## 1. Housing Price Misalignment?

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---

### I. Housing Prices — Macroeconomic and Demographic Drivers
- Rapid real housing price appreciation since the second half of the 1990s; price growth decelerated in 2005 from an annual growth rate of 17.1 percent in Q1 to 12.6 percent in Q4.
- Macroeconomic environment supporting demand:
  - Continued real GDP growth exceeding EU average over the last ten years.
  - Interest rates and unemployment fell to one-fourth and one-half of their 1995 levels, respectively.
  - Average number of employed household members rose from 1.36 to 1.54, increasing household wage income and improving affordability.
  - Immigration flows quadrupled the population of foreign residents; in June 2005 foreign residents amounted to 8 percent of the total population.
  - Average household size declined from 3.2 members in 1995 to 2.9 in 2004 (EU average: 2.4).
  - The Council of Economic Advisors projected 400,000 new households will be formed in the coming years.
  - Sharp fall in interest rates since mid-1990s and the 2001 stock market crash increased attractiveness of real estate relative to bonds and stocks.
- Housing supply and construction:
  - Over 700,000 new houses were built in 2004.
  - Housing construction expected to slow as the market cools over the medium term.
- Tenure patterns:
  - Rental market shrank from 30 percent in the early 1990s to about 10 percent of housing stock by 2001.
  - 2001 census: around 70 percent of existing houses are “main residence”; of those, over 80 percent are owner-occupied and about 10 percent tenant-occupied.
  - Census recorded around 3 million unoccupied houses, though effective rental-available stock is substantially smaller.

### I.B. Evidence on Misalignment and Policy-Related Demand Factors
- Empirical estimates of housing price overvaluation (selected studies):
  - Banco de España: Ayuso and Restoy (2003) — 20 percent.
  - Martínez Pagés and Maza (2003) — 8-17 percent.
  - IMF (2004) — 20-30 percent.
  - The Economist (2005) and other studies — 28-60 percent.
  - Caruana (2005) finds an overvaluation in the range of 24 to 35 percent above estimated long-term equilibrium and suggests gradual correction is possible.
- Policy- and legal-related factors that favor ownership over renting:
  - Fiscal incentives for owner-occupiers: income tax deduction for mortgage payments when buying a house as the main residence; practically no deduction for tenants on rent payments.
    - Mortgage payment deduction caps: maximum deductible for mortgage payments is capped to €1,803 per year in the first two years, after which the maximum falls to €1,577 per year.
    - Actual deductible amount depends on mortgage payments; in 2004 average mortgage payments were €6,357 per household (below maximum annual deduction of €9,015). Based on 2004 averages and assuming constant mortgage payments, implied average tax break would be €1,404 in the first two years and €1,179 in remaining years. For houses purchased without a mortgage loan, there is generally a one-off 15 percent deduction (capped at €9,015).
    - Average expected amortization of a 2004 mortgage was 7.2 years.
  - Legal uncertainty and eviction timelines: average eviction of problem tenants takes 12 to 14 months.
  - Rental contract protections: if contract length set below 5 years, upon termination tenant has right to extend it up to a total length of 5 years.
  - Land zoning and local revenue incentives: local administrations control land zoning and derive substantial revenue from real estate taxes, creating incentives that may limit supply of residential land.
- Government measures (2005-08 Housing Plan) intended to improve affordability and foster rental market:
  - Increased supply of subsidized housing (viviendas de protección oficial).
  - Creation of a public housing rental agency.
  - Tax breaks for rental housing developers.
  - “Fast tribunals” in Madrid and Barcelona to speed housing rental dispute resolution.
  - Impact of these measures on prices and rental market not yet assessable.

