Over the centuries history has recorded many economic bubbles and subsequent bursts. Their causes are to be found in human psychology. Traditionally greed and fear have kept each other balanced. When bubbles develop greed takes over and fear diminishes. The result is an increased appetite for risk and a belief that high returns are sustainable. When the bubble bursts, fear takes over and investment retrenches. Investment decisions become more difficult and greater returns are required when investment occurs. Over time the balance is restored.
Investing
When the investing climate is bullish, private investors and banks behave similarly. To achieve greater returns individuals are disposed to investing in more speculative assets then they would normally. Likewise, some banks will grant loans to high risk projects which appear to have a higher projected investment value.
Housing and land are like any other assets. They offer a long term investment opportunity that is equal to the returns from other investment products but can be very risks at the top of the investment cycle.
Acquiring real tangible assets like land or houses has a positive psychological effect on the investor. For most people, property investment is easier to understand than bonds or equities. A potential property investor requires liquidity and the belief that the investment will continue to appreciate in value. Knowledge of financial instruments or products is not required to enter the property market.
As the property market appreciates new investors are attracted to it. The increased demand pushes up the investment price and anticipated future returns thus increasing speculative pressures.
The quality of any investment is its ability to generate the expected returns. In the US poor quality high risk “sub-prime” mortgages were given to individuals or households who were unable to meet the cost of servicing those mortgages.
Over 50% of US households earn a maximum of $50,000. As property prices increased the lenders continued to provide mortgages to this sub-prime market. Low income households were disproportionately leveraged.
Most sub-prime borrowers were on adjustable rate mortgages which had a few years of low interest rates to attract their business followed by a sharp increase in rates. Simply put, the people taking out these mortgages were borrowing so much money for such a long period that the cash flow yield each mortgage generated became smaller each time the house increased in value. To maintain a flow of income the banks had no choice but to increase interest rates to try and recover some of the capital they lent. House price appreciation does not increase yearly cash flows until the end of the project, i.e. when the house is sold a lump sum of cash is realised.
Interest Rates
Falling interest rates reduce the cost of borrowing which is reflected in the increased value of property assets. If the market is efficient then a rough estimate of the increased value of the asset can be established.
A 1% fall in interest rates means in theory a 10% increase in house prices if the 30 Year mortgage rate is being used as the bench mark interest rate. So a fall in the 30 Year fixed rate mortgage from 8% to 6% should increase values by roughly 20% if all buyers were on a fixed rate mortgage. For interest only mortgages (Adjustable Rate Mortgage) where the interest is being paid and none of the principle, the multiplier is roughly a 16% price increase for a 1% decrease in interest rates.
Housing Supply
As housing became more affordable the return on investing in housing began to outperform other investments and so the demand for housing stock increased.
This increased the attractiveness of entering the property market to speculators and property contractors. As land value appreciates there is a rush to acquire available land so that construction can continue once current projects have finished. This leads to speculative building on low productivity locations and waste land and over building on land where the purchase price was inflated to maximise the return on investment.2
The proper procedure for building contractors would have been to analyse each building project independently and use a suitable discount rate which reflected the risk factors of each project so as to calculate the net present value of each project. One should only invest in projects with positive net present values. When the housing bubble burst the extent of the misallocation of capital became evident.3
Many of the highly speculative projects were abandoned because the cash flows stopped. The projects were not worth finishing and capital invested was written off as sunk costs.
William Seidman, former chair of the FDIC, concluded in 1996: “The banking problems of the 1980s and 1990s came primarily, but not exclusively, from unsound real estate lending” (Seidman 1996: 57)4
The banking industry plays a key role in society. Banks are not creators of money; their function is to provide liquidity for people and industry so that investment decisions can be financed. Banks allow the smooth flowing of working capital around the economy. 5
Banks want to maximise their return on investment. When a certain investment product such as collateral debt obligations or mortgage backed securities begins to produce above average market returns banking administrators increasingly turn a blind eye to their exposure to high risk investments.
