Contract Savings for Housing (Bausparen) - Basic Design and Regulations -

1. Contract Savings for Housing(Bausparen) - Basic Design and Regulations - IFC & Russian Banking Association WorkshopMarch 12, 2008Moscow Hans-Joachim Dübel Finpolconsult.de, Berlin

2. List of Contents • Types of CSH contracts and risk profile; access to loans; pricing conditions; differences to mortgage banking; • Liquidity (demand) management of CSH portfolios; • Interest rate/solvency management of CSH managing institutions; • Credit risk management of CSH managing institutions; • Institutional models (Public fund, Housing Bank, Bausparkasse, Building Society, Universal bank); • Financial regulations of CSH managing institutions (special bank act, special product regulations, etc..).

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

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

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

6. Two Types of CSH Systems Closed System Open System • Rule: Inflows = Outflows •  No capital market funds needed • Pricing can be fixed • Loans are small (S ~ L) • Outflows > Inflows possible  Capital market funds needed to fill gap • Pricing cannot be fixed • Loans can be large (S > L)

7. Comparison Germany (closed) and France (open) Also, semi-open systems exist with fixed real interest rates over saving and loan outstandings adjusted with inflation indices (e.g. Slovenia) In the end, only closed or semi-open systems bring sufficient additional value as they are able to create fixed-rate loans largely independent from capital markets circumstances.

8. Closed System – Fixed-Rates and Waiting Phases • The CSH institution decides about an allottment, if there is enough capital. • Since new savings are stochastic, waiting phases may arise. They must not be excluded in German law. • “Good brothers” (savers-only), reserves and strict asset-liability management rules help to minimize risk of waiting periods.

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

10. 2. Liquidity and Interest Rate Risk Management

11. Contract Valuation Principles • There are 3 elements of value in a CSH contract for consumers: • Savings product: but usually below market, except subsidies • Interest rate option: fixed-rate long-term loan promise in the future, with interest rate being locked in today • Credit risk option: CSH interest rate does not change during savings phase, but the creditworthiness of the borrower may – or may be low to start with and savings signal his ability to service a loan. These values change with market conditionsdemand for CSH contracts changes with market conditions.

12. Value of the Interest Rate Option • When is closing a CSH contract of greatest value? • When interest rates are currently low and expected to increase in the future. • When the volatility of interest rates is high • AND VICE VERSA !! Interest rate options may have considerable value, e.g. in 4-5 years from now 30-50 bp. The interest rate option ALONE should suffice to encourage a consumer to save below market.

13. CSH contract demand in Germany and Capital Market Rates • In the past 20 years close inverse correlation with interest rates. • Distortions in the high inflation phase (1980s crisis due to long waiting periods).

14. Allocation of Loans must Follow Strict Rules, Even if Interest Rates Do Not Change ! • Liquidity in the collective is a function of four factors: • the minimum amount of savings required for loan eligibility, • the length of the minimum savings period relative to the loan term, • the loan-to-savings multiplier, • the number of ‘good brothers’ (savers who do not take loans) relative to the totality of the saver collective. • Loan demand must be proportional to contribution; key contract steering variables are the individual and collective ‘Saver-Fund Effort Ratio’ – basically the ratio of accumulated savings to the financing demand.

15. Result of Rational Contract Design: Stable Liquidity Profile • Loan-to-savings multiplier of 1-1.2 • Initial liquidity surplus, invested in reserves to fill subsequent liquidity gap as loans start to get disbursed • Reaches steady statewhere Savings inflows + principal repaymt = Loans outflows.

16. High-Multiplier Contract Design ends in a Snowball Game • Loan-to-savings multiplier of 7 (Case: Iran) • Initial liquidity sur-plus, as before, yet cannot fill large sub-sequent liquidity gap • Does not reach “Steady-State”, I.e. Savings << Loans Only solution: “open” funding model, market interest rates

17. Central Risk Management Indicators: Saver-Fund Effort Ratios German Bausparkassenverordnung • CSFER must always exceed 1 - by law, for EACH scheme/contract type. • ISFER must always exceed 0.5, for NEW schemes always exceed 0.7. • Minimum allottment number (Mindestbewertungszahl) to control ISFER for different types of contracts.

18. Contract 1: “Stable” Savings period = 5 years Loan multiplier = 1.2 Waiting period 65% loan takers High individual and collective Saver-Fund Effort Ratio, although many loan takers. Contract 2: “Unstable” Savings period = 3.5 years Loan multiplier = 7 Waiting period = none 25% Loan takers Low individual Saver-Fund Effort Ratio, low collective ratio even although few loan takers. Stable and Unstable Contract Types – Captured by Effort Ratio Formulae

19. Effort ratios compared: Bausparkasse, Building Society (open system), Iranian lender Individual Saver-Fund Effort Ratios

20. Technical Reserves Must be Held for Liquidity Management, to Minimize Waiting Period Germany: ‘bauspartechnischerSicherungsfonds’, introduced in 1990 (Bauspar crisis in the 1980s, long, volatile waiting periods triggering demand decline) • Specification of reserve fund (up to 3% of CSH deposits) to cover fluctuations in fund flows – reserves increase if savings>loans. • Sponsored by interest revenues on non-allotted amounts (Schwankungsreserve), from the excess of such revenues over comparable CSH revenues. • Fund use (‘can’, ‘must’) triggered by indicators – effort to stabilize ISFER when liquidity situation changes. Note: the higher interest rate (contract demand) volatility, the higher must be technical reserves

21. 3. Credit Risk Management

22. CSH Loans in Germany usually ‘Senior-Sub’ 20% Downpayment 10-20% Bauspar funds (SUBORDINATED) 60-70% Mortgage (SENIOR) Legally possible in Russia ! (not CZ) Reason: Bauspar loans are small, compared e.g. to new construction costs In Austria, Bauspar frequently first rank. = 100 % of the purchase price

23. Credit Risk Management Issues • Typical regulations: • LTV of loan part (contract value = loan + accumulated savings) not exceeding 80%, i.e. CSH funding goes from, say 70% - 90%. • Share of non-collateralized lending is usually limited by law (e.g. Loans < E20K). • CSH institution has the right to refuse borrowers. • Risk-mitigating factors • Loan is below market rate. • Interest rates are fixed over whole lifetime of contract, also no Basel II pricing. • Consumer has signalled affordability through pre-savings. • Risk-increasing factors • Rudimentary underwriting process. • CSH frequently subordinated – senior-sub structure.

