Here we are in a global interest rate shock. The FT and Bloomberg are full of the direst warnings: mortgage payments to rise by £300-500 per month in the UK, mortgage rates at 7 per cent in the US, and house prices to drop 30 per cent in Hong Kong.
Over on Bonkers.ie, nobody seems to have told the Irish mortgage providers about this. Bank of Ireland and AIB are offering first-time buyers five-year fixed-rate mortgages for 2.2 and 2.25 per cent, respectively.
This is strange. Irish five-year government bonds yield 2.36 per cent. So the mortgage providers are lending money to Irish first-time buyers, on a 90 per cent loan to value, at a lower interest rate than they can lend to the Irish state.
Lending to individuals is riskier than lending to the state. But it’s also less profitable because ECB rules force banks to set aside more capital (basically, earn less profit) when lending to householders, compared to governments.
This can’t go on. Bank interest rates are going to go up. When they do, I estimate they’ll knock about €20,000 off the value of the average Irish house.
Rising rates will mess with the housing market in unfamiliar ways. Usually, a market is good for either buyers or sellers. When supply exceeds demand its a buyers’ market, when demand exceeds supply it’s a sellers’ market.
But when rates go up, it’s bad news for both buyers and sellers. It’s bad news for buyers because their purchasing power goes down. Some of this ends up getting reflected in lower house prices. But buyers as a group don’t end up better off, because their borrowing firepower has reduced. For a seller, rising rates are bad news because they make their new mortgage more expensive.
How will this shake out? Remember that for house prices to fall a lot, a lot of people have to be willing to sell their houses. So long as the economy stays strong and people have their jobs, you’d have to think there won’t be a lot of selling going on. Nothing like 2008-12, when the country was emptying out, and inventory sat unsold for years.
The following chart shows how many Irish mortgages are fixed, variable and trackers. Interest rates are forecasted to be high for two or three years. Anyone on a variable rate, tracker, or fixed for less than a year is exposed.
To get an estimate of how much rates might go up, we need a few things.
What are ECB base rates now?
What are they forecast to be next year?
How do base rates translate to Irish mortgage rates?
How do Irish mortgage rates translate to house prices?
From 2012 to 2021, the ECB kept base rates flat or negative. The worry at the time was unemployment. This year, suddenly, the worry is inflation. So the ECB has started hiking.
The ECB deposit rate is currently 0.75 per cent. It's expected to rise quite a bit further from here. Overnight interest swaps show the market's expectation of interest rates over the next year. They're expected to rise to 3.0 per cent by July.
The ECB rate filters through the entire economy, and ultimately informs interest rates. According to work done by Kieran McQuinn while at the Central Bank of Ireland, 74 per cent of base rates get translated into mortgage rates. So if the ECB were to raise rates by 2.25 per cent over the next seven months, mortgage rates would be expected to go up by 1.67 per cent.
A 1.67 per cent rise in interest rates would not be pleasant. On a €400,000 tracker mortgage, it could translate to an extra €200 per month. But it's nothing like as severe as what we're seeing elsewhere. In the US, long-term fixes are now running at 7 per cent. In the UK, even short-term mortgage rates are forecast to hit 6 per cent next year.
The following chart — which is a bit tricky to follow — shows how interest rates feed through to mortgage payments. The outstanding mortgage is on the X-axis, and mortgage payments are on the Y-axis.
What about house prices? As part of its quarterly economic commentary last week, the ESRI published a model of house prices by Kieran McQuinn. It's based on affordability (disposable income and interest rates), credit conditions (how much credit buyers get for a given income), supply (the housing stock) and demand (the number of likely buyers). Based on last week's interest rate conditions, the model found that Irish house prices were overvalued by 7 per cent relative to the fundamentals. The following chart, from the ESRI, shows how the model's estimate has compared to market prices.
How would rising rates impact fundamentals? McQuinn said all things being equal, according to his model, a 50bps increase in interest rates would lower house prices' fundamental value by 2.0 per cent.
If I plug the market interest rate forecasts into the model, and assume 74 per cent of market rates wash through to mortgage rates, what I get is a 6.7 per cent drop in fundamental values. The average Irish house is worth €295,000, so a 6.7 per cent drop would be €20,000. 6.7 per cent off the average Dublin house price of €427,000 would be €29,000.
Remember, the ESRI says house prices are 7 per cent overvalued already. So, if the market's forecasts hold up, house prices would have to fall 13.7 per cent (7 per cent plus 6.7 per cent) by next summer to line up with their fundamental values. That would be €40,000 off the price of the average Irish house, or €59,000 off the average Dublin house.
At this point, it’s only fair to credit the Central Bank of Ireland. The Central Bank tightly limits the amount Irish people can borrow for mortgages. This has had the effect of keeping house prices down, and making houses unaffordable to many. But had credit been looser in the last decade, house prices would be much more exposed to interest rate rises.
More, or less
Fundamental values, as predicted by a model, are one thing. But market prices are another. It might be that prices stay higher for longer — as we've seen, people whose jobs (and mortgage fixes) are secure are not likely to be in a rush to move house, onto a higher mortgage rate. About half of Irish mortgage holders are fixed for a year or longer.
Or it might be that market prices fall even more than fundamentals! Psychology comes into it. People buy, partially, in the expectation that prices will keep rising. The same thing applies on the way down.