LVRs are coming: Let’s think about the causes underlying this

I see the RBNZ has come out with the details of the LVR restrictions (loan-to-value limits on mortgages) they may well put in place soon.  That is cool.  I’m also a big fan of the “question and answer” style discussion of people’s submissions here.  Brennan McDonald summarises the details here.

However, in the release about this, there were several quotes about LVRs that I had to admit I had issues interpreting.  Either these quotes miscommunicate the justification the Bank is using for such policies, I have completely misinterpreted the quotes, or they communicate it perfectly and I fundamentally disagree with the association they are using.  These ones are not about housing affordability, they seem to strike at something more fundamental.

As a result, I thought I should have a chat about the quotes in question – and why I think our understanding of them, and the causal mechanisms involved, is central to thinking about policy.

The quotes are:

“LVR restrictions on residential mortgage lending can help to dampen excessive house price growth in periods when credit growth is boosting housing demand beyond housing supply,” Mr Spencer said.  “In so doing, they can reduce the risk of a rapid correction in house prices and the economic and financial instability that would ensue.

“In situations where house prices are overvalued, the further that house prices rise, the more likely it is that a disruptive downward correction will occur.  Such a correction would be very damaging if combined with a significant deterioration in economic or financial conditions.”

Credit growth is boosting housing demand beyond supply

This is extremely misleading – credit growth doesn’t “cause” things, a lift in credit aggregates must be due to something fundamental (a “primitive” of the economy).  We touched on this idea when discussing the Lucas Critique of DSGE models here.  And we touched on it when discussing the related idea of monetary aggregates.

If I am wrong here, and there is some abstract credit monster wandering around that turns up pushing things in a policy relevant way (rather than the choices of a series of individuals) – I apologise.

Anyway, so unless we can say what the primitive is, we can’t articulate why policy makes any sense – this isn’t a matter of even saying “we need lots of evidence” (even though that is generally my preference), instead it is the point that we can make a number of different arguments to justify some set of data – and we need to make sure that the policy recommendation is actually consistent with the argument we are using!

Now don’t misread me here, I do not mean we should ignore credit figures in the slightest – instead I’m saying let’s make sure our story fits them.  Since we have a bunch of things going on in the argument being made here (housing demand and credit growth) we can try to figure out why the RBNZ might want to restrict lending to highly leveraged borrowers in the housing market.

They may believe that credit growth is rising with house prices because of a generalised lift in “demand”.  If this is the case there is no real need for these policies – just hike the OCR, this is straight monetary policy!  As a result, I believe we can rule this one out as their justification.

They may instead believe that households are not appropriately categorising the risk associated with house prices.  Furthermore, they may believe that retail banks will underplay the risk associated with house prices, due to the view they will be bailed out, or due to the view they are ignoring some systemic risk externality.  In this case, the RBNZ could:

  1. Credit constrain households – think of it relative to the debate on sales bans,
  2. Ensure banks are holding sufficient equity/capital and allow private firms to price risk

The second solution makes more underlying sense to me, but the LVR restrictions are consistent with the first and will “work” in the very short term in that way.

Cool, so the Bank could say that credit availability has improved and is seeing housing demand accelerate more quickly than supply – an ‘imbalance’ that makes the financial system more fragile.  I would NOT be sold on this as a first best solution, and I think it sounds a little bit too much like social planning and fine tuning – but it would have a structural, policy relevant interpretation.  Furthermore, it could easily be justified in terms of this being a “risk management” process in financial markets – something society would buy into.

In this context, it is not the “high house prices” that are the concern in of themselves – it is the fact that the driver of house prices is based on a process, series of choices, institutional/expectations related issues, that leads to some market failure.  In this context, the high credit growth is part of the perceived issue at hand – not a cause of it!  The concern at hand is due to the view that credit creation is “excessive” and house price appreciation “too high” due to some underlying factor driving “housing demand” (and related to institutional arrangements in the regulated mortgage lending sector) – not the other way around!

Remember, people have to actually do the borrowing for “credit growth” to occur!

The risk of a rapid correction in house prices and the economic and financial instability that would ensue

Let us be a bit careful here.  We appear to be thinking about a specific situation where people’s willingness to pay is out of line with the fundamental value of an asset – and then “changes” at an unpredictable point in time in the future.  A bubble.

