Reducing the credit risk on mortgage lending

After six years of virtual stagnation in house building and house purchasing, the market is now leaping back to life.

The reasons are pretty clear. Over the past nine months, we have been getting compelling evidence on the economic recovery story. First-half growth data was surprisingly strong, but subsequent data has been telling the same story.

From the perspective of house purchasing, there is probably nothing more important than what is happening in the labour market, and here the news is very strong. We know from the Quarterly National Household Survey that employment increased by more than 31,000 in the year to the end of June, but this week we got live register figures showing that, during September, a further 4,700 people left the live register and it has now declined by 38,620 over the past year. While the live register is not intended as a measure of unemployment, it does provide a good health check on what is happening in the labour market.

The omens are good, and are supported by all of what we hear from recruitment agencies at the moment.

The evidence is suggesting that employment growth accelerated during the third quarter and this is fuelling confidence and is enticing buyers back into the housing market in particular. Unfortunately, after years of very little house-building this is leading to demand/supply imbalances and strong growth in house prices in the more vibrant parts of the country, particularly the Greater Dublin Area.

With house prices in Dublin now expanding at an annual rate in excess of 25%, the Central Bank — whose job it is to ensure stability and soundness in the financial system — is getting concerned.

In a research piece this week, the Central Bank highlighted its concerns about the current evolution of the housing market and the associated bank lending. It shows that for first-time buyers who buy at the peak of the economic cycle, the loan-to-value (LTV) ratio is a key indicator of future default potential. For non first-time buyers, the LTV and loan-to-income (LTI) ratios are both indicators of future loan difficulties.

There is nothing terribly surprising about any of this. House-buyers who pay a high price for a house and who take out a loan that is a very high percentage of the price paid for the house and which is many multiples of their income, will obviously be very vulnerable if there is any deterioration in the economy in general or their own labour market circumstances, in particular.

The Central Bank is clearly concerned that what happened after 2007 might happen again if current trends in the housing market continue. It is apparently considering placing limits on LTV and LTI ratios as a key part of its macro-prudential policy platform. On the surface, this makes sense, if you place limits on the amount of money a house buyer can borrow, you will make the borrower more resilient in the face of some economic or income shock.

There are a couple of obvious problems with this approach. In the past, when LTVs were limited, the borrower took out another loan to bridge the gap. The net result was a high LTV loan that created a vulnerability for the borrower. Another problem is that first-time buyers may have good repayment capacity but simply cannot get a deposit together. This is a particular problem if house prices are moving rapidly away from the first time buyer, as is the case at the moment.

The imposition of mortgage insurance to cover the portion of the mortgage over an 80% LTV loan would have the dual benefits of allowing a credit-worthy first-time buyer get on the housing ladder and at the same time improving the resilience of the banking system.