As Brazil's economy slowly climbs out of its deep recession, the country is turning its attention to jump-starting recovery in its real estate market. On Aug. 19, 2019, the National Monetary Council (CMN), one of Brazil's financial regulatory bodies, approved Resolução Nº 4.739 (Resolution No. 4.739), which is intended to widen the pool of funds available to finance purchases of homes in the country. The resolution removed restrictions on the use of market indices-adjusted interest rates on residential mortgages under the scope of the housing finance mechanism, Sistema Financeiro Habitacional (SFH), which represents most of the mortgages in the country. In practice, the new resolution will allow residential mortgages to be linked to Brazil's Consumer Price Index (IPCA), which will attract significantly more investors to Brazil's incipient residential mortgage-backed securities (RMBS) via Certificados de Recebíveis Imobiliários (CRIs) and covered bonds via Letras Imobiliárias Garantidas (LIGs).

S&P Global Ratings believes Resolution No. 4.739 will likely boost mortgage lending growth in Brazil over the next two to three years because issuance of CRIs and LIGs could significantly expand the credit available for home purchases. Currently, most mortgage loans are funded with savings deposits and retiree funds (FGTS), which may become insufficient to fund the demand for residential mortgages once the economy rebounds. Nevertheless, we also believe that indexing mortgages to IPCA comes with risks that must be monitored. The high volatility of Brazil's economy increase the risk of a sudden rise in inflation, which could result in a higher debt burden to homeowners, increased delinquencies, and weaker credit quality of securitized mortgages.

Regulatory Changes Make Brazilian RMBS And Covered Bond Issuance More Viable

Resolution No. 4.739 is a complementary initiative to the July 31, 2018, CMN-approved Resolution No. 4.676, which established a series of measures that lessened restrictions on home financing and have been supporting the gradual recovery of Brazil's real estate market. Resolution No. 4.739 provides lenders with the ability to adjust mortgage interest rates under SFH to IPCA rather than the referential rate, Taxa Referencial (TR), which is a daily indexer based on a daily average of 30-day deposit plus a reducing factor defined by the Central Bank of Brazil. The new resolution will likely allow the development of IPCA-linked RMBS and covered bond markets in Brazil, given that investors have a stronger appetite for inflation-linked investments, and increased demand may turn those instruments into key funding alternatives for domestic financial institutions.

Following the new regulation, the state-owned bank Caixa Economica Federal, which has an approximately 70% share of the home financing market, launched a mortgage product linked to IPCA. The new product line will have a minimum interest rate of IPCA + 2.95%, which is lower than the rates for products linked to TR, considering current inflation levels. These mortgages will have a maximum term of 360 months and a maximum loan to value (LTV) ratio of 80%. We believe that other large banks, fintech companies, and other lenders will likely follow the same path, increasing competition in the segment.

What Are The Risks For Inflation-Linked Mortgages?

IPCA-indexed real estate financing can be riskier for borrowers because wage inflation doesn't always mirror IPCA, and Brazil's inflation rate has experienced high volatility over long periods of time. Brazil's residential mortgages usually last between 15 and 30 years. During the past 20 years, IPCA has had a much higher volatility than the central bank-established TR (see chart below). Although inflation in Brazil has been below the target set by the central bank over the past three years, the index has not always behaved as expected, such as in 2015 when the IPCA surpassed 10%. It is difficult to predict how inflation will behave during the life of a residential mortgage, especially in a country with fluid political dynamics such as Brazil.

In addition, a sharp increase in inflation levels during an economic crisis could increase debt service as GDP declines. In this scenario, higher unemployment and inflation levels could lower borrowers' payment capacity while the market value of properties drops significantly, leading to a sharp increase in mortgage LTVs and higher credit risk. Thus, when S&P Global Ratings evaluates inflation-linked mortgages, we typically increase our foreclosure frequency expectation for the asset pool.

The risk of a sudden rise in LTV is particularly relevant for markets such as Brazil, where domestic lenders have limited recourse on most residential mortgages (i.e., the borrowers have no obligation to pay the balance of any debt if a shortfall occurs after the sale of the collateral). In limited recourse markets, a borrower may have an incentive to hand in the keys if little to no equity exists in the mortgaged property or if the borrower has negative equity due to adverse property price fluctuations. For example, during the Great Recession, some borrowers in the U.S., which operates mainly under limited recourse, simply handed in their keys after the equity in their homes turned negative. This caused sharp increases in foreclosures and led to a widespread drop in property values, further weakening U.S. RMBS credit quality.

Could Inflation-Linked Mortgages Lead To Loan Modifications?

The social importance of residential mortgages increases the risk of mortgage modifications as inflation increase in an economic stress scenario. For example, in Argentina, President Mauricio Macri announced that the government will freeze readjustments of mortgages denominated in UVA (a value unit linked to inflation) for four months through December 2019, following the significant depreciation of the peso and a spike in interest rates after the primary elections on Aug. 11, 2019. Although it is still unclear how this measure would be implemented, it could reduce the expected cash flow for the securitizations.

LTV And Borrower Indebtedness Are Key For IPCA-Linked Mortgage Credit Quality

Although indexing mortgages to IPCA will likely make Brazil's RMBS and covered bonds markets more viable and expand the credit available to purchase homes, we also believe a rapid growth of inflation-linked mortgages could pose risks to Brazil's real estate market, given the high volatility of the country's economic and political environment and mortgage lenders' limited recourse. On the other hand, if the origination of inflation-linked mortgages is combined with lower LTV and debt-to-income ratios, those risks can be mitigated. As such, we believe prudent originators and investors will account for those risks when defining their appetite for Brazilian floating-rate RMBS in their portfolios, and we will monitor the RMBS transactions we rate accordingly.