Residential Real Estate – Value After the Subprime Crisis

1. Residential Real Estate – Value After the Subprime Crisis Britt Gwinner, CFA Principal Financial Specialist International Finance Corporation Viña del Mar, 7 May, 2010

2. Contents • The Basic Picture – housing demand around the world • How was mortgage finance linked to the recent crisis? • Going forward

3. The International Finance Corporation • Goal: Improve lives and raise living standards through sustainable private sector development • Member of the World Bank Group, owned by 179 shareholder countries, assets USD 51.4 billion, capital USD 16.1 billion • Global—for more than 50 years has focused on developing countries • Local—full time presence in more than 80 countries and activities in many others • Housing Finance Investment Services: • Loans for mortgage lending; Collateralized mortgage lines of credit; Warehouse lines of credit; Credit enhancement for MBS; Structured finance; Equity investments; Construction finance • Housing Finance Advisory Services: • Policy and regulatory infrastructure, mortgage toolkit and training, capacity building 3

4. Section 1 The basic Picture

5. Growth and urbanization • World Bank Data Visualizer • http://devdata.worldbank.org/DataVisualizer/

6. Real estate: a tale of many markets • Real estate: more than 1/3 of the value of all the underlying physical capital in the world • Developed countries: mature residential real estate markets • Populations are stable or shrinking – demand for financing from turnover, renovation, aging population, regional growth dynamics • >90% of housing units in developed countries are of adequate quality • Emerging markets: large pent-up demand for housing • As countries develop, they urbanize • Emerging markets urbanization has been poorly planned - housing and infrastructure inadequate, housing demand is strong • Self-built houses on squatted land lack connections to sewage or water, built of inadequate materials • 44.7% of households in Africa, 25.6% in South Asia lack access to improved sanitation • 20 to 30 million housing units in Latin America lack a basic amenity such as running water, or are built of substandard materials • Inadequate housing compounds the cycle of poverty – health, social investment, wealth-building 6

7. Mortgages mostly unavailable in emerging markets But as real incomes rise, so does capacity to make a mortgage payment 7

8. HousingFinance and Growth • In emergingmarkets, housingfinanceisrelatedto new construction and as a resultfixedinvestment, and generallywithdomestic inputs, both labor and materials • In developedmarkets, housingfinanceis more linkedto trading of existinghousing and economiccycles • In the U.S., there are 7 million new loanseachyear, 6 million of which are forexistinghousing • In developedmarkets, real estate and relatedservicescountforbetween 2% and 4% of PIB • In the U.S., 8 of 10 recessionssince 1949 were proceded byreductions in residentialinvestment 8

9. Mortgages and Fixed Investment In theinitialphase of development, mortgagefinance canadd 0.5% of fixedinvestment as a percent of GDP foreachincrement in thesize of themarket Source: Duebel (2008) 9

10. Real estate as an asset class • Traditional roles: inflation protection, diversification • Securities backed by inflation-indexed mortgages are natural inflation hedges (Chile, Mexico, Colombia) • Real estate investments can decrease the cost of inflation insurance for long-horizon investors (Amenc , Martellini, & Ziemann, Journal of Portfolio Management, 2009) • IRR of about 11 percent for 60/40 stock/bond portfolio with a varying investment in real estate over time. (Performance of Real Estate Portfolios, Fisher and Goetzmann, Journal of Portfolio Management, 2005) • International real estate can reduce portfolio risk (Chua,Journal of Real Estate Portfolio Management, 1999) • A recent comment from Prof. Robert Shiller: • “After prices fall, the media begins to publish stories of investor foolishness. Investors, feeling stupid or betrayed, have a “betrayal aversion” that causes them to react intensely and sell in anticipation of future price drops.” 10

11. Investment vehicles for residential real estate (1) • Fixed Income • Residential Mortgage Backed Securities (RMBS) – True sale to special purpose vehicle (SPV) that issues bonds • Long duration, some uncertainty in principal amortization (prepayments), varying structures, stand-alone credit rating, almost no replacement of assets, no recourse to loan originator • In Peru, AAA local scale RMBS provides 32bp over 3y AAA corporate (when corporates are available, it’s a thin market), 202bp over 3y sovereign • Covered bonds – general obligation bonds with contractual and/or legal backing from a portfolio of mortgages • Long duration, prepayments may be mitigated, credit profile a function of issuer’s balance sheet and security portfolio, assets may be replaced, complete recourse to bond issuer • Yields comparable to AAA corporates 11

