ScienceDirect. Mortgage Lending for Slum Clearance

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1 Available online at ScienceDirect Procedia Engineering 117 (2015 ) International Scientific Conference Urban Civil Engineering and Municipal Facilities, SPbUCEMF-2015 Mortgage Lending for Slum Clearance Kirill Romanyuk* St. Petersburg State Polytechnical University, Politekhnicheskaya, 29, Saint-Petersburg, , Russia Abstract The paper investigates into allocation of treasury funds when major repairs are being funded. Slum clearance is part of major repairs costs. It is shown that mortgage lending can be used to reduce loading on treasury funds and make slum clearance quicker. The world experience in mortgage lending improvement is studied. In particular, mortgage securitization effect is looked into. A model of government co-financing of mortgage lending is proposed. The effect on economic performances due to application of this model is assessed. Guidelines are suggested in order to maintain high quality of the mortgage portfolio The The Authors. Authors. Published Published by Elsevier by Elsevier Ltd. This Ltd. is an open access article under the CC BY-NC-ND license ( Peer-review under responsibility of the organizing committee of SPbUCEMF Peer-review under responsibility of the organizing committee of SPbUCEMF-2015 Keywords: Mortgage lending, major repairs, government sponsorship, budget optimization, credit scoring. 1. Introduction An important objective of cities and town is to repair dilapidated buildings and clear slums. In St. Petersburg in 2013 a law on major repairs was passed [1]. According to the law, the Government of St. Petersburg has to develop and approve a program on major repairs in blocks of houses for the period of 25 years. The Deputy Chairman of the Housing Committee, Andrey Chelyadinov claimed in 2014 that about 22,000 houses of St. Petersburg required major repairs. A lot of money has to be invested into repairs and slum clearance. The estimated cost of major repairs in St. Petersburg is billion rubles. These expenses have to be funded from treasury funds and public participation. Means for slum clearance, as a rule, are provided as subsidies for purchase of new apartments. It turns out that the government, once giving permission to construct an apartment building, makes a commitment to provide new * Corresponding author. Tel.: +7(911) ; fax: +7 (812) address: kromanuk@yandex.ru The Authors. Published by Elsevier Ltd. This is an open access article under the CC BY-NC-ND license ( Peer-review under responsibility of the organizing committee of SPbUCEMF-2015 doi: /j.proeng

2 Kirill Romanyuk / Procedia Engineering 117 (2015 ) housing for residents after the useful life of this building is over. This model of major repairs financing puts a big pressure on the state budget and, what is more, does not stimulate individuals living in ramshackle buildings to take part in their own moving out. The state budget is built up from taxes. Major repairs costs may be covered fully from the means of the state budget. In this case the payment is made by all tax-payers. People living in ramshackle buildings are interested in major repairs more than others, so it is only reasonable to make residents of ramshackle and failing buildings to pay some part of the expenses. It is necessary to build such a system of slum clearance that would stimulate participation of individuals and reduce loading on the state budget. This system can be based on mortgage lending. 2. Critical review Mortgage lending is different from other types of loans due to the fact that immovable property is used as collateral and the period of loan is extended. Long periods of loans entail big credit risks for a merchant bank. Credit risks can be defined as potential failure of a borrower to meet their obligations [2]. The bigger are the credit risks, the higher is the cost of a loan, all other things being equal [3]. People get discouraged from borrowing money at a big interest rate for a long period of time. In order to increase return on assets, securitization is used worldwide. In particular, securitization of assets is common for mortgage lending. Dong in his paper [4] says that securitization has been created to diminish the bankruptcy risk and get a lower interest rate from the lender. In the paper by Heuson et al. [5] it is shown that securitization of a mortgage loan reduces the credit interest rate. The present paper demonstrates that if there is a relatively high demand for lending, securitization of assets will not affect the interest rate and amounts of the made mortgage loans. However, if the demand is relatively low, the interest rate on a mortgage loan will turn to be lower as a result of securitization. In the current condition of the financial crisis it is reasonable to apply the system of asset securitization. In Russia, considering a sharp fall in the national currency rate, this system can prove to be very effective. Securitization of mortgage loans in its classic form can result in a negative effect on the economy. Bubb and Kaufman [6] claim that mortgage securitization entailed the financial crisis in 2008 in the USA. If a mortgage loan is securitized, banks are less scrupulous about a potential borrower s creditability. The same idea is supported by other authors. For example, according to Palantin [7], mortgage securitization makes a bank less interested in selecting and monitoring the borrowers, which entails lower quality of the mortgage portfolio. In other words, if the banks know that the mortgage loan is securitized they provide loans to the borrowers with a far lower level of creditability. Torregrosa et al. [8] say that the state can act as a mortgage loan guarantor and make loans more affordable for borrowers with an average and low income. In addition, the aforesaid paper analyzes how the state through government-sponsored enterprises can contribute to lower costs of mortgage loans for borrowers. 3. Model of major repairs funding According to Nielsen [9] there is a proposal to transfer major repairs costs from municipal companies to the owners of residential property. Probably, this idea also concerns slum clearance. It is worth mentioning that the government is interested in slum clearance. Dilapidated buildings are hazardous for safety of the population. The main task is not to shuffle of the burden of the major repairs costs on the owners of residential property but to make sure that the major repairs are done. The government can subsidize slum clearance to the extent of interest on the loan. State co-financing of mortgage lending can help reduce interest on loans due to a lower credit risk. The credit risk will be smaller since the state guarantees payment of interest on the loan and thus diminishes the cost loading on the borrower. Individuals participate in slum clearance due to the payment structure of the subsidy, which is as follows. An individual who lives in a ramshackle building obtains the right for the subsidy under the municipal government decision. This person arranges a mortgage loan in a bank. The bank fixes payment on the loan. The principal is paid by the borrower whereas the interest is paid by the municipal government. After the mortgage loan is paid, this individual becomes the owner of the residential property. The individual is interested in this program as they get

