Author: Martin North

Martin North is the Principal of Digital Finance Analytics

RBNZ Says Action Needed To Reduce Housing Imbalances

The Reserve Bank of New Zealand today urged greater attention be given to reducing housing market imbalances that are presenting an increasing risk to financial and economic stability.

OECD-Comps-NZIn a speech to the Rotorua Chamber of Commerce, Reserve Bank Deputy Governor Grant Spencer said that: “Irrespective of the mix of demand and supply-based factors, the longer the excess demand persists, the further prices will depart from their underlying fundamental determinants, and the greater the potential for a disruptive correction.

“Since late 2014, housing market imbalances have become more accentuated, particularly in Auckland where the supply shortage is greatest, and house prices are particularly stretched, having increased by three times since the start of 2002.

“New Zealand is one of the few advanced economies that has not had a major house price correction in the past 45 years.”

Mr Spencer said that a downward correction in house prices in New Zealand could be prompted by a range of potential shocks, such as rising global interest rates, or a downturn in the global economy and financial markets.

With 60 percent of its lending in residential mortgages, the New Zealand banking system could be put under severe pressure in such a downturn. The resulting contraction in credit would amplify the impact to the domestic economy and financial system, making it more difficult to avoid a severe downturn.

Mr Spencer said that policies to ease the supply constraints must be the main priority, but are unlikely to yield quick results.

Considerable scope exists to streamline the multiple approval processes required to complete a residential development. There is also a need to adopt a more integrated approach to the planning and funding of new infrastructure.

“The proposed RMA reforms have the potential to significantly improve the planning and resource consenting processes.

“The best prospect for substantially increasing the supply of dwellings over the next one to two years appears to be in apartment development. The Government and the Auckland Council might consider focussing their efforts on simplifying the approvals process and increasing the designated areas for high-density residential development.”

On the demand side, Mr Spencer said that there are practical difficulties in using migration policies to manage the housing cycle.

“Nor can monetary policy be used currently to dampen housing demand, as CPI inflation is below the Reserve Bank’s target range.”

However, measures should be considered to counter the growth in investor and credit based demand for housing.

The Reserve Bank would like to see fresh consideration of possible policy measures to address the tax-preferred status of housing, especially housing investment.

“Investors are often setting the marginal market prices that are then applied to the full housing stock within a regional market. Indicators point to an increasing presence of investors in the Auckland market and this trend is no doubt being reinforced by the expectation of high rates of return based on untaxed capital gains.”

Mr Spencer said that macro-prudential policy is a potential instrument to help restrain credit-based demand pressures and improve the resilience of bank balance sheets to a potential housing downturn.

“The introduction of loan-to-value ratio restrictions (LVRs) in October 2013 helped to moderate housing market pressures despite strong net inward migration and the ongoing shortage of housing. The LVR restrictions have also improved the resilience of bank balance sheets. They will be removed or modified as market conditions allow.

“Other macro-prudential options are being assessed, including in relation to investor lending. However, such tools are not a panacea – their impact is inevitably smaller than the main drivers of the current housing market imbalance.”

Australian Growth Down And Unemployment Up – IMF

The latest edition of the IMF’s World Economic Outlook, just released, portrays a complex global picture. There are several points relevant to Australia, in the pre-budget run-up.

