Korea’s Own Coming Mortgage Crisis
by Brendon Carr
While I don’t usually rely on the Korea Times as a source of information, because it’s crappy and there is a self-censorship going on over there, it is in English and that means a link to the story doesn’t require ol’ Brendon to undertake a translation job in order to write about something on this blog. And that has some value in and of itself.
Over the weekend a story appeared on the Korea Times website about the risks associated with Korea’s housing prices and home loans, a topic near and dear to my heart. It seems Korea’s housing finance system puts borrowers at risk in a manner similar to the sub-prime meltdown and coming adjustable-rate mortgage tsunami in the States.
You see, virtually all (90%, according to the Korea Times story) of Korea’s home loans are adjustable-rate mortgages, the kind which are now roiling the US housing market as they reset. Foreign bankers at HSBC, KEB, and Citibank have tried to interest Korean borrowers in fixed-rate loan products, but the market has heretofore been wholly uninterested in such loans. Korean borrowers prefer, and therefore the banks provide, adjustable-rate mortgages. When we bought our apartment, although I specifically instructed my wife (since Korean banks refuse to lend to foreigners, even those with a good job and 12 years’ continuous residency) to get a long-term, fixed rate product, she brought back an adjustable-rate loan—and then argued with me about how stupid the long-term, fixed rate product was. (Why my wife refuses all finance advice from me may be another story.)
But Koreans do Southern California one better. Korean housing loans, in general, are also not “fully-amortizing” loans—instead, borrowers take out an interest-only loan with a term of one to three years, during which time they pay only the interest and none of the principal (although, like my family, they might save separately and pay down the principal that way). At the expiration of the term they roll the note over. Why don’t they pay any of the principal during the term of the loan? Well, for starters, just like the fools in the US housing bubble, nearly all Koreans are convinced that “Real estate only goes up. They’re not making any more land, you know.” But also, the principal balances—even on 50% LTV loans—usually exceed six or seven times the borrowers’ annual income. As a result, the interest expense is too great to add principal repayment to the burden.
Besides, because property always goes up, and lately has gone up like wildfire, only a sucker would pay principal now. You can take care of that when you sell the property, from all the capital appreciation that’s guaranteed to occur! After all, real estate only goes up. They’re not making anymore land, you know.
Now we add the risk factor of the variable-rate loans. Because of the wild property bubble inflation of the last few years, a lot of Koreans have stretched themselves by buying into properties on which they can barely afford the interest-only payments. Interest rates have been quite low of late, with housing loans in the high 5% range available (again, not to you, Mr. Good-Job Foreigner, but any Korean on the street could get one).
But what happens when the interest rate increases, say, to the high 7% range? That interest-only payment, which the homeowner could barely afford in the first place, is now almost 40% greater than it was before. A W1,000,000 payment (which would comprise half the after-tax monthly income of the average Korean wage earner) is now almost W1,400,000. It becomes that much harder to pay the interest. (Remember, most borrowers don’t touch the principal.) Also, since local banks are now required to examine the borrower’s ability to continue to service the loan, by comparing the payment burden to the disposable income of the borrower, many Korean homeowners may find it hard to roll those notes over.
And that means lots of foreclosure sales, or short sales, coming soon. But those tend to depress prices. So mark my words, Korea’s property is entering a deflationary phase. In Japan, Hong Kong, and Singapore, at least, past experience with property bubbles has shown us losses of up to 70% are possible.
Here’s where the 50% loan-to-value ratio hurts the Korean homeowner more heinously than the Americans who’ve lost their homes in the sub-prime crisis: The price decline eats up equity first—the bank’s loan gets paid off in the repossession sale, with the homeowner getting what’s left. This means in the coming bubble deflation, years and years of hard-earned cash savings are about to be lost. In the States, people get dinged on their credit scores and lose a few thousand dollars on the down payment (and no-money-down buyers just lose the imaginary bubble gains)—in Korea, people are going to lose real, hard-to-replace cash.
