Brian Gaynor: Challenge to stop housing boom turning into bubble

The latest Reserve Bank Financial Stability Report concludes that New Zealand’s financial system is sound and operating effectively. 

However it identifies three main risks:

• Soaring house prices – house prices are overvalued on several measures, particularly in Auckland, and individual debt is high relative to income.
• Dairy industry debt – financial stress in the dairy sector could rise markedly if low global milk prices persist beyond the current season.
• Loose global financial conditions – global interest rates remain extremely low and have encouraged investment in riskier assets. The Reserve Bank believes the “current benign [global] market conditions could unwind in a disorderly fashion, affecting the cost and availability of offshore funding for New Zealand banks”.

The Financial Stability Report, which is published every six months, is the fifth consecutive document to identify soaring house prices and mortgage debt as the main risk to the country’s financial system.

The big difference this time is that the Auckland housing market has been clearly identified as the main problem whereas in the past Christchurch and the rest of the country were also recognised as areas of concern.

Farming debt has been identified as a risk for the third time running and the Reserve Bank continues to warn that banks are too reliant on overseas funding.

The only risk to be removed since the November Financial Stability Report is the potential impact of a Chinese economic slowdown on the New Zealand economy.

The latest Real Estate Institute of New Zealand (REINZ) sales data shows Auckland house price growth is accelerating rather than slowing down.

The region’s median house price escalated by 17.7 per cent in the April 2015 year compared with 10.2 per cent in the April 2014 year and 13.3 per cent in the 12 months ended April 30, 2013.

The Auckland median house price has soared by 46.9 per cent over the past three years while the national median price has increased by 24.7 per cent over the same period.

Two years ago the Reserve Bank introduced the following measures to dampen down the housing market:

In September 2013 it required banks to hold more capital against high-LVR (loan to value ratio) housing loans.

The following month it introduced measures to restrict the proportion of new high-LVR lending.

The Bank’s November 2013 Financial Stability Report concluded “these policies are expected to slow housing lending and house price inflation and reduce the potential risks to bank balance sheets”.

However, the Bank noted: “It is critical that the underlying housing supply issues in Auckland and Christchurch be addressed. Restraining the growth in housing credit will only assist to moderate excess demand pressures in the short to medium term.”

Governor Graeme Wheeler wrote in the May 2014 Financial Stability Report that “the restriction of high-LVR mortgages appears to be having the desired effect of bringing activity in the housing market back towards a more sustainable level, with both house price inflation and credit growth moderating in recent months. These effects of the LVR policy are expected to be reinforced by the increase in interest rates projected in the March 2014 Monetary Policy Statement”.

The Reserve Bank Governor wrote in the November 2014 Financial Stability Report that “the Reserve Bank intends to ease or remove the (LVR) restrictions when a sustained moderation in house price inflation is achieved, and when there is little risk of a resurgence in housing market activity. The reduction in house price inflation and housing credit growth are welcome developments, along with indications of increased residential building”.

Wheeler’s optimistic comments six months ago were premature, particularly as far as Auckland is concerned. Since then Auckland’s REINZ median house price has soared 12.4 per cent, a remarkable rise in just six months.

It is worth noting that Dublin house prices never increased by more than 12 per cent in any six-month period during the height of the Irish residential property bubble in the early 2000s.

The Auckland residential property boom has developed some of the characteristics of the Dublin bubble a decade ago. These include upbeat media stories about surging house prices, frustrated purchasers queuing overnight to purchase a section or newly-built house and banks offering cash incentives on home loans.

Dublin house prices plunged 56 per cent between 2007 and 2010 and had a devastating impact on the Irish banking and financial system. The vast majority of Dublin home buyers a decade ago had no idea that prices could fall, let alone by more than 50 per cent.

To coincide with the latest Financial Stability Report the Reserve Bank released new LVR restrictions for Auckland, which will apply from October.

But the main problem in Auckland is the low level of new house construction. Auckland City Council believes 13,000 new dwellings are required each year but only 4383 new dwelling consents were issued in the March 2013 year, 5444 consents the following year and 6661 consents in the year ended March 31, 2015. Not all of these consents are turned into completed dwellings.

When asset price bubbles, either property or sharemarket, get a head of steam they are extremely difficult to stop.

The Auckland residential property boom has many of the characteristics of the mid-1987s NZX bubble, particularly in terms of valuations. Investors were piling into the sharemarket in 1987 when banks were offering 17.2 per cent on six-month term deposits and most of the high-flying listed companies didn’t pay a dividend or had dividend yields of 2.5 per cent or lower.

The 1987 market crash had huge implications for the banking and financial system, particularly the Bank of New Zealand which would have collapsed without Crown support.

The Reserve Bank has a massive challenge to stop the Auckland residential property boom turning into a fully fledged, destructive bubble.

The central bank is also concerned about the dairy sector but bank lending to agriculture is only $54.8 billion compared with housing loans of $198 billion. In addition, agriculture lending has increased by only $4.2 billion, or 8.4 per cent, over the past two years while bank housing loans have risen by $19.9 billion or 11.2 per cent, over the same period.

Dairy farmers account for 65 per cent of agriculture lending compared with 58 per cent a decade ago.

Global dairy prices have fallen by more than 50 per cent over the past year and the latest Financial Stability Report notes that “declining farm incomes are typically accompanied by sharp falls in farm values”.

It goes on to say: “If the lower dairy payout were to be sustained, there is a risk that farm values could fall sharply and exacerbate the increase in financial stress associated with lower farm incomes.”

Finally the Reserve Bank is concerned about the banking sector’s heavily reliance on overseas funding.

Gross overseas funding declined from $136.1 billion to $126.8 billion between 2013 and 2014 but has increased to $132.2 billion over the past 12 months.

Although the domestic deposit-taking corporations have become less dependent on overseas funding in recent years the Reserve Bank is indicating this situation could change because of falling export prices and an increase in the country’s balance of payments deficit.

The country’s deposit-taking corporations may become more dependent on overseas funding over the next year or two but this is a far lower risk to the country’s financial and banking system than the burgeoning Auckland housing market.

Brian Gaynor is an investment analyst and the Executive Director of Milford Asset Management.