Prepared for the

Government of PakistanbytM

Pakistan Shelter Resource Mobilization ProgramUnited States Agency for International Development

Mission to Pakistan and Afghanistan

BEST AVAILABLE DOCUMENT

Pakistan Shelter Resource Mobilization ProgramGcwemmeat olPekbtan I u.s. Alency lor international Development

Fourth Floor, 30 West Blue Area, Islamabad, PakistanTelephone: (92-51) 818463/826226 Fax: (92-51) 217131

Staff:

Jon Wegge, ChiefTechnical AdvisorJavaid I. Qureshi, Program Management SpecialistJaved Akthar, Project Management SpecialistJeanne Russell, Publications EditorTahir. Younis, Secretary

This report relies heavily on research carried out by Planning andDevelopment Collaborative, Inc. (pADCO) ofWashington, D.C., undercontract with the U.S. Agency for International Development Mission toPakistan and Afghanistan. In particular, recognition is due to the principalauthor, Mr. Daniel S. Coleman.

Except where otherwise indicated, photographs in this document were takenby Ms. Samina Rizvi of21st Century Consult~ncyand Management Services(Pvt.) Ltd. of Karachi.

This report is dedicated to the memory of the late James Wright Ladd, aconsultant to PADCO for this study. Mr. Ladd developed the financialmodels that appear in this report.

At the time this report was written, 31 Pakistani rupees (Rs. 31) wereequivalent to one US dollar (US 51).

The views expressed herein are those ofthe authors and do not necessarilyreflect those ofthe United States Agencyfor International Development, t/'eUSAJD Mission to Pakistan and Afg/,anistan, or the Government ofPakistan.

June, 1994

Contents

Introduction 1

Executive Summary 7

Background 13Housing Finance in Pakistan 13Economic Benefits ofa Housing Finance System 14The Missing Ingredient: A Housing Finance System 15

Structuring the Housing Finance Sector 21Key Elements 21TI,e Regulatory Environment 22Housing Policy 22A Housing Constituency 23

Resource Mobilization Issues 27Resource Mobilization Worldwide 27Resource Mobilization in Pakistan 30

Specific Remedies 31Government Incentive Measures 34

The Housing Refinance Facility 39HRF Operations 39HRF Terms and Conditions 41Financial Impact on tl,e HFCs 42Risks to the SBP 44Foundationfor a National Mortgage Market 45ClosureoftheHRF 45

An Apex Bank 49What an Apex Bank Is 49Examples in Developed Countries 50Examples in Developing Countries 51An Apex Bankfor Pakistan? 54

Next Steps for Pakistan's Housing Finance Sector 59Conclusions 59Immediate Actions 60

Appendix A - Financial Models 63Appendix B - Comparison ofHousing Finance Systems 69Appendix C - The Impact ofInflation on Housing Finance 75

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Introductio...,

Housingfinance offers greatpromise to become the most dynamic part ofPakistan's housing sector. The vitality it can bring to the housing economy hasdeveloped only in the past severalyears, with the introduction ofmarket-orientedlending. Whether it canfuljill the promise it holds dePends largely on thecontinuation ofpolicy reform to create an environment that not only enableshousingfinance to grow, butpermits it to flourish.

There is ample reason to have titled this paPer '~ Blueprintfor the DevelopmentofHousing Finance in Pakistan. "Housingfinance, like housing itse{f, must bebuilt on a solidfoundation,' only then can a plannedstructure be built.Market-oriented housingfinance now has a solidfoundation in Pakistan; thepurpose ofthe paper is to set out a I 'blueprint' 'for completing tlie structure ofanefficient and capable housingfinance system.

This paper has been prepared by the Shelter Resource Mobilization Program(SRMP) ofthe U.S.A.LD. Mission to Pakistan andAfghanistan. Since the SRMPhas now come to an end, the report is, in many respects, an attempt by the staffofthe SRMP to "Ieave behind" suggestions and recommendationsfor future actionsin the housingfinance sector and to provide a context that promotes greaterunderstanding ofthe housingfinance and urban sectors.

Housing Finance and Economic Growth

In countries where policy-makers have valued the housing sectorfor itscontributions to the economy, housingfinance has been an engine ofeconomicgrowth. A well-functioning housing finance system offtrs incentivesforhouseholds to save, provides investors with opPOrtunites to gain stable,long-term retums, creates large numbers ofjobsfor skilled and unskilledworkers in construction and ancillary industries, enables homeowners toleverage their physical assets intofinancial assetsfor investment, andcontributes greatly to the d.eePening and broadening ofthe finance sector.

A well-functioning housingfinance system provides credit to households,inherently broadening access to credit by individuals,' it adds SPecialized newinstitutions and creates new financial instruments to enable longer-terminvestments and stabilize loan portfolios, inherently deepening the finance sector.Evidencefrom many countries suggests that housingfinance plays a major rolein economic growth and is particularly vital to development offinancial sectorcapacity. When policy environments enablefinance sectors to movefrom

. primitive levels ofdevelopment to more sophistit:ated capabilities, housing

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finance appears to almost always be a major - ifnot the single greatest ­growth area infinance.

Housing and Housing Finance Policy in Pakistan

In Pakistan, policy-makers havefor far too long viewed the housing sector as apurely social sector. The policy outlook is that housing is a basic need, butpeople are poor,' therefore the housing sector requires subsidizedplots,subsidizedfinance, subsidized infrastructure, and subsidized services. The realityofexperience, however, shows poignantly that housing hasfar less priority thandefense or debt service, and rarely arefunds available in the quantity needed. Italso shows that byputting housing on a non-market basis, the formal privatesector can play only an extremely limited role, and that housing and urbandevelopmentfall almost totally within the preserve ofinefficient andfrequentlyincapable public sector agencies.

Put simply, the policy which hasflowedfrom this outlook is one that has becomeself-defeating. The private sector is "shut out, ~, but the public sector has neitherthe resources or capabilities to meet the minimum needs ofthe housing andurhan sectors. Pakistan's population is rapidly expanding and rapidlyurbanizing. Most housing construction is informally constructed,' most urhangrowth is unplanned and unserviced. Housing contributes little to the economyand virtually nothing to the finance sector.

Until very recently, the private sector had not been permitted to operate housingfinance companies that specialize in providing housing credit. Because there islittle credit availablefor housing, people must save the entire amount in advance,or informally borrow the savings ofothers, usually otherfamily members. Sinceeveryone needs housing, the total quantity ofsuch savings is probably very large.Yet, sincefew people save withformal sectorfinancial institutions, little ofthisvolume ofsavingsfinds its way into the finance sector. In essence, people do, ofnecessity, have a long-term view offinancing housing, but the economy lacks theinstitutions and savings mechanisms to permitpeople's housing resources toflowthrough theformal financial sector.

To see that such institutions do rise andflourish, strong leadership is requiredfrom both the private andpublic sectors. In Pakistan, people have leamedfromexperience thatfinancial institutions are not always trustworthy and that rarelydo financial institutions actually offer services to households. They approachthem with caution. At the same time, the public sector has inadequately regulatedthe institutions ofthe finance sector. Leadership is required to establish acollegial relationship that will enable housingfinance to flourish. Ifhousingfinance can not succeed, it is unlikely that otherforms oflong-term lending candevelop.

SRMPPag.2

A lack oflong-term lending is a mark ofan undeveloped economy. In Pakistan,the structure ofalmost all debt is short-term. Such debt is inherently volatile,with negative consequencesfor the economy and itsfinancial institutions. Thereis a ''mis-match'' between the need to develop the fundamental infrastructurenecessaryfor economic growth and the finance sector's ability to structureinstruments and modalities to provide the long-term credit necessary to createsuch infrastructure.

The ,Urban Context

Much ofthe impact ofthis mis-matchfalls on the urban sector. Evidencefrommany countries shows that most new economic growth takes place in urbanareas, which already contribute more to GNP than does agriculture. Finance isnot the only area ofthe housing sector that needs reform and growth. Even acasual glimpse ofPakistan's urban centers reveals severe shortfalls ininvestment in roads, water, sewerage, power, transportation,telecommunications, and maintenance ofinfrastructure. Pakistan's urban sectorfunctions poorly and is an extremely weakframeworkfor economic growth.

Although the focus ofthe SRMP was on housingfinance, the linkages betweenthe housingfinance sector and the broader urban sector are obvious and strong.Infrastructure is the skeletonfor urban development; housing provides much ofthe visible physical environment ofthe urban setting. Because the SRMP was afinance program with a strong interest in housing, it documented urbanconditions at the same time that it attempted to stimulate housingfinance.Throughout this report, a number, ofphotographs are presented to illustratePakistan's urban setting and provide an urban context in which housingfinancewill develop.

Improving the conditions in which people live requires creating awell-functioning urban sector. A well-functioning housingfinance sector willstimulate housing improvement, but, ultimately, expansion ofhousingfinance tothe point where it can meet the needs ofthe vast majority ofPakistanis mandatesthat urban planning, administration, andfinance be strengthened greatly.

The table that follows, adaptedfrom the World Bankpolicypaper titled''Enabling Housing Markets to Work, "presents a series ofpolicy strategies thatshould be adopted to make Pakistan's housing sector perform adequately andmeet the housing needs ofthe country. Taken together, the strategies make up anoverall policy that would enable Pakistan to develop a well-functioning housingsector.

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'I...

Enabling Pakistan'sThe DO's and DON'Ts

Po/icy Area: Mortgage Finance

DO:

• Allow the private &ector to lend.

• Encourage competition in mortgagelending.

• Ensure lending i& at po&itivelmarket rate&.

• Enforce foreclo&ure law& and debtrecovery mechani&ms.

• Ensure prudential regulation.

• Introduce appropriate and&tandardizedloan in&trument&.

DON'T:

• Allow interest·rate &ubsidies.

• Neglect or disadvantage resourcemobilization.

• Allow high default rate:;.

• Di&criminate again&t rental housinginvestment.

DO:

Policy Area: Property Rights

DON'T:

• Regularize land tenure.

• Expand land regi&tration.

• Privatize public hou&ing &tock.

• E&tabli&h effective property taxation.

• Make land titling expensive.

• Di&courage land transactions.

• Engage in mQ3& eviction.

• Nationalize land.

DO:

• Make &ub&idie& transparent.

• Target &ub&idie& to the poor.

• Sub&idize people, not hou&e&.

• Regularly review sub&idie&.

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Policy Area: Subsidies

DON'T:

• Build&ubsidized houses.

• Allow hidden &ub&idies.

• Let &ubsidies di&tort prices.

• Use rent control tu a sub&idy.

Housing Market to Workof Housing Policy

Policy Area: Infrastructure

-

DO: DON'T:

• Neglect infrastructure investment.

• Use environmental concerns as a reaSonta clear slums.

• Coordinate land development.

• Emphasize cost recovery.

• Ba.~e provision on demand.

• Improve slum infrastructure.

Policy Area: Land and Building Regulation

DO:

• Reduce regulatory complexity.

• Assess the cost o/regulation.

• Remove price distortions.

• Remove artificial shortages.

DON'T:

• Impose unaffordable standards.

• Maintain unenforceable rules.

• Design projects without links toregulatory and institutional refoml.

DO:

Policy Area: Building Industry

DON'T:

• Eliminate Monopoly practices.

• Encourage small-firm entry.

• Reduce import controls.

• Support building research.

• A ilow long permit delays.

• Inhibit competition.

• Create or maintain public monopolies.

• Delay p'o\';.rion ofinfrastructure.

DO:

Policy Area: Housing Policy and Institutions

DON'T:

• Balance public and private roles.

• Create aforum/or managing the housingsector as a whole.

• Develop enabling strategies.

• Monitor sector performance.

.' Engage in direct public housing delivery.

• Neglect a role for local government

• Retain financially unsustai,.al,leinstitutions.

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Executive SummaryThe Government ofPakistan has authorized theestablishment ofa private sector housing financesystem. As a contribution to the new system, the StateBank of Pakistan (SSP) will set up a Housing RefinanceFacility within tht') SSP to provide liquidity in theamount ofRs. 450 million to the housing financecompanies (HFCs). The provision of these funds to theHFCs will permit them to make more mortgage loans,which in turn will improve their financial condition andgive them room to grow and profit over the short run.

It is not intended, however, that the HousingRefinance Facility will resolve all the HFC'sfinancial resource problems. In the long run,only through the mobilization of savings,coupled with the development oflocal capitalmarkets, will adequate resources be generatedto meet the housing finance need. •

The purpose of this report is to assess the needand prospects for the growth and developmentof the nascent housing finance sector inPakistan. It discusses the resource mobilizationissues and the problems the sector mustovercome to ensure a sufficient flow offinancial resources to meet the overwhelmingneed for housing.

The ramifications of the State Bank ofPakistan's approval to use $IS million inHousing Guaranty funds to establish a HousingRefinance Facility within the SBP arediscussed and suggestions are made on howthis Facility would operate to provide someneeded liquidity to the sector.

The report takes into consideration theconcerns of the monetary authorities and thehousing fmance companies, particularly as

regards the integrity of the system and themobilization of resources.

Finally, the paper explains how the sectormight be structured to ensure its success,including the possible role of a centralorganization to regulate as well as provideliquidity to the sector.

The structure of the new private housingfmance sector in Pakistan is predicated on thefollowing principles:

• that the propensity to save within thedomestic economy is enhanced as a resultof an increase in the flow of fmancialresources and a concomitant increase inmortgage loans;

• that the increase in resources reflect realmark.up rates, and that governmentsubsidies will not be required to mobilizethese resources; and

• that the instruments and institutionsthrough which these resources flow will laythe groundwork for a capital market insecondary mortgages.

In the longrun, onlythrough themobilizationofsavings,coupled withthedevelopmentoflocalcapitalmarkets, willadequateresources begenerated tomeet thehousingfinance·need.

SRMP Page 7

I

J

.. :~'

A refinancefacility atthe State

Bank isafirst step

towardeventual

developmentofa

secondarymarket in

housingfinance.

Similarly, the State Bank of Pakistan needsassurances:

• that the companies comprising the housingfmance system be fonned of individualsand groups of the highest integrity, so as toassure the public and the monetaryauthorities that the companies will fulfillhonestly their commitments to the savingand borrowing public;

• that the companies are properly managed,and are taking necessary safeguards toassure that assets and liabilities arereasonably matched and that depositors'funds are protected.

The State Bank ofPakistlUl recognizes theimportance of housing fmance in the overalleconomic context. It understands the need tonurture these housing finance companies sothat they can fulfill the promise of providinghousing finance to the people. Moreover, theSBP is aware that the development of thehousing fmance system offers a uniqueopportunity to demonstrate how a newfmancial group should be organized, regulatedand supported, since the very newness of theHFCs pennits the SBP to start out with a cleanslate. Thus, this learning experience can benefitthe entire fmancial sector.

ike propensity to save withinthe domestic economy isenhanced as a result ofanincrease in the flow offinancial resources and aconcomitant increase inmortgage loans.

This communality of interests between thecompanies and the SBP presupposes a closeand almost collegial relationship. Thecompanies must be open with the SBP, eveninsisting that the SBP make on-site inspectionsof the companies so that they will be betterable to comply fully with the PrudentialRegulations. The SBP should assign at leastone full-time agent to regulate the companies,who would spend time with the companies

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learning about their problems and theirbusiness operations.

There should be periodic and, in fact, frequentmeetings and exchanges of wfonnationbetween the State Bank and the HFCs,recognizing that the more they know abouteach otht1', the more they will understand theother's needs and problems. An environmentof trust must be created. But if this newdirection is not taken, then an "us versusthem" attitude will prevail, with the resultbeing similar to the strained relationship thatappears to exist between the SBP and otherfinancial institutions in Pakistan.

The communality ofinterestsbetween the HFCs and theState Bank presupposes aclose and almost collegialrelationship.

An environment oftrust mustbe created-without this trustan "us versus them" attitudewillprevaiL

It is important for the HFCs to recognize thatthe Government of Pakistan is in the process ofmodifying and refming its tiscal and monetal)'policies. These changes are due in large part toa need to refonn its fmancial sector to fulfillcommitments to the IMF and the World Bank,as well as a recognition that the governmentdeficit has to be restrained. As a result, the oldsystem offmancial advances, subsidies,guarantees and outright favors are beingcurtailed and in some cases eliminated. Thismeans essentially that the HFCs will not be thebeneficiaries of the same kind of treatment thatother financial institutions had when theyinitiated operations. This does not mean thatthe HFCs are being treated unfairly; it is justthat the rules have changed. The HFCs mustrecognize and accept this fact.

The immediate next step to enhance the growthof the housing finance system in Pakistan is for

the State Bank to activate the HousingRefinance Facilitv, which is discussed in detaillater in this paper. The SBP must fonnallyissue the rules and regulations for the HFCs togain access to this Facility. At the same time,the Ministry of Finance must enter the UScapital market to borrow the Housing Guarantyfunds. The State Bank should aim to open thisFacility no later than July I, 1994.

Government regulations now pennit housingfmance companies to accept savings accounts,essentially Certificates of Investment with a 30day or more maturity date. Concurrently, theState Bank should consider the question of theHFCs being authorized to accept foreigncurrency accounts, and if approved, it should

. issue a circular to this effect, again no laterthan July I, 1994.

These two actions by the State Bank will give areal as well as a psychological boost to thehousing fmance sector. It will show that theGovernment supports the sector, and just asimportantly, it will not result in any cost to theGovernment. In fact it will be a benefit to theGovernment insofar as it will allow theGovernment to tap a very inexpensive sourceof foreign currency, the Housing Guarantyfunds. In addition, this action will encourage

the other groups to carry on with the necessarysteps to obtain their licenses to do business ashousing fmance companies. Finally, theGovernment should consider a number of taxrelated incentives to encourage savings, topromote home lending and to strengthen andenhance the financial soundness of the HFCs.

While the State Bank goes ahead with its plansto open the Refmance Facility, the HFCsshould continue with their efforts to mobilizefinancial resources utilizing those avenues nowavailable to them. Either individually orjointly, they should explore the possibility ofdesigning and utilizing some sort of specializedsavings-linked mobilization program such as aContract Savings Scheme. This woulddemonstrate to the State Bank that the HFCsare very serious about the need to mobilizedomestic savings and are fully aware of theirresponsibilities in this matter.

These schemes would include both the use offoreign currency accounts and rupee basedaccounts. The HFCs should committhemselves to devising at least onecomprehensive savings-linked scheme by JulyI, 1994. At the same time, one or more HFCshould begin to issue Certificates of Investmentto mobilize domestic savings.

A vibranthousingsector isessential tothe economyand criticalto people'ssocial andeconomicwell-being.

