Week in Review

Our armour-plated housing bubble

Bernard Hickey explains why New Zealand's housing market bubble has become armour plated and why it is proving impossible to burst, despite the predictions of overseas experts.

New Zealanders usually welcome the praise when overseas authorities describe us as the best in the world. This time, not so much.

In the past fortnight, global economic news authorities The Economist and Bloomberg Economics have both declared New Zealand houses to be vastly over-valued relative to both rents and incomes. They describe New Zealand as in bubble territory similar to those seen in other countries before the Global Financial Crisis and vulnerable to the sort of 30-40 percent price crash seen in the likes of Ireland and parts of the US through 2007 to 2010.

The Economist's long-running Global House Price Index was refreshed on June 27 with March quarter data for most countries and showed New Zealand top of the pops when it came to over-valuation relative to incomes and second most over-valued relative to rents behind Canada.

It found New Zealand prices in the December quarter of 2018 to be 57 percent over-valued relative to incomes rents, just above Australia's 42 percent overvalued in the March quarter. New Zealand was 113 percent over-valued relative to rents, just behind Canada's 120 percent, The Economist found. New Zealand prices have more than trebled since 1990, while British and American prices are still less than double what they were 30 years ago.

"On this basis, house prices appear to be on an unsustainable path in Australia, Canada and New Zealand," The Economist wrote. "Ten years ago they reached similarly dizzying heights against rents and incomes in Spain, Ireland and some American cities, only to endure a brutal collapse," it concluded. 


Bloomberg was no kinder on us and the Canadians.

Niraj Shah at Bloomberg Economics wrote last week that Canada and New Zealand were the economies most vulnerable to a correction in house prices, with Australia and Britain also at concerning levels.

"The results showed that Canada and New Zealand seem to be on the most unsustainable path, with the cost of housing compared with wages the highest in the world in both countries," Shah wrote.

This Economist chart shows NZ house prices more than trebling in the last 30 years to the sorts of levels seen in Ireland shortly before its housing market crashed in 2008. Our prices are now 40 percent higher than in Australia and 75 percent higher than in the US, relative to the starting point of 1990 in this chart.

Exceptional by most measures

New Zealand's housing market is now worth NZ$1.13 trillion, which is up by more than $1 trillion from NZ$123 billion in 1990. The increase is more than triple because there are more houses with more extras (decks/garages/rooms) added on. That's $1 trillion in untaxed capital gains, which at the top marginal rate would have generated extra tax revenues of $330 billion, or enough to build nearly 700,000 new state houses or fund the next 14 years of New Zealand Superannuation payments. 

Our housing market is worth 3.9 times our GDP and more than 7.2 times the value of our stock market. For comparison sake, Australia's housing market is worth A$6.6 trillion or 3.5 times Australia's GDP and 3.3 times the value of its stock market. America's housing market is worth US$33.3 trillion or 1.6 times US GDP and 1.5 times the value of the US stock market.

I initially put quotation marks around the word bubble in my introduction, but there should not be any debate. It's clear from any reasonable measure our housing market is over-valued relative to household incomes, rents, history, GDP and company values. Our houses are worth 14 years of our export receipts. 

Enough said. But over-valued does not necessarily mean prices are about to collapse. 

Why no panic?

So why aren't we worried enough to start taking urgent action to head off a collapse?

To be fair to the Reserve Bank and Governments of both flavours over the last 10 years, there has been some action taken and goodness knows how much higher prices would have been without the so-far limited actions.

The National-led Government of 2008 to 2017 stopped landlords from claiming depreciation on buildings and introduced a new two-year 'bright-line' test that is designed to make property traders pay tax on profits from flipping properties. The Reserve Bank under Governor Graeme Wheeler restricted high loan to value ratio lending in 2013 to both first home buyers and landlords, before tightening it even more to Auckland landlords. 

The Labour-led Government has increased the bright-line test for landlords to five years and is building 1,000 new state houses per year. It has banned non-residents from buying houses. The Reserve Bank under Adrian Orr has proposed to double the amount of capital banks have to put aside in reserve for all of their loans, including the $290 billion lent against our houses. That doubling of capital makes it more expensive for bank shareholders to lend quickly to home buyers. 

Governments have not done nothing, but they also have not done everything they could, in part because of the fear of politicians and property-owning voters that real action would reduce some of that $1 trillion of unearned wealth.

(For those who just choked on their Weetbix at my assertion about unearned wealth, the rise in value is due largely to falling interest rates, increased bank leverage, very fast population growth and various taxation and housing development policies. It has virtually nothing to do with New Zealand's real income growth in the last 30 years or any sort of sacrifice or saving. Home owners did nothing to earn that $1 trillion, other than vote against policies that might have limited that growth.)

