Misconceived and deeply flawed

Later this week submissions close on the Reserve Bank Governor’s attempt to get the some sort of debt to income restriction added to the list of possible direct controls on banks upon which the government has bestowed its favour.  (I write it in that slightly awkward way because, by law, the Governor does not need the Minister’s permission at all –  Parliament, somewhat recklessly, appears to have given all those powers to the Governor personally, but a few years ago the Governor committed to only using restrictive tools that the government had approved of.)

This would be the latest in the series of direct interventions by which the Reserve Bank has been undermining the effectiveness and efficiency of the housing finance market.  For now, the (outgoing) Governor says he wouldn’t apply a debt to income restriction even if he had the Minister’s imprimatur.  But all it will need will be another rebound in the property market and Wheeler would no doubt be keen.  Whether his permanent successor next year shares that enthusiasm is, I would hope, something the Board and the (next) Minister turn their minds to in considering possible candidates for Governor.

I probably will put in a submission, but if so it will overlap in many areas with the paper just published by my former colleague (now Tailrisk Economics) Ian Harrison.    Ian spent many years in the prudential supervisory wing of the Reserve Bank and led the work on risk modelling that has underpinned the Bank’s positions on capital, risk weights etc.  He has previously written and published his critical analysis on the Reserve Bank’s decision to treat residential mortgage loans owed by investors as riskier than the same loan on the same security when owed by owner-occupiers.  It was published under the somewhat provocative title House of Cards – and I wrote about it here.

His new paper on the proposal to have a debt to income instrument available doesn’t have a provocative title.   But it is no less forceful in its conclusions.  Here is the bulk of Ian’s press release

A report by Tailrisk Economics on the Reserve Bank’s justifications for possibly imposing debt to income (DTI) limits on housing lending, shows that that they are deeply flawed.

The main problem is that the DTI is a crude tool that does not adequately assess borrowers’ debt servicing capacities, and which will perversely target better quality loans.

“The Reserve Bank has presented no substantive evidence that higher DTI loans are ‘excessively’ risky, or that a DTI ratio of 5 is a sensible cut-off,” said Ian Harrison, Principal of Tailrisk Economics, “but there is significant evidence that DTIs do not predict loan defaults, or reduce the likelihood or severity of crises”. The European Systemic Risk Board found, in a recent assessment of GFC performance, that DTI levels did not have any “relevant effect either on the prediction of the crisis or on the depth of the crisis” .

The application of the DTI limit to investor loans, which are the primary focus of the policy, is particularly misconceived, because DTI limits are only intended to apply to owner occupier borrowers. The DTI measure assumes that when investor purchases a new property their living expenses increase. “This simply does not make sense”, Harrison commented.

The effect of the policy could be to impose an effective LVR limit as low as 30 percent on professional investors.  No other country has imposed DTI restrictions on investor loans.

“Higher future interest rates do not pose a material systemic risk, providing the conduct of monetary policy is competent”  Harrison added. “Further, the Bank’s assessment that the restrictions would have a net welfare benefit, is very optimistic. Our assessment is that they will have  a welfare cost, like most misconceived quantitative interventions.”

Much of the case the Reserve Bank seeks to make for having the ability to use a debt to income limit rests on the assumption that banks don’t do risk management and credit assessment well and that, inevitably crude, central bank interventions will do better.  The Bank’s consultation paper makes little or no effort to engage on that point at all.  It provides no evidence, for example, that the Reserve Bank has looked carefully at banks’ loan origination and management standards, and identified specific –  empirically validated –  failings in those standards.  Neither has it attempted to demonstrate that over time it and its staff have an –  empirically validated –  superior ability to identify and manage risks appropriately.

One of the Reserve Bank’s bugbears is that while the current lending practices may look broadly okay at current interest rates, those same loans will look rather less sound if interest rates rise considerably.  Of course, banks already take into account the resilience of each borrower, including their ability to cope with unexpected changes in servicing costs.    I wrote about this in my post on the most recent FSR.

… there was something a little odd in the box the Bank included on “Vulnerability of owner-occupiers to higher mortgage rates“, clearly softening us up for the consultation paper on debt to income ratios.  They argue that

New Zealand is particularly vulnerable to a sharp rise in mortgage rates as the banking system funds a large proportion of its mortgage credit from offshore wholesale markets. The cost of this funding can increase sharply if there is an unexpected increase in global interest rates or a change in investor risk appetite, and banks are likely to pass on the higher funding costs to customers through higher mortgage rates.

But mostly this is just untrue.  The Reserve Bank sets the OCR in New Zealand based on overall inflation pressures in New Zealand.  If funding spreads rise –  as they did in 2008/09 –  and domestic inflation pressures don’t the Reserve Bank can easily offset most or all of the potential impact on retail interest rates by lowering the OCR.    That is what happened in 2008/09.

Of course, retail interest rates can rise, quite materially.  As the Bank points out, new floating mortgages rose from “around 7 per cent to over 10 per cent between early 2004 and 2007”.  Of course, as we used to stress at the time, fixed mortgage rates rose nowhere near that much.  But, more importantly, interest rates here didn’t rise because foreign rates were rising, but because the economy was cyclically strong, unemployment was low and falling, and wage and price inflation were increasing.  Wages rose roughly 20 per cent in that period.

