Assessing the strength of recent residential real estate expansion
Prepared by Marco Lo Duca, Jan Hannes Lang, Barbara Jarmulska, Marek RusnÃ¡k and Emil Bandoni
Published as part of the Financial Stability Review, November 2021.
Credit-fueled residential real estate booms can present major risks to financial stability. Residential real estate booms and recessions (RREs) have often been associated with deep recessions and financial crises, especially when the RRE boom is fueled by debt. Perhaps the most striking recent example is the housing bubble in the United States before the global financial crisis (GFC). In boom times, a feedback loop of rising prices and credit growth can lead to a subsequent correction of overvalued RRE prices affecting the economy and financial system through multiple channels. A collapse in ERP prices can weigh on household spending through wealth and / or confidence effects. High household debt can further contribute to a reduction in consumption and can lead to defaults if the debts turn out to be unsustainable. Investment loans and business loans can be depreciated if the surge in ERP prices has been accompanied by a double boom in construction. Finally, the bursting of a real estate bubble can seriously affect the supply of credit and amplify the slowdown because the value of available collateral decreases and losses adversely affect the intermediation capacity of banks.
Eurozone ERP markets have seen continued expansion throughout the pandemic, but how worrying are these developments compared to the past? This box compares recent developments in ERPs at the euro zone level with the coming period of the GFC, by compiling indicators in risk ratings according to three dimensions: (i) pressures on prices, (ii) dynamics loans and (iii) the strength of household balance sheets. The analysis is complemented by an assessment of lending standards.
First, house price dynamics and overvaluation are already at levels similar to those seen at the height of the pre-GFC cycle in 2007. The average risk score for all price indicators, which covers four indicators related to real ERP price dynamics and overvaluation estimates, is close to pre-GFC 2007 levels and well above 2005 levels. (see Chart A, panel a). The recent increase in the average risk score reflects changes in the estimates of overvaluation, which are currently higher than the levels observed in 2007 for the euro area aggregate.
Second, vulnerabilities resulting from mortgage lending trends are currently lower than pre-GFC levels, but they are slowly increasing and are heterogeneous across countries. The average risk score for credit indicators, which summarize information from three measures of mortgage lending dynamics and credit spreads, indicates low overall risk (see GraphicA, panel b). This is in stark contrast to the pre-GFC period in 2005 and 2007, when the risk rating was at higher levels. While the analysis of overall credit dynamics is reassuring from a financial stability point of view, there are several euro area countries where annual growth in mortgage credit to households is already above 7% and is accelerating.
Price developments are at levels similar to those observed at the height of the pre-GFC cycle in 2007, but loan developments paint a more favorable picture
Sources: ECB, Eurostat and ECB calculations.
Notes: The lower and upper hinges correspond to the 25th and 75th percentiles. The upper / lower mustache extends from the hinge to the 90th / 10th percentile. The 2021 data is for the first quarter. Panel a: Average risk score for all price indicators covers three-year average real house price growth, house price index versus trend, house price-to-income ratio and estimates overvaluation based on an econometric model (inverted demand equation). In 2014, the 19 countries of the euro zone are covered; in 2021, 2007 and 2005, some countries are missing due to the unavailability of data (Cyprus in 2021; Latvia, Lithuania, Luxembourg, Malta, Slovenia and Slovakia in 2007; Estonia, Latvia, Lithuania, Luxembourg, Malta, Slovenia and Slovakia in 2005). Part b: The average risk score on all credit indicators covers the three-year average real growth in housing loans to households, the deviation of housing loans to households from the trend and the household loan gap. In 2021, the 19 countries of the euro zone are covered, in previous years, some countries are missing due to the unavailability of data (Cyprus, Estonia, Latvia, Lithuania, Malta and Slovakia in 2007; Cyprus, Estonia, Latvia, Lithuania, Malta, Slovenia and Slovakia in 2005). Unavailability of data inevitably results in an imbalanced sample, which could potentially affect the distribution at different times.
Third, household balance sheet vulnerabilities appear to be lower than in the pre-GFC period. Collectively, household debt levels and the debt service burden currently signal a risk similar to that of 2005 and a lower risk on average than that of 2007 (see GraphicB, panel a). In addition, while during the pre-GFC period a quarter of countries had a high risk signal, virtually no country currently has a higher than medium risk signal, which is reassuring from a financial stability perspective. However, this more favorable picture also reflects the low borrowing costs of households, which suggests risks associated with a possible tightening of financing conditions in the future.
Fourth, the risk profile of new home loans appears to be at levels similar to those of the pre-GFC period, by certain parameters. Sharp increases in prices and loans are of particular concern if accompanied by a deterioration in the credit risk profile as measured, for example, by loan-to-value (LTV) and loan-to-income (LTI) ratios. The share of loans with LTV ratios above 90% in newly issued loans currently appears to be higher than in the pre-GFC boom (see GraphicB, panel b). The share of loans with LTI ratios above 6, that is, with households borrowing more than six times their annual disposable income, is currently at about the same level as in 2007. However, as a cost Lower borrowing means increased housing affordability, for a given loan term their debt service charge may currently be lower than before the GFC.
Household balance sheet vulnerabilities are at slightly lower levels than pre-GFC, but current lending standards appear to be at similar levels
Sources: Panel a: ECB, Eurostat and ECB calculations. Panel b: European Datawarehouse GmbH (EDW) and ECB calculations.
Notes: Panel a: The average risk score for household balance sheet indicators covers household debt to disposable income, household financial assets to debt, and aggregate household debt service ratio. The lower and upper hinges correspond to the 25th and 75th percentiles. The upper / lower mustache extends from the hinge to the 90th / 10th percentile. The 2021 data is for the first quarter. In 2021, the 19 countries of the euro zone are covered; in previous years some countries were missing due to unavailability of data (Cyprus, Estonia, Latvia, Lithuania, Luxembourg, Malta and Slovakia in 2007 and 2014; Cyprus, Estonia, Latvia, Lithuania, Luxembourg, Malta, Slovenia and Slovakia in 2005). Unavailability of data inevitably results in an imbalanced sample, which could potentially affect the distribution at different times. Panel b: data available for Belgium, Germany, Spain, France, Italy, the Netherlands and Portugal, total weighted by GDP. The chart uses information on securitized mortgages only (which may lead to selection bias) which may not accurately represent national mortgage markets.
Overall, vulnerabilities in Eurozone ERP markets appear more benign than in the pre-GFC period, but the build-up of medium-term vulnerabilities warrants close monitoring and potentially political scrutiny. Overall, mortgages are less exuberant and household balance sheets seem more resilient now than before the GFC. Furthermore, despite the pandemic, the euro area banking system is more resilient compared to the pre-GFC period, reflecting better quality of supervision, stronger capital positions and, in some countries, measures that address already real estate risks. Nevertheless, the continued build-up of vulnerabilities in residential real estate markets requires close monitoring and possible macroprudential measures.
ECB – European Central Bank published this content on November 17, 2021 and is solely responsible for the information it contains. Distributed by Public, unedited and unmodified, on November 17, 2021 09:16:04 AM UTC.