Mortgaging for growth: home building serves as engine of economy.

After eight years in recovery, the Mexican mortgage market is experiencing explosive growth.

The stimulus has very little to do with the formal banking system. Rather, small, gutsy lenders who emerged from the ashes of the 1994 financial crisis deserve the bulk of the credit.

A series of government reforms beginning in 1997 appears to have been influential in encouraging the specialized lenders--known as Sofoles--to step into the market.

The Fox administration has also been instrumental in providing momentum to the mortgage process that many present and future private sector players--both domestic and international--now deem attractive.

The profit motive is quickly making its way into the process. And the industry's vitality has attracted commercial banks back into the sector with a bang.

As a result, the mortgage market will become distinctly less dependent on government subsidies, as private institutional investor participation increases in the coming years.

Before examining the players in the mortgage market, it is necessary to understand what the playing field looked like.

The Meltdown 

In 1994, Mexico experienced a financial crisis that froze the financial system in its tracks.

The abrupt devaluation of the peso triggered a financial panic, resulting in a loss of confidence that permeated throughout public institutions.

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During the first few weeks of the crisis, foreign investors reportedly lost more than US$9 billion in investments. Non-performing loans skyrocketed from levels of 10 percent of outstanding loans to a disastrous 30 percent.

The mortgage market collapsed as commercial banks abandoned the sector. Inflation soared, reaching 50 percent in 1995, and the notion that a young couple of modest means would be able to buy a new house with a mortgage became laughable.

Absurdly high interest rates, a general credit revolt spreading throughout the country, and profound loss of confidence combined to produce a prohibitive mortgage market in need of tough medicine and higher standards. It was clear that only the federal government was in a position to rectify the situation.

The role of the public and private sectors in Mexico's home financing system had fluctuated greatly in previous decades. As such, it was clear in the late 90s that the future of the mortgage market was firmly in the hands of the government.

The Turning Point

The panorama President Ernesto Zedillo faced in early 1995 was daunting. Los Pinos was torn between negotiating with the nascent Zapatista movement, addressing a financial system meltdown, arranging a bank bailout and dealing with an uncompromising Congress.

Interest rates skyrocketed and banks lent mostly to the wealthy. Angry citizens were forced to default on automobile and home loans. Credit card interest rates touched 70 percent.

The government soon faced a resurgent wave of anti-credit sentiment that found its voice through the El Barzon movement.

This popularized movement arose from an earlier coalition of agriculture associations formed in 1992. What was originally a ranchers' debtors coalition quickly transformed into a major consumer credit movement that reached a high degree of potency. This anti-credit movement was able to coordinate simultaneous protests in more than 12 cities in 1995.

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Though profoundly disturbing to the government and the banking system, there was a positive angle to this uprising. It forced the government and financiers to take notice--the public was prepared to battle what it perceived as crippling interest rates. The situation was producing foreclosures that were destroying family life and inducing suicidal tragedies.

Addressing The Crisis

The constructive dialogue that ensued involved the three major players: consumers of credit, the private banking system and the federal government.

With the near collapse of the economy as a backdrop, a series of key negotiations followed. The national banking association stepped forward with a proposal that included a temporary reduction in interest payments, suspension of judicial proceedings, a restructuring of credit and limitations on what banks could demand from debtors.

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Though many counterproposals were exchanged, the essence of what happened is that a social contract of sorts slowly emerged. The government and the private banking system recognized that business as usual would not produce the necessary results. This was a social threshold in the evolution of the credit environment in Mexico.

While much work was needed to clarify and implement an effective and transparent lending environment, the cries of the indebted had been heard and incorporated into what was to become the solid platform of mortgage reform and implementation.

An Ambitious Plan

With the private banking sector in recovery mode, the public sector shouldered the great majority of home financing activity. This has remained true during the Fox administration.

While campaigning ahead of the 2000 presidential elections, Fox predicted the housing issue could become his most enduring legacy.

The former governor of Guanajuato recognized that one of the most troublesome aspects of the financial system was its low level of savings rates. Even so, Fox sensed there was enough political consensus to support directly targeting home-starved Mexicans, but he also insisted the economy would benefit from the dynamics of increased home equity per capita.

The argument was that greater construction of financed homes would serve as an engine of economic development.

This was important not just for overall economic growth, but also to stimulate internal growth in contrast to the export growth component of the economy. A great number of unskilled laborers would benefit from an increase in construction jobs.

