The ECB compares the European real estate market with the years of the last real estate bubble in the US, which led to the financial crisis of 2008, due to the recent rise in house prices and the increase in mortgage credit. Three of the five risk indicators are already above 2007 levels. There is concern about the quality of loans, the capacity of families in the face of a tightening of financial conditions and certain countries where there is an excessive growth of credit.
The real estate bubble in the United States, which was brewing in the first decade of the century and ended with a huge financial crisis in 2008, left an important lesson, burned, for central banks: much of financial stability depends on the health of the housing market. With the loss of memory of the passage of time, it seems that the previous crisis was a thing of the banks; but the origin was in the brick. The price of real estate grew wildly hand in hand with the volume of credit.
To continue fueling the strong growth in demand for home purchases, banks lowered the bar on requirements to grant mortgages. Under these circumstances, subprime mortgages were born, mortgage loans with a high probability of default, toxic credit in the balance of banks, which was asleep until the wave of defaults began. A true survival manual for identifying overheated real estate markets, in the eyes of central bank supervision.
The ECB economists Marco Lo Duca, Jan Hannes Lang, Barbara Jarmulska, Marek Rusnák and Emil Bandoni establish five indicators, taking the reference of the US episode, to assess the current state of health of the European real estate market, within the financial stability report of the institution. The experts take into account the pressure on prices, the evolution of credit, the soundness of household finances, the risk assessment of capital, loans and the payment capacity of families.
They were five indicators that broke all the molds in the previous crisis and that have become capital sins to avoid so as not to fall into a new real estate bubble. ECB economists point out that several are being fulfilled in the euro zone market. First, “the overvaluation of prices is already at levels similar to those observed at the height of the cycle before the financial crisis in 2007.” The ECB analyzes the average risk of the evolution of prices, detecting that it remains close to the levels prior to 2008 and well above the levels of 2005.
The work of the experts downplays this extreme by taking into account the indicator of credit volume, the housing bubble is closely related to a credit bubble. “The vulnerabilities derived from the evolution of mortgage loans are currently below the levels prior to the financial crisis”, although he acknowledges that the volume is increasing slowly and is a heterogeneous aspect in the euro zone, which must be taken into account .
“While the analysis of aggregate credit dynamics is reassuring from a financial stability perspective, there are several countries in the euro area where annual growth in household mortgage credit is already above 7% and accelerating.” . From this level on, the alarms start to go off at the ECB. And they are a good handful of countries that are in this situation: Baltic countries, Malta, Luxembourg or Slovakia. But also more important markets like Belgium. And it is dangerously close to 7% Germany.
Another indicator that should give reassurance is the level of household indebtedness. The 2008 crisis triggered restrictive fiscal measures in Europe, austerity policies, aimed at correcting over-indebtedness. The volume of credit of European families suffered an accelerated de-leveraging process led by peripheral countries. In Greece and Ireland, annual home loan rates continue to fall. In Portugal and Spain, they grow moderately.
“The vulnerabilities of household finances appear to be lower than in the period before the financial crisis, the levels of household debt and the interest burden currently indicate a risk similar to that of 2005 and a risk lower on average than in 2007 “, they explain in the document. And he highlights that by country none of them set off alarms, “which is reassuring from a financial stability perspective.”
However, experts acknowledge that this calm can be quickly reversed if there is a change in interest rates. This still photo of household solvency takes place in a low interest rate scenario. This is especially relevant for households with floating rate loans or for households that will need to refinance loans at maturity.
Relative loan volume exceeding 90% of purchase price financing far exceeds 2007 levels
This potential weakness is reflected in the quality of mortgage loans. In this aspect indicators already exceed pre-crisis levels in 2008. If there is a collapse in house prices, it directly affects the credit risk assumed by the banking sector in mortgages. On the one hand, the relative volume of loans that exceeds 90% of the purchase price financing far exceeds 2007 levels. The prudent risk for a bank is to assume 80% of the home’s valuation. According to ECB calculations, approximately 50% of mortgages exceed this level. In the event of default on the mortgage, the home acts as collateral. The bank can recover part of the loan through the value of the property. If there is a drop in prices, the loan becomes riskier for the bank.
The banks’ risk assessment also takes into account the borrower’s liquidity capacity. The ECB uses the indicator that the mortgage loan should not exceed a family’s annual income by six times. Currently, it is approximately at the same level as in 2007. The last two variables act against the balance sheet of the banks themselves. The higher the credit risk, the higher the level of provisions to face possible defaults. And the higher the level of provisions, the lower the entity’s capital resources to allocate them to loans.
The housing boom and bust is inevitably associated with deep recessions and financial crises, ECB economists note. Experts explain that the phase of rising house prices is fed back with an increase in the volume of credit. In high probability, the subsequent result will be a subsequent correction of overvalued prices, with negative implications for the economy and the banking system. The collapse in prices leaves households with high indebtedness, linked to assets in free fall, which turn mortgage loans into toxic credits for banks.
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