Financial Fragility

Financial Stability Property Market Bank lending

* Stress testing 30% for in property prices

Executive summary

   1997 crisis was interplay between the property market, bank lending and the economy.

Assess the degree of financial fragility associated with bank lending and the property market Attention to impacts of interest rate increase and banks’ mortgage portfolios.

Questions

 How long will bank’s mortgage portfolios be able to withstand the upturn in the interest rate cycle without having to ask borrowers for additional payment contributions?

 What would be the impact on banks’ capital positions if there were a collapse in property prices?

(Section2) Thailand’s property market: navigating through boom and bust cycles  First cycle Since 1970, Government housing market and Established the National Housing Authority (decree provided credibility to both developers and consumers in the purchase and sale of housing) • • • 1973, boom – Oil shock Caused prices of building material up Accompanied rise in labor cost and slowing economy Demand for housing fell --------------- caused BUST

2

nd

Boom

      1976- 80 boom Financial institutions provided low interest rates to homebuyer Townhouses began to emerge in Bangkok Boom ended by the oil shock BOT limited only 18% credit growth Many projects became incomplete and new projects were shelved ----------------------- caused BUST

3

rd

Boom

     1986, transformation from an agricultural-based economy to an industrial-based economy Too many FDI (foreign direct investment) Housing project increased prices as the no. of housing unit soared Housing and townhouses boom, rising prices and strong demand ------ better speculation Real estate market slowed down in 1990 due to the Gulf War ---------------- caused BUST

Private residential and nonresidential construction, 1980-2002 and Permitted construction area, 1984-2003

4

th

Boom

     1993, Board of investment (BOI) offered 5 years income tax exemption to developers who developed low income housing units. 1995, found that half of 300,000 units in BMR which were purchased were unoccupied condominium.

1997, while the growth of the Thai economy had initially enhanced, the downfall of the housing market impacted other sectors in economy. Developers didn’t lower prices due to the rising construction prices. Price of property dropped Property crisis ----------- Bank crisis*

The crisis

       BIBF (Bangkok International Banking Facilities) Foreign loan come easy with lower rate Loan to developer at lower rate Speculation on price Loan reached 800 billion baht in 1996 28% of GDP, but no productivity Leading crisis

Outstanding property loans percent of GDP and NPLs of real estate loans

The new beginning

       2002, Houses and townhouses recovered GHB, provided long term fixed rate mortgage Reduction of special business tax from 3.3% to 0.11% Transferred fees from 2% to 0.1% Economic recovery and low interest rate, raised consumer’s ability to purchase housing by increase ability to service debt. Families have also increased demand for living.

Result, demand for mortgage loans had ballooned.

CONT’

 Extended mortgages to reduce excess liquidity.

  Mortgage is less risky and firm is collateral.

Small to medium sized developers focused on one development at a time before new project.

* The renewed confidence in the market brings questions whether the sector may be exposed another crisis again?

- Economic cycle and the growth depends on demand • • • Driving force - Low interest rate - Bank competition Any risk overinvestment---YES!, DEPEND ON BANK LENDING BEHAVIOR

(Section 3) The interconnection between the property secter and commercial bank    Pre versus Post financing (supply side/ demand side) Pre financing - for property developer as source of fund.

Post financing - for purchasers of housing as source of fund.

Before crisis

 Bank and financiers are major players.

•

After crisis

• • Bank as major player, most of financial companies closed down.

So, developer go to capital market SET, raise fund from the market rather than rely on the bank.

After the collapse of the fixed exchange rate regime, banks learned a painful lesson. (exchange rate from 25 to 57 baht) Many foreign debentures were default or not rolled over.

Index and market capitalization of the property sector

 no more BIBF , BIBF paid off their loan and avoid borrowing from foreign sources.

Breakdown of post financing, 1991-2003

CB-Commercial Bank GHB ธ .

อาคารสงเคราะห ์ GSB ธ .

ออมสิน FC- financial company

Bank played a major role

• • • • From the structures of pre and post financing, bank are the most important sources of funds of the property sector.

Commercial bank lending is important to both supply and demand of the property market.

Loose credit policy and low interest rate generated real demand, but also lead to speculative demand and excessive supply.

Watch closely for speculative bubble!

Section4 Impact of monetary policy on property prices (SVAR)

 Monetary policy movement Changes in repurchase rate Affect property price by altering bank lending and macro economy

An increase in policy rate

 Cause in short term interest rate to rise.

 In turn increase the cost of loans.  Reduce demand for credit by both developer and consumers.

