Brendan Burgess
Founder
- Messages
- 52,115
From Ronan Lyons's submission which is attached
In relation to LTI restrictions, however, there is no clear theoretical justication. Whereas there is an obvious market failure and externality by failing to limit leverage, it is clearly in the interest of financial institutions to assess the affordability of the mortgage in any case. It is not clear what LTI restrictions will bring over and above the impact of LTV restrictions. If the wider impact of the LTI restriction was neutral, the case could be made for both measures but there are negative side-effects of LTI restrictions, theoretically.
The first relates to capital markets. As proposed, limiting the ratio of the total mortgage to total gross household income is an extremely blunt tool.
It is ignorant of two features: the user cost regime (in particular interest rates) and spatial variation (discussed below). The average nominal mortgage interest rate in the decade to 1995 was over 10%, compared to less than 4% in the decade to 2012. This has a huge impact on affordability, above and beyond a simple LTI ratio. In particular, a much higher ratio of debt to income is possible in a regime where interest rates are low.
Some have argued that it would be possible to correct for this issue, by instead using a maximum ratio of the mortgage repayment (suitably stress tested) relative to disposable income. This still misses significant considerations, by conflating the mortgage for the total input costs of day-to-day life.
Consider a household making the choice between two homes of comparable size. One, however, is closer to where the family work and go to school,
and is also more energy efficient. While its mortgage repayment of e1,400 is above the maximum threshold relative to its disposable monthly income, the
family would be better off in that house than in the other home, where they would need to spend e1,100 a month on the mortgage plus an additional
e350 on petrol and e100 on domestic energy bills.
Under an LTV restriction, a household merely has to save 10% more to afford a house that offers lower energy or petrol bills, which is justified due
to the externality costs of excessive leverage. Under an LTI restriction, a household with a set income will never have the option of buying such a
house.
Even switching to monthly disposable income, rather than gross income, the LTI restriction disincentivizes healthy investment. In practical terms, LTI
will lead to greater sprawl and congestion (as well as greater fuel consumption), as it does not distinguish between what are in effect close substitutes:
additional mortgage debt compared to additional petrol or energy bills.
Spatial issues
It is possible to argue that the LTI could be tweaked even to deal with these issues, by calculating the combined burden of mortgage debt and fuel/energy
costs associated with a particular property, presumably against a higher maximum ratio relative to monthly disposable income. Even if such a complicated
system were introduced, however, it remains ignorant of the huge variation in house values around the country and the (healthy) reasons for this.
Currently, in the Irish housing market, hedonic regressions indicate that there is a 15-fold variation the price of the same dwelling { a three-bed
semi-detached house { around the country. Whereas the value of a three bed semi-detached house in Roscommon in late 2014 is below e50,000, the
value of the same dwelling in parts of South County Dublin is over e700,000. The variation in property market values is far greater than the variation
in household incomes, which { for comparable households { is closer to 50% than 1500%. Indeed, for certain sectors, in particular the public sector, there
is no variation in wages between like-for-like households.
This huge variation in values, compared to incomes, is entirely healthy. Households with comparable incomes and comparable space requirements
have the opportunity to choose different bundles of amenities. A particularly important amenity for many households is access to a thick labour market,
and for many households, the depth of consumption amenities offered by urban centres is of great value, thus proximity to larger cities is important.
But such considerations are not important for all, hence a fraction of the population chooses to live in rural locations.
Practically speaking, however, this means that an LTI restriction can never be binding across all segments of the market. Taking round numbers for
simplicity, suppose the typical first-time-buyer household earns e50,000 and they are looking for a three-bedroom semi-detached home. If a maximum LTI
of 3.5 is in place, this means their mortgage can be no more than e175,000 and the price of the home they buy can be no more than e220,000 (assuming
a 20% deposit). This is useless, both in the large parts of the country where three-bedroom semi-detached properties are worth less than half that limit
and a different kind of useless in parts of Dublin where the same home is worth more than twice that limit. Whereas the LTV is a clear measure of
leverage (and thus a maximum LTV is protection from leverage), the LTI is an arbitrary limit.
