Very slowly lifting LVR controls

It is a strange form of democracy in which an unlawfully appointed (and certainly unelected) bureaucrat, who faces little or no effective accountability, can descend from the mountain-top and decree new limits for how much different types of (potential) house buyers can borrow from banks.  But that is what Grant Spencer of the Reserve Bank did this morning with the release of the latest –  his one and only –  Financial Stability Report.  Our politicians seem to see nothing strange about this –  rabbiting on about “respecting Reserve Bank independence” in an area where there is no obvious reason for Reserve Bank independence at all.  If we have to live under the burden of regulation –  especially of the sort that directly affects ordinary citizens –  those controls should be imposed, or lifted, by politicians.  We can toss them out.  In this particular case, it is not as if there is even a clear statutory framework: the Reserve Bank is required to exercise its powers to promote “the soundness and efficiency of the financial system”, but neither they –  nor anyone else –  can really tell us what that means, or hence what limits, if any, it places on a Governor’s (or “acting Governor’s”) freedom of action. Arbitrary whims aren’t a good basis for government.

Don’t get me wrong.  I’m pleased to see the Reserve Bank making another start on easing the LVR controls (there was a partial easing a couple of years ago, but that didn’t last long).     The controls should never have been put on in the first place.   They started as a knee-jerk reaction from the previous Governor, without any good supporting analysis, and –  as so often happens with controls –  one control, originally sold as temporary, soon led to others, ever more onerous, with ill-founded exceptions.   As I summed up LVR restrictions a few months ago

They are discrimatory –  across classes of borrowers, classes of borrowing, and classes of lending institutions –  they aren’t based on any robust analysis, as a tool to protect the financial system they are inferior to higher capital requirements, they penalise the marginal in favour of the established (or lucky), and generally undermine an efficient and well-functioning housing finance market, for little evident end.  Oh, and among types of housing lending, they deliberately carve-out an unrestricted space for the most risky class of housing lending –  that on new builds.

That discrimination?

We have direct controls on lending secured on housing, but none on lending secured on farms or property development –  even though the FSR notes that the dairy debt position still looks stretched, and recognises that internationally many of the losses in financial crises are on commercial property (especially development) loans.

We have much more onerous direct controls on potential owner-occupiers than on investors, even when the nature of the underlying collateral is identical.  Even if the investor borrower might, objectively, be a much better credit  (think of someone with a really secure job like a teacher or police officer buying a first investment property, and contrast then with a person (with the same income) with a job in a highly cyclical sector (thus at considerable risk of unemployment in the next recession) buying an owner-occupied dwelling).

And we have direct controls on housing lending by banks, but not by other lending institutions.

And, again as I noted earlier

You’d never know, from listening to the Governor or reading the Bank’s material, that New Zealand banks – like those in most other floating exchange rate countries –  appear to have done quite a good job over the decades in providing housing finance and managing the associated credit risks.   We had a huge credit boom last decade, followed by a nasty recession, and our banks’ housing loan books –  and those in other similar countries –  came through just fine.

The Reserve Bank has never seriously engaged with this sort of perspective, and never told us why we should be confident that they are better-placed to make credit allocation judgements than experienced bankers whose own shareholders’ money in on the line.

Some months ago the former Prime Minister called on the Bank to lay out clear and explicit markers that would see the LVR limits wound back and eventually removed.   Unfortunately we got nothing of the sort today (indeed, the idea that the restrictions will eventually go altogether –  and we can back to having banks making credit allocation decisions, at an individual and portfolio level –  got barely a mention in the FSR itself or in the subsequent press conference).    No doubt, the bureaucrats like having toys to play with.  They stress how hard it is  for them to lay down clear markers, but appear to put no weight at all on how hard it might be for citizens who have to make their own decisions against a backdrop of such regulatory uncertainty.  Sadly, there are few effective incentives to ensure that bureaucrats and politicians internalise those costs at all.   Politicians have to face re-election (and scrutiny in the House each day), but the Reserve Bank bosses face no such pressure.

