Fran O'Sullivan: Sub-prime closer to home

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Finance Minister Michael Cullen took a while to issue his reassuring statement but yesterday he called for calm as the long overdue shakeout in global debt markets continued to raise local jitters.

"I think what we have learnt over the last week or so is the international finance system is in much better shape to cope with these kinds of events than was the case 10 years ago," said Cullen.

The Finance Minister contends that to "some extent" the seriousness of what has been occurring has been exaggerated.

Cullen may be right (so far) on the extent of the impact of the global credit crunch on New Zealand - particularly as some heat has now gone out of the kiwi dollar.

Figures released yesterday indicate New Zealanders have already been tightening their budgets by cutting back on retail spending as the impact of rising interest rates hits the mortgage belt. Couple that with figures which show the national median house price has dropped for the second month in a row and it is obvious a mild correction is under way to the household debt binge.

But there is still considerable downside risk.

In the past week, central banks from the US, Japan, Eurozone, Canada, Switzerland and Australia have pumped more than US$400 billion ($547 billion) extra liquidity into the global banking system. Others have pledged to follow suit if credit dries up because of the turmoil in the US sub-prime mortgage market and associated credit squeeze.

The People's Bank of China has said it has no plans to sell US dollar assets - which will assuage concerns at a geopolitical level.

The problem originated with the large number of loans written in the US to borrowers through the sub-prime mortgage market. These borrowers were not required to stump up a deposit, and, were able to make interest payments on their loans rather than pay down principal. That works on a rising market - but when the squeeze comes it can have dire consequences.

The globalisation of financial markets means that as an over-stretched householder in Los Angeles defaults on his mortgage, the impact spreads as many such loans have been securitised and sold on to overseas institutions.

The Bank of England - which has incentivised British domiciled banks to hold large reserve positions - has not lifted a finger. It's unclear whether the Bank of England is simply playing tough by ensuring its banks remain aware of the moral hazard of making dumb loans - "don't expect us to bail you out" - or whether its own policies have helped to alleviate financial system risk.

In New Zealand, the Reserve Bank put pressure on the trading banks to increase interest margins earlier this year. In its latest financial stability report (May 2007) the Reserve Bank said the New Zealand banking system remained sound following a favourable period of economic expansion.

"But the record levels of household debt and stretched house prices left the economy relatively more exposed to negative economic shocks."

The plus side is that capital levels in New Zealand-domiciled banks were in excess of regulatory requirements.

But the central bank warned banks were increasingly offering new mortgages that required little or no borrower deposits. The resultant high loan to value ratios from such products exposed banks to considerably more risk of loss compared to lending that requires higher borrower equity.

The Reserve Bank's analysis did not indicate how many of the high loan-to-value mortgages have been written to struggling first home owners, or, how many were loans to rental property investors that may have been guaranteed against the equity in the borrower's home or other properties.

The question however is a good one. Right now it is obvious that some such borrowers are more likely to default if the going gets tough. But there is a downside for banks, as the Reserve Bank's report points out. The loss on a high loan-to-value mortgage - where the borrower defaults - will be higher than if the loan has a more conservative ratio. That's because many mortgagee sales are at below the "market value" on the loan.

New Zealand does not have an official "sub-prime" market. Non-bank lending tends to be more directed towards consumer loans rather than mortgages. But the big explosion in residential mortgage lending suggests a considerable number of mortgages written by trading banks would fall into a "sub-prime" category.

The figures show the explosive growth in loans where the loan to value ratio is above 80 or 90 per cent is also indicative.

How many of those loans were written on the back of "bank valuations" where valuers attributed "appropriate" values to properties to justify mortgage cover? How many were prudent?

We're likely to find out a bit more about the answers to these fundamental questions if the credit crunch hits here.

But Cullen's sanguine response might turn out to be the correct one. Fifty-five per cent of total bank funding comes from wholesale sources, not simply bank depositors.

A large proportion of that is sourced from overseas group funds - but not all.

The bank's comment is apposite.

"Non-related wholesale funding can be prone to large volume shifts. A sudden change in the appetite of overseas investors for NZ assets could have the potential to sharply increase funding costs."

The question for Cullen is if overseas investors - scared by the US sub-prime issue - do increase funding costs, how many of the huge amount of loans written by NZ trading banks will turn out to be "sub-prime"?

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