Loic Chiquier summarises the housing finance findings of a World Bank assessment of east Asia’s financial markets.
Many governments place housing and housing finance among their high policy priorities because housing represents the largest class of household wealth assets, a formidable engine of economic growth and a critical component of any social shelter strategy to prevent slums. Housing finance is a major part of any domestic financial sector, through credit institutions and bond markets. Housing home-ownership requires the lever of debt finance to avoid the exclusive recourse to self-financed incremental construction, which contributes to the proliferation of slums. Cities are built not only according to urban planning, but also according to the way in which they are financed.
Since the financial crisis of 1997, residential mortgage markets in east Asia have been reviving dramatically. The same trends are observed in many other emerging economies, fuelled by retail banking, additional liquidity and lower market rates. This raises great opportunities of equitable growth development, but also challenges for policy makers and regulators to preserve the soundness of the financial sector, while expanding access to housing for lower-income households and therefore fight against poverty.
Rapid urbanisation, combined with demographic changes, is fuelling a steady increase in the demand for housing, thus exposing the housing finance system to scaling up and affordability challenges. Half the world’s population now lives in cities, many of them in slums (39% in east Asia). Between 2000 and 2020, about 1.3 billion people in the world will join cities and will also be in need of housing solutions, in particular in Asia. This urbanisation dynamic is quite marked in Thailand, India and Indonesia, and also in China, where the urban population is expected to rise from 43% in 2004 to 52% by 2020.
Rising house prices are a further catalyst to the rising need for housing finance in the region. Although property price inflation is starting to raise affordability issues, it is worth noting that in most large cities in east Asia, with the exception of China, house prices have yet to recover to their pre-1997 crisis levels. Housing finance therefore seems set to expand ever further with the ensuing risks requiring careful management.
The growth of primary mortgage markets in east Asia has been facilitated by macroeconomic recovery, financial sector liberalisation, active and liquid banks engaged in retail activities, and improved risk-based regulations. To some extent, this favourable trend is worldwide (Mexico, India, South Africa) but east Asian mortgage markets are among the most advanced in emerging economies. By contrast, many poor countries, notably in sub-Saharan Africa, remain far from reaching even a modest expansion of their housing finance system.
In Korea, mortgage markets have expanded rapidly as a result of strategic decisions by banks to diversify their lending into retail markets. In some less developed economies in the region, the level of mortgage debt has just returned to its pre-crisis levels (Indonesia, Thailand).
In China, the pace of expansion of mortgage debt has been impressive, as lending volumes keep growing and competition between banks intensifies. Mortgage lending is seen as being a more profitable and cross-selling retail activity on a risk-adjusted base than other business lines such as corporate lending.
However, caution should be exercised in China, where the mortgage portfolio has not been tested by any recession yet, but concerns were expressed about an uncertain foreclosure enforcement, sluggish property registration, weak underwriting and internal risk management policies, and under-priced credit products (for example, the new fixed rate loans). This partly explains the conservative measures taken by the regulatory authorities, including strict down-payment requirements (30% for end users, 35% for developers). The role and regulatory framework of housing provident funds in China may also be revisited as a complementary source of housing finance to banks for lower income groups.
Falling rates environment
The expansion of the mortgage sector in east Asia has been facilitated by the decline of market rates, at least until mid-2005, which enabled a larger creditworthy portion of the middle-income population to get access to housing finance. Adjustable mortgage rates vary from 5% to 8%, which remains relatively affordable. The majority of loans are indexed on prime lending rates, base lending rates or official inter-bank lending index. In Indonesia, the macro volatility has kept rates at a higher level (17%), which prevents any large expansion through conventional mortgage loans.
Since the end of 2005, mortgage rates have increased on average by 1%-1.5%. This has contributed to a slowdown in the growth of property markets, but without modifying the fundamentals of housing demand. Any further significant rise could dampen both the growth of housing finance markets and depress some specific housing sub-markets, but without triggering another financial sector crisis of the magnitude experienced in 1997.
The contractual maturities of these housing loans can go up to 20 or 30 years but the actual average life of the loans remains between 10 and 15 years (and much less in Korea). Prepayment rates remain high due to a competitive lending environment, proactive consumers who react to changes in floating rates, and some cultural bias from households against holding mortgage debt.
