New Mortgage lending continues to slow amid fall in approvals

Irish household incomes are rising strongly, driven by robust employment growth, and that would normally support the demand for mortgages, particularly against a backdrop of rising property values and low interest rates . Indeed,Irish financial institutions have seen new mortgage lending rise year on year since 2013, albeit at an erratic pace,  reaching €7.3bn in 2017 from under €2.5bn four years earlier. The number of new mortgages drawn down  annually for house purchase rose from 13,000 to over 29,000 over that period.The strength of new lending also began to offset mortgage redemptions a year ago  and the annual change in net mortgage lending  has picked up since, to 1% in September.

The market has had to adapt to  constraints on new  mortgage lending, introduced by the Central Bank in 2015, including a number of changes to the controls, most notably from the beginning of  this year, with FTB lending  allowed in excess of the 3.5 LTI limit reduced to 20% from the 25% observed in 2017. The constraint applies to lending over the calendar year  as opposed to approvals,  and the latter may not translate into actual drawdowns for a number of reasons. Banks have therefore become much more cautious on approvals, paricularly to FTB’s,   and approvals  to that segment  have been falling on an annual basis since March, declining by an annual 3.3% in the three months to September.

In fact approvals to all borrowers for house purchase  is also down relative to last year, at  9,741 in q3 against 9,876 in the same quarter of 2017. The relationship between approvals and  drawdowns can vary a lot from quarter to quarter and actual lending for house purchase in q3 was stronger than the approvals trend implied, albeit still confirming  a slowdown in the pace of  new lending.

Over 8,700 loans for house purchase were drawn down in the third quarter, 8% up on the previous year but compared with annual growth of 9.4% in the first six months, itself about half the pace seen in 2017. The value of lending for house purchase  is also slowing, emerging at €2bn in q3, up an annual 11% against 16.5% growth in H1. The implication is that the average new mortgage is also increasing, as one would expect given rising house prices, but again there is a noteworthy change; the average  mortgage for house purchase in the third quarter was €228,000, just 3% up on the previous year.

Central Bank research indicated that mortgage controls would dampen mortgage lending and house building  while also impacting  house prices and that certainly seems to be playing out, although the possible effect on prices is being offset to some degree by the scale of non-mortgage buying, which still appears to be running at about 50% of transactions. One other striking feature of the mortgage market is the strength of re-mortgaging, such that lending for house purchase has fallen to 80% of total mortgage lending, from 94% three year ago.

Finally, we have trimmed our estimates for new mortgage lending for 2018 as a whole, with €8.2bn now envisaged, including  €6.8bn for house purchase. The number of loans for the latter is projected to be just over 30,000 from 29,400 last year.

ECB rate rise next year not a done deal

In June, the ECB announced it was likely to end its net asset purchase  programme in December and that it expected to keep interest rates at their present level ‘at least through the summer of 2019‘ , albeit with a caveat relating to inflation developments remaining in line with the Banks expectation of a steady convergence to target. Some confusion ensued as to when the summer actually ends but the ECB has since indicated it is happy enough with market expectations of a rate rise at the September or October meetings next year.

Any change is more likely to initially  involve the  ECB’s Deposit rate rather than the Refinancing rate, and the latter is more significant for existing Irish mortgage holders as Tracker rates account for over 40% of the stock of mortgage loans.However,  it would then  only be a short period of time before a rise in the refinancing rate occurred if the ECB was  set to embark on monetary tightening.

Why has the Governing Council decided to signal a probable rate rise? In part because the EA economy performed strongly in the latter part of 2017 and although growth moderated in the first half of this year, to 0.4% per quarter, that is still above what the Bank considers to be potential, which has resulted in further falls in the unemployment rate. The ECB is also more confident that wages are finally responding to the tighter labour market, and as a result expects underlying inflation to pick up steadily , with the ex food and energy measure forecast to average 1.8% in 2020 from 1.1% this year. As such , the Council is more confident of a ‘sustained convergence’ in headline inflation to target.

In fact headline inflation has been above target for the past four months, oscillating between 2% and 2.1%, boosted by higher energy prices. Yet that is also squeezing household incomes ( wage growth was 1.9% in q2) and core inflation ( which excludes food , energy, alcohol and tobacco ) has remained stubbornly at 1.1% or below in recent months, slipping back to 0.9% in September.

