metadata: authors: 0: author: Sagari, Silvia B.
1: author: Chiquier, Loic
count: Hungary
docna: 0: docna: Coping with the legacies of subsidized
            mortgage credit in Hungary
docty: Policy Research Working Paper
subtopic: Urban Housing and Land Settlements,Public Sector Economics,Urban Governance and Management,Urban Housing,Housing Finance,Capital Markets and Capital Flows,Financial Intermediation,Non Bank Financial Institutions,Capital Flows,Inflation,Municipal Management and Reform,Public Finance Decentralization and
            Poverty Reduction
teratopic: Finance and Financial Sector Development
abstracts: cdata!: The authors examine alternatives for
            dealing with the initial conditions of housing finance
            facing countries making the transition to a market economy
            and moving toward a  more efficient and equitable system.
            They focus on the problem of restructuring the stock of
            housing loans that exist at the time a new regime is
            implemented.  Almost without exception, the stock of housing
            loans is yielding heavily subsidized rates, and its market
            value is significantly below its book value.  Hungary makes
            an interesting case study. The mortgage portfolio inherited
            from past regimes makes especially clear the perverse
            implications of housing finance systems based on
            across-the-board subsidized interest rates.  The authors
            propose a general approach to finding options to reduce the
            fiscal burden implicit in the subsidized housing loan
            portfolio.  They identify mechanisms to reduce the interest
            subsidy embodied in that portfolio as well as mechanisms to
            spread the associated losses among those benefiting from the
            subsidies as well as among other parties.  Clearly any
            residual subsidy must be absorbed by the government and
            ultimately by the population in the form of increased
            taxation or decreased availability of public services.  The
            problem is complex and no obvious, easily implementable
            solutions emerge.  But delaying action could hardly improve
            the situation.
geo_reg_key: 517208,517190,517191
repnme: repnme: Coping with the legacies of subsidized
            mortgage credit in Hungary
display_title: Coping with the legacies of
            subsidized mortgage credit in Hungary
listing_relative_url: /research/1992/01/699780/coping-legacies-subsidized-mortgage-credit-hungary
topicv3: Inflation m1326709 0870F4727ACED1CF8525815C00471347,Financial Intermediaries m1326973 2196,Treasury m1327009 1045,Housing Finance m1327222 612,Land and Housing m1327648 817
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Policy Research Department
no_of_pages: 31
model_extractions: <!-- Start of picture text --> Policy Research<br>Financial Policy and Systems<br>WPS 847<br><!-- End of picture text --> This paper is a product of the Financial Policy and Systems Division, Country Economics Department. Copies are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Melakou Guirbo, room J9-235, extension 35015 (26 pages). January 1992.

Sagari and Chiquier examine alternatives for dealing with the initial conditions of housing finance facing countries making the transition to a market econorrmy and moving toward a more efficient and equitable system.

The authors focus on the problem of restructuring the stock of housing loans that exist at the time a new regime is implemented. Almost without exception the stock of housing loans is yielding heavily subsidized rates, ar,' its market value is significantly below its book value.

Hungary makes an interesting case study. The mortgage portfolio inherited from past regimes - and the nature of the measures adopted to deal with the fiscal and institutional problems resulting from the old regimes - makes especially clear the perverse implications of housing finance systems based on across-theboard subsidized interest rates.

Sagari and Chiquier propose a general approach to finding options to reduce the fiscal burden implicit in the subsidized housing loan portfolio inherited from the pre-1989 regime. They identify mechanisms to reduce the interest subsidy embodied in that portfolio as well as mechanisms to spread the associated losses among those benefiting from the subsidies as well as among other parties. Clearly any "residual" subsidy must be absorbed by the government and ultimately by the population in the form of increased taxation or decreased availability of public services.

The problem is complex and no obvious, easily implementable solutions emerge. But delaying action could hardly improve the situation.

The Policy Research Working Paper Series disseminates the findings of work under way in the Bank. An objective of the series is to get these findings out quickly, even if presentations are Iess than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy.

Produced by the Policy Research Dissemination Center
# Coping with the Legacies of Subsidized Mortgage Credit in Hungary

by Silvia B. Sagari and Loic Chiquier

# Table of Contents

- I. Introduction 1 II. Housing Finance in Hungary in the 1980s 2

- A. Overview 2 B. The Subsidized Portfolio: Profile and Dynamics 4 C. The Swap between the AIousing Fund and the Housing Financial Intermediaries 12

- III. Analysis of Options 14

- A. General Framework 14 B. Mechanisms to Reduce the Subsidies 14 C. Loss-Sharing Mechanisms 20 D. The Hungarian Solution 22

IV. Conclusions 25 References 26 References
# Silvia B. Sagari and Loic Chiquier'

# **I. Introduction**

One of the current centrai concerns in financial sector analysis and policy is the widespread insolvency of financial intermediaries. Restructuring of these institutions and their portfolios has now become a priority task in a vast number of countries throughout the world. Housing finance institutions are no exception.

Most of the existing literature in the area of restructuring of housing finance institutions refers to the savings and loans' (S&Ls) case in the United States.<sup>2</sup> Some materials have also been produced in connection with the privatization of housing in England. Work in the case of developing countries has focused mainly on assessing the dimension of the problems<sup>3</sup> ; available literature on the analysis of "work-out" strategies, however, is minimal.

On the basis of the Hungarian experience, this paper discusses different approaches for the treatment of initial housing finance conditions in the process of transition toward a more efficient and equitable system. The central issue in the analysis is the restructuring of the stock of housing loans existing at the time of design and implementation of a ne".' regime. Almost without exception, such stock is yielding heavily subsidized interest rates, and its market value is significantly below its book value. In a large number of cases, this is the most important single factor leading to the technical insolvency of the institution holding the port.olio. Further, housing financial systems based on across-the-board subsidized interest rates are bound to be unsustainable from a budget perspective, and regressive from an income distribution viewpoint.<sup>4</sup> In fact, the very poor are generally likely to be renters, and not owners, and consequently poor families will get the smallest share of credit subsidies.

