Some thoughts on regulation
First of all, we would like to notify our readers that we are now on twitter @swehousingmafia. As we still use fixed-line telephones to buy and sell securities, we expect it to take a while for us to get used to this modernity, but we will do our best! Now to our first-ever blog entry.
Having written “The Swedish Housing market notes” (Notes on the Swedish housing market – 29 dec) we thought we should use it to provide further analysis of policy and other issues, which might also provide the added benefit of summarising some of our ideas in a shorter (?) format.
We claimed that the extreme rally in house prices can largely be explained by excessive propensity for consumers and banks to increase mortgage debt (beyond the optimum level in a free, unencumbered market), driven by policy errors such as poor regulation of mortgage underwriting, rent controls, tax code (deductibility of interest and capital gains deferral) and market intervention through the government mortgage bank SBAB. In addition, animal spirits such as greed, recency bias and myopia further amplify the effects. (We must provide a disclaimer by saying that we are not convinced that a fully unencumbered market is ideal either, mainly due to psychological weaknesses in market participants – but we must consider all effects to make the best choice.)
In this post we try to describe the source and interaction of such policy errors. To summarise, the argument goes roughly as follows: by capping rents to protect the lowest income households (and not adjusting for the true value of location etc.) the government limited supply of rentals; existing units were less likely to be let and there were no incentives to build new ones. As a result, supply couldn’t meet demand in the rental market at the given price. Instead, people were forced into “buying” properties. But, a lot of households cannot afford to buy a property, or pay off a normal fixed-term (say 30-year) mortgage, so the government had to allow for infinite (no amortisation) mortgages to accommodate those households; they are the ones that would prefer to rent but can’t due to the limited supply. In essence it created a parallel rental market, with the banking system as the landlord. Full recourse debt, shielding banks from credit losses, coupled with greed, myopia and other psychological biases work together with no strict regulation of mortgage underwriting (KALP) to provide leverage to just about anyone, mostly with ultra long-duration and floating-rate.
Of course, easy money and high risk appetite generally push asset prices higher, which increased profit margins for banks, both through increased mortgage balances and cheaper funding (by higher collateralisation levels on covered bonds and general risk appetite), and all participants get confirmation that leverage in the housing market is a profitable activity. This feedback loop keeps on going, until it stops. We suspect strongly that we are at that point. That was roughly that narrative of the report.
Our recommendations for policy can be distilled into the following points, which will be described in greater detail below:
– Market rents should be allowed for all rental properties, phased in over a long period of time
– The above needs to be accompanied by stricter amortisation requirements for mortgages
– Strict KALP (borrower stress test), with a stationary and consistent stress-rate across banks, accounting fully for co-op debt
– Introduce some degree non-recourse for mortgages (for example, on part of the loan)
– Standardized depreciation and amortisation for (both existing and newly built) co-ops
We explained briefly in the report that Sweden has a system where existing rental properties are tied to a rent-schedule which depends on “utility value”, a rather poor reflection of market value. In order to incentivize new construction of rental units the government has recently waived this criteria for 15-years, allowing for market rents for such units during this period.
By restricting both current supply and new construction of rentals through rent controls, the government has pushed some households into assuming more debt that they would otherwise take on in an unrestricted market. In essence, this policy has also made it more or less necessary to allow no (or low) amortization of mortgages because a lot of households which would otherwise rent are forced to “buy”. Of course, rational consumers would choose their optimal loan duration depending on their economic situation. However, we all know that rationality is a very unrealistic assumption and that preferences fluctuate wildly throughout the economic and debt cycles. In reality, given the natural upwards-sloping shape of the yield curve and the fact that leverage has been profitable, consumers have shown a strong preference for floating-rate debt, which generally has lower interest which enables greater leverage under the KALP-metric. Banks have typically not objected either as greater loan notionals typically mean greater profits. Therefore we have ended up in the rather bizarre situation where the banking system is the eternal landlord to a large part of the population, with a floating-rent contract.
