This Is NOT How To Finance Affordable Housing

Coming late to this particular party, but better late than never (excerpt):

Putrajaya allows developers to give housing loans

PETALING JAYA, Sept 8 — The Urban Wellbeing, Housing and Local Government Ministry today announced the introduction of an initiative that enables property developers to give out loans to buyers at an interest rate of between 12 and 18 per cent.

Minister Tan Sri Noh Omar said that the move is intended to assist Malaysians who are unable to get a full housing loan from banks or those who may only be given a partial housing loan….

…“Because sometimes the buyers, they don't get 100 per cent loan. Sometimes the bank only gives them a 70 per cent loan and they only have money to pay 10 per cent so the balance, the developer can give them a loan," he said during a press conference after officiating the 19th National Housing & Property Summit 2016 at the Sunway Resort Hotel & Spa….

…“This proposal is a win-win situation for both developers and house buyers. For the developers, this end-financing facility offers a second profit centre. First, of course, from the sales (sic) of these houses and second from the proceeds of the end-financing scheme that I am proposing,” he said during his speech.

He explained that all developers will be able to apply to the ministry for a money lending license beginning today in accordance to the Moneylenders Act 1951.

However the government’s award of such licenses will be dependent on a variety of factors, especially the company's financial standing.

He added that the scheme will not involve the central bank and will be wholly handled by the ministry.

I’m sorry, Tan Sri, but this sounds more like lose-lose than win-win. A lot has been said and written in the interim, so I want belabour the obvious points. Let me instead talk about the less obvious.

The first things that sprang to mind when I first read about this proposal were two well known and related theoretical principles in microeconomics – adverse selection and assymmetric information (aka the “lemons” problem).

Adverse selection happens when a policy, product or service attracts the very people most ill-suited to them. Assymmetric information describes a situation where one party knows more than the other, which causes a market failure. I’ll deal with the latter first.

Take a group of house buyers, with different capacities to pay. Banks sort these potential borrowers based on the information available to them – wages, employment status, bank account data, and in Malaysia, access to CCRIS. CCRIS lists all the credit facilities Malaysians have with the banking system and payment history, independently of what the borrowers declare. This reduces information assymmetry, so that banks can properly price their lending risks, or alternatively, the ratio of loan to value (LTV) they are willing to finance. The higher the risk, the higher the financing cost and the lower the LTV, and vice versa.

This makes for a relatively efficient market, but causes a social failure – those least likely to need loans are the ones who can access bank loans most readily and cheaply, while those who arguably need financing more are faced with steeper collateral constraints and dearer financing. Leaving that aside, pricing risk more accurately allows banks to minimise dislocations in the housing market (while maximising profits, it should be said).

Assuming this cockamamie scheme goes through however, developers won’t have anything like the advantages a bank would have. Developers won’t have access to CCRIS, won’t have the credit expertise to price loans accordingly, and won’t have the recovery mechanisms that banks have painstakingly built up over decades of institutional history and experience. As such, regardless of the actual risk involved, developer sourced loans will be more expensive than necessary, as the lending rates will have to take into account the larger information assymmetry involved.

That leads to point 2 and adverse selection: if banks are in fact pricing risks correctly (or at least, as correctly as possible), developer loans would by default attract those who have the least capacity to bear them. Banks don’t put low LTV ratios for fun, not when there’s a profit to be made; they lower them because they think the risk is higher. This creates an unavoidable spiral – developer loans carry higher interest rates because the risks are higher; but higher interest rates simultaneously increase the probability of those loans defaulting, which of course requires an even higher interest rate to offset the potential loan losses.

Which leads to point 3: If the banks become aware that some of their low LTV loans are going to see their collateral part financed by high interest rate developer loans, this would materially change their view of the risks involved. So what I think would happen would be that low LTV loans are likely to be ratcheted even lower (and the high-interest financing part get ratcheted higher), until banks give up lending to that segment of the market entirely. This is the law of unintended consequences – I do believe that providing high cost, easy access home financing will eventually effectively shut out low income home buyers from the formal banking system.

My last point before wrapping up: The only winners I see out of this proposal are property speculators. High leverage and high financing costs encourage short termism. Many people see housing as largely a human rights issue (true) and think that any price is worth the cost (false).

Let me break it down. Buying a house involves two components: the first is the flow of housing services over time (shelter), which is a basic human right. The second is an investment in an asset, for which you expect a return. For the latter, think about high income individuals buying homes at 4.5% and low income individuals buying homes at 12%-18%. The only way this would make any kind of sense would be if affordable house prices increased at a double digit pace.

The numbers change depending on what assumptions you make, but even with a bank LTV ratio of 70%, you’d need house prices to increase by 8%-9% per annum for someone with a developer loan to break even, not to speak of actually accumulating wealth. The only way low income households can get ahead in this situation is to flip their investment over the short term, while the leverage is still high and and their home equity is low. In other words, you won’t even need speculators or syndicates to ignite a house price bubble. Everybody will get into the game, because the incentives to do so are very strong. But this causes already unaffordable housing to become even less affordable.

I fail to see how this solves our housing problem.