Now, to be fair, this mess was primarily of Graeme Wheeler’s making, and Spencer and Bascand are left to tidy up the mess.  Since the LVRs were never grounded in good analysis in the first place, it is hard to set out analytically robust markers for lifting them.  But if analysis couldn’t offer much, perhaps there should have been a premium on predictability: the Bank could have laid out an expected numerical path under which over the next two years the LVR limits would be removed completely, with modest easing scheduled for each quarter.  Sure, they couldn’t have made binding commitments –  apart from anything else, some as-yet-unknown person will be calling the shots as Governor after March –  but indicative plans help provide certainty to banks, their competitors, to borrowers, and to other participants in the housing market.  And they create some hurdles that the Reserve Bank would need to get over before deviating from the announced path.    As it is, we have no idea –  no clues at all –  as to what pace the controls might be lifted at.

As a reminder, if the Reserve Bank is really concerned about the soundness of the financial system –  let alone the “efficiency” of the system, a key part of the mandate –  capital requirements (risk weights and required capital ratios) clearly dominate direct (and discriminatory) intervention in the credit allocation process.     That sort of insight was behind getting rid of direct controls back in the 1980s.

The Bank did attempt to lay out the criteria it would be using  in assessing whether and when to relax LVR limits further.  There were three.

  • Evidence that house price and credit growth have fallen to around the rate of household income growth.
  • A low risk of housing market resurgence once LVR restrictions are eased.
  • Confidence that an easing in policy will not undermine the resilience of the financial system.

The second and third aren’t specific at all, and provide little basis for citizens to hold the Bank to account.   But the second is also problematic, because the Bank has always claimed that its goal isn’t to eliminate, or even to materially dampen, house price cycles (the “acting Governor” this morning reiterated that there will always be housing cycles).  That second criterion only makes sense if there is evidence that house price cycles/increases are mostly caused by changes in bank lending standards, and the Bank has never produced any evidence for that in a New Zealand context.

The first criterion looks slightly more useful –  at least we can see the data for that.  But I’m not sure it is very robust.  First, why “household income”, when many of the houses are now bought by the small business sector –  nominal GDP growth might be as useful.  But, more importantly, the Bank’s criterion seems to cement in the current ratios of price and debt to income as some sort of equilibrium.   And they have absolutely no evidence at all for such a claim.  As they surely know, if land use is heavily-regulated then fresh shocks to demand –  from any source, including unexpected population growth –  will tend to raise debt and price to income ratios, with no particular reason to think that such movements raise financial stability concerns.  Lending standards are really what matter, not macroeconomic indicators.  And, of course, in floating exchange rate countries with a market-led allocation of housing credit, I’m not aware of a single case where housing loan losses have been central to systemic financial crises.

There was the customary self-congratulation this morning about the contribution the LVR controls have made.  The Bank keeps telling us LVR restrictions have “substantially improved” the resilience of the financial system.  It is another claim for which they advance no serious evidence.  They correctly note that the volume of high LVR loans is lower than otherwise (although a little footnote on page 6 suggests even that effect might have been quite modest), but they never ever explicitly recognise that if banks have fewer high-LVR loans they will be required to hold less capital than otherwise.  Or that since the incentive was now to lend lots of, say, 79.99 per cent LVRs –  not economically different from a loan of 80.01 per cent –  and yet capital requirements are typically materially lower on lower LVR loans, it is quite possible that the effective resilience of the banks has actually worsened a little.  As it is, their stress tests have told throughout that the banks are robust.

Two final points:

The first is that in some respects today’s moves further increase the regulatory wedge imposed between access to credit for investors, and that for owner-occupiers.  In essence, no one (or almost no one) can borrow from a bank to buy a residential rental property using a mortgage of more than 65 per cent of the value of the property.  (There is provision for up to 5 per cent of such loans to be above 65 per cent, but given the larger buffers banks operate to ensure that they don’t breach conditions of registration, it is effectively a near-zero limit).  That isn’t a decision of a professional credit-manager.  It is regulatory fiat, from people with little or no experience in credit allocation.  By contrast, 15 per cent of owner-occupied housing loans can now be to borrowers with LVRs in excess of 80 per cent.  If banks judge it prudent –  and it might well be, depending on the borrower and the overall portfolio –  some owner-occupiers will be able to borrow perhaps well above 90 per cent.    The Reserve Bank has not produced a shred of evidence –  in the past or today –  for such a huge gap, on identical collateral.   Recall my example earlier: lending an 82 per cent LVR loan to the police officer buying an investment property is likely to be materially safer than lending to, say, a person on the same salary buying a first home, but working in a highly-cyclical sector (eg construction or tourism).  Banks can make those sorts of distinctions – they get to know and evaluate their customers –  but the Reserve Bank can’t. Instead, we get crude controls slapped on and maintained for years.  It looks and feels a lot more like politicised credit preferences – owner-occupiers favoured over investors.  When politicians do it it might be odious and undesirable but….they are politicians, and they have to face the voters.  When bureaucrats do it, it is highly inappropriate.

