By Bernard Hickey
Brace yourself, but just imagine if Auckland house prices fell 55%.
Former Reserve Bank Chairman Arthur Grimes proposed deliberately 'crashing' the Auckland housing market by 40% by building 150,000 houses over six years to actually make housing more affordable. Former Reserve Bank Governor Don Brash then said Auckland house prices needed to fall 60% to achieve affordability, given waiting for income growth to catch up with flat prices would take 50 years to restore price to income multiples to sensible levels.
The Prime Minister immediately wrote off the idea of a large fall in Auckland as "crazy" because of the effect on developers and banks and the wider economy, which tried to kill the debate stone dead.
Everyone just seemed to accept that a fall of such a magnitude would be an immediately catastrophic and economy-killing event that could not be contemplated, let alone studied or debated. Surely, everyone thought, a fall like that would cause a crisis similar to the ones that broke the banks and forced taxpayer bailouts in the likes of the United States and Ireland?
Politicians of all colours and lobbyists for landlords may talk about the housing like some sort of bomb under the economy that cannot be dismantled, but would such a fall actually kill the economy, or the banks for that matter?
Luckily for us, we don't have to imagine. The Reserve Bank has done a test of just such an scenario, and quite recently.
The independent institution responsible for regulating banks and forecasting the economy said in its May Financial Stability Report that it ran a 'stress' test with banks late last year of what would happen to their balance sheets if house prices fell 55% in Auckland and by 40% nation-wide.
They crunched the numbers and found the world did not end at all.
Banks would not force everyone to sell their houses. Most home owners have vast amounts of equity to fall back on. Those in negative equity would not either send their keys back to the bank in the mail or be turfed out without warning. The incentives for borrowers and banks in New Zealand are quite different to those in the United States or Ireland. Our banks do not shoot first and ask questions later, as has been seen in current dairy payout crisis.
New Zealand's banks are very well capitalised and have not sliced and diced and sold off their mortgages into hyper-financialised markets primed to blow up 'Big Short'-style. They now mostly rely on stable long term and local term deposits for funds. They are also very profitable and the Reserve Bank found that the losses from such a big fall in house prices would eat into those profits and ultimately reduce their capital buffers from around 10.3% to 8%. But that is far from being bust. At the very worst, the Reserve Bank said it might have to stop some of them paying dividends to their parents in Australia. That is far from catastrophic.
It's also worth noting the Reserve Bank did not muck around with a simple scenario. It also assumed that the 55% fall in Auckland house prices would happen at the same time as a rise in unemployment from 5% to 13% and a recession that carved 6% off GDP. Just for good measure, it also assumed that dairy incomes remained at their currently unprofitable levels and that banks would also make losses on their business and commercial property loans. It found that losses on mortgages would only be around 1% of the bank's mortgage books.
It's worth remembering that the bulk of borrowers are having few problems servicing their debt at current interest rates. Reserve Bank figures show total interest costs are around 9% of household disposable income, which is down from a peak of 14% in 2008 and similar to levels seen in 2003. There are plenty of buffers built into the system in terms of bank capital, interest servicing costs and home equity, except for those at the most extreme end. And the Reserve Bank pointed out that interest rates would also fall in such a scenario.
There are also fewer borrowers up to their gills in debt because the Reserve Bank has deliberately and successfully forced the banks to reduce loan to value ratios over the last three years. The proportion of mortgages with Loan to Value Ratios of over 80% has dropped from almost 21% in 2013 to closer to 12% at the end of last year, and that will have improved since then because of further house price inflation.
Yes, a few property developers might see projects fall over, although there are a lot less of them leveraged through finance companies than there were before 2008. Yes, a few highly leveraged rental property investors might lose some equity. But isn't that one of the risks of doing business?
So why are politicians of all colours so afraid? And exactly whose interests are they protecting when they say such falls are "crazy" and "unnecessary"?
A version of this article was also published in the Herald on Sunday. It is here with permission.