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Contract Savings for Housing(Bausparen)

- Basic Design and Regulations -

IFC & Russian Banking Association WorkshopMarch 12, 2008

Moscow

Hans-Joachim DübelFinpolconsult.de, Berlin

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List of Contents

Types of CSH contracts and risk profile; access to loans; pricing conditions; differences to mortgage banking;

Liquidity (demand) management of CSH portfolios;Interest rate/solvency management of CSH managing

institutions;Credit risk management of CSH managing institutions;Institutional models (Public fund, Housing Bank,

Bausparkasse, Building Society, Universal bank);Financial regulations of CSH managing institutions

(special bank act, special product regulations, etc..).

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Function of CSH in the Russian Mortgage Funding Structure (per eo 2007)

Position Billion USD Billion USD Position Percent

Mortgages 30 15 Short-term deposits 50%not enabled Long-term deposits

ex, small Mortgage bonds3 Mortgage-backed securities 10%8 Unsecured loans/bonds 27%2 Agency bonds 7%2 Lender capital 7%

Total assets 30 30 Total liabilities 100%

Assets Liabilities

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1. Types and Risk Profiles of CSH (Bauspar) Contracts

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Some History of Bausparkassen and Building Societies in Europe and the U.S.

1880

1930Germany, Austria

1980 S&L/Secd Mkt Building Society Epargne LogementU.S. U.K. Germany, Austria

2004 S&L/Secd Mkt Building Society Epargne LogementU.S. U.K. Germany, (Austria)

U.K., U.S.19th century Building Society

Bausparkasse

Bausparkasse

FranceBausparkasse

France

Building Society, S&LU.K., U.S.

Saving against a loan promise in a collective capital pool is one of the oldest financial institution designs.Historically, mortgage finance in many countries competed fiercely with public sector and corporate finance - and often had to rely on collective systems.

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Closed System Open System

Rule: Inflows = Outflows No capital market funds neededPricing can be fixedLoans are small (S ~ L)

Outflows > Inflows possible Capital market funds needed to fill gapPricing cannot be fixedLoans can be large (S > L)

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Comparison Germany (closed) and France (open)

Also, semi-open systems exist with fixed real interest rates over saving and loan outstandings adjusted with inflation indices (e.g. Slovenia)

In the end, only closed or semi-open systems bring sufficient additional value as they are able to create fixed-rate loans largely independent from capital markets circumstances.

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Closed System – Fixed-Rates and Waiting Phases

The CSH institution decides about an allottment, if there is enough capital.

Since new savings are stochastic, waiting phases may arise. They must not be excluded in German law.

“Good brothers” (savers-only), reserves and strict asset-liability management rules help to minimize risk of waiting periods.

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Function of CSH in the Russian Mortgage Funding Structure (per eo 2007)

Position Billion USD Billion USD Position Percent

Mortgages 30 15 Short-term deposits 50%not enabled Long-term deposits

ex, small Mortgage bonds3 Mortgage-backed securities 10%8 Unsecured loans/bonds 27%2 Agency bonds 7%2 Lender capital 7%

Total assets 30 30 Total liabilities 100%

Assets Liabilities

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2. Liquidity and Interest Rate Risk Management

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Contract Valuation Principles There are 3 elements of value in a CSH contract for consumers:

Savings product: but usually below market, except subsidiesInterest rate option: fixed-rate long-term loan promise in the

future, with interest rate being locked in todayCredit risk option: CSH interest rate does not change during

savings phase, but the creditworthiness of the borrower may – or may be low to start with and savings signal his ability to service a loan.

These values change with market conditionsdemand for CSH contracts changes with market conditions.

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Value of the Interest Rate OptionWhen is closing a CSH

contract of greatest value? When interest rates are

currently low and expected to increase in the future.

When the volatility of interest rates is high

AND VICE VERSA !!

positivehigh

low

Expected Futurefalling rising Interest Rates

negative

Volatility

ContractValue

Interest rate options may have considerable value, e.g. in 4-5 years from now 30-50 bp.

