Do variable mortgages prevent crashes?

Last month, the Federal Reserve Bank of Richmond published a report, Foreign Housing Finance, which highlights a number of problems with the US mortgage financing system and proposes a number of reforms based largely on the financing systems employed in other developed nations.

While the entire report is interesting, the below chart, in particular, grabbed my attention:

According to this chart, around 90% of mortgages in Australia, Spain, Ireland and Korea are variable rate. By contrast, the reciprocal is true in the US, where over 90% of mortgages are fixed-rate.

Now we have all heard the claim that Australia’s housing market would be protected from a US-style collapse because, amongst other reasons, the overwhelming majority of mortgages are floating rate. And the implication of having a floating rate system is that any reduction in official interest rates by the Reserve Bank of Australia (RBA) would flow more or less directly into mortgage rates and support house prices because:

  1. forced sales would be discouraged due to the lower interest burden on pre-existing mortgages; and
  2. potential home buyers would be encouraged into the housing market by the lower mortgage rates on offer.

The hypothesis explained above runs in stark contrast to the experience of the US where, because of the widespread use of fixed-rate mortgages, the Federal Reserve was largely impotent in its ability to reduce the interest rate on fixed-rate mortgages via monetary policy.

Putting to one side the debate over whether Australia is facing a US-style housing crash (highly unlikely in my view), Ireland and Spain provide a useful test of the thesis that Australia’s variable rate mortgage structure, combined with a reduction in official interest rates by the RBA, would prevent home values fall falling significantly.

Both Ireland and Spain have experienced sharp house price declines despite having a similar share of variable rate mortgages:

There is, however, one important difference between the Spanish and Irish mortgage financing systems to Australia’s: because Spain and Ireland are members of the European Union (EU), their interest rates are set by the European Central Bank (ECB). So, in contrast to the RBA, which has the ability to directly influence mortgage rates when it sees fit, control over Spanish and Irish interest rates is vested in the ECB, which sets rates based on the EU as a whole, not individual member countries.

Because of this important difference, interest rates in Ireland and Spain were arguably set too low during the boom years and then were not reduced quickly enough during the down turn. The below chart, which has been sourced from the latest RICS European Housing Review, shows average mortgage rates in Spain since 2005 (rates would have been similar in Ireland, given they are set via the same ECB official interest rate).

As you can see, mortgage rates plummeted from around 6% to 3% in the six months to mid-2009. Yet Spanish house prices, which had peaked in mid-2008, continued falling.

Irish house prices, on the other hand, had peaked a year earlier in mid-2007, and the sharp reduction in mortgage interest rates arguably came far too late to arrest the slide.

Overall, it is hard to argue against the claim that Australia’s variable mortgage rate structure could help significantly in mitigating any housing adjustment caused by, say, a China hard landing or some other major external shock. While slashing official interest rates probably wouldn’t prevent house prices from falling altogether, they could at least turn a potential crash into a more modest adjustment – perhaps something in between the ‘slow melt’ currently being experienced in New Zealand and a UK-style correction.

As was illustrated by the Irish and Spanish experiences, the key to whether Australia’s variable rate structure is ultimately successful in forestalling any adverse shock would depend largely on whether the RBA acts quickly and decisively in dropping rates.

What do you think? Would Australia’s variable mortgage rate structure prevent house prices from crashing in the event that China experiences a hard landing (or we experience some other major shock)?

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Unconventional Economist

Comments

  1. Depends on how much of the RBA’s cut the banks passed on in the event of an economic shock I guess. Mortgage rates are already close to historic lows.

    I personally know very few people with a mortgage who could survive the sudden loss of one partners income or even a significant loss of working hours, such is the proportion of disposable income that goes into servicing payments on their McMansions. The banks would need to pass on a fairly significant sized cut from the already low levels of today.

  2. Variable rates certainly give the RBA great power to ‘Ease the Squeeze’ for existing borrowers but any objective to attract new debtors with depressed interest rates would be daft.

    That would just create a new wave of borrowers ready to squeal when there is a need – inflation – or desire to return rates to a level that are attractive for savings.

    Interest rate policy is limited cure for past bad interest rate policy.

  3. This is an excellent question. I’ll give a bit of perspective from the utility side. Utilities will typically finance large capital projects, like dams, power plants, or pipelines say, with bond issuance. They will almost always match the duration of the bond with the expected capitalization of the asset. The question to ask, then, is why don’t utility companies keep rolling over short-term financing at preferable rates, if there is a spread to be had?