A well-functioning housingfinance system requires:

• An operational and regulatory framework

• Financially soundprimary lending instiuRons

• Ready access to capital and sources ofliquidity

• A government that supports and nurtures the system

• A free market environment with real mark-ups

• A legal system that enforces lender rights

• Financialprograms to provide housing to the poor

• A realistic and dynamic housing policy

• A well-organized and active housingfinance constituency

• A levelplayingfield with otherfinancial institutions

SRMPPage9

Housing: The Good, the Poor,

Katchl Abadl••/onlla/ow river bank In K.,.chl. Condemned to lIfe In fir. "ood plain, low·lncomepeople f.ce dl...,.,when rite river .we". with .the .nnual ,.In..

".'eIJ., hou...0' the prlveleged In la/em~bad. ".,." dlacemabl. In tit. foreground a,. tlte mud andtltatch huta 0' tlte I... fotfUnete (photo coul'te8y of"aul 8. Mecerllley).

SRMP Page /0

and the Ugly

11

'.:'.',.,' ",'

A housing conatructlon proj.ct of th. Kar.chlDevelopmentAuthority. TIre pUblic aector's directInvolv.ment In I.nd d.v./opment h.. thw.rted thedevelopment of th. prlv.te a.ctor, consum.dsc.rc. public sector ...aouree., .nd I.d to highlysp.cul.tiv.'.nd marle.ta.

N.w multJ-atory "ata In th. poah Clifton SNcha,.. ofKa,.chl.

A Katchl Abadla/onga main ,./lway trackIn Ka,.chl. Th.s.a.ttI.m.nD .,. aP'Oduct of",pldurlJan growth and apubllc...ctordominated houa/ngd.llveryayatem that "la unabla to m.etd.mand•. Although '"th... encroachm.ntaa,. tacitly to/ereted'by GovWnrn.nt~n'· '.' .th. a.na. th.t th.ya,. gen.,.IIy I.ftund!aturbed-m.,.,y

,do.not,hav. ,cc",ato"'th. ",un,ti,,,., .a.tv/caa- g..,electric, water, .mlunltatlon-that the....t of th. community,

.. ...iiiiiii iiiiiiiiiiiiiiiiiiiiii_iiiii_iiiiiiiiiiiii =~ at la",• • njoya.

• I· ~:.. ' ...~.-, •••

~. I.t :. ~\. "'~"'.

. .'~::." .',

" .••• ~! :;'...

SRMP Page 11

Background

Housing Finance in Pakistan

Over the last several years, Pakistan has been In theprocess of establishing a market-based housingfinance system. The potential economic and socialInfluence of this system Is enormous and Is closelylinked to Pakistan's capability for economic success.Many Issues face housing finance In Pakistan; noneare more Important, more critical, or more Immediatethat the development ofmortgage lending as anIntegral component and substantial feature of thefinance sector.

,After years of gestation, in a quiet, persistentand deliberate fashion, a new type of privatefmancial institution was born in PakistaJi. Itwas created in a time of turmoil, whengovernments were changing, fmancialinstitutions were failing, and there wasincreasing doubt as to whether another type offmancial institution was really necessary.

But there were a few business people-lookingto the future and willing to take a chance-whorealized that Pakistan desperately neededhousing and needed to look at new ways tofmance that housing. Similarly, there werethose in government who realized that acounby like Pakistan could not afford to let thehousing situation continue as it had been.

What was it that drove these business peopleand government officials to join forces increat~g this new fmancial system? First, it wasclear that the supply of standard, affordablehousing was not meeting an overwhebningdemand, and that in fact, the housing situation

was deteriorating. While financial assistance inthe fonn ofsubsidized loans was beingprovided through the House Building FinanceCorporation (HBFC) and developed plots weresupplied by local development authorities andprovincial bodies, this was far from sufficient.In light of the reduction and eventual cut-off inthe supply offresh funds to the HBFC, homelending from the public sector was drying up.Accordingly, most families were still forced toaccumulate sufficient cash in hand to purchaseor build a home in private sector developments.Long-tenn housing fmance, the key to awell-developed housing sector everywhere inthe world, was still not available to the vastmajority ofPakistanis, regardless of income.

The huge gap between the supply and thedemand for housing, they realized, was dueessentially to the chronic shortfall in theavailability of sufficient fmancing at affordabletenos. Only the private sector could mobilizethe necessary fmancial resources to meet thedemand for housing. The creation of a new and

Benefits ofastrongmarket-orientedhousingfinancesystem:

• more andbetterhousing

• astrongerconstructionindustry

• improvedsavings rateand greaterinvestment infIXed capital

• creditflowingat market ratesand accordingto demand

• a broader anddeeperfinancialsector

..

.Previous Page BialikSRMP Page J3

Economic Benefits ofa Housing Finance System

A rupeeinvested in

housinggenerates

two rupees ofinvestment in

relatedsectors. A

job createdin housinggenerates

twojobs inrelated

sectors.

viable housing finance system that could meetthis demand was the right way to proceed;further delays would only exacerbate thehousing situation. The time to act wasripe-and they acted.

A private sector housing fmance system is nowfun<;tioning mPakistan. Two oompanies arelicensed and making mortgage loans, a thirdcompany is expected to start-up in a matter ofweeks, while four other groups are waiting inthe wings.

Yet as these companies have becomeimmersed in resource mobilization efforts and

The benefits to be derived from an active andvibrant housing sector are clearly evidentbecause investments in this important sectorgive rise to multiplier effects throughout theeconomy.

Studies in a number of countries have shownthat for each unit ofcurrency-in this caserupees-invested in housing, about two rupeesof additional economic activity are generatedin other sectors. While this multiplier effect inhousing is not much different from investmentsin other sectors, benefits from the housingsector are spread throughout theC('.()nomy-nearly all economic sectors arcaffected by investments in housing.

A second major argument for housing is itseffect on employment. In all countries,regardless of the level ofdevelopment, theemployment ofone worker in the constructionsector, including housing, will generate abouttwo additional jobs in other sectors. Byinvesting in the housing sector, thecombination of these twolinkages-investment andemployment-provide a broad stimulus to theeconomy. But the reverse is also true.Continuing to neglect the housing sector wiDhave a lingering and negative impact on theeconomy ofPakistan which wiD be felt weDbeyond the sector itself.

SRMPPageU

mortgage lending operations, the magnitudeand complexity of the task they haveundertaken has become clearer. A housingfmance operation, which requires hugeamounts of funds to be loaned for thelong-tenn, is quite unlike IlIlY other type offmancial activity.

The Oovernment, which supports the newhousing fmance system, has also begun torealize the uniqueness ofhousing fmance. It isin this context that a blueprint is presentedwhich both the housing companies and thegovernment can make use of to guide thehousing fmance system to success.

The housing sector has a significant impact onsavings in a variety of ways. Without doubt,the possibility ofpurchasing or building ahome is a major incentive for nearly allfamilies to save. This is particularly trueamong large segments of gainfully employedmiddle income workers, whose prospects forever purchasing Ii home are limited due to lackofmortgage fmance, high prices, and littleincentive to save.

Ifhousing fmance is made available ataffordable prices, then it has been shown inmost countries of the world that families willincrease their savings in order to accumulatethe required up-front capital contribution toqualify for a mortgage loan. There is no reasonto believe that the situation is any different inPakistan.

Proofof this propensity to save for housing isreflected by comparing different bousingfmance systems. In Oennany and France,where contract savings schemes arcresponsible for a large percentage of funds forhousing fmance, mortgage loans as apercentage of OOP are 33 and 35 percentrespectively, which reflects the need for apotential borrower to save a large amount ofthe price of a house to qualify for a mortgageloan. Often families in those two countriesmust save about one-third of the cost of the

--:;

The Missing Ingredient: A Housing Finance System

home, with the remaining two-thirds consistingof a mortgage loan.

In the US and Denmark, however, wherecontract savings schemes do not exist, and highloan-to-value mortgages are common,mortgage loans as a percentage of GDP aremuch higher, 47 and 44 percent respectively.In these two counbies, 80 percent and higherloan-ta-value mortgages are standard,indicating that savings is a less importantfactor in purchasing a home (see Appendix Bfor country comparisons ofhousing financesystems). This analysis clearly shows howsavings can actually increase when there is theopportunity or the requirement to save in orderto purchase a home.

Another aspect of savings relates to therelationship between savings and the price ofhousing. Although empirical evidence islimited, it has been argued that as the price ofhousing rises, savings decline, and visa versa.Housing prices frequently rise because thesupply ofhousing does not meet the demand ofa growing population with increasing means toacquire that housing. And the reason why thesupply is not increasing is because of a lack ofhousing fmance resources to facilitate the ..purchase ofhousing. Thus, an adequate supplyofhousing finance will lead to an increase in

"l

Pakistan's private sector housing fmanceindustly is clearly in its infancy. Over the pastfive years, The U.S. Agency for InternationalDevelopment, through its Shelter ResourceMobilization Program, has assisted theGovernment to begin establishing amarket-based housing (mance system. To date,two housing finance companies (lIFC) havebeen licensed and begun operations.

But even as these companies start to makemortgage loans, it is obvious that there are stillmany hurdles to overcome if they and thecompanies to folJow are to succeed asspecialized housing (mance institutions, muchless meet the needs of millions ofPakistanisfor housing finance.

the production ofhousing, lower prices and aconcomitant increase in the rate of savings.

The llvailability ofhousing finance willfrequently lead to better use of personalsavings by fllQilitating alternative investmentsin other (r.()nomic sectors. The argument here,which is clearly relevant to Pakistan, is thataccess to a long-term mortgage loan willpermit the borrower to make an alternativeinvestment in a business opportunity ratherthan use savings to fmance a home. In thisway, new investment and employment aregenerated, which is beneficial for both thepeople and the economy ofPakistan.

Access to housing (mance will lead not only toan increase in the rate of savings and in theproduction ofhousing, but it will result in thegrowth ofhome ownership. Over time, theequity accumulated in a personal residence willbe the 1I0urce of capital many entrepreneurs useto initiate new businesses, many ofwhich willbe small businesses, which are the incubatorsofemployment. While this general use of homeequity for business pwposes is probably someyears away in Pakistan, the creation of ahousing (mance system today will acceleratethe time when enterprising business people canseize this unique fmancing opportunity.

The institutional framework for housing(mance in Pakistan consists essentially of twoand. shortly, three privately owned housing(mance institutions and a sector regulatoryfunction which is housed in the State Bank ofPakistan. The Ministry ofFinance licenses thehousing (mance companies, although thisiunction is expected to be transferred to theState Bank ofPakistan at a later date.

The HBFC

A state-owned financial institution, the HouseBuilding Finance Corporation, makes housingloans with funds channeled from the StateBank ofPakistan, but it is not a housing(mance institution in the true sense of the

SRMP Page 15

An adequatesupply of'sousingfinance willlead to anincreoseintheproduction ofI,ous;ng,more valuefor price, awider rangeofchoice,and aconcomitantincrease inthe rate ofsavings.

The largestsingle

obstacle theHFCshave

encounteredisa lack o!

access tocapital at

rates whichwillaUowacompetitive

projitandan

on-lendingrate that the

uldmatemortgage

clients canafford.

word. Commercial banks, Investment Banksand other fmancial institutions provide someloans for housing finance, however, loansprovided for this purpose are seldom officiallyclassified as housing loans, rather they arestructured as personal loans. By regulation,commercial banks are prevented from placingmore than I percent of their loan portfolios inhousing loans.

The House Building Finance Corpomtion hasfunctioned for decades as the primary providerofhousing loans in Pakistan. It receives anannual budgetaIy allocation in the fonn of anadvance from the State Bank ofPakistan,which in tum it uses to make housing lolms. Itis also able to use its mortgage loan reflows tomake additional housing loans since it does notrepay the SBP advances.

As of the end ofFY 93, theHBFC had anoutstanding loan portfolio of about Rs. 16.3billion, which was derived from State Bank ofPakistan advances. The fmal SBP advance tothe HBFC will take place this fiscal year, afterwhich the HBFC must become fullyself-supporting and self-sustaining. However, itis not clear if the HBFC will have to repay anyof the advances to the State Bank. If these .advances are not repaid, then HBFC willmaintain a lending base of about Rs. 16 billion,which it can use to continue making mortgageloans.

Currently, most ofHBFC's loans are offered ata markup of 10 percent, which is considerablylower than the rate being offered by the newHFCs, giving it a competitive edge over theHFCs. IfHBFC improves its collection record,then it could continue to make as much as Rs.1.3 billion available for mortgage lendingannually, which was its lending level over thepast two years.

Yet even if the HBFC is able to continue homelending at its current rate, it's loans will coveronly a pittance of the estimated demand ofRs.18 billion and even less of the need. Clearly,input from other fmancial sourceS is required.

The government's purpose in authorizing thecreation of a private sector housing fmancesystem was to pennit this sector to mobilize

SRMPPageJ6

private financial resources for investment inlong-tenn mortgage loans to qualified families.The availability of mortgage loans would notonly lead to a significant increase in the supplyof housing, thus reducing the housing deficit,but also stimulate savings insofar as savings isthe backbone of a vibrant housing financemarket and a healthy economy.

In the year or so that the system has been inoperation, the first two companies haveidentified a number ofobstacles that haveinhibited their development as well as theestablishment of additional companies. Whilethe managers and directors of these housingfmance companies were generally aware ofthese obstacles prior to initiating operations,they were not fully cognizant of the impactuntil afier they tried to raise funds from thepublic and solicit loan applications.

Ob.taeles to Sue•••

The largest single obstacle the two existinghousing fmance companies have encounteredis a lack of access to capital at rates which willallow a profitable mark-up and an on-lendingrate that the ultimate mortgage clients canafford. The HFC:s are unable to compete withthe government ofPakistan in attracting capitalat rates that would pennit the HFCs to on-lendthat capital'to prospective homebuyers at .affordable rates.

Moreover, government paper offers tax andzakat free benefits that HFCs are unable tomatch. The HFCs will continue to be at acompetitive disadvantage with theGovernment, whether the rates the Governmentpays go up or down~ HFC paper, whilearguably ofhigh quality, will always be valuedless than government paper. Government paperis the surest investment in the domesticeconomy and establishes a benchmark or floorfor all other paper.

The HFCs are also fmding it difficult tocompete with government owned andcontrolled fmancial institutions for domesticcapital. Because these institutions arewell-established, have a track record with thepublic, and most importantly, have an explicitor implicit government guarantee, they are able

to attract fmancial resources at more favorableterms than the new HFCs.

It can be said that the new housing fmancesystem is paying the price for the failure of theGovernment ofPakistan to regulate and controlother fmancial ore.anizations, which, in thepast, have frequently mismanaged their fundsand or defrauded the public. the latest being thefmance cooperatives. The public is rightlywary to put their trust once again in a new typeof institution. Thus the HFCs are unable tocompete for funds from the "pure" savers, thatis, savers that are simply looking for thehighest return while at the same time seekingto place their money in the safest institution.

The NewHFCs

On the other hand, the pedigree of the newhousing fmance companies is impeccable. TheMinisby ofFinance chose to authorize only themost credible of the applicants to completeapplications for a housing fmance license,ultimately authorizing only seven of the 24groups to proceed. The result has been theincorporation and licensing ofa stellar groupofhousing finance companies, headed by thetwo institutions now operating. Citibank .Housing Finance. owned fully by its worldrenowned parent, and Intemationll1 HouliingFinance Limited, among whose owners areInternational Finance Corporation,Commonwealth Development Corporation,PICIC and Cresbank, represent the highest typeof institutional credibility.

It is clear that these institutions typify the levelof integrity so necessary to provide the generalpublic and government regulators withconfidence in the system. Yet they still havebeen unable to devise instruments which wouldpennit them to compete effectively with otherparts of the banking sector. To use a commoncliche, the playing field is still not level.

To date, the two operating institutions aremaking some housing loans, utilizing theirequity capital as the source of lending funds.When this source has been fully committed tomortgage lending, they may be able to accesstheir parent companies for additional funding,either in the fonn ofequity or loans.

However, these funds are expensive, since theparent compames must on-lend at rates thatthey would ordinarily make for competinguses. They are a limited resource since theparent companies are not set up to providelong-tenn loans to subordinate companies.

Besides. this defeats the purpose for creatingthe housing fmance system in the flI'st place:remember that the purpose was to mobilizenew financial resources from domestic marketsfor on-lending for housing. Moreover, lendingfrom an equity base alone is not a viablebusiness. as illustrated in the computer-basedsimulations in Appendix A.

Housing Afford.bUlly

A limited amount offunds coupled with theirhigh cost means that the market is restricted toborrowers in the higher income. brackets. A Rs.300,000 mortgage loan at 20 percent for 12years requires a monthly payment of about Rs.5,500, a payment that only a small percentageoffamilies can afford to make. To qualify forthis mortgage loan, which is sufficient tofmance the purchase or construction of a basichousing unit, a family must have a monthlyincome in the Rs. 16,500 range.

But, quoting a 20 percent markup on long-termloans appears to discourage prospectiveborrowers. The HFCs have been dismayed tosee highly qualified borrowerswalk away fromloan application interviews either because theycannot afford the high markup loans or becausethey are reluctant to take on relatively high costdebt.

There are a number ofways to mitigate thedamage high markups have on the mortgagemarket, not least being the use of adjustablerate mortgages. One of the most successful inrecent years is the Dual Index Mortgage, whichis very effective in countries with moderateinflation.

While such mortgages are not allowed inPakistan now, the continuation of highmarkups would warrant future consideration ofthe problem of affordability. The use of DualIndex Mortgages in inflationary economies isdiscussed in Appendix C.

SRMP Page 17

The presentHFCstypifythe level ofintegritynecessary toprovide thegeneralpublic andgovernmentregulatorswithconfidencein thehousingfi~lance

system.

1MW'

Children and

. ,-'

Children pIe"ngln nlbbl.h hNp. along theRiverL.,." In K.rachl.

A boy In a Katchl Abedl..t In ",.h.rtof.",.cap'.' city of"'amabad. Approx/me"'y 1100child,." undera". five dl••ve". dey.l" "a".n .~. .(World Benlf. 1"'). lIajor ifill ofyoungchIld,." .,.die"".., dl Immunlzebl.dl....... ecute rupI...toty Infect/OM .nd' ­m.'nuttlt#on (photo cou"'yof".u/8.lIacartn.y).

A hom wom.n and herchild,." Iy/"gln a.... .. K....chl Th.y recently m/greted from

A child,.,,'. petit, pattof. privete club In Defenc. punjab Provine. In tit. hope of findIng work.Houelng 'oclely In K.NeItI. lloat child,." hw. Rapid populet/on IIfOwth .nd I.c/( ofemploymentno acceu to fflcllHl. oftitle eort. opportunHl. hev. contributed to 'nc",.'ng urbe"

dec.y.

