Housing Finance in Mexico:Evolution, Strategy and Challenges Ahead

Housing Finance in Emerging Markets SeminarWorld Bank, March 2006

2

I. Introduction

II. Funding Models

III. Mortgage Products

IV. Explaining Housing Finance Recent Growth

V. Mortgage Backed Securities

VI. Challenges in Housing Finance

Contents

3

• Population of 103 million, forming 26.1 million households.

• Population growth rate of 1.9%, and life expectancy of 75.3 years.

• 76% of households are in urban and semi-urban areas.

• Per capita GNI (PPP methodology) of USD $9,590 in 2004.

• 46% of households in the informal sector.*/

• Approximately 20% of population holds a checking or savings account.

• Mortgage Portfolio / GDP of 11.1% in 2004

*/ Informal household defined as that in which no single member is a wage earner in a firm that contributes to social security systems.

Mexico key figures & facts

4

0 2 4 6 8 10 12 14

0-4

10-14

20-24

30-34

40-44

50-54

60-64

70-74

80 and up

ag

e g

rou

ps

millions of persons

Ages with tendency to form households

Demographics show the largest number of household formation over the next seven years

691

636

667

36.3

25.5

600 610 620 630 640 650 660 670 680 690 700

Th

ou

sa

nd

s o

f N

ew

H

ou

se

ho

lds

20

22

24

26

28

30

32

34

36

38

Mill

ion

of H

ou

seh

old

s

New Households Total Number of Households

According to official estimates, 672,018 new households were formed during 2005 throughout the country. This figure will rise up until 2012, when 691,242 new households will be formed.

Household Formation 2004-2020 Population by Age Groups in 2004

Source: ConapoSource: Conapo

5

4.8

9.8

22.8

36.3

41.8

0

5

10

15

20

25

30

35

40

45

1940 1970 2000 2020 e/ 2030 e/

Over the next 25 years, the number of households will grow at an annual rate of 2%.

Source:CONAPOSource:CONAPO

Mill

ion

Hou

seho

lds

42.2Number of Households in Mexico

According to the official projections, from the year 2000 to 2030 the number of households in Mexico will grow 83%. These favorable population dynamics is coupled with annual per capita income of approximately USD $8,000

6

0

10

20

30

40

50

60

70

80

90

100

To

tal M

ort

gag

e P

ort

folio

(%

GD

P)

11.1%27.7%

Source: IMF, World Economic Outlook September 2004, Central Bank of South Africa, CMHC (Canada), SSKI (India), Komoco (Korea), GHB (Thailand), China On-Line, SHF (México), Michael Lea.Figures for Korea, Thailand, Brazil, Poland, China, India and South Africa correspond to 2001.

These growth comes from the population dynamics shown above coupled with a moderate scenario of disposable income growth for Mexican families.

Mortgage Portfolio / GDP of Selected Countries

Even under conservative assumptions, Mortgage Portfolio/GDP will grow from 11.1% to 27.7% of GDP over the next 15 years

7

I. Introduction

II. Funding Models

III. Mortgage Products

IV. Explaining Housing Finance Recent Growth

V. Mortgage Backed Securities

VI. Challenges in Housing Finance

Contents

8

0

100 000

200 000

300 000

400 000

500 000

600 000

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

The pace of growth of the mortgage industry has translated into a housing boom over the last five years.

Source:CONAFOVISource:CONAFOVI

Number of Mortgage Loans Originated per year

9

The industry is still dominated by the two Federal Housing Funds, INFONAVIT and FOVISSSTE.

Source:CONAFOVISource:CONAFOVI

Number of Mortgage Loans Originated in 1995

10

But the market share of private intermediaries –banks and sofoles– is growing at a fast pace.

Source:CONAFOVISource:CONAFOVI

Yearly Rate of Growth of Mortgage Loans Originated by the Federal Housing Funds and the Private Intermediaries

-15%

23%29%

-3%

17%

0%

14%

21%

43%

54%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

2001 2002 2003 2004 2005

BANKS & SOFOLES

INFONAVIT & FOVISSSTE

11

• The board of directors is represented by workers, employers and the Federal Government.

• INFONAVIT receives on a monthly basis, 5% of the formal private sector workers payroll, and credits to personal accounts.

• INFONAVIT loans, interest rates and payments are indexed to the minimum wage (MW).

• INFONAVIT interest rates are not market rates, there is an implicit interest rate subsidy on all its lending.