    The answer I think is that their revenues from the property are mostly fixed so they try to match the financing with the expected cash flows. If there is some credit shock over that time, they may be in a huge crunch if funding dries up. For housing the rents _should_ lean an investor towards a fixed financing scheme.

    Just saying, the fact that investors in assets of similar cash flow and risk profile to housing choose fixed rate financing when housing is on a variable schedule is an odd disconnect.

    I agree that the data and analysis supporting a stable housing market due to lower financing costs are highly suspect. The underlying business case for housing doesn’t change with financing schemes; people often forget that. Governments cannot finance away risk no matter how many magic mirrors they erect.

  4. Our high incidence of variable mortgages has clearly given the RBA more bang for its buck, particularly when it slashed the cash rate in the face of the GFC.

    But will variable mortgages be such a great place to be in the longer-term, where I expect the definitive structural trend to be a rising cost of capital? I suspect not…

  5. I certainly hope you are right and the logic seems sound. A crash here would be utterly devastating but prices are just simply too high.

    At least a slow descent or a stagnation would allow other areas of the economy to adjust and take over.

    Oh for better leadership.

  6. Very interesting question. Perhaps the variable rate does provide some buffer and as you say allows the RBA a more powerful tool when required. If rates are headed north there remains the option of fixing for a period, chosen by the borrower when most suitable – another buffer.

    A large scale ‘crash’ scenario has never been my view, more like yours, a slow burn if anything. Housing plays such a powerful economic, political and emotional role in this country that I wonder if it ever did look like ‘crash’ government and banks would get together and put in place a range of measures (interest only, repayment postponement, principal reduction, etc) to ensure a ‘crash’ did not occur. One of the benefits of a smallish country with fairly uniform beliefs, a developed social conscience and a government/banking/housing complex!

    A crash is not in anyone’s interest from an economic and social perspective. In this country, housing is more than just a house.

  7. This is another ‘It’s different here’ story. Bring on the kangaroo chorus!

    Yes, variable rate mortgages do transmit RBA signals well when rates are in normal ranges. If the RBA elected for a zero interest rate policy in response to the jagged falls in land prices I foresee, the banks may well ignore RBA ‘jaw-jaw’ and elect to improve their margins to offset coming loan losses. I would if I could were I a bankster.

    IMHO, The benefits of VRM outlined are also already capitalized into Australian land prices, which vastly exceed even the US bubble (price to income) so this feature is nullified.

    Homeowners who paid astronomical prices for shelter and older deep-sunk owners sitting on tattslotto gains want Australian land prices to stay high. But these prices are crippling young adults – either they submit and commit to a lifetime of crippling repayments on a ‘starter’ home or they stand aside and live as renters – second class citizens in a property owning democracy. Do not underestimate the deep anger and frustration harbored in these young hearts.

    We have just seen property flip into major oversupply. The supply and demand dynamics that favored the boomers and ‘gearers reversed.

    The benefits of variable rate mortgages over fixed are useful but small compared to the giant forces unleashed in The Great Australian Land Bubble.

  8. I think variable/fixed rate mortgages is a bit of straw-man argument. What matters most are actual rates. If mortgages in the US were to be analysed, we may find that many of them are locked into quite low rates (or refinanced). The level of interest rate for those loans would be similar (if not lower) to what we have right now here in Au. Variable rates do give RBA/Fed power to ease the burden, but it is hard to see how when the rates are historically low.

    Btw, great site and a great bunch of bloggers + commenters. I recently moved here from US, and since then been having an education when I visit the site (daily). By day, I am an academic (though not an economist—so dont kill me), so I always appreciate a convincing, well articulated argument backed by solid data.

    • Welcome to Oz. 🙂

      MB certainly has helped me understand a bit more about Oz with its wacky policies and weird stuff going on. 😛

    • Yes, this is my understanding of the US market. Sure they have fixed rates, but if someone is offering a better rate you usually just refinance it at the better rate.

      Just because you are on a 30 year fixed rate, doesn’t mean you are going to end up on that rate for 30 years.

      Of course right now a fixed rate loan is a great thing in the US if you are only paying 3.5% on your mortgage and who cares if the Fed ups the rate.

      Personally I rather like fixed rates. They give you stability and as a mortgage holder you don’t have a gun to your head every month like you do in this country.