; ..."' ••.. ,,..:r ...... -.•

"'~':":''''I>:' :.

the Urban Environment

Young boys In en Oren'" Town engln.erlngworlcahop. Deaplte laws to the confrll'Y, childlebor Is ".,.,..lve/n Pald_n.

Th. grip ofpovertyend ./e~1e ofhousingfore.. "'mlll.. toIlv• ..sque"'n Inmale..hlff110m...TIl... lIuta» tucleedbehind upper-e/...lloualngln Kanchl,eiw med. frOm palmfrond.. reed

. matl/ng, cloth,dlscerded cnta,

;end othwselvegfKl ..meterle/.. Leclc of .educetlorr end theconaumlngatnJlIfiII. of.y~aysurvlvelI...,.th...children with IIttl.hope or opportunityfore b.tter "fe.

Fortunete children ofmlddle/ncom. femlll••running hom. from school. In 1885, the Gro..Enrollment Retlo In Prlmery School. was..tlmeted et..." (World Senle, 1882). "enyconalder .ven th... /ow "gu,.. to b. Inflated.

SRMPPageJ9

...

, ' ....... ,:.

Structuring the Housing FinanceSector

To gain the economic, financial, and social benefitsrelated to having a vigorous housing sector thatproduces the housing people can afford, the housingfinance system in Pakistan must have awell-functioning regulatory environment, a supportivepolicy environment, and a strong housing constituency.

The structure ofPakistan's housing fmancesector is predicated on the following principles:

• that the propensity to save in the domesticeconomy is enhanced by an increase in theflow of fmancial resources and aconcomitant increase in mortgage loans;

• that the increase in resources reflect realmark-up rates, and that governmentsubsidies are not required to mobil~e

these resources; and

• that the instruments and institutionsthrough which these resources flow willlay the groundwork for a capital market insecondary mortgages.

Similarly, the State Bank ofPakistan and theMinistry ofFinance need assurances:

• that the companies comprising the housingfmance system be formed of individualsand groups of the highest integrity, so as toassure the public and the monetaryauthorities that the companies will fulfillhonestly their commitments to the savingand borrowing public.

• that the companies are properly managed,and are taking necessary safeguards toassure that assets and liabilities arereasonably matched and that depositors'funds are protected.

Finally, the housing fmance companies needthe support and the intervention of Governmentto fulfill their mandate. The HFCs cannotoperate in an environment where they do nothave equal access to resources and the equalopportunity to compete for those resources. Ifthey do not have this access, then theGovernment must intervene in the market toassure the flow of resources to the HFCs. Thisassumes, further, that the Government wishesto have a viable housing finance sector and theHFCs meet the Government's standards ofperformance. Specific industry-wide incentivesthat the Government ofPakistan may wish toconsider are discussed in further detail later inthis paper.

_____K......ey Elements

SaVings Aspects

Earlier in this paper, the importance of housingwithin the economy and the relevance of astrong housing fmance sectoT in generatingdomestic savings was discussed. While there isno assurance that domestic savings will growthrough the development of the housingfinance sector, there is enough evidence todemonstrate that there is a strong relationshipbetween a buoyant housing finance system andthe rate of domestic savings. It is also clear that

II

HFCsneedasupportivei,olicyenvironmentwhere theyhave equalaccess toresources andthe equalopportunity tocompete/orthoseresources.

Previous Page Blank SRMP Page2!

There is noreal

guidance ordirection ofthe housing

sector, muchless the

housingfinancesector.

There is nowritten

nationalpolicy, nor is

there ancentral

agency thatis

articulatinghousing

policy,written orotherwise.

as long as the housing fmance sector remainsin its infant stage of development, noappreciable increase in domestic savingsgenerated by this industry will oecur. Onlythrough the overa11 growth of the housingfmance industry witt savings increase and onlythe State Bank of Pakistan, with the blessingof the Ministry of Finance, has the capacity toensure the growth of the system.

Real Market Rate Tenns

Specific resource mobilization techniquessuggested in this paper wilt in no way requirethe SBP or any other government institution tosubsidize the HFCs in their efforts to attractfmancial resources (this does not preclude theHFCs from acting as conduits for funds orsubsidies that the Government of Pakistanmight direct exclusively to poor families whoare not the usual HFC clients).

If a saving mobilization program, such as aContract Savings Schemes as suggested in thenext section, is deemed feasible, savers may bepaid a lower markup on their savings becausein return they are being offered the opportunityofobtaining a housing loan at a predeterminedtime. This is not a subsidy.

HFC lending rates are determined principa11yby their cost of funds. Companies cannot makea decent return on capital if they do not lend atterms in excess of the cost of capital andoperating expenses. Thus it is not in thescheme of things for the private sectorfmancial institution to subsidize theirborrowers, nor as private sector institutions dothey intend to request subsidies to do so.

Secondary Markets

The development of the Housing RefmanceFacility (HRF) within the State Bank ofPakistan sets the stage for the eventual creationof a secondlUY market. It is impossible todetermine how this secondlUY market willdevelop or function. Nevertheless, thedevelopment of the Housing Refmance Facilitywithin the SBP is a necesSlU}' precondition forthe creation of a viable secondlU)' market. It isthrough the development of the HRF that the

SRMP Page 22

.iII

S9P and the housing finance system will gainthe necesslU)' experience to establish a truecapital market for mortgages.

The Regulatory Environment

The State Bank of Pakistan is rightlyconcerned about the safety of any funds itmakes available to refmance loans originatedby the HFCs, as is currently contemplated.However, this risk can only be mitigatedthrough a strong and we11-functioningregulatory process, which is the responsibilityof the SBP itself. The SBP has, or will haveshortly, the responsibility for:

• Licensing new housing finance institutions(The licensing function is now theresponsibility of the Ministry of Finance;however, the SBP will assumeresponsibility at a future date);

• Writing the Prudential Regulations forthese same institutions; and

• Enforcing the Prudential Regulations.

If the Non-Bank Financial Institutions Division(NBFI) of the SBP undertakes its responsibilityproperly, then the twin risks associated withinstitutional failure and mortgage default willbe minimal. Normally, it is when a regulatoryinstitution is lax, incompetent or subject togovenunent interference that problems arisewithin the regulatory system.

It is important, moreover, that the SBP be strictbut fair in carrying oUf. its regulatory functions.It should not be arbitrary in the licensing ofnew institutions. Instead it should let themarket determine how many and whichinstitutions the market can support. Ifattritionoccurs, it will not affect the operation of theHousing Refinance Facility in as long as theSBP holds a flfSt lien on the mortgagesprovided as security for its loans.

Housins PoI/cy__

There is no real guidance or direction of thehousing sector, much less the housing fmancesector. There is no written national housing

policy, nor is there an central agency that isarticulating housing policy, written orotherwise,

The National Housing Authority of theMinistry of Housing and Works is chargedwith the responsibility of preparing a nationalhousing policy. Apparently, such a policy hasbeen drafted, but it has not been approved orenacted by the Government. This policy dearthis being filled by what could be called animplicit housing policy, which could bedefined as follows:

• ~ousing assistance, such as subsidies, isdirected mainly to selected groups inPakistani society, such as the civil servantsand militarj' rersonnel;

• Minimal housing assistance is provided tothe segments of societ3' which are too poorto provide themselves with standardhousip:-'

• The putJli" :,' ~ . r :.., -i.,l1l; <;nance agencycontinues ") F. ' .;te 1'. "l: ,J thosesegmentr. ~ . SOl" ;t}. t!:&t • ,('; able to obtainhousing loans tiL'(i"~ ~nfh. Ice;

• Private sector hou;;;.ng fmalice institutionsare permitted, however barriers are put inthe way of mobilizing financial resources;

• Transfer and registration ofproperty,which inhibit the development ofmortgage markets, are discouraged

. through the imposition ofonerous fees andstamp duties;

• And fmally, a clear, concise housingpoli~y has not been articulated.

A more plausible and explicit policy, and onethat is generally in force :n countries that havevibrant housing sectors, include the followingelements, written or otherwise:

• Subsidies are only directed to groups thatare too poor to afford adequate housingsolutions;

• Adequate land regularization and propertytitling and transfer systems are in place tofacilitate housing development and are agovernmental priority;

• Mortgage f'nance is the responsibility ofthe privat~ sector, and the role ofgovernment is to facilitate the flow ofresources to the sector.

• The major role of government in theproduction of housing is to ensure that costrecoverable infrastructure is madeavailable to the populace at large;

• The government will articulate a housingpolicy that promotes the concept of freemarkets as the most effective way to meetthe housing need.

Both the implicit Pakistani housing policy andthe suggested explicit housing policy asdescribed above are too simplistic, however,they are representative enough to indicate thatwhat Pakistan does in the policy arena is farremoved from policies in countries withsuccessful housing programs. The problemsfacing the young housing fmance sectorprimarily result from an inadequate policy

.. environment in which they can functioneffectively. In the long run, the Government ofPakistan will have to develop a housing policy,including the fmancial elements within thatpolicy, that will create an environment wherehousing production blossoms. Until that day,the housing fmance sector faces an uphillstruggle.

. A Housing Const/tuencl!-The hOUStJlg iir.I!.!lI:·11 sector suffers from a lackoforgan!7..ed groups actively supportingimprovements in and the development ofhousing. This missing constituency sorelyhampers any efforts by the indi'/;dulll HFCsand their shareholders to bring about thenecessBJY legislative and regulatory reformsthat they deem to be neccssBJY for thewell.being of the sector. An important endrecent step in rectifying this situation was thenaming of a full-time SecretBJY General of theHousing Finance Trade Group. Through thisgroup and its SecretBJY General, the industrywill be able to speak with a single voice. Theindividual HFCs must strongly support thiseffort. The history of trade associations inPakistan and throughout the world shows thatthey wode for the good of all their membership.

SRMPPage23

The historyoftradeassociationsin Pakistanandthroughoutthe worldshows thatthey work forthe good ofall theirmemhership.

Urban Roads, Traffic

Children retumlng hm .chooletop • erowd.bu.. Serore th,. bu. I. con8ldwed full...ve,.,more P8a..g.,. will be h.nfllng 0" the ,..,ledd.,. Thl. I. P8rt1eul.rly huerdou. In thebumper to bumpe, ".me ofK.,.chl. Leho,.••ndP••hew.,.

F.lalR08d.the meln

ro.dto theQu.'d-e-Az.m

In,.",.tJonelAirport, .nd

one of theb••tfOMI.In

K.,.chl.

SRMPPage24

A cem.' ce" e.".,Ing. hNVy lo.d In the Defence.,.. ofKe'.chl. Sleycl... rlck.hew•••nd • v.,'eryof.nlmel driven c.". .h.re the roed with. wide.".y ofmotorized vehlel.. ".vellng.' high.pHd.. T'eme ,.,.IItJ.. In P.kl."n .,e .mungthe hlgh..t In the world.

,S4~:~ .:0;''::::• . .. III"

.-..,:'n":.... . , " .... '. • • t •

.: :! .::: .... ~....,

and Transportation

The condition ofmany roed.l. poor. Thl. photow.. teken n..r the Con.u/ate ofBang/ad..h InKarachi.

The a"'."ce ofem/u/on.tendard. and lack ofenforcement of motorvehicle regu/atJon. ha.re.ulted In Incr,,"nglevel. ofair pollutJon Inurb.n centeno The.verege vehicle InPalfl.ten emltll 20 tJm..more hydrocarbon., 25tim..more carbonmonoxide, and 3.8 tim..a. much nltrou. oxide asthe average vehicle Inthe United Ste,..(pakl.ten NatJonalCon.ervatlon Strategy,1882).

..:. ::',

With the e"ceptlon of'./amabad, where they areprohibited, motorized rlclcshaws are Ubiquitousf..ture. of the ur"'n landscape. Re/atJve top...enger carrying capaclty-among thelowe.t, and vehicle em/sslons-among thehighest, they a,. the most Inefficient vehicle. onthe road.

SRMP Page 25

Resource Mobilization Issues

Resource MobilizationWorldwide

As the housing finance system grows, it must haveaccess to larger and larger amounts of funds. The keyfinancial concept used here Is liquidity. Liquidity In thehousing sector simply means the avallabUlty ofsufficient money to meet the demand for housingfinance. A liquidity crunch occurs when funds do notflow in sufficient quantities to satisfy this demand, andtherefore housing finance Institutions are unable togrant all the housing loans requested. A liquiditycrunch can also occur when the terms and conditionsof the available funds ,:10 not match the needs andfinancial abilities of potential borrowers.

Liquidity may be provided by the public sector,i.e., a government agency, or by the privatesector. The provision of liquidity in generaldiffers greatly in developed countries versusdeveloping countries.

The public sector in developed countriesalmost never provides liquidity directly to thehousing fmance sector, although in some cases,public fundin'~ ilt u:>ed to provide either loansor subsidies, or both, to poor families whosefmancial cO\ldition does not permit themrecourse to the private sector. On the otherhand, governments in developed countriesoften create the incentives and conditions,sometimes through direct intervention,whereby the private sector can provide thenecessBJY liquidity.

In developing countries, the reverse is the rule.Governments frequently provide liquiditydirectly to the market. Moreover, where thesegovernments intervene, more often than not thefunds flow not to poor people as supposedlyintended, but to the middle and upper incomegroups.

On the other hand, governments in developingcountries do not create the conditions wherebythe private sector can provide liquidity, andmore often, actually impede the involvement ofthe private sector in housing finance. This iscertainly the case in Pakistan, although there issome evidence that this is changing. Thecessation of State Bank funding to the HouseBuilding Finance Corporation is a step in theright direction.

Previous Page Blank SRMPPage27

Liquiditymaybe

provided bythe public

sector or theprivate

sector. Theprovision of

liquidityvaries greatlyin developed

countriesversus

developingcountries.

Although the public sector indeveloped countries r"relyprovides liquidity directly tothe housingfinance sector, itoften creates the incentivesand conditions- sometimesthrough direct intervention­whereby the private sectorcan provide the necessaryliquidity.

Financial resources for housing purposes arederived from a variety of sources. Indeveloping countries, loans and grants fromexternal donors can be a major resource,however, funding from this source can neverbe sufficient to meet more than a fraction ofthe fmancing needs. For this reason, externalfunding has been found to be more effective toan individual fmancial institution rather than anentire system.

In recent years, foreign donor funding has beenused more often to leverage change in thehousing sector, rather than as a solution to thephysical housing need. In addition, foreigncommercial loans are being viewed as apossible source ofhousing fmance.

All countries, to some degree, allocate fundsdirectly from the Central Government. Indeveloped countries, direct governmentfunding generally takes the fonn of subsidiesfor low-income families. But, in developingcountries, it more often consists ofdirectlending through a government-owned orcontrolled fmancial institution to selectedsegments of the market.

Government Housing Bank in Thailand isconsidered a good example of an institutionthat is generally free of governmentinterference, provides loans based on need, andoperates on market principles. A bad example

SRMPPage28

is when a housing fmance institution is used topromote a political agenda, provides loansbased on influence, and operates at a loss,requiring constant injections of capital.

Sources of Housing Finance

The major portion of financial resources orliquidity, particularly for the private sectorinstitutions, is derived from two basic sources:

• Deposits in home lending institutions, inthe fonn ofpassbook and time depositsfrom individuals and businesses; and

• Capital Markets, in the form of loans,bonds, securitized debt, and a wide varietyof financial instruments issued by housinglenders or specialized fmancialintermediaries.

Financial institutions mobilize deposits ingeneral by focusing on two distinct savingsmarkets: the pure savers who are seeking aninvestment vehicle, and the linked savers whoare seeking to utilize their savings for aspecific purpose.

On the other hand,governments in developingcountries do not create theconditions whereby theprivate sector can provideliquidity, and more often,actually impede theinvolvement ofthe privatesector in housingfinance.

Pure savers are always attracted by the yield ontheir savings, commensurate with the risk, andfor that reason, savings deposits from thismarket segment can be very mobile as the

depositor is constantly seeking the highestreturn. Moreover the potential market is largesince most people in the middle or higherincome bmckets do have some disposableincome to be saved.

A housingfinance systemmust attract deposits from"pure" savers as well asfrom"linked" savers. Pure saversare primarily interested in thereturn on their savingsdeposits, while linked savel'smake deposits to generateboth savings and the incomeon savings to acquire a home.

Linked savings is more stable, however thissavings universe is probably much smaller.The initial concept ofBuilding Societies in theUK and Savings and Loan Associations in theUS were for all practical purposes attuned tosavers who used their savings to access ahousing loan, although there was no formalcontract or agreem~nt to that effect.

Most developed countries utilize both depositsand the capital market to mobilize resources,although the proportion will vary depending ona number offactors. For example, primarymortgage lenders in the UK mobilize over 90percent of their housing resources fromdeposits, while in Denmark, specialized creditinstitutions generate 80 percent of theirhousing resources through the capital markets.

In the US, the proportion has been changingrapidly since the I970s when deposits from thesavings and loan associations funded 55percent of all housing loans while by 1991,deposits fell to only 33 percent. The trend inthe US as well as in many other countries hasbeen towards growth in the capital markets asthe principal supplier offmaneial resources forhousing, at the expense ofdeposits.

Resource Mobilization In India

The housing fmance sector in India has alsoexperienced a change in the composition of itsfmancial resources. The farst, and still India'slargest housing fmance institution, the HousingDevelopment Finance Corporation, initiallymobilized resources by tapping, the capitalmarkets, principally loans from other fmancialinstitutions. To complement these domesticsources, HDFC relied on international donoragencies, the largest being a USAID HousingGuaranty loan ($12~ million) and an IBRDloon ($250 million), which were instrumentalin not only providing large amounts ofliquidity, but also helped to provide credibilityto the institution. HDFC has now expanded itsoutreach by utilizing a variety of ways togenerate resources. In partlcular, it has focusedon individual and company deposits byoffering a variety of instruments with varyingmaturities to appeal to different investmentobjectives.

Today, 3S percent ofHDFC resources arederived from deposits. Capital marketresources include long-term bonds purchasedby trusts, insurance companies, corporationsand banlcs, as well as shorter term loansprovided principally by commercial banks.

The establishment of the National HousingBanIc (NHB) in India was supposed to open upa new source of liquidity for the growingnumber ofhousing fmance companies in India.However, a securities market scandal hasaffected the ability of the NHB to mise capitalfor on-lending to primary sector housingfmanee companies and it has been unable tofunction completely as a secondary housingfmance institution so far. Whether itwillovercome its managerial credibility problemsto fulfill its financial mandate is still open toquestion.

