Hive News Wednesday: S&P warns tighter lending may restrict Auckland house building and increase shortage

Good morning all.

The Catch 22 that is Auckland's housing supply crisis was front and centre in Standard and Poor's report yesterday on New Zealand's banking system. S&P warned a bank lending slowdown would restrict new house building in the months and years to come as the cycle turned, potentially increasing a shortage it estimated at 30,000 to 40,000.

The Catch 22 goes something like this: supply of new homes from the private sector is dependent on funding from the big four Australian banks and on the risk appetites of developers. Stratospheric land prices leave little oxygen for the market to breathe on in any downturn, so any suggestion of a turn in the cycle is enough to scare off developers and funders, despite the very real shortages and high prices.

No one wants to be left holding the (land) parcel when the music stops and land prices start falling. Neither the funders or the developers have long enough investment planning horizons or big enough balance sheets to 'look through' the cycle, particularly with the fear that a house price to income multiple north of 10 is unsustainable if interest rates rise substantially and economic growth slows.

The catalyst for the latest bout of nerves and a tightening of development appetites is the tighter lending criteria being applied by the big four banks -- Commonwealth Bank's ASB, National Australia Bank's BNZ, ANZ New Zealand and Westpac New Zealand. They face regulatory headwinds from both sides of the Tasman and higher funding costs, despite a flat Official Cash Rate.

The Australian Prudential Regulatory Authority (APRA) changed its rules in 2015 to require the big four to reduce their non-equity exposure to their New Zealand units to less than 5% of tier 1 capital. ANZ and Westpac are the most exposed under this rule. ANZ has to repay its Australian parent NZ$1.6 billion in loans every year for five years, while Westpac has to repay NZ$1 billion over five years. BNZ and ASB do not have the same exposures to their Australian parents.

'Banks at commercial lending limits'

APRA is also keeping a close eye on the big four's commercial property lending here, which includes lending to large residential apartment project developers. S&P said some of the local banks were up against their internal limits for lending to property developers.

The Reserve Bank has also scheduled a review of capital levels for banks, which Grant Spencer told me earlier this month was not likely to end with a recommendation for less capital (ie it's possible banks will have to put more capital aside for mortgages generally and rental property mortgages in particular). Higher capital requirements could further significantly slow lending growth.

The banks here also face restrictions on the sources of their funding, particularly now that mortgage lending is expanding faster than term deposits. Before the GFC the banks would simply dive into the 'hot' overseas money markets to fill the gap between domestic deposit growth and lending growth. But the Reserve Bank introduced its core funding ratio rules after the GFC, which limit the amount of short term wholesale money the banks can raise. That forces them to use more expensive funding sources, in particular local retail term deposits and longer term wholesale bonds.

APRA is also in the process of introducing tougher requirements to have stable funding, which requires banks to use term deposits and bonds more than 'hot' wholesale money.

The gap between deposit growth and lending growth has been rising sharply since the middle of last year, which intensifies the pressure for banks to seek more expensive stable funding sources. Some banks (and ANZ in particular) have been arguing they need to close this deposit-to-loan gap by putting up both term deposit and mortgage rates to encourage saving and discourage borrowing. This generates higher mortgage rates independently of the Official Cash Rate, which is forecast by the Reserve Bank to be flat until late 2019 at the earliest.

S&P said in the report it saw the credit cycle maturing in New Zealand and it expected both credit and deposit growth to slow.

"The outlook for slower credit growth also comes off the back of the need, in our opinion, for banks to close the funding gap (the difference between credit and deposit growth) that has been building for the last year or so, and, to a lesser extent, the recent tightening of macro-prudential restrictions," S&P said, referring to the Reserve Bank's July announcement of a 40% deposit requirement for landlords.

S&P also noted banks were looking to bolster net interest margins again after a significant squeeze over the last year as borrowers moved from more profitable floating mortgages to lower-margin fixed mortgages.

"Relatedly, banks have indicated a bias toward tightening lending standards across household, business, and agriculture lending. This has included a tighter stance on pricing for capital and risk," S&P said.

"Overall, we expect this bias to continue into the first half of 2017, particularly in light of the aforementioned headwinds. Despite the significant economic tailwinds behind Auckland and surrounding regions, we expect credit extension to the business sector to slow, particularly as we understand some of the larger banks are operating close to their internal limits on commercial property," it said.

"Further influencing the push toward a higher level of deposit and long-dated term funding will be the implementation of the Australian Prudential Regulation Authority's net stable funding ratio on Jan. 1, 2018, in our view, which is set to include--and therefore indirectly capture--the New Zealand operations of Australia's major banks."

'Supply shortage to worsen'

However, S&P forecast that house price growth would only slow, rather than go into reverse, "particularly as we expect the imbalance between supply and demand in New Zealand's largest and most populous city, Auckland, to widen further in 2017."

"At this point, we estimate the supply deficiency at between 30,000 and 40,000 dwellings. The spillover effect into other regions will continue, in our view."

S&P even saw the possibility of another acceleration in prices in Auckland because of this growing shortage.

"With banks reporting a tightening in lending standards for property development, it's conceivable that new construction will slow, despite the rollout of the Auckland Unitary Plan, applying further upward pressure on house prices," it wrote.

In other economic and financial news...

Steven Joyce and Amy Adams announced the launch of the first social bond to help 1,700 people with mental illness back to work. Australian firm APM Workcare will deliver the services.

Steven Joyce gave a speech to the Institute of Public Administration which focused on improving productivity in the state sector. He said the Government would be asking departments wanting 'cost pressure' increases in funding in the current budget round to identify productivity improvements that soften those pressures. "Ministers want to see specific measurable improvements in productivity and results through innovation as part of all major budget discussions," he said.

Wholemilk powder prices fell a further 3.7% in the fortnightly Globaldairytrade auction overnight, extending the fall since December 6 to 11.2% because of improving weather conditions and a higher supply forecast. However, Fonterra is expected to announce a fresh forecast payout of around NZ$6.25/kg for the current 2016/17 season within the next couple of days, up from NZ$6/kg currently.

Quote of the day:

John Oliver on Trump:

"He dominates the news like a fart dominates a car."

Twitpic of the day:

Dennis Hall: Somewhere on a wall in Islington -- 'Lie Lie Land'

Adam Taylor: These are the clothes Britain's top diplomat chooses to wear when he goes jogging

Have a great day

cheers

Bernard