(Reprinted from HKCER Letters, Vol.38, May 1996)
The New World of Housing Financing
IntroductionToday I would like to talk about what my friends and I call "the new world of housing finance". In the process, I shall indicate how we at the World Bank are rethinking our activities related to the development of the financial sector. Until recently, few developing countries have had pro-active and well articulated housing finance strategies concerned with the overall efficiency of financial markets. What we usually found were institutional patchwork resulting from the interactions over time between special interest groups, distant financial authorities and planning ministries preoccupied with the financing of perceived "priority sectors". Today housing finance strategies aim at developing efficient mortgage markets and are profoundly different from the thinking of a decade ago.
The forces at work behind the rapidly changing views of housing policy and housing finance are now very familiar to most of us, but I would nevertheless review them briefly. First, financial liberalization which began in the US in the late 1970s has eliminated the tight segmentation of financial activities. Second, financial innovation is leading to seamless financial markets. The focus is rapidly shifting away from specialized institutions to the provision of specialized financial services such as mortgage finance provided by financial groups. Third, global convergence in banking regulation and supervision as set by the Basle Committee, especially those on capital adequacy and asset classification, is leading to a better view of risk-adjusted lending as well as a new look at housing finance. Fourth, the digital information revolution is changing rapidly every aspect of banking and finance. Payment systems, settlement systems, internal corporate operations systems such as branch reporting now run in real time. In the case of consumer finance and retail banking, automated loan underwriting systems and "home banking" are rapidly spreading interactive, software-based relations with clients. Fifth, new macroeconomic policies are shifting away from short-term demand management in favour of stable medium term monetary and exchange rate objectives. This shift has been induced by the "rational expectations" approach to economic policy, for which Robert Lucas of the University of Chicago was awarded the Nobel prize in Economics in December 1995. One of the most visible outcomes of this policy shift is the renewed emphasis on fiscal soundness and balanced budgets: government debt should not be crowding out private finance in the capital markets.
What are the forces at work?
Finally, the collapse of centrally planned economies in the 1980s has deepened our understanding of our own market economies and what make them successful. Among other improvements, renewed thinking about the "privatization paradigm" is leading to a much better formulation of housing policy and a sounder view of housing finance. The goal is to get the subsidies directly to the neediest households and not to the middle class or to wasteful government agencies. When possible, privatization of some public activities could create additional "fiscal space" for the financing of more critical public needs. Also, social safety nets are discussed now in a more integrated way: public programs tend to consider the totality of problems facing households at risk, rather than just health or housing problem alone. For instance, we learn in industrial countries that homelessness is not really a housing issue but the outcome of much more complex social and psychological causes.
Our work at the World Bank is profoundly changed by the rapid and powerful changes in capital flows from rich to poor countries. The foreign debt crisis of the early 1980s is now mostly behind us. Today, it is not so much the World Bank or the IMF that is preaching better financial and fiscal policies. The global financial markets are getting more and more powerful at imposing their own discipline on the economic policies of individual countries. At the same time, grants and loans from official sources (such as governments and the World Bank) have not grown over the last decade. Last year, World Bank's share of gross capital flows to developing countries was about 10 percent of the total.
How is rapid financial globalization changing the work at World Bank?
In 1990, net flows to developing countries were less than US$100 billion, and less than half of these came from the private sector. In 1995, net flows had grown to US$230 billion, of which 70 percent were from the private sector. In 1990, only 10 percent of cross-border foreign direct investment went to developing countries, but today it is over 35 percent. Similarly, in 1985 developing country debt amounted to US$1.1 trillion and absorbed on the average 23 percent of export earnings of these countries. In 1995, this debt had grown to US$2.1 trillion, but debt servicing required only 16 percent of exports earnings.
Compared to the 1980s when so many commercial bankers were blinded by the safety of sovereign debt, the major change is that international financial markets are much better informed about each country, and the terms of new debt are much more differentiated by country and project risk. However, the problem we face today is that these capital flows are very unevenly distributed, with East Asia absorbing two thirds of the net capital flows and Argentina, Mexico, and Brazil accounting for much of the rest. Out of the 178 members of the World Bank (including industrial countries), about 25 economies capture roughly 95 percent of all external capital flows.
