Ukraine Banking and Finance Page No. and TOC Final

8/2/2019 Ukraine Banking and Finance Page No. and TOC Final

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Table of Contents

Capital Markets & Banking

Housing Finance & Development Study

ANNEX: KHARKOV MUNICIPAL FINANCE ASSESSMENT .......................................................................1

EXECUTIVE SUMMARY ..........................................................................................................................................4

HOUSING FINANCE ..................................................................................................................................................5

I. INTRODUCTION ............................................................................................................................................. ......8

1.1 PURPOSE OF THE STUDY ................................................................................................................................81.2 STUDY CONCLUSIONS ....................................................................................................................................9

1.2.1 Housing Finance ................................................................................................................................. ...9

1.2.2 Housing Financial Instruments ............................................................................................................101.2.3 Banking ............................................................................................................................................ ......101.2.4 Important Housing Issues ......................................................................................................................11

1.3 ORGANIZATION OF THIS REPORT .............................................................................................................12

II. ECONOMIC CONDITIONS IN UKRAINE ...................................................................................................12

2.1 EXISTING CONDITIONS .................................................................................................................................13

III. BANKING SECTOR ANALYSIS ....................................................................................................................13

3.1 UKRAINIAN BANKING SYSTEM .................................................................................................................143.2 CURRENT STATUS OF BANKING SYSTEM ...............................................................................................16

IV. LAND: AVAILABILITY AND OWNERSHIP ..............................................................................................18

V. HOUSING FINANCE SECTOR ANALYSIS ..................................................................................................195.1 PREVIOUS SYSTEM OF HOUSING SECTOR FINANCE ...........................................................................195.2 EXISTING CONDITIONS IN THE HOUSING FINANCE SECTOR ...........................................................205.3 ALTERNATIVE FINANCING CHOICES IN THE HOUSING SECTOR ....................................................225.4 SAVINGS AS A FINANCING VEHICLE FOR HOUSING ...........................................................................235.5 GOVERNMENT LOAN GUARANTEES AND HOUSING FINANCE .......................................................245.6 HOUSING FINANCE, RISK AND US SAVINGS AND LOANS .................................................................255.7 DUAL INDEX MORTGAGE FINANCING MECHANISMS ........................................................................265.8 HOUSING FINANCE BANK ............................................................................................................................285.9 MORTGAGE, FORECLOSURE AND PROPERTY LAWS ..........................................................................295.10 FOREIGN LOAN GUARANTEES FOR HOUSING .....................................................................................295.11 SUMMARY ON HOUSING FINANCE .........................................................................................................305.12 OTHER FINANCIAL SOURCES: EMERGING INSURANCE SECTOR ..................................................30

VI. HOUSING CONSTRUCTION INDUSTRY, MARKETS AND MUNICIPAL SERVICES ...............32

6.1 HOUSING CONSTRUCTION INDUSTRY .....................................................................................................326.2 CONSTRUCTION BUILDING MATERIALS INDUSTRY ...........................................................................336.3 HOUSING MARKETS: PRIVATIZATION AND HOUSING DEMAND ....................................................336.4 MUNICIPAL GOVERNMENT: HOUSING SERVICES AND UTILITIES ..................................................34

VII. CONCLUSIONS & RECOMMENDATIONS .............................................................................................35

7.1 CONCLUSIONS .................................................................................................................................................35

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7.1.1 Housing Finance ...................................................................................................................................357.1.2 Housing Financial Instruments .............................................................................................................357.1.3 Banking ............................................................................................................................................ ......367.1.4 Important Housing Issues ......................................................................................................................37

7.2 RECOMMENDATIONS ....................................................................................................................................387.3RECOMMENDATIONS FOR TECHNICAL ASSISTANCE TO UKRAINE ................................................40

7.3.1 SHORT TERM TECHNICAL ASSISTANCE ........................................................................................407.3.2 MEDIUM TO LONG TERM TECHNICAL ASSISTANCE ............................................................. ......41

ANNEX .........................................................................................................................................................................42

APPENDIX ...................................................................................................................................................................44

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Executive Summary

This purpose of this report is to provide an analysis of the housing and housing finance sector

for the Ukraine and to develop suggestions and recommendations on actions where a technicalassistance program could be provided to help facilitate the successful transformation of theUkrainian housing sector to a system based on free market principals. This study includes adescription of the previous housing finance and development activities that had beenemployed when Ukraine was part of the Soviet Union. Substantive changes to the housingsector, which have occurred since the Ukraine declared independence, have been noted.

The report provides an assessment of the Ukrainian capital markets, the central bankingsystem, the emerging commercial banking and insurance sectors, and discusses importanteconomic trends and their impact on the economy. An appraisal was also made of thedominant government housing construction industry and of the emerging private constructionenterprises. Included in this analysis is a description of local conditions governing housingownership, maintenance, land ownership, municipal finance, and the system of financing bothsingle family (dachas) and multifamily housing.

All of the factors discussed herein are interlocking mechanisms which dominate the existinghousing sector and which will fundamentally influence the direction of this industry as itevolves into a system based on market principals. Each of these factors must be analyzedcarefully in order to access the changes needed to implement a comprehensive market basedhousing program involving land, buildings, construction, building materials and financing.

The housing industry is inextricably linked to the past system of government ownership andcontrol. In order to restructure this industry to accommodate market driven forces, major

changes will be needed in government laws and policy toward the housing sector at thenational and local levels. In addition, the development of a housing financial system designedto provide wide-ranging ownership opportunities and significant economic growth will requirea major overhaul of the Ukrainian financial system and the imposition of stable economicconditions through a sound structural adjustment program. Without major comprehensivechanges, a fully functioning private housing economy will continue to be severely constrainedand economic growth will be diminished. This study attempts to put forth a rationale and asystematic strategy for transformation.

ECONOMIC CONDITIONS

The breakup of the Soviet Union has resulted in a further deterioration of the economy ofUkraine. The production of commodities has decreased and scarce goods and services aremore expensive. This phenomena has brought about economic instability, spiraling inflation(presently 400% and increasing rapidly), high interest rates (approximately 50%--althoughreal interest rates are minus 350%), excessive monetary growth, rapidly increasingunemployment and underemployment and a near catastrophic decline in the nations GrossDomestic Product (GDP).

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The old Soviet industrial system was designed so that states were interdependent on each otherfor major inputs. This system has collapsed with the movement toward political independenceand will not be able to sustain previous industrial production levels. Inputs which are imported

such as energy (gas and oil) and lumber will be priced at world market levels by year endresulting in substantial price increases and a large expenditure of scarce foreign currencyreserves. These events will be highly inflationary and can only serve to accelerate the declinein the GDP.

BANKING SECTOR

The banking system in Ukraine is currently experiencing a major crisis. Many state enterprisesare unable to repay large loans and need additional credits in order to meet operating expenserequirements. The state banking system is insolvent and depends upon the central banks forcredits in order to meet financing demands and maintain liquidity. In other words, the entirestate-owned banking sector is wholly dependent upon a continuing (and at the present time

unending) series of bailouts initiated by the government.

The instability of the state-owned banking sector has resulted in many problems for theemerging private commercial banking sector. Since funds deposited in state banks areguaranteed, depositors feel more comfortable investing savings in the state banks. Privatebanks have been unable to attract a significant volume of deposits from citizens, and areforced to rely on capital and retained earnings for lending activity. Lending activity is alsoconstrained by the lack of collateral that can be used to securitize loans. As long as consumerconfidence in the commercial banking industry is lacking, this sector will be unable to providea viable alternative to the state-owned banking sector. Although commercial banking hastremendous potential, it is still a minor factor in the banking sector.

OWNERSHIP OF PROPERTY

Private markets require private ownership. Planned economies and private economiesconverge at the crossroads of private ownership and public ownership. The focus of a socialistplanned economy is government ownership and control of productive assets. The nucleus of aprogram to transform a socialist economy must foster the evolution of private markets andprivate ownership of productive assets. The Soviet socialist experiment has failed. The successof the Soviet transformation requires that rapid privatization of land and property and thedismantling of barriers to free enterprise proceed forthwith.

