Stories about household debt and house prices are everywhere at present. For anyone interested, Radio NZ’s Sunday morning show yesterday had a 20 minute (pre-recorded) discussion with Chris Green, of First NZ Capital, and me on some of the issues. I think we agreed on more than we disagreed, both emphasizing that large falls in real house prices have happened before and will, no doubt, happen again. And the domestic economy is currently less robust than either Treasury or the Reserve Bank would have us believe.
The Radio NZ interviewer was, it seemed, keen to run with a narrative of mass collective irresponsibility, but as I’ve noted here before there is no sign that higher house prices are leading to a huge surge in consumption (any more than has happened with previous house price booms), and good reason to think that many people are very uneasy about the size of the debts they are having to assume to get into a first house. I could have added that house sales per capita, and mortgage approvals per capita are not particularly high by historical standards. Scandalous as the house price situation is, if there is a mania – contagious exuberant optimism – it must be very localized.
Tomorrow, I want to focus again on the Reserve Bank’s stress tests and how we should think about those results. But before getting into that, it is worth briefly repeating a few other relevant points.
First, there is the constantly repeated claim, especially from some commentators on the left, that the system of banking regulation incentivizes banks to lend on housing security, skewing their whole portfolios towards housing lending, beyond the natural levels justified by the underlying riskiness of different classes of loans. That is simply false. The essence of the argument is that in calculating capital requirements, loans secured on housing generally carry a lower “risk weight” than most other forms of bank credit. They do, and that is because such loans are generally less risky. Compare a loan secured on an existing house in an established suburb, supported by the wage or salary income of the occupants, with a loan to a property developer for a new project on the fringe of a fast-growing town and you start to get a sense of the difference in risk. If anything, the initial risk-weighted capital regime (Basle I) probably overstated the riskiness of a typical housing loan and understated the riskiness of many corporate loans (and sovereign exposures for that matter). In the shift to Basle II, many countries appear to allow banks to reduce risk weights for housing exposures too far. New Zealand (the Reserve Bank) was much more cautious (even than, say, APRA in Australia). As I’ve noted previously, the IMF has accepted that New Zealand’s housing risk weights are among the highest used anywhere – other countries have been coming towards us. There are reasonable arguments as to whether risk weights can ever be assigned in a fully satisfactory way – hence the support in many circles for simple leverage ratios, as a buttress to the capital regime – but there is no reason to think that all types of credit exposures should be treated identically. Bankers wouldn’t – with their own shareholders’ money at stake.
Second, there have been plenty of systemic banking crises around the world over the decades. But as the Norwegian central bank, the Norges Bank, pointed out in a nice survey a few years back, which has been cited by our own Reserve Bank,
Normally, banking losses during crises appear to be driven by losses on commercial loans. Loans for building and construction projects and (particularly) commercial property loans have historically been vulnerable. Losses on household loans appear to be a less significant factor,
This was true, for example, in the Scandinavian crises of the early 1990s – savage recessions in which (in Finland) house prices fell by 50 per cent and banking systems around the region got into severe difficulties – and in Ireland in the most recent recession. And each of those crises occurred in fixed exchange rate countries, in which the authorities had (in effect) abandoned the ability to use monetary policy to buffer severe adverse events.
Are there exceptions? Well, the US in the most recent crisis certainly looks like one on the face of it. Housing loans were at the epicenter of the crisis, and the US has a floating exchange rate. But as I’ve pointed out previously, drawing on excellent book Hidden in Plain Sight, much of what went on in the United States was the direct result of the heavy direct government involvement in the US housing finance market, and the legislative and regulatory pressure placed on private and quasi-government lenders to lower their lending standards on housing exposures. Government-directed credit is often a recipe for some pretty bad outcomes. Advanced countries where the government did not have a substantial role in the allocation of credit (especially housing credit) and where domestic monetary policy was set to domestic economic conditions – rather than, say, pegged to German conditions – did not have banking systems which experienced large losses on their domestic loan books, and especially not their domestic housing loan books. I’m not aware of any exceptions in recent decades. I looked at the post=2007 crises here.
