Response awaited on lending practice criticisms

The governor of the Central Bank has said he expects to receive responses from the boards of all the lending institutions to his criticisms of their lending practices. The letter, which was published in The Irish Times, drew sharp criticism from a couple of lenders and has provoked much debate ever since.

It is certainly true that many of the lenders have been exceeding the traditional guidelines on mortgage lending and are lending out more in relation to income than ever before. But they insist that this is a perfectly acceptable practice and that they are only reacting to market conditions.

On the other side the Central Bank argues that the housing market is in danger of overheating, if it has not done so already. Lenders who are "pushing" money at borrowers risk not only pushing the market finally into overdrive but may also be responsible for social consequences if there were ever to be a sharp fall in house prices, creating a UK style negative equity situation ion, where the value of the outstanding mortgage exceeds the value of the house.

The lenders' arguments make sense from a commercial point of view. All other things being equal every lender would like to lend as many large mortgages as possible. And it is certainly true that the Central Bank is an extremely conservative institution whose arguments are certainly of little consolation to first time buyers who see themselves being rapidly priced out of the market.

Lenders such as First Active and Irish Nationwide have publicly insisted that the market is very different now from 15 or 20 years ago. They argue that we are in an era of long-term low interest rates and thus people can afford much larger repayments than ever before.

The mortgage brokers are also, of course, on the side of relaxing the guidelines. They argue that the interest rate on a mortgage today can be 50 per cent less than the average cost over the past 30 years. For example, in the 1970s the average mortgage rate was 11.5 per cent, dropping to some 10.8 per cent between 1984 and 1988, with average mortgage rates now and including fixed rates to 2003 running at 5.5 per cent.

They also point out that longer term mortgages of 30 or even 35 years are a new development as are longer term fixed rates and that both of these innovations make monthly repayments more affordable.

This is undoubtedly the case, but it is equally true that a 30-year mortgage will work out very expensive over the longer term. Irish Permanent, which introduced the concept last year, was taken aback by the negative publicity and quickly stopped advertising the longer terms. Critics also point out that the longer term mortgage has traditionally been the first stop for any borrowers who run into difficulty as it can substantially cut the monthly repayment. But what happens if that borrower is already borrowing over the longest possible time?

Both First Active and Irish Nationwide are also advocates of the disposable income model for mortgage lending. But one of the biggest problems with this model is what exactly is counted as disposable income and there can be extremely wide variations from one lenders to another.

Some lenders take disposable income as monthly after tax income less any fixed repayments such as car loans, while others include costs such as childcare. Other items such as shift allowances, overtime, commission and bonus payments are also sometimes fully taken into account and sometimes only a portion.

There are also questions on what proportion of disposable income should be allocated to mortgage repayments. Most of the lenders suggest that this should vary between 35 per cent and 45 per cent depending on factors such as income levels, numbers of children and savings patterns and so on. They point out that many people are already paying amounts of this kind on rent.

But again this is open to question. And as critics point out it is also far easier to trade down in the rental market than to sell your home and buy a cheaper one should the repayments or rents rise.

But perhaps the biggest problem with the disposable income argument is that the amount you can borrow is based on interest rates at the time you are taking out your loan rather than on the amount of the loan you repay.

This means that someone could take out a loan equating to 45 per cent of their disposable income when rates are at historic lows of under 5 per cent. But if rates were to rise to even 7 per cent the repayment could easily mount up to well over 50 per cent of their disposable income. And for all but the highest of fliers that is very seriously extended.

Of course, the most obvious way around this problem is to insist that anyone taking out a mortgage which will take up a substantial portion of their income has to fix their repayments for a set period of say at least five years. There has been little appetite so far in this state for longer term fixes but many borrowers would probably be willing to take them on if it means affording larger loan.

The governor has also expressed concern about lenders taking parental guarantees, income from room rentals and potential future earnings into account when assessing loan application.

The lenders insist that parental guarantees have always had a place in the first time buyer market and most lenders have always considered potential future earnings particularly for those on fixed grade salaries in the public service. But whether this makes it prudent lending is of course open to question.

But perhaps what annoys the lenders most is the belief that they have been singled out as being responsible for an overheating market.

They point to auctioneers artificially engineering queues for housing simply to hype the market and to builders not only gazumping but also attempting to spread the practice of staged payments (paying the builder at various stages of construction), as other pernicious influences on the market. And in these assertions there is undoubtedly some degree of truth.