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Risks To Financial Stability; A UK Perspective

In a speech, Richard Sharp, member of the UK Financial Policy Committee, outlined the range of risks within the financial system. One topic he discusses is the buy to let sector, because investors may increase selling pressure in a downturn, if their rental incomes fall below their interest payments or if they observe or anticipate falling property prices. HM Treasury intends to consult this year on whether the FPC should have Direction powers over the buy-to-let mortgage market.

The complexity of global financial systems and markets requires that we aren’t exclusively concerned about the capitalisation of financial institutions. We are also concerned about risk of contagion and amplification and therefore we monitor systemic resilience and vulnerability wherever we see them.

The crash certainly demonstrated how specific vulnerabilities can have massive implications through amplification when the systemic is fragile or stretched. For example, although this summer’s fall in the Shanghai stock market saw peak to trough losses of 2.9 trillion dollars, there was no contagion or amplification in any way comparable to the experience of the 2007-2008 financial crisis. By comparison the US subprime losses which precipitated the financial crisis of 2007-2008 are estimated at around 400 billion dollars but, as we know now, have had a devastating impact. Unfortunately these losses were heavily concentrated on highly leveraged, systemically important financial institutions. As a result of a loss of confidence in the banking system, the subsequent contagion created profoundly greater costs. For example, economists at the IMF estimate that the aggregate cost to the US economy alone was 4.5 trillion dollars in the period of 2007-2009.Comparable UK costs over the same regime were £370 billion.

Consequently, in fulfilling its primary responsibility to contribute to UK financial stability policy, the FPC has to monitor the banking system, the financial system as a whole, and global and domestic potential sources of instability.

A particular challenge is that the UK is the home for an outsized financial sector. Bank of England economists have calculated that in 2013 the UK banking system was 450% of GDP – compared to around 100% in 1975 – larger than in Japan, the US and the ten largest EU economies.

However, a vibrant and successful financial sector is indeed a precious asset for our nation. It is a source of employment for millions of people; it is a critical source of tax revenue; it supports a number of other leading industries based in the UK, such as accounting and law; it provides for inward capital investment; it is one of the few industries in which the UK is a world leader. The FPC is building the capital and resolution framework to contribute to financial stability and to ensure there are no more bailouts.

The importance of the financial services industry to the UK is recognised by the remit the Chancellor has provided for the FPC. He charges the Committee, subject to fulfilling its primary objective on financial stability, to consider the government priority of maintaining the international competitiveness of the UK financial system. However, it is unequivocal government policy that it is unacceptable that UK citizens should underwrite banks’ balance sheets. One of the FPC’s priorities is to provide a capital and resolution framework for banks which ensures that they are capable of absorbing their own losses and are not ‘too big to fail’.

The actual losses borne by the banking system in the UK were unquestionably significant and life threatening; the six largest UK banks faced losses of up to 15% of risk weighted assets (nearly £67 billion in aggregate), with the largest losses concentrated in two institutions, Lloyds and RBS. Of course, the FPC doesn’t exist to stop any financial institution or group of institutions experiencing severe losses. Indeed, and inevitably, there may be severer losses arising from poor credit or investment judgement in the future. Our responsibility is to have the insight to ensure that we are aware of risks to the financial system and that, in particular, the systemically important institutions are well capitalised and that any severe losses don’t threaten the financial system.

However, recognising the risk of excessive regulation, the Chancellor told MPs when discussing the creation of the FPC and its objectives in 2011 – “we don’t want the stability of the graveyard.” What he meant was that although the FPC has been granted significant powers, in using these powers we have to ensure that we don’t unwarrantedly undermine economic growth through excessive regulation.

This highlights that there are real trade-offs for us, as we seek to fulfil our mandate. Firstly, we want to have well-capitalised banks but we don’t want to diminish the provision of credit to the real economy. Secondly, whilst we want the provision of credit, we don’t want to risk promoting asset bubbles. Thirdly, given its scale and importance as a source of household indebtedness, we want a disciplined property lending market; on the other hand, we don’t want unreasonably to restrict any individual’s ability to enrich his or her life through a housing purchase. Fourth, we may want to move quickly to ensure resolution, but we have to move in a globally coordinated way, which unavoidably has lengthened the process to agreeing a new resolution regime. Fifth, we want to have a safe and stable financial system, but we do not want to encourage financial services firms to feel incentivised to locate in other jurisdictions with lighter touch regulation, or to inhibit the development of new innovative sources of finance.

The FPC has been granted considerable powers to give Directions to the PRA and the FCA in relation to the use of certain macroprudential tools specified in secondary legislation. So far, in the area of bank capital requirements, Parliament has given the FPC macroprudential tools over sectoral capital requirements, and leverage ratio requirements. The FPC is also responsible for setting the countercyclical capital buffer for the UK. Further it has Direction powers also in relation to tools with respect to the housing market – currently loan to value and debt to income limits in respect of owner-occupied lending. HM Treasury also plans to consult by the end of this year on whether the FPC should be provided Direction powers over buy-to-let mortgages.

In seeking to preserve financial stability, the FPC can also make Recommendations to anybody, including to the PRA and the FCA on a “comply or explain” basis, and to HM Treasury, including on the boundaries within and around the perimeter of the PRA and FCA regulatory regimes.

