This is an excerpt from the recommendations chapter of Print: The Central Bankers Bubble.
The 30-10-30 Plan
My first recommendation is designed to help countries never get caught up in the worst of asset bubbles in the very first place: a credit-fueled property bubble. And we know, these IZNOP business models have a 100% track record of failure, and they just need a trigger to send an economy crashing back to earth. No country or central banker can outsmart or outplay an IZNOP business model. That’s what history and the laws of economics tell us. When these credit-fueled property bubbles burst they always crush the banking system that fueled the IZNOP model and leave a population confused because they thought “this time it was different.”
My 30-10-30 plan is a plan that can be universally adopted and easily regulated. Many influential economic commentators, such as Stanford economics professor Anat Admati, are arguing that banks need to hold a lot more capital than they currently hold. When banks hold more capital, it generally means they are taking less risk. Who wants to hold their money in a bank that takes excessive risk? Unfortunately, many banks around the world hold very little capital against the risks they have undertaken. Australian banks are a very clear example. This leaves them very vulnerable to economic downturns, particularly when it comes to credit-fueled property bubbles. Banks around the world that take excessive risks don’t like to hear that they should hold more capital, because it means that they make less profit when times are good, which affects the market capitalization of the bank. But banks also expect their central bank and government to be there to bail them out when the crap hits the fan. The less risk the banks take, the less chance there is that an economy will get caught up in an IZNOP business model. In addition, there is less risk that a bank, or banking system, will require a bailout or go bust!
My 30-10-30 plan can also organically force banks that lend to homebuyers to hold more capital across the board. And my 30-10-30 plan helps to provide enough buffer to the banks’ risk profiles when they lend to homebuyers. In other words, it helps to build sustainable foundations between lender and borrower.
The first part of the plan is that homebuyers may not borrow more than 70% of the purchase price of a property. A homebuyer must come up with a 30% deposit or greater. This is the cut-off line. No exceptions! For example, if a homebuyer wants to purchase a $150,000 house, he needs to come up with the first $50,000 as a deposit for the home. This gives the bank that lends to a homebuyer a lot of breathing space between the value of the property at the date of purchase versus any economic instabilities that may arise in the future.
As an example, the homebuyer purchases the $150,000 home and loses his job in the midst of an economic downturn. Because every other buyer also had to come up with at least 30% deposit for their purchases, even if the property market were to fall by 30%, the banking system would still not be put in as bad a situations as the American or Irish banks back in 2009. These situations came about because a lot of homebuyers only provided a 5% to 20% deposit to purchase a home, and the property market got caught up in the IZNOP model and property prices fell, the damage was already done. A 30% deposit or greater with no exceptions is an effective enough buffer to stop homebuyers and lenders taking on excessive risks.
The second part of the 30-10-30 plan is that homebuyers who take a loan must hold in an account the equivalent of 10 months mortgage repayments. And for arguments sake, this could be held by the bank as its own Tier 1 capital until the loan is fully repaid. These funds must come from the homebuyer’s income. Nothing else. Not a gift from parents, not a wedding gift, not casino winnings, etc. The homebuyer cannot touch this money and it generates interest while the money is held by the loaning bank. As the homebuyer’s loan comes close to being fully repaid, the last mortgage repayment the homebuyer makes will be the 10 months worth of mortgage repayments that was deposited, on top of all the interest earned. This should dramatically cut down the overall time it takes a homebuyer to pay his or her home loan.
If, for whatever reason, the homebuyer suddenly is unable to pay mortgage repayments at a particular time of hardship, the bank will extract funds equivalent to the monthly mortgage repayment from the particular account holding the 10-months’ worth of mortgage repayments. Once again, this reduces the bank’s risk on the mortgage made, and it also provides a buffer for the homebuyer to get his or her act together. It’s a win/win for both lender and borrower. As an example, if the homebuyer lost her job, she wouldn’t need to offload her property right away. She would have enough time to find another job and income source. Wouldn’t that have come in handy for Irish banks in 2009! And if the homebuyer can’t find a way to resume making mortgage repayments after 10 months without a job, well, that’s when the home enters receivership. But this strategy buys both parties a lot of time. And in most economic downturns, more time is by far the hardest commodity to find.
