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BANK OF ISRAEL
Office of the Spokesperson and Economic Information
September 15, 2013
Press Release
Borrower risk in the mortgage market: Historical development and assessment
under various scenarios
Between 2008 and 2012 the average price of a home increased by about 54 percent, while
average household income increased by only 20 percent. This fact raises several
questions about how new buyers financed the sharp increase in home prices—did the loan
to value ratio increase? Did the size of mortgages increase—and if so, how did that
influence borrowers’ repayment ability?
One of the main indicators of borrowers’ repayment ability is the payment to household
income ratio. This indicator is affected by the development of borrowers’ income, the
size of the monthly payment which depends on the size of the mortgage, the duration of
the mortgage, and the development of interest and inflation rates. Empirical studies from
around the world indicate that when a borrower’s payment to income ratio is greater than
a specific level, the probability of default increases markedly. Furthermore, research that
has studied the link between financial crises and the payment to income ratio have found
that a sharp increase in the payment to income ratio serves as a signal of a systemic
banking crisis, and the sharper the increase in the payment to income ratio, the deeper the
ensuing crisis. Therefore, from macroprudential perspectives, there is considerable
importance to monitoring the development of the distribution of borrowers’ payment to
income ratios in banks’ housing credit portfolios, and particularly in light of the sharp
increase in that balance over the previous 5 years.
In new research, Dr. Golan Benita and Dr. Ziv Naor from the Bank of Israel Research
Department estimate the development—historical and under various scenarios—of the
distribution of the payment to income ratios in banks’ housing credit portfolios. Results
of the research indicate that due to the sharp increase in mortgage sizes in recent years,
the average monthly payment for new mortgage borrowers increased at a higher rate than
the increase in average household income (Figure 1). This was despite the sharp decline
in interest rates on mortgages in recent years, and new mortgage borrowers taking out
loans with longer terms to repayment than in the past. This development led to a marked
increase in borrowers’ risk levels in banks’ housing credit portfolios, which was reflected
by a sharp increase in both mortgage borrowers’ payment to income ratio, which is
currently high compared with other countries (Figure 2), and the share of high risk
mortgages (with payment to income ratios above 40 percent). It should be noted that
before the increase in home prices, borrower risk in Israel was similar to levels
worldwide.
In addition to the historical development of the distribution of the payment to income
ratio, the researchers estimate expected developments under several scenarios. Under the
first scenario, the researchers assume that home prices will continue to increase in the
first year by a similar rate to that of the past two years and afterward will develop in line
with the expected inflation rate, average household income will increase in line with its
average growth rate in recent years, and inflation and interest rates will develop in line
with expectations derived from the capital markets. The study finds that under this
scenario, borrowers’ risk in the mortgage market is expected to continue to increase in the
coming years. This is due to the continued home price appreciation which will influence
the payment to income ratio of new buyers, and the expected increase in the interest rate,
which will raise the monthly payments on floating rate mortgages. The share of such
mortgages in total mortgage volume increased sharply from 2009–11, reaching a record
high rate of about 80 percent right before the Supervisor of Banks imposed a limitation
on the share of the floating rate component of a mortgage. As a result, the share of
mortgage borrowers’ average monthly repayment in banks’ housing credit balances is
very sensitive to changes in the interest rate.
In addition to the scenario of continued home price appreciation, the researchers
estimated the development of the payment to income ratio’s distribution under two stress
scenarios, which are based on the crisis in the economy during 2002–03: a sharp increase
in the interest rate and a recession in real economic activity, which will be reflected by a
decline in wage levels and an increase in the unemployment rate. The researchers assume
that home prices will react to changes in the interest and unemployment rates with the
same elasticity found in previous research. The results of the paper indicate that under
both scenarios, borrower risk in the mortgage market is expected to increase sharply and
is liable to lead to an increase in default rates. The findings indicate that the effect on
borrower risk of a recession in real economic activity is more significant (Figure 3).
Furthermore, this scenario potentially contains an even greater risk since—as found in
numerous studies worldwide—increased unemployment is one of the main risk factors
for defaults, in particular for borrowers with a high payment to income ratio.
Dr. Benita and Dr. Naor emphasize in their paper that as a result of the sharp increase in
home prices in recent years, banks’ potential credit loss in the scenario involving defaults
declined markedly for mortgages taken out before home prices increased, or in the early
stages of the price appreciation. However, it is likely that in a scenario of a sharp increase
in defaults with declines in home prices (as expected under the stress scenarios), banks
will find it difficult to sell a relatively large number of properties. This development is
liable to lead to an additional sharp decline in home prices and to make banks’ credit
losses more severe, as occurred in financial crises in other countries.
Supervisor of Banks directives published in August, limiting the payment to income ratio,
the term to the repayment, and the share of the floating rate component in mortgages,
work to reduce those risks.
Figure 1
Average household income and average monthly payment at the time a mortgage is
taken out
(Index, December 2003=100)
300
250
200
150
100
50
Monthly household income
Monthly payment in first year
Figure 2
International comparison: Average mortgage payment to income ratio, and
household debt to GDP ratio (percent)
35
100
30
90
25
80
20
70
15
60
10
50
5
40
0
30
USA
Payment to income ratio (left scale)
EU
Israel
Household debt to GDP (right scale)
SOURCE: Payment to income ratio: Worldwide–ECB (2011), Israel–estimate for
December 2012 calculated in this paper. Household debt to GDP ratio—OECD data.
Figure 3
Share of mortgages with payment to income ratios above 40 percent in housing
credit balance, under stress scenarios
30%
28%
26%
24%
22%
20%
18%
16%
14%
12%
10%
2009
2010
2011
2012
Recession in real activity
2013
2014
2015
Interest rate increase
2016