A Long-Term Partnership for Low-Income Housing Finance

1. A Long-Term Partnership for Low-Income Housing Finance Presentation to Parliamentary Portfolio Committee 24 August 2005

2. Knowledge is power First economy John has recently turned 30 and is interested in buying a house. He knows his credit record with the bank is good, and he has had a regular job with a good salary for the past 5 years. A friend told him that the banks will allow up to 30% of his income in repayments, so he knows what he can afford before speaking to the bank. John already has a good idea of exactly what he wants to buy and he expects to be granted a loan with little hassle. Borrower education and development of straight-forward lending products are key to increased borrower access to affordable bank lending Second economy Annah, a domestic worker with a very good employment and banking record needs to borrow R6 000 to complete the building of her house, which is already roof high. The house has been built over the last year with any extra cash she had, and with help from her employer. Annah has heard from her friends that getting a loan from the banks is a long and difficult process with lots of paperwork and little chance of success. She has thought of borrowing money from a local lender - even though the loan is more expensive than the banks' advertised rates. She is unsure and worried about being able to afford the rates charged by the local lender.

3. Poor local government creates a downward spiral Properly functioning housing markets increase realisable property values and market liquidity Tshepo bought a house in Diepkloof, Soweto for R45 000 13 years ago. He has paid his mortgage every month even though he had to endure some difficult financial times during this period not to miss a payment. Although Tshepo initially paid his monthly municipal bills, he has not paid any rates and taxes to the local municipality since a pre-paid electrical meter was installed 6 years ago – and he’s suffered no negative results for this transgression. Unpaid rates and taxes now amount to R56 000 on his property in contrast to the R12 000 outstanding on his mortgage. Tshepo wants to sell, but he has reached a stalemate - he has been told that on sale the municipality will get the full proceeds to pay his municipal arrears. He is very angry. As he cannot see how to realise any value from his property investment he has also stopped paying his mortgage loan.

4. Collateral underpin allows new lending in underperforming areas during the process of normalisation Sipho took possession of a RDP house just outside Vereeniging 7 years ago and has spent time and money improving his property. Sipho's has been offered a promotion, but needs to relocate to take up this position. He is lucky – he has found someone who is willing to buy his house for R55 000 – and who has offered to put down a 10% deposit towards a mortgage for the purchase. Recently one of the large local manufacturers closed down, leaving many of the residents in Sipho's area unemployed. Families who had been paying their bonds for years suddenly were unable to honour their debt obligations. There have been many evictions in the area and people have lost their homes. Because of these problems, there isn’t a bank in Sipho’s area that will grant a mortgage loan. If Sipho’s buyer can’t find a loan, he won’t be able to afford Sipho’s house, and Sipho won’t be able to move and accept the promotion. Sipho needs a solution for new borrowers to secure financing. Underwriting the collateral values and a methodology for dealing with PIP*s will enable lending activity in previously high risk areas * Properties in possession (I.e. repossessed properties)

5. Repayment amounts cannot be subject to interest rate increases First economy Kamil earns R9 000 a month. He and his wife bought a house when interest rates were low - initially paying R2 600 a month on his mortgage. Now that interest rates have increased his payments have risen to R3 500 a month. Kamil has had to delay the planned purchase of a second car and cut back on a number of luxuries. He and his wife have agreed that she will look for a better paying job if rates go up again. Fixed rate products are critical to maintaining the affordability of low-income lending Second economy Lindiwe earns R3 200 a month: she pays R900 to her mortgage account, R700 to buy food and R600 to repay her Edgars card account and a microloan she used to pay for school fees. Her remaining R1 000 is largely spent on municipal rates and taxes and transport. She sometimes plays the lottery if she has money left over. Although Lindiwe's microloan and Edgars card payments have not increased, her mortgage payment rose by R200 last month, and she has a letter from the bank that says it will rise again by another R150 this month. She has no idea where she will get the money to continue paying for her house.