This is fine, and we know that sudden corrections can have an effect upon economic activity, financial stability, and the effectiveness of the financial system.

But what this means for policy is only clear when we have a framework for understanding what it means, and when we also include a monetary policy reaction to such an event!
A run up in house prices, out of nowhere, would imply a transfer of resources between those who decide to buy and sell.  Similarly, a sudden collapse in house prices implies a transfer of resource between people.  Fair enough – the RBNZ shouldn’t care.

But the impact of the change in house prices on “demand” or on the “stability of the financial system” is something the Bank is concerned about.  In terms of “demand” they dance around with monetary policy (although with the view that they don’t want instability in demand created by shifts in the financial or government sectors).  In terms of “distribution” in terms of housing resources we have government dancing around.  And in terms of the stability of the financial system, and the implicit insurance view we have of it given government regulation we have the Bank with financial stability policy.

Sidenote:  It is important to mention here that we have these three government bodies – but we also, always, have the inherent willingness to pay and ability to supply associated with the private sector.  The underlying value placed on things, and choices made, are indeed by individuals – individuals making choices given views about broader social variables.  Also zoning laws etc fit within the “distribution” mention above.

So this is cool, the Bank is looking at a set of tools because they have a specific view around how the current increase in house prices is influencing financial stability – this quote is fine in that context.  But then …

Such a correction would be very damaging if combined with a significant deterioration in economic or financial conditions

Hmmm.  Such a correction is damaging IF IT CAUSES a significant deterioration in economic conditions (if the Bank cannot respond quickly enough – or we believe the Bank’s response will inherently take longer to have an impact than the mechanism that links asset prices to the real economy) or financial conditions.

The “transfer” associated with the correction is irrelevant for central bank policy – the drop in house prices transfers from those with houses to those without.  But the associated impact of the sudden change on economic and financial conditions, whatever that is, is what we view as policy relevant.

The RBNZ cannot include a transfer in their objective function, and importantly they shouldn’t be communicating that it is a transfer they are concerned about.  House prices should be able to do whatever the hell they want (in terms of the Bank’s mandate – not the government’s potentially) but the Bank does need to respond to their impact on demand and associated view of economic utilization (monetary policy) and the impact on the stability of the financial system (financial regulation, microprudential and macroprudential policy).

Now we need to also think about these channels in clearly complementarily, but separate, ways.  What exactly has happened with this exogenous shift in house prices?  There has been a wealth transfer between people.  Ok, that’s nice.  Remember, we are not trying to stop people hurting themselves – we are trying to avoid a situation where people hurting themselves hurts others.

Retail banks know there is a risk of increased default given that the market value of these housing assets have dropped – and if people default, then the banks end up facing the loss between the value of the mortgage and the value of the asset.  In this environment, there is a risk that given the tiny amount of equity they hold they could fail – this is a genuine concern of course.

“Read  it the other way around Matt!”

Instead the RBNZ may be saying that such a situation creates vulnerabilities – so that if there is some other shock (eg collapse in dairy prices) the high levels of leverage in the financial system combined with asset prices that have a long way to fall (implying redistribution that may in turn worsen credit constraints) would lead to a hellish situation.

Given this, we are looking at it in terms of a public “insurance” against a nasty shock which would be exacerbated by these vulnerabilities!

That’s cool.  I’d probably make the argument like that though.  Such as “a sharp correction is likely to coincide with a broader deterioration in financial and economic conditions, which implies accepting some restraint in the housing market now in order to insure against a systemic episode”.

The idea around having “social insurance” for a systemic episode has to be that individuals in society can’t insure themselves against this, or that certain expectations of private agents are inconsistent with a believe that they are not socially insured.  This is why such a view makes sense – and provides a policy basis for this style of regulation.


I initially just wanted to point out that the Bank had announced these things.  But after spending a bit of time looking at these quotes and trying to justify them, I felt it would be dishonest of me not to comment about the fact I fundamentally disagree with what they directly imply.

Let us remember that the RBNZ is working along two complementary roles – one is the use of monetary policy to “manage demand” through their inflation target (which is really just a way of helping to co-ordinate expectations), the other is to regulate the financial system.