In addition to these formal powers, the FPC also works closely with other authorities and committees within the Bank of England on issues of joint interest. For example, the FPC and PRA Board both agreed the design of the annual and concurrent UK bank stress test scenario, the results of which will help inform judgements by both committees.

Before using its powers, the FPC considers a wide range of information, including market and supervisory intelligence.

The Committee has developed a set of Core Indicators that it will consider when using its powers of Direction. These are indicators of key areas where vulnerabilities may build and signal an increase in financial stability risks. For example, the level of credit-to-GDP above its long-run trend (the ‘credit-to-GDP gap’) is one of the key metrics the FPC considers when setting the countercyclical capital buffer, as research suggests that periods of excess credit growth often precede financial crises.

In addition, the FPC is required by law to conduct and publish cost-benefit analysis before using its tools (unless, in the Committee’s opinion, it is not reasonably practicable to do so). In the remit that the Chancellor set out for the FPC in July, he emphasised that the Committee must communicate how decisions to use its powers are compatible with its objectives, including its judgement as to the balance of risks to its objectives, how those risks are judged to have evolved and how they are expected to evolve.

Since its formation in April 2013, the FPC has made 15 Recommendations or Directions on a wide range of topics, including on: bank capital and liquidity requirements; the UK housing market; and the resilience of the UK financial system to cybercrime. We set out our Recommendations in the biannual Financial Stability Report.

So the FPC has been fairly active in addressing risks. But what risks are we concerned about now? In July, the Committee published its Financial Stability Report, which highlighted the six major risks which, in the Committee’s judgement, are facing the UK financial system. These were risks from: (1) the global environment; (2) potential illiquidity in markets; (3) the UK current account deficit; (4) the UK housing market; (5) misconduct in the financial system; and (6) cybercrime. The Committee provided an update on some of these risks in the Record of its meeting in September.

With respect to the global environment, the Committee reported that, for the moment, things are getting somewhat less fragile in the euro area, in particular as a result of the fact that the immediate risks in relation to Greece have been addressed by the new programme agreed between the Greek government and its European partners. However, there are signs that risks to emerging market economies, particularly commodity exporters, have risen and are significant. This is partly as a result of a slowdown in China and the prospects of a potential ‘spill over’ from tighter monetary policy in the US, which could cause a material retrenchment in capital flows, as well as wealth effects. It is worth observing that one effect of US quantitative easing has been a considerable jump in the emerging market credit to GDP growth ratio. Moreover, many of the EMEs have raised significant external capital in US dollars and are therefore also exposed to the risk of currency mismatch. We need to consider whether capital markets can effectively trade such debt given liquidity concerns.

In fact we are concerned that global markets may not be able to absorb large shifts in assets, hence we are examining the capital market provision of liquidity very carefully. This year, there have been a number of short-lived, non-systemic periods of very high market volatility, which exposed the fragility of market liquidity and that disorderly conditions in one market could spill over to others.

In considering the risk of fragile market liquidity, for example assessing dealers’ ability to act as intermediaries in markets, the Bank and the FCA are working at an international level. The Committee is also closely monitoring risks from the UK’s current account deficit. However, despite the deficit being close to record highs (at 5.2% in 2015 Q1), the capital flows funding the deficit are mostly long-term in nature, reducing the risk of investor flight, and do not yet appear to be creating vulnerabilities in specific sectors.

One risk which received a lot of publicity following the publication of the September Record was the UK housing market. It is worth observing how secure the UK housing market has been to investors historically. This can be partly attributed to the fact that mortgages are typically well backed by housing assets, and that in the UK, unlike the US, mortgages are recourse loans, so homeowners can’t just walk away from their debts. However, the rapid growth in the buy-to-let market has caught our attention – the stock of buy-to-let mortgages has increased by over 40% since 2008. Why could this be a cause for concern? Buy-to-let mortgages are typically extended on interest-only terms, meaning their loan-to-value levels fall more slowly over time than owner-occupied mortgages. In addition, buy-to-let mortgages can add to procyclicality in the housing and credit markets, as investors may increase demand for property in an upturn, as they seek capital gains. Buy to let investors may increase selling pressure in a downturn, if their rental incomes fall below their interest payments or if they observe or anticipate falling property prices. As I mentioned earlier, HM Treasury intends to consult this year on whether the FPC should have Direction powers over the buy-to-let mortgage market. I believe it is important that the Committee is provided with powers. Beyond the risks the Committee have identified and, looking longer term, what troubles me?

It’s worth observing that – worryingly – global debt has increased considerably since the crash. It has increased by 57 trillion dollars since 2007 – 2014, outpacing global GDP growth over that period. As I mentioned, I’m most concerned about the fragility arising from this with respect to emerging markets.

Inevitably I have to be concerned that there are even greater risks out there which aren’t anticipated by even the best modellers of risk. As a member of the FPC, I’ve had the benefit of seeing how governmental institutions approach forecasting. It is well known that the Bank, the IMF, and other august institutions failed to anticipate the crash. Here for example is the IMF’s 2007 global financial stability map. The 2007 version singularly failed to reflect the incipient instability which was present and emerged so devastatingly – notice the radically different 2008 version.Modelling is hard – In fact, when I first encountered the optimism of some modellers, it brought to my mind a story told by the educator Ken Robinson:

A teacher noticed that a 6 year old girl was working very hard on a drawing and he asked her what she was drawing. She said she was drawing a picture of God. When the teacher said, “But no one knows what God looks like”, she replied – “they will in a minute”.

