Housing Finance Subsidies:
Handle with Care!
Douglas Diamond
March, 2003
1
Overview
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Brief Tour of the Top 8 Subsidies to
Housing Finance
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Description and Examples
Pros and Cons
Best and Worst Cases
Details in the Paper with Marja
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#1 Interest Rate Subsidy:
Direct to Lender
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Reducing the effective rate through
direct subsidies to market lenders
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E.g., reduce 15% rate by 1/3rd or by 5% or to
10% (from market); each is different
Life of loan or phase out?
Delivery: cash payment, subsidy to funding
Rationales:
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Housing is too costly: general access
Targeting: by income, size of loan, 1st time
buyer, age?
Address the tilt effect of inflation (w/phase out)
3
#1 Interest Rate Subsidy:
Direct to Lender (Cont’d)
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Pros:
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Simple to understand, relatively simple to implement
Cons:
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Pretty inefficient unless tightly targeted, because of
“buying out the base”
Inequitable if not gradated by income
Not useful for LIH issues: requires access to HF
Requires competitive lenders
Usually very bad budgeting practices
If deep, it encourages excessive borrowing,
discourages early repayment
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#1 Interest Rate Subsidy:
Direct to Lender (Cont’d)
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Worst Case: Hungary pays 10% on funds
raised by mortgage bonds
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Cost of funds < 0.0%
No budgeting of future cost
On top of Bauspar, other rate subsidies, and tax
subsidy
When loan rate < savings rate, 10x increase
Best Case: Jordan funds out of fixed pot,
fully budgeted currently, and targeted
5
#2 Interest Rate Subsidy:
Special Funds
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Reducing the effective rate by drawing on
special, non-market funds, often through
non-market lenders
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E.g., using civil service retirement funds to finance
low-rate loans to some, but not all, members of
Fund, usually through state-owned entities
Examples: Brazil, Indonesia, Mexico, Philippines
Rationales:
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A service to the contributors (but severely
undermines the main goal of the fund)
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#2 Interest Rate Subsidy:
Special Funds (Cont’d)
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Cons: All of the above (#1), plus
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Costs are more thoroughly out of sight
Deeply distortive of both purpose of fund and
evolution of HF in country; hard to reform
Highly regressive
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Benefits to higher income, cost to low income workers
Bad Cases: All, depending on:
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How deeply below-market is the rate or other nonmarket terms (FRM, indexation)
Nature of targeting
Nature of delivery system (role of private lenders)
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#3 Interest Rate Subsidy:
Tax Relief
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Reducing the effective rate by granting deduction
from taxable income for mortgage interest
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E.g., deduct interest at 15% when tax rate is 30%, so
pay only 10%
Limits on interest, loan, or house price?
Limits on tax rate (makes it a “tax credit”)?
Include implicit income from housing in income?
Rationales:
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Homeownership (but usually not targeted)
Housing too expensive (but why?)
Loans too expensive (but why?)
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#3 Interest Rate Subsidy:
Tax Relief (Cont’d)
Pros:
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Simple to implement
Equity with those who have much cash
Cheap initially, when few have loans/pay taxes
Cons:
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Cost is hidden, increasing
Causes/softens higher tax rates
Very inefficient if to boost ownership
Very regressive if not capped credit
Pushes up prices if inelastic supply
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#3 Interest Rate Subsidy:
Tax Relief (Cont’d)
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Worst Case:
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US has almost no limit and encourages
consumer debt in general
Best Case:
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UK gradually reduced the size and then
eliminated it, and has introduced other
support for homeownership.
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#4 Savings Schemes
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Subsidy related to savings for housing:
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Bauspar system in Germany
Epargne-Logement in France
Open, market rate system
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Tying of savings to access to other subsidies
Subsidy to low-income savers
Rationales
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Indicates and increases creditworthiness
Increases total savings
Stable pool of funds for lending
“Complementary funding” (peculiar to Germany) 11
#4 Savings Schemes (Cont’d)
Pros (of BS and E-L)
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May indicate creditworthiness (but may not, or info may
not be needed or used)
Stabilizes interest rate (but destabilizes the budget)
Stabilizes funding (but with major distortions; needed?)
Cons (of BS and E-L)
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Huge cost of “buying out the base”
Not much impact on housing (in Central Europe)
Very difficult to modify
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Can destabilize the system if new entrants decline
Political attractions (reward to the “virtuous”)
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#4 Savings Schemes (Cont’d)
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Worst Case:
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The Czech Republic set up a BS system in 1993, and
has not changed the 25% premium despite a sharp
decline in market rates on savings and lending (12%
on BS v. 4% market). Now almost 50% of citizens
have account
Best Case:
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Chile and South Africa tie priority access to lump-sum
subsidy to length and depth of savings
Not aware of a supplement to market rate on savings
that is closely tied to income?
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#5 Insurance:
Primary Market
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The state takes on some or all of the credit
risk associated with individual housing loans
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May or may not make an appropriate charge
All or a share or the top part of risk?
