Housing Finance Subsidies

 

Definition

Crises in housing finance systems intensify the debate about housing finance subsidies, in particular implicit and broad-based subsidies to the housing finance system. Implicit housing and financial sector subsidies in the United States and other countries have compounded the effects of excess global liquidity, high leverage in financial firms, fraudulent underwriting, private sector wrongdoing and regulatory lapses in creating the latest housing bubbles and financial crisis. The purpose of these subsidies is often not well defined, nor is their scale understood, until bubbles burst and subsidized systems have to be bailed out. At the same time, in the aftermath of financial crises, subsidized systems are often the only ones delivering housing credit. Reforms of such subsidy systems are difficult, since the ultimate costs of these subsidies are concealed, i.e., they are off-budget, they extend access to finance to middle income households, an important political constituency, and they are prone to intensive political lobbying. In most countries, there is also a real need to expand mortgage finance to the broad middle or lower middle income segment and, therefore expand the delivery of formal housing. But why not subsidize deserving households directly? And what about households that do not qualify for a mortgage loan? How will they be assisted if most subsidy funds are tied to mortgage finance systems? Many countries are currently confronting those questions—from the United States to South Africa, Mexico and Brazil. Answering those questions requires a precise diagnosis of the problems and constraints faced by households and markets in delivering housing or finance. This page frames the subsidy debate in those broad terms and shows how and why systems developed over time. But first we define what a subsidy is.  

Subsidies are often mistakenly perceived as giving or receiving something for free. From a broad perspective “a subsidy is an incentive provided by government to enable and persuade a certain class of producers or consumers of housing to do something they would not otherwise do, by lowering the opportunity cost [i] or otherwise increasing the potential benefit of doing so” (adapted from the U.S. Congress [1969]).  

For the purpose of this portal the focus is on subsidies related to housing finance, i.e., the way in which the housing asset is paid for. Housing finance subsidies can be applied to the equity in the house or to improve access to or lower cost of debt finance; they can target the acquisition, improvement, or construction of housing in either owner-occupied or rental markets. Housing finance subsidies can focus on improved efficiency of housing finance systems or assist households directly.


[i] For a household, lender or developer these costs are the yield or benefit that could have been received had the money been used for other purposes or later. The opportunity cost to government of providing housing subsidies needs to be considered within the same framework. The opportunity costs for government means that a smaller part of the budget (or fiscal revenue) will be available for other programs, often for the same group of persons.  

 

 

Background & Evolution

Of all forms of housing subsidy, housing finance subsidies are among the most prevalent, in both emerging market and advanced economies. They have a long history and are deeply entrenched in the housing finance systems of most countries. Subsidizing finance can be fairly easily achieved at a national level and is therefore often a first policy choice.  

