A key factor in the financial crisis was the exceptionally risky behaviour of banks’ lending to property developers and to households.
In turn, there was an abject failure by the Central Bank to ensure that banks did not take excessive risk, and also to ensure that borrowers did not bite off more than they could chew through excessive mortgages. The splurge of lending drove house prices to unsustainable levels by 2007. The rest is history.
As the economy began to recover in 2015, the Central Bank acted to ensure that such a failure by banks or borrowers would not happen in the future. It put in place restrictions on how much banks could lend to individual households, based on the value of the house and the mortgage holder’s income. These measures were designed to manage financial risk, not to control house prices.
Before deciding on the calibration of the restrictions, the Central Bank organised extensive consultations and undertook important research. The research showed that, contrary to what one might have expected, first-time buyers had been less likely to default on their mortgages than those who had traded up. Hence the regulations were tweaked to allow first-time buyers to borrow up to 80 per cent of the value of a house.
One uncertainty is what Irish and European households will do with the large volume of exceptional savings built up when we couldn't go out and spend
Speaking last week, the governor of the Central Bank, Gabriel Makhlouf, noted that, in the absence of the mortgage measures, the house-price-to income ratio would have been between 4.9 and 5.4 as at March 2019, compared with the actual level of 4.4 times.
With almost 50 per cent of current mortgages having been issued under the new rules, the borrowers had greater buffers to deal with a temporary loss of income due to the pandemic. As a result, the current pandemic-related downturn has been marked by relatively little mortgage distress.
As explained by the Central Bank governor, the loan-to-income limits provide a buffer against the effects of income and employment shocks, which increases the resilience of borrowers and reduces the probability of default. Loan-to-value restrictions provide an equity buffer against house price declines, and directly lower the loss in the event of a default.
House prices reached a floor in 2013, the year the economy began its recovery. In the intervening period house prices have risen by 90 per cent, with the severe shortfall in housing supply driving prices back up to 2008 levels, despite wider pandemic challenges.
However, as separate research by the Economic and Social Research Institute and Central Bank has shown, the cautious approach to mortgage borrowing has slowed the pace of rising house prices. Had more money been lent to buyers, it would have pushed house prices even higher. While developers would have benefited, the increased risk would have fallen on borrowers and banks.
If the Government wants to tackle house price inflation, it needs to seriously ramp up supply
Six years on, the Central Bank is taking a second look at the mortgage measures to see if they should be tweaked to better manage potential risks.
As economies recover from the pandemic shutdown, one uncertainty is what Irish and European households will do with the large volume of exceptional savings built up when we couldn’t go out and spend. The scale of these savings in the Republic amounts to more than twice what was spent on new houses in 2019. While only a fraction of these savings is likely to enter the housing market in the form of higher house deposits people can now pay, this could still exert major upward pressure on prices.
After the second World War, which also had led to exceptional household savings, many countries experienced a surge in house prices as some of this cash went on housing. In the United States, although housing supply responded quite rapidly, house prices rose by 25 per cent after 1945. In Sweden, the Republic and the UK, by 1948 real house prices had risen by more than 50 per cent.
Given the exceptionally slow response of Ireland’s housing supply, there must be a real concern that house prices will surge here over the next 18 months. Already in the Netherlands they are up by 13 per cent on a year ago, and in the US they are 24 per cent higher. Can Ireland be far behind?
While a tightening of mortgage rules could help calm house price pressures over the next 18 months, this is not the job of the Central Bank: its remit is to protect financial stability.
If the Government wants to tackle house price inflation, it needs to seriously ramp up supply, and it should stop throwing petrol on the flames through schemes that put more money in the hands of buyers, only to end up in the pockets of sellers.