Reserve Bank warns of risks if house price rises return, says current building activity below what's required given rapid population growth & existing shortage; 'Significant share of house lending at high DTIs'; Paper still in the works

Grant Spencer (left) and Graeme Wheeler pictured late last year.

Auckland house prices face a heightened risk of a sharp correction, due to large increases in recent years, the Reserve Bank has warned. There is a “particularly concerning” concentration of borrowers in the city with high debt-to-income ratios.

The Bank further warned of the risks posed by rising interest rates, particularly given New Zealand household indebtedness was hitting new record highs. The comments come in its latest six-monthly Financial Stability Report.

“Auckland borrowers appear particularly vulnerable to higher mortgage rates. Around 5 percent of existing Auckland borrowers are estimated to face severe stress if mortgage rates were 7 percent, compared to 3 percent of borrowers outside of Auckland,” it said.

The Bank reiterated its call to have a DTI-ratio tool added to its Macro-Prudential tool box. Although the continuing impacts of its loan-to-value ratio limits meant it would not be used currently, the Bank said the risk of a returning house price resurgence posed significant risks to the financial sector.

House prices in New Zealand remain elevated relative to incomes and rents, and any resurgence would be a concern, Reserve Bank Governor Graeme Wheeler said in the Reserve Bank’s latest snapshot of financial sector stability.

Although residential building activity had continued to increase in recent months, the rate of house building remains insufficient to meet rapid population growth and the existing housing shortage, Wheeler said.

Meanwhile, a “significant share” of housing loans are still being made at “high” debt-to-income (DTI) multiples, with these borrowers more vulnerable to rising interest rates or falling incomes.

In a media release, the Bank said it would soon be releasing a consultation paper proposing the addition of DTI restrictions to its macro-prudential toolkit.

House price concern

Vulnerabilities in the housing market had stabilised, with house price growth slowing over the past eight months, the Reserve Bank said. This reflected several factors, including tighter loan-to-value ratio (LVR) requirements on lending to property investors in October 2016; banks tightening serviceability criteria and increasing mortgage interest rates; and affordability pressures had constrained prices in parts of the country.

Household credit growth had fallen, but remained high at around 8% a year, the bank said, adding that household indebtedness continued to increase in relation to incomes.

“The outlook for the housing market remains uncertain. While building activity has increased in recent years, the rate of house building remains insufficient to meet rapid population growth and address existing housing shortages,” the Bank said in the FSR.

“Mortgage interest rates also remain low, despite recent increases. A further resurgence in house prices would be of real concern, given existing affordability constraints,” it said.

‘We need DTI tool’

The Bank said its LVR policy had improved the resilience of the banking system to a correction in the housing market.

However, a significant share of households had taken on loans at high debt-to-income (DTI) ratios and appeared to be vulnerable to an increase in interest rates or a decline in income, it said. “An economic downturn could materially weaken the financial position of these households, which could exacerbate a fall in house prices if they are forced to sell their properties.”

Although LVR policies had helped to insulate the banking system from a housing downturn, low mortgage interest rates encouraged an increase in high-DTI lending, the Bank said.

It reiterated its stance that it would not use DTIs currently if they were in the macro-prudential tool box. “However, demand drivers in the housing market remain strong, and a resurgence in house prices remains possible. Should high house price growth return and the proportion of housing lending at high DTI ratios remains high, a DTI restriction could be warranted.”

There’s more on the potential DTI tool here.

Auckland house prices at heighted risk of sharp correction

The Bank warned that “many households remain heavily indebted.” The household debt-to-disposable income ratio has increased to 167 percent, above its peak of 159 percent in 2009. Low interest rates have kept this debt level manageable, but many households are vulnerable to an increase in interest rates, it said.

Auckland households were particularly vulnerable. “The concentration of debt in Auckland is also particularly concerning given that Auckland house prices are at a heightened risk of a sharp correction, due to the particularly large price increases in recent years,” the Bank said.

“An increase in the share of borrowers with high debt-to-income (DTI) ratios has contributed to the increase in aggregate household indebtedness,” the Bank said. “These borrowers are vulnerable to debt servicing shocks, such as higher interest rates or a fall in income.