6. CONTENTS • Financial Sector Charter commitments to low income housing finance - context • Proposed solution • Implications for borrowers and government

7. Government and the Financial Sector have a shared vision for low income housing finance Our shared vision • More low-income* people owning homes • Broad BEE / wealth generation through home ownership • Fully functioning, integrated housing markets • Sustained and increasing creation of quality low-cost housing stock • Significant economic multiplier effects, including job creation and increased tax base, contributing to poverty eradication Our joint aspiration • R42bn in low-income housing finance by 2008 • Significant investment in stimulating the creation of new stock • Starting the journey of transforming the South African housing market A committed working partnership is essential to achieve this aspiration * As defined in the Financial Sector Charter - household income between R1 500 and R7 500 p.m.

8. FSC housing commitments aim to transform a market segment that is underserved, yet potentially commercially sustainable Housing in South Africa Financial Sector Charter target market The Financial Sector Charter aims to extend housing finance to the currently underserved, commercially-sustainable market 2m households earning between R1 500 and R7 500 monthly household income Of these, 800 000 to 1.1m households qualify for credit* Banks will lend to ±470 000 of these households at an average of ±R90 000 per house to achieve R42bn of FSC targeted investment in this market by 2005 Dependant on Government for 'social' housing (±7m households) Dysfunctional 'commercially-viable' market (±2m households) Functioning market (3.5m households) Total = 12.5m households (45m people) * Banking Association estimate

9. The ongoing commitment to low income housing finance is underscored by an agreed 8-point transformational agenda Transformational agenda • Increased commercially-sustainable penetration in conventional markets • Normalisation of under-performing markets • Increased provision of finance for intermediated housing, alternative tenure and incremental construction • Re-engineering the housingvalue chain • Transparent performance measurement for housing markets and role players • Legislative and regulatory reform • Integrated development with appropriate public services and social infrastructure • Building sustainable capacity along the full housing value chain Guiding principles for the design of the transformational agenda • Redress of historical imbalances • Commercial sustainability • Eradicaton of non-commercial discrimination • Transparency • Public/Private sector role clarity • Competition and innovation

10. This market transformation is critical to the growth of the financially 'empowered' economy and ultimately, South Africa's development Transformational importance of the target market Desired outcomes for FSC housing initiatives Community role models (home ownership is aspirational and achievable) • Extend the home lending 'envelope' to include all homeowners who can afford credit • Make home finance affordable to borrowers in this market, and to provide protection against interest rate shocks • Normalise underperforming housing markets so that reasonable property values and property value growth are realisable (and by doing so increase access to finance, mobility of borrowers, and commercial development activity) • Empowering potential borrowers with poor credit histories and little capital But, • FSC housing commitments target the smaller part of South Africa's current housing needs - it is not a substitute for Government's ongoing social housing initiatives Increasing 'critical mass' of home ownership and access to finance - social stability 'Engine' of entrepreneurial economic growth (with access to finance) Broader wealth generation through revival of dead capital

11. Mortgage for existing market Mortgage for underserved market • Initial focus • Quick impact with govt risk sharing Instalment Sale Agreement • 5-10 year term • No 'Servcon' Rent-to-buy Social housing Although mortgage is our initial focus, this is only a part of the transformational journey for South Africa's housing market A 'staircase' to homeownership Government Financial Sector

12. CONTENTS • Financial Sector Charter commitments to low income housing finance - context • Proposed solution • Implications for borrowers and government

13. A viscious cycle exists in the FSC target market which neither Financial Sector alone, nor Government on its own, can break Dead and dying capital (collateral) Dysfunctional Local Government and Community Governance Realisable property values fall (no buyers, deteriorating stock, rates and taxes arrears, impediments to sales) 'Value' of home ownership is reduced for home owners Borrowers are less likely to repay existing loans No registered title on property Municipal service quality is poor/ services not provided Key drivers of Bank behaviour ("redlining") Increased rates and taxes arrears Increased loss given default (security value not realisable) Increased cost of servicing loan Increased probability of default Law and order not enforced Banks cannot secure unencumbered, beneficial possession Dysfunctional housing markets Existing homeowners cannot access affordable capital for repairs/home improvements New potential buyers cannot buy into the market Home finance not economically feasible for banks or borrowers Undesirable social environment

