Interest.co.nz's companion submission to the Opposition's banking inquiry

By David Chaston, Publisher of interest.co.nz Thank you for the opportunity to make this submission. This is a companion submission to the one made by Bernard Hickey. While I do wish to make some points about the cost of consumer borrowing from banks, especially short term borrowing, it is important to put this subject in to a broader perspective. Over the past ten years, the economic landscape has changed considerably. Ten years ago, economic growth was +3% Ten years ago, 40% of mortgage borrowing was on floating rates Ten years ago, variable mortgage rates were 6.5% Ten years ago, house prices were $168,000 Ten years ago, it took 55% of median take-home pay to afford a mortgage on a median house. Ten years ago, bank profits were $1.75 billion before tax. But, today we are awash in debt, the result of a binge that will probably take at least one generation to pay back "“ if we started today. We have fallen in love with houses, pretended they are an investment, and we have taken on massive liabilities to satisfy this addiction.

The result is that housing is basically unaffordable for a single earner. The drivers of this housing crisis, both from an affordability point of view, and a debt point of view, have probably been the subject of other parliamentary hearings. But I bet the result of such inquiries has been that the "issue is complicated", and the most persuasive voices have not been from the victims of these trends, but from the beneficiaries. And so, little has been done. In fact, it is instructional that the fuel from this housing and credit binge has been from the so-called baby-boomer generation. It is also revealing the number of MP's who own 'renters' and have invested much of their personal net worth in property. I seem to recall that the last two housing ministers had or have substantial property investments. I am mentioning this because at its root cause, the drivers of the issues being inquired into here are what I believe to be pretty dodgy public policy settings. Individuals and companies respond to the signals they are given. If you make rules that makes productive investment difficult, you can hardly be surprised if people and companies seek better short term returns in activities that are 'unproductive' and can be structured to take advantage of tax rules. In my view, this isn't the 'fault' of the investors or lenders, rather the unintended consequences of poor public policy. Today, economic growth is negative. It is no good blaming the 'global recession' when Australia never went into recession. We should have been doing at least as well as them, otherwise we are accepting going backwards. Our long term record is not good. Today, only a quarter of our mortgage borrowing is on variable rates, three quarters on fixed rates. Although this proportion is rising, it did get as low as 12.5% in August 2007. And that was because for a long while we have had a significantly inverted rate curve. Economists will tell you that an inverted rate curve (where long term rates are lower than short term ones) is because markets are expecting a recession. At the time, the conventional wisdom was that the past ten years were 'special' and 'not to worry'. But the markets were right, inverted rates signal worry about future returns. We ignored the signals and made no public policy corrections to avoid the coming recession. Markets may not always be right, but they have a way better record than inactivity by regulators. Today the mortgage variable rate is 6.3%, lower than ten years ago. But that masks a major issue. Ten years ago banks did 48% of their lending for housing. At the peak of the housing bubble, that had risen to 55%. That is a huge structural shift. If fact some banks have more than 80% of their loans focused on residential housing. (Note 1.) The attraction for lending on housing can be directly tracked, in my view, to a public policy setting. The consequence is that business has been starved of working capital and development funding. And business pays way higher interest rates than do residential borrowers. A home owner may be paying 6.5% for their mortgage, but most businesses will be paying way more than 10% - in fact bank base rates are 10%, and margins on top of that typically run another 2% or more. Have you every wondered why a single individual, borrowing on average about $110,000 per mortgage, can pay so much less than most well-established business who probably borrow many times that amount? And, businesses debt is not leveraged, usually you borrow as much as you have equity. But housing borrowing is highly leveraged "“ you borrow up to ten times your equity. It makes no sense that housing credit is cheaper. The reason is in the Capital Adequacy rules regulated by the Reserve Bank. Under the so-called Basel 1 framework, banks needed half the capital to support a housing loan compared with a business loan. Under the updated Basel 2 framework, these rules got more intricate