Individuals who have taken out large amounts of debt just before housing (or other asset) markets turn can find themselves in a very difficult financial position. If the borrower has a good income, it might just be an overhang of debt that limits mobility. In principle, banks can foreclose on mortgages with negative equity, but they very rarely do so as long as the loan is being serviced. And nasty housing market shakeouts often take place in the context of severe recessions – in part because building activity is one of the most cyclical aspects of the economy and building activity tends to dry up when house prices fall sharply. But the case just has not been convincingly made that the New Zealand economy and financial system are seriously exposed as a result of current house prices per se, or of the current level of household debt. As a reminder (a) that level of debt (relative to disposable income or GDP) is little changed over the last eight years, after a sharp increase in the previous fifteen years, and (b) that level of debt did not cause evident problems when New Zealand last experienced a pretty serious recession in 2008/09. And relative to the situation on the eve of the 2008/09, New Zealand households now have a much higher level of financial assets (again relative to income or GDP) than they had then. The risks now may be more localized and concentrated in Auckland than they were in 2007, but there is little to suggest that they pose more of an independent threat to the whole economy or the financial system. On all published metrics – whether or capital or liquidity – the banking system is in better health today than it was in 2007 – and the same goes for the Australian parent banks. When you dig into the details of the Reserve Bank’s FSR, that is what the data say, but it isn’t what you hear from the Governor.
I’ve been concerned for some time that the Governor has an inappropriate focus on the US experience. He lived in the United States for more than a decade, including during the 2008/09 crisis, and although his role at the World Bank was focused on emerging markets, he got to participate in some of the international meetings that were epiphenomena around the crisis – ie lots of headlines, but of little actual relevance to dealing with the various national crises. Inevitably, that sort of experience influences a person’s perspectives. But the Governor has never given us any reason to believe that the New Zealand situation now is remotely comparable to the US situation in the run-up to the financial crisis.
Despite all the research resource at its disposal, the Reserve Bank has never published any analysis or research looking at the countries which did, and did not, have domestic financial crises (and especially ones sourced in the housing mortgage books). What marked out the US and Ireland, for example, from New Zealand, Australia, Canada, the United Kingdom, Norway or Sweden? Each had very high house prices going into the global recession of 2008/09, each had had very rapid credit growth, most were seriously affected by the recession itself, and yet some had serious domestic loan losses and domestic financial crises, and most didn’t. Almost certainly, the difference was not simply that the US and Ireland were selected for crises by some celestial random number generator, which indifferently spared the other countries and their banking systems. As he rushes from one ill-considered distortionary intervention to another, overlapping one control upon another, exempting some borrowers and some institutions but not others, and impairing the efficiency of the financial system, surely the Governor owes us at least this modicum of explanation and analysis? And that is even before we start asking questions about why the Governor (and his staff) should be thought better able to decide on the appropriate allocation of credit than private institutions whose managers have built careers on making lending decisions, and whose shareholders have considerable amounts of their own money at stake. Last I looked, the Reserve Bank – and the Governor – has nothing at stake in the matter, and they have demonstrated no track record of expertise in making credit allocation decisions. In that respect, of course, they are little different than their peers in other countries. The level of hubris on the one hand, and lack of deep thinking, research and analysis on the other, is quite breathtaking.
And yet our politicians let them get away with it. They leave so much power vested in a single unelected individual – selected by another pool of unelected individuals – whose term is rapidly running out, and who won’t be around to be accountable for the consequences of his intervention. Then again, perhaps he will. A typically well-sourced Wellington political newsletter last week claimed that the Governor is well-regarded in the Beehive and might well be reappointed. It seems unlikely – and I’d be surprised if our scrutiny-averse Governor even sought another term – but the line must have come from someone, presumably someone reasonably senior.
But, on a quite different topic, now I’m going to stick up for the Reserve Bank. Bashing government agency spending on all sorts of things makes good headlines. Bad policies deserve lots of critical scrutiny, and bad polices typically cost taxpayers a lot of money, whether directly or indirectly. But frankly I was unpersuaded by the Taxpayers’ Union’s latest effort, highlighted in the Sunday Star-Times yesterday, around government agencies’ spending on Sky subscriptions. Among core government agencies, the Reserve Bank was one of the larger spenders, with a total outlay of around $12000 in the last year. The Taxpayers’ Union specifically called attention to the Bank.
