The Unassuming Economist

From the IMF’s latest report on Denmark:

“Macrofinancial vulnerabilities remain elevated. Household leverage remains high by international standards and housing prices rose faster than incomes through the pandemic. Furthermore, a sizable share of newly-originated loans were interest-only loans, some with amortizing options that could be exercised by lenders if housing values fall. In addition, homeowners are increasingly taking out variable-rate mortgage loans and repaying fixed-rate loans which naturally increases the interest-rate sensitivity of homeowners. Thus, a domestic or regional house price correction, triggered possibly by a reassessment of fundamentals or a tightening of global financial conditions could reverberate in Denmark, weighing on the real estate market, private consumption, and investment. The impact could be amplified by the high interconnectedness of mortgage credit institutions (MCIs), pension funds, and insurance companies given their dependence on the housing sector. While the net impact is uncertain, high, and persistent inflation could weigh on bank profitability including through lower aggregate demand, or if highly-leveraged households cannot service their debt due to variable-rate mortgages resetting at higher rates.

(…)

They recognize that macrofinancial risks mainly stem from the housing market in combination with high household leverage and an increasing share of risky mortgages.

(…)

Macrofinancial vulnerabilities persist due to high leverage and an increasing share of risky mortgages. Following a prolonged period of low interest rates, high debt, combined with illiquid assets (concentrated in real estate via housing and pension assets), exposes households to price and interest rate shocks that can spill over to aggregate demand. Furthermore, many households have recently opted for interest-only mortgages with options for lenders to request amortization if housing prices fall, which could amplify adverse shocks. Many of these households would face markedly higher debt-servicing costs were they required to amortize their mortgages (DN 2021). A sharp revaluation could harm highly-leveraged households, particularly those who purchased in overvalued urban areas and low-income households. These vulnerabilities are compounded by the large and growing proportion of variable-rate mortgages, which are increasingly used to repay fixed-rate loans, exposing homeowners to higher interest rate risk. Moreover, MCIs and pension and insurance companies are highly interconnected and dependent on the health of the housing sector.

(…)

These developments warrant tightening prudential tools. Macroprudential tools aim to increase macrofinancial resilience and contain excessive risk taking. Staff recommend that new mortgages extended to highly-leveraged households be subject to minimum down-payment requirements or mandatory amortization until a minimum equity share is reached, regardless of maturity and type of interest rate fixation. As valuation-based measures can be less binding when housing prices appreciate rapidly (Chen et. al, 2020), the limits applying to ”highly-leveraged” borrowers should become binding if either DTI or loan-to-value (LTV) limit is breached, instead of the current joint requirement. Based on borrowers’ riskiness, differentiated limits on income-based measures and LTVs for interest-only and floating-rate mortgages should also be considered. In an environment of increasing mortgage rates, the “growth area guidelines” should be extended beyond Copenhagen and Aarhus and debt-service-to-income (DSTI) caps should be considered to protect against liquidity shocks. The proposed risk-based prudential framework should facilitate calibration of these measures, to account for risk differentiation across groups, e.g., first-time home buyers to improve affordability. National legislation should include borrower-based tools (limits on LTVs, DTIs, and DSTIs) in the policy toolkit (FSAP 2020).

To improve affordability, it is important to address features of the tax code and housing supply constraints that create price pressures. Incentives for the adequate supply of housing should be reviewed. Moreover, rent controls in Denmark are pervasive relative to peer countries. Once inflationary pressures abate, these should be relaxed to stimulate the rental market, while protecting the most vulnerable. Mortgage interest deductibility should be reduced as in other advanced economies, as this incentivizes larger housing purchases and higher indebtedness, pushing up prices (Gruber et. al, 2019). Linking property taxes to market valuations should be prioritized.”

From the Bank of Canada:

“The vulnerability associated with elevated house prices (Vulnerability 2) increased further over the past year. Key developments in the housing market—strong demand relative to supply, driven partly by an increasing share of investors; prices reaching all-time highs in most regions; and expectations that these price increases will continue in most major cities—point to further imbalances in prices compared with a year ago.

A large misalignment of house prices relative to longer-term fundamentals could lead to an abrupt price correction in the future. Such a correction can, in turn, bring on financial stress for households because housing often represents their largest asset (see “A large decline in household income and house prices”).

It is too early to tell whether the recently observed decrease in resale activity and prices will be temporary or is the start of a deeper, lasting decline. A sudden reversal of the influx of housing investors seen during the pandemic could amplify downward pressure on prices (Box 2).

