Loan to income limits, housing etc

I did a brief radio interview this morning on the (hardly surprising) news that the Reserve Bank had approached the Minister of Finance for initial discussions on the possibility of adding loan to income limits to the list of (so-called) macroprudential instruments the Reserve Bank could use.  Preparing for that prompted me to dig out the material on what has been done in the UK and Ireland.

It is worth remembering that the Reserve Bank does not need the Minister’s approval to impose loan to income limits.  Some years ago, Parliament amended the Reserve Bank Act in a way that seems to have given the Reserve Bank carte blanche to impose pretty much any controls it chooses, so long (in this case) as they can squeeze them under the heading of matters relating to

risk management systems and policies or proposed risk management systems and policies

This was the basis they used for the two rounds of LVR controls, and various amendments, to date.  In principle, controls could be challenged, on the basis that they were inconsistent with the statutory requirement to use the regulatory powers to promote the soundness and efficiency of the financial system.  But the reluctance of banks to take on the Reserve Bank openly –  the Bank always has ways of getting back at banks – and judicial deference on contentious technical matters effectively leaves the Governor free to do pretty much whatever he wants, at least as far as banks are concerned (the legislation gives him much less policy power over non-bank deposit takers, and none at all over lenders who don’t take deposits).

The memorandum of understanding with the Minister of Finance is non-binding, but ties the Bank’s hands to some extent.   The MOU contains an agreed list of the sorts of direct controls the Bank might use.  Legally the Bank can ignore that list.  Practically, it can’t.   But the Minister of Finance is also in something of a bind.  Since the government has been unwilling to do very much to deal with the fundamental factors driving house prices, it would risk accusations of complete dereliction of duty if the Governor came asking for the power to impose new direct controls and the Minister turned him down.  The controls might be daft, costly, and probably ineffective, but refusing the Governor’s request would be a gift to the Opposition (“do nothing Minister just doesn’t care; ignores sage Governor”, and so on).  So most probably, if the Governor wants loan to income limits added to the MOU list, they will be added.  It is still the Governor’s decision whether and how to use those powers, and if they go wrong, or prove unpopular, blame can be deflected to the Governor.  (Unlike the Minister, the Governor doesn’t have to front up in Parliament for question time each day, can’t really be sacked, and generally faces limited effective accountability –  ie questions with consequences.)

If and when loan to income restrictions are added to the list of permitted controls (not just when the Bank wants to deploy them), we should expect to see some rigorous and comprehensive analysis from the Reserve Bank, complemented by the Treasury’s advice to the Minister.  Something that showed signs of thinking hard about the possible pitfalls, and which addressed the strongest case sceptics might make would be particularly welcome from the Bank –  and novel.

Loan to income ratio limits have been applied recently in the UK and Ireland. I was interested to see a comment yesterday from Grant Robertson, Labour’s Finance spokesman, indicating that

his party could be willing to back central bank debt-to-income ratios, if they can be tailored to target investors.

However, Mr Robertson said it would not support a blanket debt-to-income ratio being introduced by the Reserve Bank as it would unfairly target first home buyers.

Presumably Robertson is unaware that in both the UK and Ireland loans to finance the purchase of rental properties (“buy to let” loans as they are known there) are explicitly excluded from the loan to income limits.  It is an instrument that, if used at all, is in effect targeted at first home buyers, usually the owner-occupiers who will borrow the largest amount relative to income (quite rationally, since they also have the longest remaining span of working life).

The fact that a few other countries adopt controls does not make them a sensible response in New Zealand.  But it is worth bearing in mind that the UK controls –  under which mortgage lenders cannot lend more than 15 per cent of their total new residential mortgages (by number) at loan to income ratios of 4.5 times or above – were explicitly envisaged as non-binding at the time they were imposed.  The Bank of England indicated that “most lenders operate within its new limit, so the measure will simply insure against potential risks to financial stability if mortgage lending standards loosen markedly in the future”.

Ireland is a little different, having come through an extreme house price boom and bust cycle, although even they noted that there was little sign that bank lending behavior was a problem in Ireland at present.  In Ireland, no more than 20 per cent of the euro value of all new housing loans for owner-occupied properties can have loan to gross income ratios in excess of 3.5.