24. CSH and Credit Risk Pricing, Competition • Case: senior-sub lending • Bank (and Bausparkasse) capital requirements tend to create gap between economic and regulatory costs of capital. • Bausparkasse prices at the margin (i.e. 6% for 70-80% LTV), banks on average (i.e. 5.5% for 0-80% LTV, but 5% for 0-70% LTV) – which option is cheaper? • Competition with mortgage insurance, agency lending creates regulatory, policy fine-tuning problem.

25. 4. Regulation

26. Examples of CSH regulations • Special bank: Germany, Austria, Czech Republic, Hungary. Idea is to fully separate collective fund and liquidity risk management. • Universal bank: France, Maghreb countries. Open systems = low liquidity risk. Usually licensing. • Special funds: Latin America and Asia, frequently as monopolistic public provident funds collecting wage taxes (often lottery effects). • Housing banks (special regulation): Iran. • Unregulated: • joint venture between the German Bausparkasse Schwaebisch Hall, a special bank in Germany, and Construction and Credit Bank of China, in Tienjin/China. China practices mandatory CSH in public funds in parallel. • Also, the Indian scheme set up by Birla homes so far is unregulated. Both schemes are very conservative and managed by experienced German lenders.

27. Are Special Banks Needed Economically? Generally, open systems more suitable for universal banks (France). Closed systems are run by universal banks (Slovenia). Closed systems need firewalls, licensing due to high risks. Fund mixing not an option for closed systems.

28. Austrian Bausparkassen are quasi-Building Societies • 1998: market rates dropped below Bauspar rates prepayments. • Product converted from fixed-rate to floating-rate with caps (i.e. semi-open system) • Balance sheet opened to allow Bausparkassen to offer mortgage loans, issue bonds/MBS.

29. Special Product Regulation – Fund Managed on Universal Bank Balance Sheet Presupposes segregability of assets from bank balance sheet (super-seniority). Comparable to covered bonds/Pfandbriefe (special insolvency privilege). Alternative is US trust. Fund supervised by trustee or auditor. Bridge loan = advance/interim loan.

30. In this Case: Cash Flow Rules To avoid excess profits as in CZ/SLK: CSH fund pays manager an investment fee and a profit share. In exchange receives an interest in non-CSH investments. Under special bank, profits are entirely internalized with the fund manager.

31. If Profits can be Fully Internalized by Special Bank.. Czech Republic: Bausparkassen mainly give interim/advance loans at market rates. Options: special reserve funds, profit allocation rules.

32. Basic Contents of a Law I • General Regulations • Core and admissible range of operations • General contract conditions and consumer information • Relation between CSH Fund and Fund Manager • Special purpose character of the CSH Fund • Firewalls between CSH and other operations of the manager • CSH depositors are secured and enjoy bankruptcy preference • Investment in CSH loans • Investment in interim/advance loans and other loans • Other investment rules • Profit allocation rules

33. Basic Content of a Law II • Risk Management Regulations • Suitability of the Fund manager • Collateralization and other sureties • Underwriting standards • Valuation standards • Individual Saver-Fund Effort Ratio (ISFER) • Collective Saver-Fund Effort Ratio (CSFER) • Protection of the real value of CSH deposits • Mandatory technical reserve fund for CSH specific liquidity risks

34. Basic Content of a Law III • Supervision • Rights of supervisors • Trusteeship and relation to supervision • Reporting and auditing standards • Approval of new tariffs or product-lines • Approval of loan transfer

35. Russian Law Proposal Compared • Standard special bank law • Problematic issues: • Collateralization requirement for loans: Russia ‘can’, German ‘must’. • Lower Bauspar-technical reserves - 1.5% vs. 3% in Germany, Russia ideally ~5%. Note: initial excess profits should be reserved. • Investment in Russian (corporate) covered bonds? • 80% interim/advance loan limit too high (CZ/SLK experience) German law: max 75% (used to be 8*capital), short-term loans (<=4 years) • If special bank is created, profit allocation rules should be improved. E.g. German insurance: 90% of excess profit to be allocated to the collective. • Special (group) deposit insurance system? No private whistleblower function at the moment. • No risk management ordinance (Bausparkassenverordnung). • No finetuning of regulatory issues – re mortgage insurance, covered bonds.

36. Some Consumer Protection Issues in CSH • With fixed spreads (Russia proposed 3%), CSH institutions make their profits to a large degree on fees. • Fees are anticipated to the savings phase to avoid their inclusion into the loan effective interest rate (annual percentage rate of charge, APRC). • Loan effective interest rates are distorted since they do not account for savings below market rates. • APRC concept should require full discounting of all savings and loan payments, i.e. Include both savings and loan phase. • Counterargument of insecurity about a possible waiting period is irrelevant in practice.

37. END Hans-Joachim (Achim) Dübel Finpolconsult.de aduebel@finpolconsult.de www.finpolconsult.de