Needless to say, this problem and its macroeconomic implications are not confined to reforming socialist economies. Apart fiom the notorious S&Ls case in the United States, many other countries have experienced serious problems with their housing financial system; Argentina, Brazil, Chile, Mexico, the Phi:.ppines, Jamaica, Turkey are among the most critical examples

**IIndustry and Energy Operations, Sahelian Department and consultant, respectively. The views and interpretations inthis document are those of the authors and should not be attributed to the World Bank Group or to any individual acting in their behalf. Thanks are due to Mike Atkin, Bob Buckley, Tim Condon, Joanna Elliott, Christine Kessides, Geoffrey Nicholson and Bertrand Renaud for useful commnents, and to Bo Wang for research assistance.**

**2 See, for example, Kane (1985), Weicher (1987), Silverberg (1990), and White (1991).**

**3Foxlcy (1977) and Renaud (1988) discuss ome asp.cts of lthe Chilean case. Buckley (1988) looks at the case of Argentina.**

**4 See Daniel (1985) for an analysis of the redistributive effects of housing state subsidies in Hungary, Renaud (1988) for an analysis of the case of Chile, and Renaud (1989) for an overall discussion of the main issues in housing finance in development.**
2

[Renaud (1988)]. In the last two decades, Chile for example, suffered two crises in its housing financial system; one in 1975/76, the second between 1983 and 1986. In both cases, the government was forced to intervene, purchasing financial assets related **tu,** housing and real state financing. However, as shown by the case of Hungary studied here, it is the dimensions of subsidized mortgage credit in socialist economies in transition what makes the issue a focal point in the process of reform.

The Hungarian case also provides a vivid illustration of the potential difficulties encountered in dealing with these problems, difficulties stemming from the economic and social ramifications of housing finance. Facing a legacy of subsidized mortgage credits, the Polish Parliament quickly approved the extreme and drastic solution of re-writing all existing housing loan contracts to eliminate subsidies. But it took nearly three years of analysis and discussions before the Hungarian authorities could design a proposal that would be acceptable to Parliament. Other reforming socialist economies may have to face a similar ordeal. Section **It** of this paper presents the origins, dimensions and implications of the problem of the subsidized housing loan portfolio in Hungary. Section III analyzes options to deal with this problem. Section IV presents conclusions.'

# H. Housing Finance in Hungary in the 1980s

# A. Overview

As in many other countries, in Hungary the issue of the availability of housing has been a major concern for a long time. In the past, housing in the cities and larger towns was typically produced and managed in the socialist sector by large construction enterprises and local councils; rural housing remained mostly in the private sector. More recently, since 1983, the focus of State support for housing shifted from construction and management of State-owned units to direct financial assistance to families for private construction. For clarity purposes, it is useful to divide the decade - wo periods: before, and after 1989.

The re-1989 Housing Financial System The housing financial system established by the Housing Act of 1983 and in place until December 31, 1988 led to the accumulation of a stock of housing loans at increasingly subsidized interest rates. Up to that point, housing loans were financed by captive deposits from the household sector which, as per the system in place, had no alternative financial intermediary to deposit or borrow from. Both lending and borrowing rates were administratively set. Loans were granted with maturities of up to 35 years, and interest rates were fixed for the life of the loan. As of December 31, 1988 such stock amounted to Ft 274 billion (approximately $ 5.3 billion) and was equivalently to approximately 20% of 1988

> 5 **The** statistical analysis was carried out with **figures** available as of April 1990, when the **first** version of **this paper was prepared. Data** up **to** December 1989 were provided by the National Planning Office. **All** other **figures,** unless otherwise **specified, have resulted from the authors'** projections, estimations and simulations.
3 GDP (Ft 1,418 billion).<sup>67</sup> The average rate on the portfolio was 3.2%.

Until late 1987, infl2?ion was low, and the difference between interest rates on deposits and interest rates on loans was positive but not significant. The losses resulting from the interest rate differential were absorbed by the budget. In 1987, these losses amounted to Ft 11 billion. In 1988, due to increased inflation, the banking system had to raise initerest rates on deposits. Gross interest increased to 14.2%. The interest subsidy accrued during the period was of Ft 31 billion or 2.2% of GDP.<sup>8</sup> These subsidies were granted with little consideration to performance or need. To the tremendous negative impact of the subsidized portfolio on the fiscal accounts, one must then add the negative implications in terms of income redistribution.

Housing Finance Reform<sup>9</sup> As of January 1, 1989, the housing financial system was reformed. Among the most important aspects of the reform was the elimination of interest rate subsidies. The new loan mortgages carry market rates, and the borrower receives a subsidy equal to a predetermined percentage of the monthly payments, directly from the budget. Also, a Housing Fund was created which took over the ownership of the total stock of subsidized loans granted by the National Savings Bank (NSB) and the savings cooperatives, in exchange for longterm bonds. However, the bonds are nothing more than an accounting entry in the books of the participating institutions. The loans continue to be managed by the institutions that originally granted them. The Housing Fund is formally part of the central government, and as such its finances are directly part of the fiscal budget.

The "loans for bonds" swap left untouched the impact on the fiscal accounts of the mismatch between the costs of the sources financing the loan portfolio and the portfolio yields. Moreover, since the bonds for which the loans were swapped yield an interest tied to NSB average cost of funds'<sup>0</sup> , and indirectly to the deposit rates, the authorities saw the need to put a 6 In Chile, as of December 1987. and after the 1983/86 crisis of the housing rinancial system, the subsidized loan portfolio amounted to approximately the equivalent of US$ 330 million, or 0.2% of the 1987 GDP (Source: Central Bank of Chile). In Argentina. by the second half of the 1980s, financial assistance to the National Mortgage Bank (Banco Hipotecario Nacional) was cquivalent to some 20% of the Central Bank's quasi-fiscal deficit [Renaud (1989)].

7 From the total portfolio of Ft 274 billion, loans granted by the National Savings Bank account for Ft 260 billion. 'Te remaining Ft 14 billion correspond to loans extended by more than 260 savings cooperatives. Overall, some 2.6 million accounts are estimated to be covered by the operation. Of these, some 1.8 million correspond to loans at rates not higher than 4%.

8 In 1989 in Poland interest rate subsidies on the outstanding housing loan portfolio were est:mated to represent _1.5%_ of the national budget.

**9** We discuss here exclusively **the** aspecis relevant to the stot;k of **loais** granted before 1989. For an in-depth discussion of overall housing policy reform in Hungary see Hegedus and Tosics (1990).

10 **The** annual yield of NSB housing loans and bonds was agreed to be **al** least equal to **the** average cost of funds, calculated as the average cost of the interest bearing liabilities including depos;s, borrowing, and bonds issued by the institution, plus a spread of 3%.
4 ceiling on these rates." For as lorig as these ceilings lasted, they put serious limitations to the effective integration of the household and enterprise financial systems as well as to the ability of all financial intermediaries to mobilize deposits from the population to finance productive sector growth.'<sup>2</sup> Very much aware of the perverse implications of the maintenance of the subsidized portfolio, over the cotirse of 1988, 1989 and 1990 the Hungarian authorities searched for and explored different alternatives to deal with the problem. The implicit financial, social and political difficulties, delayed the adoption of a solution until December 1990.

