The impact of a change in interest rates on Irish mortgage holders

The Irish Central Bank publishes data on retail interest rates on  a monthly basis and the rate on new mortgage lending receives much media attention, given that  it is significantly above the euro average (3.21% in March against 1.81%). Far less attention is paid to the average rate on existing mortgages  ( 2.6% against 2.23%) although that is the relevant figure when one is  considering the vulnerability of Irish debtors to a rise in interest rates, given the preponderance of floating rate debt.

New borrowers are turning to fixed rate loans in much greater numbers, with over half of new mortgages at fixed rates in the first quarter of 2018, but that is low relative to the euro average ( over 80%)  and has little impact on the stock of outstanding debt, which is still heavily weighted to floating rates. For example, some €60bn of the mortgage debt owed to Irish banks in the first quarter was at a floating rate , or 81%, against under €14bn at a fixed rate.

That also means that most  mortgage holders have seen a massive fall in monthly payments over the past decade, as the average mortgage rate was 5.3% in mid 2008. The scale of deleveraging since then has also helped to reduce the total   simple interest paid monthly on outstanding mortgage debt  to Irish lenders, which is currently under €2bn a year against €6.3bn ten years ago. Of course, the corollary is that interest paid on deposits has also fallen substantially, highlighting that any interest rate change is a transfer between saver and borrower.

Most analysts now believe we are at the bottom of the interest rate cycle in the euro area and the ECB will start to raise rates at some point, probably in 2019, although the precise timing is open to debate given the absence of any clear upward momentum in core inflation. How would a rate move affect mortgage holders, if and when it comes?

The average  interest rate on existing mortgages which are not fixed is 2.3%, which is biased downward by the proportion of tracker rates ( still over 40% of the total, although falling)  where the average rate is just 1.07%. These are linked to the ECB’s main refinancing rate (curently zero) and would not change if the ECB raised its deposit rate ( the most likely first move) although that would push up money market rates and hence standard variable rates ( and lead to higher fixed rates for new borrowers). An increase in the refinancing rate would however be required before all existing floating rates rose .

Although there are only some €75bn of mortgages on the books of Irish lenders the outstanding stock is just over €100bn given securitisation and sales, which implies about €81bn or so would be impacted by a rate change is we assume the same ratio of floating to fixed.The precise effect for each borrower would depend on the maturity of the outstanding debt but if we assume an average 15 years ( most existing mortgages were taken out in the early to mid noughties)  a 1% rise would increase payments by  just under €0.5bn a year, substantially more than the tax reductions in the 2018 Budget ( €335m).

Of course higher rates would also have an impact on interest rates on deposits accounts , although the precise effect would depend on whether bank margins also changed. However, although total household deposits are also up around €100bn,  some 80% are  overnight  and earning next to nothing  leaving total interest paid by Irish banks on household deposists at just €160m a year.

Rate changes generally have a bigger effect on borrowers than savers anyway and so the implication is that  Irish household  spending would still be significantly affected by a rise in interest rates  despite the recent increase in fixed rate borrowing and the deleveraging seen over the past decade.


Hitting the (Capital) Buffers

International regulation of financial institutions changed considerably in the aftermath of the 2008 financial crash. Banks are now required to meet certain ratios in terms of liquid assets as well as holding more capital in the form of equity in order to better absorb unexpected losses. Some institutions are also deemed to be systemically important, be it by virtue of global size or their significance in the domestic economy, and therefore required to hold additional equity in order to ameliorate the ‘too big to fail’ issue.

Banking tends to be very pro-cyclical and regulators have introduced an additional capital requirement which is adjustable over the economic cycle. This counter-cyclical buffer (CCyB) can be increased in an economc upswing when credit growth is strong, in order to act as additional support when credit losses start to appear, and released in a downturn in order to prevent a rapid contraction in bank lending.In the euro area the local regulator, in our case the Central Bank, is  designated to determine the size and timing of the buffer, which can range from zero up to 2.5% and is set quarterly ( a bank would then have twelve months to meet the CCyB)

What determines whether the buffer is triggered? In effect the Central Bank  has ‘guided discretion’ with emphasis placed on the stock of existing credit to GDP ratio relative to its long term trend (the’Credit Gap’). In Ireland’s case the ratio exceeded 400% at the peak  but has fallen sharply of late, down to 260% at the end of 2017, reflecting deleveraging by the private sector and the surge in nominal GDP. Consequently the ratio is low relative to the trend and as such would argue for a zero capital buffer, which has indeed been the case since it was first introduced in 2016.