The interest rate option ALONE should suffice to encourage a consumer to save below market.

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CSH contract demand in Germany and Capital Market Rates

In the past 20 years close inverse correlation with interest rates.

Distortions in the high inflation phase (1980s crisis due to long waiting periods).

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Allocation of Loans must Follow Strict Rules, Even if Interest Rates Do Not Change !

Liquidity in the collective is a function of four factors: the minimum amount of savings required for loan eligibility, the length of the minimum savings period relative to the loan

term,the loan-to-savings multiplier, the number of ‘good brothers’ (savers who do not take loans)

relative to the totality of the saver collective. Loan demand must be proportional to contribution; key

contract steering variables are the individual and collective ‘Saver-Fund Effort Ratio’ – basically the ratio of accumulated savings to the financing demand.

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Result of Rational Contract Design: Stable Liquidity Profile

Portfolio Liquidity Profile, Contract 1

-8000.00

-6000.00

-4000.00

-2000.00

0.00

2000.00

4000.00

6000.00

8000.00

10000.00

12000.00

Years

Loan-to-savings multiplier of 1-1.2

Initial liquidity surplus, invested in reserves to fill subsequent liquidity gap as loans start to get disbursed

Reaches steady statewhere Savings inflows + principal repaymt = Loans outflows.

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High-Multiplier Contract Design ends in a Snowball Game Loan-to-savings

multiplier of 7 (Case: Iran)

Initial liquidity sur-plus, as before, yet cannot fill large sub-sequent liquidity gap

Does not reach “Steady-State”, I.e. Savings << LoansOnly solution: “open” funding model, market interest rates

Portfolio Liquidity Profile, Contract 2

-50000.00

-40000.00

-30000.00

-20000.00

-10000.00

0.00

10000.00

Years

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Central Risk Management Indicators: Saver-Fund Effort Ratios

German BausparkassenverordnungCSFER must always exceed 1 - by law, for EACH scheme/contract type. ISFER must always exceed 0.5, for NEW schemes always exceed 0.7. Minimum allottment number (Mindestbewertungszahl) to control ISFER for

different types of contracts.

Loan taker savings supply 100 150Investor savings supply 50Collective savings supply 150 150

Individual saver-fund effort ratio (ISFER) = 100 / 150 = 0.67Collective saver-fund effort ratio (CSFER) = 150 / 150 = 1

Inflow Outflow

Collective loan demand

Loan taker credit demand

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Stable and Unstable Contract Types – Captured by Effort Ratio Formulae

Contract 1: “Stable” Savings period = 5

yearsLoan multiplier = 1.2Waiting period65% loan takers

High individual and collective Saver-Fund Effort Ratio, although many loan takers.

Contract 2: “Unstable”Savings period = 3.5

yearsLoan multiplier = 7Waiting period = none25% Loan takers

Low individual Saver-Fund Effort Ratio, low collective ratio even although few loan takers.

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Effort ratios compared: Bausparkasse, Building Society (open system), Iranian lender

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

1369 1370 1371 1372 1373 1374 1375 1376 1377 1378 1379 1380 1381

Years

Bank Maskan Effort Ratio

..considering waiting period

German Bausparkasse

U.K. Building Society

U.S. Savings & Loan

FUNDING

closed

open

Individual Saver-Fund Effort Ratios

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Technical Reserves Must be Held for Liquidity Management, to Minimize Waiting Period

Germany: ‘bauspartechnischer Sicherungsfonds’, introduced in 1990 (Bauspar crisis in the 1980s, long, volatile waiting periods triggering demand decline)

Specification of reserve fund (up to 3% of CSH deposits) to cover fluctuations in fund flows – reserves increase if savings>loans.

Sponsored by interest revenues on non-allotted amounts (Schwankungsreserve), from the excess of such revenues over comparable CSH revenues.