# B. The Subsidized Portfolio: Profile and Dynamics

Figure 1 shows the expected evolution of the portfolio of subsidized loans outstanding as of January 1, 1989, and its average interest rate under the assumption that the original loan contracts remain intact.'<sup>3</sup> Estimates of the interest subsidies implicit in the portfolio and their relationship to GDP are presented in Figure 2. The calculations were based on assumptions on the evolution of key macroeconomic indicators and associated projections for the rates applicable to the Housing Fund bonds (Table 1). For 1989, actual interest rate subsidic.; amounted to approximately Ft 40 billion, equivalent to near 2.5% of GDP.

**11** As of June 1990, ceilings on interest rates on household deposits were: **(i)** 22%, before taxes, for deposits for **less** than **1** year, and (ii) 26% before taxes, for deposits for **terms** longer than or equal to one year but shorter than 3 years. Deposits for 3 years or more were **not** subject to ceilings. Rates on these deposits oscillated around 27-28% before taxes. Inflation for the 12 month period ending June 1990 was **running** at about 27%. Ceilings on interest rates on household depositsof longer than six months' maturity were removed as of January **1,** 1991.

12 **The** adverse impact that acministratively set rates might have had on deposit mobilization is supponted by preliminary egtiniates in Blejer and Sagari (1991), who found that in the last few years financial savings in Hungary have become sensitive to the real level of inter at rates.

13 Information on the subsidized portfolio was limited to maturity structure and interest rates, and was available only for loans granted by N"3. These represent 95% of the total portfolio; data for the total portfolio were thus estimated as directly proportional to those of NSB. Data ..olders of the subsidized loans (i.e., distribution by level of income, age or geographic area) were not available.
**5**

# **FIGURE 1**

<!-- Start of picture text --> I<br>Evolution of Outstanding Loans |<br>and Average Interest Rate<br>300- 5<br>274<br>250 . 1 pS -. . . .. . . 0 .14<br>200- 32 Pr.C<br>C<br>.2~~~~~~~~~~~~~~~~~-<br>100<br>50~~~~~~~~~~~~~<br>1989 2017<br>Yasfrom 1989 to 2025<br>-<br>[iPrincipal average rate<br><!-- End of picture text -->
6

# FIGURE 2

<!-- Start of picture text --> 30 30<br>20 ~~~~~total norminal subs'iOlis 340 Gilliam Foantse,<br>In 0989 present-valu: 160l Billioni Forinta<br>1989 ~~~~~~~2017 2025<br>-eO- bond rates (% Subsidies.<br>Subsid les ~ifl<br>4 191_ 30<br>_<br>1.5 10 . .- iP lP - - -C; up - . llUilNiNon<br>25<br>1989 2008<br>| n-bond rates (%) subsidies In % GDP<br><!-- End of picture text -->
7

# TABLE I

AwnV(ioas on the Evolution of Key Macroeconomic Indicators and Housing Fund Bond Rates

|Years:<br>CP|(a)|195<br>15.7|1959<br>17|1990<br> <br>19.5|_1e-_<br>15|I9<br>12|1993<br>10|1994<br>|1995<br>|1996<br>|1997<br>|199<br>|I99|2000|2001|2002|_203_|2004|
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
|CostFunds|(b)|14|21.5|17|<br>'4|<br>12|8<br>t0|7<br>9|6<br>|5<br>|5<br>|5|5|5|5|_|5|
|BondRate|(c)|18|25.5|21|is|<br>16|<br>14|<br>13|S<br>|7<br>|7<br>|7|7|7|7|7|7|
|GDP (d)|1418|1705|2020|2317|<br>2614|<br>2917|<br>3203|<br>3487|12<br>|I<br>|I I<br>|I I<br>|11|I|II|if|II|
|GDP nonmnal|<br>(e)|20.2|1.5|14.7|12.8|<br>116|<br>98|<br>|3762<br> <br>|4051<br>|4370<br>|4720|5104|5520|5970|6456|695|
|GDP real|(1)|2.77|-0.86|-0.26|<br>073|.<br>145|.<br>167|3.9<br>|<br>7.9<br>|7.7<br>|7.9<br>|3.0|3.3|8.2|8.2|8.2|<br>3.2|
||||||.|.|.|1.74|1.78|2.55|2.74|2.37|299|3.00|<br>3.00|<br>3.00|3.00|
|Years:|20052|006<br>|2007<br>2|003<br>2|009|2010<br>|2011<br>|2012|2013<br>|2014|2015<br>|036||<br>||||
|CPI(a)|5|5|5|5|5|5|5||<br> <br>|<br>|<br> <br>||2017|2013<br>|219|20.19|2021|
|CostFunds|7|7|7|7|<br>7|<br>7|<br>7|5<br>|5<br>|5<br>|5|5|5|5|5|_5_|5<br>1|
|BondRate|11|it|I L|I I|<br>I I|<br>11|<br>I|7<br>I I|7<br>|7|7<br>|7|7|7|7|7||
|GDP (d)|7552<br>|8167<br>|8533<br>|95'3<br>1|<br>M31|<br>11173|<br>12034|<br>13069|I I|II<br>14134||I I<br>|I<br>|II I|11|3 1|II|11|
|GDP nominal|3.2|3.2|3.2|3.2|3.2|<br>82|<br>32|<br>32|<br>|15236<br>|16531<br>|17t79|9336|20Q12|22646|24459|26453|
|GDP rea|3.00|3.00|3.00|3.00|<br>3.00|.<br>3.00|.<br>300|.<br>300|3.2<br>300|8.2<br>|8.2<br>|3.2<br>|5 .2<br>|3.2|3.2|8.2|3.2|
||||||||.|.|.|3.00|3.00|3.00 ||3.00|3-00|3.00|3.00|3.00|
|Yeatr<br>CMI(a)|2022<br>5|2023<br>5|2024<br>_5_|2025<br>5||||||||||||||
|CostFund|7|7|7|7||||||||||||||
|BondRate|II|II||11 II||||||||||||||
|GDP (d)|23603<br>|30940 1|33462|36139||||||||||||||
|GDP n<br>a|3.2|3.2|3.**2**|.2||||||||||||||
|GDP**1ea**|3.00|3.00|3.01|3.00||||||||||||||
|tes:<br>(a)|Consme|Pnce Ind|ex in S|||||||||||||||

