Too many eggs in housing basket

Richard Herring. Marty Melville / Getty Images

New Zealanders seem to be in the Mark Twain camp when it comes to diversifying their assets.

"He said he believed in putting all his eggs in one basket, then watching it like a hawk," says Professor Richard Herring. "He went bankrupt. A wonderful writer but probably not a good investment adviser."

Herring is professor of international banking at the University of Pennsylvania's Wharton School and this year's Reserve Bank professorial fellow at Victoria University.

To his expert eye, New Zealand households' eggs are perilously concentrated in the housing basket.

"The vulnerability of the household sector is that they have a heavy concentration in housing, which is highly leveraged [debt-financed] and leveraged in such a way that they bear an enormous risk of rising interest rates. All those things are fixable."

Herring is not predicting a housing bust. Or ruling one out.

"Has the boom gone too far? We genuinely do not know. My interpretation of the evidence is that it is ambiguous. If you continue to have a stable interest rate scenario and a very robust economy with strong growth, it should all work well. But there are some indications that the household sector is pretty stretched.

"But even if we don't believe the housing boom has gone too far in New Zealand, we should still be worried about the household sector's portfolio concentration in housing. Because it really doesn't require a prior boom to cause a problem in house prices. It can happen for purely exogenous [external] reasons. But it would be worse if it had been preceded by a boom."

Between 1973 and 1980, as the country reeled from oil shocks and Britain's entry into the European Common Market, real house prices fell almost 40 per cent.

But because it was an era of rampant inflation, nominal house prices disguised the bust. They were more or less flat.

"As I talk to New Zealanders, it seems to me that the crisis that is in everybody's mind and memory is the stock market crash in 1987, not the housing slump that extended from the 1970s to the 1980s."

A study by the International Monetary Fund of 14 countries found housing slumps occurred once every 20 years on average. They are less frequent than sharemarket crashes but last twice as long and do twice as much damage to the economy.

Japan, Herring notes, has only recently emerged from a housing bust that began in 1990.

An OECD study found that house prices, relative to disposable incomes, were above their long-term averages in 11 of the 16 countries looked at.

New Zealand's multiple, where prices are 4.5 times incomes, rates as very high by international standards.

"A more relevant measure of affordability might be the cost of servicing debt, which of course depends on interest rates as well as prices. In most OECD countries the fall in interest rates has more than offset higher house prices. Australia and New Zealand are the key exceptions."

Paying the mortgage consumes a larger proportion of New Zealand household incomes than in most other countries.

"But it is not unprecedented. In the latter half of the 1980s New Zealanders managed to service even heavier debt."

High levels of mortgage debt, relative to incomes, and the fact that even fixed-rate mortgages are for what are by US standards very short terms, make New Zealand, with Denmark, the country most exposed to a rise in interest rates.

So why are New Zealanders so devoted to housing as an asset?

"Well, it has been very profitable. People looking back see nothing but increases in the nominal price of housing."

Since the economy was liberalised - and comparisons further back are problematic - the performance of the housing market has been remarkably strong, Herring says.

"Maybe not as strong as people think, because they tend not to evaluate these things with sufficient rigour, but nonetheless there is an impression that it is a very safe asset."

While people are very conscious of some of the costs of housing, like interest and local body rates, they are liable to overlook others.

"When looking at house price appreciation, we should also take account of general inflation, costs like maintenance and insurance, and the opportunity cost of the money tied up in the house [what it would have earned invested elsewhere]. To take a US example, a house bought for $150,000 in 1975 and sold for $840,000 last year looks like a healthy gain. But in real terms it represents a return of only 1.4 per cent a year."

But there is also an element of human nature called disaster myopia. "If something happens only rarely, then it is harder to imagine it. And people think, 'If I worried about all the low-probability events, I wouldn't do anything'. So they treat the risk [of a housing slump] as zero."

Then there is cognitive dissonance: "Our self-image is that we are rational, so when the data suggest otherwise, we dismiss it."

And New Zealanders display a strong degree of home bias, which is people's tendency to invest more in their own country than their country's share of world capital.

"Which is bizarre when New Zealand is such a tiny sliver of the world's capital markets. It means New Zealanders are taking enormous amounts of risk without, I think, believing they are in a risky position."

But when most of the country's largest enterprises are foreign-owned, farmer-owned or state-owned, and the sharemarket's capitalisation is therefore small relative to the size of the economy, and when there is relatively little government debt on issue, where is the prudent investor to turn to diversify?

"I think you'd have to say, 'I am in a small country,' and get over the home bias. I wouldn't feel that much better if New Zealanders were mainly invested in local shares because they would have the same exposure to shocks to New Zealand."

Apart from diversifying out of housing, there is another change he recommends to lessen the risks. That is for banks to offer longer-term mortgages.

"Particularly when New Zealanders have a larger exposure to interest rate risk than anyone else in the OECD, what is striking is the lack of a genuinely long-term fixed-rate mortgage that can be renegotiated without cost.

"When you talk to the banks, they say, 'Well we could offer a 10-year product but no one would want it, because it would be very expensive to break it if interest rates went down'."

As though they had no control over that.

"It is something that is very easy to do in modern capital markets. I think it is very wrong to have the interest rate risk thrust on the household sector, which has less capacity to deal with it than the financial sector."