We’ve been through this kind of thing before—in 1998, interest rates spiked and asset values dropped slightly, putting a lot of apartments into foreclosures and auction sales. What’s different about now and 1998 is that the world economic conditions are different, as well as local ones. In 2009 there will be no American foreign investors galloping to the rescue, that’s for sure. This is going to be ugly.
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I think when I was looking to get a loan in May, the rate was at 7.1 percent. I think that my wife told me that recently on TV the average home loan rate was 9 percent. Unfortunately because of the IT nazi’s at work I can’t look it up…
What is interesting to me is that the bank I was getting the loan from was pushing the ARM loan even though I was asking for a fixed rate. They kept saying that the rate is based off the government rate and that it only changes slightly and never in big moves. They were defintely trying to get me to sign up for the ARM. The deal wound up falling through.
Another intersting point brought up by Brendon is the korean mindset for real estate. My wife is korean and very set in her thinking about real estate. It is funny to hear her say Seoul will never go down and that it is a different market because when someone leaves Seoul, someone is right behind them to buy their property. Because Gangnam has the best hagwons, Gangnam will never go down...She also does not listen to any financial advice that I give her...sigh...she is pretty set on the fact that we must buy a house to show people we are well off and thinks renting is throwing money away…
I think the most damage from the ARM loans used in the U.S. is that a lot of them were negative amortization loans, where the outstanding balance would actually increase until the scheduled amortization would begin. Apparently, this was the only way to put a 12k a year strawberry picker into a 700k house. We all know what the end result of this type of lending is.
In Korea, the ARM loans are not negative amortization loans (AFAIK), thankfully. Though even I know people who have to move every three years, because they can only afford the interest, but were not allowed to roll over their loans. So they switch to another over-priced house, and another unmanageable mortgage.
Considering the median household income vs. median cost of house, it’s no wonder less and less are able to actually pay back the loan balance.
Everyone still thinks housing can only go up, (though I’ve been able to convince my wife otherwise). Herein lies the reason people overextend themselves even more during bubbles: “If we can make a 50 million Won profit in a year by buying a 300 million Won house in Sillim, just imagine how much profit we’ll make by buying a 600 million Won house in Gangnam instead?”
An unwavering belief in prices forever increasing doesn’t make people just invest in the commodity, it makes them want to leverage as far as they can to invest even more.
I think an eventual 70% fall for the worst areas in Seoul is not an unreasonable expectation. I know my “cheap” house in Suwon is at least 50% overpriced, and it’s still considerably less than in the neighborhood blocks.
Right. I’ve heard that too. But how many people can actually afford to buy a house in Gangnam at the current prices? And I mean, really, really afford, as in able to pay back the loan according to the amortization schedule?
A 500 million Won 30-year amortization loan at 8% costs you over 3.5 million Won a month. How many Koreans are making salaries that can service these kinds of debts?
Show her a cost of renting vs. interest costs for a mortgage calculation, maybe that will set her straight? In general, the cost keeping 400 million won tied to an 35-pyeong apartment would pay the rent of a 50-pyeong apartment in the same area. So it would be more accurate to say that buying is “throwing money away”, at least at current prices.
Great post and comments. I’d like to write a lot more but am constrained by time and keypad.
1. Foreigners can get mortgages. My anecdotal experience is that I received a mortgage loan at the same interest rate and LTV ratio as a Korean citizen. And I did it in my own name as a single man, from a Korean bank, with a minimum of hassle.
2. Not all Korean mortgages (or perhaps even the majority) are I/O loans. Mine certainly was not, although keep in mind there is a mortgage interest deduction available in relation to Korean income tax, so such loans are not a priori completely unfavorable.
3. Do the banks only offer ARMs because that is what borrowers clamor for? Or do the banks do that in their own interest and the borrowers are stuck with it? I don’t know—perhaps it’s a chicken and egg question.
4. The typical interest rate on a Korean mortgage loan is the 3 month CD rate + a margin of 1.5 - 2.0%. It would be interesting to factor the effect of that into your predictions.