As a result of all these changes, the activities of the World Bank have become more differentiated between policy advice and lending, and new lending products have to be developed. In countries with growing financial markets, new instruments such as guarantees are needed to support--not to replace--private finance, facilitate the extension of maturities, and reduce political risks. In the numerous countries that still lack access to capital markets, continuing economic restructuring needs to be supported with better policies and the financing of stronger core institutions.
It is obvious that international capital flows play a strategic role in improving investment activities, especially for urban and other infrastructure. Yet, domestic savings are and will remain the primary engine of growth, and there is much need for more efficient domestic financial markets. During the 1970s and 1980s, many countries were dominated by a central planning mentality and housing finance remained a backwater of dirigible financial policies. The contrast was great between the large role of mortgage related financial assets in industrial countries, which is second only to government securities markets, and the tiny size of the sector in developing countries.
What do these changes mean for housing policy and finance?
There are strong reasons for developing sound housing finance strategies and fully integrating housing finance with the fast growing financial markets. Nowadays, household savings form the core of domestic savings and housing assets are the major component of household assets. Moreover, housing finance is not neutral to financial development: either housing finance will support financial development, or poorly designed housing finance policies will distort and pollute the rest of the financial system through politically motivated subsidies and ill-advised regulations.
The central question to ask in order to design a coherent and sound housing finance strategy is: "Do we know why commercial banks do not lend for housing today?" Why would businesses deliberately cut themselves off from an important market? The answer lies in public policies that do not allow them to control various risks successfully. These risks include credit risk, liquidity risk, and interest rate risk. In addition, banks also face problems such as inadequate capitalization and the lack of experience with mortgage lending.
For both technological and financial risk management reasons, secondary market institutions in the form of various types of mortgage corporations play a strategic role in solving these problems. Trends in economies with the most advanced financial markets are remarkably uniform in this regard. Hong Kong itself is no exception. In his debut budget speech, the new Financial Secretary has proposed setting up a mortgage company.
What is the answer regarding financial risks?
The evolution of housing finance is toward both the retail lenders and secondary market institutions. Retail lenders include commercial banks and finance companies. They are best able to manage credit risk because they interface with borrowers. They now have a choice between keeping the loans in their portfolios and selling the mortgage loans to secondary market institutions. On the other hand, secondary market institutions can fund themselves in capital markets and could be better in managing financial risks. The form of secondary market institutions are various, such as Fannie Mae and Freddie Mac in the US, Cagamas in Malaysia, and other mortgage corporations in the Caribbean region, Central America and Jordan, etc.
To make the strategic solution linking housing finance and capital markets possible and efficient, two factors are important. First, fiscal policies must maintain balanced budgets and the government should not monopolize long-term debt markets with mandatory placements. Second, there has to be a large, long-term investor base resulting from profound reforms of social security systems and the rapid growth of privately managed contractual savings institutions such as pension funds and life insurance.
We are moving toward a new world of housing finance. Successful financial markets are most likely to evolve along the lines sketched above. However, it would be wrong to expect that all domestic financial markets soon will become identical. In fact, the purpose of our forthcoming study of housing finance in Asia is to better understand the sequencing issue and the choices available.
In the mid-1980s there was the "flying geese" concept of development in which Japan was expected to lead the countries of Asia along a very similar and predictable path. A decade later we can say that this has not happened. In fact, a writer has noted that we do not have a uniform flock, but instead very different kinds of birds indeed. Asian financial markets and housing finance in the 1990s will promise to remain as colourful and lively as ever.
Mr. Bertrand Renaud is the Housing Finance Advisor at the World Bank. He has had extensive experience working in the area of housing markets in numerous economies, including China, Korea, and Hong Kong. The above is an edited version of a presentation he made when he visited the Centre earlier this year.