Matthew Goodson: Huge risks in loan-financed housing bubble

House prices always go up ... yeah right. Photo / Brett Phibbs

There has recently been considerable commentary and even criticism of the Reserve Bank of New Zealand for holding interest rates above other countries despite CPI inflation being temporarily below the 1-3 per cent target range. The RBNZ has also been criticised by Treasury for failing to make a robust case to "intervene" against the housing market with policies such as LVR that attempt to curb the most aggressive lending practices.

Some have even called the RBNZ Muldoonist. Is the criticism justified? Should the RBNZ simply leave the market to its own devices and allow Aucklanders to indulge in our favourite pastime of swapping debt-funded houses among ourselves at ever higher prices?

There are many arguments and stories justifying the Auckland housing bubble.

Immigration is perhaps the most frequently cited. Try telling somebody in Florida, Nevada, Spain or Ireland that this factor will prevent a subsequent bust. Likewise construction costs. Likewise restrictive planning rules ... the list goes on.

The Auckland bubble is big. Deutsche Bank estimates overall NZ housing is 30 per cent overpriced relative to income and 82 per cent versus rents, with Auckland presumably being worse. However, such extremities are nothing that the world has not seen before and nor are the usual stories that temporarily justify it.

A recent study involving the Federal Reserve Bank of San Francisco looked at 17 advanced economies since 1870 and examines the long-term economic impact of housing bubbles, equity market bubbles and bank loan booms. The findings are that the financial stability risks of a moderately leveraged equity market boom/bust are very small but the risks from a loan-financed housing boom are huge.

In recent times, the impact of the Nasdaq crash in 2000 was painful for those who paid absurd prices for companies specialising in vapour-ware but the wider economic impact was limited.

Indeed, the sharp interest rate cuts by the Fed to limit its aftermath arguably paved the way for the remarkable housing and credit boom that followed and whose bust in 2008 is still being recovered from today.

The study finds that over time, real house prices experienced a number of booms and busts but largely trended sideways from the 1870s to the 1950s, after which they have risen substantially in conjunction with bank loans.

Examples of past boom/busts include the Australian real estate boom of the 1880s financed by overseas inflows and immigration which blew apart in the early 1890s and caused a deep recession verging on depression.

A US real estate boom/bust in the 1920s centred on outside money investing in Florida and preceded the equity market crash of 1929 by several years. Rather than immigration, financial deregulation was the driver of the Scandinavian boom of the 1980s and bust of the 1990s.

Japanese real estate peaked in 1991 and the study points out that by 2012, the nominal value of real estate was about half of its 1991 level.

House prices always go up ... yeah right.

Contrastingly, the study finds numerous examples of popped equity bubbles that did not turn into wider financial crises because they had very little bank finance underpinning them. Without a parallel credit boom, equity bubbles have no statistically significant effect on the depth of the economic recession that follows their bust nor the speed of recovery.

The study finds that when an equity bubble coincides with a credit boom, the subsequent economic recession lasts a year longer than it would otherwise have and there is a 3 per cent drag on the level of GDP per capita after five years; that is, the economy is 3 per cent smaller than it would otherwise have been. As an example, NZ in the aftermath of the 1987 crash springs to mind.

Conversely, house price bubbles have been less frequent but their busts have been far more damaging due to their loan financing frequently taking the banking system down with them. A house price and credit bubble crash, "can sink the economy for several years running so that even by year five the economy is still operating below the level at the start of the recession".

Spain and Ireland since 2009 are clear recent examples along with those cited earlier.

Hopefully, NZ will not join them in the period ahead.

These findings are stark. Auckland's credit-financed housing bubble is a grave threat to the NZ economic outlook - never mind the "reasons" of immigration, building costs, land availability and so forth.

Every bubble in history has had its reasons.

These pass but the permanent effects of the bubble bursting most certainly do not. Immigration may weaken, planning rules can change but the mortgage debt that has funded the price bubble remains.

Thank goodness that Graeme Wheeler and the RBNZ are beginning to pay attention to the issue. It is simply bizarre that they are being criticised for being the one official institution to show some leadership and tentatively use their limited tools to lean against Auckland house prices.

The RBNZ's tools need to be sharpened rather than tempered, with other countries providing plenty of evidence for the success or failure of tools such as stamp duty, removing the tax advantages of so-called investors, overseas investment restrictions, loan restrictions et al.

The evidence is compelling that the aftermath of a credit-financed housing bust is dire. Those who do not learn the lessons of history are doomed to repeat them.

• Matthew Goodson is managing director at Salt Funds Management, which has a $270 million listed property fund among $1.5 billion of funds under management.