      As an investor it is much better to know what your fixed costs are month on month.

      Also I feel there is only so much wriggle room in rates. In the US their rates have been bugger all for the past 4 years and prices are *still* dropping in many parts of the country.

  9. I covered this topic here http://popping-bubble.blogspot.com/2011/05/will-rba-save-housing.html

    In short I think that RBA is facing situation somehow similar to ECB situation few years ago. European Union was struggling with geographic two speed economy (Germany on one side and PIIGS on the other). ECB was not able to change rate in response to PIIGS problems because of potential damage to the rest of economy. We are facing somehow similar situation sector type two speed economy. As long as resource sector is doing well (China is doing well) RBA will not be able to respond to slowly falling house prices and service sector fall. By the time pain becomes so large and forces RBA to respond it will be too late.

    Our economy is quickly becoming EU style economy. Mining is our Germany while retail and housing are our PIIGS. Strangely, it looks that only the quicker China’s crush comes more chances for housing to survive because RBA could intervene soon enough. If China boom continues our housing is big problem.

  10. US Agency mortgages are just fixed rate. They are prepayable at no penalty or mark to market. So if a borrower has a mortgage at say 8% for 30 years but he can refinance at 6%, then he can do this at little cost.

    However, the interest rate is set by the market process using the 30 year bond as a base measure. So the US does have interest rate setting power.

    I think our variable rate system is much riskier for borrowers than the US we have just not reached the point since deregulation where this risk is highlighted.

    The problem we have and as other countries have is the big figure ie principal. However, if Australians and offshore bankers continue to plow money into our banks for mortgages at current rates or lower rates then the risk will not come home to roost. That’s the ket not the RBA setting rates.

    In a crisis I can’t see how the RBA can manage rates and the availability of funds without the result we’ve seen in the US and Europe of bank bailouts

    • If the much touted “operation twist” was ever to be undertaken by the Fed, i.e. pushing down the 30yr rate, this will give home owners the opportunity to refinance at even lower rates.

      Next step will be to consider Prince’s point below: do the punters spend the difference or pay off debt.

    • When I lived in the US my colleagues were re-financing home loans as you say, and when I look back they were “jumbo loans” and I hear many Aussies have minimum deposit loans so similar to the US.

      As long as our non mining employment is sustainable we’re probably ok, but I think we’re on a knife edge. Credit is getting harder in China as well so a slow down all round is very possible. That’s regardless of all the things we’re seen in Europe the last few days.

    • Agreee Deep T, the ability to prepay fixed rate loans in the US is much easier than here.

      In oz taking a fixed rate loan is really betting that you are better at predicting interest rates than the bank (since they get to set both rates).

      It only really makes sense if your exposure to a rise is signifcantly disproportinate to the gain on a rate fall ie you have a fixed income with very little capacity to improve earnings over the long term.

  11. Great article Leith.

    there is only one problem with the “lower interest rates will forestall a correction in house prices” argument:

    what if mortgagees, now spooked out of their skin that they have a massive mortgage, instead of taking advantage of the extra $200-800 a month in their back pocket, actually use that “surplus” to pay off their mortgage?

    Instead of spending it…..thus agg. demand doesn’t go up at all and the lowering of interest rates did nothing but hurt bank profits (they receive less interest and their assets – mortgages – reduce in size).

    This “structural shift” in saving (or disleveraging) is almost never talked about amongst the bullhawks with regard to the openly structural shift in the savings rate, which has obviously reversed.

    • ‘what if mortgagees, now spooked out of their skin’…

      You mean ‘mortgagors’. The lenders are the mortgagees.

      Apologies for impertinence – it’s a pet peeve.

    • Deus Forex Machina

      I’m with you Prince…the demand side of the equation wont be fixed simply by lower rates. I dont think the pavlovian “rate cut buy house” reaction is there anymore…

      I think, hope and pray, that Australians have learned their lessons are are rebuilding their personal balance sheets – i just hope they keep supporting their local shops, cafes, restaurants and industries while they do it otherwise its going to be a very bland economy in 5 years time.

    • I think the dropped rates ‘work’ more by allowing stressed borrowers to keep paying the mortgage, therefore reducing forced sales, rather than boosting spending power. Lower supply should reduce downward pressure on prices other things being equal.

      On the other hand, if the 1.2 million negatively gearing investors, who I believe are investing largely for capital gain, get spooked because they can’t see the expected capital gains, then I think anything could happen.