After months of exceptionally strong activity in the housing market, resales slowed considerably in March and April 2022 (Chart 7). Until the early months of 2022, demand—including from investors—was remarkably robust, supported by a desire for more housing space, record-low mortgage rates and the accumulation of extra savings. Resales are expected to soften as borrowing rates rise and the pandemic-induced demand for more housing space wanes. Recent monthly data reveal a large decline in resale activity. This could reflect a temporary echo effect from some homebuyers making their purchases earlier to avoid the latest mortgage rate increases, or it could signal the beginning of the end of the pandemic upswing.

Growth in house prices has been vigorous and regionally broad-based. In April 2022, house prices were up 24% nationally compared with April 2021, and up 53% relative to April 2020. Despite house prices increasing in nearly all areas, suburbs have experienced the strongest growth—as seen in the Toronto and Montréal regions (Figure 1).15 This dynamic is consistent with the pandemic-induced shift in preferences for more housing space, which is more affordable and widely available in suburban and rural areas than it is in city centres.

Part of the exceptional increase in house prices observed since the start of the pandemic may have reflected extrapolative price expectations. This happens when people come to expect that house prices will rise in the future simply because they have risen in the past. In such a situation, homebuyers may rush into the market out of fear of missing out or may hope to realize a sizable capital gain. Under these conditions, housing demand and prices can then become disconnected from underlying fundamentals, putting prices at risk of a correction in the future. Extrapolative expectations, particularly among investors, could amplify and accelerate price declines if a house price correction were to occur. Such a correction could dampen economic activity not only through confidence effects but also because it reduces household wealth and restricts access to credit (see “A large decline in household income and house prices”). Although house prices declined in April 2022, it is too early to tell whether this is the beginning of a substantial correction in prices.

Before the tightening of monetary policy in March, extrapolative expectations appeared to have broadened. The Canadian Survey of Consumer Expectations conducted in February revealed that many Canadians were expecting house prices to increase substantially over the next year. In fact, this is the highest rate for this response since the Bank introduced this survey question in 2016. These elevated expectations also appeared to be broadening. For the first time, the Bank’s House Price Exuberance Indicator characterized house prices in most major Canadian cities as exuberant in the first quarter of 2022 (Chart 8).16 However, these indicators were collected before the slowdown in housing activity and price growth in April. It remains to be seen whether data for the second quarter will support the same conclusion.

The share of Canadians buying homes as investment properties grew in 2021. The increased presence of investors in the real estate market can amplify the vulnerability associated with elevated house prices (Box 2).

Box 2: Vulnerabilities associated with investors in residential real estate

In an environment of low mortgage rates and rapid increases in house prices, expectations of a large capital gain can make houses an attractive asset for investors. For the purpose of this analysis, investors are defined as existing mortgage holders who obtain an additional mortgage to purchase a property. In 2021, they made purchases at a faster pace than first-time or repeat homebuyers. Investors accounted for over 22% of mortgaged purchases in the fourth quarter of 2021, up from 19% in 2019 (Chart 2-A).17

Investors are increasingly extracting equity from their existing properties to support new purchases. The share of investors who took out at least $5,000 in equity in the three months before they purchased an investment property rose substantially since the start of the pandemic (Chart 2-B). The amount of equity these investors took out through home equity lines of credit or mortgage refinancing also noticeably increased. For about one-third of these investors, the equity extracted was equal to or greater than the down payment on their subsequent purchase. This proportion is up from just over one-fifth in 2019. The increased use of equity gains to finance purchases highlights the feedback loop between rapid gains in house prices and the stronger demand for housing that investors generate.

Investors can amplify house price cycles. Investors can play an important role in the housing market if they make their property available to renters on a long-term basis. But investors can also increase vulnerabilities linked to higher house prices:18

• During housing booms, greater demand from investors can add to bidding pressures and intensify price increases.
• When prices are stable or declining or mortgage carrying costs are rising, holding real estate as an investment becomes less attractive. The incentive to sell may be greater for investors who risk falling into a negative equity position on one or more properties, also known as being “underwater.” A negative equity position can prevent the future sale of a property if the investor does not have enough liquid assets to cover the shortfall.

Although investors typically earn more income than non-investors, they tend to have higher loan-to-income ratios, once all the mortgages they hold are accounted for, and higher debt servicing costs.19^, 20 If an income shock occurs—whether a reduction in employment or rental income because, for example, some tenants become unemployed—highly leveraged investors may need to sell one or more of their properties to recover some liquid assets. Although investors may not be considered as financially vulnerable as non-investor households given the amount of equity they have tied up in real estate, investors could intensify the effect of an economic slowdown by adding downward pressure on housing demand and prices.”

