Panayotis Thomopoulos: Recent developments in housing finance
Speech by Mr Panayotis Thomopoulos, Deputy Governor of the Bank of Greece, at the European
Finance Convention, Athens, 31 January 2007.
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Ladies and Gentlemen,
It is a great pleasure and an honor to address such a distinguished audience of practitioners in the
area of finance on such a topical issue. Before speaking succinctly on the housing market and its
interlinkages with the rest of economy, I would like to say a few words about long term issues and
challenges. In particular in the field of mortgage lending the effects of today's decisions will be felt
during the next 25 or even 35 years, when the last installment of a 25 or 35-year loan is repaid.
Today most analysts and market actors seem optimistic about future developments and this because
markets are mainly preoccupied with the short term, and tend to project current trends into the future.
And if you want to lengthen the time horizon, many analysts, traders etc. will cite the famous words of
J. M. Keynes, "over the long run we are all dead", thus bringing the discussion back to current
developments and a focus on the short-term. Indeed reading the figures and short-term forecasts
about the world economy presented by the OECD, IMF and others one cannot but be optimistic. The
global economy has been growing at an average rate of almost 5% since 2001, and the short-term
prospects point to a continuing high rate of growth. The world has not seen such a high long-term rate
of growth since the 1950s and 1960s. Moreover, whereas in the past only a small proportion of the
world population (1/4) were reaping the dividends of growth, nowadays nations accounting for almost
3⁄4 of the word population are benefiting from rising standards of living, though to varying degrees.
Are these revolutionary developments and do they signal a new area of the world history? I believe the
answer is yes and yes. The developed world, that is essentially EU, US & CND, Australia, N. Zealand,
Japan & Korea, are no longer the only global actors, and the consequences of the economic
upheavals are being felt in the world political arena, cultural attitudes, social behaviour and
unfortunately the climate across the globe. Every year more than 50-60 million people from emerging
market countries, essentially in China and India, are entering the market economy, both as consumers
and as producers of tradeable goods and services. The previous great leaps were the absorption into
the market economy of only 70 million people from Korea, Taiwan, H.K. and Singapore in the 1970s
and 1980s, that is, over a 20-year period, and the absorption of an additional 30 or a little more million
from the European transition economics over the last 10 years. But those leaps implied a very slow
rate of absorption, considerably smaller than that of the last few years which has witnessed the
absorption into the market economy of large population categories from China and India.
The economic growth of the emerging and transition market economies, though a positive world
development as it is associated with diminishing income inequalities among countries leading to more
balanced world development, has, nonetheless, produced some major shocks as reflected not only in
the rising trend in energy and raw material prices but, more importantly, in the increasing pollution of
sea and land, global warming due to carbon dioxide emissions, etc. Indeed, if we want to prevent a
major climatic catastrophe on a global scale, the waste of energy, water and other resources, not only
by emerging economies but also by developed economies, will have to be reversed at a great cost in
the future. Just as under international accounting standards future liabilities, such as companies'
pension liabilities, are deducted from company incomes, so the future cost of today's actions should
be taken into account. Accordingly today's global and individual countries' GDP growth rates, which
supposedly measure the improvement in the standard of living, should be adjusted downwards. Such
an adjustment is necessary as there is too much complacency and the hidden economic costs of
today's actions are not properly taken into account. Any new era brings along new problems, requires
new solutions and increases the range of potential crises and risks, which are not properly gauged, as
they are not yet calibrated.
Moreover, by projecting today's favourable trends, financial markets often generate a benign
perception of future developments, which do not, however, reflect all the underlying forces at work.
Indeed, the significant transformation of the financial environment has led to heightened and new risks
associated with the introduction of innovative products (e.g. derivatives), the existence of highly
leveraged non-regulated financial institutions and markets, combined with world liquidity increasing
considerably faster than the value of the underlying real assets. Regarding world politics most
probably China and later India will become great world powers but during the transitional period before
a new world order is established the risk of political tensions cannot be ruled out, and their impact on
the world economy and markets cannot be fully understood today.
Another area of concern is that the benign inflation trends of the last few years, which are almost
exclusively due to moderate wage claims in the developed countries and which have more than offset
the impact of the rise in energy and raw material prices, may not continue for ever. Indeed, over the
last 5 years average real wages have been stagnant, and probably more than one-half of wage
earners have experienced real income losses, while profit margins have been rising strongly. Lately
we have been seeing the first signs of a change in labour behaviour and, although, over the next
couple of years wage growth will probably continue to be about 2% in most developed economies, this
cannot be taken for granted over the medium to longer run.
