The Irish Central Bank is scheduled to introduce new macro-prudential risk controls on Irish mortgage lending, with the new regulations taking effect on January 1st or soon thereafter. One of the regulations will limit most new mortgages to an initial loan-to-value ratio of 80% or less. There has been considerable discussion of the effect of loan-to-value limits on potential property purchasers, but the analysis has been very poorly framed.
The budgeting scenario has been described as follows:
“Consider a couple who wish to purchase a €300,000 property. With a LTV limit of 80% this will require that they save €60,000 for the down payment whereas if they were allowed to borrow 85% they would only need savings of €45,000.”
This oft-repeated budgeting scenario misrepresents the nature of market-wide LTV limits imposed by the Central Bank. This budgeting scenario gives the impression that the policy decision is about imposing/not imposing the LTV constraint on only one particular buyer rather than market-wide. It misses the large compositional effects since leveraged property buyers compete with one another for properties. The degree of leverage allowed in the banking system feeds into property prices, and this affects the opportunity set of purchasers.
A dual statement of the constrained household budgeting problem gives a better framework for thinking about the issue:
“Consider a couple who have saved a down payment of €45,000. If they face an LTV limit of 80% they can only pay €225,000 for a property, whereas if they are allowed to borrow 85% they can pay €300,000.”
This dual statement of the constrained budgeting problem is theoretically identical to the first version, but allows price effects to enter the analysis. The amount spent on property goes up as the amount of leverage in the banking system is allowed to increase. Since the LTV limit applies market-wide rather than on a single buyer, there is likely to be a large offsetting price effect. In theory it is possible, in a worst-case scenario, that the couple without the 80% LTV limit will pay €300,000 for the identical property that would have cost them €225,000 with the limit. The only difference from relaxing the constraint in that case is that they have an additional €75,000 of debt to pay, and in a more highly leverage economy. This is a worst-case scenario, but in any reasonable case there is likely to be a large composition effect through prices.
It might be useful to analyze, from the cash-constrained buyer’s perspective, the implicit cost of funds for the extra borrowing if the Central Bank increased the market-wide LTV limit from (say) 80% to 85%. Consider a cash-constrained couple with savings of €45,000 who would like to borrow as much as possible to spend on property. With the 80% LTV limit the couple is constrained to borrow €180,000 and pays €225,000 for a property. If the limit is relaxed to 85% the couple borrows €255,000 and pays €300,000 for a property. Suppose that the market-wide relaxation of the limit increases property prices (in their market segment, where there are many cash-constrained buyers) by 5%. Than the implicit cost of funds for the extra €75,000 borrowing includes a €15,000 cost due to the composition effect on prices.