On cross-country:

• Vulnerabilities in the housing sector from rising mortgage rates – OECD
• Is the global housing market heading for a downturn? Interest rate rises are cooling house price growth in both Europe and the US but experts cite several reasons for relative optimism – FT

On the US:    

• Measuring the Value of Rent Stabilization and Understanding its Implications for Racial Inequality: Evidence from New York City – SSRN
• How did house and stock prices respond to different crisis episodes since the 1870s? – Economic Modelling
• Housing Market Hot but Not a Bubble, Economists Say – Zillow
• Home prices could fall, but is it a bubble? – NPR
• The Housing Market Is Finally Chilling Out. Rising mortgage rates and a cloudy economic outlook are bringing back the balance the US desperately needed. – Bloomberg
• Three signs the US housing boom is petering out – Quartz
• Lumber Price Gets Chopped in Half Amid Chill in Housing Markets. Futures sink as soaring prices make homes less affordable. Potential home buyers having second thoughts, analyst says – Bloomberg
• How to Make Housing Less Affordable. Cutting FHA premiums will help Realtors, not new home buyers. – Wall Street Journal 
• Housing Boom Fails to Lift All Homes Above Previous Cycle’s Peak. In 477 U.S. cities, the typical home value at the end of April was below peak levels from the early 2000s – Wall Street Journal
• Solving the Housing Crisis will Require Fighting Monopolies in Construction – Minneapolis Fed
• Commercial Property Sales Slow as Rising Interest Rates Sink Deals. Sector shows first signs of cooling in over a year as higher borrowing costs narrow pool of buyers – Wall Street Journal
• Pandemic Housing Boom Puts More US Buyers in Path of Wildfires. US buyers who fled big cities are pushing up property prices in areas at high risk of burning – Bloomberg

On other countries:  

• [Australia] How the two iron laws of Australia’s property market put the squeeze on every generation. Buyers today will be stretched to their limit, just as they were by the interest rates of the late 1980s – The Guardian
• [Canada] Variable-rate mortgage borrowers enduring fastest rate hikes since 1990s – The Globe and Mail
• [Chile] Is There Financialization of Housing Prices? Empirical Evidence from Santiago de Chile – Economies
• [Colombia] The effects of public housing on children: Evidence from Colombia – NBER
• [Hong Kong] Hong Kong’s Property Market Isn’t a One-Way Bet Anymore. City’s property prices have had some dips and bumps but have been more or less irrepressible. That might be about to change. – Wall Street Journal
• [United Kingdom] Britain’s overstretched electricity grid is delaying housing projects. The grid needs to be expanded to cope with the demands of net zero – The Economist
• [United Kingdom] Soaring house prices have changed the game – even small interest rate rises will hurt millennials. Even if rates stabilise at about 5% and wages grow, the mortgage burdens of newer homeowners won’t decline much – The Guardian
• [United Kingdom] Johnson Vows UK Housing Reforms in Bid to Quell Tory Revolt. Speech is chance for premier to make true on promises to MPs. PM will again vow to ‘unlock’ home ownership, boost housing – Bloomberg

From the OECD’s latest Economic Outlook:

“House prices, along with household debt, rose steadily throughout the pandemic, even in countries in which valuations were already stretched and debt levels already high. With monetary policy now beginning to normalise, mortgage rates are increasing in many OECD countries, raising solvency concerns. However, vulnerabilities appear contained at present due to households’ relatively strong balance sheets and the limited use of adjustable-rate mortgages (ARM). Still, fragile borrowers could be at risk in economies where ARM dominate, debt-service ratios are high and monetary policy is likely to tighten substantially. The potential adverse consequences for households and financial system resilience of a sharper-than-expected house price reversal also need to be prevented, primarily by macroprudential policy tools.

The pandemic pushed house prices to new heights in many countries

House prices rose strongly and quickly in most OECD countries during the pandemic. Between the fourth quarter of 2019 and the fourth quarter of 2021, real house prices rose by 13% in the median OECD economy (Figure 1.35). On average across countries, real house prices in the fourth quarter of 2021 were about 4% higher than expected based on the underlying trend prevailing before the COVID-19 pandemic, suggesting that the pandemic has exacerbated pre-existing tensions in many housing markets. A range of factors can explain this strong and synchronised response of house prices. Exceptionally accommodative monetary conditions, a surge in household savings and unprecedented fiscal support all boosted housing demand during the pandemic, with housing supply temporarily curtailed by mobility restrictions and logistical bottlenecks. Higher financing costs should moderate future housing demand, helping the rise in house prices to abate. A slowdown is already taking place in several key markets, such as the United States, with home sales and prices stabilising or even declining in some large cities, due to rising mortgage rates.

