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

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.

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.

Borrower education

and development of straight-

forward lending

products are key to

increased borrower access to affordable

bank lending

3

Poor local government creates a downward spiral

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.

Properly functioning

housing markets increase realisable property

values and market liquidity

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.

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.

Fixed rate products are

critical to maintaining

the affordability

of low-income lending

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

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.

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

8

FSC housing commitments aim to transform a market segment that is underserved, yet potentially commercially sustainable

The Financial Sector Charter aims to extend

housing finance to the currently underserved, commercially-

sustainable market

Housing in South Africa

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)

Financial Sector Charter target 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

* Banking Association estimate

9

The ongoing commitment to low income housing finance is underscored by an agreed 8-point transformational agenda

1. Increased commercially-sustainable penetration in conventional markets

2. Normalisation of under-performing markets

3. Increased provision of finance for intermediated housing, alternative tenure and incremental construction

4. Re-engineering the housingvalue chain

5. Transparent performance measurement for housing markets and role players

6. Legislative and regulatory reform

7. Integrated development with appropriate public services and social infrastructure

8. Building sustainable capacity along the full housing value chain

Transformational agenda

• Redress of historical imbalances

• Commercial sustainability

• Eradicaton of non-commercial discrimination

• Transparency

• Public/Private sector role clarity

• Competition and innovation

Guiding principles for the design of the transformational agenda

10

This market transformation is critical to the growth of the financially 'empowered' economy and ultimately, South Africa's development

• 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

Community role models (home ownership is

aspirational and achievable)

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

Transformational importance of the target marketDesired outcomes for FSC housing initiatives

11

Although mortgage is our initial focus, this is only a part of the transformational journey for South Africa's housing market

Social housing

Rent-to-buy

Instalment Sale Agreement• 5-10 year term• No 'Servcon'

Mortgage for underserved market• Initial focus• Quick impact with govt risk sharing

Mortgage for existing market

A 'staircase' to homeownership

Government Financial Sector

12

CONTENTS




13

A viscious cycle exists in the FSC target market which neither Financial Sector alone, nor Government on its own, can break

Home finance not economically

feasible for banks or borrowers

Borrowers are less likely to repay existing loans

Increased cost of servicing loan

Increased probability of

default

'Value' of home ownership is reduced

for home owners

Realisable property values fall (no buyers,

deteriorating stock, rates and taxes arrears, impediments to sales)

New potential buyers cannot buy into the

market

Increased loss given default

(security value not realisable)

Dead and dying capital (collateral)

Banks cannot secure

unencumbered, beneficial

possession

Increased rates and taxes arrears

Municipal service quality is poor/

services not provided

No registered title on property

Law and order not enforced

Undesirable social environment

Existing homeowners cannot access

affordable capital for repairs/home improvements

Dysfunctional Local Government and Community Governance

Dysfunctional housing markets

Key drivers of Bank behaviour ("redlining")

14

There are vital 'missing ingredients' requiring joint intervention for sustainable low-income mortgage finance

• Functioning secondary and primary housing markets

• Ability to leverage property value

• Reasonable rate on loan

• Subsidy

• Certainty of repayment amount

•Standardisation and transparency

•Relevant knowledge / information

•Convenient and accessible lending supply

•Available housing stock at affordable levels

What the borrower needs

• 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

Access

• Title and beneficial physical / economic possession

• Strong governance in fully functioning communities

• Collateral deficiency solution for under-performing markets

Realisable property value (De Soto effect)

• Low-cost funding and fixed interest rate risk mitigation

• Finance-linked housing subsidy scheme

• Long-term fixed rate product at an affordable price

Affordability

Key outcomes requiredMissing ingredient

15

Five critical solution components are required to address these ingredients for market transformation

