Home loan limits and buffers won’t stop a housing bubble

Dealing with housing bubbles can get messy for central banks. Shutterstock

Australia’s central bank has formally flagged the use of macroprudential tools to address what it called “unbalanced” lending in its most recent Financial Stability Review.

Loan-to-valuation ratio (LVR) limits are the latest tool doing the rounds of central banks as they seek to cool overheated housing markets, with investors spurred on by low interest rates.

Introduced by the Reserve Bank of New Zealand in October 2013, LVR limits are now being considered by the Reserve Bank of Australia.

LVR limits restrict the proportion of new lending that can be done at high LVRs. In New Zealand, the RBNZ requires that banks limit residential mortgage lending at LVRs greater than 80% to no more than 10% of the dollar value of their new housing lending flows. The intention is to reduce demand for housing, and therefore demand-side pressure on house prices.

However, evidence from the New Zealand housing market suggests the effect has been minimal.

The median house price in New Zealand rose by NZ$30,000 (7.7%) in the 12 months to August 2014, according to the REINZ. In the hottest housing markets in New Zealand, the increase has been greater: NZ$59,493 (10.3%) in metropolitan Auckland and NZ$56,500 (12.7%) in Christchurch.

Unintended consequences

The impact is expected to be greatest for first home buyers, who are likely to be trying to buy a house with the smallest contribution possible in order to make a purchase at the earliest opportunity. Therefore, there was some expectation the impact would be greater at the lower end of the housing market. However, this has forced home buyers into cheaper homes, where their contribution represents a greater proportion of the house price. As a result, demand at the lower-price end of the market has increased and pushed prices up.

The greatest impact tends to be disproportionately on first home buyers, who are already experiencing difficulties getting into the housing market. LVR limits add to their difficulties. It increases the quantum of savings they need to make that first purchase.

At the national median price of NZ$420,000 in August 2014, increasing the borrowers’ minimum contribution from 10% to 20% requires additional savings of NZ$42,000.

With house prices continuing to rise, the increase between August 2013 and August 2014 would have required an additional contribution of NZ$6000. In metropolitan Auckland, this is worsened with the higher minimum contribution requiring an additional contribution of NZ$63,500. In addition, the increase in house prices for the 12 months to August 2014 requires a further NZ$11,890.

At the same time, any change to LVR limits will not affect potential borrowers with a sufficient contribution. This is the largest part of the market. In August 2013, high LVR lending in New Zealand represented just 25.4% of new residential mortgage lending, according to RBNZ data. This means nearly 75% of lending was not affected by the LVR regulations.

Loopholes

As with any new regulation, those affected will seek ways to (legally) get around the rules. The LVR limits are no exception.

RBNZ attempted to limit this by requiring banks to adhere to the spirit of the new regulations, as well as the specific regulatory requirements. While banks provide the majority of housing finance in New Zealand, other lenders are not bound by the LVR limits, so some high-LVR lending is still being undertaken. But the funding available to these lenders is more limited, which imposes natural curbs on the quantity of high-LVR lending available.

In addition, it appears parents are providing assistance to their children by becoming joint borrowers, providing guarantees or simply providing funds, possibly seen as an early inheritance.

All of this activity is reflected in RBNZ data. By August 2014, high-LVR lending (before exemptions) had decreased to 7.7% of new residential mortgage lending, but the decrease in new residential mortgage lending was only 10% in dollar value. Over that same time interest rates in New Zealand have increased.

It is unclear to what extent the reduction in new borrowing is driven by the increased cost of that borrowing rather than the introduction of the LVR limits.

LVR limits may be useful as a regulatory tool to manage lenders’ risk profiles, as high-LVR lending is inherently more risky. But the effect on the housing market is limited, as the New Zealand experience demonstrates.

In New Zealand, the key reason for the limited impact is that the growth in house prices is driven more by supply-side factors. This is particularly true in the most overheated markets of Auckland and Christchurch, where there is simply a shortage of housing.

Other options to reduce risk

Other macroprudential tools are available to the RBA. The first of these is the counter-cyclical capital buffer requiring banks to hold additional capital when the economy is booming. This would provide banks with higher levels of capital to cover losses when the bust occurs.

The second option is a sectoral capital overlay requiring banks to hold additional capital for particular sectors, such as housing or the rural sector.

The third is the core funding ratio (the RBA’s Net Stable Funding Ratio), which could be increased if a risk is identified. This would provide banks with a higher ratio of stable funding, including retail deposits, that is more likely to remain in the system in a downturn.

It is important to remember macroprudential tools are actually designed to build resilience into the financial system to enable financial institutions to cope when the economic boom turns to economic bust. A housing bubble does have the potential to lead to an economic bust, but macroprudential tools are not designed to prevent that and should not be used in that way.

Housing bubbles are a real concern for the RBA, and other central banks, but misusing a macroprudential tool like LVR limits is not an appropriate response. Unfortunately, there is no easy answer.