Subsidy for the mortgage interest rate. Mechanisms for housing subsidies

In general, governments need it to be relatively easy to buy a home, because we know that most people do not have sufficient resources to buy one on their own. Credit is the way forward; that is, someone must lend money to those who want to buy a home but cannot. It is the government that must find who will provide that money. We are faced with the need for a policy.

Moreover, because the State is usually the one actively seeking borrowers—an extremely important market agent—it will look for generous terms, e.g., a 30‑year loan with fixed interest rates not much higher than 10‑year Treasury bonds.

There are several ways to achieve this. We could allow the government, which has a lot of money, to lend directly at subsidized prices; but this is usually not plausible, because the State is not typically good at carrying out these operations, which are quite complex, unlike banks.

Second option: banks lend the money, but the State guarantees that loan if it meets certain requirements, so that in the event of default the bank will still receive payment. In this second option the banks are in charge of the entire operation, because they have branches, customer service, data, technology, algorithms, collect payments, know the real estate market, verify the client and the requirements, and then carry out collections. In addition, this second mechanism usually involves a payment to the State for providing the guarantee if things go well. Conversely, if things go badly, the bank does not bear the credit risk. If the borrower defaults, the State pays. Because it is insured, there is a fairly high probability that interest rates will be low compared with the market.

Third option: the guarantee is provided by a third party, such as a mortgage guarantee company or a guarantee fund set up for that purpose. These entities guarantee the operations in exchange for a modest fee paid by the banks to insure the loan. If the borrower does not pay, these entities take responsibility. Generally these entities, moreover, are public or at least guaranteed by the State, are well capitalized, and have funds to cover defaults. They are usually regulated so they are secure and do not lose capitalization, allowing the banking market to trust them. In other words, it is not a government guarantee, but they typically have a good credit rating if they issue debt. Again, it is not the government guaranteeing, but it does give its approval.

In the U.S., the third option was chosen to a large extent, with Fannie Mae and Freddie Mac. The mechanism consists of acquiring mortgages in the secondary market, if they meet the agencies’ requirements, which they will keep on their balance sheets, in exchange for delivering mortgage‑backed securities to the banks. The guarantee here is that Fannie Mae and Freddie Mac guarantee those mortgage‑backed securities, so that they indirectly finance the mortgages originated by the banks. Put simply, banks issue risky mortgages to their clients (the subsidy’s target) and receive risk‑free mortgage‑backed securities in return (guaranteed by Fannie Mae and Freddie Mac). In exchange for this, the banks pay a guarantee fee.

What is most interesting about this mechanism, finally, is that these are publicly traded companies (or were at one time), so the market could contribute capital to the subsidy. Not only banks, but any investors who find the investment attractive.

In Chile there is something very similar, but, let’s say, somewhat less sophisticated. It is Fogaes (Special Guarantee Fund), which does not use a secondary market but simply provides a guarantee to people who meet the requirements of each “program.” This is not the place for a detailed analysis of that mechanism, but it is intriguing how a bond market and securitization can be underused in a country where real estate is extremely valuable. This is because the chosen mechanism is a tender, not the general market, which rigidifies market participation in the benefit for each program or tender. By contrast, when we use the market in the form of securities, we open the option for market agents to provide that line of financing or guarantee at any time. Flexibility is a starting point for debating this mechanism. In a way, instead of securities (an asset by nature easy to trade), contracts were chosen — between the Fund and market agents — (an asset by nature hard to trade), removing flexibility, liquidity, and price discovery.

But in Chile another novel mechanism now appears to be consolidating. We are referring to a subsidy on the mortgage interest rate. This benefit continues the trend of deepening the subsidy contractually. In simple terms, the State (not an intermediary) subsidizes 60 basis points on the interest rate of mortgage loans. The structure of the mechanism, its details determined by regulations from the Ministry of Finance, is based on a reference rate from which the discount is applied.

Under this interest‑rate subsidy the financial institution still ultimately determines the benefit, only now it must negotiate and interact directly with the State. The payment the State disburses is made to the financial institution that issues the subsidized loan. And, in a sense, the loan itself is detached from the benefit, since the law emphasizes that the benefit applies to a loan that is already likely to be issued.

This mechanism begins with the so‑called Reference Interest Rate, that is, the maximum value that the interest rate on a mortgage loan may have, before the subsidy is applied, in order to qualify for this benefit, and whose determination corresponds to the Ministry of Finance. In addition, it is a mechanism that only allows operations in the primary housing market. The benefit must be passed on in full to the customer.

Again, the institutions that grant the loans, in order to be able to offer this benefit, must enter tenders or other allocation mechanisms run by the State. In fact, it is the same tender used by Fogaes.

Later, the terms between the institution and its client may change, but for the purposes of the subsidy those modifications will not alter either the calculation or the term of validity of the benefit, which will always be determined on the basis of the conditions originally agreed. The same applies for the payment of the subsidy. However, in the case of refinancing or financial portability, the benefit is deemed to have ended.

Institutions are paid in the year following the materialization of the subsidy, year by year. Payment is conditioned on compliance with the regulations, so if there is noncompliance the institution will not be able to claim payment.

The instrument documenting the credit operation includes (i) a clause that expressly states the interest rate before applying the subsidy, called the interest rate without subsidy; and (ii) a clause that states the interest rate the debtor will pay once the subsidy is applied, which will be identified as the subsidized interest rate.

For a financial institution to apply the subsidy to a mortgage loan, the interest rate without subsidy may not be higher than the Reference Interest Rate for the month of commercial approval of the loan. This reference rate is determined by the Ministry of Finance (a calculation that includes the Chilean 10‑year Treasury bond rate; a spread reflecting credit risk, cost of capital and operational costs; and a financial spread that is variable according to the movement of bank bonds. It seeks to replicate the differential between the institution’s rate and the banking rate).

Keep in mind that the client’s loan rate must be a fixed rate.

The annual amount of the subsidy corresponding to each institution is determined and paid by the State, in accordance with the subsidized interest rate. If there is a disagreement between the State and the financial institution, the calculation may be challenged administratively.

It is very interesting that the decision was made to strengthen a contractual mechanism rather than a securities‑based one. Deepening a contractual approach is safer and more skeptical of the market, but its lower risk comes with less flexibility. Remember that the purpose of this is to secure third‑party financing, not the subsidy itself. The State should seek out the agent and the terms, not finance the asset itself. Markets would need some incentives to enter the real estate business, especially in markets where supply is far lower than demand and where real estate is an extremely safe asset.