Fund use (‘can’, ‘must’) triggered by indicators – effort to stabilize ISFER when liquidity situation changes.Note: the higher interest rate (contract demand) volatility, the higher must be technical reserves

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3. Credit Risk Management

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60-70% Mortgage (SENIOR)

10-20% Bauspar funds(SUBORDINATED)

20% Downpayment

= 100 % of the purchase price

Legally possible in Russia ! (not CZ)Reason: Bauspar loans are small, compared e.g. to new construction costsIn Austria, Bauspar frequently first rank.

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Credit Risk Management IssuesTypical regulations:

LTV of loan part (contract value = loan + accumulated savings) not exceeding 80%, i.e. CSH funding goes from, say 70% - 90%.

Share of non-collateralized lending is usually limited by law (e.g. Loans < E20K).

CSH institution has the right to refuse borrowers.Risk-mitigating factors

Loan is below market rate. Interest rates are fixed over whole lifetime of contract, also no Basel II pricing.Consumer has signalled affordability through pre-savings.

Risk-increasing factors Rudimentary underwriting process.CSH frequently subordinated – senior-sub structure.

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CSH and Credit Risk Pricing, CompetitionCase: senior-sub lending Bank (and Bausparkasse)

capital requirements tend to create gap between economic and regulatory costs of capital.

Bausparkasse prices at the margin (i.e. 6% for 70-80% LTV), banks on average (i.e. 5.5% for 0-80% LTV, but 5% for 0-70% LTV) – which option is cheaper?

Competition with mortgage insurance, agency lending creates regulatory, policy fine-tuning problem.

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4. Regulation

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Examples of CSH regulationsSpecial bank: Germany, Austria, Czech Republic, Hungary. Idea is

to fully separate collective fund and liquidity risk management.Universal bank: France, Maghreb countries. Open systems = low

liquidity risk. Usually licensing.Special funds: Latin America and Asia, frequently as monopolistic

public provident funds collecting wage taxes (often lottery effects). Housing banks (special regulation): Iran.Unregulated:

joint venture between the German Bausparkasse Schwaebisch Hall, a special bank in Germany, and Construction and Credit Bank of China, in Tienjin/China. China practices mandatory CSH in public funds in parallel.

Also, the Indian scheme set up by Birla homes so far is unregulated. Both schemes are very conservative and managed by experienced German lenders.

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Are Special Banks Needed Economically?Option Character Advantage Disadvantage Applicable

situation Universal bank Open funding

Universal bank license

All housing loan products Flexible funding options (subsidy independent) No minimum scale requirement No additional regulatory/ supervisory costs Efficient originator

No special product focus No special target group focus Inefficient servicer

Small market Low inflation

Building society

Open funding Special bank license

All housing loan products Special product focus Special target group focus Flexible funding options (subsidy independent) Efficient servicer and originator

Speciality requires minimum scale Special regulatory/ supervisory costs

Mid-sized market Low inflation

Specialized CSH institution

Closed funding Special bank license

Applicable in high inflation context Special savings mobilization focus Special housing lending focus

Small loan sizes only Inflexible funding (subsidy dependent) Speciality requires minimum scale High special regulatory/ supervisory costs Inefficient originator and servicer

Large market All inflation scenarios

Generally, open systems more suitable for universal banks (France).

Closed systems are run by universal banks (Slovenia).

Closed systems need firewalls, licensing due to high risks.

Fund mixing not an option for closed systems.

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Austrian Bausparkassen are quasi-Building Societies

1998: market rates dropped below Bauspar rates prepayments.

Product converted from fixed-rate to floating-rate with caps (i.e. semi-open system)

Balance sheet opened to allow Bausparkassen to offer mortgage loans, issue bonds/MBS.

Bauspar (interim) loans 100 96Mortgage loans 100 96 Other bonds/deposits

8 CapitalTotal assets 200

Bauspar deposits

Assets Liabilities

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Special Product Regulation – Fund Managed on Universal Bank Balance Sheet

CSH Loans CSH

Bridge Loans FUND

CSH Liquid Investments

Other Liquid Investments OTHER Deposits

Other Investments ASSETS Bonds

Other Lending

Fixed Assets Capital

CSH Profit Account

CSH Technical Reserves

Other Reserves

CSH Manager Balance Sheet

LiabilitiesAssets

CSH Deposits

Bridge loan = advance/interim loan.

