Housing Conference 2015 on “Affordable Housing & Housing Finance”

1. Housing Conference 2015 on “Affordable Housing & Housing Finance” The role of Regulators in Housing Finance Olivier Hassler ohhfinance@gmail.com

2. Objectives and Constraints of Housing Finance Regulation • Within the general goals of prudential regulation • Protect depositors • Ensure financial stability and mitigate systemic risks • Formalize the awareness of risks and their management framework within FIs – e.g. internal control, reporting requirements, risk appetite framework • Ensure level playing field • Avoid regulatory arbitrage • Specific themes for housing finance • Cyclical market, prone to asset price bubbles • Liquidity risk generated by long term lending • Need of investors’ confidence • But also specific constraints • Real estate markets dynamics, often not primarily driven by credit • Objectives can be conflicting

3. Main Lessons from the 2007-2009 Crisis • A crisis mostly acute in the US (starting point) and in Europe- only a few emerging countries affected to some extent:RSA, Mexico, India • But with generally valid lessons– contrarily to the regional , also real estate related, crises of the 1990s. The last financial crisis = largely shapes the new global regulatory landscape, and provides a reference stress scenario • Three main areas: I) Micro-level credit risk • Sound underwriting criteria • Responsible lending II) Macro-level stability • Avoid losing track of credit risks through risk transfer mechanisms • Manage the use/impact of mortgages on speculation and housing market overheating III) Mitigate contagion risk through funding • Impact of confidence losses / market disruption on liquidity • Treatment of creditors in case of insolvency

4. I A) Ensure Sound Underwriting Criteria • A flurry of regulatory adjustments world wide - Examples • FSB Principles for Sound Residential Mortgage Underwriting Practices March 2011 & Apr 2012 • USDodd Frank ActJul 2010, UK Mortgage Market Reviews Dec 2010 and 2011, • Hungary, Latvia, Lithuania, Malaysia, Norway, Poland, UAE etc., since 2010 • EU: Mortgage Credit Directive • Ability to Repay = primary criteria (mortgage security = safety net) • Lend primarily based on repayment capacities • Requirement to verify stated income, no self-certification • Assessment of free disposable income and living expenditures (simple DTIs % not enough) • Verification of total indebtedness • Variable rate /FX mortgages: • Disregard initial teaser rates (fully indexed rates) • Stress tests , at origination and on an on-going basis • Income buffer • LTVs still important – Typically determine Risk Weights Note: Basle III only changes Risk Weights of mortgages by setting a 20% floor for Internal rating Bases Approach

5. I A) Sound Underwriting Criteria, Ctd • Avoid risk layering Addition of products risky features ( e.g. interest only, no-or low doc., negative amortization, teaser rates) and borrowers risky profiles: typical of subprime lending– but more generally a tempting way to create apparent affordability • Provide discipline incentives to lenders : • Linkage soundness of lending / capacity of funding: 5% risk retention rule for securitizing originators (Basle, Mexico, US, EU) • In the US: “Qualified Mortgages” • Exempted from the 5% risk retention requirement • Provides protection in case of foreclosure (burden of the proof of unfair lending born by the defending borrower) • Expected loss based provisioning (Mexico)

6. I B) Strengthen Consumer Protection • Reckless lending targeted by recent framework enhancements • Responsible lending has been defined… • Not lending against borrower’ interest • Affordability based lending • Fair information • Advisory services (ex.: South Africa National credit Act since 2007; France: ANIL network; US :Office of Housing Counseling created within HUD by the US Mortgage Reform and Anti-Predatory Act – MRAPA -, Title 14 of Dodd- Frank) • … and its legal implications strengthened • Direct legal responsibility of bankers already in some systems (South Africa, France, UK) Important innovation in the USA: • lenders legally liable for not complying with MRAPA • Dodd Frank / CFPB/ HUD “Qualified Mortgages” provide legal safe harbor • In many jurisdictions –including the US now-: unfair lending = defense against foreclosures • “Passive” over-indebtedness (post-origination hardship), an on-going debate • Ex. EU: EBA Opinion on good practices for responsible mortgage lending and treatment of borrowers in financial difficulties (June 2013) • Several options: personal bankruptcy, loan restructuring (pre-set rules? judicial discretion?) • Risks: strategic defaults (US) , moral hazard

7. II A)Ensure that risk transfers do not hide risks at the Macro-Level • Shadow banking system – Basle III, new insurance prudential framework in Europe (Solvency II) and Australia : • Securitization made more costly, restriction to its role as a risk transfer instrument (risk retention requirement) • dissuasive treatment of re-securitization • Increased due diligence and market disclosure requirements • Mortgage insurance - prudential regime already in various countries (ex. India, Australia) – Generalization: Basle Joint Forum Feb 2013 report : • same soundness criteria as for lending, • Insurers’ prudential standards = a condition to lower risk weights in lenders’ balance sheets • no regulatory arbitrage

8. II B) Preventing Housing Price Bubbles • A potential source of systemic risk –even if a small portion of credit portfolios • The amplification effect of mortgage security: housing market downturns not only increase defaults, but affect the value of collaterals • Developer loans: large amounts, high sensitivity to the fall of prices • Specialized lenders: more sensitive than commercial banks, and sources of contagion through their funding by banks or capital markets • Concentration of activity conducive to bubbles : lenders and developers often focus on thin, upper market segments , creating the conditions for oversupply • First type of macro- prudential measures: reining-in credit growth • Quantitative caps ( ex. Hong-Kong) • Limiting LTVs, as an indicator of expectation-based lending • Hard limits (e.g. India, China 201 -70%) • Higher capital charges for high LTV loans • Dynamic provisioning(e.g. Chile, Colombia, Spain) • Limiting Debt-to-service ratios (e.g. Hong Kong).

