RBNZ – Page 6 – Digital Finance Analytics (DFA) Blog

New Zealand’s Restrictions on Mortgage Lending in Auckland Will Benefit Banks – Moody’s

Last Wednesday, the Reserve Bank of New Zealand (RBNZ) announced that starting 1 October 2015 bank lending to home investors in Auckland, New Zealand, will be restricted to mortgages with loan-to-value ratios (LTVs) of less than 70%. The RBNZ also said it was raising the percentage of residential mortgage loans that can be originated outside of Auckland with LTVs of 80% or higher to 15% of all mortgage loans from 10%. These measures are credit positive for New Zealand’s banks because they will reduce banks’ exposure to riskier mortgage loans in Auckland, where house prices are at historical highs, having risen 14.6% in the 12 months to March 2015.

Moody’s says these steps would particularly benefit New Zealand’s four major banks, ASB Bank Limited (Aa3/Aa3 stable, a2 review for downgrade), ANZ Bank New Zealand Limited (Aa3/Aa3 stable, a3), Bank of New Zealand (Aa3/Aa3 stable, a3) and Westpac New Zealand Limited (Aa3/Aa3 stable, a3). These banks held approximately 86% of total system mortgages as of 31 December 2014. Additionally, Auckland, New Zealand’s largest city, constitutes the largest market for these banks, and the RBNZ reports that around 40% of mortgage originations in Auckland are to investors.

The introduction of an LTV limit on property-investor lending in Auckland will reduce the risk of recently originated mortgages experiencing negative equity, where the size of the loan exceeds the value of the property. Both house prices and household indebtedness in Auckland are at historical highs creating a sensitivity to increases in unemployment and interest rates. Although LTV restrictions are likely to dampen house price growth in Auckland, we expect the effect to bemarginal owing to supply shortages and the official cash rate, which the RBNZ sets to meet inflation targetsand remains accommodative by historical standards, continuing to support price gains. However, reducingbank exposures to high-LTV loans that are more exposed to a house price correction would benefit banks.

The LTV restrictions would not apply to loans to construct new residential properties, given the RBNZ’s focus on alleviating Auckland’s housing shortage. Although the new 15% cap on high-LTV loans outside Auckland will allow banks to lend more at higher LTVs, price growth outside of Auckland has been relatively subdued. By responding to current housing market developments and loosening restrictions, the RBNZ is making housing finance more accessible in areas of New Zealand where there are fewer risks of stimulating excessive price speculation.

The proposals are the RBNZ’s latest in a series of steps aimed at reducing excess leverage in the financial system and reducing the threat of asset bubbles. In September 2013, the RBNZ raised the capital requirements for high-LTV lending and in October 2013 imposed a 10% cap on high-LTV loans. In March 2015, the RBNZ released a consultation paper indicating that banks would likely need to hold more capital against investor loans than against owner-occupied mortgages. The RBNZ intends to release a consultation paper later this month outlining its most recent announcement.

NZ Property Investors Highly Geared – RBNZ

In the May Stability Report the RBNZ have drilled into the Investment Property sector. They say they will be publishing more detailed data, but the current article makes interesting reading. Housing investors have consistently accounted for over one-third of property purchase transactions over the past decade, with the share rising slightly following the introduction of loan-to-value ratio (LVR) restrictions in October 2013 (figure A1). Sales to investors in the Auckland market have picked up in line with the rise in sales activity since November, and this is likely to be contributing to recent strength in Auckland house prices. Investors are also a key source of new mortgage credit demand, with property investors accounting for approximately one-third of new mortgage lending over the six months ended March 2015.

Although New Zealand has not experienced a financial crisis associated with the housing market, a range of international evidence suggests that defaults on investor lending tend to be significantly higher than for owner occupiers during severe downturns. For example, Irish investor mortgage default rates were around 20 percent higher than total mortgage default rates in the two years following the GFC. Default probabilities were estimated to have been significantly higher than owner-occupiers at any given LVR. Evidence from the UK and the US also finds that default rates were relatively high among investors in severe downturns. The Reserve Bank’s proposal to apply higher risk weights to investor lending, and introduce a differential LVR threshold for investors relative to owneroccupiers in Auckland, is consistent with this evidence.

