Setting Priorities for Housing Finance in Armenia Britt Gwinner May 29, 2005

Overview The Armenian housing finance market holds promise, banks are lending to upper income households Issues include: depreciated housing stock and deferred maintenance, legal framework, lender capacity, short maturities, varying contract terms, lack of market data, market weakness outside of Yerevan Capital markets are useless if primary markets are weak - the focus for reforms should be the primary market A liquidity facility could lead to longer maturities, greater affordability, and provide incentives to improve risk management Rapid economic growth (averaging [9.6] percent in the past 5 years), low inflation (averaging [3] percent in the past 5 years), and legal reforms have contributed to a nascent mortgage industry. Banks lent an estimated USD [2.8] million in 2002 and an estimated USD [7.1] million in 2003, to total [1.5] percent of total bank assets.[1] Most mortgage lending is in USD, at fixed interest rates ranging between 14 and 24 percent, for low loan to value ratios (LTVs) of 50 percent, at an average term to maturity of 5 years, to a maximum of 7 years. [1] CBA figures cited in KfW report. Armenia Housing Finance

Robust housing finance creates jobs and growth Countries with strong financial systems grow faster than countries without them Strong housing finance systems generate savings and improved living conditions for moderate and low income households, local employment (building materials, skilled labor, financial professionals) and growth In the U.S., employment in housing and housing-related industries is estimated to have accounted for 43% of the rise in private-sector payrolls since late 2001 Rapid economic growth (averaging [9.6] percent in the past 5 years), low inflation (averaging [3] percent in the past 5 years), and legal reforms have contributed to a nascent mortgage industry. Banks lent an estimated USD [2.8] million in 2002 and an estimated USD [7.1] million in 2003, to total [1.5] percent of total bank assets.[1] Most mortgage lending is in USD, at fixed interest rates ranging between 14 and 24 percent, for low loan to value ratios (LTVs) of 50 percent, at an average term to maturity of 5 years, to a maximum of 7 years. [1] CBA figures cited in KfW report. Armenia Housing Finance

Mortgage lending in Armenia is limited, short term, lacks risk-based pricing Mortgage lending small but growing Accounted for about 4% of total bank assets end March, 2005 versus 1.5% at end 2003 Macro conditions are good: low inflation, 12% annual GDP growth ’01-’04, important remittance flows Most mortgages are to upper-income households in and around Yerevan, for short terms (3 – 5 years), at high rates of interest (13% to 19%), in USD Non-standard contract and financial terms Mortgage lenders do not currently calculate the cost of risk, or price on a risk-adjusted basis Residential construction is small but growing, and has been focused on high-cost units. The industry delivered an average of 1,400 housing units per year between 1999 and 2001, then 2,300 in 2002, and 4,700 in 2003. Of the 2003 production, 94 percent was in urban areas, even though more than a third of the population is rural. Residential construction made up about 47 percent of the total value of construction in 2003. New units replace existing, depreciated stock or serve as investments, as the household formation rate is close to zero. The dwellings delivered were expensive, averaging USD [53,000] versus an average annual public sector wage of USD [678]. Beyond these newly constructed units, much of the existing housing stock in poor condition due to a lack of maintenance. Armenia Housing Finance

Lending should extend beyond purchase money mortgages Renovation loans for windows, kitchens, floors, should be a big business for moderate and low income households, given the privatization of apartments Only 12 percent of lending was for renovations at end 2004 Renovation loans may be extended for shorter terms without a lien Obstacle: maintenance, responsibility for common spaces and structures (roofs, stairwells) Eventually, should lend to condominium associations for capital improvements Armenia Housing Finance

Construction finance should be developed Construction currently funded by developer equity and buyer down payments Limits the market to upper income buyers Much of the risk is borne by would-be buyers, who have limited means to protect themselves Many emerging markets have established legal means to enable cheaper and more stable construction finance: Partly constructed buildings are given standing in law as assets and so may serve as collateral Trusts, escrow accounts, enforced reporting requirements Securitization of construction loans Construction finance is limited and riskier than it needs to be. Project finance is provided by a combination of developer equity and down payments from individual buyers rather than banks. This means of finance lays much of the risk on would-be buyers, as there are few protections should the developer fail to complete the project. Partly constructed buildings do not have standing in law as assets. [Viability of trust structures?] Many emerging markets have been able to create substantial flows of bank financing for residential construction projects by providing legal protections to lenders and developers. Armenia Housing Finance

Primary market recommendations (1) Improve the policy, legal, and regulatory framework (educate the judiciary, clarify and strengthen foreclosure auctions and eviction processes) Training programs and regulatory incentives could address lender shortcomings Limited lender experience in underwriting and managing the risks of long term mortgage credit How to interact with borrowers to mitigate default risk when payments are late (e.g., counseling, loan workouts, deed in lieu) Armenia Housing Finance

Primary market recommendations (2) Improve transparency and liquidity: Government, banks, realtors, and appraisers should systematically gather and publish data on housing and land prices and transactions Banks should disclose data on mortgage lending as part of their periodic public disclosures (e.g., volume, weighted average maturity, weighted average yield) The government should promulgate consumer disclosure regulations on loan terms and risks, especially for non-dram loans Government and industry can cooperate to promote standards and professional training for appraisers, realtors, mortgage finance professionals (already started with realtors, work could be done on appraisal standards) Armenia Housing Finance

Primary market recommendations (3) Address maintenance shortfalls – work with municipalities, collect fees adequate to cover all costs, privatize maintenance companies Government, banks, realtors should pursue a public education program for condominium associations and improved maintenance Find a means to address mixed income populations within buildings Financial aid for lower income residents Armenia Housing Finance

Securitization not currently feasible Long-lived contracts - requires substantial trust in professional standards for and transparency of financial institutions and intermediaries (trustees, appraisers, rating agencies, audit, accounting, etc.) Requires public data on loan performance, property values Requires institutional investors Insurers all reinsure internationally, so reserves are minimal State pension system lacks reserves, absence of private pension Eventually needs credit ratings, a yield curve, reference rates Needs a steady monthly production of new mortgage originations to maintain deal flow, cover issuance costs Armenia Housing Finance

The Role of a Liquidity Facility Limit credit risk – should provide long term funding with full recourse to primary lenders upon default Provide incentives for banks to manage credit risk, standardize mortgage terms Provide long term funding for loans that meet financial, underwriting, and contractual standards Government-sponsored facility should be separate from the bank regulator Conflicts of interest can arise from the regulator owning a lending institution, e.g., the U.S. Federal Home Loan Bank Board during the 1980s Savings and Loan crisis... Governance, ownership structure should include private sector participants Armenia Housing Finance

Mortgage bonds could be a medium term goal A useful step after the liquidity facility and deposit insurance for banks as they build financial strength, earnings, and credibility Would serve as an investment vehicle for insurers, banks Less demanding than securitization Legislation is required for a sustainable mortgage bond market Establish the protection of collateral pool in case of failure of the issuing bank Requirements for the quality of the collateral pool, any permitted alternative collateral No need for specialized lending institutions Armenia Housing Finance

Conclusions Bankers are interested in mortgage markets, originations are rising – provide training, market and regulatory incentives for them to start manage risk effectively now Successful focus on the primary market will lead the way for the development of the secondary market Restrict the government role to: 1) creating the legal and regulatory framework; 2) facilitating technical assistance and professional norms; and 3) providing long term liquidity to extend maturities and so make lending affordable to lower and moderate income households. Armenia Housing Finance