Expansion of private lenders’ participation in housing finance for low income groups under the Brazilian Sistema Financeiro de

Habitação:

Analysis and Recommendations

June 15, 2010

Urban, Water and Disaster Risk Management Unit

Sustainable Development Department

Latin America and the Caribbean Region

The World Bank Group

69702

Abbreviations

a.a. Annual rateABECIP Associação Brasileira das Entidades de Crédito Imobiliário e PoupançaALM Asset Liability ManagementBACEN Banco Central do BrasilBNH Banco Nacional de Habitação (National Housing Bank)BRL Brazilian RealCaixa AO CEF Agente Operador (Caixa’s arm serving as Operating Agent of FGTS funds)Caixa AF CEF Agente Financeiro (Caixa’s arm serving as Financial Agent of FGTS funds)CBIC Câmara Brasileira da Indústria da ConstruçãoCDI Certificado de Depósito InterbancárioCEF Caixa Econômica FederalCH Companhias Hipotecariás (Mortgage Company)CIBRASEC Companhia Brasileira de SecuritizaçãoCRI Certificados de Recebiveis ImobiliáriosCUB Custo Unitário Básico (Basic Unit Construction Cost)FAR Fundo de Arrendamento ResidencialFGC Fundo Garantidor de Creditos FGTS Fundo de Garantia por Tempo de Serviçco (National Severance Fund or Provident Fund)FI-FGTS Fundo de Investimento-FGTSFIF Fundo de Investimento FinanceiroFNHIS Fundo Nacional de Habitação de Interesse SocialGDP Gross Domestic ProductIGPM Indice Geral de Preços do MercadoINCC Índice Nacional de Custos da Construção (National Construction Cost Index)MCMV Minha Casa Minha Vida MW Minimum wageNHP National Housing PlanLTV Loan to valueOGU Orçamento Geral da União (Federal Budget)PAR Programa de Arrendamento ResidencialPEC Proposta de Emenda Constitucional (Proposal of Constitutional Amendment)PSH Programa Social de Habitação SBPE Sistema Brasileiro de Poupança e Empréstimo (the Brazilian Savings and Loan System)SECOVI Sindicato das Empresas de Compra e Venda de Imóveis (the Realtors Syndicate)SELIC Sistema Especial de Liquidação e Custódia (Central Bank’s overnight rate)SFH Sistema Financeiro de Habitação (Housing Finance System)SFI Sistema Financeiro Imobiliário (Real Estate Finance System)TR Taxa Referential (reference index)

1. SUMMARY OF KEY RECOMMENDATIONS

1. Broader access to FGTS funds could have important benefits for the development of the housing finance sector. Lenders are expanding more aggressively in the housing finance market, including a gradual down-market penetration towards the low income housing segment. Competition has already intensified in the middle income segment, which explains why several lenders are now more readily interested to move further down-market. SBPE funds will not be sufficient for such a large expected market expansion, nor will it be the lenders’ preferred source of funds for long-term housing loans due to the inherent asset liability mismatch challenge. The FGTS could step into this role.

2. Participation by the private lenders in housing finance for low-income groups could help the Government meet housing development goals, such as the one million houses to be built as part of Minha Casa, Minha Vida. It would also offer diversification of lending channels to this market segment, which is now currently served only by Caixa Agente Financeiro.

3. The principal obstacles to an expanded lenders’ participation in FGTS lending are both operational and financial. Specifically, the main operational challenges include complex procedures for loan approvals and disbursements, and the delays in processing the funds. Several suggestions for streamlining the processes are proposed, including: (i) establishing target lending volumes for disbursement of FGTS funds; (ii) simplifying the rules; (iii) abolishing the second review of the loan files by Caixa Agente Operador and introducing a system of delegated underwriting; (iv) resolving asset/liability management issues; (v) resolving the issue of the Caução Hipotecária; and (vi) reviewing the organizational structure of the FGTS trustee function.

4. By contrast, the issue of remuneration would be more difficult to address in the short-term, although some targeted improvements related to the risk fee (taxa de risco) and the capped upfront remuneration (limitador) may be feasible. Revisiting the spread calculation is also a key recommendation. According to the Secretariat of the Conselho Curador, the 2.16% spread was calculated based on the average spread of the 6 minimum wage income bracket from Caixa Agente Financeiro’s historical portfolio performance and relied on cross-subsidization from higher to lower income brackets. The calculation was to serve a four-year timeframe and be subject to subsequent revision. While it was beyond the scope of this note to evaluate the adequacy the spread, the idea of envisaging an approach to incentivize private lenders to enter the FGTS market is important, especially if a detailed review of the spread calculation demonstrates that it effectively constitutes a barrier to entry and a barrier to operations in the long-run. Should incentives be required, it would be important that these (a) are adequately calibrated and withdrawn over time when economies of scale are achieved, and (b) do not come at the expense of excluding borrowers or increasing their costs.

5. Two approaches to facilitate lenders’ access to FGTS funds are presented. The first approach is to adopt a strategy of small incremental improvements, which mainly seeks to resolve smaller issues, mostly of an operational nature, without questioning the existing modus operandi of the system. The second approach would hinge on the transformation of the current FGTS structure by giving a stronger mandate to Caixa Agente Operador’s role as second tier lender, a role that is hoped would make it a stronger catalyst to the development of the housing finance market.

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2. INTRODUCTION 1

6. The Minha Casa, Minha Vida Program (MCMV), launched by the Federal Government in March 2009, provides a large package of subsidies to stimulate the construction of one million new affordable houses within a three year period. This is aimed at reducing by 14 percent the existing housing deficit in Brazil (estimated in 2007 at 6.3 million units) and contributing to employment generation in the context of the economic crisis. In addition to providing immediate stimulus to the economy, the program is targeted at the low-income segment of the population (beneficiaries are households earning up to 10 minimum wages, with 800,000 units intended for those with incomes up to 6MW).2 Program funds amount to BRL 34 billion, mostly in subsidies from the Orçamento Geral da União (OGU—the Federal Government’s budget) with support from the Fundo de Garantia de Tempo de Serviço (FGTS).

7. The main entity responsible for program administration is the Government-owned Caixa Ecônomica Federal (CEF), with its two arms: Agente Operador (the operating arm of FGTS funds) and Agente Financeiro (the lending arm). Despite its market share and substantial experience in low-income housing lending, the responsibility of single-handedly achieving the target of one million new housing units within this tight time frame would be a tall order for CEF.

8. Expanding private lenders’ participation in housing finance is therefore an imperative if Brazil is to address its significant housing shortfall and address housing needs over the short- and medium-term in accordance with the National Housing Plan (NHP), as well as to ensure the achievement of MCMV targets.

9. The Ministry of Finance (Fazenda) as well as the Ministry of Cities (MCidades) aim for a stronger involvement of private lenders within the SFH. The FGTS Conselho Curador (Council) also expressed a strong desire to increase the number of lenders in the FGTS distribution channel. The CEF Agente Operador (hereinafter referred to as Caixa AO) has expressed openness to discuss changes to the current administrative regime as a means of easing the administrative burden for lenders seeking to access FGTS funds.

10. The openness of the Government and the Conselho Curador to discuss changes is an important signal to private lenders which are interested in expanding their mortgage lending operations down-market. In this context, such interested lenders are seeking improved access to FGTS funds. The larger private lenders in Brazil have already tested the current regime of FGTS, but have encountered numerous difficulties. These difficulties are also faced by Caixa Agente Financeiro (hereinafter referred to as Caixa AF) and Banco do Brasil.

1 This report was prepared by a team comprised of Sameh Wahba (Sr. Urban Specialist, LCSUW, and Task Team Leader), Friedemann Roy (Sr. Housing Finance Specialist, GCMNB), Eric Klesta (Housing Finance Consultant) and Eduardo Rottmann (Housing Consultant), with inputs from Claudia Eloy Magalhaes (Housing Consultant) and with guidance from Loic Chiquier (Manager, GCMNB). This report integrated comments received during the roundtable organized by the Ministry of Finance’s Secretariat of Economic Policy on January 28, 2010, which was attended by the Ministry of Cities, the Ministry of Finance’s Treasury Secretariat, the Secretariat of the FGTS Conselho Curador, and representatives of private lenders, Caixa Agente Operador, Caixa Agente Financeiro, and ABECIP, as well as the written comments received subsequently from the Ministry of Finance’s Secretariat of Economic Policy and Caixa Agente Operador (Superintendência Nacional of FGTS). This report was finalized prior to the 0.75% increase of the SELIC rate to 9.50% on April 29, 2010 and thus has not taken into account its effect on the housing finance market.

2 1 MW is BRL 465.

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11. The report is organized as follows. The first section provides a concise analysis of the SBPE and FGTS systems. It also argues in favor of expanding the use of FGTS funds in light of the funding mismatch that characterizes SBPE. The second section assesses the merits of increased access to FGTS for the development of the housing finance sector for low-income groups and analyzes the extent of interest of private lenders to access such funds. The third section provides an extensive evaluation of the obstacles to increased access by (private and public) lenders to FGTS funds. Suggestions are provided on how to reverse the current participation and loan allocation mechanism within FGTS. Proposed changes to improve the administration of the FGTS regime are divided in two categories: (i) operational issues and (ii) remuneration issues. A central element in this context is strengthening the transformation of Caixa AO into a second-tier lender. Annexes to the report present the mechanics of the FGTS system, a summarized overview of the current housing finance situation in Brazil, and developers’ views on recommended changes to the FGTS.

3. FGTS VS. SBPE: ARE THE CURRENT FUNDING SYSTEMS APPROPRIATE TO ENHANCE ACCESS TO HOUSING FINANCE FOR LOW AND MIDDLE INCOME GROUPS?

12. The SFH consists of two subsystems: (i) FGTS and (ii) SBPE. In 2008, SBPE lending volumes exceeded FTGS volumes by a multiple of three. For 2009, the gap is expected to narrow. One reason is the stronger demand for FGTS lending as a result of the MCMV program, which envisages a higher deployment of FGTS funds.

13. Typically, SBPE loans are larger. The average SBPE loan amount in 2008 was BRL 120,000 compared to BRL 39,958 for a FGTS loan. Table 1 compares SBPE and FGTS in view of the benefits offered to customers as well as the practicality and suitability for lenders to meet higher expected demand for housing within the low and middle income segments.