• Access

• Affordability

• Realisable property value

Missing ingredients

1. Coordinated consumer / borrower communication and education program

2. Effective and efficient finance-linked housing subsidy scheme to increase affordability in the low-income sector

3. Centralised Conduit to facilitate access to low-cost capital market funding and fixed rate risk mitigation

4. Centralised Loss Insurance (LI) function to provide appropriate risk underpin for collateral deficiency

5. Coordinated effort to establish fully functional housing markets

Critical components of proposed solution

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

• Access

• Affordability

• Realisable property value

Missing ingredients

1. Coordinated consumer / borrower communication and education program

2. Effective and efficient finance-linked housing subsidy scheme to increase affordability in the low-income sector

3. Centralised Conduit to facilitate access to low-cost capital market funding and fixed rate risk mitigation

4. Centralised Loss Insurance (LI) function to provide appropriate risk underpin for collateral deficiency


Critical components of proposed solution

All five components are required to effectively address the missing

ingredients in a sustainable manner

Focus of this presentation

17

There is a high correlation between interest rate volatility and defaultP

rim

e le

nd

ing

rat

e, %

Acco

un

ts >3

mo

nth

s in

arrears, %

Accounts in default

Interest rate

2001 2002 2003 2004200010

12

13

14

15

17

18

0

2

4

8

10

12

16

14

11

16

ELEMENT 3. CONDUIT TO FACILITATE FIXED-RATE LENDING

18

Borrowers need a fixed rate product to protect affordability

Variable rate Fixed rate

Affordable monthly repayment (R)

580

Loan value 35 800

Subsidy value (bank proposal)

15 100

New repayment amount

665

Rate increase +3%

Initial interest rate 19%*

House value purchased

50 900

580

41 700

15 100

-

-

16%

56 800

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

Fixed rate protects borrower

affordability against

interest rate fluctuations,

and guarantees the value of subsidy in improving borrower

affordability

* Higher variable rate reflects greater default risk in variable rate lending in the target market** Assuming rate change after 24 months


19

Case for government role to facilitate fixed rate funding

1. 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

2. 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

Key requirements to help normalise the market

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

Realisable security value is essential to make home lending possible (and affordable to borrowers and banks)

• Large loan• Repayment spread over many years to make instalment amount affordable• Lowest possible interest rates

Home Loan Finance needs

• Attempt to predict borrower income/affordability well into the future• Lower risk premium (and thus lower rate) achieved because security value is

realisable

Therefore to make mortgage lending possible…

• Income is not predictable• Security cannot be attached and value realised

Unable to do this business if …

ELEMENT 4. LOSS INSURER TO UNDERPIN COLLATERAL VALUE

21

Delivery of secured lending products in this market requires that several market and non-market risks are addressed

Risk analysis of loan

Borrower ability to pay loan

Probability of default (PD)

Collections and legal costs

Loss given default (LGD)

Borrower propensity to

pay loan

Principal value outstanding on

default

Realisable asset value

-

+

and*

Major drivers of risk

• Employment status• Borrower indebtedness• Interest rate fluctuations• Unplanned household expenses

• Effectiveness of collections• Culture of payment• Borrower credit risk (credit score)• Borrower contribution (deposit)• House price inflation/deflation• Municipal efficacy/upkeep of community

• Initial loan value• Years before default (repayments to date)

* Not a mathematical function

• Interest and admin costs incurred post default• Clearance costs (electrical certificate, pest

certificates, municipal clearance)• Legal costs• PIP holding costs• Ability to secure title• Ability to repossess• Rates and taxes arrears• Presence of willing buyers with access to

finance• Relocation options


22

Case for the Loss Insurer

1. Deeper lending into non-performing areas• Enables providing mortgage lending notwithstanding

impaired collateral• Continue lending activity so that collateral value becomes

normal

2. 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

Key temporary interventions to correct dysfunctional collateral

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


23

Unpaid municipal arrears create additional liabilities for banks

Municipal arrears on non-performing loans suggest

borrower financial distress..

..however, significant arrears in the performing book (paid-up mortgages) suggests poor collections

by local authorities

• 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

Banks carry significant arrear costs on PIPs

Average outstanding municipal services payments per mortgaged property (excl. outstanding rates and taxes)

Source: Analysis of banks' data

R10 748

Performing loans (145 accounts)

R15 741

Non-performing loans (50 accounts)

PIP portfolio (572 accounts)

R8 558


24

Banks take first loss and must lend wisely

Outstanding balance on

default


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

Bank risk (35% first loss)

Banks mitigate risk of under-recovery by:• Proper assessment and valuation of

property• Efficient handling of legal collections

processIndividual loan cover

allows banks to lend in

areas where collateral is

currently dysfunctional

Potential losses

25

Although private sector can price for most instances of default, systemic risks underlying certain default scenarios cannot be accommodated

