Which borrowers are at greatest risk of any likely Reserve Bank tightening of the regulatory screws on mortgage lending?
If it was the most financially vulnerable, it would be first home buyers. But the most politically vulnerable are investors.
One of the two key metrics here is loan-to-value ratio (LVR), or what proportion of a property's value a buyer borrows. That is an indicator of the risk of negative equity if house prices fall significantly. The bank has recently reinstated curbs on LVRs temporarily lifted in the wake of the pandemic.
The other key metric is debt-to-income (DTI), or what multiple of household income the borrower is able to borrow. It reflects vulnerability to an unexpected drop in income. In that respect, the drop in the unemployment rate reported this week is an encouraging improvement, Reserve Bank deputy governor Geoff Bascand said when releasing the bank's latest Financial Stability Report.
The Reserve Bank is keen to have the power to regulate bank lending on the basis of DTI multiples, though it will be later this month before it makes the case for this to the Government.
By contrast, the Financial Stability Report makes it plain that the bank is less convinced of the merits of restricting interest-only lending, and sees limited benefit in tightening LVRs further.
In March, 53 per cent of new borrowing by first home buyers was at a DTI above 5 times, up from 40 per cent a year earlier. And 46 per cent was also at an LVR above 70 per cent, including 18 per cent above an LVR of 80 per cent.
By contrast, investors tend to borrow at much lower LVRs, but at much higher DTI multiples. So in March, 68 per cent of new lending to property investors was at a DTI of 5 times or higher, up from 55 per cent a year earlier. But only 16 per cent was also at an LVR above 70 per cent.
In February Finance Minister Grant Robertson issued a direction to the Reserve Bank — which it is required to "have regard to" — that it is "Government policy to support more sustainable house prices, including by dampening investor demand for existing housing stock, which would improve affordability for first home buyers." At the same time he injected similar language, more incongruously, into the bank's monetary policy remit.
Together with its later moves on the tax front — an extension of the bright-line test to 10 years and the phasing out of interest deductibility — the Government has made it clear that it is targeting property investors in a bid to run out road spikes in the path of the accelerating truck of house price inflation.
The Financial Stability Report asserts, with masterly understatement, that "High-DTI households are likely to have less of a buffer to absorb future increases in interest rates or falls in incomes."
Even at a median DTI, and even at the historically low mortgage interest rates prevailing over the past year, typical first home buyers would have to commit 30 per cent of their income to servicing the mortgage. If mortgage rates rose to 5 per cent, that would climb to a painful 40 per cent of their income.
And at 7 per cent, which would still be well below the levels prevailing before the global financial crisis, paying the mortgage would pre-empt more than half their income.
So you would expect a DTI tool, if the Reserve Bank was given one, to be targeted particularly at first home buyers.
But the politics of a holy war against investors, combined with their high DTI levels, suggests they would be the ones in the sights of a DTI curb.
"It looks like DTIs would have more impact on investors than we would have thought years ago," Bascand said. But any move in that direction would take some time to develop and there would have to be a consultation process.
A report from the Ministry of Housing and Urban Development (HUD), written just before last Christmas, tells us that over the past decade 35-40 per cent of property purchases have been by buyers owning multiple properties. About a fifth of current private rentals had been bought in 2019 and 2020, half of them by small investors with fewer than four properties, usually including their own homes.
The HUD report also said 37 per cent of rental property owners, or just over 107,000 taxpayers, already reported tax losses on their rental properties, losses which are now ring-fenced and cannot be used to offset tax owed on other sources of income.
Assuming a mortgage of $500,000 at an interest rate of 2.5 per cent, denying all interest deductions to an investor whose marginal tax rate is 33 per cent would add $4125 to their interest cost of $12,500 per annum.
Like the Reserve Bank, the housing ministry is not a fan of curbing interest-only loans. "Assuming the same [$500,000] mortgage, moving from an interest-only mortgage would add principal repayments of $11,200 per annum". By way of comparison, the median rent lodged during 2020 was $470 a week or $24,440 per annum.
The Financial Stability Report also offers some general observations on how it interprets the term "sustainable" house prices.
It is like the second leg of the bank's monetary policy mandate, to support maximum sustainable employment, Bascand said. There is no single neat metric of what is sustainable. Rather, the bank looks at a suite of indicators and whether they are moving away from or closer to some long-term trend.
In the case of house prices, it would be matter of looking at whether they are, on balance, converging with or departing from where fundamental drivers suggest they should be heading.
One such driver is population growth. Another is how responsive the supply side of the housing market is, as indicated by things like building consents.
Then there are the tax rules which influence expected returns to investors, and finally where interest rates are, relative to some changing idea of a neutral rate.
"Interest rates are lower than their long-run levels. We think neutral long-run rates are above where they are now," Bascand said.
By contrast, the other fundamental drivers are ones which the Government, not the central bank, can influence: the impact of immigration policy on population growth; regulatory impediments to new building; and of course the tax rules.