The$Central$Bank$of$Ireland s$proposed$mortgage$rules! Response$to$Consulta9on$Paper$87$$ 8 th $December$2014$ Francis$Simons$ fransimons@mac.com$
Summary! The$introduc9on$of$macroJpruden9al$rules$to$provide$ guard$rails $for$the$housing$market$is$to$be$ welcomed$ A$LTI$cap$at$3.5$9mes$is$however$too$low$ At$this$loanJtoJincome$ra9o,$a$borrower s$interest$payments$would$be$17.5%$of$income$(at$today s$ 10$year$fixed$rate$of$5%)$ An$LTI$cap$of$5$9mes$ $corresponding$to$interest$of$25%$of$income$would$be$a$more$reasonable$ level$ A$LTV$cap$has$a$oneJoff$effect$on$house$price$infla9on$when$it$is$introduced$(or$9ghtened)$ But$there$is$no$evidence$that$house$prices$are$out$of$line$with$fundamentals$currently$ $so$there$is$ li]le$merit$in$introducing$an$ltv$cap$at$this$point$in$the$cycle$ 1!
Context:$no$signs$of$a$house$price$bubble$reJinfla9ng$ It$is$important$to$note$that$there$are$no$signs$of$a$house$price$bubbles$reJinfla9ng$at$this$9me$ House$prices$are$low$rela9ve$to$building$costs$ Housing$market$ac9vity$levels$are$very$low$rela9ve$to$ natural $benchmarks$ While$there$has$been$a$recent$rebound$of$prices$in$Dublin,$this$appears$to$reflect:$ a$deeper$crash$than$in$the$rest$of$the$country;$and$ a$stronger$recovery$in$rents$ 2!
House$prices$are$below$construc9on$costs$in$60$percent$$of$the$country$ 0$ 50$ 100$ 150$ 200$ 250$ 300$ 350$ 400$ 450$ 500$ House$price$ Construc9on$cost$ Regions$ranked$on$price$ South$County$Dublin$ Dublin$City$Centre$ South$Dublin$City$ North$Dublin$City$ North$County$Dublin$ West$Dublin$ Wicklow$ Cork$City$ Galway$City$ Kildare$ Meath$ Louth$ Limerick$City$ Cork$County$ Waterford$County$ Kilkenny$ Kerry$ Waterford$City$ Wexford$ Offaly$ Westmeath$ Tipperary$ Limerick$County$ Longford$ Clare$ Carlow$ Monaghan$ Galway$County$ Sligo$ Mayo$ Donegal$ Cavan$ Laois$ Leitrim$ Roscommon$ 3$bed$House$Price$and$Construc9on$Cost$ Source:$Dag$Report$Q3$2014,$SCSI$2014$ Prices$less$than$construc9on$costs$in$ regions$accoun9ng$for$60%$of$the$ popula9on$ 3!
Housing$ac9vity$is$at$very$low$levels$ Thousands$ Percent$ 11.1$ 66.1$ 82.6$ 100%$ Normal $level$ 90%$ 80%$ 70%$ 60%$ 50%$ 40%$ 30%$ 20%$ 10%$ 0%$ 2.6$ House$ Building$ (Dublin)$ 18.0$ Mortgage$ Loans$ (number)$ 38.2$ Housing$ Transac9ons$ Normal$levels:$House$building$(greater$Dublin$area)$ $Morgenroth,$Edgar$"Projected$Popula9on$Change$ and$housing$demand:$a$county$level$analysis,$esri$(2014);$mortgage$lending$ $80$percent$of$transac9on$ volume;$transac9on$volume$ $UK$average$2006 2013$scaled$to$Ireland$on$popula9on$ Sources:$ESRI,$UK$Na9onal$Sta9s9cs,$Property$Price$Register$ 4!
The$Dublin$ rebound $reflects$a$deeper$decline$and$is$underpinned$by$ growth$in$rents$ Sources:$CSO$House$Price$Index,$PRTB/ESRI$Rent$Index$ 0$ 20$ 40$ 60$ 80$ 100$ 120$ SepJ07$ FebJ08$ JulJ08$ DecJ08$ MayJ09$ OctJ09$ MarJ10$ AugJ10$ JanJ11$ JunJ11$ NovJ11$ AprJ12$ SepJ12$ FebJ13$ JulJ13$ DecJ13$ MayJ14$ 0$ 20$ 40$ 60$ 80$ 100$ 120$ SepJ07$ FebJ08$ JulJ08$ DecJ08$ MayJ09$ OctJ09$ MarJ10$ AugJ10$ JanJ11$ JunJ11$ NovJ11$ AprJ12$ SepJ12$ FebJ13$ JulJ13$ DecJ13$ MayJ14$ DUBLIN$AND$REST$OF$COUNTRY$PRICES$ DUBLIN$AND$REST$OF$COUNTRY$RENTS$ Index:$Q2$2007$=$100$ Dublin$ Rest$of$Country$ Dublin$ Rest$of$Country$ 5!