Notes: (b) **Aubor'** estimates, **amed** to be equal in **chbnge** in CPI plus 2% (except _ror_ 1959) (c) Audwr. estinte, Billion Fodata (d) In Audwr. estinte, Billion Fodata aumed to be equl to cos of finds plus 4% (3O% ral yield plus 1 of management fee) (e) GDP erowh (in _)_ in nomnnol terms (M * P gowth (in %)in e tenms
8 During 1989 the authorities also granted a 45% "di.scount" for prepayment of outstanding balances. The offered discount was less than the discount implicit in thc subsidies and consequently, if the optioin were to be accepted it could have resulted in a **ne.t** gain for the budget.<sup>4</sup> Eiowever, because at the moment of the swap it was agreed that the Housing Fund borids were to be redeemed pari passu. with the collection or the loans for which they were swapped, the prepayment scheme resulted in additional expenditures for the housing **Fund** eolial to the difference between the oollections and the total nominal valuie of the Housing sund bonds to be redeemed--i.e., Ft 12 billion. As a consequence, in 1989 interest and discount-related expenditure from the stock of subsidized mortgage credit amountzd to Ft 51 billion, eqnivalent to 3% of GDP.'The nigh level of the projected interest subsidies (in particular those for the period 19901995) raised serious concerns at oLt the possibility for the budget to absorb the corresponding losses. But the problem was potentially worse. First, these figures were based on a somewhat optimistic scenario for the evolution of inflation in Hungary over that period. Further, interest losses from the portfolio are very sensitive to the cost of funds for NSB, which is signiticantly determined by deposit rates, and ultimately, by the evolution of domestic prices. If inflation were to decrease at a slower pace than projected in Table 1, say for example that it wer- to decrease by 1% per year until it reached 5 %, the burden of the housing pre-1989 loan portfoiio would increase substantially (Table 2 and Figure 3). A third estimation pictured in Figure 4 illustrates the case of worseaing inflation (Scenario C).

These results appear, in principle, counter-intuitive. With high inflation and fixed rates, the significance of the subsidized poitfolio is quickly eroded and shonld not pose any serious threat to the budget. However, under the system put in place in Hungary at the time of the "loans for bonds" swap the burden for the budget corresponding to the interest accrued on any outstanding housing bonds (or equivalently, any outstanding housin,g portfolio) increases rather than decreases with inflation."<sup>6</sup>

**14 The oftered uiscount was in fact lower than the present value of future interest subsidies, even** under **an optimistic scenario where inter, rates decline fairly rapidlv in the near future. This wsa clearly one of the factors explaining the less than enthusiastic response of the population to the 'discount' proposal. Response improved when it came to be known that the discount would be reduced to 25 % in 1990, and that further measures--such asa tax on loans--might be taken to recoup the flscal losses implicit in the pre-1989 portfolio--Ft 28 billion were prepaid in November and December 1988.**

**15 Because some Ft 12 billion in subsidies wer. carried over from 1988 to 1989, and total subsidies actually paid out in 1989 reached Ft 63 billion or 3.7% of GDP.**

**Note the following: (i) If deposit rates do not fully adjust o compensate for inflation, the impact on the budget is relatively smaller. For simplicity purposes, however, in our simulation for 1990 and onwards we assumed full adjustment. (ii) The significance of interest subsidies vis-a-vis GDP! depends fur mentally oni the evolution of GDP under a high inflation scenario.**
9

# Table 2

# Alternative Interest Rate Scenarios: Impact on Subsidies

|Year:a|1990|1991|1992|1993|1994|1995|1996|1997|1998|1999|2000|2001|
|---|---|---|---|---|---|---|---|---|---|---|---|---|
|ScenanoA(a)|25.5|<br>21|18|16|14|_13_|12|11|1,|11 1|11|_ 11|
|**Scenario**<br>**B (b)**|25.5|24.5|235|22.5|215|205|19.5|18.5|17.5|16.5|15.5|14.5|
|**Subsidies**<br>**C****_(c)_**|54,9|40.0|30.6|24.2|18.7|25.5|12.8|10.4|<br>9.6|8.9|8.j|<br>7.4|
|Subsidies B**(c)**|54.9|47.8|41.9|36.4|31.4|27.0|23.2|20.0|i7.1|14.7|12.5||10.5|
|**Yi**.s:|2002|2003|2004|2005|2006|2007 ||<br>2008|2009|2010|2011|2012|2013|
|Scenario A|I|I<br>1|II|II|II|I_<br>i|||_II1I|<br>I|II|I|
|Scenario B|13.5|;2.5|11.5|1;|I I|I I|II|I1|11|11|I I||
|Subsidies A|6.7|6.1|5.4|4.8|4.2|3.6|3.1|2.6|2.1|1.6|1.1|0.7|
|**Subsidics**<br>**B**<br>__<br>_<br>__<br> <br>_ ___<br>_|8.7<br>_<br>__|7.2|57|4.8|4.2<br>__|3o|3.1|2.6|2.1<br>_ _ _ _|1.6<br>-|1.1<br>-|<br>0.7|
||Years|2014|2015|2016|2017|2018 ||<br>2019|2020|2021|2022|20231<br>|2024 |<br>|2025|
|**SenarioA**|I I|I|1<br>I|11<br>II||I|I|I I|I I|<br>I|<br>11|I|
|ScenarioB|11|II|I1<br>|11<br>I|II|<br>I1|I I|I I<br>1|I|II|I|II|
|Subsidies<br>A|0.4|0.3|0.3I8|0.09|<br>0.05 j|0.02|0.01|0.01|0.00|0.00|0.00|<br>0.00|
|SubsidiesB|0.4|0.3|0.18|0.09|_0.05_|0.|02|0.03<br>0||0.00|0.00|<br>0.00|0on|<br>.0|

Notes: (a) Scenario A: previous optimistic scenario

**(b)** Scenario B: inflation declincs **at** a slower **pace** (c) in Billion Forints
10

# FIGURE 3

<!-- Start of picture text --> Evolution of Subsidies|<br>Scenario B<br>7C .. _ 30<br>70 -~~~~~~~~~~~~~~~~2<br>60~~~~~~~~~~~~~~~~<br>50.<br>20 l ISS l I total subsidies in nominal terms: 449 Billion Forints _ 10<br>l ~~total subsidies in real terms : 183 Billion ForintsT<br>1989 2025<br>-a- bond rate (%) subsidies<br>||Dependence of Subsidies<br>on Bond Rate Scenarios|<br>100-<br>90-<br>- 80 _<br>U 7 0 -<br>50_<br>SQ40. sci1 dditonal subsidies:_<br>8 6 ~~~~~~~98 Billion Forints In nominal terrns,<br>3 0° / 1 Bilslion Forints in real terms (1/1989)_<br>10 20-~~~~~~~~~~~22 S A a<br>0<br>1989 2025<br>LScenario A addit. subs.(Sce.B)<br><!-- End of picture text -->
11