A key driver of the higher default propensity of residential property investors is higher debt-to-income ratios (income gearing) relative to owner-occupiers. For example, an investor who has borrowed to buy four houses will end up with much larger negative equity relative to their labour income, if house prices fall, than an owner-occupier with just one house and a similar LVR. Higher income gearing reduces the incentive for the investor to continue servicing the outstanding loans, resulting in a greater tendency for investors to default when they have negative equity.

Another possible reason for the higher risks associated with investor lending is that investor house purchases have, in some countries, tended to be concentrated in areas with high expected capital growth. These expectations are often based on recent house price appreciation.

Evidence from the US suggests that increases in house prices prior to the GFC were particularly pronounced in regions where the investor share of house purchases increased. In turn, areas with rapid house price inflation experienced relatively large house price falls in the aftermath of the crisis.

In New Zealand, a significant proportion of property investors have large portfolios, implying a large degree of gearing relative to their underlying labour income. For example, the 2014 ANZ Residential Property Investment Survey shows that 26 percent of surveyed investors held seven or more investment properties (figure A2). Around half of investor commitments are at LVRs of more than 70 percent. Preliminary Reserve Bank survey data suggests that investors tend to make greater use of interest-only loans, which may partly reflect investors’ ability to offset mortgage expenses against personal income for tax purposes. As a result, investor loans are likely to retain a higher level of gearing over the long term than their owner-occupier counterparts.

The risks associated with investor lending are likely to be greatest in the Auckland region. Rapid house price appreciation in Auckland has compressed rental yields, and this is likely increasing income gearing among Auckland investors. Auckland rental yields are at record lows, while national yields are close to their 10-year average (figure A3). Relatively strong capital gain expectations among Auckland investors may explain why they are willing to accept such low rental yields. According to the 2014 ANZ Residential Property Investment Survey, investors in Auckland expected house price inflation to average 12 percent per annum in the region over the coming five years, compared to 8 percent nationwide. CoreLogic data also show that investors in the Auckland region are more likely to use mortgage finance than investors outside the Auckland region.

RBNZ Announces New LVR Restrictions on Auckland Housing

New Zealand’s financial system is sound and operating effectively, but faces significant risks, Reserve Bank Governor, Graeme Wheeler, said today when releasing the Bank’s May Financial Stability Report.

Mr Wheeler identified three systemic risks facing the New Zealand financial system.

“Auckland’s median house price is 60 percent above its 2008 level, and house prices in Auckland have been rising rapidly since late last year. This reflects ongoing supply constraints and increased demand, driven by record net immigration, low interest rates and increasing investor activity. Prices in the Auckland region have become very stretched, increasing the risk of financial instability from a sharp correction in prices.

“A second area of risk for the financial system relates to the dairy sector, which is experiencing a sharp fall in incomes due to lower international prices. Many highly leveraged farms are facing negative cash-flows, and the risks will become more pronounced if low milk prices persist beyond the current season.

“The third key risk arises from the current very easy global financial conditions. Low interest rates are encouraging investors into riskier assets in the search for yield. Prices of both financial and real assets are becoming overextended in many markets. There is an increasing risk that the current benign conditions unwind in a disorderly fashion, disrupting the cost and availability of funding for the New Zealand financial system.”

LVR Restrictions

In response to the growing housing market risk in Auckland, the Reserve Bank is today announcing proposed changes to the loan-to-value ratio (LVR) policy. The policy changes, proposed to take effect from 1 October, will:

• Require residential property investors in the Auckland Council area using bank loans to have a deposit of at least 30 percent.

• Increase the existing speed limit for high LVR borrowing outside of Auckland from 10 to 15 percent, to reflect the more subdued housing market conditions outside of Auckland.

