Senior Chinese banker on the mortgage boycotts
"Mortgages with Chinese Characteristics" decried by ex-deputy governor of Bank of China
A lot of ink has been spilled over China’s real estate industry lately, especially some homebuyers’ declaration that they will not repay the principal and interest of their mortgages, now that their apartments are not being built by developers, many of whom have defaulted on their bonds.
The mortgage boycott, revolt, strike, or crisis is not a small deal. 王永利 Wang Yongli, former deputy governor of the Bank of China (one of China’s four largest state-owned lenders), recently wrote a piece on the root cause and offered his policy advice.
Wang was in direct command of the response of the Bank of China to the 2007 U.S subprime crisis and 2008 global financial crisis. These days, Wang runs a column that frequently weighs in on China’s finance and economy.
A very brief summary of the translation below: Mortgages in China are different in that they are extended by banks to homebuyers before the apartments are built and that they are backed not just by the apartments, but also by the homebuyers’ personal credit. Not only significantly disadvantaging homebuyers who pay the full amount before even seeing their apartments and put their other assets on the line to get the loan, the arrangement - dubbed mortgages with Chinese characteristics - also incentivizes banks to overlook risks in the buildings they are financing since they can go after the homebuyers’ other assets. Wang Yongli says that must stop.
Mortgages Must Return to Their Origin
Recently, some apartments under construction (presold apartments) purchased with mortgages cannot be delivered in accordance with the time limit stipulated in the contract. Some buildings even stall at incompletion and cannot be delivered. As a result, a rapidly spreading mass "mortgage suspension" event has been triggered. That is to say, the borrowers jointly declared to stop repaying the principal and interest of the mortgages on a monthly basis before receiving the apartments they purchased.
This directly involves the banks issuing the mortgages in the disputes over the transaction of the apartments, which may have a great risk impact on the large-scale mortgages of the banks. (China’s long-standing practice of) Whole-payment in presales and mortgages have emerged as the center of the controversy.
The strict meaning of a mortgage
[Pekingnology: the practice OUTSIDE PRC]
The Chinese term for mortgages originates in the English language, and its original intention refers specifically to the housing loans provided by the bank, as a certain proportion of the contracted price, for an agreed period and in the form of repayment of principal and interest. The apartment that the borrower intends to purchase is mortgaged as the full guarantee of repayment of the loan principal and interest.
The remaining portion of the price - exceeding the loan limit - is paid by the borrower upfront to the seller of the apartments and serves as the precondition for the bank to issue the mortgages. That is referred to as a "down payment".
In addition, due to the long term of mortgages (generally 3-30 years), in order to ensure the safety of the collateral and prevent the risk of significant damage to the collateral, mortgages generally require the relevant property to be insured for the whole period of the loan period, with the insured amount not less than the total value of the mortgage. It is clear that the lender is the first beneficiary of the insurance, and the insurance policy is generally entrusted to the lender.
Between other collateral-backed loans and mortgages, similarities include: if the borrower defaults, the lender can dispose of the collateral in accordance with the contract, and the net proceeds from disposal shall be given priority to repay the loan principal and interest owed, and the excess shall be returned to the borrower.
The difference between the two is that if the net income from the disposal of the collateral is insufficient to repay the loan principal and interest owed, the bank may pursue other recourse against the borrower under the collateral-backed loans. However, for mortgages, the bank will bear the loss for the insufficient part, and can no longer recover the principal and interest from the borrower other than the house, i.e. the borrower of the mortgages has only limited liability for the loan principal and interest.
As a result, mortgages are generally only applicable to finished houses that have been completed, accepted, and can be sold in accordance with the delivery conditions agreed in a contract. Before the houses are completed and accepted, developers assume responsibility for the funds needed for the development, among which they can apply to the banks for housing development loans, and can also receive a certain amount or proportion of deposit or down payment from the buyers.
In this case, the relationship between the two parties involved in the borrowing or exchange of funds is very clear. If there is a dispute, the obligations are easier to be determined and the contractual constraints are relatively strong.