Table 1. Comparison of FGTS and SBPE

FGTS SBPEConsumer viewTarget group Until 6 MW (“Desconto”)

From 6 to 10 MW (incl. “Pro-Cotista”)From 7 - 15 MW

Benefits for consumer

Down-payment function in two ways: (i) savings accrued in the provident fund; (ii) FGTS provides an upfront down-payment subsidy (for households with income up to 5MWs)

FGTS loan interest rate is lower than SBPE loan interest rate (TR + 5% - TR + 8.16%)

Savings instrument (depending on market interest rates)

Interest earned on SBPE deposits are tax exempt

Access to a mortgage loan.3 Rates vary from TR + 9% to TR + 12 % and are typically higher than those of FGTS

Lender viewRisk management The down-payment function

lowers credit risk Liquidity management is less

problematic because financial

Risk management remains under the lender’s control

Lower reserve requirements 4

Substantial mismatch (short term

3 The savings process within the SBPE is separate from a SBPE loan. The savings process is not a prerequisite for obtaining a loan. These are two distinct features of the SBPE.

4 15 % of the SBPE deposits have to be deposited with BACEN (other deposits: 53 %).

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agents obtain long-term funds from FGTS

Access to FGTS is a huge administrative burden for financial agents

Spread may not be enough to cover all cost for the financial agent

deposits are used to finance long-term loans)

Higher spread (4 – 5 percentage points)

Higher funding cost than FGTS funds

Suitability to increase market share in housing finance

Lenders without access to SBPE funds are interested in FGTS

CEF is often perceived as the only provider of FGTS funding by consumers

MCMV Program has a stronger link to FGTS funding

Borrower can combine the down-payment obtained through FGTS with a SBPE loan

Increasing market share depends on inflow of SBPE deposits

14. Private lenders have mainly relied on SBPE as the source of funds for housing finance operations. The design of the SBPE has led to a permanent mismatch with market conditions. The most prevailing risks for lenders are:

Liquidity risk and interest rate risk. The interest rate caps on the savings (TR +6%) and the loans (TR + 12%) complicate liquidity management. For example if market interest rates go up, inflow of SBPE deposits may decrease because investors seek other investments. The breakdown of the passbook balances serve as an indication that SBPE deposits are an interest-rate sensitive instruments. About 40% of the SBPE deposits are held by 1 % of the SBPE passbook holders. Due to the considerable concentration of SBPE deposits among a concentrated number of investors, the SBPE is vulnerable to volatile inflows of savings, even if culturally it has been the preferred and perceived as the most secure investment channel. Ultimately, investors compare the return on SBPE with other returns in the market and could thus withdraw their savings as soon as interest rates of other savings products are higher.5

If market interest rates go down, then a higher inflow of SBPE deposits is expected. Lenders may want to reduce SBPE lending (within the parameters of the mandated use or diretionamento) because they may access cheaper funding outside the SBPE system. In addition, since SBPE deposits are callable on a monthly basis by the saver, lenders have to finance long-term debt with short-term funding instruments. Typically, the tenor of the SBPE housing loans is 20 years. Since SBPE is not linked to a market-based index, lenders are not able to blend SBPE deposits with other funding sources. Thus, the current regulatory regime for SBPE does not allow the lenders to reduce the existing asset/liability mismatch resulting from the short-term deposits and the long-term loans.

Spread compression. With declining interest rates, margins may decrease to a level where the housing finance business is no longer sustainable because lenders cannot reduce the funding cost, which is fixed at TR + 6 % (effectively TR+6.17% and not including the lender’s funding cost associated with the capture of SBPE deposits).

5 During the years 2002 – 2005, investors preferred government bonds over savings deposits due to differences in return between 8 and 12 percentage points. This situation prevailed despite the absence of tax exemptions for government bond interest payments that narrows the yield gap after tax by some 20 – 30 %.

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15. Thus, lenders thus face a dilemma. If market interest rates go up, inflow of SBPE deposits may fade away because investors will buy other investment products. If interest rates go down, lenders are exposed to spread compression. The short-term nature of the SBPE deposits and the resultant asset/liability mismatch when lending long-term may exacerbate the situation for lenders and explain the difficulty of anticipating an expansion of SBPE lending for housing finance. This is especially the case in light of the changes to the SBPE system that are expected to follow the drop in the SELIC rate to 8.75%, including the taxation of hitherto tax-exempt individual SBPE accounts with over BRL 50,000 (currently under discussion) and the inevitable need to rethink their remuneration.

4. WHAT BENEFITS WOULD BROADER ACCESS TO FGTS FUNDS OFFER FOR THE DEVELOPMENT OF THE HOUSING FINANCE SECTOR?

16. Lenders are expanding more aggressively in the housing finance market, which also includes a gradual down-market penetration into the low income housing segment. According to interviewed market participants, even the more conservative lenders currently offer housing loans to borrowers with earnings starting at BRL 4,000 per month (about 8 to 9 MW). Several lenders serve borrowers with incomes lower than this. Competition has already intensified in this segment, which explains why several lenders are now more readily interested to move further down-market. SBPE funds will not be sufficient (nor will they be the lenders’ choice) to fund such a large expected market expansion. By contrast, the FGTS could step into this role. A confluence of several other factors has served to facilitate FGTS’ role and has strengthened private lenders’ interest in accessing such funds. These are presented below.

17. Ensuring the Government’s housing policy objectives are met. The Government has already initiated a number of important programs to alleviate the housing crisis in the country, including most recently the MCMV program to reduce the housing deficit estimated at 6.3 million units in 2007 (Fundação João Pinheiro, 2007). According to the NHP’s projections, the available funds channeled through the SFH are probably not sufficient to meet the financing requirements.

18. Meeting such an ambitious target requires addressing two key bottlenecks. The first is related to building units for low-income families, which requires overcoming the challenges of attracting housing developers down-market, realizing economies of scale to lower unit cost, and resolving land and licensing problems. The second is related to financing the purchase of these units. While the first challenge has traditionally been an intractable problem, market observers point out that the economic crisis has spurred developers’ interest and the Law 11.967/2009 has addressed several of the land and licensing bottlenecks. Thus, the main challenge is how to expand the housing finance industry to enhance affordability. As things stand today, Brazil’s share of mortgages outstanding in relationship to GDP is one of the lowest in Latin America, despite major efforts by Government to enable the expansion of housing finance.

19. From the Government’s viewpoint, the entry of private lenders’ entry would improve the likelihood of achieving the MCMV program targets, especially in light of the tight timeframe. The overall housing finance market would expand as down-market penetration occurs. This is especially important to ensure diversification of lenders in the low-income market, which is currently dominated by CEF.

20. Risk diversification for the Government. According to Law 8.036 of 11 May 1990, CEF serves as the operating agent of the FGTS. Concurrently, CEF is a financial agent for on-lending of FGTS funds to eligible borrowers. In practice, the vast majority of on-lending under FGTS is provided by Caixa AF. The MCMV Program and the NHP envisage a substantial expansion of funds for housing, and if Caixa AF remains the primary lender under FGTS, the fund’s resources would be largely concentrated within one financial institution. This would be a concern if the significant expansion of low-income housing finance is accompanied by weaker underwriting, which has happened before in other countries such as the

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United States. Even if CEF maintains good underwriting standards, the Government’s guarantee remains a contingent liability for the Treasury. From past experience in Brazil, such a contingent liability has proven expensive. In 2001, for example, as a result of a liquidity crisis and high levels of non-performing loans, the Government had to bail out CEF. This fiscal burden was estimated by the Ministry of Finance at BRL 21 billion. Thus, a major expansion of CEF’s lending implies a heightened risk for the Government.

21. Nurturing competition in the low income housing finance market. In 2008, Caixa AF exceeded its lending target of BRL 8.4 billion by BRL 1.9 billion (according to figures provided by Caixa AO). The significant increase in funds under the directed credit system, the large existing housing deficit and the considerable annual housing demand indicate that there is ample room for private lenders, in tandem with Caixa AF, to expand within the low-income market. Moreover, the MCMV program requires Caixa AF to significantly increase its lending volume with a strong focus on financing new units. In regard to its lending experience, however, Caixa has hitherto focused on the used market segment (new lending by mid-2009 was 55 % for used units and 45 % for new units). In contrast, most of the private lenders are active in financing new housing,

22. Desire of market stakeholders to diversify financing channels of FGTS. From the private lenders’ viewpoint, this is an opportune moment to access FGTS funds because of the importance of the MCMV program and its signal effect of Government commitment to low-income housing policy and finance. Improving market conditions, the SELIC rate drop to 8.75%, and intensifying competition in the SBPE housing finance market, including from Caixa AF and Banco do Brasil, has significantly reduced spreads on SBPE lending, thus narrowing the gap with the spreads of FGTS.

23. Additionally, lenders are facing significant pressure from their developer clients to enter the FGTS market and finance their MCMV developments. Developers, especially large-scale publicly traded ones, are concerned about the concentration of the low-income housing finance market in the hands of one lender—CEF, which could leave them seriously exposed with large stocks in case of credit or liquidity problems or in a case of a change in Government policy.

24. Risk management considerations for lenders and reaching out to new target groups. The down-payment function of FGTS offers an additional buffer against credit risk which is typically considered more significant in low income housing lending. Additionally, FGTS reduces liquidity mismatches for lenders since relative to SBPE, FGTS funds are long term. Moreover, through the defined income limits, FGTS targets lower income groups than SBPE. FGTS supports a down-market strategy for private lenders. Thus, entry into the FGTS market implies extending new services to an existing client base (as would likely be the case for a bank such as Bradesco) or attracting a new client to the bank with the ability to establish a long-term fidelity relation (as would be the case with a bank such as Santander). And in either scenario, the increased compression of lending spreads for SBPE implies that, in banks’ short- and medium-term business strategies, some will be interested as they seek a market leader position in this new business line. For others, they will enter because they cannot afford to be left out given the size of the potential market.

25. Benefits for smaller lenders. Mortgage companies (Companhias Hipotecariás- CH), which do not have access to SBPE, perceive FGTS as an attractive funding channel for their operations. CH currently operate mainly as correspondent banks or service providers deriving the bulk of their business through: (a) service provision for FGTS depositors to be able to access their account funds as down-payment for a housing purchase; and/or (b) providing marketing and underwriting services for larger banks, especially Caixa AF.

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5. WHY DON’T MORE PRIVATE LENDERS ACCESS FGTS?

26. The fact that private lenders have not accessed FGTS funds thus far has meant that access has been dominated by the Government-owned CEF. As such, practically all housing finance loans using FGTS resources are provided through Caixa AF. The administration of FGTS resources on behalf of the borrowers is undertaken by Caixa AO, an operationally segregated arm of CEF which implements the policies of the Conselho Curador of FGTS.