The Bank’s own approach to forecasting underlines that they recognise limitations which any forecasters must confront. It is clear that a single point one year forecast can be materially different from the outcome in reality. Hence, the Bank produces fan charts which highlight the amplitude of uncertainty. For our Committee, which does have to be concerned about fat tail events, it is worth observing that even the fan chart approach failed to capture the extreme events that occurred in 2007/08.

However, as a practitioner, I think that general expectations of precision from central bank forecasters maybe too great. In the financial sphere we are well aware that not one of all the outstanding brains in the world can, with predictable regularity, determine which way the markets will be even in the next 24 hours let alone the next year. Consequently, whilst, I’m content that the FPC should take account of its indicators and its forecasts, it must always provide for resilience and capital strength that takes account of the reality of unpredictable events.

Will Cameron’s 200,000 starter homes really help solve the housing crisis?

From The Conversation.

British prime minister, David Cameron, has pledged to turn “Generation Rent” into “Generation Buy”, by building 200,000 affordable starter homes for under-40s by 2020. The price of the starter homes will be capped at £250,000 (£450,000 within London), and buyers will not be able to sell the properties on for five years. While the prime minister’s announcement will help address the UK’s chronic housing shortage, it is also likely to have unintended consequences.

We really ought to be building 240,000 new homes each year in England alone, if we are to meet need. Currently, we are only building about half of that amount. In fact, it was as far back as 1978 when we were last building the numbers of new houses we need today.

Challenge accepted

Minister for Housing and Planning Brandon Lewis recently said that building 1m new homes in the life of this parliament would be a good achievement. But, welcome as those homes would be, they are still fewer than we need.

The real challenge is to rebuild the construction capacity that we lost after the credit crunch, when many small and medium sized builders went out of business and many skilled construction workers left the industry as house prices fell and small builders found it hard to raise finance. So building more homes will involve boosting the number of small- and medium-sized construction firms, as well as skilled labour – all of which will take time and money.

As though the challenge of building a million homes wasn’t enough, we also need to ensure these homes are spread across all tenures: we need homes for private and shared ownership, newly built and professionally managed private rental homes and affordable rental homes. The prime minister’s announcement of additional starter homes is a useful contribution to meeting the gap between what we need and what we are currently building.

But these homes are to be secured by relaxing planning obligations for developers. Herein lies the potential for unintended consequences.

Over the last two decades, planning obligations have proved to be a very useful way of securing funds for infrastructure – such as open public spaces, schools, roads and public transport – and new affordable homes, including shared ownership and affordable rental homes.

Local authorities can use planning laws to negotiate with developers to incorporate affordable homes into their projects, and contribute toward the local infrastructure needed to support the new residents they attract. Over the years, large sums have been secured for infrastructure and affordable homes. Developers obviously incur costs when making these provisions. They ensure they can afford these extra costs by paying less for the land they buy than they would have done, if they did not have to comply with these obligations.

Prices for land tend to rocket when planning consent is granted, and it has long been regarded as reasonable for some of this potential increase to be diverted to fund infrastructure and affordable homes. Crucially, planning obligations have enabled private funding to replace publicly funded grants to housing associations, while maintaining the output of new affordable rented homes.

What’s the catch?

Now, developers will be required to provide starter homes at a discount, instead of contributing to infrastructure and affordable rental homes. This trade-off could mean that new starter homes are built, but the supporting infrastructure isn’t. It could also prevent communities from securing the new affordable rental and shared ownership homes they need. This will be a critical loss, especially since the latter have proved an effective way of helping low-income earners to get a foot on the “housing ladder”.

And while financial institutions are keen to invest in newly built privately rented housing, the scale of this activity is still modest and will not be adequate to meet the gaps in rented housing provision in the immediate future.

Perhaps the government has yet to unveil plans to increase public funding for infrastructure and to provide additional grants to build new affordable rental homes. But this seems unlikely, given the cuts to public spending we’re expecting, as we await the outcomes of the public spending review.

What we need, in addition to the government’s aspiration to build 1m new homes by 2020, is clarity about all the resources to be provided. This will allow the house-building and construction industry to gear up with confidence, and aim to reach that target across all tenures. Starter homes will help – but they shouldn’t come at the cost of schools and affordable rental homes.

Author: Tony Crook CBE, Emeritus Professor of Town and Regional Planning, University of Sheffield

Blaming the baby boomers for the housing crisis ignores the real issue: a lack of supply

From The Conversation.

Baby boomers have a greater share of the UK’s wealth than any previous generation in the modern era. And unlike their parents and grandparents, the boomer generation also holds a much higher share of this wealth in housing. Meanwhile, with house prices high relative to their incomes, many younger people and families are are unwilling or unable to accrue wealth through home ownership. Increasingly, 25 to 34-year-olds rent.

This housing wealth inequality between the generations seems unfair. But can we blame the housing wealth of the boomers for preventing younger generations from getting on the property ladder? While baby boomers have generally profited from rising property values, the real reason for the UK’s housing problem is a lack of supply.

Boomer beneficiaries

The boomer generation mostly owned their homes already before the housing boom started around 2001, as shown in the chart below. So they got to enjoy the wild ride in house values with relatively little debt to pay off. Meanwhile, wealth inequality across generations increased during this period.

