Subprime Crisis - threat is real

By: Debarttasharan Dey

The recent subprime crisis in the US, which has affected banks and markets across the world, has again highlighted the relationship between real estate and bank credit and the ramifications it has for the economy. An analysis of some of the real estate booms and busts of the past century exposes a strong correlation between banking activity and the real estate. The two are remarkably correlated in a number of instances, ranging from developed countries to emerging economies. The speculative real estate booms followed by sudden bursts were due to banks lending on liberal terms and underestimation of the risk profile of borrowers.

1920s’ Florida land bust

The 1920s was one of the most prolific economic periods of American prosperity. The chain store movement revolutionised retailing and consumer products became affordable for the masses. Cars became the symbol of a new consumer culture. Easy availability of credit for automobiles spurred sales by 300% in a decade. Banks started to offer mortgage loans and their easy availability — often on liberal terms — resulted in frenzied real estate activity in Florida, pushing up property prices to unprecedented levels. It all came crashing down on September 18, 1926 when a powerful hurricane slammed Florida. It devastated the state with high winds and surging floodwaters. The huge task of rebuilding and the financial losses inflicted by the hurricane caused thousands of residents to abandon their new homes and return to northern cities. Thus, the Florida land boom cooled. Florida entered The Great Depression in 1926, three years earlier than the rest of America with the Florida land bust and did not recover until 1941.

1980s and the S&L debacle

In the late 70s, when the US witnessed double-digit inflation rates, real estate was viewed as a hedge against inflation. It was also around this time that the savings and loan (S&L) industry was deregulated and it began lending to commercial real estate, an area where the industry did not have sufficient experience. The industry lent to many third and fourth tier developers who built poorly-conceived projects. According to an IMF study, The federal income tax code was also revised in 1981, which strongly favoured real estate investment from a tax shelter perspective. Soon after Paul Volcker took over as Federal Reserve chairman in 1979, he went for monetary tightening to control inflation, which pushed up interest rates. The Federal income tax code was again changed in 1986, severely limiting the tax shelter aspect of real estate. Many developers and investors could not repay their loans to the S&L industry. A combination of rising interest rates, deregulation, real estate volatility, lack of regulatory oversight, mismanagement and overt fraud cases led to the crisis. The result of the 1980s building boom and the subsequent bust was the S&L crisis, which finally led to a bailout by the federal government in 1989.

Japanese bubble burst

Japan faced its worst banking and real estate crisis in the early nineties. Six trillion yen worth of loans by housing lenders who had borrowed heavily from banks and agricultural co-operatives turned bad.

Seven of the eight mortgage companies slipped into insolvency. In the 1980s, when Japanese economy soared due to its export incomes, the country deregulated its financial system. Faced with new competition, lenders turned to real estate developers, who were willing to pay higher rates than individuals. The market crashed in 1990 after the government put curbs on loans to developers. After peaking in December 1989, the Japanese stock market plunged over the next nine months to nearly half its value. As Japan entered its worst recession in decades, commercial real estate lost nearly half its value. Japan slipped into a decade-long recession.

Realty and the Asian crisis

More recently, in 1997, real estate speculation compounded the Asian currency crisis. Experience shows that financial liberalisation, though potentially beneficial, can be risky if undertaken in a fragile financial environment. For instance, a developer who borrows to invest in real estate and pledges land for collateral would put the lender at double the risk if property prices witness a sudden collapse. An undeveloped Asian market made it easy to conceal unreasonably high property valuations and borrowers gained greater leverage by mortgaging properties at inflated assessed values.

The proceeds of these transactions were invested heavily in new businesses as well as expansions in the existing lines of business. By the mid 1990s, the size of the real estate sector was huge, relative to the size of these emerging economies. It was estimated that in 1997, the value of real estate in the Bangkok metropolitan region was almost half as large as the GNP of the entire economy of Thailand. Lending institutions operated under implicit guarantees, which created a moral hazard. Poor management within financial institutions too was a major source of fragility. Thus, the absence of effective market discipline and inadequate prudential regulations led to poor quality of bank’s asset portfolios.

US subprime crisis

The initial trigger for the US sub-prime crisis was increasing delinquencies in the US mortgage market. The crisis was boosted by highly leveraged lending against rapidly rising house prices. As house prices slumped in 2006, delinquencies and defaults on subprime mortgages soared, despite a benign economic backdrop. When housing prices rose, borrowers with poor credit history had the option to sell their property and square off their loans.

But when prices slumped and interest rate rose, many borrowers defaulted. This had a cascading effect on banks and hedge funds, which had mortgage-backed securities and collateralised debt obligations. Hedge funds specialising in subprime mortgage-backed securities took huge losses.

Although real estate comes across as a solid security, experience shows that real estate prices are prone to cyclic phenomena. Moreover, in countries where lending has been liberalised recently, lenders do not have the ability to assess the risk profiles of borrowers. This makes the financial system very fragile, as lending is not made on the basis of risk.

Via Economic Times