Part 3: Moral Hazard- What is to Come?

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By Ben Pauley

In part two of our Moral Hazard series, we touched on the overleverage in both the agri and private sectors of NZ and the bank and government response to both in challenging times.

Today, I want to further the discussion around the effects that are being seen from our Covid response and posit what may be to come. As always, these are merely my thoughts and encourage them to be taken as such.

Last week, we spoke about interest rates on savings to finish up the blog. These low rates create another problem in that savings seek better returns on their capital and therefore higher risk. I have seen three concerning trends in this space.

Cryptocurrencies and NFTs

Firstly, the creation of crypto currencies and NFT’s. I don’t pretend to be an expert in these at all, however, what I do know is that these markets tend to be extremely volatile, easily influenced and under regulated. We have also seen of late a lot of leverage in these markets. People are able to raise funds on margin against the investments and beyond even that we have seen companies invest hundreds of millions of borrowed money into the market. Globally, billions of dollars are flowing into this space with many putting a large part of their savings into the markets. Taking risk is not a problem as long  as you are willing and able to wear the downside of the market. Crypto currency and NFT’s have proven to be extremely volatile and have the hallmarks of a speculative investment vehicle, not a savings mechanism.

Development Funds

Secondly, we have seen the creation and significant growth of development funds as of late, promising 10% returns for wholesale investors. These funds can offer such significant returns as they are materially riskier than a savings account. Those old enough will remember how these things can go wrong with Bridgecorp’s failure in 2007. For a modern-day example, albeit on a much larger scale, look at Evergrande who we mentioned in part one.

To note, if you understand the risks there is nothing wrong with investing in these funds.

Investment Property

Lastly, investment property. Whilst property is historically a sound investment, and holds less risk than the above, I am concerned with the level of leverage taken on in this space. Over the last 18 months, there has been a huge property boom nationwide with house prices in almost every town or city rising >20%. Property investment is New Zealand’s long lasting love affair and looks to be stronger than ever.

My concern in this space is that the increasing rhetoric seems to be ‘throw caution to the wind and buy now, if you don’t, you will miss out’. 3 News the other night had a segment on Christchurch currently having the fastest house price growth in the nation, and being the last bastion of affordable property. They went so far as to have an agent on the news, asking them their advice which was ‘buy now, don’t hesitate or you will miss out’. As you can guess, I think this is somewhat irresponsible journalism.

Whilst long term, property has been a good investment, what we know from history is that overleverage tends to result in corrections and a fall in asset values.

Bringing it back to Moral Hazard

How does this all relate to Moral Hazard? Firstly, Crypto. My concern in this space is that our reactions to the Covid Crisis have spurred investment and speculation into this asset class (globally, I might add) and that a true correction of values in this space will decimate the savings of many, destroying a lot of wealth. I don’t foresee any form of bailout in this space, but rather significant losses for many.

Regarding the property funds. I estimate that there is ~$200M+ of cash invested in these funds with each attracting more every day. If there were to be a run on any of these, I do wonder about the government's appetite to allow them to collapse. I wonder if these are becoming NZ’s ‘too big to fail’ entities. These funds back some large property developers building upward of 1,000 homes between them, and a run on their capital could have dire consequences for the property and debt markets, not to mention the investments into the funds (first loss position). I wouldn’t, therefore, be surprised (particularly considering the fallout for mums and dads following Bridgecorp) for there to be some form of government bailout or assistance in the event there is a run-on funds / collapse in the groups.

Lastly, property investment. My concern in this space relates to the level of leverage in the market along with the inflated property values (home lending has been growing at an annualized rate >11% for the last 5 months! >$3bn per month…). This level of leverage means there are many interested in the party continuing. It is common for me to hear people commenting on the government and banks along the lines of ‘they can’t afford for prices to fall too sharply’. If property prices were to fall too sharply this would have a direct effect on the banks capital allocations and they may then take some losses. The average kiwi would take a huge hit on their ‘wealth’ and some may end up underwater (owing more than the value of their properties). We would likely see a huge retrenchment of spending and economic growth along with investment (harder to borrow to invest with falling asset values). Overall, it would spell a big economic downturn.

Is the private sector too big to fail?

The response, is the private sector ‘too big to fail’? Will we see a repeat of the behavior following Covid where the government and banks provide support (bail outs) to New Zealanders, and we end up with a similar situation to the agri sector in New Zealand with stagnation in growth and investment (see Japan in the 90’s and early 2000’s)?

I am not condoning a big economic disaster or large correction. I want to make that clear, I don’t want people to suffer and there to be big losses. What I do want to point out though is that economic corrections and free markets have their benefits in that they weed out inefficiencies and tend to result in capital flows to productive and good uses.

Our failure to accept these I believe exacerbates the problem and ‘kicks the can down the road’. If we kick it too far, when the chickens come home to roost, we may be staring down the barrel of a rather large economic event that is exceptionally more difficult to get through. My concern is we will continue to bail out institutions and the public, and our aversion to any level of suffering may result in an event that is many times worse and outside our control.

These bailouts and actions encourage behavior (low savings, over leverage, investment into risky and unproductive assets) that ultimately do not benefit society and create greater risk.

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