Abolition of tax relief on mortgage interest: a risk or an opportunity?
A discussion has been raging for years in the Netherlands about making cuts in tax relief on mortgage interest, but so far moves to alter the system have come to nothing. But this look set to change. The tax relief on mortgage interest was an item in every political party manifesto for the general election in June 2010 and everybody is talking about it.
A poll conducted by Maurice de Hond actually showed that a majority of the population favors altering the present scheme. The next step might be its complete abolition. Consultant Martijn de Groot explains how this could affect the risks of mortgage portfolios.
Abolishing tax relief on mortgage interest will have various effects on society, including on the national budget and house prices. It will also influence the risks in a mortgage portfolio.
This is because any abolition or relaxation of tax relief on mortgage interest would also affect the liquidity position, the interest rate results and the economic capital that banks must hold. This article looks at several items that will be hugely important for every mortgage risk manager in the coming period.
Homeowners appear to be hanging on to their present homes longer than usual because they first want to see which way developments swing. NVM, the Dutch association of real estate agents, predicts renewed doldrums in the housing market in the second half of 2010 because of the uncertainty triggered by the debate on tax relief on mortgages.
“One thing is certain: risk managers of mortgage portfolios have an extra consideration to keep them busy.”
This is being exacerbated by the impending second wave of the credit crisis that is caused mainly by the South European countries. In the more distant future the effects of abolishing mortgage interest tax relief may be even greater. If house prices really start to drop after a revamp of tax relief, homeowners will perhaps be obliged to continue living longer in their present homes to recover a possible loss on their values.
After all, a sale results in a debt that must immediately be repaid to the bank, something many homeowners are unable to do. They defer the sale of their home until the prices go up and for that reason stick with their existing mortgage.
Uncertainty for risk management
The valuation of mortgages makes allowance for a likely early repayment percentage that is usually based on historical data.
So this repayment percentage, either fixed or interest-linked, is likely to be lower in 2010 (and perhaps also in subsequent years). A significantly lower percentage influences the characteristics of outstanding mortgages, such as a lower market value, extension of the liquidity profile and a longer fixed-interest term of the mortgage portfolio.
“In the more distant future the effects of abolishing mortgage interest tax relief may be even greater.”
Theoretically, a significantly lower repayment percentage also affects the business-specific risk in the form of a model risk, due to the increased uncertainty in the model parameters.
If the liquidity and fixed-interest term really are longer than originally estimated, there will be a mismatch between the term of the mortgage and the associated financing. This will increase the interest and liquidity risk.
Financing will have been obtained too short and will need to be restructured by selling short financing and obtaining longer financing. This may put pressure on the margins in the mortgage portfolio because interest for long-term financing is higher than for short-term financing. The sign and level of the effect of the refinancing will be determined among other things by the level and steepness of the current interest curve. At present the interest curve is relatively low from a historical perspective, but steeper than normal.
Besides fewer early repayments, a possible fall in house prices will also adversely affect the credit risk run by the bank. This is because a lower value leads to a larger loan-to-value ratio, a higher likelihood of negative equity, a greater probability of foreclosure and higher losses on default because the security decreases in value. So this will increase the credit risk of the portfolio.
Ultimately, the uncertainty surrounding a possible adjustment of tax relief on mortgages affects not only the state’s coffers, homeowners and project developers, but also on the risk management policy and results of owners of mortgage portfolios. Among other things, an increase in the economic capital for credit risk can be expected and probably also for the business-specific risk on account of the increase in the model risk.
An increase in economic capital reduces the profitability of the portfolio. This will be visible in a lower RAROC (risk adjusted return on capital). The volatility in the interest result of the mortgage portfolio is also likely to increase due to the fixed interest mismatch that occurs between the mortgages and their refinancing.
The scale of all of these effects naturally depends on several factors. An important factor is the way mortgage tax relief will change. Other factors are how long it takes before the new scheme becomes known and the degree of hysteria with which the market and consumers respond to what lies ahead. Finally, the impact is also determined by the level and shape of the interest curve. One thing is certain: risk managers of mortgage portfolios have an extra consideration to keep them busy.