Why has real estate been an important part to the economy and why do we always get it wrong? Melvin J. Howard
The money cycle like the moon revolving around the earth so goes the ebb and flow of currency. Lets take a look at one that’s in the news constantly the real estate cycle. In my simple model I will say that all money is created as real estate loans, either for developers who initially built houses, offices and shopping centers or for those who end up buying these buildings. The money cycles around the economy as follows:
Suppose a bank loan first gets made to a developer of 100 units to go out and develop land. They then develop this land enough so that they can sell it at a high enough price that they can both pay the interest of 10 units on that loan to the bank as well as make a profit for their shareholders (say another 10 units). This need to return both interest to the banks and a profit to their shareholders encourages development above and beyond what would result in a zero interest monetary system (similar to the systems I spoke about in my other entry. Lets say that the developer spent the 100 units of money he borrowed on some workers to clear the land and at the brick store to buy the bricks for the house.
Lets say that the workers and the brick storeowner spend all their money (100 units in total) at the Sheri’s Furniture Store at the local mall. Sheri puts these 100 units in its checking account at the same bank. The developer sells the house to a buyer, which is you, for 120 units. You borrow this full amount of money from the bank in order to buy the house. This money gets put in the developer’s checking account. The developer pays back their 110 (which is the original 100 + 10 interest). The bank makes 10 units in profits, which it then distributes, to its shareholders, and the developer makes 10 units in profits, which it also distributes, to its shareholders. These shareholders then spend all their money at the Sheri’s Furniture Store, which has become very popular. This is also the store where you work at as a salesperson.
So at this point, bank loans total 120 to you, and there is also 120 in checking account money floating around in the economy, which has all purchased goods at the Sheri’s Store, and is accounted for in Sheri’s checking account. Over the next few years you will earn this 120 from your job at the Sheri’s store and will be able to pay off your loan. Well sort of. Lets not forget that you need to pay interest to the bank as well. So more money must be coming into the system from other places that will enable you to get the total money you need to pay off the loan plus interest.
To keep everything flowing enough money must be coming in, or being created, to enable most people access to enough money to pay off their loans. This is not true for all people, as a certain amount of bankruptcies are built into the system, but you don’t want too many or even a few big bankruptcies, as this would threaten confidence in the system, which would collapse it. What this all means is a constant supply of new money must be continuously created, and especially as others are paying off their bank loans, and thus making money "disappear". Recall that in our simple model we assumed that all money is being created by direct land development or alteration, but in the real world it’s more like half, though much of the other half is indirectly related to land alteration. So all this means more real estate development or land alteration to create this money to keep things flowing smoothly, keeping confidence in it and keep it from collapsing.
In a way then, you could say the money machine is sort of "eating up land" for its own survival. The survival of the monetary system as we know it in the past depended on land alteration or development. Ok you still with me hang in there its get exciting if you get confused wait I am just warming up. Securitization in its modern form was, like many a financial invention, initially born out of desperate times. During the Great Depression that brought in many new banking and stock market rules, such as the Glass-Steagall Act and the Securities and Exchange Commission. Such regulatory blitzes really only come along in times of utter desperation, like a complete financial and economic meltdown, and they only come along because they have to like now. Because you cant get the economy up and running unless you bring in some regulations to bring back confidence the main ingredient for a functioning economy. Restoring confidence in the financial system and stimulating credit creation was a primary aim of the banking rules and federal deposit insurance implemented during the Depression.
This was also the primary aim of another act it was called, the National Housing Act of 1934. The National Housing Act saw the introduction of the Federal Housing Administration, or FHA, whose primary function was to provide insurance of home mortgage loans made by private lenders. This insurance meant that a lender would be repaid by the government in the event of loss or default by mortgagees. During such hard economic times this mandate of the FHA would stimulate credit creation by banks and other lenders for investment in home building which, in turn, would provide more affordable housing and create jobs and stimulate further economic growth. Simultaneously, the government insurance backing would shore up confidence in the now shaken and much mistrusted financial sector.
The practical implementation of this federal mortgage insurance took the form of the chartering of a government corporation to buy and sell the mortgages that the government would insure. The first such corporation was set up in 1938 and called the Federal National Mortgage Association, also known simply as "Fannie Mae". In 1968 they split Fannie in two and made a twin sister out of her that they called Ginnie Mae (short for Government National Mortgage Association). Ginnie stayed with the government doing what Fannie used to do and Fannie ventured off into the private markets. Fannie became fully owned by private shareholders, yet with a Charter and Mandate specified by Congress. Instead of complying with SEC rules and other rules that apply to private enterprises, Fannie was instead regulated by the Department of Housing and Urban Development (or HUD) who tells her basically what business to be in, and also by the Office of Federal Housing Enterprise Oversight who monitors her financial stability. Now we are into a grey area that is not quite government, not quite private enterprise, Fannie Mae is instead referred to as a Government Sponsored Enterprise or GSE.