  12. What happens when debt is unserviceable even at the lowest possible mortgage rate. We run out of monetary policy levers. A growth of mortgage debt from here will ensure this.

    Once monetary policy becomes useless, enter Fiscal policy where it just stops short of the government buying the house for the buyee.

    Even MMTers will agree such large scale intervention to stop a 3 trillion dollar housing market falling to anything below is just “waste” of “free” money as the return of productivity on such intervention is very very low.

    • “What happens when debt is unserviceable even at the lowest possible mortgage rate.”

      Yes, I agree that’s the key point.

      A variable rate will help, and RBA can be proactive with lowering Interest Rates; but if a real, large scale recession happens, where people confidence is crashed, nothing will stop house prices from correcting significantly (unemployment, etc.)

      Let’s not forget the GFC has been the worse recession since the depression in the US and the EU. I know what house prices would do in Australia should the unemployment rate go from 5% to 9%.

  13. It doesn’t make much difference when rates go DOWN, but there are two important effects when rates go UP:

    1. with variable rates, the “pain” is spread evenly among all mortgage holders, rather than falling disproportionately on new buyers.

    2. with fixed rates, there is a huge incentive for people to stay in their existing home (or state) because if they move to a new one they will be paying the higher rate.

  14. As a First Home Buyer that is not buying – saving instead – I think the rates argument is overstated.

    Most of my contemporaries have worked out that rates change and it is the amount of capital that is required to borrow that is the problem.

    Lower rates certainly do help those already in debt, but they are losing their appeal in enticing new entrants into the market.

    • +1

      It got to the stage some time ago where the amount we (FHB couple) were required to borrow to buy was only serviceable at abnormally low rates. What kind of hopless optimist would take on huge debt in those circumstances?

    • Agreed – we are in the same position.

      As current rates appear to be on that edge and an increase in rates (to me) is more desirable for FHBs.
      Rates go up > more defaults > more stock on market forced to sell > prices down > interest on savings up

      It also means those who have not saved a large deposit have a reduced purchase power.

  15. I agree with indo. Surely the issue is the total debt burden, relative to income/GNP. In an environment of deleveraging and ‘normalising’ of asset values (whether by crash, steady decline or stable nominal but negative real growth) there will be little appetite to borrow at any rate and monetary policy is ‘pushing on a string’. This is where the US has got to.

    However, ZIRP would clearly improve the serviceability of existing debt and this must have some positive impact at the margin (therefore reducing the likelihood of a ‘crash’). IMO, of equal importance here in Australia are the structural/cultural factors such as full recourse, ‘home is the castle’ culture etc. Default really is the last option here.

    The unfortunate reality is the best we can hope for is a slow, gradual adjustment of real house prices, while mortgagees continue to meet their debt obligations and reduce leverage over time. As others have noted, the disleveraging appears to be happening at present. This doesn’t bode well for final demand, however.

    • …and perversely, the negative feedback loop of this downward pressure on demand from disleveraging in turn increases the odds of a ‘crash’ scenario…

    • Just one comment – the ‘home is the castle’ attitude and full-recourse loans also apply/applied in Ireland (where I am at the moment). It’s actually even worse here when it comes to recourse as it’s much harder to declare bankruptcy in Ireland.

      See http://www.mondaq.com/article.asp?articleid=119784:

      The BA 1988 overwhelmingly favours the rights of a creditor over the rights of the debtor and as a result, the consequences of being adjudicated bankrupt are extremely onerous. Some notable effects of being adjudicated bankrupt are that:-

      – all the debtor’s assets and property automatically vest in the Official Assignee;

      – the bankrupt must disclose any property acquired after being adjudicated bankrupt and this vests in the Official Assignee;

      – it is an offence for the bankrupt to act as an officer of any Irish company or even of any foreign company which has an established place of business in Ireland and to also take part or be concerned in the management of such a company without leave of the court;

      – the bankrupt cannot obtain credit over €630 without disclosing his status as a bankrupt;

      – the bankrupt’s salary is likely to be attached in favour of the Official Assignee; and

      – the bankruptcy may be discharged after twelve years (provided that all other requirements have been met).