14. There are vital 'missing ingredients' requiring joint intervention for sustainable low-income mortgage finance Missing ingredient What the borrower needs Key outcomes required Access • Standardisation and transparency • Relevant knowledge / information • Convenient and accessible lending supply • Available housing stock at affordable levels • Self-screening via clear, well-publicised criteria • Consumer / borrower education program • Innovative product, credit and delivery approach • Mortgage lending Code of Practice • Sufficient mortgagable housing stock Affordability • Reasonable rate on loan • Subsidy • Certainty of repayment amount • Low-cost funding and fixed interest rate risk mitigation • Finance-linked housing subsidy scheme • Long-term fixed rate product at an affordable price Realisable property value (De Soto effect) • Functioning secondary and primary housing markets • Ability to leverage property value • Title and beneficial physical / economic possession • Strong governance in fully functioning communities • Collateral deficiency solution for under-performing markets

15. Five critical solution components are required to address these ingredients for market transformation Critical components of proposed solution • Coordinated consumer / borrower communication and education program • Effective and efficient finance-linked housing subsidy scheme to increase affordability in the low-income sector • Centralised Conduit to facilitate access to low-cost capital market funding and fixed rate risk mitigation • Centralised Loss Insurance (LI) function to provide appropriate risk underpin for collateral deficiency • Coordinated effort to establish fully functional housing markets Missing ingredients Access Affordability Realisable property value All five components are required to effectively address the missing ingredients in a sustainable manner

16. Five critical solution components are required to address these ingredients for market transformation Focus of this presentation Critical components of proposed solution • Coordinated consumer / borrower communication and education program • Effective and efficient finance-linked housing subsidy scheme to increase affordability in the low-income sector • Centralised Conduit to facilitate access to low-cost capital market funding and fixed rate risk mitigation • Centralised Loss Insurance (LI) function to provide appropriate risk underpin for collateral deficiency • Coordinated effort to establish fully functional housing markets Missing ingredients Access Affordability Realisable property value All five components are required to effectively address the missing ingredients in a sustainable manner

17. ELEMENT 3. CONDUIT TO FACILITATE FIXED-RATE LENDING There is a high correlation between interest rate volatility and default 16 18 17 14 Interest rate 16 12 15 10 Prime lending rate, % Accounts >3 months in arrears, % 14 Accounts in default 8 13 4 12 2 11 10 0 2001 2002 2003 2000 2004

18. ELEMENT 3. CONDUIT TO FACILITATE FIXED-RATE LENDING Borrowers need a fixed rate product to protect affordability Variable rate Fixed rate Fixed rate protects borrower affordability against interest rate fluctuations, and guarantees the value of subsidy in improving borrower affordability Initial interest rate 19%* 16% Affordable monthly repayment (R) 580 580 Loan value 35 800 41 700 Subsidy value (bank proposal) 15 100 15 100 House value purchased 50 900 56 800 Rate increase +3% - New repayment amount 665 - Additional interest payment over life of loan** 18 360 - Rate increases result in higher monthly repayments, increased risk of borrower default, and erode the impact of subsidy in improving affordability * Higher variable rate reflects greater default risk in variable rate lending in the target market ** Assuming rate change after 24 months

19. ELEMENT 3. CONDUIT TO FACILITATE FIXED-RATE LENDING Case for government role to facilitate fixed rate funding Key requirements to help normalise the market • Access to ongoing low cost capital market funding • Tradability - commoditised liquid paper at scale • Diversified loan book (by geography and originator) • Standardised reporting and disclosure, and transparency of historical performance data • Visible and reliable single access point for investors • Economies of scale • Decisive, coordinated intervention to achieve market normalisation • Sufficient, rapid market penetration to reach the 'tipping point' for a functioning second hand housing market (key component of integrated development) • Sustainable access to funds (ensuring ongoing funding of housing finance) • Single point of application for Loss Insurer and fixed rate risk mitigation • Product standardisation to enable consumers to self-qualify • Enduring institutional focus on taking remedial action • Joint governance • Follows international precedent Without the Conduit, implementation of the proposed solution will be less affordable for potential borrowers and will not achieve a critical mass to normalise the low income market