The  economic outlook also looks less robust than it did. The ECB maintains that the risks to EA growth are balanced but at their September meeting  it was noted that a case could be made that the risks had tilted to the downside. Since then , the global outlook certainly seems to have deteriorated amid a backdrop of falling equity markets, rising trade tensions, weaker growth in China, a rising dollar, Brexit uncertainties and  Italy’s apparent willingness to breach euro fiscal rules.

Indeed, some of the hard data in the EA has been noticeably weaker over the summer months and the PMIs have also softened, with the latest reading for the EA as a whole dropping to a 2-year low of 52.7 in October, That is consistent with GDP growth of only 0.2% a quarter and it will be interesting to see whether the ECB reiterates its balanced risk view at the upcoming meeting.

It may be that the current weakness in sentiment and activity proves temporary but what may also concern the ECB is that more forward looking indicators also signal weakness ahead. The major European equity indices are all heavily in the red year to date while monetary indicators are not reassuring; M3  growth has slowed to 3.5% while the growth rate of lending to the private sector has remained becalmed at 3.4% in recent months, with mortgage lending slowing a little to 3.2%.

It is unlikely that the ECB will do a volte- face on its forward guidance at this juncture but the risks to their view on inflation have risen and it is not a done deal that rates will rise in 2019.

Irish economy grew by annual 9% in q2 following 9.3% in first quarter.

Having contracted by 0.4% in the first quarter Irish real GDP grew by 2.5% in q2, bringing the annual growth rate to 9.0%, following a 9.3% rise in q1. The implication is that is that the consensus forecast for the year as a whole ( 5.4% on Focus Economics) is too low and indeed our own projection of 6.5% may need revising, although the annual growth rate is likely to slow appreciably in the second half of the year given strong base effects.

One surprising feature of  GDP in recent years is the modest growth recorded in consumer spending, given the pace of employment and income growth. That appears to be changing however, with the annual increase in  real consumption accelerating to 4.4% in the second quarter. Government consumption is also growing strongly, at 4.2%, as is building and construction, up over 13% , driven by a 38% surge in house building. Spending on machinery and equipment excluding aircraft leasing rose by 26% so overall capital formation by the domestic economy rose by 13%, which when added to personal and government consumption gives a 6.2% rise in modified domestic demand, following a similar increase in q1.

Some prefer this concept as a better measure of real activity in the Irish economy but  GDP as a whole is the international standard, which means taking account of aircraft leasing, spending by multinationals on R&D and intellectual property (Intangibles), and of course exports and imports.   Intangibles are notoriously volatile and this was indeed the case in q2, with an annual decline of 63%, with the result that total capital formation actually fell very sharply, by  32%, giving a very different picture than the domestic investment data would imply about investment spending in Ireland.

Most of this Intangible spending is also captured as a service import, and as a result overall imports fell by an annual 6.0%, in contrast to an 11.3% increase in exports. So when account is taken of these largely multinational related activities net exports contributed some 20 percentage points to annual GDP growth, offset by an over 10 percentage points contraction from capital spending.

This contribution approach is particularly problematical when one looks at the quarterly change in real GDP. Here, the net export contribution was 6.8 points, which when added to a strong stock build and a modest rise in dometic demand implies the economy grew by 8.3% in the quarter. The reported figure of only 2.5% reflects  a very large statistical adjustment of  -€2.4bn

Irish Mortgage Arrears and Strategic Defaulters

In July, Permanent tsb sold a portfolio of around 10,700 residential mortgages. According to the bank 2,500  of these borowers were not co-operating and a further 3,850 had failed or refused treatment, which raisies the issue of strategic defaulters or debtors who won’t pay as opposed to being unable to pay. How big is this cohort and how significant are they in the context of Irish arrears?

Mortgage arrears in Ireland  are extraordinarily high by international standards but have been falling steadily for some time now. The number of PDH loans in arrears for over 90 days peaked at just shy of 100,000 five years ago, equivalent to 12.9% of outstanding  PDH mortgages, and according to the Central Bank the latest figure, for q2 2018, was  46,000 or 6.3%.

What determines arrears? We have developed a model in which PDH arrears are positively related to unemployment (affecting the borrowers income) and  the mortgage rate (over 80% of Irish mortgages are on a variable rate)  and negatively affected by the trend in house prices, which presumably is picking up an equity affect.