Home ownership rates by age and birth cohort. IFS calculations using Family Expenditure and Family Resources surveys.

Younger households either managed to buy when prices were high with the help of large mortgages only to see their house value drop, perhaps, during the subsequent bust that began in 2008. Or, if they hadn’t got on the ladder yet, the falling earnings and rising credit standards of the post-financial crisis years meant they were then unable to climb onto the ladder at all.

Not the boomers’ fault

Now, with house values again rising faster than earnings around London, it is perhaps irritating to some that so many older households sit in underused homes, while younger generations struggle to find affordable housing. The Intergenerational Foundation is particularly upset. But for the most part, this isn’t the boomers’ fault.

The relatively large climb in home values is mostly the result of a restricted supply of housing combined with demand factors that are largely unrelated to the ageing of Britain’s population. While older households have benefited from this confluence, they share only perhaps some indirect blame for it.

House prices rose sharply across England from 1996 to 2005, hugely benefiting the many boomers that had bought their homes during the previous decade. This turn of the millennium boom was the result of rising demand for a limited supply of housing stock. This was in turn fuelled by a number of smaller national trends including relaxed lending standards, increased immigration and, at least initially, widespread growth in household incomes and wealth. Perhaps underneath all this were “exuberant expectations” of continued out-sized capital gains. Changing demographics, a much lower-frequency phenomenon, probably contributed little to the demand-side push on house prices.

Geographic evidence

Since the subsequent housing bust, London has claimed the lion’s share of the increase in English house prices. Much of England north of London has seen relatively little – if any – increase in prices since then. This does not match up with where the majority of baby boomers are – they have been ageing in the wrong place to be the cause of this southerly tilt in the housing recovery.

Outside of London, England and Wales are getting older:The young are moving in droves to London. If anything, those grandparents with all their superfluous bedrooms in the villages in the north are the only ones keeping the lights on (and keeping house values from collapsing). Instead, the London-based recovery in house values relies on youth and foreigners. The young want to live in London and foreigners want to invest in it.

All the above factors have been shifting housing demand. If Britain would simply build more houses, prices needn’t have responded so drastically to this rising demand. Of course, the British housing supply problem has long been known.

Moreover, if Britain built more houses, it could build them in the places most needed and with the specifications most demanded. Supply should expand more rapidly in London and the south-east, where demand is highest. Plus, Britain’s ageing population and shifting social norms has created an ever larger demand for housing better suited to the needs of older households. Older households would be far more likely to downsize if this kind of retirement housing were built.

Supply blockers

Of course, older households, who are more likely to vote as well as to own, probably do bear some responsibility politically for blocking supply. Voting homeowners, and disproportionately so older homeowners, tend to disapprove of politicians that approve new building in their neighbourhoods. This has led to brazen political cycles in construction, which perverts the planning process, misallocates housing and raising prices.

Picture a retired couple in their mid-60’s, with children who’ve long since moved out and grandchildren who may just be old enough to visit the odd week during the summer, an empty bedroom or two still furnished with their parents’ childhoods dustily waiting for them. Barring a large change in circumstance, this couple will likely stay in their family home for many years. They know their neighbourhood. The furniture they’ve collected over the years fits just so in their present space. And if they own the average house in England, its value has grown a bit under 4% (in real, inflation adjusted, terms) on average for the last 20 years.

Over the next decade, as the boomer generation slowly ages into its golden years, the UK will have more and more of these households. Given the many risks they face and the relatively few housing choices available to them, clinging on to a house that is too large for their everyday needs is mostly rational.

Besides their pension, a house is far and away the largest store of wealth for those in their 60’s and beyond. Releasing equity by downsizing to a smaller home in a new location may be attractive in theory but there are high transaction and psychological costs in these moves. And, besides, with house prices generally growing again, the returns to be had from staying are too tempting.

Rather than using economic incentives (such as capital gains and stamp taxes) to lever boomers into smaller houses, Britain should look to correct the misaligned political and economic incentives that local councils have to block new housing from being built.

A healthy housing market with the right policies would channel the huge foreign desire to invest in English housing towards building homes for younger (and older) households. House prices would be less buoyant. Retirees with “too much house” would downsize of their own volition, in turn releasing equity for their own consumption and putting a family home back into the market for a new generation to enjoy.

This article is part of a series on What’s next for the baby boombers?

Author: Jonathan Halket, Lecturer in Economics at University of Essex

Zombie loans and a £300bn cushion: inside the Bank of England rates dilemma

From The Conversation.

When the men and women of the committee which sets UK interest rates get together these days, they are dealing with a deceptively simple question. Rates will go up, but how far and how fast? Their answer will decide the fate of a fragile recovery.

The UK economy is getting back to normal. Output has overtaken its peak of 2007 and is growing at close to the average pre-crisis rate; unemployment is low, employment is increasing. Real wages and investment have finally begun to improve. There are even signs of a return to productivity growth.

You might well argue that the financial crisis was unnecessary; that the imposition of austerity meant that recovery was slower than it needed to be and that the burden of adjustment was unfairly shared. But notwithstanding this, the economy is recovering.