“This makes them more likely to default on their mortgage or cut consumption sharply, and makes them more likely to sell their house to repay their mortgage, in response to mortgage affordability shocks. If a significant proportion of households have debt burdens that are unsustainable in the event of an affordability shock, financial stability could be threatened by direct losses on bank mortgage lending and by indirect losses on banks’ other assets, caused by an economic downturn.”

Banks have been reporting data on the DTI ratios of new lending since early 2014, it said, cautioning that preliminary data would likely to overstate the share of lending at high DTI ratios, due to collection issues such as the incomplete capture of borrower incomes.

“Despite these data challenges, it appears that the share of new lending at high DTI ratios has remained elevated. Banks report that the share of new lending at DTI ratios above five has continued to grow over the past year for first-home buyers and other owner-occupiers, to 36 percent and 42 percent respectively in March,” the Bank said.

“For investors, the tighter restrictions on high-LVR investor lending have had a significant impact on high-DTI borrowers, reducing their share of investor lending from 58 percent to 52 percent.”

It also warned on the prospect of rising interest rates. Preliminary Reserve Bank analysis on the impact of higher mortgage rates on recent borrowers suggested many would struggle to service their mortgage if mortgage rates increased.

“Mortgage rates can rise quickly. For example, the average new floating mortgage rate in New Zealand rose from around 7 percent to over 10 percent between early 2004 and 2007. Fixed interest rates may give some borrowers time to adjust to higher interest rates. However, based on banks’ current mortgage portfolios, about 40 percent of mortgages would re-price within six months and 60 percent within a year.”

Read the initial media release from the RBNZ below:

New Zealand’s financial system remains sound and the risks facing the system have reduced in the past six months, Reserve Bank Governor Graeme Wheeler said today when releasing the Bank’s May Financial Stability Report.

“The outlook for the global economy has been improving but global political and policy uncertainty remains elevated and debt burdens are high in a number of countries. A sharp reversal in risk sentiment could lead to higher funding costs for New Zealand banks and an increase in domestic borrowing costs. New Zealand’s banks are vulnerable to these risks because of their increasing reliance on offshore funding for credit growth,” Mr Wheeler said.

“House price growth has slowed in the past eight months, in response to tighter loan-to-value ratio (LVR) restrictions, and a more general tightening in credit and affordability pressures in parts of the country. While residential building activity has continued to increase, the rate of house building remains insufficient to meet rapid population growth and the existing housing shortage. House prices remain elevated relative to incomes and rents, and any resurgence would be of concern.

“Dairy prices have recovered significantly in the past 12 months, and the majority of dairy farms are likely to have returned to profitability in the 2016/17 season. However, parts of the dairy sector are carrying excessive debt burdens, and remain vulnerable to a fall in income or an increase in costs. Banks should continue to closely monitor and maintain full provisioning against lending to high risk farms,” he said.

Deputy Governor Grant Spencer said “The banking system maintains strong capital and funding buffers, and profitability remains robust. The banking system appears to be operating efficiently when compared with other OECD countries, based on metrics such as cost-to-income ratios, non-performing loans and interest rate spreads.

“Banks have generally tightened credit conditions in light of funding constraints and the increasing risks around housing. Banks are seeking to reduce their reliance on offshore funding and have raised deposit rates. The Reserve Bank supports a cautious approach to managing foreign debt, in light of lessons learned in the GFC.

“While the LVR restrictions have increased the banks’ resilience to any fall in house prices, a significant share of housing loans are being made at high debt-to-income (DTI) ratios. Such borrowers tend to be more vulnerable to any increase in interest rates or declines in income. The Reserve Bank will soon release a consultation paper proposing the addition of DTI restrictions to our macro-prudential toolkit.

“The Reserve Bank is making progress on a number of other initiatives. A review of bank capital requirements is underway and we recently released an issues paper on the intended scope of the review. We recently concluded a review of the outsourcing policy for registered banks, and the Bank and other agencies are assessing the recommendations from the International Monetary Fund’s recent (FSAP) review of New Zealand’s financial system.”