The chart illustrates the model results and the actual level of arrears. Rising unemployment and falling house prices combined to drive arrears higher from 2009 onwards before reversing course as the labour market improved and house prices began to recover. Those factors are still in place and so the model is continuing to predict lower arrears, although it is also clear that over the past few years there is a systematic error , in that arrears are running consistently higher than the above fundamentals imply.

Of course mortgage loans are secured and the level of arrears will be affected by the number of repossessions , which are also extremely low in Ireland relative to the level of non-performing loans. In fact PDH repossessions are falling and those stemming from a court order (as opposed to a voluntray surrender) peaked three years ago, declining to an annual 439 in q2 from well over 700 in 2015.

Our model predicts an arrears  figure of 32,000 for q2 this year, which is 14,000 below the actual outurn. The implication is that arrears should be falling faster given what is an extremely favourable  economic backdrop, implying a more intractable problem and also picking up some degree of strategic defaulters.

Irish rents boosted by mortgage controls and investor demand.

According to the 2016 census around 1 in 5 of Irish households were in private rented accommodatiom, against under 10% a decade earlier, with the actual numbers more than doubling to over 300,000. Over that period the average monthly rent paid fell by over 20% between 2008 and 2011  before recovering strongly and then pushing to new highs; the 2017 average was €1050 and this year will probably be around €1120 ( the rent actually paid, used here, differs from the asking rent on new lets).

What determines the level of rent? It is generally argued that rents, unlike house prices,  are not prone to speculative bubbles, largely because leverage is not involved, and the market is competitive, with a large number of individual renters. So real factors are likely to dominate  and in  our own rental model two are key. Employment appears to be a big driver of the demand for rental property while the main factor acting to dampen rental growth is the change in  the housing stock relative to the population. Consequently, the persistent upward move in rents over recent years is readily explainable, given a backdrop of surging employment and weak house completions, the latter  proving too low to prevent the housing stock per head from falling.

As can be seen in the chart, our model tracks actual rents very well, although over the last three years the model is underpredicting, by up to 10% in 2018, which implies something else is at play supporting rental values, particularly as there are now controls on existing rents in the major cities.. In our view there are two factors which together are pushing rents above where they might be given employment levels and housing supply. The first is the Central Bank’s mortgage controls, which were first  introduced in 2015 and modified since. The most recent change came into effect this year and reduced the number of mortgages for first time buyers that can exceed the 3.5 LTI limit to 20% from the 25% that had been drawn down in 2017.  Income is the key constraint for this segment of the market and the number of mortgage approvals for FTBs fell in the first half of 2018 relative to the final six months of last year. In other words, would be buyers that might have secured a mortgage on the previous criterion are still renting.

In addition, the combination of high rental yields and low returns on traditional lower risk assets ( influenced by QE) have spurred huge investor interest in the Irish rental market, from Reits, pension funds, foreign investment funds and individuals- a third of transactions  this year are to non-household buyers or an individual not occupying the property and that share has been above 30% since late 2013.

The rental market will eventually cool as the supply of housing increases ( or if there is an employment shock) but rents appear to be higher than the fundamentals dictate  as would- be house buyers have to compete with investors seeking relatively high yields and are also  constrained by controls on leverage.

 

1 in 5 new mortgage loans now not for house purchase

House price inflation in Dublin is slowing according to the recent CSO data; values rose by just 0.9% in the three months to May and actually fell in South Dublin, by 1.0%. An increase in supply is widely expected to dampen price pressures but new house sales year to date  in the Capital are marginally down on the same period last year, as are total transactions, so demand factors may be playing a part. London and Dublin prices have been highly correlated in recent years and the price falls seen in the former may be having an impact on investor interest in the Dublin market. For buyers with Irish mortgages the latest data  from the BPFI, on approvals and drawdowns, indicates that the recent tightening of mortgage controls is impacting and that affordability is becoming more important as a constraining factor.

Mortgage approvals for house purchase fell by an annual 4.6% in June and  rose marginally in the second quarter as a whole ( by 0.8%) . FTB approvals fell in q2, however, by 0.8%, and have been weak since the the first few months of the year; 10,882 mortgages were approved for first time buyers in the first half of 2018, against over 11,000 in the same period last year. A quarter of mortgage loans to FTB’s exceeded the 3.5 LTI limit last year and the permitted excess was reduced to 20% in 2018, so one might expect that to dampen lending for house purchase, particularly as affordability ( the annual payment on a new mortgage relative to income) has deteriorated given the rise in house prices and associated increase in the value of an average new mortgage. Indeed, it is noteworthy that the average new mortgage for house purchase in q2 of €225,500 was broadly unchanged on q1 and 5% higher than a year earlier, as against a 9% increase in 2017.