20. ELEMENT 4. LOSS INSURER TO UNDERPIN COLLATERAL VALUE Realisable security value is essential to make home lending possible (and affordable to borrowers and banks) Home Loan Finance needs Large loan Repayment spread over many years to make instalment amount affordable Lowest possible interest rates Therefore to make mortgage lending possible… Attempt to predict borrower income/affordability well into the future Lower risk premium (and thus lower rate) achieved because security value is realisable Unable to do this business if … Income is not predictable Security cannot be attached and value realised

21. ELEMENT 4. LOSS INSURER TO UNDERPIN COLLATERAL VALUE Delivery of secured lending products in this market requires that several market and non-market risks are addressed Major drivers of risk Employment status Borrower indebtedness Interest rate fluctuations Unplanned household expenses Borrower ability to pay loan and* Probability of default (PD) Effectiveness of collections Culture of payment Borrower credit risk (credit score) Borrower contribution (deposit) House price inflation/deflation Municipal efficacy/upkeep of community Borrower propensity to pay loan Risk analysis of loan Initial loan value Years before default (repayments to date) Principal value outstanding on default + Interest and admin costs incurred post default Clearance costs (electrical certificate, pest certificates, municipal clearance) Legal costs PIP holding costs Collections and legal costs Loss given default (LGD) - Ability to secure title Ability to repossess Rates and taxes arrears Presence of willing buyers with access to finance Relocation options Realisable asset value * Not a mathematical function

22. ELEMENT 4. LOSS INSURER TO UNDERPIN COLLATERAL VALUE Case for the Loss Insurer Without the Loss Insurer, properties in the second economy will not realise full value, continuing a dysfunctional second hand housing market that limits wealth creation Key temporary interventions to correct dysfunctional collateral • Deeper lending into non-performing areas • Enables providing mortgage lending notwithstanding impaired collateral • Continue lending activity so that collateral value becomes normal • Decisive actions to realise property value and the creation of a second hand housing market • Enhance the value of existing properties by sustaining collateral values • Facilitate a market for borrowers to buy and sell to meet their changing housing needs • Enhanced property values will result in improved community infrastructure and integrated development • Establish initial building blocks for housing solutions across other non-mortgage tenure options

23. ELEMENT 4. LOSS INSURER TO UNDERPIN COLLATERAL VALUE Unpaid municipal arrears create additional liabilities for banks Average outstanding municipal services payments per mortgaged property (excl. outstanding rates and taxes) Municipal arrears on non-performing loans suggest borrower financial distress.. Non-performing loans (50 accounts) • Municipal collection efficiencies are poor, and municipal arrears often grow unchecked (arrears plus interest claims often comprise a significant proportion of the value of the property) • Municipalities frequently rely on their preferential claim against sale proceeds for unpaid accounts, including taking properties to auction to recover arrears - both borrower and bank lose • Banks are engaging municipalities to address consistent application of regulations, collections methodologies, and capacity issues in an attempt to addres these issues R15 741 ..however, significant arrears in the performing book (paid-up mortgages) suggests poor collections by local authorities Performing loans (145 accounts) R10 748 PIP portfolio (572 accounts) Banks carry significant arrear costs on PIPs R8 558 Source: Analysis of banks' data

24. ELEMENT 4. LOSS INSURER TO UNDERPIN COLLATERAL VALUE Banks take first loss and must lend wisely Individual loan cover allows banks to lend in areas where collateral is currently dysfunctional Bank risk (35% first loss) Banks mitigate risk of under-recovery by: • Proper assessment and valuation of property • Efficient handling of legal collections process LI individual loan cover Government mitigates risk of extreme under-recovery by: • Upkeep/development of community infrastructure and social environment • Enforcement of law and order • Efficient transfer and registration • Management of rates and taxes arrears Outstanding balance on default Potential losses