The mutation of mortgages in the PRC
Since 1998, in the process of 深化住房体制改革 deepening the housing system reform in an all-round way and accelerating the development of real estate as an important industry in the country, (Chinese) banks have also introduced mortgages modeled on international practices. However, in practice, mutations emerged leading to mortgages with Chinese characteristics. They are as follows:
First, the mortgage is not just backed by the mortgaged property as a guarantee for repayment of the loan principal and interest.
When the net income from the disposal of the mortgaged property cannot fully repay the loan principal and interest owed by the borrower, the lender can still go after the borrower, who can be sued in court or even be blacklisted [and suffer significant personal costs] because the borrower cannot repay the loan principal and interest owed. That turns the mortgages into collateral-backed loans (as mentioned above).
The second is the emergence of mortgages for apartments still under construction compared with the (internationally common) mortgages for completed houses.
Before the apartments are completed, the developers pre-sell them for a full price based on the designs, demonstrations, and promised delivery dates, instead of only receiving a deposit or down payment which is a portion of the price.
Accordingly, buyers apply to banks for mortgages and use the mortgages to prepay the housing price by virtue of the contract with the developer. As banks have the right of recourse to mortgages more than the disposal of collateral (the apartment), banks often do not pay enough attention to the timely and quality delivery of apartments under the mortgages, and do not strictly select and supervise developers. All these have also become important reasons for the rapid development of full-price pre-sale, mortgages, and the accumulation of related risks.
Under this arrangement, buyers actually provide a large amount of interest-free funds for the developers (establishing a form of entrusted agent construction), which greatly reduced the capital cost and financial risk of the developers, and provided a source of income for banks (the interest of the mortgages) and government (real-estate related revenue). The arrangement makes developers a darling in the eyes of banks and the government and puts all the risks on buyers.
As a result, developers will take all possible measures to expand the pre-sale of apartments. They then use the money to expand their business, such as purchasing more land, slowing down the construction of the apartments that have been paid for to take more advantage of the interest-free funds, or even cutting corners on the building quality and their supporting facilities. Once the developers cannot deliver the apartments on time or with good quality according to the contract, the scattered and (structurally) weak buyers can hardly protect their own rights and interests.
Therefore, the international community generally strictly controls the pre-sale of houses, generally does not allow full pre-sale, only allows the collection of deposit or down payment of not more than 30% of the price, and requires developers, or through law firms, to open escrow accounts in banks to manage the funds, which can only be used for the construction of related buildings and must not be used for other purposes.
In recent years, our country is gradually tightening up the pre-sale of houses and strengthening the supervision. However, up to now, basically, after the main structure of buildings has been capped, buyers can apply for mortgages on the basis of a down payment, and part of the payment (including down payment, etc.) is required to be deposited in a designated escrow account, which is supervised by the government department in charge of housing construction regulation and the bank, where funds can be withdrawn and used by the developers in batches based on the progress of construction.
As it usually takes two to three years from the completion of a building’s main structure to its delivery to buyers, buyers still face many uncertainties out of their control with considerable risks.
As for the supervision of funds from pre-sale, due to the fact that the local government regulator is rarely held responsible for the supervision, the match between the withdrawal of funds and the actual progress in construction is often neglected. Some developers even have great influence and are easy to coordinate with all parties to evade supervision. As a result, the funds in the escrow account are appropriated and construction may be delayed or even may be left unfinished.
The arrangement gave strong support to the development of real estate [Pekingnology: effectively, homebuyers’ future income has been tapped to finance building, and that is a lot of money otherwise unavailable], but also entangled developers, buyers (borrowers), and lenders. After buyers paid the full amount, once the apartments stall, it becomes difficult to ascertain responsibility clearly. Now that housing prices are falling instead of rising, and risks in real estate are increasing, it becomes more likely that developers can’t deliver apartments timely or even can’t finish the construction. In that case, buyers will have a hard time pushing developers for a solution. And banks are bound to face more risks and disputes, as buyers decide on their own to stop repaying the principal and interest of mortgages, which will easily lead to mass incidents and systemic financial risks.