It is fine and good for the Reserve Bank to do these sorts of stress-testing exercises, looking at what happens if interest rates rise to 7 per cent, or 9 per cent.  But in any realistic assessment, those sorts of substantial increases are only remotely likely if the economy is doing really cyclically well.  If jobs are readily available and wages are rising, not many people will be under that much stress even if interest rates rise quite a lot.  And those that are should quite readily be able to sell their house and move on.  It might be painful for them, but it simply isn’t a financial stability event.

Ian makes many of the same points, including

Financial  stability  will  only  be  threatened  if  there  is  a  large  number  of  borrowers   who  can  not  service  their  loans,  and  if  there  is  a  material  fall  in  house  prices.      If   house  prices  hold  up  through  the  interest  rate  cycle  then  borrowers  who  come   under  servicing  pressure  will  generally  be  able  to  resolve  their  problem  by  selling  the   house.  A  systemic  problem  only  starts  to  arises  if  the  interest  rate  increases  cause  a   large  fall  in  house  prices.    However,  if  this  did  occur  then  RBNZ  could  readily  respond   by  reducing  the  OCR.  It  is  almost  inconceivable  that  a  large  house  price  shock  would   not  feed  through  into  broader  economic  activity,  and  into  the  inflation  rate,  which   would  naturally  require  a  monetary  policy  response.    Mortgage  interest  rate  would   fall  and  the  pressure  on  borrowers’  servicing  capacity  would  be  relieved.

He also rightly highlights how unusual it is to propose including investor loans in a debt to income limit.  The Reserve Bank likes to highlight the debt to income limits adopted by the United Kingdom and Ireland, but simply hasn’t engaged with the fact that neither country includes investor loans in its limits.   Of the Bank of England Ian notes

The  Bank  of   England  has  the  legal  capacity  to  apply  DTI  limits  to  investor  lending,  but  has  not  done  so,   because  the  retail  DTI  limits  do  not  readily  translate  to  investor  lending.  Instead  the  Bank   requires  banks  to  meet  minimum  qualitative  standards  in  their  affordability  assessments.  In   addition,  banks  are  required  to  apply  a  2  percentage  point  stress  test  to  the  interest  cost   assessment,  and  the  test  rate  must  be  at  least  5.5  percent.  Where  buy-­‐to-­‐let  borrowers  rely   on  other  income  to  support  the  loan,  account  must  be  taken  of  taxation  and  living  costs.  This   is  basically  the  methodology  that  New  Zealand  banks  apply  to  retail  investment  lending.   There  are  no  further  quantitative  restrictions  such  as  times  interest  cover.  This  is  left  to   individual  bank’s  assessments.

In its assessment of submissions, the Reserve Bank should really be expected to provide rather more justification for the inclusion of investment loans than it has done to date.

Ian concludes his press release this way

“There are simpler, and less distortionary, ways of targeting ‘excessive’ house price rises, which appears to be the Bank’s primary motivation for DTI restrictions,” Harrison said. “Banks could be required to apply a prescribed higher test interest rate to affordibilty assessments.  This would provide the Reserve Bank with an interest rate policy tool that can be directed to imbalances in the housing market.”

His is a pragmatic response.   Mine is perhaps more hardnosed –  and perhaps less “realistic”.  It is no business of the Reserve Bank to be targeting house prices, targeting whether investors or owner-occupiers are buying, or even targeting levels of household debt.  Apart from anything else, they have no robust model of the housing market, or of the incidence of financial crises, and without those all they appear to have is gubernatorial whim, or the shifting winds of political preferences.  That is no basis for sound public policy.     The Bank –  and its political masters –  needs to be reminded of its mandate in this area: to promote the soundness and the efficiency of the financial system.  Direct controls that apply to one set of lenders and not others, to one set of loans and not others, to one class of borrowers but not others, are quite simply inferior on both limbs of that mandate to reliance on indirect instrument, such as capital standards, stress tests, and a deeply informed understanding of how banks are measuring, monitoring and managing risk.   To their credit, banks in countries like ours appear to have done a good job in recent decades of managing housing loan books.  It is a shame that the same cannot be said of the central and local government politicians and officials who have regulated urban land markets to the point where a house purchase is an increasingly impossible dream for too many of our fellow citizens.    How did we allow such disastrous outcomes?

Anyway, for anyone interested in the DTI proposal I’d commend Ian’s paper.  I don’t agree with everything in it, but is a detailed review of many of the relevant issues, and of the “evidence” the Reserve Bank seeks to rely on.  I hope that, for example, the Treasury will pay careful attention when they formulate their advice on the Reserve Bank inevitable (regardless of this “consultative process”) bid for approval to add debt to income limits to their toolkit of direct controls.

 

One thought on “Misconceived and deeply flawed

  1. On behalf of major financial institutions I made advances secured by way of mortgage on houses (both for owner occupiers and investors) in the UK and NZ. That meant that while the institutions (a major building society in the UK and an insurance company in NZ) had general guidelines on loan cost to income ratios their detailed application was left to the loans officer. The calculations had to relate to the circumstances of each case; there could be no hard and fast rule. It would be administratively inefficient for an outside body to regulate. The lender and borrower are taking the risks they should determine how much risk they are prepared to take.

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