  • Legacies of both the financial and the euro area crises are still visible in many countries. To varying degrees, weak banks and high levels of debt—public, corporate, or household—still weigh on spending and growth. Low growth, in turn, makes deleveraging a slow process. Potential output growth has declined. Potential growth in advanced economies was already declining before the crisis. Aging, together with a slowdown in total productivity, has been at work. The crisis made it worse, with the large decrease in investment leading to even lower capital growth. As we exit from the crisis, capital growth will recover, but aging and weak productivity growth will continue to weigh. The effects are even more pronounced in emerging markets, where aging, lower capital accumulation, and lower productivity growth are combining to significantly lower potential growth in the future. More subdued prospects lead, in turn, to lower spending and lower growth today.
  • On top of these two underlying forces, the current scene is dominated by two factors that both have major distributional implications, namely, the decline in the price of oil and large exchange rate movements.
  • Australia’s projected growth of 2.8 percent in 2015 is broadly unchanged from the October prediction of 2.7 percent, as lower commodity prices and resource-related investment are offset by supportive monetary policy and a somewhat weaker exchange rate. 3.2 percent growth is forecast for 2016, supported by low interest rates and inflation.
  • The downturn in the global commodity cycle is continuing to hit Australia’s economy, exacerbating the long-anticipated decline in resource-related investment. However, supportive monetary policy and a somewhat weaker exchange rate will underpin nonresource activity, with growth gradually rising in 2015–16 to about 3 percent.
  • Average annual metal prices are expected to decline 17 percent in 2015, largely on account of the decreases in the second half of 2014, and then fall slightly in 2016. Subsequently, prices are expected to broadly stabilize as markets rebalance, mainly from the supply side. The largest price decline in 2015 is expected for iron ore, which has seen the greatest increase in production capacity from Australia and Brazil.
  • Exporters of commodities (Australia, Indonesia, Malaysia, New Zealand) will see a drop in foreign earnings and a drag on growth, although currency depreciation will offer some cushion.
  • Australian unemployment, net is forecast at 6.4 percent in 2015.
  • In addition to strong regulation and supervision, protecting financial stability may also require proactive use of macroprudential policies to tame the effects of the financial cycle on asset prices, credit, and aggregate demand.

 

Perspectives On Capital

The question of how much capital should a bank hold is running hot these days. To illustrate the point, lets look at the commentary surrounding the the semi-annual update of the Global Capital Index, which show the capital ratios for Global Systemically Important Banks, and which was released in early April by FDIC Vice Chairman Hoenig. The Federal Deposit Insurance Corporation (FDIC) preserves and promotes public confidence in the U.S. financial system by insuring depositors for at least $250,000 per insured bank; by identifying, monitoring and addressing risks to the deposit insurance funds; and by limiting the effect on the economy and the financial system when a bank or thrift institution fails. So what they say in significant.

Among the data in the report:

  • For the largest U.S. banking firms, the average tangible equity capital ratio – known inversely as the leverage ratio – is 4.97 percent. In other words, each dollar of assets is funded with 95 cents of borrowed money.
  • The largest regional and community banks, have tangible capital ratios ranging from 7.57 to 8.85 percent.  That is, they operate with between 1.5 and 1.7 times more funding from their ownership than G-SIBs do.

“The Global Capital Index illustrates how financial resiliency is still sorely lacking,” Vice Chairman Hoenig said. “The sector of the financial industry with the greatest concentration of assets is the least well capitalized. Plainly put, it operates with the largest amount of borrowed, or as we say, leveraged funding, and thus it is the least well prepared to absorb loss. Yet the primary measure of capital – the risk weighted measure — makes the largest firms appear relatively more stable than they really are. The reality is that with too little owner equity funding individual firms, the industry as a whole also is undercapitalized and should one firm fail, the industry continues to be vulnerable to contagion and systemic crisis. It follows that the lack of adequate tangible capital remains among the greatest impediments to successful bankruptcy and resolution.”

The Global Capital Index uses estimates of International Financial Reporting Standards (IFRS) to measure a firm’s tangible equity (loss-absorbing capital) against on- and off-balance sheet assets, as shown in column 8 of the table. The tangible capital measurement includes derivatives and other assets that are off-balance-sheet in US Generally Accepted Accounting Principles (GAAP) and Basel calculations. It is calculated by comparing equity capital to total assets, deducting goodwill, other intangibles, and deferred tax assets from both equity and total assets.

The tangible leverage ratio measures funds available to absorb loss against total balance sheet and some off-balance sheet assets. It does not attempt to predict or assign relative risk weights among asset classes. “It is more difficult to game, and it provides the most clear and complete picture of a banking firm’s ability to absorb loss regardless of source,” Vice Chairman Hoenig said.

In contrast, the ratios of Tier I capital to risk-weighted assets for all banks, largest to smallest, are above 10 percent and some of the largest have ratios of more than 15 percent. “This higher capital ratio is achieved by reducing on-balance sheet assets by a pre-assigned risk weight and excluding off-balance sheet assets, such as derivatives. This measure is misleading and overstates the strength of these firms’ balance sheets. No other industry is allowed to make these kinds of adjustments,” Vice Chairman Hoenig said. “The tangible leverage ratio provides a more accurate measure of assets and risks than the balance sheet reported under either GAAP or Basel.”

