Chapter3 Bar

Chapter 3

Box 3.6 Heterogeneity in European housing markets 

Housing finance has received a great deal of attention as a driver of financial crisis. During the early 2000s international capital flows had been channelled into mortgage lending through structural changes and deregulation of the finance industry. In the wake of a severe mortgage credit crisis in the United States in 2007, the eurozone and the United Kingdom avoided the worst of the financial fallout by keeping mortgage rates at very low levels, although Ireland and Spain experienced ballooning defaults by real estate developers which led to banking crises. Hungary, which was unable to restrain debt service costs through central bank action, had to restructure its retail mortgage portfolio, and several other European countries are still seeking a soft landing from inflated house prices.

There are a number of policies and practices at national level which can determine the likelihood of housing-related financial crises. Many would not be automatically addressed under a European banking union. This analysis considers the most important ones and the prospect of EU-level remedial action.

Mortgage products and underwriting standards

Mortgage product design and underwriting standards differ strongly across the European Union.40 Products in western Europe vary mainly in respect of the amount of interest rate risk they convey to households. This was not the case before the 1980s, when mortgages in Europe were granted as either fixed-rate (on the continent) or with interest rate fluctuations smoothed by lenders (as in Ireland and the United Kingdom). Matched funding on these terms was provided by specialised mortgage banks issuing covered bonds, or specialised building societies. Universal commercial and savings banks had very low market shares.

Consequent upon financial liberalisation in the 1980s and 1990s, universal banks moved into the mortgage market. Variable-rate lending based on interbank indices quickly gained importance. In Portugal and Spain these products displaced fixed-rate lending altogether in the 1990s. In the following decade, the Irish and UK markets moved from managed variable interest rates to the more volatile indexed rates. Even the Danish market, where fixed-rate terms of up to 30 years had been the standard, eventually shifted to variable-rate lending. Germany and the Netherlands are the only remaining EU countries whose systems offer almost entirely fixed-rate loans, although Belgium and France maintain a significant fixed-rate market share. In central and eastern Europe, with the exception of the Czech Republic, variable-rate loans dominate the mortgage market. Interest rate risk in these countries is often compounded by the denomination of loans in foreign currency. In Hungary, for example, many households prior to 2008 borrowed in Swiss francs at low interest rates. In late 2008 the strong appreciation of the Swiss franc and an increase in Swiss franc loan rates produced a payment shock for borrowers whose incomes were mostly denominated in local currency.

While underwriting payment-to-income (PTI) limits in Europe do not vary much across countries, their effectiveness in shielding lenders from default risk is highly dependent on the mortgage product. Because variable-rate loans tend to have lower interest payments for a given loan amount than fixed-rate loans, mortgage lenders in countries such as Ireland and Spain allowed young and low-income borrowers into the market who would not have met PTI limits if they had been borrowing at a fixed rate. These borrowers were also exposed to interest rate volatility. When monetary policy rates rose in 2007, their payments quickly ballooned beyond PTI limits.

At the same time, there remains significant heterogeneity in underwriting loan-to-value (LTV) ratios across Europe. Excessively high LTV ratios of loans to low-income households enhanced the severity of the UK mortgage market crisis of the early 1990s. In Ireland LTV ratios offered by banks increased during the 2000s as new bank entrants targeted young and low-income households; later, lenders tried to catch up with rising house prices. In the Netherlands LTV ratios of 100 per cent and higher became the standard because of major tax subsidies, both for mortgage interest and repayment vehicles that retire the loan. In contrast, in neighbouring Germany, which does not permit interest deduction, an 80 per cent LTV ratio is considered the norm. As a result of this diversity, the European Parliament could not agree on defining 100 per cent as the LTV limit when deliberating on the Mortgage Credit Directive earlier in 2012.

The structure of housing markets

Even if products and underwriting standards could be successfully standardised, cross-country differences in housing finance risks would remain because of variations in the structure of housing markets. These have an influence on borrower quality and house price dynamics in a way that regulation and supervision may not be fully able to offset.

Local housing supply policies greatly influence the risk environment of housing finance. Restrictive land use, density and zoning policies, as well as under-investment in infrastructure, increase the reaction of house prices to a given change in liquidity provided by banks. Within the transition region, for example, Estonia pursued elastic land supply policies around the capital, Tallinn, while Latvia maintained rigid urban land policies in Riga. As a result, the credit boom of the 2000s stimulated construction to meet demand in Tallinn, but fuelled sharp price rises in Riga. When credit and prices collapsed in 2009, default rates were far higher in Riga.

