[Viewpoint] We owe a big debt to the DTI

The business of lending based on a borrower’s monthly income mushroomed after the Second World War in America. The debt-to-income ratio (DTI), the percentage of a person or family’s monthly income that goes toward paying debt, was the brainchild of mortgage brokers who were eager to lend amid a postwar rise in housing prices.

But they could not risk lending to anyone, so they came up with a formula to gauge mortgage affordability and a borrower’s creditworthiness. Monthly fixed expenses - including all debt - are divided by monthly gross income, to show what leeway there was in a household to take on new debt.

That formula determines the borrower’s credit score, and the higher the ratio is, the slimmer the chance that individual or household has of borrowing. It’s a yardstick that was very effective for American banks and borrowers, who mostly live on monthly earnings. The debt-to-income formula became well established by the 1970s and American mortgage lenders flourished by lending 30-year fixed-rate, amortized mortgages.

The concept was imported to our country in the 1990s, but failed to gain traction in our real estate market. Korean banks lent money collateralized by real estate, and income was outside the equation. But in 2005, the Roh Moo-hyun administration waged a battle to rein in housing prices. Instead of increasing housing supplies, which would have been one strategy, the government introduced all sorts of taxes to quench demand for property.

It didn’t work. Housing prices failed to come down. Speculation continued unabated, largely because the increase in housing prices outpaced tax hikes.

Running out of ideas, the authorities reintroduced the DTI tool, and, surprisingly, it worked like magic. With the wave of a single, magic wand, the army of Korean housewife real estate investors was routed.

At the time, there were many rich housewives in southern Seoul who bought apartments with bank loans and used them as collateral to take out new loans to invest in even more properties. Some owned more than ten. There was a saying that you had to own three or four apartments to be qualified as a wealthy Gangnam housewife. Taxes were powerless against them, yet they became helpless against the DTI. Banks were required to lend based on income, but these housewives had no steady earnings from honest labor. With bank money chocked up, speculation by housewives ebbed.

The power of the DTI surprised even the financial authorities. Former Vice Finance Minister Kim Seok-dong confessed later: “We never imagined the DTI tool would be so effective. But we were too late. When used on top of a blanket real estate tax, we killed the real estate market altogether.” The effectiveness of the DTI was eclipsed by the comprehensive tax system introduced earlier.

The debt limit became pertinent once again when the incumbent government virtually scrapped the comprehensive real estate taxes. Lenders eased the DTI limit when the U.S.-triggered financial meltdown got its hooks into the local economy. Then they toughened it when signs of overheating started to emerge last year.

The market has been steady ever since. The Bank of Korea had been able to keep its benchmark interest rate unchanged in the 2 percent rage because real estate prices have remained steady. The central bank would have been pressured to raise interest rates in fear of inflation if real estate prices soared. The DTI also helped to contain household debt from ballooning beyond control.

As its power strengthened, critics of the system - mostly construction companies and speculators - began to complain. They called the debt limit the cause of the real estate market slump, destroyer of the free market system, and terminator of housing instalment sales.

They claimed sluggish sales of new apartments would be resolved if the DTI barricade is removed. The government finally gave in, slightly relaxing its grip on lenders and their DTI requirement last month.

Now we are in the middle of an election season and the debt crisis in Europe is looming over the economy. Here in Korea, critics are lobbying to remove the DTI standard. One senior financial official said politicians want the DTI regulations eased to help draw votes from local economies saddled with extensive and empty apartment complexes.

If authorities ease up on the DTI regulations, the unsold properties may draw some buyers. But the move will do more harm than good. Without a cap, real estate speculators will have a heyday with the supply glut and household debt will augment rapidly.

It is a hard time for the construction industry, but the DTI must be left as it is. Authorities should shut their ears and keep an eye on the bigger picture: the long-term health of the economy.

*Translation by the JoongAng Daily staff.
The writer is a business editor of the JoongAng Sunday.

By Yi Jung-jae