(An excerpt of Fitch’s recent report on the housing bubble in Brazil).
Hot Market Begins to Cool: After increasing roughly in line with inflation between the mid- 1990s and 2007, prices of residential properties in Brazil’s large metropolitan areas soared. From January 2008–July 2012, real prices increased 92% in São Paulo and 118% in Rio de Janeiro, according to the FipeZap Index. However, in recent months, price growth has fallen in line with income growth.
Macroeconomic Conditions Underpin Surge in Home Prices: Increasing average household incomes in combination with improving income distribution and massive credit expansion in the context of lower interest rates facilitated demand for residential properties. This new demand for housing has not been fully met by supply of quality existing housing. Moreover, new construction in large metropolitan areas is limited by lack of space, qualified workers, and building material. The resulting housing deficit pressures prices upward.
Mortgage Growth Drives Boom: Credit expansion is widely considered the most important driver of property prices. Factors contributing to mortgage growth include: sustained decrease of historically high interest rates; availability of cheap and growing savings deposits to fund mortgage lending; loosened lending standards; and legal reforms, such as changes in mortgage laws to streamline the foreclosure process.
Prices Expected to Stabilize: Prices may be reaching their limits and have started to grow in line with incomes in the past couple months. Although prices look expensive by any measure, Fitch Ratings does not expect prices to go down significantly in a benign economic environment given medium-term supply and demand imbalances.
Risk of Price Declines in Crisis Scenario: House prices are expected to be very sensitive to availability of affordable credit, which hinges on a sustained moderate-interest environment and lenders’ continued access to cheap funding. A highly concentrated mortgage market dominated by government-owned Caixa Econômica Federal (CEF, 75% market share) is a source of risk. Additionally, homeowners are more indebted, both with mortgage and nonmortgage consumer debt, and therefore could be exposed if unemployment increases from current record-low levels.
RMBS Criteria Reflects Market Evolution: Fitch addresses these risks in its RMBS criteria by applying very conservative stressed house price declines in higher rating scenarios. In a ‘AAA(bra)’ scenario, house prices are assumed to fall below levels observed in 2008 in real terms, and market value declines (MVDs), which include additional quick sale adjustments, reach up to 69%. The highest MVDs are applied to properties located in Rio de Janeiro and Brasília, where prices grew most rapidly, and current values are among the highest in the nation.
House Price Growth
In recent years, Brazil’s largest cities have experienced the highest home price increases in Latin America, placing São Paulo and Rio de Janeiro among the most expensive property markets in the Americas. From January 2008–July 2012, home prices in São Paulo and Rio jumped 144% and 178%, respectively, according to the FipeZap Index, which tracks offer prices every month in the country’s seven biggest cities. After adjusting for inflation (using the consumer price index IPC-A as a deflator), prices went up by a still impressive 92% in São Paulo and 118% in Rio de Janeiro.
The current housing boom follows a long period of subdued housing market activity dating back to 1995, when the economy stabilized and inflation came under control with the introduction of the real (BRL). Property market data tracking prices before 2007 is limited, but information from Empresa Brasileira de Estudos de Patrimônio (Embraesp) on prices for new construction in the metropolitan area of São Paulo suggests that residential housing prices remained flat in real terms between 1995 and 2007.
The housing sector has developed alongside Brazil’s broader economic success. Rapid growth of the middle classes and expansion of credit (discussed in the next section) are two key factors behind the boom. In the context of sustained economic growth and low-to-moderate inflation, real per capita GDP rose 18.6% from the beginning of 2006 through the end of 2011, according to Fitch. During the same period, unemployment dropped to 6% from 10%, the ratio of formal-to-informal employment increased, and the wide gap between the wealthy and poor narrowed a bit. Real income growth also boosted savings deposits, which grew by more than 140% between year-end 2005 and year-end 2011. This, in turn, increased the availability of cheap funding sources for mortgage lending, which was further propelled by a sustained decrease of interest rates and legal reforms.
Meanwhile, supply has not kept up with surging demand, creating an imbalance that likely will not be solved in the short term. Brazil suffers from a general lack of good-quality and welllocated residential properties. Furthermore, large cities lack space to build new residential buildings, qualified construction personnel, and building materials.
