November 28, 2016
Mortgage rule change is a Pyrrhic victory for first-time buyersPosted in Sunday Business Post · 89 comments ·
Let’s be clear, when housing supply is stuck, any increase to housing demand will produce higher prices. The Central Bank understands this logic and this is why it relaxed deposit rules last week. The deposit rules were relaxed in order for prices to rise, in order to coax builders who are sitting around waiting for prices to rise, to begin to dig foundations. This is state-sanctioned house price inflation. Nothing less. It’s like a hostage situation.
The builders/developers in cahoots with each other declare that they can’t build and make profit at current prices, so building stalls. They then put out a ransom, which is that if the state can engineer prices higher, they will build.
The state is, therefore, a hostage and as first-time buyers are voters, the politicians have an interest in getting things moving. So the state leans on the Central Bank to loosen things up. The Central Bank obliges. Under the cover that it has nothing to do with house prices, it claims to simply oversee bank lending. Prices rise.
Ultimately, the ransom is paid over by the first-time buyer to the builders, and the state, acting as the broker, gets a bit more tax revenue, the banks make a few more quid profit and we solve a supply problem not with efficiency, which would be good, but with house price inflation which is unambiguously bad.
Quite apart from the politics of this, the economics are quite straightforward. This notion that increased demand (when supply is rigid) will push up prices is pretty uncontroversial in microeconomics. The process works through two basic channels.
If it is easier to get a mortgage, first-time buyers will obviously “bring forward” their purchase because they have to save less. This is very clear. As more people bring forward their purchases, total demand goes up and prices rise because there are more bids, yet no more offers. The estate agents will (naturally) play off one first-time buyer against another and the upward momentum in prices will ensue.
However, there is another mechanism at work, which is less well understood, but can be actually more significant. This mechanism involves people’s expectations of where prices are going next. Once you change a policy – particularly a policy that was so successful and quite rigid – you trigger a whole host of other consequences.
The main one of these is the expectation that prices will go up because it is easier to borrow and will be easier in the future. Once prices rise, there is the natural momentum in expectations. So 5 per cent this year leads people to expect 7 per cent next year and so on.
Wage demands are also reframed accordingly. Additionally, there is a human tendency to conclude that if the Central Bank is prepared to reverse policy once, it will do so again.
Therefore, there is a further psychological mechanism on the part of buyers and sellers that now expects more “help” for first-time buyers. “Help” means that there is now a floor on house prices and “help” means higher prices by lowering the savings bar necessary to trigger a mortgage. As for the first-time buyer — the so-called beneficiary in all this — will they benefit? Is this prudent for buyers?
Okay, here is the new situation faced by an individual first-time buyer. She will now be able to borrow any amount with a deposit of 10 per cent. Up to last Thursday, she could have been approved for a mortgage with a deposit of 10 per cent for borrowings up to €220,000. She needed a 20 per cent deposit for all amounts over that. Now if she’s buying a home for €300,000, she will qualify for mortgage approval with a deposit of €30,000. Whereas previously, she needed a deposit of €38,000.
So will this individual be better off? At first blush, it looks like she will be, but a little knowledge of macroeconomics should cause us to rethink this rosy conclusion. The first fundamental rule of macroeconomics is known as the paradox of aggregation. This rule in plain English means that what is good for the individual is not always good for the collective. Where all first-time buyers act individually, competing with each other in the market for houses, they also influence each other profoundly.
This means that lowering the deposit ratio is great for the individual and gives her a leg up in the market, so long as no other first-time buyer avails of the new deposit flexibility. When all the rest of the first-time buyers avail of the same break, it simply cancels out the individual advantage and forces everyone to compete with each other at higher prices if the market is tight.
The same thing happens when the market is slack and faced with too many houses and broken balance sheets like it was in 2008. Banks would tell the individual who had too much debt to sell his extra apartment to fix his balance sheet. This was good advice so long as the bank didn’t tell every bankrupt the same thing because if they did (which they did) everyone would sell at the same time and prices would just fall and the seller would be faced with the same problem of trying to sell but at lower prices.
The best way to visualise this is to imagine you are at a football match and you are all siting down watching the game. Then suddenly the guy in front of you stands up to get a better view. Then you have to stand up to get a better view and in no time the whole stand is standing when we had all paid to sit.
This is how it goes with housing. What looks to the individual as being a unique advantage for her, is not because everyone can avail of it.
Rather than giving one person an advantage, because everyone avails of it and responds identically, every individual’s benefit is cancelled out by everyone else’s. We end up having the same problem, at higher prices.
This will happen here too and the Central Bank, which for the past two years has been the guardian of prudence, has turned itself into the agent of profligacy.