  • In the past, the response of many governments to poorly developed housing and housing finance markets was to take over housing production and finance or establish special entities funded by a dedicated tax on labor, often providing high but non-transparent subsidies, i.e. subsidies that do not appear on the country’s budget and of uncertain size. Such subsidy systems often combined supply-side subsidies to state-owned institutions with deep interest subsidies to developers and households in the form of below-market interest rates and low down-payment requirements relative to market risk. Such systems were frequently unstable and inefficient and required regular bail-outs by governments. Moreover, the interest rate subsidy is a regressive instrument and further increased housing inequity in most countries.
  • Comparative housing subsidy research conducted during the 1970s and 1980s in the United States [i] and Western Europe emphasized the inefficacies of supply-side subsidies. Several industrial countries moved, at least partially, to direct demand side subsidies (household vouchers) and even some Latin American countries with fairly stable macro-economies and well developed financial markets such as Chile. Such income transfers afford maximum choice to households, are efficient and transparent, and can be targeted to specific segments of the market. Moreover, they do not distort the housing or housing finance system itself and can be applied to rental and owner-occupied housing, and new and used housing.
  • In many emerging market economies the application of an income transfer system—-earmarked or conditioned upon increased housing consumption—does not yet work to improve housing conditions, however. The housing sector in many developing and emerging markets was and is still constrained by incomplete housing finance markets and inefficient land markets. Even if finance is available, the regulatory system often makes it unprofitable or unfeasible for private developers to operate in the middle-income market. Housing vouchers are therefore unlikely to improve housing conditions for the lower/middle income groups and often benefit developers rather than consumers. In Chile, for example, the voucher system worked only in that part of the market where lenders were comfortable operating. Even in industrial economies with efficient financial markets, the transfer to demand-side subsidies was never complete. Strong vested interests in the housing industry prevented phasing out of supply and tax subsidies, and there are still “real” side supply constraints that made delivery of low income housing unfeasible (see Gyourko’s supply side page on this portal).
  • During increased macroeconomic stability and growth of financial systems preceding the recent crisis, many emerging market economies began reforming their old state-dominated supply side subsidies and initiated new subsidy incentives aimed at improving housing finance markets and creating a more level playing field across state and private lenders. The objective was to serve an increasing part of the middle income segment through the private sector and reduce the overall subsidy level by the use of credit. For example, Korea began a major reform of its state housing finance systems and related subsidies after the Asian crisis, and saw steady growth in its mortgage sector and housing production for middle and lower middle income households. Equally, household subsidies are being reformed in many countries to be more transparent. These reforms are, however, complex and evolve over a considerable period of time.  
  • The recent crisis has slowed—but not derailed—this process in many countries. The private sector withdrew from the market; its place was filled, yet again, by subsidized state finance institutions using cheap credit in countries where such lenders are still prominent. In countries as diverse as the United States, Brazil, Mexico and Indonesia, state institutions make or support more than 90 percent of the mortgage loans; in other countries subsidized state guarantees cover an increasing proportion of mortgages. The challenge now is to gradually re-engage the private sector in the middle income market and expand transparent household subsidies where necessary to move further down-market. Since indebtedness of households has become a major issue in many countries (e.g., South Africa, Brazil, the United States), transparent subsidies will increasingly need to be linked to savings.
  • For households not qualifying for a mortgage loan, subsidies in developing countries and emerging markets still need to focus on upgrading the physical infrastructure of (informal) neighborhoods and the provision of serviced land and a modest superstructure or high density multi-unit housing. Incentives and support for housing micro-lenders sometimes complements these efforts to allow households to speed up the construction or improvement of their homes (Hoek-Smit, 2009). Where feasible, voucher systems for rental subsidies are introduced (e.g., transition economies).  
  • Subsidies to rental housing have been part and parcel of housing policy in post-war industrialized countries, specifically Western Europe. The instruments have changed from subsidized public housing to rental vouchers and various incentives for social or private rental investors. Public rental housing and rent control were, in the past, the prevailing models in emerging markets as well. Public housing has, however, been disregarded in most countries because of its high cost, maintenance and social problems. Rent control is slowly being phased out because it stifles investment and prevents maintenance of the stock. Very few countries have implemented alternative rental housing incentives and subsidies. Some use escalated depreciation for tax purposes and other such stimuli. Gradually, however, more attention is being paid to developing incentives to expand formal sector rental housing. (See Rental Theme page)


[i] The Experimental Housing Allowance Project, a large-scale research experiment in the 1970s in the United States tested the relative efficiency of different types of supply- and demand-side subsidies..  

 

 

Objectives and Main Approaches to Subsidizing Housing Finance

Three broad goals are usually involved, explicitly or implicitly, in political discussions about subsidy intervention in the housing sector:[i]  

  1. Improving public health.
  2. Improving justice and fairness in society, i.e. redistributing income through housing.
  3. Overcoming inefficiencies or failures in the housing or mortgage market that cannot be solved through regulation.  

The first two of these goals for subsidy intervention relate directly to improve sanitation and housing conditions, and focus on promoting welfare in society through the housing sector. But for which households or market segments? For home-ownership or rental housing? And, if homeownership is to be stimulated, is the focus on first-time home-owners only?

- Two different population groups are often distinguished in designing subsidy programs to fulfill these goals:

    • those who with some help can access mortgage finance and formal market-produced housing, and 
    • those for whom the housing market will not yet deliver housing and who require direct support to access serviced land/upgrade their living    environment or rental housing.
- An ongoing process of adjustment is necessary to ensure that subsidies benefit deserving households.  

The third goal focuses on expanding housing opportunities by pricing, and allocating costs and risks in the housing and housing finance sector more optimally. Specific market constraints that prevent mortgage and housing micro-finance lenders and/or developers from serving different segments of the population need to be identified to develop an effective package of regulatory and subsidy measures to address such bottlenecks. Such subsidy incentives to market players should be phased out as soon as the private sector is able to take on the specific risks and costs, and exit clauses need to be part and parcel of program design.  