### II. Household Debt, Wealth, and Mortgage Market Dynamics
- Aggregate indebtedness and wealth:
  - Households’ debt to income reached 105 percent by end-2004 (euro area average: 90 percent; U.S. ratio: 120 percent).
  - Household wealth rose from about 400 percent of GDP in mid-1990s to 600 percent by 2004; over 500 percent is accounted for by real estate wealth.
  - As of end-2005, households’ net financial wealth stood at 95 percent of GDP.
- Debt-service capacity and distributional metrics:
  - Median ratio of household debt payment to gross income was 15.2 percent in 2002; 7.2 percent of families had a ratio above 40 percent (Bank of Spain, 2004 sample of 5,000 households).
  - Average debt-service in the year of mortgage origination (interest and principal) has remained around 35 percent of households’ average net income over the last 10 years (Genworth study of 700,000 mortgage loans at origination).
  - Distributional example: in 2002, top ten income percentile households had debt payment to income ratio of about 8 percent; bottom 20 percentile about 32 percent.
- Drivers of stable debt-service ratios despite higher mortgage debt:
  - Interest rates fell from over 10 percent in early 1990s to about 2 percent by mid-2005 (one-year reference rate, EURIBOR).
  - Fierce competition and financial market development reduced mortgage spreads; average spread above EURIBOR for floating-rate residential mortgages about 75 basis points.
  - Mortgage maturities extended from maximum of 10 years in early 1990s to over 30 years by 2005.
- Vulnerabilities and mitigating factors:
  - Vulnerabilities:
    - A housing price fall of about 25 percent (in line with recent overvaluation estimates) could leave some households with negative equity, especially recent mortgages with LTV around 80 percent.
    - Such a fall would negatively impact consumer confidence and economic activity; construction accounts for 10 percent of GDP and 13 percent of total employment.
    - With predominantly floating-rate mortgages, tightening European monetary policy or rate increases would deteriorate debt-service capacity.
  - Mitigants:
    - Most outstanding mortgages originated with LTV under 80 percent; aggregate average LTV estimated around 65 percent.
    - Qualifying mortgages for issuance of cédulas hipotecarias must have LTV no greater than 80 (residential) and 70 (commercial) percent.
    - Rapid accumulation of home equity during the boom provides buffer; borrowing against home equity is still incipient though increasing.
    - Mortgages tend to be repaid within 7 to 8 years.
    - Increase in number of working household members from 1.36 in 1991 to 1.54 in 2004.
    - Proportion of households with high debt-service to net income is moderate: in 2004 about 8 percent of new homeowners had DTI above 50 percent versus 12 percent in 1995.
- Regional dispersion in affordability:
  - House Affordability Index (BBVA, 2005): index assumes LTV of 80 percent and debt payments-to-income ratio of one-third.
    - National average index in 2004: 1.4 (i.e., average household could afford 1.4 mortgages).
    - Index range in 2004: between 1.1 and 2.0.
    - Regions with lowest affordability: País Vasco 1.1; Baleares and Madrid 1.2.
    - Region with highest affordability: Extremadura 2.0.
  - Example: For average household income of 18,250 euros, average mortgage rate of 3.3 percent, and mortgage length of 25 years, financing capacity fixed at 1/3 of net disposable income ≈ €160,000; adding 20 percent downpayment (LTV 80 percent) => afford house up to €200,000; national average housing price in 2004 was €140,000, yielding index above 1 (1.4).

### Key Quantitative Indicators (selected)
- Housing price annual growth rate: 17.1 percent (Q1 2005) → 12.6 percent (Q4 2005).
- New houses built in 2004: over 700,000.
- Foreign residents (June 2005): 8 percent of total population.
- Average household size: 3.2 (1995) → 2.9 (2004).
- Employed household members: 1.36 (1991) → 1.54 (2004).
- Households’ debt to income: 105 percent (end-2004).
- Euro area households’ debt to income: 90 percent.
- U.S. households’ debt to income: 120 percent.
- Household wealth: 400 percent of GDP → 600 percent of GDP (by 2004); real estate wealth over 500 percent of GDP.
- Households’ net financial wealth: 95 percent of GDP (end-2005).
- Median debt payment to gross income: 15.2 percent (2002); 7.2 percent of families above 40 percent.
- Average DTI at origination: ~35 percent.
- Reference interest rates: over 10 percent (early 1990s) → about 2 percent (mid-2005).
- Average mortgage spread above EURIBOR for floating-rate residential mortgages: 75 basis points.
- Typical mortgage maximum maturity: 10 years (early 1990s) → over 30 years (2005).
- Average LTV for outstanding mortgages: 65 percent.
- Qualifying LTV for cédulas hipotecarias: ≤80 percent (residential), ≤70 percent (commercial).
- Construction share of GDP: 10 percent; share of total employment: 13 percent.
- Eviction timeline for problem tenants: 12 to 14 months.
- Mortgage-related tax parameters:
  - Maximum annual deduction (first two years): €1,803.
  - Maximum annual deduction after first two years: €1,577.
  - Average mortgage payments (2004): €6,357.
  - Maximum annual deduction in tax base referenced: €9,015.
  - Implied average tax break (based on 2004 averages): €1,404 (first two years); €1,179 (remaining years).
  - Average expected amortization (2004 mortgage): 7.2 years.
- House Affordability Index (2004): national average 1.4; regional range 1.1–2.0; País Vasco 1.1; Baleares 1.2; Madrid 1.2; Extremadura 2.0.

---

### Mortgage loans have grown rapidly in the context of a booming housing market
- Mortgage growth and composition:
  - Mortgage lending has been growing slightly faster for commercial than for residential real estate; nevertheless households still account for nearly 65 percent of the mortgage portfolio.
  - Both banks and cajas have participated in the buoyant mortgage market—cajas hold a 55-percent share.
- Credit quality, terms, and borrower metrics:
  - NPL ratio for household mortgages has fallen to historical lows (0.3 percent).
  - Most mortgages carry variable rates: 97.5 percent of those originated in 2004.
  - The one-year EURIBOR, at around 280 bp by end-2005, is the reference rate for over 80 percent of the contracts.
  - Average LTV ratios for the outstanding portfolio are around 65 percent.
  - Average debt payments to net income ratios are around one-third for those mortgages originated in 2004.
  - The average loan amount has increased significantly over the past 8 years and is as of mid-2005 around €125,000.
  - The average mortgage contract generated in 2004 had a 25-year maturity.
  - Based on past patterns, credit institutions expect an average life of the contract of only 7 to 8 years, as most households pre-pay.
- Mortgage product features and emerging variants:
  - While most mortgage loans carry floating rates, new products are starting to be offered but demand is still incipient.
  - Limited market offerings include fixed-rate for full term (rare), adjustable-rate mortgages (ARM) with revision frequency above one year (rare), and combined mortgages (rare).
  - Recently offered hybrid-rate examples: fixed for first few years (up to 5 years) then floating; “constant payment mortgages”; “interest-only mortgages”; and variations allowing annual choice between fixed 3-year rate or adjustable every 6 months.
- Representative terms from selected Spanish credit institutions (June 2005) — typical residential mortgage loans:
  - Main residence: Maximum LTV 80% — Variable interest rate: Euribor + 40bp — Commissions 0.25%
  - 100% (purpose unspecified): Variable interest rate: Euribor + 85bp — Commissions 0.50%
  - Second residence: Maximum LTV 60% — Variable interest rate: Euribor + 80bp — Commissions 0.75%
  - Any purpose: Maximum LTV 80% — Variable interest rate: Euribor + 100bp — Commissions 0.75%
- Consumer protection and supervisory guidance:
  - The Bank of Spain has repeatedly warned credit institutions and households of the risks involved in pure floating rate mortgages.
  - Credit institutions are obliged to explain to potential borrowers the risks involved in contracting a variable rate vs. a mixed or fixed rate mortgage.
  - The Bank of Spain maintains an informative web page describing relevant aspects of contracting a mortgage loan, including risks and commissions.