**FIGURE 4**

<!-- Start of picture text --> Third Scenario of Bond Rates<br>(pessimistic view of inflation trends)<br>50<br>45<br>40-<br>35-<br>30-i<br>25-,<br>!20<br>1 5D<br>~ 51 .<br>0'<br><!-- End of picture text --> <!-- Start of picture text --> D Scenario A Scenario C<br><!-- End of picture text --> <!-- Start of picture text --> Evolution of Subsidies<br>according to Alternative Rate Scenarios<br>100<br>90- R Scn oCocus7 1Bllo oit<br>lo would be required in 1991.<br>780-125 additiona. nominal subsidies are<br>E' 60- | ,required to compensate for the increasing<br>=O. 50- i l _ inflation in Scenario C.<br>40-<br>20-1#l=<br>1989 2017<br>subsidies (Scen. A) addit. subs. (Sc.C)<br><!-- End of picture text -->
12

# C. **The Swap between the Housing Fund and the** HMusing **Financial Intermediaries**

As of January **1,** 1989, the housing financial system was reformed; most importantly, interest rate subsidies were eliminated, and a Housing Fund was created which took over the ownership of the total stock of subsidized loans granted by NSB and approximately 260 savings cooperatives, in exchange for long-term bonds. It was agreed between the government and the swapping institutions that these bonds would be redeemed pari passu with the repayment of principal of the housing loans. This way, the portfolio of bonds would have exactly the same maturity as the housing loan portfolio, and the bond holdings by the participating institutions would evolve in parallel with the stock of housing loans held by the Housing Fund.'<sup>7</sup> This "loan for bonds" swap left untouched the impact of the mismatch between the costs of the sources financing the loan portfolio and its yields both on the fiscal accounts and on the overall process of savings mobilization and allocation. A look at the financial dynamics between the Housing Fund and the swapping financial intermediaries makes explicit the remaining perverse implications of effectively maintaining the subsidized loan portfolio, and the need for further policy action.

Financial Dynamics The dynamics of the finances of the subsidized portfolio can be described in simple terms as follows. At the end of each month, each swapping institution reports to the Housing Fund the cash-flow from repayments of housing loans, broken down into repayment of principal and payment of interests. The principal repayment is automatically applied to the redemption of housing bonds. The Housing fund debits the account corresponding to the loans managed by each of the financial intermediaries and credits the account corresponding to the housing bonds held by each of them.

An analysis of the financial transactions and flows with actual data for 1989 is particularly useful to shed some light on who are ultimately the "winners" and "losers" from the existence of the subsidized portfolio. For 1989, the total amount corresponding to repayment of principal of housing loans granted amounted to Ft 44.6 billion. Interest payments amounted to Ft 8.0 billion. The Ft 44.6 billion were allocated: (i) to redeem bonds (Ft 31 billion), and (ii) to finance Ft 13.6 billion promised to be granted in the conditions of the pre-1989 system.

The interest accrued on the total of outstanding Housing Fund bonds outstanding plus the 1 % management fee amounted to Ft 48.1 billion. Additiorial cash outflows for the Housing Fund resulted from: 17 **Th¢** Fund signed individual contracts with each of the swapping rinancial institutions. **These** contracts **indicate the amount of the** portfolio taken over by the Housing Fund, which gives also the amount of bonds to be issued by the Fund to each institution. As per this contract the financial institution takes the tasks **of:** providing data to the Housing Fund, following-up the changes in the stock of loans and bonds, and most importantly, collecting these loans and managing the resulting cash-flows.

The Housing Fund has a very simplified accounting system for its operations. Each institution reports to the Housing Fund the cashflow from repayments of housing loans, broken down into principal and interest. The Fund then does the corresponding bookings. A question emerges, clearly, on the reliability of such an accounting system. where the ultimate holder of a portfolio of financial assets has practically no mechanism to follow-up on the individual components.
13

- (i) the allowance (discount) offered during 1989 to promote prepayment of the subsidized stock--described before--and which amounted to Ft 12.4 billiun-1; and

- (ii) the i- terest subsidies deferred from 1988, amounting to Ft 11.9 billion.

The difference between these cash expenditures of Ft 72.4 billion and the interest income of Ft 8 billion, equal to negative Ft 64.4 billion was financed as follows:

- (i) the funds from the 20% withholding tax on household deposit interest--Ft 7.6 billion;

- (ii) new 15-year bond issues--Ft 19.4 billion;

- (iii) direct transfer from the budget--Ft 37.4 billion.

The new 15-year bonds were designated as forced investments for the social security fund (Ft 13.1 billion) and the commercial banks--50% of the before tax risk reserves, or Ft 6.3 billion (June 1989). The bonds have a _5_ year grace period for the principal which is then repaid in 10 equal installments. The interest rate has been arbitrarily set to be equal to 80% of the rate on the longest maturity Treasury Bill, i.e., the rate on the Treasury Bill times 1 minus the withholding tax rate on household deposit interest income. In 1989 this computation yielded an interest rate of 15.25% (1.25% negative in real terms). Currently, the rate is 19.2%. The interest on the bonds is accrued and paid once a year. At the end of the calendar year, the interest accrued is computed using the average of the rates for the period.

The above discussion is.interesting to underline some political economy issues, i.e., who is actually bearing the burden of the subsidized housing loan portfolio. Clearly, the most important contribution comes from the central budget--both in what has to do with the direct transfer, and the lower yield in the investments of the social security fund--, and implicitly it is shared by all the population.

However, there are two other "groups" that can be identified more specifically. These are: (i) household depositors, who must ultimately take an interest income cut; and (ii) the financial intermediaries, which are forced to invest in instruments yielding a negative real rate (and a rate that is not known until the whole calendar year has ended). As long as the amounts of the forced investments for the commercial banks are not significant the impact on their profitability and operation is minor. Yet, increased pressure on these intermediaries to share the burden of the Housing Fund deficit would introduce new distortions in the financial system."<sup>8</sup>

> 18 In **fact, it** can be easily **proved** that generalized **use** of forced investments **at below** market **rates pushes** lending **rates up and/or deposit rates** down. Alternatively, if these moves **are** 'forbidden', bank profitability is adversely affected. Giving the **concerns** in Hungary **about** the condition of the loan portfolio of **financial** intermediaries accounting for a significant share of the Hungarian financial **system, measures that decrease their profitability** should be **avoided.**
14

# **III.** Analysis of Options

# A. General Framework

The approach adopted in the search for a solution to the problems resulting from the pre1989 subsidized housing loan portfolio focuses on two aspects: (i) identification of mechanisms to reduce the interest subsidy embodied in that portfolio; and (ii) identification of mechanisms to share the associated losses among (ii. 1) those benefitting from the subsidies, and (ii.2) other parties. Clearly, any "residual" subsidy is absorbed by the Government and ultimately by the population in the form of increased taxation or decreased availability of public services.

