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Bland Unsight

Debt Service Ratios

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Been meaning to start a thread on this topic for a while. One of the things that caught my attention in the June 2014 Financial Stability report Q&A was Carney's answer to a question from Asa Bennett of the Huffington Post, (source).

Asa Bennett, Huffington Post:

Just wanted to ask - obviously, given your move on loan to income ratios and acting at 4.5, whereas Business Secretary, Vince Cable said it should be about 3 or 3.5 to stop banks throwing petrol on the fire. Why is he wrong?

Mark Carney:

Well, there's a couple of things. I mean, we looked closely at the historic performance of not just loan to income, but ultimately getting to what determines - one of the big determinants of whether or not a mortgage performs over time, which is the debt service ratio - so the total amount of debt service that a household has to pay relative to their disposable income. And at different times, at different points in the rate cycle, at different amortisation periods for mortgages, different loan to income ratios correspond to different debt service ratios. First point. In the UK, in Canada, in Northern Europe - a variety of jurisdictions - one sees that debt service ratios of around 35, 40% - once you get to those levels, when there's a shock, there tends to be a jump up in non-performance of mortgages, they become riskier mortgages. Not all of them, but on average. And with the average amortisation of mortgages in the UK today moving out towards about 27, 30 years - so they're longer amortisation than in the past - with the expected path of interest rates, including that stress 3% interest rate, the expected path of interest rates - a loan to income ratio of about 4.75 - 4.5, 4.75 corresponds to that 35%. So by restricting down into - by restricting the total proportion of those loans and then letting the banks select the more creditworthy borrowers - their judgements have to be made - we're consistent with prudent lending practices. The-three-and-a-half time level would have been more consistent with a period of much higher interest rates and shorter amortisation - similar experience.

What I took from that was that when Carney says that the Bank doesn't target house prices, he's basically telling the truth. They are targeting the debt service ratios - the fact that at a given interest rate and a given mortgage term, once you set the debt servicing ratio you're willing to tolerate you've set a limit on loans, and obviously, loans size determines sales price, but strictly speaking, what you are targeting is the debt service ratio, not the price.

Another point that emerges pretty plainly from my reading of his answer is that he is saying that if the median loan is 35%, that's trouble. You can tolerate a small percentage of mortgaged households on 35%, but you can't have everyone at a debt service ratio (DSR) of 35%.

If I assume that Carney wants households households at 30%, I can work forward from there. Local median earnings is £22k, so with a household with two £22k incomes, after tax you have £3,000/month coming into the household. That means that Carney wants no more than £900 going out on the mortgage.

The other way to come at the problem is via the house price. Where I am an entry level crap two bed will cost you about £225k. Carney's suggesting a 27 year mortgage term and the NatWest mortgage calculator gives me a 2 year fix at 3.59% (£926/month, DSR 30.9% ) or a 5 year fix at 4.69% (£1040/month, DSR 34.6%). A five year fix at 5.49% is going to cost me £1,110/month (DSR 37%)

For a laugh a 95% LTV HTB mortgage is going to be 5.69% on the 2 year fix (£1,290/month DSR 43%) and 5.89% on the 5-year fix (£1,320/month DSR 44%).

If the Bank is really targeting this debt service ratio in their attempts to promote financial stability, it is a cap on house prices by any other name, and where I am at least, we are basically already at the level of the cap on these comedy once in a lifetime mortgage rates. It also makes it abundantly clear that Carney and Osborne really don't see eye to eye on Help to Buy.

The other interesting thing is how the two sides of the ratio scale. If the mortgage rate goes up from 3.59% to 4.69% (an absolute change of 1.1%) the payment goes up from £926 to £1040. In order for the DSR to stay at 30% on the nose the household income needs to move from £3,086/month to £3,467/month - that's an increase of 12%. Not only is it a cap, but it is a cap that moves down as mortgage rates move up, especially in the absence of wage inflation. You need about 2.2% compounded for 5 years in order to move your wages 12%. I for one think the chances of seeing wage inflation like that are a lot less than the chances of mortgage rates moving up by 1%.

[Edit: link to source quote]

Edited by bland unsight

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So everyone is obliged to at some point in their lives to take on some kind of debt....debt, the right debt, at the right price, at the right time brings handsom rewards......what happens if no one no longer believes that?.....what happens when debt fails to repay? ;)

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Oo, you are optimistic. He said average loan moving out to 27, 30 years so some scope to increase prices. And anecdotally I am hearing of (otherwise sane) people I know looking at 32 and 35 year terms to stretch MMR as far as they can which is higher prices again.

