Europe: Homegrown Mortgages are Sound (Extended)

Lenders on the Continent tend to keep the risk in-house, so they're more careful about who borrows. Home buyers take on a lot less debt

By Jack Ewing

For years, European bankers have endured slights from U.S. rivals about their stodgy lending habits. Imagine: They still demand a 20% downpayment—or more—for a home loan. Adjustable-rate mortgages are a novelty. And instead of packaging loans into fancy derivatives and selling them to hedge funds, the Europeans keep them on their own books. How quaint.

Now those Old World bankers are looking mighty smart, at least when it comes to their domestic markets. True, a growing number of Europe's global banks are suffering losses from investing in U.S. debt. On Aug. 9, French giant BNP Paribas (BNPP.PA ) announced it was temporarily suspending three investment funds that are together worth more than $2 billion because a shortage of liquidity and lack of visibility made it impossible to fairly value the funds' assets. The move rattled stock markets, drove up short-term money-market rates, and helped provoke an unprecedented $130 billion liquidity-boosting action by the European Central Bank (see, 8/9/07, "Subprime: The Ugly American Hits Europe").

But on the home front, at least, there is no sign of a subprime crisis. Why? More conservative lending traditions, regulation, and restrained consumer behavior mean that banks in most of Europe have been slow to adopt the risky financial innovations now backfiring in the U.S. Banks with limited exposure to the U.S. subprime market are thriving, such as Dutch financial-services giant ING Groep (ING ), which reported a 27% rise in second-quarter profits Aug. 8.


  The biggest difference is that European lenders tend not to resell mortgages with the same abandon as Americans. The volume of mortgage-backed securities and other vehicles for offloading loans in Europe is about $1.1 trillion—a big number, but still only about 10% of the volume in the U.S., according to the European Central Bank. Instead, when they want to raise funds for mortgage lending, European banks often sell so-called "covered bonds," a $2.5 trillion market.

These resemble mortgage-backed securities, but with the crucial distinction that issuing banks must repay investors even if homeowners default. Keeping risk in-house gives lenders a strong incentive to pay close attention to the quality of borrowers. By contrast, with mortgage-backed securities, investors assume the risk.

Tradition also plays a role. Germans still typically go to their local savings bank or state-supported Landesbank for a loan. The banks keep some 80% of those on their books, and put the rest in covered bonds. Big players such as Dresdner Bank (AZ ) or Deutsche Bank (DB ), which are more likely to use mortgage-backed securities, account for only 16% of the German mortgage market. And loans to low-income borrowers are rare. "These aggressive marketing methods—no income check, interest rate discounts—that's not normal in Europe," says Stephan Rieke, an economist at BHF Bank in Frankfurt.


  It helps that Europe's real estate market hasn't swooned. Home prices in Spain, France, and Britain aren't climbing as quickly as they were a few years ago, but they haven't seen a broad decline. "The housing market is still a very safe form of lending," Bank of England Governor Mervyn King told the House of Commons earlier this year. And most Europeans could probably still make their payments even in the event of a real-estate shock. In European households with a mortgage, debt equals only about 60% of income, vs. 100%-plus in the U.S., BHF reports. "There is hardly an equivalent with the American subprime sector," Banque de France governor Christian Noyer said in July.

Of course, none of these factors helps European banks that bought derivatives linked to the U.S. mortgage market. Investors are nervous after Germany's IKB Deutsche Industrie Bank (IKBG.DE ), a midsized specialist in business loans based in Dusseldorf, became the focus of a government-organized bailout after suffering losses of at least $1.4 billion via a fund that invested in U.S. subprime credit.


  On Aug. 6, Germany's Frankfurt-Trust Asset Management froze an asset-backed securities fund to prevent panic-selling by investors. And, of course, the events of Aug. 9 suggest that credit woes could run even deeper. European central bankers are trying to reassure investors that Continental banks' exposure to U.S. subprime debt isn't big enough to provoke a crisis, but many financial-service institutions could suffer simply from a slowdown in global capital markets.

There's also a downside to European banking caution: First-time buyers have trouble breaking into the housing market. "The self-employed, single parents, and immigrant workers tend to be considered unbankable," says Toni Moss, chief executive officer of EuroCatalyst, a Netherlands think tank. In fact, there is a small but growing business serving people with more credit risk, particularly in Britain. The preferred term is "nonconforming" borrowers, rather than subprime. But no matter what name they use, lenders, mindful of the U.S. disaster, are now likely to proceed much more carefully.

With Mark Scott in London and Cassidy Flanagan in Paris

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