In Ukraine, the government owns all real property. The government allocates only a smallamount of property to individuals for the construction of homes. This is done on a ad hoc basisand must be approved by the local governments. The process of obtaining land is long andarduous, and often is frustrated by government red tape and inaction. For all practicalpurposes, the private market for land is non-existent.

HOUSING FINANCE

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Under the Soviet system, multi-family housing finance was derived from three major sources.

1. State banks provided credits from local units of government to constructnew housing.

2. Large industrial enterprises provided funds for housing construction fromretained earnings and/or from loans from state banks. Enterprise ownedhousing was provided primarily to employees.

3. Citizen groups were permitted to form private housing cooperatives, whichwere financed with savings and bank loans. Each owner of a cooperativeunit provided an up-front equity payment of 30% of the development cost.The remaining funds equal to 70% of the development cost was providedin the form of a long-term loan by the state bank (Ukrainian Social Bank).

The Ukrainian housing sector presents a unprecedented challenge to the development

community. The country, with its large population of over 50 million residents, desperatelyneeds a productive housing industry that can serve as an engine of growth to an economy thatis heavily dependent on the huge declining defense sector. The successful development of ahousing finance industry to mobilize financial resources is vital to the long-term growth anddevelopment of the entire housing sector and to the economy in general. However, housingfinance must be coordinated with other reforms such as the privatization of land and existinghousing and banking and economic reforms in order to foster sustained economicimprovement.

It is important to build the housing finance industry on fundamentally sound banking andfinancial principals so as not to risk future economic crises brought about by unsound and

unwise lending practices. The introduction of sophisticated financing instruments such as dualindex mortgages is not practical in the Ukraine. Savings represents a unique source of fundsfor the housing sector, and should be exploited to the maximum extent possible.

It is impossible to predict when economic conditions will permit a fully functioning housingsystem to grow and develop. However, the long development times that are necessary to set upa Housing Finance Bank system support a near term assessment of this initiative. The initialfeasibility assessment of a Housing Finance Bank should also include an assessment ofproperty collateralization in conjunction with a government sponsored housing guaranteeprogram.

HOUSING CONSTRUCTION

Large state-owned construction conglomerates dominate the housing construction industry.Although corporations are separate legal entities, it is hard to distinguish a company from aministry since the managerial and financial affairs are inter-linked and operating and budgetauthority is devolved from the central ministries responsible for construction. Unless theconstruction industry is privatized, the open market based housing sector will be constrainedby bureaucratic inefficiency and low productivity.

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The transformation of the housing sector from state domination to a system based upon freemarket principals will be extraordinarily complex. However, a housing sector based on freemarket principals cannot exist without a private housing market. The Ukraine has passed a law

that permits the privatization of housing, but has not yet begun privatization. Theimplementation of this law is of paramount importance and should proceed as soon aspossible. Without a functioning private market for existing housing, it will be difficult toinstall a housing finance system founded on market principals.

MUNICIPAL SERVICES

Local governments including municipal governments such as Kiev and Kharkov provide awide spectrum of public services to residents of public and cooperative housing. Governmentis responsible for maintenance and repair of housing and for supplying water and sanitationservice. The government is also responsible for providing utility service, including electricityand heat. The occupant of each housing unit has little authority over the buildings where they

live, and contribute only a very small portion of the cost of providing maintenance and utilityservices.

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I. INTRODUCTION

Private markets require private ownership. Planned economies and private economiesconverge at the crossroads of private ownership and public ownership. The focus of a socialist

planned economy is government ownership and control of productive assets. The nucleus of aprogram to transform a socialist economy must foster the evolution of private markets andprivate ownership of productive assets. The Soviet socialist experiment has failed. The successof the Soviet transformation requires that rapid privatization of land and property and thedismantling of barriers to free enterprise proceed forthwith.

Transformation of a planned economy to a market driven economy necessitates thatgovernments eliminate impediments that restrict free markets and create an environmentwhere commerce can flourish. Private markets provide the delivery of goods and servicescheaper and more efficiently than government-controlled providers. The role of governmentmust be limited to establishing the financial and legal infrastructure where market competitionis maintained and efficient production is rewarded by successful participation in themarketplace.

The role of government in the transformation is complicated. Government must institute andenforce progressive laws and policies relative to taxes, tariffs, private ownership of property,ownership of businesses, rules of commerce, free market convertibility of foreign exchangerates, sound central and commercial banking policies, prudent monetary and fiscal controls,and market rate pricing of goods and services in order to give birth to a climate wherecommerce and economic growth can prosper and individual initiative can be rewarded.Government actions to restrict commerce and impose unnecessary regulatory burdens, evenunder the best of intentions, lead to unintended results which impact adversely on economicgrowth, on the production of goods and services and on job creation.

1.1 PURPOSE OF THE STUDY

This purpose of this report is to provide an analysis of the housing and housing finance sectorfor the Ukraine and to develop suggestions and recommendations on actions where a technicalassistance program could be provided to help facilitate the successful transformation of theUkrainian housing sector to a system based on free market principals. This study includes adescription of the previous housing finance and development activities that had beenemployed when Ukraine was part of the Soviet Union. Substantive changes to the housingsector that have occurred since the Ukraine declared independence have been noted.

The report provides an assessment of the Ukrainian capital markets, the central bankingsystem, the emerging commercial banking and insurance sectors, and discusses importanteconomic trends and their impact on the economy. An appraisal was also made of thedominant government housing construction industry and of the emerging private constructionenterprises. Included in this analysis is a description of local conditions governing housingownership, maintenance, land ownership, municipal finance, and the system of financing bothsingle family (dachas) and multifamily housing.

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All of the factors discussed herein are interlocking mechanisms which dominate the existinghousing sector and which will fundamentally influence the direction of this industry as itevolves into a system based on market principals. Each of these factors must be analyzed

carefully in order to access the changes needed to implement a comprehensive open marketbased housing program involving land, buildings, construction, building materials andfinancing.

The housing industry is inextricably linked to the past system of government ownership andcontrol. In order to restructure this industry to accommodate market driven forces, majorchanges will be needed in government laws and policy toward the housing sector at thenational and local levels. In addition, the development of a housing financial system designedto provide wide-ranging ownership opportunities and significant economic growth will requirea major overhaul of the Ukrainian financial system and the imposition of stable economicconditions through a sound structural adjustment program. Without major comprehensivechanges, a fully functioning private housing economy will continue to be severely constrained

and economic growth will be diminished. This study attempts to put forth a rationale and asystematic strategy for transformation.

1.2 STUDY CONCLUSIONS

1.2.1 Housing Finance

1.2.1.1 The housing finance sector is undeveloped. The primitive nature ofthe banking system and the present economic instability have notcreated a climate where a sophisticated housing finance industry

could be mobilized to provide funds for the rapid growth andexpansion of the housing sector.

1.2.1.2 The Ukraine needs a mortgage and property law that clearly definesownership of real property and the rights of mortgage holders. Thelaw must permit property to be used as collateral for loans. The lawshould also allow the mortgage holder to originate a foreclosureprocess in the event that the borrower defaults on the mortgage.

1.2.1.3 Collateral is an essential component of loans, and any deficiency inthe availability of collateral for loan securitization will retard the

expansion of lending activity for residential development.

1.2.1.4 It is extremely importantto recognize the risks that can result fromthe implementation various financing mechanisms. The cardinalformula for economic growth is not exotic ultra-creative financingmechanisms, but a stable financial system built on free marketfundamentals and constructed with prudent financial

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instrumentation. Financing mechanisms that have worked the bestover long periods of time are those devices that have been designedto reduce or eliminate risk and embrace fundamental economic andbanking principles.

1.2.2 Housing Financial Instruments

The creation of a Housing Finance Bank (HFB) deserves consideration. Private marketsrequire that funds for housing be obtained and loaned from private sources. The HousingFinance Bank would offer a reliable mechanism for mobilizing funds for the housingsector. A housing finance bank can be provided with financial tools that will facilitatethe acquisition of funds for housing development activities.