By tweaking lending standards through the government bank SBAB politicians can exert some of control of these “banking system-rents”. Furthermore, tax deductibility of interest rates is another lever to control these rents. These policies, together with low interest rates following the financial crisis which brings down the cost of floating-rate mortgages, have turbo-charged the system with leverage, leaving little margin of error for consumers at the opposite end of the cycle. Needless to say, lowering the cost of housing is generally a popular strategy so it has been used by politicians irresponsibly. We all know that the economy rarely offers everyone a free lunch, although it might have seemed like it in the last 20 years or so.
As mortgage debt increases, dislocations start appearing and risks to consumers increase. The most obvious one is that debt is spread out across individuals who would rather prefer to rent their property rather than, say, a few property companies that provide rentals, who are generally more qualified to manage this debt.
And, while an individual living in a rental can generally break the lease at short notice without severe consequences, we have seen that the strong loan recourse makes it almost impossible for an individual to break his “lease” with the bank. That is, if house prices drop meaningfully, and the individual is forced to move, he is on the hook for the loss. Nobody gets hurt as long as prices increase, but pricing driven by leverage cannot increase ad-infinitum – debt-to-income ratios are already elevated while taxes are closer to the lows than the highs. So, at some point, someone is bound to get hurt by this policy.
At that point, policy inhibits economic mobility and the speed of recovery in a crisis. In fact, one could argue that while the intention of controlling rents was noble, i.e. to benefit less fortunate groups, the effect has really been the opposite. Without a liquid market for rentals, which tenants can vacate easily, the government has forced consumers, generally not the most economically rational agents, into quasi-rental contracts which holds them hostage for life!
Hopefully, we will never see the worst-case scenario play out; one where a large part of the population is suffocated by debt, unable to escape the burden without living on minimum wage for five years. It is worth noting that the US housing crisis was solved rather quickly partly because there was no loan recourse (correction: in some states)! There, homeowners simply left their houses (and mortgages) to the banks (and the shadow banking) system, which took massive losses upfront, got recapitalised quickly, and then recovered within a few years. In contrast, the Swedish situation of sticky debt is much more likely to lead to prolonged asset deflation, similar to Japan. It is also worth noting that, in the current environment, the manoeuvre of lowering interest rates to bring down interest expenses for households is also limited because we are not far from the absolute lower bound (Riksbank repo rate at -0.5%).
So what to do? Most obviously, the cheap political trick of lowering housing costs needs to end, as the real cost is merely transformed into opaque risks which the average consumer is unable to manage. The process of enabling free rents for new-builds during a defined period is clearly a step in the right direction. However, the period needs to be extended towards infinity, and the existing stock also needs to be moved towards market-rents, else we get a two-tiered market. This would be hugely controversial politically due to the strength of rental-associations, and the long history of the system, but could be phased in over a period of, say, 50 years to ease the blow. The government should focus on the construction of affordable housing in order to help lower income households. Simultaneously, with the increased availability of rentals with market pricing the regulators need to alter mortgage regulations towards the international model of fixed-duration loans where buying a property actually means buying a property.
Of course, this is wishful thinking and we are merely describing the “ideal” for readers (and hopefully policymakers!) to understand the choice in the continuum of outcomes between the status quo and this ideal. And it also allows us to understand the regulatory choice in terms of two, closely related, paths to the end goal. A less restricted rental market is directly related to tighter restriction of mortgage duration (i.e. more amortization). As we are moving towards the first goal (by allowing market rates for new rentals in the first step) we also need to move towards the second goal (by enforcing stricter amortization requirements) in order to prevent dislocation.
If we are to maintain floating rate mortgages with low amortisation, the latter closely tied to a liquid market for rentals as described above, we need to maintain a strict KALP-requirement with a constant stress rate across banks. Of course, for >50-year loans, the stress rate (i.e. the worst case interest) is unlikely to change much throughout time and should therefore never change (or, if anything, only upward). And it needs to be stipulated as a strict rule because otherwise a marginal player can always gain market share by lowering its stress rate, which is what has likely happened. Also, the KALP-calculation needs to include total co-op debt (both fixed and floating components).
