Housing Market Instability, Equity Loans and the Wider Economy

by Ken Gibb

I was going to write about something else today but then my wife forwarded me the speech made yesterday by David Miles, member of MPC of the Bank of England, at a conference in Dallas. His paper ‘Housing, leverage and stability in the wider economy’ has been press-released by the Bank of England [1]. His paper speaks to the capacity of central banks to help reduce leveraged debt in the housing market and thereby reduce housing market ‘turbulence’ in the wider economy. High leverage e.g. a 5% down-payment can leave owners highly exposed to small falls in house prices, let alone adverse movements in interest rates). This also speaks to earlier discussion regarding controlling house price volatility and the furore around the possible wider impacts of Help to Buy 2 and whether house prices ought to be an explicit target to be monitored and indeed intervened against by the Bank.

The argument in the paper is as follows (p.2): ‘I want to consider some of the policies – including monetary policy – that might be used to reduce the risks of turbulence in the housing market causing widespread damage. I will argue that one factor is particularly significant…leverage: that is the fact that houses are bought with such a high proportion of debt. In that context, I consider the advantages of (and obstacles to) greater use of outside equity in financing house purchase’.

His point is that the classical tool of market management, interest rates, is at best a blunt instrument. And of course the user cost of capital (broadly – interest rates minus expected house price gains) may be negative and unless one believes house price change makes up an unfeasibly large share of the CPI, a more housing/mortgage target set of policy instruments will be required. This will be particularly so according to Miles where the level of interest rates required to bring stability to the housing market are not those required in the interest of the wider economy – a classic case of too few policy tools.

So what is to be done? He repeats the recent Bank line that a ‘range of macro-prudential policy levers could be used to mitigate risks to financial stability emanating from housing markets, graduating from more intensive supervision…through variations in capital requirements on mortgage lending to limits on loan to income and loan to value ratios (p.8)’ (though the Governor viewed the latter as voluntary exhortation in recent pronouncements).

The paper by David Miles considers how to seek to reduce the proportion of home purchase that is debt and thereby reduce leverage and the instability, risk and exposure associated with it – by increasing the level of equity. How so?

A first way would be to use greater use of individual equity through lower LTV ceilings which if enforceable would of course increase the period required to save and the average age of first time buyers would remain high.

Alternatively, Miles suggests some form of outside equity or equity-like funding sharing the risk between the owner-occupier and the outside provider of funding. Such things, he points out have been looked at before in Australia, the UK and the USA (e.g. equity loan finance wherein the owner retains rights over all of the property unlike shared ownership).

The scope for developing this area further has been widely discussed by academics like Christine Whitehead, Judy Yates and other colleagues at Cambridge’s CCHPR.  In fact HTB1 looks very like such a risk-sharing device where the lender receives nothing for five years prior to a regular payment before recouping (hopefully) at sale. As Miles points out, in these cases the equity loan provider shares the risk of property price falls as well as the opportunity of sharing appreciation.

The UK is fortunate in not having tax relief on mortgage interest for home owning mortgage debt as this would, as David Miles correctly notes, act as a disincentive to reducing debt via equity loans (since deductibility depends directly on debt size). Moreover, Miles argues that even a small equity loan stake would have a major impact on leverage if home owners can provide an element of home equity themselves. His example in the conclusion of his paper is that a 10% down payment by the borrower subsequently augmented by a 20% equity loan changes the leverage ratio from 10 to 3.333 (plus the cumulative affordability saving by having lower repayments on a smaller mortgage).

The big question is how to create a successful market in equity loans, in effect, providing a private sector version of HTB1? Other questions are – should it be national or regional, should it be targeted to first time buyers and should it have ‘affordable’ ceilings placed on purchase prices? How do we encourage banks and other equity investors to tie up scarce capital in this way?

David’s paper is in effect it seems to me to be saying that the BoE’s macro prudential and monetary policy measures can influence leverage but that a promotion of an equity loan market for home owners of 10-20% of value could, on an incentive-compatible basis, share risk and significantly reduce leverage and the wider problems that go with it. He recognises that establishing such a market will not be easy: ‘various shared equity products in the past (most of which were not equity loans) have a patchy success rate. But the recently launched equity loan product provided by the UK government for those buying newly built homes (under its Help to Buy scheme) has proved popular (pp.17-18)’.

All in all, an interesting discussion – a possibly larger role for Equity Loans for macro deleveraging reasons though big questions remain as to how to establish and then make such a market work. It is good to see that prominent thinkers on the MPC are encouraging debate even if they are on the one had writing in a personal capacity but, at the same time, being press-released by the Bank. As usual it is difficult to tell how much internal consensus there is about this direction of travel.

[1] http://www.bankofengland.co.uk/publications/Pages/news/2013/132.aspx