RBNZ targets housing risks in financial stability report

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By Leith van Onselen

The Reserve Bank of New Zealand (RBNZ) has released its latest financial stability report (FSR) which contains several stark warnings about the build-up of risks in the housing market:

Vulnerabilities in the housing market have increased in the past six months. Despite some recent softening, house price growth in Auckland remains high at 9.3 percent in the year to October (figure 1.1), and Auckland’s house price-to-income ratio, at 9.6, is among the highest in the world. House price pressures continue to spread to the rest of the country, with most cities experiencing annual house price growth above 10 percent. Credit to the household sector is growing rapidly, and the household debt-to-disposable income ratio now stands at 165 percent, a record high.

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Rising house prices continue to reflect low interest rates, steady income growth, and an imbalance between population growth and the rate of house building. There is a risk that a reversal of any of these factors could cause a significant market correction. The Reserve Bank’s loanto-value ratio (LVR) restrictions have reduced the share of risky, highLVR loans on bank balance sheets and improved bank resilience to house price falls. However, resilience could be undermined if the recent increase in the share of lending at high debt-to-income (DTI) ratios is sustained. High-DTI loans are at a higher risk of default in the event of an economic downturn, so an increasing concentration of this lending is of concern…

Currently around a third of new mortgage lending is conducted at a DTI ratio of over 6 (figure 1.4). If house prices continue to increase at the current rate, further pressure on housing affordability is likely to cause a higher share of lending at these stretched DTI ratios…

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House price inflation has remained broadly flat, but elevated, since the May Report, at 11.9 percent in the year to October. Annual price growth has fallen to 9.3 percent in Auckland but price growth has generally broadened across New Zealand. Some areas in the North Island and Queenstown are experiencing extremely high rates of house price inflation (figure 3.1).

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Auckland house prices are significantly overvalued compared to incomes, with Auckland’s price-to-income ratio exceeding nine. While many other regions have seen rapidly rising house prices, prices have grown from a lower base and generally have not yet reached the same levels of overvaluation as in Auckland. Nevertheless, price-to-income ratios are rising throughout much of New Zealand, and further strong house price inflation would see prices continue to stretch relative to incomes (figure 3.2)…

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Although the composition of house price inflation has shifted, strong underlying demand is driving high price growth in Auckland and across New Zealand. Strong net immigration, limited housing construction and low interest rates continue to support house prices. In the year to September, net international immigration to the Auckland region increased to over 32,000 (figure 3.3). Inflows have also been high in other parts of New Zealand, but to a lesser degree.

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Building activity has been slow to meet increased demand for houses, particularly in Auckland. Historically, the responsiveness of housing supply has varied across New Zealand, depending on geographic, regulatory and other constraints. The ratio of the change in population to the issuance of new building consents over a period provides a simple indicator of supply responsiveness (figure 3.4). Supply in some cities outside Auckland has been fairly responsive to population growth in recent years, which should help constrain house price growth. However, it increases the risk that eventual oversupply could exacerbate a house price correction, particularly if high supply is coupled with a reversal in other fundamental drivers, such as migration…

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Household credit growth remains strong, at 8.8 percent in the year to September, and has increased since the May Report. Consequently, the household debt-to-disposable income ratio increased to 165 percent in June, above its pre-global financial crisis (GFC) peak… International evidence from past housing market downturns shows that highly indebted households are more likely to (i) default on debt and (ii) reduce consumption by more during downturns, leading to spillovers to other sectors and amplified bank losses during a housing market downturn…

Although the LVR profile of banks’ portfolios has improved, banks appear to be providing a material amount of new lending at debt-to-income (DTI) ratios of over 5… While the majority of lending at a DTI ratio greater than 5 is to higher income households, who may have more income left over after servicing debt, higher income households also tend to have higher fixed expenditure that may be difficult to reduce in a downturn. In addition, a sharp reduction in expenditure by these households could exacerbate a downturn, and banks’ origination processes are unlikely to account for these broader spill-over risks…

Another concerning trend is the share of new mortgage lending obtained by investors. In the year to June, property investors’ share of new residential mortgage commitments increased from 32 percent to 38 percent (figure 3.9). International evidence shows that lending to investors typically carries higher risk than lending to owner-occupiers, partly because investors have a greater incentive to default strategically in severe downturns.2 In light of this risk, in October 2016, the Reserve Bank tightened restrictions on banks’ high-LVR lending to residential property investors. The flow of new mortgage commitments to investors has fallen since the restrictions were announced.

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Investors also account for a disproportionate share of lending at DTI ratios over 5…

Despite the clear build-up of risks, the RBNZ has ruled-out using proposed Debt-To-Income limits “at this time” but remains open to doing so in the future if risks escalate:

A macro-prudential DTI policy would enable the Reserve Bank to limit the degree to which banks can reduce mortgage lending standards during periods of rising housing market risks, in order to protect financial system soundness…

DTI policies can support financial stability by reducing the scale of mortgage defaults during a severe economic downturn…

High-DTI households are also likely to reduce consumption more sharply during a severe downturn, in an attempt to continue servicing loans and increase precautionary savings. A number of studies have found that sharp falls in consumption by indebted households reinforced the economic impact of the GFC…

The Reserve Bank believes restrictions on high-DTI lending could be warranted if housing market imbalances and lending standards continue to deteriorate. The purpose of any restriction would be to reduce the share of riskier, high-DTI lending on bank balance sheets, to reduce the vulnerability of the banking system and the wider economy to a significant housing market downturn.

The Reserve Bank has requested that a DTI tool be added to the Memorandum of Understanding on macro-prudential policy with the Minister of Finance. The Reserve Bank has also implemented an improved system for collecting DTI data on new lending and will continue to talk with banks and other stakeholders about potential policy design.

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Full report here.

About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.