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RBA Speech: Future Directions in Financial Stability Analysis - Learning from Others and the Past; Another RBA warning on housing
Topic Started: 10 Oct 2014, 08:01 AM (391 Views)
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Future Directions in Financial Stability Analysis: Learning from Others, Learning from the Past

Rather than focusing on bubbles specifically, I'd like to step back and suggest a couple of guidelines that I think are likely to be important for staying on the right track when investigating financial stability issues.

First, get your stocks and flows straight. I believe that no model will capture financial stability dynamics unless it incorporates stocks as well as the flows into and out of them. The obvious case is a balance sheet. If you are interested in a topic related to financial stability, tracking flows of income and expenditure isn't enough. You must also track the underlying balance sheets – the debt, the liquidity position, leverage and so on. That is not a new insight. The role of balance sheets, and especially debt, was a central theme of work by Irving Fisher, Wynne Godley and many others.

I'd go further than that and say that balance sheets are not the only stock that matters. Physical stocks – of equipment, of real estate, or of particular types of capital goods such as ships – can also be very important. Long-lived physical assets can experience large price cycles because their supply – a stock – is inherently sluggish. Speculative bubble dynamics are actually not required for a painful boom-bust cycle in asset prices.

An example might help illustrate this point. The recent financial crisis was sparked by a meltdown in the US mortgage market. Mortgage defaults started rising rapidly, long before unemployment did. Many countries had booms in housing prices before the crisis. But only a few had large subsequent increases in mortgage defaults. And only in the United States did defaults rise dramatically before unemployment rose significantly. Why was that? As I've discussed elsewhere, a lot of factors contributed, not least the utter breakdown in lending standards in the US mortgage market (Ellis 2010). But also crucial was the overbuilding, the build-up of a supply overhang.

A good indicator of this is the US Census Bureau's series on the share of non-rental housing that is both vacant and for sale – the owner-occupier vacancy rate (Graph 2). You can think of it as a kind of unemployment rate for houses. The vertical line shows the December 2006 release, which was published in early 2007, before the financial part of the crisis had started.

Over more than half a century, this vacancy rate had never before risen so high or so quickly. It should be clear from this that the US housing market was in a different position to Australia's, or the United Kingdom's, or many other countries that had seen strong growth in housing prices up to that point. Because it had a supply overhang, the United States was set for a larger downturn than those other countries.[5] Looking at the flow of building work wasn't enough to see the problem. You also had to look at the resulting stocks.[6] Unfortunately a lot of people missed this point. That might have been partly because they weren't looking across different countries' experiences.

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Second, allow for incomplete information, uncertainty and thus default. Incomplete information is especially important when some people have information that others do not. From these asymmetries spring agency problems of the type that seem endemic in finance. There is already a substantial body of literature on these issues.[7] I expect that it will remain a fruitful area for research, particularly when one considers issues of organisational culture, fraud and so on.

The specific possibility of default on a loan is a fundamental building block in any investigation of financial stability issues: people who borrow cannot know for sure that they will be able to repay the debt. They might expect and plan to do so, but some unexpected bad event might prevent it. Neither borrower nor lender knows for sure who will default. While lenders might estimate a probability of default, they cannot observe it.[8]

Uncertainty about default induces lenders to impose constraints on how much they will lend to a particular borrower. Again, this is all in much older and relatively (though in some cases not entirely) mainstream literature. Some of these papers focused on companies as customers of the banking system (Bernanke and Gertler 1989); others applied similar ideas to the banks themselves, allowing for the possibility of bank runs (Diamond and Dybvig 1983).

So there are credit constraints. They take different forms but often boil down to working out how large a repayment the borrower can be expected to service. Credit constraints of this type can have macro consequences, and in particular they affect how we should interpret movements in certain macro-level quantities. If average interest rates fall, the loan amount that corresponds to that repayment is larger. Australia went from being a high-inflation country to a low-inflation country in the early 1990s. One result of that was that average nominal interest rates fell, and so the sustainable amount of debt rose relative to income – permanently. People should therefore not expect ratios of housing prices or debt to income to revert to their long-run, multi-decade averages. We have discussed this conclusion numerous times over the past 20 years.[9] Obviously if we are wrong about this, we would love to know about it. So far, nobody has come up with a counterargument to this idea, let alone a compelling one.

