Moody's Analytics says the Aussie parents of NZ's big banks have world's highest exposure to 'overvalued' houses; Hopes 'looming correction' is a smooth one

By Gareth Vaughan

Australia's banks, owners of New Zealand's big four banks, have the highest exposure to residential mortgages in the world, with these mortgages on overvalued houses, Moody's Analytics says.

Furthermore Moody's Analytics argues it would take a bold economist, who had been in a decade-long coma, to declare that an Australian housing correction was impossible.

These comments come in a report entitled Trends in Australian consumer lending by Moody's Analytics managing director Tony Hughes and senior economist Daniel Melser. Moody's Analytics is a subsidiary of Moody's Corporation.

"Irrespective of the complacency of local analysts, who sound a lot like many US housing cheerleaders circa 2006, this exposure (to home loans) represents a major concentration risk for banks and the Aussie economy," Hughes and Melser say.

"Houses appear to be overvalued. One merely hopes that the looming correction is a smooth one."

Hughes and Melser's report provides a chart showing Australian banks' residential real estate loans as a percentage of total loans comfortably above 60%, giving them the highest exposure to residential mortgages in the world, according to the International Monetary Fund. Based on interest.co.nz analysis, New Zealand's big five banks, - ANZ, ASB, BNZ, Kiwibank and Westpac, combined, have 61% of their total net loans in residential mortgages.

Could a housing collapse happen in Australia?

Of Australia's banks Hughes and Melser say the high degree of exposure to the domestic mortgage market raises many concerns.

"Recent experience has shown that house prices can fall significantly and trigger serious banking meltdowns."

They go on to ask what the chances are of a similar housing collapse, as seen in other countries in recent years, happening in Australia. 

"Many international analysts think the chances of an antipodean housing bust are quite high - it would take a bold economist who has been in a decade-long coma to declare that an Australian housing correction was impossible." 

"When trends in Australian house prices are compared globally, the signs look worrying. House prices have increased for longer and faster than in many of the markets where prices cratered during the Great Recession," say Hughes and Melser.

"Local analysts tend to be somewhat more sanguine. The 'Lucky Country' has proven to be remarkably adept at sidestepping tackles over the past quarter-century." 

The report notes that some local analysts have argued Australian tax rules that favour housing over other forms of investment tend to support more rapid house price growth than in other countries. And others argue city planning rules and poor transport infrastructure, something Auckland also suffers from, also contribute to elevated Australian house prices. 

"The problem with these arguments is that US tax laws are more favourable to housing than Australian tax laws, yet house prices still crumbled stateside," say Hughes and Melser. 

"Arguments about poor transport, natural barriers to city expansion, and troublesome local bureaucrats apply as much to Phoenix and New York as they do to Melbourne and Brisbane." 

'No special status'

Ultimately they suggest that although Australian house price growth has exceeded international norms for several decades, this is more because of a combination of complacency and surprisingly robust economic performance than any special status enjoyed by Australian homeowners. 

"Recent modelling work by Moody’s Analytics indicated that it does appear as if (Australian) housing is modestly, but not excessively, overvalued relative to fundamentals." 

In an interview with interest.co.nz in March, Ian Narev, the CEO of ASB and Sovereign's parent Commonwealth Bank of Australia (CBA), said his bank stress tests its mortgage book to 13% unemployment (it's currently 5.7%) and a 40% drop in property values. CBA therefore foresaw "modest and manageable" losses through its residential mortgage exposure even under "aggressive stress."

"Now all models have got potential flaws," Narev said. "You never know what you don't know. But against any foreseeable scenarios, driven by a hard landing in China, freezing up of credit markets, all those sorts of things, we are comfortable that we can withstand the shock," Narev added. 

'Google 'subprime mortgage crisis' if you are comfortable with this'

The Moody's Analytics report also looks at borrowers buying the likes of TVs on their credit cards or adding such a purchase onto their mortgage. Hughes and Melser note that whilst the Reserve Bank of Australia's cash rate has fallen to 2.75% from its high of 4.75% in October 2011 pushing standard variable mortgage rates down by about 1.6%, the average credit card rate has remained virtually unchanged. 

"Buying a television on a credit card attracts a 20% interest rate but, typically, the loan is paid off quite quickly. Buying the same TV using a home equity line tied to a 25-year mortgage means the rate is lower, but the borrower will be implicitly paying interest on the purchase for the remainder of the mortgage, which often extends well past the time a TV typically enters the landfill." 

Hughes and Melser say that from a bank’s perspective such a redistribution of credit tends to concentrate risk in housing values.

"Is it better for banks to make a 25-year, mortgage-backed TV loan at a low interest rate or an unsecured TV loan at a high interest rate? If house prices were guaranteed to rise, banks would be willing to accept a thin margin in the mortgage-based transaction." 

"The data suggest that over the past few years, banks are becoming increasingly comfortable with lower margins on mortgage-backed TV loans. Google 'subprime mortgage crisis' if you are comfortable with this unfolding trend," Hughes and Melser suggest. 