### Policy recommendations and legislative/market changes under consideration
- Measures to increase market flexibility to changing price conditions:
  - Trim legally established fees for changes in mortgage contracts considered “novación modificativa” that are subject to “aranceles notariales y registrales.”
  - Remove caps on credit institutions’ commissions for early mortgage repayment and for changes from fixed- to variable-rate mortgages so commissions align with risks and only borrowers opting for changes pay for them.
- Draft reform elements under preparation:
  - Streamlining commissions for early amortization; reduction and streamlining of legally-established fees (“costes arancelarios”) when modifying a mortgage contract; enhanced information requirements from credit institutions; improving legal aspects of mortgage refinancing; enhancing repayment capacity of issuers of mortgage backed securities; reinforcing independence of appraisal companies.
- Regulatory framework notes:
  - Changes from variable- to fixed-rate mortgage benefit from a 90 percent discount in legally-established fees; a 75 percent discount otherwise.
  - Current prudential framework sets caps on commissions for early repayment and for switching from fixed- to variable-rate mortgages.

### Credit institutions’ risk management and stress testing
- Large credit institutions follow international best practices in credit risk management, using scoring models calibrated to default experience based on borrower profile (including LTV, DTI, employment, age) and loan purpose.
- For mortgages with LTV above 80 percent, mortgage insurance or additional guarantees are required.
- Large institutions include automatic “sensitivity analysis” in scoring models to assess borrower DTI sensitivity to interest rate shocks (e.g., a 300 bp increase).
- For commercial real estate loans, risk management adjusts pricing, surveillance, and early warning systems based on portfolio analysis, loan purpose, borrower rating, and geographical exposure.
- Recommendation: The Bank of Spain should issue guidelines to credit institutions on best practices in mortgage lending to assist small or less-sophisticated institutions.
- Institutions’ sensitivity analysis indicates resilience supported by prudent LTVs, moderate DTI, low proportion of households with DTI > 50 percent, adequate capitalization, and very high provisioning.
- Financial institutions consider unemployment the most acute single-risk factor; some are beginning to scale down mortgage exposure.

### Mortgage-backed securities and cédulas hipotecarias (CHs)
- Spain has a well-developed market in covered mortgage bonds (“cédulas hipotecarias,” CHs).
- CHs characteristics:
  - Similar to German Pfandbriefe; only mortgages used to “cover” CHs.
  - Volume of CHs is limited to 90 percent of the issuer’s collateral pool.
  - Eligible collateral: first-lien mortgages with LTV capped at 80 (residential) and 70 (commercial) percent.
  - Through CH issuance, credit institutions benefit from relatively low funding rates while keeping the loan on their balance sheet.
- Securitization data (2004 and preliminary mid-2005):
  - 83 percent of all securitization activities were backed by mortgages (including mortgage loans and CHs).
  - About 62 percent of securitization bonds were bought by foreign investors.
- Credit quality of CHs depends on issuer soundness, portfolio quality and size, and level of over-collateralization (mandatory minimum 11 percent).
- Collateral does not constitute a special or protected fund if issuer goes bankrupt.
- Club-funding: regional cajas and credit cooperatives can access international capital markets via joint issuance of CHs.
- Box 1 legal/operational features (selected):
  - Issuers: Any Spanish credit institution regulated by the Bank of Spain.
  - Collateral: Entire mortgage portfolio; loans remain on issuer’s balance sheet.
  - Mandatory over-collateralization: issuable up to 90 percent with minimum mandatory over-collateralization of 11 percent.
  - Eligibility: Residential mortgages with LTV ≤80 percent; commercial mortgages with LTV ≤70 percent; non-performing loans ineligible.
  - Prepayment risk: Yes; residential mortgage prepayments permitted with a penalty.
  - Preferential claim: Special privilege; preferential claim on the whole mortgage loan portfolio.
  - Eligible for Tier 1 Repos with ECB: Yes.
  - EU CAR Weighting for Bank Investor: 10 percent.

