During the past five years, a constellation of factors drove an unprecedented housing boom in New Zealand. The boom fizzled out this year but left behind a set of factors that raise the risk of housing sector weakness spreading to the rest of the economy. In some respects, New Zealand looks more vulnerable to a housing-led financial crisis than the U.S.: New Zealand (NZ) exhibits higher household indebtedness (debt to disposable income: 160% in NZ vs 131% in US, 2007) a larger current account deficit as a share of GDP (8% in NZ vs 6% in US, 2007), a higher share of housing in household assets (72% in NZ vs 39% in US*, June 2007), stronger house price inflation (median home price: US$266,964 in NZ vs US$238,000 in US, September 2007) and a higher benchmark interest rate (8.25% Overnight Cash Rate in NZ vs 4.50% Fed Funds Rate in US, November 2007) with a more justifiably hawkish central bank. This brief discusses the rise and fall of the New Zealand housing market, its outlook, and how the US crisis might throw the match that lights New Zealand’s financial tinderbox.
The Past: House Prices Rise
A combination of factors drove the New Zealand house price boom: easier access to mortgage finance, low real interest rates, demographics, housing shortage, commodities boom, tax policies and expectations for attractive capital gains.
Financial sector deregulation – Mortgage credit constraints were substantially relaxed in New Zealand after 1990, with the result that a typical young borrower can now borrow some 140% more than they could previously. Lifting conservative restrictions on loan-to-value ratios and mortgage-repayment-to-income ratios encouraged the growth of first-time homeowners. Though less sensitive to changes in credit constraints, existing homeowners also benefited from looser credit: Increased leverage enabled purchases of second (or third) homes to use as rental or speculative property. (Coleman, July 2007)
Low real interest rates – Though lower credit constraints contributed to the housing boom, home ownership by the young actually decreased during the boom, which suggests easier credit was necessary but insufficient to produce the house price boom. Falling real interest rates had a larger influence on house prices after 2002: Most mortgages in New Zealand are ‘table mortgages’ where banks set mortgage repayments in nominal terms – they were not inflation-indexed. As inflation rose from below 2% y/y in 2003 to 4% in mid-2006, the real cost of mortgage borrowing declined. Declining real interest rates sparked property investment by older, wealthier households, which have more elastic demand for housing. These aspiring landlords and speculators outbid young potential owner-occupiers, raising the cost of owning versus renting. As a result, home prices rose while young home ownership fell. (Coleman, July 2007)
Demographics / Housing Shortage – New Zealand’s aging population sought to supplement retirement funds by taking advantage of a housing shortage created by migration inflows during the commodities boom.
Commodities Boom – The rising value of New Zealand’s agricultural exports (especially dairy) supported household income growth, wage growth and fiscal surpluses (3.8% of GDP over the past 5 years). Spending and investment increased as households flush with cash saw their wealth rise and expected tax cuts to eventuate in the wake of the government’s structural budget surpluses (Infometrics). At the same time, the commodities boom drew in migrant laborers, which pushed housing demand beyond supply. (Westpac, July 2007)
Tax Policy – Property taxes in New Zealand are in line with the OECD average of 2% but an unusual combination of measures encouraged property investment: 1) Mortgage interest and depreciation of rental properties could both be deducted from the property investor’s taxable income 2) Investors were allowed to use negative gearing (a tax deduction equal to the excess of interest payments over the cash flows, net of other expenses, from leveraged investments) 3) No tax on rental yields 4) No land tax 5) Investments in financial assets were subject to capital gains tax, cutting their appeal over rental property investment. (IMF, May 2007)
Expectations of rising house prices – RBNZ estimates that most landlords sell rental properties within 4 years – which indicates properties were purchased mainly for capital gains, rather than rental yields. Speculative property (those purchased for capital gain) did not enjoy the tax benefits accorded to rental property but could be easily dressed up as rental property in tax documents. When the property was sold, the capital gains tax would come to bite but the resale value often exceeded the original purchase price enough to keep after-tax returns attractive. Indeed, between 2004-2006, on average, house price inflation (14.7% y/y) exceeded the effective mortgage rate (7.5% annually). The rising trend in house prices fed expectations of further price rises, hence further capital gains. Moreover, the magnitude of the house price boom lacked precedence in New Zealand, leaving property investors little local history to dampen their optimism. (IMF, May 2007)
The Present: Housing Boom Plateaus
A sharp moderation in migration inflows and 13 OCR hikes later, the New Zealand housing boom started cooling in April:
-Residential mortgage lending growth slowed from NZ$2.2bn/mo in March to NZ$1.2bn/mo in August (RBNZ, November 2007)
-House sales in general fell 30% in the year to October (NBNZ)
-Days to Sell increased from 29 days in April to 36 days in October (NBNZ)