But why? The Reserve Bank has a variety of functions, some of which (notably the financial markets crisis management functions) which might warrant a Sky subscription even for professional purposes. But even if the rest of them are scattered around lunch and breakout rooms in the rest of the building, so what? Any organization seeks to create a climate that encourages high levels of staff engagement, and the recruitment and retention of good staff. Some people are just motivated by cash salary – always the overwhelming bulk of costs for central government policy and operational agencies – but many are motivated by a richer complex of considerations, including on-site staff facilities – which might include the quality of the cafeteria, fruit bowls, coffee machines, the Christmas Party, Friday night drinks, medical benefit schemes, access to newspapers, or even access to Sky. In the private corporate sector there is a range of different approaches – some no doubt work best for some types of workers, and some for others. Sometimes these things are actually cheap at the price – there is more motivational benefit than there is cost to the organization, which suggests everyone is better off. Access to Sky was never one of the things the Bank offered that particularly appealed to me – then again, the bonds built over a morning coffee, or gathered round a TV late on a rare afternoon when New Zealand was on edge of winning a cricket test in Australia, were probably good for the Bank, and for staff attitudes to the Bank.
I’m all for serious scrutiny of government agencies. But focus on the big picture. Look at the quality of the policy advice and research being offered up. Look at the overall costs of organisations and functions, including overall average remuneration levels – and perhaps even focus on the details when it comes to what senior managers spend on themselves. But leave managers some flexibility to attract, manage, and reward good staff – within those overall constraints – in ways that don’t leave them constantly fearing “will this be a Stuff headline”. We’ll all be a little less well off – citizens who need a good quality public sector, with a limited number of able staff – if we don’t.
croaking cassandra 
With regard to discretionary interventions, I would be interested in your thoughts about the impact of last years investor LVR restrictions. It seems to me that for a few years Auckland prices were increasing about 1% a month before the restrictions were announced. Then they sped up to 2% per month after the announcement, before going flat for 6 months. My impression is that buying behaviour was brought forward and the net effect on Auckland house prices is negligible.
However, this would not be the case in the regions bordering Auckland. For these areas the RB intervention seems to be the direct trigger for a upward momentum in house prices directly sourced from the Auckland LVR restrictions. I wonder if a case could be made that RB intervention caused the regional prices rises to start. Of course late in any real estate cycle the regional prices often start to move, so perhaps it was already primed to rise.
LikeLike
It would be very difficult to separate the various factors that might have been in play in giving a kick up to the regional markets (spillover effects from the LVR limits, lower interest rates, pure market-based displacement effects (for both investors and FHBs). It would be an interesting exercise, and the sort of thing one might hope the RB was doing internally – high-performing organisations are constantly willing to test and questions themselves and their actions. I’d like your story to be true, but that makes me appropriately wary of it!
LikeLike
Nice piece, Mike.
LikeLike
What is so different about this particular cycle is the impact of the Auckland Unitary Plan that would allow multilevel and multiunit sites in Auckland. In all the new residential zoning put forward by the Unitary Plan, it allows for, as a base minimum, a secondary dwelling ie 2 separate rentals on offer for the cost of a firewall, a new kitchen and toilet facilities in effect increasing the rental yield of all existing Auckland rental property. The minimum size of a secondary dwelling is 30sqm with no maximum size, ie you can have a secondary dwelling larger than the main dwelling.
The other variable that economists just fail to grasp is the 3.2 million tourists an increase of 400,000 in the last 12 months on accomodation in Auckland with a planned target of 4 million within the next few years. Previously the entry point was largely through Christchurch and into the South Island NZ prime tourist destination. However since the Chch earthquake all major inbound airlines, Air Asia, Air NZ, China Southern Airlines, Air Phillipines, Emirates etc are all hubbing in Auckland as the first port of call.
Note the lack of hotel building activity and the booming Air BnB business? Just because tourists all look the same as migrants lets just blame migrants for this housing problem. Why don’t we forecast the issue properly and lets plan ahead for investment in new hotels because I don’t think just talking about 26 hotels is going to get us 26 hotels.
I hear the latest $700 million Sky City convention centre and new hotel has been stalled yet again.
LikeLike
The impact of the UP rule “3.3 The conversion of a dwelling into two dwellings” that you refer to is probably still to come. Many investors don’t know about it yet, and the latest update changes the minimum unit size to 40m (which may change back to 30m again in August). Once the UP is finalised it will enable many investors to improve their yield just as you say, as well as increase the number of residential units available to Aucklanders.