### Insights from CH spreads and market signals
- CH asset-swap spreads (2002–05):
  - CH spreads narrowed since 2002; some older issues show a premium relative to the swap rate (negative spread) in 2005.
  - Increased dispersion in spreads since early 2005 driven by new, longer-term CHs which pay higher spreads.
  - CH maturities observed range between 1 and 25 years.
  - Higher spreads on longer-term instruments may reflect perceived increased riskiness from growing exposures to a possibly overvalued housing market.
  - Example issuers in spread analysis include AYTCED, BBVA, BSCH, CEDTDA, and Caja Madrid.

### OAS analysis and conclusions
- OAS analysis:
  - Option-adjusted-spreads (OAS) computed relative to German treasury bonds of similar maturity.
  - OAS analysis confirms increased uncertainty in the market in 2005 on the future evolution of Cédulas Hipotecarias (CHs).
  - Spreads and estimates sourced from Bloomberg and staff estimates; a 30-day moving average was applied to daily spreads.
  - CHs analyzed correspond to jumbo issues (≥ one billion euros) by largest banks and cajas and pooled-issues of small institutions.
- Asset-swap spread analyses produced similar results; comparable German Pfandbriefe analysis does not show increased dispersion in 2005.
- Financial-system resilience (conclusions):
  - The Spanish financial system seems to be resilient to a downturn in the housing market.
  - Large credit institutions appear solidly positioned to absorb an increase in mortgage-loan delinquency rates that could emerge from a fall in housing prices, increase in interest rates, or a downturn in the macroeconomic cycle.
  - Resilience underpinned by:
    - (a) prudent LTV ratios on the outstanding loan portfolio;
    - (b) a moderate DTI ratio for the average household;
    - (c) a low proportion of households with DTI ratios above 50 percent;
    - (d) good level of capitalization; and
    - (e) very high provisioning.
- Risks and vulnerabilities:
  - Localized risks for regional credit institutions with portfolio concentration in overvalued real estate markets and areas with many second residences.
  - A decline in house prices could leave highly-indebted households with negative equity, especially recent high-LTV mortgages.
  - An increase in mortgage rates could further deteriorate household debt servicing capacity due to prevalence of floating-rate mortgages.
  - A fall in housing prices would likely negatively affect consumer confidence, economic activity, and employment; construction represents 10 percent of GDP and 13 percent of total employment.
  - Stress testing indicates unemployment is the most significant macroeconomic risk factor for mortgage credit.
- Main recommendations (summary):
  - Recognize many factors affecting house prices lie outside FSAP scope (examples: fiscal incentives favoring home ownership, rental market constraints, de facto minimum rental contract length of five years, land policy limiting supply).
  - Bank of Spain should issue guidelines on best practices in mortgage lending, useful for small or less-sophisticated institutions.
  - Authorities could trim legally-established fees for novación modificativa and remove caps on commissions for early repayment and switching fixed/variable rates to align commissions with risks and avoid cross-subsidization by lenders.
  - A draft mortgage market reform is being prepared to address these issues.
- Contingent prudential measures:
  - If trends in household debt, real estate lending, and house prices continue, stronger prudential measures could be considered.
  - The Bank of Spain could complement moral suasion with further tightening of capital requirements on housing and construction loans.

*IMF staff note "Housing Prices, Household Debt, and Financial Stability" (excerpts from chapter "1. Housing Price Misalignment?"; and excerpts from "19. Mortgage loans have grown rapidly in the context of a booming housing market" and "33. An analysis based on option-adjusted-spreads (OAS) provides similar results").*

### 1. Housing Price Misalignment?..........................................................................................

### 1. Housing Price Misalignment?

### I. Housing Prices — Macroeconomic and Demographic Drivers
- Rapid real housing price appreciation since the second half of the 1990s; price growth decelerated in 2005 from an annual growth rate of 17.1 percent in Q1 to 12.6 percent in Q4.
- Macroeconomic environment supporting demand:
  - Continued real GDP growth exceeding EU average over the last ten years.
  - Interest rates and unemployment fell to one-fourth and one-half of their 1995 levels, respectively.
  - Average number of employed household members rose from 1.36 to 1.54, increasing household wage income and improving affordability.
  - Immigration flows quadrupled the population of foreign residents; in June 2005 foreign residents amounted to 8 percent of the total population.
  - Average household size declined from 3.2 members in 1995 to 2.9 in 2004 (EU average: 2.4).
  - The Council of Economic Advisors projected 400,000 new households will be formed in the coming years.
  - Sharp fall in interest rates since mid-1990s and the 2001 stock market crash increased attractiveness of real estate relative to bonds and stocks.
- Housing supply and construction:
  - Over 700,000 new houses were built in 2004.
  - Housing construction expected to slow as the market cools over the medium term.
- Tenure patterns:
  - Rental market shrank from 30 percent in the early 1990s to about 10 percent of housing stock by 2001.
  - 2001 census: around 70 percent of existing houses are “main residence”; of those, over 80 percent are owner-occupied and about 10 percent tenant-occupied.
  - Census recorded around 3 million unoccupied houses, though effective rental-available stock is substantially smaller.