Resource Mobilization In Indonesia

Indonesia has addressed the liquidity issue in amanner similar to Pakistan. A state savingsbank, Bank Tebungan Negara (BTN). providesalmost 90 percent of all housing loans. Itreceives funding from the Bank of Indonesia(the Central Bank) and interest-free loans from

SRMPPage29

HDFCinIndia hasexpanded itsoutreach byutilizing avariety ofways togenerateresources. Ithasfocusedon individualand companydeposits byoffering anarray ofinstrumentswith varyingmaturities toappeal todifferentinvestl,tlentobjectives.

:.....~..... _ .......~.---:',._4 .._ ..• ~ ~

The newlyemerging

housingfinance

companies inPakistan

have little orno access to

the capitalmarkets.

the Ministry ofFinance. However, it also hashad access to large IBRD low-eost housingloans. These sources contribute abouttwo-thirds ofBTN's lending resources, withinternal resources consisting mainly of depositsand savings contributing the rest. BTN isexperimenting with a contract saving plan,although to date its success has been limited.

Another state institution, P.T. Papan Sejahtera,provides some housing loans, generating itsfunds from Bank of Indonesia credits, but alsoraises funds through bond placements thatcany below-market interest rates. Finally,commercial banks provide relativelyshort-term mortgage loans only toupper-income Indonesians. To date, Indonesia,like Pakistan, has been able to tap only aminimal portion of domestic savings and localcapital markets for home lending purposes. Ithas relied instead on direct governmentfunding and external funding as the majorfunding sources.

The Indonesian Government has not pennittedthe establishment of specialized fmanceinstitutions, as has Pakistan, nor has it put in

place those conditions which would permitcommercial banks, which can make housingloans, to maximize use of the capital markets.The result is that the condition of Indonesia'shousing is clearly sub-standard and, in fact,they are quite similar to the housing conditionsin Pakistan.

The consensus among housing finance expertsis that there is no right way to mobilizeresources for the housing sector. Nor is there afonnula for determining the proportion of usebetween different resource instruments.

Institutions in most countries experiment witha variety of instruments and techniques,selecting those that work best at the time theyare being tried and used. Moreover, thoseinstitutions understand the economic andpolitical realities under which they are workingand design resource mobilization programsaccordingly.

However, it is clear that until domestic savingsare mobilized and the capital markets freed up,no country will be able to generate sufficientfunds for housing fmance purposes.

Resource Mobilization in PakistanI

The ability of the HFCs in Pakistan to gainaccess to domestic capital markets and/orattract deposits is very limited at this time. TheGovenunent taps the domestic capital marketextensively to fmance its deficit. although thepressure on Government to reduce its relianceon debt for this purpose is constant. It isvirtually impossible for private sector fmancialinstitutions to compete with the govenunent aslong p.s the latter's markup on deposits remainsat today's high levels.

Recently, a blue chip textile company had topay a markup of 19.68 percent on a 5 year termloan from the capital market. Even a largepublic agency such as Water and PowerDevelopment Authority (WAPDA) has tried,so far unsuccessfully, to borrow up to Rs. 15billion at a 19 percent markup, even thoughthese bonds can be treated as approved security

SRMP Page 30

for the purpose of investment by trusts andinsurance companies to the same extent asprime government securities. The lack of anexplicit government guaranty has been themain reason why WAPDA has had difficultymarketing this issue. These high ratescontribute to the HFcs inability to attract thepure savers.

For a fledgling HFC to obtain a similar loan, itwould have to pay a higher rate on deposits.which would require the HFC to makemortgage loans at a markup of around 25percent, which is clearly too steep for even thewealthier Pakistanis.

The limited experience to date in the HFCsindicates that the market for mortgage loansappears to dry up at 17 percent, and even atthat rate it reaches only a tiny fraction of the

market. However, these high markups, drivenby inflation, arc a relatively new development,and it is still unclear what impact such rateswill have on the market over the long run (seeAppendix C for a brief discussion of the impactof inflation on the housing fmance sector).

Deposits are an even less likely prospect as alending resource. HFCs are not permitted tooffer demand or passbook savings, although30-day time or term savings deposits areallowed. Nevertheless, the HFCs believe that itis very difficult for these time deposits, calledCertificates of Investment, to compete withsimilar instruments being offered bygovernment institutions, such as the StateBank's rate d Ij percent on 6 month T Bills.

However, an HFC must be very careful inutilizing short-tenn deposits to fmancelong-term loans. The danger of mismatchingassets and liabilities is well-known even to themost casual observer of housing financesystems. Yet this danger can be mitigated, butnot eliminated, by the existence ofwell-functioning capital markets which offerliquidity for long-tenn mortgage instruments.

In the long run, the solution is simple. Thegovernment must step aside and stop

competing with the private sector in the pursuitof financial resources while at the same time,place a high priority on the creation of along-term bond market. It must also permit theHFCs more leeway in the mobilization ofresources.

Accordingly, Government must work withHFCs to create an environment whereby theHFCs can compete successfully with the rest ofthe financial market for resources. In the shortrun, however, there are some immediate steps,discussed later in this section, that thegovernment could take to bolster the HFCs andpermit them to carry out their assignedmandate to provide housing finance to allPakistanis.

__Specific Remedies

The State Bank appears to support the newhousing fmance companies. Yet, it is clear thatthe SBP is very concerned about the capacityand the capability of the HFCs to carry outtheir objectives, that is to mobilize resourcesand make mortgage loans, while demonstratingto the public and the government that they willnot wreak havoc on the economy in the sameway as have other fmancial institutions.

Untildomesticsavings aremobilized andthe capitalmarketsfreedup, nocountry willbe able togeneratesufficientfunds forhousingfinancepurposes.

In the long run, the solution is simple. Government must stepaside and stop competing with the private sector in the pursuitoffinancial resources while at the same time placing a highpriority on the creation ofa long-term bond market It mustalso permit the HFCs more leeway in the mobilization ofresources. Accordingly, Government must work with HFCsto create an environment whereby the HFCs can competesuccessfully with the rest ofthe financial marketfor resources.

SRMP Page3}

Thert:areample

examplesworldwide

where the useofa linked,

savingsscheme has

beensllccessful as

one toolamong a

variety ofsavings and

loanincentives.

The government is demonstrating itswillingness to support the housing sector byactivating the Housing Refinance Facility in anefficient and expeditious manner. Additionalassistance will depend on the HFCsperformance, but there is no assurance fromGovernment that more assistance, other thanthat deriving from the new facility, will beforthcoming.

The HFCs should initiate several resourcemobilization activities that would fit within thecurrent SBP authoritative and regulatoryframework. In the case where SBP approvalwould be required for a particular activity, theState Bank might have to issue a circular toclarify its approval. It should not be necessaryto change the NBFI Prudential Regulations forany ofthe activities listed below.

Other Funding

Additional funding to the SBP HousingRefinance Facility (HRF), possibly through theSBP Housing Credit Fund, should beconsidered at an appropriate time, althoughSBP's current policy will not permit it toprovide any more funding. Further, anyadditional funding should be in the form ofloans, not advances or grants, to the HFCs,under similar terms and conditions as theproposed HRF. '

Such funding should be contingent on theHFC's overall performance and theirsuccessful utilization of their quota under theHRF. Consideration of new funding should betaken up only when at least two of the HFCshave exhausted their quotas of Rs. 7S millionin initial loan refinancing from the HRF.

The housing fmance companies do not requiredirect funding from the Government ofPakistan or its specialized agencies, rather theyrequire the opportunity to compete with otherfinancial institutions in the mobilization offinancial resources. To accomplish this, theGovernment might have to resort to some sortof direct intervention in the form of guaranties,insurance, or tax benefits, as is found in mostcountries that have vibrant housing financeindustries.

SRMP Page 32

A fun or partiall guarantee would permit theHFCs to tap the domestic capital market for theadditional funds as discussed above. To repeat,this sort of Government intervention does notrequire direct financial contributions to thecompanies, which is neither recommended nordesirable. In all instances, these types ofinterventions should be enacted only within thecountry macroeconomic context and policy.

Savings Schemes

The HFCs should consider devising some sortof linked savin!>.s plan, such as a ContractSavings Scheme, which would tie the openingand maintenance of a personal savings accountto an opportunity to obtain a mortgage loan at apredetermined ratio. This type of scheme couldstrongly promote savings in general inPakistan, but more importantly, could possiblygenerate large amounts of funds for mortgagelending.

The cost of marketing such a scheme is likelyto be relatively high, therefore the HFCsshould focus now on designing a scheme andthen market it when their mortgage loanportfolios increase. Schemes should bedeveloped for Foreign Currency as well asRupee accounts.

The HFCs do not requiredirectfunding from theGovernment ofPakistan or itsspecialized agencies; rather,they require the opportunityto compete with otherinstitutions in themobilization offinancialresources.

There are ample experiences worldwide, inboth developed and developing countries,where the use of a linked savings scheme hasbeen successful as one tool amon'g a variety ofsavings and loan incentives. It should be

pointed out that this sort of scheme has notbeen very successful in India because thegroup targeted by this program has a limitedcapacity to save. For it to work in Pakistan, ascheme would have to be addressedspecifically to those income groups that theHFCs have identified as having sufficientincomes to participate in a linked savingprogram.

The real advantage ofanylinked savings scheme is thatnormally savers will accept alower mark-up than thatoffered by other savingsprograms-because at theend ofa specifiedperiod thesaver will be eligiblefor amortgage loan equal to afIXed percentage oftheamountsaved.

The real advantage of any linked savingsscheme is that normally savers will accept alower markup than that offered by other savingprograms because at the end of a specifiedperiod the saver will be eligible for a mortgageloan equal to a fixed percentage of the amountsaved. The saving must be constant over anumber ofyears to demonstrate to the lendinginstitution that the saverlborrower iscreditworthy. Usually, there is a significantpenalty if the saver withdraws from thescheme.

It should be pointed out that the lendinginstitution must structure the scheme in such away that borrowings do not exceed theavailable lending funds in the institution. InGermany, for example. the ratio is 2: I,meaning each Mark saved under their schemewill permit two Marks to be borrowed over a 7year term, which has been sufficient to meetthe borrowing demand. In Pakistan, the ratio

might be as little as I: I, at least in the initialstages of a scheme.

Foreign Currency Deposits

The HFCs are permitted to accept localcurrency savings accounts. Therefore the HFCsshould also be allowed to accept foreigncurrency deposits as one way to promote themobilization of savings. Investment Banks andModllJ'abas, which are also Non-BankFinancial Institutions, are currently permittedto set up foreign currency accounts.

Since HFCs have to meet the same reserverequirements as those two fmancialinstitutions, they shouldbe permitted to acceptand maintain foreign currency deposits. Thisrecommendation might very well be moot if,within the near future, the Government permitsfull convertability of the Rupee coupled withadoption of market rates for foreign exchangecover.

Certificates of Investment

The HFCs should utilize Certificates ofInvestment (COl) to generate short-termresources for mortgage lending. To overcomethe disadvantage ofcompeting with theGovernment of Pakistan for funds, the HFCsshould utilize the COls to mobilize savingsdeposits in conjunction with a linked savingsscheme. .

Housing fmance companies are currentlypermitted to issue COIs with as little as a 30day maturity and possibly as much as tenyears. Given the expected terms of themortgage loans, a weighted average of a 5 yearterm on the COIs should be sufficient to matchthe maturities of fixed rate 12 year loans.

While short-term COIs will not and should notbe a primary general funding resource,particularly whr.:n standing alone. due in largepart to the assetlliability mismatch issue, theavailability of this relatively low-cost source offunding can help to reduce the overall cost offunds. Moreover, the HFCs should try todevise ways to utilize COls in a more creativeway as a source of funds.

SRMP Page 33

HFCsshouldbe allowed toacceptforeigncurrencydeposits asone way topromote themobilizationofsavings.

Surveys ofboth

developedand

developingcountriesshow that

withoutsome

economicincentives,

the housingfinance

industry willnot

flourish.

External Funding

The cessation of USAID operations in Pakistanwill end all US financial and technicalassistance to the housing fmance sector.Nevertheless, the IBRD and the ADB willcontinue to be a potential source of externalassistance for the housing sector.

Although no housing projects are in thepipeline of either bank, the IBRD FinancialDeepening Project with $200 million in loansfor private sector financial institutions is onepossible source of assistance to the HFCs. ForHFCs to qualify for loans under this Project,certain cQPditions in the IBRD loan agreementwould have to be modified or waived.

{(the Government ofPakistan truly desires thedevelopment ofa housingfinance sector that cancontribute to the economicgrowth and development ofthe country, and to themobilization ofsavings, thenit may have to enact a numberofindustry-wide incentives.

The Government ofPakistan would have toconcur with the incorporation of the HFCs inthis program since it is providing the full faithand credit loan guaranty to the IBRD.lftheyare able to participate, the HFCs should beprepared to respond to the implementationconditions attached to this loan. It should bepointed out that the deepening of the financialmarkets would surely involve the developmentof a capital market for housing, and for this

SRMP Page 34

WI

reason, the incorporation of lhe new privatesector housing finance system into lhis projectwould seem to be a natural fit.

Other Sources

It has been suggested that the HFCs haveaccess to the same financial resources thatcommercial banks now have. Assuming theSBP agrees to that request, the HFCs wouldthen have to adhere to the same SBP mandatedreserve requirements, including therequirement to invest 30 percent of all depositsfrom non-financial institutional sources ingovernment paper, rather than the IS percentnow mandated by the State Bank for HFCs.

If this occurred, HFCs would have fewer fundsto loan for housing finance purposes, andmoreover, due to the tenure of those deposits,the HFC would probably have to divert somelending to non-housing purposes to ensure aproper assetlliability match. This is not anargument against permitting the HFCs moreaccess to other types of resources, but merelypointing out the cost ofdoing so. The HFCsshould consider carefully whether the benefitsof converting essentially to commercial bankswould outweigh the benefits of remainingspecialized housing fmance companies.

Government IncentiveMeasures

As indicated above, the housing financecompanies can take some measures to improvetheir operations within the context of thecurrent government rules and regulations.

However, if the Government of Pakistan trulydesires the development of a housing fmancesector that can contribute to the economicgrowth and development of the countly and tothe mobilization of savings, then it may have toenact a number of industly-wide incentives.

SUlVcys of both developed and developingcountries show that without some economicincentives, the housing fmance industry willnot flourish. Incentives the Government mightconsider are the following.

Depositor Incentive Package

Income from deposits are now subject to thepayment of income tax. Under this incentive,depositor savings in the housing financecompanies would be exempt from payment ofany tax on income earned from these depositsfor a specific period, usually at least one year.This would encourage the flow of savings,particularly pure savings, into the HFCs, sinceelimination of this tax would increase thereturn to Savers.

loan Incentive Package

The present tax code in Pakistan stronglydiscourages the granting of loans for theacquisition of a home. At the present time, ahomebuyer must pay income tax on both theprincipal and markup portions of a loan topurchase a residential property for personaluse, while loans for rental property are exemptfrom income taxes.

Eliminating the tax completely on the markupportion while exempting all tax on the first Rs.50,000 of the principal would be a strongincentive to the industry. This, in turn, wouldencourage savings through linked savingsplans related to the purchase of residentialproperty.

Government Incentive Measures:

HFC Incentives

Increasing capital reserves of the housingfinance companies is necessary to enhance thefmancial soundness of the industry. Yet thecurrent tax laws require the HFCs to pay tax onprofits, which hinders the growth of capitalreserves through earnings. The Governmentcould either eliminate all tax on all or part ofHFC earnings up to an amount equal to paid-inequity, or declare a tax holiday for a number ofyears, perhaps the flrst five years of operation.Either of these two measures would permit theHFCs to achieve the required flnancialsoundness, and thereby improve their taxpaying capacity in future years.

Commercial Bank Incentives

Presently, confmercial banks may invest up toI percent of their deposits in housing loans. Toencourage commercial banks to invest thatamount and more in the housing sector, anyfunds in excess of I percent should be treatedas part of the commercial bank's investment inapproved securities for liquidity purposes,insofar as this investment is made through oneof the licensed housing fmance companies.This would help ensure an increase in the flowof funds to the sector.

The presenttax code inPakistanstronglydiscouragesthe grantingofloans fortheacquisition ofa home.

• Exempt depositor savings in housingfinance companies fromincome tax for at least one year.

• Eliminate income tax on the mark-up portion ofa home loan, andexempt all income tax on thefirst Rs. 50,000 ofthe principalamount

• Eliminate all tax on all orpart ofHFC earnings up to an amountequal to paid-in equity, or declare a tax holidayfor a number ofyears, perhaps the first five years ofoperation.

• Promote commercial bank investment in the housing sector; treatany funds in excess ofthe 1percent ceiling on housing asapproved securities when investment is made through the HFes.

SRMP Page 35

The Urban Environment:

In K.,.chl'. Ch."..., VIII.p, "'we I. no fo"".,w."" .upply sysMm. Thl. wom.n purch....w."" fo, 1 rup••pw,buck.t, f., more .XpM.tv."'.n plp.d w."".

In Pakistan, there are significant problemsassociated with the availability, distribution, andquality of water supplies. This has animmediate and significant impact on the qualityofmost people's lives, particularly those livingin the informal settlements (Katch; Abad;s) ofdensely populated urban areas.

Although formal estimates val)', it is thoughtthat over half ofKarachi's population lives inKatchi Abadis. Frequently, these communitieshave either no formal water supply, or a watersupply that is inadequate to meet demand. As aresult, residents-particularly women andchildren-spend a significant amount of theirtime collecting and transporting water fromadjacent areas. The lack of large scaledistribution systems make water a precious and

SRMPPage36

often expensive commodity. Water wallahs(vendors) travel door to door selling water, andin some instances, may sell access rights to thecommunity water tap.

Virtually without exception, most watersupplies are unsafe for consumption. Surfacewater supplies become polluted frominadequate or nonexistent solid and humanwaste disposal systems. Similarly,groundwater supplies become contaminatedthrough percolation of liquids from human andanimal waste.

Waterborne disease is common in Pakistan,and infant mortality rates from diarrhealdiseases are among the highest in thedeveloping world. Boiling water to render itsafe is not a viable option for many of theurban poor, who do not have access toelectrical connections and must rely onincreesingly scarce and expensive frrewood forfuel.

Thl. m.n 15 fortun." to h.v. a hand pump ne.rhi••hack. Howev." groundwa""conr.mlnatJon I• • • .,/ou. problem.

Water Quality and Supply

Rew••weg. oftM dreln. I"to .urf.c. we"', e.'gn,flee", ceu.. ofcontemlneted we"'r .uppll..end weterllom. dl..... (photo by Jeved AktJre,).

A ,.",. op." dre/n lined with f1II"'egeform. the me/n through"" of thl.Ketchl Abedi In Kerechl.