27. Another public bank—Banco do Brasil—is in the final preparatory steps to access FGTS funds for housing loans. Banco do Brasil recently acquired Nossa Caixa, the other public bank that had an important portfolio of FGTS housing finance loans in São Paulo. Building on this experience, Banco do Brasil is preparing to enter under the MCMV program with a target of 100,000 loans or 10% of the MCMV program.

28. Two private banks—Itaú and Santander—undertook pilot housing finance operations with FGTS funds in 2007-2008. Itaú reported issuing about 400 loans to test the system and monitor portfolio performance for a novel client segment, while Santander reported issuing 6-10 loans to test the system. The obstacles they have encountered are listed below.

29. The attempts of Santander and Itaú underline an interest of private lenders to access to FGTS to support their lending strategies in housing finance. However, the current administrative regime to access FGTS appears to deter lenders, in particular private banks. In the context of an increasing need for funding sources, easier access to FGTS may ensure available funding to allow for down-market expansion. In addition, it gives lenders time to prepare for the use of FGTS funds (e.g. training of employees, logistical and organizational set up of mortgage lending and servicing functions and platforms within their organizations). The limitations and related recommendations have been discussed with the Ministry of Finance, the Ministry of Cities, the Executive Secretariat of Conselho Curador, Caixa AO, as well as both private and public lenders and other relevant market stakeholders.

30. The list of obstacles and recommendations consists of two parts. The first parts deals with challenges and recommendations linked to operational issues. The second part covers obstacles and recommendations related to remuneration. If the Government’s policy is to enable the expansion of housing finance through facilitating (private) lenders’ access to FGTS funds, the Government would thus need to devise incentives to achieve such an objective.

a) Main obstacles related to operational issues

31. Bureaucratic and complex procedures for loan approvals and disbursements, redundant steps and controls, and delays in processing the funds. The rules established by the Conselho Curador and the Ministry of Cities and the subsequent procedures created by Caixa AO for loan approval and disbursements are viewed as bureaucratic and complex. Key requirements and procedures that are viewed as obstacles for expansion of private lenders’ access to FGTS funds are:

Multiple rules, onerous requirements and lack of automation. According to one interviewed bank, lending using FGTS funds requires following some 72 rules versus 5-6 for SBPE; as a result, processing an FGTS file requires on average 100 days versus 30-45 days with SBPE. Caixa AO also agrees that the rules need simplification. Examples of onerous requirements include the requirement to confirm that the borrower does not own any other housing unit and the need to promptly repay to Caixa AO (within 5 business days) funds received from any loan prepayment.

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Multiple criteria governing the composition of housing units financed with FGTS in line with Government housing policy. The Ministry of Cities requires that low-income housing units financed with FGTS funds reflect the national housing deficit in line with Government’s housing policy. FGTS lending is thus required to follow a pre-determined breakdown by State, household income bracket, and new versus used units. There are also ceilings to determine the eligibility of units to be financed with FGTS that are determined for a group of cities. The result is a complex grid with which the overall lending portfolio needs to comply. Stakeholders interviewed, including lenders and Caixa AO, agree that these rules should be simplified. Most concur that the key parameters should be income eligibility and maximum unit value, as determined by the Ministry of Cities.

Ultimately, while it is natural for the Government to determine the targeting of FGTS subsidies, applying the same rules to the distribution of FGTS lending may deter private lenders from participating. Other tools could be used to reach the desired public policy outcome. For example, geographic steering of subsidies would automatically influence the geographic distribution of the housing loan that compliments it. In addition, incentives (e.g. access to more FGTS funds in a competitive scheme) linked to lenders’ performance in terms of matching the desired geographic distribution of funds could be introduced.

Applicability of the multiple criteria for each lender. The main complaint by lenders is that they are required by Caixa AO to respect the exact geographic distribution requested by the Ministry of Cities. For most banks, their existing branch network does not allow them to match the required geographic distribution; this means that many either cannot operate at the national level or would opt to expand gradually rather than cover the whole nation from the beginning. One concern is that if these rules were to be relaxed, private lenders would only focus their operations in the “profitable” South and South-East regions, leaving Caixa AF alone with the less desirable business of the North and North-East. Clearly, the requirement that each lender matches the exact geographic distribution of the national housing deficit only serves to exclude all private lenders, thus limiting competition and hindering the ability to scale-up lending for low-income groups. Several private lenders could easily cover 2-3 regions in Brazil if not more, thereby introducing a healthy competition in the supply of credit. This would ultimately benefit the consumer. The Secretariat of the Conselho Curador noted that this restriction has not been imposed by the Conselho. In addition, Caixa AO noted that it would be willing to consider introducing some flexibility to lenders at the initial stage. Another concern is that the available FGTS budget could be exhausted in regions like the South and South-East that have high demandt but not the highest proportions of the share of deficit relative to the share of population (an argument which if valid, would thus require the increase of FGTS resources dedicated to low-income housing finance rather than ration against demand through geographic restrictions).

Case by case dealing, redundant controls and resultant delays. Private lenders note that at each instance of funding request, Caixa AO undertakes a complete screening of each borrower file based on data that is transmitted to them via the Internet to confirm the eligibility of each borrower. This case-by-case approach duplicates the lenders’ underwriting process and makes the process cumbersome relative to an ex post review. This time-consuming effort results in delaying the disbursement of the FGTS loan to the individual borrower.6 Moreover, this provision of data is in addition to biannual independent audit reviews required by the Caixa AO.7 The same concern was expressed by securitization companies. They report that even though their procedures were reviewed and certified, Caixa AO still undertakes a thorough review of all steps including screening

6 One bank reported that in one case as a result of the delay in obtaining the funds, a complaint was submitted by their client/FGTS applicant to the Central Bank (BACEN) and the Bank was required to pay a large penalty.

7 Caixa AO considers these procedures necessary because lenders hand in incorrect files. This is attributed to lack of familiarity with FGTS procedures and/or application of SBPE rules and underwriting processes to FGTS clients.

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developers, first-time homebuyers, accompanying every tranche of the payment, etc., which leads to duplication of efforts and requires additional time. According to Caixa AO, the disbursement process has a maximum timeframe of up to 72 hours once the request is submitted by the private lender. In addition, private lenders have the option of choosing the frequency (daily, weekly, monthly) of submitting requests for disbursement.

32. Frequent changes in rules and procedures without sufficient notice. Lenders noted that FGTS rules change frequently. For instance, in 2009, changes were reported in interest rates, income levels related to the subsidies (desconto), the classification of regions, as well as new rules related to receiving the interest differential and subsidies. Application forms for solicitation of FGTS funds for individual borrowers also reportedly changed three times between 2007 and 2009. Frequency of changes is a source of instability and concern for lenders, as it would require costly modifications of software and employee retraining. Lenders report that another cause of concern is that revised rules apply from the moment of publication of the revised manual of operations, including the need to apply the rules to their pipeline of lending in process. Caixa AO emphasized that any application that is in process would be grand-fathered under the previous rules. However, it is unclear how loan applications that are in progress but not yet been submitted to Caixa AO would be treated. With a long file processing period reported to average 100 days, frequent changes would be a source of concern for banks that intend to scale up FGTS lending. The other reported impact of frequent changes to the rules is a delay in processing files by lenders upon knowing of planned changes, especially when such changes would be more advantageous to the clients. Clearly, minimizing changes and introducing a future date for the applicability of the new rules would go a long way in reducing uncertainty.

33. Asset/Liability Management concerns. The asset/liability management (ALM) of the FGTS loans on the lender’s balance sheet is made difficult because the liability is calculated as the weighted average of the loans granted in a given period, while on the asset side the portfolio varies according to the borrower’s behavior. As such, mismatches occur when loan prepayments alter the characteristics of the portfolio, while the liability side remains unchanged. This also implies that Caixa AO calculates the payment due to it by a financial agent based on the characteristics (interest rate, loan term and amortization type) set at the initial creation of the liability account. What is required is to update the portfolio characteristics periodically based on borrower behavior. Caixa AO has indicated that this would be beyond its capacity given the volume of FGTS loans, but that it remains open to requests from financial agents to update ALM on an annual basis.

34. The issue of the Caução Hipotecária. Lenders report problems related to the registration and release of the lien given to Caixa AO at the property registry. There are high transaction costs associated with the registration of a lien on the deed in Caixa AO’s name (one additional registration procedure payable by the borrower) and the renewal every trimester of the power of attorney from the lender to Caixa AO as required by registrars (at least in Sao Paulo). This requirement does not affect Caixa AF but only the other financial agents, thereby creating an uneven playing field. In addition, there appears to be no procedure for the automatic release of the lien by Caixa AO upon completing the reimbursement of a FGTS loan. This issue has been recognized by Caixa AO, which is working with the ABECIP working group to identify solutions, including the potential submission of alternative guarantees to Caixa AO in lieu of the property lien itself.

b) Recommendations related to operational issues

35. Establish target lending volumes for disbursement of FGTS funds. An important measure to enable the expansion of housing finance for low-income groups could be the establishment of an annual target lending volume of disbursement of FGTS funds by Caixa AO, ideally with a breakdown by type of lender. Currently, a multi-year FGTS budget is allocated for housing finance but it is derived on the basis

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of the previous year’s performance and the lending volume that Caixa AF deems feasible. One way of introducing a forward looking annual target would be to link the volume of FGTS funds to be lent with the disbursed FGTS subsidy amount to achieve a target leverage ratio of such subsidies. 8 This leverage ratio recently averaged 1:6 (an average volume of subsidies of BRL 1.5 billion associated with a lending volume of about BRL 9 billion). Accordingly, the increase in FGTS subsidies to BRL 4.5 billion per year between 2009 and 2011 should witness an associated increase in the lending volume to about BRL 25 billion (this is only logical since the subsidies are disbursed to enhance borrowers’ affordability to access a loan). A similar target would not be unrealistic given that Caixa AF’s plan is to extend BRL 19 billion in loans and since Banco do Brasil is entering the scheme; yet, it would be extremely useful in enabling the expansion of the low-income housing finance market, especially if it used to assess performance.

36. Simplifying the rules. Serious simplification of the FGTS rules, especially those hindering the operations of the financial agents, is a critical measure to expand private lenders’ access to FGTS funds, as well as all financial agents’ utilization of these funds. This includes the following:

Reducing the criteria for usage of the funds to the minimum that can achieve FGTS objectives, particularly maximum unit value and household income. The criterion on regional distribution of the financed units, which aims to tackle the national housing deficit in accordance with the NHP, could serve as an incentive to allocate more access to FGTS funds or more subsidy from Government or FGTS to the financial agents that demonstrate better performance in this area. The FGTS Conselho Curador could establish distribution goals that take into consideration the housing deficit, housing demand, and the distribution of subsidies. But financial agents should be allowed, within their credit limits, to decide where they would operate according to their own business strategy.

