Extending Access to Housing Finance without Distorting Markets Marja C. Hoek-Smit Wharton School University of Pennsylvania Finance Forum The World Bank, June 19, 2002

Two Main Reasons for Limited Access to Housing Finance Market and Policy Failure Government housing finance institutions have excessive market power/price makers Subsidized credit distorts prices Incomplete Credit Markets Lack or asymmetry of information, e.g. lack of property regist. systems and mkt price info, informal incomes Risks (particular default and collateral risk) and costs to reach low/middle income segment are too high for markets to develop Each of these require different government actions

Governmental Housing Banks Governmental entity lends to consumers Fund sources range from budgetary allocations to unsubsidized deposits While no two are exactly alike, performance has been universally bad

Poor Performance of Governmental Housing Banks Subsidized fund sources mean HBS are not disciplined by the market Operating costs are therefore usually high Credit losses are usually high HB reluctant to enforce liens for social/political reasons Borrowers often view loans from HB as grants Allocation of subsidized credit often regressive and politicized May crowd out other lenders from access to funding

Housing Banks Supported by Wage & Salary Taxes “Free” funding offers maximum freedom to misallocate & misprice loans Worst misallocation: loans to developers, middle- high income home buyers Worst mispricing: bad loan design, too low rates, too long terms, too small down payments cause losses to government or pensioners (actuarially unsound) Worst return and asset diversification for savers/ borrowers: low returns for savers and too large a proportion of household savings and wealth contained in the house

Poor Choice of Housing Subsidy Instruments Often fixed rates in an inflationary environment Mostly interest rate subsidies Higher cost than necessary - - subsidy is for life of loan, usually with no adjustment for increase in hh earnings Not transparent and future costs to gvt. unpredictable because of inflation Subsidizes debt rather than housing directly - - no incentive for households to pay back fast Unattractive instrument for lenders; complex financial management and not efficient in secondary mortgage market transactions

Examples of Housing Banks and Special Funds Poor credit risk management (Indonesia, Chile, Fiji) Actual borrowers high income (Ethiopia) Poor instrument choice (Argentina, Brazil, Hungary) Politically influenced lending (Mexico) Thailand -- the exceptional success, but uncertain future

Can Government Assist in Expanding Housing Finance while Avoiding Market Distortions – An Inherent Contradiction? Structural reform of government housing finance institutions Design/reform credit-linked subsidies to borrowers to be non-distortionary Provide regulatory, institutional or financial support to decrease risks and costs of down- market lending

Structural Reform of Government Housing Finance Institutions Increase competition by providing same funding /subsidy privileges to private financial institutions Commercialization/ privatization of government banks (decreasing special privileges) Good bank - bad bank separation Eliminate or transform special funds to maximize contributors’ returns

Non-Distortionary Credit-linked Subsidies to Borrowers Subsidies on savings for down-payment upfront subsidy, avoiding subsidized savings and lending rates in a closed system Pledge default account (currently used mostly by mutuals and micro-lenders) a required deposit to be used in case of late payment Buy-down-mortgage (West and Eastern Europe) subsidize part of the monthly payment on a market rate loan during the initial years of the loan, decreasing the subsidy over time, and placing subsidy amount in an escrow account

Non-Distortionary Credit-linked Subsidies to Borrowers con’d Up-front grants/allowances as part of a housing financing package Towards deposit and closing costs Towards mortgage loan Towards loan and deposit Payment for private/NGO mortgage insurance or guarantee premiums to insure top part of the loan or other risks Payments for community mobilization/ household counseling programs

Factors To Evaluate Alternative Borrower Subsidies Macro-economic conditions (expected inflation, econ. growth and its distribution) Expectations concerning house value movements Household economy and borrower constraints to be addressed Efficiency and equity of the subsidy program Requirements for capital market transactions Budgetary requirements Administrative / budgetary requirements

Institutional/Regulatory Incentives to Support Down-market Lending Support credit risk management Facilitate establishment of credit bureau Facilitate/participate in the establishment of mortgage loss insurance or guarantee schemes Examples: UK, The Netherlands, Hongkong, Lithuania, South Africa, Mexico, under consideration in Indonesia Allow risk-based pricing (eliminate usury laws)

Institutional/Regulatory Incentives to Support Down-market Lending Support credit risk management con’d Improve property registration Establish real estate information system Decrease neighborhood risk by infrastructure/services investment Improve foreclosure laws Support community-based negotiation system to avoid bank loss in case of foreclosure Decrease political risk, etcetera.

Institutional Incentives to Support Down-market Lending con’d Improve Liquidity Position of “down- market lenders” Allow mutual/micro financial institutions to take deposits, improve regulatory system for this class of lenders and provide capacity building inputs Example: South Africa Remove legal constraints for lending by institutional investors to housing finance institutions Provide legal infrastructure for the establishment of refinancing or secondary market institutions (see other presentations)

Institutional Incentives to Support Down-market Lending con’d Reduce interest-rate risk Facilitate secondary mortgage market transactions by providing cash-flow insurance or guarantees for private security issuers Can create efficiency in secondary markets Vulnerable to fraud Participate in secondary mortgage market May be necessary to start off a SM Should have sunset clause Can create economic behemoth See other presentations