The flaws of introducing DTI
We've lived for a while now with the quiet rumblings of the Reserve Bank of New Zealand (RBNZ) wishing to introduce a new macro prudential policy of debt-to-income ratio (DTI) on the premise this is needed to ensure stability in our financial system. Much has been written about this and indeed I canvassed the subject myself when I presented at our 2016 annual Property & Trust seminar.
Lately those rumblings have become louder. The RBNZ published a paper seeking feedback on DTI being added to its existing macro prudential toolkit, and a response to that paper has also been published by Tailrisk Economics. It's a stimulating read for those interested in the effects policy has on our economy and on our own personal generation of wealth. The Argument
The RBNZ's whole argument for the necessity of introduction of DTI seems to me to be somewhat inaccurate. Some may even say outright distorted.
Our central bank bases its need for imposing DTI (total debt / total gross income = DTI ratio) on the assumption that banks' funding lent to NZ borrowers is sourced offshore. In fact, at the time of writing this article, 29% is funded from offshore sources. The argument continues that if there is an unexpected increase in the cost of such funds, the banks will undoubtedly pass that cost onto borrowers by charging higher mortgage interest rates. Consequently, this could lead to more borrowers incurring financial stress and thus defaulting, resulting in systemic instability of our financial system and generally adversely affecting our economic health overall as a nation.
Whilst there are grains of truth in this premise, I'm doubtful the answer lies with the introduction of the much wished-for DTI tool. Tailrisk Economics have clearly come up with the same conclusion noting, "…it's a clumsy tool which will have many perverse effects". Personally, I think more harm than good will come if this tool is implemented. My View
The Reserve Bank's argument doesn't ring true. The RBNZ doesn't need to introduce DTI in order to ensure stability of the monetary system. It already has this ability to ensure this state of affairs. We've got an independent monetary policy and a floating exchange rate. It's the RBNZ itself that determines the Official Cash Rate (OCR) and ultimately New Zealand mortgage rates.
If a large number of borrowers couldn't service their loans, the RBNZ may well decrease the OCR. This is because activity as a whole, together with inflation, would mean the economy was declining and they would need to act. What would they do? Probably lower the OCR because it would stimulate the economy.
Additionally, banks may follow and decrease mortgage interest rates once the OCR was dropped, providing borrowers with some relief. Banks do not always do this, however, as recent history has shown. Simply a reduction in the OCR doesn't mean banks' interest rates will drop.
Furthermore, in the case where interest rate hikes did occur, borrowers who felt pressure would likely curtail discretionary spending. True, they couldn't cut irreducible expenditure but then that is taken into consideration and accounted for when banks initially conduct a serviceability assessment on potential borrowers. See my comments later on in this article concerning buffer margins banks build into their calculations when assessing a borrower.
For those borrowers truly concerned about risk, they are likely to loan tranche and fix as we have always suggested. To a large extent, these strategies mitigate concern over potential default due to increased mortgage rates. Flaws of the DTI Arguments
There are other flaws to implementing DTI as a method of proposed loan serviceability.
Currently banks assess a borrower (in general) by using an income surplus amount method. A lender will calculate all sources of income (some are discounted down such as rents, bonuses, dividends, etc.), deduct proposed interest and principal loan payments amounts, deduct an interest rate buffer to account for future interest rate hikes, deduct other fixed expenditure such as student loans and child maintenance payments, and then finally deduct an estimated amount for living expenses. The answer to this equation gives a bank the amount of surplus income a client has in dollar terms / ratio of the borrower's total committed expenses.
Note when the bank assesses a borrower's serviceability, it is particularly interested in their essential living expenses because if that borrower comes under financial hardship, it's that irreducible spending that cannot be cut, as opposed to discretionary spending that could be curtailed.
Under this method a bank will also take into account other factors such as how vulnerable a borrower may be with respect to continual employment. The probability of unemployment occurring is considered because usually it's only when a borrower becomes unemployed that the risk of default on a loan arises. Unemployment is the biggest driver of default, not interest rate increases.
Clearly those with higher incomes can borrow more than those on lower incomes. However, borrowers in higher paid jobs tend to have greater continual secured employment prospects compared to those on lower incomes, which as stated above, is a key factor to default of loans.
Finally, when a bank engages in this assessment exercise of serviceability, it 'stress tests' a borrower's repayment ability (to an extent) and it typically uses a buffer margin of around 2% as a protection against increased expenditure and income shocks. For this reason, interest rate hikes in the future (should they occur) won't necessarily post a systemic risk because banks are already doing the job of adequately measuring a borrower's potential risk and building in a buffer to compensate for any interest rate increases they face.
All up, the current methodology used by our banks appears to have worked well. If banks had this wrong, we'd have seen many more loan defaults than what have occurred in the past, for example during the Global Financial Crisis in New Zealand.
