In the most recent issue of the World Economic Outlook (April 2008), the IMF warns that the US housing crisis is not an isolated event and that “housing prices may adjust downward significantly in many other advanced economies”. In the meantime, housing markets in several European countries (Ireland, Spain, the UK) have gone in retreat. Which country will be next? The Netherlands? The IMF’s analysis is supported by a graph indicating that housing prices in the Netherlands are overpriced by 30%. This suggestion has hit a raw nerve among Dutch politicians, policymakers, brokers and bankers. Finance Minister Bos declared that the Netherlands cannot be compared with the US, as “There is no flourishing market for risky mortgage loans in the Netherlands comparable to those that turned out to be the basis for the financial crisis in the US. In addition, our market is better supervised. We do not see any indications in the current situation that a similar crisis will occur on the Dutch housing market.” President Wellink of the Dutch central bank declared that the IMF’s analysis doesn’t take into account a number of factors which make the Dutch housing market special, such as the scarcity of housing and the system of mortgage interest rate deductability.
Yet these differences conceal a common pattern. Like the US, the Dutch housing market has fallen victim to a dangerous combination of cheap money, financial innovation, perverse incentives and weak supervision. The Dutch version might be less extreme than the US one, but that doesn’t make it risk-free. When monetary policy tightens further and mortgage consumers will get more risk-averse, the affordability of Dutch housing will decrease. A downward correction of the Dutch housing market seems eminent.
Many observers put part of the blame for the credit crisis on Greenspan. After 9/11, the Fed reduced interest rates much more aggresively than the ECB and, according to many, thereby sowed the seeds of the crisis. Yet cheap money wasn’t an exclusive US phenomenon. Between 1996 and 2006 all relevant interest rates (short-term or long-term, real or nominal) on average were lower in the Netherlands than in the US. The difference across the Atlantic was not in the average level of interest rates, but in the volatility of monetary policy. If we further consider that Dutch mortgage interest payments are fully tax deductable, we end up with real after-tax interest rates close to zero over the period 1996-2006.
The Dutch mortgage market indeed differs from the US one. It doesn’t have the same type of subprime mortgages which seduce people who can barely afford a home with low initial interest rates. In contrast, financial innovation in the Dutch mortgage industry is driven by tax shields. Mortgage providers have the incentive to prevent consumers from paying off mortgage debt. In this way, providers can cash in the interest margin over the full amount during the duration of the loan. At the same time, the consumer fully exploits his tax advantage, as the deductable interest payments are maximized. This win-win situation has led to the rise of endowment mortgages, in which funds are invested (usually in a life insurance policy) to repay the loan at the end of the term. Initially, the investment instruments were safe and guaranteed the repayment of the full loan. However, at low interest rates the tax benefit hardly outweighed the mortgage costs. To keep customers from paying off loans, providers and brokers resorted to recommending more risky investments (mainly in equities). High expected investment returns would reduce monthly mortgage payments for the consumer and increase profits for the bank. High fees on risky endowment mortgages stimulated brokers to recommend these products to consumers. They had no incentive to inform their customers about the risks involved. During stock market upswings, this mortgage product provided an irresistable opportunity to get rich using tax-enabled leverage. As a result the share of risky mortages (both endowment and interest only mortgages) increased from 10% in 1996 to more than 50% in 2006. So Bos is wrong. Although the details differ, the Netherlands did have, like the US, a flourishing market in risky mortgages.
Only recently, consumers have become aware that through a combination of high costs and disappointing investment returns, they may face a shortfall on their loan at the end of the repayment period. Though more than six million mortgages are involved, the exact magnitude of the problem is still unknown. The Dutch parliament is pushing Finance Minister Bos for more information, but financial institutions are not very forthcoming in providing details. The financial supervisors have at times warned about risky mortgages, yet they have seldom shown their teeth. No wonder that angry consumers have put their faith in aggressive lawyers, who have already started legal action against “usurious” financial institutions.
Will the Dutch housing market turn? Some claim that continued scarcity of housing will prevent a downturn. But people’s need for housing doesn’t automatically translate into housing demand. Holland is a small country, and many of its citizens would like to buy a (larger) home. But the key factor in predicting the demand for housing is affordability and there are several reasons why the affordability of Dutch housing may deteriorate. First, the era of cheap money has come to an end. Euro area inflation is now close to 4%, which is way above the ECB’s target. The ECB has recently started to increase interest rates and will continue to do so until inflation is under control. Second, the global economic slowdown will affect the Dutch economy and reduce household incomes. Third, there is some evidence that, after all the negative publicity, consumers are starting to avoid risky mortgage products. If they switch to products which guarantee their ability to pay off the mortgage loan, it will cost them more. Finally, if owners of risky mortgages do not make up the projected shortfall on their mortgage in the coming years, they are in for a costly refinance (or for a forced house sale). All these factors work to reduce affordability.
Like in the US, cheap money, financial innovation, perverse incentives and weak supervision together have pushed up Dutch housing prices. The market is therefore a likely candidate for a downward adjustment. One of the chief providers of mortgage finance, the Rabobank, however, points to a long history of pessimistic predictions which didn’t materialize. But not before have all factors influencing affordability pointed in the same direction.
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