They recognise, and have articulated clearly before many others, that financial instability undercuts their ability to manage demand.  This is fine.

Furthermore, both my views and those of the Bank appear to lead to similar policy conclusions, so in some regard this may seem trivial.

But I have a specific understanding of “why” they intervene in these ways, and the quotes appeared to be at odds with this.  And given the “why” justifies policy, scope, how these matters are communicated, and how we view value I find this issue far from trivial.

As I said, this could be that I read the quotes in a way that they implied something the Bank didn’t mean – or it could be that the Bank and its team of economists fundamentally disagrees with my interpretation of what is going on.

And if I wasn’t that I was talking to myself here, I would actually just listen to them 😉

  • Shamubeel Eaqub

    Matt, a thoughtful read of the announcement. I also scratched my head on the communication.
    I think the RBNZ is trying to line up a number of policies in sequence to insure the system against a large shock. The LVR thing is the first cab off the rank and the easiest to implement, politically and practically (from a systems perspective). I reckon changes in capital requirements will have a larger impact.
    Certainly the banks have been fighting this all the way. They are used to having lots of leverage with the public purse as lender of last resort. If it changes and they are not able to access higher risk customers, their profitability will fall.
    The causal aspect of credit driving house prices you mention is an interesting one. Presumably credit availability matters. So, when lending criteria are loosened (eg disposable income tests) there are more borrowers. When lending terms are loosened (eg lower deposits) each borrower accesses more debt. This allows valuation multiples to be higher as your WACC falls. Perhaps thats what the RBNZ were trying to get to?

    • I agree with what you are saying – direct capital settings are likely to be more effective, and more relevant. Furthermore, the underlying idea should come from credit availability indeed – given the idea that without credit constraints current institutional structure would lead to “too much” borrowing, and so as a second-best solution we might view credit constraints as useful.

      The key reason I wrote this up is because the wording a central bank uses to communicate these things is IMPORTANT – people read each word and go through and interpret. And the “credit growth drives housing demand” line was both misleading and a wee bit strange, while the “if combined with” line was just very unclear about the sort of event the RBNZ was thinking about.

      They’ll know why and will think about causal mechanisms, and the language will likely be too technical for the public (hell and even myself 😉 ), but even so it is important not to turn around and give a misleading impression – as ultimately it is the public that will determine the scope of their mandate. And the public that forms expectations that determines the effectiveness of their policies!

  • Maxamillian Shields

    Credit growth skyrocketed along with house prices pre-GFC. This looks to be happening again. Isn’t this all just the same old short-term thinking from the banks here? Because the levels of private debt aren’t sustainable. But the banks don’t really take a hit when the shit hits the fan. Banks will always want to create more money – they are super-incentivised to do so! And the OCR (and hence mortgage rates) never stopped borrowers from borrowing! Aren’t these the fundamentals behind the credit growth?

    • Credit growth is a indicator of fundamentals – I was actually trying to reinforce that point rather than undermine it. I was just keen to make sure we were being clear on the “why” to make sure our “solution” was a sensible one 😉

      It isn’t actually skyrocketing in NZ at the moment – but of course you want to be forward looking, and the Bank likely believes that there is a significant risk that persistent appreciation in house prices and rising borrowing activity is a likely occurrence, and given certain views about what is underlying this they need to lean against it.

      Also, if we think about the “why” a bit it is possible we can come up with “better” solutions – potentially going straight to equity/capital targets would be more consistent for example.

      • Maxamillian Shields

        Yes, why not hit the residential mortgage risk weightings? Having to hold .35 x .8 x loan outstanding (simplified) is bugger all. Since everyone with negative gearing generally must be expecting capital gains, why not restrict borrowing based on the earning ability of the asset. So for investment properties, if the property can’t service the loan (based on market rentals etc), then it’s a no go.

        • The risk weighting idea makes sense to me if we think the risk of a systemic event being caused by an asset class changes due to the leverage, or the relative stock of debt, in that asset class. I think it can definitely be justified.

          And tbh, our RBNZ is pretty upfront about that as well – the main reason they are starting with LVR’s is because they can introduce them most quickly, and they have the best understanding of their “quantitative” impact. As Shamubeel was noting in his comment, they will be looking at a wider range of regulation on banks over time.