Direct beneficiaries of the interest subsidy are obviously all those with outstanding loans at subsidized rates. Also, because up to 1988 deposit and borrowing rates were similar, the total subsidy implicit in each contract may be reasonably assumed to be an increasing function of the time to maturity of that contract.

The evaluation of each alternative should take into consideration mainly:

- its sustainability in terms of its impact on the Government budget;

- its feasibility, in terms of its impact on the household sector;

- its impact on any other party forced to share in the losses of the subsidized portfolio--for instance, banks or other financial intermediaries; and

-

its political viability.

# **B. Mechanisms to Reduce the Subsidies**

Direct elimination of the interest subsidies implicit in the contracts extended under the pre1989 regime could only be achieved by restructuring such contracts, substituting market interest rates for the currently fixed subsidized rates. Interest subsidies could also be reduced by restructuring the repayment schedule in such a way that the present value of the newly contracted payments is higher than the present value of the original payments.

It is clear, that nobody benefitting from the subsidy would voluntarily resign all or part of it.'<sup>9</sup> One could think of designing an incentive program that might prompt rescheduling of existing housing loan contracts. Potential components of such a program could be:

# (i) making access to other financial products or services conditional on prepayment or restructuring of current pre-1989 subsidized mortgage contracts. One type of such

> 19 Note however that the 'value' of the subsidy may differ across different parties (across borrowers, or between **the** Government and the borrower), which gives room to negotiation.
15 other financial products or services would be new loans for housing which in the context of a new housing financial policy would be mainly addressed to the higher income level group within the population. The new policy, to be designed and implemented in the near future, would allow for a variety of new instruments or financial arrangements potentially more attractive and suitable to different groups within the Hungarian population. The novelty may be in the instrument, in the purpose catered by the loan, or in both. In this sense, othe: countries have included in similar incentive programs housing loans specifically earmarked for better quality housing.

- (ii) linking the new mortgage contracts to non-financial products or services such as access to some services to be provided by the State (but not considered a primary necessity).<sup>20</sup>

- (iii) offering a significant capital discount. Note however that the discounts already implicit in the very highly subsidized rates of the pre-1989 contracts were so high that it is difficult to think of any solution, along these lines, that would not report, at the same time significant fiscal expenditures--in the form of the allowance to be paid to NSB to maintain the bond and the loan portfolio at the same value.<sup>21</sup> Further, if implemented, the discount should vary across borrowers, taking into account the age of the loans and the interest rate, since both of these aspects determine the remaining benefit to be derived from the loan contract.

In any case, the success of any incentive program of this type may be very hard to predict and the urgency to improve Government finances may call for more immediatt and certain results. In the specific case of Hungary which is the focus of this paper, "voluntary" rescheduling of existing contracts in any significant volume appeared, despite its philosophical appeal, quite unlikely. In this case, the only alternative left is to determine by law the revision of all pre-1989 contracts. In the way of example, contracts could be rewritten according to any of the following options:

- (i) maintaining repayments of principal at the same levels of the existing contracts but increasing the interest rate adding 2% annually until the market rate is reached;

- (ii) adoptirg a dual index mortgage (DIM) model whereby the installments are indexed to the wage income of the borrower (so that the debt-service/income ratio for the borrower remains stable) and the remaining balances are adjusted for inflation.<sup>22</sup>

> 20 Note, for instance, that linking a financial product--bond-to a non-financial service-telephone line-was already done in Hungary by the telephone company to promote placement of its bonds in the market.

> 21 See the sections above, for a discussion.

> 22 For a technical and detailed presentation on the dynamics of the **DDU** see Chiquier (1990).
16 In this case the housing bonds could also be indexed, maintaining the pari passu evolution of outstanding loans and bonds.

In case (i), Table 3 illustrates a possible example of irnerest rate increases. Resulting new estimates for cash outflows are depicted in Figure 5. The lower half shows the corresponding budgetary savings, both in billions of forints and in % of GDP. In this scenario, in 1992/93 for example, savings in interest subsidies would be equivalent to some 0.4 % of GDP.

Table 3 Progressive Rates Adjustment Scenario

|Interest Rate of Initial Contract|1990|i991|1992|1993|**1994**|
|---|---|---|---|---|---|
|**0**|2|4|6|8|11|
|l|3|**5**|7|9|**11**|
|**2**|**4**|**6**|**8**|**10**|**11**|
|3|5|7|**9**|10|**11**|
|3.5|5|7|9|10|11|
|**4**|5|7|9|10|**11**|
|6|7|8|9|10|**II**|
|8|9|10|**1I**|**1I**|**11**|
|10|**10**|**II**|**II**|11|**11**|
|11|11_|**1I**|**I**|**11**|**11**|
|12|12|12|12|**12**|**12**|
|**13**|**13**|13|13|13|**13**|
|**14**|14|**14**|**14**|-<br>**14**|**14**|
|**s15**<br>**.5**||**15**|**15**|i|**15**|
17

# FIGURE _5_

<!-- Start of picture text --> Impact of Interest Rate Adjustment<br>on Total Nominal Subsidies<br>60<br>5<br>50-<br>L 40 The arsa between the two curves represents<br>subsidy savings:<br>= 1 \ 16~13 Billion Forints in nominal terms, or<br>E 30 45 Billion Forints in real terms (in Jan-1989 value)<br>20-<br>10- i<br>1990 2025<br><!-- End of picture text --> initial subsidies **A** revised subsidies <!-- Start of picture text -->
|Savings Achieved through Progressive|<br>Interest Rate Adjustments l<br>20- -0.5<br>i8- r 1-n 1992 and 1993, 0.4% of GDP Could be saved 0.45<br>through this option. 0l 4<br>16 ts . _ -0.4<br>.!14- / -0.35<br>0 o12 t. , -0.3 IL<br>rC savings in Billion -- savings in %/ of GDP<br><!-- End of picture text -->
18 In case (ii), Figures 6 and 7 illustrate the evolution of outstanding loans and required subsidies under the assumption that interest rates follow the optimistic sharp decline scenario and that wages follow inflation. The DIM results in an acceleration of installments in nominal terms. Interest subsidies would be required for only three years, and in an amount far smaller than the original figures. Further, the loans' principal--and consequently, the bonds' principal--would be totally reimbursed after 12 years.

In case of a contract revision then, the advantages of adopting the DIM option are both that it saves scarce budgetary resources, and that the problem of the subsidized portfolio disappears in the short-term. From the individual borrowers' viewpoi' option (i) is "cheaper" since subsidies remain for a longer time. However, by fixing the repa, -ne v to the wage level the DIM ensures that (in relative terms) no additional burden is placed on tne monthly income.

