BIS Special Feature On Household Debt

The Bank for International Settlements has featured the issues arising from high household debt in its December 2017 Quarterly Review. They call out the risks from high mortgage lending, high debt servicing ratios, and the risks to financial stability and economic growth.  All themes we have already explored on the DFA Blog, but it is a well argued summary. Also note Australia figures as a higher risk case study.  Here is a summary of their analysis.

Central banks are increasingly concerned that high household debt may pose a threat to macroeconomic and financial stability.  This special feature seeks to highlight some of the mechanisms through which household debt may threaten both macroeconomic and financial stability.

Australia is put in the “High and rising” category.  The debt ratio now exceeds 120% in both Australia and Switzerland.  Mortgages make up the lion’s share of debt (between 62 and 97%).  In Australia mortgage debt has risen from 86% of household debt in 2007 to 92% in 2017.

High household debt can make the economy more vulnerable to disruptions, potentially harming growth. As aggregate consumption and output shrink, the likelihood of systemic banking distress could increase, since banks hold both direct and indirect credit risk exposures to the household sector.

They say  the size of household debt burdens matters too. This is best measured by the ratio of interest payments and amortisation to income – the debt service ratio (DSR).   They say that rising household debt can reflect either stronger credit demand or an increased supply of credit from lenders, or some combination of the two. In Australia, for instance, heightened
competition among lenders seems to have resulted in a relaxation of lending standards.  In addition, the interest rate sensitivity of a household’s debt service burden is likely to matter. High debt (relative to assets) can make a household less mobile, and hence less able to adjust by finding a new or better job in another town or region. Homeowners may be tied down by mortgages on properties that have depreciated in value, especially those that are underwater (ie worth less than the loan balance).

These household-level observations have implications for aggregate demand and aggregate supply. From an aggregate demand perspective, the distribution of debt across households can amplify any drop in  consumption. Notable examples include high debt concentration among households with limited access to credit (ie close to borrowing constraints) or less scope for self-insurance (ie low liquid balances).

Since poorer households are more likely to face these credit and liquidity
constraints, an economy’s vulnerability to amplification can be assessed by looking at the distribution of debt by income and wealth.  In Australia, households in the top income brackets tend to have substantially higher debt ratios than those at the bottom of the distribution (eg in 2014, the top two quintiles had debt ratios of about 200%, while the bottom two had ratios of about 50%. [Note this is based on OLD 2014 HILDA data, and debt to higher income households has risen further since then!]

In countries where household debt has risen rapidly since the crisis, and where the majority of mortgages are adjustable rate, DSRs are already above their historical average, and would be pushed yet further away by higher interest rates.

From an aggregate supply perspective, an economy’s ability to adjust via labour reallocation across different regions can weaken if household leverage grows over time. In such an economy, a fall in house prices – as may be associated with interest rate hikes – would saddle a number of households with mortgages worth less than the underlying property. A share of these “underwater” homeowners might also lose their jobs in the ensuing contraction. In turn, their unwillingness to realise losses by selling their property at depressed prices may prolong their spell of unemployment by preventing them from taking jobs in locations that would require a house move.

Elevated levels of household debt could pose a threat to financial stability, defined here as distress among financial institutions. These exposures relate not only to direct and indirect credit risks, but also to funding risks. There is some evidence that this may be occurring in Australia, where high-DSR households are more likely to miss mortgage payments.

The indirect exposure to household debt arises from any increase in credit risk linked to households’ expenditure cuts. These are bound to have a broader impact on output and hence on credit risk more generally. Deleveraging by highly indebted households could induce a recession so that banks’ non-household loan assets are likely to suffer. Financial stability may also be threatened by funding risks . The network of counterparty relationships could become a channel for the transmission of stress, as any decline in the value of one bank’s cover pool could rapidly affect that of all the others.

They conclude:

Central banks and other authorities need to monitor developments in household debt. Several features of household indebtedness help to shape the behaviour of aggregate expenditure, especially after economic shocks. The level of debt and its duration – as well as whether debt has financed the acquisition of illiquid assets such as housing – all play a role in determining how far an individual household will cut back its consumption. Aggregating up, the distribution of debt across households can amplify these  adjustments. In turn, such amplification is more likely if debt is concentrated among households with limited access to credit or less scope for selfinsurance. Since these households are also likely to be poorer households, keeping track of the distribution of debt by income and wealth can help indicate an economy’s vulnerability to amplification.

OECD Signals RBA Rate Hike

According to the OECD,  Australia – Economic forecast summary (November 2017),  things are looking better. As a result, they expect rate hikes next year to help cool the housing market. But they call out a number of risks to economic growth and says macro-prudential measures should be maintained. Also their growth rates are lower than than latest from the RBA!

The economy will continue growing at a robust pace. Business investment outside the housing and mining sectors will pick up, with exports boosted as new resource-sector capacity comes on stream. The strengthening labour market and household incomes will sustain private consumption, and inflation and wages will pick up gradually.

The central bank is projected to start raising the policy rate in the second half of 2018 and expectations of this move, together with macro-prudential measures, are helping cool the housing market. The fiscal position is sound and the government is committed to gradually close the budget deficit. In the event of an unexpected downturn, fiscal policy should be used to support activity and protect the incomes of the most vulnerable.