This division in objectives and approaches brings into focus the very different types of analyses involved in subsidy design (Hoek-Smit, 2009):

  • Identifying problems individual households face in improving their housing conditions (e.g., low income, unstable income or employment, savings constraints, poor housing collateral, lack of mortgage finance or home-ownership information) and the type of subsidy incentives that might address them.
  • Understanding specific constraints in expanding housing finance systems (e.g., funding constraints, liquidity risk, credit risks, interest rate risk, lack of housing sector and credit information), and the design of subsidy incentives to reduce them.


[i] There are various other rationales for the use of housing subsidies, such as influencing economic and political stability (commonly used to support home-ownership), and stimulating economic growth (generally used to support various countercyclical assistance to the construction sector). These goals are featuring prominently in the current subsidy measures to support the housing sector in Brazil and the United States during the current downturn. In developing countries housing markets are often too inefficient to make housing subsidies a wise choice to reach such goals.  

 

 

Key cases to watch

Canada
Canada is an interesting case: It does not subsidize the housing finance industry or households and yet has a well functioning housing system. While in the past, there might have been implicit subsidies in the CMHC guarantee, with the entry of private mortgage insurers, the playing field is level and the CMHC and private insurers compete for business under the same conditions—without government subsidies.

Egypt
The government of Egypt is changing from deeply subsidizing the supply of most new housing production and non-transparent interest rate subsidies through state banks, to an upfront household subsidy program linked to mortgage credit that leverages households’ capacity to pay for the house. The subsidy decreases with the increasing size of the loan and can be applied to the down-payment (although personal savings are always required) or to a buy-down of the monthly payments over the initial years of the loan; it decreases over time when incomes increase.  

To make sure that mortgage finance expands in line with growing demand, several support measures have been implemented on the supply side—critically the establishment of a mortgage liquidity facility. The Egyptian Mortgage Refinance Company (EMRC) enhances access to long-term funds, which is crucial for the establishment of long-term lending.

The legal and regulatory system for mortgage lending has improved considerably, in enforcement of foreclosure, streamlined property registration, consumer protection and financial education.  

Challenges remain: Lingering rent control and a slow phasing in of the new rent law limit a dynamic rental sector from developing and constrains the efficient use of existing, well located housing stock for middle and low income households. Equally, the large informal stock is not being integrated. The emphasis of the great majority of subsidies is on new construction of ownership housing (Hoek-Smit, various unpublished documents; World Bank 2009).  

South Korea
South Korea had a long history of state supply of housing and housing finance, combined with rigid land supply regulations. Its public housing stock is nearly 10 percent of the total stock. After the Asian crisis, Korea liberalized its mortgage sector, i.e., ended hidden subsidies through the state housing bank, and consolidated subsidies in the National Housing Fund. The Fund provides debt subsidies for the large down-payment (Chonsei) required in Korea’s system, targeted to households below the 40th percentile, and income vouchers for lower income groups. Housing production and quality has steadily improved and prices have stabilized.  

Challenges remain. The supply-side inelasticity reduces the benefits of increased access to finance, with negative price effects. The new subsidy programs reach only a very small proportion of deserving households and focus disproportionately on ownership rather than rental housing (See various papers and presentations by Kuyng Hwan Kim and Man Cho).  

Other countries to watch are Brazil and the United States. Brazil implemented a million houses program in 2009 as an economic stimulus program, which has been extended through 2010. Beneficiaries receive both up-front and interest rate subsidies through the budget and through the existing labor tax fund. Loans are disbursed and serviced almost entirely through the state housing bank. The scale of mortgage expansion is, however, putting stress on the state system, and private sector participation will need to be stimulated (Hoek-Smit, 2009 presentation to Fazenda; Claudia Magalhaes Eloy, 2010). In the United States, a committee is looking into the future of the now government-owned secondary market conduits, Fannie Mae and Freddie Mac, that provide an implicit subsidy to the funding side of mortgages below defined limits. Adjustments have been made in the government-subsidized mortgage insurance system, FHA, which has expanded in the aftermath of the crisis but has seen its claims increase.  

Keywords: subsidies, supply-side subsidies, demand side subsidies, access to mortgage credit.

 

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About the Editor

Marja Hoek-Smit
Contact
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Marja Hoek-Smit is the Director of the International Housing Finance Program of the Wharton School’s Zell/Lurie Real Estate Center, and an Adjunct Professor in the Wharton Real Estate Department and Department of City and Regional Planning of the University of Pennsylvania. She is also the founder and Executive Director of the Housing Finance Information Network (HOFINET).