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Posts Tagged ‘Real Estate Finance’

The previous article points out that banks invariably cause themselves harm by restricting lending when markets need liquidity and – based on recent announcements and revelations in the UK – they appear to have found a new way of hurting their customers and thereby, themselves.

There are 3 main choices for banks when seeking to cut down on levels of new lending:-

  1. Stop lending and close down a particular lending unit (the favoured choice in a recession for commercial property lending units);
  2. Impose tougher conditions for loans, so that fewer borrowers qualify;
  3. Make the cost of lending markedly greater to deter potential borrowers, possibly making other sources of finance more attractive.

Interestingly, many have opted for a fourth choice: temporary suspension of lending, ostensibly to deal with an overwhelming load of applications. This both flatters the lending institution (‘We’re so popular”) and holds the promise of a forthcoming return to the market, hopefully avoiding a further collapse in confidence that could harm their existing loans.

Depressingly, a number have opted to make lending more expensive, either by raising interest rates or by increasing arrangement fees, sometimes both. This appears to be a such a lurch towards self-harm that it might justify psychiatrists being offered seats on bank’s Board of Directors. It automatically increases the likelihood of default for struggling existing borrowers and makes any Bank of England reduction of Base Rate somewhat pointless. What’s the point if the reductions don’t get passed on to the people they are trying to help ?

Is this greed or stupidity in action ? Possibly neither, yet perhaps inadvertantly both. The banks that have chosen to do this may have other things on their mind. It’s interesting to note that those who have ‘ temporarily closed ‘ residential mortgage lending are generally Building Societies whilst those who have tightened lending criteria and also raised interest rates are banks. Commentators have suggested that this may be because these banks are seeking to build up deposits and capital reserves. This could well be true and may even be essential in a few cases.

However, as anyone who has been involved in UK property lending knows, the ability to service the debt grows more important than the underlying asset value the longer the loan period. So, for commercial property lending, where loan periods are from 2 to 7 years, both are critical to the repayment risk. Yet, for residential mortgages, where loan periods are typically between 20 to 25 years, the ability to pay interest is far more important than comparatively short-term movements in the property’s value.

So the banks that have raised interest rates on residential mortgages may help themselves in the short-term, but run the risk of creating serious problems for themselves down the line. Bearing in mind the old adage that one bad loan can wipe out the profits of a hundred good ones, increasing the likelihood of defaults by raising interest rates may not please the more discerning of their shareholders.

Why do banks behave like this ? On Robert Peston’s excellent blog he talks of stable doors and horses bolting, which is partly true, but the fundamental issue is that banks never pay enough attention to the skills of lending to property markets – of which knowing how to behave at different phases of the market is one of the most important ones.

What is so baffling and infuriating is that they have had painful lessons in the past, yet still refuse to learn from them.

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One of the most critical components of a downturn in property values is a fall in liquidity. Bank lending has been the largest component in market liquidity for a long time in the UK, usually leading institutional investment and independent equity (frequently from overseas investors, but often with a component of bank loans involved). So a decision to ‘ turn off the tap ‘ by banks is a major factor in a market turndown, as well as an accelerator of a fall in values.

This may seem an obvious statement, but few appreciate all the reasons for this, particularly the banks themselves. Banks tend to see themselves as ‘ lenders to the property market ‘ rather than realising that they are an integral part of it. Their actions affect not only other players in the market, but often also harm themselves.

Before the creation of APB, I would regularly address meetings of creditor banks to point out that precipitous action in liquidating property companies would harm the market and cause presently secure loans to become risky. On one occasion, a colleague pressed me back in my seat as I rose to speak and announced “Can we take it as a given that Richard has made his ‘responsibility to the market ‘ speech ?”.

It was then that I decided I had to go ahead with the creation of APB – an idea that had been in my mind for years. If the message had become routine – and therefore in danger of being ignored – another way of making it had to be found. Whilst there were a number of reasons for starting the Association of Property Bankers, one of my intentions was to make the banks understand their involvement in property markets and therefore to consider carefully their actions when fuelling a boom and exacerbating a crash. It has to be said that I have failed, but I still live in hope.

So what is it about ‘ turning off the tap ‘ that causes problems ? Consider these reasons:-

  1. It makes new purchases difficult .

    The obvious one. It is what most people think of when one talks about liquidity and severely restricts what Economists call ‘ real demand ‘. Less credit available means less organisations able to buy property investments or owner-occupied property.

  2. Banks finance both supply and demand.

    The often forgotten one. Buildings are primarily a factor of production and have a secondary function as an investment product. Before banks face financing the purchase of them as an investment, they finance their construction and also lend to the companies that wish to occupy them. A halt to new building arising from a restriction of available finance may eventually help counterbalance a downturn in values, but any cut-back on general lending immediately affects the ability of occupiers to take new space and may even threaten their ability to pay for the space they already occupy. Tenants going out of business is not uncommon in a recession, affecting returns and undermining confidence in the commercial property sector.

  3. Borrowers are unable to refinance existing loans.

    The generally unappreciated one. Most commercial property loans are for 3 to 5 years and sometimes 7 years. When they reach maturity, the borrower can find the bank is unable/unwilling to renew the loan and alternative sources of finance are unavailable. This can force investors to sell at the weakest time in the market and perfectly stable property investment companies can become vulnerable. Furthermore, since past increased market activity produced a lot of new lending, loan maturities can come in large clusters, forcing a lot of property on a market at a time when there are few purchasers, tipping a falling market into periods of freefall.

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This blog was first conceived some time ago, long before the word ‘blog’ came into common usage. The first few posts had been mapped out, explaining why a commercial (and residential) property crash was inevitable and how it would manifest itself. The mechanics were to be explained and emphasis was to be placed on how unexpected it would be (a prerequisite of any rapid downturn).

It was going to anticipate the inevitable scoffing and complaints that would arise in reponse to such a prediction (as happened when I did make such forecasts on various Forums).

Given my background, the importance of the role of banks and finance in booms and crashes was to be explained, with particular emphasis on the inevitable ‘ turning off the tap ‘ of finance that would precipitate a more rapid fall in property values. I’m certain that I would never have thought of the term ‘ Credit Crunch ‘, I’m afraid.

NOW, IT’S TOO LATE !

Nevermind, in forthcoming posts I will cover much of this ground in rather more detail and – no doubt – have many more interesting things to say.

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