The singular feature of the Israeli general election in January was its unprecedented focus on domestic issues, at the expense of the security and Israel-Palestine concerns that usually dominate the political agenda. Among those domestic issues, none has generated more angst than the housing price boom of recent years and its impact on young couples seeking to get a foot on “the housing ladder”.

It was hardly surprising, therefore, that the draft budget published on May 6 and now making its way through the Knesset (the Israeli parliament), included several measures that seek to address this problem. In particular, the proposal to impose a 25% tax on the sale of second (or additional) homes closes a glaring loophole in the taxation of capital gains, because currently apartments are the only asset class on which profits made by private investors are exempt. This status obviously makes them very attractive, especially when solid investments such as bank savings initiatives and government bonds are offering historically low returns. Other proposals in the budget include hiking the rate of purchase tax paid on upscale apartments and extending this to foreigners. All of the fiscal measures are thus aimed at reducing demand for apartments and houses on the part of investors, both domestic and foreign.

The Finance Ministry has thereby joined the efforts, hitherto led by the Bank of Israel, to tackle what is widely termed “the housing bubble” by the media and general public. The central bank, via its Supervisor of Banks department, has made a series of regulatory interventions in the mortgage market over recent years, aimed at reducing access to mortgage financing. The most recent was in February, when the Bank introduced a sliding scale for the capital requirement imposed on financial institutions making mortgage loans, whereby the higher the ratio of the loan to the total value of the apartment being bought (LTV), the more capital the bank is required to set aside. Previous moves, stretching back to 2010, have included restricting the overall LTV that banks may grant mortgagees and restricting the share of the mortgage that may be taken on a floating-rate basis.

However, although the central bank’s efforts, and now those of the Finance Ministry, have been directed at the demand side of the housing market, there is widespread agreement, experts say, that the desirable approach to ending, or reversing, the rise in house prices is to increase supply — and that restricting demand, by itself, will not do the job. The Bank of Israel, basing itself on the work of its research department, has consistently promoted that view; for example, deputy-governor Karnit Flug, who resigned this week, told the annual conference of the Builders’ Association on May 23 that “the relatively sharp rise in prices since 2008 is a common feature of those countries that did not experience a serious financial crisis during the global crisis [in 2007-2008]…. In every country where the banking system did not collapse, house prices rose sharply … and in every country where the banking system was able to supply credit, that brought increased demand for housing and with it a rise in prices.”

This retrospective assessment explains both why the central bank sought to stem the flow of money to the mortgage sector and also why its efforts have had at best partial success — because borrowers and lenders have had a common goal, of finding ways around the restrictions in order to transact business.

A Nonlinear Rise

The data regarding house price trends are clear-cut: Although various price indices provide slightly different outcomes, they all point in the same direction, namely sharply upward. For example, the Central Bureau of Statistics’ House Price Index — not part of the overall Consumer Price Index, which uses rental prices as its housing component — shows that nationally, prices have risen by 81% from their low point in April 2007 to the most recent data point of February-March 2013.

However, the rise has not been linear: Most of it — some 62% — occurred by April 2011, but at that point the Bank of Israel weighed in with a group of measures that did indeed cool the market, so that prices barely rose for the next year. Yet the sense of “mission accomplished” at the central bank proved premature, because in the latest 12-month period prices have risen by 10.5%, proving that the underlying trend is still firmly upward, observers note.

Flug’s analysis — that countries where the banking system emerged largely unscathed from the global meltdown then experienced house price booms — is undoubtedly correct, but it lacks detail. Zvi Eckstein, who is now the dean of the economics school at the Interdisciplinary Center in Herzliya, was Flug’s predecessor as deputy governor at the central bank, between 2006 and 2011 and was therefore involved in the Bank’s response to the early stages of the price surge. But he is now able to adopt a more objective and dispassionate view.

“It was the drastic drop in interest rates, beginning in 2009, that was the critical factor in driving demand for mortgages, and hence house prices,” Eckstein explains. “Before that, mortgage interest rates had always been positive in real terms, so that the amount of the monthly repayment had tended to rise over the life of the mortgage. Since the Israeli norm was that wages rose in nominal terms and usually even in real terms, the system was in rough equilibrium.

“However, the sharp cut in domestic interest rates in the wake of the collapse of Lehman Brothers resulted in real interest rates on mortgages falling from some 4.5%-5% to only about 3%,” Eckstein adds. “This translated into a sharp drop in the size of the monthly repayment on the average mortgage — and that made mortgages seem much more ‘affordable’ to borrowers and spurred them to take larger loans.”

Eckstein’s analysis of the mechanism of the mortgage market leads him to the same conclusion as Flug: “The problem with the housing market is that supply is insufficiently elastic — it doesn’t respond quickly, or at all, to changes in demand. Thus part of the impact of the increase in demand that stemmed from the reduced cost of mortgages was diverted into higher prices rather than increased supply.”

This assessment is not limited to former or current government officials. Irit Avissar, banking correspondent of the main Israeli business daily, Globes, has a similar view: “The low interest rates are fuelling the demand for apartments and the price rises in that market, because financing [a home purchase] has become much cheaper. But this is not the only factor at work. The lack of supply, which stems inter alia from the complex bureaucratic procedures required to bring land to market , has created the current situation in which demand is significantly higher than supply.”

