What property investors need to know about impending macro-prudential controls

We all know it has to come to an end at some time.

Something is going to stop this property boom, which has been particularly strong in Sydney and Melbourne.

And while most of us thought that it would be the Reserve Bank of Australia (RBA) raising interest rates, things may in fact be slowed down by macro-prudential controls on “high risk” lending.

Now since this latest buzzword is not in the vocabulary of many property investors, let’s look at it in more detail with a Q&A session:

What are macro-prudential controls?

These are financial regulations aimed at minimising the risk to the financial system as a whole, while traditional micro-prudential regulation limits stress individual institutions.

In essence we are talking about measures that are not associated with monetary policy (raising interest rates) which are designed to slow lending, particularly to property investors.

These could be policies such as capping loan-to-value ratios or capping debt-to-income ratios or stress testing borrowers capacity to cope with rising interest rates.

Why now?

With property prices (particularly in Sydney and Melbourne) continuing to rise at a rapid rate, the RBA and the Australian Prudential Regulation Authority appear to be considering introducing macro-prudential policies to ease mounting pressure in Australia’s property sector.

What’s happened is that over the past 20 years home prices in Australia have almost trebled while average household income has not kept up. The difference has been made up with debt. The ratio of household debt to household income is now 150 per cent – a historic high.

In their September board meeting minutes, the RBA notes that “additional speculative demand could amplify the property price cycle and increase the potential for property prices to fall later.”

According to the RBA’s Financial Stability Review, “the Bank is discussing with APRA, and other members of the Council of Financial Regulators, additional steps that might be taken to reinforce sound lending practices, particularly for lending to investors”.

Rather than raise interest rates, which would have a sledgehammer effect on our whole economy, it seems that the RBA would like to specifically limit lending to “high-risk” property investment loans.

Now don’t get me wrong…

The RBA is NOT saying we have a property bubble or that prices are going to crash. Instead they said:

“The low interest rate environment and, more recently, strong price competition among lenders have translated into a strong pick-up in growth in lending for investor housing – noticeably more so than for owner-occupier housing or businesses. Recent housing price growth seems to have encouraged further investor activity.”

As a result, the composition of housing and mortgage markets is becoming unbalanced, with new lending to investors being out of proportion to rental housing’s share of the housing stock.”

They continued with:

“The risks associated with this lending behaviour are likely to be macroeconomic in nature rather than direct risks to the stability of financial institutions… a broader risk remains that additional speculative demand can amplify the property price cycle and increase the potential for prices to fall later, with associated effects on household wealth and spending.

Yes, if property prices keep going up, they’ll have the potential to fall later. I guess that’s the property cycle isn’t it?

Have macro-prudential measures been tried elsewhere?

While you may not have heard of this before, there’s nothing new in these policy instruments, but their use mostly pre-dates the financial deregulation that occurred in the early 1980s. 

However the term became fashionable again in the wake of the GFC, as it became clear that systemic risks that had built up unchecked in the global financial system added greatly to the severity of the crisis.

Macro-prudential regulation is advocated by the International Monetary Fund, has been widely adopted around the world including Britain, New Zealand and a number of Asian countries where housing markets were perceived to pose risks to financial stability, and has become the flavour of the month in Australia.

However, assessing its effectiveness is complicated.

Across the ditch, the Reserve Bank of New Zealand last year decided to limit the proportion of bank loans with a loan-to-valuation of more than 80% to 10% of new lending in response to a housing boom in Auckland and Christchurch. Even so, property prices have once again started surging, causing the Bank to raise interest rates.

And recently the Bank of England announced that it would restrict the proportion of loans that are 4.5 times the borrower’s income to 15% of new lending. Lenders are also required to assess a borrower’s capacity to absorb a 3% interest rate hike in the first three years of the loan.

Can’t the RBA just raise interest rates?

Yes they could, but increasing interest rates is a blunt instrument that will not only affect our property markets but our economy as a whole, and that’s not what the RBA wants.

Fact is our economy is just limping along – growing at a woeful 2% (annualised) in the second half of 2014 and predicted to grow at a below trend 3% in 2015. This means raising interest rates could stop our economy dead in its tracks as consumer confidence and therefore spending dips.

On the other hand, macro-prudential policies are seen as providing policymakers with a more targeted set of instruments that might complement or even substitute for changes in official interest rates.

What does the government think about all this?

Recently, Treasurer Joe Hockey endorsed macro-prudential controls, provided they are “targeted” and “time-limited.”

His support seemingly came about after the International Monetary Fund (IMF) endorsed macro-prudential controls as “the first line of defense to address potential financial stability threats” at the G20 meeting recently held in Cairns.

Will these measures slow our property markets?

While they may do so for a short time, they probably won’t have the desired effect in the long term.

While rising property prices tend to be blamed on ugly, greedy property investors, there’s much more to it than that.

The combination of the Chinese economic revolution, which fed an Australian commodities boom and fuelled our economy; an immigration program which added a net one million people over three years at its peak; and a general shortage of housing at a time of historically low interest rates has produced a long-running property bull market driven by demand.

Sure investors contributed to property price growth, but in truth property investors only account for around 38% of the value of total loans.

In other words, even if the RBA targets “risky loans” from property investors, first home buyers, upgraders and downgraders will still remain out there pushing up property values. As will all the hordes of overseas investors who’ve been fuelling our “off the plan” and new apartment markets.

Are property investors really a threat to our financial system?

Probably not!

You see, the RBA analysed the types of households and the ages of Australia’s property investors in its biannual Financial Stability Review and found it was the highest-income households that owed most (60%) of the total investor housing debt.

Compared to homebuyers who often take out loans with very high loan-to-value ratios (using Lenders Mortgage Insurance), investors are “fairly well placed to service their debt” and “typically (used) less than 30% of their income to service their total property debt”.

Interestingly, more than half are ahead on their mortgage repayments and 70% of property investors are 40 or over, which is important because the unemployment rate for this age group is very low.

In fact, the RBA data shows that investors are typically cashed up, know what they are doing and present little risk to the financial system or the economy generally.  

Now I’m old enough to remember a regulated banking industry and credit squeezes that restricted funds for investors and businesses. Paul Keating introduced deregulation and a “free market” for many reasons: efficiency and productivity and equity because regulation simply wasn’t working.

While some would argue, “let the markets run their own course”, history shows that it is desirable to moderate our surging property markets in some way, otherwise we’re setting ourselves up for another property crash.

But remember, it is not ugly greedy investors that are causing our housing crisis.

It is mainly related to insufficient housing stock (other than in our CBDs), a lack of infrastructure and low interest rates.

The fact that investors are taking advantage of the low interest rate environment to purchase the type of properties that are in tight supply is not surprising. It’s shrewd business and the way capitalism and our housing markets have always worked.

So what’s the answer?

Clearly I’m not qualified to give one considering the experts, our authorities and economists who are much smarter than me have not been able to.

However, maybe it’s a mixture of something like allowing the right type of properties (ones that are sought by a wide demographic of people) to be built in the right locations, then enforce prudent banking practices and keep interest rates appropriately calibrated.

We’re in for some interesting times ahead.

Michael Yardney is a director of Metropole Property Strategists, a company which creates wealth for its clients through independent, unbiased property advice and advocacy.