The prolonged period of low interest rates has fuelled high house prices in large metropolitan areas. Substantial mortgage borrowing has resulted in households being highly indebted. To contain risks associated with potential large house-price corrections and financial stress, macro-prudential measures should be maintained. Australia is also vulnerable to “too big to fail” risks, due to its highly concentrated banking sector.

RBNZ Backs Supply Not DTI To Address Housing Risks

The Reserve Bank New Zeland has today published the Response to submissions on the Consultation Paper: Serviceability Restrictions as a Potential Macroprudential Tool in New Zealand.

Given the current slowdown in the housing market, the Reserve Bank considers a serviceability restriction would not be appropriate at present, but could still have a role to play in the future. In particular, the Reserve Bank does not believe DTI restrictions should be deployed in the current housing market environment and considers that the key longer term solution to housing market imbalances is to facilitate growth in housing supply in areas that need it.

In the meantime, they will continue to work with banks to improve the data being received on DTIs. The Reserve Bank is aware that system issues mean data from some banks includes overstated DTI ratios for some customers, and would like this to be gradually improved. The Reserve Bank may also provide further guidance around technical areas such as treatment of guarantees.

This is significant because many of the responses were from lenders who also operate in Australia, so we get a read on their arguments, ahead of the expected APRA paper on mortgage risk.  Good DTI data is a problem, but one which could and should be sorted.

This is interesting also, given the broader use of DTI in other jurisdictions (such as the UK) and the view expressed by IMF that DTI should be the macroprudential tool of choice.

Falling back to supply side issues squibs the core demand issues, in our view.

The NZ Reserve Bank received 25 submissions. A majority of submissions that expressed a clear view were against serviceability restrictions being added to the Reserve Bank’s toolkit. On the other hand, there were supportive submissions, and some submissions which went further and suggested serviceability instruments such as a debt-to-income ratio (DTI) restriction should be immediately deployed (not just added to the macroprudential toolkit set out in the MoU as the Reserve Bank had proposed).

Many submissions stated that loan-to-value ratio (LVR) restrictions are currently having a significant effect on the housing market and mortgage lending. Others said with mortgage rates rising recently and the housing market softening, DTI restrictions are not needed now.

Submitters expressed a range of views on whether house prices are currently overvalued. Some submissions stated that supply is the best way to correct imbalances and that LVR or serviceability restrictions cannot permanently solve housing market imbalances.

A number of submissions noted that banks’ own serviceability policies have tightened recently. Some noted that New Zealand consumer law (Credit Contracts and Consumer Finance Act 2003 (CCFA) and the related Responsible Lending Code (RLC)) requires lenders to undertake serviceability assessments. Some banks with Australian parents submitted that they are subject to the Australian Prudential Regulation Authority’s (APRA) prudential practice guide on residential mortgage lending, APG 223.2 Both the RLC and APG 223 require lenders to take the risk of rising interest rates into account when deciding if lending will be affordable.

Most of these points were consistent with the Reserve Bank’s views in the consultation paper. In particular, the Reserve Bank does not believe DTI restrictions should be deployed in the current housing market environment, and considers that the key longer term solution to housing market imbalances is to facilitate growth in housing supply in areas that need it.

We also acknowledged in the consultation paper that banks already undertake serviceability assessments and allow for the risk of rising interest rates. However, the Reserve Bank remains of the view that individual bank lending decisions may fail to take account of their impact on systemic risk during periods of intense competition for mortgage loans, and that there can be a role for limits on banks’ serviceability practices during these periods.

Canada Reinforces Mortgage Underwriting Guidelines

From Moody’s.

On Tuesday, Canada’s Office of the Superintendent of Financial Institutions (OSFI) published the final version of “Guideline B-20 − Residential Mortgage Underwriting Practices and Procedures,” which mandates more stringent stress-testing for uninsured mortgages. The guideline, which takes effect on 1 January 2018 and applies to all federally regulated financial institutions in the country, is credit positive because it will improve asset quality for Canadian banks.

The guideline sets a new minimum qualifying rate, or stress test, for uninsured mortgages at the higher of the five-year benchmark rate published by the Bank of Canada, the central bank, or the contractual mortgage rate plus 2%. Lenders also will be required to impose and continuously update more effective loan-to-value (LTV) limits and measurements.

A key vulnerability of Canadian banks is the high and rising level of private-sector debt/GDP. Canadian mortgage debt outstanding has more than doubled in the past 10 years (see Exhibit 1) and the index of house prices to disposable income has increased 25% over this period (see Exhibit 2), raising the prospect that real estate overvaluation is driving up overall household debt and overextending borrowers.

OFSI’s action is the latest in a series of macro-prudential measures aimed at slowing house-price appreciation in Canada and moderating the availability of mortgage financing. These measures will address the increasing risk that that growing private-sector debt will weaken Canadian banks’ asset quality. Canada’s growing consumer debt and elevated housing prices threaten to make consumers and Canadian banks more vulnerable to downside risks.

In addition to requiring that all uninsured mortgages be stress-tested against a potential rise in interest rates (high-ratio insured mortgages are already required to meet such tests to qualify for mandatory mortgage insurance), the guideline requires that banks establish and adhere to risk-appropriate LTV limits that keep current with market trends. Additionally, the guideline expressly prohibits banks from arranging with another lender a mortgage, or a combination of a mortgage and other lending products (known as bundled mortgages), in any form that circumvents a bank’s maximum LTV ratio.