Therefore, as president, Fox said his goal was to increase the number of mortgages granted each year of his administration. The ambitious target was to reach 750,000 mortgages in 2006, up from 350,000 in 2000.

Fox's overall goal was to grant 2 million mortgages during his term. So far, he is on target to reach that goal with 1.3 million loans made through December 2004.

The plan to achieve this goal included the following:

* Increasing resources channeled to the sector

* Expanding private sources of housing finance

* Making credit and origination standards uniform to deepen the market

* Supporting lower-income segments via directly targeted subsidies

* Supporting development of a secondary market for mortgage-backed securities.

During Fox's term, the overwhelming majority of mortgages have come from government-backed programs targeting the working class. The much smaller middle-class segment is now getting loans from banks and specialized mortgage companies.

Last year, for the first time since 1995, the private banking sector surpassed Sofoles in mortgage lending. Commercial banks accounted for 19 billion pesos in housing loans, while Sofoles were responsible for just under 17 billion pesos in mortgages.

The country's economic stability has further laid the foundation for a growing mortgage-backed securities market that is almost two years old now.

The Players

The Mexican home finance system is made up of a network of public and private entities that together offer housing loans, mostly to employees of the formal sector.

While there are government lending agencies that actually target potential borrowers in the informal sector, the number is low when compared to the total amount of mortgages written any given year.

There are seven public entities that have been primarily responsible for the revolutionary growth of the mortgage market. Six are government agencies:

* Infonavit (Instituto del Fondo Nacional de la Vivienda para los Trabajadores)

* SHF (Sociedad Hipotecaria Federal)

* Fovissste (Fondo de la Vivienda del Sistema de Seguridad Social de los Trabajadores del Estado)

* Fonhapo (Fondo de Habitaciones Populares)

* Orevis (Organismos Estatales de Vivienda)

* Banobras (Banco Hipotecario y de Obras Publicas).

The seventh, and perhaps the most dynamic, entity are Sofoles (Sociedades Financieras de Objeto Limitado).

A New Approach

The largest mortgage provider, by far, is Infonavit. Founded in 1972, its initial mandate was to serve as a pension program on behalf of private sector workers. It is funded by an obligatory 5-percent payroll deduction that employers pay into a special account, in addition to collections on its 2.1 million loans.

During its initial 20 years, its most important activities were lending to developers. In essence, this meant it provided financing to home builders, who in turn would manage the project risk, including payments from purchasers.

In 1992, Congress established a new program of individual retirement accounts designed to supplement the existing Social Security system administered by the IMSS. The new law was essentially a subtle reform of how Infonavit would work, refocusing the agency's primary responsibility toward mortgage financing instead of acting as a lender to developers and construction companies.

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By almost all accounts, Infonavit failed in its mission to stimulate the growth of a healthy housing market. There are no notable success stories from 1972 to 1992. The New York Times referred to Infonavit as "a black hole of political patronage."

The agency floundered under antiquated accounting rules that resulted in abysmal investment returns for its members--the nation's work force. It is estimated that 100 pesos contributed between 1972-1991 brought a return of 11 pesos in present value--an investment return of negative 89 percent.

In 2000, President Fox appointed a former banker, Victor Manuel Borras, to take over the reins at Infonavit. Borras immediately identified the twin problems of bad loans and financial solvency and focused on regaining the confidence of the financial system. He met with considerable success.

Infonavit's bad loan rate fell below 10 percent from as high as 23 percent. Collections on loans have risen to comprise 52 percent of the agency's income from 40 percent.

Creative new lending programs target customers who traditionally had been considered above or below the working-class clients Infonavit served. Borras has gotten help from commercial banks in designing co-financing programs that enable the agency to go beyond its normal mortgage levels.

A Notch Below

The second largest provider of mortgages is the SHF. This agency was chartered in 2001 as a development bank that covers housing.

Unlike Infonavit, SHF does not deal with the public directly. Instead, it directs funds to commercial banks and Sofoles. Aside from the relatively high volume of mortgages offered, the main importance of this agency is that it serves the broadest target market of all mortgage players in Mexico.

Qualifiers for SHF loans range from Mexicans earning very little to those earning as much as US$75,000 per year. It is the only official lender that offers mortgage products to the informal sector.

The agency is also creating a system of guarantees to stimulate the nascent mortgage-backed securities market. SHF director Guillermo Babatz told The New York Times his mission was to develop a private mortgage market. "It is much more solid if the private sector does it," he said.