• Retain the existing 10 percent speed limit for loans to owner-occupiers in Auckland at LVRs of greater than 80 percent.

“We are proposing these adjustments to the LVR policy to more directly target investor activity in the Auckland region, where house prices relative to incomes and rent are far more elevated than elsewhere in New Zealand.

“The objective of this policy is to promote financial stability by reducing the rate of increase in Auckland house prices, and to improve the resilience of the banking system to a potential downturn in the Auckland housing market.”

Mr Wheeler emphasised that while the new measures aim to moderate housing demand, policies to ease housing supply constraints in Auckland remain the key to addressing the region’s housing imbalances over the longer term.

Deputy Governor, Grant Spencer, said that the Bank will issue a consultation paper in late May, providing further details and seeking feedback on the new LVR proposals.

“Prior to the proposed introduction of the policy in October, we expect banks to observe the spirit of the restrictions and not seek to expand high-LVR investor lending in Auckland.

“Given the importance of encouraging residential construction activity in Auckland, and consistent with the existing LVR policy, the proposed LVR restrictions will not apply to loans to construct new houses or apartments.

“Consistent with the LVR measures, the Reserve Bank is establishing a new asset class for bank loans to residential property investors. Banks will be expected to hold more capital against this asset class to reflect the higher risks inherent in such lending.

“Following a lengthy consultation process, we have decided that a residential property investor loan will be defined as any retail mortgage secured on a residential property that is not owner-occupied.”

A summary of submissions received in response to the consultation will be released later this month, and details will be provided on the implementation of the new asset class, including on the proposed capital treatment of residential investor loans.

The new asset class will take effect from 1 October 2015 for new lending, with a further phase-in period of nine months for the reclassification of existing loans.

“Given the broader risks facing the financial system, it is crucial that banks maintain their capital and liquidity buffers and apply prudent lending standards. Later this year the Reserve Bank will be reviewing bank capital requirements in light of global and domestic developments affecting the safety of the banking system,” Mr Spencer said.

RBNZ Bulletin Covers Capital Markets

The New Zealand Reserve Bank today published an article in the Reserve Bank Bulletin that describes New Zealand’s capital markets, and the role they play in the functioning of financial markets and the real economy. The article is quite comprehensive, and worth reading becasue it describes the financial instruments and market participants involved, and analyses a unique dataset to provide some detail on the size of both the bond and equity markets, which together comprise local capital markets. We summarise some of the discussion.

Capital markets are the part of the financial system that involve buying and selling long-term securities – both debt (bonds) and equity instruments. Capital markets are used to fund investment or to facilitate takeovers, and to provide risk mitigation (for example via derivatives) and diversification. There is no strict definition of ‘long-term’; Potter (1995) defines capital market instruments as having a maturity of greater than one year, and we retain this classification here, noting that capital market instruments may also have no maturity date (as in the case of perpetual bonds or equity). This article further classifies the domestic capital market as all resident entities issuing into the local economy in New Zealand dollars (NZD) . The article also touches on resident entities issuing bonds offshore, and non-resident entities issuing into New Zealand in NZD.New Zealand’s capital markets are an integral part of the domestic financial system. The previous Reserve Bank Bulletin articles describing New Zealand’s capital markets were published 20 years ago. The landscape has changed dramatically since then – local capital markets have grown substantially, although remain small compared with those in many other advanced economies.

The Reserve Bank has a wide-ranging interest in New Zealand’s capital markets. The Financial Stability Report (FSR), for example, reports on the soundness and efficiency of the financial system, including capital markets. Capital markets that function effectively are important for the way monetary policy affects the wider economy. The Reserve Bank’s prudential regulation of financial institutions can also influence the type and nature of capital market instruments that develop in the local market.