Reducing the frequency of changes to the rules and procedures, and where changes do occur, grandfathering the existing loan pipeline (including files submitted to Caixa AO but not yet processed and files in process by the financial agent) by making changes applicable as of a future date, say 60 days from the date of publication.

Changes to the rules and procedures should take into consideration the operational issues facing financial agents. As ABECIB has a seat at the FGTS Council, the Conselho Curador can coordinate the envisaged changes with ABECIB instead of referring to each financial agent.

Revisiting the reporting requirements to simplify them as needed and as proposed by agents and submitted to Ministry of Cities and the Conselho Curador.

37. Abolish a second review of the loan files by the Caixa AO and introduce a system of delegated underwriting. At present, the Caixa AO assigns to every financial agent a credit limit. Before disbursement, the Caixa AO checks every loan file to confirm that it complies with the FGTS lending criteria. The financial agent can submit loans up to the assigned credit limit. This process should be replaced by delegated underwriting i.e. financial agents underwrite and service the loans but provide the loan data to the Caixa AO. The Caixa AO would still receive all loan data to meet statistical requirements set out by the Conselho Curador and inform the public about the deployment of FGTS funds. The financial agents would only be able to draw up to their granted credit line. Delegated underwriting requires an accreditation process by the Caixa AO. For this process, the Caixa AO could apply the same

8 FGTS subsidies have traditionally been the main source of credit-linked household subsidies. Yet, under MCMV OGU funds were used for the first time in recent years towards credit-linked subsidies (BRL 2.5 billion to match BRL 7.5 billion provided by FGTS). If this trend continues, the multiplier ratio between FGTS subsidies and the lending volume would therefore not be useful in establishing a lending target.

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techniques as for the assessment of the counterparty risk. Delegated underwriting should still entitle the Caixa AO to an inspection of a sample of randomly selected loans in regular intervals. Additional protection for Caixa AO is that the credit risk remains with the financial agent. Thus, a financial agent needs to ensure that there is enough collateral to cover the credit risk and in the case of decreasing collateral value, the financial agent has to exchange the loan for another loan with a better credit risk.

38. Resolve asset/liability management issues. Resolving the issue of the asset/liability mismatch requires updating the portfolio characteristics periodically based on borrower behavior. This requires instituting a procedure that allows lenders to periodically request Caixa AO to update their liability account (and accordingly the schedule of payments due to Caixa AO) to reflect prepayments, refinancing and other amortization changes. Caixa AO has indicated that it is open to this solution.

39. Resolve the issue of the Caução Hipotecária. This issue is already being addressed by Caixa AO and the working group within ABECIP as it has been recognized as an obstacle causing increased costs and delays. One possibility that Caixa AO mentions it could consider is the use of other guarantees (títulos públicos) in lieu of the lien on the deed. However, if this were to happen, it is unclear if in a case of lender’s insolvency, Caixa AO would be able to collect the FGTS loan repayment directly from the borrower. In addition to the need to resolve the issue of the associated cost, it is important to institute an automatic procedure, with a short-time service standard, to release the lien once payment of the FGTS funds by the financial agent has been made in full.

40. Review organizational structure of FGTS trustee function. The current structure of the SFH with the FGTS and SBPE as its main elements was set up after the closure of the Banco Nacional de Habitação (BNH) in 1986, under circumstances and conditions to create a similar system to promote housing for low-income groups that differs significantly from today’s situation. Therefore, the issue is if the current organizational set-up, especially related to FGTS, remains conducive to the goal of improving access to housing finance for low income groups. Although the functions of Caixa AO and Caixa AF are statutorily segregated, a clear separation is not perceived by other players in the Brazilian housing finance market or the consumer. Steps could be taken to improve organizational segregation and enhance independence. For example, Caixa AO’s activities could be bundled under its own subsidiary with its own board and treasury.

41. Another key question concerns the effectiveness of the subsidies paid out from FGTS funds. During a round table discussion organized by Fazenda on 20 November 2009, there was apparently a consensus among participants that it would be desirable to separate the subsidy policy role of the Conselho Curador from the financing function of FGTS and leave this role to the Ministry of Finance and/or Ministry of Cities.

42. Give a stronger mandate to CEF’s role as second tier catalyst of housing finance. The administrative function of the FGTS is one of many roles or business lines the Government has assigned to CEF. The introduction of delegated underwriting would emphasize CEF’s catalytic function to develop the mortgage market in Brazil since it involves the gradual development of the Caixa AO into a second-tier institution/liquidity facility. This suggestion implies the following changes:

Establish a credit line to each financial agent according to its risk (credit risk and operational risk), as is currently the case;

Establish accreditation criteria for lenders which seek to become a financial agent of FGTS funds with regular checks on their counterparty risk;

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Delegate the underwriting to the financial agent for standard loans with recourse and cancel the current process of double screening wherein Caixa AO reviews all steps in each file, effectively duplicating the financial agent’s underwriting process;

Advance the funds in a tranche system, which could be recalibrated based on performance;

Establish measures to ensure that unused or misused funds are reimbursed at market rate (e.g. SELIC); and

Set up post-control procedures with an independent audit carried out on a representative sample of the transactions each 6-12 months instead of enforcing the correct application of criteria on each loan.

43. This change would be more practical for the Caixa AO (minimizing delays and transaction costs, which would enhance the ratio of utilized relative to budgeted funds) and more attractive for the financial agents (allowing predictable and timely access of funds and minimizing transaction costs). The liability of the financial agents with their full balance sheet for borrowed funds, the disbursement in tranches and the imposition of penalties for misused or unused funds would guarantee protection of FGTS depositors and the policy objectives of the FGTS.

44. This new arrangement should also reduce cost for the borrower. Reducing transaction costs for both parties could translate into cheaper borrowing cost for individuals and at the same time improve margins for financial agents on an already low and contested spread. With the new structure, it may be possible to revisit the remuneration of Caixa AO.9

45. A reduction of the mandatory reserve amount could possibly offset an increase in the financial agents’ spread without leading to an increase in the borrowing cost to low-income individuals. Similarly, a decision to reduce the net spread of FGTS for housing finance operations could be offset by the Conselho Curador, as may be needed, together with a change in the allocation of FGTS budget among the different investment channels with a higher expected return (e.g. the new FGTS investment fund). This review would especially be warranted in light of the suggested role of Caixa AO (transformation into a second tier lender).

c) Main obstacles related to remuneration issues

46. Capped spread at 2.16% implies lowest remuneration for the riskiest client segment. The spread for the financial agents is capped at 2.16% for loans using FGTS funds, from which the risk fee (taxa de risco) levied from each institution depending on its risk rating by Caixa AO is deducted. The net spread for financial agents thus varies from 1.96% a.a. (after deducting 0.2% per AA-rated institutions) to 1.36% a.a. (after deducting 0.8% for C-rated institutions).

47. Private lenders generally complain that this net spread is too low. This is a valid concern, at least in the beginning of a process of establishing new credit operations, due to the following considerations: (a) the riskiest client segment would in effect be benefiting from the lowest spread, possibly implying a need to cross-subsidize them with less risky (higher-income) borrowers; (b) lenders, with the exception of Caixa AF, critically lack information about the credit behaviour of low-income borrowers for housing finance products (a very different product from consumer loans, for which solid information about low-income borrowers’ credit behaviour) exists; and (c) lenders would need to develop different automated underwriting and servicing systems for a new client base, with automation (needed to reduce costs in light of the limited spread) requiring an important upfront investment. 9 The National Housing Plan (PlanHab) has examined this issue in detail.

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48. Banco do Brasil acknowledges the same challenges, even if it can draw on Nossa Caixa’s portfolio for a better understanding of the target client’s credit history. For Banco do Brasil, the only solution is to go to scale rapidly. This decision has already been taken by its Board of Directors under the MCMV program, where their target is 100,000 loans. The new required system will be developed in-house, relying on staff assembled specifically for this new market. The estimated cost for the new IT system was roughly estimated at BRL1 million, requiring 6 months of work with a team of 15-18 staff. And to contain operational and origination costs, Banco do Brasil intends to follow the same model as Caixa AF of “tercerização” (sub-contracting correspondent banks and service providers to undertake origination of FGTS contracts using own or the third-party systems, against payment of a fixed fee for a successful application). This model would certainly be useful in cutting costs, but it could also entail some risks and may not be the model of choice for private lenders concerned about service quality standards and the bank’s image/brand with customers.

49. For private lenders, the decision to expand housing lending using FGTS funds is more complicated because shareholders will be demanding adequate returns. The spread under FGTS will thus be compared to an average of 3-4% a.a. for housing finance using SBPE (before accounting for the cost of capture of SBPE). According to directed lending rules by BACEN, 65% of SBPE savings must be applied to real estate finance, of which 80% (or 52% of the total) for housing loans meeting specific criteria and other eligible instruments10 (estimated average spread of 3-4% a.a); 30% must be deposited at the Central Bank (with 10% remunerated at SELIC) and the remaining 5% are free to use and could thus earn market rate remuneration. At current market conditions, this leads to a much higher overall spread than in FGTS, and effectively for extending housing finance to a less-risky client. This remains true even after factoring the risk associated with the asset liability mismatch of lending using SBPE funds, which would, all else equal, require a higher remuneration than if long-term funds such as FGTS were used.

50. Capped remuneration for borrowers benefiting from FGTS subsidy. Borrowers earning up to BRL 2,790 per month or 6 MW benefit from upfront FGTS subsidies (desconto). For these borrowers, the remuneration to the financial agent is paid upfront by Caixa AO. The amount paid equals the sum of (a) the nominal sum of the monthly spread (2.16% minus the risk fee) over the life of the loan and (b) the sum of the monthly administrative service charge of BRL 21.66 per loan, discounted at 12 percent a year. The maximum payment is capped up to a maximum of BRL 10,034.60 per loan.

51. A larger loan amount and a longer maturity period thus, all else equal, translate into a lower spread. Charts 1A and 1B—prepared by one lender—illustrate this effect. Chart 1 demonstrates that, under the current discounting parameters, a financing of up to BRL30,000 over 20 years would maintain the net spread of 1.96% for the lender, and that the effective spread drops to 1.41% if the financing went up to BRL 50,000 (63% LTV on a unit of BRL 80,000). Similarly, a 10-year loan of BRL 50,000 would maintain the spread at 1.96% whereas under a 30-year loan, the spread drops to 0.89%. As such, this clearly favours smaller loans, which would imply lower-income groups within the eligible target group of up to 6 MW.