FIGURE 6 <!-- Start of picture text --> Revised Indexed Repayments<br>on Outstanding Loans<br>300-<br>250-<br>200-<br>LL<br>X 150-X<br>c 100-<br>a.-<br>50-<br>60- - -<br>1990 2002: end of loan repayments i<br>L initial contract - indexed repayments<br><!-- End of picture text -->
19

# **FIGURE 7**

<!-- Start of picture text --> impact of Indexed R.paymente<br>on Subsidies<br>40-<br>130-<br>20-<br>1990 2002: end of loans repayments<br>-- initial subsidies -- revised subsi dies<br><!-- End of picture text --> <!-- Start of picture text --> Savings Achieved through<br>Indexatlon of Repayments<br>30 2<br>25<br>-1.6<br>20.- 11 .= 1.4<br>20 ~~~~~large savings could be achieved1.<br>immediately ifrepayments were Indexed 1.2 ;<br>(for example 1% of GDP in 1991) CD<br>-0.8 *R<br>°05-- hs!]1 E0 -0.6<br>5 ~~~~~~~~~~~~~~~~~0.4<br>.0.2<br>1990 0<br>savings In Billion - svings in % of GDP u<br><!-- End of picture text -->
20

# C. Loss-Sharing Mechanisms

Ideally, if contracts are not restructured, a mechanism should be found to have those benefitting from the subsidy absorb the corresponding losses. This was the aim of one of the options explored by the Hungarian authorities ihi 1989: a loan tLx applying across-the-board to all those debtors with housing loans with interest rates of 4% and below. For 1990 the tax would equal Ft 320 per month; from 1991 onward, the tax would vary with the rate of inflation (but would continue to be a flat amount across loan sizes).

This proposal had the strong advantage of being simple to implermient and easy to collect. However, it was regressive in nature since it did not distinguish among borrowers by their level of income, and perhaps, the increase in installments was excessively sharp--at least in nominal terms-to receive any acceptance from the population. The option was presented to Parliament which considered it unconstitutional and rejected it.

Other loss-sharing options considered by Hungarian experts resulted from a combination of factors: (i) a view that the interest rate subsidy embodied in the pre-1989 portfolio was exclusively a housing policy issue (rather than a combination of housing policy, and institutional distress and restructuring issues) and consequently that interest rate subsidies were part of a total budget for housing subsidies;' (ii) a policy decision not to have total budget expenditures allocated to housing exceed a predetermined amount; (iii) the assumption that past contracts could not be revised. Within this framework, it appeared that the only alternative available to absorb the interest subsidies in the pre-1989 portfolio was to cut other housing subsidies. Some of the ideas that were considered were the elimination of the child allowance for any child in a family after the second, or of the special subsidies for young families. These alternatives were clearly inadequate and deficient both from a social and an economic viewpoint and were never implemented.' But perhaps the most interesting observation from this approach is the notion that the interest subsidies embodied in the pre-1989 portfolio are part of a total budget for housing subsidies and that the inability to reduce them must inevitably lead to a reduction in other housing subsidies. To the extent that outstanding pre-1989 contracts were seen as final, and not subject to revision under any circumstance, it would be more adequate conceptually to see them as subsidies to the financial sector--i.e., subsidies to support financial intermediaries which have suffered a very significant loss in the market value of their assets.

Borrowers benefitting from interest subsidies could also be brought in to share the associated loss by including in the personal income tax calculations the income gain implicit in

> 23 Note however than to the extent that outstanding pre-1989 **contracts are** seen as final, and not subject to revision under any circumstance, it **knay** be **more** adequate conceptually to **see** them as subsidies to the financial sector-i.e., subsidies to **support** financial intermediaries which have lost **a** significant slare of their assets, or equivalently, financial intermediaries which have suffered a very significant loss in **the** market value of their **assets.**

> 24 In particular, the amounts involved in the proposedcut **werc** extremely smal: as compared to the size of the fiscal losses to be absoeoed.
21 below market interest rates. The "imputable income" would be computed by multiplying the 'implicit subsidy rate" times the outstanding debt. The implicit subsidy rate, in **turn,** could be computed as the difference between the on-going housing lending rate and the rate originally contracted. The advantage of this type of solution is that those borrowers in the lowest levels of income, who in an adequately designed subsidy system would receive financial support, would continue to receive the full subsidy since their income would not reach the minimum taxable amount.

Clearly this solution is not perfect. First, due to deficiencies in income measuring and reporting in Hungary, many taxable beneficiaries of the interest subsidy would not be reached. Second, it is impossible via this system to generate enough resources at the right time to relief the burden on tne central budget: modification of personal income tax legisiation is a lengthy process, the Treasury might easily have tc wait for two years before receiving any of the additional tax revenues from the new system. Despite these shortcomings, and in particular the fact that further complementary measures would need to be implemented, this approach is fairly equitable, technically sound and reasonably easy to implement.

A final alternative to discuss here is ihe indexation of the Housing Fund bonds which would allow a reduction, though only in the short-term, of the actual fiscal expendituresi associated with the pre-1989 portfolio. This alternative has a clear direct advantage in that it reduces fiscal expenditures precisely at the time when budget problems are expected to be the most severe--i.e., the next few years. Additionally, it has an indirect advantage: since a significant share of its assets would be indexed, NSB could immediately start to offer indexed deposits without automatically incurring any significant risky asset mismatch. Further, it is the international experience that, in cases of moderate inflation, indexation strongly contributes to improve the process of deposit mobilization, which would be desirable in the Hungarian context.

Implementation of this solution would require that a new agreement be *eached between the central Government and NSB<sup>26</sup> in terms of the cash-flows to be received from the Housing Fund. One possible option along these lines would be as follows: (i) the Housing Fund bonds would be indexed to the nflation rate, and would yield a real interest rate of, for example, 5% .2 (ii) NSB would be guaranteed an amount of bond redemption equal to that in the current system, i.e., equal to the repayment of principal in the stock of pre-1989 loans. This is important because it would allow NSB to gradually free the resources invested in the Housing Fund bond portfolio.

- **23** In terms of cash-flow.

- 26 Let us for simplicity ignore here the case of the 260 savings cooperatives.

This value **is** similar to that of the yield as of **the** time of this **report.**
22 Table 4 and Figure 10 show the results of a simulation on these<sup>basis. As indicated before,</sup> Housing Furd outflows are considerably reduced in the immediate<sup>short-term. Clearly, the overall</sup> problem does not disappear but is transferred into the future<sup>via the stock of indexed bonds.</sup> These represent a big legacy of domestic debt that will<sup>have to be repaid. In due time, the</sup> authorities should be able to adequately dispose of state-owned<sup>assets, and generate funds to</sup> reduce bring the debt to reasonable levels. Ultimately, the<sup>resources can only come from a</sup> growing economy, and a strong budget condition.