25. ELEMENT 4. LOSS INSURER TO UNDERPIN COLLATERAL VALUE Although private sector can price for most instances of default, systemic risks underlying certain default scenarios cannot be accommodated Default assumption Commercial risks Anticipated defaults can be priced for and managed in private sector Probability of default Systemic risks Rare instances of default not able to be priced nor managed in private sector Annualised default rate

26. ELEMENT 4. LOSS INSURER TO UNDERPIN COLLATERAL VALUE Losses at a pool level are protected by increasing LI pool cover for more extreme losses Losses resulting from risk sharing proposal (bank default assumptions) Bank losses (shareholder funds) Probability of loss Banks carry risk in the majority of cases (based on anticipated defaults/ realisation of collateral) Pool cover Magnitude of loss LI shares risk of extreme loss scenarios only Realised losses over 10 years (Bank shareholder funds plus pool cover)

27. Innovations contained in the Bank Proposal Bank "gives" (Front end) Bank "asks" (Back end) FSC targets in 2008 (R52bn origination - banks; R42bn targeted investment - all financial sector) Extended reach to previously unserved borrower income levels with banks taking a significant first loss Coordinated Borrower Education program: inform borrowers of their rights and their ability to access finance, enable self-screening and stimulate demand Enhance delivery of subsidy: qualify borrowers for subsidy, monitor provincial disbursement performance and enforce service levels, suppress gaming Innovative product: credit, valuation approach for dysfunctional markets, long-term (e.g., 20 year) fixed rate Insurance offering targeted at common causes of default with borrower as beneficiary (i.e. protecting ownership) Follow agreed Home Loan Code of Practice for the target market: selling practices, loan rehabilitation and workout, handling of defaults Initiation of value chain efficiency improvements Joint pioneering of integrated housing development Risk capital and institutional 'home' for Conduit; banks pay setup cost; borrower pays operating costs (part of cost of funds) Fixed rate hedging capital; borrower pays hedging costs Risk capital for pool cover (cover for unexpected losses) and institutional 'home' for the Loss Insurer; anticipated claims and operating costs paid by all borrowers through LI levy.

28. CONTENTS • Financial Sector Charter commitments to low income housing finance - context • Proposed solution • Implications for borrowers and government

29. 1 500 29 450 2 479 3 990 6 270 1 880 38 199/ (33 809) 105 (7%) 10 150 3 040 2 000 29 450 2 479 8 660 42 079/ (34 969) 170 (8.5%) 14 920 4 470 2 500 29 450 2 479 14 410 46 849/ (36 399) 250 (10%) 20 600 6 170 3 000 29 450 2 479 21 240 52 529/ (38 099) 345 (11.5%) 3 500 29 450 2 479 29 150 27 160 - 61 079 455 (13%) 2 945 34 620 - 4 000 22 540 38 130 63 615 580 (14.5%) 2 945 42 980 - 4 500 16 174 48 200 67 319 720 (16%) 2 945 52 240 - 5 000 11 040 59 200 73 185 875 (17.5%) 2 945 62 400 - 5 500 6 757 71 400 81 102 1 045 (19%) 6 000 3 412 2 945 84 700 73 430 - 91 057 1 230 (20.5%) 6 500 2 945 2 945 99 090 85 370 - 104 980 1 430 (22%) 7 000 2 945 2 945 114 540 98 200 - 120 430 1 645 (23.5%) ILLUSTRATIVE SUBSIDY PROPOSAL What can a borrower expect Effective loan value House-hold income Deposit (required for subsidy) Monthly repayment assumed Mort-gage** (16%,20y) Pension-backed (16%,10y) Available for house purchase Unsecured (30%,2y) Pension-backed (unsecured) loans Subsidy DRAFT Collateral-ised loans ** Nett of bond transfer and registration costs (±R3 500)

