'Safe' system encourages risk-taking by property investors

Last weekend's headlines from Forbes warning about a housing crash and economic disaster may have caused a few Auckland property owners to choke on their croissants.

But then came the denials and debunkings to soothe the nerves of heavily indebted property investors.

Economic Development Minister Steven Joyce compared Forbes' online columnist Jesse Colombo to a Ken Ring-like figure who saw bubbles wherever he looked.

Prime Minister John Key said the warnings were overblown. Economic commentators argued that Colombo's warnings were unlikely to come to fruition.


But the concerns about Auckland's houses being overvalued and New Zealand households having too much debt are valid, as is the risk that a slump might affect our banks.

Colombo's assumptions about what would happen if house prices did fall were off the mark, but the reasons are not reassuring.

Essentially, New Zealand's housing market and banking systems are unlikely to crash because they are "too big to fail". Even if they were to fall, the authorities are unlikely to let them.

We know this because we have a track record. In late 2008 and early 2009, house prices fell 10-15 per cent as the global financial crisis and a recession caused by high interest rates and a drought drove up unemployment and drove down demand for houses.

Banks came under pressure because the wholesale financial markets they used to roll over their foreign debts froze.

The Government and Reserve Bank intervened to tide the banks over and ensure they weren't forced into a United States-style rash of mortgagee sales.

The Reserve Bank lent the banks $7 billion between November 2008 and June 2009 to ensure they remained liquid. The Government also provided the banks a guarantee for $10.3 billion worth of bank bonds issued between November 2008 and February 2010.

House prices stopped falling because the authorities intervened to take pressure off the banks and New Zealand's automatic stabilisers of a floating currency and flexible monetary policy kicked in. The Reserve Bank cut the official cash rate from 8.25 per cent to 2.5 per cent in less than 12 months.

The Government also used its balance sheet to support the economy, borrowing as much as $300 million a week and increasing government debt by $50 billion to ensure benefits were paid, tax credits granted and earthquake repairs made. Those are the big differences between New Zealand's housing "bubble" and ones that burst in the likes of the US, Ireland or Spain with such disastrous effect.

At first blush, these seem like good reasons to relax. But are they really? We are now in a situation where a property investor can assume the residential property market can never fall because the Government will bail out the market. Investors can feel safe gearing themselves up to the eyeballs and betting on tax-free capital gains because their chosen asset class is "too big to fail".

This is known as a moral hazard, where the risks of an investment decision are borne by someone other than the risk-taker. In this situation, the profits are privatised and the losses are socialised.

It's a dangerous situation. It encourages investors to take more risk than is safe and the pain of any slump is eventually borne by everyone. Luckily for New Zealand, the costs of the support offered in 2008-09 were relatively light. The banks repaid the short-term loans and have repaid, or will repay, the guaranteed long-term loans.

But it does raise the bigger issue of what happens next time our economy receives a 2008-style shock. Currently, our banks are not guaranteed by the Government and the Reserve Bank has set up a system known as Open Bank Resolution — if a bank is in trouble, the Reserve Bank can shut it down and force an overnight recapitalisation that would see term-depositers receive a haircut by having their deposits written down, and the bank can open again the next day.

This is not something everyone is told when they deposit their money in a bank.

It is a fig leaf because no New Zealand Prime Minister with borrowing capacity would allow term-depositers to take that pain. They would bail out the bank in the same way the Irish, British and American Governments did.

This implicit state guarantee and its morally hazardous consequence is being rectified in these countries with deposit insurance schemes that effectively mean the banks and their saving customers pay an insurance premium for that guarantee.

That is what should happen in New Zealand, too. The Forbes warning of imminent collapse was wrong but it should make us consider the flaws in our financial architecture that make it seem safe for some investors to gear up knowing that someone else will rescue them.