Bomad for deposit too, pensions coming on line soon as well. You're giving Carney a lot of credit for basically doing ****** all to stop it.

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I love his confindence that wages are sustainable.

His view is clear that debt servicing is possible on current wages, this raises the rather wonder point of what happens if wages fecking decrease. What happens to this morons wonderful debt service ratio then?

Still I'm sure that won't happen as wage growth is fast getting out of control.

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Oo, you are optimistic. He said average loan moving out to 27, 30 years so some scope to increase prices. And anecdotally I am hearing of (otherwise sane) people I know looking at 32 and 35 year terms to stretch MMR as far as they can which is higher prices again.

Bomad for deposit too, pensions coming on line soon as well. You're giving Carney a lot of credit for basically doing ****** all to stop it.

No doubt I am optimistic. There is much more to be optimistic about.

There was a passing reference to "mortgage tenors" in the Mansion house speech, clear as mud but here is the relevant part

The value of acting early is reinforced by uncertainty around the precise impact of macroprudential tools. While these have proven effective in other countries, they are still relatively novel here. By acting, assessing, and if necessary re-calibrating, we are more likely to strike the right balance to support durable growth over the medium term.

That’s why authorities have already moved. Last autumn we took our foot off the accelerator by removing capital relief for banks on new mortgages and, with the Treasury, by re-focussing the Funding for Lending Scheme away from mortgages towards business lending. Those steps were followed by the implementation in April of the Mortgage Market Review to reinforce banks’ underwriting standards and the stress test to underpin their capital discipline.
The FPC has a wide range of other tools if further action is justified. We can direct lenders to raise capital held against mortgages or against all credit. Thanks to the FCA, we are now able to recommend a tougher interest rate stress to which new borrowers are subjected when banks assess affordability. We can also make prudential recommendations about the share of high loan to income, loan to value and long tenor mortgages in banks’ and building societies’ new lending. In this regard, I applaud the Chancellor’s intention to grant the FPC additional directive powers in relation to these aspects of mortgage portfolio composition. I also welcome the Chancellor’s commitment to adjust the Help to Buy Mortgage Guarantee Scheme to comply in full with any FPC actions.

Source: Mansion house speech, (emphasis added)

If you are trying to keep a lid on indebtedness it doesn't make any sense to ignore mortgage terms. Anyway seeing as we've killed off mortgages with an infinite term (interest only mortgages) I think that post 2008 we already have a clear direction of travel toward shorter not longer terms.

It is perhaps worth pointing out that the Mansion house speech was 12 June and then with the Financial Stability Report (26th June) we got a lending cap, so of the emboldened options, the BoE moved on one of them (LTI ratios) within a fortnight. OK - the cap wasn't as watertight as it could have been and it wasn't at the level that many (including me) would like to have seen but at least it is a cap of some sort, which again was new compared to the self-cert underwriting of the boom, as 5.5x a number that is as big as you want it to be is not any kind of cap - and we got the brutal HPI that you might expect to reflect that fact.

I accept that Carney and pals are happy to saddle households with a lot of debt, but suggesting that they aren't doing anything is going too far. (You can definitely argue that Carney and pals are not willing to tolerate households saddling themselves with debts that the households themselves, if given the opportunity, are perfectly willing to take on - and in my book that is not a trivial matter.) When compared to the acquiescence of the FSA pre-2008, Carney's regulatory circus are megalomaniac regulators, though I'll give you that being judged as better than the FSA is to be damned by faint praise.

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Where are you that house prices are that high but local earnings are that low? Looking at Bristol, "crap 2 beds" start at around £130k, median net wages are £17k, so a couple taking out a 90% mortgage on a five year fixed rate deal at 5% would have monthly repayments of <£700, putting their debt service ratio at <25%.

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Where are you that house prices are that high but local earnings are that low? Looking at Bristol, "crap 2 beds" start at around £130k, median net wages are £17k, so a couple taking out a 90% mortgage on a five year fixed rate deal at 5% would have monthly repayments of <£700, putting their debt service ratio at <25%.

South East. Live Table 577 found on this gov.uk page gives the ratios for the whole country as an excel file.

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Where are you that house prices are that high but local earnings are that low? Looking at Bristol, "crap 2 beds" start at around £130k, median net wages are £17k, so a couple taking out a 90% mortgage on a five year fixed rate deal at 5% would have monthly repayments of <£700, putting their debt service ratio at <25%.

In other news, I'm moving to Bristol, ;)

Edited by bland unsight

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No doubt I am optimistic. There is much more to be optimistic about.

