Gaynor: Banks print money

Interesting article in the NZH by Brian Gaynor. This is exactly what banks do in NZ and if any other private business did it we would call them counterfeiters. Is it time the government took steps to stop this?

New Zealand's ongoing obsession with residential property is bizarre, particularly when the main cause of the international economic crisis is a massive over-investment in housing.

Newspapers, television and radio are fuelling interest in the topic with hopeful stories about housing affordability, plunging mortgage interest rates and rising buyer interest. They are cheerleading and cajoling the banks into reducing mortgage interest rates yet there is almost no sympathy for retirees who have experienced serious erosions of income because of lower interest rates.

Amidst all this media attention there are strong arguments that the New Zealand economy would be in a much better position if we treated houses as a place to live rather than the country's main wealth creator.

The worldwide housing bubble of the 2000s was caused by a surge in credit rather than a shortage of land or population pressures.

Prices rose dramatically in most countries, particularly in the 2003-07 period, with the median New Zealand sale price surging 113 per cent from $165,000 in June 1998 to a peak of $352,000 in November 2007.

The root causes of the bubble were the whiz kids on Wall St who printed money through a number of clever and unregulated activities, particularly derivative and securitised debt.

Financial institutions effectively print money but their activities are usually highly regulated.

For example if an individual lodges money in a bank, the bank creates additional money or credit by lending a high proportion of this to other parties. The depositor still has an asset in the form of his or her bank deposit while the borrower(s) has acquired a loan that can be spent. The amount of money banks lend is controlled by regulation.

The unregulated Wall St investment banks had far fewer restrictions on their money and credit-creating abilities. The five large investment banks, Bear Stearns, Lehman Brothers, Morgan Stanley, Goldman Sachs and Merrill Lynch, were able to create far more money and credit than the regulated banks through the clever use of derivatives and securitised debt instruments.

These great big Wall St money-making machines created a huge amount of new money and most of the world's banks were keen to obtain their share of this additional credit.

Our banks were no exception and the accompanying table shows the total amount of New Zealand bank funding sourced from offshore and the total amount of bank residential mortgages.

The first point to note is the massive increase in overseas-sourced bank funding, which soared from $31.6 billion in June 1998 to $139.9 billion at the end of January 2009. These overseas borrowings now represent a whopping 40.9 per cent of total bank funding compared with just 25.5 per cent in June 1998.

In other words, almost 50 per cent of bank funding growth since June 1998 has been sourced from overseas.

The figures are even more frightening when it is noted that the current level of bank overseas funding is equal to 78 per cent of New Zealand's GDP compared with just 31 per cent of GDP in mid-1998.

A higher percentage of these overseas borrowings were channelled into the housing market with total bank residential mortgages leaping from $51.4 billion in June 1998 to $156.3 billion at the end of January 2009.

The clear impact of this on house prices can be seen when we break the figures into two five-year periods;

In the June 1998 to June 2003 period, total residential mortgage lending increased by $28.3 billion and house prices by 27 per cent.

Between June 2003 and June 2008, mortgage lending surged by $72.3 billion and house prices by 62 per cent.

It was the huge weight of money, sourced from overseas through our banks, which created the housing bubble, not the shortage of land or population pressures.

This massive offshore funding has negative implications for the economy because we pay interest on these overseas loans, which boosts the current account deficit, but houses cannot be exported and do not earn any overseas exchange. Indeed, it can be argued that a housing bubble raises imports and the trade deficit because new and renovated houses can contain high levels of imported materials.

There is also an argument that the average house price shouldn't rise by more than the rate of inflation. It is easy to understand why Sky TV's share price rises when it adds new channels and subscribers, but why should the value of a house double when no extra rooms have been added and nothing else has been done to it?

There was another round of headlines regarding the housing market during the week, with the Reserve Bank dropping its cash rate from 3.5 per cent to 3 per cent, a number of banks cutting their mortgage rates, a bank economist talking up the market and price data from Quotable Value and the Real Estate Institute.

The latter's monthly price and sales volume releases are usually presented with positive spin, regardless of market conditions, and this week's announcement was no exception. Under the heading "Activity Returns to Residential Market", the report had a number of positive comments.

One of these was that there was a significant upturn in sales volume in February, compared with January, but it failed to mention that January was the worst month ever and February is always better than January because the former includes the holiday period.

Total dwelling sales of 5228 in February were down 17.7 per cent compared with February 2008 which in turn was 32.1 per cent below February 2007 figures.

The key to the property market over the next year or two is the level of funding available to prospective buyers and the pressure on existing homeowners and investors to sell because they are experiencing financial difficulties.

A number of general observations can be made about bank funding:

Between June 1998 and June 2003, the banks lent an additional $470 million per month on residential mortgages. This funded the purchase of 3500 houses per month at the median sale price, assuming 80 per cent debt funding.

Between June 2003 and June 2008, bank lending increased by $1.2 billion per month and this would have funded the purchase of 5100 houses each month using the same assumptions as above.

In the past three months, which is when the credit crunch has really bitten, bank mortgage lending has risen by just $350 million per month funding the purchase of only 1300 houses per month, assuming 80 per cent debt funding and the $330,000 median price.

The state of the residential housing market has been primarily dependent on the availability of credit. The market boomed between 2003 and 2007 because our banks imported massive amounts of credit.

This money is fast disappearing as the credit boom of the past decade has turned into a credit crisis and our banks will not be in a position to maintain the same level of house funding as they have in the past because we don't have sufficient domestic savings to meet the demand for housing finance.

This shouldn't be viewed as a negative development because we need to generate far more wealth from productive, foreign exchange-earning activities and reduce our dependence on residential housing, which is mainly fuelled by unsustainable overseas borrowings.