A" elderly women tren~portlng we'" I" ebucket. Av.,.ge we"" con.umptJon I. ferbelow the eccep,.,d .tenderd of80 II,.,. p.rpenon per dey.

It I. common to find dre/nege ditch•• choked withrubbl.h In e,... wh.,. munlcl".l.erv/e•• for.olld w""r. collectJon er. leeklng (photo by JevedAkth.r).

SRMPPage37

The Housing Ref/fiance FacilityThe purpose of the Housing Refinance Facility (HRF) isto provide a limited source of liquidity to the HFCsthrough the refinancing ofmortgage loans originatedby the various HFCs. Initially, the HRF will be fundedwith the equivalent of$15 million in funds obtainedfrom a US Housing Guaranty, which will generate theRupee equivalent of about Rs. 450 million. Otherfinancial resources may be made available through theHRF, if and when they are identified and tapped. To beeligible to participate in this Facility, an HFC must be

, licensed under the Statutory Regulations that establishthe legal framework for HFCs.

"

The State Bank will establish an operatinggroup for this Facility within the institution.Day-to-day responsibility for managing theFacility will reside with the same division thatmanages the other five Funds in the StateBank.

As its contribution, the Non-Banking FinancialInstitution (NSFI) division will provideinformation on the fmancial condition of theHFCs and the overall quality of each'sportfolio of mortgages. The Deputy Governorfor Policy will set the terms and conditionsunder which the Housing Refinance Facilitywill function.

HRF Operations

Housing finance companies wishing toparticipate in the HRF operations will continueto originate mortgages using their internallygenerated funds. These mortgage loans will

cany market rates based on an HFC's cost offunds and its lending policies.

When a particular housing finance companyoriginates a total of at least Rs. 10 million inmortgages, the HFC will have the option ofpresenting this package of mortgages to theState Bank for refmancing. The package willbe submitted to the NBFI division, which willreview the package to ensure that themortgages meet the criteria for refinancing. Atthe same time, the NBFI will certify that theHFC is in compliance with the State BankPrudential Regulations.

Loan to Value Ratio

Assuming compliance with the regulations, theState Bank, through the Housing RefinanceFacility, will refinance the mortgage packagein an amount equal to 80 percent of the facevalue of the mortgage package being presentedby the HFC. The 80 percent rule seems to beuniversally accepted as the appropriate

SRMP Page 39

.~

J1

The housingfinance

companieswill J.,e able

tQfinancemorf,ages

with theholtying

refinancefacili.iy in all

amoulltupto 75 mil/ion

rupees, oran amount

equal to theBEes ttltal

capital,whichever is

lower.

loan-to-value (LTV) ratio for long-tennmortgages on owner occupied, sing!e familyresidences which are secured by a hen on theresidence itself.

Loan Servicing and Prepayment

If one or more of the individual mortgages inthe mortgage package is prepaid, then the HFCmust replace the mortgage with anothermortgage of comparable value and tenns. T~eoriginals of the mortgage loan documents wIllbe cancelled and copies of the new documentssubmitted to the State Sank.

The housing fmance company will continue tobe responsible for servicing all ~ortg~ge loansheld in the custody of the SSP, mcludmgcollecting monthly payments. In tum, the HFCwill make monthly payments to the SSP on the80 percent financed loan. The HFC mustcontinue to make monthly payments on theSSP-held mortgage package regardless of theperformance of the mortgages themselves.

Default

In the event an HFC defaults on a payment tothe SSP, the SSP will have recourse to theHFC assets as it would in circumstances wherethere were no mortgages in the SSP'spossession. Moreover, the SSP will be . .authorized to take title to the mortgages In Itspossession.

The SSP cannot foreclose on any individualmortgage in the package unless the mortgageedefaults. Thus an HFC default will have noimpact on the borrower's loan commitment.

Loan Security

The principal documents a~ HFC requires toauthorize a mortgage loan m.::lude but are notlimited tc· the following:

• Property Funding Agreement (MortgageLoan Agreement)

• Convcj' l'7\ce Deed

• Property Mortgage

SRMP Page 40

• Irrevocable Authority to ReceiveConveyance Deed from the Registry ofAssurances

• PromissOI)' Note

• Property Valuation Report

• Personal Guarantee

• Employer Letters

• Mortgage Insurance Policy

• Comprehensive Property InsurancePolicy

The HFC will submit to the SSP a certifiedcopy of the above documents, plus any otherdocuments required to originate a mortgageloan which will provide the SSP with theassu~ance that the documentation is complete.

The original documents will remain with theHFC, however they will be duly assigned toSSP, thus giving recourse to the SSP of theunderlying assets. The origina~ documentsretained by the HFC may be VIewed by theSSP on demand.

Reports

The HFC will submit to the SSP a monthlyreport on the status of the package ofrefinanced mortgages. This report will list allthe mortgages in the package, giving the nameof the borrower, the address of the property,the identifying HFC mortgage number, and thecurrent payment record, showing dates,payments and balances. This report will besubmitted along with the other reports due tothe SSP on a monthly basis.

Allocation of HRF Funds

Each of the seven licensed and to-be-licensedHFCs will be able to finance mortgages withthe HRF in an amount up to Rs. 7S million, oran amount equal to the HFCs total capital,whichever is lower.

If one or more of the HFCs does not initiateutilizing its allotment within two years fromthe date the HRF is opened, then the remainingbalance in the Window will be allotted equallyamong the HFC~ which have utilized their fullRs. 75 million authorization.

Program Modifications

The SSP will have the option of revising theseguidelines, including the option to makeexceptions to them for one or more HFCs,depending on the performance of the HFC. TheSSP also may be able to exclude an HFC fromparticipating in the HRF if that HFC is notcomplying with the Prudential Regulations.

Form Standardization

The HFCs are not now using standardizedmortgage lending forms. For the HousingRefinance Facility to evolve into a morecomprehensive refinancing operation, the SSPshould initiate efforts to standardize theseforms.

The USAID MIS package, available to allHFCs, may assist in this effort. It isrecommended that SSP review this package atits earliest opportunity with a view ofincorporating it into the system.

HRF Terms and Conditions

The cost of these funds to the SSP r.onsists ofthe interest cost to the US Lender of theHousing Guaranty Loan, plus any costs that theSSP may incur in the administration of the

. Facility as well as coverage for provisions andreserves.

If a fixed rate HG loan were borrowed from theUS Capital Market today, the interest rate onthe US funds would be about 8.25 percent (upabout 1.25 percent from 6 months ago), 30 yearterm and a 10 year grace period on repaymentof principal.

Amortization of the loan will take place overthe remaining 20 year life of the loan. SSP

administrative costs should not exceed Ipercent of the refinanced loan. As discussedshortly, HFCs should not be charged for theforeign exchange coverage.

Mark-Up Rate and Term to the HFCs

If a mortgage package were presented to SSPunder the above conditions, then the markup onthe SSP refinancing loan to the HFC would bein the 9 to 10 percent range. The SSP shouldjustify a higher rate, if that is required. Thematurity date of the refinancing loan will be nomore than 12 years, depending on thecomposition of the mortgages beingrefinanced.

For example, if a package consisted only of 3year reviewable mortgages, it is conceivablethat the SSP could refinance this package overa 3 year period. The reason for selecting 12years as the maximum term is that the longestfixed rate loan now being made by an HFC is12 years. Reviewable loans are being made forlonger terms, but the loans will be recalculatedat an earlier date, usually 3 years, at whichtime the markup may be changed.

Foreign Exchange Cover

The HFCs should not be required to pay aforeign cover fee on the Housing Guaranty forthe following reasons:

• At no point in the foreign currencytransaction process will the HFCs haveaccess to the foreign currency, nor willthey be a party to the negotiations or asignatory on the loan agreement betweenthe borrower (Ministry of Finance) andthe US lender. The SSP, and only theSSP, will have access to or make use ofthe US Dollars. Thus, there is littlejustification for imposing this cost on theHFCs.

• Secondly, the HG loan is a long-term, 30year loan, not short-term like almost allthe foreign currency deposits and loansflowing into Pakistan. To try to estimatean equitable fee to be fixed over a 30year period is not only impossible, but

SRMP Page 41

The USAIDMIS packagefor housingfinance can beofvaillableassistance inthestandardizationofformsforthe housingfinancecompanies andfor therefinancefacility at theState Bank.

The housingrefinance

facilityprovidesvaluable

support tothe industry

byalleviating

theneedforexcessive

injections ofequity

capital inearly years,thus giving

anHFCfurther time

to establish asound

reputationand organize

marketingefforts.

very possibly onerous to the HFCs ifinflation is tamed as the Government ofPakistan and the international monetaryauthorities expect.

• Thirdly, as a result of the HG program,the Government of Pakistan will haveaccess to hard currency at terms that areimpossible to obtain elsewhere in theprivate sector. The use of these loanfunds to refinance more costly loansfrom other sources would be a likely useto which only the SBP can avail.

Flnanc/allmpact on theHFCs

It is important to assess the impact ofadditional sources of funds on the ability of theHFCs to function as viable fmancialinstitutions. The three financial analyses thatfollow draw primarily on the FinancialPlanning Models in Appendix A. The modelsare integrated five-year swnmary financialstatements, showing the income and funds flowstatements and balance sheets of a typicalHousing Finance Company.

To undertake this assessment, it was necessaryin the first instance to prepare pro fonnafmancial statements for a typical HFC whichwill utilize its equity capital as the one andonly source of funds for mortgage loans. Next,the impact of an inflow of Rs. 7S million inloan refmancing on the typical HFC wasanalyzed to show how it would affect thetypical HFC's financial condition. Finally, thethird analysis showed the importance ofdomestic savings on the financial health of thecompany. It should be stressed that a typicalHFC was assumed for analytical purposes. Theactual situation in each of the operating orsoon-to-operate HFCs will vary.

The supporting schedules and footnotesattached to the Models in Appendix A set forththe basic revenue and expense assumptions anddistribute beneficiary payments betweenprincipal and mark-up. Preliminary iterations

SRMPPage42

or runs of ellch Illodel can he described asfollows:

The Equity Model (Run No. I): This Modelreflects the condition of an operating lIFe liS

presently constituted. The sole source ofcapital is shareholder's equity; thus, the debt toequity ratio is zero. Lending activity has begunand a monthly volume of Rs. 4.9 million isassumed at an average of seven loans of Rs700,000 each. In order to sustain this modestvolume of lending, additional capital isrequired in about the eighth month ofoperation, and again in years 2 and 4.

Profits as a percentage of net equity range from-4.6 percent in year I to about S percent in year4 and year S. Operating expense as a percent oftotal assets ranges from 13.3 percent in year Ito 9.6 percent in year S. This operating expenseratio compares with an average of about 1.3percent in the British Building Societies andreflects primarily the low volume of HFClending activity in the Pakistani market.

Financial analysis shows thecritical need to tap lower-costdeposits.

HFCs need the latitude tocreatively attract deposits.

UtUlzlnl the HouIlnl Rennance Facility(Run No.2): This Model assumes acontribution of Rs. 7S million and shows theimpact of the Housing Refinance Facility onthe typical HFC. Assuming the same volwneof lending and no further source of capital, theHRF funds are utilized in full in about month

21. The major impact of this Facility on theHFC is to delay the requirement of a thirdcontribution of additional equity capital fromyear 2 to year 4.

The impact of the HRF on profitability andoperating efficiency is otherwise minimal. Thedebt to equity ratio is 0.64 in the year ofdrawdown, but in the absence of other sourcesof capital it is reduced steadily to 0.28 in year5.

The development ofthehousingfinance market is amedium to long-term project,at best Government needs toconsider ways to acceleratethe development oftheindustry via the granting ofincentive~to ensure that asignificant impact is made onreducing Pakistan's housingdeficit in the foreseeablefuture.

Profitability actually is reduced in years 3 and4 because an assumed 60 percent of the profitmargin is paid to the State Bank of Pakistan toservice the refinancing loan. Again thishighlights the low overall volume of operationsand the critical need for mobilizing additionalresources.

Utilizing both Savings Deposits/COb andthe Housing Rennance Facility (Run No.3):This Model assumes that savings an: mobilizedat the rate of Rs. 10.0 million per month for the60 month cycle of the model. Also the HousingRefinance Facility is utilized to the full extentof the proposed initial line of credit, i.e., Rs. 75million.

The~ influx of savings deposits/COIs of Rs.600 million over the five year period enablesthe HFC to operate without recourse toadditional equity capital after the secondcontribution of Rs. 60 million is paid in towardthe end ofyear I.

Thus, paid in capital remains constant at Rs.120 million in years 2-5. Profitability showssteady ifmodest gains in years 2-5, increasingfrom 7 percent to 10.6 percent as a percent ofnet equity.

Overall efficiency is likewise enhanced asreflected in the ratio of operating expense tototal assets, which declines from 6.4 percent inyear I to 3.1 percent in year 5. This result maybe overstated as the basic assumptions ofoperating expense were not changed in thethree runs of the Model. Arguably, operatingcosts will increase somewhat with theimplementation of a savings schemes.

On the other hand, the absolute volume ofsavings mobilized is not large. The debt toequity ratio rises gradually from 2.4 in year 2to 3.5 in year 5 under the assumptions of Run #3, well below the 7:1 and 10:1 ratios foreseenin the Prudential Regulations.

The results of these pro fonna Model runscontinn the critical need of the HFCs tomobilize savings in far greater volume than sofar contemplated.

Model run # 2 shows that the HousingRefinance Facility provides valuable support tothe industry by alleviating the need forexcessive injections of equity capital in years 2and 3, thus giving it further time to organize itsmarketing efforts. Access to the HousingRefinance Facility also provides the HFCs withsome additional capital, during which timethey will be able to develop and initiate savingsprograms as contemplated in the next Model.

Model #3 demonstrates clearly the need for thecompanies to have access to domestic savingsas one of the two primary sources of housingfinance.

Finally, the models show that the developmentof the housing finance market is a medium to

'.SRiHP Page -13

The housingrefinancefacilityprovides amechanismthroughwhich donoragenciescould assistthedevelopmento,{housingfinance.

Theriak totheSBPofdefault onmortgage

payments islow, since

the value ofthe loans is

less thanhalfthe

value ofthemortgaged

property.

long tenn project, at best. It further justifies theneed for the authorities to consider ways toacceleratc the development of the industry viathe granting of other special incentives toensure that a significant impact is made onreducing Pakistan's housing deficit in theforeseeable future.

Risks to the SSP

Opening the Housing Refinance Facility willrequire the SSP to address three major risks:

• Failure (bankruptcy or closure) of an HFC

• Repayment of the underlying Mortgages

• Foreign Exchange Risk

Failure of an HFC

The SSP has in place a set of PrudentialRegulations through which it exercises a largedegree of control over the HFCs. Prompt andactive enforcement of these Regulations willensure that all HFcs are and will remainfmancially sound companies during the periodwhen their mortgages are held by the SBP.

However, in the event an HFC utilizing theHousing Finance Facility encounters financialdifficulties, the SSP has covercd this risk bynot allowing that HFC to refinance from theHRF an amount in excess of its equity capital.

Once the financial difficulties becomeknown-and it is incumbent on the SBP,through its off-site monitoring and on-sitesupervision of the HFC, to be aware of thosedifficulties-then the SSP must act withalacrity to ensure that it recovers its funds fromthe HFC, as it should in any instance where afmancial institution encounters financial ormanagement difficulties.

Repayment of the Underlying Mortgages

HFC mortgage loans are granted at no morethan a 60 percent loan-to-value ratio, that is,the amount of the mortgage loan is only 60percent of the appraised value of the propertywhich guaranties the loan. Further, the SSP isdiscounting the mortgage at 80 percent of theface value of the mortgage.

Thus the value of the refmanced loan at thetime of origination with the SSPwill be only48 percent of appraised value of the propertyand this figure will begin to decline the

By refinancing packages ofmortgages with the private sector,a first step will be taken to initiate a type ofsecondarymortgage market whereby the housingfinance company wouldU,fie seasoned mortgages to raise money in the private capitalmarket, which would then be used to redeem the mortgagesfrom the State Bank ofPakistan.

In turn, the State Bank would be able to refinance a newpackage ofmortgages that the housingfinance companyoriginates. In this way a secondary market is seeded.

SRMPPage44

moment the first monthly mortgage payment ismade. SBP's security will increase over time,as the loan-to-value declines and the value ofthe property increases. SBP's increasedsecurity on loans to the HFC does not provide-::over from the inability of lenders to forecloselegally and quickly on past-due loans inPakistan. However it should be recognized thatthe failure of an HFC to collect regularly,thereby preempting foreclosure, is significantlydifferent from what a public fmancialinstitution like HBFC might do.

If a loan is not collected, income will fall andwith it, the possibility that the HFC's capitalwill be exposed. At this point, the HFC'sshareholders will fece losses and the prospectof shareholder's loss ofcapital helps ensurefull ana prompt recovery of mortgage loans.Should an HFC fail, the SBP will devise amechanism whereby the mortgage loans willcontinue to be serviced and the SBP willrecover it's refinanced loan.

Foreign Exch8nge Risk

The SBP can mitigate its foreign exchange riskby keeping the US Dollars off-shore for use inexport financing or some other activityrequiring US Dollars for financial transactionsoverseas. It could also lend the US Dollars toan entity that needs Dollars and is willing toprovide the SSP with the requisite risk cover,as detennined by the SBP.

Foundation for a National___M..o....rt...p.!!.Se Market

As the balance on the mortgage loans held bythe SBP declines over time, an individual HFCcould begin to consider the possibility ofrefinancing the SSP mortgage package with athird party. After a few years, the mortgagescould become more attractive as an investmentto the private sector because it will have beendemonstrated that they have been repaidpromptly by the borrower, that is, they havebeen "seasoned".

..

The SSP will be able to certify that themonthly payments have been paid fully andpromptly and that the HFC has not experiencedany problems in servicing the mortgages in therefinancing loan package. Moreover the loanbalance will have declined even further,leaving a much more favorable 10an-to-vaIUl=ratio.

By refmancing this package of mortgages withthe private sector, a fU'st step will be taken toinitiate a type ofsecondary mortgage marketwhereby the HFC would use these "seasoned"mortgages to raise money in the private capitalmarket, which would then be used to redeemthe mortgages from the SBP.

In tum, the sap would then be able torefinance a new package of mortgages that theHFC originates. And so on. In this way asecondary market is seeded.

Closure of the HRF

The SSP has pennitted the establishment of theHousing Refinance Facility to assist the HFCsto gain access to additional funds in the shortterm, at least until the HFCs are able to tapother sources of capital and deposits.