In$order$to$decide$the$appropriate$level$of$a$LTI$cap,$one$should$have$a$ sense$of$what$house$pricejtojincome$ra9o$is$jus9fied$by$fundamentals$ In$equilibrium,$the$price$of$a$house$should$be$equal$to$the$present$value$of$the$rental$cashflows$it$ produces$(either$directly$for$a$landlord$or$implicitly$for$an$owner$occupier)$ Rents$should$be$net$of$deprecia9on$and$maintenance$costs$ The$discount$rate$should$be$the$cost$of$financing$house$purchase$which$we$will$take$as$the$ mortgage$interest$rate.$this$should$be$the$long$rate$i.e.$reflec9ve$of$expecta9ons$of$variable$rates$ throughout$the$life$of$the$mortgage$ We$can$express$this$algebraically$using$the$formula$for$a$growing$perpetuity$(some9mes$called$the$ Gordon$Growth$Model):$ Price$=$Rent$/$(Long$mortgage$interest$rate$+$Costs$ $Growth$rate$of$rents)$ We$can$simplify$further$by$no9ng$that$costs$(expressed$here$as$a$propor9on$of$house$price)$and$real$ rental$growth$are$both$small$(at$around$0.5%)$and$opposite$in$sign$so$we$can$assume$they$cancel$each$ other$out.$dividing$through$by$income$we$obtain$the$formula$for$the$equilibrium$price$/$income$ra9o:$ Price$/$Income$=$(Rent$/$Income)$/$(Long$real$mortgage$interest$rate)$ We$can$es9mate$these$parameters$ 6!
Rents$have$been$a$fairly$consistent$propor9on$(about$25%)$of$incomes$over$ the$last$decade$ 35%$ 30%$ 25%$ 20%$ 15%$ 10%$ 5%$ 0%$ Rent$as$a$propor9on$of$Income$ MarJ00$ OctJ00$ MayJ01$ DecJ01$ JulJ02$ FebJ03$ SepJ03$ AprJ04$ NovJ04$ JunJ05$ JanJ06$ AugJ06$ MarJ07$ OctJ07$ MayJ08$ DecJ08$ JulJ09$ FebJ10$ SepJ10$ Source:$CSO$ 7!
The$long$real$mortgage$interest$rate$is$about$3.5%$ Variable$ Es9mate$ Basis$ Long$nominal$mortgage$ interest$rate$ 5.0%$ Expected$infla9on$ 1.5%$ Long$real$mortgage$interest$ rate$ Bank$of$Ireland$10$year$fixed$rate$as$at$ 8/12/2014$ 10$year$market$expecta9on$(breakeven$infla9on$ on$french$indexed$bonds)$ 3.5%$ [calculated$from$the$above]$ 8!
A$roughJandJready$approxima9on$suggests$an$equilibrium$price$to$income$ ra9o$of$7x$ Variable$ Es9mate$ Rent$/$Income$ 25%$ Long$real$mortgage$interest$rate$ 3.5%$ Equilibrium$Price$/$Income$ra9o$ 7.1x$ 9!
It$is$important$to$note$that$high$infla9on$creates$a$credit$constraint$on$ mortgage$borrowers$ ILLUSTRATION$ Infla9on$ 11.5%$ 1.5%$ 0%$ Real$mortgage$interest$rate$ 3.5%$ 3.5%$ 3.5%$ Nominal$mortgage$interest$rate$ 15%$ 5.0%$ 3.5%$ Max$Interest$/$income$ 25%$ 25%$ 25%$ Max$Loan$/$income$ 1.7x$ 5.0x$ 7.1x$ Equilibrium$house$price$/$income$ 7.1x$ 7.1x$ 7.1x$ Imagine$mortgage$lenders$will$only$approve$loans$where$the$interest$payment$is$no$more$ than$25%$of$income$ When$infla9on$is$high,$so$too$are$nominal$interest$rates.$So$loans$have$to$be$smaller$ rela9ve$to$incomes$to$meet$the$25%$cap$ Real$variables$ $including$the$equilibrium$house$pricejtojincome$ra9o$j$are$unchanged$ 10!
This$dynamic$means$that$the$end$of$the$infla9onary$era$has$eased$credit$ constraints$and$allowed$lti$mul9ples$which$represent$not$an$easing$of$ credit$standards$but$a$be]er$alignment$of$lending$to$fundamentals$ 0$ 2$ 4$ 6$ 8$ 10$ 12$ 1975$ 1977$ 1979$ 1981$ 1983$ 1985$ 1987$ 1989$ 1991$ 1993$ 1995$ 1997$ 1999$ 2001$ 2003$ 2005$ 2007$ 2009$ 2011$ 2013$ LoanJtoJIncome$ra9o$at$which$ interest$is$25%$of$income$ 0%$ 2%$ 4%$ 6%$ 8%$ 10%$ 12%$ 14%$ 16%$ 18%$ 1975$ 1977$ 1979$ 1981$ 1983$ 1985$ 1987$ 1989$ 1991$ 1993$ 1995$ 1997$ 1999$ 2001$ 2003$ 2005$ 2007$ 2009$ 2011$ 2013$ 1975J1994$average:$2.8x$ 1995J2013$average:$7.1x$ Nominal$Mortgage$Interest$Rate$ Source:$CSO$ 11!
