Housing loans: big buffers and moderate risks

Paul Glass, of Devon Funds, had an article in the Herald yesterday, containing his agenda for action for New Zealand economic policymakers.   I was sympathetic to quite a bit of his analysis, but this section caught my eye:

It’s a technical area, but the amount of regulatory capital held against residential mortgages should be increased substantially, not just tinkered with around the edges as is currently happening. This would limit the amount of debt available for mortgages.

It is a common view, but I think it is wrong.  I’m not sure what reasoning Glass has behind his recommendation, but Gareth Morgan has argued along similar lines for years.  Morgan argues that  the bank regulatory capital regime (whether Basle I, II, or III) artificially favours lending secured on housing, because the risk weights used in calculating the amount of capital that needs to held in respect of such loans are less than those used in many other types of commercial bank assets.

Calculation of risk weights for banks using internal ratings based model (the big 4 banks) is far from transparent, but the easiest way to see the difference is in the rules for other (“standardised”) banks.  Risk weights for residential mortgages are as follows:


For loans with an LVR of less than 80 per cent, the risk weight is 35 per cent

By contrast, exposures to unrated corporate borrowers generally have a risk weight of 100 per cent.

But that is because the risks to banks from typical housing loans have been found to be less than those on many other bank assets.  This is not just an observation about boom times, or about New Zealand and Australia in recent decades, it is a result across many countries and many different circumstances.  Housing mortgages initiated by banks themselves, not under regulatory mandates to take on dubious risks, have rarely if ever played a major role in financial crises.  A recent Reserve Bank Bulletin reported on some of the international literature in this area.  A good example was Finland in the 1990s, where after a major credit boom and rapid growth in asset prices in the late 1980s, house prices fell by about 50 per cent in nominal terms, real GDP fell away sharply and unemployment rose substantially.  Banks took losses on their mortgage portfolios, but those losses were modest and not remotely enough to have threatened the health of banks.  The experience in the US since 2007 superficially looks like a counter-example, but binding federal government and congressional mandates played a key role in driving down the quality of new mortgage originations (and hence driving up subsequent loan losses).

It is not surprising that housing loan portfolios are not overly risky.  Lenders have a lot at stake, but they also have solid collateral.  Borrowers also have a lot at stake, especially in countries (like New Zealand and Australia with with-recourse mortgages).  You can escape your debts if you go bankrupt but fortunately (in my view) we don’t have a culture that is overly welcoming to bankruptcy.    And a owner-occupied home is not just a roof over the head, it is often also about a place in a community –  the local school, or sports club, or church.  So most residential mortgage borrowers do everything they can to avoid defaulting on their mortgage, and losing their house, even in very tough times.  There will always be a minority of bad borrowers, and other people who are just overwhelmed by events and the size of a shock.  Recent loans tend to be riskier than older loans –  most of us probably borrowed about as much as we could afford to get into a first house,  but mortgage portfolios age and typically get safer as they do.  And it portfolios of loans –  not individual loans –  that need to be evaluated in thinking about the risk to banks.

By contrast, the typical unrated business loans will have no collateral, revenue streams that depend quite strongly on the economic cycle (profits are more volatile than wages) and limited liability.   The nature of business is taking risk, and sometimes risks pay off and other times they go spectacularly wrong.  Empirical evidence is that a portfolio of unrated business loans is materially risker than a portfolio of unrated residential mortgages.  To be more specific, even in respect of property-based exposures, the evidence is that commercial property, and especially property development exposures, are far riskier (and more likely to lead threaten the health of banks and the financial system) than residential loan books.  Markets will, and regulators should, reflect that in their expectations around capital.

Actual risk-weighting for our big banks is more sophisticated than this description and, as mentioned, much less transparent.  Reasonable people can differ on whether anything is gained by having the IRB approach, or whether it would be better to simply use the standardised approach for all our banks –  all of which are relatively simple.

But not only is there good reason for residential mortgage risk weights to be lower than those on many/most commercial exposures, but New Zealand’s risk weights on residential loans are high by international standards.  This IMF piece, done a couple of years ago, contrasted effective risk weights on residential mortgages with those then in the UK, Australia and Canada


Sweden recently raised the minimum risk weights used by their banks on residential mortgages.  As part of the preparation for that move they produced this document, which includes this chart.  Again New Zealand risk weights on residential mortgage loans are higher than any of the banks in this chart – and are higher than the newly increased Swedish risk weights.


