The best case we can make for the Reserve Bank’s latest round of loan-to-value home mortgage regulations (LVRs) is not particularly compelling.
Or, at least, it requires stretching our understanding of the bank’s prudential regulation mandate a bit farther than I’d like. This is dangerous because maintaining an independent central bank requires that the Reserve Bank act within the narrow confines of its mandate.
Let’s first make the best case we can for the LVR and its extension. Here goes.
Suppose that the world is awash in easy money seeking homes. New Zealand’s property market seems a pretty safe bet: at least six years of central government sabre-rattling on council-imposed supply restrictions in Auckland has resulted in very little increase in real housing supply. At the same time, strong inbound migration has pushed up demand for Auckland housing. And so banks have an easy time providing loans for New Zealand houses.
In that world, we have something like an Austrian economics-style malinvestment problem in which easy credit flows into real housing assets, fuelling an asset bubble. This is not without risk. Suppose that, somehow, Auckland managed to allow more townhouses and apartments downtown or turned prime downtown real estate currently used as parking lots for used cars coming off container ships instead into apartment blocks, or abolished the metropolitan urban limit. If house prices dropped by enough, people might start defaulting on mortgages. If banks then started earning substantial losses, that could impose systemic risk through bank defaults. Despite the laudable move to open-bank resolution in case of bank failure, taxpayers could still be on the hook for some of those losses.
Inflation targeting alone cannot really address these kinds of asset price moves – and especially where the bank should be lowering rates rather than raising them. Loan-to-value regulations can only really have temporary effects on house prices. But they might help shave the peaks off of the current cycle while we continue to wait either for Auckland Council to allow more building or for migration to ease back.
The story requires a few background assumptions that I do not buy.
It requires that banks systematically underestimate the risk inherent in the Auckland property market or expect to offload any downside costs on the taxpayer through bailouts – despite the move to open-banking resolution.
Alternatively, it could require that the Reserve Bank has insider knowledge that central government really will manage to get Auckland to ease its land supply and zoning regulations sufficiently to knock back prices substantially.
But even if you believe the story and the background assumptions, you also have to believe that a substantial Auckland price correction would impose systemic risk on the banking sector. And, there, the Reserve Bank has not made its case.
In the November 2014 Financial Stability Report, the Reserve Bank reported results of some fairly tough stress tests on the banking sector. They simulated the effects of two large shocks.
In the first and more substantial one, a large recession increased unemployment to 13%, real GDP dropped by 4% and house prices dropped by more than 40% in Auckland. At the same time, commodity prices dropped substantially relative to their November levels – down to the levels we are now seeing. In the second one, interest rates jumped sharply.
Stress test reassuring
In neither scenario did banks’ capital ratios drop below minimum requirements. Further, the banks showed losses in only one year of the simulation.
The Reserve Bank then described the results of the stress tests as “reassuring, as they suggest that New Zealand banks would remain resilient, even in the face of a very severe macroeconomic downturn.”
And, as ex-Reserve Bank economist Michael Reddell points out in a recent blog post, there is also little evidence that investment property loans are riskier than loans to owner-occupiers. While international evidence suggests greater investor default, we need to be careful to compare like-for-like investments.
If investors formed the bulk of the market immediately before foreign crashes, then we could be mistaking a timing effect for an owner-class effect.
The latest Financial Stability Report provides no updated stress tests, suggesting risks to the financial sector are larger than the bank expected in last year’s simulations. While the report notes that debt-to-disposable income ratios have worsened, that worsening is unlikely to worsen the risks imposed by investor borrowing as compared to owner-occupiers.
The Reserve Bank exempted loans for new construction from the new LVR regulations, noting the importance of new construction in Auckland. But this makes a mockery of the Reserve Bank’s financial stability justification for the regulations.
Are loans for new property developments inherently less risky than those to investors who buy and renovate existing houses? And, given existing zoning and land use constraints, is it likely that an additional dwelling really does enough to reduce risk across the banking sector to outweigh the risks that the investor-class loan otherwise imposes?
Why does all of this matter? Auckland house prices seem well deserving of a policy response – should we not welcome the Reserve Bank’s continued attempts to chisel the peaks off this mountain?
Unfortunately, the policy move itself has substantial risks. We have yet to see any assessment of the costs that designating a new asset class might impose on the banks that will have to comply with the regulation.
There will be tricky boundary cases: if a buyer secures a loan against his existing property and against a new purchase, with intention of selling the former after the move, would that count as an investor or owner-occupied purchase for application of the LVR?
But the more important risk is to Reserve Bank credibility and independence.
New Zealand pioneered central bank independence and the world followed. The Policy Targets Agreement, which forms the basis of the bank’s operational independence, is a thing of beauty. But the bank’s independence is only politically sustainable to the extent that it complies with its mandate and does not undertake actions that fall outside its mandate.
Loan-to-value regulation may do a fine job of easing the final few percentage points off the market’s peak but, without those peaks themselves imposing demonstrable risk to the financial sector, they really do not seem to be part of the bank’s remit.
That they’re also consistent with the government’s objectives in Auckland is somewhat beside the point.