The existence of a sufficiently large rental housing market is perhaps the most important structural factor. As Chart 3.6.1 suggests, a large rental sector is likely to reduce the participation of young and lower-income households in the retail mortgage market. These groups tend to have low levels of housing equity and high vulnerability to changes in interest rates and unemployment. Making it easier for them to rent therefore reduces the average LTV ratio as well as PTI risk in the retail mortgage market, without necessarily preventing them from eventually owning a home. Although this implies that rental landlords will bear the default risk associated with younger and lower-income households, they may be in a better position to manage it than banks, not least because evicting a defaulting renter is far less costly than repossessing and auctioning a house. In addition, public housing allowances – which are harder to justify as a support for ownership – can help stabilise rent revenues.

Source: ECB (2009) and OTB Research Institute for the Built Environment (2010).
Note: “(<35y)” stands for under 35 years of age, “<60%” for less than 60 per cent.

For these reasons, the United Kingdom reversed its housing policy after its mortgage crisis in the early 1990s and started promoting non-profit rental housing associations and small landlords. These steps are likely to have mitigated the impact of the 2007-08 market downturn on mortgage defaults. Similarly, Germany's large rental sector (rather than mortgage regulation, which was liberalised in the 1980s) has likely kept its retail mortgage market stable. Denmark and the Netherlands, also with large rental sectors, can sustain elevated levels of mortgage debt carried mostly by middle-income households. In Ireland and Spain, in contrast, the absence of a rental housing option likely contributed to high default rates among young and low‑income households. Rental housing had almost disappeared in Spain due to harsh rent controls and extensive tenant protection. Similarly, in most transition economies there is a severe shortage of rental housing catering to young and low-income households, as rental accommodation was decimated by mass privatisations.41

Prospects for harmonising European housing policy

A pan-European policy intended to minimise the risk of financial crises originating in the housing sector would have to regulate, and potentially intervene in, a number of markets. While the powers of the European Union are expanding, full synchronisation of national policies down to locally determined land and housing supply remains implausible, even in the long term (see Table 3.6.1).

European and national responsibilities as of 2012

Policies defined largely by...
European Union (Eurozone) Member State
Capital Markets 
(Monetary policy)
Investor protection
Bank / insurer investor regulation
Investment vehicle regulation
General securities regulation
Capital market taxation/subsidies
Capital market supervision
General pension fund regulation
Mortgage bond regulations
Asset-backed securities regulations
Housing Finance Markets 
(Lender of last resort)
Depositor protection regulation
Banking/insurance regulation
Consumer protection
Cross-border collateral access
Banking/insurance taxation/subsidies
Banking supervision/resolution
Special mortgage banking regulation
Mortgage consumer protection
Public/non-profit banking investment
Sureties law (mortgage guarantees)
Housing & Ancillary Markets 
  Collateral management/foreclosure
Consumer insolvency
Private rental housing regulation
Public/non-profit rental housing regulation
Public/non-profit rental housing investment
Property taxation/subsidies
Real estate brokerage regulation
Land use, zoning, sub-divisioning and density regulations
Urban transport policies

Source: Finpolconsult.
Note: Text in red denotes areas in which a full or limited transfer of responsibilities from the national to the European level is currently under discussion or implementation.

The European Union is precluded from housing policy by its treaty, for fear of creating a similar sector to agriculture in terms of subsidisation. Assuming such concerns could eventually be overcome under a fiscal union, efficiency questions would also arise: housing investment policies have been systematically decentralised since the 1980s in the search for efficiency gains through tailored local models.

The mortgage sector is a good example for the time scale needed to reach even limited agreement on regulation. The Mortgage Credit Directive proposed by the European Commission in 2011 followed 20 years of discussion, but it only harmonises consumer protection regulation (for example, giving member countries leeway in setting LTV standards). There is little doubt that harmonising rental law would take decades.

The impossibility of a prompt unified housing policy means that a European banking union with full mutual insurance of bank debt could suffer from moral hazard problems. For example, member states might be dissuaded from investing fiscal resources in social housing programmes or forcing borrowers into costly fixed-rate protection, as bank lending to low-income households is indirectly protected against losses through membership of the banking union.

40 See ECB (2009) and Dübel and Rothemund (2011).

41 Dübel et al. (2006).

42 In practice, this could be one group in which most business is conducted by smaller committees focused on specific host countries; or possibly three groups focused on emerging European countries in the eurozone, the non-eurozone EU, and the EU neighbourhood, respectively.


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