Central bank boss hones new tools of the trade

Disturbing lumps are growing in certain areas of the property market. Some are calling for them to be cut out before they go septic.

The man tasked with maintaining the country's financial stability, Reserve Bank governor Graeme Wheeler, is under pressure to wield the knife.

He's aware of the threat that housing inflation poses, describing prices in parts of the country as "overheating" in a speech earlier this week.

Wheeler's concern is not housing affordability, but the risk of a bubble forming in the market which would rock the foundations of the financial system if it burst.

His current tool of choice - the Official Cash Rate (OCR) - may not be right for the job. Raising the OCR, often dubbed a "blunt instrument", to cool the property market would also splash cold water on a recovering economy.

But now the central bank is developing four shiny new tools.

In the next few weeks it will release a consultation paper setting out the framework and parameters for potentially using the new gadgets.

The tool that has drawn the most interest is a cap on loan-to- value ratios (LVRs) for residential mortgages, which would prevent people from borrowing above a set percentage of a property's value.

The LVR cap is supposedly more like a scalpel. The idea is that it could excise the malignant growth in the relevant bits of the housing market without flattening the whole economy.

But the big question is whether such intervention in the housing market would actually work.

The $35 billion operation

What if New Zealand already had an LVR cap in place?

Based on the latest figures from the big four Aussie banks and Kiwibank, a ban on home loans with LVRs over 90 per cent would have wiped 7.6 per cent, or $12.75b, off their mortgage books.

Push that cap down to 80 per cent, and more than 20 per cent of the banks' home loans would be down the gurgler - a staggering $35 billion worth of lending.

Of course, there's no suggestion that a cap on LVRs would, or could, be applied retrospectively.

But the numbers show how lucrative the higher-risk LVR brackets are to the banks. They also give an indication of just how much heat would evaporate out of the market if low-equity house hunters were left out in the cold.

You'd expect the banks to be worried at the prospect of having their business impinged on in such dramatic fashion.

But Kirk Hope, chief executive of industry lobby group the New Zealand Bankers Association, is remarkably calm.

"It needs to be taken in the context of the design," he says.

Hope is waiting for more details to emerge - especially the size of the cap itself, and the timing of its potential use.

"There's a lot of details that would need to be nutted out around both of those things."

As we shall see, he has good reason for not losing any sleep.

But first, let's address the question of whether banks are to blame for fuelling the housing bubble's growth with easy credit.

It's certainly true they have loosened their lending criteria from the conservatism brought on by the global financial crisis.

Auckland's Go2Guys mortgage broker Campbell Hastie specialises in first-home buyers, who often take out high LVR loans. He confirms banks have been happy to lend at 95 per cent, and sometimes 100 per cent, for the past couple of years.

"Some have got a bigger appetite than others for that space," he says.

Based on the state of their existing loan books, Westpac and ANZ have taken on the largest ongoing exposure to high LVR mortgages in recent years.

Westpac started reining that in recently, while ANZ and BNZ both aggressively courted buyers in the higher LVR brackets during the latest December quarter.

But Hastie says the banks aren't just dishing out credit willy-nilly. "On the one hand, yes, they're happy to go to 95 per cent but, on the other, they're assessing those people fairly stringently."

And Hope is sure banks have managed their risk profiles well, as evidenced by the relatively few mortgagee sales since the global financial crisis: "Even if you take into consideration mortgages that have been issued now, the risk profile won't have actually changed that much."

Botching the surgery

But capping LVRs to take heat out of the housing market is an experimental procedure.

"It probably would have the desired effect - in terms of cooling things off," says Hastie. "But we don't know what the collateral damage would be."

This week BNZ economists suggested the LVR tool could turn out to be even more of a blunt instrument than OCR.

Hastie thinks the unwanted distortions will make it unlikely the Reserve Bank goes ahead with a cap.

Firstly, it might price first-home buyers out of the market.

Hastie says it's already hard enough, especially in Auckland, to scrape together a deposit for a home. "I don't know how that would go down as far as votes are concerned."

The burden will fall on younger and lower-income people, says BNZ chief economist Tony Alexander.

"[But] people like me, almost 50 years old, mortgage paid off years ago, cash sitting there - I'll be able to go out and buy some extra houses if I want to."

He says the underlying demand for a roof overhead won't change, and cashed-up property investors will rush to fill the void instead.

One way around it would be to create an exemption for first-home buyers. Of course, that might defeat the point of the exercise.

"The moment you put any rules like that in place, people look for ways to get around them," says Claire Matthews, a banking expert at Massey University.

Borrowers could ask a friend or family member to lend them the missing bit of equity, or go to non- bank lenders who don't fall under the Reserve Bank's jurisdiction.

This "disintermediation" effect was one of the concerns the central bank noted in the past.

The banks are also likely to have some tricks up their sleeves.

"If you put an LVR cap in, what may happen is the bank may take other forms of security, for example," says Matthews.

They might even simply leave the missing portion of equity unsecured - and charge a higher interest rate to atone the risk.

Matthews says that, perversely, it's possible an LVR cap could actually boost bank profitability by giving them the ability to charge more.

Reaching for the scalpel

Of course, the Reserve Bank is acutely aware of these issues.

During the last credit bubble, the central bank and Treasury focused their collective brainpower on the concept of an LVR cap - and concluded it shouldn't be developed further.

"The reason they rejected it in the past is the complications that come with it, and particularly the potential for distortions," says Matthews.

Some of the issues the RBNZ identified in a 2011 briefing paper included avoidance, the risk of pushing lending outside the banking sector, lack of effectiveness and intrusiveness.

So what would the tipping point be to make it worthwhile?

Matthews says it will come down to just how concerned Wheeler gets about the housing market. "You do have a different [RBNZ] governor in place and he may take a different perspective."

Or perhaps not.

It's worth noting house prices have not yet surpassed the previous peak and, in some areas, they're falling in real terms. Then there's the likelihood of an OCR rise in the next year or so, which could be enough to blunt the out- of-step growth.

Unless things really heat up, it looks likely Wheeler will leave at least that new tool untouched on the operating room table.

LUMPY MARKET LVR by numbers:

$35 billion: Home loans above 80 per cent on major banks' books

$12.8 billion: Home loans above 90 per cent

42 per cent: The size of the average LVR in 2011

115,000: Estimated number of properties financed by high LVR loans

$1 billion: Higher LVR mortgages added by BNZ and ANZ in the last quarter alone

Taranaki Daily News