In neither case is there a blanket ban on loans with high loan to income ratios.  Both countries have structured their limits as “speed limits” (as was done with the LVR limits here).  Presumably the same would be done here, if LTI limits are introduced.  Encouragingly, in both countries there is no differentiation by region, and our Reserve Bank should resist pressure for any regional differentiation here.

The controls are not easily compared across countries.  In one case, the limit is by number of loans, and in the other by value.  Both appear to use gross income in the denominator, but tax rates differ from country to country, and so the effective impact of the restrictions will differ for that reason alone.  Our Reserve Bank recently published a chart suggesting that around 35 per cent of new owner-occupier loans have a debt to income ratio greater than or equal to five, but since this data is the fruit of “private reporting”, and is described as “experimental and are subject to revision”, we have no way of knowing whether either the “debt” or “income” concepts they are using –  which may well differ by bank –  are even remotely comparable to those used in the UK or Irish regulation.


(But it is worth noting that in the short run of experimental data, there is no sign of an explosion in the share of high debt to income lending.)

The income of a potential borrower is clearly one of things a prudent lender would take into account in deciding whether to lend money, and how much.  The same goes for the value of any collateral the borrower can pledge, any other conditions or covenants that are part of the loan contract, and as host of other factors.  But the fact that these considerations might be relevant to assessing the creditworthiness of the borrower does not mean they are things that should be regulated.  As the Irish central bank noted in its consultative document

An acknowledged weakness in the use of LTI as a guide to creditworthiness is the fact that income at the time of borrowing may not be a good guide to average income over the life of the mortgage or to the risk of unemployment. Lenders need to take this into account in their lending decisions and must not rely mechanically on LTI.

And yet LTI limits increase the likelihood that banks will manage to the rules –  breaches of which expose them to severe penalties –  rather than to the underlying credit risk  (where, all other factors aside) it is overall portfolio risk rather than the risk of an individual loan that probably matters a lot more –  especially for systemic soundness.  Curiously, an LTI limit risks making finance relatively more available to those borrowers with highly variable income –  borrow in a good year, and your loan might not be excess of the LTI threshold, and no one at the central bank cares much that in another year’s time your income might have halved.  It might be an unintended effect, but it won’t an unforeseeable one.

More generally, there is no good external benchmark for what an appropriate or prudent loan to income ratio should be.  At least with LVRs there is a certain logic in suggesting that, say, a loan in excess of the value of the property changes the character of loan (the top tranche is unsecured).  No one has any good basis for knowing whether a debt to income ratio (however either of those terms is defined) of 3 or 5, or 7 is unwise or excessively risky.

I don’t personally have a high appetite for debt – I’ve taken two mortgages in my life, both were about 2 times income, and both felt forbiddingly large at the time.  Then again, the interest rate on the second of those loans were something like 10 per cent.  But if, say, nominal mortgage interest rates were to settle at around 5 per cent –  not low by longer-term international historical standards –  then why would it be imprudent for a young couple aged 25 to take a 40 year mortgage at, say, six times their (age 25) income?  The upfront servicing burden would certainly be high, but twenty years hence even general wages increase (no ,movement up respective scales) would have halved the burden.  And why would it be imprudent for a bank to have a portfolio of mortgages which had some new mortgages at high LTIs and some well-aged mortgages with much lower LTIs?

(The same might go for investment property loans.  If someone is running a rental property business, the prudent ratio of debt to income –  whether wage income of the borrower or rental income – is likely to be much higher when rental yields are, say, 4 per cent than when they are 8 per cent.)

Don’t get me wrong.  There is something obscene about house prices in New Zealand –  and a bunch of similar countries with dysfunctional land supply markets. There is no reason why we can’t have house prices averaging perhaps 3 times income –  with mortgages to match –  but our policy choices have rigged the market, delivering absurdly high house prices.  If so, people need to be able to borrow at lot just to get a toe on the ladder.  Try to prohibit willing borrowers and willing lenders from agreeing such loans and you simply further skew policy in favour of the “haves”, and create an industry in getting round the controls.  There hasn’t been that much effort so far to get round the LVR controls –  through quite legal means, involving unregulated lenders –  but recall the Deputy Governor’s comments at the last FSR, that controls might now be with us for much longer than the Reserve Bank had first envisaged.  I’m not sure why the non-bank (and especially non deposit-taking) lenders have not been more active to date, but a further intensification of controls surely heightens the likelihood of larger scale use of alternative lenders.

