Sunday, March 13, 2011

A tentative suggestion

I am generally not in favour of solving problems by more regulation, but regulations which encourage stability, reduce risk and increase information can be a net economic benefit. (The problem with many regulations is that they set up poor incentives, and/or suppress or distort information: which includes a tendency to suppress information about, rather than reduce, risk.)

With that in mind, thinking of the problem of asset bubbles and the problems with property as an asset -- set out rather usefully here -- lead me to suggest that it may be appropriate to ban borrowing money to buy a house beyond its net present value (NPV) capitalisation of the present (market value) rental income. That is, to limit the debt portion of the purchase to the NPV capitalisation of the rental income (as it would be if it was offered for rent).

This would bar betting on capital gains with borrowed money (so the banking system would not be exposed to a collapse in expectations of capital growth) and would make it clear how much of the price was based on expectations of capital gains, increasing the flow of information about house prices.

The rule could be extended to commercial property as well to eliminate any fuss over definitions.

The thought was prompted by two things. First, that Texas did much better than Georgia in the recent housing problems in part of because, even though neither had a significant housing bubble, Texas has more restrictive rules about borrowing for house purchase so Georgia suffered far more from the sub-prime crisis.

Second, that when a housing bubble bursts, house prices tend to collapse back to around their rental income value. Rather than being based around some arbitrary notion of a "good number" about borrowing limits (some X% of price), the proposed rule would be based on genuine information about house value.

Increasing information, increasing stability, reducing risk, fairly straightforward to follow: a possibly useful rule.

NB: This post is a work in progress, and has been amended to hopefully make it clearer.


  1. A better way to express this is to limit the debt portion of the purchase to the NPV of the market value rental income. If a property has a rent NPV of $10,000 but I value it at $20,000 for personal reasons, then I may still pay $20,000 for the property, but I can only borrow to a limit of $10,000 for that purchase. You cannot regulate how people use their own money, but it is useful to stop artificial inflation occurring by connecting borrowing to a real value and not a perceived value.

  2. Thanks! That is a useful reformulation, which I have amended the to adopt.

  3. What you are describing could be referred to as "counter-cyclical" lending requirements. I think you'll find your suggestion is not being discounted even at the highest levels.

    The problem comes in when one region of an economic area sees rents appreciate faster than another region, or a region undergoes densification such that an existing property can be seen as having higher rents due to redevelopment. In both cases the amount being loaned out could be more than the present-day cash flows warrant. Think growth stock.

  4. Nice to be taken seriously :)

    I am not quite sure what you are trying to say in that second para. I am not trying to abolish risk, merely reduce unfortunate feedback effects.

  5. NPV values (i.e. assumes) future cashflow, and implies a continuity of ownership. Why not use a capitalisation of present market rental?

    Otherwise - very interesting, and thanks Lorenzo.


  6. Ah, now I see the distinction. Yes, good point.

  7. Lorenzo, off topic I guess, but I like two concepts proposed in this piece -

    1) The re-use of material in the renewed basic structure
    2) The recognition that the inside of a dwelling should be easily replaceable/modifiable.

    I am not on commission.