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Contract Savings for Housing(Bausparen)

- Subsidies and System Performance -

IFC & Russian Banking Association WorkshopMarch 12, 2008

Moscow

Hans-Joachim DübelFinpolconsult.de, Berlin

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List of Contents

Rationale for savings subsidies in general and CSH in particular

Mechanics of CSH subsidies & fiscal costs, comparison to Russian Law Proposal

Case study Czech Republic vs. Slovakia – impact of subsidies and system performance

Discussion

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1. Rationale for Savings Subsidies

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Rationale for Savings Subsidies in General

Reduce leverage and risk of overindebtedness (US crisis)Level playing field with mortgage subsidies (e.g. interest

deduction)Reduce default incentives Reduce loss given default for the debt investorCreate access to finance for low-income households Improve ‘ownership’ of the financing, incentives for

borrower to behave financially responsible

Milton Friedman:“There are only two types of money: my money and your

money”

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A Specific Rationale for Supporting CSH?Pro:CSH is an access to credit mechanism like mortgage insurance (protecting

first mortgage holder), which often are publicly provided/subsidized.CSH creates unique long-term prepayable fixed rate mortgage (comparable

to main US product), which private sector otherwise doesn’t deliver.Subsidy may be the only means to reduce mismatch risk (CSH daily callable).Con:CSH often primarily used for non-access purposes (e.g. modernization).Capital markets may offer long-term fixed-rate mortgages.CSH may lead to fragmentation of the financial market (esp. if special bank)Actual lending and access performance very difficult to monitor.

Principle should be to treat access/high-LTV mechanisms alike – esp. CSH and mortgage insurance and high-LTV bank lending. Problem: mismatch risk.

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2. Mechanics of CSH Subsidies

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Main types of CSH subsidies

Tax exemption on savings interestCSH premium subsidyCSH loan interest tax deductionSubsidies on the institution level

Often cumulations without consideration to distortions, total fiscal costs, targeting

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CSH Premium Subsidies – Key Questions

Where are subsidy rules laid down? CSH enabling act or annual budget? Defines ability of policymaker to change economics.

Minimum savings period? Decisive about ‘subsidy yield’.Basis of subsidy payments? New savings vs. savings plus

accrued interest.Subsidy ratio, max premium level?Income limits, age limits for children?Shall good brothers (savers-only) be entitled to subsidies?

Devil lies in the details, as will be shown shortly..

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Slovakia: Subsidies in the Annual Budget Law

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

20.0

1997 1998 1999 2000 2001 2002 2003 2004 (e)

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

20.0

BausparPremium

Tax Exemption

5/6 Yr. SavingsRate

Average BankDeposit Yieldafter Tax

Depressed returns ex-post, as premiums

were reduced

Allowed for downward adjustment as rates declined from the late 1990s on.

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Czech Republic: Subsidies in the Enabling Law

Created huge excess subsidies as market interest rates declined.

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

1997 1998 1999 2000 2001 2002 2003 2004 (e)

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

BausparPremium

Tax Exemption

5/6 Yr. SavingsRate

1 Year DepositYield after Tax

SAME Enabling Law as Slovakia *1992

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Fiscal Costs ComparedSlovakia subsidies

initially huge, then much reducedStarted with 40%

premium level, reduced already around 98 to 15%.

Czech Republic continued moderately high subsidy, which became large as market interest rates declined. Started with 25% premium

level, reduced in 2004 to 15%

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Minimum Savings Period is a Crucial Parameter – a Simulation

Subsidy is given only ONCE per savings cohort , i.e. the last is always the most profitable

The longer the savings must be held in the account, the lower is their return.

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Minimum Savings Period – 2 Years is too Short

In CZ tied to takeout of an interim/advance loan, i.e. dual excess subsidy: CSH institution can invest

CSH deposits at market rates

Borrower receives large subsidy for short savings period.

