A section from the Semiannual Survey of the Banking System to be published soon: Developments in mortgage interest rates
As a result of the increase in home prices in recent years, the public markedly increased the scope of mortgages it took out, the size of the average mortgage, and the average term of the mortgage.
· As a result of the increase in home prices in recent years, the public markedly increased the scope of mortgages it took out, the size of the average mortgage, and the average term of the mortgage.
· Israel’s banking system increased the exposure to the housing and construction industry from around 35 percent to around 45 percent of assets between 2008 and today.
· The Banking Supervision Department at the Bank of Israel has acted in recent years to impose limitations that will reduce the risk in mortgages—the risk of borrowers and of banks, and thus will reduce the ramifications of the low global and domestic interest rate environments on the housing credit market.
· The interest rate paid by mortgage borrowers is impacted on by banks’ cost of raising funds, by the risk inherent in a loan, and by the extent of competition in the mortgage market.
· Despite the decline of the Bank of Israel interest rate to a historic low in March 2015, banks’ cost of raising funds in the capital market has increased since then by around 60 basis points.
· As a result of the increase in risks in the housing credit market, and the policy of the Banking Supervision Department, which acted recently to bring about the internalization of these risks by banks, and in view of the capital adequacy requirements that are intended to maintain the stability of the overall banking system—there has been an additional increase in mortgage interest rates.
· There is considerable competition in the mortgage market, reflected in low interest rate spreads of about 1.6 percent on mortgages.
· From a long term perspective, the interest rate on mortgages is lower than that which prevailed in the overall economy in recent years, even after the increase.
From the beginning of 2008, home prices in Israel have increased by more than 80 percent in real terms. Alongside the increase in home prices, there was an increase in the number of housing transactions and an increase in mortgages taken out by the public, particularly against the background of the low interest rates and yields in the economy. These developments exposed borrowers and banks, and still expose them, to the risk of a negative impact that can derive from changes that may occur in the economic environment: borrowers’ income and the unemployment level, home prices, interest rates, and more. These changes are liable, among other things, to lead to difficulties for borrowers to make current repayments on mortgages (see reports by the Banking Supervision Department and see the Bank of Israel’s Financial Stability Reports in recent years).
Against the background of the increase in risks in the housing sector and in mortgages, the Banking Supervision Department in recent years took a series of steps in the area of housing credit: the Banking Supervision Department limited the customers’ payment to income ratio, limited the loan to value ratio, required banks to increase the capital buffers and allowances for risks in mortgages, and others. These steps were aimed at reducing the exposure of borrowers and banks to the risks inherent in housing market developments, and to reduce the risk of a scenario of difficulties in borrowers’ ability to make their repayments, as well as strengthening the ability of banks to absorb losses should the risk be realized. The Banking Supervision Department’s steps increased the cost of extending mortgages, from the banks’ perspective, and were geared to a more suitable pricing of risks by the banks. This pricing was reflected in recent months in mortgage interest rates. The Banking Supervision Department’s steps being reflected in interest rates particularly in the past year derives both from part of the steps having a gradual and prolonged impact (such as the additional capital requirement vis-à-vis mortgages published in September 2014, which banks had to meet gradually by January 2017), and from the mortgage portfolio including “older” mortgages that in some cases were not impacted on by regulatory requirements, and thus the internalization of the change in the Banking Supervision Department requirements on risk and interest rates took a longer time.
The Monetary Committee sets the Bank of Israel interest rate while taking into account a wide range of factors in achieving the inflation target, encouraging employment and growth, and maintaining financial stability. The interest rate is impacted on to a large extent by global developments as well. In March 2015, the Bank of Israel reduced the monetary interest rate to 0.1 percent, and it has remained unchanged since then.
The interest rate on credit in general, and on mortgages in particular, is impacted on by the banks’ cost of raising funds, the risk inherent in loans, and the extent of competition in the mortgage market. The Bank of Israel interest rate impacts on the cost of raising funds in the capital market, but it is important to recall that the Bank of Israel interest rate does not incorporate credit risks and is a very short term interest rate, while the interest rates in the market relevant to housing credit are long term interest rates that do reflect credit risks as well as expectations for future interest rate changes. Therefore, despite the decline of the Bank of Israel interest rate to a level of 0.1 percent, the interest rate in the overall capital market, and the cost of raising bonds by banks in particular, increased markedly. For example, the yield on banks’ CPI-indexed bonds in the capital market increased by about 60 basis points since March 2015.This increase is one of the factors in the increase in mortgage interest rates.
In parallel, the risks in the housing market continued to increase (see the Bank of Israel’s Financial Stability Reports in recent years): the increase in home prices continued, housing credit expanded and its share in the credit portfolio increased, the size of the average mortgage increased, and the term to final repayment of the mortgage became longer.
In detail: Home prices continued to rise by a rate of about 8 percent; the scope of residential loans extended remained high and is now around NIS 5.1 billion per month, on average, (Figure 2); the bank housing credit portfolio continued to expand—its balance totaled about NIS 300 billion, and together with the real estate and construction credit portfolio reached around 45 percent of the bank credit portfolio (Figure 3); in recent months there was an increase in the average term to repayment in all interest rate and indexation tracks (Figure 4, Table 1), and an increase can be seen in the size of the average loan for residential purposes (Figure 5). Alongside these, since the end of 2014 there has been an accelerated increase in housing credit extended by institutional investors, primarily in partnership with banks, although the scope of this credit remains low. This development increases the ability to expand housing credit as well as the interconnectedness in the financial system. The internalization of the increase in these risks by the banks, directed by the Banking Supervision Department, acted to increase the interest rate on housing credit.
In addition, the banks are near the end of a process in which they are working to reach capital adequacy targets required by the Banking Supervision Department, including designated capital requirements in the mortgages sector, which impact on the banks’ ability to increase credit, and thus on the increase in its price.
The analysis presented in this document indicates that there are many reasons for an increase in the interest rate on mortgages. Part of it can be explained by the increase in the price of banks’ sources and part is explained by more suitable pricing of the increase in risks inherent in housing credit. As there have not been changes in the mortgage market’s structural characteristics, which impact on the extent of considerable competition in this sector—credit backed by collateral, informed consumer conduct and the activity of three large players—it is reasonable to assume that the increase in interest rates in the mortgage market does not reflect a decline in competition in this sector.
Over time, it is likely that the increase in the interest rate will contribute to a moderation of demand in the housing market, and in parallel with activity by the government to increase supply, to a halt in price increases and even to declines.