This means that interest rates also have to get back to normal. The most recent meeting of the Bank of England’s Monetary Policy Committee left things as they were – at a historic low of 0.5%, where it has remained since February 2008. It is both the lowest rate ever and the longest period without a change in rates. This cannot go on for much longer. We will get another rate decision on September 10 and even members of the committee who usually argue for lower rates, such as David Miles, are openly discussing the moment when the rate will start to rise.

Spent force?

But why do interest rates have to rise? Well, consider the choice between spending now or delaying expenditure into the future. In an economic downturn, the benefits of increasing spending in the present outweigh the costs of reducing it in the future. This is why low interest rates, which encourage spending right now, were a useful policy response to the financial crisis.

Notes and queries. How far and how fast? nataliej, CC BY-NC

But in more normal times, low interest rates encourage levels of expenditure which may exceed the productive capacity of the economy and so cause rising inflation. They may also lead to excessive borrowing and so risk another financial crisis. Higher interest rates, which encourage saving that can be channelled into productive investment, are then more appropriate.

So, if interest rates have to go up in order to manage the transition to another kind of economy, how quickly will they rise? Here, policymakers face two major risks. The first is within the banking system.

Risk factors

Banks are holding more than £300 billion in reserves at the Bank of England. This has been a useful cushion in turbulent times (reserves increased recently during the latest Greek crisis) but going forward, the economy needs banks to make loans rather than accumulate cash.

As a first step, the Bank of England has to stop paying interest on these reserves. This will encourage banks to run down reserves and increase lending. But reducing bank reserves by, say, £200 billion will increase lending by roughly £2 trillion (economists call this the “money multiplier”: historically the multiplier has been around 10). Doing this too quickly risks destabilising the economy. So this suggests we will see a modest and gradual increase in interest rates.

Zombies in our midst. The loans that bit back. Follow, CC BY-NC-ND

The second risk lies with households and firms. Low interest rates have enabled some individuals to stave off bankruptcy by managing to keep up loan repayments. This will no longer be possible once interest rates start to rise. These are the so-called “zombie loans” that stalk the economy, and no one knows how many of these are out there, or at which point in the interest rate cycle they will become a serious danger. Caution again suggest a modest and gradual increase until the scale of the problem becomes clearer.

Level up

Finally, let’s consider how high interest rates will eventually rise.

Policymakers have suggested that the pre-crisis average of 5% may be too high. Why? First, it is not clear how much of the damage caused by the financial crisis is permanent. If the economy has sustained serious damage to its productive capacity, interest rates will need to stay low for a protracted period, until investment has rebuilt capacity.

Second, it has been argued that there are now fewer investment opportunities than there were before the crisis, as the wave of productive investments opened up by the rapid spread of globalisation and new technology has ebbed away, robbing us of opportunities to generate growth and support a robust recovery. This “secular stagnation” hypothesis argues for lower interest rates into the future.

Of course, these arguments are all about successfully managing the recovery of the domestic economy – and we know only too well that external factors, such as US sub-prime mortgages, can have devastating effects across the world. It will be a useful by-product of the expected modest and gradual rate rises from the Bank of England that if and when the next crisis strikes from out of the blue, then there remains the room to bring rates straight back down again.

Author: Chris Martin, Professor of Economics at University of Bath

Australians less likely to survive home ownership than Britons

From The Conversation.

Between 2001 and 2010 roughly 1.7 million Australians dropped out of home ownership and shifted back to renting. More than one-third did not return by 2010. These statistics, from the Household, Income and Labour Dynamics in Australia (HILDA) survey, reflect increasingly insecure jobs, the prevalence of marital breakdown and lone person households, widening income inequalities and the high levels of debt accompanying spiralling real house prices.

Rather than climbing a ladder of housing opportunity that heads in an upward direction only, a growing number of Australians are precariously positioned on the edges of home ownership. We can think of the edges of ownership as a permeable, contested border zone between owning and renting, where households juggle their savings, spending and debt as they attempt to retain a foothold on the housing ladder.

And according to new research comparing Australia with the UK, policy settings play an important role in determining who can and can’t manage to stay in the home ownership game.

The research used three panel surveys – the HILDA survey, the British Household Panel Survey (BHPS) and its successor Understanding Society. We tracked the ownership experience of 1,907 Australian and 674 British individuals that began periods of home ownership between 2002 and 2010 (a period that covers the enormous disruption caused by the global financial crisis). In each year we have recorded their tenure status.

The figure below shows the proportion of people exiting ownership year on year as a spell of ownership lengthens (the maximum spell length in this study being 8 years). For example, 8% of those Australians that had managed to sustain three consecutive years of ownership shifted into the rental sector in the following year. In contrast, 6% of British home owners transitioned into rental housing after three successive years of ownership.

Despite the turbulent British housing market conditions, and a more serious economic recession following the global financial crisis, Australians’ experiences of home ownership appear more precarious. In fact, in all but one year the exit rate is higher in Australia. For a randomly selected Australian moving into home ownership between 2002 and 2010 the chances of “surviving” as a home owner beyond seven years are only 59%. The chances of “survival” are somewhat higher at 68% in the UK. The edges of ownership appear more permeable in Australia.

Exit rate Australia and UK, 2002–2010

Authors’ own calculations from the 2002–10 HILDA Survey, 2001–08 BHPS and Understanding Society wave 2.

