Mortgage indexation as a means of restraining property speculation and promoting financial stability

Property speculation tends to lie at the heart of financial crises. Reducing the risk of financial instability thus requires measures to limit property speculation without preventing the housing market from functioning efficiently as a means of reallocating real estate between people with changing needs and access to funds. My colleague Bruce Littleboy suggested to me that one way to do this is to index housing mortgages and deposits that fund these mortgages to the index of housing prices. I think this is a very good idea. It would deter people from taking financial risks to buy real estate in the belief that they will get a capital gain and that mortgage stress will be only temporary as rising incomes will soon provide a greater capacity to service the loan. The incentive to buy real estate rather than rent somewhere to live will be reduced if one’s savings towards future real estate purchase are, in effect, insured against falling in value relative to housing prices.

As an example, consider the financing of a $500,000 property that rises in value by 10% to $550,000, for which the buyer is able to make a $100,000 deposit. For simplicity, assume the 10% price increase takes place in the first year of ownership. Under the existing system, if the buyer takes out a mortgage from, say, the ANZ bank at 7.55% over 25 years, the monthly cost will be $2969, so the annual cost is $35,628. If the property would have cost, say, $500 per week to rent and, after tax, the $100,000 deposit could have yielded, say, 4% as a bank deposit if the house had been rented rathe than purchased, then the net outlay on renting would be $22,000. By renting, the consumer suffers a 6% loss in their capacity to offer a house deposit instead of enjoying capital gain, whereas buying the property and spending an extra $13,628 to service the mortgage produces a capital gain of $50,000, a net gain of $36,372. In this scenario, it pays to own rather than rent, leading to upward pressure on housing prices that generates the capital gains.

Under the mortgage indexation proposal, the numbers would be as follows. If the house is purchased, then by the end of the first year of ownership the mortgage will have been marked up to $440,000, leaving the consumer still with 20% equity in the property. and the monthly mortgage charge at 7.55% would have gone up to $3266, so the average cost per month would have been ($3266 + $2969)/2 = $3117.5 and the cost for that year would have been $37,410. The consumer’s nominal equity in the property has grown from $100,000 to $110,000 but if they had rented and left their $100,000 in the bank not only would it still have grown to $110,000 but, at 4% after tax, on an average of $105,000, it would have yielded $4200, so the net outlay on renting at $500 per week would have been $21,800. In other words, owning costs $15,610 more than renting over the year. If it pays to rent rather than own, the chances of real estate prices actually increasing by this amount are reduced. If real estate prices do continue to increase, this will be driven by demographic and supply-side issues (that will also affect rental costs and therefore not affefct the rent/buy choice in the long run) and by preferences for ownership that have nothing to do with the prospect of capital gains, such as the greater security of tenure and control that come with owning a property. Once property speculation is removed from the equation, there will be less turnover of properties for speculative reasons and this should increase the security of tenure of one is renting.

Under current policies, the Reserve Bank tries to limit inflation by raising interest rates. In the indexation scenario, the monthly mortgage fee of $3340 is almost exactly the same as what it would cost to service a $400,000 unindexed mortgage if the interest rate were raised by 0.67% to 8.12% ($3119, according to the ANZ bank’s calculator). If the Reserve Bank steadily increased mortgage rates by that much during the course of the year in the no-indexing scenario but property prices still rose by 10%, the mortgage servicing costs for the year would be 12*($3119 + $2969)/2 = $36,528 and the property buyer would get a net capital gain of $13,472. However, since the mortgage costs an extra ($36,528 – $22,000) = $14,528 to service compared with renting the house and leaving the deposit in the bank, there is actually a $1056 loss (i.e., $13,472 – $14,528) in terms of opportunity cost. If the higher interest rates actually limited the rise in property prices, the opportunity loss would be bigger. However, so long as the current approach tend to impose smaller threats of opportunity losses than in the indexation scenario with similar monthly mortgage charges, the indexation system is likely to be more effective as a means of controlling inflation of real estate prices. If the current approach has less leverage on house prices, it is less of a deterrent against risking financial stress for the prospect of capital gain, and hence it is a policy more likely to be associated with mortgage defaults.

