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Residential Real Estate – Value After the Subprime Crisis

Britt Gwinner, CFA

Principal Financial Specialist

International Finance Corporation

Viña del Mar, 7 May, 2010

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Contents

1. The Basic Picture – housing demand around the world

2. How was mortgage finance linked to the recent crisis?

3. Going forward

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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

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THE BASIC PICTURESection 1

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Growth and urbanization

• World Bank Data Visualizer

• http://devdata.worldbank.org/DataVisualizer/

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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-building6

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Mortgages mostly unavailable in emerging markets

But as real incomes rise, so does capacity to make a mortgage payment

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country

Mortgage Debt as Percent of GDP Selected Countries

Developed countries 40-100% Emerging

markets< 20%

Chile 18% in 2009

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Housing Finance and Growth

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In emerging markets, housing finance is related to new construction and as a result fixed investment, and generally with domestic inputs, both labor and materialsIn developed markets, housing finance is more linked to trading of existing housing and economic cycles

In the U.S., there are 7 million new loans each year, 6 million of which are for existing housingIn developed markets, real estate and related services count for between 2% and 4% of PIBIn the U.S., 8 of 10 recessions since 1949 were proceded by reductions in residential investment

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Mortgages and Fixed Investment

In the initial phase of development, mortgage finance can add 0.5% of fixed investment as a percent of GDP for each increment in the size of the market

Source: Duebel (2008)

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• 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.”

Real estate as an asset class

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• 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

Investment vehicles for residential real estate (1)

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• 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

Investment vehicles for residential real estate (2)

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WHAT HAPPENED WITH THE CRISIS?

Section 2

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

underwriting

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

50

70

90

110

130

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170

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1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Do

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Year

U.S. House Prices and Mortgage Originations

House Prices

Total Mortgage Originations(Right Hand Scale)

Subprime

FHA/VA

Sources: S&P Case-Shiller, Inside Mortgage Finance

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What have mortgage defaults looked like?

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0%

5%

10%

15%

20%

25%

30%

35%

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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

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GOING FORWARDSection 3

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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

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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, letras hipotecarias 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

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THANK YOU

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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 Titulizadora Peruana 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

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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

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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