Booms and Busts in Housing Markets: How Vulnerable is New Zealand?
Victoria University of Wellington
Download Document| Date Published | 2007 |
| Version | |
| Primary Author | Richard J. Herring |
| Other Authors | |
| Theme | Real Estate Cycles and Bubbles |
| Country | New Zealand |
Abstract
House-price booms are sometimes followed by busts in which inflation-adjusted housing prices fall by 15 percent or more. This paper examines why housing markets are especially vulnerable to booms and busts and develops the hypothesis of disaster myopia which may lead both borrowers and lenders to underestimate the probability of a shock to the housing market. New Zealand has enjoyed a sustained boom in housing prices. This paper reviews a variety of evidence – indicators of affordability, measures of asset market equilibrium and econometric models based on fundamental determinants of housing prices – to consider whether the house-price boom has gone too far and will end in a bust. While evidence is mixed, the possibility of a bust cannot be dismissed. Although banks in New Zealand have a heavy concentration of exposure to mortgage lending relative to most other advanced countries, they appear to be reasonably well- protected from the direct consequences of a house-price bust. The conclusion regarding the household sector is less optimistic, however. The logic portfolio diversification implies that New Zealand residents should invest a large share of their wealth in a diversified portfolio of foreign assets to mitigate some of the risks of living in a small, relatively undiversified economy. Instead, there is a pronounced home bias in household investment that reflects the preference of New Zealanders for investing in homes. Relative to other advanced countries, households in New Zealand have very large concentrations of exposure to residential real estate. While disaster myopia may have contributed to this concentration of exposure, tax incentives have also played a role. This vulnerability of households to a housing bust is compounded, moreover, by the design of mortgage contracts that leaves borrowers with most of the risk of a sustained increase in interest rates and creditor-friendly bankruptcy laws that constrain borrowers from obtaining relief from their mortgage creditors by forfeiting their homes when their equity positions become negative. The paper concludes with a brief consideration of reforms to reduce the vulnerability of the New Zealand economy to a bust in housing prices.