In the mortgage and deposit indexation scenario, inflation of house prices will be limited but to the extent it still occurs tendencies of depositors to increase their spending as their deposits are increased will be offset by reduced spending by those with bigger mortgages to service. This is in sharp contrast to what has occurred with non-indexed mortgages, where those who purchase real estate subsequently partially index their mortgages themselves by withdrawing their capital gains (e.g. via drawing more heavily against overdraft-based mortgages) and spend them on increased consumption.

It needs to be stressed that in the indexation scenario, real estate prices could still rise despite it being impossible for those with mortgages to increase the percentage of equity they held in their properties without actually paying off their loans. If only deposit accounts that fund mortgages are indexed, the speculative focus will switch to the possible gains to be had from having deposits in the indexed accounts rather than unindexed accounts. If underlying real forces of supply and demand are expected to produce an upward trend in property prices, people will want to keep their money in the indexed accounts unless the banks reduce the nominal interest rates they pay and (if interest rates tend towards zero) impose higher account maintenance fees to discourage deposits.

Banks will tend to try to deter deposits by these means rather than increase their lending on real estate to a degree that is out of line with underlying real forces. Under the indexation system, deposits that fund mortgages would be seen as a safe haven for funds in times of inflation but, with the scope for making capital gains on mortgaged properties removed, people would only be buying real estate with the aid of mortgage finance because they wanted it for its use value and option value. This will limit their enthusiasm to take on bigger mortgages that banks are offering as a result of having surplus funds, while banks will also limit their lending, and prefer instead to deter mortgage-funding deposits, due to a shortage of would-be borrowers whom they judge to be creditworthy.

Legislation that brought in the mortgage indexation system but limited banks’ abilities to charge onerous deposit management fees would seem likely to result in banks having to offer indexed deposit accounts more generally (to the general price level) in order to limit inflows into their indexed mortgage-funding accounts. This in turn would put them under pressure to index other kinds of loans. All in all, in the absence of wage indexation, a policy that resulted in the indexation of both sides of the balance sheets of financial institutions has great potential for curtailing inflationary pressures: if prices are expected to rise, consumers will have incentives to pay off loans faster and be less willing to finance spending by borrowing when this entails an indexed loan, while there will be less of an incentive to spend money if it is protected from having its value eroded by inflation.

The automatic stabilizing forces work in the opposite direction if the economy is tending to suffer deficient aggregate demand and falling prices. If property prices fall, the indexation policy would soften the impact on the level of real spending in the economy. It would reduce the probability of mortgage defaults as mortgages would become more affordable even if interest rates were not lowered. Those with mortgages (and other indexed loans) who kept their jobs would enjoy increasing the real purchasing power, while those with financial balances would not have an incentive to hold back on spending them on the basis that things would be even cheaper in future, for if that happened, their deposits would likewise be marked down.

For the policy to work efficiently, mortgages would need to be indexed to median values in the suburb in which their respective properties are located. Indexing mortgages according to national real estate prices would cause problems since some areas will rise faster than average (thereby still providing opportunities for capital gains from speculation) while others will rise slower than average (thereby tending to have over-indexation of mortgage amounts, thereby running down homeowner equity in mortgaged properties in those regions).

If mortgages were indexed without deposit indexation occurring, rises in real estate prices on the assets side of bank balance sheets would be matched by rises in banks’ reserves rather than rises in their deposit liabilities (unless these profits were paid out to shareholders, with their accounts being credited with the dividends). This would mean that banks still had an incentive to pursue lending policies that contributed to the inflation of real estate prices, though they would find it harder to encourage customers to take up such loans. Without deposit indexation also being introduced, any tendency of real estate prices to rise despite mortgage indexation would continue to provide an incentive towards buying real estate sooner rather than later due to falling purchasing power of savings for home deposits relative to housing prices. With deposit indexation, this incentive is removed and the extent to which capital gains are captured in banks’ reserves is also limited.

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