MORTGAGE FINANCING IN DEVELOPING COUNTRIES
Presented to the Annual Meeting of the Association of
Development Financing Institutions in Asia and the Pacific (ADFIAP)
By Geoffrey Mintz. Esq.
Director of Business Development
The Foundation for International Business
and Economic Research (FIBER)
I am very pleased to be here giving this talk about housing mortgages in developing countries.
First, I will go over some factors that may impede the development of a robust mortgage finance system. Then I will give some examples of international agencies’ efforts to promote the development of mortgage finance.
Later, I will discuss two countries in more detail, Mexico and China. In China of course all property was state-owned, while Mexico has had a history of private property ownership. Lastly I will add a few comments on the Basel II Accord for measuring bank capital adequacy.
While public policy arguments generally favor providing mortgage loan opportunities, there are risks to lenders in underdeveloped countries that have hindered the availability of mortgage loans. From a policy point of view expanding the use of housing mortgages in developing countries would provide additional credit to residents and may increase real estate related and other business activity as well. For bankers it is obviously a way to invest, earn fees and build traditional banking relationships. Mortgage financing is of course much more common in developed countries, partly because of government policies, including tax incentives, that have encouraged their use.
III. COMPARISON OF THE PREVALENCE OF MORTGAGES IN DIFFERENT COUNTRIES
I have attached two charts that show the percentage of GDP represented by outstanding mortgage loans in both developed and developing countries. As you can see, the levels range from around 35% to 70% in developed countries and 1% to 17% in developing countries. While I am sure these numbers do not surprise you, the use of mortgages has been steadily increasing in developing countries over at least the past 10 years.
Now I would like to describe some of the factors making mortgages harder to use in one country than another. One major factor is the stability of the monetary system: or more generally, the macro economy.
If inflation is unpredictable, if the currency is unstable, if interest rates are subject to unanticipated changes, then the use of mortgages is likely to injure either the lender or the borrower. I will go into more detail about these issues in the case of Mexico later in this talk.
Title and Mortgage Registration
Another type of hindrance is a legal one: the ways that titles are maintained and mortgages registered. For instance:
Title Issues – The maintenance of an established and reliable way to identify titles of ownership is an important governmental role. However in many countries there may be uncertainty about the actual owner because of a lack of sufficient record keeping methods or policies that make the settlement of ownership disputes hard to resolve. For instance, when property is owned by many descendents of the original owner, but there is no way to get them to agree on how to use the property and the government makes no effort to foreclose it due to unpaid taxes. I recently saw this situation creating what appeared to be abandoned properties in Mexico.
Banks in many countries without a strong history of personal credit do not have access to credit bureaus that keep track of individuals’ borrowing and repayment histories. They also may not have access to professional appraisal companies that can value the property to be mortgaged. And they may not have developed the credit analysis skills to properly evaluate the ability of the borrower to repay the loan based on his or her employment history, income, etc.
One additional training issue for banks doing mortgage lending is fraud prevention, a form of risk management. Unfortunately fraud by both borrowers and lending officers is all too common in both developed and developing countries. Banks need to carefully craft and then continually revise systems to make sure fraudulent loans are not being made.
A recent example of fraud took place in China at the China Construction Bank. It was reported in June of this year (source: GuangDong Society News, June 27, 2003):
Auditors have found false mortgage loans involving up to 1 billion yuan (US$125 million) at eight Guangzhou branches of the China Construction Bank, China's largest property lender, Yangcheng Evening News reported Thursday.
A vice director of the public security bureau in Shanwei City was found to have obtained 37.93 million yuan in mortgage loans from the Fangcun Branch of China Construction Bank in Guangzhou through illegal means. Of this, 25,76 million yuan had been turned into personal accounts and been withdrawn. Another 32,70 million yuan is unaccounted for. The fraud was committed between 1998 and 1999.
