Preparing for the Day When Israeli Homeowners Won't Be Able to Repay Their Loans

In interview with TheMarker, the Bank of Israel's banking supervisor cautions about a scenariowhere widespread unemployment causes a wave of mortgage defaults.

David Zaken has had his hands full in his two-and-a-half years on the job as Bank of Israel banks supervisor. Not only has he been busy with challenges within the banking system - its exposure to large borrower groups or mortgage portfolios ballooning at a worrying pace - but also with the need to deal with the implications for the system of the cost-of-living protests.

To his credit, Zaken has chalked up a number of achievements, including rules issued that put a ceiling on how much a bank can lend to large groups, such as the Ofer family and companies under its control, as well as the IDB, Fishman and Tshuva groups. The ceiling was the first directive issued by Zaken after he took over the post in January 2011.

Another of Zaken's major decisions was to fully adopt the Basel III guidelines, putting the Israeli banking system in line with international standards. As a result, banks suspended dividends to expand their capital base. Basel III also caused banks to lend more to households and small businesses rather than large corporate borrowers.

The committee headed by Zaken to increase banking competition, set up on the recommendation of the Trajtenberg Committee in the wake of the protests, proposed a range of steps that the Bank of Israel is now implementing. Its crowning achievement requires banks to show clients their internal credit rating.

The central bank has also instituted procedures meant: to make it much easier for depositors to switch banks by opening and moving accounts over the Internet.

One of the thorniest issues now being confronted by the supervisor is how to ensure the stability of the bank as housing prices balloon. Zaken has already restricted variable mortgage rates to one-third the total loan in order to soften the effect of any future rate increase on monthly mortgage payments. He has also restricted mortgage financing to no more than 75% of the home's value. At the same time he instructed the banks to maintain larger capital cushions against mortgages.

'Problem, not a bubble'

Despite this, the housing market refuses to cool down. How would the bursting of the real estate bubble look? Have you taken enough steps to prevent the next banking system crisis?

Zaken: "I'm very troubled by the mortgage activity, but I'd call it a problem, not a bubble. We see the mortgages as a risk. According to the figures, everything seems alright: Housing prices have risen and late payments are on the decline, particularly in proportion to the balance of mortgage portfolios which have grown by about 10% to 13% each year. Do these figures reflect the future risk? I don't think they do. I think it's a risk factor that needs to be dealt with and we're dealing with it. The steps we're taking are quite in line with, or even more conservative than those taken in other countries. If there will be a need to take more action, we'll make more action."

Will there be more actions taken this year?

"Possibly. Absolutely."

In what area could action be taken?

"I could give you examples of what's being done around the world - restricting the payment-to-income ratio, restricting the debt-to-income ratio or the percentage of financing to the value of the home. We'll decide on the need for further steps according to developments regarding the number of mortgages, the pace at which mortgages are taken, the quality of the mortgages and real estate prices.

"The mortgage burden on young families or households worries us. Everyone asks what will happen if housing prices drop. What will happen? People will continue paying their mortgages. But what will happen if people lose their jobs? And what will happen if both spouses are fired? We're concerned about a situation where unemployment rates are higher, interest rates are higher, and also a situation where housing prices drop: in other words, a blow to debt service capacity and guarantees."

What scenario most worries you? What is the worst-case scenario in the field of mortgages?

"A drastic rise in unemployment, a hike in interest rates and a drop in housing prices - all three together. The main factors are unemployment and higher interest rates. The third factor is a drop in housing prices. This is a very problematic scenario. We're examining these scenarios but this doesn't mean it will necessarily occur."

What are the implications of this scenario for the banking system?

"It will lead to very great losses. It also depends on which bank. You can guess that banks leaning more heavily towards mortgages will be affected more by this scenario than banks with less than 20% of their portfolios in mortgages."

'Unabashedly more conservative'

Another key center of risk is the credit extended by the banks to tycoons without collateral. The first decision you made as supervisor was to restrict loans to large borrower groups, meaning you foresaw the danger of the banks' lending tycoons the maximum amount permitted by banking regulations. Should the banks also have seen the danger?

"The answer is yes, absolutely. Among the risks we see are either those connected with our own economy or those learned as lessons from elsewhere around the world. I expect that the banks will look at these matters first. We don't manage the banking system, we supervise it. Sometimes the line gets blurred. The banks need to deal with risks and manage them. If there are things we see first, either because we're tied in with international regulation or because we're more conservative - and yes, we're unabashedly more conservative - then we take these measures."

How do you rate the banks on this past year's debt restructurings?

"What needs to be ascertained in the debt restructurings, as is being done, is that the bank acts to collect on the debt for the bank's benefit rather than irrelevant or foreign considerations, or even a potential conflict of interests. We think the bank needs to exhaust all procedures for collecting the debt. We examine the reasonableness of the debt restructurings but we don't have investigative tools. We don't eavesdrop on the banking system - we're not the Israeli police. But we do have tools to check whether or not the restructuring is reasonable. We look at everything, at the history - the underwriting, the settlement, the security backing - really everything. We know very well how to check. We have 10 people sitting in Tel Aviv checking the transactions. It's their job. That's what they do all day long."

How did it happen that IDB Development Corporation received NIS 750 million without collateral despite the checks performed by 10 people sitting in Tel Aviv?

"We don't check each and every loan in real time and not all the credit in the system. We aren't brought loans for approval. We check retroactively. We do sample checks, not all of the borrowers all of the time."

Are you worried about a scenario of the IDB group being liquidated and the repercussions on the banking system?

"If it were necessary to perform a write-off or provision for credit losses, it was done. So it won't have any monetary effect. If you assume that liquidation will also harm the companies at the bottom of the pyramid, then there could be greater damage to the banks. But I think this assumption is too strong."

Are there bankers who, in your opinion, made unreasonable decisions?

"That's being smart after the fact. The system has changed. Deals that were once made either aren't being made today, or are done at a spread that reflects their risk."

Do you think that the heads of banks need to weigh considerations of educating the market when formulating debt restructurings?

"No. The banks need to weigh economic considerations. But I'd like to qualify this. At one end are the poor and weak borrowers, and if the consideration is accommodating the borrower and helping the community then I think it's a perfectly fine consideration. There is also the other end and we all know to what example is being referred to [the decision by Bank Leumi to cancel a debt settlement in which it intended to forgive NIS 150 million of Ganden Holdings' debts while forgoing Nochi Dankner's personal guarantees] - some will attribute this to educating the public, in other words showing that there's no discrimination between such a businessman and John Doe for example. You see in this education, but it also includes an economic aspect. The move endangered and therefore harmed the bank's reputation. I see an economic aspect in this - the fact is that it had a public effect that had an influence and affected the bank's reputation.

"Anyone who took out a loan must repay it, period, to the very last shekel. It doesn't matter who the borrower is. If we don't maintain this principle then the backbone of the banking system doesn't exist. Debts must be repaid."

Eyal Toueg