A "correction" in Auckland's housing market could threaten New Zealand's financial stability.

High debt levels combined with the city's changing market are potentially a danger, particularly if borrowers' incomes fall, migration levels drop and demand falls away, investor buying decreases or mortgage rates rise, according to a Reserve Bank report just out.

"There is a growing risk of a correction to Auckland house prices, which could have a large impact on the financial system due to the high level of household indebtedness.

Tighter restrictions on lending to Auckland investors have been introduced from 1 November. The restrictions are expected to help mitigate financial stability risks by reducing the proportion of riskier mortgage loans and dampening Auckland's rapid house price inflation," it says, citing the threat from housing's downturn along with two other factors.

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A significant proportion of mortgage lending is being undertaken at elevated debt-to-income ratios and although low mortgage rates are relieving pressure on these indebted households, some borrowers could quickly come under pressure if their labour incomes decline or mortgage rates increase, the report said.

"With prices becoming increasingly stretched relative to household incomes and rents, there is increasing potential for a sharp price correction in Auckland. A correction could be triggered by a range of demand-side factors, such as a deterioration in labour incomes, an unexpected rise in mortgage rates, a reversal in migration flows, or a sudden reduction in investor appetite.

There is a risk that a downturn could be amplified by a rise in sales by investors, given that investors have more elevated debt-to-income ratios, and appear to be purchasing on the basis of expected capital gain. Falling house prices could in turn weaken economic activity if indebted borrowers attempted to restore balance sheets by reducing consumption," the report said.

A correction could be triggered by a range of demand-side factors, such as a deterioration in labour incomes, an unexpected rise in mortgage rates, a reversal in migration flows, or a sudden reduction in investor appetite.

The report follows yesterday's Real Estate Institute data, and other information, which has showed changes in the Auckland market lately.

The Reserve Bank summed up the situation.

"The financial system faces three key risks, which have increased over the past six months. First, weakness in global commodity markets is expected to result in a second consecutive year of weak cash flow for dairy farmers, which could aggravate the existing high levels of indebtedness in the sector. "Second, Auckland house prices have become increasingly elevated relative to incomes, increasing the risk of a significant price correction. Finally, there is an increased risk of a further disruption to global funding markets," it says.

The combination of low mortgage rates, high household debt and increasing house prices poses a significant risk to the financial system, it says.

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"Global and domestic interest rates have been historically low for a number of years, and have declined further in recent months. Sustained periods of low interest rates tend to result in upward pressure on asset prices, as the cost of debt falls and required asset yields decline.

"Declining borrowing costs can partly explain the 17 per cent increase in house prices over the past year. Although low mortgage rates are enabling a significant increase in debt repayment by existing mortgage borrowers, rising house prices have put upward pressure on buyer debt-to-income ratios. As a consequence, the aggregate household debt-to-income ratio has remained at historically elevated levels," the report said.

"Housing debt increased at an annualised 8 percent in the three months to September and new mortgage commitments have increased sharply and are running at around 36 percent of outstanding mortgage debt.

"As a result, the characteristics of new mortgage commitments are being reflected in overall bank mortgage portfolios relatively quickly," the report said.