Anatomy of a bust

The causes of Ireland’s great economic bust promise to provide rich pickings for academics for many years to come. This one-in-a-generation catastrophe has many fathers but, as a new Central Bank paper ably sets out, lax credit was the daddy of them all.

As the paper, Credit conditions in a boom and bust property market, demonstrates, Ireland was by no means alone in showing strong property price growth from the mid-1990s (although, as the paper states “amongst countries which experienced house price booms, the Irish case stands out.”)

In common with many other countries, an array of benign macroeconomic factors combined to build the bonfire under real estate prices: strong income growth, stable monetary conditions that emerged after the interest rate volatility of the early-1990s, and a sustained period of low interest rates.

Add to that the effects of financial innovation on the financial system and consequent availability of credit. Widespread use of derivative instruments and repurchase (repo) agreements “enabled financial institutions to better manage exchange rate, interest rate and credit risk. Lower risk resulted in greater use and a reduced cost of interbank lending, thereby, enabling institutions with a surplus of funds to lend to those in deficit.”

As Ireland’s banks now struggle to glean retail deposits in a negative real interest rate environment, with the wholesale markets now completely out of bounds, it’s worth recalling the extent to which Irish retail banks were able to inflate their balance sheets through recourse to the wholesale markets.

The two charts tell the story more eloquently than words: the staggering take-off of international wholesale funding of the Irish banks and the yawning gap that emerged between private sector credit and deposits up to the peak in 2008.

But of course mere availability of credit should not intuitively mean an automatic commensurate rise in prices. Rational purchasers, after all, should normally evaluate the investment on its merits. But that is to discount the capacity for people to get caught in the hysteria of markets – something with many precedents before the great Irish bust.

What the Central Bank paper tries to do is separate the availability of credit from other factors that caused the boom (and bust).

The authors take loan level data from the mortgage books of the four major financial institutions to attempt to assess the causes of house price movements in Ireland between the influence of easing credit conditions and the impact of standard macroeconomic variables. “In so doing, we can identify, over the period 2000 - 2011, the relative contribution of more liberal mortgage credit policies to house price inflation. “

The research throws up some staggering statistics:

In 2000 the average income fraction (that is the proportion of the average borrower’s gross income allocated to mortgage repayments) was just over 16%. By 2008 that figure had jumped to over 25%. By 2011 this figure had fallen back to below 16%.

It is a similar story with loan-to-value ratios. In 2000 this was about the 58% mark. By 2006 it was 77% (and this is against the background of red hot price appreciation). By 2008 this had dropped to under 67%.

Mortgage term statistics also betray the folly of credit policies. Until 2002 the average mortgage term was 20 years. This took off in 2003 to 25 years before increasing further to reach a peak of 30 years in 2010.

The statistics also show that first-time buyers were particularly exposed by lax credit policies with income fractions, loan-to-value ratios and mortgage terms well ahead of those extended to second and subsequent time buyers and buy-to-let investors. For example, LTV ratios for first time buyers in 2006 topped 90% while average mortgage terms were 35 years.

As the report notes the legacy of lax credit has been truly severe. Since 2007, Irish house price declines have been the most severe across the OECD.

“Given that nearly 40 per cent of the total stock of Irish mortgages was issued between 2004 and 2007, when prices were at their highest, the sharp subsequent decline has given rise to a significant degree of negative equity being experienced by Irish households,” the report notes. “When coupled with the sharp increase in unemployment experienced by the Irish economy post-2008, the possibility of substantial credit risk in the mortgage books of Irish banks was one of the main reasons for the financial crisis which engulfed the Irish banking sector.”

Of course, that cloud remains very much with us and the true cost has yet to be reckoned in full, but as the next round of bank stress tests in the new year approach, and the new personal insolvency regime can be expected to increase momentum, so a fuller picture can be expected to emerge in the near future.

Credit conditions in a boom and bust property market, by Yvonne McCarthy and Kieran McQuinn.