There was a passing reference to "mortgage tenors" in the Mansion house speech, clear as mud but here is the relevant part

Source: Mansion house speech, (emphasis added)

If you are trying to keep a lid on indebtedness it doesn't make any sense to ignore mortgage terms. Anyway seeing as we've killed off mortgages with an infinite term (interest only mortgages) I think that post 2008 we already have a clear direction of travel toward shorter not longer terms.

It is perhaps worth pointing out that the Mansion house speech was 12 June and then with the Financial Stability Report (26th June) we got a lending cap, so of the emboldened options, the BoE moved on one of them (LTI ratios) within a fortnight. OK - the cap wasn't as watertight as it could have been and it wasn't at the level that many (including me) would like to have seen but at least it is a cap of some sort, which again was new compared to the self-cert underwriting of the boom, as 5.5x a number that is as big as you want it to be is not any kind of cap - and we got the brutal HPI that you might expect to reflect that fact.

I accept that Carney and pals are happy to saddle households with a lot of debt, but suggesting that they aren't doing anything is going too far. (You can definitely argue that Carney and pals are not willing to tolerate households saddling themselves with debts that the households themselves, if given the opportunity, are perfectly willing to take on - and in my book that is not a trivial matter.) When compared to the acquiescence of the FSA pre-2008, Carney's regulatory circus are megalomaniac regulators, though I'll give you that being judged as better than the FSA is to be damned by faint praise.

Of the 3 measures you highlight, I can only look at my own situation and think they chose the least effective brake of the 3 and that is not so much of a brake as encouragement to lend regionally. Married to govt policy (not Carney's remit) about H2B and pensions, I'm not putting the champagne on ice.

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The idea that house prices could ever fall simply wasn't on the radar. As Spencer Dale indicated at the Treasury meeting on Tuesday, in due course they are expecting household debt levels to rise again as a proportion of income, even above 2008 levels. Younger households are presumed to take on large amounts of debt in order to buy homes from those who are mortgage-free.

They were explicit with this in the FSR:


FSRNov2013e.gif


Mark Carney actually mentioned it, and in a response to a youngish journo he joked that one day the guy would have to take on a large mortgage if he wanted to buy a home (I'm paraphrasing from memory).

We didn't get to see the journo's reaction.

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Carney is doing f-all. Other than impacting sentiment by talking rates up and the market slightly down that is.

Firstly, there isn't a cap at 4.5x. The cap is that 15% of mortgages written cannot be >4.5x. So in theory a bank could write 85% of mortgages at 4.49x salary and then write 15% at 15x salary and Carney would be happy! Luckily he knows they aren't THAT reckless. In Q1 only 9% of mortgages were greater than 4.5x so the incremental impact of this rule is nowt.

Secondly and my fave measure from the FSC is the dreaded stress test. Whereby lenders have to asses the impact of a 300 bps hike in the first 5 years of a mortgage on affordability. Well 90% of mortgages last year were fixed rate and a handsome proportion are 5 year fixes. What happens to the monthly payment on a 5 year fix if interest rates move 300 bps? Diddly squat! So the B of E are pushing people into 5 year fixes. But in 5 years house prices could be down 30% nominal and interest rates at 5% and that won't be pretty when folks re-mortgage!

Carney is a bonafide Keynesian money printing bankster twerp. Load up on physical gold (in your vault not his) and be patient!

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Carney is doing f-all. Other than impacting sentiment by talking rates up and the market slightly down that is.

Firstly, there isn't a cap at 4.5x. The cap is that 15% of mortgages written cannot be >4.5x. So in theory a bank could write 85% of mortgages at 4.49x salary and then write 15% at 15x salary and Carney would be happy! Luckily he knows they aren't THAT reckless. In Q1 only 9% of mortgages were greater than 4.5x so the incremental impact of this rule is nowt.

Secondly and my fave measure from the FSC is the dreaded stress test. Whereby lenders have to asses the impact of a 300 bps hike in the first 5 years of a mortgage on affordability. Well 90% of mortgages last year were fixed rate and a handsome proportion are 5 year fixes. What happens to the monthly payment on a 5 year fix if interest rates move 300 bps? Diddly squat! So the B of E are pushing people into 5 year fixes. But in 5 years house prices could be down 30% nominal and interest rates at 5% and that won't be pretty when folks re-mortgage!

Carney is a bonafide Keynesian money printing bankster twerp. Load up on physical gold (in your vault not his) and be patient!

I didn't realise the 5 year fix exemption from MMR till I read it in the London thread earlier. I still don't quite believe it.

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The idea that house prices could ever fall simply wasn't on the radar.

...

Yeah right - note that FT is posting in November 2013

Financial Stability Report Q&A seven months later, in response to Paul Mason's jibe that the BoE is the Bank of Zero (i.e. doing nothing and impotent).