Residential risk weights, or overall required capital ratios, might still in some sense be too low in New Zealand.  But the onus should be on those calling for such increases to make the case that the threat to financial stability is greater than what is already allowed for in the bank capital framework.  The Reserve Bank did stress tests last year looking at the impact of a really quite severe adverse shock, in which nominal house prices fell a long way and unemployment rose substantially (it usually takes both to cause real trouble).  Not one of the banks, let alone the system as a whole, had its capital materially impaired in that scenario.  Those tests may well have been flawed, they may have missed something important, and they certainly won’t have captured everything that mattered, but on the information we have actually available the New Zealand banking system currently looks pretty well-placed to cope with a severe shock affecting the residential mortgage book.  With the stock of credit growing at only around 5 per cent per annum, that also should not be a great surprise.

And since housing seems to be one of those areas where to cast doubt on one possible explanation/solution is to risk being accused of thinking there is no issue or problem at all, I refer anyone inclined to react that way back to my take on housing.

Islamic banking and equity-based mortgages

Media reported yesterday on a local Muslim woman who had sought to interest New Zealand banks in offering mortgage products that met Islamic restrictions on the payment of interest.  The article suggested that a Kiwisaver provider was interested in offering such products.  There were some small lenders offering such products prior to the 2008/09 recession but they did not seem to survive.

I’ve long been intrigued by the ideas and practice of interest-free finance.  My own Christian tradition for centuries banned, or regarded with intense disfavour, lending at interest.  That drew first on Old Testament provisions, which prohibited Israelites from lending to fellow Israelites in need at interest (while allowing loans at interest to outsiders).  The stance was reinforced by perspectives from Aristotle, rediscovered in the Middle Ages, arguing for the inherent sterility of money.  Prohibitions on lending at interest were eventually removed but  it remains a powerful vision for some (for me).   Within the Christian community, outfits like the Kingdom Resources Trust in Christchurch try to put it into practice.

The injunctions against interest are apparently much stronger and more pervasive in the Koran. In his recent book, Beggar Thy Neighbour, Charles Geisst reports that “of all the prohibitions against undesirable activities in the Koran, usury is mentioned the most.  Interest, or riba, is considered usury and no distinction is made between them”.   This was a distinctly counter-cultural stance, as compound interest had apparently been common among Arabs before the coming of Islam.

If interest is prohibited, profit-sharing arrangements –  equity finance, in effect – are not frowned on at all.  They have a element of uncertain return – economic risk –  for which some reward is appropriate. Predominantly-Muslim countries, and individual Muslims. have grappled with how to apply the prohibitions on interest in today’s world.  The large Muslim minority in the UK and the large financial sector with global connections has led to considerable interest there.  In his pre-crisis heyday, Gordon Brown wanted London to become the global centre of Islamic banking.

My interest in interest-free finance once got me a trip to Iran, as a member of an IMF technical assistance mission. This was shortly after the Iran-Iraq War and the death of the Ayatollah Khomeini, in an earlier phase of opening to the West.  I got on the mission because of my (innocuous, non-US, non-UK) New Zealand passport.  From my perspective, two weeks in Iran was made easier by the fact that I didn’t then drink alcohol at all.

I was (am?) a bit of an idealist, and went in fascinated to learn more about trying to apply the interest-free teaching in practice.  And I like to think we offered them some helpful advice –  monetary policy without interest isn’t particularly intellectually or practically difficult.  But I came away somewhat disillusioned.  We met a variety of people – bureaucrats, bankers, and even some theologians (we wanted to better understand what the permissible limits were).  Some were more earnest than others, but the overwhelming impression I came away with was of people trying to devise instruments to the limits of the letter of the law (Koran), with little regard for the spirit.   I’m not, for a moment, suggesting that that was the approach of individual devout Muslims across the country, but among the groups we engaged with the focus was on products that had the economic substance of interest, but not the legal or exegetical label of interest.

I’m not sure that that was, or is, unrepresentative of many Islamic banking products.  Take mortgages as an example.  A widely-used UK website , Islamic Mortgages, covers a wide range of sharia-compliant mortgage products.

In a nut shell how does an Islamic mortgage work for different types of purchases?