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13 Comments

Gareth - I guess Moody's Analytics had little to offer when it came to discussing underwriting loans to fund productive asset classes? - they are inevitably already foreign owned and financed with the same foreign wholesale funding that our banks utilise to extend excessive residential real estate funding. The exit choices are stark for all. 

There seem to me to be three separate risks at play. Could there be a housing price crash of 20-30% or even 40%? Probably yes, although the highest levels seem unlikely.
Could there be an employment/income crash affecting a small but significant proportion of people's ability to meet repayments? The CBA moot unemployment of 13%. Again there could be such a scenario, although it seems unlikely right now.
Will one or both of the above cause the major banks to fall over domino like? Probably not it seems to me. My guess is that the average equity at current prices in housing in New Zealand (and presumably Australia) is well over 50%; and even for those with a mortgage, the average is probably over 30-40%. 
So the risk to the banks becomes the people who have taken out a mortgage relatively recently at say 80% plus LVR, and who become unemployed, or significantly underemployed. That is likely to be a very small subset. And their houses could still be sold off to recover most of the loans.
My understanding is that NZ and Australia have at least a couple of key differences to the American situation. In US law, a mortgagor can hand the keys back to the bank and walk away from his/her loan with no other penalty than losing their equity in the house. Here the debt follows you, so you have to go bankrupt to avoid the loan.
And in sub prime the US banks were actively selling to people they knew had no chance of meeting the cashflow needs of the loans, as the banks could package up the subprime loans and sell them off to other institutions. No care or responsibility.
The banks here may well have been guilty of spruiking up lending activity, but they have to hold the risk themselves, so are likely to have repayment tests that work most of the time.
If one of the first two scenarios unfolds, there will be great social pain, but not necessarily bank failures. The social pain will cause authorities to take steps to ease the pain, which will help any stress to the banks.
The banks may have other risks- farming comes to mind; or if they have somehow left themselves exposed to foreign derivatives or currencies. A housing crash is unlikely in my view to be top of their risk list; although it is one of society's bigger risks.

"Now all models have got potential flaws," Narev said. "You never know what you don't know. But against any foreseeable scenarios, driven by a hard landing in China, freezing up of credit markets, all those sorts of things, we are comfortable that we can withstand the shock," Narev added.
 
Begs the question of who "we" is/are.....

  • shareholders
  • local deposit holders
  • users of transaction services
  • borrowers
  • Government
  • Taxpayers
  • off shore bond holders
  • bank management

 
and of the folk that are not "we" how does the model look for them........
 

Henry,
You have more succinctly made one of the points I was trying to make above. The banks depositor risks in a residential property crash seem low; although I'm sure their shareholders would do it tough for a couple of years.
That is different to the risk of a property crash (or at least significant correction) happening, which seems relatively high. And the losers then could be many.

and of the folk that are not "we" how does the model look for them........
 
Not good:
 
Section : Banks on both sides of the Tasman are busy issuing  both debt and capital securities
 
With the recent ANZ additional tier one issue and the launch of the Westpac tier two security, we are now beginning to understand the pricing of capital securities post 1 January 2013 when Basel III was implemented.
 
In New Zealand senior bank issues are coming thick and fast, however aside from Kiwibank no New Zealand registered bank has yet to issue a tier one or tier two under the Basel III banking standards.
 
Given New Zealand’s ‘big four’ banks are  Australia’s ‘big four’ banks, the inevitable pricing comparisons are relevant (technicalities of issuing such instruments in New Zealand aside)
 
Last week Westpac (Australia) became the first of the ‘big four’ to issue a loss absorbing tier two capital security. The pricing on the instrument is expected to be between 230bp to 245bp over the 90 day bank bill rate.
 
ANZ (Australia) recently allocated A$1bn under its additional tier one offer at a margin of 340bp over the six month bank bill rate. So if we start from the lowest ranking securities, the ordinary equity, the cost of equity as defined by the equity risk premium is ~800bp for one of the ‘big four’ banks.
 
We then move one notch higher into the additional tier one (hybrid) space where as we have just witnessed ANZ compensate investors with a 340bp margin.
 
Up another notch and investors receive 230bp to 245bp for tier two and then we arrive at the senior level where current pricing in both Australia and New Zealand is ~100bp to 110bp (5yr).
 
Tier one investors not really being rewarded
 
The question needs to be asked, are investors being rewarded for the risk now that we have securities that can be converted to equity if the Australian Prudential Regulation Authority (APRA) deem the bank to be non-viable (i.e. needs financial assistance from security holders).
 
Tier two holders are invested in a security that acts much more like a bond with compulsory coupons, five year maturity (likely) whereas tier one investors are faced with discretionary dividends, perpetuity and possible conversion.
 
We would argue that investors taking on this type of equity risk, with a fixed upside should be rewarded with a margin somewhere closer to the cost of equity.