LikeLike
I did a simple comparative of international visitors in December 2010 before the earthquake and compared that to December 2015.
Total International Visitors NZ 2010 = 2,525,044
Christchurch Airport 2010 = 519,204
Total International Visitors NZ 2015 = 3,131,927
Christchurch Airport 2015 = 449,664
Most of the increased number of travellers are increasingly coming into Auckland. This is increasingly putting more and more pressure on Auckland housing these international visitors.
http://www.stats.govt.nz/brows…
31/03/2015 Air New Zealand is pulling its last remaining long haul flights from Christchurch, cancelling direct seasonal flights to Tokyo.
http://www.stuff.co.nz/busines…
04/12/2015 Philippine Airlines plans to make its new service to Auckland via Cairns a non-stop flight from Manila. The flag carrier for the Philippines completed its first flight to New Zealand on Thursday afternoon touching down at Auckland International Airport.
http://www.stuff.co.nz/travel/…
11/01/2016 AirAsia X is returning to New Zealand with flights from Kuala Lumpur to Auckland via the Gold Coast from March. In April 2011 it launched a four-times weekly service to Christchurch, but withdrew in May the following year as it focused on its Asian network and Australia.
http://www.stuff.co.nz/busines…
LikeLike
Much of that CHC directed traffic was originally Queenstown bound anyway – and in the earthquake aftermath, many carriers just re-routed their flights to go straight to Queenstown (ZQN). ZQN has had double digit annual pax growth rates for several years now, and is likely to get that into the future for years more. And all of that is within a background of exploding demand for international air travel and falling real international airfares (have you seen the latest price war going on over the pacific?).
I heard a stat which said that fully half of all international visitors to NZ now go to Queenstown.
So all of this is hardly a strictly earthquake related phenomenon. But the wider story about impacts on regional economies is as true for Auckland as it is for Queenstown: they’re both extremely unaffordable, landlocked markets with distorted real estate related impacts. But obviously, I wouldn’t worry about the macro impacts from a much much smaller number of predominantly overseas property investors losing money in the event that the Queenstown real estate market tanks.
LikeLike
Ryan, whatever stats you have heard, best to check next time, is wrong. Christchurch is certainly the largest airport after Auckland International airport for international arrivals and it is still not up to where its traffic numbers were prior to the earthquake. In effect, Auckland is now picking up the additional visitors and these visitors are taking up a huge amount of accommodation space in Auckland. There has been no new major hotels in Auckland built in the years subsequent to 2010. So you can blame the 14k real migrants and the 36k international students granted permanent visas each year or you can focus on the real problem and that is that all the 3.1 million tourists surprisingly look like these migrants for our housing woes???
12 months to December 2015 International visitors
Auckland airport 2,217,088
Christchurch airport 449,664
Wellington airport 213,120
Queenstown airport 203,376
Seaports 31,760
Dunedin airport 11,648
Rotorua airport 2,544
Hamilton airport 0
http://www.stats.govt.nz/browse_for_stats/population/Migration/international-visitor-arrivals-dec-15.aspx
LikeLike
Ryan are you an economist by profession because I am starting to see a pattern of poor research and analysis based on heresay?
LikeLike
GGS: I don’t see anything that I’ve written there which is erroneous – certainly I don’t place much heft in a stat which I’m referring to as ‘I heard a stat which said…’, and I’ll accept if that’s incorrect.
I was referring to growth patterns in passenger traffic in the past few years, not immigration figures per se, so we may have been talking across one another.
LikeLike
Hi Michael,
Of course lending is skewed towards mortgages in NZ. We have an insane system systemic issue where you cannot default on a mortgage and the debt follows you everywhere. This is completely distortionary. NZ should adopt the same system that the US has and allow mortgages to be defaulted on.
LikeLike
You can a,ways default on your mortgages in NZ. It is called bankruptcy.
LikeLike
I doubt it would really make much difference. After all, limited liability companies borrowing to buy investment properties borrow on much the same terms a first home buyer does.
LikeLike
But isnt that due to the personal guarantees that are given by the director/shareholders of the limited liability company?