• INFONAVIT relies on payroll deduction for its collections when borrowers are employed by firms in the private sector. Collection mechanisms for unemployed borrowers or those migrating to the public or the informal sectors still need to improve.

• Average dollar amount of their loans: $22,000

INFONAVIT

12

• Similar objective and sources of funding than INFONAVIT, FOVISSSTE is a wage-based housing fund for federal employees, and is the institution in charge of providing housing financing to over two million of federal government employees.

• The board of directors is represented by different government agencies and by ISSSTE (the public pension fund for federal employees).

• FOVISSSTE receives on a monthly basis, 5% of the federal employees payroll, and also collects through a pay-roll deduction mechanism.

• FOVISSSTE loans, like those of INFONAVIT, are indexed to the minimum wage and pay lower than market interest rates; however to a greater extent.

• FOVISSSTE lags behind INFONAVIT on revamping its operating procedures, particularly regarding the servicing of the loan portfolio.

FOVISSSTE

13

• Sofoles were created in 1994 as a result of NAFTA. They are Non-bank banks similar to mortgage banks in US.

• They have two basic characteristics : Cannot take deposits from the public. Can only lend to a specific sector: housing, automobiles, education, etc.

• Since then, Sofoles have successfully been originating and servicing loans under FOVI & SHF programs:

Delinquency rates below 2.5%.

Relatively homogeneous originating and servicing standards, as well as standardized loan product.

Sofoles will originate approximately USD 5,700 million of loans in 2006.

SOFOLES

14

Construction loans for

homebuilders and mortgage

loans for individuals

SOFOLES

Collections on outstanding

portfolio.

World Bank and IADB

Central Bank Loans (Guaranteed by the

Federal Government)

FOVI, which was run out of the Central Bank until the creation of SHF, started funding SOFOLES in 1995.

15

Collections on outstanding

portfolio

World Bank and IADB

Central Bank Loans

Banks

Construction loans for

homebuilders and mortgage

loans for individuals

SOFOLES

Debt Markets

SHF started operations in 2002, overtaking the activities of FOVI and has the capacity to fund in the markets

16

• SHF was created in 2001 as a government financial institution with the mandate to foster the development of primary & secondary mortgage markets.

• Has “full faith & credit” of federal government on risks taken through 2013 and must be self-supporting afterwards. SHF prices its products at market and has an intermediate ROE goal of 10% in real terms.

• Today acts as wholesale mortgage bank & guarantor.

SHF provides long term funding to financial intermediaries and hedges the inherent interest rate risk. SHF cannot lend directly to the public.

SHF offers mortgage insurance, timely payment guarantees on bonds and a cover against nominal minimum wage (to allow homeowners to have payments linked to minimum wage inflation).

Overview of SHF’s mandate and activities

17

LOANS

Financial Intermediaries

• Banks• SOFOLES $

$

Mortgage Insurance

MBS

K

MBS

Mortgage Portfolios

SPV

Capital Markets

Financial Guaranty Insurance

SHF and its role• SHF’s main challenge is to develop an efficient market for

mortgage-backed securities (MBS) through its role as guarantor and liquidity provider, acting as well as the main catalyst for the standardization of loan documentation and origination & servicing practices.

18

SHF: Financial Highlights (December 2005)

Assets USD $10.1 bn

Liabilities USD $8.8 bn

Capital Net Worth USD $1.3 bn

Mortgage Loan Portfolio USD $8.6 bn

Mortgage Insured Risk-in-Force

Managed Portfolio (FOVI)

USD $1.3 bn

USD $5.3 bn

19

• Until 1994, banks were the only private intermediaries doing mortgages in Mexico.

• In 1995, the “Tequila Crisis” bankrupted the Mexican banking system and private banks abandoned the mortgage market. Past-due loans became rampant, specially in the mortgage portfolio of banks. Banks did not have efficient collection mechanisms or foreclosure procedures.

• By 2004 it became clear to banks they had been out of a profitable market, and they entered back aggressively by:

Undercutting Sofoles in price

Buying up the largest Sofoles

Banks

20

Banks and Sofoles owned by them originated more loans than independent Sofoles for the first time in 2005.

Source: SHF and CONAFOVISource: SHF and CONAFOVI

Number of Mortgage Loans Originated per year by Sofoles and Banks

-

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

2001 2002 2003 2004 2005

INDEP. SOFOLES SOFOLES OWNED BY BANKS BANKS

21

Market Segmentation by Income and Labor Condition(Percent of households living in urban areas)

Underserved market segment

Infonavit & Fovissste

Sofoles & Banks

11.80%

Monthly Income $USD

Households with Social Security

5.9% 16.3% 24.5%

Households without Social

Security23.7% 17.3% 12.3%

< $420 $420-$840 > $840

Despite the growth of the mortgage market, almost half of the population is still not served by the existing mechanisms.