As a clear example:
If a homebuyer were to purchase a $150,000 home with a $50,000 deposit. The home loan would come to $100,000. In the first year, the monthly repayment on a 10-year loan that charges 10% interest is $1,666. Therefore to secure the loan, the homebuyer must deposit $16,666 into a holding account he cannot touch. The only reason this account can be touched is if the bank needs to take monthly mortgage repayment installments out of this account if the homebuyer is experiencing financial hardship. As the sum value of the loan becomes smaller as it gets paid off, these held funds will be able to make repayments for a prolonged period of time. I.e., five years into the mortgage repayments, the homebuyer still owes the bank $50,000 and is still paying 10% interest. That means this buffer should last 20 months in a period of financial hardship.
Overall, I believe this holding of funds that are equivalent to 10 months of mortgage repayments would be a good way to helping both the bank and borrower from getting themselves into a financial mess. It’s also an important tool to prevent a property market from getting caught up in an IZNOP model. And I make a fair argument that the bank could hold this equivalent of 10 months of mortgage repayment to be classified as Tier 1 capital until the loan is fully paid.
The third part of the 30-10-30 plan is that homebuyers aren’t allowed to spend more than 30% of their after-tax monthly household income on their mortgage in the first 12 months. Furthermore, a bank cannot lend a homebuyer a sum of debt that would mean that they would have to spend more than 30% of their income on mortgage repayments. This is important for many reasons.
Firstly, this protects the banking system from lending to homebuyers who have very generous parents willing to take excessive risks on their children’s home purchase. As an example, in Australia parents come up with massive deposits for a home for their middle-aged kids, and still their children are stuck paying more than 50% of their incomes on mortgage repayments in a record low-interest-rate environment.
Secondly, it assures that regardless of what a household earns, the homebuyer will still be able to spend the greater proportion of his income on the greater economy outside of real estate. If a homebuyer is thick in an IZNOP model, he is exhausting so much of his income (prior to possibly losing his job) on mortgage repayments, that he, and his lender, are contributors to the break down of the IZNOP model. All it takes is for him to lose his job!
Thirdly? It just makes common sense! Nobody should live in a home and feel like they cannot enjoy life and spend some money outside of that home. And if interest rates rise, well, there’s a big buffer compared to the household members that already spend 60% of their disposable incomes on mortgage repayments and then have to pay more when interest rates rise.
The overall benefits
There are so many external benefits to the 30-10-30 plan. It’s also a plan that doesn’t impede on property developers, construction, and property investor activity. In fact, it would offer property investors a much better annual gross rental yield. Because the 30-10-30 plan stops the property market from finding its way into an IZNOP model, it means less overall risk is taken for purchasers.
In November 2014, look at how much it cost property investors in Houston, Texas, and Melbourne, Australia, to purchase an investment property that would earn $30,000 in gross rental yield. It’s not hard to guess which city is caught up in an IZNOP.
House Price to attain $30k gross rental income
As you can see, the common property investor in Houston is earning the same in gross rental income as the Melbourne property investor, but spending $500,000 less! If a Houston property investor spent $722,891 on three investments properties, the investor would be getting back almost $100,000 a year in gross rent. With my 30-10-30 plan, there’s no way that the Melbourne property market would ever be able to get as overly priced as it has in the first place, which would allow for property investors to earn a much better yield on their property and monthly incomes!! Not just a monthly losing tax write-off while in pursuit of capital gain! And believe me, when the credit-fueled Australian property bubble bursts, some great jokes could be made if the problem wasn’t so grave.
Today, the American property market is probably the market that could adopt the 30-10-30 plan with minimal impact on its economy. Property across the country (apart from a very small handful of major cities) is relatively affordable when compared to many overseas First World countries. And I truly hope this 30-10-30 plan is explored by banking regulators and central banks around the world.
There are simply too many instances wherein too much risk is taken by both the lenders and borrowers and property markets get caught up in IZNOP business models. America saw a stock market crash in the late ‘80s and early 2000s, as well as in 2008/9. But the last crash was the worst on the back of a credit-fueled property bubble bursting. Japan’s credit-fueled property bubble burst and it was all over for them. So why do global economic regulators allow for these IZNOP models to happen in the first place, now that we know what the end result is?
The 30-10-30 plan is the regulator’s best friend when it comes to protecting an economy from going anywhere near the worst of economic edges. But unfortunately, it’s too late for countries like China and Australia. Their IZNOPs will burst. But hopefully, in the future, their governments will never let property prices get so far out of reach through the use of toxic credit again! Let’s never forget, buying a home is more often than not the largest investment an individual will make in a lifetime. And it is the single asset class that can put the neck of any economy under the guillotine’s blade.
Lindsay David is the author of Australia: Boom to Bust and Print: The Central Bankers Bubble. David recently founded LF Economics and holds an MBA from IMD Business School