### I.B. Evidence on Misalignment and Policy-Related Demand Factors
- Empirical estimates of housing price overvaluation (selected studies):
  - Banco de España: Ayuso and Restoy (2003) — 20 percent.
  - Martínez Pagés and Maza (2003) — 8-17 percent.
  - IMF (2004) — 20-30 percent.
  - The Economist (2005) and other studies — 28-60 percent.
  - Caruana (2005) finds an overvaluation in the range of 24 to 35 percent above estimated long-term equilibrium and suggests gradual correction is possible.
- Policy- and legal-related factors that favor ownership over renting:
  - Fiscal incentives for owner-occupiers: income tax deduction for mortgage payments when buying a house as the main residence; practically no deduction for tenants on rent payments.
    - Mortgage payment deduction caps: maximum deductible for mortgage payments is capped to €1,803 per year in the first two years, after which the maximum falls to €1,577 per year.
    - Actual deductible amount depends on mortgage payments; in 2004 average mortgage payments were €6,357 per household (below maximum annual deduction of €9,015). Based on 2004 averages and assuming constant mortgage payments, implied average tax break would be €1,404 in the first two years and €1,179 in remaining years. For houses purchased without a mortgage loan, there is generally a one-off 15 percent deduction (capped at €9,015).
    - Average expected amortization of a 2004 mortgage was 7.2 years.
  - Legal uncertainty and eviction timelines: average eviction of problem tenants takes 12 to 14 months.
  - Rental contract protections: if contract length set below 5 years, upon termination tenant has right to extend it up to a total length of 5 years.
  - Land zoning and local revenue incentives: local administrations control land zoning and derive substantial revenue from real estate taxes, creating incentives that may limit supply of residential land.
- Government measures (2005-08 Housing Plan) intended to improve affordability and foster rental market:
  - Increased supply of subsidized housing (viviendas de protección oficial).
  - Creation of a public housing rental agency.
  - Tax breaks for rental housing developers.
  - “Fast tribunals” in Madrid and Barcelona to speed housing rental dispute resolution.
  - Impact of these measures on prices and rental market not yet assessable.

### II. Household Debt, Wealth, and Mortgage Market Dynamics
- Aggregate indebtedness and wealth:
  - Households’ debt to income reached 105 percent by end-2004 (euro area average: 90 percent; U.S. ratio: 120 percent).
  - Household wealth rose from about 400 percent of GDP in mid-1990s to 600 percent by 2004; over 500 percent is accounted for by real estate wealth.
  - As of end-2005, households’ net financial wealth stood at 95 percent of GDP.
- Debt-service capacity and distributional metrics:
  - Median ratio of household debt payment to gross income was 15.2 percent in 2002; 7.2 percent of families had a ratio above 40 percent (Bank of Spain, 2004 sample of 5,000 households).
  - Average debt-service in the year of mortgage origination (interest and principal) has remained around 35 percent of households’ average net income over the last 10 years (Genworth study of 700,000 mortgage loans at origination).
  - Distributional example: in 2002, top ten income percentile households had debt payment to income ratio of about 8 percent; bottom 20 percentile about 32 percent.
- Drivers of stable debt-service ratios despite higher mortgage debt:
  - Interest rates fell from over 10 percent in early 1990s to about 2 percent by mid-2005 (one-year reference rate, EURIBOR).
  - Fierce competition and financial market development reduced mortgage spreads; average spread above EURIBOR for floating-rate residential mortgages about 75 basis points.
  - Mortgage maturities extended from maximum of 10 years in early 1990s to over 30 years by 2005.
- Vulnerabilities and mitigating factors:
  - Vulnerabilities:
    - A housing price fall of about 25 percent (in line with recent overvaluation estimates) could leave some households with negative equity, especially recent mortgages with LTV around 80 percent.
    - Such a fall would negatively impact consumer confidence and economic activity; construction accounts for 10 percent of GDP and 13 percent of total employment.
    - With predominantly floating-rate mortgages, tightening European monetary policy or rate increases would deteriorate debt-service capacity.
  - Mitigants:
    - Most outstanding mortgages originated with LTV under 80 percent; aggregate average LTV estimated around 65 percent.
    - Qualifying mortgages for issuance of cédulas hipotecarias must have LTV no greater than 80 (residential) and 70 (commercial) percent.
    - Rapid accumulation of home equity during the boom provides buffer; borrowing against home equity is still incipient though increasing.
    - Mortgages tend to be repaid within 7 to 8 years.
    - Increase in number of working household members from 1.36 in 1991 to 1.54 in 2004.
    - Proportion of households with high debt-service to net income is moderate: in 2004 about 8 percent of new homeowners had DTI above 50 percent versus 12 percent in 1995.
- Regional dispersion in affordability:
  - House Affordability Index (BBVA, 2005): index assumes LTV of 80 percent and debt payments-to-income ratio of one-third.
    - National average index in 2004: 1.4 (i.e., average household could afford 1.4 mortgages).
    - Index range in 2004: between 1.1 and 2.0.
    - Regions with lowest affordability: País Vasco 1.1; Baleares and Madrid 1.2.
    - Region with highest affordability: Extremadura 2.0.
  - Example: For average household income of 18,250 euros, average mortgage rate of 3.3 percent, and mortgage length of 25 years, financing capacity fixed at 1/3 of net disposable income ≈ €160,000; adding 20 percent downpayment (LTV 80 percent) => afford house up to €200,000; national average housing price in 2004 was €140,000, yielding index above 1 (1.4).

