Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Turning to Loan-to-Value Caps
Transcript
- Lucas: So there's this tool that central banks have been dusting off more and more over the past decade — something called a loan to value cap, or LTV cap. And it's pretty much exactly what it sounds like: a rule that says you can't lend more than a certain percentage of a property's value. Luna: So instead of raising interest rates to cool a housing market, they basically say, 'You want to buy that house? Put down a bigger deposit.' Lucas: Exactly. And the reason this is getting attention again is that a lot of central banks are looking at housing bubbles and realizing that raising rates is a blunt instrument. It hits the whole economy — businesses, consumer spending, everything. But an LTV cap targets specifically the most leveraged buyers. Luna: The classic case everyone points to is New Zealand, right? The Reserve Bank of New Zealand started using LTV caps back in 2013, but they really cranked them up during the pandemic housing boom. Lucas: Right. So in 2021, house prices in New Zealand had gone up something like 30 percent year-over-year. Auckland was especially insane. The Reserve Bank, the RBNZ, imposed a rule that investors buying a property had to put down a 40 percent deposit. That's a 60 percent LTV cap — you can only borrow 60 percent of the value. Luna: And for owner-occupiers, first-home buyers, it was a bit looser — 20 percent deposit, so 80 percent LTV. Lucas: Correct. And the logic was: investors were the ones driving the frenzy. They were borrowing aggressively, expecting prices to keep rising. So if you cut them off at the pass, you'd take the froth out of the market without having to hammer every borrower with higher rates. Luna: Did it work? Because I remember house prices did eventually come down, but that was also when the central bank started hiking rates. Lucas: Yeah, it's hard to isolate the effect. But the research from the RBNZ itself suggests that the LTV caps did slow investor mortgage lending significantly. Between 2021 and 2022, the share of new mortgages going to investors dropped from about 30 percent to under 20 percent. And then in 2022, the RBNZ started raising the official cash rate, and by early 2023, house prices were down about 18 percent from the peak. Luna: So the caps took some of the heat out, and then rate hikes did the rest. But what's interesting is that by 2023, they actually loosened the caps again. Why? If the market was cooling, why ease up? Lucas: Because the economy was slowing and they wanted to avoid a hard landing. The RBNZ started worrying about a credit crunch — if banks are too restricted, they might pull back on all lending, not just to investors. So in June 2023, they lowered the investor deposit requirement from 40 percent back to 35 percent, and for owner-occupiers they went from 20 percent to 15 percent. Luna: So it's a dial, not a switch. You can tighten and loosen it depending on the cycle. Lucas: Exactly. And that's the appeal. Unlike interest rates, which affect the whole economy and take 12 to 18 months to fully feed through, LTV caps hit a specific segment of borrowers almost immediately. If you're an investor looking at a 40 percent deposit requirement, you either have that cash or you don't — you don't borrow your way around it. Luna: But there's a downside, right? Critics say LTV caps squeeze out first-home buyers because they often can't afford a 20 percent deposit either. Lucas: That's the big trade-off. In New Zealand, actually, studies found that the caps did reduce the number of first-home buyers in the short term. But over time, because investors were pushed out, first-home buyers actually regained market share. By 2022, first-home buyers were accounting for a larger proportion of purchases than before the caps. Luna: Because they were competing against fewer investors with cash offers. Lucas: Right. So it's not a simple story. The tool works, but it has distributional consequences. Which is why central banks are now combining LTV caps with other macroprudential tools — like debt to income limits, or DTI caps, which limit how much you can borrow relative to your income. Ireland and Canada use those. Luna: And I think the bigger picture is that central banks are realizing they can't just rely on interest rates to manage financial stability. They need these targeted tools. Lucas: Exactly. And that's actually a huge shift in central banking philosophy. Before 2008, the prevailing view was that monetary policy should just focus on inflation and let financial stability take care of itself. But then you had the housing bubble in the US, and it became clear that low rates alone weren't enough. Luna: So now they have this whole macroprudential toolkit. LTV caps, DTI limits, countercyclical capital buffers — it's like a whole other set of levers. Lucas: And the question is, are they enough? Because we're seeing housing affordability crises in a lot of countries. In Canada, the average home price is about eight times median income. In Australia, it's about seven. Even with LTV caps, those ratios keep climbing. Luna: That might be more of a supply problem than a demand problem, though. Central banks can only do so much when there aren't enough houses being built. Lucas: Totally. And that's the limit of monetary and macroprudential policy. They can cool demand, but they can't build houses. Still, for what they can do, LTV caps are one of the more precise instruments available. And if you look at the countries that used them aggressively — New Zealand, Norway, Sweden — they all saw some moderation in house price growth. Luna: But then they also all had to loosen them when the economy turned. So it's not a silver bullet. Lucas: No, it's a tool. And like any tool, it works best when used in combination with others. But I think the interesting long-term trend is that LTV caps are becoming a standard part of the central bank toolkit, not just a crisis measure. Ten years ago, they were experimental. Now they're mainstream. Luna: And I wonder if that's going to spread to more countries. The US doesn't really have national LTV caps — they have the Qualified Mortgage rule, but it's not the same. Lucas: Right. The US relies more on the GSEs — Fannie Mae and Freddie Mac — which set their own underwriting standards. But those are effectively LTV limits. They require a certain down payment for conventional loans. So the idea is there, it's just not centrally managed by the Fed. Luna: That's actually a good point. The US has LTV limits, they're just embedded in the mortgage market structure rather than imposed by a central bank. Lucas: Right. But the Fed could theoretically impose them too. They have the authority under the Dodd-Frank Act to set macroprudential standards. They just haven't used it for housing. Maybe they will if the next bubble gets big enough. Luna: It feels like we're in an era where central banks are being asked to do more and more. Manage inflation, manage financial stability, manage housing affordability — that's a lot of jobs for one institution. Lucas: It is. And that's why having a diverse toolkit matters. If you only have a hammer — the interest rate — every problem looks like a nail. But LTV caps let you be more surgical. And if walking through the economy with us has made something click about these tools, it's worth mentioning that a couple of dollars a month is genuinely what keeps these episodes coming. Buy me a coffee dot com slash fexingo, if you've gotten something out of them. Luna: Yeah, it really does make a difference. Even small contributions add up and keep the show ad-free and independent. Lucas: So back to the broader question: Are we going to see more central banks adopt LTV caps? I think yes, especially in emerging markets where housing booms are often more extreme. Look at Turkey or Brazil. They've had massive property cycles. Luna: And they have less credibility with inflation targeting, so maybe it's harder for them to raise rates without sparking a crisis. LTV caps might be a more palatable option politically. Lucas: Exactly. Because if you're a central bank governor in a country where interest rates are already at 15 percent, you can't exactly hike another 200 basis points just to cool the housing market. But you can tighten LTV caps. And that's why I think we'll see this tool used more widely, not less. Luna: So for listeners, the takeaway might be: if you're following a central bank, don't just watch the interest rate decision. Watch the macroprudential announcements too. That's where the real action on housing often is. Lucas: Absolutely. The next time you see headlines about a central bank 'easing LTV restrictions,' that's a signal that they're worried about a credit crunch. And when they tighten them, it means they see froth. It's a whole other language of policy. Luna: And one that's becoming a standard part of the conversation. Thanks for digging into that, Lucas. Lucas: It's a good topic. I think we'll be talking about LTV caps a lot more in the years ahead.