1.2.2.1 Financing mechanisms such as a housing loan guaranteeprogram should be considered in tandem with thedevelopment of a housing bank.

1.2.2.2 Dual index mortgages are not viable as a financingalternative.

1.2.2.3 Savings (aka equity financing) can be a significant source offunds for housing development during a period of transitionto a market economy.

1.2.2.4 It is not feasible to implement sophisticated financialinstruments during periods of economic instability and

hyperinflation.

1.2.2.5 Foreign loan guarantees should only be provided if theypromote investment or are made in conjunction withsubstantive economic reform.

1.2.2.6 The privatization of land and housing is necessary to createprivate markets and foster the development of the housingfinance sector.

1.2.2.7 Government should not make any onerous restrictions on

financing or home ownership.

1.2.3 Banking

1.2.2.1 The state banking system is insolvent and depends upon the centralbanks for credits in order to meet financing demands and maintainliquidity. In other words, the entire state-owned banking sector is

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wholly dependent upon a continuing and unending series ofgovernment approved bailouts.

1.2.2.2 The development of the commercial banking sector offers a real

long-range opportunity for the development of a market drivenhousing finance system. Banks and bank branches are beingestablished throughout the country, and their growth and expansionshould provide the basis for the development of a network ofinvestors and borrowers for housing.

1.2.2.3 The limited technological capability of the commercial bankingsector, the ancient nature of the funds clearance procedures in theUkraine and the economic instability prevalent throughout theeconomy prohibits the introduction modern financial and secondarymarket financial instruments that facilitate capital formation fordevelopment activity.

1.2.2.4 Commercial bank lending for housing construction andrenovation is not viable in the present economic environmentof hyperinflation and high interest rates.

1.2.2.5 Bank lending for the housing sector can only be made on ashort-term basis until economic stabilization andcomprehensive reforms are achieved.

1.2.4 Important Housing Issues

The Soviet housing model embraces socialistic planning. All of the major facetsof the housing sector are constructed around socialist concepts. The transition toa market economy requires that the rapid privatization of land and property andthe dismantling of barriers to free enterprise proceed forthwith.

1.2.2.1 Structural economic reforms that can serve as a foundation tobuild a self-sustaining economy must be implementedpromptly.

1.2.2.1 Land must be privatized and made available to the public

without unreasonable restrictions.

1.2.2.1 Unless the privatization of land and housing proceedsrapidly, the lack of property for loan securitization willpresent a major restraining factor to the growth of lending inthe housing sector.

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1.2.2.1 Without a functioning private market for land and existinghousing, it will be difficult to install a housing systemfounded on market principals.

1.2.2.1 The construction sector must be broken apart and privatizedin order to restore some level of efficiency and productivityto construction output. Without privatization, theconstruction sector will be constrained by bureaucraticinefficiency and low productivity.

1.2.2.1 Municipal Finance--The existing municipal finance system will needto be substantially overhauled with the introduction of a free marketsystem. The government will need to reduce and in many caseseliminate the subsidies to service and utility providers. A system ofuser fees and property taxes will need to be installed. Theimplementation of the new system will be enormously complicated.

1.3 ORGANIZATION OF THIS REPORT

This report provides an analysis of the housing industry of the Ukraine with special emphasison the housing finance sector. Other sectors such as banking1 and municipal government arecovered in order to provide an understanding of their relationship and impact on the housingsector.

In addition to housing finance, this report focuses on a wide range of areas which includemacroeconomic conditions, the commercial and state banking sector, bank lending practices,financing sources, the housing construction industry, construction materials industries, land

availability, property ownership, housing market demand, and municipal services.Althoughthe scope of this study was directed primarily at housing finance, the importance of ancillaryissues such as land and property privatization, banking sector conditions and the economicclimate requires that the report be expanded to provide a more comprehensive analysis ofother areas as well in order to provide an accurate picture of the depth of the problems forboth housing and housing finance.

The report concludes by summarizing the findings of the study and by offeringrecommendations for reform of the housing and housing finance sector as well as the housingand banking industry. Section 7 lists specific suggestions for short term priority technicalassistance and for medium term and longer range priority needs.2

II. ECONOMIC CONDITIONS IN UKRAINE

1 The banking and financial system are a critical component of the housing finance sector. An in-depthunderstanding of the present banking sector is essential in order to understand housing finance needs and todevelop recommendations for technical assistance.2 All of the conclusions of the report impact either directly or indirectly on housing finance.

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Until recently, the Ukraine was part of the Soviet Union (USSR). The government andeconomy of the Ukraine has been administered under a policy of highly centralized planningand control. Government policies have resulted in an insular economy that was, in manyrespects, isolated from the world economic and financial system. Government controlled

prices and wages and products were produced in accordance with central planning targetsinstead of market demands. The Soviet system brought about economic stability and lowinflation, but was unable to provide an adequate supply of basic necessities and brought abouta very low standard of living. Central planning resulted in poor quality consumer goods,inadequate and low quality housing, poor medical care, shortages of food staples and aseriously underdeveloped service industry.

2.1 EXISTING CONDITIONS

The breakup of the Soviet Union has resulted in a further deterioration of the economy ofUkraine. The production of commodities has decreased and scarce goods and services aremore expensive. This phenomena has brought about economic instability, spiraling inflation

(presently 400% and increasing rapidly), high interest rates (approximately 50%--althoughreal interest rates are minus 350%), excessive monetary growth, rapidly increasingunemployment and underemployment and a near catastrophic decline in the nations GrossDomestic Product (GDP).

The old Soviet industrial system was designed so that states were interdependent on each otherfor major inputs. This system has collapsed with the movement toward political independenceand cannot sustain previous levels of industrial production without inputs from other formerSoviet Block countries. Inputs that are imported such as energy (gas and oil) and lumber willsoon be priced at world market levels resulting in substantial price increases and increasedexpenditures of scarce foreign currency reserves. These events will be very inflationary and

can only serve to accelerate the decline in the GDP.

The Ukraine is at a crossroads.It is urgent that economic reforms which can serve as afoundation to build a self-sustaining economy be implemented promptly. Reform measures willpermit the dynamics of the market economy to be mobilized in order to more effectivelymanage the considerable resources of the Ukraine and to increase the productive capacity ofthe economy. If reforms are not implemented and the economy continues its deterioration, it islikely that shortages of food staples and other vital commodities will accelerate. This processcould lead to a wave of political instability that would pose a serious threat to the immediatefuture of the country.

III. BANKING SECTOR ANALYSIS

The Ukrainian banking sector is similar to the banking system that was employed throughoutthe former Soviet Union and in the former Soviet Satellites. The banking and financial sectorgreatly differs from western financial systems and is not able to provide many minimalservices which would be expected of a modern banking and financial system. Each

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government owned bank has one or more branches located in the 24 regions (Oblasts) of theUkraine in addition to Crimea and Kiev, which are special regions.

The banking sector is presently structured as follows as follows:

3.1 UKRAINIAN BANKING SYSTEM

Central Bank The primary function of the Central Bank of the Ukraine is toprovide liquidity to the financial sector by disbursing funds or credits tolower tier banks in order to meet industrial, commercial, social andgovernmental financial requirements. These credits are provided inaccordance with planned budget expenditures and can be extended as eitherloans or grants. In essence, the central bank serves a treasury-disbursing agentfor financial needs.