In relation to LTI restrictions, however, there is no clear theoretical justication. Whereas there is an obvious market failure and externality by failing to limit leverage, it is clearly in the interest of financial institutions to assess the affordability of the mortgage in any case. It is not clear what LTI restrictions will bring over and above the impact of LTV restrictions. If the wider impact of the LTI restriction was neutral, the case could be made for both measures but there are negative side-effects of LTI restrictions, theoretically.
The first relates to capital markets. As proposed, limiting the ratio of the total mortgage to total gross household income is an extremely blunt tool.
It is ignorant of two features: the user cost regime (in particular interest rates) and spatial variation (discussed below). The average nominal mortgage interest rate in the decade to 1995 was over 10%, compared to less than 4% in the decade to 2012. This has a huge impact on affordability, above and beyond a simple LTI ratio. In particular, a much higher ratio of debt to income is possible in a regime where interest rates are low.
Some have argued that it would be possible to correct for this issue, by instead using a maximum ratio of the mortgage repayment (suitably stress tested) relative to disposable income. This still misses significant considerations, by conflating the mortgage for the total input costs of day-to-day life.
Consider a household making the choice between two homes of comparable size. One, however, is closer to where the family work and go to school,
and is also more energy efficient. While its mortgage repayment of e1,400 is above the maximum threshold relative to its disposable monthly income, the
family would be better off in that house than in the other home, where they would need to spend e1,100 a month on the mortgage plus an additional
e350 on petrol and e100 on domestic energy bills.
Under an LTV restriction, a household merely has to save 10% more to afford a house that offers lower energy or petrol bills, which is justified due
to the externality costs of excessive leverage. Under an LTI restriction, a household with a set income will never have the option of buying such a
house.
Even switching to monthly disposable income, rather than gross income, the LTI restriction disincentivizes healthy investment. In practical terms, LTI
will lead to greater sprawl and congestion (as well as greater fuel consumption), as it does not distinguish between what are in effect close substitutes:
additional mortgage debt compared to additional petrol or energy bills.
Spatial issues
It is possible to argue that the LTI could be tweaked even to deal with these issues, by calculating the combined burden of mortgage debt and fuel/energy
costs associated with a particular property, presumably against a higher maximum ratio relative to monthly disposable income. Even if such a complicated
system were introduced, however, it remains ignorant of the huge variation in house values around the country and the (healthy) reasons for this.
Currently, in the Irish housing market, hedonic regressions indicate that there is a 15-fold variation the price of the same dwelling { a three-bed
semi-detached house { around the country. Whereas the value of a three bed semi-detached house in Roscommon in late 2014 is below e50,000, the
value of the same dwelling in parts of South County Dublin is over e700,000. The variation in property market values is far greater than the variation
in household incomes, which { for comparable households { is closer to 50% than 1500%. Indeed, for certain sectors, in particular the public sector, there
is no variation in wages between like-for-like households.
This huge variation in values, compared to incomes, is entirely healthy. Households with comparable incomes and comparable space requirements
have the opportunity to choose different bundles of amenities. A particularly important amenity for many households is access to a thick labour market,
and for many households, the depth of consumption amenities offered by urban centres is of great value, thus proximity to larger cities is important.
But such considerations are not important for all, hence a fraction of the population chooses to live in rural locations.
Practically speaking, however, this means that an LTI restriction can never be binding across all segments of the market. Taking round numbers for
simplicity, suppose the typical first-time-buyer household earns e50,000 and they are looking for a three-bedroom semi-detached home. If a maximum LTI
of 3.5 is in place, this means their mortgage can be no more than e175,000 and the price of the home they buy can be no more than e220,000 (assuming
a 20% deposit). This is useless, both in the large parts of the country where three-bedroom semi-detached properties are worth less than half that limit
and a different kind of useless in parts of Dublin where the same home is worth more than twice that limit. Whereas the LTV is a clear measure of
leverage (and thus a maximum LTV is protection from leverage), the LTI is an arbitrary limit.