          I’d also keenly note that the idea of such strong regulation on banks is strongly pinned to the idea that they are “socially insured” – there is a long string of arguments here, and we have to make sure our policies are consistent with them. Which is why discussing these causes is so important 🙂

        • Alfred Duncan

          My expectation is that given some lvr cap (would it be 80%?) it would still be possible to get a 90% loan, it is just that the extra 10% would be an unsecured, personal loan carrying a high interest rate and a high risk weight (from memory unsecured personal loans have 100% risk weight).

          This is actually “hitting risk weights” in practise, and encouraging front loading of payments, or improvements (to lift the value and secure the extra 10%). Perhaps a more ideal policy would be to implement risk weights that are dependent on leverage, and I suspect that some banks’ internal models do this, but forcing everything above a limit to be considered unsecured is a pretty good way to go, and I think has a parallel with common practise for commercial lending.

  • Alfred Duncan

    For any banking experts: how much of NZ banks’ mortgage debt is tied up in covered bonds? And, what do we know about renegotiation/forbearance under the terms of covered bonds?

    It is notoriously difficult for trustees to renegotiate securitised loans—certainly a problem in the US as bank-held-loans have actually enjoyed some mutually beneficial forbearance and renegotiation. I imagine that covered bonds shouldn’t hold up this process, so long as the banking intermediary “covers” any losses to the security holder following the renegotiation.

    Do banks expect “cramdowns” in the event of a crash in NZ (readjusting the securitised portion of the loan to say 80% of the new value, while redenominating the remainder as unsecuritised)? This is a policy favoured by the IMF.

    Time to dust off NZ’s bankruptcy law methinks. At first glance it looks pretty sensible relative to other countries. I like the three year time frame. Ireland has recently stiffened their bankruptcy laws—a bizarre move, as any kind of contract model would tell you that shifting the contract terms in favour of the lender in the event of a recession, ex post, is just about the silliest thing you can do.

    Matt, in an earlier post you opined that investors were probably less risky credits than homeowners? Do you have any evidence for this? My prior would have been the opposite, given equal leverage. Primary residents generally have better incentives to make improvements, and have a positive wedge between their valuation and the market valuation (it is costly to move… one grows fond of one’s castle). Also, in the US again, we see a lot of negative equity in states which have non-recourse loans. For example, Richmond California is trying to use eminent domain laws to force debt reductions. This doesn’t make any sense if the homeowners could just get rid of their negative equity by dropping the keys off at the bank. This is indicative of either loans not really being non-recourse, and people holding higher internal valuations of their own property than the market valuation.

    I can provide links to stuff, but this comment is getting way too long already!

    • Interesting question Alfred, hopefully someone turns up with some data – given I would like to know as well.

      “Matt, in an earlier post you opined that investors were probably less risky credits than homeowners?”

      Woah, buyers are definitely less risky than people investing in building the housing stock, if I’ve accidentally said this I’m sorry – I think the complete opposite :O

      At the moment policy is set up given this view on relative risk, and there may be a question of whether it is “too far”, but I definitely think current owners are a less risky bunch than investors – both in theoretical terms and in terms of data!

      Now if you mean a difference sort of “investor” – say someone buying a second house vs someone buying a first house – the question gets more interesting.

      In this case, the comment will have been more about which groups are more highly “leveraged”. I can definitely buy your point that people buying second homes will not feel an attachment and may sell etc etc, but they are also likely to have the underlying funds to pay off any loss on the property – I can’t get past the idea that these first home buyers with 90%+ mortgages would essentially be paying extremely high rent for a house effectively owned by the bank, a situation that would make bankruptcy appealing.

      However, it is a very good point – and I find the behavioural element of what you are saying appealing. In this way, people who buy second properties in leveraged ways are also very risky. Hence why the LVR rules will still capture them – it is only if sufficient equity is held in the house that the rules don’t hold!

      • Alfred

        Thanks for your reply! And yes I worded that poorly, I was using “investor” to mean someone purchasing a second house. Your point is a good one about first home buyers being more likely to be more highly leveraged than the typical owner of multiple properties—although I would love to see some data!

        • Data is key, agreed. And more and more is becoming available all the time!

