Former Economics Editor of the NZ Herald

Brian Fallow: Debt monster keeps on growing

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Until politicians act, the quest for capital gains - and investors' readiness to borrow - will be irresistible.
Reserve Bank deputy-governor Grant Spencer. Photo / Mark Mitchell.
Reserve Bank deputy-governor Grant Spencer. Photo / Mark Mitchell.

The Reserve Bank was radiating signals this week that its next intervention in the housing market may well target debt-to-income ratios rather than the loan-to-value ratios it has focused on hitherto.

Any move in that direction is not imminent.

Apart from anything else, it would require a change to the bank's memorandum of understanding with the Government, as restrictions on debt-to-income ratios are not among the four macro-prudential tools it is currently free to use.

Regulating debt-to-income would be tricky to design, especially if you don't want to make life even more difficult for first home buyers.

And many small businesses rely on mortgaging a property to raise the funding they need, but have highly variable income streams.

However Prime Minister John Key is not ruling out such a move.

Even as governor Graeme Wheeler and deputy governor Grant Spencer were fronting a Wednesday press conference on the release of the bank's financial stability report, the Real Estate Institute was reporting that the median house price in Auckland has climbed 13 per cent - or $92,000 - over the past year.

Aucklanders' incomes on the other hand, it is fair to assume, have not risen at anything like that pace.

And mortgages and rents have to be paid out of household incomes.

Nationwide, households' housing debt rose 8 per cent in the year ended March, the fastest growth since 2008.

But New Zealanders' collective (not average) income from wages and salaries - the lion's share of household income - rose more slowly, by 4.8 per cent over the same period.

The ratio of household debt to income - at 162 per cent - now exceeds the previous peak on the eve of the global financial crisis.

The Reserve Bank expects credit growth to continue to exceed income growth.

"Low mortgage interest rates have helped contain debt servicing costs but the household sector would be vulnerable to an increase in interest rates or an economic downturn," it says.

Wheeler was clear that, given the state of the global economy and the extraordinarily loose monetary policy other central banks are running, it will not be feasible for him "to increase interest rates in the foreseeable future.".

But, in the careful language of the financial stability report, "While a large increase in mortgage rates seems unlikely in the current global environment, a relatively small increase could put pressure on some borrowers."

By the end of last year, new borrowers in Auckland faced a debt servicing ratio of 46 per cent of their income, Reserve Bank data shows.

That is not too far shy of the brief period in 2007 when debt servicing costs were soaking up just over 50 per cent of new borrowers' incomes in Auckland.

And that was when floating mortgage rates were nearly twice what they are now.

Then there is the question of how secure those household incomes are. It would be unwise to assume that the other 99.8 per cent of the world economy has lost its capacity to sideswipe us with some sort of shock that would send unemployment climbing again.

Another area of concern is that household debt has been growing faster than deposits.

That makes banks more reliant on tapping wholesale debt markets offshore to fund their lending here.

The turmoil in those markets earlier in the year - though it has subsided, at least for now - has seen credit spreads (the risk premium on that source of funding) ratchet up, raising the banks' cost of funds and putting pressure on their net interest margins. Hence their notorious failure to fully pass on March's cut to the official cash rate.

While LVR restrictions have strengthened the resilience of banks' balance sheets, the impact on house price inflation has been more modest and transitory.

Fundamentally, house price inflation is driven by the imbalance between demand (swollen by net migration gains) and supply (hobbled in Auckland's case by regulatory restrictions and Nimby politics).

But that said, there is no doubt that investors play a key role in pushing up prices.

They represent 42 per cent of the buying in Auckland in recent months and in much of the market they are the marginal buyers. It is the point at which they drop out of the bidding that sets the price the home seeker has to pay to secure a property.

That rise to 162 per cent in the debt-to-income ratio is heavily influenced by investor borrowing. For owner-occupiers, the ratio is a more modest 109 per cent, though that is still a record high.

Investors also rank high for interest-only loans.

This is no surprise. The tax laws treat the buyers of rental properties as having gone into business, the landlord business, and therefore entitled to deduct the costs incurred, including interest, in earning a taxable income (rents).

The banking system, on the other hand, sees them as people borrowing on the security of real estate and will lend as much as the Reserve Bank will allow. With rental yields in Auckland now below 3 per cent - absurdly matching 10-year Government bond yields - it is clearly expectations of capital gain that are driving the prices they are willing to pay. And those are the prices a would-be owner-occupier has to outbid.

They don't have to worry too much about what is happening to tenants' incomes. That is topped up by an accommodation supplement - a straight subsidy from taxpayers to landlords.

They don't have to deal with tenants at all, if they don't want to, using a property management service instead. They can sit back and enjoy all the benefits of leverage in a rising market, amplifying the increase in their equity, until it is time to sell and pocket a tax-free capital gain.

It is very hard to match that deal by investing instead in the kind of business that expands the economy's output of goods and services and employs people.

It is a sterile use of households' rather meagre savings.

But until politicians muster the fortitude to deal with the tax distortions and take on the ever-growing vested interest in the status quo, the incentive to profiteer from extended periods of excess demand for housing will prove irresistible.

13 per cent Annual increase in the Auckland median house price

8 per cent Annual rise in housing debt

162 per cent Ratio of household debt to income

- NZ Herald

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Former Economics Editor of the NZ Herald

Brian Fallow is a former economics editor for the New Zealand Herald. A Southlander happily transplanted to Wellington, he has been a journalist since 1984 and has covered the economy and related areas of public policy for the Herald since 1995. Why the economy? Because it is where we all live and because the forces at work in it can really mess up people's lives if we are not careful.

Read more by Brian Fallow

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