And didn't the experts say a bank failure in NZ is very low risk? At least one NZ bank  has failed in the past, and required a bailout, so they happen, even in NZ. The problem is that it was a generation ago, so people have forgotten.
Someone is going to take a haircut with over inflated house prices, and if a bank fails due to it, then it likely be the savers who take the hit with the OBR. What I just don't understand is why if savers take a haircut, why they aren't given shares in the bank, so in time they will liekly be paid back, like they did overseas. NZ is the only country in the OECD without insurance, which is desperately needed I think, especially with NZs banks so exposed to this housing bubble.

Even without an OBR savers money is at risk, all investment is a risk. Its just that without an OBR there is an implicit free insurance policy on saved's money that they dont pay for provided by the Govn and the tax payer.
Second insurance, who is the counter party to the risk? ie who do banks get a "policy" off? I cant see a private company taking on such a risk when its pretty certain and pretty big, not without substantial premuims anyway.
Does that mean you mean the banks should pay the Govn a few pennies to cover your money? thats what it usually comes down to I find, no one wants to pay a true premium to cover their money, its always someone else who's expected to pay and thats usually the tax payer, me. Given a free choice I wouldnt cover your money.
Of course the saved's can always take their money out and put it elsewhere, you are free to do so.
Shares, its quite possible that could happen, doesnt seem un-reasonable. However given the monolithic risk profile that all the banks have its not un-reasonable to assume once one bank goes the others will be tottering as well, and with confidence gone they all go.
Just who covers that?
The answer is the OBR, to my mind its not a policy to cover one bank, its a policy to cover all banks from an impact to big for the Gon to cover (think Ireland). The OBR as a system keeps the shops open so we can get food when they all go toes up...and that for me is its critical function.
Oh and by the way, where is the impact on senior bank staff who set such policies? or the risky lending their staff are doing driven by bonuses and threats etc?
For me we should have some legislation that could jail these CEOs whenthey expose us to such impacts....instead they'll get golden parachutes.
regards
 
 
 
 
 
 
 
 
 
 

Even without an OBR savers money is at risk, all investment is a risk. Its just that without an OBR there is an implicit free insurance policy on saved's money that they dont pay for provided by the Govn and the tax payer.
 
Correct, so banks and their equity less borrowers need to pay up and reward the depositors with the requisite equity premium not a paltry near risk free rate of 2.5% plus.

Its very simple, if you dont like the return and the risk you are free to move your money anywhere else you choose.
regards
 

So, now we are talking about  the risk of a 'bank run'. That would not be pretty but with banks like the BNZ, having a Loan to deposit Ratio of %160 it must be risk on.
 
 

Sir Mervyn King comment on prosecuting bankers

 

On the 19th June 2013, the Governor of the BoE, Sir Mervyn King in his Mansion House speech confirmed that the bankers must have been prosecuted under the exiting law and regulations. He said that the "firms that pose a risk to taxpayers [i.e. the financial institutions], cannot be prosecuted because of their systemic importance" (sic) and are "too big to fail, too big to jail" (sic) (at 18:38 of the Bloomberg recording). I.e. he clearly implied - and from the Governor of the BoE it is as direct statement as it can conceivably be made - that the bankers would have normally been prosecuted under the existing laws, but the structural arrangements which defy the spirit and the letter of the existing law seemingly preclude this. And this cannot be accepted: such reasons are clearly against the public interest and undermine the public trust in the justice system. Is it the case that there are small people that can be easily prosecuted and there are those who can conspicuously break the law, make themselves fabulously rich, bankrupt the country, turn lives of millions into complete misery and do all that with impunity accepted by the government? This appeared to be a message of Sir Mervyn about the government handling of the financial mess. 

The founding article of this blog, "The largest heist in history", proposed over four years ago: 

"In a normal free market economy a business that fails should be allowed to collapse. If a business is a giant pyramid scheme, like the current financial system, it must be allowed to collapse and its executives and operators should face prosecution. After all running pyramid schemes is illegal." Sir Mervyn: at long last, welcome to the club!

 

 

 

So, now we are talking about  the risk of a 'bank run'. That would not be pretty but with banks like the BNZ, having a Loan to deposit Ratio of %160 it must be risk on.
 
Yep, take your money and run. The warning cannot be clearer - the RBNZ has clarified the situation as has Forsyth Barr - unsecured lenders are set to be shorn and yet unrewarded.

""The problem with these arguments is that US tax laws are more favourable to housing than Australian tax laws, yet house prices still crumbled stateside," say Hughes and Melser. 
"Arguments about poor transport, natural barriers to city expansion, and troublesome local bureaucrats apply as much to Phoenix and New York as they do to Melbourne and Brisbane."
No rant fromm philbest or hughP that these guys like westpac are stupid or dishonest?
or maybe these ppl  dont have a political axe to grind and understand who to do analysis.
regards

hard to get too worried about the NZ banks - I mean the way  Sth Canty Finance got bailed no problems at all , the gummint arent likely to let bigger fish flop are they ?     I do have a feeling that whoever gets to be PM in Oz is  not going to be much help to NZ either. Also I am getting some nasty stories of layoffs in Qland etc , gonna be interesting to see how the Iwi there cope or will they return to Aoteoroa