### Key Quantitative Indicators (selected)
- Housing price annual growth rate: 17.1 percent (Q1 2005) → 12.6 percent (Q4 2005).
- New houses built in 2004: over 700,000.
- Foreign residents (June 2005): 8 percent of total population.
- Average household size: 3.2 (1995) → 2.9 (2004).
- Employed household members: 1.36 (1991) → 1.54 (2004).
- Households’ debt to income: 105 percent (end-2004).
- Euro area households’ debt to income: 90 percent.
- U.S. households’ debt to income: 120 percent.
- Household wealth: 400 percent of GDP → 600 percent of GDP (by 2004); real estate wealth over 500 percent of GDP.
- Households’ net financial wealth: 95 percent of GDP (end-2005).
- Median debt payment to gross income: 15.2 percent (2002); 7.2 percent of families above 40 percent.
- Average DTI at origination: ~35 percent.
- Reference interest rates: over 10 percent (early 1990s) → about 2 percent (mid-2005).
- Average mortgage spread above EURIBOR for floating-rate residential mortgages: 75 basis points.
- Typical mortgage maximum maturity: 10 years (early 1990s) → over 30 years (2005).
- Average LTV for outstanding mortgages: 65 percent.
- Qualifying LTV for cédulas hipotecarias: ≤80 percent (residential), ≤70 percent (commercial).
- Construction share of GDP: 10 percent; share of total employment: 13 percent.
- Eviction timeline for problem tenants: 12 to 14 months.
- Mortgage-related tax parameters:
  - Maximum annual deduction (first two years): €1,803.
  - Maximum annual deduction after first two years: €1,577.
  - Average mortgage payments (2004): €6,357.
  - Maximum annual deduction in tax base referenced: €9,015.
  - Implied average tax break (based on 2004 averages): €1,404 (first two years); €1,179 (remaining years).
  - Average expected amortization (2004 mortgage): 7.2 years.
- House Affordability Index (2004): national average 1.4; regional range 1.1–2.0; País Vasco 1.1; Baleares 1.2; Madrid 1.2; Extremadura 2.0.

*Source: IMF staff note "Housing Prices, Household Debt, and Financial Stability" (excerpts from chapter "1. Housing Price Misalignment?").*

### 19.      Mortgage loans have grown rapidly in the context of a booming housing market

### 19.      Mortgage loans have grown rapidly in the context of a booming housing market

### Mortgage growth and composition
- Mortgage lending has been growing slightly faster for commercial than for residential real estate; nevertheless households still account for nearly 65 percent of the mortgage portfolio.
- Both banks and cajas have participated in the buoyant mortgage market—cajas hold a 55-percent share.
- Figure 5 (Bank of Spain, 2005) shows mortgage CR, annual growth and mortgage CR to HH, annual growth, and the ratio of HH mortgage CR to mortgage CR.

### Credit quality, terms, and borrower metrics
- NPL ratio for household mortgages has fallen to historical lows (0.3 percent).
- Most mortgages carry variable rates: 97.5 percent of those originated in 2004.
- The one-year EURIBOR, at around 280 bp by end-2005, is the reference rate for over 80 percent of the contracts.
- Average LTV ratios for the outstanding portfolio are around 65 percent.
- Average debt payments to net income ratios are around one-third for those mortgages originated in 2004.
- The average loan amount has increased significantly over the past 8 years and is as of mid-2005 around €125,000.
- The average mortgage contract generated in 2004 had a 25-year maturity.
- Based on past patterns, credit institutions expect an average life of the contract of only 7 to 8 years, as most households pre-pay.

### Mortgage product features and emerging variants
- While most mortgage loans carry floating rates, new products are starting to be offered but demand is still incipient.
- Limited market offerings include:
  - Mortgages set at fixed-rates for the entire length of the mortgage contract (rare).
  - Adjustable-rate mortgages (ARM), whereby the fixed rate is revised at a given frequency (above one year) (rare).
  - Combined mortgages, with a part at floating rate and another part fixed-rate or ARM (rare).
- Recently offered hybrid-rate mortgage examples:
  - Mortgages set at fixed-rates for the first few years (up to 5 years) and floating rate for the rest of the life of the mortgage.
  - “Constant payment mortgages”: variable rate mortgages with equal payments throughout the contract; ups/downs in interest rates extend/reduce maturity but leave service payments constant.
  - “Interest-only mortgages” that leave for the final payments a large proportion of the principal.
  - A variation of “interest-only mortgages,” where every year the borrower can choose between a fixed rate for the next 3 years or one adjustable every 6 months.
- Representative terms from selected Spanish credit institutions (June 2005) — typical residential mortgage loans (Table 4):
  - Main residence: Maximum LTV 80% — Variable interest rate: Euribor + 40bp — Commissions 0.25%
  - 100% (purpose unspecified in table row): Variable interest rate: Euribor + 85bp — Commissions 0.50%
  - Second residence: Maximum LTV 60% — Variable interest rate: Euribor + 80bp — Commissions 0.75%
  - Any purpose: Maximum LTV 80% — Variable interest rate: Euribor + 100bp — Commissions 0.75%

### Consumer protection and supervisory guidance
- The Bank of Spain has repeatedly warned credit institutions and households of the risks involved in pure floating rate mortgages.
- Credit institutions are obliged to explain to potential borrowers the risks involved in contracting a variable rate vs. a mixed or fixed rate mortgage, including medium- and long-term risks of a hike in interest rates.
- The Bank of Spain maintains an informative web page describing relevant aspects of contracting a mortgage loan, including risks and commissions.

