Following up my ‘AUT Policy Observatory’ report on ‘Housing Prices Relative to Consumer Prices: An Analysis’.

Last week the Reserve Bank reported stress tests to assess the ability of borrowers to cope with higher mortgage interest rates. Assuming 7 percent p.a. – close to the average two-year mortgage rate over past decades – the RBNZ found that up to 5 percent of current borrowers would be put under severe stress and would not be able to meet day-to-day bills for food and power.

Stress test are an internationally used system of assessing what might happen under certain assumptions. Of course reality is more complicated, but like many measures it provides some insight into possible futures.

I guess one lesson is that the RBNZ will be cautious about raising its Official Cash Rate by the two or so percentage points which would push up mortgage interest rates to near 7 percent but it may have little option if world rates rise. It probably will increase them cautiously if it has to in, say, eight steps of a quarter of percentage point each, taking more than a couple of, or more, years. (In certain kinds of financial crises it may have to bump them up much faster.)

That means that those who are particularly vulnerable to financial stress from high interest rates may have time to adjust. (Whether they will is another matter.) In any case banks have had a signal that they should not increase advances to such potential vulnerables.

The stress-test report is yet another indicator that the housing price boom may be coming to an end (despite the ongoing optimism of some spokespeople for real estate agents). A report I prepared for the AUT Policy Observatory puts what may happen in a historical context. 

I used the longest housing price series available, starting over half a century ago in 1962, comparing it with consumer prices. For most of the period – the first 40 years – house prices rose a little faster than consumer prices, at about 1.4 percentage points a year. There is nothing special about this. You might expect them to rise a little more because land nearer city centres is limited.

However, since 2002 the rise has been much greater at 8.2 percentage points annually (12.4 percentage points if we omit the period when the Global Financial Crisis was at its most intense.) This is so much higher than the past trend that it is almost certainly due to a speculative bubble financed by offshore borrowing. (There are other lesser factors such as the failure to build enough houses and there has been housing pressure from immigration.)

The statistics suggest that our house prices are now about two-and-a-half times higher than they would have been had they risen at their pre-2002 rate. Alternately, housing prices would have to fall 60 percent to be back on track.

Typical home owners might feel poorer (speculative bubbles always make one feel wealthier than one really is – before they pop) but a lower price for their houses would not make much difference. They would still get the same value from living in them and outgoings would be much the same. Even if they have to move, on average the new house price would be proportionally lower.

There are two big groups who would be markedly affected. One are those without their own homes. They would now find it easier to find the deposit for a house and also to service the mortgage, so they might be able to buy their first house.

On the other hand, many who have been investing in housing would be worse off. For example, if housing prices were to stabilise or fall, the investor who has bought a house with as much debt as they could get away with, relying on the tenant’s payments to cover the mortgage while getting their return from the capital gain, would be faced with a zero or negative return. (They are especially vulnerable to rising interest rates.)

(A third potentially large badly-off group is home owners who lose their jobs.)

So how likely is a house price stabilisation or a price drop? The answer is ‘almost certain’, although we cannot be as certain when. Speculative bubbles are always like that. It is possible the market has already peaked; if not it will. (The sooner it peaks, the easier it is for the economy to adjust, but those exposed when it stabilises or falls hope that it wont be yet.)

It is difficult to predict the course of the adjustment. There are so many possibilities, for so many things are going on. I looked at history to make an assessment. It turns out that the typical price fall relative to inflation is about 2 percent a quarter – or 8 percent a year. So we have had not had the price crash some have predicted, presumably based on what has happened in America. My report argues that our institutional arrangements are different from those in the US and they cushion a rapid fall. (It acknowledges that sharp drops are possible in some regional markets.)  So it expects that the housing price falls will be sluggish. However the historical record is that the relative falls have never lasted for longer than five quarters. In fact it is going to take six or so years to get back to the long-run trend at the 2 percent a quarter rate fall. Who knows what might happen over that period – especially if interest rates also rise?

There will be a lot of distress among those who have over-borrowed and among investors who had not realised they were actually speculating. On the other hand, more will be able to buy their first homes.

There is another phenomenon which will add to the pain. During a speculative bubble the housing market is ‘liquid’, in the sense that there is a lot of buying and selling. Speculation adds to the ‘depth’ of a market so that people who have to change their housing – for family reasons, jobs, life style (the garden is too big) or aging (need better access) – have a big range of choices which dry up after the ‘downturn’. Those who service the buying and selling of real estate – including lawyers, valuers, and removal firms as well as realtors – will have less business.

So it will not be easy; speculative bursts never are. History reminds us they happen, especially in market economies when governments fail to take prudent measures early enough.