30. Coordinated borrower education program Consumer education - Borrower education Origination intermediaries (incl. NGOs) DPLG Finance-linked housing subsidy scheme Scheme design/ policy Funding of subsidies Subsidy administration - Fixed rate solution that mitigates interest rate risk and provides capital market access Joint governance Joint governance Capital guarantee Institutional support Joint governance Set-up and ongoing operation Product innovation Origination Underwriting Servicing Financial sector Risk underpin for collateral deficiency in underperforming markets Joint governance Institutional support? Joint governance Capital guarantee Institutional support? Joint governance First loss Set-up and ongoing operation - Coordinated effort to establish fully functional housing markets Policy framework Facilitate role-player involvement Fiscal support Concerted push into underserved areas Continued innovation around provision of finance • DPLG - Rates and taxes - Services/ utilities - Infrastructure enablement • Other dept's responsible for governance To deliver on this proposal, a joint, coordinated effort is required involving banks and various role players within Government DoH National Treasury Banks / lenders Other players

31. Subsidy Economic growth (increasing employment and transformation of the second economy) Disbursement 15* Loss Insurer - 0.1 0.2 0.2 0.3 0.3 0.6 LI levies - all mortgages LI claims + running costs Government risk capital Improve municipal collections performance (DPLG) Enhance service delivery Uphold law and order (beneficial economic possession) Control of social housing Tax capability - (0.1) (0.2) (0.2) (0.3) (0.3) (0.6) - 0.5 1.8 3.8 5.6 7.2 11.7 Investment by Government PROJECTED VALUES Rbn Government levers to mitigate risk and reduce cost 2005 2006 2007 2008 2009 2010 … 2014 Conduit Interest rate stability and inflation targeting Funding opportunities uniquely accessible to government Deepening/extension of fixed rate capital markets Capital availability appropriate for this risk Access to international capital markets Total low income housing finance Conduit loans Government risk capital 35 39 44 49 55 63 106 - 2 6 13 20 28 70 - 0.3 1.1 2.5 3.5 4.3 6.7 * Based on jointly revised subsidy model

32. In this model, the responsibilities and rewards for both Government and the Financial Sector in empowering low-income borrowers to access mortgage finance continually drive both parties to the Partnership … for Government … for the Financial Sector Improved servicing of entry-level housing finance needs Increased competition Broader economic impact (GDP growth, SME stimulation, job creation) Healthy ROE FSC targets Reputational upside Expansion of the formal financial sector ‘Accelerators’ that drive the speed and depth of broader lending… • Protecting stability of financial sector • Capital commitments (LI pool cover and interest rate risk mitigation) • Capacity to: • Manage financial delivery • Ensure establishment of fully functioning housing markets 35% first loss position on individual loans Shareholder capital at risk against 3% first loss position at pool level Risks against last-loss position (investors) ‘Brakes’ that prevent irresponsible lending… Explicit and implicit ‘checks and balances’ ensure committed partnership aimed at rapid yet prudent expansion of ‘lending envelope’

33. Comprehensively addressing all aspects of this agenda will require significant investment in time, effort and funding over several years… Primarily Financial Sector Primarily Government Joint effort 2004/2005 2006/2007 2008 and beyond Affordability support (subsidy) Ongoing product innovation e.g. unsecured lending, installment sale Ongoing process and system innovation / re-engineering Consumer / borrower education Sizwe negotiation Mortgage solution (Project Sizwe) Broader sector participation (including LOA and pension funds) in low-income mortgage funding Sizwe operational Planning of Sizwe implementation rollout Stimulating creation of new housing stock via e.g. financial innovation, facilitating and incentivising new development, streamlining regulatory framework, etc Establishment of formal performance measurement and monitoring systems Facilitating normalisation and integration of under-performing markets via e.g. strengthening of local governance, facilitation of community / infrastructure development, regulatory / legislative reform Competitive activity aimed at meeting FSC targets and shared objectives, supplemented by competitive product innovation, affordability support, components of Sizwe mortgage solution, etc

34. Where are we now? Milestone reached Date MoU Joint Statement Envisaged agreement date 31 March 2005 23 May 2005 1 September 2005