Longer term fixed rates
As in many emerging economies, the Asian housing finance system is dominated by adjustable rate loans, which have been attractive during a phase of declining market rates, but which convey larger credit risk in the long run should any adverse shock occur. The origination of loans offering longer term fixed rates (or at least capped floating rates) is a valid objective, which is actively pursued by public-specialised financial institutions to reduce the vulnerability of the financial system, and to facilitate the accessibility of housing finance for lower-income households.
No significant change has taken place yet in the share of fixed rates as a proportion of new lending in Asia, but these products may now be easier to commercialise among borrowers who are looking for a greater safety. In countries like Mexico, macroeconomic stability and long-term institutional investors have permitted that development, even if many households still prefer indexed loans on CPI or Minimum Wage Index. The development of local currency mortgage markets is highly preferable to hard currency ones that expose households unaware and/or unable to hedge the embedded devaluation risk.
However to grow this product range on a sustainable basis, the funding structure should also be diversified from the dependence on short-term deposits to a more balanced funding structure, including longer-term mortgage-backed securities bonds that transfer part of the interest rate risks to investors. In less developed emerging economies, fixed rate mortgages remain an expensive luxury good that cannot scale up in an affordable way, and adjustable or indexed loans still prevail, along with higher credit risks to be managed, informed about and supervised.
Affordability remains key
Despite the more attractive credit conditions, the large informal labour market in Asia (in Indonesia 74% of the labour force) and rising housing prices confront housing finance systems with challenges of accessibility. Even in countries where mortgage markets are large, as in Thailand, a majority of households still do not leverage debt and rely on equity-financed self-construction, which results in delayed and expensive access to home ownership, incremental construction, slum proliferation and pressure for subsidies. In Indonesia, the proportion of equity-financed self-construction is 65%. In most emerging economies, mortgage markets still fail to reach the lower and moderate income classes, thus fuelling the development of slums.
Affordability tools developed at different scales in emerging economies include complementary components, including smarter-targeted and efficient subsidies to tease down market lenders and developers (interest buy downs, upfront subsidies, subsidised insurance premiums, etc), the development of more vibrant rental residential markets within an hospitable regulatory and tax environment (often the most neglected part of any national social housing strategy although critical for a poor and mobile part of the population), and residential leasing products that require less down-payment. In addition, an expanding housing microfinance industry is vital to finance home improvement and progressive housing for the lower and informal income groups, but more affordable rates may be reached if micro-lenders can reduce their costs by scaling, sharing risks, leveraging debt and becoming more competitive.
Other initiatives under way include default insurance products for mortgage lenders, often with some capital involvement of the public sector. Such products help lenders to reallocate their credit risk with lower down-payment requirements, and to facilitate the expansion and deepening of mortgage markets. They also provide credit enhancement solutions to the development of mortgage securities.
For example, the HKMC in Hong-Kong (China) has been steadily extending its mortgage insurance programme since 1999 through a limited first loss guarantee (for loans exceeding 70% loan-to-value). The local housing guarantee funds in China have been less successful in that regard and require further reforms. The development of mortgage insurance requires an adequate regulatory framework, compatible with an actuarial insurance approach and fed by reliable data.
Housing supply obstacles
Besides macroeconomic considerations, most emerging economies, including those of east Asia, find the development of their housing finance system is mainly constrained by land supply rigidities and urban development regulations, which is driving a faster rise of housing prices than household incomes despite more favourable credit conditions. This is visible in some of the largest cities in China despite the tighter regulations on speculative housing construction imposed by authorities on developers, investors and local governments. On the contrary, in Malaysia and Indonesia, house price-to-income ratios seem to be stable and affordable (price/income ratio of between 3 and 3.6 in Indonesia) thanks to a comprehensive land and housing policy.
Another limiting factor in some cases is the difficulty of scaling up construction finance in the area of affordable housing without any undue exposure to risks (many regulators limited such bank lending after the crisis), given market unfriendly urban development and construction rules, and the under-capitalisation of developers. Another related challenge consists of protecting the advances of households paid to developers.