The central bank is also responsible for circulating currency. Prior to 1992,the ruble was the currency used in Ukraine and throughout the entire USSRand was controlled by the USSR Central Bank located in Moscow. Becauseof a severe shortage of rubles (due to inflation), the Russian republicdiscontinued its supply of currency to the Ukraine after the Ukraine declaredindependence. In order to advert a shortage of currency, the Ukrainedeveloped a intermediary Ukrainian currency known as the Coupon toprovide for short term currency and liquidity needs. The Coupon will beredeemable for the new Ukrainian currency that is expected to be introducednext year. The new currency will be known as the GRIVNA.1

The Central Bank also is responsible for all foreign currency operations. All

foreign currency selling and buying transactions must be processed throughthe Central Bank in accordance with government policies. Governmentalauthorities must also approve foreign currency expenditures.2

In western economies, the central bank serves as a interbank clearinghousefor debits and credits to member accounts. This is accomplished throughprocessing of checks and the electronic transfers of funds. In modernfinancial systems, clearance procedures can be approved in a manner ofhours or days (with checks) and are highly automated with state of the artcomputer hardware and software. These systems can process billions oftransactions per day. They are necessary to maintain functioning free markets

and are highly advantageous to the free flow of commerce for domestic andinternational transactions.

1 The ability of the central bank to successfully introduce the GRIVNA is uncertain. Presently, there are noplans to link the currency to any commodity such as gold or to another standard such as the dollar or theEuropean Monetary System.2 Black market currency transactions are common throughout the Ukraine, especially in Kiev.

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The bank clearinghouse functions for the Ukraine have not been developed tothe standard of western clearance procedures, and therefore much accountclearing must be completed through manual cash transactions.3 This system isan serious impediment to free market commerce since the collection of debts

can take extended periods of time and may not be compatible with theliquidity requirements of various enterprises. In periods of high inflation andhigh interest rates, this can cause business activity to decrease since profitscan be reduced or eliminated by the cost imposed by declining currencyvalues (inflation) and by high interest costs.4

The ancient nature of the clearance procedures in the Ukraine and theeconomic instability prevalent throughout the economy prohibits theintroduction modern financial and secondary market-based financialinstruments that facilitate capital formation for development activity andencourage economic growth.

Ukrpromstroibank The Ukrpromstroibank (hereinafter called the IndustrialProjects Bank of the Ukraine or IPB) is chartered to provide loans or directcredits to industrial enterprises for investment projects approved by the state.

Direct credits and loans are provided to industrial enterprises for investmentprojects such as the construction of plants or the purchase of equipment formanufacturing. Funding is also provided for working capital, also by loansand direct credits. Industrial enterprises (which are primarily hugemanufacturing conglomerates) have also constructed housing, schools andother socially beneficially projects for the benefit of their respectiveemployees. These enterprises received bank loans for many of these projects.5

All loans to industrial enterprises were repaid to the IPB that theoreticallytransferred funds back to the Central Bank.

Ukrsocialbank The primary function of the Ukrsocialbank of the Ukraine(hereinafter called the Ukrainian Social Bank or USB) is to provide loans ordirect credits to social enterprises for social development projects approvedby the state. Social development projects are defined as those which serve asocial or public purpose such as housing, hospitals and medical facilities,schools, transportation facilities and commercial shops.

Direct credits and loans have been provided from the state (Oblasts) for

social investment projects. The ISB was also responsible for providing loans3 One process for account clearing resulted in semiannual gatherings of all industrial enterprises where hugeamounts of cash would be shoved across tables in order to clear account imbalances.4 When the economic environment is intrinsically unstable, one would expect that businesses would have aincentive and a greater need to engage in barter transactions since commodities with more stable free marketprices are more highly valued and inflation resistant than unstable currencies. Barter transactions are inherentlyinefficient and act as an impediment to the growth of business activity.5 Many projects were funded in whole or in part with retained earnings.

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to housing cooperatives for new construction of approved multi-familyprivate housing. Cooperative housing loans will be discussed in a latersection of this report entitled Housing Finance Sector Analysis.

Ukragroprombank The Ukragroprombank of the Ukraine (hereinafter calledthe Ukrainian Agricultural Industrial Bank or AIB) provides loans or directcredits and loans to agricultural industrial enterprises that are primarilylocated in the rural areas of the Ukraine.

Sberegatelniy Bank The Sberegatelniy Bank of the Ukraine (hereinafter calledthe Depository Bank or DB) is the major bank where Ukrainians depositpersonal savings. The Depository Bank paid interest on savings in accordancewith the time frame selected by the depositor. Depositors who invested fundsfor longer periods of time received higher interest.

Commercial Joint Stock Bank Recently, commercial banks have begunoperations. Commercial banks are free market banking institutions that havebeen capitalized with private funding and are privately owned.6Commercialbanks are similar to western banking institutions in that funding sources areobtained from either investors or depositors and are the sole source of lendingactivity.

As of September of 1992, there were approximately 120 commercial banks,30 of which were located in Kiev. The banks have very little regulation andoperate outside of a centralized bank regulatory environment. There is nodeposit insurance or other guarantees provided to banks by the Governmentof Ukraine, and the security of customer deposits is entirely dependent uponsound banking operations of the respective institutions. Because commercialbanks are thought to be risky, they have not been able to attract a largeamount of funds from depositors.7 Funds for lending and investing activityhave come from invested capital and/or retained earnings.

Most commercial banks have become involved in investing in projectsthrough loans or equity infusions and are owner/investors of many of thebusinesses which for which they have provided funds. Therefore, banks havetaken upon the role of merchant banks or investment banks in addition tocommercial banks as defined by the banking system in use the United Statestoday.8

3.2 CURRENT STATUS OF BANKING SYSTEM

6 Bank ownership to foreigners is restricted and must be approved by the Ministry of Finance.7 In fact, many banks have not been able to attract any deposits from the general public.8 Many banks have invested in and are owners of insurance companies and have incurred substantial additionalliabilities and risks.

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The banking system in Ukraine is currently experiencing a major crisis. Many state enterprisesare unable to repay large loans and need additional credits in order to meet operating expenserequirements. The state banking system is insolvent and depends upon the central banks forcredits in order to meet financing demands and maintain liquidity. In other words, the entire

state-owned banking sector is wholly dependent upon a continuing (and at the present timeunending) series of government-approved bailouts. The alternative to a bailout would be toeliminate or reduce subsides, which would collapse many state owned enterprises and rapidlyincrease unemployment.9 A continuation of credits to unprofitable enterprises is highlyinflationary and will lead to greater economic instability and a slowing of the reform process.

The interest rate and inflationary environment have subjected the state and the fledglingprivate banking industry to huge risks for which they are inadequately prepared. State banks,in addition to owning a large number of nonperforming loans to state owned enterprises, haveexperienced numerous problems with loans to housing cooperatives. Banks made loans tohousing cooperatives for the construction of private multifamily housing. The loan amountwas equal to 70% of the estimated cost of the housing and was made during a period of

rapidly increasing construction prices. Price increases resulted in loan funds being exhaustedprior to the completion of construction leaving projects unfinished and cooperative loans in adefault status.10

The instability of the state banking sector has resulted in many problems for the emergingprivate commercial banking sector. Since funds deposited in state banks are guaranteed,depositors feel more comfortable investing savings in the state banks. Private banks have beenunable to attract a significant volume of deposits from citizens, and are forced to rely oncapital and retained earnings for lending activity.11 Lending activity is also constrained by thelack of collateral that can be used to securitize loans.12 As long as consumer confidence in thecommercial banking industry is lacking, this sector will be unable to provide a viable

alternative to the state banking sector. Although commercial banking has tremendouspotential, it is still a minor factor in the banking sector.

Many of the present problems can be traced back to the structure of the old Soviet financialsystem. The central bank, through the budgetary process, provided credits to thousands ofenterprises that lost money13 and were inefficient providers of goods and services. Theoversupply of financial credits to the economy was inherently inflationary. However, withwages and prices rigidly controlled and with goods and services in short supply, citizens were

9 This event could also be politically destabilizing. It is likely that the IMF will require reduced subsidies inreturn for hard currency credits which the Ukraine will need in order to purchase needed foreign sourcedcommodities (especially oil and gas).10 There is no provision in Soviet or Ukrainian law to deal with bank foreclosures of properties. In the words ofone vice-president of the USB, These things never happen, and there was no need for any laws to deal withthem. Now that we have this problem, we dont know what to do. We have taken control of the unfinishedproperties, but we are not sure that we have a legal right to do so. We are sitting here and we dont know whatto do.11 There is no state or privately supported deposit insurance program for commercial banks.12 Most fixed assets are property of the state and cannot be used to securitize loans.13 Many of the government owned enterprises showed large profits, but this was due to price fixing and/orbudgetary allocations of credits.