12. Investment vehicles for residential real estate (2) • Equity • Rental apartment buildings, property developers, land banks, private equity • Residential rental - works best where laws permit a reasonable balance of tenant and landlord rights and responsibilities • Rental reforms recently passed in Brazil, considered in Mexico, others have stronger market traditions (Uruguay) • Hybrid • Real Estate Investment Trusts or Funds – United States, Asia, increasingly in emerging markets – while tax advantages not relevant to most pension fund investors, return may be 12

13. Section 2 What happened with the crisis?

14. U.S. subprime boom and bust – finance driven, excessive leverage, weak credit underwriting

15. What have mortgage defaults looked like? 15

16. A largely external crisis • There are no subprime mortgages in emerging markets • Lending generally to high income borrowers, with low LTVs and full documentation • Emerging sovereigns and corporates benefitted from low borrowing spreads during the boom • But, macro management has broadly been strong, emerging markets come out of the crisis with relatively low decline in GDP, many cases of growth • At the worst of the crisis, funding retreated to New York, London, Madrid, etc. • Limited development of some capital markets mitigated bad effects –e.g., Egypt, Guatemala • Relatively strong economic performance protected others – China, India, Brazil, Peru 16

17. Section 3 Going forward

18. What haven’t private pension funds invested more in real estate? • Constraints • Macroeconomic volatility – inflation, inconsistent policies, financial crises - Mexico ‘95, Russia ‘98, Argentina ’01 • High real rates + volatility make government debt more attractive • Lack of long term fixed-income instruments, lack of secondary market liquidity, yield curves • Investment channeled through personal rather than institutional means • Uruguay rental apartment buildings built & owned by individuals, family firms • Informal markets flourish because of faulty legal and regulatory structures 18

19. How to boost private pension fund real estate investments? • Lower real rates make private fixed income issues more attractive • Recent history in Chile, Mexico, Brazil, Colombia, Indonesia, India, China, etc. • Promote a range of long term fixed-income instruments, and a range of credit ratings – move away from incentives to pure triple-A markets • Permit securitization, covered bonds, funds, REITs – issuer chooses best execution • Chile as a model – 1980s reforms created AFPs, letrashipotecarias • Wider range of pension, insurance benchmarks • Promote secondary bond market liquidity • Benchmark government yield curves – extend maturity, issue to promote liquidity • Strengthen exchanges transparency, efficiency • Improve legal and regulatory structures of real estate markets • More efficient land use planning, title registration, contract enforcement 19

20. Thank you

21. Annex - LAC RMBS during the crisis Reliance on local investors, mostly low mortgage delinquencies, persistent demand from private pensions and insurers • Chile – Structured issuances up 6 times in 2009 v. 2008, of this, 9% was RMBS • Panama – La Hipotecaria 9 RMBS issues through 2008, securitized consumer loans 9/08, rolls commercial paper through 3/09, issues MTNs 4/09 – all to local investors • Peru – corporate issuances, structured finance for auto, consumer, leasing, and TitulizadoraPeruana issues RMBS 02/10, USD 34.5 million, oversubscribed • Mexico – Severely affected by the crisis, downgrades in RMBS issues by failed lenders, but strong performance by RMBS from major banks, Infonavit, Fovissste 21

22. Annex - LAC RMBS during the crisis (cont.) Colombia • USDeq 2.4 billion issued since 2002, trading at average price of 104.6 at end March, 2010 • UVR (inflation-adjusted), increasingly nominal fixed-rate peso • Prepayment rates have run 10.5% UVR, 14% peso, defaults < 2% • Structured finance volume 2009 almost twice 2008 • TC placed USDeq 791 million in RMBS 2009, more than half of recent issues purchased by domestic pension funds 22

23. Contact Info: W. Britt Gwinner Principal Financial Specialist International Finance Corporation Miguel Dasso 104, Piso 5 San Isidro, Lima 27, Perú +51 1 611-2573 wgwinner@ifc.org