Housing prices are at record highs owing to price increases in the urban areas of Toronto, Ontario, and Vancouver, British Columbia. Macro-prudential initiatives dampened volumes and prices in Toronto over the summer, but the effects of similar moves in Vancouver last year appear to be lessening this year as prices regain momentum. We believe that high consumer leverage could result in future asset-quality deterioration in an economic downturn or a housing price correction. Although Canadian banks have demonstrated prudent underwriting standards in the past, this is attributable in part to thoughtful regulatory oversight.

The new guideline follows a consultation period that ended in August. Some industry participants recommended a delay in implementation, cautioning that the combined effect of multiple macro-prudential measures affecting the mortgage market risked unduly depressing the housing market, thereby triggering a severe price correction.

Housing and Financial Stability

An excellent speech by Fed Vice Chairman Stanley Fischer at the DNB-Riksbank Macroprudential Conference Series, Amsterdam, Netherlands

It is often said that real estate is at the center of almost every financial crisis. That is not quite accurate, for financial crises can, and do, occur without a real estate crisis. But it is true that there is a strong link between financial crises and difficulties in the real estate sector. In their research about financial crises, Carmen Reinhart and Ken Rogoff document that the six major historical episodes of banking crises in advanced economies since the 1970s were all associated with a housing bust. Plus, the drop in house prices in a bust is often bigger following credit-fueled housing booms, and recessions associated with housing busts are two to three times more severe than other recessions. And, perhaps most significantly, real estate was at the center of the most recent crisis.

In addition to its role in financial stability, or instability, housing is also a sector that draws on and faces heavy government intervention, even in economies that generally rely on market mechanisms. Coming out of the financial crisis, many jurisdictions are undergoing housing finance reforms, and enacting policies to prevent the next crisis. Today I would like to focus on where we now stand on the role of housing and real estate in financial crises, and what we should be doing about that situation. We shall discuss primarily the situation in the United States, and to a much lesser extent, that in other countries.

Housing and Government
Why are governments involved in housing markets? Housing is a basic human need, and politically important‑‑and rightly so. Using a once-popular term, housing is a merit good‑‑it can be produced by the private sector, but its benefit to society is deemed by many great enough that governments strive to make it widely available. As such, over the course of time, governments have supported homebuilding and in most countries have also encouraged homeownership.

Governments are involved in housing in a myriad of ways. One way is through incentives for homeownership. In many countries, including the United States, taxpayers can deduct interest paid on home mortgages, and various initiatives by state and local authorities support lower-income homebuyers. France and Germany created government-subsidized home-purchase savings accounts. And Canada allows early withdrawal from government-provided retirement pension funds for home purchases.

And‑‑as we all know‑‑governments are also involved in housing finance. They guarantee credit to consumers through housing agencies such as the U.S. Federal Housing Administration or the Canada Mortgage and Housing Corporation. The Canadian government also guarantees mortgages on banks’ books. And at various points in time, jurisdictions have explicitly or implicitly backstopped various intermediaries critical to the mortgage market.

Government intervention in the United States has also addressed the problem of the fundamental illiquidity of mortgages. Going back 100 years, before the Great Depression, the U.S. mortgage system relied on small institutions with local deposit bases and lending markets. In the face of widespread runs at the start of the Great Depression, banks holding large portfolios of illiquid home loans had to close, exacerbating the contraction. In response, the Congress established housing agencies as part of the New Deal to facilitate housing market liquidity by providing a way for banks to mutually insure and sell mortgages.

In time, the housing agencies, augmented by post-World War II efforts to increase homeownership, grew and became the familiar government-sponsored enterprises, or GSEs: Fannie, Freddie, and the Federal Home Loan Banks (FHLBs). The GSEs bought mortgages from both bank and nonbank mortgage originators, and in turn, the GSEs bundled these loans and securitized them; these mortgage-backed securities were then sold to investors. The resulting deep securitized market supported mortgage liquidity and led to broader homeownership.

Costs of Mortgage Credit
While the benefits to society from homeownership could suggest a case for government involvement in securitization and other measures to expand mortgage credit availability, these benefits are not without costs. A rapid increase in mortgage credit, especially when it is accompanied by a rise in house prices, can threaten the resilience of the financial system.

One particularly problematic policy is government guarantees of mortgage-related assets. Pre-crisis, U.S. agency mortgage-backed securities (MBS) were viewed by investors as having an implicit government guarantee, despite the GSEs’ representations to the contrary. Because of the perceived guarantee, investors did not fully internalize the consequence of defaults, and so risk was mispriced in the agency MBS market. This mispricing can be notable, and is attributable not only to the improved liquidity, but also to implicit government guarantees. Taken together, the government guarantee and resulting lower mortgage rates likely boosted both mortgage credit extended and the rise in house prices in the run-up to the crisis.