For a minority of individuals in the surveys, labour market mobility might be a factor encouraging a temporary shift out of ownership, as people relocate to take advantage of job opportunities. However, it is clear from the data that the majority of moves out of home ownership are related to financial stress. For example, 15% of those Australians leaving home ownership reported difficulties in paying utility bills in one or more years before exit, while only 7% of those with enduring ownership spells reported such difficulties. 9% of departing Australians fell behind on their mortgages, but only 2% of those with enduring ownership spells testified to such difficulties. Similar patterns are revealed in the British data.

This is no surprise. What is striking is that financial stress is more likely to cause a loss of home ownership status in Australia than it is in Britain – a puzzling feature of the findings which cannot be explained by differences in the personal characteristics of Australian and British members of the panels. If, for instance, ownership reached further down the Australian income distribution we might expect more insecure housing experiences among Australian home buyers. But controlling for these possible differences does not explain our results.

Why is Australia different?

There are instead signals in the data which suggest institutional differences across the two countries are at play. There are two factors that could disproportionately draw marginal Australian owners into the rented sector, while propping up the ownership ideals of their British counterparts.

First, and most obviously, the rental sectors of the two countries are quite different, and appear to have a different function at the edges of ownership. The higher likelihood of exit from ownership in Australia may reflect the role of the larger unregulated Australian private rental sector in “oiling the wheels” between renting and ownership. The size, geography and diversity of the Australian private rented sector make it relatively easy for households to adjust housing costs to income by moving before mortgage stress becomes excessive.

Arguably, therefore, renting performs a risk management role, offering temporary, relatively easily accessible, refuge for those on the edges of home ownership. From this perspective, the earlier exit of Australian households who experience financial stress may be seen as the product, in part, of a well-functioning housing system in which the rented sector offers a general safety net. This does occur in the UK, but to a much more limited extent, via a small social rented sector which offers a ‘soft landing’ for households with some very specific (largely health-related) housing needs.

Second, however, there are differences in the two countries’ social security systems. Historically, British home owners with particular financial needs (such as the loss of all earned income) have been eligible for what is now known as support for mortgage interest (SMI). This may postpone or prevent the need to sell up. There is no such safety net for mortgagors in Australia.

Whether, in the long run, either institutional “solution”(growing the rental sector or subsidising mortgagors at risk of arrears) is satisfactory is a topic for policy makers to discuss.

Other options include shared ownership and equity share, which, if provided at scale could offer an escape valve for financially stretched home owners, perhaps improving on the diversity offered by the Australian private rental sector.

On the other hand, if households in either country have the need or appetite to swap the costs of owning for those of renting or shared ownership regularly or routinely, then it must be time to consider the financial instruments that might enable them to do so without incurring the massive transactions costs, and domestic upheaval, of selling up and moving into a rental property.

Authors: Gavin Wood, Professor of Housing at RMIT University, Melek Cigdem-Bayra, Research Fellow at RMIT University, Rachel On, Principal Research Fellow, Bankwest Curtin Economics Centre at Curtin University, Susan Smit, Honorary Professor of Geography at University of Cambridge.

UK Budget Emasculates Negative Gearing

This week the UK Chancellor, George Osborne delivered his latest budget. One strong theme was the need to reduce the bias towards buy-to-let property investors against owner occupied purchasers. Currently, landlords can claim tax relief on monthly interest repayments at the top level of tax they pay of 45 per cent. Mortgage interest relief is estimated to cost £6.3billion a year. Buy-to-let lending has accounted for more than 15% of mortgages taken out – compared with 50% of new mortgages in Australia. The UK has seen the proportion grow by 8% in recent years.

“First, we will create a more level playing-field between those buying a home to let, and those who are buying a home to live in. Buy-to-let landlords have a huge advantage in the market as they can offset their mortgage interest payments against their income, whereas homebuyers cannot. And the better-off the landlord, the more tax relief they get. For the wealthiest, every pound of mortgage interest costs they incur, they get 45p back from the taxpayer. All this has contributed to the rapid growth in buy-to-let properties, which now account for over 15% of new mortgages, something the Bank of England warned us last week could pose a risk to our financial stability. So we will act – but we will act in a proportionate and gradual way, because I know that many hardworking people who’ve saved and invested in property depend on the rental income they get. So we will retain mortgage interest relief on residential property, but we will now restrict it to the basic rate of income tax. And to help people adjust, we will phase in the withdrawal of the higher rate reliefs over a four year period, and only start withdrawal in April 2017”.

So now, this will change, in a move which will ‘level the playing field for homebuyers and investors’, according to the Chancellor, the amount landlords can claim as relief will be set at the basic rate of tax – currently 20 per cent. The change will be tapered in over the next four years. The expectation is that as a result more first time buyers will be able to enter the market.

The Bank of England recently said it would monitor buy-to-let lending more closely, and analysts are concerned about the potential impact should UK rates rise, even with the current incentives in place. A record of a June 24 meeting of the BoE’s Financial Policy Committee shows the bank asked staff to gather evidence for the government consultation later this year, and to look at what action it could take before gaining further formal powers. Last week the Bank of England warned that a surging buy-to-let market could pose a risk to financial stability as landlords are potentially more vulnerable to rising interest rates.

