Bank Profits and House Prices

So, here’s a starter for ten. What’s the connection between the ANZ Bank’s recently announced $655 million half-yearly profit and the growing crisis of housing unaffordability in Auckland?

It’s a question that is rarely asked. All sorts of answers are proffered to explain Auckland’s housing crisis, but almost all are answers to the wrong questions. No one bothers to ask the obvious and central question – where does the money to fund the rise and rise in house prices actually come from?

Instead, the explanations offered generally reflect the political prejudices of those providing them. The government is anxious to blame a shortage of supply and – since this failure of the supposedly infallible market to achieve equilibrium cannot be admitted – it must be attributed to “rigidities” that prevent the market from operating properly.

Those “rigidities” can easily, it seems, be identified. They arise, it is argued, because of local government bureaucracy and the requirements of the Resource Management Act. The answer is to remove these impediments and free up more land so that private developers can build more houses for profit.

This supposed remedy has the great advantage of not only cutting local government down to size, but also of providing valuable profit-making opportunities to the government’s supporters in property development.

The Opposition agrees that market failure and a shortage of supply are to blame and that the remedy is to build more houses; but, instead of waiting for property developers to sniff out profit-making opportunities, their answer is to use the power of government, both central and local, to ensure that the required houses are built at affordable prices.

Yet others take a more technical and less political approach, pointing to failures in planning and transport policy and bemoaning the irrationality of waiting for the “free market” to do its irresponsible and inadequate best to resolve the problems.

Most are agreed that those problems are the result of market failure. No one, it seems, bothers to ask whether the housing market is really just another market, operating according to the normal laws of supply and demand or whether, on the contrary, it doesn’t exhibit such unusual characteristics as to make it completely atypical.

The housing market is, after all, like no other. The asset that is traded provides an essential element of life and valuable utility – a place to live. It retains and often increases its value over generations, rather than – as with most commodities – being consumed or otherwise losing value with the passage of time.

Most importantly, it involves an asset for whose purchase many people are able to command resources far in excess of their purchasing power in respect of any other commodity. Today’s house prices could not have reached anything remotely like their current level if it were not for the fact that purchasers are able to raise large sums on mortgage, secured by the assurance that – when they come to sell (or the bank forecloses) – other purchasers will be able to do likewise.

The constant availability of mortgage finance at ever-increasing levels is, in other words, the central element in the structure of house prices. And we get closer to understanding the problem when we recall the hugely significant change that occurred three decades ago in the way mortgage finance was provided.

Up until that point, mortgage finance was largely provided by building societies – mutual societies which relied for the funds they lent for house purchase on the savings provided to them by their members. But in the 1980s, the building societies demutualised and became trading companies. Even more importantly, they were muscled aside by the banks which rapidly discovered that lending on mortgage was easy, secure and extremely profitable.

The new dominance of the banks in mortgage lending was given added significance by a power that the banks have and building societies did not. Whereas the building societies were limited by the resources made available to them by lenders, the banks suffered no such constraint. They were able to create mortgage finance out of nothing, by the stroke of a pen. There was virtually no limit as to how much they could lend, provided that there was adequate security for the loans they made. And that problem – adequate security – was easily taken care of because they could simply go on lending to new generations of borrowers and purchasers who could afford, with the banks’ help, to pay the ever-inflating prices.

The banks had discovered a huge machine for generating profits. They could charge interest on money they themselves created, and they could ensure that their lending was virtually risk-free by virtue of their willingness to go on lending so that prices (and the value of the assets that provided their security) kept on rising.

This change – the most important change in our monetary conditions for generations – is only dimly understood. The Reserve Bank, however, is becoming uncomfortably aware of the instability of the situation we find ourselves in. If the banks should suddenly encounter a downturn and incur significant bad debts, and house prices turned down rather than up, the whole ramshackle structure could come tumbling down. Others can see that huge bank profits – removed from our economy and transferred back to Australia – are a heavy burden for our balance of payments. Yet others understand that the asset inflation in the housing market is the major source of inflation and a huge driver of widening inequality, as those who can access mortgage finance prosper and others are left behind.

The Bank of England has recently conceded that 97% of all money in the UK is created out of nothing by bank lending and the greater part of that goes on house purchase. We are in exactly that same situation; there is no solution to housing unaffordability until the banks are made to behave more responsibly.

Bryan Gould

7 May 2015.