The individuals who manage these investments get even more capital support and manipulate and exploit the rules because they are generating greater returns over a very short period.6
Banks by their nature have a fundamental imbalance in the way they operate. They borrow short on the interbank market and lend long term for assets such as property.7
During the credit crisis this short term borrowing between banks dried up. This imbalance created perennial risks as banks had insufficient liquidity to meet their long term exposure. Banks that lend for housing and property speculation are always at risk of becoming illiquid.
Land or property is a slow turning asset and cannot be changed into any other form of asset quickly.8
When a bank funds a loan it has to increase its deposits. The banks assets and liabilities increase equally. During the course of business mortgage banks will accept a claim on assets that have been provided as collateral. As the economy prospers and banks expand their balance sheets, they provide even more mortgages and thus need to increase the amount of capital they hold as insurance against any future liabilities. 9
As real estate continues to appreciate, investors continue to invest cash in real estate rather than other investments such as bonds, equities or bank deposits.10
As property prices increase, investment yields fail to cover the mortgage. Cash flow from these assets diminishes, inflows of cash to service these loans disappears, and the amount of liquid capital the banks have on deposit falls. When investors cannot repay their borrowings banks seize the property assets. They cannot sell the real estate to raise capital to replenish their capital base. 11
Leverage is common for all banks. That’s their business model.12
This is why they are vulnerable to downswings in the economic cycle. During economic expansion speculation gets out of control.
In the downswing the real estate value and potential cash flows are reversed. Cash flows and future sales values are less certain making investment decisions more difficult.
As the economic climate begins to deteriorate banks are left with a portfolio of repossessed property and little income as borrowers cannot maintain their mortgage commitments.
The banks become illiquid and cannot fulfil their role as lenders of working capital for the economy.
Corporate Investment Decisions
In theory, firms should continue to grow their business until the marginal return is equal to marginal cost of funding that expansion.13
Over the last decade firms were accessing short term funds for long term funding requirements. The commercial paper markets were funding industrial organisations and banking operations.
Since the collapse of the credit markets, credit rationing and funding for new projects has been curtailed by the illiquid banking industry.
Loans to organisations are packaged in two formats:-
1) Lines of credit for short term working capital commitments.
2) Term loans for business expansion projects. 14
FDIC data show that commercial and industrial loan volume grew sharply from 2006 to 2007, but fell when the recession started. As banks grew cautious on loans, firms drew down their existing credit lines to meet their working capital requirements. During stable economic conditions soft rationing occurs. Specialised lenders exist and provide competitive financing rates.15
The greater the information the more assessable the risks are. When banks become illiquid, rising lender costs rather than adverse lender evaluation of the borrower are suggested as explanations of why borrowers face excessive costs or have their proposals rejected.
The banks begin shortening the maturity of their business loans and adding stricter covenants and tighter credit standards.16
As the economy gets worse market information becomes less reliable and sources of finance become extinguished.
Soft rationing conditions turn to hard rationing conditions. Corporations will ration capital to current projects rather than explore financing options beyond their customary sources of financing because the cost of financing those loans maybe to close to the marginal benefit of the projects.17
The firm may decide to use retained earnings for future projects or not invest in new projects at all.
Since 2008 a shift has occurred in external financing for organisations. For organisations that are ranked investment grade, firms which have low debt to equity ratios, the bond market has been the new source of external financing.18
Short term bank credit lines have been replaced by long term debt issuance. 2009 was the first time in the US and Europe that the amount of money raised in the bond markets exceeded the bank loan market. Thompson/ Reuters estimate this at $900 billion for corporate bonds vs. $494 raised through bank loans.
This trend will continue for the next few years. As banks continue to rebuild their balance sheets and implement new capital regulations the bond market will become the source of financing for many organisations.