Presupposes segregability of assets from bank balance sheet (super-seniority).

Comparable to covered bonds/Pfandbriefe (special insolvency privilege).

Alternative is US trust.

Fund supervised by trustee or auditor.

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In this Case: Cash Flow Rules

CSH New Deposits

CSH Loan Amortization CSH

Bridge Loan Amortization FUND

CSH Deposit Interest New Liquid Investments

Liquid Investment Principal

Liquid Investment Interest

CSH Loan Interest CSH CSH Deposit Interest

Bridge Loan Interest MANAGER Credit Risk Provisions

CSH Fee Revenues

Investment Management Fee

Non-CSH Cash Inflow Non-CSH Cash Outflow

Investment Management Fee

CSH Profit Share

Distribution Costs

Servicing Costs

CSH Manager Cash Flows

Cash OutflowCash Inflow

CSH Deposit Withdrawals

CSH Loan Disbursements

CSH Technical Reserves (net)

To avoid excess profits as in CZ/SLK:

CSH fund pays manager an investment fee and a profit share.

In exchange receives an interest in non-CSH investments.

Under special bank, profits are entirely internalized with the fund manager.

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If Profits can be Fully Internalized by Special Bank..

Czech Republic: Bausparkassen mainly give interim/advance loans at market rates.

Options: special reserve funds, profit allocation rules.

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Basic Contents of a Law IGeneral Regulations

Core and admissible range of operationsGeneral contract conditions and consumer information

Relation between CSH Fund and Fund ManagerSpecial purpose character of the CSH FundFirewalls between CSH and other operations of the

managerCSH depositors are secured and enjoy bankruptcy

preferenceInvestment in CSH loansInvestment in interim/advance loans and other loansOther investment rulesProfit allocation rules

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Basic Content of a Law IIRisk Management Regulations

Suitability of the Fund managerCollateralization and other suretiesUnderwriting standards Valuation standardsIndividual Saver-Fund Effort Ratio (ISFER)Collective Saver-Fund Effort Ratio (CSFER)Protection of the real value of CSH depositsMandatory technical reserve fund for CSH specific

liquidity risks

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Basic Content of a Law IIISupervision

Rights of supervisorsTrusteeship and relation to supervisionReporting and auditing standardsApproval of new tariffs or product-linesApproval of loan transfer

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Russian Law Proposal ComparedStandard special bank lawProblematic issues:

Collateralization requirement for loans: Russia ‘can’, German ‘must’.Lower Bauspar-technical reserves - 1.5% vs. 3% in Germany, Russia ideally

~5%. Note: initial excess profits should be reserved. Investment in Russian (corporate) covered bonds?80% interim/advance loan limit too high (CZ/SLK experience)

German law: max 75% (used to be 8*capital), short-term loans (<=4 years) If special bank is created, profit allocation rules should be improved. E.g.

German insurance: 90% of excess profit to be allocated to the collective.Special (group) deposit insurance system? No private whistleblower

function at the moment.No risk management ordinance (Bausparkassenverordnung).No finetuning of regulatory issues – re mortgage insurance, covered bonds.

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Some Consumer Protection Issues in CSH

With fixed spreads (Russia proposed 3%), CSH institutions make their profits to a large degree on fees.

Fees are anticipated to the savings phase to avoid their inclusion into the loan effective interest rate (annual percentage rate of charge, APRC).

Loan effective interest rates are distorted since they do not account for savings below market rates.

APRC concept should require full discounting of all savings and loan payments, i.e. Include both savings and loan phase.

Counterargument of insecurity about a possible waiting period is irrelevant in practice.

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END

Hans-Joachim (Achim) Dübel

Finpolconsult.de

aduebel@finpolconsult.de

www.finpolconsult.de