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Housing loans collateral shortfall

HOW big is the shortfall between housing loans and their collateral?

The short answer is that no one can be certain. We have chosen to use data from the Cyprus Central Bank (CCB) to make a calculated guess as to what this could be. The data covers the period 2008 Q1 – 2012 Q2 and is publically available.

Loans granted over the past few years had varying requirements in relation to property values [the maximum allowable Loan-to-Value (LTV) ratio was 80% for primary residence and 70% for a second home] and there was/is some confusion as to what the definition of the Market Value (MV) of a property was/is, e.g. with or without VAT.

We do not know the actual value of the properties that banks used as collateral to grant the various housing loans, but the CCB provides a breakdown of the amount of housing loans outstanding per quarter. Whilst we cannot be certain as to the ratio between property value and loan amount, it would be reasonable to assume that most loans would be at the limit of the allowable ratio, i.e. the loan would be 80% of the value of the property. Thus, if we assume that these loans are 80% of the properties’ values, we can work our way back to calculate the hypothetical MV of the collateral.

Having calculated the value of the collateral, we then need to adjust these property values according to the movement of house prices over the period (the ratio between loan and value may have been 80% at the time of granting the loan, but as property values have decreased, ceteris paribus, this ratio must have increased). In order to be consistent, we have used the CCB’s residential price index to make these adjustments. We then recalculated the ratio between loan amount and property value in order to see how this has changed. As shown in the tables the LTV ratio for loans granted in 2008 is above 90% and almost all other loans are circa 85-90% of property values.

It is now time to “play” with our model. A reduction in house prices by a further 5% from 2012 Q2 prices, increases the LTV ratio, but leaves property values still higher than the total loan amount.

Reducing prices by 10%, leads to a shortfall in the value of the collateral relative to the loans of €69 million (1.0% of all housing loans granted over the period 2008 Q1 to 2012 Q2). Reducing prices by 15% leads to a shortfall of €353 million (4.9% of all housing loans), by 20% to a shortfall of €803 million (11.2% of all housing loans), and by 25% to a shortfall of €1.334 billion (18.6% of all housing loans). Remember that this only relates to housing loans granted from 2008 onwards. Commercial loans, consumer loans, etc. are not part of this assessment.

Before we move on to address the implications of the above, it is important to comment why we have not reduced the balance of the loans during this period. Notwithstanding that most housing loans have an interest only/”teaser rate” at the beginning of the loan term, in the early part of a loan’s term the majority of the payment relates mainly to the interest and not to the loan. Only as time passes and the loan is slowly repaid, does the interest payment result in a decrease in the outstanding loan amount.

As noted, a decrease of more than 5% in property values will begin to result in a number of borrowers going into negative equity. This has significant implications both to them, as they will be paying off a loan that is bigger than the value of their house, and to the bank, as its exposure to potential loses will increase. Furthermore, it reduces the bank’s options if loan default does occur, as the potential income from the asset will not be enough to repay the outstanding loan. Thus, banks will be forced to crystallise their losses on the sale of the collateral, increasing their need for capital, and then to choose whether pursue the borrower or his guarantors for the balance.

In our calculations we have not accounted for a number of other costs that would be related to any sale, and for which there would be a further shortfall from the bank. These would include: rolled up interest, unpaid common charges, immovable property tax, estate agent fee, transaction fee (transfer duty), legal fees, etc. Thus, even if property prices do not fall further (highly unlikely) the shortfall amount will increase simply by accounting for these added costs to the bank. Loan recovery data from the USA put these costs at 30-40% of a property’s value at the time of loan default, i.e. a further decrease in the property’s value by 30-40% in addition to any decrease in house prices.

There are another three unanswered questions. How long will it take for the bank to take possession of the property? If the bank does take possession and tries to sell it, who will buy? And more importantly, who will finance the buyer?

It would appear that we have entered “limbo”, where, as the economy deteriorates, debtors default on their housing loans, increasing banks’ loses, causing banks to require more capital to account for these loses, constraining lending and causing the economy to deteriorate further. This becomes a self-fulfilling and self-fuelling negative feedback loop, which will require a jolt in peoples’ psychology, the economy and the property market in order for all to break out of it.

If you think that this scenario is far-fetched, have a look at Ireland. House prices in Dublin are 56% lower than at 2007 and in secondary cities the drop is between 70-80%. The percentage of mortgages in arrears of 90 days or more is 10.9%. As shown in the attached tables, if a 56% decrease in house prices was to occur in Cyprus, then the shortfall between housing loans and their collateral for the period 2008 Q1 – 2012 Q2 would be circa €2.445 billion. Assuming a rate of default of 10.9%, the expected loses to banks would be €267 million. Sláinte!

Pavlos Loizou MRICS

Lead Consultant, Leaf Research