In some cases lenders may not have sufficient funds to make as many loans as they would like to. As mortgage markets mature there usually arises a need for a secondary loan market, often with securitized mortgage bond obligations. Often this secondary market is sponsored by a government-backed finance company that buys the mortgages from banks (with or without recourse to the bank in the case of default) and then reissues them as a constituent part of a large bond offering.
Some social factors are the result of government policies. For instance the desire of people to borrow or save is in part influenced by how the government taxes savings and gives tax incentives to borrowers. If home owners want to avoid being in debt, that reluctance to borrow would reduce the demand for mortgages.
As hinted at under “Title and Mortgage Registration” above, foreclosure laws as well as other laws can have an important effect on the development of the mortgage market. In India for instance cumbersome foreclosure laws were changed to allow speedier action by lenders to recover and auction property from defaulting borrowers: see the 2002 Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act.
While this factor does not necessarily make mortgage financing difficult, it does set the stage for many of the regulatory approaches. The newly industrialized states, as well as socialist countries that have liberalized their economies, are facing somewhat different challenges than countries in which private property has a longer history. Many of the formerly socialist countries initially granted all of the land ownership to the government, which in turn has passed the ownership in many cases to individuals, for instance by selling an apartment to the family that had rented it. In that case title will be clearly defined, but the methods of recording it may have been recently established: a fresh slate. In countries where property has been handed down through generations many ways of maintaining ownership and mortgage records particular to that local region may have to be considered by lenders.
International aid organizations have helped to establish stronger mortgage markets in many countries. Some of these programs have involved subsidized mortgages granted to middle or low income home owners. Other programs have been meant to strengthen the credit assessment skills of the banks or to create an entity that would repackage and guarantee the loans so that they could be resold to investors. Other programs, such as one here in Mongolia, simply finances the surveying of the property in the country so as to establish for future reference clearly defined and recorded lines of demarcation between parcels of land.
Here are slides of excerpts from, or summaries of, press releases primarily from the Asian Development Bank and the International Finance Corporation arm of the World Bank. These will give an idea of the kinds of projects they think are needed.
July, 2002 -- The World Bank will lend $5.5 million for 12 years out of a total cost of $8.2 million to
improve Algeria’s titling and registration systems and
train bank staff in credit assessment skills.
Funds for Housing Loans – Vietnam
December, 2002 – The ADB will help finance about 27,500 mortgage loans in Viet Nam for low income people to buy or improve their homes. ADB will lend the Housing Finance Project US$30 million out of the $51.8 million total cost. Participating financial institutions, the government and beneficiaries will meet the balance.
Funds for Housing Loans – Russia
2002-3 -- The IFC will give a 10 year, $80 million for residential mortgage lending to Raiffeisenbank in Russia. In 2002 the IFC provided Delta Credit with a $20 million 10-year loan and more recently approved an additional $66 million of financing for residential mortgages.
Also, presently the IFC is giving the Russian State Duma advice on developing mortgage backed securities legislation.
2003: This IFC Program run by Citibank and funded by the government of Japan will train employees from 12 Chinese banks in credit evaluation.
February, 2002— The International Finance Corporation has invested in Advantage China Holdings Limited in order to establish joint venture companies in China to provide home mortgage origination, borrower credit analysis, and contract underwriting services to Chinese banks. As one of the first of its kind mortgage service companies, the project is expected to encourage the establishment of other market players. ACHL will help banks strengthen their credit assessment capabilities in residential mortgage lending and expand their lending in a financially prudent way, thus supporting the growth of residential housing and construction. IFC's presence will provide the company with the credibility that it needs to establish relationships with Chinese banks and gain access to financing.
As I have already mentioned, lenders in many countries are developing the credit assessment skills that they need in order to make loans that will be paid back profitably. In many countries there are currently no credit bureaus that keep track of borrowers’ repayments, and in many cases borrowers would not have developed a credit history even if there were organizations to keep track of their credit, because borrowing is not prevalent.