Fovissste, the No. 3 lender, was established alongside Infonavit in 1972. Its capital base was derived from a 5-percent employee payroll contribution similar to that which funded Infonavit.

Fovissste's mission is exclusively dedicated to public sector workers. In this sense, its future growth is limited.

The agency most responsible for the lowest income levels within the formal sector is Fonhapo. It was created in 1982.

Funding for Fonhapo is derived from federal and state tax revenues. It also serves as a conduit for international NGO grants directed at the lowest income segments of the population. It is as distinct from many of its lending peers in the types of home loans it offers; these being mostly home improvement credits and "progressive housing projects."

Orevis are state housing agencies funded by state tax revenues. They issue a large number of loans at the state level, though small in individual size. Because of its state-by-state focus, the agency helps greatly in balancing lending between heavily populated urban areas of Mexico and the less populated rural, poor states.

The seventh entity, the Sofoles, operates as a private, non-bank financial institution. Sofoles were authorized by the Finance Secretariat in 1994. One source of inspiration for their creation was a Nafta-induced belief that they would attract financial intermediaries from Canada and the United States to participate in the consumer market of Mexico.

Sofoles are single-purpose financial corporations that may only engage in one specific lending activity, such as mortgages, automobile loans, or specific consumer loans.

It is clear that their biggest impact is in the housing market. The SHF government loans have been their most important source of capital to date, but private capital is entering the Sofoles market as banks look to expand their tiny portion of the market.

A Solid Foundation

In the past few years, several factors have come together allowing for optimistic predictions. Economic stabilization is clearly the most important of the variables.

For a country like Mexico, accustomed to the high cost of capital, the relatively quick transition to a much lower interest rate environment has created a myriad of opportunities as country risk has dropped to acceptable levels. Rating agencies such as Standard & Poor's and Moody's have not only raised the green flag as a result of the government's macroeconomic management, but also with regard to Mexico's private mortgage transactions of the past couple of years.

Domestically, the 1997 Pension Reform Act has done much to advance the idea that the mortgage industry is poised for an important next step.

The future of Mexico's mortgage market will be found in what many confidently predict will be a mixture of public and private mandates.

In September 2004, BBVA-Bancomer purchased Hipotecaria Nacional, the largest Sofoles specializing in home mortgages. Earlier that same year, BBVA agreed to provide US$175 million in financing for Consorcio ARA, one of the most important home builders in Mexico. Interestingly, Infonavit was part of the agreement, in effect consenting to cover 25 percent of the financing, with BBVA Bancomer providing the other 75 percent.

More striking is a transaction that took place in December 2003. The Sofoles Su Casita created the first-ever mortgage-backed security in conjunction with General Motors Acceptance Corporation, USA.

Though common in the United States, the deal was without precedent in Mexico and was hailed as opening a new age of private funding for the domestic mortgage market. Almost the entire transaction was taken up by local institutions, fulfilling the prophecy that Mexico's mortgage industry had moved into a new age of capital intensity.

Since then, Infonavit and private lenders have sold roughly US$400 million in mortgage-backed securities. These instruments allow lenders to grant new loans with the money raised.

In January, another landmark was passed when the first-ever trade on the secondary market was made.

The Future

Policymakers in Mexico hope to continue this trend of private institutional capital involvement, not only in the primary market, but also in the all-important secondary markets.

Such markets can greatly expand sources of financing, reassure investors about liquidity in the market and, at the same time, improve the government's risk management.

Both Zedillo and Fox sought to strengthen primary and secondary markets in a manner that incorporated public and private funds. The private secondary mortgage market offers the potential to dramatically increase the source of funds for the mortgage sector of Mexico and alleviate the costs of the government.

Private pension funds are leading the way in the primary market, but foreign interest is growing. This signals a break from the previous model of high dependence on the state apparatus and limited participation by the private sector.

The picture is promising and developments are sprouting such that a recent article in The Wall Street Journal opined that the housing boom could produce Mexico's own suburban dream and help fill out the country's scant middle class.

Sofoles Loans

Jan-Nov

2004     2,043,651
2003     1,848,301
2002     1,538,942
2001     1,264,500
2000       874,459
1999       697,158
1998       561,778
1997       373,745
1996       189,122
1995        12,631

Source: Mexican Society of Sofoles

Note: Table made from bar graph.

Ramon Ruiz ([e-mail]) is a managing partner of Vintage Partners.