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forced to save excess currency. In the event that citizens were lucky enough to purchase acommodity such as a color television or and automobile, they could immediately sell thatcommodity for a value far in excess of its cost.14

It should be no surprise that prices have increased dramatically with the freeing of pricecontrols on many commodities and the advent of limited free markets. It is interesting to notethat the excess saving of rubles (also known as the ruble overhang), present when the SovietUnion began its economic reform efforts, was seen as a major threat to economic stability.15

The massive subsidization of efficient industries by the central banks of Russia and Ukraineand the freeing of prices on privately produced goods have ignited hyper-inflation, which hasseverely devalued the excess savings incurred during the long tenure of the Soviet system.

The volatile nature of the money markets and the uncertain future direction of the economy donot provide a good climate for capital markets or for capital formation, which is needed forlong term asset based lending.16 Commercial bankers are reluctant to lend long-term moneysince they are unable to match loan funds with long-term deposit terms. Certificates of

deposits in the current economic climate seldom have terms of more than three months. Inaddition, the lack of private ownership of fixed assets removes the major source of bankcollateral needed for loan securitization.Bank lending for the housing sector is limited andwill only be made on a short-term basis until economic stabilization and comprehensivereforms are achieved.

IV. LAND: AVAILABILITY AND OWNERSHIP

All real property in the Ukraine is owned by the central government. The government allocatesonly a small amount of property to individuals for the construction of homes. This is done on aad hoc basis and must be approved by the local governments. The process of obtaining land is

long and arduous, and is often frustrated by government red tape and inaction. For allpractical purposes, the private market for land is non-existent.

In the United States, we view single-family housing within the context of financing. When wethink about buying or building a home, our major concern is our ability to qualify forfinancing and meet financial obligations. The availability of land, building materials orcontractors is not a constraining factor, except for price. However, in the Ukraine, the majorconstraintin the construction of new housing by the private sector is the availability ofland.

14 In the case of color televisions, they could be purchased when found for about two months wages, and couldbe immediately sold for wages that would equal three years wages. These price distortions provide evidence ofthe severe inflation which was being depressed by government controls.15 It was thought that citizens with excess ruble savings would all begin to spend their currency immediatelyfor foreign goods and ignite hyper-inflation and a foreign currency crisis. Many economists were suggesting atthat time that excess rubles be traded for housing in order to gain control over money supply and inflation.16 This is especially true for undeveloped capital markets similar to those which exist in the Ukraine.

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For the market based housing sector to grow and prosper, the privatization of land mustproceed rapidly.1 Without a free market in land, the housing construction industry will beencased in gridlock, and the growth and development of that sector will be severely limited.For the housing sector to serve as an engine for growth in the economy, land must be

privatized and made available to the public without unreasonable restrictions.

2

V. HOUSING FINANCE SECTOR ANALYSIS

Under the Soviet system, multi-family housing finance was derived from three major sources.1

1. State banks provided credits from local units of government to constructnew housing.

2. Large industrial enterprises provided funds for housing construction fromretained earnings and/or from loans from state banks. Enterprise ownedhousing was provided primarily to employees.

3. Citizen groups were permitted to form private housing cooperatives, whichwere financed with savings and bank loans. Each owner of a cooperativeunit provided an up-front equity payment of 30% of the development cost.The Ukrainian Social Bank provided the remaining funds equal to 70% ofthe development cost in the form of a long-term loan.

5.1 PREVIOUS SYSTEM OF HOUSING SECTOR FINANCE

The state planning apparatus developed five-year plans and budgets that allocated funding fornew housing construction and for rehabilitation of existing housing on an annual basis. Since

the cost of labor and materials were fixed, construction prices were set with a high degree ofcertainty. Project construction was completed using a combination of loan and grant2 funds.Most housing was built under the auspices of the state, and tenants were selected from awaiting list. Tenants paid a nominal monthly fee for maintenance and utility services.3

The primary lending program for housing was the 70/30-loan program established forcooperative housing. This financing vehicle was very popular with users but only financedabout 5%-7% of new multifamily housing. All owners of co-op units were required to provide

1 The privatization of land must be institutionalized. It is very important to develop a legal and administrativeprocess for the disposition of land. Land sales can also serve as a revenue source to local governments, therebyalleviating the economic costs of their political transformation.2 One government representative thought land could be sold to private developers as long as the housing unitswhich were constructed were provided to individuals of the waiting list for housing at the governmentcontrolled price.1 Single family housing was primarily financed with savings, but made up only a small percentage of housingconstruction.2 Funds were obtained from taxes on state enterprises and other government revenues in addition to directcredits.3 The payment of this fee only covered a very small portion of the cost of services. For all practical purposes,an extensive array of costly services were provided free to the tenants.

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an equity contribution of 30% of the project cost prior to the commencement of construction.When equity financing was in place, the bank (primarily the Ukrainian Social Bank) made70% loans available to the project. Loans were made for a term of 25 years with an interestrate of .5%. Loan payments were reasonable for the average wage earner, and the program was

very popular with participants. The quality of construction was better than most state ownedhousing, since many of the co-op members were also employed by construction enterprises.The major obstacle to individual groups who wanted to form co-ops was obtaining land forconstruction. Once land was obtained, the process moved foreword quickly.

Some families were fortunate to be provided with a parcel of land in or near theircommunities, where it was feasible to construct a single family home. Most of these homeswere constructed by private contractors and paid for in cash by tenant-owners. Often homeswere constructed over a long period of time (several years) because of a shortage of buildingmaterials and limited financial resources of the new owners.4 It was possible to obtain a loanfrom a bank for construction of single-family homes, but bank financing for single-familyhomes was not a major line of business for state banks.

5.2 EXISTING CONDITIONS IN THE HOUSING FINANCE SECTOR

State banks are now in great financial difficulty. With housing construction costs increasing ata pace much greater than wage inflation, the private cooperative housing program is no longerviable. Although the housing finance program technically remains an ongoing residentiallending program, it is not being used.

In the past few years, the cost of a house has increased from 100,000 rubles to over 1,000,000rubles5. However, the maximum home loan from a state bank for private housing cooperativesis 80,000 rubles6, less than 8% of the cost of an average new home. With the average cost of

1,000,000 rubles, this financing mechanism is not a viable.7

State banks formerly loaned fundsat an interest rate of .5% per annum. The interest rate has been increased recently, but is not inline with inflation. Since the state banking system is not based upon free market principles, itis not a practicable mechanism for a housing finance system. Were state banks to beprivatized, their usefulness in the housing finance sector could be made workable in a morestable economic environment.

4 Most homes are constructed in areas where there is no water, sewerage or paved roads.5 These costs are estimates. Rapid inflation is causing home prices and worker wages to change dramaticallyand quickly. This estimate is considered to be a snapshot of average wages (70,000-90,000 rubles per year andaverage costs of new housing (600,000-1,350,000 per year) in September of 1992. These average will be used

in this report to describe problems with housing finance issues.6 This may soon be increased to 500,000 rubles with a 25% interest rate.7 With the high inflation rate, recent buyers of co-op housing units using loan funds are observing a dramaticdecrease in the fixed rate loan payment on an inflation adjusted basis. If inflation continues unabated foranother year in the 400% to 1000% range the loan payments will be negligible as a percentage of income.However, the value of the home will increase on par with inflation, again proving that real estate (especiallyleveraged real estate) in a high demand market with high inflation is one of the best investments that aconsumer can make.

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The development of the commercial/merchant banking sector offers a real long rangeopportunity for the development of a market driven housing finance system. Banks and bankbranches are being established throughout the country and their growth and expansion shouldprovide the basis for the development of a network of investors and borrowers. Although the

commercial banking sector is small and rudimentary in its banking practices, the growth anddevelopment of a market driven economy will push banks to expand and to develop moresophisticated practices rapidly. The high education level of the citizens of the Ukraine andtheir ability to develop international networks should help to facilitate this process.