9. II B) Preventing Housing Price Bubbles,Ctd Improved approach: targeting specific speculation factors: • Restricting the financing of multiple investments (2nd or 3rd investment) • Reducing LTV caps (Malaysia 2010, Canada 2010, Singapore, UAE, Indonesia 2013) • prohibiting lending (China) • Limiting non-residents investments (China – local level-, reversed by many communities since 2014) • Prudential tightening in selected, overheating areas- Korean example: 40% LTV in Seoul metropolitan area (2002), on higher priced houses (2006), delineation of speculative zones with contra-cyclical LTV and DTI limits • Restrictions on off-plan sales financing (Dubai, Saudi Arabia, Indonesia)

10. II B), CtdThe Limits of Macro-Prudential Steps • Not all price appreciations are bubbles • Real estate market Intrinsically cyclical –e.g. leads an lags between demand and supply • Structural housing shortage, supply bottlenecks • Lack of alternative investment opportunities • Purchasing power of non-residents (incl. nationals) • Mortgage lending is not the main engine of market exuberance • Often a largely cash market • Land speculation • Off-plan purchases prone to speculative contract flipping • High LTVs not necessarily a bet on future appreciation (young households) • Anti-speculative measures must directly target the housing market • Land management policy • Taxation– see China 2013, Singapore 2009-2011 (level of registration charges increased to up 16% for short holding period, up to 16%; + 3% or 10% stamp duty surcharge for second houses) • Stimulation of affordable housing supply Ex. Viet Nam bubble management: 2013 subsidized mortgage loan programs ( 600 million US$) targeting the middle income segment (Quintiles 3 &4) to induce a redirection of –even on-going- housing developments • Strengthening the developers industry to control over-supply and avoid contagion effect

11. II B), Ctd … But Financial Authorities’ rolecanbebroader • Monitoring prices In quite a few countries, the construction of price indexes have been initiated by the Central Bank – Indonesia, Morocco- or related agencies (Mexico SHF, India NHB) • Promoting real estate observatories with a stability focus • Length of upturn phases (may fuel perception of enduring appreciation) • Sellers’ markets drive appreciation • Turn-over and sale rhythm of new developments • Analyses by segments (location, price brackets) critical to spot overheating areas • Best practices: Thailand (pioneer), Canada, Korea • Identifying over-evaluations not an easy task - are “fundamentals” really fundamental? • Rents to prices ratio: numerous drivers, not a simple indicator • Income-to-price ratio: averages of little value in highly segmented housing markets, income distribution by geographic areas needed but not always available

12. III A) Ensuring resilience to funding market disruptions • Mortgage lending particularly sensitive to liquidity risk • Long term, frequently illiquid asset class • Regular temptations to play the yield curve through short term wholesale funding, critical role of investor confidence in refinancing requirements • Specialized lenders among the hardest hit by the 2007-2009 crisis: non-bank mortgage banks in the US, Northern Rock (UK), Depfa (Germany), Mexico SOFOLEs • Hence the importance of prudential norms for liquidity management – Basle III new liquidity ratios: • Liquidity Coverage Ratio: ensuring that estimated monthly cash out-flows are covered by liquid or easily monetizable assets • Net Stable Funding Ratio: ensuring that a FI can function without mobilizing market funding for a year

13. III B) Secured funding and insolvency situations • Raising long term debt for mortgage lending implies special security for investors… Basis of mortgage-related securities: securitization, MRCs, covered bonds • … and correlatively the “structural subordination” of other creditors : • Allocation of high quality assets to a specific category of creditors, via encumbrance or sale • Amplified by over-collateralization • Ranking competition with deposits and deposit insurance: a critical consideration … • … extended to senior unsecured debt trough the new resolution regimes (USA, EU, Brazil, Switzerland) SS debt holders could be bailed –in to avoid costly government bail-out interventions and enhance market discipline • A new responsibility for financial stability Authorities: contributing to the legal mechanism (permitted overcollateralization, debt ranking) and its enforcement (degree of flexibility?)

14. Conclusion: a delicate balancing act between conflicting objectives for Regulators • General economic stimulation through monetary easing vs risk control (incentive to risky, high return seeking behaviors) • Reining-in RE market risks and overheating vs market deepening: high LTVs required for first –time buyers, needs of informal sector households (US: fears of Qualified Mortgage concept on non-traditional lending) • Control risky effects of competition between FIs without limiting competition • Control risks without over-regulating • Too strict sets of rules stunt product innovations (example of extreme standardization of products by the Colombian mortgage law) • Too costly impact of regulation may deter lending • … But benefits of enhanced soundness to be quantified and factored in (see in the US: estimation by the Consumer Financial Protection Bureau of the quantitative impact of Qualified Mortgages more efficient foreclosure process