The Irish Central Bank discussion paper on macro-prudential policy tools published yesterday seems to be a trial balloon for possible caps on Loan-to-Income (LTI) and Loan-to-Value (LTV) ratios for new residential property mortgages in Ireland. The general theory behind imposing these limits is laid out clearly in that document; there is no reason to repeat it here. I want to discuss some notable features of the Irish environment which strengthen the case for these caps (but do not make the decision easy).
The most obvious and notable feature of the Irish mortgage environment is the extremely high level of mortgage arrears in Ireland relative to other national markets. During and after the crash, Ireland built a very strong safety net for mortgage borrowers in arrears. This safety net has benefits, but it also has big costs. Even with LTV and LTI caps in place, Ireland will have a high arrears rate for the foreseeable future. It is now built into the system as a feature, not a bug. Imposing LTV and LTI caps will help in keeping arrears from spiralling out of control again. Hallisley et al. (2014) confirm empirically that recent Irish mortgages in default are cross-sectionally linked to mortgages with high initial LTV and LTI.
Another key argument in favour of these caps has to do with Ireland’s unusual “space” in economic geography. Both physically and in terms of trade links, Ireland lies “near the border” of three very large currency zones (euro, dollar, and pound). This provides Ireland with lots of economic opportunities, but exposes her to the vicissitudes of international credit flows in three directions. Ireland’s credit cycle and business cycle are quite detached from the core economies of the eurozone. Ireland needs to exploit its unusual economic geography, making risky bets in various export-focussed sectors such as in pharma, IT, medical devices, agrifood, but not making risky bets with its indigenous financial sector. The downside is too big and the upside is too small.
There are also some compelling arguments against the caps. Would the caps dilute the upward trend in Irish property prices? Would this hinder badly needed housing construction? I do not want to hazard an opinion on property market price implications but the international evidence seems to be that these types of measures have a modest negative impact on price trends. Perhaps since construction costs are so high in Ireland, we need to allow unusually risky mortgage lending to compensate for high construction costs? It seems a bad idea to sacrifice prudential financial regulation to encourage property price trends or as a bulwark against high construction costs.
There is also a zero-sum aspect to these caps which is likely to generate political flack. The caps do not directly change the properties for sale, but a given property will be sold to Family A (required mortgage loan meets the caps) versus Family B (required mortgage loan does not meet the caps). This zero-sum transfer will generate easy material for the Joe Duffy Show, with the members of Family B in deep distress about their perceived mistreatment by these caps which prevented them from purchasing the desired family home which went to Family A instead. The problem though is that Family A and Family B are not really getting identically the same loan package from the bank. Family B, with their proposed too-risky loan, would be adding a little more instability to the Irish financial system, and this instability would be paid for by the general public, rather than by them or the bank. So they are asking for a hidden risk-subsidy from us and our children, paid for via increased medium-term risk of financial instability and bailouts.
One argument against the caps comes from the possibility of a differential socioeconomic impact. Certain types of purchasers, such as younger buyers without parental help on a down-payment, will be less likely to qualify for mortgages than others. This in turn could contribute to a rental/ownership differential linked to family socioeconomic features (age, parental wealth). This is perhaps the strongest argument against the caps.
I am unsure if imposing the caps is the right course, but the unusual environment in Ireland certainly makes them worthy of careful consideration. This proposed move by the Irish Central Bank will be politically unpopular; it goes against a number of politically-powerful interests. The costs of the caps would accrue in this political cycle, and the benefits in later ones. It will be noteworthy if the Irish Central Bank has enough strong independence to take this type of politically unpopular action.