Irish Central Bank tightens mortgage controls

The Central Bank introduced macroprudential controls on Irish mortgage lending in early 2015 with a focus on Loan to Value (LTV) and Loan to Income (LTI). The controls are subject to annual review and were initially amended  in January 2017 with  another set of ‘refinements’ just announced , to take effect from 2018.The latter includes quite a significant modification to the way the LTI control operates and in our view represents a tightening of credit controls, although one does not get that impression from the Central Bank release.

Currently, 20% of Principal Dwelling House (PDH) lending can exceed the 3.5 LTI limit. Data released by the Central Bank  shows that  PDH lending for the first half of 2017 amounted to €2,770m and that €487m exceeded the limit, or 17.6%, indicating that the limit is being observed, at least for that six month period  (  it  actually applies over a  full year).  Yet the data reveals a marked divergence between FTB’s and other buyers; over 24% of lending to the former was in excess of the 3.5 LTI limit, while for the latter the figure was only 10%.

Clearly the LTI limit is a much bigger issue for FTB’s in an environment of scarce  supply, strong house price inflation and where around half of house sales are going to non-mortgage buyers . As the controls currently stand there is no specific constraint on the amount of  FTB lending in excess of the LTI limit , as long as the overall lending figure is within the 20% exemption.

The Central Bank has responded by amending the LTI exemption. From January the overall 20% limit no longer operates, with  a 20% exemption  limit allocated to FTB lending and 10% to other lending. Had these applied over the first half of the year FTB lending would have been €61bn lower, with no material impact on other lending.

Just over half of PDH lending is currently to FTB’s so the implication is that there is now a 15% overall exemption limit in practice, given a 20% allocation to FTB’s and only 10% to other buyers. The Central Bank argues that FTB lending is less risky than to second or subsequent buyers ( although credit agancies seem to have a different view) , so justifying differential LTV’s and now LTI exemptions, but the changes would appear to mask an effective tightening in overall lending standards. The Bank notes that ‘the refinement is not expected to have a significant impact on the functioning of the market’  but it clearly will limit overall exemptions relative to the  current postion.

Cyclical Mortgage Controls might be better

The Irish Central Bank surprised many people, not least the Government I suspect,  by announcing changes to their macroprudential mortgage rules. The Bank had called for submissions on the controls , and received a good number, including one from this writer , but the rhetoric from Dame Street did not indicate a great appetite for change. In the event the Governor announced what was termed  ‘refinements to improve effectiveness’. Lenders have been granted  more discretion, in that 20% of total lending to non First Time Buyers (FTB) can be above the 80% Loan to Value (LTV)  ceiling , a change from the previous 15% discretionary figure, while FTB’s can now borrow up to 90% LTV , regardless of the price of the property (that limit was previously capped at €220,000). Moreover, up to 5% of lending to FTB’s can be above 90% LTV.

The Loan to Income (LTI) ceilings were unchanged, at 3.5,  and of course the LTV limits are just that; banks are not compelled to adjust their existing loan standards. Indeed, a recent Central Bank analysis of mortgage lending over the first half of 2016 showed that lenders were not fully utilising their available discretion to exceed either the LTI or LTV rules.

These changes also come in the wake of the Government’s Help to Buy scheme, which allowed FTB’s claim back income tax ( to a maximum of €20,000) to be used towards the deposit on a newly built home. One wonders if that subsidy would have been introduced had the new rules been in existence, as the combination of the two certainly provides a massive boost to FTB’s buying power in the property market. Take a couple with a combined income of €75,000,   borrowing €250,000 . Prior to the new rules they would have had to save €35,000 in order to buy a property worth €285,000,  perhaps taking four or five years. Now they could increase their loan to €256,500 (still inside the LTI limit)  and only have to find €8,500  as a deposit if the property was a new build ( a 10% deposit of €28,500 less the €20,000 from the Help to Buy scheme) implying it would take a far shorter time to amass that sum. Alternatively, all or part of their original savings could now be used to buy a more expensive house. In effect, purchasing power has been brought forward and leverage increased.

Credit appears to be driving only about half of current transactions in residential property but given the existing supply issues the boost to FTB’s buying power may well have some impact on price, although that is the mechanism which will eventually lead to a bigger supply response, albeit with a time lag.

The controls are designed to ‘enhance the resilience of both borrowers and the banking sector’ but are actually pro-cyclical; an 80% LTV still means the average size of a new mortgage will rise at the same pace as house prices ( for example, at a house price of €200,000 the mortgage would be €160,000  but rise to  €240,000 if house prices rose to €300,000). A cyclically adjusted LTV might be more appropriate, as put forward in our submission to the Central Bank. When house prices are low and credit growth weak, for example, the LTV limit might be 85% or 90%, but then decline as prices and credit growth pick up, to perhaps 75% or 70% at the top of the cycle. This would not eliminate cyclicality, but would dampen it, particularly if the LTI limits were also flexible over the cycle.

One obvious issue with this proposal is that the Central Bank would have to decide where we are in the credit and house price cycles. However, they currently have to do that anyway, at least in terms of credit; under new capital rules, some banks have to set aside additional capital ( counter-cyclical buffers) in good times in order to cushion losses in bad, and the Irish Central Bank sets this buffer every quarter, in part dependent on the current credit/GDP ratio relative to the long term trend. The buffer is currently set a  zero, reflecting the fact that credit is still contracting and the ratio to GDP is very low.

In addition, the Bank has a number of models that monitor residential prices relative to fundamentals. Deciding whether house prices are overvalued is not an exact science (  as it happens most models point to undervaluation , if anything, at this time) but if a number of indicators were to flash red the Bank could lower the LTV and LTI limits if a cyclically adjusted regime was in effect.

One final point. Research at the ECB supports the case that a debt service limit is more effective  in protecting borrowers and lenders than other macroprudential controls, as again outlined in our submission, although at the moment the absence of a credit register is a key impediment to implementation.