All of the commercial bankers who were interviewed for this report expressed a strong desireto participate in the financing of new housing and in the financing of housing rehabilitation.Although banks are not presently involved in lending activity for home construction, thebankers feel that the expansion and modernization of the housing stock is an area withsignificant economic growth and profit potential.

Without exception, all of the commercial bankers interviewed for this report expressed an

unequivocal interest in developing a mortgage-lending program. However, they repeated thatmortgage lending is not viable in the high interest rate climate. The bankers are maintaining apolicy where most loans were of a maximum of three months duration at an interest rate ofapproximately 50%. Most depositors, who received about 30% for their short-term deposits,refuse to deposit funds for more than three months.

Commercial banks do not have the underwriting capacity to evaluate a large-scale housingfinance program. Presently, loans must be collateralized using gold, foreign currency, or itemswith proven tangible worth. Most lenders will not accept job history, credit history (For allpractical purposes, there is no credit history.) or verification of pervious income and presentfinancial condition as acceptable means upon which to evaluate the creditworthiness of

borrowers.

Collateral is an essential component of loans, and any deficiency in the availability ofcollateral for loan securitization will inhibit the expansion of lending activity for development.It is very important to noteproperty is the major source of traditional loan collateral. Sincemost property in the Ukraine is owned by the state, the availability of property for collateral isseverely restricted. Unless the privatization of land and housing proceeds rapidly, the lack ofproperty for loan securitization will present a major restraining factor to the growth oflending in the housing sector. (This point will be repeatedly stressed throughout this report.)

Commercial banks will have to develop credit systems and a capacity to underwrite loansprior to engaging in a large-scale program of lending for housing or other commercialbusiness activity. Banks will also have to develop in-house lending policies and requirementsrelative to loan portfolio diversification, risk reduction, underwriting standards,nonperforming credits and house rules which limit excessive credit and capital exposure.

Commercial banks are not now engaged in systematic lending for the housing sector. With50% interest rates and construction costs of new housing six to twelve times the averagesalary, the economics of lending are not prudent. For example, if a homeowner earning 90,000

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rubles per year were to construct a new home at a cost of 750,000 rubles (a very inexpensivehome) with a 80% mortgage, he or she would have to borrow 600,000 rubles. The annualinterest cost of this loan would be 300,000 rubles per yearthat is 3.3 times the owners annualsalary. The repayment of this loan would pose an onerous burden on the borrower, with loan

default as the likely outcome.

8

The rapidly changing economic environment creates great uncertainly, as borrowers andcommercial lenders have no basis upon which to judge future economic conditions.Commercial bankers and borrowers alike recognize that medium and long term lending andborrowing is not practicable in this environment.9

5.3 ALTERNATIVE FINANCING CHOICES IN THE HOUSING SECTOR

In an inflationary environment, the cost of commodities increases rapidly in proportion to thedecrease in the value of currency. Therefore, commodities often have greater perceived valuethan currencies, and currency holders seek to convert currency to commodities with stable

values. This process leads to excess demand for commodities and invites hoarding, whichexacerbates the inflationary spiral.

One of the most valuable investments in a period of inflation is the family home. If housing isin short supply, the family home maintains a real economic value in stable and unstabletimes.10 A home may even have an enhanced value since those with local currency are eager toexchange their currency for a home, resulting in excess demand and higher prices for homes.Owning a home with a long term fixed interest rate mortgage is even better, since rapidlydecreasing currency values reduce the real cost of the monthly mortgage payment and ineffect, offering the home at a great discount to its owner. However, it is important to note thatthe holder of the mortgage receives his or her payments in currency with greatly reduced

purchasing power. The owner of the mortgage loses an amount equal to the gain of themortgage payer. Since mortgage providers understand this phenomenon, they are reluctant toinvest funds for long terms (7 to 30 years) unless they have strong confidence in the future ofthe economy.11

As homes often maintain their value in real economic terms, one would expect and theevidence should support the assumption that construction activity for new private homes andthe purchase of existing homes would occur in spite of high inflation. This is true in Ukraine,

8 It should be noted that commodity price inflation appears to be well in excess of wage inflation. This is duein part to the cost of foreign inputs being raised to world market levels and the increase in food and othercommodities being sold at much higher prices by private vendors who offer better service and better products.9 With inflation now accelerating past 400% and expected to increase beyond 1000% next year, one wouldexpect a deterioration in the banking environment whereby deposits beyond a few days is not feasible. In Kiev,there were many transactions where local individuals refused to accept Ukrainian currency and would onlyaccept foreign currency.10 We have assumed for discussion purposes that housing demand is greater than housing supply.11 In Argentina, the author is aware of a situation where a few years of hyper-inflation resulted in semiannualmortgage payments for luxury apartments costing only about twice the amount of the cost of a taxi fare to thebank where mortgage payments were made. The payer did not pay off the entire mortgage because the legalcost of paying a prepaying a mortgage was much greater paying the mortgage itself.

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if land can be obtained. However, lending activity, due to the high cost and uncertain natureof short-term borrowing, does not support construction activity. This leaves two principalsources of financing for housing construction, savings (or equity) and loan guarantees wherethe economic risk is assumed by the government. In the Ukraine, new private homes are being

financed with savings, as loan guarantees do not exist.

5.4 SAVINGS AS A FINANCING VEHICLE FOR HOUSING

Financing a new home with savings is usually the most costly method of financing. Undermany free market scenarios, savings would not be the preferred method of financing. Thereasons are clear. Most families do not have the funds on hand that would be necessary topurchase or construct a home outright. Second, it is more feasible to borrow on a long-termbasis to purchase a home since the yearly occupancy costs are lower and the home will beused and will maintain its value over a long period of time.

In many developing countries, the cost of building a new home is expensive to residents in

proportion to local incomes, but relatively inexpensive when compared with prices for newhomes built in more developed western countries. In fact, the cost of a new home in Ukrainewould be in the neighborhood of $5,000 to $12,000, not a particularly large sum by westernstandards. It would not be unreasonable to assume that many residents of the Ukraine (ormany other developing countries) could obtain savings in the amount of $5,000 to $12,000.Foreign currency may have been obtained from friends or relatives in the west or may havebeen earned from business activities or the ownership of jewelry. The currency or savingscould be used to buy some building materials from the west or could be converted to localcurrency to purchase a new home.12

In fact, equity finance (savings) was a common manner in which a city home was financed in

the United States in the early 20th century. Long-term mortgage rate instruments did not exist,and bank lending was extended for only a period of a few years. Only in 1939, when theNational Housing Act of 1939 was passed, did affordable long term mortgage financingbecome viable for many Americans.

There is evidence that savings are being used to finance significant new home construction inthe Ukraine. This is especially true in the western Ukraine where many new high qualityhomes have been constructed.13 Interviews with private contractors have verified that there is ademand for new single-family housing construction using savings, with much of savings beingin the form of foreign currency.

Clearly, the long-range prospects of the housing sector would be weakened if savings were thesole source of capital for the housing industry. However, with the economy highly unstableand the private construction industry small and of limited capacity, equity finance (savings)

12 As a point of fact, many of the new homes in the Ukraine are financed in this manner. Private contractorshave indicated that many families have saved hard currency received from friends and relatives or from variousjobs.

13 Source: Mr. Don Bohdan Wynnyczok, International Executive Service Corps, Country Director, Ukraine

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offers a major opportunity to stimulate the growth of the private housing construction industry.Equity financing will provide a market for housing construction and enable small constructionfirms to begin to build capacity for expanded sector development in the coming years.

5.5 GOVERNMENT LOAN GUARANTEES AND HOUSING FINANCE

This section of the report will investigate the feasibility of providing government loanguarantees to the banking and finance sector as a means of mobilizing long term market ratefinancingfor the housing sector. Loan guarantees could provide a mechanism where marketrisk was assumed by the central government, providing a climate for capital formation.Beforeproceeding, it must be noted that loan guarantees represent a huge liability of the governmentand could be a source financial instability during times of great economic difficulty.It wouldalso be feasible to investigate the substitutability of land and/or housing collateral as areplacement for loan guarantees.

