 166 housing finance policy in emerging markets which the developer or related parties are forbidden from participating in. e main criteria examined by the fund are land ownership, building per- mits, and the legally de ned format of the sale agreements, but the fund does not perform any actual screening of the developers or of their projects. e fund usually takes the property being developed as collateral. Developers pay membership fees and a risk-based premium of between 1 percent and 2 per- cent for each project (key criteria: self- nance of the developer, amount of advance payments, history and status of the developer, and quality of the col- lateral). e fund also helps households by checking the consistency between expenditures and construction progress, and developers who use the advance payments instead of freezing buyers' deposits in escrow accounts. At the end of 2004 (a er ve years of operations), 800 p rograms were insured ($500 million). e fund now has a database on developers' performance, critical to build any accessible rating system of developers. e fund has developed no real certi cation function yet,2 but has t he potential to become a s elf- regulatory body capable of becoming a q uality label. If well implemented, such a solution may be appropriate for protecting the advances of households, but it should be stressed that this guarantee would not secure the available nancing needed to nish the construction process in the event of a develop- er's failure.3 e risk is all the greater given that the lien on the partially built property is of little use if its market value is less than overall costs. A more secure system--and therefore costly in t erms of charged pre- miums--would also cover this risk (the fact that the housing units may not be delivered at the right time, at the expected price or quality) through pri- vate insurance products or performance bonds. Nevertheless, the protection of the consumer can go too far, as shown in Turkey. Banks do not like to lend to most developers, viewing them as risky and undercapitalized. us, they make loans to consumers who pre-purchase the house. Problems in the timing and quality of construction led the Turkish Consumer Protection Agency to require that banks retain full liability for poor quality or untimely delivery for a period of ve years for the full pur- chase price of the property. is excessive protection is an inhibitor to bank 2. e fund has r ejected no a pplications, in a n environment of acute housing shortages and many public developers. 3. Buyers can request a judicial injunction to complete construction by any means at the expense of the defaulting developer, but if insolvency is the reason behind the default, it is likely that this remedy remains theoretical. construction finance in emerging economies 167 lending.4 A new law passed in March 2007 reduced this liability to the rst year of the loan. Financing by Banks e developer and the bank should share the vast majority of the project risk, as these institutions have the resources and expertise to manage it. In many countries, construction lending is a widesp read and pro table business for banks. e banks employ engineers and architects to judge project progress and quality, thus mitigating risk. ey can underwrite the developer to ensure that it has the requisite experience and resources to complete the project. e bank can use progress payments combined with periodic reviews by experts to manage the project risk. Construction lending is riskier than permanent nance--thus the ability to charge an appropriate interest rate re ecting risk is important to the market.5 e interest rate, as well as the degree of leverage allowed by the bank will depend on the risk of the project, market trends, and the strength and reputation of the developer. e typical construction loan process is illustratedin gure7.1. e devel- oper acquires the land, and the bank nances the construction and some- times part of the land infrastructure, typically a short-term (six- to 24-month, depending on the size of the project) progress-payment loan, which is repaid from sales of individual houses or units. e same or di erent lender may provide mortgages to nance purchase. ere are a number of obstacles in obtaining bank construction nance, however: · e weakness of developers in many countries, characterized by lim- ited own equity (in order to scale up debt and large-scale projects), poor accounting practices, and a lack of nancial transparency (for 4. Many, though not all, developers are part of conglomerate groups, including banks, in part motivating the connection. e law, however, applies to any bank loan, even if provided by a lender una liated with the developer. 5. In some markets, lenders have o ered reduced interest rates in return for a share in the sales price. is reduces the construction cost for the developer and aligns incentives between the bank and the developer; however, it increases the risk for the lender and may be prohibited by regulators. 168 housing finance policy in emerging markets Figure 7.1. Basic Construction Finance Model example, in many emerging economies very few developers are listed on stock exchanges) and, sometimes, unethical business practices. Regulators may require minimum developer equity for bank lending; for example, the People's Bank of China (PB oC) has recently taken several measures to cool o construction nance by mandating that banks require at least 35 percent of own equity from the developer. Paradoxically, this has increased the amount of presale nancing as developers attempt to minimize their equity investment. · A lack of expertise within the lending institutions. Lenders need in- depth knowledge of local real estate markets (prices, demand drivers, and so forth), the realities of the sequenced development process, and the capabilities and capacities of developers, and also must be experts in project management. is line of business is appropriate for banks, but growing it safely requires speci c skills and legal techniques. Due diligence must be conducted on development and construction rms to verify their track records, ensure their integrity, and evaluate their capacity to manage the construction and sales processes. Ongoing supervision must be conducted on each project to ensure nancial construction finance in emerging economies 169 integrity, proper delivery and quality, progress in completing distinct stages of the project linked to loan disbursements, and so forth. Some- times, banks enter this speci c lending without adequate capacities. While there are no shortcuts in proper risk management, there are tech- niques that banks can use to mitigate risk. One exa mple is t o ring fence- project assets nanced by the construction loan from the rest of the assets of the developer (see Brazil example). Isolation helps to ensure that, should the developer have di culty completing the project, the bank as rst lien holder will be able to transfer its management to another developer to nish the project. Isolating the project also helps to distinguish buyers' cash deposits from other cash the developer manages, and so may increase the likelihood of returning the deposits should the project not move forward. Ring fencing can be done by segregating the land and structures in a special-purpose, lim- ited liability company that is legally o the developer's balancesheet. us, in the event of developer bankruptcy, the project can be transferred to another developer to complete. Alternative solutions are constantly being developed, although they are o en far from perfect. Besides the models described for Brazil and Algeria, here are a few more remedies recently introduced in various countries, most combining public reforms and market forces: In Ukraine, housing construction funds have been recently introduced to regulate the construction period process. Prudential regulations are applied to the management companies of the funds, including capital and reserves requirements for developers expressed as a signi cant portion of the col- lected advances.6 In case of a di culty, the fund manager can change the developer. In practice, the developers sponsor management companies, so the system remains limited by a lack of independence. At least nancial risks are better shared between the developer and households, and a regulatory body (as a new function assigned to the non-bank nancial regulator) exer- cises on- and o -site oversight functions to ascertain that collected funds are used as appropriate. At this stage, this system has not been stress tested. eir use remains recent, limited, and not mandatory. It may play a more e ective marketing role among developers as a quality label, and is similar to escrow 6. A total of 20 percent for the capital and 10 percent for the operational reserves. 170 housing finance policy in emerging markets in which part of the advances are held in r eserve until various completion milestones are hit. In Pakistan, the nancial authorities have contemplated the project of imposing external rating for construction lending. Two rating agencies have developed a methodology to assess the relative capacity of the developer to deliver as per speci ed terms and quality, as well as the transfer of the owner- ship in time, but the project has not been enacted yet. is proposal aimed at enhancing standards among developers and helping investors assess their risks, but rating agencies cannot substitute for the lender's responsibility to originate a sound portfolio of construction loans. e other technical hesita- tion related to whether the developer or the development project should be rated. e alternative road now contemplated consists of rst developing an overall legal and regulatory framework for the development industry. Funding from Capital Markets In Mexico, market mechanisms have been introduced to improve the pro- cess. Developers do not ask for large advances from clients--notably among lower-income groups--but seek construction bridging loans from SOFOLs (specialized housing nance lenders), and get repaid by the sales proceed upon completion of the homes when their clients take out long-term mort- gage nance. e government entity Fondo de Operacion y Financiamiento Bancario a la V ivienda (Operating Fund and the Housing Bank Funding; [FOVI])/SHF was the main source of funds for construction loans made by SOFOLs, but it has now stopped in order to refocus its activities to support long-term mortgage markets. As a result, a large proportion of these bridging loans have been securitized (about $1.4 b illion by early 2006). e struc- turing of these securities is relatively complex and tailored to the speci cs of these bridging loan receivables,cash ows, and risks. Bridging loans are orig- inated, disbursed, and serviced by SOFOLs according to speci c conditions, including a complete feasibility study, a detailed schedule of disbursements according to the supervised progress of the project, individualized units sold through mortgages through the construction period, preventive servicing procedures and speci c workout-phase procedures for development projects likely to default, and so forth. ese securities can also enjoy a partial guar- construction finance in emerging economies 171 antee by the public SHF. is securitization helped to leverage resources and expand the scope of a ordable housing projects, without exercising excessive pressure on the households or the lenders. is mechanism also helped to enhance transparency, safety, and standardization among di erent construc- tion projects.7 In the United States, bank nancing leaves the lender confronted with a signi cant risk if the developer defaults. Bank nancing has therefore gradu- ally made way for commercial mortgage-backed securities, which pool such loans and sell them o as securities to institutional investors. As the risk is then spread, credit rates may be lower. ere has been a more recent trend, however, of more construction loans back on the balance sheet of banks, as bond markets tend not to o er the same level of operational exibility that a bank may provide to a developer. Financing of Buyers Developers are a natural distribution channel for residential mortgage credit, as they want to sell houses as soon as possible to repay their own debt and redeploy capital in other pro table projects. e developer has an incentive to minimize costs and maximize the speed of the mortgage origination pro- cess, but has no exposure to the quality of the resulting credit. But in some emerging economies where mortgage lending is hardly accessible, in order to sell their units some developers have no choice but to provide credits to their clients; for example, through sale installments or even loans when the law permits. e developer usually retains the property title until the last install- ment or the sale contract, or may o er a leaseback contract. Variants can be found in many countries, including Egypt, Brazil, Ivory Coast, Russia, Georgia, or India, as a telling sign of an underdeveloped mort- gage nance system. e price and level of installments are adjusted to re ect an equivalent xed rate of return, which is o en high and not disclosed--as other credit features are--in a transparent and comparable way. e term of 7. Developers are selected according to their recognized professionalism. Projects must comply with several criteria: maximum 65 percent LTV for construction projects--lower LTV for land infrastructure--limited to large cities, good commercialization strategy, trust accounts where sale proceeds are paid, clients eligible for future mortgage loans, possibility of out-of-court property recovery to transfer the project if necessary to another developer, etc. 172 housing finance policy in emerging markets these loans is usually between three and seven years. e credit a ordability is limited, although better than with no credit at all. e performance of these loans is usually good,8 as the developer keeps control of the property title and can replace a delinquent client. Some of these housing credit receivables have been securitized in Brazil. Buyers have certain risks--in the event of a devel- oper's failure, they may not be able to obtain title or receive credit for their payments. is happened in Russia. Other cases of abused households refer to immediate evictions processed by developers a er one single declared late monthly installment, without refunding the buyer with the interests as part of prior installments (which implies a huge penalty in in ationary times). Although most de velopers would prefer ac tual mortgage loans t o b e extended by banks to nance their clients, when this is not possible, they must require larger equity advances from their clients (commercially and nancially unattractive); delay repaying their own suppliers, sub-contrac- tors, and land sellers (including the state, as in E gypt); or raise additional equity to facilitate customer purchase. Many developers do no t have suf- cient treasury capacities to o er such advances, as the economic nature of their activities require them to roll over their equity and pro ts as rapidly as possible into new land and development operations. e need to provide such credits also represents a ba rrier against competitiveness for smaller and new developers. When real estate markets face an adverse cycle, devel- opers also nd it di cult to keep providing long-term lending, thus further depressing housing markets. e servicing of these loans may be delegated to agents or even to man- dated banks. A professional lender is normally better equipped than a devel- oper in loan underwriting and servicing standards, risk management, and cross-sale of other services. Lenders aretypically subject to guidelines related to risk concentration, consumer information, and providing servicing-per- formance incentives, and have developed procedures in case of construction delays. In the event of signi cant in ation, installments should be indexed. In Brazil, the law limits the credit rates of such loans at an index (Consumer 8. e pool performance reported by some developers in Brazil (for example, Rossi) would be superior to the mortgage portfolios held by banks. In Egypt, only 2 percent of such loans are estimated to be non-performing. Some of these developers are said to be quite exible when a loan needs to be restructured. construction finance in emerging economies 173 Price Index) plus 12 percent as a capped real rate. is yield is considered to be quite attractive compared to other market benchmarks. Unlike mortgage loans, such installment-sale loans extended by developers are not supervised by the Central Bank. Some of the developers have started to either securitize them or sell them directly to interested banks (usually with a discount, but the all-in price is still more attractive than through securitization). A more advanced step for developers consists of capitalizing some profes- sional and regulated mortgage lending institutions such as Mexican SOFOLs that would provide mortgage loans to households. Another funding step consists of mobilizing capital markets through the securitization of these loans, as in Brazil and Mexico. An apparent obstacle comes from the lack of credit standards and nancial supervision, but it may be overcome by sea- soned and performing loans and the use of professional servicers and secu- ritization conduits. Other Regulatory Aspects Bank regulators typically set restrictions on construction lending in t erms of allowable LTV ratios, appraisal norms for the underlying collateral, and portions of the project that are allowed to nance. For example, in the United States, banks are restricted to 65 percent LTV for raw land, 75 percent LTV for land development or nished lots, 80 percent of multifamily residential construction, and 85 p ercent for one- to four-family residential construc- tion. In addition, unlike residential mortgage loans, construction loans do not usually have the bene t of any lower-risk weighting for capital adequacy purposes, because of their inherent higher exposure to real estate cycles and credit risks. In some countries, banks are not allowed to provide land loans, while in others the ratio of land to total loans is restricted (for example, to a portion of the bank's equity re ecting the riskier nature of the lending). Lenders also have to have a clearlyde ned and documented lending process for real estate, including origination policies and methods, target markets, appraisal guide- lines, and sta quali cations. Chapter 8 Risk Management and Regulation W. Britt Gwinner and Michael Lea All lending involves a variety of risks that must be allocated, managed, and priced, but the 10- to 30-year maturities and the legal aspects of mortgage lending pose unique risks. Risk t aking by lenders and investors should be regulated and supervised--by both regulatory authorities and market partic- ipants. e principal risks associated with nancial intermediation are well known: credit, market, liquidity, foreign currency, operations (or business), and political. Mortgage value depends on a host of factors, including house prices, interest rates, and the legal environment for enforcing the mortgage lien. Mortgage lenders establish risk measures and methods for mitigating risk that re ect these characteristics. In many cases, measures appropriate for mortgage lenders di er from risk measures and tolerances for shorter-term and unsecured lending. In addition to product-speci c issues, real estate lending can be a source of systemic risk, as banking and real estate crises are frequently correlated. e fact that inappropriate lending, pricing, and risk management can create problems for the broader nancial system and macro economy presents spe- cial challenges for regulators. 175 176 housing finance policy in emerging markets By de nition, emerging markets su er from a lac k of public, detailed nancial information, and they lack liquidity in both the nancial and real estate markets. e lack of information and liquidity, along with the cyclical nature of the property markets, can lead lenders and regulators to restrict the ow of credit to housing, to the detriment of the market and economy--in particular, to moderate- and lower-income borrowers. Yete ective risk man- agement techniques and enlightened regulatory policies can create a climate for safe lending. In this chapter, we review the major risks present in mortgage lending, review how they are managed in an emerging-markets context, and highlight the way regulations shape the market. We end t he chapter with a co ncise summary of the factors that led to the subprime crisis in the United States as a case study in risk management and regulatory issues. The Risks of Housing Finance Like all lending, housing nance is exposed to a number of risks. es e risks can be classi ed into seven categories: 1. Credit risk: the risk that the money will not be returned, with what- ever interest or other charges are due, in a timely manner; 2. Liquidity risk: the risk that the money will be needed before it is due; 3. Market risk: the risk that changes in market conditions will alter the scheduled cash ows (real or nominal) among the parties involved in intermediation. is includes interest rate risk, prepayment risk, in ation risk, and exchange rate risk; 4. Agency risk: the risk that a divergence of interests will cause an inter- mediary to behave in a manner other than that expected; 5. Operations or business risk: the risk that the organization, controls, information syst ems a nd t echnologies a re inadeq uate f or s afe- guarding the institution; 6. Systemic risk: the risk that a crisis at one institution or in one part of the system will spread to the rest of the system; 7. Political risk: the risk that the legal and political framework within which the lending takes place will change. risk management and regulation 177 e ability to manage and price these risks is a major determinant of the availability and cost of housing nance, as well as the provision of credit for a ordable housing. e ability to do so in turn depends on the soundness of the economic, primary market, and regulatory infrastructure. e two most important prerequisites for managing risk in housing lending are macroeco- nomic stability and an e ective legal framework for property ownership and mortgage lending. Macroeconomic stability is very important for several reasons. First, it has a majore ect on the demand for mortgages. High rates ofin ation and nom- inal interest rates are typical features of many emerging economies. es efea- tures have the e ect of reducing mortgage a ordability. A volatile economy also a ects the supply of funds and the characteristics of mortgages o ered by lenders. In a volatile environment, lenders are concerned about liquidity risk and reluctant to o er long-term loans. is may lead them to not o er mortgages or only o er short maturity loans that in turn are less a ordable for consumers. Lenders and investors may prefer short-term assets, in part because of the di culties of forecasting in ation and interest rates and thus the cash ows of their portfolios. FRMs create substantial cash- ow risk for lenders in v olatile environments.1 Variable rate mortgages are riskier for borrowers in a volatile environment, as interest rate change causes payment shock. In turn, this increases the credit risk of mortgage lending (for example, Colombia, Mexico from the early 1990s). e distinguishing characteristic of mortgage nance is t he use of the mortgage lien to secure the loan. As a result, credit risk depends on (1) the borrower's ability to pay the loan from income or other resources; (2) t he risk that, in case of default, the collateral sale price will be less than the out- standing balance on the loan plus costs of foreclosure; and (3) the risk that the collateral cannot be seized in a reasonably rapid manner. e inability to foreclose and repossess the collateral in the event of default is a major source of risk in many emerging markets.2 e time and expense in foreclosure deter lending, particularly for lower-income households, and raise the cost of borrowing. Extensive research shows that banks provide a greater supply of larger mortgages at lower rates of interest in regions and countries 1. See chapter 3 on mortgage instruments. 2. See chapter 5 on legal issues. 178 housing finance policy in emerging markets that have shorter and more dependable foreclosure processes (Pence 2006; Jappelli, Pagano, and Bianco 2002; Clauretie and Herzog 1990). Many of the same factors that restrain the growth of mortgage nance also create challenges for regulators: legislatures may not fund regulators at adequate levels, and courts may not support regulatory actions. Di culties in enforcing the mortgage pledge increase the cost of resolving failed institu- tions when public authorities are forced to take them over. Special foreclo- sure powers for public authorities may reduce the cost of resolving crises, but in the long run serve to enforce market distortions.3 In many developing countries, issues related to land title remain a major barrier to housing nance. An acc urate and comprehensive land registra- tion system is a necess ary condition for e ective property rights. e lack of an e ective title registration system is a major barrier to the development of markets in used housing, which are o en more a ordable than new con- struction. It is also a barrier to lending, as borrowers that cannot establish clear title to their property cannot pledge it as collateral for a loan. Credit Risk e two primary measures of credit risk are 1) probability of default and 2) loss given default. Probability of default measures the likelihood that the bor- rower will fail to make payments over the life of the loan. Loss given default measures the net cost t hat the lender will su er in the event of default and foreclosure. Loss given default is t ermed as a loss b ecause lenders usually lose when they have to foreclose and sell a property. Losses from foreclosures arise primarily when house prices overall have declined, but they may also stem from the costs of maintaining the house if it remains vacant for a period a er foreclosure, and from the legal fees and other costs of foreclosure. Mortgage lenders underwrite credit risk in three broad areas: 1) the ability and willingness of the borrower to repay the loan; 2) t he value of the col- lateral relative to the loan amount; and 3) t he lender's ability to e ciently 3. For example, Colombia created a co mpany to dispose of the assets of failed banks in t he wake of the 1998 crisis. is company, Central de Inversiones S.A., was given legal powers to foreclose and evict borrowers that reduced its cost, but did nothing to create con dence on the part of private-sector lenders that lacked such special powers and so faced much longer average recovery periods and costs. risk management and regulation 179 enforce the mortgage lien in case of default. Each of these is assessed at the time the loan is originated, and periodically throughout the life of the loan. Lenders gauge the borrower's ability to pay by comparing monthly debt payments to income, and by assessingthe presence of liquid reserves, savings, and investments. e most common measure for ability to pay is the ratio of the monthly debt service or the mortgage payment to monthly income, also known as the e ort ratio. e debt service-to-income ratio is calculated by dividing total monthly debt (including mortgage loan payment, monthly installment payments, and minimum payments on all r evolving debt) by gross monthly income. e higher the ratio, the greater the stress that debt payment places on the household. In t he past, a verage accep table deb t s ervice-to-income ra tios ra nged between 25 and 35 percent. In recent years, there has been an upward dri in maximum (and average) ratios. is re ects the generally benign conditions associated with relative macro stability in many countries. It also re ects the frequent underreporting of income in emerging economies. us, in Egypt lenders are by law permitted to lend up to 40 percent for normal loans and 25 percent for social housing loans. e same maximum applies in ai land (despite the fact there was a major market downturn in the mid-1990s); how- ever, in Indonesia and Argentina, two countries with recent bouts of insta- bility, the maximums are only 30 p ercent, and in Ro mania the maximum is 35 p ercent. Lenders may vary permissible debt sevice-to-income ratios to take into account compensating factors, such as t he presence of liquid reserves a er closing of the purchase transaction, low LTV, or the presence of mortgage insurance. Lenders generally ass ess willingness to pay by collecting information on the borrower's historical record of payment of other debts, such as con- sumer loans and auto loans. Increasingly, the technology of credit scoring is spreading as a way to collect a range of information to predict the perfor- mance of a given borrower and express in a single number their willingness to pay the mortgage.4 Credit scores re ect the borrower's payment history on all debt over a given period of history. Although credit scoring has been introduced in some emerging markets (Brazil, Mexico) a lack of data (par- ticularly through a complete cycle), and the unwillingness of many lenders 4. See chapter 4. 180 housing finance policy in emerging markets to share proprietary performance data, limits its usefulness as a n under- writing tool. e amount of equity the borrower has in the property is a major factor underlying willingness to pay. us, one of the simplest means to manage mortgage credit r isk is t o s et a maxim um acceptable LTV. e less cer - tain lenders are regarding future house-price trends or the legal su pport for enforcing the mortgage lien, t he less lik ely that high-LTV lending will emerge. In emerging markets, with limited experience in lending, relatively volatile property markets, and less cer tain legal en vironments, regulators tend to establish a ceiling on LTV. In Korea, the limit is 60 percent for non- speculative and 40 p ercent for speculative areas. In China a nd Russia, the limit is currently 70 percent; in Romania, 75 percent; whereas in Egypt and Mexico it is 90 percent. ere is a 100 percent limit in ailand and no max- imum LTV in Poland. In other countries, limits are imposed by covered bond legislation (Hungary, 70 percent; Chile, 75 percent). Mortgage lenders set thresholds for the credit risk of loans that they will originate based on their risk tolerance as lenders and on the nancial return that is available in their market if they bear di erent levels of credit risk. To estimate probability of default and loss given default at origination, lenders require information on the property, primarily an appraisal of its market value and information on the borrower, such as the amount and stability of monthly income, other assets the borrower may hold, the source of the down payment, and the borrower's credit history. e lack of credit information is a signi cant barrier in most emer ging markets, as borrowers o en do not have a credit history or ability to prove their income. Many emerging-market borrowers are employed in the informal sector, so their income is o en more volatile anddi cult to substantiate. Still other borrowers systematically underreport income to avoid taxes. Lenders have begun using nonstandard ways to underwrite or qualify borrowers. e experience of ailand (box 8.1) is instructive. Credit risk management takes place through servicing as well as the orig- inal underwriting of a loan. E ective servicing involves more than payment collection but also active monitoring of repayment performance and correc- tive actions once delinquency begins. Lenders can reduce the credit risk of mortgage lending by securing the repayment stream; for example, through payroll deduction (as does Mex- risk management and regulation 181 Box 8.1. Innovative Underwriting in Thailand The Government Housing Bank (GHB) of Thailand has developed a number of innovative ways to underwrite loans to lower-income households (Khan 2004). These include the following: Hire purchase prior to mortgage: House purchasers lease for three to five years, after which they can become mortgagors upon record of regular monthly installment payments; Regular payment incentives: borrowers that save regularly prior to obtaining a mortgage benefit from a lower interest rate. GHB spearheaded the creation of a credit bureau to share the credit histories of their 700,000 borrowers, 90 percent of which are low to moderate income (loans below $25,000). ico's Institute of the National Housing Fund for Workers, known by its Spanish acronym INFONAVIT), or direct debits of borrower's current bank accounts (as do South African banks). Collections are a challenge for bor- rowers with informal incomes. Mexico's SOFOLs place repayment o ces in the developments they nance to allow the borrowers to repay the loans in cash near their homes (boxes 2.1 and 8.2). is is more e ective than asking them to come into a lending or bank branch, which may be inconvenient or time consuming, and works in a country in which the mail services are not reliable. Lending to lower-income households generally involves greater risks for lenders than higher-income loans. e income of poorer households is less stable and more di cult to document. Such households typically have short or negative credit histories and fewer resources to withstand shocks. In addi- tion, the transaction costs o f making housing loans--particularly smaller, a ordable loans--o en make them unattractive for lenders. Relatively small loans to low- or moderate-income households require more work (that is, higher transaction costs) and usually result in less revenue than larger loans to middle- and upper-income households. 182 housing finance policy in emerging markets Box 8.2. Proactive Servicing in Mexico Since 1996, the SOFOLs have been providing mortgage loans to low- and moderate-income households (incomes two to eight times minimum wage) in Mexico. As of mid-2004, they had an outstanding portfolio of approximately $4.5 billion (Babatz 2006). Their delinquency rates are below 2.5 percent. They have pioneered innovative underwriting and servicing techniques for the affordable housing market in Mexico, including point-of-sale servicing and use of nontra- ditional measures such as rent and utility payments for informal borrower credit histories. Without subsidies, SOFOLs serve households earning between the median income and the 75th percentile, where banks traditionally served house- holds earning more than the 75th percentile. In Mexico, SOFOLs arose a er the banking crisis of the mid-1990s to pro- vide a ordable housing nance. ey have been highly successful in man- aging the risks and costs of servicing this market. Other Risks Liquidity Risk Liquidity risk refers to the risk that money will be needed before it is due. A lender faced with short-term and unstable sources of funds (for example, sight deposits, short-term bank loans) may not make mortgages because of the risk that it cannot meet i ts cash o ut ow needs. A ssets that cannot be pledged as collateral for short-term borrowing also increase liquidity risk. Liquidity risk is no t unique to housing nance but is ra ther a b roader nancial sector stability issue. I n modern nancial markets, central banks provide the ultimate backstop for liquidity. In addition, deposit insurance reduces the likelihood of massive withdrawals from depository institutions; however, the long-term nature of mortgages creates greater liquidity risk than other types of lending. is is frequently cited as a reason why banks will not provide housing nance in emerging markets. Lenders manage liquidity risk through funding diversi cation and planning. risk management and regulation 183 Liquidity risk is subject to regulatory constraints such as ratios of long- term assets to long-term liabilities or liquid-to-total assets. Such regulations can be deleterious to the mortgage market, however. e West African Eco- nomic and Monetary Union sets a minimum of 70 percent for the ratio of long-term assets to long-term liabilities and does not include core deposits in its long-term liabilityde nition. In countries with no bond markets and little long-term nance, the inability to provide long-term mortgage loans out of core deposits e ectively precludes lending. One way for government to improve the liquidity of mortgage assets is to accept mortgage securities as collateral at the discount window--a solution massively used by the central banks of countries a ected by the subprime crisis to maintain some liquidity in the mortgage backed securities market.5 Nevertheless, independent central banks may not wish t o provide speci c sector support or may be uncomfortable with the credit quality of the securi- ties. Government can take a limited and targeted role in reducing liquidity risk for primary lenders by backing a liquidity facility.6 Liquidity risk is especially apparent for non-depository lenders, as shown in t he c urrent U.S. subprime mortgage cr isis. Many such lenders f unded their inventory held for sale with commercial paper or warehouse loans from banks. When investors became nervous about the credit risk of the lender and collateral, the lenders found themselves without access to short-term funding, leading to forced asset sales into a depressed market and bankruptcy. Market Risk Market risk stems from uncertainty with respect to expected in ation, actual in ation, real interest rates, and exchange rates. Lending for a longer term, as for housing, greatly increases these risks. e macroeconomic environ- ment and the characteristics of the mortgage instrument are the principal determinants of cash ow risk. For example, a low-cost prepayment option may be a desirable feature of the mortgage instrument for the consumer, but it signi cantly increases the cash- ow risk to the lender. Environments that 5. Central banks widened for this purpose normal eligibility criteria of MBS to their rediscount window. 6. See chapter 15 on mortgage securities. 184 housing finance policy in emerging markets are more volatile generate greater risk, which reduces the a ordability and availability of funds. FX-denominated mortgages may have attractive rates at a particular point in time but exchange-rate uctuation can lead to signi - cant cash- ow risk for mismatched lenders and borrowers. In Mexico, the government has created an innovative risk management program to cushion the risk of macroeconomic shock for borrowers and investors. ere are a wide range of metrics and methods to understand and miti- gate market risk by both lenders and investors. Well-run institutions employ a range of tools to underst and their market-risk position and manage risk within the tolerances set by management and the board. Managers o f dep osit-funded lender s ha ve t o trade o st ability o f net income with stability or growth in the estimated market value of equity. Net income measures the periodic income available as a r esult of the lender's operations. Changes in the market value of equity re ect the value that man- agement creates for shareholders. While it is management's primary task to maximize the value of shareholder's equity, that overall goal has to be bal- Box 8.3. Managing Market Risk Since 1999 in Mexico, mortgages have been originated with a market-risk hedge that is intended to cope with extraordinary or permanent decreases in real minimum wages. This swap allows borrowers to make payments that are linked to the minimum wage index while the loan principal is indexed to consumer price inflation, protecting lenders (Babatz 2006). The swap is implemented under the administration of Sociedad Hipotecaria Federal (SHF), a government-owned mortgage development bank. The borrower and the government share the cost of the swap. The former pays a 71-basis-point fee that, in conjunction with a credit line backed by the government, creates a fund intended to meet a temporary lack of payment flows to securities issued by the lender. The fund is arranged to be able to support a 25 percent deterioration in real wages over a 30-year period. If the fall is higher (lower) the SHF would incur losses (gains). The swap allows bor- rowers, particularly lower-income borrowers, to have a loan with payments better matched to their incomes, while lenders get payments that more closely conform to investor requirements. risk management and regulation 185 Box 8.4. Polish Foreign Exchange Lending Requirements Polish authorities have been concerned about the rising proportion of FX- denominated loans among their residential mortgages--62 percent by the end of 2005. This trend resulted from the low nominal rate of Swiss franc mortgages relative to zloty-denominated loans. While the Swiss franc loans are initially more affordable, borrowers earning zlotys are exposed to FX fluctuations, which can create greater credit risk. A ban was considered but abandoned as market unfriendly. The Commission for Banking Supervision instead issued recom- mendations in 2006 related to mortgage lending, including for FX-denominated loans. Banks are expected to adjust their underwriting policy (notably through a lower LTV), and assess the creditworthiness of clients by assuming the higher credit rate of a Polish Zloty New (PLN) loan, and a loan principal augmented by 20 percent to simulate the impact of a devaluation. Banks are expected to peri- odically assess the quality of their mortgage portfolio, and particularly exposed banks are expected to conduct periodic stress tests assuming a devaluation of 30 percent persisting for 12 months. The stress test results are reported to the National Bank of Poland. Banks must also improve their credit information to clients in a comprehensible way. They should first offer PLN loans, obtain from the client a written consent of being aware of the FX risk, and simulate loan repayments in a negative devaluation case (rate as of PLN credit loan, and a prin- cipal higher by 20 percent). anced with the need to maintain relatively stable net income and the capacity to pay dividends. e nancial terms of a mortgage loan (that is, xed or oating rate, con- stant or price-level-adjusting principal) allocate market risk between bor- rowers, lenders, a nd, in ma ny markets, investors. FRMs p lace market risk in the hands of the lender, and require matched funding and protection from prepayment risk. Floating rate and in ation indexed loans place at least some market risk in the hands of the borrower, and require attention to payment shock (treated above under cr edit risk), and to any mismatch between the nature and timing of the indices to which the loans and the lia- bilities that fund them are linked (basis risk). Economies that have less liquid 186 housing finance policy in emerging markets xed-income markets may have di culty in establishing a reliable index for oating rate mortgages. An increasing source of market risk in C entral and E astern European countries arises from the heavy use of mortgages denominated in or indexed to foreign currencies. In Poland, 62 p ercent of the outstanding loans were FX linked at the end of 2005, with even higher percentages of 80 percent in Ukraine and 82 percent in Romania. e regulators in these countries have expressed concern about the borrower credit risk associated with currency devaluation, as well as the lender market risk stemming from unhedged posi- tions. e National Bank of Romania has adopted a basic ca pital adequacy ratio of 6 p ercent for mortgage loans, instead of the 4 p ercent rate applied in most European countries under Basel I. As part of the e ort to encourage lending in lo cal currency, the National Bank of Romania raised the basic capital required for FX-denominated assets to 130 percent of the basic ratio. Additionally, banks are restricted to an absolute lending ceiling for FX loans of 300 percent of their capital. e National Bank of Poland has recently adopted tough disclosure and risk management guidelines for FX lending (box 8.4). Agency Risk Agency risk occurs when there is a separation in the functions of lending. Agency risk occurs at the primary-market level, where lenders may depend on brokers to market and process loans and appraisers to value the col- lateral. In secondary markets, investors depend on third-party originators and servicers to underwrite, collect, and remit payments. It is also a major concern in government guarantee programs, as the government is exposed to a moral hazard (use of guarantees leading to more risky behavior). e presence of agency risk increases the cost o f lending and securitization. Lenders and investors manage agency risk with contract terms, quality con- trols, and technology. Nevertheless, this risk materialized at various levels of the lending chain in the United States, from unscrupulous bankers and appraisers to moral hazard in securitized portfolios, and was a driver fo the subprime crisis. risk management and regulation 187 Operational Risk Operational risk is a broad, catch-all topic, including risk of loss from incom- plete documentation, automated system failures, data entry errors, rogue traders, and computer security breaches. e transaction intensity of the mortgage business makes mortgage lenders particularly subject to opera- tional risk. e documents that establish the mortgage lien are usually long and complex. e long term to maturity of mortgages increases the likeli- hood of error. Mortgage originators need e ective controls, systems, and business processes to manage the credit underwriting process and all of the associated paperwork. Mortgage servicers need r obust automated systems and controls toe ciently process the monthly payments on the thousands of relatively small, long-term loans that they make. Banks that issue mortgage bonds or mortgage-backed securities need robust and sophisticated systems to administer the monthly cash ows to investors for maturities of 10 years or more. While it may seem obvious that mortgage lenders should employ e ec- tive operational systems and internal controls, the lack of such systems has magni ed losses in most mortgage-related nancial crises. In credit booms, lenders have o en loosened control of processing legal requirements in the press to compete for loan volume. is was the case in Mexico, Indonesia, ailand, and Colombia in the 1990s, and in the United States in the 1980s and in the recent subprime lending boom. In the wake of each of these crises, it was f ound that many banks lacked the basic do cumentation to enforce mortgage liens. Operational risk can become more important as the mortgage value chain is "unbundled" through securitization. As separate participants specialize in elements of the process (for example, origination, servicing, securitization), there are more actors involved and additional chances for operational error, as control over separate steps moves from one organization to another. Tra- ditional bank regulators may not have authority or responsibility for regu- lating servicers. In the United States, Europe, and Mexico, the industry has come to rely at least in pa rt on rating-agency evaluations of the capacity of servicers. In Colombia, the mortgage securitization rm Titularizadora Colombiana sets the industry standards for servicer capability, and rates the 188 housing finance policy in emerging markets separate servicers as a way of indicating the rms eligible for servicing loans it will purchase. Systemic Credit Risk Systemic credit risk can arise if there is a sudden and sharp decline in prop- erty values. e decline may be local in na ture (for example, a la rge rm leaves the area or goes bankrupt) or national (for example, because of a large, unanticipated change in t he in ation rate). A ma rket failure may exist if lenders cannot diversify mortgage credit risk. For example, U.S. S&L associa- tions were forced by regulation to operate on a narrowly de ned geographic basis until the 1980s, and were exposed to signi cant concentration risk (for example, the oil-producing states in the Southwest). Mortgage insurance can diversify risk and increase the supply of mortgage credit.7 Real estate prices move in cycles, sometimes with tremendous volatility, which creates r isk for lenders and for t he st ability of nancial systems.8 Volatile real estate prices make it di cult to value the collateral underlying the mortgage, and to ass ess the credit risk of mortgage portfolios. During Colombia's real estate bubble of the 1990s, residential real estate prices rose 28 percent between 1992 and 1994, and then fell 30 percent between 1994 and 1999.9 Because of this and other factors, including rising unemployment and the structure of the in ation index of the loans, defaults rose to a third of the system-wide mortgage portfolio, and the resulting collapse of several spe- cialized mortgage banks lay at the core of the nancial system crisis. Similar stories can be told for real estate lending in Japan in the 1980s, in t he oil- patch states of the United States in the 1980s, in the East Asian crisis of the 1990s, and in the rise and decline of subprime lending in the United States. e subprime crisis demonstrates how real estate bubbles can be propa- gated across the global nancial system. A real estate bubble created in part by loose monetary policy in the United States was intensi ed by a mortgage bubble that became a mo rtgage and real estate bust a ecting all types o f lenders in the United States and abroad. 7. See chapter 13. 8. W heaton 1999. 9. Cardenas and Badel 2003. risk management and regulation 189 Research sho ws t hat r eal est ate b ubbles ma y r esult f rom co- movement with the overall economy, from policy choices such as changes to tax law, or from myopia on the part of economic actors.10 Policy makers in both developed and emerging markets make policy choices that produce or de ate price bubbles.11 It can be argued, however, that myopia is worse in emerging markets, where information is s carcer and markets are less e cient. Real estate markets in developed economies generally enjoy greater price transpar- ency, more e cient markets for urban land, and better market infrastructure, including e cient property and lien registry systems, lower transaction costs, stronger legal frameworks for ownership and contract enforcement, and more sophisticated nancial systems. ese features can mute thee ects of a bubble and provide for a more rapid adjustment to a collapse in prices. Political Risk e political risks of mortgage lending relate to events that reduce earnings from mortgage lending because of political intervention in the selection of borrowers, the rate adjustment process, the mortgage terms and conditions, or the foreclosure and eviction process. For example, the Colombian Supreme Court invalidated the index us ed on mortgage contracts in t he middle o f a s evere eco nomic do wnturn, le ading t o subst antial loss es f or mo rtgage lenders. A new government in Nicaragua forgave the mortgage loans of the state housing bank upon assuming power in 1979, o nly to have the bank attempt to reinstate the loans at a later date when the nancial implications of this action became clear (Mathey 1990). The Role and Tools of Regulation E ective regulation can foster the creation of more stable and resilient lenders and nancial markets. ese can support the extension of housing nance, contributing to economic growth and individual welfare. e long history of 10. Wheaton 1999. 11.See for example, DiPasquale and Wheaton (1992) o n the e ect of tax code changes in t he United States on real estate prices during the 1980s. 190 housing finance policy in emerging markets Box 8.5. Keystone Bank On September 1, 1999, the U.S. Office of the Comptroller of the Currency closed the First National Bank of Keystone, saying investigators were unable to account for some $515 million of the $1.1 billion assets recorded on the books of the 85-year-old bank. The bank had long been the economic mainstay of Keystone, a small town in a depressed coal-mining region of West Virginia. It soon became clear, however, that bank officer fraud, risky bank strategies, and poor oversight had turned Keystone's only financial institution into one of the costliest failures for the Federal Deposit Insurance Corporation since the Great Depression. Losses to the Federal Deposit Insurance Corporation (which compensates depositors for insured deposits when a bank fails) rose from that early estimate of $515 million to estimates in spring 2002 of $780­$820 million. Keystone's failure at the height of the late 1990s economic boom sent shock waves through the regulatory and banking community. It concentrated attention on bank exposure to subprime loans and securitization risks, and on the need for regulatory bodies to act decisively when they suspect that management might be obstructing regulatory scrutiny. Keystone's business centered on providing high LTV home equity loans, including home improvement and debt consolidation loans. It was feted as one of the most profitable small banks in the country and in 1999 it reported assets of $1.1 billion. Beginning in 1993, the small-town bank began to purchase ever-larger volumes of low-quality loans from third parties to repackage into asset-backed securities that could be sold to investors in the financial markets. By 1999, it had processed some $2.6 billion of loans in nearly 20 major deals. On the liability side of its balance sheet, it took advantage of the emerging wholesale deposit market to an unusual degree. This market allowed banks to collect deposits in chunks of millions of dollars from brokers, as opposed to the traditional route of gaining new funds by attracting larger numbers of individual, local depositors. Concern about its rapid growth led the U.S. Office of the Comptroller of the Currency in 1997 to transfer responsibility for reviewing Keystone to a unit that focused on problem banks, and in 1998 the bank was banned from accepting any further brokered deposits. In July 1999, examiners discovered by means of direct (continued) risk management and regulation 191 Box 8.5. Keystone Bank (continued) verification with the bank's loan servicers that $515 million in loans carried on the bank's books were not owned by the bank. On September 1, 1999, regulators closed the bank. Investigators found that loans recorded on the bank's books had been sold and the value of certain residual interest grossly inflated. Bank officers engaged in extensive fraud, siphoning off loan payments to personal accounts. At an industry level, the collapse revealed the level of losses that can be incurred when a small bank begins to take advantage of innovations in banking and financial markets such as wholesale brokerages and securitization. Some commentators blamed the authorities for not closing the bank sooner, citing a lack of cooperation between regulatory agencies, particularly the Federal Deposit Insurance Corporation and the U.S. Office of the Comptroller of the Currency. For its part, the U.S. Office of the Comptroller of the Currency said that the case had helped to alert it to the risks in subprime lending and the complexities of asset securitization and residual valuations. Source: Sunguard Bankware Erisk 2002. nancial bubbles and panics shows that nancial market participants have not always been willing to hold adequate capital, to disclose fully the risks they engage in, or to manage risk e ectively. e challenge for authorities is to balance the faster economic growth that can follow from lighter regula- tion against the costs that may result from the failure of lenders. In general, regulation should provide positive incentives for a va riety of competitive institutions to deliver nancial services to those who demand them. On speci c technical issues, such as nancial reporting, disclosure of risk, and appropriate levels of risk-based capital, authorities can look to international standards for guidance. Research shows that incentives for prudent banking through transpar- ency and market discipline are more e ective than regulations based pri- marily on rules and checklists.12 Emerging market nancial-disclosure rules are o en below international standards for best practice, security trading 12.Barth, Caprio, and Levine 2001 and 2006. 192 housing finance policy in emerging markets tends to be infrequent and illiquid, and audit rules are o en weak. In such an environment, regulators can contribute signi cantly to economic growth by improving disclosure regimes and by instilling greater market discipline. E ective supervisors in any market depend on a variety of tools, including risk-based examinations, o -site monitoring using reports, statistics, analyt- ical models, monitoring of housing and nancial markets, and dialogue with management. As nancial institutions in sophisticated markets have engaged in increasingly complex businesses, some of the largest and most costly bank failures have resulted from a lac k of understanding of risk on the part of management, investors, and regulators (box 8.5). As a result, in all markets, it is essential that regulators examine nancial institutions, verify the accuracy of their disclosures, assess their nancial health, assess the quality of their nancial risk management, and monitor the e ectiveness of external audi- tors and credit rating agencies. International Standards for Reporting and Capital Globalization of nancial markets has brought with it the promulgation of international standards for safety and soundness regulation and for nancial disclosures that seek to better address the risks of new technologies. e Basel Committee on Banking Supervision of the Bank for International Settlements (BIS) has set standards for bank safety and soundness regulation (the Basel Core Principles)13 and for risk-based capital requirements (the Basel I and Basel II accords).14 e International Accounting Standards Board has pro- mulgated International Accounting Standards (IAS). All of these e orts have involved extensive consultations between regulatory and other authorities in developed countries, and to a lesser extent, emerging markets. Although its terms and shortcomings pose challenges, more than 50 emerging markets are moving to adopt Basel II, albeit on country-speci c schedules that are slower than that established for internationally active banks from G-10 countries.15 e weakness of nancial regulation in many emerging markets is a s ource of ongoing concern. Financial regulators in 13.Basel Committee on Banking Supervision 1997. See http://www.bis.org. 14.For the source documents describing the Basel accords, see the BIS Web site, www.bis.org. 15. Fratzscher 2004. risk management and regulation 193 many emerging markets have yet to implement many of the central tenets of the Basel Core Principles, potentially leading to material weaknesses in the implementation of Basel II. Some aspects of Basel II are inappropriate for emerging markets that lack well-developed capital markets. Basel II fails to directly address market risk in the banking book, an omission that is particularly important for the regulation of mortgage lenders. ere is a risk that implementing Basel II in the absence of an adequate infrastructure would lead to results that would at best be misleading, and at worst could lead to regulatory arbitrage and a material misunderstanding of the risks that banks face. Finance companies, mortgage bankers, and securitization companies o en fall outside of the purview of prudential bank regulation because they are not thought to a ect the integrity of the payments system, and because they do not capture deposits. So long as they are supposed not to pose a systemic risk to the nancial system, it has been widely considered in most countries that non-depository lenders should enjoy lighter regulation. is consensus was challenged in the case of ailand, where bank lending to lightly regulated nance companies help precipitate the 1997 crisis. e approach has b een challenged again in the subprime crisis, where the vast majority of the riskier subprime lending was carried out by lightly regulated subsidiaries of deposi- tory institutions or e ectively unregulated non-bank lenders. e issue is to determine whether the greater economic growth that may result from lighter regulation outweighs the risks to the system that may result from institu- tional failure or from having unregulated entities create assets that are traded in the broader system.16 e subprime crisis has changes the terms of this trade-o (see the last section of this chapter). Provisions A provision is a reserve that the lender establishes against expected losses on its portfolio of residential mortgage loans. As part of managing risk, banks should regularly review the quality of their loan portfolios. e supervisor 16.Carmichael and Pomerleano 2002, 190. 