52. It is important to note that the parameters used today (no discounting of the advance payment for the spread over the loan duration while discounting the TSA at 12%) exaggerate the magnitude of the problem relative to a more logical approach of discounting both the spread and the TSA at an appropriate discount rate (e.g. SELIC). Yet, even though the calculation would differ from those shown in the charts, the same idea ultimately holds except it will take a larger loan amount or a longer maturity than illustrated to trigger a drop in the spread.

10 Key criteria for housing loans are maximum unit value of BRL 500,000; maximum financing of BRL 350,000; and maximum lending rate of TR+12%. FCVS, CRIs and other housing-related papers are also eligible.

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7.9297.9788.0674.338

10.845

13.545 16.245

0,89%1,07%

1,41%

1,96%

4.000

6.000

8.000

10.000

12.000

14.000

16.000

18.000

120 240 300 360 Months

8.067 8.067 8.067

11.930

10.8458.676

6.5074.338

1,96% 1,96%1,81%

1,41%1,26%

--2.0004.0006.0008.000

10.00012.00014.00016.00018.00020.000

20.000 30.000 40.000 50.000 55.000 FinancingAmount

Dif. Juros C/ Limite Dif Juros S/ Limite Spread Médio

53. Since FGTS resources are targeted at social housing, the intent of this rule by the Conselho Curador is clearly to incentivize the issuance of smaller loans, which would be serving the lowest income segments of the population. Caixa AO notes that the cap of BRL 10,034.60 is derived based on a financing of BRL 37,000 for 240 months at an interest rate of 6%, which when complemented with the BRL 23,000 upfront subsidy under MCMV for the income group of 3-4 MW would enable the purchase of a unit of BRL 60,000 (about USD 34,000) as per the current objective of the Government housing policy. Yet, this approach of favouring the issuance of smaller loans to the lowest income households within eligible groups contradicts the more gradual down-market penetration strategy that private lenders would normally opt for (i.e. start with the 5-6 MW clients with unit values near the maximum permissible limits then progressing to the 3-4 MW clients).

Chart 1. A and B. Impact of loan size and maturity period on spread for desconto clients

Assumptions: BRL80,000 unit value; BRL50,000 financing (in Figure 1-A); Maturity 20 years (Figure 1-B); Interest Rate: 5.64% a.a.; Administration fee (TSA) BRL21.66 per month, discounted at 12%; Maximum payment (limitador diferencial de juro): BRL10,034.60

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54. Risk fee (taxa de risco). Each lender, public or private, extending loans with FGTS resources is assessed and levied a risk fee by Caixa AO, to reflect the institution’s credit risk. The risk fee is as follows: Rating AA = 0.2% a.a. (the risk rating of Caixa AF11, and the largest private banks); Rating A = 0.4% a.a.; Rating B = 0.6% a.a.; and Rating C = 0.8% a.a. Caixa AO conducts an annual audit of the financial agents interested in accessing FGTS resources in order to assess the rating and adjust the cost of risk. Private lenders, especially the largest banks, take issue with the risk fee as it erodes an already perceived thin spread.12 Two issues are cited to support a review of the risk fee: (a) the credit risk rests fully with the financial agents because they are held responsible for the repayment of FGTS funds, even if individual borrowers are in default; and (b) the institution’s risk (called counterparty risk) is already reflected in the FGTS line of credit granted by Caixa AO to each institution (which can range from BRL 600,000 for one interviewed agent (“repassadora”) to over BRL 1 billion). Private lenders are of the view that the line of credit should be the main determining factor for the level of risk, especially as the spread is already viewed as too low. This opinion is also shared by the NHP.

d) Recommendations related to remuneration issues

55. Revisit the spread calculation. The 2.16 % spread was introduced in Resolution 460 of 2004, together with several other aspects of the program. According to the Secretariat of the Conselho Curador, the 2.16% spread was calculated based on the average spread of the 6MW income bracket from Caixa AF’s historical portfolio performance and relied on cross-subsidization from higher to lower income brackets. The calculation was to serve a four-year timeframe and be subject to subsequent revision. The Conselho Curador has the mandate to undertake revisions of program aspects from time to time to ensure they reflect market and time changes. ABECIP technical note No. 13 of July 2009 calls for an increase of the spread to 3.5%, which would align it with current competitive spreads under SBPE (even if the latter’s market segment is less risky). While it is beyond the scope of this note to evaluate the adequacy of this proposed spread, the idea of envisaging an approach to incentivize private lenders to enter the FGTS market is important, especially if a detailed review of the spread calculation demonstrates that it effectively constitutes a barrier to entry and a barrier to operations in the long-run (e.g. what is the impact of economies of scale on spread reduction). Should incentives be required, it would be important that these (a) are adequately calibrated and withdrawn over time when economies of scale are achieved and (b) do not come at the expense of increasing cost for or excluding borrowers, which would make it politically unacceptable.13

56. It would also be useful to identify a market-based approach to determine the financial agents’ spread in FGTS. One possibility for the medium- to long-term is to auction the right to access FGTS funds on the basis of criteria, including the proposed spread to be offered by the financial agent (together with an assessment of financial soundness to regulate the amount of funds to be accessed) and the proposed regional coverage (to reward lenders that would address areas where the housing deficit is concentrated). This would ensure that competing lenders offer their best spread terms to access the funds, while still ensuring adequate returns. A complementary set of measures would ensure that advanced funds to lenders that remain undisbursed or were disbursed in contradiction to FGTS regulations are remunerated back to Caixa AO at market rate (SELIC). 11 There is much debate as to whether Caixa AF actually does pay the risk fee. 12 The Companhias Hipotecarias (CH) face a particularly difficult situation. The FGTS credit limit granted to

them are very limited and operationally inefficient (e.g. BRL 600,000 for Cobansa), their taxa de risco is much higher (0.8% a.a.), and decisions of credit approval and cash-out are taken by Caixa AO. These conditions are too tight to allow for economies of scale and to foster the distribution of FGTS loans by the Companhias Hipotecarias, even though they traditionally are more prepared to deal with low-income borrowers than the private banks.

13 It is proposed that this review not only examine the spread but the entire cost structure including the cost of Caixa AO (including the legal reserve requirements and the net spread).

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57. Review the capped remuneration of BRL 10,034.60 for loans to borrowers benefitting from the FGTS subsidy. Although this cap is intended to encourage lending of smaller loan amounts and thus serves as a form of targeting to lower income groups, it serves as a double constraint. FGTS loans are already subject to income thresholds, which typically limit the maximum loan amount a borrower can obtain (and is able to afford), and thus serves the targeting purpose. A way to resolve this issue is to delink the subsidy component from the lending component. Instead of subsidizing the spread (with the issues related to discounting), the subsidies should be directly paid to the borrower as a down-payment subsidy, thus reducing the loan amount all else equal.

58. Revisit the way the risk fee (taxa de risco) is applied. This risk fee serves to cover the counterpart risk of the FGTS operating agent. Since the financial agents guarantee the funds lent by FGTS with their whole balance sheet, there is typically ample security-cover to ensure a repayment of the FGTS funds to the Caixa AO in the event that a borrower defaults on her/his FGTS loan to the financial agent. A specific concern is the bankruptcy of a financial agent. In this case, Caixa AO should have a priority claim to the collateral which is offered as a security for the FGTS loan over other creditors. The loan contract should contain this right of the Caixa AO. To price the counterparty risk, the Caixa AO should apply an international rating methodology to ensure an efficient and equitable process.

6. THE VISION OF CHANGE: HOW TO IMPROVE ACCESS TO FGTS?

59. There are two approaches to facilitate lenders’ access to FGTS funds to enable an expansion of housing finance for low-income group:

The first approach is to adopt a strategy of small incremental improvements, which mainly seeks to resolve minor issues, mostly of an operational nature, without questioning the existing modus operandi of the system. This strategy, which would ultimately lead to innumerous discussions and even more alterations, would likely miss the opportunity to significantly improve access of low- and middle-income groups to housing finance that has been afforded at the current moment under MCMV (wherein developers, lenders, Government and the Conselho Curador all appear to share the same interest of expanding lenders’ access to FGTS funds).

The second approach would hinge on the transformation of the current FGTS structure by giving a stronger mandate to Caixa AO’s role as second tier lender, a role that would make it a catalyst to the housing finance market. The recently introduced policy of purchase by FGTS of developer debentures is supportive of the proposed transformation. Expected benefits from this approach would include faster processing of FGTS loans, higher efficiency, more competition among financial agents which should lead to better customer service, and most importantly lower transaction costs for both Caixa AO and the financial agents. Together with increased competition, these actions could translate into a lower cost of borrowing for low-income households. This new arrangement could be implemented gradually under the CEF’s stewardship.

7. CONCLUDING REMARKS

60. To achieve the targets of MCMV in the short-term and of the NHP in the medium-term, expanded private lenders’ participation in housing finance and access to FGTS funds is necessary. At this current juncture, it is also desired by lenders, developers, the Conselho Curador and the Government. This rests on the premise that SBPE and FGTS are (or should be) complementary funding sources, catering to different income segments and allowing better asset/liability management for those financial agents that use both. The main change today relative to recent years which witnessed the same debate over access to

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FGTS is that private lenders are strongly interested in accessing FGTS funds under the MCMV program. However, to enable this, it is critical to tackle the operational and remuneration obstacles through improvements to the FGTS operations (which would benefit all financial agents including Caixa AF and Banco do Brasil) and with Government incentives (at least in the start-up period of operations until reaching economies of scale) that could facilitate lenders’ participation.

61. Recommended improvements to operational issues are relatively simple to implement. Dialogue between Caixa AO with public and private lenders and ABECIP on how to address these issues is well advanced. Yet, recommended changes related to remuneration issues, which are more difficult to address, should also be considered insofar as they serve as barriers to entry for financial agents. The central element of these recommendations is the gradual transformation of Caixa AO into a second-tier lender under the stewardship of CEF.

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ANNEX 1. FGTS AS A FUNDING SOURCE IN HOUSING FINANCE

The Fundo de Garantia de Tempo de Serviço (FGTS), created by the Federal Government in 1966, is today a fund administered by the government-owned CEF. Its objectives are twofold: To provide protection to the workers by creating compulsory savings to be used in certain

circumstances throughout their professional life To finance social housing, sanitation and infrastructure.