Loan to value ratio controls haven’t solved, or materially alleviated, housing market pressures.  For all the rhetoric, not even the Reserve Bank’s modelling suggested they would. There is some short-term relief –  helping those not affected directly, at the cost of the more marginal potential borrowers –  but it doesn’t last.  There is no reason to think that loan to income ratio controls would be different. They tackle, rather ineffectually, symptoms rather than causes, and over time mostly alter who owns houses, not how much is paid for them.  The Reserve Bank will argue that even if the controls don’t change house prices, they still enhance financial stability, but there is not even any serious evidence of that. First, they have not shown any evidence that financial stability is threatened –  and their own tough stress tests keep delivering quite reassuring results –  and second, and perhaps as importantly, they have made no effort to analyse what risks banks will take on if controls prevent them lending as much on housing as they might like.  Banks are profit-maximizing businesses, and deprived (by regulation) of some opportunities they will surely seek out others.

Far better for the Reserve Bank to recognize that it has no mandate to control house prices (or even the growth of housing credit), and in any case it has no tools that will do much over time anyway.  Its responsibility is the overall soundness of the financial system.  If the risk weights on housing loans look wrong, let them make the case for higher weights and consult on that. If the overall capital ratios look too low, then again make the case.  Using those tools will do less damage to the efficiency of the financial system, and better secure the soundness of the system, that one new wave of direct controls after another.  At the current rate, Graeme Wheeler will be giving a good name to Walter Nash, the first person who imposed so many controls on our financial system. (I usually eschew references to Muldoon in this context, but over his full term he deregulated the financial system more than he reregulated it).

Of course, there is still no sign of those actually responsible for the house price debacle doing much about it.  I haven’t yet read the full proposed National Policy Statement, but the material I have read is full of central planner conceit, and seems unlikely to achieve very much.  And I find it seriously disconcerting –  if perhaps not overly surprising –  that the Ministry for the Environment released a supporting document yesterday on “International approaches to providing for business and housing needs” .  But this survey of international approaches drew exclusively on the UK and two Australian states (New South Wales and Victoria).  Since London, Sydney and Melbourne are some of the cities with the most dysfunctional housing markets in the world, indicated by price to income ratios similar to, or even higher than , Auckland’s, you have to wonder why MfE would look to those places for guidance or insight.  When the Productivity Commission report on land supply was released last year, I criticized them for a similar focus –  they’d visited various places, but not the functioning land supply markets of the US.

One might have hoped that government agencies, and ministers, who were serious introducing a well-functioning competitive urban land market might have devoted at least some serious analytical attention to the experiences of thriving cities in the US which manage to cope with rapidly rising populations with markets in which house price to income ratios fluctuate somewhere near 3.

Having said all this, I’m not very optimistic that the house price problems will be solved. I went to a good lecture yesterday on housing by the Chief Economist of Auckland Council, Chris Parker.  He has a lot of good analysis and ideas which I can’t discuss here –  he told us it was under Chatham House rules, under which we could say what was said, but not who said it, but he was the only speaker….. –  but I wanted to ask him the same question I’ve posed here previously: is there any example anywhere of a city or country that has materially unwound the thicket of planning controls once they were in place.  If not, perhaps we can be first.  But, if so, it doesn’t look as though we are getting there fast.

(Which does make the government’s continued indifference to the huge population growth, largely driven by immigration policy when there is no evidence that that population growth has been systematically benefiting New Zealanders, ever more inexcusable).



18 thoughts on “Loan to income limits, housing etc

  1. When we have a target to bring 4 million tourists over a 12 month period coming through Auckland filling up accomodation space and pushing up daily rents to $120 a nite. Not sure why you are so worried about a tiny number of 14k migrants plus 36k poor international students per year trying to get some work experience in NZ before they return to their home countries. The whole intent is to build an enduring relationship with these international students who would be leaders in their respective fields and will have a future enduring relationship with NZ.


