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? This paper estimates the development, historically and under various scenarios, of the distribution of the payment to income ratio—one of the main indicators of borrowers’ repayment ability—in banks’ housing credit portfolios. We find that in recent years there has been a sharp increase in both the average payment to income ratio, which is currently high compared with other countries, and the share of high risk mortgages (with payment to income ratios above 40 percent).
In addition to the historical development of the distribution of the payment to income ratio, we estimate the expected developments under several scenarios. Under the first scenario, we 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. We find 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.
In addition to the scenario of continued home price appreciation, we estimate 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. We 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. 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.