194 housing finance policy in emerging markets should assess the bank's ability to identify, classify, monitor, and address loans with credit quality problems in a timely manner. Supervisors generally set provision requirements for lending institutions, and the content of these regulations varies widely among countries. Where data is available and loans are standardized enough to calculate expected loss, lenders should base the general provision on the estimated expected losses of the portfolio. For instance, in C anada, the United States, Hong Kong, and Mexico, for portfolios of homogenous loans, such as residential mortgages of a given cohort, interest rate, and loan maturity, the general reserve re ectsthe statistically expected lifetime loss on the portfolio.17 us, the general reserve will be equal to the average default and loss rates experienced for loans of the type that make up the portfolio. Distinct from the general provision, speci c provisionsrepresent likely losses on individually identi ed loans, and are cre- ated as loans actually default, generally as a growing percentage of the out- standing balance as time in default passes. IAS 39, " Financial Instruments: Recognition and Measurement," deter- mines provisioning requirements for loans held on balance sheet. From an accounting perspective, a loan should be fully provisioned (that is, 100 per- cent) once the lender believes it will not be able to collect. In practice, the de nitions and thresholds for provisioning vary widely among countries. Provisions can be used to manipulate earnings. In good times, since provi- sions are tax deductible, banks have an incentive to excessively provision in order to reduce taxes and reserve income for later periods. In a time of crisis, lenders may preserve earnings by failing to provision against rising defaults, postponing the harm to p ro ts and shareholders' dividends. Alternatively, provisions have been a s ource of regulatory forbearance in times o f crisis. As defaults grow during a crisis, regulators may allow lenders to postpone the recognition of loss, as they did during the S&L crisis in the United States during the 1980s. Provisions are a matter of judgment informed by available information. Supervisors should develop regulations for general and speci c provisions that re ect the best estimate of the quality of the loan. In mortgage lending, it is possible to generate such estimates in markets that have an adequate data history. Where data is inadequate, supervisors should prescribe provisioning 17.Laurin and Majnoni 2003 and Poveda 2000. risk management and regulation 195 Box 8.6. Spain's Statistical Provision One of the historical shortcomings of loan provisions has been their pro- cyclicality. Banks have a tendency to reduce provisioning levels as time passes from a credit crisis. In the event of a new shock, they are forced to quickly raise provisions to compensate for rising defaults. In an attempt to counter this pro- cyclicality, since 1999, Spain has imposed what they call a statistical provision that is designed to be countercyclical by using statistical expectations of loss to determine the provision. Provisioning is based on (statistically) expected losses. When loan specific provisions are low, a "dynamic" component is added to them and accrues. When the need for specific provisioning exceeds expected losses and statistical provisions, the previously accumulated surpluses are used to cover the gap. In the Spanish system, Banks may estimate risk using a standard methodology provided by the Bank of Spain, or they may use their own estimates of expected risk, given demanding requirements for the data and quality of their models, including the requirement that data cover at least one full credit cycle. In the standard methodology, residential mortgages are considered to be low-risk assets, and carry a 0.1 percent coefficient for the purposes of the statistical provision, versus 0 percent for risk-free assets, and 1 percent for consumer loans. rules that re ect what is known of local performance, and of performance in other countries with similar characteristics but better data. For instance, Argentine banks are required to hold a 1 p ercent provi- sion against all current loans, with escalating percentages as delinquencies advance. e required provision for delinquent or doubtful collateralized loans is r oughly that of uncollateralized loans at each stage. er efore, a collateralized loan that su ers f rom " inadequate compliance" requires a 3 percent provision, while an uncollateralized loan in a simila r condition requires a 5 p ercent provision. Interest accruals for loans in ex cess of 90 days of delinquency must be completely provisioned against. Loans consid- ered unrecoverable must be completely provisioned, whether collateralized or not. Mortgage loans in default may bene t from a provision of less than 196 housing finance policy in emerging markets 100 percent if the bank obtains a letter from a lawyer attesting to the value of the collateral.18 In terms of international standards, the Basel Committee has issued a con- sultative paper that provides principles that are in line with IAS 39.19 Neither the consultative paper nor IAS 39, however, provide uniform loan classi ca- tion techniques, nor a st andard procedure to assess loan risk.20 us, reg- ulators have to balance prudential considerations against somewhat vague accounting requirements. Capital Requirements for Primary Lenders Capital is the reserve held against any kind of unexpected or extreme nan- cial risk. e capital requirement should re ect risk--it should change as the risk level of the institution changes, and so reward better risk management. Capital should represent a bright line for the regulator and for the regulated. Capital requirements should provide a signal to the markets of the risk that the institution bears. Over the past 20 y ears, many lenders and regulators have revolution- ized t heir a pproach t o ma naging ca pital, mo ving f rom a st atic, hist oric approach to one that is risk-based and forward-looking. Large, internation- ally active banks have moved the farthest, adopting sophisticated, quantita- tive approaches to risk management and capital allocation. Mortgage lenders in t he United States and Europe have led t he devel- opment of quantitative models for credit and interest rate risk, involving options-based approaches to address issues particular to mortgage lending. Mortgages present speci c credit-risk issues f or managing capital: depen- dence on local real estate market dynamics; dependence on the appraised value of the collateral; and dependence on the ability to execute the mortgage pledge in case of default. e long term to maturity of mortgages can add volatility to the value of capital. It is management's responsibility to measure, monitor, and mitigate risk in i ts b usiness. M inimum capital r equirements exist as r eserves aga inst 18.Banco Central de la República 2005. 19. Basel 1998. 20.Laurin and Majnoni 2003, 2. risk management and regulation 197 extreme events. ey are created under t he assumption that management does its job correctly. Supervisors can use examinations and disclosures to prove that management is s ound, and when they reveal problem circum- stances, supervisors can take action, such as r equiring additional capital. Each lender's management and board should have a plan for managing cap- ital in terms of the risk appetite and risk pro le of the institution. Super- visors should review the adequacy of the bank's risk assessment and the capital requirement that follows. ere should be active dialogue between the lender and supervisor on the risks the lender takes and the means that it employs to mitigate those risks. Basel II Capital Standards and Mortgage Lending Basel I created a preference for mortgage lending, according a 50 percent risk weight for low LTV loans. is was done under the assumption that mort- gage lending was demonstrably safer than other forms of lending. is has not always been the case, particularly in emerging markets. Many issues pa rticular to mortgage lending are addressed in t he Basel II standards.21 Several are not, including geographic diversi cation and the market risk of mortgages held in t he banking book. Basel II ca pital stan- dards that are directly relevant to mortgage lending address: the credit risk of loans held in the banking book, credit enhancements, and investments in mortgage-backed securities. In applying Basel II ca pital standards, the lender a nd supervisors may choose between two broad levels of sophistication. e choice depends on the technical capabilities of the lender, the complexity of their business, and the capacities of the supervisor: · e standardized approach is a n extension of Basel I wi th addi- tional risk categories that allow for selected re nement of the risk sensitivity of capital requirements. It is likely to be the approach of choice for less sophisticated banks, and for emerging markets that 21. e chapter focuses on the applicability of Basel II to mortgage lending in emerging markets. It does not address many of the equally important challenges that face emerging market imple- mentation of Basel II in other asset classes. 198 housing finance policy in emerging markets Box 8.7. Colombia Crisis By contrast, to some developed economies, the regulatory authorities in emerging economies may have reasons to consider that residential mortgage markets should not be treated as a low-risk class of assets, if the legal framework is inhospitable to lenders and if the macroeconomic environment is instable. This concern is acute after experiencing a brutal crisis often preceded by a long period of good performance. Most Latin American countries went through such an ordeal with significant fiscal impacts in order to bail out borrowers or lenders (Brazil, Colombia, Mexico, Argentina, Uruguay, and so forth). The recent crisis of the mortgage sector in Colombia (1997­2002) was severe, as shown below. It was caused by a macro crisis (GDP contraction, higher market rates, unem- ployment, fall in housing prices) and by a legal and regulatory instability (long foreclosure delays, but also legal changes to the whole portfolio, which was made of hazardous indexed loans). The portfolio quality has recovered since (less than 5 percent nonperforming loans [NPLs]) thanks to debt restructuring programs and to the securitization of NPL mortgage portfolios. Source: Titularizadora Colombiana, March 2006. risk management and regulation 199 move to B asel II. e most im portant issue f or mortgage lenders under the standardized approach is the risk weight for mortgages retained in the banking book. For large internationally active banks, this will fall from 50 percent under Basel I to 35 percent under the Basel II standardized approach in the case of residential mortgages. Also important for mortgage nance, the standardized approach allows for the use of external credit-rating agency ratings of credit enhancers (such as mortgage default insurers), and of asset-backed securities, including MBSs. Use of credit rating agencies presents challenges for emerging markets, which o en have no such rms, or lack the practical ability to enforce standards for credit ratings. · e internal-ratings-based (IRB) a pproach p ermits banks to hold capital according to their own estimates of risk parameters such as the probability of default and the expected loss given default of their credit p ortfolios. I n e cient mo rtgage ma rkets, w here mo rtgage lending represents the safest business lines of many banks, the IRB approach will result in a dramatic lowering of risk weights, to as little as 10 percent.22 IRB requires sophisticated technology and technical sta on the part of both lenders and supervisors. Lenders must dem- onstrate that their models and the procedures for using them are well developed and robust, and their data adequate to assess risk. In gen- eral, Basel II requires at least ve years of detailed data history for a given asset class to establish default and loss statistics. is is inade- quate for mortgage lending, given the long cycles of real estate prices. Supervisory agencies need budget to employ, train, and retain sta with the capacity to evaluate the lenders' models and methods. e reduced risk weight for mortgages in t he banking book recognizes the high value of the mortgage pledge in co untries with liquid real estate markets, well-de ned valuation rules, and e cient contract enforcement. In well-developed mortgage markets, foreclosure may take as little as three months. In emerging markets, however, foreclosure generally takes years, and expected losses rise quickly with the length of time required to foreclose. 22. e risk weight for residential real estate has a 10 percent oor that will be imposed for at least the transition period to adoption of Basel II, de ned as the rst three years of e ectiveness of the accord. (Basel 2004, paragraph 266, page 58). 200 housing finance policy in emerging markets As a result, the Basel committee notes that the 35 percent weight should be applied only when valuation criteria establish the security of the collateral, and where the default experience of mortgages justi es the lower weight. Otherwise, supervisors should require a higher risk weight. Unless t hey ca n demo nstrate lo wer r isk, emer ging ma rket r egulators should not adopt a 35 p ercent risk weight for mortgages. Few emerging market regulators have the resources to supervise the IRB approach to capital standards, and none of these will adopt it within the time frame of wealthy countries. For example, Russia and Colombia will continue to require a 100 percent risk weight as they move to adopt Basel II according to their own schedules. ailand, on the other hand, is applying a 35 percent risk weight for loans below 3 millio n baht, despite the fact that the regulators are not adopting any other part of Basel II. Basel II also asks regulators to determine capital requirements for opera- tional risk. Operational risk is measured in terms of the likelihood of pro- cessing errors and associated expected losses, and the likelihood of incidents such as undesired access to proprietary systems by computer hackers. er e is, however, a s carcity of data on operational risk in e very market, be it well developed or not, and the methodology for developing assessments of operational risk is immature. Given the lack of data and research for G-10 internationally active banks, it is lik ely to be some time b efore extensive quanti cation of operational risk is available in emerging markets. Capital Requirements--Supervisory Standards Basel II calls o n regulators to evaluate the quality and accuracy of each bank's r isk ass essment, r isk ma nagement, a nd in ternal co ntrols. P illar 2 places responsibility on banks to improve their risk management practices. Supervisors are responsible for judging the e orts of banks to assess and mitigate risk. Supervisors are to intervene where necessary, including by requiring additional capital. e Basel committee expects regulators to use Pillar 2 to determine the regulatory and capital treatment of risks that are not explicitly included in the capital adequacy requirements of Pillar 1. r ee of these risks are particularly important for mortgage lenders: risk management and regulation 201 Credit Concentration Risk Basel II is silent on the topic of geographic diversi cation, an important omis- sion with respect to mortgage markets. Real estate values are driven by local economic and regulatory factors, so geographic diversi cation plays an impor- tant role in mitigating credit risk in mortgage lending. One estimate showed that the economic capital required for a portfolio of regionally concentrated loans to highly rated borrowers in the United States would be two-and-a-half times that of a diversi ed portfolio to similarly rated borrowers (Calem and LaCour-Little 2004). is is intuitive for countries with large, economically diverse territories such as t he United States or China. Even in small co un- tries, however, house-price levels and trends can vary dramatically between the centers of major cities and the surrounding countryside. For instance, in Armenia, the price per square meter for housing in the center of the capital is more than three times that of the country's second city. Further, Armenia is a good example of another emerging-economy phenomenon, where rapid residential real estate price increases in the most economically active region of the country are driven by speculation more than by the need for shelter.23 Supervisors should gather and publish data on house price trends in local and national markets. ey can use this data to estimate default and loss rates, and so gauge the risk of regionally concentrated loan portfolios. Supervisors may also simulate stresses to lender p ortfolios using histori- cally based worst-case scenarios. In concentrated markets, and particularly where there is a r isk of speculative bubbles, regulators should be wary of overexposure to a single region or location, and should raise capital require- ments for riskier portfolios. Supervisors should encourage mortgage lenders to diversify their portfolios. Market and Liquidity Risk Portfolios of 15- or 20-year mortgages require similar term funding. While oating rate mortgages may reduce interest rate risk, they still present 23.Like many emerging economies, Armenia lacks viable individual savings vehicles aside from real estate. Banks pay less than the in ation rate on deposits, there is no p ublic market for equity or debt securities, and there is no private pension system. 202 housing finance policy in emerging markets liquidity risk. Banking supervisors generally use ratios to monitor liquidity risk as described above. Some, however, have adopted more involved stress test requirements. While Basel II does not include standards for market risk in the loan portfolio, many countries require lenders to apply industry best practice for asset liability management, and some impose capital require- ments for the lending portfolio. In 2002, India's National Housing Bank, promulgated guidelines for asset-liability management at India's specialized housing lenders, which are known as housing nance companies (HFCs). HFCs are permitted to take deposits and make residential mortgage loans. e National Housing Bank guidelines re ect the speci c risks of longer- term mortgage lending funded by short-term deposits. e rules include guidance for the development of nancial indicators of risk and manage- ment information systems to monitor term mismatch and liquidity on the balance sheet. At the time they were promulgated, they were exible in that they recognized the lack of management and automated systems at many HFCs. e guidelines en visioned a n e volution f rom sim ple t echniques such as categorizing cash ows by maturity buckets or bands, to calculating duration of equity and risk-adjusted return on capital. Importantly, they also address the governance aspects of market risk management, calling for HFCs to est ablish risk committees for both management and boards of directors. Argentina's standard is demanding in that it expects all banks to be able to estimate value at risk for every asset class in both domestic and foreign cur- rency. At the same time, it necessarily requires a number of assumptions about the structure of the balance sheet. Risk capital for interest rate risk of non- quoted assets such as loans is based on the estimated maximum expected loss of the value of the net asset position at a 99 percent con dence interval over a three-month time horizon. Capital requirements for net asset positions are de ned in terms of assumptions about which liabilities fund which assets. e Argentine regulation allows banks with strong capital, assets, manage- ment, earnings, and liquidity (CAMEL) ratings to recognize that a large part of their deposit baseise ectively permanent, even if contractually short term in nature. ese banks are permitted to assign up to 50 percent of short-term deposits to fund long-term xed rate assets.Adjustable rate loans that have a rate linked to an external index are considered to have a maturity equal to the reset frequency of the index. For adjustable rate loans with administra- risk management and regulation 203 tive variation, where the bank has t he contractual ability to vary the rate, 40 percent are considered to be xed rate, re ecting the experience in most countries that, in case of crisis, banks are not able to raise the rate on such loans as quickly and as high as market conditions might dictate. is inability to adjust rates in time of crisis re ects the heightened credit risk that results from such moves, as well as political pressure to keep rates stable.24 Mortgage Loan Design In many markets, lenders have employed loan design techniques to reduce the initial payments required on a mortgage, and so make it possible for the borrower to initially a ord the payment. ese may include "teaser" interest rates that start out lower than market, but escalate with time, or "negative amortization" features that trade o a lower initial payment with a growing principal amount. Such loan designs may lead to higher defaults if ho use prices fall or interest rates rise unexpectedly. A proliferation of exotic loan designs contributed to the high default rates in t he Colombian crisis and led to a reaction by the Supreme Court to ban the designs and allow only xed-rate lending (real and peso). Likewise, a er the devaluation shock and banking crisis in Turkey in 2001 all index ed and variable rate loans were outlawed. e mortgage law passed in 2007 allo ws these instruments but requires life-of-loan caps and detailed disclosure to borrowers. Supervisors should require lenders to provide stress test results for all portfolios of loans, and they should pay particular attention to the assump- tions and results for complex product designs. Other Regulator Actions Regulators can encourage or require other actions to strengthen the mort- gage lending systems of individual countries. Such actions can be particu- larly important to reduce the probability and severity of housing cycles. 24.Banco Central de la República 2005. 204 housing finance policy in emerging markets Real Estate Market Information One step is to actively foster the development and publication of accurate, detailed information on real estate prices and transactions. In any market, speculative price bubbles are hard to spot until a er the fact; however, the task of detection is made more di cult if there is a lack of consistent infor- mation on the prices themselves, and on the factors that lead to changes in real estate prices. Regulators in many markets track the performance of real estate markets. Central banks and regulators in China, the United Kingdom, and many other countries monitor real estate markets. ailand (GHB) set up a Real Estate Information Center in 2004 to provide real-time price and transaction data--in part to help policy makers spot bubbles that preceded the Asian nancial crisis of 1997. SHF is doing the same in Mexico. e U.K. Financial Services Authority (FSA) discusses the impact that a possible fall in house prices would have on consumer wealth and expenditures, on the health of lenders, and on the economy as a whole in its risk outlook for U.K. nancial markets (FSA 2006). Management and Reporting Standards Regulators should produce management standards and reporting require- ments f or lender s, a nd inc lude adher ence t o t hese st andards as pa rt o f examination criteria. Lenders should be able to articulate a coherent and rea- sonable strategy for lending to a given real estate market and their means for mitigating risk in that market. Riskier products should have limits in terms of total assets or total capital. Examiners should review plans for credit risk, market risk, and operational risk, and compare performance of lender port- folios and of management against the plans. Examples of such rules in the United States include three interagency reg- ulations: · On real estate lending, U.S. regulators require that each lender estab- lish and maintain written policies that establish appropriate limits and standards for real estate lending, and that these be reviewed by the board of directors at least annually. ese standards must establish risk management and regulation 205 portfolio diversi cation standards, prudent underwriting standards, and loan administrations standards. e regulation requires lenders to monitor conditions in real estate markets where they operate. 25 · On lendin g f or r esidential r eal est ate co nstruction, r egulations require t hat lender s demo nstrate under standing o f a nd exp ertise regarding real estate construction lending. e rules set LTV require- ments for construction loans, and for the use of appraised values in establishing LTVs. For instance, the value used for a co nstruction loan must take into account not only the assumed price of the nal units to be sold, but the remaining costs that would be incurred to complete the project and market the units.26 · Guidelines were recently proposed for o ering nontraditional mort- gage products such as in terest-only loans. ese set requirements for the underwriting of riskier adjustable rate loans, such as t hose that have built-in rate increases. ey also would impose additional reporting requirements to the regulator for lenders that o er such products.27 ese guidelines proved to be of little e ectiveness, and have been replaced by more forceful prescriptions since 2007 (see the section on the subprime crisis). Taking Corrective Actions In markets that are very rapidly rising, regulators may be compelled to take action t o r educe sp eculation. S uch ac tions co uld inc lude ra ising ca pital requirements for real estate loans, lowering the permitted LTV level for mort- gages, requiring lower payment-to-income ratios for new loans, or imposing taxes on sales of properties held for less than some threshold period consid- ered longer than the time horizon of a short-term speculator. Such actions, however, could intensify real estate cycles if timed wrong. In some markets, such as Shanghai, anecdotal information indicated that in 2004 and 2005, speculative investment surged with many buyers who were 25.Federal Reserve 1998. 26.Appendix C to Part 208 of the Code of Federal Regulations (CFR)--Interagency Guidelines for Real Estate Lending Policies. 27.Federal Reserve 2005. 206 housing finance policy in emerging markets holding properties for less than a month or two. e Chinese government undertook a n umber of short-term responses, such as lo wering required LTVs for loans in Shanghai and imposing taxes on owners that held proper- ties for less than ve years. While these measures appear to have had ane ect in slowing down price increases, they had a negative e ect on the mobility of middle-class households via the ve-year minimum hold to avoid tax. In considering such measures, it could be possible to limit transactions to the upper end of the market, where price speculation is likely to be greater since valuations are already higher, by de nition. e U.S. regulators face a c hallenge with the weakness in t he subprime mortgage market. Underwriting was clearly relaxed and inappropriate loan products sold to borrowers in this market segment. ere is active discussion of tightening underwriting guidelines and determining product "suitability" (See Consumer Protection, chapter 6), but regulators must be careful in pro- mulgating these rules, as a sudden contraction in credit availability will exac- erbate the foreclosure problem. Financial Reporting and Disclosures by Primary Lenders Accurate and thorough nancial reporting contributes to market discipline and e ciency. Accounting standards provide detailed rules for reporting balance sheet values and periodic income and expense. Pillar 3 of Basel II provides standards for information disclosure that help investors and regula- tors to better understand the risks carried in a lender's portfolio. In addition, lenders should disclose indicators of the level of market risk that they incur in funding long maturity mortgages. Developed market mortgage lenders should face little challenge in com- plying with IAS standards for loan accounting or with Pillar 3 core quantita- tive and qualitative disclosure requirements for credit risk and market risk. In many emerging countries, however, more detailed disclosures for credit and market risk will have to await the development of improved systems and management methods. In most emerging markets, the move to regulation based on market dis- cipline is co nstrained by the lack of a su pporting infrastructure of nan- cial reporting practices. Many emerging markets have not yet adopted IAS risk management and regulation 207 or clear rules for audit practice and auditor independence. Most emerging market regulators lack the budgets to hire enough technically quali ed sta at salaries that are competitive with the private sector. As a result, they are o en unable to supervise rapidly innovating business processes in detail. For example, neither Colombia nor Russia has fully implemented IAS, and regu- lators in each face substantial challenges in enforcing existing standards. In an e cient market, investors penalize lenders that fail to comply with disclosure standards. In less e cient markets, regulators and auditors have a gr eater r ole in p romoting a nd enf orcing dis closure st andards. B eyond reporting of operational r isk parameters, t he di culties with Pillar 3 in emerging markets are likely to lie in ob taining legal a uthority to require nancial disclosures, and in obtaining regulatory resources to enforce such standards. Further, markets will have to develop more depth to accurately value assets such as mortgage servicing rights. Regulation of Secondary Mortgage Institutions As discussed in the mortgage securities chapter (see chapter 12), secondary market institutions have been created in a n umber of emerging markets. ese include both liquidity facilities and mortgage securitization compa- nies. Many of the former have been created with extensive involvement of the Central Bank, which directly or indirectly supervises their activities (for example, Egypt, Jordan, India, Malaysia, Trinidad). In Mexico, the liquidity facility is subject to prudential regulation by the uni ed banking and securi- ties regulator. Sound prudential regulation of liquidity facilities is in keeping with their principal function of supplying liquidity and capital market access to mortgage lenders. eir security issuance is regulated and supervised by domestic security regulators and local rating agencies. Case Study: The U.S. Subprime Crisis e United States' crisis in subprime mortgage lending revealed a number of failings in ind ustry risk management and regulation. Emphasizing the importance of good risk management and regulation, the subprime crisis has 208 housing finance policy in emerging markets disrupted international nancial markets to an extent exceeding all expecta- tions. Even though riskier subprime ARMs made up no more than 8 percent of all U .S. mortgages in 2006 (MB A 2007), t he ripple e ect of the unex- pected rise in subprime defaults has already led to the failure of several U.S. non-bank lenders, a well-regarded U.K. lender, and a German Landesbank. Uncertainty about the exposure of highly rated European and U.S. banks to subprime defaults revealed fundamental weaknesses in international credit markets, and created an international credit crunch. The Property Boom and Loose Credit Underwriting e recent real estate boom and the decline in long-term interest rates were important contributors to the rise of subprime lending. National average property prices rose 86 percent between 1996 and 2006 (Shiller 2007). While all mortgage lending grew rapidly with rising house prices, subprime lending came of age in t his most recent boom. Subprime originations rose from 9 percent of total mortgage lending in 2001 t o 20 p ercent in 2006. P roperty speculation grew as the boom persisted. Lenders came to rely more on the rising value of collateral to secure the loan than the borrower's ability to repay from income. e quality of loans deteriorated and underwriting cri- teria were relaxed (Demyanyk and Van Hemert 2007). In 2006, 38 percent of subprime loans had a combined LTV of 100 percent or more. Half of all sub- prime loans had low or no documentation of borrower income or assets. As property prices began to decline between 2005 and 2007, many of the more highly leveraged borrowers found themselves in nega tive equity, with the value of the debt exceeding the value of the house, making it impossible to re nance these loans. Speculative borrowers with negative equity are much more likely to default than other borrowers. By the third quarter of 2007, serious delinquencies (90 or more days delinquent or in foreclosure) for sub- prime loans rose to 11.38 percent from 6.78 percent in 2006 (and about 18 percent for ARM subprime loans) By comparison, serious delinquencies on prime conventional mortgages rose to 1.31 percent from 0.79 percent in the same period a year earlier (MBA 2007). risk management and regulation 209 Reduced Reliance on Credit Enhancements Loosened underwriting contributed to decreased use of mortgage insurance (MI). MI provides an important third-party review of underwriting quality, and a credit enhancement that facilitates securitization. Lenders encouraged low- and moderate-income borrowers to take out more pro table subprime ARMs instead of FHA or privately insured FRMs by o ering faster disburse- ment and reduced documentation requirements. Until 2006, federal tax rules favored 100 percent "piggyback" nancing with a combination of an 80 LTV rst lien and a 20 percent second lien piggyback mortgage at a higher rate of interest. e market share for loans originated with MI fell from 26 percent in 1997 to 11.5 percent in 2006. Risky Loan Design e design o f many subprime loans exacerbates the e ects of declining house prices and rising interest rates, leading to increased defaults. Riskier designs include ARMs with complex features, interest-only mortgages, and more complex designs. For instance, to make loans initially more a ord- able, many subprime ARMs featured low interest rates for a relatively short period of two or three years ("teaser" rates) that subsequently adjusted sharply higher. ese loans were termed 2/28 o r 3/27 b ecause the initial xed-rate period could be two or three years, but the loan amortized over 30 years. Other loans, known as "option ARMs," enabled borrowers to pay a variable amount each month, allowing for minimal or no amortization and capitalizing any unpaid interest into the principal outstanding. Even option ARMs, however, eventually require the borrower to adhere to a minimum payment schedule. So long as house prices were rising quickly, borrowers could wait two or three years and then use property appreciation and their recent payment history to re nance out of risky loans. Once house prices began to fall, however, many highly leveraged borrowers found themselves unable to either re nance or to make the new, higher payments. At the end of September 2007, serious delinquencies for subprime ARMs reached 15.63 percent, 4.25 percent higher than the serious delinquency rate for all subprime loans (MBA 2007). 210 housing finance policy in emerging markets Lack of Consumer Information e poor credit quality of subprime loans is exacerbated by poor levels of consumer information. U.S. laws require detailed disclosure at the time of purchase or re nance, but in a f ormat that is di cult to understand with many details extraneous to their understanding the risk of the loan (Guttentag 2002, 2004). is is a particular concern when lending to house- holds with limited levels of nancial education. Some subprime lenders have en gaged in ag gressive ma rketing a nd p redatory lendin g b ehaviors (FTC 2007). is is symptomatic of the fee-based compensation system and a breakdown in the historic incentives for solid underwriting in the securi- tization market. Breakdowns in the Behavior of Participants in the Securitization Value Chain e subprime crisis revealed weaknesses in t he incentive structure of the securitization model. Historically, the incentive to maximize v olume and reduce costs by loosening underwriting standards has been countered out- side of the subprime market by the need to maintain a good reputation with servicers and securitizers, and contractual requirements to buy back loans that default too early. e reputation incentive was attenuated by cost and market pressures. ere has b een strong demand for high-yield securities with little attention paid to due diligence by investors. Rating-agency default models have not adequately re ected default risk, a nd the expectation of rising house prices reduced lender concerns about possible defaults. e dif- culty of enforcing contractual loan repurchase requirements became clear in the early part of 2007, as early payment defaults rose, and many non-bank lenders were driven into bankruptcy by demands that they take back the defaulting loans. inl y sta ed servicers lack the capacity to handle a large volume of loss mitigation e orts, and so move quickly to foreclosure, further depressing housing markets. risk management and regulation 211 The Influence of Trends in International Capital Markets Capital market trends contributed to the growth in sub prime lending, the loosening of underwriting standards, and to the subsequent international liquidity crisis. First, since t he nancial crises of 1998, t here has b een an accumulation of liquidity on the part of international investors. As in a- tion, sovereign risk spreads, and nominal interest rates fell in most co un- tries a er 2000, investors have increasingly struggled to nd opportunities to earn returns greater than in ation. Securities backed by subprime mortgages o ered such an opportunity, given the high nominal interest rates paid by the underlying collateral and the high credit ratings conferred by product structuring a nd t hird-party cr edit enha ncements, suc h as b y mo noline credit insurers. Between 2001 a nd 2006, t he portion of subprime origina- tions that were securitized rose from 46 percent to 75 percent (Ashcra and Schuermann 2007). Unable to evaluate rating agency models and unable or unwilling to model increasingly complex structures, international investors relied on credit rating agency analysis instead of their own research. Rating agency models of subprime loan performance, however, did no t take into account t he dec lining under writing st andards, ho use p rice dec lines, o r interest rate increases that became evident in 2007. As subprime defaults rose above rating agency expectations, the performance of lower-rated subprime securities deteriorated. Reduced Transparency Resulting from Complex Security Structures and Incomplete Information on Exposures e subprime crisis was w orsened by the complexity of subprime secu- ritizations, the fact that they are not traded o n exchanges, and a lac k of clarity as to which investors are exposed to potential losses. Many subprime transactions involved successively packaging subordinated bonds to create highly rated securities, which are in greatest demand. Subordinate bonds from several deals were o en packaged and structured to create a highly rated bond. In the absence of exchange-based market makers, it becomes di cult to obtain quotes when there is uncertainty about the value of the underlying collateral. In addition, privately placed securities are not sub- 212 housing finance policy in emerging markets ject to speci c dis closure r ules. Furthermore, comprehensive data do es not exist o n the holdings of subprime-backed securities by hedge funds or other special investment vehicles. Nor is there public data on the expo- sure of major banks to these funds. As performance of subprime collateral worsened, it became di cult to price subprime-backed bonds, to trace the potential performance of structures, or to assess the e ect on investors. As a result, many market participants stopped transacting as they waited for the picture to clear. e lack of disclosures and due diligence was made worse when banks created leveraged investment funds known as structured investment vehicles that issued short-term debt against higher-yield, long- maturity subprime securities. Regulatory Failures in the United States Contributed to the Growth of Risky Subprime Lending Practices ere a re m ultiple na tional a nd st ate r egulators in volved in mo rtgage lending, all o f w hich w ere slo w t o addr ess t he w ell-publicized r isks o f relaxed subprime credit underwriting. Many non-bank U.S. lenders are not subject to prudential regulation. In all, 30 percent of subprime loans were made by lightly regulated subsidiaries of banks and 50 percent were made by independent mortgage companies that are not subject to prudential regula- tion (Gramlich 2007). While several federal regulatory guidance notes were issued on subprime lending, they did no t apply to the unregulated non- depository lenders. B eyond t he issue o f unregulated lenders, prudential regulators and legislators have been reluctant to impose suitability require- ments on mortgage lenders. The Risks of Subprime Practices and Those of Lending to Moderate- and Low-income Households Should Not Be Confused It is important to note that problems with low-income subprime mortgage borrowers resulted primarily from failures by lenders and investors, and not from low borrower income. FHA loans to households with income levels risk management and regulation 213 similar to lower-income subprime borrowers have not defaulted in unusu- ally large numbers during the past tw o years. e success of micro nance in emerging markets has demo nstrated t hat low-income households can manage debt, and that lending to low-income households can be pro table. The Subprime Crisis Was Avoidable Many U.S. policy makers raised issues about the boom in subprime lending for a number of years prior to 2007. e crisis resulted from a disregard of basic credit precepts, such as t he need f or robust loan underwriting stan- dards, the need for nancial transparency, and the risks of excessive leverage. Developing-country policy makers can avoid these mistakes by ensuring that lenders follow long-established rules for credit management and consumer protection, and that capital market access is provided with a variety of tools in the context of reasonable standards for transparency. Chapter 9 Contractual Savings for Housing Hans-Joachim Dübel is chapter explores the use of contractual saving schemes for housing (CSH) as a way to nance housing. CSH has been historically a central mechanism of raising capital for housing nance. With the broader use of capital markets in developed nancial markets today, it has become primarily a complemen- tary nancing tool to bank- nanced mortgage loans. Yet, CSH have enjoyed renewed growth in recent years, as the product has been exported to Eastern European countries, as well as farther a eld, such as to China or India. CSH schemes are also popular in the Middle East and North Africa and parts of Latin America. e concept is simple, relying on the potential borrower to save money over a number of years, thus building up some equity, while at the same time demonstrating their reliability and capacity to repay a debt. Once the saving period is over, a loan will be advanced to the saver, which will typically be equal or represent some low multiple of the amount already saved. Both loan and accumulated equity are jointly disbursed. In the most widely encoun- tered variant, interest rates for savings are xed below the market rate; the incentive to follow through on the scheme is provided by the promise of a similarly below-market, xed-rate loan. 215 216 housing finance policy in emerging markets e simplicity of t he product, however, comes with r isks in t erms of liquidity and interest rates, both for the nancial institution and the saver or borrower. In many countries subsidies have been attached to CSHs in order to address these risks, and the net impact on housing nance systems has not always been positive. It is therefore advisable to study the bene ts, risks, minimum institutional requirements, and subsidy dependency of the system carefully before implementing it. e section starts by describing the features of today's CSHs, followed by a brief overview of their historical development.1 It then discusses the main bene ts and risks of CSH s chemes, their suitability for housing- nance- system development purposes, the minimum institutional requirements for lenders, and questions of subsidization. e section ends by drawing conclu- sions for emerging markets. Key Features of a Contractual Savings Scheme for Housing General Character CSHs link the savings e orts of an individual to a collective fund with the entitlement to receive a loan from this fund at a future date. CSHs, in their simplest form, t herefore, make f unding f rom other s ources unnecess ary. Since CSH does not require a developed market for savings capital, it is one of the oldest and simplest collective funding mechanisms in housing nance. Basic Structure of a CSH Contract In a CSH contract, the individual agrees with the lender to receive a loan in the future a er the successful completion of a savings phase. At this point, accumulated s avings a nd loa n a mount a re disb ursed t ogether t oward a housing nance purpose. 1. For an earlier analysis of the French and German systems, see Lea and Renaud 1993. contractual savings for housing 217 Figure 9.1. Basic Structure of a CSH Contract e typ ical CS H co ntract lif e has t hree p hases: t he s avings p hase, a waiting phase between the dates of formal loan eligibility and actual loan allocation, and the loan phase. CSH contracts are long term, as mortgage loans; they will be closed over 10 and 20 years, and longer. e savings phase typically takes between one-fourth and one-third of the contract maturity; for example, ve years followed by a loa n amortizing over 10 y ears. e length of the waiting phase in a CSH contract may vary, depending on the availability of funds from the saver collective or the capital market. Figure 9.1 shows the basic structure. Open and Closed CSH Schemes Open CSH schemes use capital market funds for loan allocation, if a short- fall in liquidity from a lack of new savers arises. In this way, a waiting phase can be excluded or minimized; however, because capital market funds are mixed with collective funds, it is impossible to guaranteea xed-loaninterest 218 housing finance policy in emerging markets Table 9.1. Main Differences between Open and Closed CSH Schemes Product feature Open CSH (l'Épargne Logement) Closed CSH (Bausparen) Rate determination Variable deposit and loan rates Fixed deposit and loan rates Deposit interest rate Competitive after-tax yield Below market after-tax yield Loan interest rate Deposit rate plus fixed servicing fee Deposit rate plus fixed spread, rate usually below market Loan volume Loan interest paid cannot exceed 2.5 Loan-to-savings multiple of 1­1.5 times times deposit interest received accumulated savings Waiting phase None Lender cannot waive waiting phase, minimized through special reserve Source: Dübel 2003. rate in advance. Open schemes therefore generally carry variable deposit and lending rates. eir main value lies in providing a savings product and a sim- pli ed access to a loan, that is, a credit option. An example of an open scheme is the French pargne-logement (table 9.1). Closed CSH schemes, in contrast, rely solely on the resources provided by the saver collective. Apart from loan amortizations, new liquidity is derived exclusively from the deposits made by new saver generations. is entirely intergenerational nancing str ucture ena bles c losed CS H t o o er xed- interest rates on both the savings and loans sides. Still, some interest rate risk emerges in closed schemes through the risk of liquidity gaps that is tradition- ally managed by letting contracts ripe for allocation wait for loan disburse- ment until liquidity is reestablished ( gure 9.1). e waiting phase, however, can be minimized through proper liquidity management techniques, and in advanced systems today is very short. Essentially, thus, the closed CSH con- tract with its xed-rate loan promise adds an interest rate option product to the savings- and credit-option products of the open form. An example for a closed CSH system is the German Bausparen (table 9.1). As will be shown further below, closed schemes have frequently run into liquidity p roblems, esp ecially w hen o perating in hig h-in ation environ- ments. erefore, semi-open schemes have evolved that combine aspects of open schemes--for example, in ation indexation--with aspects of closed schemes-- xed real deposit and lending rates. contractual savings for housing 219 Financing Function of CSH CSH schemes are designed t o provide long-term funds for housing; how- ever, because they rely either mostly (open schemes) or exclusively (closed schemes) on collective resources, the nancing function of an individual sav- ings contract is economically limited relative to the scale of a larger housing nance investment, for example, a new house. For example, taken together, the disbursements for new lending in closed- schemes can by de nition not exceed the sum of new savings and loan amor- tizations in any given period. Unless there are many savers who decide t o not take up a loan (good brothers), this limits the loan amounts that can be promised to an individual saver in relation to his or her savings. A typical closed CSH contract will t hus fund loan volumes only moderately greater than savings amounts (see below). Open CSH schemes can provide higher multiples, albeit only at variable interest rates. Because of the limited nancing amounts per contract, CSH loans from closed schemes need to be co- nanced by other loans in the case of larger investments. is may require the subordination of CSH loans to mortgage loans. In the German Bausparen system shown in table 9.1, for example, CSH loans are typically second mortgages to a rst mortgage loan from a mort- gage or savings bank. CSH and Other Housing Finance Products e f ollowing dis cussion is f ocused o n r egulated, p ermanent, v oluntary, closed, and bank-managed CSH schemes. At this point, reference to other housing nance products is useful. While CSH s chemes originated in t he mutual building s ociety move- ment( gure 9.2), almost all present-day building societies operate with open funding mechanisms, using deposits and partly issuing securities. Building societies have generally abandoned the direct link between prior savings and loan eligibility. CSH-type mechanisms are also applied by many public-housing nance schemes in emer ging ma rkets t hat co llect co ntributions f rom s alaried employees against promising to make loans to them. e link between prior 220 housing finance policy in emerging markets savings and loan entitlements in suc h schemes, however, is usuall y weak. Moreover, mandatory contributions create a completely di erent incentive structure for savers. As a collective mechanism doing lending based on the prior creation of a payment history, CSH schemes contain strong elements of micro nance. Because of the binding loan promise they make, however, institutions that manage CSH schemes are typically more tightly regulated than micro nance lenders. eir closest analogs are insurance companies, which also manage collective funds earmarked to speci c payouts. As a source of second-tier debt and evidence of repayment commitment, CSHs compete with a number of access products to mortgage nance, most notably, mortgage products addressing insu cient equity (for example, pig- gyback second mortgages) and mortgage loan insurance. Historical Development of CSH Schemes Developed Mortgage Markets CSH schemes and their managing institutions grew out of the Anglo-Saxon building society movement of the late 18th and early 19th century. e rst such society was created in Britain (Birmingham) in 1775; the United States followed in 1831 (F rankford, Pennsylvania). All B ritish colonies adopted them until the 1850s. In 1869, German sponsors made the rst attempts to found building societies (Breslau); however, it took until 1924 until the rst society was successfully launched (Heilbronn). Given the nascent stage of capital markets, until the 1920s, building soci- eties anywhere were operating under contract savings principles: obtaining a 10-year mortgage loan from a U.S. S&L association in the 1920s, for example, required a contractual savings period of typically ve years.2 It is instructive to compare further developments in the United States and Germany. In the United States, the S&L system was fundamentally changed in the 1930s, when the federal government had to address a national mortgage market crisis. A 1934 ac t introduced federal insurance for xed-rate loans 2. See Vittas 1995. contractual savings for housing 221 Figure 9.2. Origins of Building Societies, Savings & Loans, and Bausparkassen with up to 20 y ears maturity and LTV ratios up to 80 p ercent. Moreover, deposits invested into an S&L b ecame explicitly insured, which facilitated the attraction of deposits made by savers not interested in receiving a loan.3 Taken together, these steps considerably weakened the mutual character of the S&Ls, eliminated the need to prior collection of savings from prospective borrowers. e U.S. system further changed in t he a ermath of the 1980s S&L industry collapse which saw the transfer of much the nancingfunction to the semi-public institutions Fannie Mae and Freddie Mac as well as a swi development of the securitization and insurance markets allowing for lower borrower equity. In the United Kingdom, many building societies converted to a bank charter in the 1980s and 1990s a er the building societies lost their preferences as housing nance providers. Germany in the 1930s moved in the opposite direction. Regulations for Bausparkassen were passed in 1934 that de ned a closed (that is, exclusively collectively funded) system producing xed-rate loans--on a pure private basis without government intervention. In 1938, g overnment regulation designated Bausparen to the role of second mortgage provision. Also, a er the war, the German housing nance system remained mainly private and split between rst and second mortgage lenders; mortgage securitization 3. See Colton 2002. 222 housing finance policy in emerging markets and insurance developed only recently. Austria in 1939 adopted the German regulations, but a er World War II, wi th government intervention in t he form of large-volume preferential second mortgage lending, assigned t o Bausparen the role of rst mortgage lending.4 France initially created the l'Epargne Logement scheme as a clos ed scheme with xed rates in 1965, but modi ed it in 1970 due to high in ation to combine elements of British building societies (variable interest rates, open funding) and German Baus- parkassen ( xed spreads between the variable lending and savings rates, public savings premiums).5 CSH in Emerging Markets CSH schemes have developed spontaneously in many economies with devel- oping nancial systems, or nancial systems in distress. An example is the Mexican Auto nanciamentos of the 1980s that responded to insu cientcap- ital supply for housing nance.6 e origin of the German Bauspar system in the 1920s is related to a dearth of capital market funds for housing during a period of high nancial-sector stress.7 However, only few spontaneous schemes graduate into permanence. e CSHs that are currently in existence in emerging markets are typically derived from successful European schemes with a de veloped regulatory structure. Examples a re N icaraguan, P eruvian, T unisian, a nd M oroccan s chemes, which were designed along the lines of the French l'Epargne Logement, or the Bauspar schemes in the Czech Republic, Slovakia, Hungary, and Slovenia that follow the German or Austrian models. More recently, closed CSHs have been launched in India and the province of Tianjin, China with the support of German Bausparkassen. ere are plans to introduce CSH in Russia. Apart from mandatory schemes not covered in this section, public housing institutions have als o ventured into CSH as a me ans to attract low-cost 4. I n Austria, a er World War II public loans became the main second-mortgage funding mech- anism allowing Bauspar loans to be ranked rst. In Germany, in contrast, savings banks and mortgage banks insisted on being secured by rst mortgages, which led to the subordination of Bausparen. 5. See Lea and Renaud 1995 for a detailed comparison of the French and German schemes. 6. See Bernstein 1996. 7. See Berndt, Degner, Hamm, and Zehnder 1994. contractual savings for housing 223 Box 9.1. CSH--an Islamic Finance Product in Iran Loan promises linked to deposit schemes are an everyday life feature in Iran and widely socially, religiously, and legally accepted. Contract savings deposits, including for housing finance purposes, were offi- cially recognized by the 1987 Law on Usury-Free Banking as gharz-el hasaneh, that is, deposits compatible with Islamic finance principles, which enjoy a preference in the bankruptcy code. The Law on Usury-Free Banking makes it impossible for banks to pay returns on deposits of a "predetermined figure," for example, fixed interest. In addition to lotteries and random "profit" allocations, loan promises are only one of three allocation mechanisms allowed to generate a return on deposits. In addition to the only regulated CSH deposits offered by the public housing bank, Bank Maskan, it is estimated that there are hundreds of unregulated schemes in Iran offered by banks and savings cooperatives. deposits. Several institutions in Asia, Latin America, and Africa run them, o en with the intention of formalizing informal market practices that have widespread cultural support. An example detailed further in box 9.1 is t he Iranian housing bank, which relies for most of its funding on CSH. In Islamic nance with its prohibition of interest, loan-linked deposits play a sp ecial role as one of the few admissible shariah-compliant deposit products. Managing Risk under a CSH Scheme Risk Profile of CSH Contracts CSH contracts in the open form generate two and in the closed form three linked nancial products, with the associated implications for lender r isk pro les. All contracts combine a savings and a credit option product: · Savings product. CSH savings deposits are legally daily callable by the saver, as ordinary bank demand deposits. However, the entitlement to receive a loan or a savings premium subsidy, which both enhance 224 housing finance policy in emerging markets the deposit yield, will typically be linked to a minimum length of the savings phase. Moreover, lenders are o en entitled to delay or even block savings withdrawals, especially if reserves are low.8 is incen- tive structure turns a de jure short-term deposit into a de facto long- term deposit, mitigating liquidity and interest rate risk for lenders.9 · Credit option product. e saver is co ntractually entitled to a loa n broadly proportional in size to his or her savings amount, with usu- ally only unrestrictive additional underwriting. In properly regulated schemes, however, the lender can still turn down a prospective bor- rower or housing object in order to limit credit risk. In addition, CSH rarely uses price discrimination by credit risk: loan pricing will gener- ally be identical for all savers. e reason is the strength of the cred- itworthiness signal that a successful savings e ort over an extended period provides for the ability to service a loan.10 e main risk management advantage of open CSH schemes is minimal, or diversi ed, liquidity risk through the option to attract additional capital market funds. e main disadvantage is a higher vulnerability to credit risk, as interest rate risk is hig her under va riable rate contracts. Proponents of closed CSH systems argue therefore that the central value of the CSH, the isolation of a collective from interest rate volatility, is diluted, and that open schemes are e ectively building societies. In the closed CSH system, in con- trast, the interest rate volatility is minimized by providing the saver with an interest rate option product. · Interest rate option product. Closed CSH systems x both deposit interest rates and future loan interest rates upon contract signature. Since there is no obligation for the saver to borrow in the future, this is tantamount to acquiring an interest rate option, which the saver may or may not exercise, depending on the interest rate situation 8. For example, German lender Schwäbisch Hall reserves the right to delay payout of withdrawals for 6 months. Further delays are possible if aggregate withdrawal requests exceed 25 percent of the sum earmarked for loan allotment. 9. As a result, CSH deposits are usually classi ed as term deposits in banking statistics. 