Indeed, the  negative credit gap in Ireland is very large ( the current ratio is 75% below trend) which implies it would take years before it closes even with a resumption of positive credit growth, and therefore years before that measure would trigger a rise in the counter cyclical buffer, However, the Central Bank has recently drawn attention to the rise in new lending  and noted in its most recent review of the buffer (in March) that ‘it could … be the case that the Bank sets a positive CCyB rate prior to the credit gap measures indicating the need to do so‘.

In that context it was interesting that the Bank has just published research here   on the ratio of new mortgage lending to household disposable income. That ratio exceeded 30% at the peak of the boom and then collapsed to a low of 2.5% in 2011 before recovering in recent years and  is currently at 6.7%. Is this too high? The average ratio going back to 1998 is over 13 so that would not indicate a problem but of course the average includes periods where credit standards were very loose. The research piece attempts to answer the problem by estimating a model based ratio, driven by structural factors such as long term interest rates, demographics and an index designed to measure the effectiveness of the financial and regulatory system( the latter two prove to be the key drivers).

In fact the model throws up a current figure close to the existing ratio, and although the growth of new lending is slowing it still exceeds income growth, with the implication that the ratio will continue to rise, albeit at a slower pace. So this new emphasis by the Bank on the flow of new lending as opposed to the stock of existing  private sector debt  may in time be used to justify a rise in the CCyB even though the standard Credit Gap would argue against.

Irish housing transactions fall in q1 with cash buyers still dominating

The CSO’s Residential Property Price index for March showed prices still accelerating nationally, with the annual change at  12.7% from a downwardly revised 12.5% in February and 12.1% at the end of 2017. Property price inflation in the capital slowed, to 12.1% from 12.6% the previous month, but picked up strongly over the rest of the country, to 13.4% from 12.3% . Prices  were particularly strong in the mid-West (Clare, Limerick and Tipperary), rising by an annual 16.4% but fell for the second consecutive month in the Border counties, reducing the annual gain to 8.8%. Within Dublin, house prices in the city rose by an annual 14.2%, with South Dublin lagging, showing  a rise of 9.6%.

The housing market is generally perceived as characterised by chronic excess demand although the exact amount of new supply (house completions) is subject to some doubt. The number of housing transactions is available though, through the CSO, and the figure for the first quarter is actually down on the previous year, at 13,967 versus 14,500. The decline in turnover was particularly acute in Dublin, with transactions down 10% to 4,500.

The number of mortgages drawn down for house purchase in q1 , at 6,400 , was up by some 10% on the previous year, but that still implies that over half the transactions in the quarter (54%) were financed by non-mortgage buyers, a persistent feature of the market. First time buyers account for more than half of loans but are clearly competing against investors, both corporate and individuals, as well as each other, for the limited supply available.

Moreover, the approvals data, a leading indicator of drawdowns, indicates that lending is actually slowing, and quite sharply; approvals in q1 were  down on the previous year, by 4%, and by 13.7% in March alone. We have noted before that the Central Bank’s latest modifications to their mortgage controls, which took effect this year, was an effective tightening, as only 20% of FTB loans can exceed the 3.5 LTI limit , as opposed to an actual 25% last year. Indeed, new  mortgage lending was offset by redemptions and repayments in the three months to March. In other words net lending was negative and with new lending slowing and accounting for less than half the transactions in the market it is hard to argue that prices are being fuelled by credit. Rental yields in excess of 5% is obviously attracting buyers in a QE driven environment of zero short rates and  10 year bond yields of under 1%.