Housing Tradeoffs

By Eric Crampton 01/07/2013

The RBNZ is looking more seriously at loan-to-value ratio regulations to curb house price appreciation.

I’ve been skeptical about LVR regulations. If adopted as a “thou shalt not loan more than x% of the house’s value” commandment applying to all new loans, they would have substantial effects on first home buyers unable to lean on family for support. If Matt Nolan is right that the banks really still have some implicit guarantee despite the OBR mechanism, there could be public interest in such regulations; a serious recession coupled with housing bubble collapse would then have banks taking a large hit while auctioning defaulted properties. But, any “making houses more affordable” justification for the regulations seemed exceptionally weak as the policy seemed likely to induce a level shift followed by a return to the prior price path. In other words, we’d be back on the same path of housing price appreciation after a one-off drop in prices concentrated among those homes favoured by first home buyers.

Fortunately, the RBNZ is not as silly as all that. They write:

we favour speed limits over outright restrictions. We do not want to ban high LVR lending; we would prefer to restrict it as a share of banks’ total new lending. With a speed limit approach, we expect banks would need to build in their own internal buffers to give themselves a margin of error. Such buffers could reduce as banks become better at controlling their proportion of high LVR lending. Within the speed limit, each bank would make their own assessment of which customers received high LVR loans, based on their own criteria including other risk measures, such as debt servicing capacity, and the potential long-term value of those customers to the bank.

Implemented this way, much of the beautifully written snark I had prepared now has to be deleted.* The equity effects still hold, but in attenuated form. When property prices start ramping up along with LVRs, first home buyers without family backing will get hit even more strongly than they are currently, but so long as the LVR proportion is set sensibly, it won’t bind most of the time.

Further, RBNZ recognises all the workarounds that are likely to emerge. Parents will take out a mortgage on their paid-off homes to lend to the kids as starter capital; there’s nothing the bank can or should do about it. A secondary loan market will emerge, but borrowers there will incur higher interest rates than they would in the mortgage market, so the system still works to discourage high LVR loans at the margin.

I’m still having a hard time seeing how the policy has anything but transitional effects on home affordability though. I would expect the regulation to result in a one-off drop in the price of starter homes, followed by a move back to the prior expected path of price increases. Effects on homes farther up the food chain will be rather substantially attenuated as the LVR is still less likely to bind for those with reasonable existing home equity to apply to a new home purchase with the sale of the old one; ability to service the mortgage out of existing income ought to bind before the LVR does for anybody with enough equity. NBR notes that John Key wants first-home buyers exempted from the rule; I have a hard time seeing that it would be binding on anybody under that scenario unless lots of folks are buying investment properties with no equity. If lots of investment properties are being bought on very high LVR loans, then I move from mildly meh to somewhat in favour of the regulation change.

Now here’s the RBNZ:

While the Reserve Bank’s mandate is to promote financial stability, not social equity, there are clear implications here for housing affordability. As house prices and debt levels trend increasingly upwards, so too housing becomes less affordable, particularly for first home buyers. While macro-prudential policy measures might make credit less accessible for a period, they should help to make house prices more affordable in the longer term. Such measures should also reduce the risk of a sharp housing downturn and the loss of equity that would result, particularly for highly indebted home owners.

I agree with Nolan that the RBNZ doesn’t have a housing affordability mandate. The best reason I can see for RBNZ’s running this is as part of its prudential supervisory role looking over the banks so that they’re less likely to take on too much housing risk in the expectation of being able to lay it off on taxpayers in case of a substantial downturn.** I have a much harder time seeing this as part of inflation policy: CPI is based on rent, not property prices, rents seem to lag prices, and I doubt that the policy has much effect on housing prices except among the homes purchased by first-home buyers, and even there only tapering off peaks as LVR spikes.

And it seems odd to highlight affordability for first-home buyers when the policy is most likely to make it rather harder for them to finance their first homes.

* The Game of Thrones analogy might have been overwrought anyway; you’ll now never get to judge.

** Again, though, I think that the OBR mechanism does a lot to prevent that state of the world from obtaining.

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