While the banking executives did include warnings about the need to be careful in implementing these measures, the very first sentence of the Financial Times article kicks off with the typical, if unlikely, interpretation that high demand for low risk assets is a sign of high risk taking:
A group of leading financial executives have urged authorities around the world to bolster their crisis-busting arsenals amid fears that ultra-low interest rates have increased the risks of financial instability.One of the proposed regulations would be a limit on mortgage levels relative to incomes. It is common for banks to use guidelines for debt expenses relative to income. But, this would limit the size of the mortgage. The FT article says, "Authorities in countries ranging from the UK and Switzerland to Israel and Hong Kong have been making greater use of these regulatory levers to curb rising asset values, especially in the housing market."
As I mentioned on a recent post, while we tell ourselves there isn't generally widespread support anymore for explicit price controls, this sort of thinking really is a softer version of the same thing. And, this is so wrong-headed. I have outlined here many times how home prices, more or less, behave like a very long term real financial asset - because that is what homeownership is. We shouldn't expect anything else. Yet, everyone seems to simply accept the idea that prices in the 2000s were crazy - "exuberant" - because nominal prices were high.
Let's apply that logic to bonds. Here is a graph of the price of a 10 year bond, with a $100 face value and a 10% coupon rate. Why, look at that! The market price doubled between 1985 and 2010. This is the price for a certificate with a fixed level of income - $10 per year. This must be irrational exuberance! Why would sane investors pay twice as much for the same income?
So, what would be the best policy here?
1) Don't do anything.
2) Correct the irrational exuberance with a tight money policy.
3) Make a rule that banks can't sell these bonds for more than $140.
Unfortunately, #2 is exactly what we did from 2006 to 2008. Imagine if we had done policy #3 instead. Bond issuance would collapse if we did that to the bond market.
So, I would expect new home building to dry up if this rule became constraining. But, housing has a stable existing stock. I suppose in the housing market, the market reaction on existing homes would be to treat them as if there was a rolling call option at the price level that would tend to trigger the loan limit rule. If long term interest rates remain low enough to make this policy constraining, then housing supply would continue to be inhibited, and rent inflation would continue to climb. But, before I think through this more, I want to look at a few graphs to show how misplaced this entire concern is.
First, here is a measure of the mortgage payment required to buy the median new home, as a portion of median household income. This was not particularly high in the 2000s, and it has been extremely low since then. Since home prices in the 2000s were mostly a product of low real long term interest rates, they didn't require large mortgage payments, because mortgages also had low rates. This is basic asset/liability matching. The funny thing is, we have this whole set of controversial quasi-public institutions set up to create this asset/liability match, and now we ignore the fact that we have it when we interpret activity in the housing market.
Using Federal Reserve and BEA data, we can compare estimated rent and mortgage payments all the way back to at least 1950. Mortgage debt service was much higher in the 1970s.
Here we can see that the way to lower home prices is through very loose monetary policy. If housing was a problem that needed to be solved (it didn't), then the solution would have been to create expectations for 5% inflation. Mortgage payments for new homes would have been higher, so there would have been less pressure on home prices. And, for households with variable mortgages, their nominal home values and incomes would have gotten a 5% annual boost to help alleviate any difficulties.
But, I want to go back and think about what effect a loan size to income limit would have on the housing market if it was a tighter constraint than debt service to income ratios.
One of my running themes here has been that housing does tend toward a no-arbitrage price level - the aggregate market is relatively efficient. In the late 1970's and 1980s, real long term interest rates were almost as low as the 2000s, (although very high inflation and inflation uncertainty muddy the picture). This would justify a high Price/Rent ratio. It appears that home prices still found an efficient level in that period, and that households tended to downsize in order to settle at a debt service level that was manageable. This makes sense. There would have been tremendous incentive to own property that would appreciate along with inflation.
But, if a loan size limit becomes the constraint, households buying with leverage won't be able to bid the prices of homes up to the efficient level. So, when the efficient price moves above the level that regulators would allow a mortgaged purchaser to fund, wealthy households would have an advantage, because they would be able to use cash equity to bid the prices of homes higher. Households without a large pool of savings would need to downsize in order to buy homes at the market price (because the price would reflect some demand from cash buyers). Homeowners in general would earn excess returns because limited mortgage availability would limit demand and prevent the efficient price from being reached.
It would like a combination of today's housing market and the early 1980s market. There would be less new homebuilding because of the artificially low price level, which would cause rents to continue to climb. That would possibly be mitigated by the downsizing among new owners. But, just as there now is, returns to ownership would be very high, so owning a home would be lucrative, especially for institutional owners who could obtain outside financing. So, there would be a tendency for homeownership rates to fall and for institutions and households with high net worth to capture above-market returns.
If the inhibition of supply was strong enough, this would lead to a vicious cycle of rents rising faster than incomes, so that marginal households would qualify to buy smaller and smaller homes. This would further erode the ownership rate and produce high returns for well-funded owners.
Marginal households that did manage to purchase highly leveraged homes would see especially large returns because they would reap the excess returns on home ownership but their interest expense would not reflect a premium, since there would not be a constraint on the banks themselves to issue mortgages. But, I think an end result of these trends would be to push back toward a pre-HUD context where ownership was less mortgage-dependent and less owner-occupier based. Eventually, landlord funding and organizational foundations would be available for landlord owners to earn those leveraged excess returns.
To the extent that the landlord market developed and housing prices were bid to near-efficient levels, there would be lower rent inflation and lower homeownership rates. To the extent that this didn't happen, marginal households would tend to purchase downsized homes, rents would tend to rise over time, and real estate owners would earn excess returns.
I wonder if these possible trends, themselves, (stagnant housing stock, less credit expansion and more equity ownership) would tend to have a downward influence on real long term interest rates, adding to the vicious cycle of pushing home prices above the loan constraint.