LikeLike
I don’t know the details but i’d be surprised if you set up a company to buy one house, 70 or 80% LVR loan,if you paid much more – with no guarantees – than you’d pay as an individual borrower. It is a while sense I read the US stuff, but there is quite a bit of work there on how much difference there was between states with and without recourse
LikeLike
Bank requires all directors to sign personal guarantees. If you use a family trust then the bank requires all trustees to provide personal guarantees excluding professional trustees.
LikeLike
Thanks for clarifying that.
The more general point raised by an earlier commenter is whether our system of with-recourse mortgages biases the banking system to residential mortgage finance. I’d argue not. First, full-recourse mortgages (and indeed, any lender requirements for personal guarantees) is a market matter, about how private contracts have evolved, not a legislative one. If there is any legislative biasing it is in those jurisdictions which prohibit full-recourse mortgages. More specifically, even though large chunks of the US were without-recourse, it didn’t prevent a really large accumulation of household debt, and a really nasty shakeout, in the US. Our system – without legislative interference – remains the more common one, certainly in the Anglo world.
LikeLike
Birkdale is now an affordable $700k entry point,
madness takes its toll,
but not for very much longer…
LikeLike
Rents in Birkdale would more than double under the Unitary Plan, allowing a second dwelling at a cost of a firewall, new kitchen and toilets. No additional car parking required and no additional living space.
LikeLike
Listened to Kathryn Ryan, radio NZ 101.4, this morning. Another poor researched attempt by an experienced economist, Kerry McDonald, former managing director and chief economist at the Comalco Group to just blame property investments being able to claim tax losses. It is quite incredible the lack of understanding with business matters. If you are running a rental property business then it is only fair that you get to claim the running costs. In fact property investors as a business group are being unfairly treated because depreciation on building has been removed. Even Australia allows depreciation of 2.5% on building. Economists in NZ must seem to believe that buildings do not depreciate, the paint never peels, the roof never rusts, pipes never age and wiring never deteriorates.
And yet Kerry McDonald makes this huge erroneous unresearched and unreasoned comment that property investors get this huge tax benefit and then wonder why our housing stock continues to deteriorate. It is because NZ economists have this strange idea that you can run a rental business without costs.
LikeLike
I didn’t hear the interview, but on this (quite rare!) occasion I agree with you entirely. Re your final sentence though, only some NZ economists
LikeLike
Might be better to hear the McDonald interview before agreeing (entirely) with this Michael.
Running costs for a rental business are tax deductible, capital expenditure is not, being normally covered by depreciation. Depreciation was subsequently excluded because investors purpose was capital gain from a market appreciating asset, which benefit is not taxable.
Interest possibly should be excluded for the same economic reason – but certainly the leverage of interest should be. That occurs when residential property investors borrow 100% say of cost when 40 to 50% of that is secured against alternate property (including self-occupied) having equity acceptable to a lender.
LikeLike
THanks Phil. I will try to listen to the interview, but my position is that negative gearing – incl for interest and depreciation – is an appropriate feature of a comprehensive income tax system. I have some sympathy with Nordic approaches, which tax capital and labour income differently, and if such a model were ever adopted here, it would certainly require different offsetting rules.
LikeLike
Michael, so called negative gearing is probably appropriate so long as its functioning does not have aberration. McDonald merely pointed out that this distortion was the second biggest driver to housing demand, the other being immigration.
Currently 100% of borrowing costs to acquire a rental property are deductible; whereas that portion raised against alternate private property (self occupied) is actually equity released – certainly the lender considers that.
Further allowing this challenges the contention that investment in rental property is an income earning activity as the costs invariably negate the income – the true purpose is capital accretion, which although having its own risks, tax not one.
LikeLike
Phill, the big assumption you make is that property goes up in capital value all the time which it does not. IRD looks at what the taxable activity is. If the taxable activity is buying and selling property then you are taxed on the profit from buying and selling. If it is a rental property then you are taxed on the costs of that rental activity. It is not up to IRD to tell a business person what level of borrowing is required to run their business. The business risk resides with the business. Banks will lend you 100% against the equity of your own home for any business. It is silly to single out the rental business and say it is wrong to provide rental accomodation.
LikeLike
I would add that now having seen McDonald’s paper I have a considerable degree of sympathy with what is is saying – especially on immigration policy, albeit less so on housing. I will probably do a post shortly about his piece.
LikeLike