It is not, nor was it ever intended to be, a majoror a permanent source of liquidity for thecompanies, although addition funds could befunneled through the HRF to the HFCs if theyare forthcoming from other sources.

As the incubator of a national mortgagemarket, it would be possible for the HRF toevolve into a private sector secondal)'mortgage institution, albeit with some sort ofgovernment guaranty.

It is also possible that the HRF will be closedat a future date as other sources of capital arefound, and the proceeds of the HRF could beused for other related financial purposes thatcould be more germane to the housing financesystem at that future date.

SRMP Page 45

Eventualdevelopmentofasecondarymortgagemarketrequires SBPaction nowto track theperformanceofthemortgages itrefinances.

Rather than tllke up bagging, thla handicappedKarachi man pref.ra to a.1I boxea of tJ..ue paperat "ame IntenectJona.

In/{irmai Urban

F,..h fruit hawk.,. occupying a footpath InKarachi'. Emp,..a Marke"

A a"..t palmlatandhlacathaving an

afternoon napon a Karachi

footpath. Leckofemployment

opportunltJ.. Inthe formalaecto,haacreated an

array ofa"..tvendors

p.ddllng thel,good. and

.ervlc•••

SRMPPage46

Employment

""oona bolng.old In O,.ngl Town. In thoNckflfOund la a tiro tub. rep.'r .hop.

A Dhobl (w••herm.n)colony In K.r.chl, who,."l11e .c.I. h.ndw••hlng ofcloth•• I.don.. Cloth•• orocollected, wI.hod, dried,Iron.d and dollvorod tothe home vlo blcyc/. ordonkey cort forapproxlmotely R•• 2tSOp.,.1oo Item. (about $'f).A .,.b/o proto,,'on forten. of thou.and. ofmen In urbon cent.,.. Intho po.t, Dhabi'. a,..'owlybut .toodlly beingreplac.d bymod.mlaundy appllanc•• In thehom••

On. of.worol cobblorallned up on a Ko,.chlfootpoth-wlltlng for ped."'ona to hovo th.'roho...hln.d.

SRMP Page 47

An Apex BankIt has been suggested that Pakistan might benefit fromthe creation ofa central housing finance Institution,which might be called an apex housing bank, toprovide liquidity to the sector as well as give It someguidance and leadership. Other elements of II viablehousing finance sector, Including a national policy, arealso lacking, and a central organization might behelpful In filling these gaps. Sefore determining If thisorganization Is trUly needed, It Is necessary to definewhat an apex bank Is, as well as review the experience,history and role ofsimilar Institutions In othercountries.

What an Apex Sank Is

In general. an apex housing bank is anali-powerfUl central organization thatessentially controls completely the housingfmance sector. At the very least, it shouldundertake two major functions:

• License and regulate the industJy; and

• Provide liquidity to the primary housingfmance companies.

Regulatol)' functions can include controls onissues such as lending and savings rates. loanceilings. etc.

A distinction should be made between primll)'IDd secondary housing fmance institutions.Primll)' institutions. sometimes called retailinstitutions. deal directly with the public forsavin,s and Joan pwposes. Secondary orwholesale institutions deal only with primary

institutions. generally in the provision ofliquidity to the latter.

In a broader sense. other functions such as theformulation of housing fmance policy. thedesign offmancial programs. and in general.promotion and representation of the entireindustJy could be included within this oneinstitution. In practice. in those countries whereapex banks elOst in one form or another. thenumber offunctions it is responsible for doesnot include all the functions listed above.

Apex banks are usually creatures ofgovernment. and are either a parastatalorganization or awholly owned subsidiary of'one of the major government agencies Of'

ministries associated with the housing orfmance portfolios. Generally. the staffof theinstitution is comprised ofcivil servants. andthe Government has a strong influence over thepolicies and actions of the institution regardlessof the fact that the charter usually gives it alarge degree of ~utonomy.

An apexhousing bankis anall-powerfulcentralorganizationthatessentiallycontrolscompletelythehous;ngjinance sector.

PreVious Page BlGaSRMPPage49

The role ofgovernment

is tofacilitate the

flow offundsto the

markets,while at thesame time,

notincurring

any costs inthis effort

There is noreason why

Pakistanshould not

strive toemulate this

type ofsystem.

Apex banks are frequently established incountries where the private sector, particularlythe finan\le sector, is weak, and where thegovernment has inhibited, deliberately orotherwise, the development of a private sectorhousing fmance industry. Apex banks may alsobe created to implement a particulargovernment fmance incentive, such as agovernment tax or levy to fund housing.

At one time, apex banks were stronglyencouraged by the donor community as theanswer to alack of private sector housingfmance institutions in developing countries.Then, but not now, the donor institutions feltthat creating one central finance institution forhousing would be more effective and have aspeedier impact on the housing sector thantrying to star! up private sector institutions incountries where capital was short and humanresources wanting.

Examples In DevelopedCountries

Apex housing banks do not exist in thedeveloped countries. A review of the literatureon housing finance systems does not reveal onesingle fully developed country, i.e. the twenty­four OECD countries, where a singleinstitution provides both of the majorfunctions: liquidity to and regulation of thehousing fmance system. Instead a variety ofinstitutions are involved in these two functions,as well as the ancillary functions mentioned inthe previous section.

Regulatory

This function is almost always carried out by agovernment or parastatal agency. The UnitedKingdom has one major reguiatOl)' body, theBuilding Societies Commission, for institutionsthat accept savings as well as make loans,while Denmark also has one regulatory body,but oddly enough, this body is the Ministry ofIndustry.

One of the most logical systems is in France,which has a regul&tol}' system governed bythree entities under the Ministty of Economy,

SRMPPage50

Finance and the Budget, and the Governor ofthe Bank of France. In that country, theCommittee on Banking Regulations writes theregulations, the Committee on CreditInstitutions approves the regulations, and theCommission on Banking oversees or enforcesthe operations.

Liquidity

The provision of liquidity to the housingfinance system varies. In Germany and France,housing contract schemes provide a steadyflow of liquidity as new savers provide thefunding for savers who have completed theirsavings contract period. In Denmarkparticularly, but in all other countries as well,the mortgage lending institutions have accessto liquidity by issuing mortgage bonds whoseproceeds are used to fmance housing loans.

A true secondary mortgage market exists onlyin the US. Three nationwide financialorganizations raise huge amounts of fundsfrom the US capital market, which in tum theyuse to buy mortgages from qualified primaryinstitutions. The largest and most important ofthese institutions, the Federal NationalMortgage Association (FNMA), is a publiclyheld, private corporation, although it wasoriginally a government agency. It obtainsfunds to purchase mortgages through the saleof its own debt and mortgage backed securities,and provides a corporate guarantee of timelypayment of principal and interest on thesesecurities.

By virtue of its special status and connection tothe government, FNMA enjoys an importantadvantage in the debt market as investorsperceive that there is no default risk on its debt.That perception derives not from highcorporate risk ratings, but rather from FNMA'sorigins as a public agency coupled with thebelief that the federal government will not let itfail.

In this case, the US government has assuredthe flow offunds to mortgage markets, that is,liquidity, at no colt to the government or thetupayer. The same is virtually true withrespect to the other developed countryinstitutions providing liquidity to the mortgage

•

markets. The lesson to be leamed here is thatthe role of government is to facilitate the flowoffunds to the markets, while at the same time,not incurring any costs in this effort. There isno reason why Pakistan should not strive toemulate this type of system.

Polley

In most developed countries, HousingMinistries, along with the Governmentagencies or ministries that make monetary andfiscal policy, provide the policy frameworkwithin which these housing finance systemsoperate.

In the US, for example, the Department ofHousing and Urban Development (HUD)makes housing policy to include housingfmance policy, but this Department isinfluenced strongly by the Office ofManagement and Budget in fiscal matters andthe Department of the Treasury in monetarymatters.

Policy is also set by the various Institutionsthat provide liquidity to the sector, such asFNMA's policy (in conjunction with HUn) onthe loan ceiling for FNMA qualifiedmortgages. Input on policy decisions is derivedfrom the various trade associations and well asfrom consumers, that is, the mortgageborrowers.

Promotion and Representation

Usually there is a strong trade association thatpromotes the sector and provides theconstituency support that is so critical to thesuccess of the sector. In all cases, this tradeassociation is supported by dues from itsmembership. It is almost unheard offor anindividual fmancial institution to foregomembership in this trade associate~ the stigmais just too great and the herd mentality toostrong.

A good example of II trade association is in theUnited Kingdom, where the Building SocietiesAssociation has been active since 1869. It actsas the collective voice for the buildingsocieties, representing their interests to

government, parliament, the media and othertrade bodies. It also provides infonnation andexplanations of all legislative and regulatol)'developments to its membership. With thegrowing involvement of other institutions inthe provision ofmortgage lending in the UK,the Council ofMortgage Lenders was createdin 1989 to serve this expanding membership.

Product Development

The development offmancial programs isusually left to the individual institutions, and incountries where individual institutionalinitiative and innovation in this aspect isencouraged, the institution that first develops anew saving or loan instrument usually gains acompetitive advantage.

In countries that are more rigid in theiracceptance of innovation, new instruments areusually borrowed from other countries, albeitslowly. Securitization ofmortgages, which isthe issuance of liquid debt instruments securedby pools ofmortgages, originated in the US,but is slowly expanding to some Europeancountries.

Example. In DevelopingCountries

Developing countries in general have weakhousing markets. Most housing is providedthrough the infonnal sector, with institutionalfmance playing a relatively minor role in theprovision ofhousing. National govcmmentsundertake a disproportionate role in themanagement and control of the fmancial sectorwith the result that free market initiatives sri:limited. Where they exist, private sectorhousing fmance institutions are often severelyrestrained in their savings and lendingactivities. They are able to operate only at the

. sufferance ofgovernment institutions andbureaucrats.

Adistinction should be made between primaryand secondary national housing banks. Manydeveloping countries have what are called"national housing banks," but most of thesebanks are prim lUY lending institutions that

SRMPPage51

In countrieswithsuccessfulhousingseeton, thereis a strongtradeassociationthatpromotesthe sector andprOVidesconstituencysupport

The role ofHBFCinPakistan

.fhould be toeither

lJPerate on amark6?t basis,

N (}r to a'·~.'lally

providefinancing for

individualswhose

incomes donotpermit

them toaccess the

private sectorinstitutions.

directly serve the public and are usuallywholly-owned government subsidiaries orparastatals. They make mortgage loans toindividuals, usually loans to lower incomesegments of the population, although inpractice this is not always the case. In somecases, they also accept deposits from thepublic.

Within the universe of national housing banks,two types exist in developing countries. One isa market driven institution, with littlegovernment interference, that is able tocompete with the private sector for resourcesand to make mortgage loans at market rates. Agood example of this type of institution is theGovernment Housing Bank of Thailand. Otherthan the fact that it is owned by thegovernment of Thailand, its commercialoperations are little different from any otherprivate sector fmancial institution thatmobilizes fmancial resources to makemortgage loans.

A second type of primary housing fmanceinstitution on the national level is one thatexists primarily to direct funds to selectedsegments of the society at below market orsubsidized lending terms. This type of primaryinstitution is able to lend for housing at theserates because it obtains low rate financingresources from the government or othersubsidized sources. However, most often itundercuts any private sector institution tryingto compete in the market, and always distortsfree market conditions.

In Asia, a good example of this type ofinstitution is Indonesia's Bank TahunganNegara. For all intents and purposes, the HBFCin Pakistan is a primary national housing hankof this second type, although the cessation ofgovernment advances will force it to competein the financial markets if it is to prosper andgrow.

The secondary hnlJsing finance or apex bankmodel could be ~,)i-'licable to Pakistan sinceprim8l)' housing finance institutions from thepnvate seClOi nect1 a secoll1ary institution atleast to provide liquidity, Th)s is particularlyrelevant since the rol,.! of hB~ ': should be toeither operate 0, \ a market basj,~, 01 to actuallyprovide financing for indivic!.uals whoseincomes l'O nG! rl' '"l1it 'hl"JI to access theprivate sectu,' 'ILI'ltions.

Yet exampies in other dC"JCIOping countries ofan apex housing bank r.crving the primaryhousing fm...'1ce s~:"r are rare. The mostrelevant is India's National Housing Bank.This institution WllS crcll'.ed in 1988 to regulateand control the privatr, ..iector housing fmancecompanies, providl. '.~uidity to these sameinstitutions, mobiliz(l funds, promote theindustry, design new financial products, and inshort, carry out almost any function as long asit was deemed beneficial to the industry. It wascreated to be an all-encompassing apexhousing bank.

It was created at a time when one privatelyheld company, HDFC, was extremely

Apex banks are frequently established in countries where theprivate sector, particularly thejinance sector, is weak, and wherethe government has inhibited, deliberately or otherwise, thedevelopment ofa private sector housingjinance industry. Apexbanks may also be created to implement a particular governmentjinance incentive, such as a government tax or levy to fundhousing.

SRMPPageS2

successful, and the success of this oneinstitution was spawning additional companiesat a rapid pace. In many circles, it was felt thatthe time had BlTived to create a centralorganization to undertake most of industry'scentral functions, including assuming theregulatory functions of the Reserve Bank ofIndia. Most importantly, it was felt that theBank would be more successful at raisingcapital for all the housing fmance companiesthan each institution could accomplish throughits own efforts.

In developing countries,nationalgovernmentsundertake a disproportionaterole in the management andcontrol ofthe financialsector, with the result thatfree market initiatives arelimited. Where they exist,private sector housingfinance institutions are oftenseverely restrained in theirsavings and lending activities.

Unfortunately, the Bank was involved in thesecurity market scandal in 1991, whoseramifications continue to be felt today. Tosome degree, this scandal has permeated theentire fmancial sector, thus it is impossible todetermine how much the scandal had affectedthe viability of the Bank, or whether theconcept of a central housing fmance bank inIndia is aflawed one. The fact remains that theBank has not been vCl)' successful in carryingout its mandate. It continues to license andregulate the industJy, following the proceduresset up by the Reserve Bank, of which theNational Housing Bank is a·wholly ownedsubsidiary.

Insofar as India is operating under less thanfree market conditions, the Bank controls thecompanies in the sense that it sets interest

rates, authorizes types of deposits, limitsaccess to the capital market, etc. This type ofcontrol is felt by some observers to becontradictory to the Bank's role as the providerof liquidity. With this authority, it is possiblefor the Bank to influence rates to assure a flowoffunds to itself at the expense of the primaryinstitutions.

The scandal has sorely affected the ability ofthe Bank to raise capital in the fmancialmarkets. The Reserve Bank provided an initialfunding of 600 crore, which the Bank is usingto provide loans to eligible housing financecompanies. The largest housing financecompany, HDFC, has not sought access tothese funds, having been able to raise sufficientfunds for on-lending through its own marketingefforts.

Most companies have been able to mobilizecapital resources equally as well as the Bank,meaning that Bank does not have any innateadvantage as a Central Housing Bank, ownedby the Government. While the Bank has raisedsome funds through bond issues, it has notbeen able to establish itself as a secondarymortgage institution, providing liquidity to thesector. .

The National Housing Bank of India has notbeen successful in carrying out the twinfunctions ofpromotion and productdevelopment, due in part at least to the scandal.Nevertheless, it is probable that the Bankwould have had difficulty carrying out thesetwo functions anyway, given the lack of skillsand capabilities within· the Bank in these twoareas.

It is difficult to say what will happen to theBank. The scandal has put the Bank in adefensive mood, and until the scandal is put inthe past, it will not be possible for it to attemptto fulfill its mandate. Some observers believe

. that the Bank should consider lowering itssights, and instead focus on providing only afew services well.

Continued services would include theenforcement ofPnulential Regulations, whichimplies preparing a kind ofcredit rating for allhousing fmance companies regulated by the

SRMPPage53

It isabundantlyclear that thelack ofahousingpolicy, ofwhichhousingfinance isamajorcomponent,is impedingthedevelopmentofthehousingsector.

Acomprehensive

housingpolicy is

necessarybecause oj

theinter-sectorial

nature ojhousing and

its relation toand impact

on othereconomic

sectors.

Bank. The financial control functions wouldnot be handled by the Bank since, as shownabove, it might influence its decisionsregarding mobilizing capital.

The Bank should also continue to function as asource of liquidity so long as the liquidity isrationed to low-income families. Many expertsbelieve that if the Bank were to carry out thesebasic functions well, while leaving to thecompanies and their trade association theremaining functions, then the Bank could besaid to fulfill a needed role in the housingfinance industry.

An Apex Bank for Pakistan?

In Pakistan, the basic functions of an apexhousing bank are, or are not, being fulfilled inthe following manner:

Regulatory

The State Bank of Pakistan writes and enforcesthe regulations for the housing fmancecompanies and the Ministry of Financelicenses the companies. According to theWorld Bank, while the "SBP has strengthenedsubstantially its supervision oversight..... itneeds to do more in particular with regard tocapital adequacy, other prudentialrequirements, off-site monitoring and on-siteinspection". Assuming the SBP is assigned thelicensing function, and further that the StateBank continues to improve its regulatorycapacity, then this function is fully covered.

Liquidity

The SBP intends to open the HousingRefinance Facility which will provide Rs. 450million in liquidity to the HFCs. While thisamount will help the nascent HFCs, it iswoefully inadequate to meet their liquidityneeds. Even the addition of the Rs. 700 millionfrom the SBP Housing Credit Fund or anyother source will fall far short of actual needs.The Housing Sector will eventually need toaccess billions of rupees to meet the housingfmance requirements. Clearly this function isnot being met now, although the creation of

SRMPPageS4

this Facility might he a first step in thedevelopment of a capital market for mortgages,as has been mentioned previously. whichwould generate the necessary funds over thelong run.

Policy

Both the Ministry of Finance llnd the StateBank of Pakistan provide some guidelines anddirection for the industry. however there is nowritten policy or consensus on what thehousing finance policy is in Pakistan, notwithstanding the mandate of the NationalHousing Authority to formulate a housingpolicy.

Promotion and Representation

The HFCs have started a trade group, includinghiring a full-time Executive Secretary as ofMay, 1994. This is an excellent start, however,the size of its membership will limit theresources it can use to promote the system.Since trade groups or associations aresupported financially by their membership, thesmall membership base here is inadequate nowto support an active trade association withoutoutside assistance, as will be required for thefltst year of existence of the trade associationand perhaps longer.

Financial Instruments

The HFCs design their own savings and loaninstruments and financial products. No centralinstitution in Pakistan has the demonstratedcapacity to cany out this function now and it isdubious whether any type of institution otherthan the HFCs could gain sufficient experienceto carry out this in the housing finance market.