The number of mortgages for house purchase  actually drawn down in q2 amounted to 7,381 or 9.2% above the same period in 2017, a slower pace of  growth than the 9.6% increase in q1 and the 14.7% recorded in q4 last year. The value figure was €1.7bn, up an annual 14.7%, against an 18.5% annual rise in q1. The growth in total mortgage lending ( i.e including top-ups and re-mortgaging/ switching) was unchanged at 22%, however, amounting to €2bn in q2 , driven by  a doubling of re-mortgaging/ switching over the year. Indeed, the latter amounts to 14% of total loans in q2 and one in five mortgage loans are now not for house purchase, the highest share since 2011.

In sum, the growth in mortgage lending for house purchase is slowing, and the average new mortgage is also growing at a more modest pace , with FTBs squeezed by affordability and tighter mortgage controls. The steady stream of lower mortgage rate announcements indicates banks are responding, and that competition is more intense in re-mortgaging and switching.

Irish economy contracts in Q1 but annual growth increases to 9.1%

The Irish economy contacted in the first quarter of 2018 according to preliminary data from the CSO. Real GDP declined by 0.6% , largely due to a sharp  5.8% fall in exports, including both goods and services. Trade data  indicated that exports leaving Ireland had risen substantially so the weaker figure was due to a fall in contract manufacturing (offshore exports credited to Irish based firms).  Final domestic demand was broadly flat, with modest increases in investment (0.6%) and government spending (0.4%) offsetting a 0.3% contraction in consumer spending. Surprisingly, perhaps, construction spending actually fell, by 0.4%, but this was offset by a 9% rise in spending on machinery and equipment. The big negative contribution from exports was in contrast to a very large stock build which added over 3 percentage points to GDP growth.

Looking at the annual change, real GDP growth in q1 was 9.1%, largely driven by the external sector ( export growth of 6.1% against a 1.1% fall in imports) and the strong stock build. The weakness in imports partly reflected a fall in investment spending of 3.8%, with growth in construction and machinery and equipment offset by a plunge in R&D expenditure, which largely relates to multinationals and deemed a service import.

The CSO release incorporated revisons to past data, including  reductions in the level of GDP; the 2017 figure is now  some €2bn lower at €294bn. Real growth last year is also now lower, at 7.2% versus an initial 7.8%. Last year’s quarterly figures have also changed, although the previously published pattern- weak growth in the first half of the year followed by a surge in the second half- is still intact. That  still implies that the anual growth rate will slow as the rest of the year unfolds, which of course is required if the consensus growth figure of around 5.5% is achieved.

The revisions also impacted Modified National Income, the concept developed by the CSO to adjust GDP for the effect of multinationals on profits, R&D expenditure and aircraft leasing. The 2016 figure is now put at €176bn, from an initial €189bn, with the 2017 estimate at €181bn, or less than 62% of published GDP. The CSO believes that this modified figure is a better indicator of Irish income although in 2017 it grew by just 3% and that is in nominal terms, which sits uneasily with other indicators such as  the growth in employment , tax receipts and household incomes .

Full Employment in Ireland-are we there yet?

The Irish unemployment rate fell to a fresh cycle low of 5.1% in June, from 5.6% in March and 6.6% a year earlier. The monthly estimate is subject to revision but on the face of it implies that  employment growth has accelerated from an already strong pace and that Ireland is approaching full employment. The  speed of the decline has  certainly surprised most analysts; the Department of Finance   anticipated unemployment bottoming out next year at 5.3% from an average 5.8% in 2018. In fact, Government budgetary projections are predicated on the view that the economy is already operating above is potential, although one rarely hears that articulated by Ministers.

Full employment does not mean a zero unemployment rate; there will always be churn in the labour market (frictional unemployment) and some workers may not have the skills, education or aptitude to take up the available jobs (structural unemployment). The scale of the latter, in particualr, is hard to gauge so estimates of what unemployment rate is consistent with full employment often vary and can change over time; the unemployment rate has surprised to the downside of late in both the US and the UK, for example. Ireland has also experienced  lower unemployment in the past, with a rate under 4% in the early noughties and a sub 5% reading  in the years before the 2008 crash.