Global-Capitall-Index

 

 

Lending Finance Tops Out?

The ABS data today provides an insight into the various categories of Finance to February 2015. The total value of owner occupied housing commitments excluding alterations and additions rose 1.0% in trend terms, whilst the value of total personal finance commitments fell 0.1%. The value of total personal finance commitments fell 0.2%. The trend series for the value of total commercial finance commitments rose 2.9%. Revolving credit commitments rose 4.8% and fixed lending commitments rose 2.1%. So, we see a rise in commercial lending (which of course includes investment property lending.) The rate of momentum in housing lending on the other hand appears to be slowing somewhat.

LendingFinanceFeb2015Looking at the relative share of investment property lending, we see it has turned down from a peak of 30.3% of all commercial lending to just of 29%, but still high compared with 2011. Banks are still preferring to lend for housing, though we are seeing a rise in commercial lending which is not property aligned – this is to be welcomed, and we need to see more, as productive lending to business will translated into real economic growth, whilst lending for property purchase inflates house prices, bank balance sheets, and household net wealth in book value terms.

COmmercialFinanceandPropertyFeb2015Turning to housing lending, values still rising and a total of $31 billion was lent for property across all categories in the month. This is a record.

HousingFinanceFeb2015Looking at the mix, 38% was for investment housing, 30% for owner occupation, and 20% for refinance.

LendingMixFeb2015We see that just of 50% of secured loans (excluding refinance) were for investment purposes. Refinance was high, in response to the RBA rate cut in February.

HousingLendingFinanceFeb2015Looking at the percentage movements, month on month, we see the rate of growth slowing across the board, with investment lending slowing the most. This could well indicate a potential turning point in the months ahead, despite strong demand for investment property in the system.

HousingFinancePCMovementsFeb2015

A Sharp Downturn (Though Unlikely) In China Would Impact Australia – World Bank

The latest East Asia and Pacific Economic Update from the World Bank says

“a significant slowdown in China, though unlikely, would exert large spillovers, particularly on commodity exporters. In China, a disorderly unwinding of real and financial vulnerabilities could trigger a sharp slowdown in investment and output growth. A steep decline in property prices could force developers and banks to deleverage quickly, leading to a sharp contraction in real estate investment. A disorderly unwinding of local government financing could trigger a sharp slowdown in infrastructure investment. A wave of bankruptcies in primary and heavy industries suffering from overcapacity could seriously derail fixed investment in otherwise healthy industrial sectors. And excessive risk taking in the shadow-banking system could eventually force a rapid cutback in liquidity and credit, deeply curtailing investment.

A slowdown of this order remains unlikely, given the substantial policy buffers available. As discussed in the October 2014 East Asia and Pacific Economic Update, there are significant fiscal, institutional, and exchangerate buffers to prevent a disorderly unwinding of debt. Ample fiscal space is available to deploy targeted stimulus or bail out debtors. The savings rate is 50 percent of GDP, financial repression restricts savings outside the banking system, the financial system is still predominantly state owned, and capital controls on bank lending and portfolio investment prevent sharp outflows. Foreign reserves, at US$3.9 trillion, are by far the largest in the world, and net international assets exceed US$2 trillion.

However, should a sharp slowdown materialize, it would exert large spillovers across the region. A onetime 1-percentage-point decrease in China’s GDP growth relative to the baseline (stemming from a 2-percentagepoint decrease in investment growth) would reduce growth in the region by approximately 0.2 percentage points (World Bank 2014). The impact would be relatively larger for commodity exporters, and for economies more tightly integrated into regional supply chains (Ahuja and Nabar 2012). In addition, the significant negative impact on Australia and New Zealand, among the world’s largest commodity suppliers, would lead to indirect spillovers on the Pacific Island Countries, given their tight links through trade, investment, and aid”.

When Is Macroprudential Policy Effective?

Given the buoyant housing market, and the potential risks which are exposed, there has been significant interest in the potential use of macroprudential tools to try and help alleviate the worst excesses. But some question whether they are, in fact, effective. A recent Bank For International Settlements Working paper casts some interesting light on this question. BIS Working Papers No 496 When is macroprudential policy effective? by Chris McDonald of the Monetary and Economic Department was released in late March.

