Easy money at a painful price

From kathleen barrington: 21 February 2010

By Kathleen Barrington

During 2006, I contacted a number of solicitors in a new west Dublin suburb to enquire about what sort of debts they saw buyers assuming when a property was being conveyed.
One said he had seen cases where a first-time buyer couple would take out a mortgage of, say, €300,000. Then, when the couple learned that the market value of their home had increased by a certain amount – let’s say 10 per cent – one year later, they would be back, signing papers to release the extra €30,000 in the form of an equity release mortgage.
When I enquired why they wanted to raise the extra borrowings, he indicated that it may have been to buy a car, go on a holiday, splurge on general lifestyle expenditure – or even, in some cases, to raise the cash to meet the mortgage repayments on the original mortgage!
A glance through any of the tabloid newspapers in 2006 quickly demonstrated that there was a large volume of advertising urging people to release the equity in their homes to fund their lifestyles, or to pay off other consumer debts by consolidating them on to existing mortgages. The scale of the advertising alone suggested that the phenomenon was considerably widespread during the boom.
Figures from the Irish Bankers Federation effectively confirm that buyers were using their homes as ATM machines from which they could extract cash at will if they fancied a shopping spree during the boom.
For instance, the IBF data for 2006 shows that almost €12 billion was released into the economy that year, in the form of ‘top ups’ and ‘remortgages’.
A ‘top-up’ is defined by the IBF as a further mortgage advance to an existing borrower, which is issued to finance expenditure other than house purchase. The figures published by the IBF show that, in 2006 alone, more than €6 billion was released into the Irish economy in the form of top-ups.
A ‘re-mortgage’ is defined as a loan which is issued by one lender to refinance an existing mortgage with another lender which mayor may not include further equity release.
Again, the IBF figures show that a further €6 billion in re-mortgages was made available in 2006.
Last week, the IBF produced the mortgage drawdown figures for 2009. The figures showed that just €8 billion of mortgage loans were issued in 2009, while the volume of new lending was down 47 per cent compared with the previous year.
The total value of top-ups drawn down during the whole of 2009 was about €1.1 billion, about one sixth the level released into the economy in 2006, while the total value of re-mortgages was also about €1.1 billion.
That’s an awful lot less home equity being released into the economy. It also raises the question of how great the correlation between equity release and consumer spending during the boom was, and what implications that correlation may have for future consumer spending – and, by extension, for Ireland’s hard pressed retailers.
Research carried out by the Federal Reserve Bank of San Francisco last month*, which was cited in a recent Central Bank of Ireland paper, examined the relationship between global household borrowings, house prices and consumption.
It found that countries with the largest increase in household borrowings tended to experience the fastest rise in house prices over the same period, and that the same countries tended to experience the biggest declines in household consumption as soon as property prices commenced falling.
For every incremental dollar of house price appreciation, the average US homeowner extracted about 25-30 cents in cash via home equity borrowing, which was used primarily for consumption or home improvement. It concludes that this indicates that ‘‘house price appreciations fuelled by easy mortgage credit was a significant driver during the boom years’’. It is striking that the IBF data shows that top-ups alone accounted for about 33 per cent of all mortgage lending here in 2006, suggesting that Irish people, too, were extracting a similar proportion in cash via home equity borrowing to that of their American counterparts.
The researchers noted that household borrowing in many industrial countries grew rapidly in the years leading up to the financial crisis. Of the 16 countries surveyed, the increase in the household borrowing ratio was second-highest in Ireland in the ten years to 2007.
Countries experiencing the largest increases in household borrowing before the crisis tended to experience the most severe recessions, where severity was measured by the percentage decline in real consumption from the second quarter of 2008 to the first quarter of 2009.
Consumption fell most sharply in Ireland (down by 6.7 per cent) and Denmark(a drop of 6.3 per cent). Both countries saw huge increases in household borrowings prior to the crisis. The researchers concluded that recession severity in a given country reflected the degree to which prior growth was driven by an unsustainable borrowing trend.
There is little sign that anything has improved in Ireland in the intervening period.
The latest retail sales data for 2009 – which would not have been available to the San Francisco researchers – showed that sales fell by 7.5 per cent in 2009 compared with 2008.
The newest data would not come as a surprise to the San Francisco economists, however.
They predicted that the efforts of householders in many countries to reduce their elevated debt loans, via increased saving, could result in sluggish recoveries of consumer spending.
Even if debt reduction were accomplished by forms of default such as foreclosures and bankruptcies, that would still involve significant costs for consumers, including the tax liabilities on forgiven debt, legal fees and lower credit scores.
The research is sobering for any retailers betting on a consumer recovery any time soon, as the fall in house prices means that the giant ATM on which consumers were relying is no longer functioning properly.
And with house prices still falling, the chances of consumers being able to raise funds to spend through equity release are remote.
The researchers point out that higher saving rates and correspondingly lower rates of domestic consumption growth would mean that a larger share of GDP growth would need to come from business investment, net exports or government spending.
With government spending highly unlikely here, this means that only growth in business investment and exporting can drive future GDP growth and consumer spending here.