# **D. The Hungarian Solution**

After nearly three years of studies, analysis, and discussions,<sup>the Hungarian authorities and</sup> experts finally found and agreed on a "solution" to deal<sup>with the subsidized mortgage portfolio</sup> inherited from the pre-1989 housing financial system. By December<sup>1990, with the approval of</sup> the Budget Law the Hungarian Parliament also approved<sup>a proposal thereby contained by which</sup> holders of subsidized housing loans had to choose between:

- (i) accepting an increase to 15% in the interest rate attached<sup>to their housing loans for</sup> 1991, with future interest rates also administratively set<sup>taking into consideration</sup> interest rates levels; or

- (ii) being granted an immediate 50% principal write-off and,<sup>simultaneously, having the</sup> outstanding balances yield market rates.

In both cases, additional payments resulting from the modification<sup>in the original contracts</sup> were constrained to a maximum of Ft 1500 per mon.h per<sup>borrower. Information was not</sup> available at the time of this work on the options selected by the<sup>Hungarians.</sup>
23 Table 4 Indexation of Bonds Principal

|Years (JanIst)|1989|1990|1991|1992|1993|1994|1995|1996|1997|1998|<br>1999|<br>2000|
|---|---|---|---|---|---|---|---|---|---|---|---|---|
|Present System|||||||||||||
|Total Portfolio|274.0|245.1|223.2|204.9|186.8|169.6|1'4.0|139.7|127.0|115.5|106.3|<br>97.4|
|Installments|37.6|29.5|25.2|24.4|22.9|20.6|18.8|16.7|15.0|12.2|11.8|<br>11.1|
|-->Interests:|8.7|7.6|6.9|6.3|5.7|5.1|4.5|4.0|3.5|3.1|2.8|2.6|
|-->Pincipal|28.9|21.9|18.3|18.1|17.2|15.6|14.3|12.7|11.5|9.2|8.9|8.5|
|With Indexation,|||||||||||||
|Interests Paid|(a)|12.3|13.7|14.9|16.0|16.9|17.6|18.3|19.0|19.5|20.2|21.0|
|OutstandingPrincipal|||||||||||||
|in nominal termns|(b):|245.1|273.1|298.9|319.6|337.6|352.4|366.3|379.2|390.5|404.7|420.1|
|in real terms||245.1|217.9|196.8|178.4|162.4|148.7|136.8|126.4|117.3|109.5|<br>102.4|
|Subsidies|(c)|4.6|5.2|_5.8_|6.3|6.8|7.3|7.8|8.5|9.1|9.4|9.7|
|Years|2001|2002|2003|2004|2005|2006|2007|<br>2008|2009|2010|2011|2012|
|Present System|||||||||||||
|Total Portfolio|88.9|80.9|73.0|65.3|57.7|50.3|43.8|37.3|31.2|25.2|19.2|13.4|
|Installments|10.4|10.1|9.6|9.3|9.0|7.9|7.6|7.1|6.9|6.7|6.4|5.5|
|->Inteiests:|2.4|2.2|2.0|L.8|1.6|1.4|1.2|1.0|0.9|0.7|_0.5_|0.4|
|->Principal:|8.0|7.9|7.7|7.6|7.5|6.5|6.4|6.1|6.0|6.0|5.9|5.2|
|With Indzxation,|||||||||||||
|interests<br>:|21.8|22.7|23.7|24.8|25.9|27.0|28.3|29.7|31.2|32.8|34.4|36.2|
|nominal debt:|436.8|455.0|474.4|495.2|517.3|540.9|566.8|594.4|624.0|655.4|688.7|724.2|
|real debt|95.9|90.9|84.6|79.5|74.8|70.5|66.6|62.9|59.5|56.3|53.3|50.5|
|Subsidies<br>:|10.1|10.5|11.0|11.4|11.9|12.4|12.9|13.4|13.9|14.4|14.9|15.0|

Notes: (a): On the indexed outstanding principal, interest rate: 5% (b): if P(t) represents this nominal outstanding indexed debt at year t, and I(t) the market interest rates at date t (here the scenario A of bond rates), then: P(t+ 1)= P(t) * (I +lftl) - interests(t) - Repayments of Principal under present System. I (a) 5% * P(t) (c): Subsidies just compensate :he differences of intcrest rates between the Average Rate of corresponding Portfolio and these 5%: the low initial subsidies result of this indirect recapitalization of interests.
24

# **FIGURE 10**

<!-- Start of picture text --> Impact of bond indexation on Principal,<br>in nominal and real terms<br>250- 24 1600<br>-11400<br>1200<br>2 0 10 - .. X./ .. ....100.....................................................<br>0~~~~~~~~~~~~~~~~<br>IS . ........... ............................. , ................ .60 0 m<br>10990<br>. 10<br>-400<br>.2~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~<br>245 -0<br>100~~~~ ~ ~~ ~ ~ ................. ...... . ........................<br>I U-nominal -4-real<br>principal principal<br><!-- End of picture text -->
25

# **IV. Conclusions**

This paper has looked at different alternatives to deal with initial housing finance conditions in the process o. transition toward a more efficient and equitable system. The central issue in the analysis has been the restructuring of the stock of housing loans existing at the time and implementation of the new regime. Almost without exception, such stock is yielding heavily subsidized rates, and its market value is significantly below its book value.

The case of Hungary is particularly interesting. The significance of the mortgage portfolio inherited fi-om past regimes, as well as the nature of the early measures adopted to deal with the resulting fiscal and institutional problems make especially clear the perverse implications of housing financial systems based on across-the-board subsidized interest rates.

This paper proposes a general approach to the search of options to reduce the burden to the fiscal accounts implicit in the subsidized housing loan portfolio inherited from the pre-1989 system. The approach focuses on two aspects: (i) the identification of mechanisms to reduce the interest subsidy embodied in that portfolio; and (ii) the identification of mechanisms to share the associated losses among those benefitting from the subsidies as well as other parties. Clearly, any "residual" subsidy is to be absorbed by the Government and ultimately by the population in the form of increased taxation or decreased availability of public services.

The problem is very complex and there are no solutions that are obvious and easy to implement. Yet, delaying action could hardly improve the situation. In the case of Hungary, the most appealing alternative would have been to reduce the losses via a voluntary rescheduling of the contracts. This was in fact one of the options given to the population. Alternatively, pre-1989 borrowers would be granted an immediate 50% principal write-off and have an automatic adjustment of rates on their outstanding balances to market levels. Details were not available at the time of this work on the decisions made by the Hungarians; however, preliminary evidence indicates that the vast majority chose the second option. It remains to be analyzed what is the short-term impact on fiscal finances of the significant principal write-off. We leave this analysis to future work in this area.