Loan-to-value (LTV) and debt-to-income (DTI) limits have become increasingly popular tools for responding to house price volatility since the global financial crisis. Nonetheless, our understanding of the effects of these policies is uncertain. One aspect not well understood is how their effectiveness varies over the cycle. It is also not clear if the effects of tightening and loosening are symmetric. This paper seeks to address these issues by considering the effects of policy changes at different parts of the housing cycle. Then, controlling for this, I evaluate if the effects of tightening and loosening are symmetric or not.

There are at least two inter-related reasons for using macroprudential policies: (i) to create a buffer (or safety net) so that banks do not suffer overly heavy losses during downturns; and (ii) to restrict the build-up of financial imbalances and thereby reduce the risk of a large correction in house prices. Here I examine the relationship between changes in LTV and DTI limits and the build-up of financial imbalances. There is a growing group of economies that use macroprudential policies to target imbalances in their housing markets in this way. This analysis relies on the experience of these economies: many of which are from Asia, though the results are likely to be relevant to other economies as well.

The literature on the effectiveness of macroprudential policies at taming real estate cycles has grown quickly since the 2008 financial crisis. For a wider discussion on the effectiveness of macroprudential policies, the background papers by the Committee on the Global Financial System (2012) and the International Monetary Fund (2013) provide a good overview. The consensus is that these measures can contain housing credit growth and house price acceleration during the upswing. Kuttner and Shim (2013) estimate the effects of a range of policy changes on housing credit growth and house price inflation across 57 economies. They find that tightening DTI limits reduces housing credit by 4 to 7 percent, while tightening LTV limits reduces housing credit by around 1 percent. Crowe et al (2011) also find evidence that LTV limits prevent the build-up of financial imbalances. They find that the maximum allowable LTV ratio between 2000 and 2007 was positively correlated with the rise in house prices across 21 economies.

By looking at 100 policy adjustments across 17 economies, I find that changes to LTV and DTI limits tend to have bigger effects when credit is expanding quickly andwhen house prices are relatively expensive. Tightening measures (such as lowering the maximum LTV ratio) during upturns lower the level of housing credit over the following year by 4-8 percent and the level of house prices by 6-12 percent.

Conversely, during downturns they reduce housing credit by 2-3 percent and house prices by 2-4 percent. This is consistent with the finding of Classeans et al (2013): that the persistent (or long-run) effects of LTV and DTI limits increase with the intensity of the cycle. Several measures of the housing cycle correlate with the effects of changes to LTV and DTI limits. Stronger credit growth before tightening is associated with bigger effects. While there might be several reasons for this, one explanation is that lending is available to more marginal borrowers during booms. High house-priceto-income ratios are also correlated with bigger tightening effects. Limits on LTV and DTI ratios appear to become more constraining when houses are expensive. This may be an important element for explaining cross-country differences in the effectiveness of macroprudential policies, given that house-price-to-income ratios can differ substantially.

Tightening LTV and DTI limits appears to be more effective than loosening them, as found in past research. In downturns, ie when credit growth is weak and house prices are relatively cheap, tightening reduces the level of housing credit by around 2-3 percent and loosening raises it by 0-3 percent. Given the bounds of uncertainty, these are not that different – consistent with loosening having small effects because it usually occurs during downturns.

Digital Disruption and P2P Lending

DFA research was featured in a Sydney Morning Heald feature today “Banks look vulnerable as lucrative loans market gets personal online” by banking reporter Clancy Yates. The article nicely highlights some of the interesting and potentially disruptive plays in the evolving Australian market, including the peer-to-peer lending sector.

FactCheck: was Australia on a debt trajectory heading to 122% of GDP?

From The Weekend Conversation:

“given we inherited a trajectory of debt and deficit heading to 122% of GDP, which was the Greek-like proportions the Prime Minister talked about. We have halved, just through our legislated measures, we have halved that trajectory. So now we are heading towards just above 50% of net debt to GDP. – Assistant Treasurer Josh Frydenberg, interview with Fran Kelly on RN Breakfast, March 26, 2015″.

Mr Frydenberg and other Abbott government ministers have, on several occasions, told voters their measures have trimmed a debt and deficit trajectory heading to 122% of GDP down to just above 50%.

