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Bernard Hickey looks at the lessons we should learn from warnings about our over-valued property market and the need for a deposit insurance scheme

Bernard Hickey looks at the lessons we should learn from warnings about our over-valued property market and the need for a deposit insurance scheme

By Bernard Hickey

Last weekend's headlines from Forbes warning about a housing crash and 'economic disaster' may well have caused a few Auckland property owners to choke on their Sunday morning croissants.

But not for long because the rest of the day was full of denials and debunkings to soothe the nerves of a few heavily indebted property investors.

Economic Development Minister Steven Joyce compared Forbes' online columnist Jesse Colombo to a Ken Ring-like figure who saw bubbles wherever he looked.

Prime Minister John Key said the warnings were over-blown. Economic commentators rightly argued that Colombo's warnings were unlikely to come to fruition.

However, the concerns raised about Auckland's houses being over-valued and New Zealand's households having too much debt are valid, as is the risk that a slump would affect New Zealand's banks.

Mr Colombo's assumptions about what would happen if house prices did fall were wildly off the mark, but the reasons for that wrongness are not as reassuring as they might appear at first.

Essentially, New Zealand's housing market and banking systems are very unlikely to crash because they are both 'Too Big to Fail.' Even if they 'should' fall, the authorities are unlikely to let them fall dramatically.

We know this because we have a track record.

New Zealand house prices fell 10-15% in late 2008 and early 2009 as the Global Financial Crisis and a recession caused by high interest rates and a drought drove unemployment up and demand for houses down. Banks came under pressure because the wholesale financial markets they used to roll over their foreign debts froze.

The Government and Reserve Bank intervened to help tide the banks over and ensure they weren't forced into a US-style rash of mortgagee sales. The Reserve Bank lent the banks NZ$7 billion between November 2008 and June 2009 to ensure they remained liquid. The Government also gave the banks a helping hand by providing a guarantee for NZ$10.3 billion worth of bank bonds issued between November 2008 and February 2010.

House prices stopped falling because the authorities intervened to take pressure off the banks and New Zealand's automatic stabilisers of a floating currency and flexible monetary policy kicked in. The Reserve Bank cut the Official Cash Rate from 8.25% to 2.5% in less than 12 months.

The Government more generally also used its balance sheet to support the economy, borrowing as much as NZ$300 million a week and increasing government debt by NZ$50 billion to ensure benefits were paid, tax credits granted and earthquake repairs made.

Those are the big differences between New Zealand's housing 'bubble' and ones that burst in the likes of America, Ireland or Spain with such disastrous effect. Our government and Reserve Bank were willing and able to intervene in such a way as to make sure our 'Too Big to Fail' property market and banks did not fall too sharply.

At first blush these seem like good reasons to relax and ignore the scary headlines courtesy of Mr Colombo and Forbes.

But are they really? There's a saying in banking that a small debt that cannot be repaid is a problem for the borrower, while a really big debt is a problem for everyone and the bank in particular.

New Zealand is now in a situation where a property investor can rightly assume that the residential property market can never really fall much because the Government will always 'bail out' the market. Residential property investors can feel safe in gearing themselves up to the eyeballs and betting on tax-free capital gains because their chosen asset class is 'Too Big To Fail'.

This is a situation known as 'moral hazard', where the risks of an investment decision are borne by someone other than the risk taker. In this situation the profits are privatised and the losses are socialised.

It's a dangerous situation in the long run. It encourages investors to take more risk than is safe and the pain of any slump is eventually borne by everyone, particularly when the Government has to borrow to support an economy or a banking system.

Luckily for New Zealand, the costs of the support offered in 2008 and 2009 were relatively light. The banks repaid the short term loans and have repaid or will repay the guaranteed long term loans.

It does raise the bigger issue of what happens next time New Zealand's economy receives a 2008-style shock. Currently, our banks are not guaranteed by the Government and the Reserve Bank has set up a system known as Open Bank Resolution. This specifies that if a bank ever were to get into trouble, the Reserve Bank could shut it down and force an overnight recapitalisation that would mean term depositors received a 'hair-cut' by having their deposit written down and the bank could open again the next day.

It is a fig leaf because no New Zealand Prime Minister with borrowing capacity would allow term depositors to take that pain of a hair cut. They would bail out the bank in the same way the Irish, British and US governments did.

This implicit government guarantee and its morally hazardous consequence is being rectified in these countries with deposit insurance schemes that effectively mean the banks and their saving customers pay an insurance premium for that guarantee.

This month the Reserve Bank of Australia has recommended just such a scheme in Australia. That is what should happen in New Zealand too. Without an open acknowledgement of this 'Too Big To Fail' problem we run the risk of creating an ever more dangerous problem of moral hazard.

The Forbes warning of imminent collapse was of course wrong, but it should have caused us to consider more deeply the flaws in our financial architecture that mean it seems safe for a class of investor to gear up in the knowledge someone else will always rescue them.


This article was first published in the Herald on Sunday. It is here with permission.

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Right on the money Bernard. Yes the property market has become too big to fail and of course the government/authorities will never admit to it. Ironically, our most leveraged bank, Kiwibank, is tax payer owned and it's almost 100%guaranteed they'll be bailed out come a market meltdown. And guess who else will come cap in hand along with Kiwibank?