The assets of the FGTS amount to BRL 231 billion in August 2009 (BRL 217 billion by Dec 31st 2008) and in 2008, the gross contribution to the fund was BRL 48.7 billion (net contribution of BRL 6.03 billion).

a) FGTS Operations

In Brazil, by law, every worker (except civil servants and self-employed) has to open a FGTS account at CEF in which the employer deposits 8% (2% in apprentice contracts) of the employee’s gross pay every month. The FGTS account is remunerated by the CEF on the 10th day of each month at TR+3%.

Every employee (or their dependents) is allowed to make withdrawals (up to the full balance) on their FGTS account in case of: Redundancy, unjustified dismissal, end of fixed term contract, or company closure Retirement or 70th birthday Fatal illness (either AIDS or cancer) and death Natural disaster 3 year-inactivity of FGTS account After at least 36 months of contribution to the fund:

- Prepayment of existing housing loans under the FGTS or SFH schemes,- Purchase of the main residence, in urban areas and with an appraisal value within the SFH limits,

if the employee has no outstanding SFH loans and is not the owner (or owns less than 40%) of a house (finished or under construction) in the city of principal employment.

In 2008, of total withdrawals of BRL 42.7 billion, withdrawals made in order to purchase a main residence amounted to BRL 5.65 billion (731,928 cases).

Allocations of funds for housing, sanitation and infrastructure loans from the FGTS are defined by the Conselho Curador taking into consideration plans of Federal Government, with a minimum of 60% of the funds earmarked for social housing loans. Historically, the FGTS has been one of the principal sources of funds of the Sistema Financeiro de Habitação (SFH). In 2008, the total Federal budget allocated to social housing finance was BRL 21.95 billion, split into the following purposes (see table 6 for more details):

Table 1. Allocation of FGTS Funds in 2008Budget (BRL billion;

Percentage)Realisation (BRL billion;

Percentage)Housing loans 10.45 (48%) 9.25 (88%)Sanitation 5.95 (27%) 3.16 (53%)Infrastructure 1.0 (5%) 0.0 (0%)Pro-Moradia 1.0 (5%)FAR (residential rental program) 2.0 (9%) 0.44 (15%)Subsidies (“descontos”) 1.5 (7%) 1.34 (86%)Total 21.95 14.19 (65%)

Source: Relatorio de Gestão FGTS 2008

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Only 65% of the total funds allocated to social housing-related purposes in 2008 were used, and 48% of the total amount went for housing loans to individuals purchasing their first home (9% were used for FAR leasing programs, 7% for subsidies, 27% for sanitation and 5% for infrastructure). This is at a time when the national housing deficit is estimated at 6.3 million units, which are needed to address existing housing problems including substandard housing, overcrowding and excessive rent payments14 (this is separate from the estimation of future demand due to new household formation).

Another feature of 2008 is the creation by the FGTS of a line to purchase CRIs, debentures having as collateral housing loans to developers and builders, with a limit of BRL 3 billion. Out of this amount, BRL 0.84 billion were reserved for CRIs , and only BRL 0.04 billion were used in 2 deals in 2008. Furthermore, the FGTS allocated in 2008 BRL 5 billion to the FI-FGTS, an investment fund created to invest in development projects (energy, trains, ports, roads and infrastructure). For 2009 the budget allocated to social housing finance is BRL 17.44 billion, detailed in table 7. Another BRL 10 billion were allocated to the FI-FGTS.

Table 2. Allocation of FGTS Funds in 2009Initial Budget prior to MCMV* (BRL billion; Percentage)

Housing loans 9.4 (54%)Sanitation 4.6 (26%)Infrastructure 1.0 (6%)FAR (residential leasing program) 0.0 (0%)Subsidies (“descontos”) 1.6 (9%) CRIs 0.84 (5%)Total 17.44

Source: FGTS Conselho Curador Secretariat* Budget was revised after MCMV; subsidies increased to BRL 4.1 billion and the amount allocated for housing loans and FAR increased to BRL 19 billion.

b) Individual FGTS program components and their achievements

The growth in the last 4 years has been spectacular (+356% between 2004 and 2008). The forecast for 2009 is also for a high increase (+90%) in FGTS loans due to the MCMV program. There are several schemes within the FGTS, either to individuals (Carta de Credito Individual, Carta de Credito MCMV, Pro-cótista) or to developers and municipalities (Pro-Moradia, Saneamento, Infrastructure, PAR).

The Pro-Moradia scheme is a program for urbanization of slum areas, which includes a component for building resettlement housing for families living in at-risk areas or in areas that need to be resettled for the works. To implement the resettlement program, municipalities borrow from FGTS, which has allocated BRL 1.05 billion in 2008 (5% of the total FGTS budget) for this purpose. Beneficiary population have monthly gross incomes below BRL1,395 (3MW).

The main schemes for residential loans are the Carta de Credito Individual and the Carta de Credito MCMV, which are described below. Also described below are the Pro-cótista program and the line dedicated to the purchase of CRIs.

14 According to Fundação João Pinheiro based on 2007 data from the PNAD (National Household Sample Research performed annually by IBGE). This deficit calculation, which is different from the 7-8 million estimate of the NHP, includes families in precarious units, co-habitation with other families, or an excessive rental payment (defined as more than 30% of income).

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Loans to individuals (Carta de Credito Individual / MCMV)This program is targeted towards households with gross monthly income up to BRL 3,900 (BRL 4,625 for housing under the MCMV scheme and BRL 4,900 in cities with more than 500,000 inhabitants) in order to finance: In urban areas: (a) the acquisition of a newly-built or second-hand house as main residence; (b) works

and improvements in the main residence; and (c) the acquisition of land In urban or rural areas: (d) the construction of a house as main residence; or (e) the purchase of

construction material.

At least 50% of the funds would be allocated to the acquisition (or construction) of newly-built houses.

Participants:1. Conselho Curador, which consists of 24 members equally divided between representatives of

Government and the private sector (employers and employees, and their associations). The functions of the Conselho Curador are to establish the criteria and processes of the program and to periodically appraise and review the implementation of the program and its results.

2. Caixa AO, which is responsible for: Implementation of the program within the budget limits, Selection, appraisal and audit of the financial agents, Analysis and approval of credit proposals, Appraisal of real-estate developments, and Reporting to the Conselho Curador and the Government.

3. Agentes Financeiros (Financial Agent, private or public financial institutions including Caixa AF), whose attributions are to:

Provide the applicants with the necessary information, and technical and legal assistance while applying for a loan (including recommendation on how to protect the environment),

Study and select the applications according to the program criteria, Present the selected proposals to the Caixa AO, Be responsible for the duly reimbursement of the loans to the FGTS, Underwrite the loans, Follow-up the loan during the life span of the contract, Follow-up the construction projects and provide technical assistance to the borrowers during the

construction phase, Report on a monthly basis selected data of the scheme to the Caixa AO, and Audit annually at its own cost the portfolio of loans funded by the FGTS by an independent audit

firm and send the report to the Caixa AO.

4. Borrowers whose responsibilities are the initial down-payment and the timely payment of the loan installments. In order to qualify for this scheme, applicants should meet the following conditions:

No outstanding SFH loans; No ownership (or less than of 40%) of a house (finished or under construction) in the city of main

activity; Participation of at least 5% of the appraisal value of the house during the first year (taking into

account the down payment, interest payments, insurance payments …); Maximum Debt to Income ratio of 30% on gross income; and Contracting of a life and disability insurance policy.

5. Partners, which intervene in the implementation process (assessment of borrower’s creditworthiness, study of the viability of development projects, implementation of construction projects ...).

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2008 Results: The Carta de Credito Individual is the main program of the FGTS. In 2008, the distribution amounted to BRL 6.58 Billion (99% of budget) in Carta de Credito Individual versus BRL 1.11 Billion (93% of budget) in Carta de Credito Associativo.

Chart 1. Loan distribution of the Carta de Credito Individual Program in 2008In purposes In numbers

In amounts

Source:

Funding of the financial agents: The Caixa AO allocates a credit limit to the financial agents on an annual basis. The reimbursement of the Caixa AO is scheduled according to the weighted average (in both amount and duration) of the loans granted to the individual borrowers.

Borrower prepayments, which imply a faster amortisation schedule, should be transferred to the Caixa AO in less than a month (otherwise a fine of 2% and 1% deferred interest rate). In case of cancellation, the proportional remuneration of the financial agent paid upfront by the FGTS for the cancelled period should be returned.

Additionally, the financial agent should pay every month to the Caixa AO a fee on the full balance of outstanding loans which corresponds to the rating of the financial agent: (a) Rating AA: 0.2% a.a.; (b) Rating A: 0.4% a.a.; (c) Rating B: 0.6% a.a.; and (d) Rating C: 0.8% a.a. The Caixa AO carries-out every year an audit of the financial agents in order to assess their rating and adjust the cost of risk.

The disbursement of the loan principal takes place, loan by loan, when the Caixa AO receives the loan documents from the financial agent, in an individual account dedicated to the borrower according to the

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loan payment schedule and should be credited by the financial agent in the borrower’s account after two working days after the value date of the operation and liberated the day of signing.

Furthermore the documents of the loan guaranties should be presented 60 days after the signing.

Remuneration of the Financial Agent: The remuneration is twofold: Spread on the loan equal to 2.16% a.a. paid monthly:

- by the borrower if monthly gross income is greater than BRL 2,790, - by the FGTS if monthly gross income is less than BRL 2,325,- For incomes in between, TR+1% by the borrower and TR+1.16% by the FGTS.

Administration expenses of BRL 21.66 monthly - paid over the term of the loan by borrowers with monthly gross income greater than BRL 2,790 - paid by the FGTS as the Net Present Value at 12% a.a. of future monthly payments of BRL21.66

for borrowers with monthly income below BRL 2,790.

The remuneration of the financial agent paid for by the FGTS for “desconto” clients is limited to the minimum of 75% of the loan principal and BRL 10,034.60.

The financial agent will charge the cost of the house appraisal to the borrower. The financial agent could also receive a fee of 3% of the loan amount for the follow-up of the construction phase (2% for collective operations).

Selection of the financial agents: The Caixa AO is responsible for the selection, appraisal and audit of the financial agents. The financial agents must be registered in the Central Bank as members of the SFH (resolution nº 1980 of 30/04/93 by the National Monetary Council). Furthermore the Caixa AO appraises the financial agent’s capacity in three aspects: Legal: registration in the Central Bank, updated documentation of shareholders, capital structure,

organisational structure, and financial statements Managerial: technical and operational capacity in terms of employees’ experience, procedures, IT,

with special emphasis on risk control and loan servicing Financial: financial analysis of the company, in order to ascertain its long term stability in terms of

capital, cash flows and profitability.