But where do those numbers come from and how much credence should we place in them?

The Intergenerational Report

When asked for a source for those numbers, a spokesperson for Mr Frydenberg directed The Conversation to the Intergenerational Report, released by Treasury in early March, in particular Chapter 2, which states under section 2.1.3 Balance Sheet that:

Under the “previous policy” scenario, net debt is projected to reach 122% of GDP in 2054–55. This represents $5,559 billion in today’s dollars and is equal to $139,900 per person (Chart 2.4). The projected level of Australian Government debt is significantly improved under the “currently legislated” scenario. Net debt is projected to reach 57.2% of GDP in 2054–55 ($2,609 billion in today’s dollars) under the “currently legislated” scenario.

Remember, the debt in question here is domestic currency debt accumulated by government due to budget deficits (where government spending has exceeded tax revenue). It’s not about debt owed by Australians to foreigners which is denominated in foreign currency. Nor are we referring to private debt owed by businesses and households. (Australia’s foreign debt is very low, and even smaller is government foreign debt. Private debt is obviously very large but rarely highlighted as a concern, even though that was a major issue for the US in the GFC).

So the Assistant Treasurer has accurately quoted figures from the Intergenerational Report, which forecast that Australia was on a trajectory to reach debt worth 122% of GDP in 2054-55.

However, while he’s been accurate in quoting it, a number of economists regard the figures in the Intergenerational Report as problematic and politicised.

Treasurer Joe Hockey has rejected claims that the report is a political document, saying:

Some will claim it’s a political document. So be it… But the numbers and the trends are there, whether it’s the Liberal party, the National party, the Labor party, the Greens or Palmer United, the fact is the trends are still there.

Uncertainties

There is a significant random element to budgets, which naturally governments treat opportunistically. For instance, the surpluses under the earlier Howard government were largely due an inflow of revenue from the mass privatisations of assets in the 1990s.

To begin with, any forecast 40 years ahead is fraught with uncertainty. Another problem with long term predictions is that very small changes in figures attached to factors under consideration, when compounded, induce large changes in the projections. Minor tweaks to economic models can have major consequences when projected 40 years into the future.

For example, a PwC report released in July 2013 estimated that the Australian governments’ debt levels as a proportion of GDP will rise to 77.9% by 2049-50 – a significantly different scenario that shows that different economic models can produce vastly different results when projected over long time periods.

The Intergenerational Report’s Appendix C on methodology refers to a wide range of assumptions made about demographic changes but some of those assumptions have been criticised by other economists, like the University of Queensland’s John Quiggin.

The report says on page 111 that “various models that produce the projections are under the guidance of a senior Treasury steering committee designed to ensure internal consistency and legitimacy of assumptions.”

But it is not clear if these models factor in the costs of reduced government spending on health, education and the environment. For instance, if the health budget is cut, hospital admissions and workdays lost would increase, in turn affecting economic activity.

Debating debt

The background – and highly politicised – question behind all of this is: how worried should we be about government debt?

On one side of that debate are those who take what has been called a neoliberal position. They are concerned that government activity funded by borrowing will raise interest rates and crowd out private business activity, which is viewed as more efficient.

On the other side are Keynesian economists, who argue that governments may need to run budget deficits – especially in times of downturn, like the GFC. Such budget deficits will be cancelled out when the economy consequently improves and unemployment falls, they say, because the tax take will increase and welfare payouts will fall. In addition, government spending on infrastructure and research and development would support the growth of industry, they argue, hence a certain amount of government debt is necessary.

In fact, debt has been remarkably variable and volatile over time and across countries with very differing levels of development and patterns of economic growth. Debt is influenced by a large range of factors, including economic growth and inflation.

Verdict

Mr Frydenberg’s quote that “we inherited a trajectory of debt and deficit heading to 122% of GDP.. [and] just through our legislated measures, we have halved that trajectory” is an accurate reflection of the findings of the Intergenerational Report. However, without more detail on how the authors of the report arrived at that figure of 122%, it is not possible to say if it is true or not. And while Mr Frydenberg has been accurate in quoting it, the report’s modelling has been criticised by a number of economists.

Review

The FactCheck is clearly correct in finding that Mr Frydenberg’s statement accurately reflected the estimates of the Intergenerational Report 2015.