In the United States, loan guarantees exist as a government approved financing mechanism

and long term home mortgages have implicitgovernment (and some private) guarantees ofprincipal repaymentequal to 80%-100% of the principal amount of the mortgage. Loanguarantees have been and continue to be a valuable tool in the mobilization of capital forhousing sector development. Indeed, loan guarantees have, over a period of decades, helped tofacilitate the allocation of tremendous resources to the housing sector and have resulted in anunprecedented high percentage of home ownership. The large amount of capital that has beeninvested in the housing sector has generated economic activity that accounts for a largepercentage of the US Gross Domestic Product (GDP).

Since 1939, the US financial system has been relatively stable, except for the period duringand after the Second World War (from 1941-1948) when new housing activity was at a

standstill as a result of the war effort. The stability of the financial system and the relativelylow inflation provided a climate where mortgage loan guarantees and a system of federallysponsored savings and loan associations were effectively used to mobilize capital for thehousing sector. Until the 1970s, these financing mechanisms functioned well. Economicgrowth permitted the United States government to maintain the liability for the loanguarantees without placing a significant burden on government financial resources until fixed-interest rates were freed, resulting in a negative arbitrage spread between short term depositrates in S&Ls and short term interest rates in money market certificates.

The system of loan guarantees has worked because private holders of capital were willing toassume interest rate risk and invest funds in medium and long-term securities. Investors haveprovided significant amounts of the capital that was necessary for the growth of the housingsector. Without the confidence of private investors and their willingness to invest in mortgagesecurities, loan guarantees would not have been a valuable tool for capital formation in thehousing sector.14

14 Mortgage backed securities with loan guarantees may have not been as popular if property were notcollateralized to mortgage loans.

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5.6 HOUSING FINANCE, RISK AND US SAVINGS AND LOANS

In the United States, a system of savings and loans (S&Ls) were developed to provide funds tothe housing sector. Inflation and long-term interest rates until the 1960s were relatively low.

The stable economic environment and a system of deposit insurance gave investors theconfidence to invest funds in savings and loans. Savings and loans were successful inattracting funds because they were permitted to pay higher rates of interest on deposits thanbanks, and therefore acquired a larger deposit base. The S&Ls loaned their deposits tohomebuyers on a long term basis at about 2% above the interest paid to depositors, and werethus profitable in thestable interest rate environment.

In the 1970s, interest rates began to move upward dramatically as new regulations permittedbanks to increase interest rates. In order to prevent massive withdrawal of funds from S&Lsand an ensuing liquidity crisis which would threaten the solvency of the entire S&L system, itwas necessary to permit S&Ls to increase interest rates to levels which were competitive withbanks. However, the increased interest rates that savings and loans were paying to depositors

were higher that the interest received from long-term loans that had been made tohomeowners. The negative interest rates caused catastrophic earnings losses to the savings andloans and forced a systematic erosion of the capital base of each institution. The S&Ls, withgovernment support and direction, had loaned funds on a long term basis at a fixed interestrate, but held short term deposits with variable interest rates and thus were subjected to majorrisks during periods of increasing interest rates. In order to maintain the solvency of thesavings and loan system, the US Government had to expend billions of dollars to recapitalizethe S&Ls, in effect bailing out the system.

The US government instituted financial reforms for banks and savings and loans anddiscouraged banks and S&Ls from issuing long-term loans secured against only short-term

deposits in order to avoid a future potential calamity in the banking industry. In fact, a secondcrisis appeared when interest rates increased again, however, S&Ls had reduced their risks bypackaging many of their loans into mortgage backed securities and selling them to long terminvestors who assumed interest rate risk.15

This brief discussion of the US experience with its housing finance system was made in orderto provide the reader with some knowledge of the dangers and pitfalls of governmentsponsored guarantees and government designed housing finance systems. It is clear thatinterest rate increases in the US in the early 1970s (which were minimal by world standards)caused an enormous strain to the US financial system. Had the interest rates increased to 20%or 30% at that time, the financial system could have collapsed without an enormous injectionof funds by the US Federal Reserve Bank.16

Conversely, the US experience with housing finance is also noteworthy in that the successfulefforts to mobilize capital through savings and loans resulted in a tremendous growth in the

15 Banks and savings and loans still have interest rate risk, but this risk applies only to a small number of loansand for shorter periods of time.16 This action would have been dramatically increased money supply, and probably would have caused asignificant jump inflation.

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housing sector and in the US Gross National Product. Housing was and still is an engine foreconomic growth and job creation. It seems clear that US housing finance policy providedmajor advantages despite the risks and problems created by unfortunate policy decisions.

It is extremely importantto recognize the potential risks and dangers as well as the rewardsthat can result from the implementation various financing mechanisms. The cardinal formulafor economic growth is not exotic ultra-creative financing mechanisms, but a stable financialsystem built on free market fundamentals and constructed with prudent financialinstrumentation. Financing mechanisms that have worked the best over long periods of timeare those mechanisms that have been designed to reduce or eliminate risk and embracefundamental economic and banking principles. Creative financing mechanisms that attempt toleapfrog or overlook market distortions are likely to end up accelerating financial instabilityand imposing added burdens and costs to sector development.17

Financing mechanisms such as a housing loan guarantee program should be considered. Aprogram designed to provide guarantees ofpartial principal repayment (70-80%) of housing

mortgages should be considered as part of a long range program to allocate funds to thehousing sector, once economic stabilization is achieved. Guarantees represent enormouspotential liabilities and should only be employed if substantial risk reduction measures areemployed. These measures include fair market property valuations, substantial homeownerequity requirements and loss prevention programs with substantial reserves.

5.7 DUAL INDEX MORTGAGE FINANCING MECHANISMS

The development of creative housing financing mechanisms has been important to the successof the US Housing Finance Industry. The success of mortgage instruments here has fostered asimilar belief that the design and development of mortgage financing instruments for the

housing industry in Eastern Europe and the former Soviet Union (including Ukraine) wouldprovide a foundation upon which the housing industry could grow rapidly in harmony withfree market principals.

The major housing financial instrument being advocated by many housing economists is theDual Index Mortgage Program. This instrument has been designed to accommodate theproblems associated with high interest rates and high inflation.18 In periods of high interestrates, the interest cost of financing can increase dramatically. As we have seen from ourexample discussed before, interest costs can increase to a point where they are higher that theability of the mortgage payer to meet his financial obligations. In the event, a homeownerwould most likely default on his or her mortgage obligation.19

17 This is especially true if these mechanisms are widely used.18 In undeveloped capital markets, long term fixed interest rate mortgages do not exist. Mortgages which havea long term schedule for the repayment of the principal have conditions which allow interest rates to be resetperiodically to interest rates which are updated to reflect any change in the market conditions.19 In the sophisticated financial environment in the United States, the dual index mortgage has never been popular.A modified dual index mortgage known as the Graduated Mortgages Payment Program was never able to gainpopularity with users.

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Housing economists have recognized this problem and developed dual index mortgages thatinsure that monthly or periodic mortgage payments would not overburden the payer withunreasonable costs. Under the dual index system, the mortgage payment never exceeds acertain percentage of income of the homebuyer (approximately 30%), regardless of the

interest rate. If the required mortgage payment is in excess of 30% of the income, then theunpaid balance is added to the principal base of the mortgage. The theory is that the increasein the principal amount of the mortgage will keep pace with inflation and the burden of cost tothe homeowner will remain the same.In reality, Dual Index Mortgages are automaticmonetary destabilizers, and they exacerbate monetary expansion. The feature of Dual IndexMortgages, which effectuates automatic increases in the principal balance of the mortgageloan, serves as a catalyst to accelerate inflation and economic destabilization.

In order to be effective, a dual index mortgage must provide a good investment opportunity toboth the seller and the buyer of the mortgage. The investor providing funds must be convincedthat it is feasible to make a long-term investment in a highly unstable financial climate.Investors must be convinced that they are being provided with a satisfactory risk-adjusted real

return on funds invested.20It has not yet been proven that investor confidence and interest inthis financing mechanism is adequate to achieve a significant level of capital formation.