In 1989, the Resource Management Act, the Reserve Bank Act and increased taxation on pensions all combined to trigger a once-in-one lifetime lump of capital gain for home owners that most think can never be repeated. See more from me on 1989 as Year Zero for the housing boom. 

But it also unlikely to be taken away.

Bubbles usually burst, except for ours

Usually, a massive over-valuation of a particular type of asset is temporary. 

Either a demand or a supply response, or both, will rectify the imbalance, either quickly or very, very slowly. In Ireland, vast amounts of over-building, bank collapses and a very sharp economic downturn were enough to trigger their 50 percent-plus crash. Spain's 35 percent slump was triggered by banking collapses, over-building, an ageing population and a long grinding recession.

US housing prices fell around 30 percent in most markets through 2007 and 2008 because of an over-supply of new houses, bank collapses, higher interest rates and then a recession. House prices fell globally in the late 1980s (although not that much in New Zealand) because of a sharp rise in mortgage rates to over 20 percent in some cases. Australia's house prices have fallen around 10 percent in the last 18 months because of much tighter bank lending rules and a big increase in apartment supply, especially in Sydney and Melbourne, where prices are down by 15-20 percent. 

But none of those things have happened in New Zealand in the last 30 years and are unlikely to in the next decade at least.

Our layers of armour plating

I had thought in 2008 that New Zealand's house prices would also fall 30 percent in a similar way to what was seen in America. Our prices were more over-valued than even America at that stage, and our economy was staring down the barrel of a similarly large recession. Our banks were also very exposed to the short term credit markets in London and New York that froze repeatedly through late 2008 and early 2009. Many also feared a sharp rise in interest rates as the global economy recovered would deflate our bubble.

But the market didn't slump nearly as much here as overseas. Instead, prices fell just 10 percent through 2008 and then rebounded to fresh record highs by early 2012 for a variety of reasons. Then a series of automatic stabilisers kicked in and a structural change in the global economy towards ever-lower inflation supported prices.

Firstly, the Reserve Bank cut the Official Cash Rate by nearly 600 basis points in less than a year, starting in July 2008. New fixed mortgage rates fell from nearly 10 percent to 5.9 percent by early 2009. They have since fallen to under 4.0 percent as the globalisation of services markets through the mobile phone drives prices lower in the same way the globalisation of manufacturing did through the 1990s and 2000s. The percentage of disposable income going to service household debt in New Zealand has actually fallen from 14 percent in early 2008 to under 8.0 percent now, despite household debt rising by over $100 billion.

Secondly, the Reserve Bank helped the big four Australian banks avoid a cash crunch by lending them more than $7 billion over late 2008 and 2009 to make sure they could roll over their own short term loans from US and European banks. Our Government also provided a guarantee for $10.4 billion worth of bonds issued by the New Zealand arms of the big four Australian banks and, obviously, Kiwibank. Unlike in Ireland, Spain and America, our banks did not collapse and therefore there were no receivers forcing mortgagee sales through to cover bank debts. That's because our Government effectively gave them a short term bailout, but didn't talk about it much at the time, for obvious reasons.

Thirdly, we got lucky with China's immediate and effective response to the Global Financial Crisis (GFC), which was to unleash a wave of state-funded infrastructure spending on roads, apartments, railways and airports. That ramped up iron ore and coal prices because they are used to make concrete and steel. Australia was the largest supplier of both to China and Australia was our largest trading partner at the time. China was our second largest trading partner back then, and the combined effect of China's astonishing growth for the last decade and Australia's unending growth (it has not had a recession since 1991) delivered a double whammy that cushioned the blow of the Global Financial Crisis. That all unleashed another wave of middle class spending by Chinese households. Our Government also borrowed over $60 billion to spend on infrastructure and supporting incomes from 2008 to 2014 through the GFC and the two Christchurch earthquakes.

Fourthly, our population growth from migration has been twice as fast as Australia, Britain, Ireland and America over the last decade. Other countries with flat to falling house prices, such as Spain, Japan and France, also have flat to falling populations.

Fifthly, we started the Global Financial Crisis with a structural shortage of houses built up over 30 years of systematic under-building connected to the end of state house building, the end of Government subsidies for home loans and house building, the onset of restrictions linked to the RMA and a growing reluctance by both the Government and councils to fund new infrastructure for houses. See more on that from my comment piece last week on council infrastructure funding tools.

The plates are even thicker now

Those five factors are all still there puffing up our bubble and holding it tight. If anything, the pressures are greater.

