Credit risk: mortgages 2023

Supervised institutions incur a two-fold credit risk when they grant a mortgage: firstly, there is a risk that customers are unable to meet their interest and amortisation obligations, resulting in a credit default for the lending institution. The better customer affordability is, the lower the risk of default. Secondly, there is a risk that the value of the property that serves as collateral for the loan falls in the event of default, and the lending institution therefore incurs losses. The risk of a large loss in the event of default increases if property prices collapse in a crisis. This risk can be mitigated if the lender does not permit excessive loan-to-value ratios and borrowers are required to provide sufficient equity.

The total volume of outstanding mortgages lent by banks has continued to rise. This is largely due to sharp growth in lending for investment properties. Growth in lending for investment properties has slowed somewhat but is still significantly positive. The rise in mortgage interest rates means that banks’ margins have also risen. This has a positive impact on profitability (see previous section), particularly for small and medium-sized banks for whom the mortgage business is the main source of revenue.

New loans for buy-to-let properties (residential apartments or houses let by private individuals) have been falling since interest rates began to rise. This is due to the fact that higher interest rates mean this type of investment is producing a lower return and is thus less attractive.

Since interest rates began to rise, the share of new mortgages with a variable interest rate (i.e. linked to SARON) is twice as high as during the negative interest rate environment. Affected borrowers are therefore exposed to greater interest rate risk or affordability risk.

In addition, FINMA has observed that many banks do not use sustainable lending criteria. This means they tend to overestimate what borrowers can afford. In these cases, for example, the projected interest rate was set too low or the affordability threshold too high. In addition, many banks grant a very high proportion of “exception to policy” loans, i.e. loans that are outside their own lending criteria.

The chart shows the distribution of projected costs in relation to the affordability criteria of 45 banks. These figures relate to the financing costs of an investment property with a loan-to-value (LTV) ratio of 75% and a residential property with an LTV of 80%. It illustrates how banks use very different assumptions for projected costs (projected interest rate and ancillary costs) in their lending policies, and in some cases include only a very limited buffer for unforeseen events. In combination with elevated borrowing costs this can lead to higher affordability risks for customers that can in turn lead to greater loan defaults for banks.

The rate of price growth in the residential property market only began to slow in mid-2022, even though interest rates began to rise at the end of 2021 and the number of transactions has fallen since then owing to the resultant weakening of demand. However, as supply is very limited, transaction prices are still being paid that have led to rising price indices.

Higher interest rates have put pressure on the valuation of investment properties. However, vacancy rates are at an historic low and rents have also risen due to the higher underlying interest rates, which has an offsetting effect on the valuation of investment properties. High immigration and the large number of asylum seekers have created strong demand for rental properties. As only small numbers of new homes have been built in recent years, this has led to a very tight rental market. A further point is that demand from institutional investors for residential property is likely to be sensitive to the changed interest rate environment as the rise in interest rates means that other attractive investment opportunities are now available.

A real estate crisis would have a serious impact on the Swiss financial centre. If property prices fell significantly, the collateral for these loans would be worth much less than was assumed when they were first granted. This would result in appreciable losses for the mortgage lending institutions. FINMA stress tests show that a severe real estate crisis could result in total losses in the double-digit billion range. Some banks would hold too little loss-absorbing capital for the mortgage portfolio to cushion these losses.

In view of the high overall volume of mortgage lending, banks’ capital buffers are extremely important. The countercyclical capital buffer reactivated by the Federal Council at the end of September 2022 therefore continues to apply. Once the final package of Basel III reforms enters into force, banks using the standard model will have to set aside considerably more capital for mortgages on investment properties than for mortgages on owner-occupied properties due to the differing risk levels.

Compared to the banking sector, the share of mortgage lending in the insurance industry remains low and is on a declining trend. However, insurance companies are exposed to the real estate market through direct and indirect investments in property. Property held directly and indirectly and mortgages make up an average of 18% of insurers’ investment portfolios. A real estate crisis combined with rising interest rates would therefore have significant consequences for insurers’ solvency and coverage of tied assets.

(From the Risk monitor 2023)