3 306 Kirill Romanyuk / Procedia Engineering 117 ( 2015 ) cheaper residential property. At the same time, payments for the loan are sequenced in time, which provides moderate cost loading. 4. Application of major repairs financing model Let us assume that the initial subsidy does not cover the full cost of the new residential property that an individual who lives in a ramshackle building would like to buy. This individual can have no money to pay the rest of the amount. In this case the individual will have to make a mortgage loan. In Russia the average interest rate on a mortgage loan in rubles for individuals is a little higher than 12% yearly according to the Central Bank of the Russian Federation [10]. Government co-financing of payments on mortgage loans during slum clearance can reduce the interest rate down to 10% per annum. Suppose the mortgage loan is made for 10 years. The interest rate is 10% per annum. Interest payments are made monthly. The government pays the interest on the loan. The amount of interest payments on this loan will be 50.42% of the initial cost of the apartment. Let us round it to the integer. So, the government will have to pay as interest payments 50% of the initial cost of the apartment. Thus, the government can, rather than pay a 100% subsidy to one owner of dilapidated residential property for purchase of a new apartment, finance two owners of dilapidated residential property and pay interest on mortgage loans for two equivalent apartments. Let us calculate the net present value (NPV). Let us accept the current discount rate of the Central Bank of the Russian Federation equal to 8.25% [11]. The NPV excluding capitalization of interest is 38.86% of the initial cost of the apartment. In this case, even when two identical mortgage loans are financed there is saving in the amount of 22.28% of the initial cost of residential property. Suppose the mortgage loan is made for 20 years. The interest rate is 10% per annum. Interest payments are made monthly. The government pays the interest on the loan. The amount of interest payments on this loan equals % of the initial cost of the apartment. The amount of the interest payments is approximately the same as the initial cost of the apartment. The NPV excluding capitalization of interest is 61.94% of the initial cost of the apartment. It is worth mentioning that payments on the mortgage loan are sequenced in an extended period of time. The cost loading on the state budget is lower because there is no need to pay the whole amount at once. This helps to clear more slums with the same loading on the treasury funds. 5. Discussion of the results Major repairs are an important task in many cities of the world, including St. Petersburg. The issue concerned slum clearance is one of the things to be done in terms of this task. This paper suggests a model of slum clearance financing. This financing relies on mortgage lending. According to this model the government pays interest on the mortgage loan. The state participation makes it possible to reduce the interest on the mortgage loan. This model can help to considerably diminish loading on the state budget. In the example above for the 10 year s loan the reduced loading on the budget in nominal terms is 50%. In the form of NPV, cost cutting of the state budget funds is 61.14%. In the example of the 20 year s loan, the amount of payment from the budget remains the same. In the form of NPV, cost cutting of the state budget funds is 38.06%. Payments of the mortgage loan are sequenced in time. The loading on the budget when the mortgage loan is cofinanced by the government is sequenced in time. Thus, slum clearance can be done quicker and the loading on the budget will remain the same. At the same time this financing model is relevant for those living in ramshackle buildings. It is dangerous to live in dilapidated houses. At some point the dwellers of such houses have to move to other apartments. The model of government co-financing makes mortgage lending more affordable. To pay off such a mortgage loan, depending on the market conditions, can be cheaper than renting suchlike accommodation. On the example of the government cofinancing of the 10 year s mortgage loan, the NPV for the borrower is 67.94% of the initial cost of the apartment. Cost cutting for an individual according to this slum clearance program is 32.06% of the cost of the new apartment. In the second example of the mortgage loan for 20 years, cost cutting for the borrower in the form of NPV is 48.90%