However, Mr Frydenberg’s statement referred to the “trajectory” that the government inherited. The “previous policy” scenario of the Intergenerational Report was not “inherited” – it includes substantial budgetary drags due to Abbott Government policies. The “previous policy” scenario of the Intergenerational Report is based on the 2013-14 MYEFO figures, which amongst other changes from the Labor government’s policies, assume the abolition of the Carbon and Mining taxes, and the creation of a paid parental leave scheme.

The Intergenerational Report assumes that a number of welfare payments will decline substantially relative to average wages, that health spending will grow much more slowly over the next decade than the last, and that governments will cut income taxes even when deficits and debt are rapidly increasing.

In analysing concerns about debt, it is worth noting that if governments fund services today with borrowing, they effectively ask taxpayers of future years to pay for them through higher taxes and lower living standards than they would enjoy otherwise. Although there are academic debates about whether budget impacts are mitigated through changed consumer behaviour or inheritances, the intergenerational transfer of budget deficits (sometimes labelled as “intergenerational theft”) is often cited as a reason to avoid increasing government debt. – John Daley, Chief Executive Officer at Grattan Institute.

Have you ever seen a “fact” that doesn’t look qu

Greek Bad Bank Potentially Positive, Likely Insufficient – Fitch

According to Fitch Ratings, the Greek government’s intention to create a “bad bank” is a positive step towards achieving reform because it recognises that high volumes of non-performing loans (NPL) are impeding new lending. Nevertheless, banking sector reform proposals included in a broader package presented to eurozone partners on 1 April 2015 appear insufficient relative to the scale of the problems faced by Greek banks, despite potential benefits for banks’ asset quality and liquidity.

The package describes banking sector deficiencies as ‘critical’. We agree with this and believe failure of the banks is a real possibility, as indicated by the ‘CCC’ ratings assigned to the country’s largest banks.

NPLs have reached staggeringly high levels. Fitch estimates that domestic NPLs at National Bank of Greece, Piraeus Bank, Eurobank Ergasias and Alpha Bank (which together account for around 95% of sector assets) reached EUR72bn at end-2014, equivalent to 35% of combined domestic loans. Net of reserves, Greek NPLs reached a high EUR30bn and still exceeded the banks’ combined equity.

The proposal to create an asset management company, or bad bank, using remaining funds from the Hellenic Financial Stability Fund (HFSF), to deal with NPLs is potentially positive for the banks’ asset quality. The asset manager may also help banks’ weakened liquidity position if they, for example, receive HFSF-related funds in exchange for transferred NPLs.

However, the asset manager is unlikely to provide a material near-term solution to Greek banks’ asset quality problems unless it is highly geared. This is mainly because the volume of NPLs held by Greek banks vastly exceeds the EUR10.9bn HFSF buffer that would serve as capital for the bad bank.

The funding profile of the asset manager is still unclear. Fitch notes that Spain’s bad bank model, which hinged on government guaranteed bond issuance, with bonds qualifying for discount at the ECB, is unlikely to be replicated in Greece as Greek bonds cannot currently be pledged as collateral to the ECB. Fitch anticipates that Greek banks would still need to retain (and finance) sizeable stocks of unreserved NPLs, constraining future credit growth.

Furthermore, establishing correct values for the troubled loans will be difficult given the exceptionally challenging operating conditions. Therefore any transfers to an asset manager are likely to require asset write-downs, potentially further eroding banks’ solvency.

Fitch notes that Ireland and Spain’s bad banks have helped restructure balance sheets – but in these cases, troubled loans transferred to bad banks were linked to real estate. This is not the case in Greece where impairments are spread across all segments, making it more difficult to identify loans eligible to be transferred to an asset manager and to establish appropriate haircuts.

Proposals to introduce supervisory reform are potentially positive but will also be challenging to implement within a short timeframe, particularly in view of the period of extreme stress that the country is undergoing.

The proposals include a suggestion that NPLs should be resolved in a “socially fair” manner, which along with further wording, appears to hint at potential creditor unfriendliness. Fitch is uncertain whether some debt forgiveness is on the cards and whether the proposals point to state-directed lending ambitions. Similarly, proposals include expansion of the role of the Bank of Greece to encompass consumer protection, a function which, in other countries, often includes debtor-friendly measures.