The current wave of “mortgage suspension” by buyers/borrowers to defend their rights is a result. This risk has existed for a long time and has accumulated in large quantities, and it is only a matter of time before it explodes. Its outbreak is only a matter of time. Therefore, we must find out the root cause of the problem, solve it as soon as possible, and eliminate the hidden danger.
Mortgages must return to their origin
It must be made clear that all mortgages can only be made with the property as collateral - the full guarantee for repayment of loan principal and interest, and the borrower will only assume limited liability with the property. This is to force the lender to ensure that the relevant real estate can be delivered on time, with good quality, and without legal disputes. This is also about forcing banks to reasonably determine the amount of the loan - its portion of the full price - and repayment method based on the risks associated with the mortgages.
Under such circumstances, the banks are bound to strictly control the mortgages for apartments under construction, and mainly issue mortgages for apartments already completed.
Even if banks issue mortgages for apartments under construction, since they will assume the risks of defaults, they will be forced to strengthen the selection of developers and supervision of construction. This will also effectively curb the expansion of the pre-sales in full, and better protect the legitimate rights and interests of buyers.
In this regard, the financial regulatory authorities need to improve the relevant laws and regulations, and the government needs to reduce the administrative interference in housing development and mortgages. We should consider canceling the pre-sale in full amount as soon as possible, unifying the control standard of the deposit as a proportion of the price, and holding the local government regulator responsible for their supervision of the escrow accounts.
Properly handle the risks of mortgages
Regarding the mass "mortgage suspension to defend rights" incident that has broken out and spread rapidly, we should attach great importance and handle it as soon as possible and properly.
The balance of mortgages issued by China's financial institutions has exceeded 30 trillion yuan ($4.44 trillion). Among them, the amount for apartments under construction is not very large. The amount for apartments that cannot or would not be delivered on time should be even smaller.
However, most of the balance originated from mortgages for apartments under construction. Many of the apartments have already been delivered. But there are many conflicts left over by the homebuyers and developers, and there are the economic downturn, falling housing prices, and increasing pressure (for homebuyers) on repayment of mortgages. If the root cause can’t be identified and the "mortgage suspension to defend rights" incident itself can’t be resolved timely, it is likely to intensify larger hidden contradictions, trigger more mortgage disputes, and stimulate greater social unrest and financial risks.
Local governments should take lead in the problem-solving.
Conduct a comprehensive review of the pre-sold apartments under construction, and clarify the actual scale of pre-sales, the possibility of timely completions, and the levels of risks.
For apartments under construction that have been pre-sold but have not yet reached the delivery date, apart from strengthening the supervision of the escrow accounts (including deposit, down payment, mortgages, etc.), the local government should require the developers to come up with practical arrangements to ensure that the apartments can be delivered on time and with good quality in accordance with the pre-sale contract.
For the developers who have pre-sold apartments but are unable to deliver them on time with good quality, the local government should, in addition to requiring them to compensate the buyers in accordance with the pre-sales contract, require developers to bear the responsibility of repaying the principal and interest on the mortgages taken by buyers until the delivery of the apartments. As a result, the bank should suspend buyers’ obligation in the mortgages, and sign the corresponding tripartite agreement with the developer and the buyer.
For pre-sold apartments that developers have difficulty completing, the local government can take the lead in asset restructuring and transfer, or organize government buy-out with the active support of banks, to aid the construction so that the apartments are completed and delivered as soon as possible.
If the homeowners of apartments that have been delivered take the opportunity to transfer their problem with developers, the contracts between them must be held and concessions to the homeowners shall not be easily made (by the local government).
[Pekingnology: some of them have legitimate complaints over the quality or facilities promised by developers, and some have demanded compensation from developers now that housing prices remain stagnant and began declining.]
The real problem is home buyers’ willingness to pay developers/builders before they sign off on the completion of dwelling to specifications. Mortgages in other world are loans to home buyers too, and a lot of them do not limit the liability to the dwelling. But builders in other worlds obtain interim financing in their own to build and can’t get payment from buyers until units are completed to spec and signed off by buyers. And banks released money onto to a trust and wait for the buyers sign off.