Too many eggs in property basket

ECONOMICS:Irish financial institutions have made an exceptionally large bet on the property sector, writes PAUL TANSEY.

IRISH FINANCIAL institutions have placed most of their lending eggs in the property basket. Of the total stock of loans outstanding to the private sector as of March 2008, more than €3 out of every €5 represented property-related lending.

In cold cash terms, loans advanced by Irish financial institutions to the private sector amounted to €401 billion as of March 2008, according to data published recently by the Central Bank. Of this, €251 billion, or 62.6 per cent, comprised property-related lending.

Moreover, while activity in building, construction and property development has suffered a severe slowdown over the past year, the State's banks and building societies have kept faith with their principal source of past profits.

Total private-sector credit increased by €58.9 billion or by 17.2 per cent in the 12 months to the end of March 2008.

Over the same period, the property-related component of private-sector credit advanced by almost €34 billion.

Thus, even in a year marked by a major construction downturn, property-related lending accounted for 58 per cent of the total growth in private-sector credit.

From this pattern of lending it is clear that the fortunes of Irish financial institutions in the future will be dictated largely by the performance of the property sector. While property lending has delivered handsome profits to Irish financial institutions in the past, the future appears uncertain at best.

Property-related loans are of three principal types.

First, and most important, are residential mortgages extended to personal borrowers.

Households borrow principally for housing. Of the €168 billion in outstanding personal debt, residential mortgages account for €142 billion of the total. These residential mortgages represent 35.5 per cent of all outstanding private-sector credit in the State, as can be seen from the table.

However, households have been punting on property as well as acquiring homes in which to live. Of the €142 billion in outstanding residential mortgages, loans for the purchase of principal private residences comprise almost €108 billion or just over three-quarters of the total.

In addition, personal borrowers have raised more than €33 billion in mortgages for "buy-to-let" properties. Besides these speculative plays, the €1.4 billion in mortgages borrowed for holiday homes appears positively puny.

The capacity of households to finance mortgage repayments will remain largely unimpaired for as long as both unemployment and interest rates remain relatively low.

While the unemployment rate, already 5.5 per cent, is forecast by the Economic and Social Research Institute to edge upwards to a peak of 6.9 per cent by 2011, of itself this should not cause a significant level of mortgage defaults at the aggregate level. However, at an individual level, many unfortunate households may find the going tough if jobs are lost.

Trends in mortgage rates are more worrying. The days when the European Central Bank (ECB) beat the drum on interest rates and the domestic banks and building societies marched in step are gone for the present, casualties of the credit crunch.

The ECB has not raised core interest rates in the euro zone since last June. However, in recent months, increases in mortgage rates - and new restrictions on mortgage availability - have become an almost everyday occurrence as scarce liquidity continues to increase the cost of cash on wholesale money markets.

Moreover, the ECB's finger is still on the interest-rate trigger, awaiting an opportune moment to raise rates to counteract growing inflationary pressures within the euro area.

Even with all these caveats, Irish financial institutions should not face any major difficulties on their residential mortgage loan books even if economic conditions continue to deteriorate in the short run. They may need, however, to keep a wary eye on the "buy-to-let" brigade if rents continue to fall while vacancy rates and interest costs edge upwards.

Any difficulties faced by financial institutions on the residential mortgage front pale into insignificance when compared to the problems posed by their lending to property developers, the second strand of Irish property-related lending.

Politely known as lending to real-estate activities, loans outstanding to property developers had reached €83 billion by March 2008.

At that date, loans advanced by Irish financial institutions to property developers accounted for 20.7 per cent of all private-sector credit.

The amount of credit outstanding to developers does not include any accrued interest.

Moreover, in the past 12 months Irish credit institutions increased their lending to property development by €16.2 billion, or 24.3 per cent.

This was the second-fastest rate of sectoral credit expansion in the economy over the past year, surpassed only by financial intermediation, about half of which is related to IFSC activities.

Property developers face particularly difficult market conditions at present.

Deals have dried up. There is little new development. Site values have taken a major hit. Cashflow is at a premium. New house prices are being heavily discounted by developers themselves.

As property prices fall, loan-to-value ratios are rising. There is a major overhang of commercial and retail property. Commercial rents have turned downwards. Interest and financing costs are rising.

That said, the leading developers have deep pockets, filled by 15 years of almost unbroken success.

The third type of property-related lending is credit outstanding to the construction sector, which amounted to €25.6 billion by March 2008, an increase of €2.9 billion or 12.7 per cent on a year earlier.

Leaving aside residential mortgages extended to personal borrowers, the total amount of loans outstanding to property development and construction amounted to €108.6 billion at the end of March 2008.

This represents 27 per cent of all outstanding private-sector credit in the economy.

Irish financial institutions have thus made an exceptionally large bet on the Irish property sector. If it proves to be a beaten docket, the whole economy is in trouble.