  16. Variable interest rates affects the delinquency rate, with a secondary effect the effect on house prices. Take Spain for example. Their unemployment rate is estimated to be around 20%, however their delinquency rate is only 2.5%. In contrast, the US have unemployment rate of 9% and delinquency rate is 8%. Variable interest rate protects the banks more than the home buyers.

    http://www.bloomberg.com/news/2011-07-13/dial-a-crowd-confronts-debt-laden-spanish-banks-by-thwarting-foreclosures.html

  17. I don’t understand why the free market principle of personal responsibility doesn’t work anymore in the developed world. Wasn’t that the free market best regulator? Why should other people pay for someone’s excesses and exuberance? This is not a free market approach to the problem, it is very much socialist. Wasn’t the socialism something bad? We are living in the worst kind of socialism, where the bad decisions are rewarded and their consequences are socialized, but the good ones are penalized. There is no other way of remembering or understanding what is good and what is bad, but via bearing the consequences. How would people behavior change if they don’t bear the consequences of their own actions? Is there any other means of changing people’s behavior, which I am not aware of? Please, could someone explain to me?

    • Who says capitalism, the way we know it, means free markets? Before we jump on blaming socialism, it is important to understand that both socialism and capitalism, in their extreme, are equally bad.

  18. I can’t see the RBA being able to move decisively in the event of an external shock. Any major economic event will almost certainly trigger a new round of QE in the US. This in turn will cause commodities to spike and therefore faster inflation and further overheating in the mining sector.

    The only way the RBA is going to get a clear shot at economic stimulation is if the Atlantic economies and China go down together at the same time.

  19. Excuse me if this is out of line, but…

    The first chart is loans made ‘in’ 2009. Is that not well after the US started having a housing decline? Does it tell us anything at all about the US in fact, when we can’t see the previous 8 years of loans? They could have been 99% variable for all we know?
    I do get what this article is about though, and I don’t entirely disagree with it’s points, but I do question the premise on which it was written if that revolves around the first chart.

  20. I heard an RBA officer speak recently, and he noted the predominance of variable rate loans in Australia. He said the RBA liked it – very useful to macroeconomic policy making.

    But the point he made about it was not that it tended to prevent crashes, but that it could help prevent bubbles – as the RBA did in relation to Australian house prices in the early 2000s.

    Some might beg to disagree with the RBA’s claim of success in this regard.

  21. Since mid 2009 you could get a sub 4% loan in Ireland (all ECB ammo fired).

    Over the next 18 months prices fell a further 24% FROM THAT TIME to be 40% from peak.

    Mortgage rates are still sub 4% and prices are still falling.

  22. I don’t really see how fixed or variable makes much difference unless you’re offsetting cost of living expenses. I imagine forced sales are due to becoming unemployed, whereby the mortgage type would make no difference.

    • +1

      Indeedly doodly.

      Don’t forget highly leveraged pyramiding: equity in 1 buys 1, then buys 2, then 4, then 8. Take off 20% and you are in the poo.

      Plus, boomers cutting and running.

  23. I think the difficulty of this post is that it makes its comparisons solely through the financial lens, without looking at the structure of the different housing markets when the interest rate changes were made.

    One material difference between Australia and Ireland (and also I think Spain from my reading) is the volume of new housing which is now excess stock. Australia does not have suburbs of new, empty, unsold and unsellable houses that exist in parts of Ireland due to a government that was hell bent on making itself look like a great feller by heaping fuel onto an overheated market with all sorts of support and removing of restrictions (also addicted to very high property transfer taxes, way higher than here).

    Therefore it is difficult, I think, to talk about falling Irish house prices solely through the interest rate/variable rate prism. If you want to do that, then you need to look at countries with similar housing stocks and with different mortgage rate structures.

    The correct comparison between Australia and Ireland is that if you have banks that exercise just a little bit of quality control in mortgage lending, and a government that doesn’t heap fuel on a construction bubble to get itself reelected, then you don’t get empty suburbs and house prices don’t keep falling after variable mortgage rates have hit the bottom and housing markets are much more responsive to central bank interest rate policy.

    I don’t know whether the Spanish government was as appalling as the Ahern Irish government, but Spain does appear to have a very large over supply of stock which will take a long time to clear (similar to Ireland where they are talking of bulldozing unsold new houses to bring the market back to some balance), something we’ve not had here.

  24. Also there is the factor that a lot of 55+ people want to cash out -no debt, no investment properties, no shares.

    However you have the bankers feedback loop of 80% mortgage rehypothication on deposits as described by DT.

    There is only one risk management strategy that I know of that succeeds.

    “No man was ever shot while doing the dishes.”