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Asset Price Risks: Inflated Property Values Mean Higher Loss Assumptions In European RMBS And Covered Bonds

In this report, S&P Global Ratings explores how current prices affect our assessment of European housing markets' under or overvaluation in the context of our global residential mortgage-backed securities (RMBS) criteria. The assessments differ by country, and we consider most European countries' housing markets to be overvalued relative to the long-term trend in affordability metrics.

Across Europe, house prices increased during the COVID-19 pandemic and while appreciation was a consistent trend, the cause was not initially transparent, given unprecedented disruption to economies and borrowers' finances.

Over the long-term house prices generally tend to be positively correlated with income levels but other factors can also be significant, such as changes in property purchase taxes, mortgage regulation, and prevailing interest rates. During the pandemic, buoyed by the low-rate environment, purchase tax cuts, and purchasers flush with excess savings, some countries--notably, the U.K., Sweden, Austria, and Netherlands--saw significant house price appreciation that did not correlate to wage growth.

How Do We Assess Under Or Overvaluation?

In our credit analysis of residential mortgage pools backing RMBS or covered bonds, we establish a broad measure of under/overvaluation for the relevant housing market. This later informs the scale of market value declines we assume in our rating stress scenarios.

In European countries, our starting point for assessing housing market under or overvaluation is a simple measure of affordability: the average house-price-to-income ratio. If recent values for this measure are significantly higher than the long-term average, then we may consider the market to be more over-valued and vice versa. For these assessments, we typically use data from the OECD and, in the U.K., the Office for National Statistics and the Land Registry. We also consider other factors--such as the interest rate and fiscal environment--and assess whether these are relevant to understanding the level of housing market under or overvaluation in a country or region.

Data on house-price-to-income ratio in Europe has shown considerable volatility from the start of the COVID-19 pandemic in March 2020. Lower income means housing becomes less affordable relative to the long-term average and that the house-price-to income ratio will worsen, all other things being equal.

Pandemic-related economic shutdowns during 2020 and 2021--along with support measures to counter their effects--likely had a distorting effect on this data. For example, reported income may have been temporarily lower while lockdowns were in place.

Because of volatility we suspended updating under and overvaluation and property indexation at the start of the pandemic. We updated models to reflect the updated calculations on under and overvaluation in January 2022.

Current Estimates Of Under Or Overvaluation

Current estimates of under and overvaluation differ by country and are detailed in the chart below.


Chart 1


In the U.K. we distinguish and apply different estimates of under and overvaluation based on region. London and the South-East are together considered to be 50% overvalued, while all other regions are 20% over valued.

Property Indexation And Estimating Under Or Overvaluation

House price increases following a loan's origination are, in isolation, credit positive. They increase borrower equity, which in our analysis of mortgage pools backing RMBS and covered bond transactions means a lower estimated propensity to default, as well as a lower loss severity if the borrower does default.

Changes in our under or overvaluation assessment can lower or increase assumed loss severities by ratings category. Similarly, the application of indexation can move overall estimation of loss severity upward or downward.

If house prices increased by 10% without any increase in income level or movement in other factors that may support prices--or if income levels declined over the same time period--then this would point towards house prices becoming increasingly overvalued. In other words, it may be the start of a speculative bubble forming. This would likely increase the overvaluation or lower the undervaluation, which would lead us to increase our market value decline (MVD) assumptions.

Because house prices and under or overvaluation are linked in our analysis, we generally update indexation and reassess our under or overvaluation at the same time. Where possible we use data up to the same period.

We expect to update indexation and the under or overvaluation annually. Ordinarily, movements in house prices and the implied under or overvaluation are not significant on a month-to-month or quarter-to-quarter basis. However, if we consider movements to be significant enough to update more frequently, we will do so and communicate this.

What does this mean for residential-mortgage pools?

Our over or undervaluation metric shows affordability compared to a long-term average. Therefore, it may influence how much property prices could fall in certain scenarios. We expect a greater correction in property prices is more likely in an overvalued market than in an undervalued one.

In our global RMBS criteria, our assessment of over or undervaluation applies to our MVD assumptions when calculating the loss severity for each loan. Up to 50% of the overvaluation amount is added to the MVD, while 20% of the undervaluation is subtracted from the MVD. For example, for a loan in a country with 15% overvaluation, if the standard MVD assumption for a certain rating scenario level is 30% the MVD would be 37.5% (30% + (15%*0.5)), assuming 50% of the overvaluation amount were applied. Conversely, for a country undervalued by 15%, the MVD assumption for that same rating scenario would be 27% (30% – (15%*0.20)).

In addition to changes to our overvaluation assessment, house prices have increased significantly across Europe. As explained in our criteria, when indexing such loans, we apply 100% of upward movements and 100% of downward movements. The overall effect on a mortgage pool will depend on the geographic distribution and valuation date of the properties backing the loans in the pool.

Related Criteria

This report does not constitute a rating action.

Primary Credit Analyst:Alastair Bigley, London + 44 20 7176 3245;
Secondary Contact:Casper R Andersen, Frankfurt + 49 69 33 999 208;

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