Bank of Russia warns about risks of mortgages involving letters of credit and assignment of equity construction contracts (01.03.2024)

The Bank of Russia records the emergence of new schemes used to purchase housing under construction, which carry risks for buyers.

Some banks together with developers offer equity construction contracts (ECCs) when issuing mortgages to borrowers. Under these contracts, part of funds for purchasing a flat is placed not in an escrow account but is covered by a letter of credit. Banks use these funds and earn an additional income, part of which may be given to the borrower as a discount on the mortgage rate during the construction period. The developer may agree on this scheme so that the bank could issue mortgages and increase sales.

Risks for individuals under this scheme stem from the fact that, unlike escrow accounts which are insured by the government in an amount of up to ?10 million, funds under such a letter of credit are not secured at all. If the licence of a bank, where the funds are kept under a letter of credit, is revoked, a person may lose both money and a flat, while remaining in debt to the bank for a mortgage loan because, in fact, the ECC has not been fully paid.

Moreover, developers may sell housing to affiliated persons during the period of construction, entering into ECCs with them at a price that is several times lower than the market price, and these funds are placed in an escrow account. When assigning an ECC, a person has to pay the real market price, but in addition to the rights of claim under the ECC, he/she receives an escrow account with funds only in the amount of the original (underestimated) price of the flat, and the remaining money (price difference) is immediately transferred to the seller affiliated with the developer and not credited to the escrow account at all.

In this situation, a person carries the risks in case of the developer’s default. If the developer fails to meet its obligations, this will result in a loss of most of the funds actually paid for the flat (the difference between the actual price paid and the amount of funds in the escrow account).

The Bank of Russia considers such schemes as a violation of the basic principles formulated in the law on participation in shared-equity construction,¹ which says that the developer may raise people’s funds under an ECC using escrow accounts in order to minimise risks for these people.

Banks and developers who use such schemes are, in fact, taking advantage of people’s ignorance. In particular, the law does not clearly specify the timeframe when exactly the funds should be credited to the escrow account and says that this should be done in accordance with the contract, but no later than the house commissioning date. In practice, this means that, from a legal point of view, it is possible to draw up a contract in such a way that the funds will remain without any insurance protection for several years while the house is being built, or part of the funds will not be transferred to the escrow account. However, people may not realise the risks which they assume in this situation.

The Bank of Russia considers such practices unacceptable and will inform credit institutions about its opinion (including as part of a supervisory dialogue). Banks should provide high-quality support for equity construction and pay attention to the cost (non-market conditions) specified in ECCs signed between developers and legal entities (including affiliated ones).

In the near future, the Bank of Russia plans to complete work on establishing a Standards Committee which shall primarily focus on adopting a mortgage lending standard. The standard will set forth the inadmissibility of imposing obviously complicated and risky mortgage products on people. Thus, restrictions on the duration of keeping raised funds in the borrower’s account before transferring them to an escrow account (including under a letter of credit) should become an integral part of the standard for protecting the interests of mortgage borrowers. In case of non-compliance with the standard, the regulator will apply coercive measures stipulated by law. If a bank provides incomplete and (or) unreliable information to the borrower, the Bank of Russia will consider the possibility of applying Federal Law No. 192-FZ² in order to suspend sales of such products.

In addition, the Bank of Russia will consider the possibility of amending regulation aimed at ensuring that artificially exaggerated prices for housing as a result of fees (direct or indirect, such as using the letter of credit scheme) are duly reflected in financial risk indicators (loan-to-value (LTV) ratios,³ risk coefficients for calculating capital adequacy ratios and macroprudential buffers to them, and macroprudential limits (MPL⁴) in the future). This will limit the issuance of such risky loans. There will also be a supervisory review of the correctness of banks’ assessment of the cost of real estate when calculating LTV ratios.

The Bank of Russia also plans to discuss with the Russian Government the possibility of amending the rules for government-subsidised mortgage lending in order to completely prevent the provision of subsidised mortgage loans when developers use such schemes, which will protect the interests of recipients of government-subsidised mortgage loans.

Concurrently, the Bank of Russia deems it necessary to request Russia’s Ministry of Construction to consider the possibility of amending Federal Law No. 214-FZ, which would prevent the implementation of the schemes described above.

The regulator recommends that people pay close attention to ECCs, namely to what they say about the procedure and timeframe for crediting funds to escrow accounts. To mitigate risks, funds should be kept outside the escrow account no longer than is required to make payments (usually no more than a few days from the date of ECC registration). Significant deviation from this, as well as payments by means of a letter of credit mentioned in an ECC, may evidence that the contract is not drawn up in the buyer’s interests and entail additional risks to him/her.