Analysis: Don’t count your LVR chickens

The Reserve Bank is widely expected to signal a relaxation of its unloved Loan to Value Ratio restrictions on home buyers. Politicians and first home buyers hope any relaxation will help them buy a house sooner, but they should be careful what they wish for, writes Bernard Hickey.

Earlier this month the Reserve Bank gave its most concrete indication yet that it was looking at relaxing its restrictions on Loan to Value Ratios for home buyers. It may give more detail in his half yearly Financial Stability Report due out on Thursday, but the regulator of banks is clearly more comfortable that the heat has finally gone out of the market and preparing to loosen restrictions it said in mid 2013 would be temporary. Nearly five years on, the driver is finally looking at releasing the hand brake, albeit very, very slowly.

But before first home buyers pop open their bottles of Lindauer and call their friendliest banker, they should understand how these restrictions are currently structured and what a loosening would mean in practice. They should then step back and ask themselves what they're really wishing for, and how likely it is to happen any time soon.

Firstly, there's an unfortunate perception that relaxing the restrictions would make it easier for first home buyers to buy a house at current prices. That's not true for a couple of reasons.

1. Completely removing the current version of the LVR restrictions would simply make it easier for existing home owners to spend more to move into a more expensive house, and for that house to be snapped up by a rental property investor. That landlord would be able to easily outbid a first home buyer because they invariably have more equity to offer due to having been in the market and benefiting from capital gains that first home buyers haven't had. That means they would have much more borrowing power and renewed expectations of tax-free capital gains to fuel their appetites. Unless there is an immediately offsetting and simultaneous reduction in demand from migrants or rental property investors because of changed regulations, or a big immediate increase in the number of houses, prices could quickly rise ahead of first home buyers. They would miss out to rental property investors and face even higher entry prices if they were to get lucky.

2. Many believe that the Reserve Bank's changes to its LVR restrictions in mid 2015 and mid 2016 allowed it to carve first home buyers out of the restrictions and would allow it to remove restrictions for first home buyers and not for rental property investors. This is not true. The Reserve Bank treats all owner-occupiers the same in its restrictions, which means older home owners who move from one house they live in to the next would be able to pay much more for another house, thus pushing up the price of all houses and rewarding all existing home homers with yet more untaxed capital gains. That would make homes more expensive for all buyers including first home buyers, not just existing home owners. The Reserve Bank could, in theory, leave the restrictions on landlords, but relax them for owner occupiers. But that would not stop all landlords from buying, given about 14 percent of landlords nationally buy homes without needing a mortgage. In Auckland, around 30 percent of landlords are cash buyers, so they would be unaffected.

Secondly, most people salivating over the prospect of a relaxation think it is a 'digital' decision for the Reserve Bank (ie it will either leave them on or remove them completely). The impression built up in recent days is they are about to be completely removed, possibly as early as Thursday. That is just plain wrong.

Reserve Bank Governor Grant Spencer made very clear in comments on November 10 that a complete removal was nowhere near imminent. The bank was simply thinking about what criteria it would use to indicate when the market was cool enough to think about taking them off. Even then, any removal would be gradual and cautious.

"We're certainly reviewing the LVR restrictions and the criteria that we would adopt for their removal, and we'll be saying more about that at our FSR in a couple of weeks," Spencer said then.

"When we introduced them we certainly said these were a temporary measure and at some point we would look to remove them, but if we're looking to remove them that wouldn't be done in one hit. It would be a gradual, more cautious approach," he said then.

So the Reserve Bank is more likely to say that it would like to see house price inflation dormant for a certain period or maybe even some deflation. It may also want certainty that some of the demand and supply drivers, namely net migration and housing supply shortages, were gone before removing the restrictions. It could, for example, lift the speed limit for owner occupier loans needing less than a 20 percent deposit from 10 percent of lending to, say, 20 percent, and then on up to 100 percent over a period of many years. That would not remove the need for a 20 percent deposit for most, just 10 percent of borrowers, many of whom would be existing owner occupiers.

It's worth remembering too that when the Reserve Bank introduced its first 'blunt' version of LVRs in mid 2013 that did not discriminate between investors and owner-occupiers, it hoped they would be temporary and would immediately take the steam out of the market. Instead, prices rose another 14 percent over the next two years. So the Reserve Bank introduced a 30 percent deposit requirement in Auckland for landlords in mid 2015, hoping that would put out the fire. Instead, prices rose another 22 percent by mid-2016. Only once the full 40 percent deposit requirement for landlords was introduced from mid-2016 has the market finally cooled, and it's only in the last three to six months that the bank has been convinced the rise has finally stopped.

But remember, prices rose 46.5 percent AFTER the Reserve Bank started putting on restrictions to slow the market. This latest version 3.0 of the policy of a 40 percent deposit requirement for landlords was a third desperate attempt to slow the market. The Reserve Bank is unlikely to be so sure of its success when the first two versions of the policy failed to slow the market and only a third and dramatic escalation cooled the market. If it was being consistent and symmetrical about its policy, it would wait for prices to fall back 31 percent to their mid 2013 levels before removing the restrictions.

