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It Wasn’t a Bubble—It Was a Double Bubble

Saturday, September 12, 2009

Many are accustomed to thinking in terms of a 'housing bubble.' But this is only part of the story. In fact, the first decade of the 21st century brought us a real estate double bubble—one in housing, and one in commercial real estate.

Many are accustomed to thinking in terms of a “housing bubble.” But this is only part of the story. In fact, the first decade of the 21st century brought us a real estate double bubble—one in housing, and one in commercial real estate. They both involved property prices increasing by an obviously unsustainable 90 percent over six or seven years, and they both involved notable expansion of real estate risk on the balance sheets of the highly regulated commercial banks.

The first graph below shows the double bubble. There is a remarkable similarity in the shape of the two bubble price curves, with commercial real estate prices peaking about a year and a half after the housing price peak. From the peak, prices of both have fallen more than 30 percent.

Since both these sectors are highly leveraged, the impact of such drops in asset prices on lenders’ credit losses is massive. Note that the drop in commercial real estate prices from their peak has happened faster. This seems consistent with the purely economic nature of the sector, while housing adjustments are complicated by personal factors of home ownership.

 Chart 1

It is said that the most costly four words in finance are “It’s different this time.” Certainly seductive arguments were made about how this boom was different because of financial innovations. But of course it was not different. “The failures for the current year have been numerous … unfavorable conditions were greatly aggravated by the collapse of unwise speculation in real estate.” Yes, indeed. But that was published in a report of the comptroller of the currency—in 1891.

In the final analysis, the most costly words in finance turn out to be three: ‘Leveraged real estate.'

Also costly are these nine words: “It seemed like a good idea at the time.” Anybody who has had to make decisions subject to uncertainty has had this thought. As bubbles expand, it seems like a good idea to everybody to make more loans at the same time.

We have heard a lot in recent Washington discussions about how regulation and “traditional” regulated banking will keep us out of trouble. Well, did the regulated banks avoid the “good idea” of expanded lending into the inflation of the double bubble? They did not.

In the final analysis, the most costly words in finance turn out to be three: “Leveraged real estate.” Time and again through financial history, this has set up the bubble and then the bust.

Of the total loans of all commercial banks together, a remarkable 56 percent ($3.8 trillion) are real estate loans, including both housing and commercial real estate credit. Put together with the price drops of the double bubble, this is truly sobering.

Between 1996 and 2006, the concentration of real estate risk in the banks’ total loan portfolios grew dramatically, from 40 percent to 57 percent. After being flat to declining for several years after the last real estate lending crisis of the early 1990s, it headed rapidly up, as shown here:

 Chart 2

In the smaller banks, those with assets of under $1 billion, real estate loans constitute a whopping 74 percent of all loans. There are about 6,500 of these smaller banks, or over 90 percent of all banks. In the smaller banks, real estate loan concentration steadily rose for over 15 years:

Chart 3

The good news about the second bubble is that commercial real estate, while a very large asset class, is much smaller than housing. At the prices of the top of the market, its total value was estimated at $6.7 trillion compared to residential real estate of about $22 trillion, or about one-third. These numbers would now both be reduced by about 30 percent.

However, the proportion of commercial real estate loans to residential housing loans in the loan portfolios of banks is much greater, $1.6 trillion compared to $2.1 trillion, respectively, or about three-quarters. So the second bubble will have an impact on banks greater than its overall market weight.

Leveraged real estate bubbles are by definition fed by rapidly expanding loans, supported by the rapidly rising prices of their real estate collateral. So to put the whole story together, we graph the expansion of the total real estate loans of the regulated banking system, indexed to the year 2000=100, against the double bubble real estate price indexes. An eloquent picture results:

 Chart 4

Under the original National Banking Act of 1863–64, national banks were not allowed to make any real estate loans at all. That was an extreme position, but we repeatedly find ourselves at the opposite extreme, all our regulation notwithstanding.

Alex J. Pollock is a resident fellow at the American Enterprise Institute, Washington, DC.

FURTHER READING: Pollock recently wrote “Ten Ways to Do Better in the Next Financial Cycle,” “Is a ‘Systemic Risk Regulator’ Possible?” and “Why Not Negative Interest Rates?” Also in The American, Pollock wrote “A Theory of Two Big Balance Sheets,” explaining the recent period of bubbles, busts, and bailouts, “Did They Really Believe House Prices Could Not Go Down?,” and “Your Guide to the Housing Crisis.”

Images by Dianna Ingram and Darren Wamboldt/Bergman Group.

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