  • you choose property, agree price, undertake survey
  • bank enters into contract to buy the property from vendor
  • bank sells property to you at higher price
  • the higher price is paid by you in equal instalments over a fixed term, irrespective of what happens to Bank of England base rate
  • Leasing:
  • choose property, agree price
  • bank undertakes survey, buys property and sells it to you for the same price, in return for payments spread over fixed period up to 25 years
  • in addition to monthly payments, you pay a sum for ‘rent’ – assessed annually in line with market trends
  • you can overpay (as with a conventional flexible mortgage) to buy the house more rapidly

These are interesting products in their own right, but the first is simply economically equivalent to a mortgage with a fixed interest rate for the entire life of the loan.    Neither the purchaser nor the lender will necessarily regard themselves as paying or receiving interest, but the payment streams over the life of the contract (“fixed term”) will be the same as those on a conventional table mortgage with a fixed interest rate for the same term.  And the risks  – credit, market, counterparty –  seem very much the same.

An alternative type of product might be an equity-based housing finance product.  In conventional housing finance markets, the purchaser puts up some equity, and a lender provides the balance.  The lender receives an interest-rate and is exposed to the (hopefully small) risk that the borrower defaults and that the house can’t be sold for enough to cover all the outstanding debt.  Any increases in the value of the house – whether changes in market prices generally, or as a result of improvements/extensions – accrue to the owner.

But it would be technically quite feasible to envisage a model in which the person wanting a house to live in, and the financier, became equity partners in a joint business venture to own the house.  You, the, resident would presumably pay rent to the joint venture, some portion of which would be passed to the equity finance partner, and when the house was eventually sold gains and losses would be shared, proportionately, between you and the equity partner.  You have risk, the equity financier has risk, and no one is paying or receiving interest –  in form or in substance.  It would be simple enough, technically, to structure the contract to allow the resident’s equity share to rise over time (instead of “principal repayments”, one uses the funds for equity repurchases from the JV partner).

I’m not sure if such contracts exist anywhere in the Islamic world.  In the West, without the theological concerns about interest, there is good reason why they don’t exist.

If I’m a young person in the West buying a first house, a bank might lend me 90 per cent of the value of the house.  Most mortgages are table mortgages and are repaid gradually, so that in time the owner’s equity share is large, heading for 100 per cent.  All the Bank cares about after that is my ability to service the debt.  And that depends largely on avoiding prolonged periods of unemployment.  If house prices fall that poses a risk –  banks can call in a mortgage if the value of the collateral drops below the value of the mortgage –  but it typically only crystallises if the flow debt service isn’t being met, and if house prices fall so far that not all the debt can be repaid when the house is sold up.   Within limits – quite wide limits – banks don’t care about or monitor the maintenance you do on your house.  If you don’t do the maintenance, mostly it is your loss.  And they don’t care at all about changes in market rentals in your neighbourhood, or for your specific type of house.  Conventional mortgages are simple, easy, and cheap to monitor.

But equity-sharing contracts would be enormously costly to monitor and manage, especially in a country with such a variegated housing stock (rather than lots of high-rise uniform apartments).  If you are only an equity partner in a house, your incentive to do maintenance is attenuated –  and likely to weaken especially in periods of personal financial stress.  So a financier providing a large equity stake would probably want to pre-specify maintenance obligations and standards (and would then need to monitor compliance).  You’d need to negotiate all alterations and extensions.  Rental rates vary, as do market values.  Perhaps a real rental yield could be pre-specified in the initial contract, but any arrangement for the resident to gradually buy out the outside equity partner requires an agreement on market value at the time of the transaction.  Transactions costs rapidly start to mount.  They might work within a relatively closed community – say, a local church community where effective monitoring costs might be reduced, or a small mosque-based credit union  –  but it is difficult to see them being effective, and economic, more generally.

In their recent book House of Debt, the US academics Atif Mian and Amir Sufi, argued that equity-sharing contracts should become the norm for housing finance.  They argue that such contracts would materially reduce the risk of financial crises, and that the main reason such contracts aren’t common is because of the tax system and the role of US government agencies.  I’m very sceptical of both claims, and would post the note I wrote on why –  but it would take 20 working days to get OIA clearance.  This post is quite long enough, but if anyone is interested I can explain my scepticism in a later post.

UPDATE: The later post on equity-sharing mortgages.