That is unlikely, but a full and immediate removal is just as unlikely. A very graduated and cautious removal after various milestones have been met for migration falls and housing supply rises are more likely.

Some, including Finance Minister Grant Robertson, hope that the new Labour Government's assurances about a ban on foreign buyers, the removal of negative gearing for landlords and the extension of the two year bright line test for capital gains for property traders to five years might give the Reserve Bank some reassurance that some demand is being taken out of the market, and that it can therefore take these offsetting factors into account now as it relaxes the rules.

However, all of those changes have yet to be enacted or have any effect, just like the Government's promises to ramp up building of affordable homes. The Reserve Bank is likely (and has said) that it will be cautious about how it takes into account future reductions in demand or increases in supply. It has seen so many promises in the past that have come to nothing, and so many surprises pushing prices up, that it would be understandable it it wanted to see the whites of the eyes of these changes before easing restrictions because of promises that they are coming.

'Trust us, we'll help you out'

Robertson, who is already likely to have been briefed on the FSR, was asked about the future of the LVRs at a stand-up news conference before the Labour Caucus meeting on Tuesday. He pointed to the Government's plans to restrict demand by foreign buyers and landlords as factors that may give the bank room to move, although he cautioned the bank was independent and would make its own decision.

"Some of the initiatives that we are bringing in on the demand side will take some time to come into force, but no doubt the bank will have something to say about that tomorrow," Robertson said.

Asked if it was time for the LVRs to be removed, he said: "From the beginning we have been concerned about the impact of LVRs on first home buyers. Obviously we have seen some change in the balance of the housing market between investors and first home buyers. We want to do everything we can to support first home buyers in. That remains our chief concern with the implementation of LVRs."

Ease restrictions to stop prices falling?

Robertson was then asked if the various Government measures would add too much downward pressure on the housing market at a time that house prices are flattening and falling.

"That will be exactly the kind of issue that the Reserve Bank governor will take into account. We do have a number of measures designed to clamp down on speculation. We also have to get the creation of and the building of houses on the supply side done. So that will take a little bit of time, but I am sure that the Resreve Bank Governor will be well aware of the measures we have," he said.

Asked if the extra demand and supply side measures meant the Reserve Bank would not need restrictions on LVR buyers, he said: "Well, that’s right. We’ve always been concerned about them hurting first home buyers. But this is an independent decision for the bank to make. They will be well aware that we have a number of measures to crack down on speculation and stimulate supply. The issue is: they take a little bit of time to come on stream and have effect."

Asked about figures showing first home buyers nationwide were increasing their share of buying, Robertson said: "They are doing better, they are doing much better. But we still need to dramatically increase the supply of affordable homes for them."

This is true nationally, but in Auckland the share of buying by landlords has actually risen from 36 percent when the restrictions were introduced in 2013 to 41 percent now.

The problem for Robertson is that the bank cannot just remove the restrictions for first home buyers. It would also have to remove them for all owner-occupiers, including existing home owners. Those two groups of owner-occupiers make up nearly 65 percent of the market. That would mean taking the brakes off for 65 percent of buyers.

Chart from data collected and displayed by Core Logic.

'We're sceptical on increased supply'

Meanwhile, real estate agents and rental property investors are already rubbing their hands together with the assumption that those brakes are about to come off and the property market can start racing again. That would be great for existing home owners and those who are paid by commissions on higher turnover, but are unlikely to benefit first home owners in the absence of other substantial measures to dampen demand from population growth, landlords and existing owner-occupiers, as well as increasing housing supply.

The Reserve Bank itself estimated earlier this month that as many as half of the 10,000 new homes a year being planned by the Government would actually just offset houses that would have been built anyway by the private sector. That means the Reserve Bank has already discounted some of the supply impact that Robertson hopes the Reserve Bank can 'bank' on when making its judgement about whether to relax the restrictions.

Why not let prices fall?

The other elephant in this room is what all the players except first home buyers are unwilling to talk about: falling prices. Robertson and Spencer appear determined to take action on the assumption that prices cannot fall or be allowed to fall, including to the extent of loosening restrictions to stop further falls.

The dirty little secret of the debate about housing affordability is that house prices would need to fall substantially to become affordable again to first home buyers. Simply building more homes and restricting migration will not be enough, given previous shortages and house price rises. Prices need to fall to make housing affordable for first home buyers on average wages any time soon.

Even talking about allowing or encouraging prices to fall would be politically suicidal because there are more home owners than first home buyers, and home owners vote at much higher rates than first home buyers and renters. The Reserve Bank would also not be keen to suggest such a fall in prices, given it could slow economic growth by slowing household consumption growth, and may cause banks some discomfort. It would not be fatal discomfort though, given the Reserve Bank's own stress tests show the banks could easily cope with a 50 percent fall in Auckland house prices.

The brutal truth for first home buyers is that politicians and central bankers don't really want to help first home buyers that much. If they did, they would be making policy to actively drive house prices down, or at least not relaxing restrictions just as house prices in Auckland were showing signs of falling.

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