The stress test - there's no reason to come to the conclusion that the stress test is zero. As Andrew Bailey just outlined, a 35% house price shock - it's a stress scenario, it's not a prediction, just to be clear. But in conjunction with a 6% increase in the unemployment rate - stress scenario, not a prediction - a sharp increase in interest rates and a three year recession, do banks and building societies in this country have balance sheets today that are resilient enough to withstand that type of stress? And if they don't, the PRA and the FPC will consider actions that those institutions need to take to address them.
So it would be a big mistake to look at the stress test, which we're undergoing right now, and conclude that this anything other than a very serious exercise that may have consequences for some banks and building societies.

It is perfectly reasonable to be cynical, but you can take a thing too far. When was Mervyn King's Bank of England given the remit to look at whether or not Lloyds Group could survive a 35% house price correction on the extended premise that there would also be a hike in unemployment, a sharp rise in interest rates and a three year recession - and happily talk about it at a press conference and almost joke about the fact that the 35% fall was a scenario, not a prediction, (which means it is a prediction BTW)? And even if they had the inclination to look, did they have the regulatory authority to do anything about it? King knew that all he could do was preach sermons. And then the banks blew themselves up, and then things changed.

You ought to hold off joking at the expense of new posters that they are suffering from Stockholm syndrome, :P . If we take our identity as the victims of invincible crap banks then we are always going to see things one way, even when in reality it is the other way.

Ask a mortgage broker if nothing has changed.

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I didn't realise the 5 year fix exemption from MMR till I read it in the London thread earlier. I still don't quite believe it.

I noted it in a thread some time ago.

Here's the relevant snapshot from the FCA handbook (my highlight):

FCA_handbook_MMR_interestrate.gif

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Carney is doing f-all. Other than impacting sentiment by talking rates up and the market slightly down that is.

Firstly, there isn't a cap at 4.5x. The cap is that 15% of mortgages written cannot be >4.5x. So in theory a bank could write 85% of mortgages at 4.49x salary and then write 15% at 15x salary and Carney would be happy! Luckily he knows they aren't THAT reckless. In Q1 only 9% of mortgages were greater than 4.5x so the incremental impact of this rule is nowt.

Secondly and my fave measure from the FSC is the dreaded stress test. Whereby lenders have to asses the impact of a 300 bps hike in the first 5 years of a mortgage on affordability. Well 90% of mortgages last year were fixed rate and a handsome proportion are 5 year fixes. What happens to the monthly payment on a 5 year fix if interest rates move 300 bps? Diddly squat! So the B of E are pushing people into 5 year fixes. But in 5 years house prices could be down 30% nominal and interest rates at 5% and that won't be pretty when folks re-mortgage!

Carney is a bonafide Keynesian money printing bankster twerp. Load up on physical gold (in your vault not his) and be patient!

If you believe this you are ignorant, and if you don't, why post it? What is Crap Bank plc going to do with these 15x salary loans - securitize them and sell them to a German dentist as AAA-rated MBS? That ship sailed. So they keep them in their loan book. How is a loan like that likely to behave? What if your bonus is subject to a 7 year claw back clause? What happens to your job if you are part of the bank that approves and grants mortgages and your idiocy drives the crap bank into the welcoming arms of UKAR and the days of Crap Bank plc writing new mortgage business come to an abrupt end? It is not 2007 any more. We had a financial crisis. Things changed.

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30% is the target? That's monstrous!

...

Can I have the source for those charts? Are the debt service ratio for the economy or for new mortgage business? It kind of matters, don't you think?

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I noted it in a thread some time ago.

Here's the relevant snapshot from the FCA handbook (my highlight):

...

I'm happy with the idea that rates might go higher - but a high-LTV 5 year fix is going to come in at about 5.5% today. With the 10-yr gilt at 2.6% and the amount of debt being carried by the economy at the level that it is at, are we seriously considering the idea that these 5-year fixes are not going to be able to re-mortgage within 100 bps of 5.5%. If they can't, surely you're going to get your house price crash, if you haven't had it already...

My assumption is that the market can't really handle 4% on a repayment basis and is just trying to pretend that it can, wandering on like a zombie, because it hasn't understood that it is already dead.

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. Things changed.

I do agree it will take 70 years before we forget this one and make the same mistakes.

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Ask a mortgage broker if nothing has changed.

I did.

I can borrow £10,000 more than I could a year ago if I push the term out to 32 years...

Edit: I think BTL, still unregulated, is far more likely to be the issue and that too is reliant on rate rises for it to happen.

Edited by 8 year itch

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I did.