The$LTI$cap$should$be$increased$ The$Central$Bank$has$proposed$a$LTI$cap$of$3.5x$ While$this$is$reflec9ve$of$historical$underwri9ng$standards,$those$standards$were$the$product$of$the$ infla9onary$era$and$out$of$line$with$fundamentals$ At$today s$(ten$year,$fixed)$mortgage$interest$rate$of$5%,$that$would$make$interest$payments$just$17.5%$ of$income.$rents,$by$comparison,$are$typically$25%$of$income$ In$the$context$of$house$prices$which$are$already$low$rela9ve$to$construc9on$costs,$there$are$nega9ve$ consequences$for$sevng$a$lti$cap$too$low$ House$prices$are$set$ar9ficially$low$rela9ve$to$fundamentals$ Construc9on$ac9vity$is$also$suppressed,$prolonging$an$already$deep$and$long$construc9on$ recession$ Because$there$is$too$li]le$construc9on,$rents$tend$to$rise$ The$Central$Bank$should$be]er$align$the$LTI$cap$with$fundamentals.$If$the$LTI$limit$were$to$allow$ interest$payments$of$up$to$25%$of$income,$then$it$should$be$set$at$5x$ 12!
An$LTV$cap$is$a$less$effec9ve$macroJpruden9al$tool$which$might$be$used$as$ a$ brake $on$an$overhea9ng$market! A$LTV$cap$does$less$good$a$job$of$ac9ng$against$high$house$prices.$High$loanJtoJvalue$lending$is$only$ problema9c$when$house$prices$are$ too$high,$but$the$tool$does$not$assess$the$appropriateness$of$ current$prices$ It$might$make$sense$to$think$of$a$cap$on$ Loan$to$Fundamental$Value $but$this$in$fact$translates$to$the$ LTI$cap.$If$house$prices$of$7x$income$can$be$jus9fied$on$fundamentals$then$an$LTI$limit$of$5x$effec9vely$ generates$an$ltv$cap$of$70%$of$fundamental$value$ It$seems$that$an$LTV$cap$in$the$presence$of$an$LTI$cap$actually$acts$proJcyclically$i.e.$restrains$lending$ more$when$prices$are$low$than$when$they$are$high.$this$clearly$is$not$a$desirable$property$ An$LTV$cap$might$have$a$useful$role$to$play$in$reining$in$an$overhea9ng$market$ The$cap$essen9ally$works$as$a$temporary$brake$on$demand.$While$some$poten9al$purchasers$are$ pushed$out$of$the$market,$they$do$rejenter$the$market$once$they$have$saved$large$enough$a$ deposit$$ But$now$is$not$the$right$9me$to$apply$the$brakes.$House$building,$housing$transac9on$volumes$and$ mortgage$lending$are$all$at$low$levels$ 13!
High$LTV$lending$is$only$high$risk$if$it$precedes$a$recession$and$house$price$ crash$ LOSS$RATE$BY$LTV$BAND$AND$YEAR$OF$ORIGINATION$ 10%$ 9%$ 2007$ 8%$ 7%$ Loss$Rate$ 6%$ 5%$ 4%$ 3%$ breakeven( 2%$ 1%$ 2004$ 0%$ 10J20$ 20J30$ 30J40$ 40J50$ 50J60$ 60J70$ 70J80$ 80J90$ 90J100$ LTV$at$Origina9on$bands$ Source:$Central$Bank$of$Ireland.$Loss$rate$calculated$as$90+$default$rate$9mes$loss$given$default.$ Breakeven$loss$rate$assumes$10$year$average$life$and$30$bps$margin$before$losses$i.e.$breakeven$at$300$bps$ life9me$loss$rate$ 14!
The$incremental$impact$of$an$LTV$cap$in$the$presence$of$LTI$cap$appears$to$ be$projcyclical$ PROPORTION$OF$LOANS$OVER$80%$LTV$AND$UNDER$3.5x$LTI$ Percent$ 40$ 35$ 30$ 25$ 20$ 15$ 10$ 5$ 0$ 1996$ 1997$ 1998$ 1999$ 2000$ 2001$ 2002$ 2003$ 2004$ 2005$ 2006$ loss,( making( vintages( 2007$ 2008$ 2009$ 2010$ 2011$ 2012$ 2013$ Source:$Central$Bank$of$Ireland$ 15!