Prudent organisations with low debt to equity levels will source capital for new projects from the bond markets rather than the short term commercial paper market.
Conclusion
The collapse of the banking industry in the US was closely linked to the speculation in real estate. I’ve analysed the trends that resulted in the banks becoming illiquid. Greed and speculation caused the housing bubble. The riskier the project the greater the return required to justify the investment. The banks ignored the long term risks in favour of short term returns. Investors in property increased their personal risk, their risk tolerance19 (emotional reactions to risk) by believing that the property assets they were investing in were “safe as houses “and the banking community over-estimated the risk capacity20 (the financial ability to take on risk) of the investors in property.
From a corporate perspective, rationing of capital for new projects became a board room issue.
The commercial loan/paper market was replaced by the corporate bond market as the provider of external funding for organisations.
Prior to the banking crisis an organisation had funding options to support new projects. All projects that had positive net present values were considered. As funding became more expensive capital rationing occurred and for many organisations in financial difficulty hard rationing occurred. No new projects were undertaken because the firm was unable to fund them.
Notes/References
1) Shiller, R. (2005) Irrational Exuberance (2d ed. ed.) Princeton University Press
2) Gaffney, M. (October 2009) Money, Credit and Crisis, American Journal of Economics and Sociology Vol.68 No.4, pp. 1018
3) Gaffney, M. (October 2009) Money, Credit and Crisis, American Journal of Economics and Sociology Vol.68 No.4, pp.1018
4) Gaffney, M. (October 2009) Money, Credit and Crisis, American Journal of Economics and Sociology Vol.68 No.4, pp. 1000
5) Gaffney, M. (October 2009) Money, Credit and Crisis, American Journal of Economics and Sociology Vol.68 No.4, pp. 986- 988
6) Gaffney, M. (October 2009)Money, Credit and Crisis, American Journal of Economics and Sociology Vol.68 No.4, pp. 985
7) Gaffney, M. (October 2009) Money, Credit and Crisis, American Journal of Economics and Sociology Vol.68 No.4, pp. 987
8) Gaffney, M. (October 2009) Money, Credit and Crisis, American Journal of Economics and Sociology Vol.68 No.4, pp. 1001
9) Gaffney, M. (October 2009) Money, Credit and Crisis, American Journal of Economics and Sociology Vol.68 No.4, pp. 1007
10) Gaffney, M. (October 2009) Money, Credit and Crisis, American Journal of Economics and Sociology Vol.68 No.4, pp. 1004
11) Gaffney, M. (October 2009) Money, Credit and Crisis, American Journal of Economics and Sociology Vol.68 No.4, pp .1009
12) Gaffney, M. (October 2009) Money, Credit and Crisis, American Journal of Economics and Sociology Vol.68 No.4, pp. 1013
13) Mukherjee, T.K. and Hingorani V.L. (Summer 1999) Capital-Rationing Decisions of Fortune 500 Firms: A Survey, Financial Practice and Education, pp. 7
14) Demyanyk, Y., Cherny, K. and Zaman, S. (May 2009) The Credit Environment for Business Loans, Banking and Financial Institutions, pp. 37
15) Mishkin, D. (Summer 1964) The Credit Rationing Artifact in Light of an Expanded Price Rationing Theory, The American Economist , pp. 6
16) Demyanyk, Y., Cherny, K. and Zaman, S. (May 2009) The Credit Environment for Business Loans, Banking and Financial Institutions, pp.38
17) Mishkin, D. (Summer 1964) The Credit Rationing Artifact in Light of an Expanded Price Rationing Theory, The American Economist ,pp. 9
18) Duyn, A.van. (December 2009) Supply Shocks in Store after Switch to Bonds, Financial Times p. 28
19) Smith, K.R. (July 2009) Empirical Wealth Management, The Wall Street Transcript, pp. 4
20) Smith, K.R. (July 2009) Empirical Wealth Management, The Wall Street Transcript, pp. 4
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