Three lessons for policy makers building housing finance systems

Rob McGaffin attended the Wharton Business School International Housing Finance Programme (IHFP) in Philadelphia from the 4 – 15 June 2012.  A similar course that is more tailored to the African context is to be run in Cape Town from the 1 – 6 October 2012.  The course is called the Housing Finance Programme for Sub-Saharan Africa and is being jointly presented by the Wharton Business School, the Centre for Affordable Housing Finance and the University for Cape Town.  More information about the programme can be found at this link.  In this blog, Rob sets out three of the key lessons offered by the course.

Policy makers considering the development of housing finance systems  should consider three especially important lessons:

1. Housing finance is but one of many key elements that need to be in place for successful housing delivery to happen.
2. Finance is required at each stage of the housing delivery chain – lack of finance in any one area will undermine the entire chain.
3. Mortgage-backed finance systems that dominate housing finance thinking fail to address the breadth of housing finance needs.

Lesson 1: Housing finance is but one of many key elements that need to be in place for successful housing delivery to occur. 

To begin with, the entire delivery chain needs to in place or else the financial interventions will have a limited impact and or negative unintended consequences will result.

Delivery Chain:

Land – Development Rights – Infrastructure – Development – Construction – End user Finance – Public Services – Private Services – Management

However a number of key additions, including public/private services and management, need to be added to the chain.  Although the term “housing delivery” is used, most people actually have the objective of delivering viable neighbourhoods made up of both residential and non-residential uses.  Similarly, it is recognised that a house is in fact a multi-dimensional asset containing an array of values.  However, a significant amount of a houses value is created by the context in which it is situated.  Therefore, if one is to deliver houses of value to people, one has to in fact deliver the entire package of viable neighbourhoods.  For this reason, housing finance should not be restricted to only the residential structure itself.

Furthermore, due to the fact that property is characterised as being long-lasting and fixed in space means that it is susceptible to externalities and depreciation.  Numerous life-cycle costing studies have shown that often the operating costs over a life of a property are significantly higher than the initial capital costs to construct it.  Therefore, to protect the value of a residential unit (and the neighbourhood); it is imperative that the unit and area be properly managed.  As a result, finance pertaining to on-going management costs should be part of any housing finance programme and strategy.

Lesson 2: Finance is required at each stage of the housing delivery chain – lack of finance in any one area will undermine the entire chain.

The second lesson follows on from the first: finance is required at each stage of the delivery chain and conceptually therefore housing finance should cover all these stages on the chain.  Furthermore, different types of finance will be applicable to these different stages and in different contexts where the underlying conditions may differ.  For each stage, the following forms of finance will be applicable to varying degrees:

Forms of Finance:

Secured debt finance – Unsecured debt finance – Savings – Direct income – Equity – Grant finance

Lesson 3: Mortgage-backed finance systems that dominate housing finance thinking fail to address the breadth of housing finance needs.

The third lesson is that the mortgage-backed finance systems that dominate most of the thinking around housing finance are flawed in the following ways:

• In many African countries and cities, a number of the underlying conditions necessary for mortgage finance (legally registered title; consistent, regular, long-term income stream; ability to repossess; etc.) do not exist.
• Due to the mis-match between the duration of the source of funding and the lending that occurs, derivatives are often used to source funding from the capital markets.  This in itself is not a problem and such markets have an important role to play in enabling such financial systems to operate.  However, where such derivative trading is used as a source to generate profits, the entire systems is threatened.  In order to make profits through derivatives one has to in essence bet against the market, which by definition will only be successful in a limited number of cases.  Doing so is therefore very risky and considering the high levels of gearing of banks, the consequences can be extreme as seen in the sub-prime crisis.
• In many cases, the easing of underwriting to facilitate housing ownership and address the affordability constraints of households is highly problematic, as it does not address the source of the problem.  The Wall Street Journal (4 June 2012) published an article stating that the real incomes of US households had not increased since 1990.  This, together with the fact that real house prices had increased over that period, resulted in the decline of housing affordability.  This is not a problem that can be overcome by extending greater finance into this market as the affordability issue is not addressed and repayment problems over time will occur.  Over-gearing poorer households is a recipe for disaster.
• Similarly, the use of standard debt to household income ratios such as 30% are equally problematic as they fail to recognise the different spending patterns and demands on households across the income bands.  Research in South Africa suggests that such ratios should be closer to 15 – 20% rather than 25 – 30%.  In short, the levels of debt finance extended should be limited to what households can sustainably afford.
• Loan to value ratios fall into a similar trap.  This is because the value of the house is determined at the date of the loan and yet the value of a house is likely to fluctuate over the term of the loan depending inter alia on the nature of the housing cycle.  To make matters worse, the house is by definition over-valued at the top of the cycle and under-valued at the bottom.  This is because prices will revert to the mean over time, which means that by definition, house prices at the top of a cycle must come down over time.

The problem is further exacerbated because lending criteria are generally less stringent over boom periods and higher loan to values are permitted.  Therefore, not only are the houses over-valued but also higher loans are given out against the “over-priced” assets, putting both the household and bank at risk.  Secured lending can be problematic at the lower end of the market because the asset value of the houses is low, liquidity in the market is low, household incomes are low and very importantly, the nature of the household income is uncertain.  As a result, it is often very rational for a household not to take up secured lending opportunities because their precarious economic position results in their houses being vulnerable to repossession.  Shorter term, unsecured lending (micro-finance) is in many ways better suited to this market.  The downfall of this finance is that it is very expensive.  The question remains whether a hybrid solution can be found?  Could a product be designed where a small (R5000 – R50 000) secured loan is made over a shorter period (e.g. 3 – 5 years) on a rolling basis?  If so, the key challenge to be overcome is the cost associated with small loans.

It is clear therefore that trying to address the affordability issue through housing finance alone will not solve the problem and may in fact threaten the financial and other related markets in the process.  Furthermore, the housing finance needs to relate and be structured around the housing delivery process, with the finance being tailored to each stage of the process and the different contexts in which the delivery takes place.