That perhaps argues that the unemployment rate could certainly fall further, and particularly as the participation rate ( that proportion of the population over 15 in the labour force) is still much lower than it was a decade ago, averaging 62% over the past year as against well over 66% in 2007. A return to the latter level would equate to an additional 170,000 joining the labour force, equivalent to three years  employment growth given the current pace of job gains.

That kind of a move in the participation rate seems highly unlikely, however, given the modest level of net immigration currently seen relative to the pre-crash period. Nonetheless, the pool of available labour is bigger than captured in the labour force data, as the figures also record those who are seeking work , but not immediately, as well as those available for work but not yet seeking it. The CSO defines these two groups as the Potential Additional Labour Force (PALF) and this figure is sizeable, amounting to 120,000 in the first quarter. The unemployment rate adjusted for the PALF is therefore much higher, at 10%, although it is problematical to compare this with the historical experience as there was a step jump following the switch to a new survey methodology in the latter part of 2017.

Employment is now marginally above the pre-crash peak  and if labour is getting scarcer one might expect to see an acceleration in wage growth as firms bid for workers. That has not been evident, however, at least as yet. Average weekly earnings in the private sector rose by an annual  1.8% in the first quarter of 2018 following a 1.7% rise in 2017, but that followed  a 2.3% increase in 2016. Low consumer price inflation may be a factor but wage inflation is surprisingly soft in some areas where there is perceived to be a scarcity premium, notably construction, with average earnings growth of 1.1 % in the first quarter and only  0.3% last year.

It is also worth noting that although total employment is again  around the pre-crash peak  the composition  is more evenly distributed across sectors. Then, 10.5% of jobs were in construction alone but that proportion in 2018 is only 6%, with the total employed some 100,000 below the peak. Employment in industry too is 20,000 below the pre-crash level  and also lower in retail (36,000) and financial services (4,000) Indeed, although some private sector areas have seen job gains, notably Hotels and Restaurants (30,000 ) and Professional and Scientific (12,000), most of the increase has occurred in areas dominatd by the public sector, including Education (30,000) and Health (40,000).

Ultimately, the clearest sign that the economy has reached full employment is when the unemployment rate stops falling and that is only observed ex-post. However, the current distribution of employment, the absence of aggregate pay pressure and the relatively low participation rate all point to the likelihood of unemployment falling further in the absence of a demand shock. The latter is always a risk, of course, be it from Brexit or from a broader global slowdown.

New supply data implies housebuilding consensus may be too optimistic.

Annual house price inflation accelerated  to 13% in April, the strongest pace for three years, bringing the increase from the cycle low to 76%, albeit still leaving prices nationally some 20% below the previous peak. Credit does not appear to have played a significant role in this recovery, at least to date ( net mortgage lending has only recently stopped falling and new lending appears to account for only half of transactions) and analysts have emphasisied more fundamental factors on the demand and supply side of the housing market.

In that model  housing demand has exceeded supply for some time now with the implication that prices will continue to rise ( absent a shock to employment or a steep rise in interest rates) until housing supply has picked up to a level which brings balance to the market. Supply, as in new housing completions, is picking up from historically low levels and in time is generally expected to approach and then meet estimates of annual housing demand. For example, the ESRI expect completions to exceed 23,000 this year and to reach 37,000 by 2020.

That expectation was based on completions data from ESB connections which put the annual figure at over 19,000 last year, although some thought that overstated the actual flow of new properties. Fortunately, the CSO has now started to publish completion figures on a quarterly basis, based on a range of sources , and they imply that completions may be much lower than generally expected over the next few years. The new figures, dating back to the first quarter of 2011, show completions of  57,000 over the past seven years, against an ESB total of over 90,000, a difference of 33,000. Last year’s total is now put at under 14,500, or 5,000 less than the ESB figure, and for this year the CSO figure  for q1 is 3,500. The latter may have been adversely affected by the weather but a full year figure of 17,000 or so seems much more likely than  anything approaching 25,000.

The implication is that the housing stock has been growing at a slower pace than previously thought  and that the stock  per head of population , a key variable in many demand/supply models, is still falling ( it started to decline in 2011) and will continue to decline for the next few years. Indeed, new population projections by the CSO highlight that demographic pressures will remain a feature of the Irish market; the population is projected to grow by over 300,000 by 2021 on a high net migration scenario or by 1.3% per annum, against a housing stock still growing by  well under 1%.

 

 

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.