Property bubbles and bank non-performing loans

How worrisome are real estate bubbles for the banking system?

Based upon the recent subprime and then global financial crisis, very worrisome indeed. The reason why real estate is so important to our whole economic life is because we take it for granted. For households, our house is likely to be the largest single investment for most families.

For companies, the real estate and fixed assets are often, other than inventory, the most important asset, especially as collateral for loans from banks. For banks, the largest single asset held for collateral against bank credit is real estate. For local governments, real estate sales and property taxes comprise the most important source of revenue.

Hence, most people equate buoyant house prices as an indication of prosperity, and most property developers would like to convince governments that they should never let property prices deflate.

The surprising thing about real estate value is how often economists ignore balance sheet values until it is often too late. The real estate value is 225% of US GDP. It took only a 20% drop in real estate prices to wipe nearly 45% of GDP, precipitating the deepest crisis in US recent history. It was only after the US regulators finally decided to look closely at the credit of the US banking system that it was discovered that as much as half of total credit are real-estate related (particularly through mortgages or mortgage-backed securities).

On March 10, 2011, the 2010 Fourth Quarter US Flow of Funds data was published by the Federal Reserve Board. Real estate assets comprise US$18.2 trillion or 25.7% of total household assets. Real estate values lost US$6 trillion in the two years 2006-2007, US$1.2 trillion in 2009, and after a modest recovery in the first half of 2010, for the full year, lost another US$0.6 trillion in 2010. The result is that net worth of households may have recovered a bit from higher financial assets due to the zero interest rate policies, but is still US$7.9 trillion down from its peak year of 2007.

The same pattern is seen in the US non-financial corporate sector. Real estate assets account for 25.6% of total assets, and that has lost US$2.4 trillion or 26% from its peak in 2007. Commercial real estate seems to have stabilised somewhat in 2010, but the numbers do not completely show up in the non-performing loans of the banks.

Based upon the testimony of the Federal Deposit Insurance Corp to Congress, there is a clear association between the number of failed or failing banks with their exposure to real estate loans, particularly commercial real estate acquisition, development and construction loans (ADC). In the three years 2005-2008, ADC loans increased 75% and the concentration of ADC loans to total capital rose from 26% in 2000 to 50% in third quarter 2007.

Loans disbursed quickly tend to go bad. More than half of the subprime loans originated in 2006 and 2007 had defaulted by November 2010. Foreclosure of mortgages reached 2.8 million in 2009 and exceeded 2 million in 2010.

At the end of 2009, non-current residential construction loans held by FDIC insured banks rose from 1.45% of such loans to 25.7%. As a result of bad loans to the real estate sector, 322 FDIC institutions failed since 2008 (out of roughly 7770 such institutions) and another 860 banks are designated as “problem institutions”.

Many of these troubled institutions failed because of high concentration in ADC loans in commercial or residential real estate.

The S&P/Case-Shiller Housing Index showed a 2% decline in the year to September 2010, whereas commercial real estate prices showed around 3% increase. Nevertheless, rents for commercial real estate are still falling.

Thus, despite the quantitative easing, which seems to have helped in causing equity prices to go up, real estate prices have not recovered that much, suggesting that if real estate prices still go down, the banking system would still be vulnerable.

Why is real estate so important in the banking sector books? The main reason is that real estate is the primary collateral and base asset against leverage. What securitisation and financial derivatives have done is to leverage these assets considerably and, therefore, when the primary base asset price is falling, the value of the financial derivative assets fall on a multiplied basis, due to the leverage effect.

In a recent speech to Cambridge University, Lord Adair Turner, chairman of the UK Financial Services Authority, argued that neither the Basel III reforms nor the measures against “too big to fail” are sufficient to ensure global financial stability. He argued for higher capital ratios than those set under Basel III and also further regulatory measures against shadow banking.

In particular, he argued that it was the balance between debt and equity contracts in the economy and financial system, as well as the maturity transformation that are the basic risks in the financial system.

He is surely correct that financial instability is driven by human myopia and imperfect rationality as well as poor incentives” and that in order to make the financial system more stable, it will require a multi-faceted and continually evolving regulatory response.

Like Lord Turner, the US Financial Crisis Inquiry Commission is finally convinced that it is human failings that caused the financial crisis. It was the failing in ideology that markets are self-correcting that caused financial regulation to be “market friendly”. However, it is also the low interest rates that gave rise to asset bubbles and central banks cannot continue to deny that they had no role in allowing asset bubbles to form.

As we have now seen from the Japanese experience, real estate booms and busts have a long demographic cycle. In the growing stage for the population, real estate prices can grow, but when the population ages and then declines, real estate prices can deflate, causing massive losses if there was an asset bubble.

You may not be able to stop bubbles completely, but surely there are tools to stop the banks over-lending to that sector. What goes up can come down.

Tan Sri Andrew Sheng is author of the book From Asian to Global Financial Crisis and adjunct professor at the Tsinghua University and University of Malaya. - By Andrew Sheng (The Star)

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