-House sales at the lower-end (less than NZ$300K, typically associated with investment properties) declined 30% in the year to October, 41% in the past 24 months (NBNZ)
-Building consents declined 8.3% y/y in September
-Median house price flatlined at NZ$350k for the past 6 months to October after rising NZ$8k/mo in Q1 (BNZ, REINZ)
-Housing confidence is down. A declining share of survey respondents believe house prices will rise next year. Only a net 12% were optimistic in Q3, versus a net 32% in Q2 (NZH)
-Affordability is low, blocking new entrants to the market. The median house price is now 9.9 times the median income. 5 years ago, it was 6.3 times. The average house price is 6 times the average household disposable income – nearly twice the long-run average of 3.4. (Fairfax)
-Rates for fixed mortgages (85% of mortgages) rose to 9% or higher; 1-5 year floating rates rose to 10.5%. Fixed mortgages face a reset to higher rates after 100bps of rate hikes from the RBNZ this year and possibly more next year (ASB; RBNZ, November 2007)
-Property investments are highly leveraged. It now takes 80.5% of one median income to pay the mortgage on a median priced house purchased in October (Fairfax)
-Rental yields fell to 4% in October (Westpac, November 2007)
-Houses are overvalued – investor value (according to prevailing long-run interest rates, marginal tax rates, rents and expected capital growth) fell from NZ$328k in December 2006 to NZ$260k in October, at which time the median house price was NZ$350k (Westpac, November 2007)
The Future: Stagnation and Decline?
Forecasters project continued stagnation and slight decline in housing pr
ices for at least the next 4 years:
-Monetary policy looks likely to stay restrictive in 2008. Though retail spending and housing have showed signs of weakening, inflation pressures have sprung up elsewhere: wages (3.3% y/y growth in September), oil prices, expansionary fiscal policy. RBNZ may also need to see falling, not just flat, median home prices before they feel inflation pressures have subsided (NBNZ)
-Houses are highly overvalued and will take at least 4 years to restore equilibrium between rents and house prices ((Westpac, November 2007; FitchRatings)
-Even if household disposable income rose 5%/yr, interest rates returned to average levels and house prices stagnated, the affordability of owning a home wouldn’t return to normal levels for 8 years (Westpac, November 2007)
-Banks spooked by the US subprime crisis may slow loan growth as they price risk more cautiously going forward
-The ability of households to take on more debt is unlikely to rise much more.
On the other hand, there are some brakes to slow a housing market slide:
-Global food price inflation will support earnings in New Zealand.
-Continued tightness in the labor market (unemployment at 20-year lows) will keep job security and wage growth strong.
-The ongoing commodities boom will continue to attract migrant inflows.
-Housing undersupply has not been fully resolved.
-There are many willing homebuyers who have been priced out of the market. They would form demand support should prices fall.
-Fiscal spending will rise next year, an election year. Finance minister Michael Cullen is hoping to make it easier for people to buy first homes.
Risks of a New Zealand version of US Subprime Crisis
The outlook for New Zealand’s housing market is already bad but the US subprime crisis could make it worse. Though New Zealand would not have its own subprime mortgage crisis per se (as there are no subprime mortgages and securitization is absent), U.S. subprime crisis-induced risk aversion has other theaters where it can turn New Zealand’s weakening housing sector into a wider financial crisis:
Interbank money market – As in August and November, the US subprime crisis can raise funding costs globally as US and european banks hoard liquidity to cover losses and assets brought back to their balance sheet. New Zealand banks rely heavily on USD money markets for funding as it is more liquid than local and other money markets. When investors become reluctant to buy bank assets and prefer the safety of government bonds, New Zealand bank bill rates rise to reflect the higher premium they demand to take on bank risk. (RBNZ, November 2007)
FX Market – The increased sensitivity to developments in the US and their effects on G-3 and global growth elevates market volatility. Higher volatility sours the environment for carry trades as it becomes more difficult to predict currency direction. Carry trade unwinding reduces long positions in the NZD. A fall in the NZD raises the value of overseas foreign debt. Reduced demand for the New Zealand Dollar in the FX swap market increases the implied FX swap rates, which makes it more expensive for New Zealand banks to convert funds raised in USD to NZD. (RBNZ, November 2007)
Credit Market – US turmoil increases risk aversion worldwide. This can reduce demand for NZD-denominated assets as investors switch focus from yield to valuation. Decreased demand for uridashi (corporate bonds sold to Japanese retail investors) and eurokiwi bonds is particularly problematic as it can raise interest rate swap rates. In the past, the hedging of offshore NZD-denominated bonds through the New Zealand interest rate swap market depressed swap rates in the 2-3 year part of the yield curve. This enabled domestic banks to offer relatively low fixed interest rate mortgages for real-estate purchases as it was relatively cheap to swap short-term funding for longer-term funding (RBNZ 2005).