10.This is particularly important in t he context of the current widespread introduction of risk-based capital requirements in mortgage finance through the Basel II banking regula- tions, which have brought along an increasing differentiation of pricing between different credit risks. contractual savings for housing 225 at the time when his or her investment need occurs. To nance the interest rate option, deposit interest-rate levels will usually be below market. An indirect advantage of closed schemes is therefore a reduction in credit risk t hrough greater interest-rate st ability. e downside, to b e explored in detail below, is that closed CSHs may be exposed to signi cantly higher liquidity risk compared to open CSHs, should their conditions become unat- tractive for new saver generations. e subsequent discussion focuses on some key risk-management issues in closed CSH systems. Demand Fluctuations e saver will val ue the CSH contract by simultaneously determining the value of the loan interest-rate option embedded in the xed-rate loan promise and any loss in savings income relative to the market rate that he or she may incur in the rst period as a price for receiving the option. In particular, the option to receive a future loan fora xed interest rate will rise in value, if the saver expects interest rates to rise. Moreover, the more the value of the interest rate option rises, the higher the volatility of interest rates is. e CSH contract may in fact become extremely valuable as a protection against interest rate risk from the saver's perspective. is is a characteristic situation for countries with high levels of monetary instability or banking sector fragility, in w hich xed-rate housing nance products are o en not available at all. In a macr oeconomic stabilization scenario with declining interest rates and decreasing interest rate volatility, however, the reverse will be true: the option value and therefore the contract value and savings incentives may drop to very low levels. e contract value may even become negative if the opportunity costs of higher remunerated savings today exceed the value of the interest rate option. Because of these interest rate dynamics, demand for new savings contracts with speci ed xed terms will vary with the current interest rate environ- ment as well as saver's perceptions of future interest rate trends. Figure 9.3 226 housing finance policy in emerging markets Figure 9.3. Closed System CSH Contract Demand and Capital Market Rates, Germany, 1973­2007 shows how in the past 20 years in Germany the inverse of capital market rates and demand for CSH loans closely correlated with each other--that is, when capital market rates declined the demand for CSH rose, and vice versa. Such uctuations require liquidity management at the nancial-institution level in the form of technical reserves (`bauspartechnische Sicherung') in order to avoid potentially long waiting periods.11 11.Distortions in the high in ation phase--a liquidity crisis in the 1980s had lead to long waiting periods--disrupt the correlation for earlier years. As a consequence of the events of the 1980s, a new technical reserve was introduced in Germany with the purpose to minimize waiting periods. contractual savings for housing 227 Inflation Risk In anin ationary context, the low and xed savings returns of closed CSHs-- usually between 0 and 5 percent--lead to an erosion of the value of deposits and therefore inability to provide a su cient house nancing contribution. is problem can be addressed with two strategies: savings subsidies that li deposit rates closer to market levels, or a conversion of the closed scheme into a semi-open scheme retaining only xed real interest rates while using Box 9.2. Prepayment Risk in the Austrian Market Austria's Bauspar system traditionally operated with a relatively high 6 percent fixed loan rate (as opposed to about 4 percent in Germany). In 1999, Austrian mortgage rates dropped by for the first time in decades below 6 percent. The banks not only aggressively competed among themselves for greater market share; they also did so with Bausparkassen, with whom they had formal co- financing arrangements. Since Bauspar loans were pre-payable--consistent with the logic of a closed savings system aimed at minimizing use of loanable funds--the Bausparkassen were hit by an unprecedented prepayment wave. As the returns on government bonds, the main alternative asset for Bausparkassen, had dropped already to 4 percent, the mismatched Kassen experienced severe spread compression and even some negative spreads. The reaction was a change in the predominant loan product from a 6 percent fixed-rate loan to an adjustable-rate loan with a 6 percent interest cap; initially, even a wholly adjustable-rate system had been considered, but the government had refused to continue to pay savings premiums for a system without any interest-rate risk protection. The Bausparkassen started an institutional trans- formation, and with the change in the loan instrument opened their financing structure. At least one institution--S-Bausparkasse--today offers mortgage loans up to 300,000 (for a couple) without a contractual savings requirement, and acquires funding from both contract savings and capital market sources (including MBS). 228 housing finance policy in emerging markets in ation indices to adjust outstanding balances or nominal components of interest rates. As an example of the former strategy, a er introducing the scheme in 1992 the Czech Republic and Slovakia used savings subsidies that fully compen- sated for the di erence between contract and market savings rates. e pre- dictable result was high initial pro ts of the CSH institutions, who invested their excess liquidity while contracts had not yet become ripe for loan alloca- tion at market interest rates into securities.12 e alternative to indexing CSH contracts on both the savings and loans sides at the time was practiced in Slovenia, where the National Housing Sav- ings Scheme operates with xed real S&L rates over a base rate that is pub- lished by the Central Bank. e resulting interest rate is variable, but still o ers some risk protection through constant spreads. Box 9.2 shows with the Austrian experience that the reverse problem, dis- in ation risk, also may be problematic for closed CSH systems. Since, for liquidity management reasons CSH loans are usually pre-payable, if contract rates are set too high, a drop in market rates to levels below the CSH lending rate may force the managing institution to reinvest large sums prepaid at low or negative spreads. In the a ermath of the crisis, Austrian Bausparen was moved from a xed-rate to a variable-rate system with caps. Contract Design Flaws Even under stable macro conditions and absent demand uctuations, closed CSH systems remain exposed to latent illiquidity risk through badly designed contracts. On t his micro level, liquidity risk is a f unction of four factors, three of which are contractual: the minimum amount of savings required, the length of the minimum savings period relative to the loan term, and the loan-to-savings multiplier. e fourth factor is b ehavioral and needs to be estimated by the CSH lender: the number of "good brothers" (savers who do not take loans) relative to the totality of the saver collective. e key contract design variable is the loan-to-savings multiplier, which in its simplest speci cation is the ratio of the value of the loan claimed divided 12.See Dübel 2003. contractual savings for housing 229 by savings accumulated at the point of calculation. An individual contract will be ready for loan allocation, if a cer tain threshold value of this multi- plier, or equivalent "e ort ratios" of the saver vis-à-vis the collective, has been reached.13 Typical actuarial values for admissible loan-to-savings multipliers range between 1.2 and 1.5, depending among other things on the assump- tions about the share of good brothers in the portfolio. CSHs that violate actuarial contract design rules will generate extended waiting periods for savers willing to take up a loan, and possibly even lose credibility. Nevertheless, they can be frequently found in in ationary envi- ronments in emerging markets, especially in cases where no measures have been taken to preserve the real value of savings, as described before, and thus high loan-to-savings multipliers are conceded. Box 9.3 describes the Iranian case, in which excessive loan-to-savings mul- tipliers resulted in the illiquidity of the scheme run by the national housing bank. Box 9.3. Illiquidity of the Iranian Housing Savings Scheme The Iranian national housing bank, Bank Maskan, according to an analysis done by the author in 2004, managed a collective CSH fund with individual contract parameters as follows: length of minimum savings period relative to loan term: 1/30 (minimum length: six to 12 months, depending on loan amounts); loan-to- savings multiplier: 7-10 (maximum levels); 0% savings rate and 15% loan rates. The choice of short savings periods and large multipliers responds to the erosion of savings through inflation--between 15 and 20 percent in recent years--and in particular, house price inflation. Based on the chosen calibration, however, and despite the high spread, the fund cannot reach a steady state-situation in which cash inflows equal outflows. As a result, the housing bank uses additional market-priced funds to fill the cash flow deficit. Since it cannot raise loan rates under its contract savings com- mitment, the housing bank's margin is squeezed by the higher marginal cost of non-collective funds. (continued) 13. e threshold values vary by type of product; for example, in t he German Bauspar system there are "fast" and "slow" saver products. 230 housing finance policy in emerging markets Box 9.3. Illiquidity of the Iranian Housing Savings Scheme (continued) The liquidity gap arises even though the good brother ratio of the scheme stands at 65 percent. Many of these good brothers are reportedly willing loan takers, that is, potential bad brothers, but are rationed by the housing bank because of insufficient funds. This rationing occurs also through low maximum loan sizes (underadjustment to inflation) since legally the housing bank is not allowed to impose a waiting period after loan eligibility has been reached. As a result of unattractive conditions, the scheme faces the danger of losing credibility as a housing finance solution among the population. Once created, resolving such situations is di cult: if the saver has a legal right to obtain a loa n without waiting period,14 signi cant bailout e orts that usually involve public subsidies may be needed. e equally problem- atic alternative is the ad hoc conversion of the closed scheme into an open scheme; that is, the funding of the loan claims with a mix of capital market funds and collective funds, which implies changing the interest rate condi- tions on existing contracts. Misallocation of Excess Liquidity e reverse problem, an excess liquidity with resulting problems in properly allocating funds to housing investment, may arise in the case of schemes that have attracted deposits too quickly, for example, because of high subsidies or deposit rate controls elsewhere in the nancial system. e problem is exacerbated if CSH loan investment conditions are han- dled too rigidly, or there is subst antial scope for credit risk. In the Czech Republic, because of the exorbitant deposit growth rates pushed by large sub- sidies and initially restrictive investment conditions, it took 12 years a er the inception of the system, until 2005, for the aggregate loan-to-deposit ratio of the system to surpass 30%. As a way to invest the excess funds, the institu- 14.In developed CSH systems, the managing institution is no t allowed to promise immediate loan allocation a er the eligibility threshold has been reached, in order to gain a degree of freedom of liquidity management. contractual savings for housing 231 tions acquired large bond portfolios, including mortgage bonds which helped to reduce general mortgage market interest rates to one of the lowest levels in Europe.15 Since a massive cutback of subsidies in 2004, loa n growth has surpassed deposit growth and in 2007 the loan-to-deposit ratio has reached 47%, still a low ratio for a S&L sys tem. e share of CSH deposits actually invested in low-interest rate CSH loans remains at only 10%. Box 9.4 describes another case of how in Tunisia a combination of deposit rate regulation elsewhere in the nancial system and restrictive loan invest- ment conditions in the 1970s led to similar problems of excess CSH deposit accumulation. e perceived inability to nance housing and the interest rate liberalization of 1983 triggered a withdrawal wave of savers that made a restructuring of the scheme unavoidable. Box 9.4. Liquidity Fluctuations and Disconnect from the Housing Finance System in Tunisia The Tunisian Caisse Nationale d'Epargne Logement was created in 1974 as a public lender that developed a closed CSH with fixed S&L rates to fund its opera- tions. Contract parameters were sufficiently conservative (four-year minimum savings; loan multiplier of 2) to avoid illiquidity. As interest rate controls prevailed in Tunisia--real interest rates dropped from 3 percent in 1974 to minus 9 percent in 1983--and government subsidized the system, demand for CSH deposits became very dynamic. Problems arose in the early 1980s, because the system had generated too few loans relative to its high liquidity levels: loan eligibility was limited to new construction, yet low loan-savings multipliers only allowed for small loans, and complementary first mortgage loans were unavailable or unaffordable to the target group of the system. A latent confidence crisis in the ability of the scheme to finance housing solutions became manifest in 1983­4, when the government removed interest rate controls and withdrawals of CSH deposits rose. (continued) 15.According to computations by the Czech Academy of Social Sciences, mortgage bond to mid- swap spreads averaged -51bp throughout 2001­2004; spreads to government bonds averaged 17bp over the same period. 232 housing finance policy in emerging markets Box 9.4. Liquidity Fluctuations and Disconnect from the Housing Finance System in Tunisia (c0ntinued) In 1986, Caisse Nationale d'Épargne Logement was transformed into a housing bank, Banque de l'Habitat. At that point, all lending rates were adjusted to market rates and tenors were lengthened. The closed CSH became replaced by a semi-open CSH, with S&L rates now determined through fixed spreads over the financial market index TMM. In the 1990s, private lenders also entered the market for CSHs, and Banque de l'Habitat became only one of their suppliers. Under the semi-open schemes, loan multipliers have doubled (from 2 to 4), raising the available financing volumes. Most lenders now also offer complementary mortgage loans. Excess liquidity r isk can b e limited t hrough reduced s avings subsidies, removal of deposit rate distortions, and more exible loan-eligibility criteria. CSHs as a Policy Choice in Emerging Markets e introduction of CSHs in emerging markets has been advocated based on three nancial sector arguments: · e lack of long-term funding instruments, hindering speci cally the development of xed-rate mortgage products; · Problems of access t o mortgage nance for young and low-income households because of high down-payment requirements and low credit-risk information availability - in that regard it is claimed that CSH can contribute to greater nancial stability; · As a means to generate loan supply in areas not covered by standard mortgage nance and characterized by low loan volumes and high servicing costs, especially modernization and small property-trans- action loans. contractual savings for housing 233 A fourth, macroeconomic argument has been that CSHs contribute to a greater mobilization of savings for housing and therefore general economic development. Careful analysis should be applied when determining whether these prob- lems exist, what their magnitude is, and what alternative solutions exist that address them at minimal costs to society. Mobilization of Savings Although CSH clearly adds to the menu of term deposits and thus will stimu- late savings, there is only weak evidence supporting the introduction of CSH, primarily f rom t he s avings mob ilization p erspective. e mo netization o f emerging eco nomies dep ends p rimarily o n macr oeconomic st ability a nd the soundness and distribution power of the banking system. Lack of access to bank deposits, or weakly managed banks, are serious problems in ma ny Figure 9.4. Role of CSH Deposits for the Financing Structure of Monetary Financial Institutions, Czech Republic, 2002­07 234 housing finance policy in emerging markets emerging markets, but these problems should be overcome by a broad-based banking-sector development strategy. Shortly a er CSH were introduced in the Czech Republic, a national banking crisis related to non-performing old debts assisted CSH deposit growth as CSH institutions were exclusively foreign. Later the entire banking system was sold to foreign owners, and consumers ceased to make a distinction. We have seen in the cases of Iran (box 9.3) and Tunisia (box 9.4) that regulations may limit the development of alternative deposit instru- ments, but here the appropriate answer should be deregulation. It has also been argued that CSHs speci cally contribute to a larger overall savings ratio,16but such claims seem rather dubious if not tested against the alternatives of devel- oping other contractual savings instruments, such as life insurance, pension funds, and mutual funds, or simply savings arising from paying down a mort- gage loan. In contrast, a too aggressive strategy to introduce CSH may crowd out of other classes of deposits. Figure 9.4 demonstrates the inverse relation between CSH deposits and other time deposits in recent years in the Czech Republic, where high historic subsidy levels lead to CSH deposits absorbing up to 37 percent of time deposits in 2006. Lack of Long-Term Funding Similarly, the case for CSH as a lo ng-term funding instrument necessary to support housing nance in emerging markets is weaker than it was his- torically for developed markets. As a class of deposits issued through retail banking mechanisms, CSH deposits are inexpensive to distribute, usually protected under existin g deposit insurance mechanisms, and thus are rel- atively low cost a nd liquid. As organized mortgage securities markets and their institutional investors develop globally, however, these advantages fade. Where such institutional nance is a vailable and stable, xed-rate lending can be supplied on a truly matched-funded basis and thus will impose less interest rate risk for the lender than CSH deposit funding.17 Absent loan mul- 16.See Börsch-Supan and Stahl 1991 for an analysis of the Bauspar system in Germany. 17.CSH deposits are a hybrid between term and demand deposits: they are formally callable daily, with the likelihood of exercise of the call option being blocked by the embedded incentives (loan promise, public savings premia). e lower these incentives, the higher the likelihood of exercise of the call option and the shorter the duration of CSH deposits. contractual savings for housing 235 tiplier restrictions, mortgage nance can also provide larger individual loan volumes than CSH. e choice will depend on relative costs of and stability of access to bond nance versus CSH nance, which is determined by the macroeconomic risk situation, relative regulatory costs and relative public subsidies, and investor risk appetite, among other things. Figure 9.4 shows that as the CSH deposit funding share declines in the Czech Republic due do declining subsidies, the bank bond market catches up in nancing function. For systems with higher bond market instability, however, CSH can be a useful additional long-term funding source. In Russia, for example, due to a repeated history of banking failures, mid-sized banks have great problems to tap the bond markets and seek for CSH as a di versi cation source for long-term funding. Similarly, there is potential in India and other cases, where bond market development has been slow. Credit Risk Mitigation and Financial Stability CSH has e ven more obvious advantages in a n environment of high credit risks of mortgage lending, which in emerging markets is created by income uncertainty, high credit-information opacity, and high in ation-risk levels. High in ation levels, in particular house price in ation, may even jeopardize nancial stability in developed markets. In such environments, risk mitigation through the provision of su cient equity is o en superior to a pure risk management or transfer approach (for example, through a mortgage-loan insurance product enabling higher LTVs). ere are two main mechanisms: · Reduced leverage: CSH increase the equity bu er available for rst mortgage lenders in case of a default--the equity portion contained in a CSH disbursement generally accumulates with other downpay- ments to a larger equity position. Higher equity of the borrower at stake helps to rationalize both housing purchase and loan under- writing decisions, especially with regard to controlling in ated house prices. 236 housing finance policy in emerging markets Box 9.5. CSH System Choice in Transition Countries in the 1990s Over the past 15 years, most transition countries have developed housing finance institutions that are similar to Western European ones. The markets are dominated by universal banks, but include mortgage banks or universal banks issuing mortgage bonds and national housing funds. CSH choice has been highly controversial. The Czech Republic and Slovakia were the first countries to adopt a closed CSH system run by special bank Bausparkassen in 1992/3 . Both countries subsidized CSH initially very highly with the aim of deposit rates matching high market levels during the initial transition phase. This rendered the schemes very popular but also cannibalized the housing policy budgets. Against this backdrop, Poland cancelled a 1997 law proposal introducing Bausparkassen (Chiquier et al. 1998). A system managed through special accounts by universal banks similar to l'Epargne Logement, Kasy Mieszkaniowe, remained. Kasy Mieszkaniowe became illiquid and ceased to write new business by 2001. A key reason was the support through tax credits rather than premium grants, which discouraged its use as a mass scheme. Lithuania, for similar reasons as Poland, and with the smaller mortgage market, in 2002 decided against introducing Bausparkassen. Slovenia in 1999 introduced a housing savings scheme managed by the National Housing Fund with the goal of increasing competition between banks and bringing spreads down. The scheme is semi-open, operates with a loan-to-savings multiplier of 2, a transferable right to receive a housing loan from the bank and has thus brought high liquidity into the housing market. It is only moderately subsidized. Specialized CSH institutions also in the meantime exist in Hungary, Croatia, and Romania. The system is being discussed in a number of countries, including Russia and Armenia. contractual savings for housing 237 · Signalling of creditworthiness through pre-savings: Borrowers with low ability to pay are ltered out before they reach the loan stage, and vice versa borrowers discriminated by the market receive a chance to demonstrate their ability to pay. ere is li ttle emerging market evidence available as y et to test those hypotheses. In the Slovenian case, a high loan-to-savings multiplier has been held to have lead to increasing house prices in the presence of inelastic land supply, which has p rompted government to address the latter problem. In both the Czech and Slovakian cases to make CSH work in practice as a risk mitigant for rst mortgage lending, legal problems still need to be overcome. e Austrian CSH crisis of 1999 (box 9.2) also suggests that the risk sharing between di erent lenders may be unstable for competition reasons. Similar problems, however, are shared by competing instruments, such as mortgage insurance. Also, there appears to be support to the signaling argu- ment for pre-savings. Czech lenders charge ca 50bp higher mortgage interest rates to borrowers without a CSH contract, due to higher credit risk. In devel- oped markets, the recent U.S. mortgage market crisis can be seen as evidence to support both equity and signaling functions that CSH can deliver. It is less convincing, as has been argued, to cite German or Austrian house price sta- bility as linked to the use of CSH, as both cases feature high rental housing shares in the total housing stops. is not only pre-empts a subprime market, but also early homeownership and allows for longer pre-savings periods. e downside is that where access to credit is available accumulating large savings volumes may generate excessive costs for borrowers, due to foregone capital gains and extended rental tenure, which is w hy CSH got margin- alized in hist orical perspective. Also, as sho wn with the German case the system itself is not shock-proof--especially under high and volatile in ation. Finally, the U.S. crisis suggests that in a system with a strong focus on pro- viding second mortgages even small ad justments of the legally admissible LTVs may lead to far higher credit risk levels than historically incurred by the Bausparkassen. 238 housing finance policy in emerging markets Stimulation of Modernization and Small Transactions Lending Market e case for CSH is strongest, when considering its use outside the "standard" mortgage nance market for new construction or purchases. CSH o ers not only small-volume loans, its closeness to micro nance techniques means that frequently costly or unavailable mortgage registration can be avoided.18 is means also that the system is s elf-targeting towards lower-income house- holds. e cases of Slovakia and India show that paramount importance of the distribution approach for such target groups: Slovakia's P.S.S. was a ble to distribute tens of thousands of small loans very fast, while BHW initially failed in t he more challenging Indian environment. Even as nancial sys- Box 9.6. Attempts to Introduce CSH in India The BHW Home Finance in India is a subsidiary German Beamtenheimstät- tenwerk (BHW) Bausparkasse, now part of Deutsche Postbank. The Easy Home Loan Deposit scheme was created in 2002 as a closed fixed-rate system, regu- lated as other fixed-rate deposit schemes applicable under the Indian mortgage company charter. The scheme entailed a savings phase at 5 % p.a. over 3 years and a loan phase at 7 % p.a. at 5 years. The loan-to-savings multiplier was limited to 1. The scheme was not specifically subsidized beyond the general tax prefer- ences for mortgage borrowers; in exchange for the absence of savings premia, contract conditions prohibited savings from being withdrawn prematurely. The scheme was initially well received by consumers. In the Indian context char- acterized by high levels of informality, the target groups were lower-income and lower-middle-income households for whom the available funding could mean an option to buy low-cost housing or land; however, many of those households have no bank accounts and BHW over time ran into difficulties to organize distribution and collection. After a series of problems with collection agents, the scheme was discontinued by BHW in 2006 and accumulated savings were reimbursed. BHW as of 2008 plans launching a new scheme whose details have yet to be disclosed. 18.In the Czech Republic and Slovakia, for instance, between 2/3 and 4/5 of CSH loans are not collateralized by mortgages. Reconstruction and modernization loans make up for roughly half of the portfolio. contractual savings for housing 239 tems develop and access to bank accounts becomes universal, viable alterna- tive small-loan o ers from universal banks may not appear because of high origination and servicing costs. CSH lenders can overcome this through spe- cialization and a large numbers of loans. CSH also has advantages over unse- cured consumer loans, whose rates charged are generally very high because of higher credit risk. Institutional Requirements for CSH Lenders Regulation of CSH Schemes Analogous t o in surance s chemes, CS Hs co me wi th signi cant control problems since a ma naging institution, the "lender," derives its pro t from investing the resources on behalf of a s aver collective. e saver collective does not only need protection against credit risk, but also against a misuse of funds saved below market rates for investment, generating market rates for the lender. A similar problem arises between collectives at di erent times, as CSHs have built-in incentives to prefer current over future saver genera- tions that might be le without su cient liquidity to receive loans. Since CSH schemes are of the greatest value when interest rates are xed, and their funding instrument is callable, liquidity and asset-liability management risks require greater detail regulation than in t he case of a tradi tional building society or mortgage bank, which are both matched funded. For these rea- sons, CSHs should be formally regulated. At the core of CSH regulations should be the de nition of balance sheet and cash ow principles for the legally and technically separate fund owned by the saver collective. e fund manager should be required at least to be a regulated nancial institution that is specially licensed for managing CSHs. Especially in c losed s chemes, t he licensing should require s eparate r isk- management capacity within the institution and a speci c set of rules that consider the mathematical limitations and risk pro les discussed above. Par- ticularly important are proper contract design and in higher in ation con- texts su cient technical reserves for liquidity management. Regulators and onsite and o site supervisors should have sta specially trained for analyzing and supervising CSHs. 240 housing finance policy in emerging markets Clearly, a system promising to o er non-mortgage and second mortgage loans needs also carefully de ned underwriting criteria. Frequently encoun- tered legal rights to a loan a er the savings phase, let alone options to inherit such rights, are an impediment to sound underwriting. Incentives should be given to register mortgages wherever possible, for example, by addressing registration costs and legal issues. In addition to loan underwriting, liquidity investment criteria are central. e existing approaches to regulation and supervision are not uniform. European CSHs are mostly enabled by sp ecial laws; however, with quite di erent solutions.19 More worrisome, the recent schemes implemented in emerging markets seem to be more lightly regulated than their European counterparts (for example, India, proposal in Russia). is seems to be inad- equate, given their risk content, especiallyifa xed-rate loan promise is given in a volatile interest rate environment. A mo re fa r-reaching in stitutional sp ecialization o f CS H lender s t han licensing, that is, as sp ecialist banks, has b een criticized as le ading to an undesirable fragmentation of the banking system in emerging markets. In fact, universal banks o ering CSH under licensing appears as the most e cient option for smaller nancial systems. Peru, Nicaragua, and Slovenia have followed the French example in that regard. e specialist bank solution has been adopted in Germany, Austria, the Czech Republic, Slovakia, and Hungary. e argument here has b een for maximum risk-management quality and exclusive business focus. P.S.S. in Slovakia, for example, may be credited with having pioneered a new origi- nation, s ervicing, a nd r isk ma nagement inf rastructure f or t he S lovakian housing nance market.20 A possible compromise model for emerging markets could be a building- society-type sp ecialist ba nk o ering CS H next t o o ther ho using nance products. An example is S-Bausparkasse in Austria. Its business model com- 19. e German banking act (Kreditwesengesetz), for example, goes as far asoutlawing all deposit- taking that is linked to a loan promise; the exception being tightly regulated CSH deposits under the special bank system of Bausparkassen. is system is supervised by a specialized department of the supervisory authority. e French legislation does not require a sp ecial bank for operating CSHs. Regulation takes place under a special unit of the treasury that also oversees other contract savings, such as insurance and pension schemes. 20.It should be noted that most sp ecialist banks o ering CSH in t he mentioned countries are subsidiaries under holding structures that o er the complete range of banking or contractual savings products. contractual savings for housing 241 Table 9.2. CSH Subsidies in Central and Eastern Europe Compared Germany Russia Hungary Czech Republic Slovakia Status Current Proposed Current 1992­2003 Current 1992­1997 Current Minimum 7 years 5 years 4 years 5 years 6 years no 6 years savings period* constraints New savings 8.8 20.0 30.0 25.0 15.0 40.0 15.0 premium in percent Maximum 117 499 360 195 156 186 112 premium amount in US$ Optimum new 1330 2496 1200 780 1040 465 745 savings amount in US$ Income limit in 33280 None None None None None None US$** Annual subsidy 2.44 7.52 13.83 9.23 4.75 n.a. 4.75 yield in percent*** Source: Author's research. Notes: * shorter minimum savings periods exist if consumers take out housing loans early, ** for singles, value doubles for couples, *** assumptions: income tax exempt savings yield at 20% marginal income tax; no income tax deductibility of savings; interest paid on accumulated subsidies; annual subsidy payment; no closing costs of CSH institution. bines scale and exibility on the product and funding side with a su cient risk management and regulation framework for CSH. Subsidies for CSHs CSH Subsidies in Emerging Markets e question of whether CSHs deserve special savings subsidies as part of the overall housing policy menu is very controversial. e high and diverse sub- sidies proposed and implemented in Central and Eastern Europe CSH have put heat under that debate.21 ey allowed CSH institutions to fund them- selves very cheaply as the government picked up the di erence between CSH deposit rates and market rates. ose subsidy yields reached levels between 5% and 14% in Central Europe, much higher than in Germany. Large returns 21.See Diamond 1999 for an attack on CSH subsidies in Central and Eastern Europe. 242 housing finance policy in emerging markets Box 9.7. CSH Subsidies in Hungary The Hungarian housing finance system has been traditionally deeply subsidized; the HUF mortgage subsidy schemes introduced under the Szechenyi plan in 2000 and abolished in 2005 had offered interest rates as low as 3-5% with market rates well above 15%. In the same spirit and in addition following the Austrian CSH subsidy dogma to always match bank deposit rates, the Hungarian CSH system offers deep savings subsidies; an extremely short minimum savings period of only 4 years in combination with a high state premium of 30 percent of the annual savings amount as well as comprehensive tax exemptions enhance the 2% paid by the Bausparkasse by another 14% to even above market deposit rate levels. Given the higher Forint and house price inflation, also more relaxed maximum eligible savings amounts are chosen than in neighbouring countries. Still, due to the deep HUF loan subsidies until 2005 followed by a surge in foreign currency loans (2007 > 80%, mostly Swiss Francs) and amnesia about the associated risks, the success of CSH so far is only moderate. The current estimated 250,000 outstanding contracts represent only a twentieth of the level of the Czech Republic, with a comparable population size. During 2007, however both new savings contract enrollment and fiscal expenditures considerably picked up. HUF 18.6 billion of premiums were paid in 2007, up from 14 billion in 2006, and the current financial market turmoil that reduces foreign currency loan supply and creates volatile HUF financing conditions is likely to further enhance demand. Box 9.8. Planned CSH Law and Subsidies in Russia During 2008, in Russia concrete plans were discussed to introduce a Bauspar system. Russia's banks suffer from considerable funding mismatches. A number of mid-sized banks challenging the market leader Sberbank, the national savings bank, has limited access to deposits and heavily relies on the volatile Eurobond and interbank markets. Apart from the operations of the agency for home mortgage lending (AHML), which are limited by fiscal constraints, there is no long-term refinancing market for mortgages. Long-term savings could be a welcome diversification instrument. (continued) contractual savings for housing 243 Box 9.8. Planned CSH Law and Subsidies in Russia (continued) The Russian law has been proposed by German Bausparkasse Schwäbisch Hall. The proposed regulations soften the German law in a number of points. Examples are lower requirements to use mortgage collateral for housing loans, a higher ratio of interim financing to total lending, and a lower level of technical reserves designated to minimize waiting periods. Also, with a maximum state premium level of RUR 14,000 p.a. (USD 560), a minimum savings period of only 5 years and a state premium ratio of 20% of savings, the subsidy program promises to become expensive. Compared to the Czech Republic, the maximum state premium p.a. planned for Russia is 3 times as high, compared to Germany 4-8 times (differentiation by marital status). Also, Germany and the Czech Republic now feature minimum savings periods of 7 and 6 years and state premium ratios of 8.8% and 15%, respectively. on equity of CSH institutions were the result, especially in the setup phase where funds are exclusively invested at market rates.22 For scal reasons, some countries had to cut back later; however such cutbacks have come with long delays (Czech Republic). e subsidy debate highlights the lack of certainty of CSH institutions over the intrinsic value of their product. However, subsidies--at least of the scale given in C entral and Eastern Europe--are not an essential feature for the successful introduction of CSHs. See box 9.6 for the Indian case, where the access-to-credit motivation proved su cient to attract demand; the scheme failed for technical reasons. Nor do speci c risk aspects of CSH require per- manent subsidies (see discussion above). e same can be said about mort- gage loan and insurance products, however, which are nevertheless frequently subsidized as they bene t mainly the politically powerful middle class. CSHs have therefore not been an exception in attracting sometimes large amounts of economically hard-to-justify subsidies. 22.See Dübel 2003 analyzing the case of the largest Slovakian CSH institution P.S.S. 244 housing finance policy in emerging markets Guiding Principles CSH subsidies can be justi ed only as part of a consistent overall housing nance subsidy framework. e rst guiding principle here should be neutrality of user costs of capital fordi erent instruments, considering all subsidy sources.23 Neutrality should be observed in pa rticular in t he market for high LTV loans or equivalent insurance products, which is highly sensitive to the subsidy and public-guar- antee structure. Evaluation criteria of CSH subsidies should moreover consider the e - ciency with which they are allocated, for example, by assessing the invest- ment m ultiplier a nd substi tution e ects as co mpared t o o ther ho using nance instruments. A central point here is to ensure a su ciently high loan-to-deposit ratio: in the Czech Republic, CSH deposits became so strongly subsidized that the loan-to-deposit ratio stagnated until very recently at low levels and CSH e ectively subsidized t he b roader mo rtgage s ector. S tarting f rom almost identical initial conditions, CSH had a mo re robust lending performance in Slovakia with close to 100% loa n-to-deposit ratios since e arly a er the system's inception. Alternatively, subsidies can be speci cally tied to a loan takeout, a decision France took concerning l'Épargne Logement subsidies in 2003 and Germany implements from 2009 onwards. Alternative forms of equity support for borrowers, such as grants or partial use of tax-preferred retirement savings accounts for downpayments, should also b e co nsidered. Finall y, w hile CS H s chemes a re pa rtly s elf-targeting through the small loan amounts they produce, income and other limits may considerably improve the targeting e ciency. Conclusions for Emerging Markets CSHs continue their existence despite the swi capital market development in housing nance. ey conceptually t into an early nancial-sector devel- 23.Dübel 2003 co mpares mortgage-market subsidies in t he Czech Republic and Slovakia and nds that the subsidy dependency of CSH loans ishigher than of mortgage loans in the former case, and lower in the latter case. contractual savings for housing 245 opment context as an initial mortgage product and into a mature nancial- sector development context as a product generating access to credit for young and low-income households as well as nonstandard housing nance loans. e system o ers a n umber of advantages, including its simplicity, a way to mobilize long-term liabilities, and, in the absence of credit scores or formal income, it can provide a lender wi th proof that the borrower is able to service a mo rtgage loan. e ability of the system to function within informal environments is pa rticularly relevant for emerging mar- kets. e commitment made during the savings phase and the deposit that is accumulated greatly reduce the credit risk of operating in environments without formal institutions providing credit scoring and credit histories. A nal and important advantage of the system is that it can allow long-term xed-rate loans to be o ered, even in environments where long-term xed- rate funding may be unavailable. Despite some expansion to emerging markets the schemes have had dif- culties in t he presence of changing economic circumstances and macro instability. F alling in terest ra tes in emer ging ma rkets in pa rticular ha ve meant that potential borrowers would have little incentive to start saving at below-market rates in a CSH system in order to lock in a future lending rate now. Falling rates, moreover, tend to interact with strong house price growth, which could mean that initially contracted loan amounts will be insu cient to buy a p roperty and savers that have the option to borrow immediately rather than saving and borrowing later will forego capital gains. e CSH mechanism is also heavily reliant on new savers coming onboard and providing liquidity for the continued disbursement of loans. In a stable in ation environment the system can work well attracting new savings, but in ation cycles may mean the system is exposed to corresponding demand uctuations. A r eacceleration of in ation in pa rticular can result in loa n rationing, which in a contractual scheme can damage con dence. Even in a benign in ation environment, contract design discipline is needed to avoid intergenerational snowball e ects. CSH systems in emerging markets there- fore need liquidity-stabilizing mechanisms such as a technical reserve fund and proper risk-management capacity. A danger is, moreover, that policy makers in emerging markets take the savings disincentives in a falling interest rate environment, or the heavy reli- ance of the CSH on su cient new savers in the steady state, as an excuse for 246 housing finance policy in emerging markets introducing large and permanent savings subsidies. Such subsidies are not a necessary condition for the long-term success o f a CS H. Experience has shown that, when inappropriately applied, especially during the introductory phase, scal costs can be substantial and the amounts of savings generated can no longer reasonably be channeled into loans and housing investment. Policy makers lo oking to CSH as a t ool for de veloping their housing nance systems should assure themselves that the appropriate regulatory framework is in place that is able to deal with the speci c type of risks arising from CSH. Any excessive dependency of these schemes on regressive and costly subsidies should be avoided. Policy makers are advised to compare the advantages and shortcomings of this model with alternative housing nance systems within their respective countries and market environments, in order to manage credit risks, facilitate access to housing nance, and to mobilize long-term funding. Chapter 10 State Housing Banks Olivier Hassler and Bertrand Renaud At some stage of their nancial development, many countries have established and used state-controlled banks to provide nance for housing. Although their overall performance has b een quite disappointing, both in t erms of nancial performance and social impact, this model continues to attract the attention of policy makers, as observed for example in Africa, where more state-owned housing banks are being created or contemplated. Housing has deep social implications and is p art of any national shelter strategy. Hence, confronted with a market failure, the absence of provision of nance, or a de cient coverage of mortgage markets throughout the income distribution, governments are induced to choose an intervention method that may quickly yield results--or at least be seen as a visib le sign of a political will. e temptation is then great to use the state housing bank model, which has kept resurfacing in many countries, although the model o en does not o er an appropriate answer to the issues underlying the market failures. Like many other types of state-owned banks, housing banks o en fail to achieve the balance between conducting e cient and viable banking operations, and pursuing their social housing goals. 247 248 housing finance policy in emerging markets e chapter is o rganized by rst providing a sho rt description of state housing banks (SHBs), then by delineating their rationales, and analyzing the reasons why many of them failed. Available safeguards and alternative options to achieve the same goals are then discussed. Finally, some strategies to make existing institutions evolved are discussed. A Brief Overview of State Housing Banks Definition and Classification SHBs in this discussion are taken as public-sector nancial institutions oper- ating in t he retail housing nance market. is de nition excludes state- sponsored second-tier mortgage institutions, be they state-sponsored entities acting as liquidity facilities or securitization agencies, or vehicles channeling public resources toward primary lenders (Federal Mortgage Bank of Nigeria [FMBN], Gabon Compte de Re nancement de l'Habitat, Venezuela Banco Nacional de la V ivienda [National Housing Bank, Venezuela]). Provident funds t hat a re r etail ho using lender s b ut a re no t ba nks (f or in stance, INFONAVIT in Mexico, PAG-IBIG in the Philippines, and Housing Trust in Jamaica are also excluded [see chapter 11, where housing provident funds are treated in greater depth]). Because of the importance of funding in the business model, and the dif- ferent kinds of issues that it raises, a simple typology of SHBs can be made according to their dominant source of funding. 1. Most of their funds are deposits, as in Chile (B ancoEstado), Brazil (Caixa Eco nomica), Alg eria (C aisse N ationale d 'Epargne et de Prévoyance [CNEP]), T unisia (B anque de l 'Habitat), I ran (B ank Maskan) or ailand (GHB). ese banks, which are typically sav- ings banks, have a strong funding basis, and the ability to o er a wide range of banking products. 2. Specialized banks without any large-deposit collection capacity that raise funds on bond markets. is was the case with Banco Hipotecario Nacional in Argentina; Crédit Foncier in France, a quasi­SHB until 1999; and the Credit Immobilier et Hotelier in Morocco. state housing banks 249 3. B anks t hat most ly us e public nance s ources such as ma ndatory savings or wage taxes, central bank facilities, or government grants and loans. Although rarer, this model exists o r has b een used, for instance, in Cameroon (Crédit Foncier du Cameroun), Pakistan, and Bangladesh (House Building Finance Corporation [HBFC]). Types of State Housing Banks ere are many variants of SHBs driven by nancial policies and shaped by the local environment and its evolution. For example, some SHBs date back to the post-World War II period prior to the macroeconomic reforms and nancial liberalization that started in the 1980s. Since then charters, man- dates, sources of funds, regulations, and operations have o en changed for the SHBs. In Latin America, state housing banks that combined apex functions (re - nancing facilities), some regulatory powers, and direct lending were created in most countries in the late 1960s and early 1970s. Most have been closed during nancial crises, but some survive in s ome of the smaller co untries and nancial markets of the Caribbean and Central America (Dominican Republic, Guatemala, or Nicaragua). In Brazil, Caixa Economica Federal is a h ybrid of a de velopment bank and a retail commercial bank, including the functions of a SHB. It o ers a large variety of services, and has become the largest mortgage lender a er the takeover of the Banco Nacional de Habitaçao. Caixa, which has a la rge deposit base, and also channels most of the payroll tax funds earmarked for housing nance from the Fundo de Garantia do Tempo de Serviço (FGTS) provident fund, and scal transfers from the government. In Central and Eastern Europe, state-owned savings banks have taken a large share of the mortgage lending market, but have also evolved into uni- versal commercial banks exposed to increased competition from other mort- gage lenders. In economies where the commercial banking sector is small and the mort- gage nance infrastructure is o nly partially in p lace, there is co nsiderable interest in creating new SHBs. is is the case in Sub-Saharan Africa where 250 housing finance policy in emerging markets SHBs have been established or revitalized (examples: Ivory Coast, Congo, Mali, Senegal, Gabon, Namibia, and Rwanda). In some countries, state entities combine retail housing-loan services with real estate developer functions. Examples can, or could, be foundin ai land, Indonesia, Algeria, Egypt, Rwanda, or Pakistan. is is a dangerous combi- nation, notably when projects are driven by some political considerations, because of the lack of independent assessment of development market risks and the absence of a sp eci c capital bu er that a p rudent lender r equires from developers. The Rationale for Creating a State Housing Bank e rationale for SHB is linked to the broader issue of state involvement in nance. In extreme cases, some SHB, for instance in P akistan, Algeria, or Iran, re ect a legac y of specialized sector banks implementing a cen trally planned eco nomy p olicy. W ith eco nomic lib eralization, t he deba te has shi ed toward how to best address the observed failures of market forces in responding to social or economic needs: (i) S hould the state intervene through SHB to serve the population underserved by the private sector? or (ii) Should the state implement background reforms, adequate regulation, and proper incentives to favor the expansion of markets? As set out in other chapters in this book, the government should play a role in supporting the development of housing nance systems. ere are segments of the population that are underserved, or not covered at all by the market, and not only during the early phases of development. None of the successful mortgage nance systems in exist ence today have developed without some form of active support by the government. e practical question is whether, and under which conditions, an SHB has the ability to e ciently ll market gaps. Within this context, SHBs generally represent an attempt to provide an institutional answer to three kinds of actual and relevant issues: · Provide a nancial service that the market fails to o er. As a driver to jump-start the market ("the infant market argument"), the SHB is then seen as a p ioneer and leader in housing lending, helping to state housing banks 251 improve the lending infrastructure and demonstrating the commer- cial feasibility of such lending among other nancial institutions. · Cater to the needs of segments of the population underserved by the commercial nancial sector. Lending to lower- or informal-income groups, or to households who live in areas not served by bank net- works, involves higher origination and servicing costs, higher risks, and fewer cross-selling opportunities. SHBs are perceived as a natural substitute to mainstream lenders, notably because their pro tability goals may be lower than private lending institutions, and because of to the implicit state backing of their risk exposure. · Provide a us eful p olicy im plementation t ool, as S HBs a re visib le and easy to create. ey can react to instructions given by govern- ments. For instance, the ai government selected housing as one of the drivers of the economic recovery from the 1997 crisis, by using GHB to channel below-market mortgage loans to stimulate construc- tion and absorb an excess of unsold homes on the market. In France, Crédit Foncier, which had a quasi-monopoly on the main type of sub- sidized housing loans, was used to transmit the variations in the vol- umes of housing subsidies deemed necessary to enliven, or dampen, demand cycles. The Model Failed in Many Countries A striking feature when looking at the large number of SHBs created since the middle of the 20th century is the frequency of bailouts and rescue opera- tions. is has b een observed across di erent economies and institutions, such as Alg eria (CNEP, 1997), Ar gentina (B anco H ipotecario N acional, 1990­3), Brazil (Banco Nacional de Habitaçao, 1996, and Caxia Federal in 2001), Cameroon (Credit Foncier du Cameroun), Colombia (Banco Central Hipotecario, 1998), F rance (Credit Foncier de F rance, 1996­9), I ndonesia (Bank Tabungan Negara, 1997), I vory C oast (BHCI recapitalized twice), Pakistan (HBFC, 2001), R wanda (Caisse Hypothécaire du Rwanda, 2003), Tanzania (1995), a nd Uruguay (B anco H ipotecario del U ruguay [BHU], 2002), among many others. 252 housing finance policy in emerging markets Box 10.1. The Fiscal Cost of Bailing Out State Housing Banks Banco Hipotecario del Uruguay (BHU). Made vulnerable by a high delinquency rate (40 percent NPL in 2001) and considerable asset-liability mismatches, BHU collapsed during the Uruguayan financial crisis of 2002. Besides a restructuring plan that included a change of business model, the bank was recapitalized--for the third time since the mid-1960s. A first capital injection was carried out by the government in 2002, for about $730 million. At the end of 2004, the company's equity was still negative by an equivalent amount. BHU's lending activity was interrupted until 2006, which did not prevent its financial situation from wors- ening. Further recapitalization measures through the transfers of assets and liabil- ities were still ongoing in early 2006. The recapitalization needs could amount to $1.5 billion, or 93 percent of the loan portfolio outstanding in 2001. Bank Tabungan Negara. This Indonesian SHB had been entrusted in 1974 with the distribution of subsidized housing loans. Bank Tabungan Negara had a monopoly on the subsidy scheme. Being funded by loans from the Central Bank at privileged conditions enabled it to extend much longer-term loans (20 years) than the private sector, and to win an 80 percent market share in volume despite charging a larger intermediation margin. The poor recovery performance-- the delinquency rate went above 25 percent at the end of the 1980s--put Bank Tabungan Negara in a precarious financial situation. The bank managed to improve its risk management, achieving some improvement in this area, but at the same time sought to expand its business by diversifying it toward corporate lending. The lack of capacity in this area was evidenced by a high level of arrears: 100 percent of the corporate loans went into default during the 1997 Asian crisis. When Bank Tabungan Negara transferred its impaired loans to the agency in charge of restructuring the banking system, it incurred an overall loss exceeding $1 billion, more than 20 times the yearly budgeted amount of housing subsidies. Crédit Foncier du Cameroun. This is a specialized institution that was established in 1977 by the government. Its loan portfolio, about $150 million * at the end of 2004, is mostly funded by a wage tax and marginally from savings deposits. In (continued) state housing banks 253 Box 10.1. The Fiscal Cost of Bailing Out State Housing Banks (continued) the 1990s, CFC ran into deep difficulties caused by two main reasons: (i) very low recovery performances--80 percent of the portfolio was nonperforming--partly because of defaults by the government itself and other state-owned entities, and (ii) excessive operational costs. The company incurred large recurrent deficits, made an irregular and ill-conducted diversification attempt toward commercial banking, and went into deep organizational and financial distress, resulting in a sharp reduction of its activity. The regional Central Bank required several times that draconian measures be decided by the public shareholders. Restructuring plans were designed in 2003­4, and a de facto recapitalization took place by allo- cating the accumulated proceeds of the wage tax to the company's own funds, a non-budgetary support that can be estimated to have amounted to at least two thirds of the gross loan portfolio. Sources: Moody's Investors Service Banking System 2004; Gandelman and Gandelman 2004; and Hoek- Smit and Diamond 2004. * Gross figure Some have been closed down; others have been recapitalized several times. e scal cost of the respective bailouts both through the SHB and their cli- ents has b een staggering, notably in co mparison with the on-budget pro- grams of social housing subsidies, suggesting a dramatic policy failure in these countries in t he long run. For example, the last r estructuring of the Caixa Econômica Federal (CEF) in Brazilin2001 scally cost about $8 billion, or 25 budgetary years of the main federal program of social housing subsidies. ese fa ilures e vidence a hig her degr ee o f vulnera bility t han no rmal banks. is re ects structural weaknesses within the SHB model, related to a permissive attitude toward risk management and operational policy, and administrative- and rule-based culture (rather than risked based), ampli ed by some implicit state backing. e sensitivity to crisis is also caused by spe- cialization, which may lead to an excessive exposure to real estate market downturns, ampli ed by hazardous diversi cation attempts in commercial real estate. is section analyzes more precisely the factors behind this struc- tural fragility. 254 housing finance policy in emerging markets State Housing Bank Failings Weak Corporate Governance A rst series of aws can be found in the legal foundations of SHBs, which are o en governed by a special legislative act in derogation of general corporate and banking status. ese acts o en lower the accountability and pro tability requirements t hat p rivate entities must meet b ecause o f t he q uasi-state- agency status of the bank. Related to this status are also restrictions in the business model, in particular over lending operations (types of loans, speci- ed interest rates, business limitations, and so forth), which add some. More important perhaps than majority ownership itself is t he power of appointing t he management and control over t he bank's business p olicies through management. ese powers most f requently belong to a nancial authority. In many cases, management results from appointment of a senior o cial from the ministry of nance, central bank, or another state institution, rather than professional bankers, giving the institution a more administrative than nancial culture. Moreover, the government exercises direct access to the management of the bank and the conduct of its business; for instance, in the setting of lending conditions. is organization goes hand in hand with o en weaker oversight by the nancial supervisors. State banks are o en subject to less stringent prudential requirements than other banks, as well as reporting obligations. is, jointly with a prevailing administrative approach, facilitates weak accounting systems and internal controls. One o f the telltale signs of major problems at a housing bank is w hen it does not produce reliable and timely reports on its nancial position and on its subsidy programs. Government control also makes the role of the board of directors o en of little relevance as an outside evaluator of the bank's performance and its com- pliance with the public interest objectives that it is supposed to pursue, o en characterized by quantitative housing-policy targets. Too much government intervention in t he bank's management, as w ell as t he board of directors' incomplete mandate, can lead to accountability de ciencies. Seeking a balance between social goals and nancial e ciency should be the core function of the management, but this o en turns into a compromise between political interference and rent-seeking behavior. Opportunities for politically driven business interventions trade o against privileges exploited state housing banks 255 by the SHB to its own advantage, at the expense of the public good. is may result in some kind of implicit agreement by which the SHB bows to political pressures while the politicians allow the SHB to capture some public bene ts. e linkage to government o en gives the bank the ability toin uence policy decisions. is would typically be to promote the interests of the SHB and may not coincide with the best interests of the wider population. Lax Management of Credit Risk e portfolio performance of SHBs is o en poor, with a common NPL ratio of 20 to 30 percent in emerging economies. It has reached 70 percent or more in some cases. e intensity of NPL problems may even be hidden by poor accounting practices and misleading loan classi cations.1 Several reasons may explain this unfavorable outcome: Because of the subsidization of loans and the application of administra- tive rules, risk-based lending may be partially replaced by "formula lending" that does not allow SHBs todi erentiate among customers according to their credit risk. In mortgage markets where private players are active, adverse selection takes place that is con ned to "formula" lending, to the detriment of the SHB. As a public policy tool, the government assigns the SHB goals based on new loan production rather than improving performance or pursuing politi- cally unpopular measures such as recoveries from nonperforming loans. Loan servicing in SHBs is o en mediocre, because such lenders tend to be more lenient than commercial lenders, and borrowers are more inclined to be delinquent when borrowing from a state-owned bank. Moral hazard is signi cant in the model, and seems di cult to avoid. 