As residential real estate prices were boosted by high demand and inadequate supply in all major metropolitan areas, most notably São Paulo and Rio de Janeiro, speculators have entered the market and influenced prices at least in parts of the market. However, their influence on prices is difficult to measure.
Expansion of Credit as Main Driver
The expansion of the country’s mortgage market is widely seen as the most important driver of the property price boom. Hundreds of thousands of properties were financed with new mortgage loans each year. Since 2005, mortgage lending as a percentage of GDP grew to 5.4% in May 2012 from 1.5%, based on figures reported by the Central Bank of Brazil (BACEN). However, by developed world standards, this percentage is still paltry.
In Brazil, mortgage lending taps traditional funding sources, especially savings deposits and, for subsidized lending, the Fundo de Garantia do Tempo de Servico (FGTS), a Brazilian workers’ fund. Under Brazil’s Housing Finance System (SFH) created in 1964, banks must direct 65% of savings deposits to housing finance, which includes mortgages, but also other assets related to real estate lending. By law, interest rates on mortgage loans funded via savings deposits are, to a large extent, capped. Once the benchmark rate goes below a certain level, mortgage lending becomes increasingly attractive to banks, which can offer reasonably priced loans to borrowers without sacrificing returns. Since 2006, mortgage lenders have benefitted from decreasing benchmark interest rates, in addition to a growing volume of savings deposits.
The benchmark interest rate (SELIC) hit historic lows during the past couple years, both in nominal and real terms, helped by economic stability and an environment with reasonable inflation levels. The SELIC rate, which never dipped below 15% until 2005, averaged 12.5% in 2008, 9.9% in 2009, and 9.75% in 2010. In 2011, rising inflation forced the BACEN to increase rates up to 12.5% before starting to cut them again in August of the same year. As of the publication date, the SELIC stood at 7.5%.
The development of the mortgage market was also enabled by legal reforms, including changes in mortgage laws and the introduction of alienaçaõ fiduciária (AF), or fiduciary lien, which streamlined the foreclosure process by considerably reducing time needed to seize and liquidate property of defaulting borrowers. AF was introduced by law in 1997, but started to replace the traditional mortgage (hipoteca) only in 2004.
Large banks dominate residential mortgage lending. Caixa Economica Federal (CEF), a government-owned savings and mortgage bank, is far and away the leader, commanding about a 75% market share. CEF increased its portfolio to BRL156 billion in March 2012 from about BRL20 billion in 2005. Other major lenders include private giants Banco Itaú-Unibanco, Banco Bradesco, and Banco Santander, together with government-owned Banco do Brasil.
By increasing loan volumes, extending loan maturities and modifying LTV and DTI standards, lenders have opened up the mortgage market to millions of new borrowers. In this regard, mortgage terms extended to 30 years in 2008 from an upper limit of 20 years and maximum LTVs expanded to 90% in 2009 from 80%. More recently, in June 2012, CEF further increased loan terms to 35 years and provisioned for LTVs to go up to 95% for certain clients. Notwithstanding certain changes in underwriting criteria, some loan characteristics still remain simple by developed world standards; for instance, all mortgages in Brazil are fully amortizing with fixed interest rates (with or without indexation).
In spite of price increases, buyers have been able to purchase homes without increasing their down payments or initial monthly debt service. This is especially true if current credit conditions are compared to the previous environment. Before the expansion of the Brazilian mortgage market, mortgage financing was scarce and often consisted of expensive and relatively shortterm loans provided by homebuilders to buyers of newly constructed residences. In the new lending environment, home buyers can afford pricier homes at the expense of taking on more debt, albeit cheaper debt by historical standards. By way of example, for a given income, maximum DTI, and down payment, the property price can easily be more than 50% higher if financed with a standard 30-year bank loan rather than a short-term loan from a construction company. This “affordability” has contributed to price inflation.
Prices May Be Reaching their Limits
The sizable price increases in some cities have prompted talk of a housing bubble. During the past three years, rental yields have been sharply lower than mortgage rates (the latter starting at about 8% annually) in Brazil’s major metropolitan markets. Rental yield reflects a property’s annual net income divided by its purchase price. When it becomes cheaper to rent a home than to purchase one, buyers might retreat from the market. Decreasing rental yields (see the chart below) in São Paulo and Rio could be an indication that properties are overvalued unless there are expectations for further income growth or significant capital appreciation.