    • The real problem is how do we get these 4 million tourists to spend in Auckland instead of rushing off to the Westcoast and the South Island and spending all their money outside of Auckland giving Auckland the perception that we are a low productivity city per capita and squeezing out the poor local renters when tourists pay $120 a nite.


  2. This question is really for Chris Parker, but maybe Michael can enlighten me: why is the public servant I help pay for (or any public servant, really) holding meetings of such import to the general population under Chatham House rules? I’m sure many, many Aucklanders would love to benefit from his knowledge, if only to rebut the many myths that dominate this issue.


  3. Chris can no doubt answer for himself if you contact him, but I think there is heightened sensitivity around (a) the local body elections, and (b) the independent hearings panel deliberations and subsequent council decisionmaking. Chris’s views were expressed in an op-ed in the Herald a couple of weeks ago,


  4. It is not just parts of the US that has competitive land supply markets. Germany for instance does pretty well and over a long period some of which included reasonable pop growth.

    Luc I think the reason Chris needs to be circumspect regarding his knowledge of Auckland’s housing market is the upcoming local government elections.

    I have written an article about the rising importance politically of housing and tied it with some social and political considerations.

    Michael one place to consider is the unwinding Japanese housing bubble. It is hard to know what the exact cause was due to such a difference in culture and institutions. Alain Bertaud has said the voluntary land reallocation practice I discussed in another article was something they used in there urban areas. There is another article related to that on Making Christchurch website.


    • Thanks Brendon

      I’ve always been uneasy about citing the German experience because in a sense it hasn’t been tested by population pressure. If we had a flat population we would have much lower big city house prices (not 3x income tho); it is just that the supply distortions would bite less.

      Yes, Japan is interesting and I”d like to know more about that experience. Of course there was a lot else going on – the dramatic slowing in trend GDP and productivity growth as they caught up with the West, and the changing demographics, as working age population growth ended and then started to move into reverse.


  5. I was surprised that measurement of LTI ratios is “experimental”. I would have thought the RBNZ would be measuring all sorts of things to look for trends, whether good or bad. And why would they consider implementing limits on LTI if they don’t know what they are, and that they are currently bad (knowing that they also can’t really define “bad”).

    You mention the profit-maximising nature of the banks. I believe their current love of mortgage lending is at least partially because of the risk weighting assigned to mortgages by the RBNZ and/or the international equivalent. So the current risks the banks are taking is not solely their choice, but is guided by these risk weightings, just as they would be guided differently if an LTI was introduced. Either or neither may be better or worse, but I don’t think you can say that it would necessarily be worse.


    • Worth remembering that Wheeler has brought a whole new approach, for good or ill. Previously, the Bank put greatest weight on ensuring that the risk weights were reasonable, the capital models appropriate, and the overall capital requirements adequate. Under that model they didn’t need detailed standardized data themselves on either LVRs or LTIs (or DSRs for that matter). But if you want to use direct controls on specific components of balance sheets then you need proper standardized, tightly defined, data, and that takes some considerable time to get in place (system changes in banks as just one constraint).

      On risk weights, it is a possible story. I’m skeptical myself, since we know that risk weights on housing in NZ are materially higher than those almost anywhere else, and also know that collateralized lending has far lower losses than the uncollateralized lending that people often assess the housing risk weights against. Of course, it is also worth asking the question again.

      In this specific case tho, I wasn’t suiggesting the current risk weights were ideal, just that banks will respond to one opportunity being closed off by looking for others, and the Rb has not put out any analysis on what those alternatives have been.


    • If the LTI is intended to slow down investors then it is rather difficult for first home buyers because I vectors have the benefit of the tenants income plus their own income. How does the Wheeler hope to discourage investors? Looks more like another way of keeping get first home buyers out of the market and renting.


  6. Not sure if you can answer this Michael but did you leave the lecture hopeful a consensus would form around how to tackle the problem and deliver a solution?

    Or am I right in sensing that for many decision makers (cabinet ministers in particular) they actually see houses at 10x incomes as a “good thing” and hence don’t want to make substantial changes….


