Brazil's housing market boom continues to make headlines. From January 2008 through April 2012, home prices in Sao Paulo and Rio de Janeiro jumped 135% and 169%, respectively, according to the FipeZap Index, which tracks prices every month in the country's seven biggest cities.

Average home prices in Sao Paulo and Rio de Janeiro rose nearly 25% during the 12-month period ending in April. In view of this growth, Fitch Ratings continues to closely monitor property market conditions and evaluate their associated credit risks.

Expansion of the country's mortgage market is the most important driver of the boom. Since 2004, mortgage lending as a percentage of GDP has grown fourfold, to a still low 5.2%, as reported by the Central Bank of Brazil (BACEN). Caixa Economica Federal (CEF), a government-owned savings and mortgage bank and the country's biggest mortgage lender, increased its portfolio from R$58 billion ($29 billion) in September 2009 to R$150 billion at the end of 2011.

In Brazil, mortgage lending taps traditional funding sources - savings deposits and, for subsidized lending, the Fundo de Garantia do Tempo de Servico (FGTS), a Brazilian workers' fund managed by CEF. But savings accounts are growing slower than mortgage lending, spurring the need for alternative funding sources. The Brazilian Association of Real Estate Loans and Savings Companies (ABECIP) expects that a mortgage funding gap will materialize as early as next year. This projected deficit could spark Brazil's nascent RMBS market.


Residential Mortgage Lending

Under Brazil's Housing Finance System (SFH) created in 1964, universal banks, savings associations and CEF must direct 65% of savings deposits to real estate lending or related assets. This requirement and the ample availability of cheap savings deposits have limited RMBS growth so far.

Large banks dominate residential mortgage lending. CEF is far and away the leader, commanding 75% of market share. Other major lenders include private giants Banco Itau, Banco Bradesco and Banco Santander, along with government-owned Banco do Brasil. Construction companies also lend to home buyers, but at high rates and significantly shorter tenors, and with less sophisticated underwriting criteria.

Encouraged by economic growth, a favorable interest rate environment and cheap savings deposits, Brazil's large mortgage lenders have significantly grown their residential loan portfolios since 2005. By extending loan maturities to 30 years and adopting traditional loan-to-value (LTV) and debt-to-income (DTI) standards, lenders have opened up the mortgage market to millions of new borrowers. Still, in spite of certain changes in underwriting criteria, loan characteristics remain simple by developed world standards; all mortgages in Brazil are fully amortizing with fixed interest rates.

Mortgage market development was facilitated by legal reforms, including changes in mortgage laws and the introduction of the alienacao fiduciaria, or fiduciary lien, which streamlined the foreclosure process by considerably reducing the time needed to seize and liquidate property of defaulting borrowers.

Alternative funding sources for bank mortgage lending like securitization and portfolio sales are more expensive than traditional funding - savings deposits and FGTS - and currently play a minor role in residential housing finance.


RMBS Market: Still Teething

In 1997, the federal government approved Law 9514, which created Brazil's Real Estate Financing System (SFI) to operate alongside SFH. SFI introduced securitization of real estate receivables into the housing finance ecosystem and made mortgage lending more flexible for banks.

Securitization of real restate receivables is typically done via Certificados de Recebiveis Imobiliarios (CRI). Securitization firm Companhia Brasileira de Securitizacao (CIBRASEC) issued the first CRI in 1999 in the amount of R$10.9 million. Until 2007, Brazil's RMBS market was limited to residential loans originated by construction companies and developers. In August 2007, BancoABN AMRO Real (ABN) issued the first bank-originated CRIs backed by residential mortgage loans. The deal's senior tranche amounted to R$86.4 million; the junior piece was worth R$12.9 million. Fitch rated the senior note 'AA(bra)'.

Overall, residential mortgage securitization, a historical pillar of structured finance in the United States and Europe, remains a negligible source of mortgage financing in Brazil. But recent market activity points to change.

In March 2011, CEF tested the RMBS market by issuing CRIs for a total R$258.6 million, more than 2.5 times the ABN issuance. Fitch rated the senior series 'AAA(bra)'. Even larger CEF mortgage portfolios were securitized later that year and sold to FGTS, the Brazilian workers' severance fund managed by CEF.


Brisk Economy Underpins Housing Boom

The housing sector has developed alongside Brazil's broader economic success. Rapid growth of the middle classes and expansion of credit are two key factors behind the boom.

In the context of sustained economic growth and low-to-moderate inflation, real per capita GDP rose 18.6% from the beginning of 2006 through the end of 2011, according to Fitch. During the same period, unemployment dropped from 10% to 6%, the ratio of formal-to-informal employment increased and the wide gap between the wealthy and poor narrowed a bit. Real income growth boosted both buying power and savings deposits, which in turn increased the availability of cheap funding sources for mortgage lending.