*Consequently  Decreases house buying, planned fixed investment and two component of real output.

 In turn contributes to fall in property price.

Structural identification estimate 14 day purchase rate (RP14) Each variations:

r

is the 14-day RP rate

i

is the nominal MLR

l

is mortgage lending by commercial banks

y

is the log of GDP measured at 1988 prices

p

is the condominium value index.

RP14 (Shock1)

For the shock to reach maximum effect on each variable, it takes:  1 quarter of MLR   half year of GDP 2.5 years for mortgage lending  1.25 years for property prices Full impact of one standard or 150 basis point increase in RP14 imply a 23 basis point increase in MLR   1 billion baht decrease in mortgage lending 1 billion baht reduction in real GDP  1.2% fall in property prices

Response to an RP14 shock with short run and long run Short run Shock dissipate over time, the effect of monetary policy shock is transitory.

Long run

Property price variance decomposition (%)

SVAR model’s result shows: • 40% of variation in property price explained by variation in MLR • 30% by variation in RP14 • bank mortgage loan explained less than 5% of variation in property price.

Overall impact of monetary policy on property price

Monetary policy plays and important role in:  Bank lending   The economy Property price So, applying monetary policy to deal with property prices Effect other sectors of the economy

(Section5) Assessment of financial fragility in the current market environment

    Measuring sensitivity of mortgage plans to interest rate increase In the past, fixed rate (high rate) Now float exchange rate Mortgage loan

Example of mortgage payment plan

   If the interest rate is 3.75% for the first two years Fixed minimum payment 7,020 baht and assumed MLR remain at 5.75% and payment contract over the 20 year contract term.

Float at MLR or MLR+ salary 20,000 baht/month x 60 times = Max loan loan 1,000,000 baht at MLR 5.75, 30-35% of salary repayment 20 years.

Pay per month 7,020 baht MLR + 60 base point MLR+, 8.25% = additional 1,020 baht, = 5% of salary So, pay per month 8,040 baht, = 40% of salary

Payment profile of a hypothetical mortgage contract when MLR remains at 5.75%

Stress testing, banks

’

capital

1.

2.

3.

4.

5.

 To assess the impact of a property price collapse on banks’ capital positions Increase in required loan-loss provision Loss of interest income Increase in NPL resource costs Losses on impairment of properties foreclosed Losses from bank-owned AMCs

Schematic representation of the stress test model

(Section6) Implication for policy

1.

Monetary policy Interest rate MLR Provision requirement Mortgage insurance Preemptive strike

2. Effective monitoring and early warning system

  1.

2.

3.

4.

5.

6.

7.

Real estate information center (REIC) at GHB Index Land housing permit Housing start Housing competition Home sale Housing transfer Housing price index Housing finance

Lists of selected indicators used by other countries in their monitoring system that relevant in Thai context.

 1.

2.

3.

Experiences from other countries that have gone through similar property boom and bust cycle.

Affordability index (A rise in the index represent deterioration on households’ capacity to afford a mortgage) Buy and rental gap (which compare the cost of purchasing and maintaining a residential unit to a cost of renting ) Cancellation of future project

Lending behavior of bank and their risk exposures     LTV profile In some countries, bank lending practice (must check every 3 months) Bank are loosening or tightening credit policy.

Look at D/E ratio

3. Sound credit risk management practices by banks        Sound credit risk management keep financial imbalances in check.

Move from collateral-based lending to risk-based lending practice.

Risk based lending emphasizes a borrower’s future cash flow.

RADOC, bank’s risk-adjusted return on capital Credit risk models for property loan portfolio (data on LTV, loan age, loan size and loan type) Pool database DIA (FDIC in USA) the institution of deposit insurance to be more careful when making loan for Thailand

4. Prudential regulation and supervision

  Primary instrument for financial stability Extend to information disclosure and corporate governance  Provide safeguard to measure for financial institution system Three major prudential measures 1.

2.

3.

Loan classification standards and tightening of provisioning requirements.

Restriction on the maximum LTV 70%for mortgage loans larger than 10 million baht.

Mandatory disclose requirement for houses valued more than 100 million baht.

Concluding remark

      Property market and banking sector are two sectors in the economy that matter to financial stability.

Banking sector is no cause for undue alarm.

Thai bank have enough capital and loan loss reserves to withstand the impact of isolated 30% decline in property prices.

No banks would fail under the stress scenario.

Need authorities to closely monitor developments in the property market and banks’ lending practice.

Lastly, protect themselves from fluctuations in the property market.