Another factor boosting credit availability and house price appreciation before the crisis was extensive securitization. In the United States, securitization through both public and private entities weakened the housing finance system by contributing to lax lending standards, rendering the mid-2000 house price bust more severe. Although the causes are somewhat obscure, it does seem that securitization weakened the link between the mortgage loan and the lender, resulting in risks that were not sufficiently calculated or internalized by institutions along the intermediation chain. For example, even without government involvement, in Spain, securitization grew rapidly in the early 2000s and accounted for about 45 percent of mortgage loans in 2007. Observers suggest that Spain’s broad securitization practices led to lax lending standards and financial instability.

Yet, as the Irish experience suggests, housing finance systems are vulnerable even if they do not rely on securitization. Although securitization in Ireland amounted to only about 10 percent of outstanding mortgages in 2007, lax lending standards and light regulatory oversight contributed to the housing boom and bust in Ireland.

Macroprudential Policies
To summarize, murky government guarantees, lax lending terms, and securitization were some of the key factors that made the housing crisis so severe. Since then, to damp the house price-credit cycle that can lead to a housing crisis, countries worldwide have worked to create or expand existing macroprudential policies that would, in principle, limit credit growth and the rate of house price appreciation.

Most macroprudential policies focus on borrowers. Loan-to-value (LTV) and debt-to-income (DTI) ratio limits aim to prevent borrowers from taking on excessive debt. The limits can also be adjusted in response to conditions in housing markets; for example, the Financial Policy Committee of the Bank of England has the authority to tighten LTV or DTI limits when threats to financial stability emerge from the U.K. housing market. Stricter LTV or DTI limits find some measure of success. One study conducted across 119 countries from 2000 to 2013 suggests that lower LTV limits lead to slower credit growth. In addition, evidence from a range of studies suggests that decreases in the LTV ratio lead to a slowing of the rate of house price appreciation. However, some other research suggests that the effectiveness of LTV limits is not significant or somewhat temporary.

Other macroprudential policies focus on lenders. First and foremost, tightening bank capital regulation enhances loss-absorbing capacity, strengthening financial system resilience. In addition, bank capital requirements for mortgages that increase when house prices rise may be used to lean against mortgage credit growth and house price appreciation. These policies are intended to make bank mortgage lending more expensive, leading borrowers to reduce their demand for credit, which tends to push house prices down. Estimates of the effects of such changes vary widely: After consideration of a range of estimates from the literature, an increase of 50 percentage points in the risk weights on mortgages would result in a house price decrease from as low as 0.6 percent to as high as 4.0 percent. These policies are more effective if borrowers are fairly sensitive to a rise in interest rates and if migration of intermediation outside the banking sector to nonbanks is limited.

Of course, regulatory reforms and in some countries, macroprudential policies‑‑are still being implemented, and analysis is currently under way to monitor the effects. So far, research suggests that macroprudential tightening is associated with slower bank credit growth, slower housing credit growth, and less house price appreciation. Borrower, lender, and securitization-focused macroprudential policies are likely all useful in strengthening financial stability.

Loan Modification in a Crisis
Even though macroprudential policies reduce the incidence and severity of housing related crises, they may still occur. When house prices drop, households with mortgages may find themselves underwater, with the amount of their loan in excess of their home’s current price. As Atif Mian and Amir Sufi have pointed out, this deterioration in household balance sheets can lead to a substantial drop in consumption and employment. Extensive mortgage foreclosures–that is, undertaking the legal process to evict borrowers and repossess the house and then selling the house–as a response to household distress can exacerbate the downturn by imposing substantial dead-weight costs and, as properties are sold, causing house prices to fall further.

Modifying loans rather than foreclosing on them, including measures such as reducing the principal balance of a loan or changing the loan terms, can allow borrowers to stay in their homes. In addition, it can substantially reduce the dead-weight costs of foreclosure.

Yet in some countries, institutional or legal frictions impeded desired mortgage modifications during the recent crisis. And in many cases, governments stepped in to solve the problem. For example, U.S. mortgage loans that had been securitized into private-label MBS relied on the servicers of the loans to perform the modification. However, operational and legal procedures for servicers to do so were limited, and, as a result, foreclosure, rather than modification, was commonly used in the early stages of the crisis. In 2008, new U.S. government policies were introduced to address the lack of modifications. These policies helped in three ways. First, they standardized protocols for modification, which provided servicers of private-label securities some sense of common practice. Second, they provided financial incentives to servicers for modifying loans. Third, they established key criteria for judging whether modifications were sustainable or not, particularly limits on mortgage payments as a percentage of household income. This last policy was to ensure that borrowers could actually repay the modified loans, which prompted lenders to agree more readily to the modification policies in the first place.

Ireland and Spain also aimed to restructure nonperforming loans. Again, government involvement was necessary to push these initiatives forward. In Ireland, mortgage arrears continued to accumulate until the introduction of the Mortgage Arrears Resolution Targets scheme in 2013, and in Spain, about 10 percent of mortgages were restructured by 2014, following government initiatives to protect vulnerable households. Public initiatives promoting socially desirable mortgage modifications in times of crises tend to be accompanied by explicit public fund support even though government guarantees may be absent in normal times.

