The growing systemic risk in German construction loans

Many Germans are no longer financing their properties soundly: little equity and low repayments – otherwise, they simply can't afford a house or apartment. This is risky. For the system, too.

When a German homeowner fulfills their dream of owning their own home, they do so in a very sound manner. They start saving while still in school, pay the closing costs in cash by age 30, and finance only 70 percent of the house price with a loan. In the years and decades that follow, they earn enough regularly to pay everything off according to plan. They then spend their well-earned retirement contentedly as a homeowner, sitting on the bench in their front yard.

That's the stereotype. And often, the image of the respectable homeowner still holds true. But increasingly, it no longer does. Because not everyone is lucky enough to inherit a lot of money, receive financial support from wealthy parents, or have a straightforward work history with consistently high incomes. And at the same time, property prices continue to rise due to low interest rates and high demand.

Property prices have been rising for years

The market research company F+B has just published updated price statistics showing that condominiums have increased in price by 2.2 percent and single-family homes by 1.8 percent within just three months. Year-on-year, prices rose by a substantial 7.1 and 5.2 percent, respectively. This is many times the normal rate of inflation. Extending the timeframe only slightly reveals the true extent of the real estate boom in Germany: According to F+B, condominiums have increased in price by an average of 31 percent over the past five years, and by a full 40 percent since 2006.

For many households, apartment prices exceeding €300,000 are no longer easily manageable, especially since high property transfer taxes and real estate agent fees are driving up closing costs. The only solution: contribute less equity to the loan and make slightly lower repayments so that the monthly payment, including interest and principal, is just about affordable with their salary.

Herein lies a danger that, according to credit expert Hans-Joachim Dübel, could even lead to a genuine systemic crisis. With his company Finpolconsult, Dübel advises governments worldwide. He previously worked at the World Bank and focuses extensively on residential mortgage lending in Europe. "A typical pattern is this: with falling interest rates and rising demand, real estate prices also increase dramatically," says Dübel. "To remain competitive, banks are forced to continually lower their lending standards."

Hide the loan term

These declining standards include, for example, accepting a slightly lower equity stake more frequently than usual. Or offering a lower initial repayment rate. And above all: completely ignoring the actual loan term – a mistake many borrowers make. This is precisely the Achilles' heel of the classic German fixed-rate mortgage: If, with low interest rates, the repayment rate remains too low over the long term, it becomes impossible to repay the loan within one's lifetime. Because the lower the repayment rate, the longer the loan term.

For example, someone who borrows €300,000 from the bank for construction at 1.5 percent interest and 3.5 percent repayment will be debt-free after just 25 years. However, if the repayment rate is reduced to 1.5 percent, the loan term extends to almost 50 years. Such long periods are simply unmanageable for both the borrower and the banks and savings banks.

“At some point, a point is reached where falling margins, increasing loan-to-value ratios, and extremely long loan terms coincide with stagnant prices,” warns credit expert Dübel. This is a typical sign of the peak of the price cycle and can be empirically verified in many European countries.

Is the market overheating?

In Germany, too, there are increasing signs that the market is overheating. Project developers and construction companies in Berlin, for example, who also offer financing through partner firms, now consider an initial repayment rate of 1.5 percent to be quite normal. The lending platform Interhyp reports that the proportion of those planning to take out 100 percent financing has increased by almost 60 percent compared to 2015 – from 9.5 percent to 15.1 percent of those interested in mortgage loans. In contrast, only ten percent are willing to contribute more equity to cope with rising prices.

“Repayment rates may have risen on average because many households have a sufficiently high income,” says Dübel. “But what’s crucial for a crisis situation is the lower end of the market – those borrowers with low incomes, high loan-to-value ratios, and low repayments.”

Dübel says that mass defaults by borrowers are not necessary for a credit crisis to occur: "Even in the USA, the rate of loan defaults in the middle-income segment was not 30 percent, but two to three percent. Given the thin equity base for housing loans, that was enough to bankrupt the major mortgage lenders Fannie Mae and Freddie Mac."

Government plans a new law

The banking system, and savings banks in particular, are ill-prepared for fundamental market changes such as rising interest rates and falling prices. "If, for example, savings banks continue to finance too high a proportion of real estate loans through deposits, and loan terms and fixed interest periods keep increasing, we could face a savings bank crisis," said Dübel.

The German government is apparently aware of the risks currently posed by mortgage lending. A law is to be passed before the next summer recess that will strictly regulate the granting of construction loans – in case the market overheats. The draft law proposes a cap on the proportion of debt financing. It could also stipulate a repayment period within which a certain percentage of the loan must be repaid. Furthermore, a limit on a borrower's debt-bearing capacity could be defined. Fourthly, it would be possible to make a minimum repayment mandatory. Interest-only loans would then no longer be conceivable.

The federal government says a de minimis threshold will be established for small loans. Loans for financing renovations and refurbishments will also be excluded, as will refinancing and social housing construction. Existing loans will not be affected.