and sophisticated, but the bottom line is banks needed even less capital for housing loans. It concerned the Reserve Bank enough to insist on some regulatory top-ups in the Basel 2 capital adequacy calculations, but the basic structure was retained. Now, if you give anyone an incentive like this "“ you only need half the capital to back a housing loan "“ it cannot be a surprise as to what happened. Banks chased housing lending. In fact, the government set up a new bank in the middle of this debt and housing splurge to supply even more of it. It became a frenzy. But business paid the cost. Credit was rationed towards housing, costs were focused on business. It has become even harder to grow a productive business in New Zealand. Median house prices today are $340,000, more than double the level ten years ago. In contrast, GDP has grown only 74% in nominal terms. That means 'unproductive' housing values grew at least a quarter as fast again as the economy. It is no wonder, lenders had to scramble overseas to find the funds to meet the demand. You probably know the statistic that we have been spending $1.11 for every dollar we earned, as a country. Well the housing component was $1.25. It was and is unsustainable. People like us have been saying so for quite some time. But who is to argue when even the Prime Minister had seven 'renters'. The whole country seemed to be hooked on housing and housing debt, including those responsible for setting public policy. Your inquiry here is focusing on a perceived injustice; people are paying too much for short-term housing credit, especially after the Reserve Bank has lowered its OCR to 2.5%. But in my view, it's the wrong question. You should be asking how to raise the cost of credit for housing, so as to reduce our dependence on it as an investment, and to free up the capital so it can be used for growing the economy. You should be much more worried about our national productivity. If that was a focus, the misallocation of credit to housing would be seen as strategic impediment to our economic well-being. House prices need to come down, we need to borrow less for them, we need to spend no more than three or four times a median income for a median-priced house. We need to not make rules that make houses scarce and expensive. But so long as baby boomers have so much of their nest-eggs tied up in rental housing, it is going to be hard political work to make the adjustment. And it will be so much easier politically, to champion the perceived cost pressures on those 'investors'. But it is not really investment, it is greed, even if it is by really nice voters. Generating conditions that raise house prices is creating something-for-nothing. In the end, it is not sustainable. We have noted in relation to the finance company failures, that burned investors always think it is someone else's fault. But in the end, they all wanted high returns, for no risk, and no work. The housing market is also very much like this. As nice as they may seem individually, people who chase these gains want high returns, for no risk, and no work. And if they don't get what they expect, it is always someone else's fault "“ especially the 'thieving banks'. Are short term interest rates stubbornly high? The short answer is no. The long answer is no as well. As a nation, we have borrowed too much for housing, and a very big and growing proportion of that borrowing has had to be supplied by foreign lenders. Risk premiums "“ you can define them as the difference between US and NZ sovereign debt yields, or define them as the credit default swap spreads "“ either way, they are high for us. They peaked in the period November 2008 to March 2009, and to be fair to the banks, our domestic interest rates rose in this period, but nowhere near what banks had to pay. They are lower now, but compared with ten years ago, there is still 100+ bps more now than before the credit crunch. The irony in all this, is that if we solely relied on NZ based funding, there would not be nearly enough funds available and the interest rate would have to rise substantially to encourage investors to save more to get those higher returns. It is foreign lenders who have kept the cost of our credit cheap. Their cheap money, has deprived savers here of better returns. Our banks have supplied what we want, based on the public policy settings we gave them, at a low price we would not otherwise have had available to us. But is an addiction we will find hard to break. And, denial is the first hurdle in any effort to confront an addiction. Considering the big picture here, the short term rates we pay for housing are too low, not too high. Finally, I wish to address why we don't like 'foreign banks' - and whether they are making too much money. Firstly, most of us are quite satisfied with our bank, even if we agree with the statement that all banks charge too much. Customer satisfaction with banks has been measured in great detail for a long time. All the evidence points to high levels of 'satisfaction' and