Cyclical Mortgage Controls might be better

The Irish Central Bank surprised many people, not least the Government I suspect,  by announcing changes to their macroprudential mortgage rules. The Bank had called for submissions on the controls , and received a good number, including one from this writer , but the rhetoric from Dame Street did not indicate a great appetite for change. In the event the Governor announced what was termed  ‘refinements to improve effectiveness’. Lenders have been granted  more discretion, in that 20% of total lending to non First Time Buyers (FTB) can be above the 80% Loan to Value (LTV)  ceiling , a change from the previous 15% discretionary figure, while FTB’s can now borrow up to 90% LTV , regardless of the price of the property (that limit was previously capped at €220,000). Moreover, up to 5% of lending to FTB’s can be above 90% LTV.

The Loan to Income (LTI) ceilings were unchanged, at 3.5,  and of course the LTV limits are just that; banks are not compelled to adjust their existing loan standards. Indeed, a recent Central Bank analysis of mortgage lending over the first half of 2016 showed that lenders were not fully utilising their available discretion to exceed either the LTI or LTV rules.

These changes also come in the wake of the Government’s Help to Buy scheme, which allowed FTB’s claim back income tax ( to a maximum of €20,000) to be used towards the deposit on a newly built home. One wonders if that subsidy would have been introduced had the new rules been in existence, as the combination of the two certainly provides a massive boost to FTB’s buying power in the property market. Take a couple with a combined income of €75,000,   borrowing €250,000 . Prior to the new rules they would have had to save €35,000 in order to buy a property worth €285,000,  perhaps taking four or five years. Now they could increase their loan to €256,500 (still inside the LTI limit)  and only have to find €8,500  as a deposit if the property was a new build ( a 10% deposit of €28,500 less the €20,000 from the Help to Buy scheme) implying it would take a far shorter time to amass that sum. Alternatively, all or part of their original savings could now be used to buy a more expensive house. In effect, purchasing power has been brought forward and leverage increased.

Credit appears to be driving only about half of current transactions in residential property but given the existing supply issues the boost to FTB’s buying power may well have some impact on price, although that is the mechanism which will eventually lead to a bigger supply response, albeit with a time lag.

The controls are designed to ‘enhance the resilience of both borrowers and the banking sector’ but are actually pro-cyclical; an 80% LTV still means the average size of a new mortgage will rise at the same pace as house prices ( for example, at a house price of €200,000 the mortgage would be €160,000  but rise to  €240,000 if house prices rose to €300,000). A cyclically adjusted LTV might be more appropriate, as put forward in our submission to the Central Bank. When house prices are low and credit growth weak, for example, the LTV limit might be 85% or 90%, but then decline as prices and credit growth pick up, to perhaps 75% or 70% at the top of the cycle. This would not eliminate cyclicality, but would dampen it, particularly if the LTI limits were also flexible over the cycle.

One obvious issue with this proposal is that the Central Bank would have to decide where we are in the credit and house price cycles. However, they currently have to do that anyway, at least in terms of credit; under new capital rules, some banks have to set aside additional capital ( counter-cyclical buffers) in good times in order to cushion losses in bad, and the Irish Central Bank sets this buffer every quarter, in part dependent on the current credit/GDP ratio relative to the long term trend. The buffer is currently set a  zero, reflecting the fact that credit is still contracting and the ratio to GDP is very low.

In addition, the Bank has a number of models that monitor residential prices relative to fundamentals. Deciding whether house prices are overvalued is not an exact science (  as it happens most models point to undervaluation , if anything, at this time) but if a number of indicators were to flash red the Bank could lower the LTV and LTI limits if a cyclically adjusted regime was in effect.

One final point. Research at the ECB supports the case that a debt service limit is more effective  in protecting borrowers and lenders than other macroprudential controls, as again outlined in our submission, although at the moment the absence of a credit register is a key impediment to implementation.


Bit early to blame Central Bank for house price fall

The CSO’s  residential property index   for February showed a fall in Dublin prices for the second month in a row, the 0.7% decline bringing the fall over three months to 2.4%. This still left the annual rise at over 21% but the market in the capital has clearly lost some momentum over recent months and some have claimed that the Central Bank’s new macro-prudential controls on mortgage lending are responsible. Prices excluding Dublin were flat in February but also fell on a three month basis, albeit by only 0.3%, so adding to the perception that there is a common factor at work across the country.

The evidence is not persuasive, however, at least not yet. The rules only came into operation in late January , for a start, and there does not appear to have been a significant shift in the recent pattern of mortgage approvals ahead of the decision. Mortgage approvals in the three months to January rose by an annual 55,5%, and as such not materially different from the 56.5% in the three months to December. Housing transactions in January were actually very strong, according to the Property Price Register(PPR), rising by an annual 68% . The available February data does show a marked deceleration in the pace of annual growth in transactions, to 35%, but that figure may be quite different when all the filings are included, which does take time.

The Central Bank’s own research (1) also suggests that the mortgage limits on Loan to Value and Loan to Income will have little impact on prices but a more significant  effect on mortgage lending and on the supply of housing, which they suggest will be some 2-3% lower per annum for a number of years ,resulting in a loss of some  2000  units  after 4 years relative  to an unchanged policy forecast. That  reduction in supply will put upward pressure on prices , so dampening any downward effect from tighter credit standards.

Any such simulation depends on the housing model used of course, and the ESRI (2) has just come out with some findings of its own. These also point to a significant effect from the new mortgage rules on house completions, with a supply fall of some 4%-5%, although they predict a larger effect than the Central Bank on prices, albeit  still a modest 4%-5%.

Another problem inherent in linking recent price trends in residential property to the Central Bank regulations is that not all housing is behaving the same way. Apartment prices nationally rose by 1.9% in February and by 2.5% on a three-month basis. Apartments in the capital also rose strongly on the month, by 2%, and by 1.8% over three months. The price series on apartments is extremely volatile but apartment prices in Dublin have now risen faster than houses over the past year (by 24.5% versus 21.1%).

Perhaps a better explanation for the most recent slowdown in house prices is simply that a market which appears to be primarily  driven by cash buyers is likely to lose momentum. That’s not to suggest that prices are likely to fall sharply but that annual house price growth in excess of 20% is unlikely to be repeated for long in the absence of excessive credit growth. New mortgage lending is picking up , and showing very strong percentage growth given the low base, but it is still accounting for less than 50% of housing transactions. Indeed, the latest PPR figures show transactions of over 15,600 in the final quarter of 2014, with the number of new mortgages drawn down for house purchase amounting to less than 7,000 , or 44% of the total.

(1) ‘Assessing the Impact of macro-prudential measures’ Central Bank of Ireland, Economic Letters , Vol. 2015, No.3

(2) ‘Quarterly Economic Commentary’, Spring 2015, ESRI