  • HJC

    Hi Matt, your comment that ‘credit growth doesn’t “cause” things’ is interesting. Are you departing from the market monetarists and those that believe in hot potatoes? You seem to be departing from the Woodfordian view that the endogeneity of money is supply driven.

    • Good question, glad you asked – I was considering popping something down on this but didn’t.

      My impression is that the hot potato effect is a view on the transition mechanism for a “shock”. The fundamental cause of an issue must be the initial shock based on primitives, and then within a broad economy there is a transition mechanism which leads this shock to have an impact.

      Now, this transition mechanism has either an observable, or an unobservable causal chain eg we might know that a “shock” to house prices then leads to a higher willingness to borrow and fund spending on goods and services which increases demand for housing – or we may not. The view on this causal chain does matter – but I can understand why it may be unobservable, and why we may justify policy in any case … in fact this is often the role being given to a systemic risk externality. I find this area difficult though, and again would rely on empirical estimates and a view of “burden of truth and insurance” as I’m under the impression people do.

      However, stating that credit growth in of itself causes a lift in housing demand doesn’t provide an initial shock – credit growth is not a primitive of any model I can conceptualise.

      This matters as our initial view of this shock does influence our view on what is policy relevant and what matters. If we are only trying to deal with rising house prices, why not ban foreign owners, why not ban sales althogether? If “credit growth” is the cause, why not just refuse to let credit grow by moving to full reserve banking, or nationalising banking, and taking control of the lever directly?

      In truth there are inherent trade-offs underlying all this, and by making credit growth sound like an unconditional driver of housing demand – so it is both a proximate cause and not conditional on anything – we are giving a misleading view of these trade-offs.

      Furthermore, a policy innovation by the government (including the Bank) is a form of “shock” – as a result, understanding the form of the shock is important for understanding what is appropriate given the transition mechanism … as it will be working through those channels but is due to somethin.

      “You seem to be departing from the Woodfordian view that the endogeneity of money is supply driven”

      Sorry I’m a bit confused with this – my view was that the endogeneity of money is due to the fact that the money supply is endogenous, as in shifts in investor and consumer demand can change the supply of money, or more broadly credit. I’m not quite sure what you mean by the endogeniety of money being supply driven – are you inferring something about banks willingness to supply credit under different conditions being a function of the point in the economic cycle?

      • HJC

        Just to be clear, the hot potato view is that if there is more money in the system than that demanded, then it effectively spends itself until prices or output adjust to restore equilibrium. I’m not sure how this sits with your ‘transition mechanism’, but this contradicts the idea that the money supply responds to demand in the way implied by the endogenous money theory.

        With regard to the supply-driven idea, an example would be the Romer’s horizontal MP curve: Although it’s constructed so that the CB sets the short-term interest rate, the implication is that it still sets the money supply indirectly (and hence the price level). I think Woodford’s models, even though they mostly drop money altogether, imply the same thing.

        • With the hot potato business you are implying something like Nick Rowe I believe:

          This just gives us a mechanism by which the money supply rises given an “exogenous shock” – rather than a description of a shock, or policy in any sense.

          Now the idea of the horizontal LM/MP curve is the central bank is setting the price in money markets. But given that, we want to know what occurs when there is some sort of “shock” – policy, a change in consumer sentiment, a change in animal spirits, changes in preferences or expectations about house prices these are all forms of shocks.

          It is these primitives and the shocks associated with them that lead to the process that shows credit aggregate growth, or changes in prices – these are symptoms of a cause (where the cause is a shock to a primitive). Credit growth must be “due to” something, and understanding what policy we should put in place and why must stem from asking ourselves what that something is!

          In this context the “supply of money” is indeed endogenous to the description at hand. Given that description we can then ask ourselves what type of policy is appropriate. I see this type of view as both consistent with the idea of money being a hot potato and “endogenous money” – in fact I see both of those as consistent, in so far as I accept the endogeniety of money. Namely that, changes in non-policy primitives (preferences and expectations of individuals and banks) can influence the money supply independent of central bank policy, and through an iterative process.