What Has Been Done? What Needs to Be Done?
With the recent crisis fresh in mind, a number of countries have taken steps to strengthen the resilience of their housing finance systems. Many of the most egregious practices that emerged during the lending boom in the United States‑‑such as no- or low-documentation loans or negatively amortizing mortgages‑‑have been severely limited. Other jurisdictions are taking actions as well. Canadian authorities withdrew government insurance backing on non-amortizing lines of credit secured by homes. The United States and the European Union required issuers of securities to retain some of the credit risk in them to better align incentives among participants (although in the United States, MBS issued by Fannie and Freddie are currently exempt from this requirement). And post-crisis, many countries are more actively pursuing macroprudential policies, particularly those targeted at the housing sector. New Zealand, Norway, and Denmark instituted tighter LTV limits or guidelines for areas that had overheating housing markets. Globally, the introduction of new capital and liquidity regulations has increased the resilience of the banking system.

But memories fade. Fannie, Freddie, and the Federal Housing Administration are now the dominant providers of mortgage funding, and the FHLBs have expanded their balance sheets notably. House prices are now high and rising in several countries, perhaps as a result of extended periods of low interest rates.

What should be done as we move ahead?

First, macroprudential policies can help reduce the incidence and severity of housing crises. While some policies focus on the cost of mortgage credit, others attempt directly to restrict households’ ability to borrow. Each policy has its own merits and working out their respective advantages is important.

Second, government involvement can promote the social benefits of homeownership, but those benefits come at a cost, both directly, for example through the beneficial tax treatment of homeownership, and indirectly through government assumption of risk. To that extent, government support, where present, should be explicit rather than implicit, and the costs should be balanced against the benefits, including greater liquidity in housing finance engendered through a uniform, guaranteed instrument.

Third, a capital regime that takes the possibility of severe stress seriously is important to calm markets and restart the normal process of intermediation should a crisis materialize. A well-capitalized banking system is a necessary condition for stability in bank-based financial systems as well as those with large nonbank sectors. This necessity points to the importance of having resilient banking systems and also stress testing the system against scenarios with sharp declines in house prices.

Fourth, rules and expectations for mortgage modifications and foreclosure should be clear and workable. Past experience suggests that both lenders and borrowers benefit substantially from avoiding costly foreclosures. Housing-sector reforms should consider polices that promote efficient modifications in systemic crises.

In the United States, as around the world, much has been done. The core of the financial system is much stronger, the worst lending practices have been curtailed, much progress has been made in processes to reduce unnecessary foreclosures, and the actions associated with the Housing and Economic Recovery Act of 2008 created some improvement over the previous ambiguity surrounding the status of government support for Fannie and Freddie.

But there is more to be done, and much improvement to be preserved and built on, for the world as we know it cannot afford another pair of crises of the magnitude of the Great Recession and the Global Financial Crisis.

 

NZ Reserve Bank Consults On DTI Restrictions

The NZ Reserve Bank has released its consultation paper on possible DTI restrictions. The 36+ page report is worth reading as it sets out the risks ensuring from high risk lending, leveraging experience from countries such as Ireland.

Interestingly they build a cost benefit analysis, trading off a reduction in the costs of a housing and financial crisis with a reduction in the near-term level of economic activity as a result of the DTI initiative and the cost to some potential homebuyers of having to delay their house purchase.

Submissions on this Consultation Paper are due by 18 August 2017.

In 2013, the Reserve Bank introduced macroprudential policy measures in the form of loan to-value ratio (LVR) restrictions to mitigate the risks to financial system stability posed by a growing proportion of residential mortgage loans with high LVRs (i.e. low deposit or low equity loans). This increase in borrower leverage had gone hand-in-hand with significant increases in house prices, particularly in Auckland. The Reserve Bank’s concern was the possibility of a sharp fall in house prices, in adverse economic circumstances where some borrowers had trouble servicing loans. Such an event had the potential to undermine bank asset quality given the limited equity held by some borrowers.

The Reserve Bank believes LVR restrictions have been effective in reducing the risk to financial system stability that can arise due to a build-up of highly-leveraged housing loans on bank balance sheets. However, LVRs relate mainly to one dimension of housing loan risk. The other key component of risk relates to the borrower’s capacity to service a loan, one measure of which is the debt-to-income ratio (DTI). All else equal, high DTI ratios increase the probability of loan defaults in the event of a sharp rise in interest rates or a negative shock to borrowers’ incomes. As a rule, borrowers with high DTIs will have less ability to deal with these events than those who borrow at more moderate DTIs. Even if they avoid default, their actions (e.g. selling properties because they are having difficulty servicing their mortgage) can increase the risk and potential severity of a housing related economic crisis.

While the full macroprudential framework will be reviewed in 2018, the Reserve Bank has elected to consult the public prior to the review. This consultation concerns the potential value of a policy instrument that could be used to limit the extent to which banks are able to provide loans to borrowers that are a high multiple of the borrower’s income (a DTI limit). A number of other countries have introduced DTI limits in recent years, often in association with LVR restrictions. In 2013, the Bank and the Minister of Finance agreed that direct, cyclical controls of this sort would not be imposed without the tool being listed in the Memorandum of Understanding on Macroprudential Policy (the MoU). Hence, cyclical DTI limits will only be possible in the future if an amended MoU is agreed.

The purpose of this consultation is for the Reserve Bank, Treasury and the Minister of Finance to gather feedback from the public on the prospect of including DTI limits in the Reserve Bank’s macroprudential toolkit.