I can borrow £10,000 more than I could a year ago if I push the term out to 32 years...

The rationale behind the MMR interest rate test is that after 5 years the borrower will have paid off a significant proportion of the loan principal and therefore be less vulnerable to rises in rates.

The affordability test under MMR has to be made with the assumption of a maximum loan term of 25 years, even if the actual mortgage duration is longer than this. However, since there's no interest rate test required if the borrower is taking a 5-yr fix, this appears to have left a weakness in the regs. For a 25-year mortgage at 5%, roughly 11.5K on an original 100K will have been paid off after 5 years. However on a 35-year mortgage only 6K will have been paid off, leaving the borrower more exposed to a sharp rise in interest rates.

A few days ago Santander extended its maximum loan term for HTB equity loans from 25 to 35 years, despite announcing other measures which appeared to tighten its lending criteria.

One of the arguments against the use of macroprudential tools to keep a lid on house prices is that one way or another lenders will always find a way to circumnavigate regulations, just as they did with capital requirements before the financial crash.

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The rationale behind the MMR interest rate test is that after 5 years the borrower will have paid off a significant proportion of the loan principal and therefore be less vulnerable to rises in rates.

The affordability test under MMR has to be made with the assumption of a maximum loan term of 25 years, even if the actual mortgage duration is longer than this. However, since there's no interest rate test required if the borrower is taking a 5-yr fix, this appears to have left a weakness in the regs. For a 25-year mortgage at 5%, roughly 11.5K on an original 100K will have been paid off after 5 years. However on a 35-year mortgage only 6K will have been paid off, leaving the borrower more exposed to a sharp rise in interest rates.

A few days ago Santander extended its maximum loan term for HTB equity loans from 25 to 35 years, despite announcing other measures which appeared to tighten its lending criteria.

One of the arguments against the use of macroprudential tools to keep a lid on house prices is that one way or another lenders will always find a way to circumnavigate regulations, just as they did with capital requirements before the financial crash.

That's what I'd do if I were a bank.

Try push people into HTB mortgages over longer terms for more mortgage interest payments. Then they have the governbankment underwriting the riskiest part of the loan. Those mortgages will then be easier to bundle up and sell as a MBS.

I've posted on here before that the MMR will just be used to extend mortgage terms. The thing that makes initial payments more affordable when testing at a higher interest rate, is to spread the payments over a longer term. This of course means people pay lots more mortgage interest to the banks. "Sorry you cannot afford this mortgage because of new regulations..... but we can help you.... if you extend it from 25 to 35 years you can afford it because the payments are cheaper and we can fix them for 5 years."

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That's what I'd do if I were a bank.

Try push people into HTB mortgages over longer terms for more mortgage interest payments. Then they have the governbankment underwriting the riskiest part of the loan. Those mortgages will then be easier to bundle up and sell as a MBS.

I've posted on here before that the MMR will just be used to extend mortgage terms. The thing that makes initial payments more affordable when testing at a higher interest rate, is to spread the payments over a longer term. This of course means people pay lots more mortgage interest to the banks. "Sorry you cannot afford this mortgage because of new regulations..... but we can help you.... if you extend it from 25 to 35 years you can afford it because the payments are cheaper and we can fix them for 5 years."

OK, but the Canadian governbankment has just done the opposite, brought mortgage terms down from 30+ yrs to 25. Plus there's the issue of cashflow. I believe lenders generally prefer 20/25yr mortgage terms because the payments are higher, while fixes are Osborne's trick to hold up debt production. He doesn't want mortgagors making overpayments.

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That's what I'd do if I were a bank.

Try push people into HTB mortgages over longer terms for more mortgage interest payments. Then they have the governbankment underwriting the riskiest part of the loan. Those mortgages will then be easier to bundle up and sell as a MBS.

I've posted on here before that the MMR will just be used to extend mortgage terms. The thing that makes initial payments more affordable when testing at a higher interest rate, is to spread the payments over a longer term. This of course means people pay lots more mortgage interest to the banks. "Sorry you cannot afford this mortgage because of new regulations..... but we can help you.... if you extend it from 25 to 35 years you can afford it because the payments are cheaper and we can fix them for 5 years."

But don't the actual facts of the matter as set out in FreeTrader's post rule that out particular tactic as a way of circumventing the MMR rules. If the bank has to conduct the affordability test as if it were a 25-year term, even if it isn't, then moving to longer terms doesn't enable larger loans to me made. At risk of being even more of a bore than usual, isn't it just a plain fact that these regulations are tighter than what went before (which was basically the banks' own analysis of the risks it was taking - i.e. at times, nothing).

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