          Now we may say that we have endogenous money and credit because of PREDICTABLE CYCLICAL elements to the behaviour and expectations of individuals, firms, and banks! In that context, the central bank could use specific countercyclical policy to lean against this – even in this case, it is not the credit growth causing housing demand – it is the behaviour and views of individuals borrowing to fund the lift in housing demand they are experiencing, which pushes up credit growth!

          • HJC

            I’m just not sure that you can agree with Rowe that the ‘stock of money is supply-determined’ and also that it cannot be the cause of anything (i.e. an effect only). I think you might need to explain more about how these two (opposing) views are reconcilable.

            • Aha, ok now I’m starting to click onto what we’re talking about! Fair call.

              I misread what was going on with the hot potato concept – I am definitely in the equilibrium setting camp. My talk about transition mechanism is just the idea of the process with which we move to eqm in the market.

              But I want to think about this a bit more carefully. There must be some corresponding way we could see the external creation of money, and its corresponding use, as behaving in a way similar to the way Nick Rowe describes. And my answer here would be that it represents a different “monetary policy rule” – the fundamental reaction function of the central bank must be different in both cases.

              Now again here though, the credit growth we observe is caused by the increase in investor/housing demand – not the other way around. Policy isn’t doing anything – but banks are creating credit to meet a lift in demand. The quote suggested that the increase in credit occured exogenously and was pushing up demand for housing – which I’m not convinced about.

              Note, if it is just an increase in general demand lifing credit aggregates we’d normally look to increase the cash rate – as a result, this also suggests that the key “issue of interest” is something else entirely! In this case, systemic risk!

              • HJC

                By all means think more about how the two views can be reconciled. But from the point of view of the monetarists any “excess” creation of money is (before too long) inflationary and should prompt a reaction from the CB. It cannot be refluxed or destroyed as in an endogenous money economy.
                So this is different from what you are noticing – that money is being created specifically to facilitate property purchases and price rises, but the cause is not the money creation, it’s the purchase intentions themselves.
                I think there is a deeper issue here, but I was mostly trying to get a handle on your (what seems to me) new endogenous money thinking.

                • Ahhh, my thinking isn’t new – inflation comes from largely from expectations in of themselves, and this view is pretty much as mainstream as you can get! And in both the above views, the constraint comes from capacity and the way agents change prices and set expectations given that – hence why I feel there must be a way to tie them together.

                  I seriously do think there must be some correspondance here – the comment section on this is grand:


                • HJC

                  I think that ‘inflation set by expectations’ might be a bit high level for this kind of discussion, most sides would agree with that.
                  In the comments it didn’t look like Glasner and Rowe ever agreed. For what it’s worth, I think that Glasner has the stronger grasp on how credit money works though.

                • The physical economy and inflation expectations are central parts of what goes on though – and I often find them underplayed eg:


                  That would be why, even though Glasner and Rowe do not agree on the transition mechanism fully, their policy conclusions are very similar. I will try to have a sit down and see if I can more clearly write this out at some point 🙂

                • HJC

                  Fullwiler has a very good grasp on what is ‘possible’ in the modern banking system. Expectations should be based on this. Inflation expectations based on a perception that the CB can ‘expand the money supply’ are only ‘rational’ in a model that assumes this to be possible. But this is not a model that has endogenous money. To take this further we would be talking about the difference between Real Analysis and Monetary Analysis.

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  • philbest

    Matt, look up some good solid academic analysis of the South Korean housing market over the last few decades.

    They have had a housing affordability problem for decades. As recently as the 1980’s, this was not associated with credit at all; mortgage finance was so unavailable that young people saved most of the purchase price of a home, and in fact national savings were very high because of this.

    Very strict LVR’s have been a feature of the South Korean mortgage industry right from its early stages – 50% is typical, with tinkering taking it up and down by 20% each way. Yet even LVR’s or around this level have not stopped house prices maxxing out, young people locked out of the market, AND significant expansion in mortgage debt.

    “Supply” is everything. Economists who do not get it, need to be made to write this 1000 times like naughty schoolboys.

    • I think pretty much every economist in NZ recognises that any long-run concerns about the level of affordability are due to supply 🙂

      I suspect the RBNZ has something else in mind with LVR’s, namely concerns about banks taking on excessive risk in a situation where they are implicitly backstopped by government. I don’t think they should be talking about prices at all, but they seem to disagree on that point …

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