Throughout the remainder of the document we have listed a number of questions, but feedback can cover other relevant issues. Information provided will be used by the Reserve Bank and Treasury in discussing the potential amendment of the MoU with the Minister of Finance. We present evidence that a DTI limit would reduce credit growth during the upswing and reduce the risk of a significant rise in mortgage defaults during a subsequent severe economic downturn. A DTI limit could also reduce the severity of the decline in house prices and economic growth in that severe downturn (since fewer households would be forced to sharply constrain their consumption or sell their house, even if they avoided actual default). The strongest evidence that these channels could materially worsen an economic downturn tends to come from countries that have experienced a housing crisis in recent history (including the UK and Ireland). The Reserve Bank believes that the use of DTI limits in appropriate circumstances would contribute to financial system resilience in several ways:

– By reducing household financial distress in adverse economic circumstances, including those involving a sharp fall in house prices;
– by reducing the magnitude of the economic downturn, which would otherwise serve to weaken bank loan portfolios (including in sectors broader than just housing); and
– by helping to constrain the credit-asset price cycle in a manner that most other macroprudential tools would not, thereby assisting in alleviating the build-up in risk accompanying such cycles.

The policy would not eliminate the need for lenders and borrowers to undertake their own due diligence in determining that the scale and terms of a mortgage are suitable for a particular borrower. The focus would be systemic: on reducing the risk of the overall mortgage and housing markets becoming dysfunctional in a severe downturn, rather than attempting to protect individual borrowers. The consultation paper notes that DTIs on loans to New Zealand borrowers have risen sharply over the past 30 or so years, with further increases evident since 2014. This partly
reflects the downward trend in interest rates over the period. However, interest rates may rise in the future. While the Reserve Bank is continuing to work with banks to improve this data, the available data also show that average DTIs in New Zealand are quite high on an international basis, as are New Zealand house prices relative to incomes.

Other policies (such as boosting required capital buffers for banks, or tightening LVR restrictions further) could be used to target the risks created by high-DTI lending. The Bank does not rule out these alternative policies (indeed, we are currently undertaking a broader review of capital requirements in New Zealand) but consider that they would not target our concerns around mortgage lending as directly or effectively. For example, while higher capital buffers would provide banks with more capacity to withstand elevated housing loan defaults, they would do little to mitigate the feedback effects between falling house prices, forced sales and economic stress.

The Reserve Bank has stated that it would not employ a DTI limit today if the tool was already in the MoU (especially given recent evidence of a cooling in the housing market and borrower activity), it believes a DTI instrument could be the best tool to employ if house prices prove resurgent and if the resurgence is accompanied by further substantial volumes of high DTI lending by the banking system. The Reserve Bank considers that the current global environment, with low interest rates expected in many countries over the next few years, tends to exacerbate the risk of asset price cycles arising from ‘search for yield’ behaviour, making the potential value of a DTI tool greater.

The exact nature of any limit applied would depend on the circumstances and further policy development. However, the Reserve Bank’s current thinking is that the policy would take a similar form to LVR restrictions. This would involve the use of a “speed limit”, under which banks would still be permitted to undertake a proportion of loans at DTIs above the chosen threshold. By adopting a speed limit approach, rather than imposing strict limits on DTI ratios, there would be less risk of moral hazard issues arising from a particular ratio being seen as “officially safe”. Exemptions similar to those available within the LVR restriction policy would also be likely to apply.

 

G20 Data Gaps Initiative – Real Estate Data Hole

Interesting speech from Prof Claudia Buch Vice-President of the Deutsche Bundesbank on “Data needs and statistics compilation for macroprudential analysis.” Availability of data on real estate markets does not match the importance of these markets for financial stability. The lack of data is profound.

Surveillance of risks to financial stability requires good data and information. The second phase of the G20 Data Gaps Initiative plays an important role for improvements in the statistical infrastructure. Apart from providing a conceptual framework for the collection of data, implementation of new concepts nationally and internationally will be crucial.

First, with its framework for the evaluation of financial sector reforms post-implementation, the FSB has started an ambitious project. The success of this project will depend crucially on the timely and comprehensive availability of granular data. Now is the time to start developing protocols defining how statistical and policy evaluation work can be integrated more closely.

The real estate sector plays an important role for the real economy and the financial system. Monitoring developments in real estate markets is, therefore, key to an early identification of vulnerabilities.

  • More than two-thirds of all Europeans own the homes they live in. Residential property typically forms the largest component of homeowners’ wealth.
  • The majority of households borrow to finance a home purchase. In many places, housing assets can be used as collateral to access funding.  Mortgage debt is thus the main financial liability of the household sector.
  • Mortgage loans are also a major asset of the financial system. In advanced economies, about 60 percent of banks’ total lending portfolios are held in the form of mortgage loans.

Given this large exposure of financial institutions, risks to financial stability can occur if a strong rise in house prices coincides with a strong expansion in mortgage loans and an easing of credit standards.

Risks can build up if market participants form overly positive expectations regarding future developments in debt sustainability. They may not give due consideration to the possibility that asset prices may fall and that interest rates may rise. If property prices subsequently decline, and if this is coupled with a simultaneous increase in default rates, banks may not be able to offset losses from mortgage lending.

The bursting of credit-driven real estate price booms does significant and long-lasting damage to the real economy.  A fall in house prices may also affect financial institutions more directly through their specific investments in residential real estate assets.