This mirrors concerns raised by the Reserve Bank of New Zealand who cite considerable evidence that investment loans are inherently more risky:

the fact that investment risks are pro-cyclical
that for a given LVR defaults are higher on investment loans
investors were an obvious driver of downturn defaults if they were identified as investors on the basis of being owners of multiple properties
a substantial fall in house prices would leave the investor much more heavily underwater relative to their labour income so diminishing their incentive to continue to service the mortgage (relative to alternatives such as entering bankruptcy)
some investors are likely to not own their own home directly (it may be in a trust and not used as security, or they may rent the home they live in), thus is likely to increase the incentive to stop servicing debt if it exceeds the value of their investment property portfolio
as property investor loans are disproportionately interest-only borrowers, they tend to remain nearer to the origination LVR, whereas owner-occupiers will tend to reduce their LVR through principal repayments. Evidence suggests that delinquency on mortgage loans is highest in the years immediately after the loan is signed. As equity in a property increases through principal repayments, the risk of a particular loan falls. However, this does not occur to the same extent with interest-only loans.
investors may face additional income volatility related to the possibility that the rental market they are operating in weakens in a severe recession (if tenants are in arrears or are hard to replace when they leave, for example). Furthermore, this income volatility is more closely correlated with the valuation of the underlying asset, since it is harder to sell an investment property that can’t find a tenant.

Reaction from the UK has been predictable, with claims the changes will put rents up, slow new property builds, and lead to a deterioration in the maintenance of existing rental property. In addition, some claim it will lead to landlord deciding to sell their property, releasing more into the market. Finally, there is debate about the comparison between investors and owner occupied property holders – Homeowners are not running businesses nor do they pay capital gains tax, for example, on disposal of their property.

That the UK is taking steps when 15% of property is buy-to-let should underscore the issues we have here when 35% of all mortgages are for investment property, and more than half of loans written last month were for investment purposes. This is bloating the banks balance sheets, inflating house prices, and making productive lending to businesses less available. The UK changes provides more evidence it is time to reconsider negative gearing in Australia

The Future Shape of Banking Regulation

In a speech entitled “The fence and the pendulum“, by Martin Taylor, External Member of the Financial Policy Committee, Bank of England, he discusses the thorny problems of macroprudential policymaking, which very much include the bank capital and too-big-to-fail agenda. It is worth reading in full.

He concludes:

This is a crucial time for the new international order in bank regulation. We are close to agreement on new standards that the industry, in the UK at least, is not too far off meeting. Four years ago that would have seemed a highly desirable outcome but quite an unlikely one. It’s good for our economies, and it will turn out to be good for the financial industry over the next quarter-century. At the same time the emergence – well, they never went away – the increasingly shrill emergence of voices calling for a regulatory softening is both structurally wrong and conjuncturally wrong. It remains the ungrateful job of the supervisors to save the banks from themselves. The shortness of human memory span and the speed with which we forget the ghastly misjudgements of the recent past: these are the enemies, the unresting enemies, alas, of financial stability.

Bank of England Maintains Bank Rate at 0.5%

The Bank of England’s Monetary Policy Committee at its meeting on 8 May voted to maintain Bank Rate at 0.5%. The Committee also voted to maintain the stock of purchased assets financed by the issuance of central bank reserves at £375 billion. The Committee’s latest inflation and output projections will appear in the Inflation Report to be published at 10.30 a.m. on Wednesday 13 May. At the same time, an open letter from the Governor to the Chancellor of the Exchequer will be published, following the release of data for CPI inflation of 0.0% in March.

The previous change in Bank Rate was a reduction of 0.5 percentage points to 0.5% on 5 March 2009. A programme of asset purchases financed by the issuance of central bank reserves was initiated on 5 March 2009. The previous change in the size of that programme was an increase of £50 billion to a total of £375 billion on 5 July 2012.

The Bank will continue to offer to purchase high-quality private sector assets on behalf of the Treasury, financed by the issue of Treasury bills, in line with the arrangements announced on 29 January 2009 and 29 November 2011.

UK Lending Update

The Bank of England just released their lending trends data for first quarter 2015. Included in the report is some relevant data on investment or buy-to-let loans. BTL mortgages accounted for 15% of the total outstanding value of UK-resident mortgages as at end-2014 Q4. The rate of possession of buy-to-let properties was almost twice as high as for owner-occupied ones.

Overall, the rate of growth in some measures of the stock of lending to UK businesses picked up in the three months to February. Net capital market issuance was positive in this period. Mortgage approvals by all UK-resident mortgage lenders for house purchase rose slightly in the three months to February compared to the previous period. The stock of secured lending to households increased, but the pace of growth has slowed since 2014 H1. The annual growth rate in the stock of consumer credit was little changed in recent months.

Pricing on lending to small and medium-sized enterprises was little changed in the three months to February. Respondents to the Bank of England’s 2015 Q1 Credit Conditions Survey reported that spreads on new lending to large businesses fell significantly. The Bank’s series of quoted interest rates on fixed-rate mortgages decreased in 2015 Q1 compared to the previous quarter. Quoted rates on some personal loans continued to fall.

Contacts of the Bank’s network of Agents noted that credit availability had eased further, including for most small and medium-sized companies. Respondents to the Bank of England’s Credit Conditions Survey expected demand for bank lending to increase significantly from small businesses, increase from medium-sized businesses and be unchanged from large businesses in 2015 Q2. Lenders in the survey reported that the availability of secured credit to households was broadly unchanged and that
demand for secured lending fell significantly in the three months to early March 2015.