But when thinking about economics of the Great Depression Fisher was on the ball. He even came up with a new theory: debt deflation. The key problem was excessive indebtedness and how this interacted with falling prices. In essence, by cutting back their spending to repay their debts people would cause prices to fall, thereby increasing the real value of what they owed. As Fisher put it:
The very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed. Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: the more debtors pay, the more they owe.4

The Chicago Plan certainly has merit but I'm not totally convinced a totalitarian money supply is the way to go. I'd sooner see banks required to have much heavier equity requirements. Had this been put in place years ago, property values would be about half what they are now, hence the reduction in market risk.

"The result is that if, as I believe, some of the leading industrial countries do come to experience deflation, the effects will be profound. There will be a significant impact on corporate finances and levels of corporate failure, major effects on all asset classes, and it will cause disruption to the financial system, with serious implications for the solvency of financial institutions and the health of the real economy. In short, deflation poses a potent threat to the stability of the whole economic and financial system. Not good deflation, but deadly."
oh boy....

The Nineteenth Century
Amazingly enough, the Nineteenth century was a period of deflation, rather than inflation. From the end of the Napoleonic Wars in 1815 until the start of World War II in 1914, there was no inflation in most countries, and in many cases, prices were lower in 1914 than they had been in 1815. Prices fluctuated up and down from one decade to the next, but overall, prices remained stable.

Ah the 19th century! The time when Anglo culture went into overdrive. Booms, busts, big families, massive increases in populations, massive expansion of peoples into new lands. Massive transformation of those lands. Changes that took a 1000 years in Europe took 10s of year....
Hard to imagine in our peak scared times of today.....

Fisher's plan was rehashed by Benes and Kumhof at the IMF a few years ago. Made a lot of sense to me. Even Friedman didn't think the banks should be allowed to create credit/money supply

the biggest concern is that the govt is not even trying to minimise the extent to which it is the lender of last resort. I would do the following:
Draw up an agreement stating the govt WILL bail out those banks who sign up to the guarantee on the agreed terms ie: - year one, guaranteed bank pays 40% tax, - year two, bank pays 45% tax, year 3 50% tax etc etc etc. Those who do not sign up are explicity ruled out of a guarantee - the exclusion is watertight
ALL banks would have no choice to sign up, because they fear a bank run from depositors to a competitor who has a guarantee. Banks operating position will remain unchanged as the tax is on EBIT, but the incentive to solidify the balance sheet becomes imperitive due to shareholder pressure.
Basically the govt needs to play chicken with the banks - it can afford to as it holds all the cards given the banking system has proven itself incapable of operating without taxpayer assistance.

The OBR goes someway to do that, however just how far is indeed very questionable. 
Second how do you set a premium?  Personally I'd say there is a certianty of a bailout inside of 10 years, maybe 5, so what should the permium be? 10%? per annum?  Just who will pay that when they think worst case they get it for free anyway?
Who will actually pay? why tax payers, PAYE, one man bands, small businesses ie people such as myself who have been prudent are likely to have to bail out the bankrupt properrty specualtors en-mass, is there another (any?) option?
You dont pay chicken IMHO, this is our economy.   Now if I had a crystal ball and knew the OBR was going to save us then I'd use it and let the banks go under taking them into Govn control long enough to sort the debt out and then sell/give them back.  Of course no one has such a crystal ball. Like Lehman's one false step and we have anarchy.

The OBR is useless. Once rumours start about one bank, all the rest will be tarnished too. Money will pour out of New Zealand on a safety first basis. The problem would become systemic and the RB and government would have no choice but to step in with guarantees in the first instance, and cash if that failed. The central premise behind the OBR that depositors do their own due diligence on their bank is a nonsense. And we have regulators, including the RB who can't provide warnings or guidance on banks because to do so might invite the very instability they are trying to avoid. The whole thing runs on confidence.

"Just who will pay that when they think worst case they get it for free anyway?
thats the point - make it watertight, if Bank A dont join the govt guarantee scheme and take the tax hit then Bank A DONT GET BAILED OUT. Which bank would expose themselves to this??

What a tangled web with no politically palatable solution. Because both Labour and National (and the RB) have allowed the banks free reign to extend as much credit to the property market as borrowers can stomach, any attempt now to crimp this with meaningful prudential measures or higher capital ratios etc will bring cries of armageddon from the financial sector.  
And they may be right. The level of debt and the proportion of it in property is so big that any significant fall in prices will leave the big banks very exposed. To do nothing just invites the exposure to get even larger.
What politician will voluntarily cause a recession and drop in property prices in the name of financial system stability? It's in the mandate of the RB but what governor want's to be remembered for the same thing. Given the size of the debt is it even possible now to enact financial stability measures without causing the financial instability you're trying to prevent? Better for the reputation to takes small baby steps or token gestures and exclaim later "who could have known" or "nobody saw this coming" and keep on dancing. Pass the parcel to the next lot.

"Because both Labour and National (and the RB) have allowed the banks free reign to extend"
but isnt this the free market in action?
"What politician will voluntarily cause a recession and drop in property prices"
None, not one IMHO.