1. For instance, the classi cation of nonperforming accounts takes place a er a lo nger-than- normal arrears period, or is partial (interest only, or one loan only despite a larger exposure of the same debtor). 256 housing finance policy in emerging markets Assets/Liability Mismatches One of the major policy motivations for setting up a SHB is to o er long-term loans, notably at a xed rate (more attractive and secure for households). e private sector may not o er such loans if it cannot manage the liquidity and interest-rate risks. is may be because of an inherently unstable core deposit base, underdeveloped bond markets, or an absence of hedging tools. Providing long-term xed-rate loans may be a reason to establish an SHB, but such an institutional move does not provide a remedy to the underlying issue: creating an institution does not create a source for long-term resources. is confusion o en ends up transferring a signi cant amount of nancial risks to the taxpayer. Some selected examples show how common this problem is: In Japan, the Government Housing Loan Corporation was cr eated in 1950 to nance the postwar reconstruction. Its funding was mainly public (special government program and grants). e Government Housing Loan Corporation loans to house purchasers would have a rst 10-year period with a xed rate below market and a 25-y ear period with a p reset xed interest rate.2 As such conditions could not be matched by private markets, other lenders were crowded out in this spectrum of maturities (and focused on shorter-term loans). In Iran, the Bank Maskan o ers long-term loans up to 20 years at xed rates funded mostly with savings-for-housing schemes where the minimum requested duration of t he preliminary s avings p eriod varies b etween six months and 3.5 y ears and the ratio between accumulated savings and the amount customers are entitled to borrow can be as hig h as 7. ere is no hedge for the long-term loans the bank commits itself to extend. In Mali, the Banque de l'Habitat was established in 1995. Despite a short- term funding base (including savings-for-housing schemes of a maximum and minimum period of one year) and a lack of external matching resources (limited bond markets), it has b een granting mortgage loans for up to 20 years. Its liquidity risk is large,3 and interest risk worse, especially with con- tractual housing schemes, which set the level of rates in advance. 2. In 2002: 2.755 and 4 percent respectively. 3. Public entities have been directed to deposits funds with Banque de l'Habitat (Mali)--a far from stable solution. state housing banks 257 e Banco Hipotecario de U ruguay (BHU) was cr eated in 1912. BHU was the predominant provider of housing nance and had 80 percent of the market in 2002. BHU cumulated three types of asset-liability mismatches: (i) liquidity risk--20-year loans, while most of the funding was sight deposit; (ii) interest rate risk--loans were granted on a xed-rate basis before switching to a va riable rate regime; and (iii) c urrency risk: a er 1980, U .S.-dollar- denominated deposits grew to a signi cant percentage of BHU's liabilities while loans remained mostly denominated in indexed local currency. Many housing bank failures resulted from this type of imbalance, taking a heavy toll on the national resources as the mismatches worsened during a crisis and the subsequent rescue operations. Misallocation of Subsidies and Rent-Seeking Policies As part of their social lending mandate, SHBs are o en the privileged and sometimes exclusive vehicles of rationed subsidies. at channeling may create various problems. e SHB that allocates the subsidized loans is in a position to exercise some discretion in the allocation of the assistance, even if it must comply with eligibility criteria. In some cases, this leads to fraud or corruption among the bank's sta . More commonly, part of the subsidies end up supporting the SHB itself. ere is always a temptation to use a "free" resource to cover operational costs, which are o en higher than normal and would be di cult to sustain in a co mmercial environment. e problem is aggravated when subsidies are incorporated in the funding of the SHB; for instance, through the provision of resources at below-market rates, as t his lower funding cost results in an above-normal intermediation spread and is not entirely passed through to the borrowers. In this case, economicine ciency develops on top of the social misalloca- tion of bene ts.4 More indirect forms of support exist, suc h as g overnment guarantees along with their impact on investors (lower risk weight, eligibility for liquidity ratios, or reserve requirements), but also implicit guarantees, tax relief, or 4. es e aws are ampli ed when government funding is ca rried out through Central Bank lending. Creating high-powered money to nance long-term investments is bound to eventu- ally lead to escalating in ationary pressures. 258 housing finance policy in emerging markets other preferential features granted to the SHB, such as moree ectiveforeclo- sure proceedings unavailable to other lenders. ese indirect bene ts seem less costly, as they do not appear in budget expenses, but (i) they make any social cost-bene t analysis of the SHB intervention di cult to measure, and (ii) they may prove di cult to remove when the market has developed. SHB as Obstacles to the Growth of Housing Finance Markets? Many of the design aws presented above are interrelated. Poor governance is involved in a loose recovery policy and free purchase of nancial hedges; that is, through transferring balance-sheet mismatches to the government. Capturing subsidies is a n inducement not to obs erve str ict dis cipline in managing risks. When all these shortcomings are present, SHB can have a negative e ect on the development of the market and the extension of access to housing nance, if t his privileged subsidy circuit excludes other players from the market, and if the privileges do not remedy the de ciencies of the infrastructure of credit markets, such as the dearth of long-term capital in the economy. To the contrary, SHB may introduce further market distor- tions by being able to o er products that no co mpetitors can ever match. is impact goes beyond the moderate-income segments that SHBs are sup- posed to serve. Because of their low pro tability and poor track records in managing credit risks, it is fairly common to see SHBs shi their actual com- mercial target upward in the income distribution and nally compete with mainstream lenders on their ground. Available Safeguards and Alternative Options Before creating an SHB, government should determine what type of market failures are constraining the development and deepening of the market. If the unwillingness of the commercial nancial sector to promote housing nance is the result of structural de ciencies and not the existence of more pro table and easier lines of business, an SHB will not foster the development of the supply--and to the contrary may stunt it. is will also be true if the state housing banks 259 market impediment lies in macroeconomic conditions. ere are examples where the strengthening of the market infrastructure and the improvement of the macroeconomic conditions were su cient to jump-start the market. For instance, Estonia has b uilt in a li ttle more than a decade a ho using nance system that reaches 25 p ercent of its 2005 GD P. In Pakistan, the improvement of the nancial parameters and the liquidity of the banking sector triggered a surge in the supply of housing nance. Loans outstanding went from YSD 330 million at the end of 2003 to 900 million at the end of 2005. is was ac hieved without any involvement of the SHB, which was itself being overhauled. If the government considers that an institution is the right answer because the problem is the absence of a "market maker" and of development engine, then its design should meet some critical conditions to ensure it e ciently ful lls its social and economic purposes. Good Governance e rst condition for making an SHB work is to establish its operation on strong corporate governance principles and insulate it from short-term polit- ical interference. ese principles include the clear de nition of corporate goals, transparency of results, independence and accountability of the man- agement with respect to the board of directors, clear and independent risk management organization, separation of ownership, and control functions.5 One prerequisite is to submit the SHB to general corporate laws and, above all, to the standard oversight of the banking regulator. Public-private partnerships can be a way to ensure the existence of checks and balances, by creating an inner pressure for corporate results and helping to insulate the SHB from political interference. is solution runs the risk of exacerbating the capture of subsidies or other bene ts by the private sector. 5. For a detailed analysis, see OECD 2004 and BIS 2006. S ee also van Greuning, Hennie, and Bratanovic 2003. 260 housing finance policy in emerging markets Autonomy of Funding Establishing an SHB without ensuring its ability to raise funds autonomously is a sure recipe for the failure of the model. Without a savings mobilization capacity, resulting from either the absence of a dep osit network and/or to the underdevelopment of the capital market,6 an SHB is entirely dependent on government support. Funding loans through budgetary resources opens the gate for abuses and market distortions as mentioned above. Moreover, it is an economically ine cient solution, since it results in stringently con- straining lending volumes and subjects them to uncertainty and volatility. Private lenders are never on an equal footing. Most of the limited number of examples of SHBs that have evolved successfully are banks that are issuing mortgage-related securities, thereby pioneering at the same time the devel- opment of the capital market: BancoEstado in Chile,GHBin a iland,Banco Hipotecario in Ar gentina, and Crédit Immobilier et H otelier in M orocco (which opened the MBS market in 2003). Alignment of Corporate Interest with Market Development e challenge of SHBs comes from mixing nancial objectives and social objectives. It is extremely di cult to keep a balance between the two series of incentives. Any organization that enjoys privileges and a rent situation will seek to maximize for itself the bene ts stemming from these advantages--a risk that not only exists in t he case of wholly state-owned banks, but also when private partners are associated with the structure. at is why it is of utmost importance to separate subsidies from nance and not let them become a source of income for the bank. Also, it is critical, besides good governance rules, to design business plans that clearly include performance objectives,de ne indicators, make the renewal of special advan- tages conditional on the achievement of objectives, and ensure the transpar- ency and the publicity of the actual achievements by the SHB. 6. An essential feature for a specialized, nonbank. An archetypical example of such an arrange- ment is Crédit Foncier de France, the inception of which in the mid-nineteenth century was backed by the simultaneous creation of mortgage bonds. state housing banks 261 Examples of SHBs Meeting These Conditions Success is de ned b y co ntributing t o t he o verall ma rket de velopment and p roviding nance t o under served ca tegories, w hile ac hieving s elf- sustainability both in t erms of nancial results and of funding. Very few SHBs are reported to have ful lled these expectations. In Asia, the GHB of ailand has been operating on a commercial basis without being dependent on state subsidies and has managed to run its com- mercial activities in a professional and competitive manner. Its leadership in lower-income housing nance rather re ects its strategic position vis-à-vis other lenders, than any privilege. e bank has played an innovative role and was a price leader during the takeo of the housing nance system during the 1980s and early 1990s. In Chile, BancoEstado is an example of where the market di erentiation between the SHB and other banks re ects di erent business strategies, not the existence of special privileges. Its case is reviewed as such below. Box 10.2. The Case of BancoEstado (Chile) BancoEstado--originally Banco del Estado de Chile--was created in 1953 through the merger of four state-owned S&L institutions. While historically mainly focused on lending for housing, it has recently engaged in strategic diversification and has become thethird commercial bank of the country. The bank's customer profile evidences the emphasis on low- and middle-income groups; * it has a 25 percent market share of mortgage loans in terms of value, but over 70 percent in terms of numbers of loans. Yet, the recovery performance of the bank on these loans is high, with a three-month delinquency rate steadily below 1 percent (0.62 percent in 2007) and better than the average of the Chilean banking system. ** Its net return on assets is satisfactory (0.48 percent in 2004­5), albeit lower than the coun- trywide average of 1.27 percent. The two key success factors are (1) BancoEstado has always been operated on commercial principles. Although the government appoints its board members, except one, its management is composed of profes- sionals rather than political appointees or civil servants. The bank is subject (continued) 262 housing finance policy in emerging markets Box 10.2. The Case of BancoEstado (Chile) (continued) to normal banking regulation and supervision, including asset-liability man- agement norms. Its shareholder, the state, imposes a strict profitability requirement: the bank pays a corporate income tax at a higher rate (40 percent) than private companies, and pays out 75 percent of its profits as dividends. The bank is managed with full autonomy vis-à-vis its sole shareholder. It is prohibited to lend to other state-owned entities. (2) BancoEstado has a large savings- collection network resulting in attracting a large population of small savers (80 percent of the country's savings accounts, but the average amount of its accounts is about one-third of other banks). Moreover, the active geographic extension policy allowed the bank to be the only financial institution present in 65 percent of the municipalities. Thanks to its customer base, and not because of some distri- bution privilege, BancoEstado is the main channel for housing subsidies. * Below the income threshold for bankability, it is the government that provides housing finance--until 2002 through mortgages directly extended by the Housing Ministry (with a very poor recovery rate); now merely through subsidies. ** This quality is of utmost importance for the cost of funds in Chile, where a large portion of mortgages are funded through bonds that are PT securities guaranteed by the loan originators and collateralized by the loan's portfolios. Fitch Ratings 2006. Housing subsidies in Chile do not pass through the accounts of lenders, but benefit directly to households, with a requirement of prior savings, and their allocation is neutral vis-à-vis the distribution network. Box 10.3. The Case of the Government Housing Bank (GHB) of Thailand GHB was established in 1953 under specific legislation with a dual purpose: housing finance and housing development. The latter activity was transferred to another government body, the National Housing Authority, in 1973, when the company experienced a crisis triggered by losses on its developer loans. The GHB was recapitalized and assigned a new strategy. It became a commercially run institution, which abides by good corporate governance rules, focuses on the quality of its portfolio, and posts positive results ($109 million in 2005 for assets totaling $13.3 billion). GHB developed a network of more than 120 branches, which allowed it to mobilize funding through its deposit base. GHB succeeded in combining the support to lower-income groups and the function of a driver (continued) state housing banks 263 Box 10.3. The Case of the Government Housing Bank (GHB) of Thailand (continued) for the whole market development. It does provide loans at below-market condi- tions, by concentrating on providing lower-income borrowers with the benefits of the advantages its enjoys as an SHB: lower spread on bond issues, absence of dividend, and, for a long time, lesser capital requirements than other lenders. Also, GHB participates in some government-lead social housing and slum upgrading programs--targeting households that the financial system would not serve. At the same time, GHB plays a role as a market developer. Its activity has not prevented the overall growth of the supply of finance for housing, provided now by 17 other players. It played a countercyclical function during the 1997­ 2001 fall of the mortgage market: while lending by commercial bank dropped, GHB's activity level remained the same and its market share jumped from its traditional 29 percent range to over 35 percent. It is sponsoring market infra- structure developments through its involvement in the inception of a retail credit bureau, a real estate information center, and a mortgage insurance scheme. In mid-2006, the Housing Bank announced a $1 billion issue of MBSs, the largest securitization transaction ever in Asia except Japan. Policy Alternatives Market de velopment ca n st art sp ontaneously, b ut t his is no t t he most common process. More o en, t here is a need f or a dr iving force, or a "market maker," to spark the growth of the supply in an embryonic market. Besides establishing a S HB, a g overnment may want to consider alterna- tive routes to broaden access t o housing nance. It must be stressed that whatever option is chosen, it cannot be successful if, in pa rallel, the basic obstacles that motivate the abstention of market players--mortgage lending infrastructure, st ability o f f unding, macr oeconomic co nditions, a nd s o forth--are not addressed. 264 housing finance policy in emerging markets Regulatory or Contractual Credit Orientation In s ome countries, credit direction has b een us ed to overcome market failures. In the United States, the Community Reinvestment Act of 19777 seeks to prevent "redlining" of underserved areas by imposing on banks minimum r equirements t o p rovide nancial s ervices--and, in t he rst place, o ering bank accounts. India is another example of administrative direction, with the concept of "priority lending" requirements, including for the housing sector, which lending institutions must ful ll. In underde- veloped markets, this approach can be ine ective if the basic environment remains weak, in pa rticular in t erms of adequate funding and e ective credit-risk management tools. In Nigeria, for instance, quotas for home lending--5­6 percent of total lending--had been prescribed in t he early 1980s, but remained ine ective because of the shortcomings of the lending environment, and despite sanctions provided for by the Central Bank. e regulation was dropped in 1993. A more fruitful approach, which can better take into account lenders' constraints, is to induce nancial institutions to serve lower-income groups through contractual arrangements. is is the route chosen by South Africa, where the largest commercial banks signed in 2005 a memo randum of understanding with the government, in line with the broader 2003 Finan- cial Sector Charter, in which they committed themselves to provide a cer- tain volume of loans to the low-income market segment over four years. Participating banks adjusted their lending policy accordingly, developed new products,8 and established new departments dedicated to a ordable housing loans.9 Second-Tier Institutions Instead of creating a p rimary market lender t hat may ultimately compete with or crowd out other lenders, a government may consider supporting a 7. Dia mond 2002. 8. See FinMark Trust 2007, Rust 2007 and 2008. 9. It should be noted that this solution is not without its problems. Issues surrounding sharing of credit and market risk have meant that it is not fully implemented in South Africa's town- ships. state housing banks 265 second-tier institution (liquidity facility or conduit as described in the capital markets chapter). ere are two potential advantages: a second-tier institu- tion may have a catalytic e ect on the market by opening up new funding channels, and it may reduce barriers to lending by mitigating uncertainties or additional risks that block market development. is approach only works if the primary market is su ciently developed and bond markets exist, how- ever. Government ownership or backing (for example, through guarantees) of a second-tier institution can be a more e cient form of subsidy because it bene ts the whole primary market instead of being reserved to a p rivi- leged circuit at the detriment of other players. ere are therefore convincing examples of secondary market facilities that have actually played a ca ta- lytic role in the development of the housing nance market (see the related chapter in this book). Such an approach, however, does not address in itself all the concerns described above, in particular the shortcomings of mixing nance and subsidies and the risk of the institution capturing part of the state support. Care must be taken to calculate and budget the contingent liability of such support, for which the institution must be an agent with duciary obligations rather than a recipient that is in a position to pass only part of it on to the market. Public-Private Partnerships Asanalternativetocreatingaspecializedhousingbank,agovernmentmaywish tostimulatemortgagelendingthroughstrategicinvestmentinorinitialsupport tohousing nancecompanies. eadvantagetothismodelcouldbetheability tocombineprivate-sectormanageriale ciencywithgovernmentpolicygoals. e main successful example is HDFC in India. HDFC, established at the end of 1977, was promoted by Industrial Credit and Investment Corporation of India (ICICI), the then state-owned development bank, and particularly by the personal involvement of its chairman. ICICI, however, only invested a small amount--5 percent of the total of seed capital in the new institution. e government also brought initial support by guaranteeing the company's long-term debt, and directed public-sector institutions, in particular, insur- ance companies, to nance HDFC. Moreover, a r egulation was pass ed that made loans to specialized housing nance companies eligible for the priority 266 housing finance policy in emerging markets lending obligations imposed on commercial banks. HDFC grew to become the main driver of the market development, acting as the promoter of other specialized institutions as well as the supporter of other housing-related ser- vices, while at the same time being a successful business. Key for this success was the actual, but limited, support by the government that did not con ict with a business model focused on recovery policy and resource mobilization. Such a combination has been di cult to replicate elsewhere up to now. HDFC helped establish similar institutions in other countries, for instance, Bangladesh and Ghana. Despite the expertise and dynamism of these two institutions, the model has not been successful as in India because of unfa- vorable context--lack of e cient external funding and negative impact of an SHB in one case, macroeconomic instability in the other. is shows that an institutional model is itself not enough, but that structural and environment conditions conducive to housing nance are required in any case. "Double Bottom Line"--Social and Commercial--Private- Sector Lenders ere is a n increasing interest around the world in co mbining nancial viability with social bene ts in sectors such as housing that are at the cross- roads of nance and social purposes. Instead of developing a p roprietary instrument, government may want to foster the development of entities susceptible to bringing business-based solutions to the needs of households underserved by the mainstream nancial sector. In many countries, there is an array of micro nance institutions or nancial cooperatives that can, or could where a proper environment exists, develop housing nanceproducts. is is the case in several African countries, for instance: Caisses Populaires du Burkina Faso, Nyesigiso cooperatives in M ali, Banques Populaires du Rwanda, and MUCODEC in Congo. In Paraguay, the quasi-sole providers of housing nance are credit unions or nancial cooperatives. Given the o en deep penetration of such networks in the income spectrum, they might be a more e cient use of public sponsorship than specialized state entities with a narrow scope. state housing banks 267 Exit Strategies For the countries where ine cient SHBs exist, there are few exit solutions besides winding them down. ese alternatives are constrained by the bank's condition and the nancial context in which it operates.10 Enable a "Corporatization Process" to Create a Commercially Run Institution Ensure the SHB operates on commercial principles (pro tability, as evidenced by tax and dividends-payment capacity, a condition for sustainability). is approach typically involves the removal of privileges and distortion factors to establish a level playing eld for other lenders. In turn, this requires the sepa- ration of subsidies from nance by having two separate balance sheets: one for the social subsidy program of the state managed by the bank, preferably for a fee, the other being the commercial balance sheet of the bank meeting the reporting standards of any commercial bank. e government must make sure that the housing bank falls under t he direct regulation and supervision of the bank regulators. Also, the corpora- tization process typically involves bringing in a new set of experienced bank managers who will instill nancial and administrative discipline. Two recent experiences illustrate this strategy: Pakistan, with the trans- formation of the HBFC, and Algeria, with the turning around of the once- crippled CNEP. HBFC, in Pakistan, established in 1952, was for a long time the sole pro- vider of formal nance for housing. HBFC was a n institution run by non- professional bankers. It relied mostly on Central Bank for its funding at below-market conditions. It did not target modest households as it should have, and had a very lax recovery policy. e government decided in the late 1990s to put HBFC back a oat, and to bring it up to acceptable e ciency standards with the view of eventually selling it to private investors. Shutting the institution down was s een as p olitically unfeasible since HBFC was a t that time the only lender of anysigni cance in the country. A recapitalization 10.A valuable perspective on state-owned banks can be found in C aprio, Fiechter, Litan, and Pomerleano 2004. 268 housing finance policy in emerging markets was carried out, mainly through Central Bank debt forgiveness. e granting of new credit facilities by the Central Bank was b rought to a hal t. Conse- quently, HBFC was ob liged to considerably reduce its new lending activity and to focus on payment recoveries, which had b ecome its only source of funding. A ne w management was a ppointed, chosen from among profes- sional bankers. A deep modernization of internal procedures and informa- tion system was undertaken, and corrupted practices were fought. Currently, new demand-driven products are being designed, and the participation of private shareholders in the company's capital is being considered. CNEP in Algeria is basically the Algerian savings bank, with more than 6 million accounts. It used to have the monopoly on real estate nance within a state-owned banking system, both for individuals and for public housing programs. e state massively used this savings channel for nancing public developers. For many years, CNEP operations were largely driven by admin- istrative and political criteria. Many loans were granted without clear prop- erty title, especially to public developers, to which land used to be allocated through sim ple administra tive allo tment let ters. M oreover, CNEP 's o wn development subsidiary was directed by public authorities to build programs that met low demand. Nonperforming loans ended up amounting to about 75 percent of the portfolio, including loans to the in-house developer. In 1997, the government bailed out the institution plan at a time where a deregulation policy opened real estate nance to other players. e "Caisse" was recapitalized and turned into a co mmercial bank subject to C entral Bank oversight--instead of being based on a speci c law and regulated by the Ministry of Finance. Part of the impaired public-developer portfolio was exchanged for treasury bonds. In a new restructuring plan in 2000­1, the government bought unsold stocks of housing units for DA 13.7 billion (US$180 million) and sponsored the selling of 35,000 other units. New ma nagement launched a f orceful reorganization, f ocusing on t he overhaul of the accounting system and on the recovery policy. e emphasis on recovery implied a fall in the production of new loans, but the recovery rate reached 85 percent on the pre-restructured portfolios, and 95 percent on the post-2000 production. Since 2004, CNEP has resumed more active lending. state housing banks 269 Partial or Full Privatization Bringing in ma rket dis cipline a nd eco nomic b usiness stra tegies ca n b e strongly buttressed if private partners, who will require pro table results and risk-based management, are brought in, w hile at the same time t he share- holding government retains a say in the general strategy of the institution. e danger with partial privatization, however, is that private investors may be rent seekers who exploit privileges rather than pursue sound business or development strategies.11 erefore, seeking to establish a private-public partnership should rely on a true commercial franchise for which the gov- ernment provides initial support, and should be accompanied by the dis- mantling of any market-distorting advantages. Banco Hipotecario in Argentina12 is an example of success in ac hieving the ass ociation o f p rivate sha reholders w ho p ursue a co mmercially o ri- ented policy and a government with enough in uence to guide the company toward market segments that are complementary of the mainstream banking sector. Banco Hipotecario Nacional was an SHB operating since the last years of the 19th century. In the 1980s, it was the main provider of mortgage loans in the country. Its funding sources were deposits from public sector entities and loans from the Central Bank.13 Its performance was increasingly poor. Its customer base shi ed upward in the income distribution. e bank incurred considerable mismatches between short-term liabilities and 25-year maturity assets that followeddi erent indexation mechanisms. Because of the discrep- ancy between the loan balance appreciation and housing prices, as well as a lax r ecovery policy, the portfolio quality drastically deteriorated, ending with a 67 percent rate of nonperforming loans. ese conditions resulted in a severe crisis, leading the Central Bank to intervene in 1987. Banco Hipote- cario Nacional's deposits were transferred to Banco de la Nación, and it was prohibited from direct lending. For a w hile, B anco H ipotecario N acional b ecame a w holesale lender extending loans through a netw ork of correspondent banks. In 1991­3, i t 11. e example of American government-sponsored enterprises shows that the bene t of gov- ernment support can be diverted not only by the corporation's sta , but by its shareholders. 12.See Cristini and Moya 2004 a nd Gautier, Hassler, Freire, Goytia, Clichevski, Cristini, and Moya 2006. 13. is is the opposite of the company's original concept, which implied the issuance of mortgage bonds. 270 housing finance policy in emerging markets went through a deep r estructuring. It contributed to the promotion of the market by providing funding to primary lenders. It developed original con- struction nance structures, set out underwriting standards for unsalaried borrowers, and entered into partnership with some provincial housing agen- cies in charge of low-income housing (Instituto Provinciales de Vivienda). In 1996, following a 1995 law that established a securitization framework, it pioneered the issuance of MBSs. e next step was to partially privatize the company, a part of a more gen- eral policy promulgated in 1996. I n all, 46 p ercent of the bank's capital-- from then on, Banco Hipotecario SA (BHSA)--was sold to private investors in early 1999. Interestingly, despite retaining a majority of shares, the gov- ernment handed over control of the board of directors to the latter, who appoint nine out of 13 directors. e privatization law authorized the bank to directly lend to primary borrowers again. In exchange for various obligations meant to support social policy goals,14 the law kept the bene ce of certain privileges,15 but provided for a sunset clause, set in August 2007. During this decade, housing nance surged in Argentina, with all the major banks o ering the product. BHSA retained a leading position in the market.16 e company`s recovery performance and pro tability strongly improved, and itbecamethe rst Latin American company to issue AAA mortgage securities in the United States. Yet, BHSA kept a special role in moderate- and middle- income market segments, resulting in particular from partnerships with local government assistance programs. e soundness of its operation was demon- strated by the way it overcome the 2001­2 crisis, despite being deeply a ected by it. It was t he rst Argentinean entity to reschedule its external debt, and reopened the domestic securitization market in 2004. NPL ra tio quickly fell below the 2001­2 crisis level.17 e company's main challenge is to diversify its funding sources and expand its deposit base. 14. e main obligations are to allocate 10 percent of the construction loans to small cities, to maintain a fund allowing debt forgiveness to borrowers in distressed economic situations, and to ensure a balanced geographical distribution of loans. 15.Income tax relief on loans extended before 1997, r ight of selling and managing mortgage- linked insurance products, and special procedures for forced sales. 16.BHSA market share jumped to over 30 p ercent of new lending a er the 2002 crisis, which brought mortgage lending to a halt for awhile. In terms of loans outstanding, its market share is about 20 percent. 17.A total of 7.3 percent of all loans at the end of 2005, and 5.9 percent in December 2006 (Fitch Ratings 2006). state housing banks 271 Conversion of an SHB into a Second-Tier Refinance Institution is option is ra re because it is g enerally not realistic. e administrative culture that prevails in many housing banks is incompatible with that of a capital market organization; in addition, the operations and systems would need a total overhaul. Although theArgentine case experienced some success in becoming--temporarily--a second-tier nancier, the example of Nigeria is more representative of the di culties of such a conversion. State Support to Private Sector SHBs o en are the sole, or at least the dominant, provider of housing nance (Brazil, Mali, Pakistan before 2003, and Uruguay). In this case, their opera- tion cannot be stopped suddenly: market capacities have to be built up rst or in parallel, for fear of depriving households of an already all-too-limited supply of nancial services. Several experiences can be mentioned as being very successful in avoiding an interruption in the nance supply, and in fostering the growth of alternate nance providers on a sound basis. In Jordan, the government in 1973 created the Housing Bank for Trade and Finance, according to the classic, pre-liberalization-era housing bank model: a special law, a sp ecialized activity, and implicit subsidies (t ax exemption, reserve requirements). e bank--which was a public-private partnership-- was conservatively run, with the objective of economic e ciency prevailing over political interferences. Its existence, however, was not favorable to the entry of new players in the market, and its actions did nothing to establish a source of long-term capital. erefore, the Jordanian government decided to change its status in 1997. Its speci c framework was removed, and it was authorized to become a full- edged commercial bank. e Housing Bank for Trade and Finance diversi ed its activities, and progressively stopped lending for housing. In the meantime, a second-tier liquidity facility, the Jordan Mort- gageRe nance Corporation (JMRC), was created with the purpose of raising capital from the nascent bond market and of lending this relatively long-term resources to any participating mortgage lender. As described in chapter 12, 272 housing finance policy in emerging markets Box 10.4. The Case of the Federal Mortgage Bank of Nigeria At the end of the 1960s, in the context of National Development Plans, the government of Nigeria developed a policy of direct intervention in the housing sector, both as a pro- vider of new units and of housing finance. The existing specialized lender, the Nigeria Building Society, was bought by the government, and, in 1977, converted into a new organization, the Federal Mortgage Bank of Nigeria (FMBN). Established on a specific legal basis, and wholly owned by the federal government, FMBN was entrusted with providing long-term housing credit, either as a retail or a wholesale lender. Its funding sources were the federal budget, the Central Bank, and the banking system, which was directed to allocate a minimum percentage of its lending to housing. The system proved ineffective. FMBN recovery performance was very low. The overall investments in housing dropped during this period. At the end of the 1980s and early 1990s, the government switched to a liberalization policy, and sought to foster private-sector lenders, but within a specialized, subsidized circuit led and supervised by public institutions. Primary mortgage institutions (PMIs) were established within a framework for specialized companies, modeled on building societies. FMBN transferred its primary lending activity to a state-owned PMI, the Federal Mortgage Finance Limited, to become a second-tier refinancier and also the regulator and supervisor of the PMIs. * In 1992, the National Housing Fund (NHF), mainly funded by mandatory contributions from salaried employees, was created to provide funds at below-market conditions to the PMI system through FMBN. The new structure failed to have any catalytic effect on the supply of housing finance. The Federal Mortgage Finance Limited, which inherited a portfolio of mostly nonperforming loans from FMBN and had excessive operating costs, did not play the expected role of market leader for PMIs. It was liquidated in 2004. FMBN suffered from impediments affecting the role of the NHF, both from cumbersome procedures in its PMI refinancing activity and from poor management that translated into recurrent operational deficits. The FMBN-NHF channel provided the equivalent of only $40 million in mortgages over 13 years (excluding developer loans). As part of a broader policy revision, FMBN's business model is being revised. FMBN should become a second-tier facility channeling capital market resources toward primary lenders, a perspective that became realistic with the establishment of fully funded pension funds in Nigeria. * The oversight function was transferred to the Central Bank in 1997. state housing banks 273 JMRC has had an impact in setting quality standards for loan origination and servicing and improving the lending terms. It became a catalyst and triggered the entry of new mortgage lenders. In all, eight banks are now active in the mortgage market and their supply of loans did much more than o set the withdrawal of the Housing Bank for Trade and Finance. In Pakistan, while the housing bank HBFC was being overhauled, a con- ducive framework for lending for housing in g eneral was est ablished: an out-of-court foreclosure procedure was created (2001), credit reporting sys- tems were developed for loans to individuals, tax incentives were devised for mortgage borrowers, and a str engthening of the real estate developer industry was p romoted. Comforted by a no ticeable improvement of the macroeconomic environment, in particular by a sharp fall in interest rates, commercial banks entered the market. In less than two years (2003­4), 20 lenders were active and together o ered a higher volume of nance than the hitherto dominant HBFC. In Korea, the evolution of the SHB was quitedi erent. e Korea Housing Bank (KHB) operated on a commercial basis from the day of its creation in 1967 within a nancial policy environment of strong directed credit as the only mortgage lender. A critical step took place in the 1970s, when the gov- ernment agreed to separate social operations from the balance sheet of KHB and to nance the NHF from explicit scal resources; KHB was paid a fee to service the loans. KHB's charter changed from a specialized to commercial bank and became the Korea Housing and Commercial Bank (KH&CB) in 1997. e new charter, however, committed KH&CB to making no less than 50 percent of its loans to housing. e Ministry of Finance also maintained its power to appoint senior executives. In order to strengthen its performance by means of strategic investors, KH&CB became the rst Korean bank to be listed on the New York Stock Exhange the same year. KH&CB was among the small minority of banks that weathered the 1997 nancial crisis unscathed because it did not make loans to large business groups, or chaibols. It main- tained a bad loan ratio of below 3 percent. In 2001, KH&CB had become the largest commercial bank in Korea through its merger with Kookmin Bank. Today, Kookmin Bank (the name the merged institution retained) maintains it quasi-monopolist dominance of the mortgage market and it remains the sole servicer of the NHF social lending. Together, the two portfolios repre- sent 85 percent of the Korean mortgage market. Meanwhile, the new govern- 274 housing finance policy in emerging markets ment-owned Korea Housing Finance Corporation started operating in 2004 as a secondary market institution that aims to diversify mortgage distribu- tion channels and to lower the heavy dependence of the Korean market on ARM loans of very short maturities. Conclusion: A Decision Tree for Policy Makers One major problem with SHBs is that they apparently ll a vacuum imme- diately and provide loans for a f ew years before the risks and distortions embedded in the model start unfolding on a full scale. It is therefore critical that policy makers draw the lessons from the past and from other countries, and clearlyde ne the goals they want to achieve before jumping to a solution that seems an easy answer in the short term, but tends to becomea scal time bomb or an impediment to market development. e question that is the root of many others is whether the government wants primarily to provide nancial services itself, and replace the market, or develop the market as deeply as possible. If the second option prevails, the next q uestion is t o determine what prevents the commercial sector from o ering this service. If, as is usuall y the case, the answer lies with fundamental de ciencies in the market infra- structure and environment, the government's priority should be to focus on remedying such de ciencies. Establishing a st ate entity under suc h condi- tions will do little good, as the state-owned housing bank will encounter the same problems as commercial lenders (and more so given the di culties of a government lender in co ntrolling risk through underwriting and collec- tions). Establishing a secured lending environment, providing access to ade- quate funding sources, and ensuring macroeconomic stability, in particular a decline of risks premiums included in interest rates, will likely trigger the growth of lending for housing. If the main obstacles rather lie with the strategies of mainstream banks, which prefer other business lines and are not keen to invest in housing loans, then a government may want to support the emergence of "market makers" susceptible to having a catalytic e ect on market development. is can take the form of specialized institutions as in India or Mexico, with indirect gov- ernment support, or of second-tier institutions as in J ordan or Malaysia, state housing banks 275 along with a strategy of improving the legal and regulatory infrastructure. If the market failure mostly a ects lower-income groups, the government may want to strengthen alternative lenders that "naturally" cater to their needs. It can also devise an assistance policy--direct demand subsidies, support to mortgage insurance or to savings for housing scheme--opened to any loan distribution channel, which can provide the required incentives for private institutions to enter new market segments. If a ne w institution seems de nitely needed to drive the market expan- sion or deepening, governments should prioritize the second-tier facility model. is model will beine ective without a conducive environment, both in the primary mortgage market and on the capital market. Moreover, to be successful, it also requires good governance rules and a clear distinction between subsidies and corporate results. It is only when none of the options of this decision tree are feasible that the SHB concept should be considered--and preferably not as an exclusive implementation tool of the development strategy. But many conditions must then be met: all of the above plus good governance principles, sunset clauses on regulatory or nancial privileges, and a road map toward privatization. is is the best way to ensure that the institution is demand driven and has successfully established a new market. Chapter 11 Housing Provident Funds Loïc Chiquier A common problem in emerging markets is high levels of in ation, which discourages s avings co mbined wi th unde veloped ca pital ma rkets. es e problems conspire to limit any activities that would rely on the availability of long-term funds. A solution to this problem seen in a number of emerging markets is the creation of housing provident funds (HPFs). ey are essen- tially long-term saving schemes that operate through mandatory contribu- tions. While this can be an e cient and rapid way of raising long-term funds in environments where this would not otherwise be possible, it can also engender a number of costs. One of the main di culties is in ensuring that the HPF does not distort market pricing through unrealistic and regressive subsidies. is chapter reviews some of thedi erent models and structures of HPFs, as well as some issues that have arisen with their creation. Description of HPF HPFs are specialized nancial institutions that collect mandatory savings from employees--from the public or private sector--expressed as a de ned 277 278 housing finance policy in emerging markets percentage of their salary. Sometimes the employers are also required to make additional proportional contributions (for example, one-to-one match in China). e HPF then manages these accrued long-term savings, which areo en remunerated at a below-market yield. is permits the contributing members of the HPF to · withdraw their accrued savings as a do wn payment for a ho using investment (but they cannot otherwise withdraw their savings before retirement); · receive long-term housing mortgage loans, usually at a preferential rate (either directly lent by the HPF or through another lending insti- tution); · bene t from retirement savings as addi tional income to the retire- ment system; and · receive unemployment severance payment (in some cases). e organization, products, and governance of HPFs are shaped to re ect their multiple functions. Although they act as dep osit takers and lenders, they are not banks and are o en not regulated as such (in terms of capital adequacy, provisioning, nancial oversight, and so on). Although they pro- vide retirement bene ts, they are neither regulated as a pension fund or sub- ject to investment limits and performance benchmarks. ey are typically created through a speci c law, or in some cases their existence is laid out in the constitution. eir activities and products are determined by law. Subsidies HPFs were o en created when and where private lenders were not active in long-term housing lending, as a self-funded housing nance system capable of producing a sizeable amount of new housing loans. HPFs have been created in many emerging economies, including Mexico, Nigeria, Brazil, Jamaica, the Philippines, and China. Although o en plagued by nancial ine ciencies and regressive cross- subsidies, their market shares in ho using nance can be quite signi cant. ey ma y e ven do minate r esidential ma rkets (70 p ercent ma rket sha re housing provident funds 279 together for the HPFs in M exico at the end o f 2005), ma inly as t he result of the recurrent and quasi-tax nature of their collected mandatory savings. A er reaching a cruising regime, the re ows from the portfolio can also be recycled into even more new loans. In other cases (for example, the National Housing Trust in Nigeria), they fail to provide any sizeable funding to develop a critical mass in the housing nance system. is occurs because employees try to avoid paying their con- tributions when the interest rates on saving are negative in real terms, and the proportion of savers to borrowers is exceptionally low. HPFs o en nance favored population groups in preferential credit con- ditions, but not necessarily among the lower- or informal-income segments. HPFs are then exposed to considerable political pressure and interference from changing governments. Most of the time, this is t o the detriment of their nancial sustainability as lendin g institutions and pension funds, as seen, for example, in the Philippines (Filipino Development Housing Fund; PAG-IBIG) or Mexico (Fondo de Vivienda para los Trabajadores al Servicio del Estado; FOVISSTE]). In Mexico, the other large HPF (INFONAVIT) has been restructuring to improve its e ciency and governance. eir implied level of cross-subsidization can be larger than any other state program of housing subsidies. It depends mainly on three core factors: (i) the proportion of contributing savers who will ne ver receive a lo ng-term housing loan (but have their savings under-remunerated to the detriment of their future pensions), (ii) the interest rate gap below market levels for the savings and credits, and (iii) t he mortgage portfolio performance (the less performing, the more ine cient subsidies). is system of cross-subsidies is o en socially regressive. e proportion of borrowers to savers is lo w by arithmetic necessity, given the relatively large amount and long-term nature of housing loans (less for eligible home improvement purposes). is reality is no t necessarily an issue, except if the loan interest rates are subsidized by the under-remunerated savings of the contributing members. Informal-income households also do not access these preferential credits as they are not formally employed. e problem of cross-subsidization is co mpounded when most o f the credit subsidies bene t higher-income households that could have a orded private-market loans, and are actually funded by lower-income employees to the detriment of their retirement. 280 housing finance policy in emerging markets Even in the favorable case of an HFP refocusing its preferential housing lending to the underserved populations to minimize t he regressive nature of cross-subsidies, it sacri ces its provident fund function to become an indirect taxation and redistribution vehicle, although (i) this role is o en not integrated within the national housing policy of the government (given the HFP legal and corporate governance structure), and (ii) thesesubsidies do not appear as on-budget scal expenditures (ine cient but sometimes perceived as convenient by some governments exposed to tight scal constraints). Governance e multiple mandates and legal f oundations of HPFs a re o en re ected through an ine cient corporate governance structure. e main body is a special council or board, composed of an excessive number of persons rep- resenting di erent stakeholders (several ministries, including labor, nances and housing, private construction and nancial sectors, trade unio ns rep- resenting the employees, and so forth). is o en results in a co mbination of a quasi-independence, poor accountability, and high degree of inertia in opposing strategic reforms. Once in operation they serve strong vested inter- ests--developers, unions, public sector workers--which makes it di cult to change (for example, moving away from subsidization, even if detrimental to the lower-income savers). Abuses and corruption are also encouraged by a lac k of transparency; for example, part of the credit subsidies may be wrongly captured by devel- opers when setting their sale prices, if households cannot freely choose their housing investment. e lending also su ers from administrative rigidities that con ict with industry standards and the nature of the market demand. A lack of transparency may a ect the process of credit and home alloca- tion. For example, many HPFs accept as housing investment only a home purchase (sometimes only a nished home built by a de veloper) versus a demand from poorer members for lower credit for renovation and repairs on their existing homes. ese funds can deter the rise of private mortgage markets, if ne w pri- vate lenders cannot compete against the HPF's preferential conditions. An uneven playing eld may be created by undue legal and regulatory privileges, housing provident funds 281 but also from the following strategic di erence: no private lender can survive substantial defaults by relying on contributions from member wages or by paying a negative real return on savings (as the Mexican HPFs did during the 1990s). Sometimes, HPFs als o enjoy the exclusive privilege to deduct loan payments directly from salaries (which is cheaper and safer), nor do they pay income taxes or have to reserve capital against unexpected losses. Development of an HPF Many variants exist, notably whether the HPF is a direct lender (as in Mexico and China) o r not (as in B razil or Singapore). But many HPF sha re some common features at a certain stage of their development: · low-income s avers cr oss-subsidize a smaller n umber o f b etter-o borrowers; · the accrued savings are not su ciently remunerated for retirement needs; · administration costs of HPF are high and the lending performance is poor; · their presence may hinder the expansion of other private lenders. A challenge in countries where private lenders enter the mortgage industry consists for the HPF in enco uraging private lending for middle-income households rather than competing against them. is implies a need t o revisit their own credit products (develop co- nancing, let other lenders use the savings as down payment or guarantees), better target their bor- rowers, im prove lendin g e ciency, na rrow t he in terest ra te ga p wi th market rate conditions, and target the subsidy element only for the under- served groups. Such reforms have been initiated in Brazil by the Fundo de Garantia do Tempo de Serviço (FGTS) and in Mexico by INFONAVIT. At a certain stage of their development, HPFs are confronted with a strategic choice between their functions as a p ension fund, housing lender, and sub- sidy distributor: If the priority consists in im proving the retirement of members while private mortgage markets may expand, HPFs should optimize and diversify 282 housing finance policy in emerging markets their investments rather than increase their market shares as a primary mort- gage lender. e housing lending should be then separated from the provi- dent fund operations, and the main activities focused on e ciently investing in a diversi ed way the savings through nancial markets (including market- based re nancing of other mortgage lenders). is evolution of a separation between the savings and then lending--see Singapore--o en represents the best scenario, when technically and politically feasible. If the assigned p riority mandate rather consists in facili tating housing nance for the underserved population, the HPF sho uld revisit its credit policy to better target its loans. Should it lend t o informal-sector workers who did not contribute through savings, strengthen all aspects of its lending operations, le verage o ther p rivate lender s t o s erve mem bers,1 p rice i ts housing loans according to market realities, target subsidies in a transparent and e ective way (ideally through lump-sum grants), or provide a comple- mentary second-lien housing loan to the main mortgage credit, which is pro- vided by another private lender (as developed in France)? International Experience China e HPF was initially introduced as a pilot program in Shanghai in 1991 and later extended nationwide in 1995, in o rder to kick-start a housing nance system that could carry on the housing policy reform (for example, trans- form housing from welfare to commodity). HPF o perations are now con- ducted through 320 management centers. e interest rates are regulated by the People's Bank of China, while the Ministry of Construction and Ministry of Finance are responsible for overseeing the scheme at the national level. At the local level, housing committees determine policies with the management centers. Commercial banks are appointed to handle the deposits, lending, and nancial management.2 1. For example, byco- nancing loans, as is now the case with INFONAVIT. But HPF savings can also be used as guarantees and down payments for other lenders. 