Commercial Mortgage Lending and the Macro economy

This is something I wrote some years ago, and have revised a bit. It light of recent events in the commercial lending market, I thought it worth resuscitating.

Mera and Renaud (2000) demonstrate that the phrase “Asian Financial Crisis” was misleading. Green’s (2001) review of the book noted[1]:

[Asian Financial Crisis] suggests homogeneity: that “Asia” is one place, and that the financial crises faced by various countries there in the late 1990s were fundamentally similar. The fact that so many countries that were geographically close faced crises that were temporally close makes it easy to conclude that the crises had common roots.

Nevertheless, real estate did have a role in many of the countries that experienced a crisis, and the size of that role likely explains differences in the relative magnitudes of the crisis. In Japan, crises resulted in part from changing demographics and central bank regulatory and monetary policy, but also because of poor commercial real estate underwriting.

In Taiwan, land prices rose and then stabilized, and never crashed as they did in other Asian Economies. In Hong Kong, land prices fell, but because of the lending system there, which required property investors to use substantial equity funding, real estate had little effect on the overall health of the economy. The Chinese office market became badly overbuilt—especially in Shanghai—but the economy there continues to chug along, at least for now. But in Indonesia and Thailand, poor understanding of real estate fundamentals, along with collapsing currencies, caused real estate markets to fail. In contrast, Korea’s crisis arose largely from an unsustainable system of corporate lending. Real estate likely played a fairly small role in Korea’s crisis, and the country recovered almost immediately. It is worth spending a little time talking about the large real estate crises in Japan, Thailand and Indonesia, as well as the ability of Korea to avoid such a crisis.

Edelstein and Paul (2000) explain the sources of the extraordinary run-up in land prices in Japan in the 1980s, and the government’s response to that crisis. They maintain that the run-up in land prices from 1984 to 1991 was not the product of a speculative bubble, but rather of fundamentals of the Japanese economy. As Mera (2000) points out, Japan managed to survive many challenges to its economy quite well, including the second oil shock and the Plaza accords of 1986, which caused the yen to appreciate substantially and thus rendered Japanese exports less competitive. At the same time that Japanese incomes were rising sharply, interest rates in the country remained quite low. If we think about the Gordon Growth Model, i.e. R = i-g, where R is the capitalization rate, i is the discount rate and g is the growth rate, we would expect rents to be capitalized into high property values.

Moreover, as Edelstein and Paul point out, land in Japan is much scarcer than it is in other places: Japan’s population is a little under half of the United States’, yet its land area is only 4 percent that of the United States, and its habitable land in an even smaller percentage than that. Japan’s population density is thus 25 times larger than the United States’, and its GDP per square mile is 15 times large. Again, this is entirely consistent with Japanese land price levels being substantially higher than in the United States.

The property bust arose, according to both Mera and Edelstein and Paul, because of changing and with government policy.

With respect to fundamentals, we know that the Japanese economy slowed sharply in the 1990s. Part of the reason for this had to do with real estate related problems in the banking system, but part of the reason for this had to do with broader issues facing the Japanese economy. As to the former, Edelstein and Paul note that banks in Japan were allowed to count corporate stock holdings as reserves. This, of course, is the exact opposite of how banking is supposed to operate: reserves are supposed to be assets in which the financial institution has a risk-less position, such as cash and high quality government securities. Instead, Japanese banks counted very risky assets--equity--as reserves. Much of the underlying value of that equity was in the form of real estate, some of which was highly leveraged. Consequently, even a small downward turn in real estate markets had a profound effect on the banking system, which in turn had large repercussions for the financial system as a whole.

Making things worse was the fact that Japanese banks failed to recognize their real estate losses on their balance sheets: non-performing assets effectively drove equity levels in Japanese banks to levels below zero, and consequently created perverse incentives for Japanese bank managers.

At the same time, as the Japanese economy slowed, changes in expectations led to an increase in the underlying capitalization rate for real estate and other assets, and has therefore causes the values of all those assets to decline sharply. The existence of leverage has exacerbated this phenomenon further.

The most spectacular failures in the banking system with respect to real estate: Thailand and Indonesia, and especially Indonesia. Chapters by Bertrand Renaud (on Thailand) and Dominique Fischer (on Indonesia) give us harrowing stories of how poor underwriting, abetted in part by the “unholy alliance” between lenders and developers, can lead to a full fledged financial crisis.

The US has no cause to be smug about this, of course, as it invented the process with the Savings and Loan crisis of the 1980s. Both the Renauld and Fischer stories can be told simply enough: lenders assume rent and property value growth at some extremely high rates, which in turn produces very low capitalization rates. This in turn causes appraisers to assign high values to properties. These high values provide the support lenders need to advance loans, which typically have higher loan-to-value ratios. The high-loan-to-value ratios are justified by the fact that property values “always” rise, and that therefore the equity in the loan will quickly get sufficiently large to discourage default. At the same time, the financial institutions had reason to believe that governments (or NGOs) would prevent them from failing, meaning that the downside risk to the risky loans was attenuated. This led to a classic moral hazard problem, where risk was not appropriately priced.

The problem with this, of course, is that sometimes values and rents stop rising, particularly when building outpaces demand. All that needs to happen is for the real estate sector to grow more rapidly than the economy; at that point, everything can come unglued. And so it did: interruptions in rising rent trajectories caused real estate loans to become delinquent. But then things got even worse. The embryonic financial crisis in Thailand and Indonesia caused foreign, and especially Japanese, capital to flee. This led to currency devaluations. Because real estate loans were often denominated in foreign, rather than home currencies, the debt obligations of borrowers got much larger, which in turn led to more defaults. It was thus the combination of poor underwriting and a lack of understanding of currency risk that contributed to the downfalls of the two economies. In Indonesia, GDP fell by a stunning 15 percent in just one year.

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[1] Much of the discussion of the Asian financial crisis below closely follows Green (2001).