The availability of data on real estate markets does not match the importance of these markets for financial stability. The European Systemic Risk Board (ESRB 2016) has thus recommended “closing real estate data gaps”. Much work needs to be done to improve data on real estate in terms of coverage as well as of comparability across countries.

The lack of data is profound. For Germany, indicators are available only for (aggregated) prices and credits. Information on credit standards is insufficient for monitoring financial stability. Information is limited to the Eurosystem’s quarterly Bank Lending Survey (BLS). But this survey includes only qualitative information, and it is constrained to a sample of 139 large banks. As regards markets for commercial real estate, reliable indicators on both price and lending volumes are lacking.

The G20 Data Gaps Initiative aims at improving the availability of Residential Property Price Indices (RPPI) (IMF and FSB 2016). By the year 2021, G20 economies are to provide nationally available data on Commercial Property Price Indices to the BIS. In September 2016, the BIS had already published such data, including information on coverage and methodologies, for a number of countries.

Second, we have made much progress in the surveillance of non-bank finance or “shadow banking”. Assessing risks in this area requires drilling down further, using the infrastructure that we have in terms of data and methodologies. But it also requires further developing our analytical tools, especially in order to strengthen our understanding of shock transmission channels and the relevance of common exposures and inter-sectoral linkages for the latter, including those that extend across borders.

Third, international capital flows have many positive effects – but can also propagate shocks across borders. To address this concern, timely and granular data are needed for policy use. An improved sharing of and accessibility to sufficiently granular data is crucial for monitoring systemic risk. This implies the use of common identifiers in order to allow a better linking of different micro datasets and a more refined analysis of channels of propagation.

The Impact of Macroprudential Tools

The BIS just published an interesting working paper – “The impact of macroprudential housing finance tools in Canada“.

Do policies which seek to regulate serviceability, such as debt to income, or debt servicing ratios, work better than loan to value controls? A highly relevant question given the fact that some central banks are going down the debt to income approach (e.g Bank of England has implement high DTI thresholds) and Reserve Bank NZ is exploring this at the moment).

It seems from their research that income related constraints work well for higher income households, but loan to value methods work better for households with more constrained incomes. So perhaps DTI measures should be targetted at more wealthy households seeking larger loans.

This was a paper produced as part of the BIS Consultative Council for the Americas (CCA) research project on “The impact of macroprudential policies: an empirical analysis using credit registry data” implemented by a Working Group of the CCA Consultative Group of Directors of Financial Stability (CGDFS).

The paper combines loan-level administrative data with household-level survey data to analyze the impact of recent macroprudential policy changes in Canada using a microsimulation model of mortgage demand of first-time homebuyers.

They found that policies targeting the loan-to-value ratio have a larger impact on demand than policies targeting the debt-service ratio, such as amortization. In addition, they show that loan-to-value policies have a larger role to play in reducing default than income-based policies.

The results of the experiments suggest that wealth constraints are more effective than income constraints at affecting mortgage demand, particularly on the extensive margin, for a given proportional change and the given starting points of policy parameters (95% maximum LTV and maximum 25-year amortization for insured mortgages).

Income constraints, however, are just as effective as wealth constraints for high-wealth homebuyers. The focus of the empirical analysis and the model, however, is on mortgage demand, and ignores some aspects of the general market for housing as well as potential supply effects.

From changes in consumer demand, we fnd that LTV constraints, which work through the wealth channel, are effective housing finance tools. Given that the average household is able to meet changes in cash flow, we conclude that, at least with the types of changes we observe to amortization, that changes directed at household repayment constraint are less effective. Households are attracted to these products, however, they are not binding.

An important contribution of this paper is the use of microsimulation modeling to capture the interactions of multiple policy tools and the non-linearities in consumer responses. This model imposes some structure on how we interpret the data while still being highly flexible in capturing nonlinear responses that more traditional, rational forward-looking dynamic stochastic general equilibrium models generally have difficulty capturing. The model allows us to map the impact of a policy change on the percentage of FTHBs who enter the market and their demand for credit. The results of our microsimulation model suggest that the wealth constraint has the largest impact on the number of FTHBs who enter the housing market and amount of debt that they hold. However, the impact of changes in amortization, which affect the income constraint, do affect high-wealth households. Finally, we show that LTV policies seem to reduce the impact of interest rate shocks on household vulnerabilities relative to income-based policies.

A caveat of our results is that we have taken as given that lenders are able to change the supply of credit exogenously in response to changes in macroprudential policy. This appears
reasonable, given that banks do not face default risk in the Canadian (insured) mortgage market. However, if there is a tightening, banks might react strategically to price mortgages
in a way that partially offsets changes in macroprudential policies. More importantly, we do not capture general equilibrium effects. A relaxation of mortgage insurance guidelines leads to entry of FTHBs, which can lead to house price appreciation, which leads to further entry and greater house price appreciation. This can affect both current and future mortgage demand in a way that is not captured in the model.

Note: BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.

RBA and Macroprudential

In a speech “Has the Way We Look at Financial Stability Changed Since the Global Financial Crisis?“, Michele Bullock, RBA Assistant Governor (Financial System) discussed the RBA’s perspective on macroprudential.