Boom or Bust?

In other words, there has not been, nor is there currently any sign of, a building boom — rather the contrary. There has certainly been a sharp rise in prices, although whether this constitutes a boom, let alone a bubble, is open to debate. And there has, without any doubt, been a massive boom in mortgage lending. Bank of Israel data show that household mortgage debt outstanding to banks rose from NIS136 billion at the end of 2007 to NIS242 billion at the end of 2012, an increase of some 78%. The biggest annual rise, in both absolute (NIS29 billion) and percentage (17%) terms, took place in 2010, after which the rate of increase moderated to some 10% per annum in both 2011 and 2012. This year saw intense activity in refinancing old mortgages to take advantage of low interest rates, but demand for new loans was restrained — until May, when it abruptly surged, apparently driven by a rush to close deals before a 1% rise in VAT that took effect on June 1 pushed up the price of new apartments.

The only other significant source of mortgage loans is the government, which offers subsidized mortgages of limited size to specific groups, mainly young couples buying first homes away from the center of the country and new immigrants. But the availability of these loans is steadily declining, so that the overall amount owed to the government fell by one-third in the three years through December 2012, as repayments of existing loans far exceed the disbursement of new ones.

Although the commercial banking system has a virtual monopoly on mortgage lending and the Israeli banking system is widely criticized for its low level of competition, the mortgage sector is a striking exception. “The banks are generally competitive in their retail operations, but nowhere more so than in the mortgage business, where fierce competition has driven margins to very low levels”, notes Eckstein. He adds that “one of the factors behind this is that the Basel II rules reduced the capital requirements on mortgage loans, relative to those imposed on corporate lending, giving the banks a strong incentive to direct resources to the mortgage market.”

This helps explain why the Bank of Israel has sought to offset the relative advantage of mortgage lending by imposing its own restrictions on that sector — albeit with limited success. In fact, the central bank’s motives for intervention, as well as the tools that it has used, have varied over time. In 2010-2011, it viewed the inflationary impact of rising house prices as the main threat it faced, because the country was still experiencing high economic growth then and the surge in purchase and rental prices was pushing overall inflation up and forcing it to respond by raising interest rates.

But over the last two years, the macro-economic environment has changed dramatically: growth rates have fallen and inflationary pressures have largely dissipated, allowing — or requiring — monetary policy to respond with a series of interest rate cuts. Despite fears that these would trigger an intensification of the mortgage lending boom, the data cited above show that this has not happened. Instead, the central bank’s concerns are now focused in a very different direction — that of macro-prudential risk, relating to both the lenders and borrowers in the mortgage market.

This risk stems from the changed banking landscape that has been created in recent years by, on the one hand, the wave of mortgage borrowing, especially by young couples and, on the other, the lack of corporate lending by the banks, observers say. The borrowers find themselves chasing rising prices and hence obliged — if they are to purchase at all — to take larger loans. As Eckstein notes, the fact that interest rates are near record lows makes these loans seem affordable — but if rates rise, they will quickly become unaffordable. The other risk is also macro-economic, but from the other direction. Whereas rising interest rates presupposes higher growth, if the current slowdown gets worse and unemployment rates — which are also near record low levels — begin to rise, many families will not be able to service the debts they have taken on.

Clamoring for Lower Prices

Lastly, the Bank of Israel is worried that house prices might actually fall sharply, whether in response to a government effort to ramp up building starts, or because of general economic weakness. Although the general public is clamoring for lower prices, anything more than a mild decline would be bad news for the banks, which are exposed to both the apartment buyers, via their mortgage loans, and the contractors who build the apartments and who are also financed by bank loans. Indeed, the proportion of corporate lending going to the construction sector has risen over recent years, thereby increasing the exposure of the banking sector to the housing and real estate sector — and providing further justification for the banking regulator to be concerned and to intervene, observers say.

In light of the sharp rises in prices and the large increase in mortgage lending, it is not surprising that talks of a house price bubble, or at least of a mortgage lending bubble, is conjuring up visions of the very bubbly real-estate markets in the U.S., Ireland and Spain before the crash of 2007-2008. However, any such comparison has very little basis in fact, experts point out. First, and perhaps foremost, most borrowers are not over-extended — because they are not allowed to become over-extended.

“In terms of leverage, there is no ‘bubble'”, maintains Avissar. “The level of financing most house-buyers take can still be considered reasonable — on the average, around 60% of the property’s value — certainly compared to other countries.

“Therefore”, she continues, “the key metrics seem to be OK at the moment: The amount of problem loans is still low and so is the degree of leverage. The banks claim that even stress tests modeling extreme scenarios do not result in losses that would pose a threat to their stability.”

Eckstein goes even further. “Currently, there is no systemic threat — even if there were a general price decline of 20% in home prices” he says. That is certainly comforting, as far as it goes, but the absence of a threat to the financial system does not mean that all is well, observers warn. The socio-economic — and political — pressures being generated by rising house prices and the increased indebtedness that goes with them still demand a solution, although that is plainly beyond the purview of the banks and their regulator.

This solution, as most everyone agrees, must come primarily via an increase in supply and a relaxation of the constraints that currently impede supply. The new government must find the will and the ways to achieve this goal, observers say, whilst avoiding an over-reaction which would destabilize the market and inflict losses on borrowers and lenders.