Need for Capital Leads to Desire for Securitization
Again, availability of capital for banks to lend is another key factor in developing countries. The capital banks are willing to lend for mortgages also ties into the risk that the banks are willing to undertake in regard to their loan maturity dates, asset class allocation, etc. Since banks lend long term and borrow short-term, they need to evaluate their flow of funds. Once proper credit assessment skills have been put in place, banks may consider removing some assets from their balance sheets by allowing them to be securitized. After securitization, they may still service the loans themselves or it may done by a separate organization. The market for securitization of loans is developing in several countries with the help of the IFC and the ADB.
When the loans are securitized, they may be put into a pool where the relationship with the borrower for each loan is still managed by the originating lender. If country’s laws make it difficult or expensive to transfer the mortgage, title to the loan may not actually be transferred from the lender to the entity issuing the securities. It may only receive the right to the payment stream. If the loan defaults there is usually recourse to the original lender, but some securities are rated without recourse. Even so, most countries allow the loans to be taken off the banks’ books for capital adequacy requirements.
The loans may be placed in a separate corporation or Special Purpose Vehicle that will then own the loans. The SPV will issue mortgaged backed securities with ratings from a rating service. There often will be different tranches some of which will be guaranteed to be paid before others, so there will be different credit ratings (and interest rates) for each tranche.
In many cases the rating services evaluating the securitization will give a higher rating if the loans are insured or guaranteed against default and/or if they have recourse to the originating institution. In some countries special issuers buy the bank loans, then group them together and issue them as housing bonds on a non-recourse basis, Fannie Mae, for instance in the US. Other issuers retain recourse to the original lender in case of default like Cagamas Berhad in Malaysia. Cagamas Berhad lets the original banks continue to service the mortgage and to act as the custodian.
Below are some projects for countries that are moving toward securitization:
Securitization Related Projects
July, 2002-The International Finance Corporation (IFC), the private sector development arm of the World Bank Group, will give a six year US$5 million line of credit to the Bulgarian-American Credit Bank AD (BACB) to help expand the mortgage finance market in Bulgaria. IFC will also seek to support the Bank's issuance of mortgage bonds.
Nov 2002 - The Inter-American Development Bank today announced the approval of its first private sector mortgage bond guarantee in support of the equivalent of $50 million in mortgage bonds to be issued by Banco Colpatria to local institutional investors in Colombia. The IDB partial credit guarantee will backstop up to $5 million, or ten percent of the total face value, of the mortgage bond obligation, thereby leveraging the IDB’s participation tenfold.
The guarantee is designed to support Colombia’s pioneer effort to establish the mortgage bond as a new instrument in Colombia’s capital markets, with Colpatria as the first issuer of such a security, as permitted by new financial regulations in 1999.
The IDB support for this transaction is intended to provide a demonstration effect for other private issuers as well as for investors in Colombia, increasing the volume of securitization instruments locally and benefiting the depth and diversity of the Colombian capital market.
June, 2001-The International Finance Corporation is making its first investment in emerging market mortgage backed securities (MBS) with a Won 54 billion (US$41 million) investment in bonds issued by the Korea Mortgage Corporation (KoMoCo). IFC is the first ever foreign, and lead, institutional investor in an otherwise entirely domestically placed MBS issue. KoMoCo, Korea's first specialized secondary home mortgage market entity, was established in September 1999 with IFC's assistance.
The issue consists of a senior tranche Won equivalent $174.4 million and a subordinated tranche of $7.4 million, is backed by Won-denominated mortgage loans and collateralized by residential properties located in Korea. IFC hedged its foreign exchange risk through US$/KRW swaps.
In additional to currency risks for foreign investors, there are the political risks of government appropriation, etc. Political risks may be insured for through the World Bank’s Multilateral Investment Guarantee Agency (MIGA), and in some cases, the US Over-Seas Private Investment Corp (OPIC). For instance in 1999 MIGA insured $50 million that Lloyd’s Bank lent for mortgages in Argentina.