An investor in a dual index mortgage must have assurance that he or she has a clear controlover the mortgage investment in case of a default by the homeowner. In other words, theinvestor must have collateral. There must be clearly defined legal procedures for foreclosuresor other events of default, and investors must have confidence that the procedures andinstitutions that adjudicate disputes are functioning effectively, efficiently and fairly within theframework of the law.

The test to determine the effectiveness of dual index mortgages is to develop a program that

attempts to attract investors to provide funds for dual index mortgages.In a fluid free marketsystem, financing programs can only be successful if lenders and borrowers can be matched ina system of funds allocation. Economists have proven that highly unstable markets are adisincentive to long-term capital investors. The two major questions regarding dual indexmortgages is as follows:Is the dual indexing feature an adequate incentive for investors toinvest funds on a long term basis in an unstable financial environment? Will homebuyersaccept the provisions of dual index mortgages that add large principal balances to theirmortgages balances?

None of the bankers who were interviewed for this study expressed any interest in mortgagelending or in dual index mortgages in the current economic climate. Commercial bankers inthe Ukraine invest bank funds that consist primarily of capital and retained earnings, as mostbanks have not been able to attract a significant amount of deposits. Therefore, the bankerssentiment should be interpreted as an adverse market reaction to dual index mortgageinstruments.

20 The investor must be convinced that his principal will keep pace with inflation and that his return oninvestment will exceed the rate of inflation. In other words, if inflation is 100% per year, the return to theinvestor must be in excess of 100% per year by an amount which satisfies his or her risk adjusted rate of return.

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It is not clear that dual index mortgages are be viable for the Ukraine. The only private sectorfinancial institutions capable of mobilizing funds are commercial banks, and they do not havethe technological capability or the desire to engage in a dual index mortgage lendingprogram. If price inflation continues to exceed wage inflation, the mathematical matching

formulas of the dual index concept would cause principal balances increase faster than realestate values, thereby creating a built-in disequilibrium for both the lender and the borrower.21

The problems with dual indexing outweigh the benefits, and there are more questions thananswers about how dual indexing would work. The belief in the value of Dual IndexMortgages is ill conceived at the present time. Dual Index Mortgages are not recommended asa financing alternative.

5.8 HOUSING FINANCE BANK

In the Ukraine, the creation of a housing finance bank (HFB) should be considered. The HFBwould be comprised of one or more institutions whose purpose would be to raise funds forlong-term investments in the housing sector, once economic stabilization is achieved. The

Housing Finance Bank could serve as a depository for funds for the housing sector and couldbe an intermediately between the banking sector, which would originate mortgage loans andthe investment sector, which would provide capital through the purchase ofcollateralizedmortgaged backed securities.

The bank could be developed with state of the art technology to allow the design andimplementation of sophisticated financial instruments for both investors and borrowers. Thisinstitution could operate with many of the government and market support mechanisms22

which have been provided savings banks in the United States and the European Communityand to the Federal National Mortgage Association in the US. In addition, the institution could,in conjunction with commercial and investment/merchant banks, develop programs and

financial instruments which would be attractive to providers of low risk capital.

The bank could be provided with the authority to collateralize mortgages with property and toissue 80% government loan guarantees on each mortgage so that providers of funds could beinduced knowing that a substantial amount of the principal value of their funds could beprotected by government guarantees23. Since each investor would be buying a collateralizedmortgaged backed security which would be comprised of thousands of mortgages fromthroughout the country, added comfort would come from the fact that no single default wouldhave a measurable impact on that security. The individual risk would be factored out of thesystem leaving systematic risk as the principal form of uncertainty.

21 A home owner would have concerns regarding dual indexing if he or she believed that the value of themortgage would be greater than the value of the home at the end of the mortgage term. What would occurwhen the mortgage period expired. Would the owner become a perpetual renter? Would the mortgage holderbecome a shared owner? How would these problems be adjudicated?22 Such as government backed loan guarantees, lower reserve requirements or specialized tax benefits.23 Loan guarantees should not exceed 80% of the loan value and should decline in proportion with principalamortization.

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Investors would also have some comfort in knowing that the mortgages were secured byhousing that met strict underwriting tests. Underwriting, if performed according to standardsin effect in the European Community or the in United States, would insure that homes wereconstructed according to well-designed building codes. Homebuyers who defaulted on their

mortgages would lose invested equity (savings) in the amount of 10%-40%, depending uponthe requirements for down payments. Down payments offer financial protection to both thegovernment guarantors and the holders of collateralized mortgage backed securities bydecreasing lender risk. Down payments are a form of primary mortgage insurance and permitgovernment guarantees to assume the position of secondary mortgage insurance.Loanguarantees should not exceed 70% of the value of the home. Value should be defined as fairmarket value or actual cost, whichever is lower.

Although current economic conditions in the Ukraine are not conducive to a successfuloperating environment for a housing finance bank, it is appropriate to begin to access thefeasibility of developing this institution with appropriate Ukrainian governmental officials.Developing a housing finance bank in the Ukraine will require considerable time and effort,

and the bank could be instrumental to the growth of the housing sector.

5.9 MORTGAGE, FORECLOSURE AND PROPERTY LAWS

The Ukraine does not now have a law that permits housing mortgages. In order to develop afully functioning housing industry, it is very important to begin a process whereby a housingloan program could be supported within a legal framework. The first priority should be thedevelopment of a law that permits mortgages on property and sets forth the conditions of eachmortgage.A mortgage law should be developed. The mortgage holder should be permitted tooriginate a foreclosure process in the event that the borrower defaults on the mortgage andmakes no reasonable attempt to bring the mortgage current.

The second priority will be the development of regulations that govern the adjudicationproceedings regarding disputes relative to mortgage defaults. Included in the process will bethe authorization to create new legal institutions (or modify existing ones) that will besanctioned by law to resolve disputes and facilitate foreclosures.

The government of the Ukraine also needs to develop property laws. Property laws will defineownership of real and intellectual property, and will permit property to be encumbered ascollateral for mortgages and other financial instruments.Property laws will facilitate thetransfer of property from sellers to buyers.

5.10 FOREIGN LOAN GUARANTEES FOR HOUSING

Foreign loan guarantee programs provide hard currency loans to country borrowers, and mustbe repaid in hard currency. If loan funds are provided to homebuyers as a result of loanguarantees, and funds for repayment is to be obtained from homebuyers, then homebuyersmust assume exchange rate risk in addition to all of the standard risks inherent with a homemortgage loan.It is not appropriate to require homebuyers to assume foreign exchangerisk.

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If exchange rates fluctuate (say devaluation of the host country currency), then thehomeowners mortgage repayment will increase. Unless there is a corresponding increase inworker income (usually there is not), then the mortgage payment will increase without a

proportional increase in wage income. This increases the risks of loan default. If mosthomeowners could not afford or refused to pay the increased mortgage payment, thegovernment would be forced either to pay the loan from hard currency reserves or to defaultand re-negotiate the loan if excess foreign currency were not available. In essence, this wouldbe a massive government subsidization of the housing industry and would allocate scarcefinancial resources from other important sectors of the economy.

Foreign loan guarantees can be considered when economic stability is attained. Foreigndonor governments should extract agreements from borrower governments that the fundsbeing provided through foreign credits will be allocated to productive investments. If foreigncredits are allocated to consumption, the loans may serve to destabilize the economy byimposing added foreign debt burdens without contributing to the productive sector of the

economy.

5.11 SUMMARY ON HOUSING FINANCE

The Ukrainian housing sector presents a unprecedented challenge to the developmentcommunity. The country, with its large population of over 50 million residents, desperatelyneeds a productive housing industry that can serve as an engine of growth to an economy thatis heavily dependent on the huge declining defense sector. The successful development of ahousing finance industry to mob

Ukraine Banking and Finance Page No. and TOC Final

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