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John Paine - September Financial Newsletter

Global Pacific Corporation - September Newsletter

September Newsletter
John Paine - Global Pacific Corporation Limited

In last month’s newsletter I noted that globally “we’re seeing a easing in the growth of house prices - not an easing in the prices themselves”.

And I quoted U.S. Market Watch real estate editor Steve Kerch’s rationale why “housing is still a good investment today and why regular people, not the speculators, will continue to buy in the months and years ahead.”

I’ve since been asked why I followed that quote with Steve’s observation that “no one is yet sure what the complete fallout will be from all of the exotic mortgages that have been originated in the last four years.”

Well here’s why.

The world’s been awash with cheap money for some years now. This has brought about an unprecedented growth in what is known as the “carry trade”. In simple terms this means funds are borrowed in a low interest regime - like Japan - and invested where returns are higher – like New Zealand.

Such an arbitrage covers a variety of markets. Here the carry trade, in conjunction with the enormous issue of Eurokiwis and Uridashis, are largely the reasons (fixed rate) residential mortgages have been relatively cheap here – and more importantly –housing finance has been so easy to get. And not just from traditional sources like banks, there’s been a huge increase in non-bank lending here too.

This abundance of easy cheap money has largely been the reason for the massive rise in house prices and the strength of the New Zealand dollar.

Another reason residential mortgage finance has been so easy to get is the way banks lend money. This is a result of the “capital adequacy” ratios banks are required to keep. This is well explained in an article on David Chaston’s excellent web site - to see click here

In essence banks like lending on houses as loans secured by residential mortgages get extremely favourable treatment under this system. According to this article, at the end of 2001 the key New Zealand retail banks had 39.2% of their total balance sheet assets in residential mortgages, but by the end of 2005 this had risen to 48.6%. This is a rise in residential lending from $65 billion to $114 billion in only three years.

No wonder banks are happy to enter into an interest rate war. Many are setting up subsidiaries to compete with the easy low doc loans introduced by the non-bank lenders over the last few years. The National Bank’s the latest to do it here.

So what’s been the effect of this easy money and what dangers does that now present?
• The housing boom has been a global phenomenon driven by the same factors of easy cheap money. Any change in these factors would not be isolated to one country.
• The abundance of easy cheap money has a number of economists worried the global liquidity boom is feeding a price bubble in real estate, and like the dot com bubble of 2000, could end in global recession.
• In an attempt to curb rising inflation Central Banks have increased base interest rates. This has resulted in rising residential mortgage interest rates.
• The U.S. Fed raised its rate 14 times in a row, only to pause the last time. European banks have raised their rates recently. The Australian Reserve Bank raised rates last month and is expected to raise them again. Japan seems to have given away its zero interest rate policy and even the People’s Bank of China raised its rate two weeks ago.
• Many economists are saying the Central Banks have been too weak about raising interest rates to combat inflation - and more rises will be necessary.
• Recent articles coming out of the U.S. show sales of new homes are down 21.6% in the past year with inventories of unsold homes rising to an 11 year high. Existing home sales are down 11.4% in the past year with inventories of unsold homes at a 13 year high. There is a question that this might spark a global slowdown. To see the Observer article click here
• Some economists in the U.S. are predicting a steep drop in house prices. One is forecasting the biggest housing slump in decades next year. “Every housing indicator is in free fall, including house prices” he said.
• Those home borrowers previously protected from interest rises by low fixed rate mortgages taken out a few years ago, now are now facing interest rate rises of up to 2% to refix.
• The wealth effect of the dot com bust of 2000 was limited to those who were invested in the share market. Increased interest rates and a drop in house prices affects the wealth of all house owners - which will have an ongoing effect on all aspects of the economy.
• Due to the sluggish nature of house prices –which do not react instantly to changes like the financial markets – the effect would not be felt for some time. The seller’s psychology in a market slowdown is to hang on in the hope of a better price. This increases the days to sell and reduces the number of sales – but has no effect on prices in the meantime.
• I was talking to a group of Real Estate agents last week and they were telling me those less affluent house owners, with little disposable income, who have borrowed 80% and even 100% of the value of their home, are facing dire times.

The global economy is in a delicate balance.

Central Banks are in a difficult position. They’re trying to combat inflation by raising interest rates. But not enough to cause a housing crash – which would have a major negative effect on the global economy. The Bloomberg article printed in last Monday’s Herald explains the Central Banks’ dilemma very well. To see click here .

So what about here in New Zealand?
• The labour market remains very tight with unemployment reaching a record low of 3.6%. This will inevitably result in labour cost inflation but any downturn in the labour market would leave the household sector very vulnerable.
• Annual net immigration is back over 12,000. While that’s not much to counter the slowdown in domestic demand, it is favourable for the housing market.
• Tourism - now New Zealand’s largest export earner – is looking strong with the lower NZ dollar and our “safe haven” status. International visitor numbers are expected to reach 3.1 million by 2012, up from 2.4 million in 2005.
• Sceptics would say the Reserve Bank is unlikely to mount a serious attack on inflation until after the 2008 election - by which time the tax cuts and government spending the parties promised to get elected, will have arrived.

Right now we’re well away from anything like a recession. And normally it would take a sharp jump in both interest rates and unemployment to bring it on.

But New Zealand is not isolated from global events. And these could trigger a downturn in everything – including the housing market.


John Paine B.Sc. Dip BIA
Global Pacific Corporation Limited
Web site

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