Brian Fallow 's Opinion

The Economics Editor of the NZ Herald

Brian Fallow: Loan-to-value no magic bullet

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Reserve Bank eyes tools to help prevent booms and busts that devastate household and bank balance sheets.

Reserve Bank Governor Graeme Wheeler. Photo / Mark Mitchell
Reserve Bank Governor Graeme Wheeler. Photo / Mark Mitchell

The Reserve Bank is looking to add the regulation of loan-to-value ratios in the mortgage market to its medicine cabinet.

But it had another go last week at stomping on the idea, which seems to have taken root in some quarters, that it would be some kind of new wonder drug, which will allow it to deal to a feverish housing market while the rest of the economy enjoys low interest rates and less pressure on the exchange rate.

It might help. It might mean interest rates do not have to work as hard as they otherwise would.

But it is not a mechanism to quarantine the housing market from the rest of the economy and enable us to have one monetary policy for it and another for the tradeable sector.

Evidence is mounting that the housing market is heating up, especially in Auckland.

On Friday the Real Estate Institute reported that its housing price index had risen 14.4 per cent over the past year in Auckland, to a new high.

And the explanation that that just reflects a lack of vendors is wearing thin. Turnover in Auckland last month was just 8 per cent lower than the average October in the boom years 2003 to 2007 inclusive.

The Reserve Bank in the Financial Stability Report it released last week said that credit conditions in the residential mortgage market seemed to have been relaxed somewhat over the past year.

"Discussions with banks suggest that high loan-to-value ratio (LVR) loans are now beginning to form a significantly larger share of new mortgage lending than has been the case for most of the period since the financial crisis," it said.

"However, with households still relatively indebted and house prices remaining overvalued on some metrics, banks will need to remain alert to the risks associated with a marked acceleration in credit growth to the household sector."

Ten years ago the ratio of households' housing debt to disposable income was 100 per cent. By 2009 it had climbed to more than 140 per cent. It has eased to 130 per cent, but remains high by historical standards.

Ten years ago the house price to income multiple was 3.3 times. It climbed to more than five times income during 2006 and 2007. It has come back to 4.5 times but, again, is stretched by historical standards.

From such a starting point anything like a repeat of the housing boom of the mid-2000s invites calamity, in the form of a subsequent bust that would devastate household and bank balance sheets and trigger the kind of slump which a number of Northern Hemisphere countries are struggling to escape from.

Hence the focus on the part of the Reserve Bank and its regulatory peers offshore in developing and refining "macro-prudential tools".

These are intended to reduce the risk to the stability of the financial system arising from rapid credit growth of the kind associated with asset booms.

LVR regulation is one of four macro-prudential instruments at various stages of readiness.

From the start of 2014 the Reserve Bank will be able to require banks, with 12 months' notice, to hold a "counter-cyclical capital buffer" - additional equity which will raise the cost of lending during times of rapid credit growth as well as providing a cushion against losses during times of financial distress.

It can also adjust the core funding ratio, which requires banks to source most of their funding from retail deposit and longer-term wholesale sources.

This is primarily intended to mitigate the "rollover risk" starkly evident during the global financial crisis when short-term wholesale funding markets froze, but it also provides a mechanism for raising and lowering banks' cost of funds and thereby influencing the credit cycle.

The Reserve Bank could temporarily raise the risk-weighting attached to particular kinds of loans, such as residential or farm mortgages, so that banks have to hold more capital against those parts of their loan books.

While LVR regulation is used in a number of countries overseas, there are always differences which make a difference between those economies and ours.

There is a risk that would-be borrowers will bypass regulated New Zealand banks in favour of other sources of finance.

An obvious potential drawback with LVR regulation is that it could make it even harder for first-home buyers to get on to the housing ladder.

In that context it is telling that Governor Graeme Wheeler, when discussing LVRs last week, twice made the point that countries which use it typically provide some kind of exemption or relief for first-home buyers. It tends to be targeted at people who are trading up or buying investment properties, he said.

If a similar exemption applied in New Zealand's case it would, of course, limit the effectiveness of LVR regulation.

The tricky part is knowing when the use of such tools would be appropriate.

Work continues, the bank says, on developing a set of reliable indicators to capture both warning signs of rising imbalances and timely indicators of realised stress.

There are also issues of accountability and governance about the use of such interventions, which are being thrashed out with the Minister of Finance and the Treasury. They need to get on with that.

Spurred by low interest rates, growth in mortgage lending has been accelerating since the start of the year, though at an annual pace of 2.5 per cent it is subdued compared with the double-digit increases we saw between 2003 and 2007.

With double digit house price inflation in New Zealand's largest city, on top of the particular challenges of the second largest, Christchurch, momentum is clearly building. But Wheeler said: "At the current state of the housing market, even if we had the ability to use that instrument [LVRs] we would not seek to use [it] at the current time."

The bank was also at pains to stress, as it has before, that macro-prudential tools are intended to strengthen the resilience of the banking system, not to be an instrument of monetary policy.

The bank has two statutory tasks, price stability and financial stability, and macro-prudential policy would be targeted at the latter. Nevertheless the causality works in both directions.

Moves to moderate the effects of the cycle on bank and household balance sheets are likely also to dampen the cycle itself, reducing inflation pressure and with it how high interest rates have to go and the risk of collateral damage via the exchange rate.

LVR regulation, in short, falls into the category of "mates" that monetary policy needs, like fiscal policy, tax policy and competition policy.

It is not a substitute for the official cash rate.

- NZ Herald

Brian Fallow

The Economics Editor of the NZ Herald

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