Conclusions

This leads to the question as to whether acentral organization is required now inPakistan. The State Bank of Pakistan iscurrently functioning as a de facto central orapex housing finance organization. It is, orsoon will be, canying out all the necessaryregulatory functions and it is the only

institution that will be providing liquidity to thesystem, albeit meager. Thus it is fulfilling thetwo basic functions of an "apex housingbank."

Whether the sap is able to fulfill completelythese two functions is another issue. No doubtthe housing fmance system will requireadditional liquidity•and although the SSP isadamant it will not provide this liquidity fromits own resources, it will support funding fromother sources. It is not evident that a newcentral organization would be any moreeffective in providing or promoting access tothis liquidity than the sap.

The State Bank ofPakistan isor soon will be carrying outall housingfinanceregulatory functions, and it isthe only institution that willbe providing liquidity to thesystem, albeit meager. It isnot evident that there isanything to be gained bycreating a new centralorganization to handle the.fietwo basic functions.

There remains a housing policy vacuum inPakistan. A comprehensive housing policy isnecessary because of the inter-sectorial natureof housing and its relation to and impact onother economic sectors. Instead, ad hocdecisions have become a substitute for acoherent, written and explicit policy.

In the housing finance sector, the SBP is nowmaking some housing finance policydeterminations which emanate from its actionsand decisions. But it is abundantly clear thatthe lack of a housing policy, of which housing

..

fmance is a major component, is impeding thedevelopment of the sector. However, thepreparation of a housing finance policy by thesap or a central organization will be relativelyfutile if it is not integrated into an overallhousing policy. Whether the National HousingAuthority is able to hl\ve its housing policy orany other such policy accepted is an unknownat this time.

In most countries, the consensus is that astrong collective voice in the form of a tradeassociation-divorced from thegovernment-is the most effective tool that agroup of individuals or institutions can deviseto represent them. The HFC's efforts toorganize and make operational the housingfinance trade group is probably the mostimportant step now being taken in thisdirection.

This group has the potential to become the truespokesman or representative and thus bringabout the necessary changes to make thehousing finance system successful. A centralorganization such as a apex housing bank withits close government ties cannot take the placeof a trade association, although it couldcomplement the trade association, assuming agood working relationship. Finally. the designof financial instruments and products is afunction better left to the HFCs,

It can therefore be concluded that it ispremature to consider the creation of a centralhousing finance institution, This docs not meanthat the establishment of such an organization,however structured, would not be necessary ata later date, This issue should be revisited oncemore housing finance companies areoperational, the Housing Refinance Facility isfunctioning, and the Trade Group is carryingout its responsibilities fully, While it is dilTicultto determine the date that the issue of an apexbank should be addressed once again, it isprobable that it should be canied out no laterthan two years hencc or mid-1996.Nevertheiess. another assessmcnt on the needto establish a central organization could becarried out whencver there is a consensus onthe need to do so,

SRJ\4P Page 55\

A centralorganizationsuch as a aapex housingbank, with itsclosegovernmentties, cannottake the placeofa trade'association.

Infrastructure and

,;,:,':.;.::...... ":,' .. "., .

•. , ':·:::::;jj:::::::::.:::;;:;::;:t::i;;;:::;;[!~;~i;~MjU~Municipal w..te collection In an amu.nt neighborhood In Karachi. L.u then 55" ben.fltfrom garbage coll.ctlon s.rvlce, which I. g.nerally limited to w.elthl.r section. of town.Collected wa.t. Is dump.d In low lying or other Inappropriate eree., contributing togroundweter conmmlnetlon and the spread ofdl...... Uncoll.ct.d gerbeg. Is bum.d,cau.'nga'r pollutlon and the productlon ofdioxin., which ar. extr.m.ly toxic. Recently,an orgenlc we.te compostlng plant b.gan operating In Kerachl, end more ere planned foroth.r major cltl.s (Natlonal Cons.rvatlon Strat.gy, 1002)

Th..em.nar.openingbloclced gutt.rlin••, whichar. a chronicprobl.m InKerachl.

r

SRMP Page 56

Urban Services

~'. '.":.

PI.stlc b.gs .nd other tresh obstructing the trow of.n expo.ed sewege dr.ln that ./so Is enobstruction In a road.

In Karachi,wat.r supplies.resc.ree.nde".tle even In

high Incomeneighborhoods,

where water I.often pureh..ed

from mobiletIInk.,•.

SRAIP Page 57

Next Steps for Pakistan gsHousing Finance Sector

Conclusions

The private sector housing finance system Is new InPakistan. To achieve success, the system mustovercome significant barriers to mobilize resources formortgage lending, and It must design mortgageinstruments that are affordable and marketable toPakistani families that desperately need new and betterhousing. At the same time, the companies must beable to undertake these functions profitably, thussatisfying their owners and shareholders. To this end,the sector needs the support of Government, and inparticular, the State Bank of Pakistan, which isundertaking an important role In the development ofthe new system.

•

The State Bank of Pakistan recognizes theimportance of housing finance in the overalleconomic context. It understands that it needsto nurture these institutions so that they canfulfill the promise of providing housing financeto the people.

Moreover, the SSP is aware that thedevelopment of the housing finance systemgives the SSP the unique opportunity todemonstrate how a new financial group shouldbe organized, regulated and supported, sincethe very newness of the HFCs permits the SSPto start out with a clean slate. Thus, thislearning experience cun bcncfitthe entirefinancial sector.

This communality of interests between thecompanies and the SBP presupposes a closeand almost collegial relationship. Thecompanies must be open with the SBP, eveninsisting that the SSP make on-site inspectionsof the companies so that they will be betterable to comply fully with the prudentialregulations.

The ssp should assign at least one full-timeagfrttto regulate the companies, and this agentshould spend time with the companies learningabout their problems and their businessoperations. There should be periodic and, infact, frequent meetings and exchanges ofinfonnation between the two, recognizing that

SRJvIP Page 59

Immediate Actions

xu

The StateBank of

Pakistanmust

formallyissue the

rules andregulations

for thehousingfinance

companies togain access

to thehousing

refinancefacility and

setup anoperational

structure.

the more they know about each other, the morethey will understand the other's needs andproblems, An environment of trullt must becreated. But if this new direction is not taken,then the usual "us vcrsus thcm" attitude willprevail, with the result being similar to thestrained relationship that appears to existbetwccn the SBP and other financialinstitutions in Pakistan.

It is important for HFCs to recognize that theGovernment of Pakistan is in the process ofmodifying and refining its fiscal aud monetarypolicies. These changes are due in large part toa need to reform its financial house to fulfillcommitments to the IMF and the World Bankas well as a recognition that the governmentdeficit has to be restrained.

As a result, the old system of financialadvances, subsidies, guarantees and outrightfavors are being curtailed, and in some cases,eliminated. This means essentially that theHFCs will not be the beneficiaries of the samekind of treatment that other financialinstitutions had when they initiated operations.This does not mean that the HFCs are beingtreated unfairly; it is just that the rules havechanged. The HFCs must recognize and acceptthis fact.

The SBP has made a commitment to the HFCs;it is activating a Housing Refinance Facility,and making Rs. 450 million available to

Throughout this paper, many suggestions andrecommendations have been made about whatthe housing fmance companies and theGovernment of Pakistan should do to ensurethe success of the housing fmance system.Following is a summary of recommendedactions and designated responsibilities toachieve those actions.

The initial step requires the State Bank toactivate physically the Housing RefmanceFacility, based on the recommendations in this

SRMPPage60

11

TI.e HFC!t' mU.ft continue tomake loan~', thereby gainingaccess to the hou.fingrefinance facility" They mu~'t

also try new ways to mobilizeresource.f, using thosemechanisms now permittedunder the existing regulations.

refinance mortgage loans, The HFCs mustcontinue to make loans, thereby gaining accessto this Facility, an~ try new ways to mobilizeresources, using those mechanisms nowpermitted under the existing regulations.

For its part, the SBP must cooperate with theHFCs in their scarch for ways to mobilize newresources, and it must seriously consider thecreation of some incentives to promote thehousing fmance sector. If the HFCs aresuccessful over the next few months or years,and the new cooperative relationship betweenthe two groups succeeds, there is no doubt thatthe SBP will throw its weight behind theefforts of the HFCs to genemte more housingfinance activity in Pakistan.

paper. The SBP must formally issue the rulesand regulations for the HFCs to gain access tothis Facility and set up an operational structlu·e.

At the same time, the Ministry of Finance mustenter the US capital market to borrow theHousing Guaranty funds. The State Bankshould aim for this Facility to open no laterthan July I, 1994.

Concurrently, the State Bank should considerthe question of the HFCs being authorized to

accept foreign currency accounts, and ifapproved, issue a circular to this effect, againno later than July I, 1994.

These two actions by the State Bank will give areal os well as a psychological boost to thehousing finance sector. It will show that theGovernment supports the sector, and just asimportantly, it will not result in any cost to theGovernment. In fact it will be a benefit to theGovernment insofar as it will allow theGovernment to tap a very inexpensive sourceof foreign currency, the Housing GuarantyLoan fWlds. In addition, this action willencourage the other groups to carry on with thenecessary steps to obtain their licenses to dubusiness as housing fmance companies.

The State Bank, along with the Ministry ofFinance, should also begin to consider the useof tax incentives, along the lines suggested inthis report, to support the housing financesystem.

While the State Bank goes ahead with its plansto open the HRF, the HFCs should continuewith their efforts to mobilize financial

resources utilizing those avenues now open tothem.

Either individual1y or jointly, they shouldexplore the prospect of designing and utilizingsome sort of savings linked scheme to mobilizeresources. This would demonstrate to the StateBank that the HFCs Ofe very serious about theneed to mobilize domestic savings and that theHFCs are ful1y aware of their responsibilitiesin this malter. These schemes would includeboth the U'.lC of fm'eign currency accounts ;: .drupee based accounts to mobilize savings. TheHFCs should commit themselves to devisir' b atleast one comprehensive savings linkedscheme by July I, 1994. At the same time, oneor more HFCs will begin to issue Certificatesof Investmc:nt.

The actions listed above are not one-sided.Both key players in the housing financesector-the State Bank of Pakistan and th~

housing fmance companies-are being askedto take steps to support the system. If eachparty agrees to take actions along thesesuggested lines, then the Housing FinanceSystem is off to an excellent start.

The most important action to he taken ne:d is for the StateBank, The Ministry ofFinance, and the Housing FinanceCompanies to create a sound working environment thatpromotes financial integrity and enhances resourcemohilization for the housing sector.

SRMP Page 6/

Appendix A

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/

EaUITY ONLy HFC·PLANNING MODEL RUN',

INCOME STATEMENT Y.m..1 ~ ~ ~ :lsW..§Inrorolr Inoome OPI 5,368 16,814 28,014 38,888 49,231Foe Inoome (11 882 882 882 882 882Invoetmenr Inoomo (21 5,241 6,946 4,972 6,215 2,206

Torellnoomo 11,481 23,102 33,928 46,986 52,319Poreonnol Expense (31 12,000 13,800 15,810 18,251 20,988Othor Oper. Expense (41 3,600 4,140 4,761 5,416 6,296Interost Exponse 0 0 0 0 0

Totol Exponso 15,600 17,940 20,631 23,126 21,284Ner Inoomo Bolore Tall 14,1191 5,162 13,291 22,260 25,034Allowanoo, for Inooma Tex (51 0 18931 (4,7871 (8,0131 (9,0121Nat Protir Ahor Tall (NPAT) 14,119) 4,869 8,510 14,246 16,022Allow. Loon LOlles (61 (1,1161 (1,116) (1,176) (1,1761 (1,1761Not Aftor Allowanoos (NPAA) (5,295) 3,693 7,334 13,070 14,846

NPAAlNET EaUITY -4.6% 2.0% 3.9°A, 5.0% 5.3%OPERATING EXPENSEITOTAL ASSETS 13.3% 9.8% 10.7% 8.8% 9.6%

E!LNDS FLOW STATEMENTSOURCES OF FUNDS Year 1 Yw..1 Year 3 ~ X!!L§NPAT 14,1191 4,869 8,510 14,246 16,022Add Back Allow.Loan losses 1.176 1,176 1,176 1,176 1,176Repayment of Prinoipal 581 2,024 3,784 5,929 8,545Capital Contriburion 120,000 60,000 0 60,000 0REFINANCE FACILITY 0 0 0 0 0Sovlngs Deposlts/COls 0 0 0 0 0Foreign Currency Deposits 0 0 t 0 0 0Long Term Foreign Loons 0 0 0 0 0RE·FINANCE FACILITY 0 0 0 0 0Reduction in Working Capital /58,839) (9.26!}) 45,330 (22,5511 33,057

Total Sources 58.800 58.800 58.800 58.800 58,800USES OF FUNDSLoan Disbursements 58,800 58,800 58,800 58,800 58,800Fixed Assets 10,000 0 0 C- O

Total Usas 58,800 58.800 58.800 58.800 58.800

BALANCE SHEETASSETS Year 1 Year 2 Year 3 Year 4 X!!L§Cash 3,466 2,040 2,291 3,073 3,376Short Term Investments 45,372 56,068 10,487 32,256 /1,1041Housing Loons O/S 58,219 114,994 170,011 222,882 273,136Housing Loans RFF/SBP 0 0 0 0 0Residual Inrerest 0 0 0 0 0Fixed Assets 10,000 10,000 10,000 10,000 10,000

Toral Assets 117,057 183,102 192.788 268,211 285.409LIABILITIESAccounts Payable 0 0 0 0 0REFINANCE FACILITY 0 0 0 0 0Savings Deposits/COls 0 0 0 0 0Foreign Currency Deposits 0 0 0 0 0Long Term Foreign Loens 0 0 0 0 0Allowance for Loan Losses 1.176 2,352 3.528 4,704 5,880Capital 120,000 180,000 180,000 240,000 240,000Free Reserves 14.1191 750 9,260 23,507 39,529

Net Equity 115.881 180.750 189,260 263,507 279,529Total Liabilities 117,057 183,102 192.788 268.211 285,409

Debt:Equity Ratio 0 0 0 0 0

Notes:(1) Fee income is estimated at 1.5% of the value of new loan originations.(21 Excess cash is invested in short term instruments at an assumed rate of 16% p.o. (see Schedule of Investment Inca(3) Personnel Expense is estimated at Rs 1.0 million per month, increasing by 15% annually.(4) Other expenses are estimated at 30% of Personnel expense.(51 See Schedule of Income Tax Calculations below.(61 Allowence of loon losses is estimated at 2% of new loan originations. 19-May-94

SRM!' Page fJ5

UTILIZING REFINANCE FACILITY HFC·PLANNING MODEL RUN # 2Borrowing Limit: RI76,OOO,OOO

INCOME STATEMENT .tlli.! Yoar 2 Yonr 3 Yoar4 Yoor 5Intorolt Inoomo Ops 5,358 16,874 28,074 38,888 49.231Foo Inoomo (1) 882 882 882 882 882Involtmont Incomo (21 5,241 6.726 6,681 5,968 11,574

Totol Incomo lL.i!!..1 24,482 ~5,637 45,738 ll.§UPorsonnol Exponse (3) 12,000 13.800 15,870 18,251 20,988Othor Opor. Exponso (41 3.600 4,140 4,761 5,475 6,296Intorost ElCponso 2,245 8.837 8.589 8,316

Total Exponso 15,600 20,185 29,468 32,315 35,601Net Inoomo Bolore TalC (4,119) 4,297 6.169 13.423 26.086Allowonco for Incomo TalC (5) 12361 (2.221) (4,832) (9.391)Not Profit After TolC (NPATI (4,119) 4.061 3,948 8,591 16,695Allow. Loan Lassos (61 (1.1761 (1.1761 (1.176) (1,176) 11 ,176)Not Aftor Allowanoos (NPAAI (5,2951 2,885 2,772 7,415 15.519

NPAA/NET EQUITY ·4,6% 2.4% 2,2% 3,9% 5.8%OPERATING EXPENSEITOTAL ASSETS 13,3% 9,1% 10.3% 8,9% 7.9%

FUNDS FLOW STATEMENTSOURCES OF FUNDS ~ Yeor 2 Yoer 3 Y.lli..1 Yeor 5NPAT (4.119) 4.061 3,948 8,591 16,695Add Book Allow.Loan losses 1.176 1.176 1,176 1.176 1,176Repayment of Principal 581 2,024 3,784 5,929 8.545Capital Contribution 120,000 0 0 60,000 60,000REFINANCE FACILITY 75,000 0 0 0Savings Doposits/COls 0 0 0 0Foreign Deposits 0 0 0 0Foreign Loans 0 0 0 0Roductlon In Working Capital (58,839) (23,0161 51,802 (14,774) (25.264)

Total Sources 58,800 59.245 60.709 60.922 61,152USES OF FUNDSLoan Disbursements 58,800 58.800 58.800 58,800 58,800RFF·Debt Servico Prinoipal 445 1.909 2,122 2,352Fixod Assots

Total Uses 58.800 59,245 60,709 60,922 61.152

BALANCE SHEETASSETS Year 1 Yeor 2 Yoor 3 ~ Yeor 5Cosh 3,466 1.699 1.891 2,621 3,432Short Term Investmonts 45.372 70.156 18.162 32,206 56,659Housing Loans O/S 58.219 21.827 79,314 134,904 188,158RFF·80% 74.534 72,558 70.382 67,982RFF·20% 18.634 18,139 17,595 16,996Fixod Assots 10,000 10.000 10,000 10,000 10.000

Total Assets 117.057 196.849 200,064 267,708 343.227LIABILITIESAccounts PoyabloREFINANCE FACILITY 74.555 72.648 70.524 68,171Savings Doposits/COlsForeign DepositsForeign LoonsAllowanco for Loan Lassos 1.176 2.352 3,528 4,704 5,880Capitol 120,000 120,000 120,000 180.000 240,000Free Roserves (4.119) (58) 3.890 12,481 29.178

Not Equity 115,881 119.942 123.890 192,481 269.176Total Liabilitios 117.057 196.849 200.064 287,708 343.227

Debt:Equity Ratio 0 0,64 0.61 0.39 0.28Notes:(1) Fee income is estimated at 1.5% of the value of new loan originations.(2) Excess cash is invested in short term instruments at an assumed rate of 16% p.o.(3) Personnel Expense is estimated at Rsl.0 million/month. inoreasing by 15% annually.(4) Other expenses are estimated at 30% of Personnol oxpense.(5) See Schedule of Income Tax Calculations below.(6) Allowance of loan lassos is estimatod at 2% of now loan originations, 05/19/94