2. In some cases, management centers also collect funds and provide nancial supervision. housing provident funds 283 ese savings earn a low interest rate. e participant's employer provides a one-for-one match to the employee's deposits. e employee can only use the funds for the purchase or major repairs of housing or to supplement retirement income. When purchasing housing, the member can withdraw the savings and obtain a loa n at a p referential rate. Upon retirement, the employee can withdraw the account for other purposes. By t he end o f 2005, HPF s avings r epresented RM 626 b illion co l- lected f rom 63.3 millio n em ployees. D espite a n RM 283 b illion mo rt- gage portfolio, their housing lending remains limited (versus 1.6 tr illion mortgage portfolio held b y commercial banks). Only 45 p ercent of col- lected savings has b een provided as housing loans and only 8 p ercent of savers are housing borrowers. Fund loans have performed well, with only a 0.12 p ercent delinquency rate as o f the end o f 2005. ese credits are not used very much by lower-income groups, but HPF ra ther competes with banks for upper-income borrowers. Despite preferential credit rates, their accessibility and impact remained limited. Over time, HPF lending has mainly bene ted upper-income households or privileged employees, but did no t help the many households that are unemployed or margin- ally em ployed. A t otal o f 80 p ercent o f HPF lendin g in B eijing w ent to t he purchase of hig h-cost housing, w hile in S hanghai 44 p ercent of lent f unds went to 4 p ercent of contributors. HPF lendin g is a r egres- sive p olicy in w hich the lower end o f the income distribution receives a limited bene t in t he form of reduced-yield savings, helping to cross- subsidize the loans to upper-income HPF participants. In addition, some HPFs ac t as ine cient lenders, for example, in p ro- cessing loan applications when compared to the commercial banks. ey are administratively managed, resulting in cumbersome procedures and market- unfriendly limitations. e loan amount is capped while housing prices keep increasing. ere are reported cases of corruption and misused funds for other priorities of a local government, notably when the local management center supersedes banks in controlling all nancial transactions. e performance of China's HPFs leads to several important policy lessons: · e HPFs were created as a means to create long-term mortgage mar- kets at a time in w hich banks were absent from the market. Since then, most banks have been competing on mortgage lending, so the 284 housing finance policy in emerging markets activities a nd ma rket p ositioning o f t he HPF sho uld b e r evisited accordingly (lower income, complementary funding, etc). · HPF preferential lending fails to meet the a ordability purpose, as its design favors higher-income workers. Most members will not receive a loan over their lifetime and are forced to save at below-market rates. e functions of subsidy and nance should be separated and subsi- dies better targeted. · e HPFs are insu ciently diversi ed (most of their assets are in real estate loans from a particular area). e system should be more con- solidated. · HPFs are regulated by the Ministry of Construction, which has no expertise in nancial regulation and which has a potential con ict of interest: the desire to develop housing as opposed to safe and sound lending. As a matter of safety and soundness, HPF activities should be regulated by a quali ed nancial regulator. Singapore Residents in Singapore are required to put a large proportion of disposable income into the Central Provident Fund (CPF). Virtually all employees pay as much as 35 p ercent of their gross income (for those 35 y ears of age or younger) into the CPF, which invests the savings in a diversi ed portfolio of domestic and international assets that earn a positive real return for partici- pants. e CPF acts as a pension fund rather than as a housing lender. A majority of housing nance is provided by the Housing Development Board (HDB), a g overnment agency that develops, nances, and manages housing. HDB requires a 20 percent down payment for its loans, and house- holds can borrow from the CPF for the down payment and amortization of their housing loan, but these funds must be repaid over time. e savings in the CPF are used for down payment and loan repayment but not for direct subsidized lending, which reduces the possible confusion of roles. In the past, HD B provided both market rate and subsidized loa ns. e Ministry of Finance lends to HDB at the government borrowing rate and the HDB provides interest rate subsidies to households according to need. As of 2003, HDB no longer provides market rate loans--households are expected housing provident funds 285 to ob tain cr edit f rom ba nks. HD B co ntinues t o p rovide co ncessionary interest-rate mortgage loans for rst-time at buyers and current HDB bor- rowers who are upgrading from smaller ats ( rst-time buyers and married households wi th c hildren r eceive p riority). e subsidized a nd ma rket- rate lending sectors are quite separate segments of the business. Borrowers obtaining market-rate credit from a bank can also use their CPF savings for their required down payment. In addition, housing loans account for only a small fraction of CPF uses of funds, so the CPF can operate in an actuarially sound manner to provide the highest return for its participants, in keeping with international standards for pension fund management. Mexico ere a re tw o la rge HPFs, o ne f or t he em ployees o f t he p rivate s ector (INFONAVIT) a nd t he o ther f or p ublic-sector em ployees (FO VISSTE). Both have been operating for more than 30 years. Both collect 5 percent of the salaries of employees through individual savings accounts (withheld at source by the employer). Both make direct mortgage residential loans to their members. e credits are quite subsidized in t he case of FOVISSTE. Members may withdraw their savings to use as a down payment to purchase a house, together with a loan from either their HPF or from a private lender. Any savings remaining at retirement are available to supplement retirement income. INFONAVIT loans are linked to an index of wagein ation, to which a spread is added that varies by income category, cross-subsidizing borrowers in lower-income segments. e two funds represent 70 percent of the Mexican mortgage market by the end o f 2005 (INFO NAVIT 60 p ercent, FOVISSTE 10 p ercent) despite a rapid growth of private-market lending by SOFOLs and banks. In partic- ular, INFONAVIT went through several operational reforms that helped to increase its share of primary mortgage markets.3 3. From 49 percent in 2000 to 60 percent in 2005 in terms of outstanding balance. As a share of the new 2005 production of mortgage loans, INFONAVIT weighted 67 percent and 44 percent respectively in number of loans and in loan amounts. 286 housing finance policy in emerging markets Box 11.1. The Reforms of INFONAVIT in Mexico INFONAVIT management implemented operational reforms during the last six years that have significantly improved the performance of INFONAVIT. The main blocks were to modernizing information and accounting systems, improving the procedures in mortgage origination and servicing, appointing external debt col- lectors, better tracking the evolution of employees who left their jobs (operational risk as one of the main reason of defaults), and creating new committees for risk management, auditing, and strategic policy. By lending according to mortgage industry standards, these reforms enabled INFONAVIT to increase its lending, improve the cash flows, and pay a return on savings comparable to private pension funds (Afores). INFONAVIT has adopted international accounting standards and made itself subject to the financial regulator oversight--Comisión Nacional Bancaria y de Valores--and is now subject to all reporting and control rules of commercial banks. The default rate has been reduced to 8 percent. Its savings pay a positive net real yield (3.5 percent in 2005), close to the net yields of private pension funds in the last years. But on average since 1997, its yearly performance has been lower by 0.4 percent than the private Afores. INFONAVIT has widened its cooperation with the private sector, providing its members with the ability to leverage their savings. Members may simultaneously originate the purchase of a house with one credit from INFONAVIT and another from a private lender. They may also use their INFONAVIT savings as a down payment for a loan originated by another lender. In order to grow, INFONAVIT has also initiated a securitization program. This move requires credit policy reforms in favor of more transparency, advanced systems, rigorous improved standards, and market-based pricing. So far, securiti- zation has been expensive through high over-collateralization ratios (between 18 and 23 percent). Any sizeable expansion would require more market-friendly and better-priced underlying loans. INFONAVIT has been targeting its subsidized lending only to the underserved households. Between 2002 and 2005, 76 percent of its originated loans went to individuals earning 7 times the minimum wage or less, a segment that is lightly served by SOFOLs, and not at all by banks. This means less regressive cross- subsidization. Despite this, INFONAVIT only lends to about 20 percent of qual- ified participants, and the ratio of borrowers to savers remains low. housing provident funds 287 Both HPFs su ered from political in uences and weak nancial manage- ment for many years, which resulted in a poor performance both as lenders and asretirementplans. ey were under pressure to provide subsidized housing loans to favored groups, and extensive forbearance to borrowers, with the same moral hazard issue as faced b y any other public lender. Prior to 2000, b oth recorded default rates on mortgage loans in the excessive range of 30 to 40 per- cent. INFONAVIT paid negative real rates of return on savings during much of the 1980s and 1990s, while FOVISSTE built up a funding shortfall. Most mem- bers failed to receive a loan, and had not much le to collect at retirement. ese HPFs found it hard to reconcile their functions as housing lenders, subsidy distributors, and pension funds. ey had to ration credits (by 2000 only one loan for seven savers at INFONAVIT), which remain accessible only by the formally employed minority. Despite governance reforms, the risk remains that future governments may return to politically in uenced nancial policies. ey cannot represent the sole and maybe even the main solution to resolve urban housing shortages, or to extensively lend for a ord- able housing (they will soon reach a plateau level). All these reforms correspond to major improvements, but have not resolved the internal con icts between its roles as lender, pension fund, and subsidy pro- vider. ere is an inherent con ict between maximizing returns for savers and providing low-cost mortgage nance through cross-subsidies. Will the core functions as a housing lender and as pension fund require further separation? FOVISSTE has made less p rogress than INFONAVIT, in terms of oper- ational reforms and corporate governance. It is now developing new auto- mated systems and streamlining its business processes, but more remains to be done: management reforms, external audit committees, basic data on the portfolio and its performance, oversight by Comisión Nacional Bancaria y de Valores, and international accounting standards. FOVISSTE also provides deeper rate subsidies than INFONAVIT, but itse ect on the market is limited because of its restricted membership base. Brazil Most of the housing nance system remains funded by the FGTS, which operates as an HPF. In 2005, the FGTS provided R$5.5 billion of on-lent 288 housing finance policy in emerging markets housing credits, plus R$1.2 b illion of complementary up-front housing subsidies (448,000 loa ns, inc luding 150,000 micr o-consumer loa ns). I n 2006, the FGTS should reach R$10 billion for housing credits and R$1 bil- lion in subsidies. e FGTS collects a le vy of 8 p ercent of all f ormal private-sector sala- ries (inc luding t he em ployees f rom g overnment-held co mpanies). is total represents an impressive amount each year (4 percent of GDP). es e contributions are credited to "accounts" of individual workers. Savings are remunerated at tasa referencia (reference rate) plus 3 percent, which is the minimum imposed by FGTS law but stands below in ation. By comparison, voluntary housing savings--SBPE system managed though most banks--are much better remunerated (yield higher by 3 percentage points), and short- term rates from Sistema Especial de Liquidação e Custodia are even higher. Its performance as a pension fund has been poor, and its own administra- tive costs high. e savings become available to the worker in case of lay-o , retirement, or for application to housing expenditures. Although severance and retirement may be provided to only the contributing members working in the formal sector, housing loans may be granted to any eligible borrower, even if not contributing to the FGTS. Part of the accrued savings are invested into treasury securities, while another part is invested into infrastructure loans and housing loans at a rate of return of tasa referencia + 6.2 p ercent (considerably below free-market mortgage rates). Every year, the council decides how much funding will go to housing loans (recently expanding but historically quite uctuating and unstable contributions), as the fund is also subject to political pressure. e FGTS does not directly extend mortgage loans but nances the Caixa Econômica Federal (Federal Housing Bank; CEF), a st ate-owned bank that is both the sole operator of the FGTS for originating and servicing housing loans, and the appointed management agent of the FGTS (part of this role consists of guaranteeing a return to the FGTS even if other lenders fail to per- form). e spread charged by the CEF is 2.16 percent. e system is designed to pay back to the FGTS a xed remuneration of tasa referencia + 6.16 per- cent, and discriminate credit rates across di erent borrowers (subsidized rates only for low-income ones). housing provident funds 289 is system has nanced a ra tioned number of loans. A la rge part of the portfolio was non-performing when CEF needed t o be recapitalized in 2000.4 e FGTS program has been gradually but steadily re-focused on the lower income groups with 77 percent of the number of loans going to households with incomes less than 5 times the minimum wage. In 2005, this movement was pursued with the FGTS stopping new lending to higher income groups (10 times the minimum income) and introducing upfront subsidies for lower income households (less than 5 times the minimum income). e next c hallenge co nsists in b roadening t he distr ibution o f t hese housing nance resources through to other competing lenders, which could distribute this attractive program (reduced credit risk by the upfront subsidy and the cheaper credit rate). Philippines PAG-IBIG is an HPF, which operates as a p ublic corporation with its own board of trustees. Its mandates are multiple, including investing the collected savings into assets for retirement purposes, and directly lending for housing both to developers and to the employees-members (a retail portfolio of about a half-million households). e portfolio is hig hly subsidized (t he less t he loan amount, the cheaper the interest rate, which ranges between 6 and 12 percent). Special devices have been introduced to improve debt recovery (penalties for late payments, rent-to-own leasing, loan restructuring). PAG- IBIG is a p ublic housing lender t hat leads the market. It is f unded by the savings contributions (mandatory since 1994; b etween 1 a nd 2 p ercent of the wages for the employees according to their wage, and 2 percent for the employers). It has b een tapping bond markets since 1997 t o increase its funding capacity. Its w eaknesses lie wi thin subst andard nancial r eporting, w eak ass et liability management (increasing pressure for additional liquidity), tech- nological gaps, high proportion of non-performing loans (NPLs), in suf- 4. Until 2001, a large number of nonperforming loans characterized the balance sheets of CEF and Banco de Brasil. e federal government absorbed those loans at a net cost o f approxi- mately 6 percent of GDP, three-quarters of which was due to the restructuring of CEF. 290 housing finance policy in emerging markets cient delinq uency ma nagement, a nd ineq uitable cr oss-subsidization between savers and borrowers. e more its lending is under performing and cross-subsidized, the lower its performance as a provident fund for the taxed employees. Its subsidized lending also hampers the growth of private mortgage lending. ese features suggest the need f or strategic choices, depending on whether other sources for low-income housing nance may emerge, according to the level of macroeconomic stability, and the health of the mortgage nance system (historically plagued by ine ciencies and high risks in the Philippines), as well as the capacity to nd mechanisms to lend to low-income households. Even if the case for such a special lending circuit based on mandatory savings is con rmed, the issues of default leakage and cross-subsidization need to be addressed. Nigeria National Housing Fund e National Housing Fund (NHF) was established in 1992 with the objec- tive of facilitating the provision of houses for Nigerians at a ordable prices, ensuring a constant supply of loans, and providing long-term loans to mort- gage institutions for on-lending to contributors. Nigerians earning Naira (N)3,000 or more per year (about $24 per year) are required to contribute 2.5 percent of their monthly income to the fund. is is a very low threshold-- it has no t been revised since t he inception of the system--which should result in including the near totality of the salaried workers in Nigeria. e fund could also receive voluntary contributions, thus allowing non-salaried workers to participate in it. In addition, commercial banks are theoretically required to invest 10 percent of their loans and advances, and insurance com- panies are to contribute 10 percent of their non-life funds and 20 percent of their life funds, but these provisions have not been enforced. Contributions earn a rate of interest of 2 percent. Loans are channeled through a special- ized circuit comprising the Federal Mortgage Bank of Nigeria, which runs the fund, and a network of specialized institutions. Contributors, and only them, can request a loa n a er having contributed for at least six mo nths. e amount of the loan is not related to the amount of contributions, but is subject to a ceiling of N5 million. Interest rate is set at 6 percent, well below market rates, which were 20 percent (all in cost) in early 2006. housing provident funds 291 e scheme has had li ttle success. It disbursed a c umulative amount of N5 billion in 13 years in individual loans.5 e number of bene ciaries were 5,250 at the end of 2005, compared to 2.8 million contributors--or a ratio of 540:1. NHF funds are e ectively accessible mostly by high-middle-income groups, which can a ord the mortgage payments on the loan amounts not covered by the NHF funds and can access bridge nancing before NHF funds are allocated--a process that can take more than two years. Partly because of the low probability of bene ting the system, the actual number of contribu- tors is moreover far below the theoretical scope--in the range of 12 million employees. Furthermore, it is said that diversions of contributions from their legal use take place.6 Voluntary contributions are insigni cant. A new legislation has been dra ed for NHF, which could partially remedy the aws of the system in tw o key aspects. First, the fund would be given the structure of a trust, and administered by a board of trustees compelled to stronger accountability obligations than now. S econd, the relationship between contributors and borrowers would be changed, possibly limiting the reverse subsidization mechanism: the wage level above which salaried workers would have to contribute would be raised to seven times the min- imum wage, and NHF w ould be entitled to lend t o noncontributing, low- income households. e law, however, would set interest rates at below the market level for both for savings and lending, thus giving a new legal comfort to a still potentially regressive subsidization scheme. 5. And N8 billion for developer nance. 6. I gbinoba 2005. Chapter 12 Mortgage Securities in Emerging Markets Loïc Chiquier, Olivier Hassler, and Michael Lea Despite its recognized economic and s ocial importance, housing nance o en remains underdeveloped in ma ny emerging economies. Residential lending is typically small, poorly accessible, and depository based. Lenders remain vulnera ble t o signi cant cr edit, liq uidity, a nd in terest ra te r isks. As a result, housing nance is relatively expensive and o en rationed. e importance of developing robust systems of housing nance is paramount as emerging-economy governments struggle to cope with population growth, rapid urbanization, and rising expectations from a growing middle class. e capital markets in many economies provide an attractive and poten- tially large source of long-term funding for housing. Pension and insurance reform has created large and rapidly growing pools of funds. e advent of institutional investors has given rise to skills necess ary to manage the complex risks associated with housing nance. e creation of mortgage- related s ecurities (b onds, pass-t hroughs [PTs], a nd str uctured nance instruments) has p rovided t he m ultiple in struments b y w hich ho using 293 294 housing finance policy in emerging markets lenders can access these important sources of funds and better manage and allocate part of their risks.1 e use of mortgage-related securities to fund housing has a lo ng and rich history in ind ustrial countries. Mortgage bonds were rst introduced in Europe in the late 18th century and are a major component of housing nance today (EMF 2005). M ortgage PT securities were introduced in the United States in t he early 1970s a nd along with more complex structured nance instruments now fund more than 50 percent of outstanding debt in that country. Today, mortgage-related securities have been issued in almost all European and many Asian and Latin American countries. ere have been numerous attempts to develop mortgage securities to secure longer-term funding for housing in emer ging economies. e view has been that such instruments can help lenders more e ciently mobilize domestic savings for housing, much as t hey do in ind ustrial countries. In addition, mortgage securities are pursued to develop and diversify xed- income markets as a co mplement to government b onds for institutional investors. Despite the strong appeal of nancing housing through the capital mar- kets, there are signi cant barriers to the development of mortgage securities in emerging markets. eir success is dep endent on many factors, starting with a proper legal and regulatory framework and liberalized nancialsector, and including a developed primary mortgage market. Perhaps not surpris- ingly, the experience in developing mortgage securities in emerging markets has been mixed. is paper reviews that experience and explores the various policy issues related to this theme, including the supportive role of the state. e organization of t he chapter is as f ollows. First, t he rationales for introducing mortgage securities to fund housing are reviewed. Second is a discussion of the many prerequisites that underlie successful introduction. ird, there is an exploration of the role that government can play in devel- oping these instruments, from both a theoretical and functional perspective. Fourth is an examination of the experience of issuing mortgage securities in selected emerging markets, including a summary of the lessons learned from 1. For a comprehensive review of securitization activities in emerging markets, see Merrill Lynch Guides to Emerging Mortgage and Consumer-Credit Markets, vols. I­III. For detail on security types, see Davidson, Sanders, Wol , and Ching 2003. mortgage securities in emerging markets 295 these experiences, both in general and with speci c reference to the proper role of the government. Why Are Mortgage Securities Important? Mortgage securities can perform a number of valuable functions in emerging economies. eir introduction and use can improve housing a ordability, increase the ow of funds to the housing sector, and better allocate the risks inherent in housing nance. In economies with pools of contractual savings funds, mortgage securities can tap new funds for housing. Institutional investors (pension, insurance funds) with long-term liabilities are potentially important sources of funds for housing as they can manage the liquidity risk of housing loans moree ec- tively than short-funded depository institutions. Investors that specialize in certain securities can broaden the types of loans and borrowers served by the primary market. Securities issued against mortgage pools may vary widely in their duration and credit quality, so di erent investors can select the securi- ties that meet their particular preferences. An increase in the supply of funds can, all other things equal, reduce the relative cost of mortgage nance and improve accessibility to nance by the population. e resulting increased liquidity of mortgages helps to reduce the risk for originators and their required risk premium. e ability to dispose of an asset within a reasonable time and value, a crucial factor for mobilizing long-term resources, is a s ervice that capital markets, as opposed to banking systems, can provide. A frequently expressed reluctance of primary-market nancial institutions to provide housing loans is a lack of long-term funds. is is not only a matter of availability of resources: deposit-taking institutions can be cash rich, but be rightly concerned by the management of their liquidity situ- ation over a long period.2 Access to the long-term funds mobilized by insti- tutional investors can reduce the liquidity risk of making long-term housing 2. ere is a degr ee of speciousness to this argument, however. In most countries, depository institutions have a core of long-term deposits. Although the contracts may be short term, they are typically rolled over and can fund long-term housing loans. An institution can provide a signi cant percentage of its loans for housing while accepting only a mo dest amount of liquidity risk. is statement frequently masks other reasons for not providing housing loans, including high transaction costs, high perceived credit risk, and so forth. 296 housing finance policy in emerging markets loans and lengthen the maturity of loans, thus improving a ordability, par- ticularly in low-interest-rate environments. A third rationale for introducing mortgage securities is to increase com- petition in p rimary markets. e development of capital-market funding sources f rees lender s f rom ha ving t o de velop exp ensive r etail f unding sources (for example, branch networks) to mobilize funds. Securitization, for example, can allow small, thinly capitalized lenders who specialize in mortgage origination and servicing to enter the market. ese lenders can increase competition in t he market and can lower margins and introduce product a nd t echnology inno vation in to t he ma rket. e exp erience o f Australia in the 1990s provides dramatic evidence of the power of capital- market-funded lenders to change a market (Gill 1997). e market entry of wholesale-funded specialist lenders led to a reduction of 200 basis points in mortgage spreads during the 1994­6 p eriod. e subprime markets in the United Kingdom and United States were created by new entrant specialist lenders funded through securitization. Increasing competition and specialization can in turn increase e ciency in the housing nance system. Greater specialization can lead to cost-savings and reduce spreads. e phenomenon of unbundling has b een associated with development of secondary mortgage markets. As the functional compo- nents of the mortgage process are unbundled, specialists emerge and obtain market share through scale economies in processing, access to information, and technology and risk management. Capital market funding can also help smooth housing cycles. Lenders relying on deposits may be subject to periodic out ows because of economic downturns or widening di erentials between deposit and alternative invest- ment rates (for example, if deposit rates are regulated). Access to alternative sources of funds through the capital markets may allow lenders to keep pro- viding housing nance throughout the cycle.3 3. e subprime credit crunch of 2007 demonstrated that securitization can have destabilizing e ects as well. A combination of rising default rates on U.S. subprime loans and falling house prices led to a panic among investors in subprime and other non-government backed mort- gage securities as well as more complex mortgage-related securities (for example, collateral- ized debt obligations (CDOs)). eir refusal to hold or buy such securities not only shut o funding to the mortgage market but also destabilized the banking industry as trust in banks that held or lent against such securities disappeared. e interbank lending market was dis- rupted and overall bank lending declined, leading central banks in Europe and the United States to inject liquidity into the system in an attempt to stabilize the market. mortgage securities in emerging markets 297 Finally, there are general economic bene ts to developing capital markets, including nancial deepening, fostering economic growth, and improved sta- bility of the nancial system. e ability to spread risk and match maturities can stimulate investment and lower the cost of capital to lenders. Creating long-term assets can foster the development of contractual savings institu- tions by providing an attractive low-risk alternative to government debt. What Are the Prerequisites for Issuing Mortgage Securities? As part of the broader securities markets, mortgage securities also require a macroeconomic and scal environment conducive to the supply of good quality securities and demand for them, and a legal, regulatory, and institu- tional infrastructure capable of supporting e cient operation of the securi- ties market. Beyond the basics, t here must be a demo nstrable market need f or the type of funding o ered by the capital markets. It is almost al ways the case that capital market (wholesale) funding is more expensive than retail (typi- cally deposit) funding on a debt-only, non-risk-adjusted basis.4 Why would a mortgage lender look to the capital markets for funding? ere are three main reasons: · e lender may be capital constrained, as was the case of the Chartered Institute of Housing in Morocco during its restructuring period, or the Colombian Saving sand Loans a er their crisis. In such circum- stances, the all-in costs of wholesale funding may be less than retail funding, taking into account the high expense of equity capital, if the capital savings enabled by securitization (if t he lender ca n get the assets o the balance sheet for risk-based capital purposes) can more than make up for the higher cost of debt. From a balance sheet and regulatory-capital-management perspective, however, the lower- 4. at is before consideration of the operating costs of raising funds through branch deposits. ese costs are o en ignored or understated, as lenders may view them as xed or allocate them to other activities of the branch. e transaction costs of wholesale funding need also to be taken into account. 298 housing finance policy in emerging markets risk weight of residential mortgages may lead the lender to securitize other classes of assets.5 · e lender may be liquidity constrained. Wholesale funding may be cheaper than retail, particularly on the margin, where raising addi- tional funds through retail sources may entail pricing up the stock of outstanding deposits. Lenders may want to diversify their funding sources as well. Even if wholesale funding is currently more expen- sive than retail, a lender ma y wish t o create a w holesale funding channel to better manage liquidity and funding risk in t he future. e more liquid the lender, however, the less likely they are going to ascribe a liquidity premium to mortgages. e lack of securitiza- tion in ma ny Asian countries re ects the liquid conditions of the banks a er the scal crisis. However, overdependence on wholesale nance, as in t he use of specialst subprime lenders in t he United States or the United Kingdom can lead to institutional failure in the event of a market disruption. · e lender may have cash- ow risk management needs. For example, it may wish to o er products the characteristics of which are di cult to manage via traditional retail means, such as a long-term xed-rate mortgage (FRM). On-bala nce-sheet f unding of such loans entails signi cant cash- ow risk, both interest-rate risk if not match funded and prepayment risk if the borrower has that option. Lenders o ering reviewable ARMs (a common emerging market mortgage instrument in which the lender adjusts the interest rate at its discretion) will have less need to fund these through wholesale sources, as they entail vir- tually no interest rate or prepayment risk. As observed in Hong Kong, liquid and performing banks found little appetite for securitizing their mortgage loans despite the active presence of a p ublic secondary- mortgage company (Hong Kong Mortgage C orporation; HKMC). e countries with the greater proportion of funding coming from the wholesale markets (Denmark, Germany, United States) have high proportions of mortgage loans with extended xed-interest periods (Mercer, Oliver, Wyman2003). e objective of introducing FRMs for 5. For example, consumer loans with a 100 percent risk weight rather than residential mortgage loans with a 35 percent risk weight or even lower under the revised Basel Internal Risk Based Approach. mortgage securities in emerging markets 299 lower-income households in Korea is the main driver of the Korean Housing Finance Corporation's securitization activities. To supply funds there must be a demonstrable investor demand for mort- gage-related securities. Speci cally, there must be a class of investors with an appetite and capacity for securities backed by mortgages. O en the demand comes from depository lenders. More importantly, the demand may come from institutional investors such as lif e insurance companies or p ension funds. ese investors will have long-term liabilities and thus seek longer- term assets to match their cash ow and investment needs. When will in vestors be interested in mo rtgage-related securities? er e are several prerequisites: · Mortgage securities must o er attractive risk-adjusted returns. In most cases, institutional investors will lo ok to mortgage securities as a n alternative to government bonds that provide a benchmark yield, as they typically represent a default-risk-free, liquid-investment alterna- tive. Investors will seek a premium over government bond yields to re ect credit risk, liquidity risk, and transaction costs of purchasing and managing the assets. When this premium is insu cient, as was the case in Russia for the mortgage loans purchased by the public sec- ondary mortgage company (Agency For Housing Mortgage Lending, a sizeable development is unlik ely to occur, beyond the ine cient scope of any mandatory investment. Any large-scale development of MBS markets in China is limited by the relatively low yield of mort- gage loans (less than 6 percent); in addition, issuers may not be found among banks that do not face capital or liquidity constraints (given abundant and cheap core deposits). e premium required by inves- tors may be reduced if credit enhancement (either by third parties or through structuring) is credible and if there is some market liquidity (for example, if there are market makers committed to trade at posted prices with acceptable bid-o er spreads). Likewise, mortgage securi- ties can be an alternative to corporate bonds, o ering greater security re ecting their collateral. · Investors m ust have a ca pacity for mor tgage-related s ecurities. In markets in w hich g overnments a re issuin g deb t ex cessively, t he 300 housing finance policy in emerging markets capacity of institutional investors to purchase mortgage securities may be limited or nonexistent (that is, the government may crowd out other issuers). Capacity may also be related to the liability mix of the investors. If investors have short duration liabilities, they will seek short duration assets as a ma tch. Investors may prefer short duration assets in volatile environments to minimize the price risk in their portfolios. · Investors must beable to invest in mortgage-related securities.Investors must have the legislative and regulatory authority to invest in such assets, and the regulatory treatment (for example, for capital ade- quacy, liquidity and asset allocation purposes, eligibility for technical reserves) must be well de ned. In many countries, such investment rules do not recognize the existence of speci c mortgage securities. Even if there are willing issuers and investors, there are a number of infra- structure r equirements underl ying t he de velopment o f mo rtgage ca pital markets. Without going into detail regarding each of the requirements, issu- ance will depend on: · An adequate legal, tax, and accounting framework for securitization and secured bond issuance. e accounting and tax treatment of mort- gage securities for both issuers and investors must be clear and com- plete--in particular, for the creation of bankruptcy remote-issuance vehicles (Special Purpose Vehicles [SPVs], Special Purpose Corpo- rations, Fonds Commun de Cr éances, Mutual Debt Funds, and so forth). Adequate disclosure of information on the collateral and the issuer is necessary to assess risk. Many countries have been struggling with such issues, such as Poland, China, and ailand, although prog- ress is being made on that front. · Facilities for lien registration. Mortgage securities are backed by mort- gage loans. ere must be an accurate and timely recording of the lender's interest in t he collateral. Recording of liens must involve modest cost as well. · Ability to enforce liens. Because investors can be last-resort bearers of the credit risk attached to underlying mortgages, the enforceability of the lender's security interest is a major determinant of the attractive- mortgage securities in emerging markets 301 ness of mortgage-related securities. If liens are not enforceable, there is little to distinguish mortgage-related securities from those backed by unsecured assets. · Ability to tr ansfer ( assign) s ecurity in terest. In th e ca se o f secu ri- tization, there is a tra nsfer of the lender's bene cial interest to the investor. e legal system must recognize and record the transfer and it should involve only a modest cost. In the case of mortgage bonds, the ability to transfer bene cial interest is important in the event of bankruptcy of the issuer. · Protection of investors against b ankruptcy of or iginator or s ervicer. e credibility of the legal provisions ensuring bondholders that the collateral backing their assets would stay out of the reach of other creditors in case of insolvency proceedings is of the essence. For secu- ritization purposes, the concept of an SPV or other construct that isolates the collateral pool from the issuer or servicer is essential to obtain o -balance-sheet acco unting a nd capital treatment f or t he issuer. e concept of a bankruptcy remote-issuance vehicle is critical for the development of securitization and is o en lacking in country law, notably in civil code systems. What Has Been the Experience in Emerging Markets? ere have been many examples of individual transactions by banks or cre- ation of institutions as securities issuers in emerging markets (table 12.1).6 ese tra nsactions ra nge f rom sim ple mo rtgage b onds t o co mplex pa y- through securities. ere have also been a number of mortgage-securities- issuing institutions created in emerging markets. 6. Mortgage bonds are bonds that are issuer obligations and issued against a mortgage collateral pool. Investors have a priority claim against the collateral in the event of issuer bankruptcy. Mortgage securities can be simple pass-through securities issued against a speci c collateral pool subject to cash ow matching or pay-throughs that are multiple securities issued against a single collateral pool. Pay-throughs modify cash ows between borrowers and investors to meet the needs or requirements of investors typically by prioritizing the repayment of prin- cipal across securities. Conduits purchase mortgages (typically accepting the credit risk) and issued mortgage-backed securities. Liquidity facilities make collateralized loans to primary market lenders funded through bond issuance in t he domestic capital markets. For more detail on the individual cases, see Chiquier, Hassler and Lea 2004. 302 housing finance policy in emerging markets Table 12.1. Capital Market Finance of Housing in Emerging Economies Structured finance Structure finance Mortgage bonds (Asia, Africa) (Latin America, CEE) Conduits Liquidity facilities Chile China Argentina Argentina India Colombia Hong Kong, China Brazil Brazil Jordan Czech Republic Korea, Rep. of Colombia Colombia Malaysia Hungary Malaysia Chile Hong Kong, China Mexico Kazakhstan The Philippines Mexico Korea, Rep. of South Africa Latvia Thailand Panama Trinidad Trinidad Poland Morocco Peru Thailand South Africa Trinidad Latvia Russia Source: Chiquier, Hassler, and Lea 2004. With a couple of exceptions, the percentage of funding obtained from the capital markets in emerging countries is low. Very early and for a long time, Chile has the highest percentage, mainly in the form of mortgage (covered) bonds. Hungary obtains over 60 percent of housing funding and the Czech Republic over half of its funds through mortgage bonds. Approximately 30 percent of funding comes through MBSs in Colombia. ere are several examples of successful introduction of mortgage secu- rities in emer ging markets, including mortgage bonds in Chile , the Czech Republic, and Hungary; MBSs in Colombia and Mexico, and liquidity-facility bond issuance in Jordan and Malaysia.7,8 Covered Bond Issuers e oldest example of capital market funding of housing in a n emerging country is the Chilean mortgage bond market. Covered bonds are the domi- nant xed-income instrument in t he market and enjoy widespread accep- tance without having ever received government guarantees. e Letras de 7. e main criterion of success is repeat issuance of standardized securities, a signi cant share of funding for housing coming from the capital market, and secondary trading in these secu- rity instruments. An additional contributor to success is t he ability to engender signi cant change in the primary market (for example, lengthening maturity, bringing new lenders to the market). 8. Although not reviewed in this chapter, the Home Mortgage Bank of Trinidad may also be con- sidered a success. Home Mortgage Bank was created in 1985 along similar lines as Cagamas. It has a similar structure and prerequisites as Cagamas and is the major nongovernment bond issuer in the country. Recently it evolved through MBS issuance and introduction of primary mortgage insurance. mortgage securities in emerging markets 303 Crédito (Letters of Credit) were reintroduced in 1977 a er the collapse of the Chilean S&L system. ey bene ted from the creation of private pension funds around the same time that provided a natural investor in the bonds. e Letras are issued by commercial banks and modeled a er the Danish mort- gage bond system with a full passthrough of principal and interest. Chilean mortgage bonds are general obligations of the issuer backed by preferential access to the collateral. ey provided nearly 70 percent of mortgage funding through the late 1990s. More recently, their share of mortgage funding has dropped sharply (down to 39 percent in 2005) as a dec line in interest rates created a wave of prepayments and a reduced yield for investors. Over half of mortgage funding now comes from bank deposits. e success of the Letras was followed by the introduction of Mutuos Hipotecaria Endosables (whole loan sales), which accounted for 20 percent of funding in 1999 before falling to 10 percent in 2005, and MBSs, which accounted for 6 percent of mortgage lending in 2005.9 By the criteria of issuance volume and share of total funding (over 50 per- cent in each country), covered mortgage bonds in the Czech Republic and Hungary can be considered a success. Both countries have passed robust leg- islation de ning the instruments that allow access by the dominant lenders, mainly commercial banks (as direct issuers in Czech Republic and indirectly in Hungary).10 In both cases, however, the bonds bene t from high subsidies that encourage their use. In Czech Republic, the bond interest is tax exempt. In Hungary, only mortgage banks (funded by covered bonds) can provide loans that qualify for a government program of interest rate subsidies, and most of the bonds have been issued by the mortgage banking subsidiaries of (OTP and FHB banks). e FHB mortgage bank issues bonds backed by the mortgage loans it has originated, but also backed by mortgage liens it has purchased from other commercial banks, which retain the loans and credit risk on their books. As such, the FHB ac ts as a cen tralized capital market funding source for other lenders that are not specialized or just have smaller portfolios (similar to a liquidity facility). 9. e Mutuos Hipotecarios Endosables are in particular issued by specialized originators. 10.Although mortgage banks have an 85 percent market share (2005), one of them, FHB, pur- chases the mortgage liens from partner commercial banks that retain all of the credit risk and therefore most of the margin. 304 housing finance policy in emerging markets MBS Issuers MBSs were issued by several mortgage banks in Colombia in the 1990s but the volume of issuance accelerated a er 1999 with the creation of Titularizadora Colombiana (TC) in 1999. B y 2005, TC had securitized over 30 percent of the outstanding mortgage stock. e company's securitization program has facilitated the restructuring of the mortgage market and banking system. TC has issued securities backed by NPLs and recently issued a covered bond. TC is a private conduit owned by the major mortgage lenders in Colombia (the International Finance Corporation [IFC] is also an investor). Its creation was prompted by a severe economic crisis combined with a portfolio mismatch that bankrupted the Corporaciones de Ahorro y Vivienda in 1998. Creating a new, well- capitalized intermediary to issue MBSsallowed these lenders to obtain needed funds from the capital markets at reasonable yields. Although the government has no ownership interest in TC, it provides tax exemption of interest on the securities. e government also provides--for an actuarial-based fee--timely payment guarantees on social housing loans securitized by the company (also available to other issuers). TC issues structured securities backed by speci c pools of mortgages. e securities are internally credit enhanced through a co mbination of subor- dination and excess interest with no ext ernal guarantees. ey have been successful in p lacing relatively complex securities in t he domestic capital as evidenced by the declining spreads associated with each issue, which fell from more than 5 percent to 2 percent from 2003 to 2006. MBSs have been issued by both public- (INFONAVIT) and private-sector (SOFOLs) entities in M exico. While more recent (the rst securities were issued in 2004), the issuance volume has steadily increased (over $1.8 billion in 2006) and the range of security features and forms of credit enhancement (public, private, international nancial institution) have expanded. Credit enhancement t hrough pa rtial mo rtgage in surance a nd s ecurity pa yment guarantees from a government development bank, the SHF, has been instru- mental in developing the market.11 SHF provides top loss mortgage insurance on individual loans covering up to 35 p ercent of exposure. Recently, SHF signed contracts with two U.S. private mortgage insurers to reinsure 70 per- 11. e SHF also functions as a liquidity facility, providing back-to-back loans to SOFOLs, funded through bond issuance. mortgage securities in emerging markets 305 cent of its risk. e companies will also enter the market as primary insurers in the future, with SHF gradually refocusing on social interest housing loans and special risks. SHF also provides partial guarantees on MBSs, with the issuer t aking a rst loss (subordination or over-collateralization) position.12 r ough 2008, SHF had provided guarantees on 49 issues for more than $4.5 billion13 SHF has encouraged private sector insurers and guarantors to enter the market. e private securitization market took o in 2007, wi th several SOFOLs issuing securities using internal credit enhancement or private guarantees. e largest SOFOL, Hipotecaria Su Casita, issued the rstpeso-denominated security and have sold portions of two issues in the United States. Starting in 2006, commercial banks began issuing MBSs, and the largest lender, INFO- NAVIT, has also had several issues without an explicit guarantee. By some criteria, Banco Hipotecario SA (BHSA) in Ar gentina could be considered a success. BHSA was successful in tapping international markets through issuance of structured, pay-through securities. BHSA showed how structuring could improve the marketability of mortgage loans, allowing it to break the sovereign ceiling with its securities. Although BHSA s ecuri- ties were not guaranteed by the government, it was exempt from the gross proceeds tax on the sale of mortgages; however, BHSA only concluded ve transactions before the devaluation crisis and therefore did no t have the opportunity to show that it was a sustainable model. Forced peso cation of the bonds led t o their default and demonstrated the risk of currency mis- match. Since the end of 2004, the bank has resumed issuing MBSs--for still short, but growing maturities--which are denominated in pesos and include innovative structured features. While BHSA acco unts for one-third of the market, the Argentine mortgage market is very small--less than 3 percent of GDP. Only 6 percent of funding comes from the capital markets. 12. e garantia de pago oportuno, or timely payment guarantee, is a credit enhancement at the deal level of the structure. Sometimes referred to as a partial guarantee, the garantia de pago oportuno is similar to a credit line. If the trust does not have su cient cash to make a given payment, the line of credit can be drawn to pay both interest and principal. Once the line of credit is repaid, it can be drawn down again, if the need arises. e fee to the provider of the garantia de pago oportuno is part of the expenses of the trust (see Crédit Suisse 2006). 13.Silva de Anzorena 2009. 306 housing finance policy in emerging markets Liquidity Facilities14 e largest and most successful liquidity facility has been Cagamas Berhad in Malaysia. It was cr eated in 1985 w hen the banking system was in t he midst of a liq uidity crisis. Its objectives are to help lenders manage risk, expand mortgage markets, and de velop private b ond markets. C agamas funded as m uch as 30 p ercent of the mortgage market in t he 1990s a nd has been the largest private debt-security issuer in t he country. Its re - nancing activities have been mostly conducted through purchases with full recourse, although it has started to conduct securitization activities as well more recently. A er the Asian nancial crisis of 1997­8, banks have been liquid and have signi cantly reduced their re nancing of mortgage loans to Cagamas, with its market share falling to 10 percent. Cagamas has also pioneered the capital market funding of Islamic loans, which may be a role model for other Islamic countries. e Central Bank is a mino rity owner of Cagamas but chairs its Board of Directors. is role has been providing comfort for private-sector inves- tors through an implicit state guarantee and a prudential policy. In the past, Cagamas' loans and bonds received favored regulatory treatment, including a low-risk weighting, eligibility for the interbank market for its bonds, exemp- tion from stamp duties for its purchases of mortgage loans, and an exemp- tion from statutory reserves for the re nanced lenders in order to help them meet their imposed quotas of social housing loans. ese preferences were eliminated in 2004. Until 2004, all o f Cagamas' purchases were for a xed period (three to seven years) with full recourse to the originating bank. Its bond issues are "agency" debt, unsecured obligations of the corporation but in e ect backed by its mortgage loan portfolio. It started to buy mortgages without recourse and issue mortgage pay-through securities in 2004, mainly to nance loans made to civil servants through a special program. e Jordan Mortgage Re nance Corporation (JMRC, a liquidity facility) has funded 13 percent of the outstanding mortgage debt JRMC has encour- aged more banks to lend and facilitated a lengthening of loan maturities. Its 14.See Hassler and Walley 2007. mortgage securities in emerging markets 307 volume of issuance accelerated in 2005 update?--the test will be whether it can sustain its success. JMRC was founded in 1997 to expand competitive mortgage lending by o ering re nancing of mortgage loans to banks. Its creation coincided with a nancial deregulation of the state housing bank that opened up the market for other lenders. It re nances banks that provide a pledge of their mortgage loans (120 percent over-collateralized) and issues private bonds. Similar to Cagamas, the Central Bank of Jordan is a mino rity shareholder and board chair, and JMRC-re nanced loans and bonds receive favorable regulatory treatment. It has achieved relatively low spreads on its bonds because of their low perceived risk. JMRC has had a ca talytic e ect on the mortgage market, which has grown to more than 11 p ercent of GDP. Borrowers have bene ted from longer mo rtgage t erms, lo wer ra tes, a nd hig her L TVs. A s wi th o ther liquidity facilities, JMRC's business uctuates with the market and the rela- tive liquidity of the banking system. JMRC is exploring the introduction of MBSs and Islamic nance. ere have been numerous less successful attempts at developing mort- gage capital markets. Many fail to generate an ongoing ow of business (for example, MBSs issued by Colombia S&Ls and Philippine banks and the gov- ernment pension fund, several securitization conduits [Cibrasec in Brazil, the Agency for Housing Mortgage Lending in Russia (until recently), the Secondary Mortgage Corporation in ailand]) and cannot be regarded as successful (from a business perspective), at least to date. Initially successful issues by government-owned conduits in Hong Kong and Korea have not been sustained, as banks are reluctant to sell loans and the entities securi- tize loans primarily from special programs.15 ere are various reasons for this lack of success, inc luding a lac k of investor acceptance, weak legal a nd regulatory framework, and securities being an overly expensive funding option. All the cases with limited results have attempted to use more complex security designs, usually pay-through 15. e Hong Kong Mortgage Corporation is a conduit owned by the government with an explicit guarantee for its securities. It has issued co rporate bonds, PT, and structured securities. It has also developed a mortgage insurance program with private-sector reinsurance. e Korea Housing Finance Corporation is a 100 p ercent government-owned conduit (successor to an earlier public-private partnership, Komoco) that securitizes loans originated by the National Housing Fund. 308 housing finance policy in emerging markets structures. ese instruments may be too complex for the markets in which they were introduced. ere are a n umber of countries still in a tak e-o phase, including India, Morocco (through two large and successful mort- gage securitizations piloted through a conduit to help the main housing bank Crédit Immobilier et Hotelier manage its liquidity needs), and South Africa. In these cases, there have been pilot issues a er many long years of develop- ment. It remains to be seen whether they will be successful on a larger scale. Although emerging market lenders have continued to tap the capital mar- kets since the onset of the global capital markets crisis it is clear that the pros- pects for continued growth will be adversely a ected.16 Safety and Soundness Regulation in Mortgage Capital Markets Mortgage-Backed Securities Securitization has broadened and deepened capital markets in many coun- tries, a nd mo rtgage s ecuritization in pa rticular has im proved access t o housing nance and reduced its cost. Well-structured MBSs a re attractive investments for pension funds and insurance companies. e securitization technology permits issuers to tailor cash ows to the needs of institutional investors. ese advances represent a broadening in the market for risk, and depend on an understanding on the part of investors that acceptable risks exist with less than a triple-A rating.17 On the other hand, weak management of investments in s ecuritization bonds has lead to a few spectacular bank failures (see box 8.5). Risks in secu- ritization include credit risk from the collateral and from the structure of the securitization trust, liquidity risk for the servicer and investor, operational risk for loan servicers and bond administrators, legal and reputational risks for the issuer, and, in subordinated bonds, more leverage than appearances 16.For example, TC, Su Casita, and the Korean Housing Finance Agency have all issued MBSs in 2008, albeit at wider spreads than previous issues. 17.International S waps a nd D erivatives A ssociation co mment t o B asel C ommittee, J anuary 2003. mortgage securities in emerging markets 309 might imply. Securitization has mo tivated new capital rules in t he United States and Europe, and now under the Basel II Capital Accord. Supervisors can encourage growth in the securitization market by setting ground rules for its operation. ese include standards for disclosures in the issuing prospectus, risk-based capital requirements for issuers, guidelines for assessing the capacities of institutions to issue and administer securitizations, and capital rules for investments in securitization bonds, particularly subor- dinated bonds. Central to understanding risk in securitization is the notion of "true sale." e pool of assets resides in a n SPV that must exist legall y separate from the issuer. ere can be no p ossibility for the issuer t o control the collat- eral or retrieve assets from the securitization pool a er the collateral pool is transferred to the SPV.18 In many countries, the notions of true sale and SPV require special legislation, or at least con rmation by the courts. When regulators rst look into securitization, they are o en tempted to view potential risks in terms of the strength of the issuer; however, in a true securitization, the SPV stands alone as a legal entity. e value of a securiti- zation depends upon the performance of the pool of collateral and the struc- ture of the securitization itself. In turn, these factors have little to do with the performance of the issuer. e only in uence that the issuer should have would be over the quality of servicing of the collateral pool. Securitization transactions can be complex. In understanding the risks and rewards of a given transaction, supervisors should ask a series of basic questions: How does the issuer p roduce earnings on the transaction? In each transaction, how has the issuer added value, and where does the value appear? In each transaction, who ends up with risk, and how much do they hold? What is each bond class worth to the issuer or to investors? What will it be worth tomorrow? What are the terms of the securitization that deter- mine the value of the bonds, given the performance of the collateral? e issuer should make the answers to these questions readily available to the market as a w hole, and to regulators via the prospectus, nancial reports, and conversations. Most PT securitizations create two basic classes of bonds: senior and sub- ordinated. e senior bonds have a priority of the principal and interest ows 18.Basel Committee 2004, 115. 310 housing finance policy in emerging markets from the collateral pool, and so receive a hig her rating and fetch a b etter price from investors. But risk allocation through securitization is a zero-sum game. e lower risk to the senior bond investors is o set by the higher risk to the subordinate bond investors. e cash ows and, as a result, the values of subordinate bonds are much more volatile than those of senior bonds. If a co llateral pool prepays or defaults at rates higher than originally expected, the subordinate pool may receive less cash ow, and so have less val ue. e protection a orded the senior bond (as well as the value of the subordinate bond) will depend on the magnitude and cash ows of the underlying collateral. us the rating and valuation will dep end on the accuracy of the forecasts of prepayment and default. Because increased defaults can destroy the value of the subordinate pool, many structured nance underwriters look to the servicer to retain the sub- ordinate bond. If the servicer buys the subordinated bond, it will have a sig- ni cant incentive to service the collateral pool e ectively, and make sure that the loans perform well so that the subordinated bond performs well. But then the transaction may not be o balance sheet. Holding the subordinate bond on balance sheet is riskier than holding the senior bonds. As a result, there are extensive rules in international accounting standards (IAS) regarding the valuation of such securities, and capital rules increasingly address that risk as well. e Basel II framework provides a set of requirements for asset securitization that are based primarily on agency ratings, but with special exceptions for subordinated tranches. Mortgage Bonds Like securitization, mortgage bonds are created from the cash ows of a col- lateral pool; however, distinct from securitization, the collateral pool and resulting bonds remain on the issuer's balance sheet as assets and liabilities. Mortgage bonds permit issuers to match the terms of funding and assets, and to issue long-term liabilities at a lower cost than general obligation bonds. Mortgage bonds are attractive investments for pension funds and insurance companies. Mortgage bonds can be legally simpler than MBSs, and the lack of customization can contribute to their liquidity. mortgage securities in emerging markets 311 Mortgage b onds provide additional s ecurity over a g eneral obligation bond of the lender, in that the cash ows of the collateral pool are pledged to support the bonds. e value of mortgage bonds remains linked directly to the nancial strength of the issuing institution. e presence of the collateral pledge can raise the rating on the resultant bonds by one to four notches, depending upon circumstances. In Europe, where mortgage bonds are a popular means of funding long- term FRMs, the collateral pool receives special protections in law.19 e loans that make up the collateral pool and the resulting bonds are o en recorded in an o cial register. In the event of issuer bankruptcy, the collateral pool is separated from the rest of the bankruptcy estate and made available to the bondholders under the management of a specially appointed manager. Rules govern the permissible assets that may be placed in the collateral pool, and they regulate the interest-rate risk possible in a mortgage bond by requiring complete matching between the collateral and the bonds. Many emerging countries permit the issuance of mortgage bonds, but few have the extensive legal infrastructure that support mortgage bond markets in Nordic and other European countries. As a result, few countries outside of Europe have truly extensive markets in mo rtgage bonds.20 Establishing a mortgage bond framework21 implies at least amendments to the bank- ruptcy law to allow the ring fencing of collateral, asset quality norms, and matching rules between the bonds and the cover pools. In addition, regula- tors can promote transparency and growth of mortgage bond markets by set- ting minimum rules for prospectus disclosures and for disclosures regarding the performance of the collateral pool as time pass es. Beyond disclosures, depending on the authority granted to them, supervisors may issue decrees to establish ring fencing of collateral, matching requirements, and collateral registers, or they can propose legislation to establish such legal protections. 