Optional or mandatory?
Targeted?
Rationales
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Deal with uncertainties (small or large) about legal
or political environment for recovery
Cover extra risks associated with lower-income or
high LTV lending
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#5 Insurance:
Primary Market (Cont’d)
Pros
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Can diversify risk over submarkets and over lenders
within a country
Can deal with some of the uncertainty about extending
credit at lower income levels or higher LTV ratios (but
should only take part of risk that market cannot
currently; set a sunset?)
Cons
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Dangers of adverse selection, moral hazard, political
pricing and management
Reduction in pressure to resolve sources of risk
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#5 Insurance:
Primary Market (Cont’d)
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Bad Cases:
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Brazil insured against excessive accumulation of
capitalized inflation and is still paying a huge bill.
Philippines was operating a system that seemed
not actuarially sound.
US’ FHA has had to be recapitalized twice
Good Cases:
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Lithuania and South Africa have limited their
capital commitments to mortgage insurers, and
operate on commercial principles. South Africa’s
MI has commercially reinsured its risks.
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#6 Insurance:
Funding Market
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The state takes on some or all of the financial
risks associated with the operation of wholesale
funding systems
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Implicit or explicit?
Public or public/private or private?
Securitization or liquidity facility or mortgage bank
Rationales
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A “blanket guarantee” removes all perceived risks
involved in potentially more efficient ways of
accessing capital markets, helping to achieve larger
scale and greater innovation
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#6 Insurance:
Funding Market (Cont’d)
Pros
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Such direct intervention can force change in the
funding market
Useful for redirecting funds within a diverse
country
Cons
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As with all guarantees, the losses are potentially
very large and there may be incentives to take
advantage of the situation to some degree
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Needs to be matched with statutory or regulatory limits
that limit risk taking and encourage prudent
management; also a sunset might be the best idea.
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#6 Insurance:
Funding Market (Cont’d)
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Good Case:
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A private securitization conduit such as Fannie
Mae can drive a lot of good innovation, but
also has incentives to take on excessive risk
(e.g., act as a mortgage bank).
Better Case:
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Liquidity facilities such the US’ Federal Home
Loan Bank, Cagamas in Malaysia, and the
JMRC in Jordan, are inherently lower risk.
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#7 Lump Sum Grant
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In principle, the state provides those in the
target group a sum of money to use to buy a
house in the way they see best
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This is potentially the most efficient and transparent
subsidy, since the size of grant is clear, the use is least
constrained, and the least distortion to the market
In practice, the assistance comes with strings, such as
buying a newly constructed house at a specific
location, or it is tied to borrowing. It may also be
difficult to implement.
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#7 Lump Sum Grant (Cont’d)
Pros
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Cost is transparent and budgeted
Allocation can be made transparent (forces discussion
of “equity”) and can be used to encourage savings
Beneficiary evaluation tends to be closer to market
costs
Cons
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Usually tie in to “non-market” new housing, with
debatable resale value and perhaps dubious locations
May require “non-market” finance to make feasible
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#7 Lump Sum Grant (Cont’d)
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Good Cases:
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Chile pioneered this, but had to rely on statesponsored lending to make it work (see #8)
South Africa did so on a massive scale, but relied on
“free” land and infrastructure and “first-come, firstserved” allocation, and did not integrate finance
Pure Case:
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Germany offers all first time homebuyers a grant
spread over 8 years, that can help downpayment or
with financing
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No redistribution, but much better than other subsidies to
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middle-class ownership
#8 State Housing Banks
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Direct state intervention into the primary
market, through a state-controlled entity
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Could be partly private, or on commercial
principles
Market or special funding, instruments
Rationales
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In theory, it can pioneer the business of marketrate lending for housing.
In practice, it is usually a convenient shortcut in
developing housing finance without establishing
proper conditions.
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#8
State Housing Banks (Cont’d)
Pros
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Such an institution will deliver in the short-run, and,
if run on commercial principles, could possibly draw
private lenders into the market
Cons
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Irresistible to political process to shortcut funding
and credit risk realities
Also tends to prevent private entry, incur huge
credit losses, use inappropriate instruments, be a
channel for corruption, and have high operating
costs. Often a financial disaster.
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#8
State Housing Banks (Cont’d)
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Bad Cases
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Almost all, especially when tied into special
funds (see #2)
Not So Bad Cases
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Jordan and Thailand were able to keep theirs
on commercial principles, and demonstrate
potential for lending at lower middle income
levels.
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Summary Ratings?
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Good, bad, or ugly?
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One can make such generalizations, but in fact,
not black and white, so won’t do so here. E.g.,
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Tax subsidies not so bad if a credit and tightly limited
Lump-sum subsidies not so good if require access to
finance, and that’s not possible without hidden
subsidies (e.g., state housing bank)
Key is close connection to goal, structuring to be
efficient, transparent, equitable, and non-abused
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