SRMP Page 66

SAV'NGS DEPOSITS lQ&QQ Por Month HfC·PLANNING MODEL RUN f 3REFINANCE FACILITY; 1..MQQ Limit

INCOME STATEMENT Yw..l ~ fur..1 ~ :wrJiIntoro8t Inaomo OP8 15,309 48,213 80,212 111,108 140,659Foo Inaome (1) 2,520 2,520 2,520 2,520 2,520Involtmont Incomo (2) 6,620 11,491 15,906 13,293 12,357

Total Inaome ~ ~ 98.638 126.921 155.537Personnel Expenso (31 12,000 13,800 15,870 18,251 20,988Othor Opor. Exponse (4) 3,600 4,140 4,761 5,475 6,296Intorest Expenso 8,800 23,600 54,571 73,501 91,724

Total Expen80 24.400 41.540 Thm u..m 119,008Net Incomo Boforo Tax 49 20,684 23,436 29,694 36,528Allowonco for Incomo Tax (51 13461 18,0671 18,4371 (10,6901 113,150)Net Profit Aftor Tax INPAT) (296) 12,617 14,999 19,004 23,378Allow. Loon Lassos (6) 13,360) 13,3601 13,360) 13,360) 13,3601Not After Allowoncos (NPAA) 13,656) 9,257 11,639 15,644 20,018

NPAA/NET EQUITY -3.1% 7.0% 7.9% 9.4% 10.6%OPERATING EXPENSEITOTAL ASSETS 6,4% 4.0% 3.5% 3.2% 3.1%

FUNDS FLOW STATEMENTSOURCES Of FUNDS Yeer 1 Year 2 Year 3 Yoar 4 Year 5NPAT (296) 12,617 14,999 19004 23,378Add Back Allow.Loan losses 3,360 3,360 3,360 3,360 3,360Repayment of Principal 1,661 5.783 10,810 16,940 24,415Capital Contribution 120,000 0 0 0 0REFINANCE FACILITY 0 75.000 0 0 0Savings Deposits/COls 120,000 120,000 120.000 120,000 120.000Foreign Deposits 0 0 0 0 0Foreign Loans 0 0 0 0 0Reduction in Working Capital 180,924) 148.316) 20.740 10,817 (801)

Total Sources 163.800 168.445 169.909 170,122 170,352USES OF FUNDSLoan Disbursements 153.800 168,000 168,000 168.000 168,000RFF-Debt Service Principal 0 445 1,909 2,122 2,352fixed Assets 10,000 0 0 0 0

Total Uses 163,800 168.445 169,909 170.122 170,352

BALANCE SHEETASSETS X2lli. ~ ~ Year 4 Year 5Cash 4,042 3,560 3,881 4,783 6,234Short Term Investmants 62,683 111,480 90,419 78.700 78,050Housing Loans 0/5 166,339 235,388 395,048 548.828 695,412RFF·80% 0 74,534 72.558 70,382 67,982RFF·20% 0 18,634 18,139 17.595 16,996Fixad Assets 10,000 10,000 10,000 10,000 10,000

Total Assets 243,064 453,596 590,046 730.288 874,674LIABILITIESAccounts PayableREFINANCE FACILITY 0 74,555 72.646 70,524 68,171Savings Deposits/COls 120,000 240,000 360,000 480,000 600,000foreign Deposits 0 0 0 0 0Foreign Loans Q Q Q Q QAllowance for Loan Losses 3,360 6,720 10,080 13,440 16,800Capitol 120,000 120,000 120,000 120.000 120,000Frea Resorves (296) 12,321 27,320 46,324 69,703

Net Equity 119,704 132,321 147,320 166,324 189,703Total Liabilities 243,064 453,596 590,046 730,288 874,674

Debt:Equity Ratio 1.0 2.4 2.9 3.3 3.5Notes:(11 fee income is estimated at 1.5% 01 the value of new loon orilJinations.121 Excess cosh is invested in short term instruments at an assumed rate 01 16% p.a.(31 Parsonnel Expense is estimated ot Rs1.0 million/month, increaSing by 15% annually.141 Other expenses ara estimated at 30% of Personnel expense.(51 See Schedule of Income Tax Calculations below.(6) Allowance of loan losses is estimatad at 2% of new loon originations. 19·May·94

....·R"") Fag!' 6 7

AppendixB

PreYlous Page BIcDiJr SliMP Pax,"

/

Comparison ofHousing FinanceSystems

The purpose of comparing housing financesystems in other countries was to determinewhat, if any, experiences would be applicableto Pakistan. Systems in five developedcountries-UK, France, Germany, Denmarkand the US-were reviewed, along with thosein two developing-India and Indonesia. Thesituation in Pakistan was also included to giveperspective to the other country situations.Seven different indicators, as described below,were compared in each country where thatinformation was available. A countrycomparison chart appears at the end of thissection.

Homeowner Mortgage Debt as a Percentageof GDP: This ratio generally gives a goodindication of the depth of the housing financemarket. A high ratio as is found in thedeveloped countries means that the housingfinance sector is well-developed and thatmortgage loans arc readily available to themajority of the population. A low ralloindicates the reverse. Not surprisingly, the fivedevcloped countries have high ratios, with theUS the highest at 47 percent, while the twodeveloping countries, plus Pakistan, have lowratios, generally in the single digit range.

Existence and Role of an Apex Bank: ThisIndicator was ineluded to aseel1ain whether theconecpt of an apex hOllslllg bank was acommon feature. The information, both in thechurt as well us elsewhere, indicates that an

apex bank, meaning a centralized secondaryhousing finance institution with multipleregulatory and financing roles, is not common.None of the developed countries have apexbanks, while only India has such an institution,and in this case, the jury is still out as towhether it is successful.

On the other hand, national housing banksproviding direct loans, usually to low-incomeborrowers, arc quite common throughout theworld, although they are not universallysuccessful. Successful housing banks that servelow-income families with targeted loans, whileat the same time being market driven, do existin countries such as Thailand, Korea, Jordanand several other countries. More common arecases where the national housing banks arehighly politicized, money losers, undunfocused in their lending policies.

Sources of Mortgage Lending: This indicatorshows that there arc essentially twoinstitutional sources of mortgage lending­specialized mortgage credit institutions anddeposit institutions, including commercialbanks. The information available does notindicate which source is the better, since all thedeveloped countries have successful housingfinance systems that utilize these two majorsources in different percentages.

One trend which is not shown on the chm1 isthe increasing use of mortgage credit

SRAIP POKe 7/

in~titutions because of a need to hedge againstchanges in the cost of funds for mortgagelending. In developing countries, external loansarc a third source, and in fact, both Indonesiaand India have had access to World Bank,ADB and USAID Hou~ing Guaranty loans Inaddition, developing countries also make uscof direct government advances for housing.Other studies have indicated that the greaterthe reliance on use of government grants andexternal loans as a source of mortgage lending,the more likely the housing stock in thatparticular country is in a poor condition.

Funding Instruments: Deposits by individualsavers are still the major method of mobilizingresources for on-lending for housing purposes.This is truer in developed countries than indeveloping countries, because in the latter,government financial assistance plays a largerrole. The use of capital markets to mobilizehousing funds is increasing throughout theworld, and even in developing countries,collateralized and non-collateralized debt isbecoming more widely used.

Techniques such as savings linked loanprograms have also been shown to be a majorresource in a few countries, and is probablyworth more consideration that it has been givenin other countries. The greater the developmentof the capital market, the higher the use ofspecial ized secondary market instruments suchas mortgage backed securities.

Tenure and Type or Mortgage Loans: Thetrend is for longer and longer tenure loans,although the maximum tenure seems to haveleveled off at 30 years. Fixed rate loanscontinue to be the most common type of loan,although the longer the tenure, the higher theinterest rate. Adjustable rate and reviewableloans have become more common in recentyears in the developed countries as lendershave tried to protect themselves against rises intheir cost of funds. In tum, this has led to theincrease in the use of specialized creditinstitutions as a major source of mortgagelending and the capital markets as a morelikely way of mobilizing resources (see above).

In developing countries, tenure is generallyshorter than in developed countries, while the

SR¥P Page 72

usc of lixed rute loulls is more common.Innation. which is l110rc of u prohlem 111

developillg countries, clearly is II fllclor herc.The longer tenure in developed coulltnesrenects the higher degree of sophistication andmurket dcpth.

Role or GO\'ernment In Regulatory/ControlAspects: At one extreme is the limited role ofthe government as expressed in thedevelopment and enforcement of PrudentialRegulations as is the case in the UK. At theother extreme is an all.encompassing role ofgovernmcnt wherc the government requires thelending institutions to seck pennission toinitiate any new hOllsing finance activity 01'

program. But even in the developed countriesthe role of most guvernments is more activl: illcontrolling and regulating the housing financemarkctlhan in the UK.

Areas where govclllmenl is commonlyinvolved include deposit and mortgageinsurance, as in the US; some financialinstitution ownership, as in Gernlany andFrance; setting of mortgage contract ternlS, asin Denmark. In nearly all developing countries,government is much more heavy handed in itsregulatory and control requirements. althoughenforcement of these regulations tends to beeither lax, selective, or politically motivated.

Setting of Lending Rates: In developedcountries, it can be said that the market sets thelending rates, while in developing countries,the government sets those rates. However, inthe developed countries, the market isinfluenced, as it should be, by the amount ofdown payment the borrower lays out and by hiscredit rating. Insurance programs that coversome of the risk also influence lending rates insome developed countries. The fact is that themore market oriented countries, which alsotend to be the developed countries, let the freemarket hold sway.

As a developing country, Pakistan has a longway to travel before it reaches the point whereit is providing housing finance to the masses.With less than two percent of GDP inhomeowner mortgage debt, it is anunnderstatement to say that the housing marketlacks depth.

........... ·<!::::~:~M~~RI~Q~()FHOlJSINGFINANCE· SYSTEMS

Sources of Funds for IFunding Instruments ITenure & Type ofMortgage Lending (in order of Mortgage Loans

importance)

~·i1I~•iI!.1

•

j.:1

I·:1

'iojJi!1I

'. ~

Country

us

UK

Germany

France

Denmark

India

HomeownerMortgageDebt as a %of GOP

41% (1991)

NA

33% (1990)

35% (1990)

44% (1990)

<5%

Existence and Roleof an Apex Bank

Does not exist

Does not exist

Does not exist

Does not exist

Does not exist

Exists to promote,regulate andprovide liquidity tothe sector.

Deposit Inst: 30%Com. Banks: 30%Mortgage Credit lnst:35%Other:5%

Deposit lnst: 94%Other: 6%

Deposit lnst: 55%Mortgage Credit lnst:22% .Contract Inst: 13%Other:l0%

Deposit Inst: 85%Banks: 10%Other: 5%

Mortgage Credit lnst:80%Deposit lnst: 12%Other: 8%

Deposit Inst: NAGov't Housing Institute:NA

Mortgage-backedsecurities; Deposits;Collateralized debt

Deposits;Uncollateralizeddebt;Mort. backedsecurities

Deposits;Mortgage bonds;Contract savings;Uncollateralized debt

Contract Savings;Deposits;Collateralized debt

Mortgage Bonds.Deposits

Deposits.Term Loans.Uncollateralizeddebt. External Loans

30 year fixed andadjustable rates

25 year reviewablerate

10-30 year fixed and25-30 reviewable rate

15 year fixed rate

20-30 year fixed rate

7-30 year fixed rate,reviewable

Role of Government inregulatory/controlaspects

Govt. deposit insurance.support for secondarymarket agencies.mortgage insurance

Prudential regulation

Control over terms andinst. use of bonds &contract savings, limitson insurer investments,subsidized contractsavings, state-ownedsavings banks

Subsidized contractsavings, deposit rateregulation. stateownership of some banks

Control over Credit inst.entry, mort. contractterms, insurance/pensioninvestments

Deposit and lending rateregulation. Loan ceilings.LTV regulation.

Setting of lendingRates

Market pricing for up to80% LTV; Govt &private insuranceprograms set priceabove 80%

Market pricing up to80% LTV; insurancepremium sets price over80% + loans

Rate based on borrowercredit risk and LTV ratio

Rate based on borrowercredit risk and LTV ratio

Rate based on borrowercredit and LTV ratio

Rate based on borrowerincorr.e assessment.giving an average LTVof 55%

Indonesia < 5% Does not exist Govt. owned Credit lnst:95%Others: 5%

Govt. Loans.Deposits. ExternalLoans

20 yr fixed (govt lnst.), I No private HFCs10-15 yr (Com. Banks)

NA

IIlA-N"ot-Available~~

Pakistan 2% Does not exist Govt. Credit Institution:NA

Govt. Loans. 10-14 yr fixed. 3 yrrenewable

Prudential Regulation 60%

Appendix C

Previous Page .BlaDkSUMP Page 75

The Impact ofInflation on HousingFinance

The transition from state-control to amnrket-oriented economy has almost alwaysheen accompanied by high rates of inflation.Pakistan appears to be no exception to this ruleas evidenced by the large nwnber of deficitarypublic enterprises and the high share offinancial market borrowing of the Government.Inflation rates in excess of ten percent perannum are rcflected immediately in the marketcost of money and lenders arc reluctant tocommit funds much beyond one to three years.Commercial bank lending becomes extremelyprofitable as low cost sight deposit funds arclent at rates of 20 percent and higher.

In this environment, thc mortgage markets arcamong the first to suffcr, as evidenced bynumerous examples throughout the worldeconomy. In the United States, high inllationand high interest rates from 1978 to 1986brought about a complete transformation of thehighly devcloped mortgage markets. TheSavings and Loan institutions (thrifts), whichdominated the funding of residentialmortgages, were constrained by rcgulation andgiven tax incenti\'cs to invest almostexclusively in lixed-rate, level-paymentmortgages funded oy insured depositc/rs.

As so-called "low cost" funds dried up in theface of inllation in excess of ten percent andII1terest rutes approaching 20 percent, theavailability of fixed-rute savings deposits driedup. Dcpositors withdrew their money from the

thrifts in favor of money market mutual fundsand other high interest bearing short terminvestments. Deregulation of the mortgagemarkets increased competition from thecommercial banks and specialty mortgagelenders. Thrifts tried to adapt to the newmarket conditions by buying increasinglyexpensive short-term money (throughCertilicates of Deposit) and directed theirlending activities into high risk short term realestate development schemes. The result waswidespread failure and a drain on theGovernment-sponsored insurance fund whichwas itself bankrupt.

Despite this spectacular tum of events whichreceived widespread publicity, the resilience ofthe U.S. economy was such that the mortgagemarkets emerged strengthened, if anything,from the experience. The markets adapted tothe high nominal cost of money via a shin toAdjustable Rate Mortgages and dcvelopmentof a major secondary market for mortgage­backed securities sold in the capital markets.

Today the U.S. residential mortgage market isdivided about equally between the three majortypes of institutions: the thrifts who survivedthe crisis of the 1980s. the commercial bankswho entered the market in a big way, and thespecialty mortgage originating institutions. Allthree Iypes of financial institutions rely heavilyon the ability of the capital market to absorbhuge amounts of mortgage-backed securities

Previous Page Blank SR.",'/' Page 77

through thc intCl1l1Cdilltion of thrccgovcmmcnl.spon:lOrcd sccondnry I1Illrkctinstitutions, FNMA (Fanny Mne), FIILMC(Freddic MIlC), and GNMA «jinny Mac)Fnnny MIlC, created hy the (iovemmcnt duringthc depression of the 1930s, WIlS whollyprivlltized in I%8, lind is hy fill' the largestfactor in the secondary markct. II huys themortgages of some 2700 participntinginstitutions and in March 1994 had days whenit was originating up to lJ8$20.0 billion in newsecurities. This amount is equivalent to thecurrent annual lending ratc of thc World Bank.

Developing economics have gencrally had lesssuccess in coping with inflation. The firstcasualty of high inflation and concomitant highinterest rates is usually the long-tenn mortgagemarket. The breakdown of the long-tenn, fixednominal rate mortgage contract in the face ofinflation and the difficulty of replacing it withother contractual fonns has led to the virtualdisappearance of private, unsubsidizedmortgage lending in many developingcountries.

Economists have long studied thisphenomenon and discovered a rather simpleexplanation, which resides in the nature of theannuity payment contract. The higher thenominal rate of interest, the higher is theproportion of interest in the early yearpayments. This results in initial paymentswhich are not affordable to the vast majority ofthe population and is described as the annuity"tilt" which, although in large part artificial, isnonetheless real. The effect is that contracts aredistorted and therefore inequitable; borrowerscannot afford the payments in the early yearswhen they pay too much interest; lenders arepenalized in later years when the interestportion of the equalized payment is too low.The result is that few contracts clear the marketat these high nominal rates. The experience ofthe HFCs in Pakistan tends to confirm the"tilt" at work. Both operating companil~s

lending at nominal rates of 20 percent perannum report that only a small percentage ofpotential borrowers can afford these rates.

One solution to the problem of inequitablecontracts created by inflationary distortion isprovided by the Dual Indexed Mortgage

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(DIM), which hns hccn succcssfullyimplcmcnt~'d in Mexico in rcccnt yellrs lllld isbcing introduced in Ilungllly nnd other fonnersocialist economics.

In the ()uallndexcd Mortgage, the principalbulancc outstanding is adjusted nnnually to anIIgreed Indcx, say the CPt. Paymcnts of theborrower, in tum, arc pegged to a pcrcentage ofannual incomc, say 30 perccnt maximum. Asthe borrowers wages 01' other income rises overtime (largely inflation adjusted) so do nominalmonthly payments. The fundamental equity ofthis kind of contract was perceived hy thefinancial institutions and the gcneral public inMcxico, and is now the generally lIcceptcdmortgage instrument in that econol1lY.

An example of a DIM was calculatcd andcompared to the typical 12 year, 20 percentannuity offered in Pakistan. Worthy of note isthe fact that the DIM carries about a threepercent annual cushion, the amount by whichthe wage index might lag behind the CrI orother index applied to the principal payments.The effect of a mismatch in indexing mayresult in payments extending beyond thenominal 12 year period. The risk of loss is sosmall, however, in tenns of the Present Valueof money, that in Mexico the financialinstitutions are witling to cap a contract andabsorb any eventual residual loss. In Mexicothe terms are typically a nominal IS yearmortgage with payments capped at the end of20 years.

'In Pakistan the impact on affordability of aDIM such as illustrated in the example isdramatic. Initial monthly payments are abouthalf on the same amount of borrowing. Evenwith a lag in payments of about three percentper annum, which is extremely unlikely in agrowing economy over the long term, thecontract could be capped after a 15 year periodwith a residual amount of only Rs. 518 (to bewritten otT) on an original loan of Rs. 1,000,00

It should be pointed out that indexation ofloans is not permitted in Pakistan today. Thepurpose of this example is to show how onetype of indexed mortgage could function inPakistan in the event circumstances permittedthis type of mortgage.