Exposure to Australia – Australian banks own 90% of New Zealand bank assets. These parent banks back investment funds which could suffer losses on investments in U.S. CDOs and other structured credit. In fact, some already have: Fortress Funds, Basis Capital and Absolute Capital suspended withdrawals and reported billion-dollar losses. Trouble at the australian parent banks can lead them to cut business in their New Zealand subsidiaries. (RBA, September 2007)
While risk aversion is the ‘lighter’ and any or all of the above theaters the ‘match’, local private sector vulnerabilities are the ‘financial tinderbox’:
Household sector – Household debt increased by 73.6% from December 2002 to December 2006, attributable to higher house prices – most property investments are 80% leveraged. In 2007, household debt reached 160% of disposable income and debt servicing costs 14% of disposable income (this ratio is higher for low- and middle-income households). More than 70% of the household portfolio is held in real estate, an illiquid asset. Of 16 developed countries, FitchRatings found New Zealand homes are the most overvalued on a price-to-rent ratio basis. Not only have rental yields fallen to unattractive lows, but capital gains have stagnated and property investors have begun to report losses. Borrowing costs look likely to rise or stay high: The Reserve Bank maintains a tightening bias and the country’s dependence on foreign financing renders it vulnerable to external shocks. Without housing market growth to rely on, household solvency is staked on continued economic and income growth.
Bank Sector – Banks are exposed to household vulnerabilities: As of June 2007, residential mortgage lending comprised 45% of total bank assets. Banks show a growing tendency towards risky lending, e.g. growth in high loan-to-value lending, loans issued with little or no deposit, lending on margins too low to even cover operating and capital costs (Keen 2007). To finance mortgages, banks issue more uridashi and eurokiwi bonds than any other sector, private or public. This issuance answers for most of New Zealand’s foreign debt, now 118% of GDP. Half of all New Zealand’s foreign debt liabilities is short-term (maturities less than 1 year).
Non-Bank Finance Sector – Here the U.S. crisis has already struck. Bridgecorp, 5 Star Finance and PropertyFinance Securities are some of the high credit risk companies that have been placed into receivership this year. Failures were typically associated with property development finance, consumer lending and mezzanine finance (McDouall Stuart 2007). Over a NZ$1 billion of household debentures have been affected since 2006. Fortunately, these companies constitute only a small fraction of GDP and the finance sector as a whole. Furthermore, the overall share of non-bank deposits in total household financial assets is relatively small (1.5%) and so is bank exposure to non-bank finance companies. (Parliament, September 2007)
Macroeconomy – Though commodity prices may stay strong in the medium to long-term, economic growth is forecast to slow in 2008. Services still contribute 2/3 of GDP and high interest rates are starting to dampen activity in the sector. Flat or falling housing values may also kill the wealth effect. New Zealand’s largest trade partner, Australia, is also set to slow next year. (ANZ, October 2007)
Not all is doom and gloom down under. Just as the housing market has brakes to slow a market slide, there are barriers to keep a housing downturn from metastasizing into a financial crisis – or at least mitigate one should it occur.
Reserve Bank of New Zealand – In response to the mid-August spike in bank funding costs, the RBNZ sought to ease liquidity through cash injections, a broadening of the acceptable types of collateral that can be used to secure funds from the Reserve Bank, and
the introduction of a tiered rate system that makes it more expensive for banks to hold more cash than is required for payment system needs. The bank has also been pumping in more settlement cash than ever before since July 2006.
Risk Aversion – Though a flight to quality hurts demand for NZD assets (mostly corporate bonds) and pressures interest rate swap rates higher, it also lowers government bond yields which pressures swap rates lower. Lower swap rates means lower cost of swapping from short-term to long-term financing.
High and possibly higher OCR – Like risk aversion, the high interest rate (8.25%) can be both a blessing and a curse. Though it sets a high benchmark for lending rates and tames economic growth, high yield supports NZD bonds and hence the NZD. With an RBNZ still battling inflation, high yield looks unlikely to go away anytime soon. Even if the RBNZ were to cut 100bps, New Zealand would still have the highest benchmark interest rate in the G10.
Low rollover risk – The majority of offshore investors in New Zealand hold NZD bonds to maturity. Moreover, the source of demand has been shifting from short-term investors (e.g. margin traders) to more stable, longer-term investors.
Healthier household savings than officially thought – NZIER (October 2007) argues officials underestimate the household saving rate as they ignore tax evasion and small businesses financing via mortgages (which should be recorded under business not household account).
Commodities boom and tight labor market – Unrelenting growth in demand for food and biofuel and the boost to commodity prices from a weaker USD would support export earnings and household income. In addition, agricultural expansion would push up land prices.
Chart Source: Reserve Bank of New Zealand