This, once again, needs to apply equally to all lenders. The reason is quite simple: would you sign a 50-year full-recourse lease on a property, with a floating rent, without knowing the worst-case payment you would be liable to? Of course one shouldn’t, and one should ideally make sure that this worst-case gives ample room to cover living expenses. The KALP stress-rate can be lowered with increased amortisation as the de-facto risk goes down with loan duration. More simply, the faster the loan is paid back, the lower the “weighted” loan balance throughout a full interest rate cycle. Regulation should take this into account, but we skip the details of such a calculation.
A well-known issue with banks is that they are prone to myopia; letting short term incentives (such as quarterly earnings, annual bonuses, market share etc.) get in the way of a longer term evaluation of profitability and risks. And, even when the bankers are well-incentivised the evaluation of risk is usually based on some historical measure of risk which, often, especially at the end of a multi-decade bull market, does not capture the full distribution of outcomes, and therefore frequently underestimates risk (we are of the opinion that it is very hard to over-estimate). As a result, a wide range of regulations have been designed to manage the banking system, such as Basel. While we think regulation generally moves in the right direction on a global basis, we think regulations specific to the Swedish housing market needs to be developed with this in mind. That’s why we think general recommendations such as the current KALP, where the stress-rate is not set in stone and co-op debt is not necessarily accounted for, are prone to fail.
Another important defect in the Swedish system, which we have reiterated many times, is that banks have full recourse on mortgages, ie. the can pursue the individual borrower for as long as necessary. This means that their (perceived and actual) credit risk is rather low, which brings down their funding cost and increases their risk appetite. Imagine what happens in a negative scenario where asset inflation reverses and a large part of the population get stuck in negative equity (i.e. owe the bank money they don’t have). We believe the most likely (and humane) solution is that the government will be forced to take these loans from the banks, restructure them (or write them off) in order to prevent a large part of the population from becoming debt-zombies. By this train of thought, the economic cost of this full recourse is likely implicitly underwritten by society, and is therefore an implicit subsidy to banks. We believe that, for interests to be aligned, the cost should be borne by the beneficiary, i.e. the banks, and that the easiest way is for (part of) mortgages to have recourse only on the property. It is up to politicians to determine the probability of bailing-out of such loans in case we end up in that situation, and adjust the proportion of recourse accordingly. We suspect it should be in the 10-50% range.
Newly built co-ops
New co-ops has become a vehicle for real estate developers to extract excessive profits by hiding the true cost from consumers in the form of co-op debt. Some banks don’t account for this debt properly, and education among home buyers is insufficient to guarantee informed choices. Therefore, the price tag needs to clearly specify the total price (including co-op debt), as suggested by government report on the subject that we mentioned in our paper. Furthermore, co-ops should be required to publish an income statement, using standardised depreciation and amortisation periods, and not just a cash flow statement. To be clear, this should apply to existing cooperatives as well. This would enable the tenant to see the actual economic cost of their tenancy, making it easier for them to see what level of “co-op equity” they are buying into. That is, they can make a more informed decision with respect to the expected level of future investments required for the building to function as a going concern. This will also mitigate the conflict of interest between the developer and the financial planner in new co-ops. We keep this section brief as it seems that the regulator is already aware of these issues, as mentioned in our report, and changes seem to be on the way.
Unfortunately, we haven’t spent much time researching construction regulation or zoning laws, so we will refrain from commenting on those in any depth. It seems like limits on construction did constrain supply further for a long period, but this imbalance seems now to have been reduced. We will simply note that this is obviously important for the supply side of a functioning market, but doesn’t strike us as the main obstacle to equilibrium in the rental market; price controls being much more important in our (perhaps uninformed) view.
P.S. We very much welcome feedback, especially of the negative kind. We are always trying to improve our understanding of the world and, as such, need to remind our readers that our ideas are definitely not laws of nature, but rather work in progress based on our research thus far. Also, this list of policy recommendations is by no means complete, but are the most obvious ones from the perspective of our report D.S.