To sum up there are risks in the horizon: a) steep rising costs from global warming, pollution and the
quick rate of depletion of non-renewable resources; b) apart from the proximate concerns regarding
the Middle East imbroglio there are political risks further down the road, which are associated with the
emergence of new global powers during the transition to a multi-polar world; c) crisis in segments of
the financial markets which may necessitate drastic measures at a high cost to prevent a spill over;
and d) increasing income inequality in the developed world may trigger, especially in Europe, a
backlash with sudden wage increases putting pressure on inflation. Seeing today's 10, 20 and 30-year
interest rates on mortgage loans, and low bond rates in general, I have the feeling that these risks are
not fully reflected in interest rate spreads.
Focusing more on the specific subject of interest today, I am afraid that, in addition to financial assets,
some countries' real assets, including housing are overvalued today, and a disorderly adjustment of
asset values could have important effects. This is what has been called the $400 trillion question.
Financing of the housing sector is an area of economic analysis that has come to prominence only in
the last couple of decades. Two, perhaps inter-related, developments have contributed to this new
prominence, financial innovation and the wide gyrations in housing prices that have been observed in
the last two decades, starting with the real estate collapses in Japan and other Asian countries. No
one can claim that house prices never fall or that real estate is an area of boring stability. In recent
years, the housing sector has thus emerged as a major channel for the transmission of monetary
policy but also as a reason for concern regarding financial stability.
Financial innovation has allowed financial intermediaries to structure their products more in line with
consumers' demands and to take on more risky products as the possibilities of securitizing their
exposure has increased. Since housing finance is normally very long-term - typically mortgages are
for twenty to thirty years - the mismatch of maturities is correspondingly more acute. Securitization
allows financial intermediaries to overcome this problem to some extent and thus facilitate the
extension of more credit in this market. However, transferring risks does not mean that nobody will pay
the bill if conditions deteriorate and those who will pay the bill are usually also bank clients (or the
banks may pay compensation to holders of securitized bonds in order to minimize reputational risks);
thus "securitization does not completely insulate banks" and this simple maxim tends to be ignored
today.
Consumers for their part have a wider array of options to choose from and this has led to an increase
demand for mortgages. At the same time, the removal of many regulatory restrictions and the
increased integration of markets, especially in Europe, have led to increased competition and an
overall reduction in interest rate spreads to the benefit of consumers. Many borrowers who were
previously excluded from the market now have access to affordable credit and can enter the housing
market. A particular phenomenon that is widespread across the Atlantic but is starting to spread over
here is equity withdrawals, whereby homeowners use the accumulated equity in their houses to
finance current expenditures. Whilst this may depress savings in an economy, it may also improve its
resilience to shocks, as the interest rate on mortgage-backed loans is normally lower than for other
forms of consumer credit.
Another issue that may be acting toward increasing the risks in the economy is the propensity of
market participants to take on risks which they do not fully understand. A specific example is the
proliferation of mortgages in foreign currencies, which make borrowers vulnerable to little understood
exchange rate risk and lenders to credit risk, which may remain hidden for a long period as long as
everything goes well. Of course, extension of credit to new borrowers at a time of diminishing spreads
coupled with little understanding of risks may be a source of concern regarding financial stability,
especially if house prices become stretched.
This brings me to a second issue, of housing finance as a channel of monetary transmission.
Obviously, as households take on more housing debt, they react faster and more strongly to interest
rate movements, thus allowing the Central Bank through their interest rate policy to have a greater
influence on macroeconomic activity. A faster and fuller pass-through of interest rates facilitates the
conduct of monetary policy and enhances its effectiveness. In this context much depends on whether
mortgages are with fixed or floating interest rates. Countries, of course, differ widely on this, for
historical, legal or other reasons.
Whether the expansion of the mortgage market is responsible for the often-observed significant
increases in housing prices is a moot point. There are many good reasons that support higher prices,
such as demographic changes, as smaller families require more overall living space, expectations that
real and nominal interest rates will remain low, and regulatory restrictions that curtail land supply.
Surely, the ample liquidity that has been pumped into the markets in recent years has created
conditions conducive to speculative excesses. Most countries in the euro area have not yet had any
experience of significant correction in nominal housing prices. It is possible that both borrowers and
creditors have underestimated this possibility and in some cases both credit expansion and housing
prices increases look questionable.
Developments in Greece are a good illustration of the forces that operate throughout Europe. After the
full liberalization of the financial sector we have seen a real revolution of housing finance. Since 1996,
mortgages have more than doubled as a share of banks' portfolios, while there was a fivefold increase
of mortgage debt as a proportion of GDP. The first trend was the result of falling interest rates and
increased competition that led banks to search for new areas of profitable expansion. Households, on
the other hand, facing improved conditions, as exemplified by that fast growth of GDP and lower costs
of borrowing, reacted quite rationally by increasing their indebtedness. The ratio of homeownership in
Greece has been among the highest in Europe, fluctuating around 80 percent in recent years.