Solution is to allow for interim/advance loans but force savers to continue to save, later prepay (Germany), OR reduce subsidies for shorter savings periods.

Return per savings cohort by holding period

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Subsidy Structures ComparedRussia Germany

Status proposal 2006 bis 1992-2003 2004 bis 1992-1997 2004

Subsidy rules enabling law special law

Min savings period, housing use 2 years 7 years 2 years 2 years no constraints 1.5 years

Min savings period, savings only 5 years 7 years 5 years 6 years no constraints 6 years

Premium ratio 20% 8.8% 25% 15% 40% 15%

Basis of premium New savings & interest New savings

Maximum premium basis E 1,918 E 1,024 (couples) E 600 E 800 E 357 E 571

RUR 70,000) E 512 (singles) CZK 18,000 CZK 20,000 SKK 15,000 SKK 20,000

Maximum premium E 384 E 90 (couples) E 150 E 120 E 143 E 86

RUR 14,000 E 45 (singles) CZK 4,500 CZK 3,000 SKK 6,000 SKK 3,000

Income limits None E 51,200 (couples)

E 25,600 (singles)

1 Euro = approx. 36.5 RUR 30 CZK 25 CZK 42 SKK 35 SKK

Slovakia

annual budget law

None

New savings New savings

None

enabling law

Czech Republic

Premiums often lead to returns exceeding market deposit rates.Fairly generous premium levels – esp. considering income levels.No income targeting outside Germany.

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Czech Republic: Growth without Limits At peak time, numerically 63% of Czech inhabitants had CSH contracts.

Children, elderly enrolled to maximize subsidies per household.

In 2004 reform, despite changes in subsidies, government was unable to impose minimum age for children.

Means also limited screening function of pre-savings for mortgage lenders.

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Limit Subsidies to Loan Takers only?2006 French Epargne Logement reforms tied savings premia to actual

loan takeout. In open systems rational, as savings premia are mere subsidies

distorting competition of deposits with capital market funding further. In France EL funds were channeled to non-EL mortgage uses, at some point supported 30% of mortgage lending.

In closed systems, good brothers (savers-only) are needed to stabilize liquidity and minimize waiting periods. System would require much higher reserves without. Subsidy also reduces mismatch risk.

Government should tie support to global loan-deposit ratio, generate incentives to keep good brother ratio low (e.g. min savings period).

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3. CSH System Impact: Case Study Czech Republic vs. Slovakia

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Dimensions of CSH System Impact

Profitability impactFinancial sector structure impactHousing sector structure impactFiscal impact

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Profits of CSH Institutions Compared

Czech CSH institutions ran into market rate decline 2000/01 with too high deposit rates.

PSS quasi-monopoly.

Return on equity

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Slovakia: MOF Opposed Repatriation of Profits

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

% o

f A

sset

s

EBTD

Additions toReserves

DisclosedProfit

Source: P.S.S., author’s calculations. Notes: EBTD – Earnings before Taxes and Depreciation.

P.S.S. CSH institution with RoE of 40-60% initially.

Reason: ‘Austrian’ subsidy model - up to market deposit rate. No CSH borrowing initially.

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Czech Republic Created Strong Financial Market Distortions

Slovakia

-5%

0%

5%

10%

15%

20%

1994 1995 1996 1997 1998 1999 2000 2001 2002

Inte

rest

rat

es/P

rem

ium

s

0%

2%

4%

6%

8%

10%

12%

14%

16%

CS

H D

epo

sits.% o

f Term D

epo

sits

Interest rates,l.h.s.

BausparPremiumYieldAdvantage,l.h.s.

CSH Depositsas % of TimeDeposits

0%

2%

4%

6%

8%

10%

12%

1994 1995 1996 1997 1998 1999 2000 2001 2002

Inte

rest

rat

es/P

rem

ium

s

0%

5%

10%

15%

20%

25%

CS

H D

epo

sits % o

f Time D

epo

sits

Interest rates,l.h.s.