A rating from a well recognised rating agency must be presented to the Caixa AO. Every year the financial agent has to update the documentation and its rating in order to be allowed to distribute FGTS loans and the Caixa AO will allocate every year a line to the financial agent according to its risk.

Subsidies: For 2009, the Conselho Curador determined that the distribution of subsidies (“descontos”) to the borrowers should be as follows (the distribution is being applied to each financial agent): Minimum of 62.5% to borrowers in urban areas within the MCMV scheme, for newly-built houses

licensed after March 26, 2009, out of which 80% should go to municipalities of at least 100,000 inhabitants;

Maximum of 2.5% to borrowers in rural areas within the MCMV scheme, with monthly income of less than BRL 833;

Minimum of 35% to borrowers in urban areas, out of which:o Maximum of 30% to households with monthly income less than BRL 760 with a minimum of

83% for FGTS loans implemented collectively,o Minimum of 50% for newly-built houses under the Pro Moradia scheme.

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The borrowers with gross monthly income below BRL2,790 are entitled to receive subsidies (“descontos”) to pay part of the house purchase in urban areas.

The amount of the subsidy to the borrower varies between BRL1,000 and BRL 23,000 for 2009 and depends on: Size of the city of residence (5 groups – RJ, DF, SP; other municipalities with more than 100,000

inhabitants; between 50,000 and 100,00; between 20,000 and 50,000; and below 20,000); Type of operation (7 types – acquisition of newly-built or second-hand house, construction, purchase

of construction material, with or without the participation of the municipality).

In rural areas, the subsidy is limited to BRL7,000 for borrowers with gross monthly income below BRL1,860.

The subsidy could be granted just once to a given borrower and it is the financial agent’s responsibility to inform and control the centralised borrowers’ data base (as indicated in chart 3).

Chart 2. Allocation of subsidies within the FGTS scheme2008’ Subsidies per income tranches Average loan and subsidy amounts

Source:

The Pro-Cotista ProgramLaunched in 2007, this program is based on the same structure as Carta de Credito Individual but is specific to holders of FGTS accounts, with the following conditions: Minimum of 3-year seniority of the FGTS account Minimum of 3-year contributing to the FGTS Active work contract or a FGTS balance of at least 10% of the appraisal value of the house

This Program was implemented to allow for an access to a housing loan for higher income FGTS contributors (which otherwise could not access FGTS funding due to the income thresholds). The purpose of the loan is the purchase of a main residence (either newly-built or second-hand) or the construction of a main residence with a maximum appraisal value of BRL 500,000. The maximum LTV is 85% for newly-built houses (80% for second-hand) and the maximum term 30 years. The loan interest rate is TR+8.66% a.a. and the funding cost for the financial agent is TR+6% a.a.

Compared to the Carta de Credito Individual, here the financial afent has a right to up to BRL 25 monthly as administrative expenses.

In 2008, the Federal budget allocated to the Pro-Cotista Program was BRL 1 billion, out of which BRL 0,698 billion (70%) were used to finance 7,400 FGTS account holders.

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Since first, there is no income limit for the borrowers in this program, and second, the house value is linked to the SFH, the Pro-Cotista Program acts as a direct competitor to the SBPE scheme.

Line for the purchase of the Certificados de Recebiveis Imobiliários (CRIs)In order to develop the secondary market of CRIs and therefore increase the concession of housing loans, the FGTS allocated in December 2008 a line to purchase CRIs having as collaterals housing loans for the acquisition (or construction) of a main residence.

Participants:

1. Caixa AO, which is responsible for: Implementation of the program within the budget limits, Selection, appraisal and audit of Securitisation Companies and Fiduciary Agents, Analysis and approval of credit proposals, Appraisal of real-estate developments, Reporting to the Conselho Curador and the Government,

2. Securitisation Companies, whose attributions are to: Provide information of the loans which are the CRIs’ collaterals (monthly or quarterly), both on

existing portfolio and for new issues Buy housing loans from credit institutions to serve as collaterals of CRI issues Fully reimburse the cash amounts received by the Caixa AO in order to purchase CRIs Notify the borrowers for the cession of the loans made through CCIs (Cedula de Credito

Imobiliario) transfer Transfer all prepayments received by the borrowers to the Caixa AO Provide the applicants with the necessary information Assess the technical, financial and legal aspects of the real-estate developments which are

collaterals of the CRIs Guarantee the Caixa AO for the completion of the real-estate development Study and select the files according to the program criteria,

3. Fiduciary Agents (financial institutions approved by the Central Bank), which attributions are to: Protect the beneficiaries’ interests by controlling the Securitisation Companies and replacing the

Securitization Companies in case of insolvency Cover any loss incurred by mismanagement of the Securitisation Companies

Conditions: The Securitisation Company should open a specific credit line at the Caixa AO’s offices. The purchase of the CRIs issued by the Securitisation Company is made at par. The collaterals should be performing loans (no arrears) for the acquisition of a main residence (first occupancy).

The maximum loan amount is: BRL 130,000 in the metropolitan areas of SP and RJ BRL 100,000 in municipalities above 500,000 inhabitants, RIDE and capital cities BRL 80,000 elsewhere

The maximum appraisal value of the guarantee is: BRL 195,000 in the metropolitan areas of SP and RJ BRL 150,000 in municipalities above 500,000 inhabitants, RIDE and capital cities BRL 120,000 elsewhere.

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Exceptionally for 2009, the maximum appraisal value is BRL 500,000 for houses within the SFH scheme, the maximum interest rate of the loans is TR+12% a.a. and the interest rate of the CRIs is: TR+6% a.a. for appraisal values below BRL 200,000 TR+7% a.a. for appraisal values between BRL 200,000 and BRL 400,000 TR+8% a.a. for appraisals values above BRL 400,000

The maximum term of the CRIs is 180 months.Additionally, the Securitisation Company must pay every month to the Caixa AO a cost of risk on the full balance of outstanding loans which corresponds to the rating of the Caixa AF: (i) Rating AA: 0.2% a.a.; (ii) Rating A: 0.4% a.a.; (iii) Rating B: 0.6% a.a.; and (iv) Rating C: 0.8% a.a.The Caixa AO carries-out every year an audit of the Securitisation Company in order to assess the rating and adjust the cost of risk.

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ANNEX 2. OVERVIEW OF SYSTEMS AND COMPONENTS IN HOUSING FINANCE

Housing finance in Brazil is dominated by the Sistema Financeiro da Habitação (SFH). SFH, created by Federal Law 4.380/1964, is a closed-circuit system offering below-market rates on a limited pool of funds, namely savings accounts (cadernetas de poupança) and FGTS (Fundo de Garantia por Tempo de Serviço). The funding system is completed by capital market based loans (established through the Sistema Financeiro Imobiliário, SFI, created by Federal Law 9.514/1997) and on alternative funding components, like developer funding, self-finance, or funding through housing cooperatives and consórcios.

CEF, which assumes the two (operationally segregated) roles of operating agent of FGTS and financial agent, plays a major role in the SFH. CEF is practically the only financial agent for FGTS funds and one of the main ones for SBPE-funded loans. It is also the operator of a number of low income subsidy programs15, out of SFH, such as Crédito Solidário (funded by FDS – Fundo de Desenvolvimento Social), PAR – Programa de Arrendamento Residencial (funded by FAR – Fundo de Arrendamento Residencial through FGTS loans), FAT (Fundo de Amparo ao Trabalhador), FNHIS (Fundo Nacional de Habitação de Interesse Social, federal budget funded) and notably of the MCMV program, which aims to enable the construction and finance of one million housing units in three years, funded by the OGU and FGTS.

The main private banks with access to poupança remain concentrated on SBPE loans catering to upper and middle income groups, though they are increasing their down-market penetration and their interest to expand their access to FGTS funding. Mortgage companies, constrained by their high funding costs and limited scale of operations, focus lending to the upper income segment or provide a servicing function to FGTS account holders seeking to access their account deposits to purchase a house (usually coupled with an SBPE loan). Smaller mid-market banks often concentrate on developer finance. A newcomer that is expected to have impact in market is Banco do Brasil, focusing both on SBPE and FGTS loans. Different agents and funding sources typically serve different public segments, as illustrated in Table 1.

Table 3. Housing finance by income group, agent nature and funding sourceIncome group Income level (BRL) Agent Funding sourceUpper >7,000 Self-financed/Developers Equity

Banks Free market and SBPEMortgage companies and Sociedades de Crédito Imobiliário

SFI

Middle 4,600-7,000 Banks SBPECEF SBPE and FGTS (up to 4,900

except for Pro-Cotista)Consórcios, housing cooperatives Equity

Moderate –2,800-4,600 CEF FGTS often with subsidy programs including PAR

Banks SBPE (usually down to 4,000 income and sometimes less)

Low <2,800 CEF Construction material loansFGTS subsidy programs

PSH agents Federal funds (PCS/FDS and FNHIS)

Local and state public sector agents (CODHAB, COHAB)

Local and state funds, with or without federal funds

Source: based on Hoek-Smit, M. (International Housing Finance Program, Wharton Real Estate Center) and Duebel, H. and E. Rottmann, Business Environment Final Report, Low-Income Housing Finance Project, IFC.

15 An exception is PSH (Programa de Subsídio Habitacional), funded by federal budget, and distributed through specialized agents, many of them Sociedades de Crédito Imobiliário.

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Lending by public sector agents remains predominant for the lower income segment, and this will be further reinforce when Banco do Brasil steps (Table 2 presents the expected breakdown of new loans for 2009). By contrast, SFI despite its constant expansion remains small scale with a focus on commercial real estate and high-end housing; however, it is already competitive in terms final cost with SBPE.

Table 4. Expected breakdown of new loans by type of institution and funding source for 2009Funding Agent Amount (BRL million) Number of loansSBPE Private banks 19,200 310,000

Public banks (CEF) 12,800FGTS Public banks (CEF) 19,000* 450,000SFI Mortgage companies 2,000 5,000Equity Developers 15,000 120,000

Consórcios 3,000 50,000Source: ABECIP and CEF forecasts; BACEN; CBIC; SECOVI-SP (*FGTS Budget)

A funding costs and prices summary for different programs is presented in Table 3.