Secured lending to individuals. The number of mortgage approvals by all UK-resident mortgage lenders for house purchase increased slightly in the three months to February compared to the previous period. Approvals for remortgaging also rose slightly. The stock of secured lending to individuals increased, but the pace of growth has slowed since 2014 H1. The monthly net mortgage flow was little changed in recent months.

Overall, gross secured lending was higher in 2014 than in recent years. Within this, the share of gross lending for buy-to-let purposes increased. BTL lending represented 13% of total gross mortgage lending in 2014, with gross advances having recovered from its post-crisis trough though still below its 2007 peak. BTL mortgages accounted for 15% of the total outstanding value of UK-resident mortgages as at end-2014 Q4. A buy-to-let mortgage is a mortgage secured against a residential property that will not be occupied by the owner of that property or a relative, but will instead be occupied on the basis of a rental agreement. In 1996 the Association of Residential Letting Agents, the trade body of estate agents dealing with rental properties, along with four lenders set up its first BTL initiative to encourage private individuals to invest in rental property. This market grew steadily and the share of BTL lending in total gross mortgage lending increased until mid-2008, according to data from the Council of Mortgage Lenders (CML).

After the onset of the financial crisis, gross buy-to-let lending fell more sharply than total mortgage lending. Reflecting discussions with the major UK lenders, the July 2011 Trends in Lending publication noted one reason for this decline in 2008–09 was that the availability of this lending was said to have tightened as some specialist lenders exited this market. Another reason was that wholesale funding markets — often used to fund BTL lending — became impaired.

Gross lending for BTL purposes has grown since 2010, reflecting both supply and demand factors, and was £27.4 billion in 2014. Over the past five years the share of total BTL lending in overall mortgage lending has picked up to 15% in 2014 Q4, higher than in the pre-crisis period, according to data from the CML. Data based on the Bank of England and Financial Conduct Authority’s Mortgage Lenders and Administrators Return (MLAR), derived from a different reporting population and definitions of residency, also show that gross BTL lending grew faster than overall gross mortgage lending in recent years. Contacts of the Bank’s network of Agents noted that the rental market had continued to grow strongly in recent months, supporting continued steady growth in buy-to-let activity.

Gross buy-to-let advances for remortgaging have also increased in recent years. Its share of the total grew from 32% in 2002 to 52% in 2014, with the share of gross advances for house purchase at 45%. The share of the number of BTL mortgages for house purchase in the total number of house purchases has increased from its trough in 2010 to 13% in 2014 though remains below its 2008 peak, according to data from the CML. A significant proportion of advertised BTL mortgage products in the four years after the financial crisis were at loan to value (LTV) ratios below 75%. The number of advertised BTL mortgage products at LTV ratios of 75% and above has increased since mid-2013, but most are below 80% LTV ratio.

Data on quoted rates for fixed-rate BTL mortgages from Moneyfacts Group indicate that they have fallen since the onset of the financial crisis. This follows the same broad pattern as the aggregate measures of quoted rates on fixed-rate mortgages published by the Bank of England. Spreads over reference rates initially widened on fixed-rate BTL products, as mortgage rates fell by less than swap rates. Since 2013, spreads on these products narrowed as relevant reference rates increased. In recent months, spreads ticked up as fixed BTL rates fell by less than these swap rates. Floating BTL mortgage rates have also decreased since the onset of the financial crisis. The decrease was similar to that for rates on fixed BTL products since 2013. With Bank Rate unchanged, spreads over Bank Rate for floating-rate BTL mortgages have narrowed in recent years. Looking ahead, lenders in the Bank of England’s Credit Conditions Survey expected a reduction in spreads on BTL lending in 2015 Q2. Indicative BTL rates by LTV ratio ranges have also decreased over the years. Rates for LTV ratios below 75% have fallen sharply over the past twelve months.

BTL mortgages as a proportion of the total number of outstanding mortgages more than three months in arrears rose sharply at the start of 2009, around the same time as the overall mortgage arrears rate. The BTL arrears rate fell back and has been lower than that for all mortgages in recent years. In some contrast, the possessions rate on BTL mortgages peaked much later than that for owner-occupied mortgages and while it has fallen recently, still remains higher than that for owner-occupiers. But the CML noted that some of the differences in the path of arrears and possession rates seen when comparing the BTL sector with the wider market reflects the use of receivers of rent in the BTL sector. Other things being equal, the use of receivership may have mitigated some increase in reported BTL arrears and possession rates and delayed the increase in reported BTL possessions.

The rate of possession of buy-to-let properties was almost twice as high as for owner-occupied ones, even though the rate of underlying arrears on buy-to-let lending remained lower in 2014, according to data from the CML. They commented that this was because lenders offer extended forbearance to owner-occupiers to help them get through periods of financial difficulty without losing their home.

Bank of England maintains Bank Rate at 0.5%

The Bank of England’s Monetary Policy Committee at its meeting today voted to maintain Bank Rate at 0.5%. The Committee also voted to maintain the stock of purchased assets financed by the issuance of central bank reserves at £375 billion.

The Committee’s latest inflation and output projections will appear in the Inflation Report to be published at 10.30 a.m. on Thursday 12 February.