Referring to APRA’s 2014 “tightening” of mortgage lending, she says that whilst borrowers risks may have lowered, “the initial effects on credit and some other indicators we use to assess risk may fade over time”.

Agreed. It is clear that the regulators have not done enough to tame housing credit growth, conflicted as they are between seeing housing momentum as a replacement for the fading mining boom on one side, and the risks to households, their high levels of debt, and broader financial stability on the other. Actually, we think the Council of Financial Regulators (that shadowy body, chaired by the RBA, and including APRA, ASIC and Treasury) has failed to manage the fundamentals in the past few years. Did they not see the risks, or did they choose to ignore them? In that light, Bullock’s comments have a hollow ring!

Post-GFC, there is now more acceptance of the need to take action when system-wide risks are rising. This is reflected in the increasing use of what are commonly known as macroprudential policies.

As my colleagues David Orsmond and Fiona Price note in a Bulletin article in December 2016, there is no universally accepted definition of macroprudential policy. They define it as ‘the use of prudential actions to contain risks that, if realised, could have widespread implications for the financial system as a whole as well as the real economy.’ They also note that the use of such tools has increased in a number of countries post-GFC.

In Australia, we see macroprudential policy as part and parcel of the financial stability framework. As we have set out on other occasions, the essence of macroprudential policy is that prudential supervisors recognise potential system-wide risks in their supervision of individual institutions and react accordingly.[3] APRA can and does take an active supervisory stance, modifying the intensity of its prudential supervision as it sees fit to address institution-specific risks, sectoral risks or overall systemic risk. A recent example might help to illustrate this.

In 2014, the Australian regulators took the view that risks were building in the residential housing market that warranted attention. There was very strong demand for residential housing loans, particularly by investors. Price competition in the mortgage market had intensified and discounts on advertised variable rates were common. There also seemed to be a relaxation in non-price lending terms. The share of new loans that were interest only was drifting up and the growth of lending for investment properties was accelerating. Unsurprisingly in this environment, the growth in housing prices was strong, particularly in Melbourne and Sydney.

The regulators judged that more targeted action was needed to address the risks – to put a bit of sand in the gears. So APRA tightened a number of aspects of its supervision. It indicated that it would be alert to annual growth in a bank’s investor housing lending above a benchmark of 10 per cent. It also set some more prescriptive guidelines for serviceability assessments and intensified its scrutiny of lending practices. ASIC also undertook a review of lending with a focus on whether lenders were complying with responsible lending obligations.

There is no doubt that the actions did address some of the risks. Nevertheless, the early experience suggests that, while the resilience of both borrowers and lenders has no doubt improved, the initial effects on credit and some other indicators we use to assess risk may fade over time. We are continuing to monitor their ongoing effects and are prepared to do more if needed.

Where to from here? With the GFC close to 10 years ago now and a substantial amount of regulatory reform having been undertaken, the focus is turning to implementation and taking stock of the effectiveness of the reforms. This is reflected in the FSB’s current agenda. But there is also some thinking to be done about how monetary policy considerations should factor in financial stability issues, and the role that macroprudential policies might play in addressing system-wide risks in a low interest rate environment.

In conclusion, I would like to return to the question I posed at the beginning of this talk, and in fact the question I posed myself when I first came into this area a few months ago – has the way we look at financial stability changed since the GFC? While the basic way we look at financial stability has not changed, experience with the GFC reinforced the need to focus on system-wide issues. We need to spend time analysing them and thinking about whether policy responses might be required. We are still learning how best to do this.

Investors Boom, First Time Buyers Crash

The ABS released their Housing Finance data today, showing the flows of loans in January 2017. Those following the blog will not be surprised to see investor loans growing strongly, whilst first time buyers fell away. The trajectory has been so clear for several months now, and the regulator – APRA – has just not been effective in cooling things down.  Investor demand remains strong, based on our surveys. Half of loans were for investment purposes, net of refinance, and the total book grew 0.4%.

In January, $33.3 billion in home loans were written up 1.1%, of which $6.4 billion were refinancing of existing loans, $13.6 billion owner occupied loans and $13.5 billion investor loans, up 1.9%.  These are trend readings which iron out the worst of the monthly swings.

Looking at individual movements, momentum was strong, very strong across the investor categories, whilst the only category in owner occupied lending land was new dwellings.  Construction for investment purposes was up around 5% on the previous month.

Stripping out refinance, half of new lending was for investment purposes.

First time buyers fell 20% in the month, whilst using the DFA surveys, we detected a further rise in first time buyers going to the investment sector, up 5% in the month.

Total first time buyer activity fell, highlighting the affordability issues.

In original terms, total loan stock was higher, up 0.4% to $1.54 trillion.

Looking at the movements across lender types, we see a bigger upswing from credit unions and building societies, compared with the banks, across both owner occupied and investment loans. Perhaps as banks tighten their lending criteria, some borrowers are going to smaller lenders, as well as non-banks.

We think APRA should immediately impose a lower speed limit on investor loans but also apply other macro-prudential measures.  At very least they should be imposing a counter-cyclical buffer charge on investment lending, relative to owner occupied loans, as the relative risks are significantly higher in a down turn.

The budget has to address investment housing with a focus on trimming capital gain and negative gearing perks.  The current settings will drive household debt and home prices significantly higher again.