David Whitburn

We are well in truly into a recession now, and the property market is in its downturn phase of its cycle in all areas of New Zealand.  Tourism is feeling the pinch, as are many manufacturing firms and exporters, and the construction sector is taking a right hammering.  The number of section sales has plummeted from 709 in July 2007, to just 295 in July 2008.  The number of properties sold in July 2008 was 6,660 with a median sale price of $345,000, which dropped nearly by 50% in volume down to 4,489, with the median price retrenching to $340,000.

With interest rates still high and considerably above their corresponding 10 year average rates, and pressure for rising employment, and with business and consumer confidence down, there is little pressure for rents to increase and house prices to rise.  In fact the pressure is downwards.

US Subprime issue deepens

There have been some interesting developments with subprime mortgage lending in the United States. Subprime lending evolved with the realization of a demand in the marketplace for loans to high-risk borrowers with imperfect credit.  Many companies entered the market when the prime interest rate was low, and real interest became negative allowing modest subprime rates to flourish; negative interest rates are hand-outs, such that the more you borrow the more you earn.  Traditional lenders were more cautious and historically turned away potential borrowers with impaired or limited credit histories.  Statistically, approximately 25% of the population of the United States falls into this category.

In the third quarter of 2007, subprime Adjustable Rate (essentially like floating rate) Mortgages only represented 6.8% of the mortgages outstanding in the US, yet they represented a truly massive 43.0% of the foreclosures started.  Subprime fixed mortgages represented 6.3% of outstanding loans and 12.0% of the foreclosures started in the same period.

Beginning in late 2006, the US subprime mortgage industry entered what many observers have begun to refer to as a meltdown. A steep rise in the rate of subprime mortgage defaults and foreclosures has caused more than 100 subprime mortgage lenders to fail or file for bankruptcy, most prominently New Century Financial Corporation, previously the nation’s second biggest subprime lender.  The failure of these companies has caused prices in the $6.5 trillion mortgage backed securities market to collapse, threatening broader impacts on the US housing market and economy as a whole.  The crisis is ongoing and has received considerable attention from the US media and from lawmakers during the first half of 2007.

However, the crisis has had far-reaching consequences across the world. Tranches of sub-prime debts were repackaged by banks and trading houses into attractive-looking investment vehicles and securities that were snapped up by banks, traders and hedge funds on the US, European and Asian markets. Thus when the crisis hit the subprime mortgage industry, those who bought into the market suddenly found their investments near-valueless – or impossible to accurately value. Being unable to accurately assess the value of an asset leads to uncertainty. With market uncertainty, banks reined in their lending to each other and to business, leading to rising interest rates and difficulty in maintaining credit lines. As a result, ordinary, run-of-the-mill and healthy businesses across the world with no direct connection whatsoever to US sub-prime suddenly started facing difficulties or even folding due to the banks’ unwillingness to budge on credit lines.

Observers of the meltdown have cast blame widely. Some have highlighted the practices of subprime lenders and the lack of effective government oversight. Others have charged mortgage brokers with steering borrowers to unaffordable loans, appraisers with inflating housing values, and Wall Street investors with backing subprime mortgage securities without verifying the strength of the underlying loans. Borrowers have also been criticized for entering into loan agreements they could not meet.

Many accounts of the crisis also highlight the role of falling home prices since 2005. As housing prices rose from 2000 to 2005, borrowers having difficulty meeting their payments were still building equity, thus making it easier for them to refinance or sell their homes. But as home prices have weakened in many parts of the country, these strategies have become less available to subprime borrowers.

Several industry experts have suggested that the crisis may soon worsen. Lewis Ranieri, formerly of Salomon Brothers, considered one of the inventors of the mortgage-backed securities market in the 1970s and 1980s, warned of the future impact of mortgage defaults: “This is the leading edge of the storm. … If you think this is bad, imagine what it’s going to be like in the middle of the crisis.” Echoing these concerns, consumer rights attorney Irv Ackelsberg predicted in testimony to the US Senate Banking Committee that five million foreclosures may occur over the next several years as interest rates on subprime mortgages issued in 2004 and 2005 reset from the initial, lower, fixed rate to the higher, floating adjustable rate or “adjustable rate mortgage”.  Now there is nothing new about securitising mortgages – I was exposed to this as a commercial law solicitor when I worked at leading NZ law firm Russell McVeagh – our banks and credit card companies do this too.

Some economists, including legendary free-marketeer and former Federal Reserve Board chairman Alan Greenspan in March 2007, expected subprime-mortgage defaults to cause problems for the economy, especially so if US home prices fell dramatically.

In late March 2008, massive Real Estate Investment Trust (REIT), Friedman Billings Ramsey, reported the default rate on securitized subprime loans hit 25.2% in December 2007. (The default rate includes loans 90 days or more past due, in foreclosure, and real estate owned.)

Conclusion

As for what this means for us – watch out.  House prices have been dropping since November 2007 and there is more coming with the subprime debacle meaning it will be harder to raise finance offshore.  Since NZ spends more than it saves (like so many other ‘western’ countries) we need to borrow from abroad.  Debt has fueled NZ and clearly US house price growth for much of the past decade.  Now it is pay back time and balance is getting restored.  I just hope their is not too much collateral damage along the way.

Through my Vice Presidency of APIA, as well as being a property mentor and well networked in property investment circles, I know that there are many investors that have bought what turns out to be massively overpriced sections and apartments that they bought off the plans in NZ and Australia who have settlements due or due shortly that are about to face default or financial ruin.  There is some carnage ahead.  For those with good equity resources, keep it that way and enter the market to cherry pick the bargains that make the difference in your portfolio, that are well below value and provide a sound cashflow for your portfolio.

Sources: Real Estate Institute of New Zealand, ANZ National Bank, BNZ, Wikipedia, Professor Niall Ferguson.

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