Table 5. Funding costs and interest rates charged to borrowers according to funding systemFunding Applicable Index Cost of funding

(annual)Return (annual)

Final price to borrower (per year)

SBPE TR 6% 9.0% to 11,5%*FGTS TR 3% 5.0%-8.16% (normal);

8.56% (Pro-cotista) **SFI TR

CDI (swapped on IGPM)7%90% to 100% CDI 10% to 11%

10.5%***

CDI SELIC**** n.a. 8%-10% pre-tax n.a.Developer IGPM***** n.a. n.a. 10.5%***

Source: Authors’ calculations*Cannot exceed TR+12%. Recent market research in August 2009 found rates as low as TR+8.2% (CAIXA pacote), but mainly at TR+8.9% (including CAIXA, Banco do Brasil, Bradesco and Santander)** Variable with income and accordingly with subsidy level***IGPM+12%; in October 2009, IGPM pointed -1.31%****SELIC rate 8.75% since September 2009*****During construction term, only INCC or CUB (construction price indexes) 16.

During the 1960’s and 1970’s, SFH proved to be an important instrument of housing policy, via BNH, the National Housing Bank. Both BNH and the intricate multi-index system then created showed vulnerable during the 1980’s, in a scenario of high inflation and unemployment rates, which eventually led to the liquidation of BNH and to a quasi-stagnation of housing finance along the late 1990’s and early 2000’s.

A number of legal reforms, associated with better economic conditions and the gradual decrease of interest rates, reactivated the system, recently expanding its production to levels comparable to the early 1980’s.This steep expansion is noticeable through figures as such presented in Table 4, below.

16 INCC Índice Nacional de Custos da Construção (National Construction Cost Index) surveyed and published by Fundação Getúlio Vargas; CUB, Custo Unitário Básico (Basic Unit Construction Cost), supplied by the State Sinduscon (Sindicato da Indústria da Construção (Construction Industry Syndicate), equal to construction cost per square meter of a 8-storey apartment building of two bedrooms apartments, surveyed in all Brazilian states. Both indices are published monthly.

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Table 4 – SBPE loans evolutionYear Housing Units Amounts (BRL Million)

Construction Acquisition Total % Increase Construction Acquisition Total % Increase2004 24,961 28,865 53,826 47.5 1,394.4 1,607.9 3,002.3 35.42005 34,762 26,359 61,121 13.6 2,855.2 1,996.8 4,852.0 61.62006 45,433 68,440 113,873 86.3 4,483.5 4,856.8 9,340.3 92.52007 88,778 107,122 195,900 72.0 9,278.0 9,004.7 18,282.7 95.72008 162,299 137,386 299,685 53.0 16,220.8 13,811.5 30,032.3 64.32009* 62,602 87,001 149,603 -8.2** 6,407.3 10,001.6 16,408.9 0.2***January to July. ** Compared to Jan/Jul 2008.Source: ABECIP

The crisis led to a decrease of total financed units, caused by a drop in new housing developments in the first half of 2009 relative to the same period of 2008 (62,600 units versus 91,500)17. However, this effect was compensated by a larger amount of finance for used housing, leading to comparable total amounts to 2008 (BRL 16.4 billion). This inverted the balance in favor of acquisition loans (See Table 5).

Table 5 – Breakdown of construction and acquisition loans (amounts)Year Construction Loans (%) Acquisition Loans (%)2004 46 542005 59 412006 48 522007 51 492008 54 46Jan/Jul 2009 39 61

Source: ABECIP

While market share of used units has remained dominant and relatively unchanged along the last few years, the loan amount for acquisition has increased rapidly in the same period (See Table 6).

Table 6 – Breakdown of loans between new construction and acquisition and average loan amountsYear % of loans (amounts) Average loans (BRL 1,000)

Used housing New housing Construction Acquisition Total2006 77.3 22.7 99 71 822007 74.6 25.4 105 84 932008 72.4 27.6 100 101 100Jan/Jul 2009 72.3 27.7 102 115 110

Source: ABECIP

Market conditions improvement and better regulation also led to higher lender confidence, resulting in higher LTV’s (See Table 7). NPL figures also decreased, mainly due to the adoption of Alienação Fiduciária (Trust Deeds). According to ABECIP, Alienação Fiduciária contracts, which now represent about 99% of all new housing finance loans, presented a NPL of 1.18% in June 2009.

17 ABECIP

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Table 7 – Evolution of LTV’s and NPL’s in SBPEYear LTV (%) NPL (%)2004 46.8 9.662005 47.8 8.502006 53.2 6.302007 56.4 4.332008 58.6 3.07Jan/Jul 2009 60.2 2.84

Source: ABECIP

SBPE loan distribution remains concentrated in the South-East, mainly São Paulo (See Tables 8 and 9).

Table 8: SBPE loan breakdown by region Table 9: SBPE loan Breakdown in the South-EastRegion % Amounts State % AmountsSouth-East 61 São Paulo 44.0South 15 Rio de Janeiro 9.3Center-West 11 Minas Gerais 6.5North-East 10 Espírito Santo 1.5North 3

Source: ABECIP

In spite of all changes and improvements and the accompanying expansion of the private lenders’ role in housing finance, the impact of the financial crisis saw an important reduction in SBPE lending to both developers and homebuyers. CEF stepped in to fill the resulting void, leading to an estimated breakdown of market share as shows in Table 10 below.

Table 10. SBPE loans breakdown estimate per agent mid-2009INSTITUTION MARKET SHARECEF 60 %ITAÚ 12% – 15%SANTANDER 8% - 10%BRADESCO 4%-5%OTHERS 10% - 16%

Source: Estimates by several market observers

CEF’s role will be further expanded under the MCMV program, where it is responsible for administering OGU resources18 that are to be channeled via FAR, in addition to its role administering FGTS. According to CEF, by November 30, 2009, the institution had received developer proposals for 567,000 units; of these, 176,000 units have been formally contracted (102,000 for 0-3MW, 56,000 for 3-6MW, and 18,000 for 6-10MW). Despite a major acceleration of contracting by CEF, which in two months saw the number of contracted units increase by almost 300 percent (only 60,000 units had been contracted by September 30, 2009), the figure still represents only 44 percent of the intended target for 2009.19 According to the Estado de Sao Paulo, some 45,000 units had been delivered by October 15, 2009.

Despite the Government’s strong intervention in the housing finance market over the past decades, Brazil still faces a considerable housing challenge in its deficit of 6.3 million homes. Compared to other Latin American countries, the ratio of mortgages outstanding to GDP, at around 6-7%, is too low. With the MCMV Program, industry analysts see an opportunity for a significant shift in the housing market, in particular if the Government manages to ensure a broader involvement of the financial sector in housing

18 According to CCFGTS officers, by the time this report is being written, only FGTS funds had been applied.19 Maia, Samantha: Plano habitacional fica aquém da meta, in Valor Econômico, December 4, 2009

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finance. Equally important would be to tackle the “access to land” challenge, which remains one of the key obstacles of access to affordable housing in Brazil. The MCMV program introduced important reforms related to access to and development of land, facilitating the issuance of environmental licenses, reducing the cost of property registration (making it free for low-income households under the program) and making it possible to operationalize the ZEIS instrument and enable land tenure regularization. Yet, a sustained momentum for reform in the areas of access to land, land use planning and regulatory controls is an equally important measure to address the housing challenge.

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ANNEX 3. VIEWS FROM DEVELOPERS ON RECOMMENDED CHANGES IN FGTS

Market moment: After years concentrating on upper income groups, Brazilian developers rediscovered the “economic” and “super-economic” segments delivering small units for middle and low-middle income families. Powerful players, like Cyrela, Gafisa and Odebrecht, created lower market divisions, and the few companies traditionally focused on this segment, like MRV and PDG, experienced a steep expansion and opened new regional markets20. This trend was helped by better economic conditions, an increase in housing finance through SBPE and FGTS, and by MCMV, with its large subsidies that helped households with incomes of 5-6 MW access housing in the main metro areas of Sao Paulo, Rio de Janeiro, and others.

Funding expansion needs: This market expansion is increasing the pressure for higher funding volumes, and making clear funding access limitations, especially FGTS, currently only served by CEF. A higher number of financial agents would be strongly favored by real estate developers that often have on-going strategic partnerships with large private financial institutions. Though not a short term need, at least to large players, production funding may eventually become a bottleneck, as smaller companies try to compete into this market. Today, most middle size developers often have production funded by non-retail middle sized banks21, with short term loans or even some venture capital, while final borrowers are served by SBPE or CEF/FGTS loans. The international crisis effect, in early 2009, dried up this market, pressing FGTS Council into authorizing FGTS investment on developers’ debentures. A recurrent suggestion among developers remains the resuming of “Plano Empresario”, a tandem of production and final borrower credit lines, highly used at BNH times22.

Operational issues: Though CEF is regarded as outstanding in bureaucratic difficulty, with an average of 100 days for delivering a loan, private banks are also criticized by their operational procedures, which usually take over 30 days. A large expansion of this market would require a simplification of these procedures; as a comparison, an automobile loan takes about 5 workable days to be screened and authorized. An increase of the financial spread, if needed to attract more agents to this market segment, is not regarded as a problem by developers due to the large repressed demand, even if with a higher cost to the final borrower.

Need for more permanent low income housing funding: Though supportive of MCMV, developers are aware of the challenge related to its magnitude and timing; as such, several expect it to come short of its ambitious targets, even if recognizing it will trigger a considerable increase in housing production. As for banks, they will go down market where the large unattended demand stands, though cautiously. This is due to lack of experience with the subsidized lower income segment of the market as well as dealing with local governments, who are expected to play a major role in the program for this income level (e.g. by availing land). MCMV is thus regarded as a “big lab”, of which many lessons will be learned. CBIC, representing developer associations and public works contractors,23 expects its Constitutional Amendment Proposal, called Moradia Digna, to pass in 2010 and serve as a platform by the end of MCMV. Moradia Digna calls for 2% of federal budget, 1% of states and municipalities’ budgets to be used for a low income housing subsidy fund, targeted at households with income below 3 MWs24. This may allow better targeting of FGTS, easing pressures on FGTS Council for supplying more subsidies.

20 Large publicly traded and highly capitalized companies were pressed to open new fronts in poorly served inland capital cities (Manaus, Belem, Campo Grande and Cuiaba). This nationwide coverage is unseen since the 1990’s after Encol’s bankruptcy, which saw important legal changes, like the introduction of Patrimônio de Afetação.

21 Like Votorantim, Banif and ABC Brasil, with no sight or SBPE deposits.22 The two lines were linked by a “repasse”, through which production finance loan was paid and final profit (if

existent) transferred to developer. 23 Câmara Brasileira da Indústria da Construção. 24 It is not clear at this moment how this fund will be harmonized with FNHIS.

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