Firstly, the Reserve Bank is expected to cut the Official Cash Rate to 1.0 percent by mid-November, which could see fixed mortgage rates drop towards 3.5 percent. That's because inflation remains under the middle of the RBNZ's 1-3 percent target range and both the global and local economies are slowing, which is sucking further air out of inflation, aside from housing costs. The Government's spending plans detailed in Budget 2019 are forecast to actually reduce stimulus in the economy, which would force the Reserve Bank to push even harder on the interest rate lever. That may change next year, but for now the Reserve Bank is doing all the heavy lifting.

The central bank is already talking about what it would have to do if the OCR was cut all the way to zero percent, including so-called quantitative easing. That would involve the Reserve Bank inventing money to buy assets such as mortgage bonds to lower long term interest rates. Both lower interest rates and quantitative easing have been blamed for further pumping up asset prices. The irony is the Reserve Bank is having to look at buying mortgage assets because there are not enough New Zealand Government bonds. Pushing this policy to the absurd extreme of buying assets to support the economy, the Reserve Bank would eventually have to start buying shares (as the Bank of Japan has had to do) or even houses itself. That's one bidder you would not want to come up against at an auction...

Secondly, the already-miniscule risk of a banking crisis is getting smaller because Reserve Bank is forcing banks to hold more capital. The Reserve Bank has also reduced the chance of a slump in house prices driven by mortgagee sales because its LVR policies have reduced the riskiest type of lending with deposits of less than 20 percent to less than seven percent of lending from almost 20 percent of lending five years ago. There Reserve Bank estimates that less than seven percent of households would be 'under water' with negative equity if house prices fell 20 percent, which is down from nearly one in six households under water five years ago.

The banks could easily cope with a house price slump

The last Reserve Bank stress test of the banking system in 2017 found a 35 percent fall in house prices and a rise in the unemployment rate to 11 percent would reduce aggregate bank profits over the following five years to $4 billion from $36 billion, which would leave banks well above minimum capital levels. They would not even lose money over that period, let alone chew heavily into their capital. And that test was done before house prices rose another 6.9 percent and home owners' equity rose another $77 billion in the last two years. 

Thirdly, the Government is bringing in a formal term deposit guarantee, which further reduces the chance of a bank collapse. The Reserve Bank also stands ready again help banks with cash shortages as the lender of last resort, and the Government would no doubt offer a wholesale debt guarantee again if global financial markets froze.

Fourthly, migration remains stubbornly high. As Newsroom's Laura Walters reported today, the coalition Government has pivoted away from talk about drastic migration cuts and towards quality of skills and stamping out exploitation. Residency applications show thousands more are applying than the Government's new targets. And while the Government has made some changes to migration settings, so far policy changes have been largely tinkering at the edges, and have not led to any significant drop-off in migration. Annual net migration has remained consistently high since 2014. In April, it was 55,800. Over 224,000 new migrants have arrived in New Zealand in net terms over the last four calendar years.

Fifthly, housing construction may be at record highs by number of consents in annual terms, but it remains well below the early 1970 peaks once adjusted for our population, and even on a monthly basis. There have been 126,332 dwelling consents issued over the last four years, while the number of new households formed is estimated by Statistics New Zealand to have risen by 175,000 over that time. The housing shortage was variously estimated from around 50,000 to as high as 500,000 before this latest population surge. Even with the record house building of the last four years, that shortage has risen by another 50,000 houses.

Why supply is so inelastic here

When prices have spiked to unsustainably high levels in other markets, the usual market reaction has been for lots of new houses to be built at the new higher prices to generate profits for builders and developers.

That is what happened in the likes of America, Spain, Ireland and in the CBDs of Sydney and Melbourne. 

But here, our infrastructure funding systems are broken with little prospect of that changing. Also, the underlying drivers for excessive demand, including leveraged tax-free capital gains for home owners, high net migration and Government support for the banking system, remain intact.

It's no accident that the owners of that $1.13 trillion worth of property forced Prime Minister Jacinda Ardern to abandon plans for a capital gains tax for the forseeable future.

Short of a complete meltdown in the global financial system, some sort of decade-long global depression and a complete transformation in the way we plan, fund and build housing infrastructure and houses, that amour plating remains intact. 

First-home buyers may be hoping for some sort of Exocet missile to burst the bubble. They will wait in vain in the absence of a global financial armageddon.

If that happens, they will have other things to worry about, and no one to borrow money off to buy a home, let alone someone to build it. 

* Article corrected to make clear overvaluation of 57 percent is against incomes, not rents. That overvaluation is 113 percent. 

Bloomberg Economic's housing market dashboard.
Bloomberg Economics house price heat map.

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