Before long it was thought that the Mae sisters were too lonely and so a cousin came to live with them it is officially called the Federal Home Loan Mortgage Corporation, but known as Freddie Mac, who looks a lot more like Fannie than Ginnie. Freddie is another GSE or Government Sponsored Enterprise, owned by private shareholders but regulated by HUD still with me?
The job of Fannie and Freddie has been to provide an active secondary market for home mortgages of low to middle income families. That is, while they don't make home loans directly themselves, they buy individual home mortgages from primary lenders such as banks and mortgage companies. Then they package together bunches of these loans and sell them back into the capital markets as mortgage-backed securities. The primary objective of creating such active secondary markets for these mortgages is to make sure that enough capital is available for affordable mortgages for families with low to moderate incomes. Without the ability to sell off such mortgages for cash to another party, banks and other lenders would make fewer loans in the low to moderate income groups and/or charge higher interest rates for fear of default and burdensome foreclosures.
Up until the 1980s the mortgage-backed securities issued by these entities looked more like what is known as simple "passthroughs", whereby an investor in a security issued by Fannie or Freddie simply got a share of the interest and principal paid by the underling group of mortgagees, with a guarantee on repayment provided by Freddie Mac or Fannie Mae. But the 1980s ushered in the rise to power of the investment banking houses and so began a totally new world of asset securitization. One of the problems with the "passthrough" type securities mentioned earlier is that the cashflow stream is uncertain. It can be very long, with long fixed rate mortgages, and can also change suddenly if interest rates drop and mortgagees decide to prepay their loans. This can make such investments quite unattractive to say, to long-term investors such as pension funds and insurance companies who are looking for guaranteed payments long into the future. Furthermore, shorter-term investors might find these instruments altogether unattractive. Investment banks of the 1970s and 1980s invented a different type of mortgage backed security to get around these problems. Basically, given a pool of home mortgages, you could come up with a series of different tranches of securities or bonds or notes that you would issue against that pool. The first, or senior, tranche from the pool would have a fixed interest rate and set principle repayments and be the first set of cashflows to be paid out of the pool. The next tranche might only get interest payments and then start getting principle only when the senior tranche is fully paid off, and so on all the way down to the Z-tranche or the "toxic sludge" of leftovers that only gets repaid once ever other tranche is repaid.
The senior tranche is the most secure instrument and so gets the lowest interest rate. The toxic tranche is more like a speculative investment and has a high potential yield but also high risks associated with it. In this way, a pool of pretty unglamorous and ordinary mortgages could give birth to a smorgasbord of different financial instruments to suit anyone's tastes.
The capital markets of the 1980s thought this was just about the most fantastic monetary invention since fractional reserve banking and they were wild about it! Fannie and Freddie alone have grown to have trillions of dollars of home loans under their belts. Not only has this invention helped the GSEs - Fannie Mae and Freddie Mac - provide ever more capital for home financing, it has also facilitated secondary markets in mortgage-backed securities issued by various other bank and non-bank entities i.e. mortgage loan companies. This invention that was able to turn the humdrum home mortgage into a slew of fancy securities to match anyone's desires multiplied the attractiveness of mortgage-back securities many times over and, consequently, capital had been flooding in to the mortgage market ever since.
But lets not stop there! The Investment banks realized that anything with a future stream of cashflows could be bundled up in such a fashion and have a set of designer financial instruments issued against that bundle. By the late 1980's auto loan and credit card receivables were being bundled up in such a fashion. By the 1990s the securitization market was extended to cover future record and movie sales, health club membership fees, tax liens, life insurance policies and catastrophe insurance, to name a but a few. Name anything with a future stream of cashflows, and it can be securitized! Notably, in the late 1990s we also saw securitization become used more and more by banks to sell corporate loans off to the capital markets.
Securitization is attractive to both the issuer and the investor in the new securities for various reasons. For the issuer - that is, the one who originated the mortgages or first issued you a credit card - securitization has several attractions. One, especially so for banks, is to free up regulatory capital, or the "safety net" for depositors that I spoke about earlier. It should be noted that the current rules specifying the level of "safety nets" that bankers must maintain in the form of shareholder capital, actually encourage banks to remove low risk assets from their books and retain the higher risk assets. Another attraction of securitization is the removal of undesirable assets from the balance sheet, and into "off balance sheet" vehicles. Other attractions include that securitiztions issued through an SPV can be a cheaper way of raising capital and increasing liquid assets, rather than having to go directly to the capital and debt markets.
What this explosion in securitization has done was to create an explosion in the availability of capital for investment in whatever is being securitized. Hence we have seen an explosion in credit card offers, home equity loans and basic home loans, auto loans, corporate financing, media and entertainment financing, and so forth. So whom do we blame for the mess we find ourselves in now. There is plenty of blame to go around I myself am a big fan of innovation and creativity in the debt and capital markets. To stifle it or to put up unbearable roadblocks would do us more harm then good. So what is the answer? Maybe like dark matter that holds the universe together we know its out there but we just cannot see it yet the (answer) I mean.