In the 1990’s in China there began a substantial transfer of ownership in the cities from state run organizations to individuals. Many of the apartments and houses that were rented (at low monthly rents) have been sold to the renters. While ownership of the house is transferred, the land is leased from the government for 70 years. It is expected that the leases will be renewed at the end of this period. This privatization process has encouraged investment in housing renovation and in economic growth, as the owners are willing to spend money to improve their living situations. There are government policies as well that support the expansion of average living space per person and development of new housing that has actually led to a temporary excess supply in some places, particularly of luxury housing.
Financing has been provided by Housing Funds that were established in 1992 and are funded from the income of employees and matching contributions from the state owned enterprises.
Renters who wished to buy their apartments were able to obtain low interest rate mortgages from the Housing Fund in their city for up to 70% of the total price. [Drawn from “The Mortgage-Backed Securities Market in the People’s Republic of China” by Bob Yau-ching Chan in Mortgage-Backed Securities Markets in Asia published in 1999 by ADB]
As inflation abated, the Housing Fund rates went to market rates. During the past several years, banks have been making mortgage loans as well. According to the July 3rd, 2003 People’s Daily, banks now lend 61% of the financing for all real estate (including construction), with 9% of their total outstanding loans being for mortgages and 17% for other real estate financing. House buyers now need to put down only 20% of the purchase price on their first home. According to an August 6, 2003 article in the Asian Times, 80% of Shanghai residents now own their own homes.
As banks have become active in issuing mortgages, all of this housing activity has encouraged banks to think of ways to sell their loans. Some loans, particularly non-performing loans have been sold to foreign investors. (As Dr. Martin Feldstein has pointed out, if you look at China’s domestic non-performing loans as actually part of the government debt, as a proportion of GDP it is very manageable, particularly because it is all internal, not external debt.) I will skirt those other debt issues and focus on mortgage securities.
The government has been slow to encourage exemptions from local mortgage registration rules that would allow easy transfer of the mortgages in the case of a securitization. Some securitization plans announced in 2000 between the China Construction Bank and the Australian Macquarie Bank appear to not have taken place, perhaps in part due to those issues. However, recently there have been some sales of loans to Chinese Trust and Investment Companies which have not required the actual transfer of ownership of the mortgages.
It appears that this mortgage loan securitization involves pass through flows of funds from the banks to the security purchasers, without the actual transfer of the mortgage. It is not clear from this report whether the interests in the trusts may be actively traded, raising the question of whether this is really a sale more than a securitization. Here is a description from the a July 21, 2003 article in Finance Asia by Melissa Thomas and Ruoying Chen:
Recently [China's trust and investment companies], the TICs, have begun enthusiastic marketing of a useful new vehicle, the collective capital trust plan, to the banks for [mortgage securitization]. The TICs are exclusively authorised to set up such trust plans, which pool investment funds entrusted by a number of individual investors (currently up to 200, with a minimum investment per "settlor" of RMB 50,000) for designated investment purposes, under the management of the trustee. This area was opened to the TICs in June 2002. So far the highest profile plans have been in the area of urban infrastructure, like the fund established to lend to the Chaoyang District Government in Beijing for construction in the Central Business District.
Recently a trust plan has been established by the Xinhua TIC to acquire interests in residential mortgage loans owned by Shenzhen Commercial Bank. The exact structure employed is not clear, but it does seem that the Bank required that the loans remain on its balance sheet. In return, investors were invited to rely on the Bank's guarantee of their return. The Bank also offered holders of trust plan certificates credit on the basis of a pledge of the trust plan certificates. . . . So far trust plans are limited to a relatively small scale, and TICs are not authorised to issue bonds or securities, both factors which may limit the development of this vehicle.
The Need For Monetary Stability
Now let me get back to the first issue I mentioned which is the stability of the monetary system. Instability creates risks to either the borrower or the lender, depending on how the loan is structured. Creating a loan structure that would minimize risk to both the lender and the borrower would encourage the use of mortgages. In a time of wild inflation few mortgages will be arranged. Therefore the discussion here assumes that the level of inflation appears fairly low or predictable at the time the loan is taken out.