4 Kirill Romanyuk / Procedia Engineering 117 (2015 ) of the cost of the new accommodation. Cost cutting for an individual according to this slum clearance program is more than half of the cost of the new apartment. The government, according to the major repairs financing model that is suggested in this paper can manage budget spending and cost loading on an individual through parameters of the mortgage loan. Co-financing of the mortgage loan for 20 years is more expensive for the state, but monthly payments made by the borrower are twice lower. Vatin et al. [12] analyzed apartment price dependence on many circumstances such as district where house is allocated and communications conditions. These circumstances determine a quality of apartment. Attractiveness of the district depends on sophistication of public transport, roads and social infrastructure [13]. Individuals under government co-financing of mortgage lending have more options to chose apartment's quality. According to Gaevskaya et al. [14] urban planning is a form of resettlement management and it can be used to make concept of "sustainable project" real. A development that meet needs of the present generation without doing harm to new generation is named sustainable development [15]. Government co-financing system can be applied to capital construction and in particular to sustainable projects. 6. Controversial issue According to the experience of the USA, securitization of mortgage lending can result in a financial crisis. That happened in the USA because the banks, knowing that the mortgage loan is securitized, started to provide borrowers with low creditability with these loans. When such schemes as securitization of mortgage lending are used there has to be a limitation of acceptable creditability for a potential borrower. This solution will make it possible to maintain the quality of the mortgage portfolio at a higher level. To set such a limitation there should be standard methods to assess creditability of individuals. Then the government will be able to control the quality of the mortgage portfolio. The question is what method of credibility assessment is to be the basis for such standardization. Apart from creditability assessment methods there can also be an issue about how to define probability of default of a bank to make the system of mortgage lending more secure. There are different methods of classification that are used to assess creditability of a potential borrower and to define probability of default of a bank: genetic algorithms [16,17], decision trees [18,19], discriminant analysis [20], logistic regression [21], nearest neighbor [22,23], neural network [24,25], multilayer perception [26], support vector machine [27,28] and many others. In the paper [29] it has been analyzed that the most popular methods are support vector machine and multilayer perception. 7. Conclusion The paper studies the issue of slum clearance financing. Mortgage lending is used as a basis for slum clearance. Securitization of mortgage lending is looked into as well as its positive and negative effects on economic performances. It is shown that securitization of mortgage lending can reduce the quality of mortgage loans rather than the amount of interest rate. A model of government co-financing of mortgage lending for residents of ramshackle buildings makes it possible to reduce loading on the state budget and speed up slum clearance. It is shown that with the help of mortgage loans parameters the state can manage treasury funds spent on slum clearance. Guidelines are proposed for improved asset securitization in mortgage lending. References [1] O kapital'nom remonte obshchego imushchestva v mnogokvartirnykh domakh v Sankt-Peterburge, Zakon Sankt-Peterburga ot , [Issue on community property major repairs in Saint Petersburg apartment blocks, Saint Petersburg Law from Dec , ], (2013) Vestnik Zakonodatel'nogo Sobraniya Sankt-Peterburga, 40.(rus) [2] Cole, R. et al. Principles for the Management of credit risk (2000) Basel Committee on Banking Supervision, Basel, pp [3] Lee, C.F., Lee, A.C. Encyclopedia of finance: (2006) Springer 855 p. [4] Dong, G.N. Mortgage securitization, housing market and real output: a time-series causality test using structural VAR (2012) Columbia University, 37 p.

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