19.Prime examples are Denmark and Germany. 20.Chile being one notable exception. 21. e Capital Markets Board of Turkey has created guidelines for mortgage bonds and MBSs. See www.cmb.gov.tr for a copy of the law passed in 2007. 312 housing finance policy in emerging markets Reporting for Secondary Market Instruments Mortgage lending and securitization require faith in the long-term future of local capital markets, something that is missing in most emerging markets. While mortgages and MBSs extend to 10, 15, and 30 years, most emerging markets lack liquidity in t he xed-income market beyond one year. Aside from performance itself, one of the best ways to build credibility is to disclose detailed information about the collateral pools, securitization trusts, and the expected performance of bonds created in s ecuritization structures. Such disclosures should begin at the time of issuance, and continue throughout the life of the securities. MBS and mortgage-bond investors want to know about the expected and actual credit performance of the collateral that backs the securities. ey want to know how the collateral pays o over time; ho w the pool evolves with regard to the original projections. is information is especially critical for MBS-subordinated bonds and interest-only bonds, the value of which is extremely sensitive to the performance of the collateral. Investors also need to know about the management capabilities of issuers. eir systems, controls, and business processes need to be adequate to ser- vice the bonds for periods of 20 years and more. Mortgage Bonds A mortgage bond is an obligation of the issuing bank, with a collateral pledge in case the bank fails. As a result, institutional exposure is more important than collateral exposure. Investors want to know about the overall nancial strength of the institution. For the collateral, investors will want to know about expected prepayment and default rates, and performance over time versus those expectations. e issuer should specify if and how prepayment risks are passed to bond inves- tors. In most co untries, investors will p refer to see diversi ed residential occupancy loans versus risky non-standardized commercial property in the pool. e prospectus should disclose individual and pool LTV ceilings, valu- ation and matching principles, geographic diversi cation, and information on where and how the mortgage liens have been registered. mortgage securities in emerging markets 313 Many mo rtgage b ond inden tures ena ble t he issuin g ba nk t o r eplace defaulted collateral. It is essential to disclose the amount and nature of eligible replacement assets, whether non-mortgage assets are permitted and which, and replacement procedures. e prospectus should describe any indepen- dent and permanent monitoring of the cover, the registration of cover assets, and the nature of the privilege that mortgage-bond holders enjoy in bank- ruptcy of the issuing institution. Securitization Reporting Securitization is a me ans to allocate the risk and reward embedded in t he pool of loans that make up the collateral. e securitization process cannot create more value than that which exists in t he collateral pool. In fact, the costs of the transaction will consume some of the value. As a result, at the time of the transaction, the issuer should not see undue gains on sale of the senior class, nor on the sale and repurchase of retained subordinate tranches. An example of an undue gain or loss would be one that is out of line with market movements in in terest rates that would create a ma rket-to-market gain or loss on the assets transferred to the SPV. e transfer to the SPV must qualify as a sale. Under IAS 39, there are two broad conditions for sale: 1) t he transferor cannot reacquire assets, unless the asset is readily obtainable in market, or reacquisition is at fair value price; and 2) the transferee has the right to sell or pledge the asset. In assessing fair value, the best evidence is ma rket price, but lenders are expected to use a model when there is no price available. It is then up to the auditor and regu- lator to accept the calculated fair value. Basel II Capital Requirements Under Basel II, mo rtgage bonds are treated as o ther security investments, with risk weights set in terms of agency rating. In adopting Basel II, the EU plans to or does provide reduced-risk weights for mortgage bonds issued in countries that have demonstrably robust legal frameworks that support the bankruptcy remoteness of the mortgage bond collateral. 314 housing finance policy in emerging markets Table 12.2. Basel II Standardized Risk Weights for Long-Term Bonds B+ and below Rating AAA to AA­ A+ to A­ BBB+ to BB­ BB+ to BB­ or unrated Risk weight 20% 50% 100% 350% deduction Source: Basel Committee on Banking Supervision 2004. MBS investments are treated under the Basel II Securitization Framework, assigning risk weights in terms of rating-agency ratings, unless the issuer uses the IRB approach for the type of underlying collateral that is securitized.22 So a mortgage lender that uses IRB for its retained loan portfolio would be required to use IRB for MBSs that it retains or purchases. Key issues have to do with the treatment of subordinated bonds and credit enhancements. is section brie y touches on those key issues, wi thout reproducing all o f the requirements. In t he st andardized approach, r isk w eights a re assigned b y rating, as shown in table 12.2 for long-term bonds. As can be seen in the table, very low-rated bonds are deducted from capital. Since subordinated bonds o en are issued at a very low rating or without a rating, they are o en deducted from capital. Under the standardized approach, when a bank other than the issuer provides credit enhancements to a securitization, it has to calculate a capital requirement for that exposure. e capital requirement on the cov- ered exposure is calculated as if the bank o ering the enhancement were an investor in the securitization. e IRB a pproach to securitization exposures is als o guided b y agency ratings, but it provides more categories of weights, and for unrated bonds, it enables banks that have internal rating systems to use them to establish risk weights for capital. In the words of the accord, " e risk weights depend on (i) the external rating grade or an available inferred rating, (ii) whether the credit rating (external or inferred) represents a lo ng-term or a sho rt- term credit rating, (iii) the granularity of the underlying pool, and (iv) the seniority of the position." Granularity refers to the number and size of assets in the collateral pool--more granular pools have a la rge number of small 22.Basel Committee 2004, 113 and 126. Basel II also provides the Supervisory Formula Approach to setting capital requirements for investments in ass et-backed securities. e Supervisory Formula Approach uses the investor's estimation of risk to set capital levels. e Supervisory Formula Approach is complex and has strict requirements for the data and methodology to be used. Very few banks are expected to actually use the Supervisory Formula Approach. mortgage securities in emerging markets 315 loans. ere are extensive conditions for the use of internally derived ratings, and they must be mapped to the ratings systems of external agencies. The Role of the Credit Rating Agencies e market for structured nance issues such as MBSs is la rgely driven by credit ratings, at least in pa rt because of the complexity of securitization structures. In the early days of the structured nance market, issuers worked with rating agencies to establish rating criteria that would make structured credits comparable to traditional corporate issues in the eyes of investors. e dependence on ratings has persisted even though many institutional inves- tors in developed markets state that they rely more on their own analysis than on ratings. Even when investors model cash ows accurately, it is di cult for them to anticipate changes in the collateral payment stream that may result from unexpected defaults or prepayments. A recent study found that down- grades of structured products had a strongere ect on structured bond prices than do do wngrades on corporate bonds, and structured product down- grades are anticipated less by prices than are bond downgrades.23 Since securitization is a ratings-driven market, it is necessary to obtain a rating to make a public transaction possible. Rating-structured nance is a specialized function, and is dominated by the largest rating agencies. Many emerging countries lack rating agencies. In countries that have them, ratings of structured transactions such as mortgage securitizations are o en carried out by teams of experts drawn from foreign o ces that specialize in suc h transactions. Given their central role in the development of capital markets, emerging country regulators should be aware of the transparency, methodology, and capabilities of rating agencies active in t heir markets. Particular attention should be paid to questionable practices such as nonpublic ratings and unso- licited ratings. Agencies should have rigorous and systematic rating method- ologies, be independent of the rms they rate, have well-established systems to manage the con icts of interest inherent in charging fees for ratings, and publish their rating methodologies. 23.Ammer and Clinton 2004, as cited in Committee on the Global Financial System 2005. 316 housing finance policy in emerging markets Rating agencies should have consistent and clear methodologies, particu- larly for mortgage bonds and for structured products such as MBSs. For each of these products, the intrinsic legal structure provides a vehicle for reducing subjectivity in the rating. Each has a p ool of homogenous collateral, a his- torical base for estimating the future performance of the collateral, and an algorithm for assigning the collateral cash ows to the bonds. As a r esult, the rating agency depends less on subjective judgments about the quality of earnings going forward, and can instead look to the experience of like col- lateral to estimate expected defaults and prepayments. Rating agencies have assumed a central role in developed capital markets with only limited regulation of their activities.24 eir increasingly important role in international capital markets, contrasted with some notable failures to anticipate bond defaults, has raised questions about the role and oversight of rating agencies (one of the most recent failures being their rating Enron as a good risk until four days before it declared bankruptcy).25 International regulatory bodies have also undertaken reviews of the role of rating agencies, generally with an eye to promoting transparency without imposing a detailed methodology for the rating process. 24.In 2006 a b ill to overhaul the framework for registering and overseeing credit rating agen- cies was pass ed in t he United States. e legislation removed the Securities and Exchange Commission (SEC) from the process of approving certain credit rating agencies as Nationally Recognized Statistical Rating Organizations. Instead, the SEC will register credit rating agen- cies that meet a newde nition, and would oversee the companies through inspections, exami- nations, and enforcement. Principal objectives of the legislation were to enhance competition in the industry and to improve the transparency and consistency of the ratings methodology. ere are currently ve Nationally Recognized S tatistical Rating Organizations: A.M. B est Company, I nc.; D ominion B ond R ating S ervice L imited; Fi tch, I nc.; M oody's I nvestors Service, Inc.; and Standard & Poor's. 25. e ratings process has drawn extensive criticism in the 2007 subprime mortgage crisis. e rating agencies have been accused of being overly optimistic in their ratings based on over- reliance on models with limited historical data. More fundamentally, they have a con ict of interest as they are advisors in the design of structural nance products that they rate. For an analysis of the role that rating agencies played in the crisis see Mason and Rossner 2007. mortgage securities in emerging markets 317 Lessons Learned The Basics A country must have a su cient legal, regulatory, and primary market infra- structure in place before mortgage securities can take hold. A good frame- work is a necessary but not a su cient condition for success. e sheer di culty of developing infrastructure is one reason why there has been only limited success in introducing mortgage securities in emerging markets. e legal a nd regulatory complexities of mortgage securities and specialized institutions are formidable even in sophisticated developed econ- omies. It is the case that many pieces of the puzzle have to be put into place before a picture emerges, and in a number of countries, the introduction of mortgage securities is still a work in progress. It would be easy if setting up an appropriate legal and regulatory frame- work were su cient to establish a market, but this is far from being the case. Many co untries ha ve de vised a f ramework f or s ecuritization o r co vered bonds, but the time lapse between the creation of the legal infrastructure and the actual development of regular issues can be very long--as much as four and 10 years. e development of a satisfactory legal framework for mort- gage securities is also o en complex and time consuming (o en requiring amendments in existing laws or new laws), notably in civil code legislative environments where the concept of a trust may be missing as a convenient, exible, and bankruptcy-remote special vehicle to issue MBSs. In rare cases, technical aws in the framework explain the di culty; for instance, Chile's securitization law in 1999 w here SPVs had to buy portfo- lios before issuing securities, or in Poland where the securitization law did not permit sellers to hold any subordinated tranche, or in ailand until the legal and regulatory framework for SPVs was improved. More o en, exog- enous obstacles stunt the actual use of a framework, however well designed. For instance, in Poland the length of the lien registration process that could take up to several months in Warsaw--before a more recent modernization e ort--had been a strong impediment to the issuance of mortgage bonds. In India, the extension of securitization is hindered by the level of stamp duties on the assignment of nancial assets (between 3 and 14 percent of the mort- gage balance in many states). 318 housing finance policy in emerging markets e most di cult obst acles t o o vercome a re o en t he o nes t hat a re anchored in lo cal market conditions. For MBSs, a ma jor hindrance is t he lack of a "market" for credit risk. In most emerging economies, there are no insurers, guarantors, or investors ready to take over the risk from the lenders. In this case, MBS sellers must use internal credit enhancement tools, which are necessarily very expensive if hig h ratings are sought. Also, in t he case of PT instruments, there are o en few investors willing to buy the prepay- ment options embedded in the loans, which are very di cult to value in the absence of historical data and uncertainties about borrowers' behavior.26 In many emerging markets, it is still di cult to lay o cash- ow risk. Inves- tors will not accept long-term instruments or prepayment risk. Many issuers and investors do not have the necessary systems and capabilities to manage amortization and prepayment. A simple and fundamental factor that can block the growth of mortgage securities is the lack of development of the primary market itself. Although the lack of long-term funding is an issue that can impede development, the growth path starts with the lending activity--even in the case of specialized institutions created to remedy the lack of interest of commercial banks.27 For va rious r easons--the b uilding u p o f a p ortfolio, na me r ecognition, time needed to arrange issues, and, in the case of securitization, high issu- ance expenses--the volume of loans must rst reach a critical mass before making e cient use of capital market instruments. It is unrealistic to expect to issue mortgage securities as long as overall market lending remains below a certain threshold. 26. e recent sharp reduction in t he volume of mortgage bond issuance in Chile r e ects the negative reaction by investors to a wave of unanticipated prepayments, the risk of which was underpriced. 27.It is a basic r ule that specialized institutions rely on capital market for their funding, but at the start of their activity they typically use their equity or bridge nancing from banks before tapping the capital market. e lack of bridge funding has slowed development of a private secondary market in Korea. Specialist mortgage companies have entered the market and suc- cessfully issued mortgage pay through securities. ey have been very small scale and thus expensive, however. e mortgage companies have not been able to get signi cant amounts of reasonably priced warehouse funding, which has limited their ability to aggregate loans to create larger pools. mortgage securities in emerging markets 319 Market Demand Potential issuers in many countries have not perceived a need f or creating or issuing mortgage securities. e need for securitization has been low, as capital ratios have been improving in most co untries, implying less need for o -balance-sheet nance. In recent years, most dep ositories have been liquid and not in need o f signi cant new sources of funds. In most ma r- kets, deposit funding is signi cantly cheaper than capital market funding, providing a further obstacle to capital market funding. Lenders not pressed by liquidity or capital constraints such as liq uid banks also tend to prefer retaining their high-quality mortgage loans on their balance sheets, and to access bond funding through a liquidity facility or by issuing their mortgage bonds, rather than taking the securitization road. e structure of mortgage markets is also an obstacle in some countries. If a market is dominated by a few large, liquid depository institutions, it will be di cult to create a successful mortgage securities market. e large lenders, who may ration mortgage funds, do not need the funding and can under- price new competitors using wholesale funding. ese lenders do not need mortgage securities to manage cash- ow risk either, as their main mortgage instrument is an ARM that can match funds with deposits. ere must also be a demand for such securities by investors. In part this is an infrastructure issue. ey must have the authority to invest and be able to realize the bene ts of a low-risk investment through risk-based capital treat- ment, reserve eligibility, and so forth. In addition, investors must understand and be able to manage the complex risks of mortgage securities. is requires a combination of disclosure and education at the least. Importantly, it requires a commitment on the part of issuers for regular issuance, as liquidity is a major characteristic in demand by investors. Government must play a role by leaving su cient space for issuance. Excessive government debt issuance crowds out mortgage securities and does not give them a chance to take hold. Simplicity It is notable by our measure of success that simpler instruments and insti- tutional designs have been more successful. Some of the most successf ul 320 housing finance policy in emerging markets examples of mortgage capital market development came from covered bond issuance. ese instruments are relatively simple--with credit enhancement from the balance sheet of the issuer. e more successful institution designs have been liquidity facilities rather than conduits. It is a sim ple fac t t hat t here are limits to t he complexity t hat can b e imposed on emerging markets (Pollock 1994).28 While there may be great appeal to securitization (and conduits that issue such securities), their com- plexity raises the cost of issuance and reduces liquidity. e instrument and issuer has to be tailored to the needs of the markets. is suggests the use of simpler product variants to facilitate investor acceptance and designs that will work in the current context. It is perhaps best to think of mortgage secu- rities in an evolutionary context--starting with simple designs (for example, bullet bonds) that do not tax the infrastructure or investor capabilities and introducing more complex designs as the market develops. Of course, it ulti- mately depends on the market--complexity can be good if it meets the spe- ci c needs of investors but it can undermine liquidity and the development of a secondary market. Although there may appear to be logical successio n between mortgage bonds, a much older and a simpler instrument, and MBSs, the two instru- ments in fact meet di erent needs. ere is no linkage in the timing of their respective development, and ideally, both instruments should be simultane- ously available in a diversi ed market. Securitization will remain a preferred road for mortgage lenders subject to balance sheet pressure, forcing them to better manage their scarce capital, or to better manage their liquidity and market risks, as s een in M orocco (housing bank in dire straits funding during a transition phase a er a crisis); Mexico (non-depository lenders facing growing funding challenges as their portfolio is expa nding beyond government funding limits); or Colombia (former S&Ls faced with restructuring problems and a signi cant exposure to market risks). 28.Excessive complexity is one of the root causes of the subprime crisis of 2007. Investment banks created derivative securities (collateralized debt obligation CDOs) by combining highly rated tranches with structured pay-through securities backed by subprime loans. e CDO tranches themselves were recombined into new CDOs. e underlying characteristics of the mortgage pools were poorly disclosed and investors relied too much on the ratings without looking at the origins of the securities. mortgage securities in emerging markets 321 It can be observed that there may be an excessive focus on institutional creation in ad vance of other f undamentals. Simply creating a s econdary market institution will not create a market. For example, in Russia there was considerable technical assistance investment in t he creation of the Agency for Housing Mortgage Lending (AHML). e creation of this institution in 1997 preceded the dra ing of a mortgage law and development of a primary market, as well as of the needed legal and regulatory framework for mortgage securities. AHML did virtually no commercial business through its early life (through 2003). With the passage of a comprehensive package of legal and regulatory reforms a ecting both primary and secondary mortgage markets in 2006, the role and activities of the agency became more signi cant. How- ever, it provides for only 12 percent of outstanding lending, and a number of banks have also issued mortgage securities. Development e orts in many emerging countries have focused on insti- tution de velopment, pa rticularly co nduits wi th g overnment in volvement. In many cases they may be ahead of their time (or solutions in search of a problem). Governments and technical assistance providers may need to spend more time and resources on infrastructure development to allow individual issues of mortgage bonds and securities before investing in institutions. Role of Government e success stories in this analysis all involved important government sup- port. As emphasized repeatedly in this text, the government must provide a strong legal and regulatory infrastructure. It is no accident that the most suc- cessful emerging (for example, Chile and Malaysia) and developed (Australia, Denmark, United Kingdom, United States) market examples of mortgage security issuance are those countries with the strongest infrastructure. In both Malaysia and Jordan, the government provided critical support in the form of seed capital by investing in a mortgage securities issuer and incentives through the regulatory treatment of the products and securities. In Chile, the Central Bank temporarily acted (for two years) as t he main investor of mortgage bonds to help jump-start the market, and facilitated market development by creating institutional investors through pension reform. In Mexico, the government development bank SHF provided crit- 322 housing finance policy in emerging markets ical credit enhancement to early issues. Government support in Colombia took the form of tax incentives for investors and a temporary program of priced state guarantees, which may be turned o when not perceived as necessary once market investors have regained enough con dence in t he MBS markets. All of these initiatives allowed institutions to come to market with more favorable nancing terms than can be done by private-sector institutions alone. Government can also develop a s econdary market in mortgage securities through liquidity support and reserve eligibility. Pro- viding guidance on disclosure and standardization are additional important roles for government. Credit enhancement through a government guarantee can be an impor- tant way to catalyze a market. Itisdi cult to get investors to accept (or price) the complex risks of mortgage securities. A government guarantee, whether implicit through ownership or explicit, eliminates one risk, allowing inves- tors to focus on the others. But guarantees are dangerous as they can involve adverse selection and are detrimental to the government, and the govern- ment could end up with large contingent liabilities. Also, government sup- port can create a monopoly that dominates a market and generates excess returns for its shareholders. us, a sunset provision should be considered in conjunction with government guarantees or nancial support.29 e importance and risks of government guarantees has been amply dem- onstrated in t he subprime mortgage crisis. Issuance of private label MBS has virtually disappeared in the United States with the only capital market funding being provided by the government-sponsored enterprises (Fannie Mae and Freddie Mac) and government agencies (Ginnie Mae). However, the combination of past accounting scandals, large losses from mortgage and subprime securities investments, and plummeting share prices have forced the U.S. government to make its support for the GSEs more explicit. It is important to create a proper incentive structure in the design of sec- ondary markets. For example, in the United States private mortgage insur- ance companies take the rst loss on high LTV loans and lenders are subject to (credible) recourse by the GSEs in cases where loans are not originated to 29.An example of an ex ante sunset is the government guarantee given to CaissedeRe nancement Hypotecaire in F rance, which was wi thdrawn on schedule a er three years. In the United States, the Student Loan Marketing Association (Sallie Mae) successfully dropped its govern- ment status in 1996. mortgage securities in emerging markets 323 agreed standards. Mexico has adopted a similar approach, requiring issuers to take a rst loss position in front of the SHF guarantee. In theory, the risks can be better managed by the private sector, as it has an incentive to properly underwrite and price risk in order to maximize the value of the franchise. Inevitably, however, this approach creates economic rents for the institutions bene ting from the guarantee and can lead to greater risk for government (for example, through leveraging the guarantee) if not properly regulated and supervised. is has been the case with the U.S. GSEs, where critics point out that the model of implied guarantees privatizes pro ts and socializes risks and losses. A critical function for government is to build the proper legal and reg- ulatory framework. ere must be proper safety and soundness regulation of issuers, and the framework must clearly de ne the structures, treatment of issuers (for example, true sale), and investors (authority and incentive to invest). Proper tax treatment is cr itical in de veloping mortgage securitiza- tion. First and foremost, there should not be double taxation of the security issuance vehicle. ere should not be excessive stamp duty or taxes on the registration of securities or their transfer. In addition, regulation must elimi- nate arti cial arbitrages. Government support has drawbacks as well. Even if the government is a minority shareholder it typically wields majority in uence. is could lead to inappropriate lending programs or investment, as is the case with many housing banks. Questions also arise as to how long the government needs to support securities issuers. For example, Cagamas was a mo nopoly pro- vider of service. e government did remove its regulatory privileges a er nearly 20 years of successful operation; however, it may be that the insti- tution should be privatized or phased out in fa vor of direct-lender bond issuance. TC dominates the securitization market in pa rt because of the tax exemption (but also because of the liquidity in i ts bonds and reputa- tion). e tax exemption was initially due to be withdrawn in 2006 but was recently extended to 2009. Selecting the right options for a given context may speed up the process. Selecting a model based on simplicity, type and number of primary market players, regional experiences, capital market infrastructure, and legal a nd regulatory infrastructure is k ey to market development. Blind replication of practices prevailing in de veloped markets should be avoided. Investors 324 housing finance policy in emerging markets should be actively involved in the preparation of policy choices, as their skills and capacities are an important factor for the acceptance of instruments. Chapter 13 Mortgage Insurance Roger Blood Mortgage defa ult in surance (MI) su pports ho using nance a nd macr o- 1 economic goals for a growing number of housing nance systems, both in mature and still-developing economies. Starting with a hist orical perspective, this chapter will help public- and private-sector o cials who may be considering whether MI may have some useful role to play in their country's housing markets, and, if so, what options for implementation may be more or less attractive to pursue. Drawing upon examples from a number of diverse countries, we shall look in particular at prerequisite conditions for MI to succeed, key program fea- tures, regulatory and capital issues, credit-risk management tools, consumer issues, technology, forms of sponsorship, and options for public-private col- laboration. e chapter ends with examples of adverse experience in several countries that may suggest ways to avoid similar pitfalls elsewhere. 1. Also known in certain countries as mortgage credit insurance, mortgage guaranty insurance, mortgage indemnity insurance, and lenders' mortgage insurance. is chapter's discussion of MI is directed at mortgage lending secured by individual, primarily owner-occupied, residen- tial dwellings. Much more limited MI programs also have been used in several countries for income-producing residential and commercial properties. 325 326 housing finance policy in emerging markets Definition and Unique Features of MI Stated simply, MI p rotects mortgage lenders and investors against loss b y reason of borrower default. Such losses arise when the realizable value of the collateral property securing the mortgage is insu cient to repay in full the borrowers' outstanding debt. Whether government or privately sponsored, MI has several unique fea- tures relative to other forms of insurance: · e nature of the hazard covered--economic catastrophe. · e long duration of the insured risk, that is, the full term or life of each mortgage loan. · e unusually long cycle of risk, which follows general economic cycles. · Risk performance that is uniquely dependent upon government eco- nomic policies. Because of the long-term need to protect against economic catastrophe, MI requires special analytic and regulatory tools, even in countries where pre- requisite conditions for MI are favorable. Purposes of MI MI can serve to meet a number of worthy public policy goals, including: · expanding ho meownership via lo wer do wn-payment nancing, including to households of limited means; · developing mortgage and capital markets by building investor con- dence; and · strengthening credit risk management in the banking system. While the predominant reason given at present for individual countries' use of MI is t o reduce the amount of cash r equired to buy a ho me, there are signi cant exceptions, both now and historically. One o f the leading objectives of public MI programs both in the United States and Canada four mortgage insurance 327 decades ago was t o set improved physical standards for new and existing housing. While that goal has largely been achieved in these countries, it is one that should not be overlooked in less a uent areas. In some economies where lenders are reluctant to make any home mortgage loans, MI can be used to jump-start the process. Government-sponsored MI in particular may be directed at unserved or underserved market segments de ned in wa ys other than just inability to accumulate cash savings. Some developing countries faced with serious market impediments, mainly relating to foreclosure proceedings and collateral recovery, have considered introducing MI so that lenders might avoid these problems by shi ing col- lateral recovery risks and costs to a third-party insurer, at least until needed market reforms are implemented. MI is no t well suited to solving this par- ticular problem. Compared with direct subsidies, publicly sponsored MI may be a more e cient, o -budget policy tool for expanding residential mortgage markets, but only where an emerging economy's underlying primary market mecha- nisms are already working reasonably well. Countries that Have MI Today MI in some form is available for residential lenders in over two dozen coun- tries (see table 13.1). Most of these programs are government sponsored and are of fairly recent origin. e following discussion focuses mainly on programs that have insurance like features, such as risk-based premiums and capital reserves. Where public sponsorship is involved, a government's ability to structure and run its MI program according to long-established insurance and commercial principles has been, and will continue to be, a key success factor, both for long-term viability and for achieving social and public policy objectives. Prerequisite Conditions for MI Success In order for mortgage default insurance to help a country advance toward its macroeconomic and housing policy goals, its primary housing markets 328 housing finance policy in emerging markets Table 13.1. Selected Countries with MI Programs, 2008 Country Year of origin Sponsorship Algeria 2000 Public Australia 1965 Private* Belgium Public (regional government) Canada 1954 and 1963 Public and private Colombia 2004 Public Finland mid-1990s Public France 1993 Public-private combination Guatemala 1961 Public Hong Kong, China 1999 Public-private reinsurance Iceland Public India ongoing project Public-private combination Ireland 1999 Private Israel 1998 Private Italy 2003 Private Kazakhstan 2004 Public Latvia ** Public Lithuania 1999 Public Mali 1998 Public-private combination Mexico 2004 and 2007 Public and private Morocco 2004 Public New Zealand 1997 and 2004 Private and public Netherlands 1957 Public-private combination Peru 1999 Public The Philippines 1950 Public Portugal 2003 Private South Africa 1989 NGO/private reinsurance Spain 2002 Private Sweden 1992 Public and private United Kingdom pre-1970 Private United States 1934, 1956, and 1987 Federal, private, and state West Bank and Gaza 2000 Public Sources: MI program surveys conducted by author. * Initial public sponsor, privatized in 1997. Competing private firms began in the 1970s. mortgage insurance 329 rst must function reasonably well. Otherwise, not only will the cost of MI be excessive, its presence might actually mask the urgent need for primary market reforms. Table 13.2 provides a checklist of prerequisite conditions for MI success. Each factor above should be examined for any speci c shortcoming that would impede the ability of MI to function as intended, or would raise its cost prohibitively. Some of these factors (for example, collateral recovery) are more critical than others (for example, industry associations). An added consideration, thought not an absolute prerequisite, is a coun- try's geographical size and diversity. " e law of large numbers" and the need to diversify risk are universal underpinnings for all insurance lines, including MI. A la rge, populous country having many far- ung urban and regional markets, such as t he United States or India, can better avail itself of MI's potential bene ts than can a geographically compact nation with one or two dominant urban centers. e latter type of country, when contemplating MI, will face both greater overall risks and diseconomies of scale. Experience across numerous countries suggests that the threshold of ini- tial feasibility for government to o er MI is lower than for private enterprise. For example, a p rivate rm will need a p roper regulatory framework and some mortgage experience (actuarial) data in order to launch MI in a country where none has existed theretofore, whereas a public start-up program may not require so rigorous a foundation. Accordingly, where private MI exists Table 13.2. MI Prerequisite Conditions for Success Regulation and legal Primary mortgage market · Laws and judicial system (esp. foreclosure, collateral · Banks' lending and loan servicing practices recovery) · Insurance product acceptance · Mortgage and title registration · Transaction costs (transfer, regulation) · Bank/lending regulation · Property taxation · Insurance regulation · Property valuation/appraisal practices · Mortgage insurance regulation · Condominium governance and maintenance · Industry associations, standards (lenders, builders, sales agents) Information Other · Housing markets, sales price information · Economic policies fostering stability, personal savings · Borrower credit information (credit bureau) · Government, political support · Standard definitions--residential lending · Citizens' attitudes toward homeownership, debt · Mortgage portfolio experience/performance repayment · Pricing model data requirements Source: Author's own research. 330 housing finance policy in emerging markets today, almost invariably a publicly sponsored program has preceded it (for example, United States, Canada, and Australia). Even emerging economies that appear to meet prerequisite conditions for adopting MI should not view MI as a pa nacea. Table 13.1 shows that most of the numerous MI programs operating in developing markets are of recent origin and have not undergone the test of time and economic stress. Key Program Characteristics Among the many variables that drive the risk of home mortgage default and loss, loan-to-value (LTV) ratio (a proxy for borrower equity) has predomi- nated, b oth historically and across international b oundaries (t able 13.3). So strong is t his correlation that some emerging economies--and histori- cally even the United States--have imposed regulatory LTV limits on bank lending or loans eligible to back mortgage securities. Countries that o er MI use it predominantly to induce lenders to make higher-risk, higher-LTV-ratio loans, thereby reducing the amount of cash savings that borrowers must accumulate to purchase their rst home. Max- imum LTV ratio--insured versus uninsured--in any given country, is, there- fore, the rst MI program feature to consider. Table 13.3. LTV Correlates Strongly with Default Risk and Losses Six-country averages indexed to 75.01 to 80 percent LTV * LTV ranges (percent) Default probability Loss severity 50.01­60 0.26 0.15 60.01­65 0.62 0.40 65.01­70 0.73 0.63 70.01­75 0.84 0.83 75.01­80 1.00 1.00 80.01­85 1.20 1.15 85.01­90 1.48 1.29 90.01­95 1.88 1.41 95.01­98 2.31 1.46 98.01­100 2.69 1.52 Source: Fitch IBCA 1998. Model assumptions applied to BBB-rated MBS. * Australia, Germany, Netherlands, Spain, United Kingdom, and United States mortgage insurance 331 In most co untries, at the time MI is ini tiated, mortgage lenders gener- ally are willing to lend without insurance up to some benchmark LTV ratio, beyond which they feel overexposed to loss in the event of borrower default. While this LTV benchmark varies from country to country and also may increase over time, the introduction of MI covering at least the top layer of risk exposure above the lenders' benchmark LTV can induce lenders to raise their top LTV up to the insurer's higher limit. Insured LTV limits, likewise, will vary from country to country, and tend to increase over time as satisfac- tory experience unfolds. A reasonable "rule of thumb" where MI is ne w to a market may be ini- tially to set the maximum insurable LTV at a le vel where it reduces the required borrower down payment by one-half. Hong Kong and Kazakhstan, for example, used MI t o cut the minimum borrower down payment from 30 percent without MI to 15 percent insured. U.S. private insurers originally introduced MI that lowered minimum down payments from 20 percent to 10 percent. Israel's new MI program permitted borrowers to buy homes with 20 percent down, compared with 40 p ercent previously. Once a successf ul underwriting record could be demonstrated, the United States and Hong Kong programs, for example, then further reduced their minimum down payments--the United States in several increments over 30 years. Until now, some 100 percent of LTV loans are insurable. Individual Loan Coverage How much coverage against losses should MI provide for individual home loans? T wo p rinciples sho uld a pply in makin g t his im portant decisio n regarding program design: (1) to avoid "moral hazard"2 and to control cata- strophic losses, the MI provider should share some risk with the originating lender; and (2) t he lender's likely collateral recovery under adverse condi- tions should be estimated and need no t be insured. Where MI is us ed as credit enhancement for MBSs, t he amount of loan level coverage needs to ful ll rating agency requirements. Further, if a co untry's risk-based capital 2. "Moral hazard" refers to a pa rty that acquires insurance cover whose behavior changes as a result of the curtailed exposure to loss in suc h a way as to increase the risk that is b eing insured. 332 housing finance policy in emerging markets regulations (discussed further below) bestow a lender bene t on those who use quali ed MI, t he amount of coverage must be su cient to earn such favorable treatment. Admittedly, some MI programs that provide 100 percent loan-level cov- erage, both government and private, have succeeded. Among these are the Federal Housing Authority (United States) and public and private MI pro- grams in Canada and Australia; however, many others, both old and new, have bene ted from risk sharing ("coinsurance") with their lender-poli- cyholders. ese include the U.S. private and state-level public insurers, as well as p rograms in H ong Kong, South Africa, Israel, and Lithuania (the latter of which changed its program from 100 to 25 percent coverage in 2002). New MI programs in Kazakhstan and Mexico also are designed with partial (top-down) loan coverage. Premium Rates Establishing a n MI p remium ra te str ucture a ppropriate t o a ny na tional market entails several considerations. Most important, of course, is t o set rates at a level that are both su cient to cover future losses, including under severe economic stress, but not so high as to impair a ordability. In most co untries wi th ne wly de veloping mo rtgage ma rkets, t here is little or no usable mortgage performance history to provide the type of data required to project, even roughly, future default frequency and loss severity. Where policy makers conclude that MI will b ring near-term bene ts to a country's housing and mortgage markets, they need not await the time when such data becomes available. As long as the national economy and nancial and housing markets show reasonable stability, a suitable MI premium can be adopted to enable a government-sponsored program to get under way. e initial MI premium should be set conservatively (it can always be reduced later on), based upon benchmark foreign-experience data, adjusted to re ect potentially higher risks and volatility associated with the domestic market. is approach recently was us ed in K azakhstan and, to a less er degree, in Mexico, where some local data existed, but was insu ciently robust for rate- making purposes. mortgage insurance 333 Elaborate pricing models are not needed to create a public MI program. It will n ormally su ce to apply conservative rates at the outset, with later re nements as experience develops. is data then can also be held out to attract private, including foreign, MI risk capital. e inc lination (uniq ue t o a g overnment-sponsored MI p rogram) t o set premium rates at levels insu cient to cover future losses--in order to improve a ordability--should be resisted. Rather than risk the future insol- vency of a public MI fund, given the political and scal pain such a failure would cause, it is far better to target transparent needs-based subsidies-- including MI premium subsidies--to work in conjunction with an actuari- ally sound MI fund. An example of this enlightened approach is found in Lithuania, where many of the less-indebted middle-income country's bor- rowers are income quali ed to receive separately budgeted MI p remium subsidies, thereby boosting a ordability. e major variables that determine default frequency or loss given default (severity) also drive premium rates, including, most notably, the following: · Loan-to-value ratio · Loan term · Percent of insurance coverage (for programs that o er di erent cov- erages) · Type of mortgage instrument (for example, xed versus variable rate or payment) · Owner-occupation versus investor-owned rental unit A detailed exposition of MI pricing methodology is beyond the scope of this chapter. We shall note only that MI pricing does entail economic stress modeling to ensure the buildup and retention of capital reserves su cient to withstand abnormally high default and loss rates associated with severe national economic adversity. A second programmatic pricing decision to be made, a er overall rate adequacy and risk classi cations have been established, is how to structure the actual MI premium payment. e lender, as bene ciary, purchases the MI coverage, but--one way or another--the cost of the MI coverage must be passed through to the borrower (who also "bene ts" by making a lower down payment). Among the premium payment options are the following: 334 housing finance policy in emerging markets · Add the cost of MI to the loan interest rate · Charge MI as a separate add-on cost, monthly or annually · Charge the full cost o f MI as a n up-front lump sum, d ue at loan closing · Add the full up-front MI premium charge to the initial loan amount, thereby nancing the cost over the loan life (but also increasing the initial LTV ratio) Each of these options has ad vantages and disadvantages with varying degrees of transparency. In a developed market, the ideal is for the MI pro- vider to o er as many payment options as the market may have reason to use. For a start-up situation in a less-developed market, the up-front lump sum charge, "capitalized" as part of the beginning loan amount, may be preferable. It is the most a ordable for the borrower; it provides maximum funding to the insurer's loss reserves; and it is administratively simple. Whatever pay- ment options may be o ered, the lender should clearly disclose this cost to the consumer. Eligible Loans All MI programs, both public and private,de neandrestrictwhatisaninsur- able loan. Limits can relate to property type (for example, individual dwelling units versus entire apartment buildings); loan purpose (for example, home purchase versus home construction or improvement); or mortgage instru- ment terms (for example, fully amortizing loans versus loans with lump sum due dates) and rst lien mortgages versus junior or subordinated loans. Table 13.4 below reveals some variety among country MI programs regarding types of insurable residential loans. As discussed in the "lessons learned" section later in this chapter, e orts to extend MI beyond the insurance of mortgage loans secured by individual, mainly owner-occupied dwelling units--even to nancings that on the sur- face seem quite closely related--has sometimes failed at considerable cost. mortgage insurance 335 Table 13.4. Insurable Loans, Selected Countries Country Program Insurable loan feature Remarks Algeria SGCI Individual dwelling units only Australia Private MI Canada CMHC All residential, including Also guarantees mortgage construction loans and rental securities apartments, retirement homes Estonia Kredex Home purchase or renovation Guatemala FHA Single homes, construction loans Hong Kong, China HKMC New, individual dwelling units Kazakhstan KMGF Mali FGHM Single homes only Market has no condominiums Netherlands NHG Home purchase loans only The Philippines HGC Single homes, multifamily Also guarantees mortgage development, and construction securities loans; long-term leases South Africa HLGC Loans secured by home, pension Special program for borrowers fund balance; also lease-purchase with AIDS Sweden BKN Owner-occupied, co-op, rental New, rehab apartments only United States FHA-MMIF 1-to-4-family properties only; Separate program for rental (federal) amortizing loans only housing United States Private MI 1-to-4-family properties only; Subject to strict "monoline" completed construction only regulation United States Mass MIF (state) 1-to-4-family owner-occupied properties only Source: Author's own research. Underwriting Method Another key feature of all MI programs relates to the method by which risks are assumed, which typically will be stipulated contractually with the insured lender. is program feature entails not only risk management, but also mar- keting, information technology, and cost-e ciency aspects, each of which needs to be weighed and balanced in designin g and implementing an MI program. ere are basically four types of underwriting methods available to an MI provider: 336 housing finance policy in emerging markets · Substantial participation with the insured lender in the direct under- writing of the loan · Underwriting review and prior approval of loan documentation gen- erated by the lender · Electronic data transfer and "automated underwriting," (AU) using experience-based decision model, with human review of "marginal" cases identi ed by the "AU" decision program · Authority to bind the MI coverage on individual loans delegated to the lender subject to the lender's compliance with agreed-upon stan- dards and procedures and periodic reporting Few, if a ny, examples of the rst of the above methods is f ound today, although the U.S. government's FHA program operated in t his fashion for many years, even to the extent that the entire property valuation process was run by the FHA independent of the lender. is alternative, though perhaps the safest, is simply too cumbersome and costly to be accepted in any com- petitive marketplace. Review under writing o f indi vidual loa n do cuments--either s elected documents or the full loan package--strikes a balance between the need to screen risks adequately versus cost a nd e ciency concerns. Such "review underwriting" was f or ma ny y ears t he do minant p rocess f or MI under - writing in most advanced markets, including the United States, Canada, and Australia-- rst via mail, later by fax. e process worked successfully, with same- or next-day response meeting market needs. Automated underwriting now has largely supplanted MI review of loan documents in most ad vanced markets w here credit and loan exp erience databases are su ciently rich to validate the decision models that underpin automated underwriting systems. e e ciency of this underwriting method has reduced MI costs considerably, with no apparent weakening of risk man- agement until the market turmoil that started in 2007, which generated high delinquencies in insured portfolios such as the "Alt A" segment (borrowers with decent credit records but undocumented income), or 100 percent LTV loans with no borrower equity. In the United States, another strong impetus for this advance has been the dominant role of Fannie Mae and Freddie Mac both as providers of MBS capital to insured lenders, but also as standard set- mortgage insurance 337 ters for all mortgage-market participants in terms of both automated under- writing and information technology. Underwriting a uthority delega ted b y t he MI p rovider t o t he lender is a co mmon, though far from universal, practice in b oth developing and advanced markets. Among the programs outside North America that employ delegated underwriting are the National Housing Credit Guarantee Board (BKN) in S weden and Home Loan Guaranty Company (HLGC) in S outh Africa, while Hong Kong is just beginning to test it out. e simplicity and e ciency of this method of risk assumption makes it appear a very attractive option for both the lender and the MI provider; however, this approach also entails three potential disadvantages: First, the MI that delegates its underwriting function to the insured lender may nd that it has assumed greater risks than anticipated. Second, the "value added" that secondary mortgage investors may per- ceive from an independent third-party review of pooled mortgage loans by the insurer may be diluted. ird, the lender who assumes delegated underwriting authority may nd later that the insurer will nd "technical violations" of the delegated under- writing agreement as an excuse to deny the payment of claims. e potential for such contention can increase with the frequency of claims submitted. One reasonable approach to delegated underwriting can be for the MI provider to award this bene t to individual insured lenders that demonstrate their commitment and ability to produce quality loans. Of course, the sup- porting technology needs t o be in p lace to assure timely monitoring, and regular on-site compliance audits are essential. In any event, the under writing method(s) employed over time in a ny country should balance the inevitable needs for adequate information and control, prompt and cost-e cient service, and technology platforms avail- able to both the MI provider and its users. Public MI p rograms typically--though not always--have incorporated additional program features that emphasize their social and public policy goals, as discussed in further detail in the following section. 