The risks to banks are that they will make a long-term loan at a fixed rate, only to find that because of unexpected inflation or currency devaluation their cost of money rises sharply. While the use of secondary markets for the resale of mortgages would allow the lenders to shed much of the risk to purchasers of the mortgage backed securities, of course in many developing countries there is no such securitization market for the loans.
The monetary risk to borrowers is that they will borrow at variable rates and then find that interest rates spike well above their ability to make payments on the loans.
In Mexico macroeconomic changes put considerable stress on the mortgage system. For instance in the 1960’s and early 1970’s the government had a mandatory lending ratio requiring lenders to issue long term mortgage loans at fixed rates. In the late 1970’s the banks faced severe financial losses as inflation rose. In 1984 the government encouraged banks to make variable rate mortgages using an innovative approach that linked the monthly mortgage payment to the change in the minimum wage rate, instead of the change in the interest rate (called a Dual Index Mortgage).
If the interest rate increased faster than the minimum wage, then the difference between the two rates was capitalized and added to the principal due. This method provided safeguards to the borrows so that they would not – as a result of monetary policy -- unexpectedly be subject to a high monthly payment that they could not afford to make. While it also created a risk to the bankers that the duration would be lengthened if interest payments were capitalized, the original plan by the government’s a Central Bank rediscounting facility (the FOVI) lessened the banks’ risks by stepping in to pay off the loan at the end of its term if the borrower qualified for assistance.
After the banks were privatized in 1991 they converted these minimum wage rate sensitive loans to ones that varied with the inflation rate, rather than the wage rate. After the Mexican government devalued its peso in 1994, interest rates went up to 70%, while inflation went up to 40%, and wages increased by only 17%. Many borrowers defaulted; they may not have had the payment rate continued to be linked to the wage rate instead of the inflation rate. *
* (Source: “International Center for Economic Growth Near East Program Policy Brief 9909” drawn from “Housing Finance in an Inflationary Economy: The experience of Mexico”, by Michael J. Lea and Steven A. Berstein, Journal of Housing Economics, March 1996).
The new Basel II Accord on Risk Management due to be implemented in 2006, while not immediately or directly applicable to developing countries’ banks has caused some concern as they relate to residential mortgages. For instance in August of last year Asia Risk Magazine reported that the Australian Prudential Regulation Authority (APRA), Australia’s regulator, felt that the sophisticated Internal Ratings Based Approach (IRB) large banks may employ under Basel II to assess residential mortgage risks may give a much lower risk weighting compared to the 50% weight originally suggested by Basel II.
This weighting was lowered to 35% by the Third Consultative Paper in April 2003. That weighting is what would likely be employed by smaller banks that do not do their own sophisticated risk calculations (i.e., that do not use the IRB Approach). While Australia wanted 20%, 35% appears to be a reasonable compromise number. Commercial loans are to be weighted from 50-100%. China will not be implementing Basel II, but will use its own capital adequacy requirements that are said to be similar to the 1988 accord, according to the China Daily.
The regulation will retain an 8 per cent minimum capital adequacy ratio requirement, but will also include requirements for supervision and information disclosure, two extra elements in the new accord. The accord is only binding for "internationally active" banks in 10 developed countries, but is used by banking regulators worldwide as a reference.
The Bank for International Settlements is pressing for the Basel Accord to also contain rules that would require the true economic effect to be the determining factor in whether to remove loans from a bank’s books for capital adequacy purposes after the loans’ securitization. For instance if there is recourse to the issuing bank in case of the mortgage borrower’s default and no over capitalization of the securitization or other mitigating factors (such as insurance), then the bank may still bear the economic risk of default.
There are two kinds of factors limiting the broader use of mortgages in developing countries. The first is the regulatory process of registering and transferring the mortgages, which often has a local law component. The second is the development of the credit assessment skills and capital market access that lenders require to do profitable mortgage lending.