Fixed-rate loans dominate the mortgage landscape

The exposure of households to rising mortgage rates will be damped by the limited use of flexible or adjustable rate mortgages (ARM) in many OECD countries (Figure 1.36, Panel A), although there are also differences across countries in the typical period for which interest rates are fixed (van Hoenselaar et al., 2021). With the exception of Japan and, to some extent, Spain, the largest mortgage markets in advanced economies are heavily dominated by fixed-rate mortgages. In contrast, ARM contracts, which have been shown to be associated with a higher probability of default on mortgages when interest rate rise (Gross et al., 2022), are prevalent in several countries in Southern (Portugal and Greece), Eastern (Poland, Bulgaria, Romania and the Baltics) and Northern Europe (Sweden, Finland and Norway). If monetary policy normalisation proceeds gradually, borrowers should be protected from a sharp increase in financing costs over the medium term. Financially fragile borrowers in countries with independent monetary policies and rising inflation pressures could nonetheless experience a substantial rise in their debt servicing costs, particularly in countries where the ratio of mortgage costs to disposable income is already high for the lowest income quintile (van Hoenselaar et al., 2021).

Households’ savings are high and debt service ratios are still low

Household balance sheets are currently stronger than before the global financial crisis (GFC) in many countries. Stronger regulation in the aftermath of the GFC has limited the amount of risk-taking in the household sector over the last decade. In addition, the recent rise in household debt has been matched by a significant rise in household savings during the pandemic. These savings should support the repayment capacity of many households exposed to adjustable rates, especially if interest rates were to increase more rapidly than expected. Moreover, the low interest rate environment is still keeping average debt service ratios (DSR) in the household sector close or even below their long-term norms (Figure 1.36, Panel B), and significantly below what is considered a stressed DSR. However, aggregate numbers might conceal important heterogeneity, and risks remain that the repayment capacity of low-income borrowers could deteriorate, given the withdrawal of pandemic income support measures and higher inflation.

Macroprudential policies could be strengthened further

Real estate prices might adjust more abruptly. A sharp deterioration in the growth outlook, or a sudden increase in inflationary pressures, could accelerate a correction in housing markets, with potentially damaging consequences for households’ and banks’ balance sheets. Given the large uncertainty surrounding the outlook, it is critical that there are adequate buffers in the banking sector to ensure resilience to unexpected fluctuations in property markets.

Most countries already have policies in place to limit over-indebtedness and associated risks. Following ESRB recommendations (ESRB, 2022), many European countries have recently announced increases in their countercyclical buffer (CCyB) after some relaxation during the pandemic, including some measures explicitly targeting risks in the real estate sector. For instance, Germany’s financial regulator, BaFin, proposed in January 2022 to (i) raise the countercyclical buffer on banks’ domestic exposures to 0.75% of risk-weighted assets (RWAs) from 0% and (ii) to apply an additional systemic risk buffer of 2% of RWAs specifically targeted at residential real estate mortgage loans.

Preventive measures to limit further price increases, such as additional steps to lower LTVs or DSTI ratios, might also be welcome to moderate risks. Some countries have already taken steps to tighten existing tools to moderate new housing loans, while others could consider implementing those tools. In addition to these macroprudential instruments, reforms in rental regulation and property taxation may also be effective means of addressing housing pressures over time. Those tools, along with stronger public investment in social housing and potential land use reforms, especially in job-rich urban areas, could ease the tensions that are still likely to prevail in the medium term (OECD, 2021b). Although the supply of new construction slowed down only moderately during the pandemic, new housing permits and starts dropped significantly in many OECD countries. This gap, along with ongoing supply bottlenecks and labour shortages, is likely to amplify the structural housing shortages affecting many countries.”

From Shuddhasattwa Rafiq:

“This paper analyses the effects of different types of macroeconomic downturns on house and stock prices. While pre-crisis asset price bubbles are identified as major signals for macroeconomic fragility, recent literature document that house and stock prices are interlinked during recovery periods. To delve deeper into this post-crisis asset price behaviours, we project house and stock price paths following three different macroeconomic crises, normal recessions, financial recessions, and disasters, using historical macro-financial dataset since the 1870s for 17 western economies. We find that financial recessions have the most detrimental effect on house and stock prices followed by severe disasters like war and extreme weather. The results also reveal that stock prices drop substantially immediately after financial crisis and rebound within six years, while impacts to house prices are more persistent. The differences in magnitude and persistence of these effects can be attributed to the nature of crisis and asset class.”