338 housing finance policy in emerging markets Meeting Social Objectives Government MI programs in particular need to justify themselves, not only in terms of being nancially self-sustaining but in als o stimulating more homeownership and lending opportunities. Usually they are also expected to serve a targeted segment of the population that may otherwise not have access to home nancing. In developing economies such groups most o en include both lower-income families and the "informal sector," where non- salary incomes tend to be irregular and hard to document. Government- sponsored MI, though not a direct housing subsidy, should not be expected to serve the very wealthy or to help nance luxury housing. Typically, there are three simple means, one or more of which govern- ment MI uses to target its bene ts to low-, moderate- and middle-income households. ese methods are insurable limits expressed in t erms of (1) loan amount, (2) home price, or (3) household income. Of these, household income limits tend to be the most restrictive, while loan amount limits are the most permissive. Even with insurable loan limits, for example, a wealthy borrower could still purchase a very expensive home. While social goals for most p ublic MI p rograms may be most dir ectly addressed with some form of household income limits for eligible loans, as noted above conditions in de veloping markets may not permit many bor- rower incomes to b e reliably do cumented. Of t he above-noted t argeting methods, loan amount is the most easily veri ed. Any such limit, however, ought to reach well up into the middle of the market so as to create a broad base of demand and to include a relatively low-risk segment of the market in order to strengthen credit risk management. As a practical matter, any public MI program with household income limits probably does not need ei ther insurable loan or home price ceilings. Any subsidies ass ociated with a p ublic MI p rogram are best designed t o be both transparent and distinct. at is, s eparately budgeted funds may be used to subsidize lo wer-income borrowers' MI p remiums, to directly subsi- dize a portion of the required cash deposit, or even to temporarily "buy down" or subsidize the borrower's interest payments. But the MI program's premium rates should be fully loaded, and reserves fully funded, to cover all future losses and ongoing program costs. Such precautions will help to avoid the political mortgage insurance 339 backlash that might well accompany future calls for the government to "bail out" a depleted MI fund facing large immediate and future claims obligations. Lithuania's MI p rogram is un usual in t his r egard. A bout o ne-half o f insured borrowers--those below a set income threshold--currently bene t from signi cant MI premium subsidies. In the United States, lower-income borrowers covered under the Commonwealth of Massachusetts' MI program receive a 20 p ercent MI premium discount, but this bene t is achieved via an internal cross-subsidy from higher-income borrowers covered under the program. e Philippines' Home Guaranty Corporation program employs similar cross-subsidies to support quali ed "social housing." Another type of subsidy--cross-subsidies--can play a useful role in some countries' MI programs. Rather than classifying premium rates according to variations in credit risk, some countries intentionally cross-subsidize among classes of insured borrowers, either by applying a unif orm rate (historical policy of the FHA in the United States) or by applying lower rates to higher- risk classes (the Philippines). In both instances, the public-purpose goal is to secure for borrowers of lesser means access to home nancing on terms at least equal to the rest of the market. To the extent that premiums are cross-subsidized or other means are employed to serve borrowers at the lower end of the income spectrum, to compensate for the added risk and remain viable, the public MI must adopt suitable al ternative under writing a nd r isk ma nagement st andards (f or example, rigorous homeownership and credit counseling). Special MI Products for Mortgage-Backed Securities (MBS)/Structured Finance For the primary home mortgage market, nearly all MI programs provide, that is, "certify," coverage for individual home loans, most o en with par- tial risk coverage. Although 100 p ercent coverage tends to use insurance capital ine ciently and is susceptible to moral hazard, such coverage does translate easily from the primary to the secondary and MBS market, where investors have no appetite for assuming unfamiliar risks. Modern-era MI programs that provide primary lenders less t han 100 p ercent loan-level 340 housing finance policy in emerging markets coverage can provide two types of companion products when the need arises to satisfy MBS investors, as well as rating agencies upon whom such investors will rely. Mortgage Pool Insurance Mortgage pool insurance provides a specially designed second-tier MI cov- erage for institutional MBS investors who are unfamiliar with mortgage risks and who wish t o rely on investment ratings, including third-party credit enhancements. Mortgage pool insurance typically provides 100 percent cover for individual defaults in a n MBS mo rtgage pool. Pool coverage, however, is subject to a stipulated aggregate loss limit for the overall pool. Normally, the rating agency, using stress-test modeling, will establish the pool policy's required aggregate loss limit ("stop loss"), a percentage that will depend upon both the risk characteristics of the particular mortgage pool and the desired rating for the security that is backed by the insured loan pool. Timely Payment and Cash-flow Protection Timely pa yment a nd cash- ow prot ection o en will be n eeded o n a n investment-grade-rated MBS issue as an adjunct to mortgage default insur- ance. Security holders expect not only ultimate recovery of their mortgage principal, but also timely repayment of principal and interest according to the payment schedule provided in the o ering document. If a number of insured loans in the mortgage pool fall into arrears, a temporary cash- ow shortfall will develop that is not acceptable to the security holder. While a variety of structured nancing techniques exist to address such shortfalls (for example, lender obligation to advance payments owed by delinquent borrowers, spe- cial reserve funds), a timely payment guaranty from a government-backed or highly rated private third-party insurer has become an MBS mainstay in several countries. e largest, and most w ell-known, MBS timel y payment guaranty pro- gram is t he Government National Mortgage Association (Ginnie Mae) in the United States, which is used in tandem with pools of loans insured by the mortgage insurance 341 FHA and guaranteed by the Department of Veterans A airs. e Ginnie Mae cash- ow guaranty, which backs up the loan servicer's obligation to advance out-of-pocket all payments due on delinquent loans, is provided for an added annual fee of six basis p oints. ese insured advances are recovered later when the underlying FHA or Department of Veterans A airs claim payment is made, or when the delinquent borrower brings the loan current. Timely payment guarantees are provided in s ome other countries with active MBS markets, including Australia, where all MBS and all MI are pri- vate. In Australia, for a nominal premium, private "AA"-rated MI providers o er timely payment guarantees of up to 24 months for pooled loans that back highly rated MBS issues. In short, as some countries' primary mortgage markets mature to include securitization, primary MI also can and should evolve, mainly in two respects that will satisfy non-mortgage investors' needs: rst, to eliminate most loan- level credit risk; second, to protect not only against ultimate loss of capital following borrower default and collateral recovery, but also against interrup- tion of mortgage pools' scheduled cash ows from borrowers' periodic loan repayments. Credit Risk Management Although they have little control over external forces a ecting risk, including macroeconomic policies of the national government, public and private MI providers alike have at their disposal a powerful array of credit risk manage- ment tools. Most of the risk management tools noted below can be put in place during a program's planning and design and start-up phases. Regulatory Issues Regulatory concerns mainly, though not exclusively, relate to privately spon- sored MI programs. ese concerns fall into two basic categories: · Rules directly governing how an MI program will operate · Rules governing how banks and secondary investors use MI 342 housing finance policy in emerging markets Table 13.5. Credit Risk Management Tools Risk management tool Example Rules and incentives to prevent adverse selection of risk Seek reduced risk-based capital for high-LTV-ratio by insured lenders insured loans Share risk exposure with originating insured lenders Partial, rather than 100%, loan-level coverage Share risk exposure with qualified third parties Quota share loan-level or excess-of-loss portfolio-level reinsurance Employ risk-based pricing based upon economic risk Charge higher premiums for rate-indexed loans, based modeling and proper risk classification on simulated volatility Define clearly both risks covered and risks excluded Do not "second-guess" a lender's underwriting to deny a claim. Exclude fraud or material misrepresentation from coverage Define clearly insurable loan types Maximum LTV ratio; first liens; completed properties; single dwelling units Define master-policy (lender contract) terms and Describe clearly all lender actions needed to sustain conditions meticulously and clearly coverage, submit claims Define clear eligibility and performance standards for Insured lenders must have their own regulators; originators and administrators of insured loans administrators of insured loans must have adequate IT platform; apply sanctions against substandard loan administrators Require adequate information reporting, internal and Design and maintain a loan-level database capable of external, to monitor significant risks tracking significant risk factors and concentrations; invest early and wisely in information technology Maintain effective loan underwriting methods, approval Review each individual insured loan document package criteria until alternative methods are proven to be reliable; publish and adhere to approval criteria Diversify risks geographically In a large country, maintain a physical presence in all key regions; in a small country, if private MI, seek to write MI in multiple countries Maintain effective local and regional housing market Establish independent "human intelligence" on major intelligence builder-developers; deploy underwriting and quality control staff in regional facilities Invest in comprehensive, proven methods of quality Employ qualified internal and external operational control, including fraud detection auditors Control excessive or adverse risk concentrations Limit, by various means, aggregate risk assumed in very large projects Employ conservative loss-reserving methods Track and analyze delinquent loan behavior patterns and reserve accordingly Manage defaults and pending claims aggressively and Offer incentives to defaulting borrowers to convey mitigate losses creatively property title voluntarily Shield the entire operation from political influence Strictly limit staff dealings with elected politicians on business matters; structure board with strong private- sector representation Source: Author's own analysis. mortgage insurance 343 Key regulator concerns regarding MI behavior, taking account of its unique features noted earlier, should include the following: · Maintaining adequate capital reserves relative to total risk exposure, including ability to survive economic catastrophe · Segregating t his uniq ue f orm o f insurance f rom o ther in surance lines · Controlling con icts of interest and maintaining underwriting inde- pendence between the mortgage insurer and the insured lender · De ning classes of insurable loans · De ning insurable lenders (for example, regulated lenders only) · Requiring suitable loss p rovisioning on delinquent and foreclosed loans · Ensuring adequate, but not excessive rates; nondiscriminatory rates; disclosures · Requiring appropriate examinations and actuarial audits · Restricting excessive risk concentrations · Ensuring su cient liquidity; avoiding risky, illiquid, or other inap- propriate investments · Applying appropriate standards and reserve requirements for poten- tial reinsurers e most co mprehensive MI r egulation is f ound in t he United States, where all insurance is regulated by the individual states. e National Associ- ation of (state) Insurance Commissioners has promulgated a "Model Act" for mortgage guaranty insurance that provides a useful and comprehensive ref- erence point for undertaking MI anywhere in the world. Some markets, for example, Hong Kong, Canada, Australia, and Israel, have enacted individual regulatory provisions similar to some of those appearing in the U.S. Model Act, such as the monoline restriction, special MI contingency reserve, and stringent risk-to-capital ratio limits, while not adopting the entire Act. One alternative to having a comprehensive MI law is to adopt a more abbreviated regulation under w hich the regulator then issues a n MI in surance license based upon its approval of, and the insurer's adherence to, a detailed business plan. Canada, for example, operates in this fashion. 344 housing finance policy in emerging markets Although not regulated in the same sense as private MI providers, the most soundly conceived government-sponsored MI p rograms are those that o perate under r ules simila r t o t hose g overning p rivate in surance programs. Most important a re t he r ules requiring ac tuarial s oundness, including premium rates and reserving formulas. Less important for gov- ernment programs are the rules relating to con ict-of-interest and con- sumer protection. Public MI programs that have, since the early 1990s, bene ted from strin- gent rules include, most notably, the FHA's Mutual Mortgage Insurance Fund (MMIF) and the Canada Mortgage and Housing Corporation's MI fund. As described in the nal section of this chapter, each of these programs encoun- tered solvency challenges in the late 1980s. As a result of their nancialstress, each was subjected to stringent new rules and required to operate under more rigorous commercial principles; each is stronger today as a result. Some developing countries that have, or are contemplating, a p ublic MI program do not yet have any legal or regulatory provision for a mort- gage-insurance type of fund. Mexico and Mali are examples where the MI fund has been established, at least temporarily, as a special type of banking institution. Although the risks of home mortgage lending and mortgage insurance are similar in some ways, the MI fund does need insurance-spe- ci c rules, for example, for segregated capital accounts, actuarially based premiums, and rules for catastrophic loss reserves and loss provisioning that are di erent than for banks. In short, while private MI may require more extensive regulation than a public provider, the public MI must be subject to e ective core regulations requiring a prudential, commercially based activity. e nal section of this chapter discusses historical MI fail- ures in several countries; weak regulation or supervision o en was a con- tributing factor. Because MI r isks embody both insurance and real estate lending traits, its ideal regulator in a national government probably is of the type where all major nancial institutions (banking, insurance, securities) are consolidated under a single authority, for example, Sweden (Swedish Financial Supervi- sory Authority), the United Kingdom (Financial Services Authority), Canada (O ce of the Superintendent of Financial Institutions), and Australia (Pru- dential Regulatory Authority), rather than under f ragmented authorities, most notably the United States. As MBS activities have grown, along with the mortgage insurance 345 in uence of the Basel Accords, over risk-based capital, this type of regulatory framework for MI b ecomes even more advantageous. As noted further in the following section, a uni ed and coordinated nancial-institutions regu- lator can minimize lender opportunities to engage in unhealthy "regulatory capital arbitrage." Finally, consideration should be given to what rules governing MI should be statutory versus what should be established by ministerial regulation. In short, rules that are rarely in need o f change are better enshrined by law; those that may evolve with changing market conditions are better le to the regulator's discretion. Bank Risk-Based Capital Rules In gauging the outlook for MI in any country, banking regulation can be at least as important as insurance regulation. Of course, the MI provider needs its policyholders to be nancial stable and competent lenders. More speci - cally, however, how banks' risk-based capital regulations are implemented under the Basel Accords in any given country can directly in uence--posi- tively or negatively--prospects for MI success. It may be only a small overstatement to say, " ere is no natural market demand for MI." In fact, le to their own devices over time, private lenders may be inclined to retain for themselves (while possibly underestimating) whatever risk premium the market may be willing to pay for making higher LTV-ratio home loans. Even where MI is seen as a tool to jump-start a dys- functional or reluctant private-lending market, natural demand for MI may not be sustained over time, or lenders may adversely select for insurance pro- tection only those loan applications they perceive to be inferior risks. For the public-purpose objectives of MI to work well--reaching under- served market segments, extending a ordable homeownership, and fortifying credit risk management system-wide--regulated banks need a broad-based incentive to use MI in a wa y that averts adverse risk selection. Experience in some countries shows that the risk-based capital weightings judiciously applied to home mortgages can be used to achieve these ends. As noted earlier and illustrated in table 13.3, LTV ratio is the predominant variable, over both time and geography, which drives default risk on home 346 housing finance policy in emerging markets loans. High LTV (low borrower equity) loans in any given environment pro- duce much higher default and loss rates than lower LTV loans.3 In deciding how, and whether, to grant favorable risk weightings on resi- dential mortgages, it makes sense for a central bank to recognize this dra- matic inverse relationship between borrower equity and risk, rst by setting a sensible LTV cap on home loans eligible for favorable capital treatment. If domestic mortgage experience data is lacking, this important decision can be well grounded in rich international experience tying borrower equity to mortgage risk. en, to advance the above-noted public p olicy goals ass ociated with the use of MI, it also makes sense for a central bank to recognize--consis- tent with Basel--the added insurance-sector capital support of MI serving to o set the higher credit risks of high LTV lending. Without quali ed MI credit enhancement,4 home loans exceeding the set LTV benchmark should not be risk weighted any more favorably than a commercial mortgage. Countries w hose ba nking r egulators c urrently assign a r educed-risk weight for home mortgages exceeding a designated LTV ratio but covered by private MI coverage include the United States (90 percent LTV); Australia, Italy (80 percent LTV); and Israel (60 percent LTV). Finally, nancial-sector r egulators o perating under emer ging B asel II rules need to guard against "risk arbitrage" by primary lenders. Credit-risk- based capital rules need to be consistent, particularly among direct primary lenders, mortgage holders under various forms of structured nancings and securitization, and mortgage insurers as t hird-party credit enhancers. e rules should not provide any incentive for perverse lender behavior, that is, to undertake transactions that allocate, shi , or substantially increase credit risks solely to exploit inconsistency in risk-based capital rules. 3. Overall loss rates are computed as default frequency× loss severity. Table 13.3, shows expected losses on 98­100 percent LTV loans to be more than four times the expected losses on 75­80 percent LTV loans. Recent empirical studies suggest that several variables, including credit scores, rival LTV as predictors of borrower default. ese indicators, however, relate more to early borrower credit failure than long-term mortgage loss incidence. 4. MI that is government backed or that has been assigned a high investment rating for claims- paying capacity. Also, loan coverage that reduces lender exposure to an LTV level that is con- sidered safe without MI. mortgage insurance 347 Consumer Issues Several issues r elated to consumers (borrowers) have arisen in co untries having the most extended MI experience, including: · De nition of bene ciary · Subrogation rights5 · Refund of unearned premiums Issues relating to who is the bene ciary and what are (or what should be) the rights of subrogation under the MI policy are somewhat related, so we shall discuss them together. e MI provider always issues its policy (typically in the form of a "master policy") to the insured lender. en, the lender, upon the payment of the MI premium and some form of underwriting review, receives certi cation that individual loans submitted for insurance are covered under its master policy. e question regarding who is the bene ciary has arisen largely because the premium charge ultimately is borne by the borrower. is question elevated into a heated consumer issue in several countries mainly when MI providers, upon t he pa yment o f c laims--especially under dep ressed ma rket co ndi- tions--have pursued dispossessed borrowers to pay o their remaining debt a er the mortgaged home has been resold. Problems a rising f rom mo rtgage in surers s eeking r ecourse aga inst defaulted borrowers have arisen mainly in the United Kingdom, Australia, and New Zealand and, to a lesser extent, in the United States. In Australia and New Zealand, the issue was e ectively clari ed going forward by changing the name of the product from mortgage insurance (MI) to lenders mortgage insurance (LMI). For those who may be structuring a new MI program--public or private-- this question mer its t houghtful attention and a bala nced approach. One middle-ground approach used in the United States has been to exempt bona de o wner-occupant b orrowers f rom mo rtgage in surer r ecourse (ex cept 5. "Subrogation" is an insurance term referring to the right of the insurer, upon the payment of a claim, to "step into the shoes" of the insured and assert any rights the insured may have had to recover losses from a third party. In the case of MI, this means the MI assumes the lender's rights to pursue the defaulting borrower for any unpaid debt outstanding a er resale of the collateral property. 348 housing finance policy in emerging markets where any such borrower acted deceitfully). e argument can be made that one who borrows for investment purposes, that is, to rent out the dwelling unit, rather than live in it, is party to a commercial transaction who has not lost his or her home. Such a defaulting borrower should remain liable to pay any remaining debt a er the pledged collateral has been resold.6 Under MI programs where the entire premium is prepaid--o en 3 to 4 percent of the total loan amount--a consumer protection question can arise with respect to a program's provisions for partial refund of premium paid in the event that the insured loan terminates much earlier than expected. Some such refund provision should apply, at least over the early years of the loan. Some programs, including in the United States and in Israel, have o ered the choice of a nonrefundable premium at a discounted rate compared with the refundable MI premium option. Inrecentyears,so-called"captiveinsurance"hasgainedgroundamongMI usersinseveraldevelopingmarkets.InsuredlendershaveformedMIa liates orsubsidiariesexpresslydesignedtocaptureashareofthetotalMIpremium throughvariousr isk-sharingarrangements,forexample,reinsurance.C on- sumerconcernsregardingthispracticemayarisetotheextentthatthelender's pro tmotivemayresultinthecostofMIbeinghigherthanitotherwisemight be,orMImightberequiredonloansthatwouldotherwisebemadeuninsured. Finally, in s ome co untries, a n a ttractive co nsumer b ene t has b een appended to some existing MI programs. In mid-2004, two leading private MI rms, as well as the state-sponsored Massachusetts Mortgage Insurance Fund, announced the addition of "mortgage payment protection" coverage to their standard MI programs. For no additional premium payment, bor- rowers who become involuntary unemployed can have six to nine monthly mortgage payments made directly by the insurer to the lender on their behalf. Similar, though not identical, mortgage payment protection programs have existed for some years in France and the United Kingdom. 6. A corollary to this observation is that only borrowers who are personally liable for repayment under their mortgage loan agreement should be eligible for MI. mortgage insurance 349 Information Technology For the two key reasons of managing risk and controlling costs, the public or private MI provider must pay keen attention to applicable and specialized information technology. All insurance lines rely heavily on statistical data. MI's information needs are especially demanding. As noted earlier, MI needs three basic types of data: (1) housing market and home price data, (2) b orrower income and credit data, and (3) home mortgage performance data. In most developing markets, for a number of reasons, such information is more di cult to obtain than, say, data needed to write auto, homeowner, or life insurance. More o en than not, mortgage performance data of the character and duration needed by MI does not even exist at the outset. For a public or private insurer to be nancially self-sustaining it needs to operate under the "law of large numbers," which means gathering and man- aging large amounts of external and internal data, and doing so e ciently. In the most advanced markets, MI providers are electronically connected to their insured lenders, credit reporting bureaus, and property information databases. ey rely on large mortgage performance databases to validate their automated underwriting decision models. Massive credit history data- bases and predictor models now generate Fair, Isaac and Company (FICO) and r elated loa n-scoring syst ems t o su pport b oth MI under writing a nd pricing. Drawing on huge property transaction databases, automated valu- ations are even beginning to supplant individual home appraisal reports. Property and mortgage registry systems are being converted to electronic form, able to provide MIs and other market players with near-instantaneous reporting. Behavioral models now are being used to guide MI c laims-ser- vicing personnel on the use of their time and resources. GovernmentMIprogramsinparticularneedto"keepup"withprivatelenders forthesakeofbothriskmanagementandmarketing.IntheUnitedStates,for example,lagginglegislationandunderinvestmentint echnologyhasp roved costlytotheFHA'sMMIF,bothintermsofmarketshareandlossmanagement. Bycontrast,theCMHChasstayed"aheadofthetechnologycurve";forexample, withitsEMILIautomatedunderwritingsystemandelectroniclenderinterface forbothissuingnewinsurancecerti catesandforprocessingclaims. 350 housing finance policy in emerging markets Table 13.6. Advantages and Disadvantages of Public and Private MI Schemes Public MI advantages Private MI advantages · Zero or minimal regulatory capital · Credit risk management expertise · Ability to impose uniform standards · Cost and operational efficiency · Better able to cover catastrophic risk · Investment in technology · More inclined to serve small market · Ability to spread risk across international borders · More inclined to operate in untested primary market · Product design/marketing responsiveness · No requirement to pay taxes or produce a return on · Free from political influence invested capital Source: Author's own analysis. Sweden's BKN is another MI program notable for its leading-edge invest- ment in information technology, which has paid o in terms of extremely low operating costs relative to outstanding guarantees. Automated processes include lender registration of new loan guarantees issued as part of its "del- egated underwriting" system, and the electronic linking of BKN's database with a national database of property registrations. Most developing markets are not prepared to take full advantage of these information technologies. But, any business or strategic planning for starting a public or private MI sho uld consider these things as t hey relate to local market conditions and its anticipated rate of development. At a minimum, with respect to IT, the MI provider should keep up--and ideally remain a bit ahead of--the lenders it serves. Whatever the state of a market's IT development, any MI sponsor will have a vital interest in p romoting standardized and robust loan-level mortgage data collection by lenders and loan administrators, including detailed loan characteristics at origination and loan-performance detail from origination to termination. Public-Private MI Partnerships As noted earlier, most countries' MI programs today are government spon- sored. Yet, many public o cials where government MI already exists or is planned also want to attract private MI risk capital in support of their public policy objectives. mortgage insurance 351 Government and private MI bring advantages and disadvantages, respec- tively, to the marketplace, most notably those shown in table 13.6. Not surprisingly, policy makers seek to devise constructive public-private MI partnership arrangements that can realize "the best of both worlds." Fol- lowing are a n umber of such arrangements that are currently in us e or in active planning. Public MI Provider Supported by Private Reinsurer(s) is partnership device is used in a number of countries, including the fol- lowing: · e United States-- e State of Massachusetts' MI fund reinsures a quota share 90 p ercent of its credit risk with a la rge U.S. MI rm, thereby adding geographic diversi cation and writing capacity. · Hong Kong-- e HKMC presently reinsures 80 p ercent of its MI risk with four highly rated private reinsurers--two domestic and two United States­based. · Mexico--Private reinsurance with one or more U.S.-based MI rms (initially 50 percent quota share) is a core component anticipated by Mexico's revised public MI program, currently being launched by the Socieded Hipotecaria Federal (SHF). · South A frica-- e H ome L oan G uarantee C ompany (HL GC) (a nongovernmental organization originally capitalized by t he S outh African government) has for some years relied upon a U.K. reinsurer for capital support and added wr iting capacity. Unlike the govern- ment insurers noted above, HLGC also depends upon its foreign reinsurer for the investment-grade rating that has made its guarantee viable with domestic lending institutions. Advantages o f t he g overnment MI a nd p rivate r einsurer pa rtnership arrangement include the following: 352 housing finance policy in emerging markets · e up-front guarantee, issued b y a g overnment agency, serves to minimize--or e ven elimina te--insured lender s' r isk-based ca pital weighting under Basel rules that strongly favor government-backed loans. In many countries this has proved a major incentive for banks to engage in low-down-payment residential lending. · e government MI program may be subject to added market disci- pline, especially in terms of pricing and screening of risks. e public agency can bene t from the reinsurers' knowledge and experience regarding, for example, marketing and product design. · If a small country, the government MI can e ectively diversify its risk beyond national boundaries. · e reinsurer can familiarize itself with a new or emerging national market without having to invest so heavily in est ablishing its own direct writing capability. · e government program's writing capacity--therefore, its mission achievement--can be greatly expanded without requiring a co rre- sponding increase in capital or contingent risk. Caveats applicable to this particular arrangement include the following: · e r einsurer sho uld t horoughly under stand t he MI b usiness in country-speci c terms · e private reinsurer should be an active risk management and mar- keting partner, not just a nancial partner for the government MI · e g overnment p rogram sho uld no t b ecome vulnera ble t o a ny sudden reinsurer withdrawal from the market · Ultimate catastrophic risk coverageisle to the private partner, rather than the government Government Backup for Private MI Provider is type of partnership arrangement has worked well in Canada for many years. Canada has one public MI (CMHC) and one private MI (Genworth, formerly GE Canada). Under a catastrophic form of "reinsurance" arrange- ment, the private MI has paid about 10 percent of its annual premium into mortgage insurance 353 a special reserve fund, and, in return, its policyholders are covered up to 90 percent on any claim that the private MI might ever fail to pay as a r esult of future insolvency. is special arrangement helps to place the competing public and private MI providers in Canada on a relatively "level playing eld." Of particular value, the 90 percent backup coverage translates into 90 percent risk-based capital relief under the Basel bank capital agreements. e Homeownership Guarantee Fund, the Netherlands' quasi-private MI program, also operates with a form of catastrophic government backup. In the event the Homeownership Guarantee Fund were unable to pay its claims, the national government and the municipalities are obliged to step in on a 50­50 basis a nd cover the fund's entire de cit in t he form of interest-free loans. is g overnment bac kup tra nslates in to a zer o r isk-based ca pital weighting for insured home mortgage lenders in the Netherlands--as noted, a strong incentive for banks to make such loans. Of the above two MI partnership models in which the public and private player respectively assumes r isk in a p rimary or secondary role, given the above noted advantages of each, which alternative is preferable? While the answer will dep end somewhat on a co untry's individual cir- cumstances, including its stage of mortgage market development, a sovereign government should be better suited to lling a backup position that includes assuming ultimate catastrophic (systemic) risk; a p rivate MI p rovider, in turn, ought to be better suited to providing direct primary lender and market interface and assuming the risks that are most measurable and predictable. As a p ractical matter, drawing a b right-line distinction between these two types of risk can be a di cult exercise. So, one may ask, why is the more preferable of these two basic alterna- tives the one less frequently found in practice? Among the likely answers are: First, if the primary market is not well developed, private MI providers will be reluctant to engage in dir ect underwriting and market interface; they will p refer to negotiate reinsurance arrangements t hat assure rea- sonable control of risks and costs and opportunity for pro t. Second, in a developing market, the government may be in a better position to impose rules and terms for the type of program that will meet its perceived public policy objectives. A no te o f ca ution: W hile g overnment mig ht a ppear ide ally sui ted t o assume catastrophic MI r isk, experience shows this not always to be the 354 housing finance policy in emerging markets case, as illustrated later in this chapter. A sovereign government under scal duress may not always ful ll its obligations when they are presented, whereas a triple-A-rated private MI will have rigorously stress-tested capital reserves dedicated to payment of claims at depression levels, and an enforceable obli- gation to do so. ese two alternatives for allocating risk between public and private MI partners need not be mutually exclusive. A working blending of the two may be found in a form of "mezzanine" coverage used elsewhere by private rein- surance rms. Under such an arrangement, the public MI w ould assume both a limi ted rst-tier risk and ultimate systemic risk, while the private carrier would assume a middle , or mezzanine, layer of risk. In the private sector, the reinsurer's liability may be triggered when the loss ratio in a given year reaches a threshold percentage; the reinsurer's liability is exhausted, in turn, when the loss ratio for that period reaches and exceeds a second, much higher, trigger point.7 Government-Sponsored Enterprises (GSEs), Privately Insured8 Unique to the United States, this MI public-private partnership bears men- tion, if not imitation. Fannie Mae, Freddie Mac, and the Federal Home Loan Banks--all formerly government entities--are today federally chartered, pri- vately owned special-purpose enterprises whose core mission includes pro- viding capital market access for primary home mortgage lenders. Together, these three GSEs fund over two-thirds of all U.S. home mortgage loans. In their own right, they guarantee, for a fee, repayment of the mortgage pools they buy and securitize. As hybrid entities, the GSE boards include both private- and public-sector o cials. Although privately owned, they receive 7. e applicable period for establishing the loss-ratio triggers may be either the year in which losses occur or the year during which the risk was originated, the latter being known as "book of business" risk. 8. is discussion describes the recent pre-crisis structure of the three U.S. housing nanceGSEs. In late 2008 two these quasi-government enterprises--Fannie Mae and Freddie Mac--facing severe portfolio losses and technical insolvency--were ordered into conservatorship by their federal regulator and infused with massive infusions of "bailout" capital by the national gov- ernment. e U.S. Congress will eventually determine whether their future sponsorship will be public, quasi-public, or private. mortgage insurance 355 special government bene ts and are subject to some social targeting of their nancing activities. All three GSE's partner with domestic private mortgage insurers--two by statutory mandate and one voluntarily--by relying on pri- vate MI risk capital to cover top-layer credit risks on their securitized high LTV loans. Whichever o f t he a bove p ublic-private pa rtnership mo dels ma y b e adopted, the national government should properly account for its net state exposure (contingent liabilities net of reserves and reinsurance) as part of its total public debt. e matter of public-private MI partnership should be viewed dynami- cally, that is, in t erms of possible sequencing of optimal arrangements as a country's mortgage market develops and matures. e nature of this sequence normally should be toward progressively more private assumption of MI risk, subject only to continued ful llment of core social objectives. Such a progression, tracking with overall market maturation, might go through the following stages: Stage One: Government MI as sole provider Stage Two: Government MI with private reinsurer(s) State Three: Adoption of "sunset provision" for government provider Stage Four: Possible entry of private MI provider(s) in tandem with government Stage Five: Sale of minority ownership in g overnment provider to private partner(s) Stage Six: Ceding of controlling or 100 percent interest in govern- ment provider to private MI investor (that is, partial or full privatization, with exercise of sunset provision) with government assum ption a nd r etention o f ca tastrophic (systemic) risk; also, possible reinsurance of higher-risk loans meeting targeted social goals. Public-Private MI Competition Several ad vanced ma rkets--notably t he U nited S tates, C anada, a nd Australia--have experience with competing public and private MI programs. 356 housing finance policy in emerging markets In each instance, public MI preceded private MI. While this con guration evolved, rather than being an explicit public policy decision, both regulators and customers may derive certain bene ts from it: · Premium rate and service competition helps both the market and the regulator. · While restraining monopolistic behavior by a sin gle public or pri- vate provider, the government-sponsored MI program can continue to target "down market" or other underserved markets (for example, rural housing, low-income, informal sector) that a for-pro t MI may nd less attractive. Toend ure,t histyp eo fp ublic-privateco mpetitionr equiresaco nscious balancingactbypoliticiansandregulators. egovernmentinsurerwillhave inherent nancialandmarketadvantages(forexample,notaxes,norequired investorreturns,lessstr ingentregulation,minimalr isk-basedcapitalweight forlenders).Yet,thecompetitiveplaying eldmustbekeptreasonablylevelin lawandregulation.Despiteperiodicgrumbling,theUnitedStatesandCanada have,forthemostpart,maintainedsuchabalance.WhiletheprivateMIshareof Canada'smarketisconsiderablysmallerthanintheUnitedStates,theCanadian government,asnotedabove,hascontinueditscapitalbackupfortheprivatepro- vider,therebyhelpingtoensurethatCanada'sMImarketremainscompetitive. Australia has g one a di erent route; in 1997 t he national government withdrew from the MI ma rket, selling its once dominant public MI entity outright to a foreign-owned private MI rm. In New Zealand, by contrast, a pilot, publicly sponsored MI program was begun in 2003 with a single lender. Targeted at low-income, mostly rural and small-town borrowers, it does not for now appear to be competing directly with the two established commercial MI providers. Market expansion by either the public or private programs, however, could result in direct competition. Despite the perceived advantages of sustaining competing public and pri- vate MI in some developed markets, this probably is not a model for a devel- oping economy to emulate. Any of the previously referenced public-private MI partnerships probably would be preferable. mortgage insurance 357 Table 13.7. MI Program Reversals and Resolutions--Selected Cases United States Problem: For about 20 years up until 1996, the FHA Resolution: The FHA Assignment Program was allowed insured lenders to receive a 100% claim terminated in 1996. Since then, improved techniques payment on many delinquent loans without having to for helping delinquent borrowers resolve their problems foreclose prior to submitting the claim. Instead, the and for mitigating MI losses have produced dramatic lender would simply assign ownership of the delinquent positive results. mortgage to the FHA. Only borrowers who were delinquent "through no fault of their own" and who were determined to have a "good chance of bringing their loan current" could have their loans transferred from the lender to the government MI. Then, a 1995 study concluded that FHA's Assignment Program had cost the MI fund an extra $1.5 billion and that about 2/3 of all loans assigned to FHA ended up in foreclosure anyway. The government's effort to help distressed borrowers or save money by servicing delinquent loans in lieu of private lenders was a costly failure. Canada Problem: Following two severe regional recessions Resolution: Federal legislation was passed requiring in the 1980s, the government-sponsored CMHC's that CMHC be run according to commercial insurance reserves became depleted to the point where it had to principles, including actuarially based premium rates seek additional funding from the federal treasury. Funds and capital reserves. These reforms were implemented, needed to pay claims were advanced by the government including increased premium rates. to CMHC in the form of a loan. Prior to this event, CMHC's claims reserves had been funded based upon year-to-year loss projections. Problem: The remaining private MI firm in the Resolution: After an extended effort, an agreement 1980s suffered severe claims losses in the country's appears to have been reached to establish a "level major energy-producing province. These losses were playing field" between the public and private MI aggravated by a provincial foreclosure law prohibiting providers, including recourse rights for both only on lender or MI recourse against defaulting borrowers, loans over 75% LTV, with clear borrower disclosure regardless of ability to pay. Many borrowers simply required. "walked away" from homes whose resale values had fallen well below the outstanding mortgage balance. The competing government MI, exempt from provincial law, retained full recourse rights. United Kingdom Problem: In the 1980s, economic weakness and the Resolution: Program reforms, including reduced bursting of a home price "bubble" in the London area coverages, clarified contract terms, greater risk sharing, and several other markets caused MI carriers to face and higher prices. Formation by some lenders-- massive claims and losses, resulting in the failure of reluctant to continue using third-party insurers--of one leading insurer and nonpayment of many claims by affiliated "captive MI" companies. Eventual entry of others. Poorly written insurance contracts resulted in new international MI providers. Unfortunately, the widespread misunderstandings and disputes between commingling of MI with other homeowner-related insurers and lenders. "Mortgage indemnity" insurance coverages continues and MI regulation has not been experienced a severe and lingering loss of credibility. strengthened. The Philippines Problem: After 50 years of ongoing operations, the Resolution: Despite the program's full government government-sponsored MI in recent years experienced guaranty, many claims went unpaid during the heavy claims and losses and a depleted balance sheet. program's suspension. Although claims gradually Lacking capital, it temporarily suspended writing new are being honored--partly in cash and partly with coverage, while awaiting a substantial capital infusion government credits and paper, many prior claims from the government. Although economic instability was remain unpaid, still awaiting requested legislative a contributing factor, the severest losses were caused by appropriations. The insuring activities that caused such defaults on large-scale development-related loans. high claims have been terminated. continued 358 housing finance policy in emerging markets Table 13.7. MI Program Reversals and Resolutions--Selected Cases (continued) Sweden Problem: The public MI fund paid out losses amounting Resolution: Program regulations were changed, to over US$1.1 billion on risks that it underwrote during including severe restrictions on guaranty amount as the early 1990s. These claims were mostly from loans percent of property valuation. Economic conditions secured by rental apartments, and, to a lesser extent, improved. MI losses on loans insured since 1994 have cooperative projects. Causes of widespread defaults been miniscule, but so also has new business volume. included cost-based valuations that proved too high relative to market values, exacerbated by deep recession and the absence of borrowers' personal liability on non- owner-occupied loans, along with higher taxation and reduced subsidies for the housing in question. Even during the several years when so many insured loans went bad, the MI program's loans on owner-occupied homes suffered minimal claims. Mexico Problem: FOVI, the predecessor to SHF, the current Resolution: SHF, under its recently reformed MI public MI agency, provided its insured lenders with a program for new originations, also has revised and 50-50 "pari passu" credit guaranty scheme during the relaxed requirements for receiving claim reimbursement 1990s under which the underwriting was delegated for defaulted loans under the old FOVI credit guaranty to the originating lender. For years, the program paid program. Establishing credibility for Mexico's new public almost no claims. The reason: conditions for submitting MI program is being done in part by restoring the old a valid claim, including required documentation that program's credibility. the loan had been originated in accord with program requirements, were so stringent that lenders were unable to recover under the guaranty when borrowers failed to repay. Source: Author's own research. Lessons Learned is chapter began by relating the 1930s debacle of an entire MI industry in the United States. Learning from that experience, both public and private MI providers have operated more soundly over recent decades than they might have otherwise.9 Over the past few decades, a number of MI programs and providers have su ered signi cant, though less dramatic, reversals. From each of these, how- ever, something of value might be gleaned for an MI program operating at a later time and in a di erent country. Table 13.7 provides a number of such experiences, including inferences that may be drawn. Some useful inferences that may be drawn from these international MI experiences include the following: 9. While the MI industry largely avoided assuming the risks and devastating losses caused by subprime lending, it has experienced severe and growing losses from the Alt-A market seg- ment, as well as on negatively amortizing "Option ARM" and 100 percent LTV loans. mortgage insurance 359 · e success o r failure of an MI p rogram in a de veloping market cannot be judged until it has faced a nd survived a major economic downturn. Very few emer ging economies have t o date reached a point where their current MI programs either have encountered eco- nomic adversity or have registered a ma jor impact on the markets they serve. · e closer that an MI program adheres to its main mission of sup- porting ho meownership--that is, in suring loa ns s ecured b y indi- vidual owner-occupied dwelling units--the more stability it is likely to demonstrate in times of adversity. · MI pricing must be actuarially based and maintained at levels that will be self-sustaining over the long term. A false sense of well-being that prevails in upward-trending markets should not be the basis for reducing MI tari s. · ough generally not required to make a pro t or pay taxes, a public MI should adhere to established commercial and insurance principles. · e terms of MI coverage should be established clearly when a loan is rst insured so that loss reimbursement at the time of claim is pre- dictable and prompt, barring fraud. · Default r isks co vered b y MI need t o b e sha red wi th o riginating lenders in such a way that lenders face some contingent risk exposure on loans not properly underwritten or serviced. · Foreclosure la ws need t o p ermit r ecourse aga inst defaulting b or- rowers who are able to repay their debt. MI providers need to have at least some limited ability to assume a lender's recourse rights a er the payment of a claim. · A sovereign MI guaranty may not be fully reliable, despite the favor- able capital treatment it bestows upon lenders. Even government- backed programs need to have su cient dedicated capital reserves and cautious screening of the type of risks to be insured. · Collateral recovery as a condition for claim payment is highly advis- able. If the collateral property cannot be recovered in a r easonably predictable time frame, then the bene t of the mortgage being a high- quality secured asset, whereby loss exposure can be mitigated, is lost to the MI provider. 360 housing finance policy in emerging markets Conclusion Mortgage default insurance can be a useful supporting component of a devel- oping housing nance system, especially in reaching aspiring rst-timehome buyers who have di culty saving the large down payment needed to qualify for an uninsured bank loan. While potentially valuable, MI is not a panacea. Some developing econo- mies may view public MI as a wa y to jump-start home mortgage lending without having to implement painful primary market reforms. Others may see MI as a costless way to subsidize homeownership for low-income or other socially needy families. Any such MI initiatives should be avoided; their true costs may be deferred or concealed for some years, but will eventually emerge at a most unwanted time. Public MI should not become a vehicle for dumping bad contingent risks on the government. Enduring social bene ts of a public MI will only materi- alize if the program operates under key insurance and risk management prin- ciples. is worthy goal, in turn, is unlikely to be realized unless the public MI is subject to strong, commercially oriented regulation and supervision. Many developing countries will nd it di cult to induce a private-sector MI rm to enter their market as a primary provider. Lack of historical mort- gage performance data and other market information, impediments relating to collateral recovery and mortgage and title transfers, and limited business- volume prospects o en present a level of uncertainty and perceived risk that will deter early entry by a private rm. is does not mean a lack of interest; however, housing nance o cials may need to chart an alternative course of action to make MI a reality and to eventually attract private risk capital. e government may need to assume the role of initial MI sp onsor, at least as a mo del or pilot to demonstrate its viability. As part of a larger plan and e ort to grow the housing nance sector, such a step can pay dividends beyond simply proving that it can be done. Properly positioned and supported, MI can serve as a ma rket cata- lyst, not only for increasing loan volume, but helping to set standards that will raise the home mortgage's investment quality for banks and secondary investors alike. is chapter has o ered an international blend of historical experience, program information, suggestions, and caveats about MI, all for the purpose mortgage insurance 361 of giving some insight and help to those who are facing decisions regarding whether to go ahead with MI, or having already decided, how to go about it. Chapter 14 Residential Rental Housing Finance David Le Blanc, with major contributions from Richard Green and Claude Taffin Introduction Recent years have witnessed the fast de velopment of residential mortgage markets all over the world. In countries such as India, China, Turkey, Mexico, and Morocco, the introduction of market-friendly reforms has permitted the private mortgage sector to start expanding rapidly. By contrast, rental housing remains underdeveloped and under nanced in many emerging economies. An inhospitable environment facing the rental sector is directly re ected in t he large portion of the housing stock that is outside the bounds of formality. Without alternatives to buying a f ormal dwelling, which is o en una ordable to a large portion of the income distri- bution, households resort to informal housing, be it owned or rented. us, in many countries a large informal rental market exists, in which the landlords are mostly individuals, not rms. e nancing of this rental stock is over- whelmingly based on equity.1 By contrast, in developed countries a number of nancing options for rental housing has developed over the years. 1. In parallel, there may exist a small r ental segment at the higher end of the market, owned by private investors and operated by professional rms, and aimed at housing more wealthy 363 364 housing finance policy in emerging markets In many countries, the rental sector houses the youngest and poorest parts of the population. In emerging economies, many renters would not be able to buy property, even if mortgage nance were more developed. e challenge facing policy makers is thus to provide a ordable rental housing opportu- nities for these categories. One of the tools that can be used to achieve this is rental subsidies. ese subsidies m ust navigate between two con icting goals: they have to enable the supply of a ordable rental housing for low- income households, while at the same time no t discourage investment in rental housing; for example, maintaining attractive risk-adjusted returns for rental investors. Developed countries have put in place various types of rental subsidies, either for the sector as a whole in order to stimulate investment, or more targeted to middle- and low-income households. e main issue with these subsidies is that they are usually scally expensive, and therefore may seem beyond the reach of most countries, which face at the same time more pent-up housing demands and less favorable macroeconomic conditions. e main objective of this chapter is to take stock of the various ways by which residential rental housing in emerging economies could be nanced and subsidized in order to enable the provision of a ordable rental accom- modation for middle- and low-income families. The Rental Sector in Housing Policy The Importance of Enabling a Vibrant Rental Sector Enabling the development of a healthy formal rental-housing sector is impor- tant for a number of reasons: First, the rental sector is a natural outlet for households that do not have su cient income to a ord buying a ho me, or that have not saved enough to meet down-payment requirements for ownership. Young adults and the poorer f ractions of t he p opulation t into t hese categories. In countries where the private rental market is small or declining, the interim role played by the rental stock is missing, and one sees young adults living longer with their parents. categories of the population including young professionals. residential rental housing finance 365 Second, vibrant rental markets are key to active resale markets and ex- ible labor markets. Mostly because of transaction costs, o wnership entails high mobility costs, which can penalize mobility. Ownership can thus pro- vide negative incentives to relocate closer to jobs (mobility trap). In contrast, mobility within the rental sector entails relatively low xed costs, which can be seen as an advantage in societies going through rapid changes in the struc- ture and localization of employment. is would characterize most transi- tion countries (see World Bank 2005). ird, a robust rental sector is needed to give households a larger choice for asset investment. In most co untries, housing as a n asset has t he two drawbacks of being indivisible and relatively illiquid, which a ects the way households can manage their portfolios. As a tenure choice, rental may allow households to avoid overinvestment in housing, compared to other assets. As an investment, rental housing generates a source of income that comple- ments other income sources. In many developing countries it can also be a substitute for nonexistent pension systems, thus being a critical element of welfare improvement for the elderly (UN-Habitat 2003). Lastly, a ordable rental markets make it easier for households to accumu- late down payment funds and thus promote mortgage markets, increase the value of housing assets, and facilitate the uidity of resale housing markets. e importance of a functioning formal rental market is all the more crucial when the mortgage market is no t fully developed, because access t o own- ership is mo re di cult. Usually, as mo rtgage markets develop, LTV limits tend to increase, which facilitates access to homeownership by households at early stages of the life cycle (for example, with low savings but high future income streams). In parallel, credit providers tend to serve more families in lower-income brackets, thus allowing a greater portion of the middle- and low-income p opulation to access ho meownership. B efore these favorable outcomes are realized, though, rental markets have an important role to play in the life cycle of most families.2 2. A manifestation of the need for rental markets in undeveloped nancial systems is the exis- tence of intermediate systems between ownership and rental. Residential leasing is one such system. Antichresis, by which landlords basically raise equity from tenants in exchange for a limited time of rental without payments, is very popular in some Latin American countries. e Chonsei system in Korea is another well-known example. Such practices are obviously made easier by the absence of low-down-payment mortgages, and would probably tend to disappear when the mortgage market expands. 366 housing finance policy in emerging markets Imbalance between Rental and Homeownership Despite compelling reasons for enabling a vib rant rental sector, the rental sector has received, at best, limited attention in many developed countries and emerging economies, in comparison to homeownership.3 Support o f ho meownership has emer ged f rom di erent perspectives depending on the regions and historical contexts. Homeownership has been actively supported by many governments on the grounds that it promotes citizenship, essentially by giving a st ake to individuals in t he society. is paradigm is characteristic of the United States which subsidizes homeowner- ship through the tax system (deductibility of mortgage interest and property taxes, non-taxation of imputed rent, virtual non-taxation of capital gains) and the nancial system (lowercost nance through support of government- sponsored enterprises). Ownership of one's home has been seen as providing many social and economic bene ts, including in particular the free usage of the space allowing families to set up businesses or income-generating activi- ties within the premises. Homeownership is also thought to provide neigh- borhood externalities through maintenance and improvements. For example, promoting homeownership has been an explicit policy choice in most coun- tries of Latin America. Transition economies constitute a special case, in the sense that high ownership rates mainly result from mass privatization of the housing stock undertaken in the post-Soviet era (see World Bank, 2005). In many countries, the stated or implicit preference of the government for o wnership has r esulted in a n une ven p laying eld b etween t he tw o main tenure modes and ownership o en bene ts from more favorable tax regimes and subsidies. A result of this imbalance is that in many countries, rental housing is co nsidered as a n unpro table and risky investment. It is not uncommon to see private investment in t he sector stopping for whole periods of time, up to a point where the size of the sector decreases. is hap- pened, for example, in the United Kingdom a er drastic rent controls were put in place in the a ermath of World War II. As argued above, the role of rental markets is potentially greater in coun- tries still at earlier stages of mortgage-market development. What o en hap- pens in t hose countries, though, is t hat formal rental markets are weak or 3. For a complete discussion on this issue, see UN-Habitat (2003). residential rental housing finance 367 virtually nonexistent. As families need shelter whatever the circumstances, these countries witness the development of informal rental and ownership markets in all kinds o f forms, o en resulting in economically and socially suboptimal outcomes. Overall, this is all t he more regrettable, as no sust ainable alternative to public rental housing has yet emerged in many developing countries. Public rental housing played a major role in t he 1960s a nd 1970s in almost e very region of the world, but has steadily declined since. Plus, the bulk of subsidies to households have been shi ed to sustaining homeownership. Private-sector tenants receive little help of any kind. As a consequence, some entire segments of the poor populations have been mostly le out of the subsidy system.4 Rental Housing as an Investment Rental investment can basically be decomposed in a series of cash ows. e rst cash ow consists in an initial investment in a property (development), including land costs, construction costs, nancial costs, "so " costs such as fees, and taxes. A er completion of the units, the project generates a series of periodic cash ows re ecting on one hand the collection of rents from the dwellers, and on the other hand the operation and maintenance costs as well as the taxes incurred by the landlord. A er the end of the exploitation phase, the property can be sold by the owner, which generates a positive cash ow and is generally subject to tax. is sequence of cash ows determines the net p resent value and the internal rate of return of the rental project. Net operating income, de ned as the di erence between rents and operating and maintenance costs, is the key element considered by nanciers when considering whether to provide nancing for a rental project.5 e one positive component of net operating 4. For example, the rental market still houses between 20 a nd 40 per cent of households in Argentina, Brazil, Chile, Mexico, and Peru, and data show that the homeownership rate among t he p oorest households ( rst quintile) has dec lined in all t hose countries during the last decade (World Bank 2004). In other regions of the world the rental sector is by far the dominant tenure status for the poor; yet a negligible proportion of housing subsidies is reaching them. 5. e availability of ways of nancing involving leverage is of the utmost importance, especially for institutional investors. 