Other factors influenced credit availability. Economic stability helped create an environment with reasonable inflation levels and a low benchmark interest rate (SELIC), which hit historic lows during the current boom. By law, mortgage loans funded via savings deposits are, to a large extent, capped. Once benchmark rates go below a certain level, mortgage lending becomes very attractive to banks. This has been the case since 2007.

As credit became available to home buyers, housing demand flourished. This, coupled with inadequate supply, boosted residential real estate prices in all major metropolitan areas, most notably in the Sao Paulo and Rio de Janeiro areas, where the country's mortgage financing concentrated.

In addition to new middle-class homeowners, millions of low- and low-to-middle-income Brazilians are becoming homeowners with the help of Minha Casa Minha Vida, a massive public housing campaign managed by the federal government, CEF and municipal governments.


Is the Boom a Bubble?

Reduced affordability and sizeable price increases in some cities have prompted talk of a housing bubble.

During the last three years, rental yields have been sharply lower than mortgage rates (the latter starting at around 9% annually) in Brazil's major metropolitan markets. Rental yield reflects a property's annual net income divided by its purchase price. When it becomes cheaper to rent a home than to purchase one, buyers might retreat from the market. In Sao Paulo and Rio, decreasing rental yields (see graph above) could indicate that properties are overvalued.

In addition, house prices have increased disproportionately to the rise in household incomes both in nominal and income-adjusted terms, as evidenced by the graph on the next page.

But the most recent figures show signs of a slowing market. In both Sao Paulo and Rio, income-adjusted prices leveled off during the last six months. Also, when compared with other booming emerging markets, Brazil's largest cities still seem relatively affordable. For instance, Fitch estimates average house price-to-income ratios in Shanghai and Moscow to be more than double the ratio in Sao Paulo.

Brazil's housing deficit has no doubt contributed to rising property prices. As new product comes to market and imbalances between supply and demand diminish, prices may adjust downward.


RMBS Ratings Criteria: Evolving with the Market

We consider the macro-risk of a hot market and focus on the idiosyncratic risks associated with specific transactions. We cautiously monitor Brazil's real estate sector and constantly adapt dynamic rating criteria to market developments. Our recently republished RMBS criteria for Brazil, for instance, reflects revised assumptions relating to the estimation of default and recovery rates for Brazilian mortgage portfolios.

When rating RMBS transactions in Brazil, Fitch identifies original LTV and DTI as main drivers for the expected frequency of foreclosure of loans and the securitized portfolio as a whole. Other factors considered in default analysis are underwriting and servicing standards, type of mortgage product, delinquency status of loan, realized amortizations and borrower as well as geographic concentration. Apart from the current LTV, the main drivers of expected recoveries for defaulted loans are market value declines and foreclosure costs.

In its asset analysis, Fitch combines external data with its knowledge and expertise in developing analytical assumptions as inputs into asset and cash-flow models. The agency takes into consideration information from several sources, including CEF, Fitch-rated RMBS transactions, BACEN and studies on the macroeconomic, legal and political environment.

The combined effects of the updated assumptions will be used to rate all new and existing Brazilian RMBS transactions. Moving forward, we will continue to closely follow evolving market conditions and incorporate changes into our ratings criteria.


Supply and Demand: The Long-Term Dynamics

Macro-fundamentals look to support substantial long-term growth in Brazil's housing market. Based on data from higher education institution Fundacao Getulio Vargas (FGV) and the government-run Brazilian Institute of Geography and Statistics IBGE, JP Morgan projects that the expected increase in number of families through 2030 will be 1.5 million per year, of which 50% will earn above three minimum salaries. These emerging consumers will demand housing.

Currently at 9%, the SELIC rate is just 25 basis points off a 15-year low and is expected to go down at the end of the month. Policymakers want to keep interest rates low. This, of course, hinges on a stable inflationary environment.

Assuming that favorable economic conditions persist, consumer indebtedness stays under control and housing supply keeps up with demand, Brazil's property market will dramatically develop over the next 15 years.


Mortgage Financing Set to Shift in 2013-14

Growth in housing and advancement of the mortgage market go hand in hand. In spite of exceptional growth in mortgage lending over the last couple of years, Brazil's mortgage market remains undeveloped. At 5.2%, the share of mortgage lending to GDP is tiny when compared to 77% in the U.S. and 10%-15% in other Latin American countries. ABECIP expects mortgage lending to reach 10% of GDP within the next three years.

But meeting demand for mortgages via traditional funding sources will likely be a challenge. Analysts anticipate a funding shortage as soon as next year, marking a fundamental shift in the market. As mortgage lending outpaces the growth of savings deposits, banks will look to alternative funding sources. And one of those alternatives looks likely to be RMBS.

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