those levels are rising. They are way higher in New Zealand than in Australia. In fact, it is the continuous stream of news reports from Australia that builds the 'conventional wisdom' that bank service levels are poor here. It makes great copy. The occasional confirming story from here also helps "“ the break fees one is a recent example. Banks face an odd situation "“ high levels of satisfaction, but wobbly levels of loyalty. But perhaps that is as it should be "“ competition keeps them on their toes. It is far, far easier to switch banks today, than ten years ago. Few countries "“ none that I know of "“ have bank satisfaction levels as high as New Zealand. In most western countries, there are real levels of anger, among wide groups of society, about banks and bankers. It is an unusual situation here, and long may it continue. Do banks make too much money? I won't address the question of whether they pay enough tax, although I suspect the nub of that issue goes to public policy settings as well, and their unintended consequences. Ten years ago, trading banks made a profit of $2.2 billion and paid $0.6 billion in tax. In 2008, they made $4.7 billion and paid $1.4 billion in tax. In 2009 it looks like their profits will decline by about 20% - so they have grown at the same rate as GDP in this period. Bank profits grew faster than they otherwise would have because of the housing bubble. They will fall similarly. (Fix the housing distortion, and you "˜fix' bank profits.) Despite the lending distortions I am very critical of, they are among the handful of investment-grade credit-rated banks in the world. There are only about 25 such banks worldwide, and we have 6 of them operating here, and all the big four are among them. We have been uniquely lucky so far during this credit crisis. But rapidly falling bank profitability, or a sudden change in asset quality will almost certainly bring a credit rating down grade. The cost of funds will rise in such an event. And consumers will pay "“ almost certainly the cost of that credit-rating downgrade in higher risk premiums will be far higher to the economy than the cost of 'high' current profitability. Be careful what you wish for. No matter what you think of credit rating agencies, it is in our interests to have investment grade banks. For every resulting one percent rise in risk margins that flow through to our retail interest rates, will cost our economy about $2.3 billion and reduce the tax take by $0.7. There is one final thing to say about bank profitability. We have been tracking it for ten years. It went up, not down, after Kiwibank was launched in 2002 - see Note 2 below. Kiwibank has helped the market be competitive (even if those benefits helped fuel the housing bubble), but its existence has not reduced main bank profitability. Oddly, the growing Kiwibank customer base has not seen a commensurate fall in customers at the main banks. Kiwibank's existence has helped the Australian-owned banks raise their standards, and raise their profits. Meanwhile, Kiwibank makes profits just exceeding the Agency Fee transfers from NZ Post. There has been no significant impact on the NZ economy, and there has certainly been no transfer of profits from Australian owned banks to the NZ taxpayer as shareholder in Kiwibank. If anything, taxpayers have had to fork out for more capital. The only impact we can determine is that other smaller NZ banks have not really grown much, perhaps held back by Kiwibank. But we would be wrong to conclude that our profitable and strong core banks have insulated us from excessive stresses and costs of the global financial crisis. That honour goes to their Australian parents, whose strength and credit lines enabled their NZ subsidiaries to tap foreign credit markets when those sources would otherwise have been closed. Can you imagine the stress the New Zealand economy would have faced had the National Bank have been still owned by British-based Lloyds TSB? We dodged a real bullet there. In summary, my submission is that "¦ - the RBNZ capital adequacy rules have grossly distorted bank lending, and helped fuel an unsustainable property bubble, - lower costs for consumer lending, especially for housing, is very bad for our economy, and is a major contributor to our appalling productivity levels, - unless we want to pay even more for our credit, we need our banks to be profitable and healthy, - the issues the committee is investigating need to focus on public policy settings that improve the corrosive slippage in our economic performance in the last ten years. Remove the incentives to invest in 'renters', improve the incentives to invest in productive activity. Thank you. Submitter: David Chaston Publisher, www.interest.co.nz JDJL Limited 206 Jervois Road, level 1, Herne Bay PO Box 47-756, Ponsonby AUCKLAND Notes: 1. Kiwibank 2. According to RBNZ data (G3), in the six years since the establishment of Kiwibank, bank profits "distributed" were $12.2 billion. In the six years to 2002, they were $6.1 billion.