22

I. Introduction

II. Funding Models

III. Mortgage Products

IV. Explaining Housing Finance Recent Growth

V. Mortgage Backed Securities

VI. Challenges in Housing Finance

Contents

23

• Minimum wages are set once a year during January.

• INFONAVIT and FOVISSSTE originate loans denominated in Minimum Wages, so monthly payments and the outstanding balance are updated every year according to the increase decreed on the Minimum Wage.

• These loans are characterized by a negative amortization profile and increasing monthly payments, as shown in the figure.

• Sofoles originate most of their loans (90% up until 2004 and 70% nowadays) with the balance indexed to inflation, but with monthly payments indexed to the Minimum Wage, causing a similar negatively amortizing profile.

The bulk of the mortgages originated in the last few years are indexed in some way or the other to the Minimum Wage.

Loan Indexed to the Minimum Wage

4,000

5,000

6,000

7,000

8,000

9,000

10,000

11,000

12,000

1 21

41

61

81

10

11

21

14

11

61

18

12

01

22

12

41

26

12

81

months

$P

es

os

-

100,000

200,000

300,000

400,000

500,000

600,000

Monthly Payment Outstanding Balance

$P

es

os

24

BorrowerSOFOLESDebt and

Derivatives Markets

UDIS UDIS UDIS

Minimum Wages

Minimum Wages

UDIS

• This product was designed during the years of high and volatile inflation and interest rates. It protects consumers from negative macro shocks, and at the same time makes it possible to fund in the markets since it is UDI-denominated.

Minimum Wage – UDI Swap

Sofoles may offer inflation indexed (UDI-denominated) loans with payments indexed to the M.W. due to a swap SHF offers.

25

Financial Conditions of Mortgage LoansFOVISSSTE INFONAVIT BANKS

(PESOS)SOFOLES (PESOS)

SOFOLES (UDIS)

Minimum Downpayment 0% 0% 10% 10% 10%

Maximum Tenor 30 years 30 years 20 years 20 years 25 years

Currency /Index Minimum Wages

Minimum Wages Pesos Pesos

Principal in Udis,

payments in M.W.

Interest Rate (A) Δ%M.W. + 6% Δ%M.W. + 9% N.A. 15.79% Π + 12.95%

Interest Rate (B) Δ%M.W. + 6% Δ%M.W. + 9% 12.28% 15.74% Π + 12.16%

Initial payment per $1000 of outstanding balance (A) 5.99 8.94 * N.A. 13.76 10.65

Initial payment per $1000 of outstanding balance (B) 5.99 12.22 * 12.36 13.72 10.50

Loan Limit in USD$ (A) 43,000 25,210 N.A. 23,500 23,000

Loan Limit in USD$ (B) 48,050 25,210 59,500 50,510 50,000

A) For an individual w/ Monthly income of 980 USD.B) For an individual w/ Monthly income of 2,100 USD.

* For an individual w/ 35 years old

26

I. Introduction

II. Funding Models

III. Mortgage Products

IV. Explaining Housing Finance Recent Growth

V. Securitization

VI. Challenges in Housing Finance

Contents

27

• Stabilization programs based on prudent fiscal and monetary policies made inflation and interest rates decrease sharply over the last 10 years.

• Social security reform introducing defined contribution plans based on personal accounts managed by private pension funds, fostered long term savings as well as demand for long term & long duration securities.

• The creation of a long-term yield curve for government securities enabled the pricing of fixed-rate mortgage products.

• The reform of sate-level civil codes enabled the sale and purchase of mortgage portfolios without over-burdensome requisites.

• Reforms of federal laws that enabled a more efficient recovery of guarantees.

Housing finance has benefited from a host of reforms that took place over the last decade.

28

Inflation and Interest Rates on Government Securities(Year-End)

0%

5%

10%

15%

20%

25%

30%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Rate on 3 Yr Peso Sec.

Rate on 10 Yr Peso Sec. Inflation

Inflation reduction and the development of a yield curve for peso securities have been instrumental to housing finance.

29

• INFONAVIT

Concentrated on financing the acquisition of homes, abandoned construction finance.

The allocation of loans among the Fund’s beneficiaries was made transparent, so individuals know the criteria they should meet to get a mortgage, and homebuilders know approximately how many people will get a loan in each state.