Section two of the article describes capital markets in general, and defines New Zealand’s capital markets in a global context. The instruments and players involved are explained. Section three discusses why capital markets are important for any economy, while section four highlights the Reserve Bank’s interest in capital markets. Section five describes New Zealand’s capital markets and uses a unique dataset to provide detail on the size of the non-government bond market in particular. Section six notes developments since the 2009 Capital Markets Taskforce review.

One interesting piece of data relates to bond issuance. The total amount of bonds outstanding in the local market (excluding Kauris) has more than doubled since 2007 in nominal terms, rising from just over $50 billion (30 percent of GDP) at the start of 2007 to $121 billion. More than two-thirds of this rise is due to an increase in central government debt, while nearly 20 percent of the increase represents bond issuance by banks. The increase in government bond issuance is linked to the shift from fiscal surpluses to deficits during the Global Financial Crisis (GFC), and further issuance following the Christchurch earthquakes.

New Zealand banks increased their issuance of long-term debt sharply in the immediate post-GFC period. This followed from a number of changes in the global environment, including the risk of a negative credit rating from international rating agencies stemming from a reliance on short-term funding, a lack of global liquidity, and a cessation of some wholesale funding markets during the depth of the GFC (increasing the risk of a failure to roll over upcoming funding needs). In addition, New Zealand registered banks are now required by the Reserve Bank to raise a greater proportion of funding that is likely to remain in place for at least one year, as part of the prudential liquidity policy introduced in 2009. The Reserve Bank’s prudential liquidity policy was implemented to reduce the risk posed to New Zealand’s banking system by an overreliance on short-term wholesale market funding.

As at October 2014, the New Zealand (central) government sector had issued 61 percent of New Zealand’s bonds outstanding (figure 6). By comparison, the share of the local government sector was 8.5 percent, with 18.5 percent issued by banks or other financial institutions and 9 percent by non-financial corporates. SOEs comprise the remaining 3 percent. This breakdown has changed markedly since 2007; as previously noted, central government debt makes up a much larger share today, while the proportion of non-financial corporate bonds has fallen from 19 percent to its current level of 9 percent of the total. Although the nominal amount of bonds outstanding has increased for all sectors, nonfinancial corporate bonds have decreased as a share of GDP, falling from 5.7 percent to 4.5 percent currently (possibly reflecting weaker overall demand for business credit in the past five years). Note that figure 6 does not include bonds issued by New Zealand entities in offshore markets; if included, the share of government bonds would decrease.

Looking ahead, New Zealand’s equity and bond markets have grown in size and depth in recent years. Despite this, the size of New Zealand’s capital markets remains small and underdeveloped by international standards, while the banking system continues to dominate funding for New Zealand firms. On the one hand, the relatively small size of New Zealand’s capital markets might simply reflect the small size of the economy: some economies simply lack scale to support a flourishing capital market.

Laeven (2014) argues that, “in an increasingly globalised world, not every country needs to develop a fully-fledged physical capital market at home. The optimal balance between local capital market development and integration in global capital markets will depend on country circumstances, such as economic size and stage of development” (p.19). As noted in this article, larger New Zealand corporates already have access to global markets – both public debt markets and private placements.

On the other hand, many believe that further development of both equity and bond markets in New Zealand would help to underpin economic growth (CMD Taskforce, 2009). Indeed, capital market activity over the past few years has been heavily influenced by a wide range of continuing regulatory and policy initiatives to support New Zealand’s equity and bond markets. Looking ahead, the growth of KiwiSaver scheme funds and the recent partial privatisation of SOEs could add further depth and liquidity to the domestic equity market, and in turn increase international interest and participation. In addition, the development of an alternative public growth market, introduced last year by the NZX, could help to encourage more SMEs to raise funds via public listing (by offering lower compliance costs). Other policy and regulatory initiatives including formalising crowd funding via crowd funding licences issued by the FMA, could further serve to reduce capital-raising costs for small firms. That said, most of the regulatory initiatives are very recent, and at this point, it is difficult to assess how much difference these changes will make over the longer term