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Bernard Hickey looks at the lessons we should learn from warnings about our over-valued property market and the need for a deposit insurance scheme

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Short headline: 
The moral hazard in our 'Too Big To Fail' property market

By Bernard Hickey

Last weekend's headlines from Forbes warning about a housing crash and 'economic disaster' may well have caused a few Auckland property owners to choke on their Sunday morning croissants.

But not for long because the rest of the day was full of denials and debunkings to soothe the nerves of a few heavily indebted property investors.

Economic Development Minister Steven Joyce compared Forbes' online columnist Jesse Colombo to a Ken Ring-like figure who saw bubbles wherever he looked.

Prime Minister John Key said the warnings were over-blown. Economic commentators rightly argued that Colombo's warnings were unlikely to come to fruition.

However, the concerns raised about Auckland's houses being over-valued and New Zealand's households having too much debt are valid, as is the risk that a slump would affect New Zealand's banks.

Mr Colombo's assumptions about what would happen if house prices did fall were wildly off the mark, but the reasons for that wrongness are not as reassuring as they might appear at first.

Essentially, New Zealand's housing market and banking systems are very unlikely to crash because they are both 'Too Big to Fail.' Even if they 'should' fall, the authorities are unlikely to let them fall dramatically.

We know this because we have a track record.

New Zealand house prices fell 10-15% in late 2008 and early 2009 as the Global Financial Crisis and a recession caused by high interest rates and a drought drove unemployment up and demand for houses down. Banks came under pressure because the wholesale financial markets they used to roll over their foreign debts froze.

The Government and Reserve Bank intervened to help tide the banks over and ensure they weren't forced into a US-style rash of mortgagee sales. The Reserve Bank lent the banks NZ$7 billion between November 2008 and June 2009 to ensure they remained liquid. The Government also gave the banks a helping hand by providing a guarantee for NZ$10.3 billion worth of bank bonds issued between November 2008 and February 2010.

House prices stopped falling because the authorities intervened to take pressure off the banks and New Zealand's automatic stabilisers of a floating currency and flexible monetary policy kicked in. The Reserve Bank cut the Official Cash Rate from 8.25% to 2.5% in less than 12 months.

The Government more generally also used its balance sheet to support the economy, borrowing as much as NZ$300 million a week and increasing government debt by NZ$50 billion to ensure benefits were paid, tax credits granted and earthquake repairs made.

Those are the big differences between New Zealand's housing 'bubble' and ones that burst in the likes of America, Ireland or Spain with such disastrous effect. Our government and Reserve Bank were willing and able to intervene in such a way as to make sure our 'Too Big to Fail' property market and banks did not fall too sharply.

At first blush these seem like good reasons to relax and ignore the scary headlines courtesy of Mr Colombo and Forbes.

But are they really? There's a saying in banking that a small debt that cannot be repaid is a problem for the borrower, while a really big debt is a problem for everyone and the bank in particular.

New Zealand is now in a situation where a property investor can rightly assume that the residential property market can never really fall much because the Government will always 'bail out' the market. Residential property investors can feel safe in gearing themselves up to the eyeballs and betting on tax-free capital gains because their chosen asset class is 'Too Big To Fail'.

This is a situation known as 'moral hazard', where the risks of an investment decision are borne by someone other than the risk taker. In this situation the profits are privatised and the losses are socialised.

It's a dangerous situation in the long run. It encourages investors to take more risk than is safe and the pain of any slump is eventually borne by everyone, particularly when the Government has to borrow to support an economy or a banking system.

Luckily for New Zealand, the costs of the support offered in 2008 and 2009 were relatively light. The banks repaid the short term loans and have repaid or will repay the guaranteed long term loans.

It does raise the bigger issue of what happens next time New Zealand's economy receives a 2008-style shock. Currently, our banks are not guaranteed by the Government and the Reserve Bank has set up a system known as Open Bank Resolution. This specifies that if a bank ever were to get into trouble, the Reserve Bank could shut it down and force an overnight recapitalisation that would mean term depositors received a 'hair-cut' by having their deposit written down and the bank could open again the next day.

It is a fig leaf because no New Zealand Prime Minister with borrowing capacity would allow term depositors to take that pain of a hair cut. They would bail out the bank in the same way the Irish, British and US governments did.

This implicit government guarantee and its morally hazardous consequence is being rectified in these countries with deposit insurance schemes that effectively mean the banks and their saving customers pay an insurance premium for that guarantee.

This month the Reserve Bank of Australia has recommended just such a scheme in Australia. That is what should happen in New Zealand too. Without an open acknowledgement of this 'Too Big To Fail' problem we run the risk of creating an ever more dangerous problem of moral hazard.

The Forbes warning of imminent collapse was of course wrong, but it should have caused us to consider more deeply the flaws in our financial architecture that mean it seems safe for a class of investor to gear up in the knowledge someone else will always rescue them.

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This article was first published in the Herald on Sunday. It is here with permission.


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