Loan origination mechanisms were greatly improved.

Cash inflow was significantly increased through the improvement of collection mechanisms of both the payroll tax and the loans outstanding.

The origin of growth in housing finance over the last few years differs from one program to the other.

30

• SOFOLES

Sofoles built a platform over the last ten years that allows them to originate and service mortgage loans in an efficient manner.

Long-term matched funding has been made available through SHF programs, allowing Sofoles to concentrate on their lending activities without any exposure to interest rate and prepayment risks.

Purchasing power of individuals has strongly improved as interest rates have come down, thus increasing the demand for mortgages.

New programs where individuals may buy a home with a loan from a Sofol that is complemented by a loan from Infonavit (which will be paid out of future payroll taxes) has allowed Sofoles to go down-market.

The origin of growth in housing finance over the last few years differs from one program to the other (continued…)

31

I. Introduction

II. Funding Models

III. Mortgage Products

IV. Explaining Housing Finance Recent Growth

V. Securitization

VI. Challenges in Housing Finance

Contents

32

Annual savings, that flow through the banks is not sufficient to finance the growth of the mortgage market, on the other hand, the resources, of institutional investors would be more than enough.

Source: SHF Estimations

Annual growth of a Mortgages Portfolio of Banks and Sofoles vs. Banks and Institutional Investors

2

2.2

2.4

2.6

2.8

3

3.2

3.4

3.6

3.8

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Number of times

0.15

0.2

0.25

0.3

0.35

0.4

0.45

0.5

Number of times

Saving Banks / Mortgages PortfolioSaving Institutional Investors /

Mortgages Portfolio

Securitization is a must given the savings structure of the Mexican economy

33

Benefits of Securitization

• The benefits of developing an MBS market in Mexico must be measured against the ultimate goal of securitization:

34

Securitization should help to enhance affordability

• Securitization of mortgages spurs investment into modeling and pricing of risks by investors, mortgage insurance companies, financial guarantee insurance companies, structuring agents, rating agencies, etc.

• Better pricing of risks means that investors will be better positioned to buy mortgages that:

Are higher LTVs (lower downpayments)

Have lower FICO scores.

Lack all the standard documentation.

35

Challenges for the development of an MBS market

1. Ability to issue (local scale) AAA rated securities without being fully supported by Federal Government guarantees.

2. Properly allocating market and prepayment risk among participants.

3. Building confidence among investors, particularly institutional investors.

4. Developing entities or “conduits” that specialize in the acquisition of loans, issuance of MBS and investing on the “equity pieces” of the structures.

5. Ensure the continuity of the business model by fostering liquidity all along the credit cycle.

36

1. Issuing (local scale) AAA rated securities• Financial intermediaries that originate and service to a high-enough

standard so that delinquencies are kept low enough to make securitization feasible.

• Credit enhancement mechanisms that can support the AAA rating and keep the incentives of the different participants aligned.

• Building databases good enough to model frequency of default and severity of loss, to the satisfaction of investors and rating agencies.

• A legal system that supports foreclosure on delinquent loans, the issuance of securities from an SPV, and a tax code that avoids double taxation of profits when an SPV exists.

37

• Mortgage insurance is viewed by SHF as the best-suited credit enhancement mechanism (of those provided by third parties) to promote a sound mortgage market and the development of securitization in Mexico.

• There are at least three options to choose from to foster the development of a mortgage securitization market:

Mortgage Insurance (MI)

Financial Guarantee Insurance (FGI)

Investors in “mezzanine” and subordinated pieces of MBS.

1. Issuing (local scale) AAA rated securities (continued…)

38

How does MI compare with other mechanisms to foster the development of mortgage markets?

1. Issuing (local scale) AAA rated securities (continued…)

39

1. Issuing (local scale) AAA rated securities (continued…)

• SHF is betting on building a MI industry as the backbone of the Mexican mortgage market. A lot of effort has been devoted to entice private MI companies to participate in the Mexican market.

• Mortgage Insurance should be complemented with the development of Financial Guarantee Insurance (FGI), a market for Mezzanine Bonds and other forms of credit enhancement.

• Sustainable asset quality is a necessary condition for market development, and MI can help maintain the quality of the underlying portfolios.

402. Properly allocating market and prepayment risk• Interest rate and prepayment risks must be borne by:

• Consumers: Through Adjustable Rate Mortgages (ARMs) and / or agreeing to large prepayment fees; or

• Intermediaries / SPVs: Issuing floating rate notes to finance prepayable fixed-rate mortgages; or

• Investors: Acquiring pass-through MBS.