In addition, house prices have increased very disproportionately to the rise in household incomes both in nominal and income-adjusted terms, as evidenced by the chart below. Although statistical information is limited and there is a wide dispersion of prices and incomes across and even within neighborhoods, available information clearly shows that reasonably sized and good quality properties in Rio de Janeiro and São Paulo have become very expensive for the broader middle classes. House price-to-income ratios (average property prices divided by estimated average household incomes) are above 5.0x in São Paulo and above 7.0x in Rio de Janeiro. These ratios are far greater than those in Western Europe and North America. Home ownership thus requires increasing leverage and longer-term debt, which may explain the recent move of government owned CEF to increase the maximum loan term to 35 years.
Not surprisingly, recent figures show signs of a slowing market. In both São Paulo and Rio, income-adjusted prices have leveled off since year-end 2011. However, Fitch does not expect significant broader property price decreases in a base economic scenario, since supply and demand imbalances likely will not be resolved in the near term. Also, when compared with other booming emerging markets, Brazil’s largest cities still seem relatively affordable. For instance, Fitch estimates average house price-to-income ratios in Shanghai and Moscow to be far greater than the average ratio in São Paulo.
Risk of Price Declines in Stress Scenarios
In the event of stressed economic scenarios, Fitch acknowledges the risk of a considerable decrease in home prices. Reasons are manifold. House prices are expected to be very sensitive to availability of affordable credit, which hinges on a sustained moderate interest environment and lenders’ continued access to cheap funding. Furthermore, Brazil’s highly concentrated mortgage lending market relies on just a few big lenders, mainly CEF. In addition to the risk of a decline in mortgage financing, housing prices are sensitive to employment. Home owners are more indebted than in the past and therefore could be exposed if unemployment increases from current record-low levels. Besides mortgage debt, many households have considerable consumer debt, which is usually not captured in the DTI limits set by the banks. Since home buyers are often first-time owners and borrowers, they may not plan for periods of lower income and may underestimate the costs of maintaining a property.
In a recession scenario featuring an increase in unemployment, default rates and forced sales of properties can be expected to rise and subsequently drive down property prices. Solvent borrowers may choose to walk away from underwater properties since the AF foreclosure process does not envisage further recourse to borrowers after property seizure, exacerbating the situation. Lenders may end up with a large stock of properties and corresponding losses, and lending may dry up. This, in turn, would make houses unaffordable for potential acquirers, further driving down prices.
Property prices could also be negatively affected if cheap funding ran out or if the central bank were forced to increase the SELIC rate to contain inflation.
It should be noted in this context that alternative funding sources for bank mortgage lending like securitization and portfolio sales are more expensive than traditional funding and still play a minor role in residential housing finance. However, the growth of traditional funding sources has been slower than the growth in mortgage lending since 2005, spurring the need for alternative funding sources in the next few years. This projected deficit could spark Brazil’s nascent RMBS market, but could also drive up mortgage rates. Currently, Brazilian RMBS pay interest rates well above rates on savings deposits and also above certain mortgage rates. Consequently, the SELIC rate will have to stabilize at record-low levels to allow mortgage rates to remain stable.
Updated Fitch RMBS Criteria Reflect Property Market Developments
The development of residential property prices and associated risks play an important role in Fitch RMBS criteria. When rating RMBS transactions, Fitch calculates stressed recoveries for defaulted loans, which are, among other factors, determined by estimated house price declines in tested rating scenarios.
Fitch therefore cautiously monitors Brazil’s real estate sector and constantly adapts its rating criteria to market developments. The increased risks resulting from the recent property price increases are reflected in Fitch Research on “RMBS Latin America Criteria Addendum – Brazil,” dated February 2012, available on Fitch’s Web site at www.fitchratings.com.
As a consequence, Fitch applies very conservative stressed house price declines in higher rating scenarios. In a ‘AAA(bra)’ scenario, real house prices are assumed to fall by 50%-55%, depending on the region. The highest house price declines are applied to properties located in Rio de Janeiro and the Federal District, where prices grew more rapidly and property prices are amongst the highest in the nation.
Additionally, Fitch reflects the expected premium a seller is likely to have to suffer for selling a property in a depressed market through quick sale adjustments, which equal 30% of the stressed property price. The resulting MVDs reach 65%–69% in a ‘AAA(bra)’ scenario.
Source: Fitch Ratings