PROVIDING LONG-TERM FINANCING FOR HOUSING:THE ROLE OF SECONDARY MARKETS

by

MICHAEL LEADIRECTOR OF RESEARCH

INTERNATIONAL UNION FOR HOUSING FINANCECARDIFF, CALIFORNIA

and

LOIC CHIQUIERMORTGAGE FINANCE PRACTICE GROUP

CAPITAL MARKETS DEVELOPMENTTHE WORLD BANK

Office of Development StudiesBureau for Development Policy

United Nations Development Programme

___________________________The views and findings in this report are the sole responsibility of the authors. Mr. Chiquiers contribution is based on a detailed case study of Cagamas. This study is being published as a World Bank Working Paper, written by Mr. Chiquier and supervised by Mr. Bertrand Renaud, which does not represent any official position of the World Bank Group. Mr. Chiquier is grateful to Mr. Huang Sin Cheng, Ms. Noor Ashikin Ismail and the whole team of Cagamas for their high-quality assistance and hospitality.

DRAFTNOT FOR QUOTATION

NOT FOR CIRCULATION

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Housing is a major aspect of human development. As noted by the World Bank (1992), housing investment typically accounts for 2% to 8% of GNP, and the flow of housing services for an additional 5% to 10% of GNP. Residential real estate represents around 30% of world wealth, greater than both bonds (27%) and equities (19%). Residential construction is a major employer often accounting for more than 5% of total employment. Housing is an important economic sector with linkages to the real and financial parts of the economy.

Housing is a major good. Households typically spend between 20% and 50% of their income on housing, with a typical ratio of around 30%. In many countries and cultures, homeownership represents the ultimate dream control over ones existence. Housing is the major portfolio asset of most households and thus a major component of wealth. However, housing is quite expensive: The price of a house is typically two to four times the annual income of the household. The expense, along with the fact that housing is a durable good providing a flow of services over time, means that most households seek long term loans to build or buy their own home. This also applies to landlords who seek finance for rental housing.

Housing is a highly visible, key indicator of social welfare. Access to decent housing has important environmental, health, and employment effects. The property tax, which is mainly a wealth tax on housing, accounts for 25% of all local government revenues.

In developing countries, housing is a major economic, political and social issue. As populations continue to grow and urbanization accelerates, the necessity of providing adequate housing mounts. Renaud (1998) has captured the relationship between urbanization, housing investment and national wealth (figure 1). He points out that the worlds rate of urbanization is reaching a peak, in particular in China and India, and as a consequence the need for additional resources for this sector is increasing. This raises the logical question: where will these resources for housing come from?

Trends in Housing Finance

Graph 3 of figure 1 suggests an answer. As per capita income rises, so does the share of urban real estate assets in national wealth. This suggests why mortgage finance is so important to the development of housing and national economies. If real estate assets can be effectively used as collateral for household borrowing, households can benefit from both a reduced cost of funds (relative to borrowing on an unsecured basis) and from an improved availability of funds. As discussed below, access to real estate as collateral greatly enhances the attractiveness of housing loans to investors and thus the potential development of secondary markets.

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Figure 1

100 %

50 %

Industrialization and Urbanization

Housing Investment and Urbanization Level

Urban Real Estate Assets in National Wealth

Peak Rate of Housing Investment

2-3 % of GNP3-4 % of GNP

Peak Rate of Urbanization 75-80 %

Per Capita Income

Per Capita Income

Per Capita Income

35-40 %

1

2

3Growth of R

eal Estate Assets

7-9 % of GNP

15%

THE WORLDS RATE OF URBANIZATION IS REACHING ITS PEAK

Source: Renaud (1998)

Historically, many governments have thought of housing, particularly for low- to moderate-income households, as a government responsibility. They have created programs and institutions to funnel public (taxpayer) resources or forced savings of households into subsidized housing production or housing finance programs. In almost all cases, governments have found that such programs provide insufficient resources and poorly targeted benefits. And in many cases, they have found that poorly designed housing finance systems have created serious budget and financial sector stability problems.

Over the past 15 years, there has been a pronounced trend towards increasing the private sector role in financing housing, with governments adopting an enabling role. This trend is manifest in financial liberalization that has broken down artificial barriers between market segments and encouraged increased competition in the provision of housing finance. As a result, housing finance is no longer the province only of special schemes or entities supported by tax and regulatory preferences but is increasingly a product offered by mainstream financial institutions (Diamond and Lea, 1992). Financial innovation has also played a role through the introduction of cheaper financial instruments and increased functional specialization with greater efficiency and improved risk management (Lea, 1996). Finally, the reform of pension plans and the growth in long-term funds for investment is opening up new opportunities for housing finance.

A relatively new development in housing finance is the secondary mortgage market. A secondary market involves pooling and sale of mortgage loans. Although this activity has been around for a long time, it has greatly expanded in recent years, reflecting the creation of new and specialized institutions and innovations in technology and security design. And secondary

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markets are not exclusive to developed countries. There are several examples of successful secondary markets in developing countries with prospects for many more.

This paper reviews the role secondary markets can play in expanding the availability of funds for housing in developing countries. Several different secondary market models are introduced and their experience in developing countries reviewed. The benefits of secondary markets for developing countries and the obstacles that exist to their creation are explored. The experience of Cagamas, the National Mortgage Corporation of Malaysia, is discussed. Cagamas is one of the most successful examples of a secondary market institution in a developing country. In the conclusion, the future role and limitations of the secondary market model are summarized.

Traditional Mortgage Lending

To understand secondary mortgage markets it is important to understand the functional components of the mortgage lending process.1 As shown in figure 2, the traditional model is based on portfolio lending in which one institution performs all the major functions: originating a mortgage to a homebuyer, servicing it (primarily collecting and processing payments from borrowers and record-keeping) and performing all the risk and portfolio management functions, including funding. (The portfolio lender may purchase a few services from third-party vendors, such as appraisal and credit reporting). Portfolio lenders may be depository institutions such as commercial banks, savings banks, savings and loan associations, building societies; contract savings institutions; or European-style mortgage banks.

Figure 2: The Traditional Home Mortgage Delivery System

Traditional Mortgage Model

PortfolioLender

PortfolioLender

Borrowers

Originate

Service

ManageRisk

Fund

The advantages of the traditional model are institutional simplicity (one institution performs all of the functions), and the ability to provide multiple services to clients (achieving economies of scope). The disadvantages of the traditional model, particularly when depository 1 For an in-depth discussion, see Lea (1998).

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institutions are lenders, are relative inefficiency because depositories typically have higher cost ratios than capital market funded lenders and inherent mismatches that generate liquidity risk and interest rate risk.

Commercial banks have traditionally shunned mortgage lending because of these risks. Liquidity risks can arise because mortgage loans are long term and deposit liabilities are short term. Interest rate risk arises when there is a mismatch in the maturities and inte