Instead we see some people confidently opining that property prices are however many per cent overvalued. What is the model behind these statements? As far as I can tell, there is never a real model, only an assumption that if the national ratio of prices to incomes or rents is however many percentage points away from some multi-decade long-run average, it must revert to that average. Yet there is no theory that says things should work that way. Credit constraints matter, and if those constraints should change, say because of regulatory change or disinflation, then the sustainable level of these kinds of ratios will also shift.[10]

Read more: http://www.rba.gov.au/speeches/2014/sp-so-091014.html
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Another RBA warning on housing

Callam Pickering

The Reserve Bank of Australia (RBA) has weighed in yet again on the introduction of macroprudential policies to slow down lending activity.

In a speech yesterday, the RBA’s Head of Financial Stability Luci Ellis -- who has been critical of such intervention in the past -- noted that “risks had been building” and that the RBA and the Australian Prudential Regulation Authority (APRA) are discussing “steps that could be taken to reinforce sound lending practices”.

Only a couple of months ago the RBA derided macroprudential policies as the “latest fad”. Now they seem completely on board, with RBA assistant governor Malcolm Edey last week noting that he expected “an announcement before the end of year”. What prompted the change in direction is unclear but it’s a welcome development.

As the centre of the debate is rising speculative activity -- particularly in Melbourne and Sydney -- which currently accounts for almost half of new mortgage lending (The dangers of a wildly imbalanced housing market, September 9). Obviously, according to Ellis, “that can’t continue forever”.

But such an outcome was easily predicted and it’s a shame that it has taken the RBA so long to recognise the potential risks. Low interest rates have always been associated with a rise in speculative activity and the risk increases further when rates are at a historically low rate. The longer they stay at a low level the more likely that imbalances develop and the greater the risk of a nasty correction.

Making matters worse is that a vast majority of investor activity has been unproductive. Less than a tenth of new investor activity has been directed towards increasing the housing stock, with the remainder an investment in existing property.

Given the low rental yields in Australia -- a result of awfully generous negative gearing and capital gains concessions -- few new investors buy existing property for their income flow. As a result, over 90 per cent of investor activity in the property market is speculation; a gamble that prices will continue to rise.

It goes without saying that this is a particularly risky strategy, although one that has proved lucrative in the past. But there is good reason to believe that Australian house prices won’t replicate these past gains (Why property is no longer a safe bet, September 10).

Even the RBA governor Glenn Stevens has questioned whether ‘baby boomers’ have allocated too much of their wealth to the property sector (Have baby boomers made a big investment mistake?, September 4).

Currently it remains unclear what form these macroprudential policies will take. Based on previous musings by the RBA, they appear to favour increasing the interest rate buffers that banks apply to customers seeking out a loan.

By comparison, other countries have imposed restrictions on the level of loan-to-valuation ratios (LVRs) or house price-to-income ratio. It’s not particularly clear where APRA sits on this discussion and ultimately it will be their role to enact and monitor these policies.

But what can we expect from such policies? According to a recent report by the International Monetary Fund (IMF), “empirical studies thus far suggest that limits on loan-to-value and debt-service-to-income ratios have effectively cooled off both house price and credit growth in the short term”.

Restrictions on LVR borrowing in New Zealand has resulted in a noticeable decline in risky lending and house price growth has moderated somewhat – although on the latter it can be difficult to disentangle the effect of macroprudential policies and the impact of interest rate normalisation.

The housing market in England -- which introduced macroprudential policies only a few months ago -- is also showing signs of moderation.

On the basis of that evidence, property investors in Sydney and Melbourne should be getting nervous and new investors may want to be a little more cautious.

However, it’s important to note that macroprudential polices are not a panacea for all our property problems. They are not designed to address affordability nor are they necessarily equitable. Addressing housing affordability in the medium-term will require a very different approach to housing by governments at the state and federal level and by our major banks.

It’s also worth noting that an overzealous regulator could potentially crash the housing market if they introduce overly harsh macroprudential policies. Given the RBA and APRA have been slow to act and overly cautious, that doesn’t seem like it’ll be a risk but it is worth keeping in mind.

In my opinion, our regulators have taken too long to act and any attempt to unwind our imbalanced property market will result in prices declining somewhat (though that shouldn’t be interpreted as a reason to avoid intervention). The extent to which will largely depend on the economic climate at the time and whether low interest rates can support non-mining investment and employment.

It’s hardly ideal for house prices to be falling right now -- not while we face so many other challenges -- but the systemic risks of not doing anything vastly outweigh any short-term pain.

Read more: http://www.businessspectator.com.au/article/2014/10/10/property/another-rba-warning-housing
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