• In most emerging countries, shedding market risk onto consumers by selling ARMs is dangerous given that market volatility can very easily translate into high delinquency rates.

• SHF thinks that in the case of Mexico, investors are the best-suited participants to undertake market and prepayment risks, and will insist on pass-through structures.

412. Properly allocating market and prepayment risk (continued…)

• The issuance of pass-through MBS should foster research to accurately price prepayment risk.

• This will also foster the development of mortgage products that include prepayment fees in exchange for a lower rate.

423. Building confidence among investors

• Provide information –both at origination and over the life of the MBS– to facilitate pricing by investors. Information includes frequency of default, severity of loss and prepayment related issues.

• Standardize loan documentation, MBS documentation, MBS characteristics. MI and FGI are elements that can be used to facilitate such standardization.

• Agreeing on pricing conventions is also necessary.

• Issue regularly and in issues that are as large as possible.

• Foster liquidity of MBS supported by the items mentioned above.

43

4. Development of “Conduits”

• These entities are the key to transform loan portfolios into MBS.

• Conduits specialize at managing the market risk between time of origination and time of issuance.

• Conduits are also necessary to keep incentives aligned.

The combination of MI and a Conduit that owns the “equity piece” of the structure is enough to continuously monitor the behavior of the loan portfolio and the quality of the portfolio servicer.

• Surprisingly for SHF, the development of Conduits has been as difficult as the development of an MI program or the development of the MBS structure.

44

5. Ensure the continuity of the business model throughout the credit cycle

• All in all, MBS must deliver lower cost of funds for mortgages relative to on-balance sheet financing.

This means that all the process is transparent enough and credible enough to everyone involved (MI, FGI, Conduits, investors, rating agencies).

• It is important for mortgage markets to have mechanisms in place to ensure liquidity of the market at every stage of the credit cycle.

This is a role that has been played in the US by Fannie Mae and Freddie Mac in the past three decades that is rarely mentioned.

45

Originators

Intermediaries

Trusts(SPV’s)

Mortgage Insurance

Companies

Debt Capital Markets

Market Makers

Derivatives

InvestorsMBS

K

Servicing

Capital at Risk

The Model

Financial Guarantee Insurance Companies

Universal TypeFIEH

• Contrary to what has been said, SHF will not mimic the activities of Fannie Mae or Freddie Mac.

• The aim, however, is the same: to bring liquidity to the mortgage markets to foster home affordability and ownership.

46

Originators

Intermediaries

Trusts(SPV’s)

Mortgage Insurance

Companies

Debt Capital Markets

Market Makers

Derivatives

InvestorsMBS

K

Servicing

Capital at Risk

Financial Guarantee Insurance Companies

Universal TypeFIEH

• SHF will offer up to 35% MI, partial FGI, and act as market maker on MBS.

• SHF will not buy mortgages.• SHF will not structure the MBS.• SHF will not offer 100% FGI.

• With securitization investors undertake market and prepayment risk, while credit risk is now shared by MI, investors in equity pieces, FGI, and investors.

The Model (cont..)

47

The development of an MBS market in Mexico

• Mexico needs to develop an efficient and deep secondary mortgage market to meet the potential demand for mortgages over the next years.

• The first securitization took place in December 2004. Since then, nine transactions sponsored by Sofoles have gone to market for a total of approximately USD 575 million.

• This year we expect the issuance of approximately USD 925 million in MBS sponsored by Sofoles.

• To remain competitive relative to banks, Sofoles will need to focus on originating to the standards required of MBS structures.

48

I. Introduction

II. Funding Models

III. Mortgage Products

IV. Explaining Housing Finance Recent Growth

V. Securitization

VI. Challenges in Housing Finance

Contents

49

Challenges Ahead

• Increase the importance of banks and Sofoles in housing finance relative to the Federal Housing Funds.

• Keep the growth of banks’ and Sofoles’ portfolios while maintaining the credit quality of these.

• Develop an efficient and deep secondary mortgage market to meet the potential demand for mortgages over the next years, and to keep Sofoles competitive relative to banks.

• Translate all these advances in housing finance into affordability for the consumer (lower interest rates, higher LTVs, lower monthly payments).

• Devise a housing solution based on public-private partnerships for those households that will not be able to afford a mortgage any time soon.

Housing Finance in Mexico:Evolution, Strategy and Challenges Ahead

Housing Finance in Emerging Markets SeminarWorld Bank, March 2006