Growing secondary markets
Secondary mortgage markets remain by-and-large underdeveloped as a funding source for national housing finance systems. This is particularly so when considering the rapid growth in primary markets together with legal and regulatory changes undertaken to foster a securitisation market. In addition, there has been strong government support for the secondary market in nearly all of the countries in the region (Hong Kong HKMC since 1987, Thai SMC since 1998, Indonesian SMI since 2005, Malaysian Cagamas since 1987, Philippines, the Korean HKFC nationalised in 2004).
In China, different legal and regulatory routes are being tried out (trust certificates traded on the interbank bond market or investment fund certificates on the stock market). Several regulatory issues were fixed by authorities to enable the two pilot securitisation deals in 2005. Yet more rules need to be consolidated on themes such as true sales, rating agencies, and different disclosure and investment rules
Most countries are still lacking a private credit enhancement system, including pool guarantees or individual mortgage insurance, so the structuring of the transaction has to rely on expensive internal enhancement for the issuer (leaving little capital relief) or public guarantees, which transfer part of the risk into fiscal liabilities.
More work is needed to accelerate the development of mortgage securitisation, but it is not necessarily the only route to development of secondary mortgage markets. Other forms of private mortgage securities may be more robust, cost effective and simple to implement, at least during a transition phase before scaling up securitisation in a cost-effective way. Possible systems to explore include liquidity facilities or covered bonds.
Liquidity facility
A liquidity facility has operated successfully for a number of years in Malaysia (Cagamas Berhad). This draws on the experience of existing models in countries such as France, Mexico and even the US (Federal Home Loans banks).
Cagamas Berhad was created in 1987 as a private specialised company to help housing lenders to manage their financial risk and expand their lending, as well as to develop private bond markets. Capital came mostly from the financial institutions and 20% of the shares are held by Bank Negara. The company has been purchasing residential loans from competing lenders (most of the loans are adjustable rate) on a full recourse base and for limited periods, funded by issuing private bonds. Cagamas has been operating as a liquidity facility rather than a securitisation conduit. Key regulatory and stamp duty privileges were granted to its refinanced loans and issued bonds to reflect the low-risk nature of its activities, and to compensate for quotas of social housing loans set on all credit institutions. The privileges related to its bonds were removed in 2004 because Cagamas competes with other issuers.
The environment for its development was favourable: a developed bond market infrastructure; a stable macroeconomy; an efficient system of title registration; a proactive housing policy that permitted the production of affordable housing; and regulated and competing private credit institutions. Its funding of mortgage markets reached 41% at the peak of the crisis (operating as a private funding buffer in adverse times), reducing to 12.6% as more liquid banks mobilised alternative funding. It acted as a catalyst to the growth and affordability of mortgage loans, as banks extended longer term loans with the knowledge that they may always tap Cagamas funding.
Cagamas has been a major issuer of private bonds (still 14% of all private bond stock as of 2005). It has diversified its products according to the evolution of the market needs. In addition to housing loans, it started to purchase conventional and Islamic hire purchase with full recourse in 1998 and 2001 respectively. The structure of the lending industry also changed with a lesser role for specialised lenders.
Cagamas started securitising in 2004 the housing loans made to civil servants by the government, whereas private lenders are more reluctant to securitise their best assets, which comprise of mortgage loans. A refinancing window has also been operated for Islamic housing debt. Now Cagamas is changing its course by also exploring the securitisation of non-housing loans.
Covered bond development
Covered bonds also draw on European experience, where such products are well developed in Denmark, Germany, the Czech Republic and Hungary, but also outside Europe in Chile. The bonds are issued directly by the primary banks as on balance sheet funding instruments. The rating of such bonds is enhanced by a cover pool mostly made of safe mortgage loans: bond investors benefit from privileged rights in case of bankruptcy. This can enable large lenders to access bond markets at favourable conditions without having to sell their best mortgage loan assets.
The development of covered bonds requires legal and regulatory work to ascertain both the bankruptcy privilege and the matching requirement during the whole life of the bonds (including eligible mortgage assets, replacing requirements, specific register for the cover assets, adjusted bond disclosure and oversight system) in unambiguous and protective terms for the investors.
Loic Chiquier is head of the housing finance practice at the World Bank.