Thanks for this post. It’s good to know I’m not alone. My wife and I just bought an apartment and my wife got a ‘not fully amortizing’, adjustable-rate loan. Fortunately, we were able to pay a huge down payment, but I truly hope that the interest rate doesn’t go up from 6.3%. It’s frustrating to pay only interest for 2 years!
Sure, it’s not the best time to buy, but rent is getting ridiculous, and we really want our own place (it’ll be all ours in just 20 short years!).
And besides, you know, they aren’t making any more land and real estate always goes up.
I am happy to find this blog. I was thinking to buy a house here in Korea so I tried to do some research before buying one as an investment, seek advise and I found this website. I agree, the property here is too high at this moment. Not to mention the interest rate & property tax. Hopefully there is some action from current government to cool down the property.
Don’t take my word as gospel. I could be wrong.
Reply to Tero’s point:
While I agree with what you’ve basically said one should be careful about renting in Korea as well. Jeonsae (did I use the correct spelling??) can be very dodgy as well..theoretically you get the principal back if you break or finish the contract with the owner of the property.
My wife (who’s Korean) lives in Cheong-ju and I work in the Busan area (no I’m not an ESL instructor-most of the time anyways) are renting so most of our “capital” is tied up in the “rental deposits”. My worry is if the owners of the two apartments we rent run into financial difficulties they can run off with our money. Yes, I know theoretically we can hold on to the apartments but the legal procedures involved in this I’m told take a long while, during which time of course you’re in a bad spot.
Brendon, if you’re right about the property bubble here bursting (Japanese style) coupled with the sub-prime mortgage snafu in the U.S. should I be worried about our money being in somebody else’s account??
I went to a lecture about mortgage market in Korea in my school, and here is a short quote from a paper written by the lecturer:
And of course, I heard the “property never goes down” story countless times too. My korean friend, who lives in Germany, wanted to get a flat with mortgage there, because “rent is wasting money,” and was shocked when i told her it’s nonsense and that german real estate prices were flat or falling for a decade. My schoolmate works for Wooribank, and told me about his friends whose (interest only) payments skyrocketed recently, and who struggle with it. I mean, the real estate bubble is so overblown here it must be reaching outer space by now. I agree with Brendon, I think this will get uggly too.
I think a lot of people with ARMs are going to be surprised when the interest rate increases from the current ~9% The Bank of Korea will need to raise the base rate if inflation persists. It’s currently running at 6%. And this isn’t a country with a lot of natural resources, land, or a free market. Who can afford to buy an apartment if the interest rate is 10% or more? Fewer buyers = less demand.
Remember when people were making/investing huge amounts of money simply putting up a website 10 years ago? Maybe at the time you wondered to yourself, “How can this make any sense?” Well, it didn’t make sense and the house of cards collapsed in the dot bomb. Listen to your gut.
Housing markets are collapsing in Shanghai, Beijing, the US, etc. It is only arrogance that would make us in Korea think we are immune to the coming real estate deflation. The apartment my company rents for me is new, looks good at a glance, but was hastily made and detailed workmanship is lacking. It’s poorly insulated, heating and cooling are expensive, the elevator doesn’t go down to the parking garage so everyone parks on the sidewalk in front of the building if they need to haul groceries. Hanjin cranks these things out like nobody’s business and pouring concrete is a mainstay Korean industry that won’t go away anytime soon. Even if the housing market deflates substantially. Could you imagine what would happen to the economy if all those construction workers were laid off?
The apartment I live in is considered pretty nice by Korean standards and probably typical for the manager level worker. This 3 bedroom on the 4th floor is supposed to go for about $600K US. My two story house on a 3000 sq ft lot in Oakland, CA was worth that price two years ago and is now worth about $400K. My gut tells me prices are coming down at least 50%.
That said, the market is eroding in key areas but has not collapsed here yet. Should Korea do something to ensure it doesn’t? Or should Korea just let the housing market do it’s thing
I come back from the bank and was told that in Korea there are no caps on how much the interest rate on ARM mortgages can increase. That seems crazy to me. To the people with ARM mortgages, is this true?