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

0% 6% 12% 18% 24% 30% 36% 42% 48% 54% 60%

Systemic risksRare instances of

default not able to be priced nor managed in

private sector

Commercial risksAnticipated defaults can

be priced for and managed in private sector

Annualised default rate

Probability of default

Default assumption


26

Losses at a pool level are protected by increasing LI pool cover for more extreme losses

-0.1

-0.05

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

-16%-14%-12%-10%-8%-6%-4%-2%0%

Realised losses over 10 years (Bank shareholder funds plus pool cover)

Probability of loss

Losses resulting from risk sharing proposal (bank default assumptions)Bank losses (shareholder funds)

Pool cover

Banks carry risk in the majority of cases (based on

anticipated defaults/ realisation of collateral)

LI shares risk of extreme loss

scenarios only

Magnitude of loss


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




29

What can a borrower expectHouse-hold income

Available for house purchase

Mort-gage** (16%,20y)

Monthly repayment assumedSubsidy

Collateral-ised loans

Pension-backed

(unsecured) loans

**Nett of bond transfer and registration costs (±R3 500)

Deposit (required for subsidy)

ILLUSTRATIVE SUBSIDY PROPOSAL

Pension-backed (16%,10y)

Effective loan value

Unsecured (30%,2y)

2 000 170(8.5%)

8 66029 450 42 079/ (34 969)

2 479 10 150 3 040

2 500 250(10%)

14 41029 450 46 849/ (36 399)

2 479 14 920 4 470

3 000 345(11.5%)

21 24029 450 52 529/ (38 099)

2 479 20 600 6 170

1 500 105 (7%)

3 99029 450 38 199/ (33 809)

2 479 6 270 1 880

3 500 455(13%)

29 15029 450 61 0792 479 27 160 -

4 500 720(16%)

48 20016 174 67 31942 980 -2 945

4 000 580(14.5%)

38 13022 540 63 61534 620 -2 945

5 000 875 (17.5%)

59 20011 040 73 18552 240 -2 945

5 500 1 045 (19%)

71 4006 757 81 10262 400 -2 945

6 000 1 230 (20.5%)

84 7003 412 91 05773 430 -2 945

7 000 1 645 (23.5%)

114 5402 945 120 43098 200 -2 945

6 500 1 430 (22%)

99 0902 945 104 98085 370 -2 945DRAFT

30

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

3. 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

2. Finance-linked housing subsidy scheme

• Scheme design/ policy

• Funding of subsidies

• Subsidy administration

• -

1. Coordinated borrower education program

• Consumer education

• - • Borrower education • Origination intermediaries (incl. NGOs)

• DPLG

4. 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

• -


• 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

31

Investment by Government

2005 2006 2007 2008 2009Government levers to mitigate risk and reduce cost2010 … 2014

LI levies - all mortgages

LI claims + running costs

Government risk capital

Loss Insurer

• 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

- (0.1) (0.2) (0.2) (0.3) (0.3) (0.6)

Disbursement

Subsidy• Economic growth (increasing

employment and transformation of the second economy)

15*

* Based on jointly revised subsidy model

PROJECTED VALUES

Rbn

Total low income housing finance

Conduit loans

Government risk capital

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

35 39 44 49 55

- 0.3 1.1 2.5 3.5

63

4.3

106

6.7

- 2 6 13 20 28 70

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

• Improved servicing of entry-level housing finance needs

• Increased competition• Broader economic impact (GDP

growth, SME stimulation, job creation)

… for the Financial Sector

• Healthy ROE • FSC targets• Reputational upside• Expansion of the formal financial sector

• 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)

‘Accelerators’ that drive the speed and depth of broader lending…

‘Brakes’ that prevent irresponsible lending…

Explicit and implicit ‘checks and balances’ ensure committed partnership aimed at rapid yet prudent expansion of ‘lending envelope’

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

Planning of Sizwe implementation rollout

Sizwe negotiationMortgage solution (Project Sizwe)

Sizwe operational

Broader sector participation (including LOA and pension funds) in low-income

mortgage funding

Ongoing product innovation e.g. unsecured lending, installment

sale

Ongoing process and system innovation / re-engineering

Affordability support (subsidy)

Consumer / borrower education

Facilitating normalisation and integration of under-performing markets via e.g. strengthening of local governance, facilitation of community / infrastructure development, regulatory / legislative reform

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

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?

• MoU

• Joint Statement

• Envisaged agreement date

31 March 2005

23 May 2005

1 September 2005

DateMilestone reached

Documents

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