### Policy recommendations and legislative/market changes under consideration
- Measures that could increase market flexibility to changing price conditions:
  - Trimming legally established fees for changes in mortgage contracts considered “novación modificativa” that are subject to “aranceles notariales y registrales.” Lower fees would facilitate changes in mortgage contracts, such as extending maturity, helpful in cyclical downturns.
  - Removing caps on credit institutions’ commissions for early mortgage repayment and for changes from fixed- to variable-rate mortgages, allowing the market to determine these commissions so that (i) they align with risks incurred by credit institutions, and (ii) banks do not cover these risks through higher lending rates—so only borrowers opting for changes would pay for them.
- A draft reform of the mortgage market is being prepared to address: streamlining commissions for early amortization; reduction and streamlining of legally-established fees (“costes arancelarios”) when modifying a mortgage contract; enhanced information requirements from credit institutions; improving legal aspects of mortgage refinancing; enhancing repayment capacity of issuers of mortgage backed securities; and reinforcing independence of appraisal companies.
- Regulatory framework notes:
  - Changes from variable- to fixed-rate mortgage benefit from a 90 percent discount in legally-established fees; a 75 percent discount otherwise.
  - Current prudential framework sets caps on commissions for early repayment and for switching from fixed- to variable-rate mortgages, with specifics noted for variable-rate mortgages, subrogation cases, and government recommendations for fixed-rate conversions.

### Credit institutions’ risk management and stress testing
- Large credit institutions follow international best practices in credit risk management, using scoring models calibrated to default experience based on:
  - Borrower’s profile including LTV ratio, debt-to-income (DTI), employment, and age.
  - Purpose of the mortgage: primary residence, secondary residence, or investment.
- For mortgages with LTV above 80 percent, mortgage insurance or additional guarantees are required.
- Large institutions include automatic “sensitivity analysis” in scoring models to assess borrower DTI sensitivity to interest rate shocks (e.g., a 300 bp increase). If DTI exceeds internal thresholds, applications are rejected or additional guarantees required.
- For commercial real estate loans, risk management adjusts loan pricing, surveillance frequency, and early warning systems based on: portfolio analysis before/after loan inclusion; loan purpose; borrower internal/external rating; and geographical exposure.
- Recommendation: The Bank of Spain should issue guidelines to credit institutions on best practices in mortgage lending to assist small or less-sophisticated institutions.
- Sensitivity analysis by large financial institutions indicates resilience to sizeable shocks to the mortgage portfolio, supported by:
  - Prudent LTV ratios on outstanding portfolio.
  - Moderate DTI ratio for the average household.
  - A relatively low proportion of households with DTI ratios above 50 percent.
  - Adequate levels of capitalization.
  - Very high provisioning of problem loans.
- Financial institutions consider unemployment the most acute single-risk factor for mortgage exposures.
- Some institutions are beginning to scale down mortgage exposure by setting more stringent loan criteria.

### Mortgage-backed securities and cédulas hipotecarias (CHs)
- Spain has a well-developed market in covered mortgage bonds (“cédulas hipotecarias,” CHs).
- CHs are similar to German Pfandbriefe; difference: only mortgages are used to “cover” CHs.
- Volume of CHs is limited to 90 percent of the issuer’s collateral pool.
- Eligible collateral constrained to first-lien mortgages with LTV capped at 80 (70) percent for residential (commercial) mortgages.
- Through CH issuance, credit institutions benefit from relatively low funding rates while keeping the loan on their balance sheet.
- Securitization data (2004 and preliminary mid-2005):
  - 83 percent of all securitization activities were backed by mortgages (including mortgage loans and CHs).
  - About 62 percent of securitization bonds were bought by foreign investors.
- Credit quality of CHs depends on issuer soundness, mortgage portfolio quality and size, and level of over-collateralization (mandatory minimum 11 percent).
- Unlike some other covered bonds, the collateral backing CHs does not constitute a special or protected fund if the issuer goes bankrupt.
- Club-funding: regional cajas and credit cooperatives can access international capital markets via joint issuance of CHs and other securities backed by a common mortgage pool.
- Box 1 key legal/operational features (selected):
  - Issuers: Any Spanish credit institution regulated by the Bank of Spain.
  - Collateral: Entire mortgage portfolio; transfer of loans: No (loans remain on issuer’s balance sheet).
  - Mandatory over-collateralization: issuable up to 90 percent of eligible mortgage loan portfolio with a minimum mandatory over-collateralization of 11 percent.
  - Eligibility: Residential mortgages with LTV ≤80 percent; commercial mortgages with LTV ≤70 percent; non-performing loans ineligible.
  - Prepayment risk: Yes; residential mortgage prepayments permitted with a penalty.
  - Preferential claim: Special privilege; preferential claim on the whole mortgage loan portfolio.
  - Eligible for Tier 1 Repos with ECB: Yes.
  - EU CAR Weighting for Bank Investor: 10 percent.