Mortgage demand has probably been used to improve housing conditions rather than enter the market
for the first time. Demand from economic immigrants has supported this trend by allowing existing
homeowners to sell their entry-level properties in order to move to more expensive ones. As I see it,
we are still in the process of stock level adjustment, as the level of mortgage indebtedness at 27% of
GDP is still below the European average (of about 38%), though the gap is narrowing rapidly.
House prices increased fast at the start of this period relative to disposable income, although we are
seeing some leveling-off lately. Research conducted at the Bank of Greece by Sophocles Brissimis
and Thomas Vlassopoulos shows a two-way causal relationship. Increasing house prices have
allowed or forced households to borrow more, while at the same time the availability of housing credit
has fuelled house prices.
The steep increase in mortgage lending, starting from a very low level, did initially create problems for
the quality of Greek banks' portfolios. Initially, the ratio of non-performing mortgage loans appeared
quite high, but over the last six years it has almost halved. With pressure from the Bank of Greece and
following the development of more comprehensive credit control systems, the ratio of non-performing
mortgage loans now stands at about 31⁄2 percent down by 1 percentage point in two years, indicating a
much better ability of Greek banks to manage their risks. This is reinforced by the fact that mortgages
in Greece are normally lower as a percentage of market values than elsewhere. Moreover, Greeks are
more sentimentally attached to their homes than are Americans and other Europeans, and therefore
perceive house-eviction as a terrible social blow. It was useful that the rapid expansion of mortgage
credit took place at a time of high growth and macroeconomic stability since this allowed banks to
absorb the "growing pains" emanating from their entry in this market without impairing their stability.
Developments in South-Eastern Europe in many ways resemble Greece's experience in the preceding
decade. One significant difference is the relatively low stock of existing housing units, which are often
of a rather low quality for today's needs. There is thus a much more urgent need to upgrade and
expand the housing stock. Given the relatively benign climate in those countries recently, households
may be inclined to overextend themselves. These emerging market economies are starting from a
very low level of financial development, which translates also into a very low level of housing credit.
This low level of housing credit is more a result of financial under-development rather than of skewed
credit policies on the part of financial institutions. It is to be expected therefore that housing credit will
expand quite fast for the foreseeable future as the financial sector expands toward advanced
economies' levels. This is quite a rational reaction of creditors and borrowers to the economic situation
and may accelerate for those countries that join or are expected to join ERM II and later EMU. In those
countries, the reduction of the risk premium and perceived policy stability will also encourage credit
expansion. While from a macroeconomic point of view all these developments may seem quite
predictable, there is a fear that both borrowers and lenders in these countries may not have an
adequate understanding of the risk they are taking. Financial institutions may lack the necessary
expertise to manage a fast expansion of their housing loans portfolio, and in the rush to gain market
share they may extend credit to ever-riskier borrowers. While the ratio of non-performing loans in
South Eastern European countries does not look threatening now compared with other emerging
markets, one should note that overall household credit in these countries is much lower and thus more
manageable than elsewhere and the macroeconomic situation has been quite propitious.
Two further differences are worth noting: a strong penetration of foreign-owned banks and a large
percentage of loans are in foreign currency. The first special characteristic is the significant
penetration of foreign banks in these countries, which typically control more than half of the local
market. I should add here that Greek banks are quite active in this area and are expanding fast.
Foreign banks may be a source of stability. They bring with them a much longer experience, direct
access to the capital markets of mature economies and, last but not least, they are supervised by their
home country's supervisors who also have a longer experience. In the particular circumstances of
these countries, it is also worth noting that foreign banks and their supervisors are less prone to
succumb to pressure from local politicians. The challenge for them is to adapt their experience to the
realities in their host countries.
The second interesting characteristic is that the highest rate of growth of loans in foreign currency is
not in countries with a fixed exchange rate regime, like Bulgaria, but in countries that have a policy of
inflation targeting coupled with a benign neglect of the exchange rate. It is true that in recent years the
ample supply of liquidity internationally has combined with increased risk tolerance on the part of
investors to support a rather stable external environment for emerging and transition economies and in
particular predictable exchange rates. While we all hope it is going to continue, we should be well
aware that recent years have been a departure from longer-term trends. In addition, in some countries
in the region one suspects that a process of real appreciation is taking place, a process that will have
to be corrected sooner or later. The current account deficits observed in many countries in the region
raise concerns regarding their sustainability. Any loss of confidence on the external side may easily
cause some upheaval in the domestic financial market.
Countries in South-Eastern Europe have the advantage of being able to learn from best practices
developed in more advanced countries and avoid the mistakes of others. They should take the
opportunity offered now by a relatively stable international environment and their domestic fast growth
to put mortgage lending on a stable footing. The credit information infrastructure should be
strengthened, the legal procedures for dealing with defaults should be simple, clear and transparent,
and both banks and borrowers should realize the risks they take, especially as they move to more
sophisticated instruments.