368 housing finance policy in emerging markets income, the rent, is of course a critical element of the pro tability of a rental project. Other elements impacting the net operating income relate to the various costs borne by the landlord during the rental period. e main costs relate to the following: · Management of the building--this comprises physical management of the structure, tax and administrative management, and commer- cial management, including minimizing the vacancy periods. · Maintenance of the building--in many countries this item can become problematic, as the division of responsibilities between landlords and tenant relative to maintenance are not clearly de ned. · Taxes and fees--there are two components to this item: taxes and fees applying to the structure, which can in part be paid by the renters, and taxes on rental income which are paid by the landlord. Looking at the structure of these costs, it appears that management costs, and to a lesser extent maintenance costs, allow for economies of scale. us, higher returns can potentially be achieved for multifamily buildings than for single rental houses. In order to achieve these economies of scale, however, two conditions must be met: · Financing must be available--the size a t which economies of scale are maximized is signi cant; thus, investments of the appropriate size will necessitate leverage. · Professional real estate management capacities must exist. ese two conditions are o en not met in emerging economies. Mostofthecash ows generated by a rental project are uncertain. us, the decision of the investor to invest or not in rental housing is dictated not only by return considerations, but also by risk considerations. e main uncer- tainties that distinguish rental investment from homeownership investment concern the collection of rents, which constitute the bulk of the positive cash ows generated by the project. In addition to rent payment risk, risks pecu- liar to rental versus ownership include the following: residential rental housing finance 369 · Vacancy risk, stemming from the fact that the probability that a given unit in the project will be vacant and may remain vacant for a long time, is not known; · Eviction risk, meaning that evicting a delinquent renter involves costs and may prove di cult, whether because the judiciary system tends to interpret the texts in favor of tenants, or because the execution of judiciary decisions against tenants is not enforced; · Disposal of the asset, in the sense that the law may restrict the land- lord from using the dwelling units as he or she wishes (for example, to renovate, remodel, sell or destroy the unit). ese risks are in uenced or directly governed by the legal and regula- tory f ramework t hat r egulates r elations b etween t enants a nd la ndlords. When this framework is p erceived as t oo coercive by landlords, the latter stop investing in formal rental housing, and, when alternative investments are missing, which is frequently the case in emerging economies, informal rental develops. The Challenges of Developing Rental Housing in Emerging Economies e development of rental markets in emerging economies is hindered by many constraints that do no t speci cally relate to the lack of nance for rental housing. ese bottlenecks can be classi ed into two main categories. e rst category includes adverse macroeconomic conditions and inappro- priate regulatory environments applying to housing construction (building codes, housing standards) in general. In some countries, macroeconomic fundamentals do not permit the two sides of the market to match. A fairly common case is the combination of low incomes and high interest rates, which generates a basic a ordabilityproblem. Household income is very low, and a small fraction of households could a ord to pay the rent of a minimal-size d welling as de ned legally. e problem is co mpounded in a hig h-interest-rate en vironment, b ecause t he o ppor- tunity cost o f investing in r ental housing is hig h. As a co nsequence, at the required level of nancial return, there is no demand for the minimum-stan- 370 housing finance policy in emerging markets dard product developers are allowed to construct. Or, conversely, current rent levels are not attractive enough to generate new investment. is has been the case in Brazil, for example, because of consistently high interest rates. Minimal habitability st andards are o en s et t oo hig h by t he national housing policy. Unrealistically set minimal habitability standards are poten- tially a stumbling block to a ordability policies, both in the ownership and rental sectors. In some countries, the construction costs o f the "minimal unit" (that is, a unit having the minimal characteristics deemed to necessary to provide "decent" shelter) are far above the means of a large portion of the income distribution. is means that, either large subsidies will ha ve to be provided in order to make standard housing units a ordable to everyone, or some portion of the population will have to be housed in units not matching minimum habitability standards. Mobilizing enough (direct or indirect) sub- sidies to house all households in standard units o en just proves to be unsus- tainable. As governments cannot explicitly recognize the necessity to lower minimal standards, there will be room for a large informal or substandard rental sector. e existence of a repressed rental demand for units smaller than the min- imum standards is visible in many big cities of the world where low-income workers choose to live close to jobs in substandard rental tenements, where they usually pay high rents. e so-called tugurios in Lima and the cortiços in Brazil are Latin American examples; collective rental accommodation in Dhaka, Bangladesh, is another example. A common feature of informal rental products in Dhaka and São Paulo is that they are reportedly very pro table. us, it is p robable that there would be both social gains and a p ro table niche for private-sector involvement, were the governments willing to accept to lower standards to include similar types of dwelling units. e second category of obstacles includes other factors related to the envi- ronment of the rental sector, and speci cally: · the legal a nd regulatory framework governing the landlord-tenant relationship, · rent control, and · the tax system applying to rental housing. residential rental housing finance 371 Box 14.1. Returns on Formal Rental Housing in São Paulo, Brazil In many cities comparable to São Paulo, the rental sector would be a natural outlet for low-income housing demand. A survey done for the municipality of São Paulo in the central districts of the city in 2004 showed that the rental stock has been in constant decline, going from 60 percent of dwellings in 1980 to 22 percent. This can be associated with low returns on rental investment in general. Data from the survey showed that average gross returns ranged from 7.6 to 14.4 percent, depending on the type of units. When adjusted for maintenance costs, vacancy, and nonpayment risks, these returns are far lower than those of other types of investments (in 2006 the current yield of government securities wass around 18 percent). Generally sp eaking, in ma ny co untries, g overnment p olicies in t hese domains tend to depress returns (o en by increasing the costs associated to rental operation), while at the same time incr easing risks of rental invest- ment. When the overall environment of the rental sector is perceived as too coercive by potential investors, private investment in formal rental housing stops. is may provide a ra tionale for the government to start providing rental housing directly but, in t urn, the existence of an important public rental sector may hinder the development of the private rental market. Rights of Landlords and Tenants Many of the cash ows determining the returns on a rental investment are inherently uncertain. e risks associated with the income streams associ- ated to a rental property are in uenced or directly governed by the legal and regulatory framework that governs relations between tenants and landlords. Many governments like to present themselves as t he defenders of tenants, versus landlords, and impose stringent conditions on the scope of rental con- tracts, as well as on their execution. Examples include the following: 372 housing finance policy in emerging markets · imposing minimal durations for lease contracts and legal limitations to the yearly increase in rents, · imposing strict conditions to recovery of the dwelling by the landlord, · systematic interpretation of the texts by the judiciary system in favor of the tenants, and · reluctance or refusal of the executive branch to enforce court deci- sions of eviction against defaulting tenants. All these circumstances basically increase the rental risk faced by inves- tors. is type of problem has plagued countries as diverse as Egypt, India, France, and Morocco. In addition, the political sensitivity of these issues makes changing the legal framework a real challenge that cannot be tackled frequently. Rent Control e introduction of rent controls used to be a st andard measure even in market economies if rents in the private rental market were considered too high from a political standpoint. A famous example is the rent freezing intro- duced in several European countries during the First World War, which was maintained for decades therea er. As a consequence, the private rented stock almost disappeared in the United Kingdom andsu ered from lack of mainte- nance and underinvestment in France, which eventually built up the political pressure for mass production of public rental housing in the post-World War II period. e economic e ects of rent control have b een a nalyzed ext ensively.6 Economists traditionally distinguish " rst generation" rent controls, which basically freeze the rents to their current nominal level, from "second gen- eration" rent control, which apply milder co nstraints. A pa rticular sort of second-generation rent control is tenancy rent control, whereby initial rents are set freely (for example, the rent can be freely adjusted whenever a new 6. See, for example, Arnott and Johnston 1981, Arnott 1995, Basu and Emerson 2000 and 2003, Fallis and Smith 1984 and 1985, Glaeser and Luttmer 2003, Gyourko and Linneman 1989, and Igarashi and Arnott 2000. residential rental housing finance 373 tenant moves in), but the progression of the rent for the duration of the lease is xed or capped by an index.7 First-generation r ent co ntrol, w hen im posed o n t he existin g ho using stock, constitutes a forced, uncompensated transfer from the landlord to the tenant. In some countries (for example, Egypt), the controlled unit can pass to the heirs of the sitting tenant with no or minimal adjustment of the rent, in which case the unit itself is practically transferred to the tenant, while all the costs and liabilities remain on the owner's shoulders. is has resulted almost universally in high vacancy rates (owners prefer to leave their units empty than to rent them out), absence of maintenance, absence of rehabili- tation and upgrading of the controlled stock (in some cases going up to the collapse of buildings), as well as low residential mobility. Illegal subletting and increased key money charges are also common practices in the rent-con- trolled sector, as in public rental housing (see for example, Arnott and Anas 1992 for the Swedish case). e main other e ect of rent control is to deter any new investment in the rental sector. Egypt and France a er World War II o er extreme examples of the negative e ects of rent control. Evidence on second-generation rent controls is mo re mixed. While it may have positive e ects in cases where landlords may have some monopoly power (Igarashi and Arnott 2000), it is nonetheless thought that such sys- tems penalize frequent movers (in practice, mostly young people), because landlords factor in the fact that the rent is xed for the duration of the lease into the initial rent (see Basu and Emerson 2000 for a discussion on India on this aspect). To summarize, countries that have imposed hard types of rent control have witnessed a dwindling of the rental sector. Unsatis ed rental demand, as well as investors' money, has been carried over to the informal housing sector, with precise outcomes depending on the countries.8 It is now widely accepted that the best remedy against situations of scarcity and high prices in the private rental market is comprehensive housing market deregulation and, where appropriate, introduction of explicit public subsidies. 7. For example, this form of rent control is the prevailing regime in France, and is also prevalent in India. 8. In developing countries, informal housing has played a role of adjustment between demand and (insu cient) formal supply. In transition countries, where the stock was alr eady pro- duced and impossible to hide, many ingenious ways of circumventing rent controls have been devised, with the same motives of escaping the administration. 374 housing finance policy in emerging markets Ito en proves di cult, however, to shi from a system in which implicit subsidies are paid to tenants by landlords, to one in which subsidies must be paid for up-front by the government.9 Countries wanting to phase out rent control have o en proceeded gradually. Usually, rent control on the existing stock is maintained, while new construction is exempted from it. is cre- ates a dual rental market, with very low rents in the rent-controlled segment, and very high rents for uncontrolled units. is can be seen in Egypt and Lebanon. Unfavorable Tax Regimes In many countries, the stated preference of the government for ownership versus rental as a tenure status has translated into a favorable tax treatment for homeowners. By contrast, rental housing o en o ers limited tax advan- tages compared to other types of investments. e asymmetry between rental and ownership for tax purposes is o en visible in the form of the following: · Favorable tax treatment of capital for developers, such as acceler - ated amortization, exemption of construction tax, etc. For example, in Morocco, considerable tax breaks are granted to developers con- structing social housing (de ned as units with value under an MDH 200,000 [US$24,000] ceiling) for ownership; these advantages are not available for rental programs. · Tax advantages to homeowners such as income tax deductibility of mortgage interest (India, Mexico), temporary exemption of property tax, and more favorable local taxes. For individual investors, the proportion of gross rental income that can be deducted for income tax purposes is o en not su cient to cover the real management and maintenance costs, or the provisions for amortization of rental investment are not as attractive as t hose applying to other forms of capital investment. 9. Rent control can be a highly inequitable form of income redistribution as well. As it is unit based at opposed to individual or household based and not means tested higher income indi- viduals or households frequently bene t. residential rental housing finance 375 As a result of these tax policies, the choice between rental and ownership from the point of view of both investors and households is biased, because the cost of capital is lower for ownership than for rental.10 Social Rental Housing Historically, social rental housing in developed countries may be seen as the outcome of a situation where the housing conditions of the poor were seen as unacceptable or generating too many negative externalities (notably in terms of health conditions and crime), and private nance was not available for production on a signi cant scale. Countries wanting to implement social housing programs thus had to nd low-cost resources to nance them. In a country like France, specialized nancial circuits allowing for subsidized resources for lending to social housing companies were put in place. In the version that was widel y developed in s ocialist economies, in t he United States and in Western Europe a er the Second World War, most units produced under the system were managed by the government (local or cen- tral) or by companies controlled by the government. Units were allocated to households selected according to more or less transparent criteria. Generally, rents were set with no or few references to market rents. is model of housing production and management has generated many economic and social issues. erefore, over time, developed countries have adjusted t heir s ocial rental p rograms. Al though t he degree a nd sp eed o f change has di ered across countries, some general patterns can be identi ed: · ere is a general tendency to disengage government at all levels from the ownership of rental properties and from direct management of social units. A well-known example is the policy of privatization of the municipal housing stock in the United Kingdom, through a right- to-buy scheme or the transfer to housing associations. 10. is issue has been thoroughly investigated in the United States. See for example Poterba 1980, Hendershott 1980, Hendershott and Shilling 1982, Hendershott and Ling 1984, DiPasquale 1989, and DiPasquale and Wheaton 1992. 376 housing finance policy in emerging markets · Rents in the public-rental sector are more o en set in reference to pri- vate rents--be it through "fair market rents" (United States), rents found in comparable units in the neighborhood (United Kingdom), etc. · Governments and regulators tend to introduce competition in t he attribution of subsidies and o -market (low-cost) nancing, by pro- moting competitive biddings and yardstick competition (for example, in the United States for tax-exempt bonds or projects nanced by the housing tax credit, and the United Kingdom for additional nancing for rehabilitation). ere is als o a g eneral tr end t oward usin g ma rket-based f unding f or public rental housing, made possible by the development and liberalization of the nancial sector in the 1980s. Macroeconomic stability and decreasing interest rates a er the introduction of the Euro further encouraged social landlords t o t urn t o ma rket nance. F or exa mple, t he Housing Fina nce and Development Centre of Finland (ARA) uses modern nancial-market instruments, including securitization. France and Austria are now the only countries in the Euro zone that still use a state subsidiary to nance the social rental sector. Speci c intermediaries, however, are o en needed to help smaller inves- tors access capital markets and secure guaranteed loans (for example, in Fin- land, the Netherlands, and the United Kingdom). In the 1960s and 1970s, many developing countries replicated the basic public rental model with even less s uccess. Reasons for failure included, among others:11 (i) units built at too-high standards and una ordable to low- income residents, even with low rents; (ii) lack of basic commercial concerns, resulting in construction of public units in places where there was no demand for them; (iii) p olitically driven attribution of units or implicit encourage- ment by politicians not to pay the rents; (iv) exacerbated social problems resulting from the absence of basic infrastructure, water and sanitation, jobs, and services in t he neighborhoods of the public compounds, resulting in economic segregation of the residents; and (v) lax ma nagement practices, resulting in low rent collection and nancial stress for the public companies, 11.For a discussion on this point, see UN-Habitat (2003) and Villoria Siegert (2004), and refer- ences therein. residential rental housing finance 377 and eventually in lack of resources for operation and maintenance, then for new production. is lack of sustainability has led to the scaling down or abandonment of public rental programs in ma ny countries. Public rental housing has b een abandoned in most L atin American countries, with the notable exception of Brazil, which has developed a residential leasing program (Programa de Arrendamento Residencial [Residen tial L easing P rogram; PAR]). Poland has also been an exception, with the creation of a special fund for municipal rental housing. Both programs, however, are currently facing sustainability problems. e experience of these two countries is discussed in the section on country examples. Some Market Financing Models for Rental Housing is section brie y outlines various nancing strategies relying on the market that can be applied to rental housing, from the least to the most sophisticated nancially. Obstacles relevant to emerging economies are also discussed. All-Equity Based is model is prevalent in many developing countries where access to nan- cial market is limited, and rental housing is perceived as too risky by insti- tutional investors. is could be a valid description of the context prevailing in Morocco, for example. Households already owning a dwelling (formal or informal) having saved enough cash decide to add one oor to their house (or to build another house in the neighborhood) in order to rent it out, a er comparing the return they get from this investment to the returns they could get on alternative investments (the set of which may be fairly limited, espe- cially for non-banked households). Compared to institutional investors, individual landlords o en largely escape the tax system, both during the production phase and the exploita- tion phase, which increases the return on the investment. ey also are able to enjoy a closer relationship with their tenants, which confers the following advantages: (i) usually, there is only one tenant household, which avoids con- 378 housing finance policy in emerging markets tagion problems; (ii) the landlord may install individual meters for water and electricity or at least individual connections, which he ma y cut in cas e of nonpayment of the rent; this, along with the risk to the neighborhood reputa- tion of the tenant, lowers the risk of nonpayment; (iii) very o en there is no formal lease contract, which allows the landlord to bypass legal and judicial di culties in case of problems. For all these reasons, the returns to individual landlords can be higher than those of institutional investors and explain why the latter are absent from the rental sector. is strategy has obvious drawbacks: · the invested money is not leveraged; · because of the (varying) degree of informality of the process, the con- structed dwellings largely escape the tax system, but also the bene t system--renters are di cult to identify and be provided bene ts; · the investment is very illiquid, especially in the case of a oor in the landlord's home; · there is no diversi cation of risks. ere are many variants to this case. In Saudi Arabia, some real estate companies are beginning to invest in multifamily rental apartments, based mostly on own equity. At the same time, these companies are actively paving the way for alternative ways of funding projects (bank loans or direct tapping of capital markets). Real Estate Investment Trusts (REIT) A more sophisticated form of rental investment consists in investment funds (whose legal nature and structure can vary depending on the country), whose purpose is investment in rental housing. e prototype of such funds is the U.S. equity real estate investment trust (equity REIT). e funds raise equity from investors, and then buy, develop, or manage the rental properties directly. e basic concept of these structures is to allow the pooling of equity for invest- ment in rental projects in a tax-e cient manner. Simply stated, an equity REIT serves as a conduit through which income is passed, in the form of dividends, from a real estate portfolio to shareholders. If certain conditions are met the residential rental housing finance 379 income that is passed through is not taxed at the REIT level. Such vehicles pro- vide liquidity to the rental equity market, both because individual investors can invest in shares with low unit value compared to a physical investment in rental housing, and because shares can be traded on a secondary market. North America has w ell-established REITs. Australia, Japan, Singapore, Hong Kong, New Zealand, and South Korea also have well-established, or newly formed, REITs. In the EU, four countries (Belgium, France, Greece, and t he N etherlands) ha ve c lear t ax-e cient REIT str uctures in o pera- tion, while Italy utilizes a h ybrid structure. e two largest economies in the region, Germany and the United Kingdom, introduced tax-transparent REITs in 2007. Two other European countries, Russia and Turkey, also have existing REIT structures. Compared to the individual investor model described above, the advantages of real estate investment funds such as REIT o r the French Société Civile de Placement Immobilier (Real Estate Investment Trust; SCPI) are the following: · net returns are potentially higher because of professional rental man- agement and economies of scale; · risks are reduced because the portfolio of the fund consists in mul- tiple properties, which can be located in di erent regions or parts of the cities, and thus, rental and geographic risks are mitigated; · there is no "indivisibility e ect" (no minimum investment required), which is good in terms of portfolio composition for individual inves- tors; · the investment is more liquid. Of course, appropriate regulation, especially in terms of accounting, pru- dential rules, and consumer information, has to be set up by the regulating authority in order to avoid misuses of investors' funds. In France, SCPI are submitted to regulations that closely resemble those of other nancial prod- ucts, in terms of governance, accounting, and disclosure of information. SCPI owners also bene t from the tax incentives applying to individuals investing in new rental housing. Usually, commercial rental investment is more pro table than residential housing, which in turn is more pro table than social rental housing. us, private investors attracted by those structures will not necessarily be inter- 380 housing finance policy in emerging markets ested in s ocial housing investments, unless addi tional tax advantages are granted to social projects. Examples of equity REITs used to nance social housing exist, however. A prominent example of such a REIT is t he Com- munity Development Trust based in New York, the primary goal of which is to preserve and increase the stock of a ordable housing through long-term equity investments and mortgage lending. is privately held REIT invests in a ordable housing in more than 20 states and has attracted private investors who are currently receiving a yield of nearly 5 percent per annum. Bank-Supplied Credit for Residential Rental Investment Lending for rental housing investment is essentially long term. er efore, all the potential issues associated with long-term lending by banks (liquidity and interest rate risks, instruments for matching asset and liability dura- tions, existence of a demand for long-term paper) are relevant and should not b e underestimated. ese issues, ho wever, are not sp eci c to rental investment lending, and we refer the reader to other chapters of this book for a t horough discussion. In this chapter, we start from the premise that banks do lend long term to other sectors, for example, mortgage lending for homeownership. What, then, are the obstacles that could prevent lending for residential investment? e provision of loans to investors eager to undertake residential rental projects relies on the willingness of the banks to engage in this activity, as well as t heir getting su cient know-how in t his kind o f product. e two conditions can be problematic in speci c countries. First, in ma ny co untries (inc luding de veloped co untries), r esidential rental housing is perceived as less pro table and more risky than commercial rental.12 us, banks will tend to engage rst in commercial lending. Second, lendin g f or r esidential r ental ho using is v ery di erent from retail lending for ownership. Multifamily housing nancing is a co mpli- cated venture, involving a whole range of stakeholders. In addition, unlike 12. e reasons for high risks in the residential rental market have been elaborated on in the pre- vious section. For example, the capacity of enforcing the lease contracts may be low. Low fore- casted returns can be the consequence of legal caps to rent increases, low household incomes, or high maintenance costs. residential rental housing finance 381 Box 14.2. Underwriting Criteria for Multifamily Rental Loans Contrary to owner-occupied loan underwriting, which involves evaluating the bor- rower as much as the property, underwriting residential rental loans is closer in spirit to underwriting business loans and relies heavily on the examination of the cash flows generated by the project. Although the assessment of the risk of rental loans will include commercial criteria such as market need, zoning, architectural merits, availability of community resources, etc., lenders will typically focus on three ratios when underwriting income properties: Loan-to-value, similar to mortgage lending for ownership; Debt coverage ratio (defined as net operating income over debt service), and Breakeven ratio (debt service + operating expenses over gross operating income). Breakeven measures the amount of vacancy the property is able to sustain without incurring negative operating income. In the United States, there are some commonly accepted benchmarks for these ratios. For example, a debt coverage ratio of 1.20 or more is necessary to get a mortgage. In the case of replacement of credit enhancement facility, credit pro- viders or enhancers also typically require that the property has performed well in terms of occupancy rates over a specified period prior to closing. single-family construction, no st andardized debt instruments or nancing process exists and multiple funding sources are common. As a business line, it is closer to project nance, as it relies heavily on the examination of the cash ows generated by each particular project. As such, it is less sub ject to automated procedures of loan approvals and other re nements that have facilitated mortgage lending in many countries. is implies that lending for multifamily housing will generally be done by a speci c department in the nancial institution, comprising speci c pro les of sta and using speci c models for assessing the risks of the projects. For all t heses reasons, some banks choose not to develop this activity. 382 housing finance policy in emerging markets Finally, lack of information on rental markets and on housing markets in general can be detrimental to the development of a lending activity to multi- family housing. e assessment of the nancial viability and pro tability of a rental project relies heavily on projections of future rents, operating expenses, and real estate prices. e rst two parameters determine the sequence of net operating income streams, while the second drives the behavior of the inves- tor's net equity in the project. A lack of information on the housing market as a whole, which is common in developing countries, thus translates into di - culties in projecting key nancial parameters over the life cycle of the project. is results in the price of credit being higher to compensate for the higher perceived risks and, secondly, banks will be less inclined to develop speci c products for rental investment. Capital Market Financing In a rental investment project, at least two kinds of cash ows can be used for the purpose of structuring nancing instruments: the repayments of a mort- gage taken on the project, and the cash ows (net rents) generated directly by the project. Consequently, there are di erent avenues for tapping capital markets: Examples include the following: · issuance of bonds or securities backed by the mortgages made b y banks or other lenders for rental investment (residential commercial mortgage-backed securities); · direct nancing of the rental project on capital markets by bonds, with or without backing from a non-bank intermediary (used in the United Kingdom for the nancing of social housing); · issuance of bonds by local governments, the proceeds of which are lent to rental projects (municipal tax-exempt bonds in t he United States). e rst type of bond is a particular kind of mortgage bond or MBS. e second case is c loser to methods used for the nancing of infrastructure, whereby the bond yields a re directly based on the future income streams generated by the project. In the third case, what the investor is buying is the residential rental housing finance 383 municipality's (or its a liate's) signature, not directly the individual project owner's quality. Commercial Mortgage-Backed Securities Lenders can access t he capital market through securitization of the mort- gages provided to rental investors. In the case of rental housing, the associated products are called (multifamily) commercial mortgage-backed securities.13 In the United States, GSEs such as Freddie Mac purchase multifamily rental loans for securitization. In Europe, some social housing entities have been using transactions similar to commercial mortgage-backed securities to sell some of their portfolio loans. e best known example is the Fennica trans- actions of ARA (which is the Housing Fund of Finland) (see box 14.3). Box 14.3. Securitization of Multifamily Rental Loans and Social Housing Loans In the United States, Freddie Mac buys rental loans for securitization. The products ("Multifamily PCs") are secured by structures with five or more units designed principally for residential use, with terms generally ranging from five to 30 years. They offer the Freddie Mac guarantee of timely payment of interest and full and final payment of scheduled principal. Generally, Freddie Mac requires the following of all mortgages it purchases: be secured by properties with occupancy rates of at least 90 percent for the three months prior to loan closing and as of the loan closing date, have debt coverage ratios of at least 1.25 for the first mortgage and 1.15 for the first mortgage and any subordinate mortgages, and have LTV ratios not exceeding 80 percent for the first mortgage or 85 percent for the combined first and subordinate mortgages. (continued) 13.Commercial mortgage-backed securities are similar to MBSs b ut backed by loans secured with commercial rather than residential property. Commercial property includes multifamily, retail, o ce, etc. 384 housing finance policy in emerging markets Box 14.3. Securitization of Multifamily Rental Loans and Social Housing Loans (continued) Social housing is provided throughout Europe, and there are a number of examples of the use of securitization for funding purposes in a wide range of methods in quite a few countries. In Sweden, through the Framtiden issues made between 1995 and 2001, the city of Gothenburg sold a number of portfolios of loans to multifamily housing companies that provide low-cost rental houses for families to an SPV, which raised funds in the asset-backed capital markets. Similarly, in Finland through the Fennica issues, funds have been raised in the asset-backed capital markets by the sale of loans made by ARA subsidized by another agency of the Republic of Finland to social housing borrowers for the purchase or construction of multifamily rental housing. In Belgium, this is also the case with the Atrium and Eve issues, where loans made to social housing companies for the provision of low-cost single-family housing were securitized; and in the Netherlands with the Colonnade and Dutch Housing Association Finance issues going back to 1997, which financed the securitization of loans to Dutch housing associations guaranteed by a specially established state entity. Direct Tapping of Capital Markets Securitization of rents is a technique that can be compared to the securitiza- tion of mortgages. Future ows of rents from a given project and for a limited period of time are sold to an investor, like future loan repayments. e default risk is also transferred to the investor. Investors and rating agencies will be interested by the potential for the project, as measured by the expected evolu- tion of rents (and allowances when applicable) and vacancy rates. Since the introduction of securitization in the United Kingdom, securiti- zations of social housing receivables have been completed by housing asso- residential rental housing finance 385 ciations and other Registered Social Landlords (RSLs). While the biggest housing associations have gone to the market on their own, e Housing Finance Corporation Limited (THFC) has played an increasing role as a pro- vider of funds for RSLs that will not or cannot do t he same. THFC issues bonds on behalf of its client RSLs. Before the nancial crisis, 30-year bullet (interest-only) structure bonds issued by THFC on behalf of RSLs achieved margins under 100 basis p oints under t he treasury-bond rates for similar durations, with a AA rating. e motives of social lenders in the United Kingdom to use rent securiti- zation (as opposed to secured nancing) are not so much capital e ciency or bad credit conditions;14 for most RSLs, banking credit remains the most asset-e cient source, based on current asset-cover ratios being achieved. Rather, the demand stems from the potentially loan-capital-intensive nature of RSL development activity and the need to underpin the supply of assured investment funds for supporting a long-term business.15 Credit Enhancements and Insurance Products A number of nancial products aim at rendering the investment in residen- tial rental housing more attractive. A distinction can be made between: · insurance products devised to insure the cash ows produced by the property to the landlord, · credit enha ncement p roducts a pplying t o indi vidual mo rtgages (aimed at primary lenders), and · credit enhancement products applying to the bonds issued to nance the investment (aiming at achieving a triple-A rating for the bonds). Among the rst category, one nds insurance for rental payment for land- lords (timely payment or nonpayment). In Europe, insurance companies 14. ere is no equivalent to the Basel capital adequacy regime for housing associations. Equally, the sector has an extremely good credit track record. 15. Undiversi ed s ocial lender s a re (a rguably) co untercyclical b usinesses, w hereas w holesale bank funding tends to be cyclical. Hence, measures to diversify funding to include elements of capital markets funding, as well as bank and building society funding, should be considered prudent. 386 housing finance policy in emerging markets o er this kind of product to landlords through real estate agencies. Subsi- dized versions of this product also exist (for example, LocaPass in France, nanced out of the "1 percent levy"). In the second category, mortgage insurance is the most popular product. Mortgage insurance insures lenders against loss on mortgage defaults. In so doing, it makes capital more readily available to developers. In the United States, HUD provides mortgage insurance for pro t and non-pro t sponsors in Section 221(d)(3) and Section 221(d)(4) for the construction or rehabilita- tion of rental and cooperative housing for moderate income groups. e pro- gram allows for long-term mortgages (up to 40 years) that can be nanced through Government National Mortgage Association MBSs. In Europe, local and central governments have o en played a role in guar- anteeing loans made to social housing institutions. Guarantees are still o ered by local governments to public housing projects (France)16orbymutualfunds to social housing projects (France, United Kingdom, the Netherlands). In Slo- vakia, the state guarantees loans for the construction of rental apartments for lower-income groups in order to provide incentives to the use of private nance. In the Netherlands, a complex system of guarantees for social housing loans has been put in place, in which the state and municipalities play the role of last-resort guarantor on top of other guarantees. Alternative o r addi tional s ecurities ca n b e p rovided t o t he lender b y securing reserve funds that can be tapped in the event of late payments or default. Recent loans to housing associations in the United Kingdom were secured by mortgages on social housing properties and cash reserves in favor of the issuer and bond trustee. In the event of default, the bond trustee will have the right to collect the rents and manage the secured property. Bond enhancement products provide security for the bondholders and impact the bond rating. A higher rating translates into a more favorable bond interest rate and ultimately a lower mortgage rate. ese products are distinct from mortgage insurance in that they typically do not look at the quality of individual credits within a pool. Rather, they provide additional security on top of what is already provided by, for example, mortgage insurance. In the 16.In return, there is a reservation of 20 percent of the units nanced with the guaranteed loan. residential rental housing finance 387 Box 14.4. Bond Enhancement Products for Multifamily Rental Housing Credit enhancement products used for securities based on multifamily housing are of the same kind as those existing for other types of mortgage securities. In particular, they include the following: guarantee of payment of mortgage principal and interest that is used to pay the bond investors; liquidity facility, aimed at meeting the scheduled cash flows in the event the borrower is not able to meet its commitments; and principal reserve fund, particularly in the case of variable rate bonds. Principal payments may be made to a principal reserve fund held by the trustee rather than directly amortizing the bonds. Payments made to a principal reserve fund will accumulate. At the maturity of the bonds, the funds accumulated in the principal reserve fund will be paid to the bondholders. Alternatively, they can be used to redeem bonds. United States, all bond- nanced mortgages issued under tax-exempt bond- nanced programs must be credit enhanced.17 Country Examples is s ection dis cusses exa mples o f p rograms o f p ublic su pport t o t he nancing of rental housing nancing from selected developed countries and emerging economies. e choice of the countries and programs is a imed at illustrating the variety of the subsidies used and the diversity of public- private partnership arrangements through which they are implemented. e examples also try to highlight the di culties and pitfalls embedded in public support programs. 17.Eligible credit enhancers include banks, mortgage insurance companies, bond insurers, the FHA, Fannie Mae, Freddie Mac, and Ginnie Mae. e di culties of bond insurers and mort- gage insurance companies in the nancial crisis have led to a virtual cessation in private sector credit enhancement. 388 housing finance policy in emerging markets The Low-Income Housing Tax Credit (LIHTC) in the United States A ordable rental housing in the United States is provided through a combina- tion of federal and state programs, very o en with supplementary nancing or subsidies f rom o ther in stitutions (N GOs, lo cal g overnments).18 Ea ch state has i ts own housing nance agency, whose goal is t o provide a ord- able housing opportunities for low-income families throughout the state. State agencies review and select projects for nancing on federal programs, based on transparent criteria.19 Federal subsidies are rationed and awarded through competition b etween projects. Housing nance agencies usually also have their own programs, which can complement federal programs (in some cases, a development becomes eligible for state credits once the housing nance agency has approved an application for federal credits. If a develop- ment does not receive federal credits, it cannot receive state credits). e two main federal programs directed at a ordable rental housing are embedded in the Tax Code: · LIHTC is a 10-year tax credit granted to investors investing in a ord- able rental equity. Housing tax credits can either be syndicated to generate part of the required equity or be utilized directly to o setthe borrower's tax payments. · Tax-exempt b onds f or m ultifamily r ental ho using nancing are bonds issued by local governments for special government purposes, including the production of a ordable rental housing. e purpose of the federal LIHTC program is to create a nancial incen- tive (in the form of tax credits) for private investors (both pro t and non- pro t) t o in vest in t he de velopment o f lo w-income r ental ho using. e 18.Apart from subsidies to the production of a ordable rental housing, the United States also has an important federal program of direct subsidies to renter households (Section 8 vouchers). is program has b een analyzed in a n umber of papers to which we refer the reader (for example, Crews Cutts and Olsen 2002). 19.In addi tion t o e valuating a pplications f or cr edits, t he ho using nance ag encies mo nitor housing credit properties to ensure that rents are maintained at the agreed levels, that tenants' incomes do not exceed the allowable limits, and that the apartments are well maintained. residential rental housing finance 389 developer sells the tax credits to a p rivate investor (both individuals and corporations) through a process know as "syndication." A "syndicator" is an organization that helps set up a partnership between the developer and the private investor to cooperate on tax-credit projects. e developer is typically the general partner, while the private investor is a limited partner. e devel- opment capital thus raised will be paid through the syndicator's equity fund in stages, which are subject to negotiation.20 e private investor bene ts by using the tax credits to reduce its annual tax liability each year during 10 years. e tax credit is an actual dollar-for- dollar reduction in the amount of taxes due to the tax authorities. As a partner and co-owner of the project, the investor enjoys other tax advantages, such as accelerated depreciation on the buildings and passive losses. During the period 1995­2005, 1,100,000 ho using units have been con- structed under the program, and their nancing, design, and target popu- lations ha ve va ried signi cantly acco rding t o st ate a nd lo cal needs a nd preferences. On average, an additional 110,000 units are created each year, representing approximately 30 percent of all multifamily housing construc- tion annually. e program has proven successful at both creating a ordable housing and providing good returns on investments. Competition for tax credits has increased as investors have become more familiar with the pro- gram. For example, the amount of private investment raised per dollar of tax credit rose from $0.47 when the program was originated in 1987 to $0.62 by 1996. As investors have become more comfortable with the program's min- imal risk level, the returns they require in order to invest in an LIHTC prop- erty has fallen from an internal rate of return of 28.7 in 1987 to 18.2 by 1994 (assuming an eight-year pay-in) (Cummings and DiPasquale 1998). Brazil: the Residential Leasing Program (PAR) Brazil o ers a good example of a country in which the legal framework gov- erning the relations between tenants and landlords are judged well balanced, 20.A typical payment schedule would be 30 p ercent upon formation of the partnership, 40 percent upon completion of construction, and 30 p ercent upon completion of occupancy. erefore, the developer will need t o secure predevelopment loans, construction loans, and "bridge" loans to nance the development until tax-credit payments are received. 390 housing finance policy in emerging markets but where adverse macroeconomic conditions have prevented private rental markets to develop during the recent years. e PAR constitutes an attempt by the Brazilian federal government to introduce a residential leasing program aimed at reaching low- and middle- income groups. e PAR is targeted at households with income between four and six minimum salaries. Bene ciary households rent their units and have a buy option a er 15 years. e program applies to newly constructed units and to renovated units as well. e PAR is managed by the main public housing bank, CEF. Municipali- ties play a key role in the program.21 ey negotiate with CEF on the loca- tion of the program and the counterpart funding that will be brought by the municipality (usually in the form of land provided for the construction of buildings, or through the donation of municipal residential buildings to be renovated); they participate in the design of the construction or rehabilita- tion program (approval by CEF is needed). ey propose a list of bene cia- ries of the program to CEF, which then screens applications and makes the nal selection of bene ciaries. It can be estimated that the value of the nancial subsidy embedded in the PAR corresponds to 55 p ercent of the unit value; however, the total subsidy rate is higher, because some costs are not included in the value of the unit used for rent calculation, such as the value of the land donated by the municipality when applicable, the value of infrastructure built and not included in the unit price, the value of exemptions of local taxes, etc. Overall subsidy rates for the PAR can be estimated to be around 70 percent of the total unit value. e PAR is considered in Brazil as a successf ul example of cooperation between municipalities and actors from other government levels. Since the inception of the program in 1999, 160,000 housing units had been constructed or renovated and 75,000 were under construction at the end of 2006. However, the PAR illustrates thedi culties faced by governments wanting to deliver nished housing units meeting minimal q uality criteria to low- income households who could not a ord them otherwise. Because of very high subsidy rates, the nancial balance of the program has been put at risk, 21.PAR also works with associations (very o en cooperatives gathering members of professional corporations). e cooperative usually provides the land and selects the applicants. residential rental housing finance 391 despite the existence of low-cost resources from the provident fund FGTS. Maintaining such a hig h level of subsidies is sim ply not sustainable in t he long run. Poland: the TBS Experience Private residential rental markets are currently underdeveloped and under - nanced in Poland. Among other factors, this can be attributed to unfavorable legal and tax environments. e National Housing Fund (KFM) is a p ublic rental program that has nanced, between its inception in 1996 a nd the end o f 2005, t he comple- tion of 61,600 new rental units for moderate income tenants (an additional 11,800 dwellings were under construction at the end of 2005). e program has been steadily growing in size, with production in 2004 st aying at 9,100 dwellings, but in 2005 declined to 8,000 dwellings. e Fund is directly administered by the state bank, Bank Gospodarstwa Kra- jowego (Bank of the National Economy) through long-term credits extended to nonpro t landlord organizations (TBS). No fee or margin is applied (but the bank's treasury may commercially invest the budgetary allocations before disbursement). e repayment performance of this subsidized long-term port- folio until 2004 was excellent, partly because of subsidized credit rates. e ma in o perators a nd b orrowers a re no n-pro t ass ociations (TBS) championed by municipalities, and some rental cooperatives and sometimes even private developers (in total about 450 institutions by the end of 2004). e applied rents must cover the credit repayment and all maintenance and renovation costs, and should not exceed 4 percent of the replacement invest- ment value. e KFM also nances infrastructure loans directly to munici- palities, but this activity is still relatively marginal in size. e rental associations or cooperatives are required to provide 30 per- cent equity, the fund nancing up to 70 percent of the project. is down payment may be derived from the tenants, who as a result consider them- selves as quasi-owners and are selected through this quali cation. is sit- 392 housing finance policy in emerging markets uation may end up running against targeting goals22 and create problems for housing allocations.23 e program does not target low-income tenants in particular. e KFM does not control the declared incomes, as this responsibility is delegated to the TBS and the sponsoring municipality according to its own local housing policy, but anecdotal evidence suggests little follow-up monitoring and eval- uation. is experience is unique in transition economies. e KFM was designed at a time o f high market interest rates, a depressed construction cycle, and a moribund public rental sector. A er ten years of operations and impor- tant changes in the economy and housing markets, the following assessment could be made. e funding of the KFM depends excessively on budgetary grants from the national housing budget. As repayment in ows from the long-term loans are marginal, any expansion is a ected by planned budgetary cuts. Out of PLN5.3 billion of credits disbursed by the KFM until 2005, about PLN3.2 bil- lion, or 60 percent, has been funded by government budget grants. e rest was mainly funded by long-term public debt contracted a er 2002 from two multilateral institutions in order to keep expanding the program. is vulnerability would be reduced if KFM loa ns were less subsidized. Narrowing the gap with market conditions seems increasingly needed f or the next generation of KFM loans that would not target lower-income ten- ants. Co- nancing and re nancing with commercial banks, as well as issuing domestic bonds, should be considered to relieve the pressure of budgetary funding. In order to bridge its funding needs, t he KFM is c urrently con- sidering re nancing by selling its current portfolio for a 20-year period to mortgage banks. It is als o paying for the interest rate di erential with the requested market rate, including a margin for the purchasing banks. 22.Households that provide a large down payment may not receive subsidies through low rents funded by subsidized credits. 23.Many of these households will not become legal owners when their incomes increase. residential rental housing finance 393 Conclusions As mentioned in the introduction, rental nancing in most developing coun- tries is still in an emerging state. Although it can be argued that the circum- stances vary a lot across developing countries, most o en the reasons behind this lag can be found among the following main obstacles and bottlenecks. In many countries, the environment remains hostile to a thriving private rental sector. In many emerging economies, some stumbling blocks remain for the development of formal rental markets, relating to the inadequate- ness of the legal and judiciary framework and to adverse macro-economic conditions. Such an adverse environment may in turn result in the absence of nancial-sector involvement or absence of investors' demand for rental products or derivatives. Among all t he possible ways to nance rental housing, banking credit is likely to develop rst in many countries, because the banking and nan- cial infrastructure is already in place. It requires specialized lines of product that do not necessarily exist, however, even in countries where the banking system is fairly developed. Rental nance is a complex enterprise. Financing apartment communities--both existing buildings and new construction--is more complex than single-family nancing, because of the greater diversity of properties and the perceived higher risk associated with apartments. In addition, unlike single-family construction, no st andardized debt instru- ments or nancing process exists and multiple funding needs and multiple funding sources are common. A ordable housing adds to this the need for additional subsidies or "gap nancing" to bridge the shortfall between avail- able debt and equity. In the context of most emerging economies, helping the low-income pop- ulations through rental subsidies is c hallenging on many grounds. Making rental housing a ordable amounts to nding ways to design "smart" subsi- dies in order to attract private capital toward rental housing. Rental subsidies, however, pose special challenges when compared to ownership subsidies. ey tend to be scally expensive, and their implementation faces informa- tion problems. As a result, it is di cult to target the neediest populations. e public sector alone cannot solve the housing problems of low-income households. More and more o en, interventions on rental housing markets occur through public-private partnerships, by which di erent levels of gov- 394 housing finance policy in emerging markets ernment participate in va rious forms to the nancing of the units located in their jurisdictions, together with private entities. e diversity of these partnerships across countries also suggests that there is no single best (one- size- ts-all) choice of partnerships in nancing a ordable rental housing. Rather, the solutions chosen should depend on the institutional context of the country (for example, the degree of executive and nancial autonomy of local governments); on the tax system; on the development of the nancial and capital markets; and on the fraction of the population that is t argeted (private involvement is higher for middle-income households than for low- income households). Chapter 15 Housing Microfinance Franck Daphnis, with contributions from the World Bank Housing Finance Group The Rise of Housing Microfinance A home is the most important asset most people will ever own. Yet, access to housing nance is limited in most emerging economies, as residential mort- gage lenders do not nance the housing needs of the poor, when exposed to large cash- ow and credit risks. Low-income households o en lack the income to a ord a market-rate mortgage for a completed house that meets common q uality st andards,1 a nd lendin g r emains limi ted t o u pper- a nd middle-income households with steady and veri able incomes. Only in a few countries such as M exico or Malaysia have mortgage lenders reached down to nance moderate- or median-income households. Beyond lending markets, most large-scale programs of housing subsidies have fallen far short of achieving their social objectives. 1. Rental may o er standard quality housing for the lowest-income groups. In emerging markets, squatting, land invasions, and informal rentals have emerged as responses to de cient formal housing markets. 395 396 housing finance policy in emerging markets As a result of these and other factors, the main funding sources for low- income households to acquire housing, besides their own savings, have been trade credit or neighborhood moneylenders at expensive credit terms (10 to 20 percent or more per month). In this context, micro nance institutions (MFIs) have observed that some of their clients use micro-enterprise loans to improve their housing condi- tions2 as a supplement or alternative to saving. Many client homes serve as both the micro entrepreneur's shelter and place of work. As a result, some MFIs ha ve expa nded t heir ra nge o f micr o nance loa ns f rom en terprise lending to personal asset building (housing). e resulting housing micro - nance (HMF) products are short-term, cash- ow-based loans for renovation and incremental construction purposes. Micro loans can be useful for low-income households that have acquired a plot of land, but lack formal title, and that lack access to formal nancial systems. By borrowing small amounts for successive short periods of time, such a household can nance discrete upgrades to a progressively self-built structure, such as an improved roof, a cement oor, or connections to munic- ipal services. e short maturity of each loan suits the volatility of informal incomes. e lack of a mortgage lien is attractive to the poor who do not wish to put their most important asset at risk to secure a larger and longer-term loan, or who do not want to pay for additional fees to register a mortgage. e development of HMF shows that economically active poor people can nance some of their housing needs incrementally and a ordably and under conditions that allow the lender to cover all associated costs. HMF clients and traditional mortgage borrowers should in principle travel in di erent circles. If an individual is able to obtain a mortgage loan, that individual is bankable and can get a mortgage loan or a personal loan for home improvement pur- poses at a credit rate lower than what MFIs o er. At the same time, the HMF market (current and potential), comprises individuals with a demonstrable capacity to repay, albeit one that only MFIs recognize at the present time. If ever supplied at a la rger scale, HMF co uld play an important role in helping to provide an answer to the "qualitative" housing de cits,3 and com- 2. Many microenterprises are located in t he entrepreneur's home. See Ferguson and Haider 2000. 3. Quali tative de cits refer to the prevalence of substandard housing units. Quantitative de cits refer to the lack of su cient units to house the population at an acceptable standard of space per inhabitant. housing microfinance 397 plement conventional mortgage markets that remain bordered by an "access frontier"--as developed by D. Porteous and FinMark--with the example in gure 15.1 of the Government and Banking Association charter target group in South Africa.4 e potential reach of HMF ma y be found among those who do no t qualify under current banking criteria but would pay for a higher credit rate for a HMF loan. ey are in the "current market" development zone of resi- dential mortgage markets. e emergence of HMF, its rise and nancial performance (in terms of risk-adjusted p ro tability) in s everal co untries has sho wn t hat inno va- tive solutions can stretch traditional paradigms and o er e ective nance alternatives to the poor. It is still early in the extension of micro nance to housing, however, and success has no t yet been replicated on any signi - cant scale beyond a few countries. While HMF has the potential to reach a sizeable proportion of households in co untries with thriving micro nance Figure 15.1. Government and Banking Association Charter Target Group in South Africa 4. D e nition paraphrased from Melzer 2006. 398 housing finance policy in emerging markets industries, HMF portfolios worldwide remain tiny relative to GDP or total bank assets. Other factors limiting HMF expansion include high rates and the reality that HMF is primarily a means of nancing home improvement rather than new construction. Still, the growth of HMF is relatively recent, and much remains to be done to document its successes and shortfalls, standardize its methods, and dis- seminate best p