BausparPremiumYieldAdvantage,l.h.s.

CSH Depositsas % of CZKTimeDeposits,r.h.s.

Czech Republic

CSH deposits in excess of demand leads to reinvestment into other eligible asset, esp. covered bonds. CZ as a result has some of the lowest covered bond interest rates.

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When CZ Was Forced to Reform, new Contract Originations Collapsed

Demand stop-and-go not healthy for liquidity management.

Wider distortions for financial system and savings ratio.

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Reducing Subsidies Takes Time due Lag Effects

Still under new subsidy formula (2004) considerable subsidies, as these are paid over 5 years per cohort

until 03 04 reformsmax support 4.5K max support 3K CZK

min savings 5 yr min savings 6 yrsmax amt 18Ksupport 25% support 15%

02 reform allowed interim/advance loans

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Incentive and Performance Problems of Czech CSH Institutions Extremely low loan-to-

deposit ratio due to excessive subsidies, absence of second mortgage concept, no pressure on institutions to lend directly (securities).

PSS Slovakia, German Bausparkassen run almost 100% loan-to-deposit ratio.

Government indirectly stimulated interim loans.

System cannibalized itself by depressing market rates indirectly – interim loans per 07 almost same rate as CSH loans.

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As before, in total CZK million

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Portfolio Composition of CSH LendersTable 10 CSH Loan Portfolio Composition, Slovak Republic 2001 P.S.S. VUB-Wuestenrot

Modernization 37.0 35.1 Transaction (housing and land) 39.9 33.1 New construction 23.0 16.2 Other 0.1 15.3 Sources: Annual reports of P.S.S.and VUB-Wuestenrot.

Table 21 CSH Loan Portfolio Composition, Czech Republic June 30, 2002 Entire industry

Modernization 39 Transaction (housing and land) 39 New construction 17 Other 10 Source: Roy (2003).

Primary business is modernization and small real estate transactions (old housing, land). 100,000s of small loans.

Per 2007 relevance also in rental housing modernization.

Reason for low new construction relevance is absence of option to finance ‘senior-sub’ with a first mortgage lender.

Possible in Russia?

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Czech Republic: Dynamics of CSH and Mortgage Lending has Diverged

Outstanding loan volumes in billion CZK

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Positive Spillover Effects for Stability of the Mortgage Market?

Czech market more stable than neighbours (related also to use of covered bonds, fixed-rate system), but also more subsidized.

CSH savers receive “ca 50bp” margin discount from mortgage lenders (lender).

Distribution system is enhanced(Slovakia better than Czech Republic)Modernization lending important in ageing economies. Small loans support lower-income households without access to credit.

House price income ratio in Czech Rep House price income ratio in Poland

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Russia ConsiderationsPro Con

Banks require partly large downpayments – CSH facilitates

In some corners, unsound practices (high LTV, CHF/JPY lending)

Foreign bond markets volatile, accessible only to few banks

Deposit funding share too low High RUR interest rates, CSH

can isolate for a part of the financing

High house price inflation makes high LTVs and pre-savings attractive .. This may lead to risky

CSH practices (high multipliers, low ISFERs)

Recent banking crisis (2004), i.e. how many banks can credibly handle scheme?

Small branch networks, high distribution costs of deposits

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Russia Mortgage Funding Structure

Position Billion USD Billion USD Position Percent

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

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

Total assets 30 30 Total liabilities 100%

Assets Liabilities

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System has Value, But the Costs must be ContainedAvoid new banking and insurance sector

fragmentation Integration into universal banking frameworkCapital, investor regulation delicate (high-LTV market)

Sound regulatory structure to contain crisis costsSpecial regulation needed

Create legal preconditions CSH needs possibility for senior-sub legal structure,

stand alone problematicLimit and target subsidies

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END

Hans-Joachim (Achim) Dübel

Finpolconsult.de

aduebel@finpolconsult.de

www.finpolconsult.de