  7. I don’t think anyone in power really believes the high house prices are “a good thing” – I think it is more a defensive line to bat away criticism.

    It seems to me there is a fair amount of convergence on the broad nature of a good response to dealing with the supply side issues. But the ability, and willingness, to implement that sort of approach seems to me in real question. Personally, I think a sticking point is the continued policy focus on intensification, which risks riding roughshod over “rights” (real and perceived) of existing owners/users. If that were put to one side – and left to develop organically, as it probably would – then there does seem much difference between Nat and Lab on, eg removing the MUL (and stuff that goes with it) or even, at a high level, on funding mechanisms for infrastructure (eg something like the MUDs, with appropriate differential rating, adapted to NZ circumstances).


  8. The solution is actually quite simple. Mt Eden, Epsom, Remuera, Mt Roskill , One Tree Hill has to be rezoned 18 levels. The Unitary Plan is for single dwelling between metropolitan cities The distance between our metropolitan cities ie New Lynn, Manukau, Albany and Auckland CBD precinct is 30 to 40 km. That’s really expensive infrastructure between each high rise metropolitan city.


  9. Michael
    I’ve just finished reading Mervin King’s book “The End of Alchemy”. The book is the first by a central banker of the GFC period that analyses the underlying causes of the GFC and what needs to be done to avoid a repeat (Geithner, Bernanke, etc. focussed on the events following the Lehman’s collapse rather than on why the whole system teetered or what should be done to stop a repeat). King’s book is a fascinating dissection of regulatory failure and a reminder that regulation does tend to fail.
    King uses the following quote to point to a core problem; ‘You never change things by fighting the existing reality. To change something, build a new model that makes the existing model obsolete”. Central bankers had (and have) a well-developed model and were (are) not going to jettison it sans an equally well developed alternative, even if the existing model resulted (results) in failure.
    King’s focus areas are financial stability and system stability.
    On the former area he recommends a change to how central banks guarantee “crisis liquidity”. In his model systemically significant banks would be required to have 100% liquidity backup against deposits. This could come either from banks holding liquid assets or (and this is the novel bit) from getting central bank pre-commitments of funding against illiquid assets, so a bank would know in advance of any crisis that their (say) residential mortgage book could be used as collateral against central bank funding up to (say) 50% of face value. King advocates that liquid assets plus discounted collateral should be 100% of deposits.
    That isn’t especially relevant to your analysis of RBNZ’s use of L/V or I/V to direct/influence bank lending to households. In that regard what is more relevant/interesting in King’s book is his view that central banks have a strong Keynesian bent and tend to respond to weak demand by making money more available and cheaper, and that this is a mistake!
    He postulates that household “whole of life” spending tends to be based on individual appraisal of whole of life income. So householders will happily load up on debt (to support current consumption) if they see future income growth enabling the whole of life income=outgoings. In King’s opinion, in the USA and UK (no doubt the logic is applicable elsewhere) households have been over optimistic about their income prospects, and this has given rise to a fundamental disequilibrium as households have piled on the debt while they wait for income growth.
    In King’s opinion central banks should not stoke this fire. Rather they should encourage household recognition of actual future income and hence better judgement as to what current consumption should be for lifetime consumption = income.
    He quotes his predecessor Eddie George “we have a choice between two speed growth and no growth and chose two speed growth”, George was referring to high growth in consumption and low growth in production.
    King is of the view that central banks make a mistake when they follow George’s approach.

    This may all seem a bit tangential to your comments about RBNZ’s current policy settings and approach. But I think King makes some persuasive criticisms of the current central banking model and their tendency to look at only short term stability. In King’s opinion, the key item on the agenda should be household debt and whether NZ households have front-ended a lot of future consumption, and what happens if the expected income growth implied by current borrowing levels does not eventuate.


    • Thanks Tim. King’s book is sitting near the top of my to-read pile, so I’ll no doubt write something about his take on things (and perhaps that of el-Erian) when I’ve read it. I’m a little skeptical that income expectations explain very much: at least in NZ the consumption share of GDP has been basically unchanged thru 30 years of good times and bad. Typically, people tend to understate the importance of land supply distortions in explaining the sharp rise in gross household debt.


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