As I noted in my housing post yesterday, in some ways it is a bit odd for the Reserve Bank to be starting to declare victory now.  For the last few years there has been little or no prospect of any material oversupply of physical dwellings (or urban land).  There was little effective liberalisation and huge population pressures, and much of the new building has been on a pretty small scale, done by the private sector.   But now net immigration looks as if it may have turned a corner, easing some of the demand pressures.  A series of tax and regulatory changes will also dampen demand, at least temporarily, a little.     And the government is talking up “build, build, build”, in a government-led process designed to generate a huge number of new houses in the next decade  You might be sceptical, as I am.  But it is explicit government policy.  And government-led investment projects face considerably weaker market disciplines –  and often operate on a considerably larger scale –  than private sector ones.    Government interventions in the housing finance market were a big part of what went wrong in the United States. Physical oversupply was a big issue in Spain, Ireland and (parts of) the United States.   How confident can the Reserve Bank be that if Kiwibuild really gets going at the scale envisaged that the risks can be effectively managed?   It is, after all, almost certain there will be at least one recession  –  wich won’t be foreseen – in the 10-year horizon of Kiwibuild.     I’m not using this as an argument for keeping LVR restrictions on –  they aren’t fit for purpose, and in any case the Bank bowed to political pressure to exclude loans for building new houses (the riskiest sort of housing loans) from the LVR controls altogether.  But I think they are wrong if they believe, as they stated this morning, that risks are now easing.  And capital standards are a better, less intrusive, way to manage any risks.

The sooner the LVR controls are behind us the better,  Sadly, unless the right Governor is chosen, that day doesn’t seem likely to be soon.

I’ll have some comments tomorrow on some other aspects of the FSR.

4 thoughts on “Very slowly lifting LVR controls

  1. The trouble with leaving the dumb LVR’s in place too long is the reduction in rental housing stock from the normal cycle of house sales. And its just ridiculous outside Auckland.

    Surely these are stupid patch up ideas instead of doing the obvious thing and allowing people to build houses where they want. Worked for hundreds of years before “town planning” arrived to make our lives better.

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  2. Back in the day, prior to the 1987 crash, the bulk of housing finance was provided by Insurance Companies and Building Societies or State Advances and then Solicitors for second Mortgages. Banks hardly figured. The non-bank financiers only lent out funds they had. You had to have insurance or belong to a Building Society to get housing finance. They (generally) only lent up to a maximum of 70% of the valuation of the property coupled with a servicing test. ie DTI. Then the banks got into the game – by taking over the Insurance Companies and the Building Societies and Wealth Companies.

    So the question is were the non-banks dumb in those times under those circumstances. What makes 10% LVR’s in this new millennium so much more workable when it wasn’t prior to 1990

    LVR’s and DTI’s served NZ society for 100 years? and you say they are dumb?
    Get rid of them you say

    The difference is Banks can conjure up money and source foreign wholesale funds that the non-banks couldn’t

    I guess your answer will be to increase the tier capital ratios – but my real question is how much better off are we under a bank-driven system when the non-banks system had a built in hand-brake-speed-governor

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    • Of course, in that old model there were no govt-imposed LVR/DTI controls. Moreover, at times State Advances happily – and quite rationally – lent to 90%, and plenty of people topped up to 90% or more with second or third mortgages (especially in the 70s and early 80s. For a couple starting out at 23 (say), a 90% LVR loan, repaid over 40 years, is a highly ratonal and efficient financing solution.

      Personally, i don’t think we have evidence that we need further increases in capital ratios: housing lending just isn’t that risky.

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    • It was more than a handbrake. It was giving a group of people a privilege that allowed that group to grant benefit to a select few.
      That kind of privilege was what Roger Douglas stepped up to get rid of. And thank goodness for that.

      It was a great challenge to get a house mortgage back then and it was support for a state controlled housing program where you could beg for a house from the Great Provider, the State. A bit like say Lorea or the communist states of past.

      Do you think we should return to that or have satisfactory functioning mortgage market that the participants can meet customers needs while assessing the risk to their own private business?

      I suggest that most of us would.

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