In the current low interest rate environment, European market mortgage underwriting policies on debt-to-income (DTI) ratios could lead to the weaker performance of floating-rate loans, according to Fitch Ratings.
The DTI ratio measures the financial commitments of the mortgage applicant against an applicant's net income, including the instalment of the requested loan. This is one of the key drivers behind the mortgage underwriting policies of European banks.
For floating-rate loans, the DTI ratio has some limitations as a tool in assessing loan affordability, as the applicant's debt service commitments on the requested loan will be subject to varying interest rate levels.
The rating agency said that this can be addressed by factoring in the potential increases in interest rates into the assigned ratio, but such an approach to DTI calculations has rarely been employed by European lenders.
"In those countries where the bulk of mortgage originations consisted of floating-rate products, such as Italy, Spain, Portugal and Greece, the limited use of forward-looking DTI ratios was one of the main factors that contributed to the wave of delinquencies and defaults experienced in 2007 and 2008 by floating-rate loans originated between 2003 and 2005," said Michele Cuneo, senior director in Fitch's European structured finance team.
Euribor-linked loans originated between 2003 and 2005 had an initial DTI ratio based on interest rates of around 2%.
As such, when Euribor moved to around 4% in 2007 to 2008, the affordability of these mortgages was significantly affected, especially for loans that were originally approved with high DTI ratios.
Fitch said it expected that floating-rate loans originated in the current low interest rate environment by banks whose underwriting policies do not rely on forward-looking DTI ratios will show a similar sensitivity to interest rate shifts as the 2003-2005 vintages.
These loans are likely to be even more sensitive to interest rate movements in terms of lenders who did not tighten their DTI thresholds during the financial crisis. This happened as low interest rates resulted in more low-income borrowers have become eligible for a loan.