Mortgage Finance in Transition Countries--Learning from Common Mistakes
by Raymond J. Struyk

Hungary, Poland, and Russia addressed the development of mortgage finance comparatively early during their transition. They have generally succeeded in putting in place the necessary legal base for mortgage lending and in launching responsible lending operations. They were also able to remove the vast majority of home ownership subsidies from the banking system. High marks go to Russia’s support of home purchases through its down payment subsidy scheme. Nevertheless, some policies were not optimal, and countries that are just now developing their mortgage finance system may be able to learn from these experiences.

• Poland now has elements of the German mortgage system. The bausparkassen system is a closed system in which mortgage loans from specialized housing banks are funded exclusively from the savings of future would-be borrowers. Because it is a closed circuit—only the funds saved are lent—interest rates on both savings and deposits can be substantially below market levels, with borrowers subsidizing themselves by accepting low interest rates when first saving. Mortgage banks are components of the rapidly developing mortgage loan market. The government supports home ownership through deep tax subsidies to those households purchasing new units.

• Russia’s financing model is one of commercial banks working with a nascent refinancing facility. Here too home purchasers receive costly tax benefits, but in addition, down payments by moderate-income families are subsidized. Commercial banks act as loan originators together with a liquidity facility, the Agency for Housing Mortgage Lending. The agency is an open joint stock company, initially fully owned by the government, that purchases mortgages in much the way Fannie Mae operates in the United States. However, because credit and liquidity risks have made banks reluctant to originate loans, a number of builder-financed operations have also emerged, along with some bank-operated contract savings schemes. These schemes are numerous and probably assist with the purchase of more units each year than formal mortgage lending. Moreover, a number of oblasts (regional governments) and municipalities have initiated interest rate buy-down subsidy schemes with their own budget funds. These schemes undermine the demand for market rate mortgages from banks.

• Macroeconomic stability. As illustrated starkly by the Russian case, and to a lesser degree by conditions in Hungary and Poland, even with a good legal and institutional framework in place for housing finance, little borrowing for home purchases will occur when the economy is characterized by substantial turbulence. High interest rates and uncertain future incomes discourage borrowers from taking long-term loans, and instability increases banks’ exposure to the credit, interest rate, and liquidity risks inherent in mortgage lending. Economic stability strongly promotes housing investment by making mortgage loans attractive to both sides of the market.

• Government action. More important than subsidies in inducing banks to make mortgage loans with at least a five-year term is a strong mortgage law that minimizes the credit risk associated with lending. While this sounds obvious, some Commonwealth of Independent States countries still prohibit eviction in the case of foreclosure when a home purchase mortgage loan is in default. Beyond this, judges need training in any new mortgage-related law and senior judges need to review early rulings to be certain that they are in line with this law and that judges are not still invoking Soviet legal principles. Reliable, accurate, and prompt title registration systems are also a necessity. Finally, the government, working with local bankers’ associations, must develop training programs to ensure proper loan underwriting and servicing, which will help minimize credit risk.

• Specialized instruments, not special institutions. The development of housing finance in the Visegrád countries has been dominated by the creation of institutions to execute special tasks: bausparkassen for housing-linked contract savings schemes and mortgage banks to attract funds from capital markets to housing lending. The disadvantages of this approach are clear. New institutions are costly to develop, take time to become operational, and make the whole housing finance system inflexible. While specialization has its advantages, countries initiating the development of their housing finance systems would be well advised to rely first and foremost on universal banks.

• Best home ownership subsidies. If a government determines that assisting with home purchases is a priority for the nation, then experience shows that three attributes are most desirable. First, it should make subsidies demand-side subsidies. The best among these are down payment subsidies of the type implemented in Russia. Second, it should target subsidies to lower- and moderate-income households, with larger grants going to lower-income families. Third, it should avoid long-term budgetary commitments, such as multiyear subsidies to lower interest rates on mortgage loans. Such commitments limit a government’s ability to shift programs in response to changing conditions in the country. Incremental funding also often causes legislators to underestimate the total cost of the commitments they are making.

• Wrong home ownership subsidies. The list of subsidy mechanisms with undesirable features is long. Prominent entries include the following:

• Permitting interest rate write-downs.

• Capital markets. Obtaining funds from capital markets is a way of obtaining funds for financing mortgages, particularly in countries where the banking system is characterized by low liquidity and banks’ liabilities are concentrated in short-term instruments. Despite its putative attractiveness, no country in the region has yet succeeded in systematically channeling funds from general capital markets into housing loans. Neither mortgage banks nor liquidity facilities have proven themselves.

• Rental sector: the essential complement. Some governments in the region used mass privatization as a way of trying to wash their hands of the enormous rental housing responsibilities they formerly held. In other countries either the national government or local governments have used the municipal (former state) housing stock as an economic shock absorber, keeping rents low to cushion the impact of adverse economic developments. A few, such as Poland, continued this policy long after strong economic growth kicked in. Government policy for the rental sector has a dual role. Obviously, the longer rents are controlled and kept far below market levels while tenants’ rights are kept strong, the weaker are renters’ incentives to spend more of their own money to become homeowners. At the same time, a functioning rental housing market is needed to provide housing to those who cannot afford or do not want to become homeowners. Controlled rents also discourage private investment in the sector. Hence, continuing reform of the rental sector is the handmaiden of successful and efficient home ownership policies.

The author is senior fellow at the Urban Institute, Washington, D.C., and director of the institute’s Transition Policy Network. This article is based on the overview in the volume Home Ownership and Housing Finance Policy in the Former Soviet Bloc: Costly Populism, edited and coauthored by Raymond Struyk, Sally Merrill, Nadezhda Kosareva, and Andrei Tkachenko and published by the Urban Institute in 2000. For information go to http://www.urban.org/housing/costly-populism.html. To order a copy go to www.uipress.org, or in the United States call toll free (877) 847-7377.