### Insights from CH spreads and market signals
- Analysis of CH asset-swap spreads (2002–05) yields:
  - CH spreads have narrowed since 2002; for some older issues, spreads in 2005 show a premium relative to the swap rate (i.e., negative spread), reflecting positive market sentiment about issuers and mortgage portfolios.
  - Since early 2005 there is increased dispersion in spreads of different issues driven by new, longer-term CHs which tend to pay higher spreads.
  - CHs’ maturities in observed issues range between 1 and 25 years.
  - The considerably higher spreads on longer-term instruments may reflect market perception of increased riskiness associated with growing exposures of credit institutions to a possibly overvalued housing market.
  - Example issuers in spread analysis include AYTCED, BBVA, BSCH, CEDTDA, and Caja Madrid.

*Source: IMF staff summary of “19. Mortgage loans have grown rapidly in the context of a booming housing market” (Bank of Spain data and IMF analysis).*

### 33.      An analysis based on option-adjusted-spreads (OAS) provides similar results

### 33.      An analysis based on option-adjusted-spreads (OAS) provides similar results

### OAS analysis and key findings
- The option-adjusted-spreads (OAS) were computed relative to German treasury bonds of similar maturity (note that the German treasury bonds have almost zero spread relative to the Spanish treasury bonds).
- The OAS analysis confirms previous findings of increased uncertainty in the market in 2005 on the future evolution of Cédulas Hipotecarias (CHs).
- Sources for the spreads and estimates: Bloomberg and staff estimates. A 30-day moving average was applied to the daily spreads.
- The CHs included in the analysis correspond to jumbo issues (at least a billion euros) by the largest banks and cajas, as well as “pooled-issues” of different small credit institutions, such as AYTCED and CEDTDA, where the managing societies are AyT and TdA, respectively.

### Asset-swap spreads context and supplemental analyses
- An analysis based on asset swap spreads produced similar results (Figure 6 and Figure 7).
- A similar analysis on the asset swap spreads conducted for the German Pfandbriefe market does not show evidence of an increase in the dispersion of spreads in 2005. Results are available from Avesani and García Pascual (2005) upon request.
- Figures referenced:
  - Figure 6. Spain: Asset Swap Spreads of Cédulas Hipotecarias (In basis points). (A 30-day moving average applied.)
  - Figure 7. Spain: “Jumbo” Cédulas Hipotecarias Asset Swap Spreads (in basis points): By Issuer (5 largest) and Maturity Date. (A 30-day moving average applied.)
  - Figure 8. Spain: Option Adjusted Spreads of Cédulas Hipotecarias (In basis points). (A 30-day moving average applied; spreads computed relative to German treasury bonds of similar maturity.)

### Conclusions on financial-system resilience (V. CONCLUSIONS AND RECOMMENDATIONS)
- The Spanish financial system seems to be resilient to a downturn in the housing market.
- Large credit institutions appear solidly positioned to absorb an increase in mortgage-loan delinquency rates that could emerge from a fall in housing prices, increase in interest rates, or a downturn in the macroeconomic cycle.
- The resilience of credit institutions is underpinned by:
  - (a) prudent LTV ratios on the outstanding loan portfolio;
  - (b) a moderate DTI ratio for the average household;
  - (c) a low proportion of households with DTI ratios above 50 percent;
  - (d) good level of capitalization; and
  - (e) very high provisioning.

### Risks from increasing mortgage-portfolio size
- Localized risks could emerge among regional credit institutions with portfolio concentration in overvalued real estate markets, especially in areas of heavy concentration of second residences and real estate development.
- A decline in house prices could leave highly-indebted households with negative home equity, especially those holding mortgages originated at high LTV ratios.
- An increase in mortgage rates could further deteriorate the debt servicing capacity of households, since a majority hold floating rate mortgages.
- A fall in housing prices would likely have a negative impact on consumer confidence, economic activity, and employment, especially on the construction sector, which represents 10 percent of GDP and 13 percent of total employment.
- Stress testing analysis indicates unemployment is arguably the most significant macroeconomic risk factor for mortgage credit.

### Main recommendations (summary)
- Recognize that many factors affecting house prices and measures to dampen rises lie outside the purview of the FSAP (examples given: fiscal incentives favoring home ownership, rental market constraints, de facto minimum rental contract length of five years, land policy limiting supply). The government has adopted several measures intended to boost the rental market and address land use issues.
- Specific recommendations that could make the market more flexible:
  - The Bank of Spain should issue guidelines to credit institutions on best practices in mortgage lending; guidance could be useful for small or less-sophisticated institutions and could expand upon the general recommendations presented by the Bank of Spain in the 2003 Memoria de Supervisión Bancaria.
  - The authorities could trim legally established fees for changes in mortgage contracts considered “novación modificativa” that are subject to “aranceles notariales y registrales” to facilitate changes in mortgage contracts such as extending maturity.
  - The authorities could remove the caps on credit institutions’ commissions for early mortgage repayment and for changes from fixed- to variable-rate mortgages to (i) align commissions better with risks incurred by credit institutions and (ii) avoid that banks cover these risks through higher lending rates so only borrowers exercising the option pay for it. A draft reform of the mortgage market is being prepared by the authorities to address some of these issues.

### Contingent prudential measures
- If current trends in household debt, real estate lending, and house prices continue, stronger prudential measures could be considered.
- The Bank of Spain could complement its ongoing moral suasion with a further tightening of the capital requirements on housing and construction loans.

*IMF staff report content (excerpt)._cr06210 - 33. An analysis based on option-adjusted-spreads (OAS) provides similar results*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06210.pdf_