When a DTI method is utilised to assess a borrower's serviceability, a stance is taken that all borrowers with the same level of income will have the same level of expenses. Thus, family size and personal circumstances are largely ignored under DTI. This makes no sense. A single person may well have the same income as a married person who has two children, but their expenses could be lower due to their living costs being far less than those a borrower with a family would incur.
The assumption of expenses becomes even more unreasonable when DTI is applied to an investor wanting to purchase an investment property. This is because when a borrower purchases a new property, it is automatically assumed their living expenses increase. But that is not always the case.
For these reasons alone (an assumption that all borrowers with the same income have the same expenses, and additional property acquisitions result in increases to existing living expenses), it seems illogical to me to prefer the DTI method of assessing serviceability over the current utilised methodology where a differential in expenses is taken into account and expenses aren't just assumed to exist.
This brings me to the next point. Under a DTI method, riskier loans could actually end up on a bank's books whilst good quality loans to borrowers could fail to be written. This does nothing to help either the stability of a bank or the overall stability of the financial system. This could come about because the RBNZ want all loans to be subject to DTI. In the UK where DTI is used, investor loans (or buy to let loans as they are referred to) are not subject to DTI assessment. Application of DTI to all loans is likely to lead to the exact opposite of the RBNZ's desired objectives, as the following examples demonstrate. Example 1
A property investor has housing assets valued at $5m. She wants to borrow $2.5m, which would put her LVR at 50%. She will have an interest coverage ratio of 2.4. Banks tend to want interest coverage ratio of 1.25 as a minimum or greater. Income earned will be $300k being a 6% net yield on assets. Overall this would be a good risk loan and in the normal course of business, the bank would write this business.
However, if DTI was used, it is doubtful the loan would be written at all. This is because DTI would be 8.3 ($2.5m / $300k) and assuming a DTI limit of 5 was the magical number imposed by the RBNZ, the loan wouldn't qualify. This is despite the fact the proposed loan is far less risky that a lot of business loans, farm loans, etc. that are made. Example 2
Take another example of a homeowner who wishes to buy a rental investment property. She has a home worth $1m with existing debt of $200k. LVR therefore is 20%.
She enjoys an annual net income of $91k pa. Her annual mortgage repayments of principal and interest at 6.5% pa amount to $15k. Additionally she has to meet other living expenses of $30k, so in total her annual expenses are $45k. Net surplus income is therefore $46k.
She wishes to purchase an investment property for $750k. She'll borrow 100% by borrowing against the equity in her home. She'll take out an interest-only mortgage at 6.5% pa, thereby incurring annual mortgage repayments of $48,750. To this expense must be added the costs of rates and insurance hence total property expenses will be $55,500 pa. Weekly rental income of $800 will be received. Ultimately the property will run at a loss of $13,900 pa. For simplicity's sake, I'm ignoring tax back on this loss.
Her total surplus will be $32,100 pa ($46,000 - $13,900).
If a DTI ($950,000 / total income $166,600) was the measure of whether this loan would be written it's likely to fail because it would be 5.7, which transgresses the limit of a DTI of 5. This is a crazy outcome. This borrower would have over $32k of surplus income and that isn't taking into account sizeable dividends from her business.
Even if interest rates moved higher, there is still plenty of surplus income for this borrower to meet loan repayments.
Furthermore, if the borrower was to come under pressure, she is likely to sell the house. In other words, it's probably not the bank that will take a hit. Hence a systemic problem of loan defaulting amongst borrowers who are in the same situation is unlikely to occur.
The above examples serve to show the application of DTI brings about bizarre results when applied to investor loans. This is one of the reasons other countries do not use DTI when assessing a borrower's serviceability in respect of these types of loans.
Other concerns I have with the implementation of DTI surround the actual assets themselves. When harsh rules are applied, borrowers seek solutions. We've seen this when the RBNZ misguidedly applied a two tier LVR throughout NZ. One path borrowers will take is undoubtedly the purchase of new builds. This is because DTI is not meant to apply to newly built houses. If the DTI is about creating financial stability however, shouldn't it be applied equally to all housing stock? Summary
I don't believe the RBNZ has made a good case for the use of DTI. The methodology does not adequately assess borrowers' service capabilities. Furthermore, a borrower's service ability can and does change over time. Hence the original DTI measure is unlikely to be a good indicator of the person's capability to handle a debt servicing event in the future. I guess this is why no evidence has actually been produced to show that assessing a borrower's serviceability by using DTI can predict loan defaults or indeed reduce the probability of such defaults occurring.
Our banks currently do a fine job of assessing a borrower's serviceability and should be permitted to get on with their roles. That is not to say other tools, such as increasing bank capital, shouldn't be looked at. This would go some way to achieving the desired objective of the RBNZ, as the quantum of capital held against the risk of a bank's loan portfolio will serve as a stability factor should the envisaged scenario of economic recession, housing value decreases, mortgage interest rate increases and borrower defaults occur. Accordingly, requiring banks to increase the capital they hold appears a far more practical option than the implementation of DTI, which I believe would fail to achieve the very objective it seeks to attain – stability of our financial system.