Wednesday, 2 July 2008

Primitive property slumpism

I'm nicking/misusing the term 'primitive slumpism' (which Trots seem to use as a pejorative term for the celebration of economic crises as a force for radicalising the proles). I'm using it here to refer to my own simplistic understanding of what might be going on in the property market, specifically how banks can amplify the problem.

The idea that banks can get get carried away during a property bubble is not a new one. Will Hutton recently explained how the process worked in one of his columns in the Observer. What's interesting though is the role of the banks when the bubble bursts. Below is a nice and clear description of how this might work taken from an essay by Richard Herring (this one, not this one) and Susan Wachter in the bubble book I'm reading this week:

Bank behaviour may also play an important role in exacerbating the collpase of real estate prices. A decline in the price of real estate will decrease bank capital directly by reducing the value of the bank's own real estate assets. It will also reduce the value of loans collateralized by real estate and may lead to defaults, which will further reduce capital. Moreover, a decline in the price of real estate is likely to increase the preceived risk in real estate leding. All these factors are likely to reduce the supply of credit to the real estate industry. In addition, supervisors and regulators may react to the resulting weakening of bank caapital positions by increasing capital requirements and instituting stricter rules for classifying and provisioning against real estate assets. these measures will further diminish the supply of credit to the real estatte industry and place additional downward pressure on real estate prices.

That sounds pretty believable to me, though it does suggest if I understand it right that if banks' capital ratios are to be revisited then we might want to wait a bit. In addition the essay also makes the point that depositor protection (which is clearly a good thing) has the effect of insulating banks against market pressure. Why pull your money Northern Rock style if you know it is underwritten by an insurance scheme?

There's another interesting bit later in the essay where they discuss herding by banks in respect of risk. Herding is something that will be very familiar to anyone who has looked at active fund managers, and it was explored quite a bit in the Myners Review of course. I've never really considered how it might affect banks though, especially in the midst of a crisis. Here's what they say:

A bank knows that if it takes on an idiosyncratic risk exposure and loses, it may face harsh regulatory disciline, including termination. But if it is careful to keep its risk exposures in line with those of other banks, even if a disaster occurs, the regulatory consequences will be much lighter. The supervisory authorities cannot terminate all banks or even discipline them harshly. Indeed, the authorities may be obliged to soften the impact of the shock on individual banks in order to protect the banking system.

When you think about it, this makes a lot of sense (from the banks' point of view) but it is also really annoying. These massive financial rewards are handed over to financial institutions for their expertise and insight, yet it seems a lot of what they do involves just sticking with the pack, even when the pack is behaving in a very risky way.

Anyway, it's turning out to be a great book.


Nick Drew said...

I'm not a banker but I've seen banks in action at very close quarters and the two passages you quote seem spot-on to me. There's another aspect you might find interesting.

When a slump occurs in an industry based around a specific class of assets, obviously banks who've lent against those assets have something to worry about, to a greater or lesser degree. In particular, they worry about the first of their clients (whose business is based on said asset-class) going bust. This is because they might be forced to take over the assets and attempt to sell them, to recover the debt. They then may discover, and be forced to 'realise' (in the technical sense) that they are worth bugger-all.

Here's the domino problem. If they are forced to write off / write down the assets they've just taken possession of, they must do the same for the similar assests of all the other clients in their book: so the first man down may bring down the whole sector, at a stroke.

SO - what the banks do is (and it's a tacit conspiracy between the lot of them - they all have the same interest in the matter, and perhaps we do too !), everything in their power to ride out the storm, hold their noses, whistle in the dark, and not drive the first guy to default.

Of course, sometimes, like now, it can't be done - in particular when the asset-values in question are too transparent to be ignored. But in other cases the asset-values are less obvious, so it's easier to put off the full (downwards) re-valuation.

Example: in 2002, the year following Enron's demise and a collapse in electricity prices, the most heavily-leveraged industrial sector ever (UK power generation industry) was collectively in massive trouble (British Energy went bust, famously). The banks were left holding the keys of a large number of power plants, with the distinct possibility of a sector-wide domino-collapse.

But they very cleverly held their collective nerve, avoided making really massive write-downs, and successfully rode the storm. (Having said this, the global project-finance sector retracted from 70-odd banks to just 15 as a direct consequence - this was a truly major event - but no banking disasters in the process: you probably don't even know about it).

On the wider stage, the global 'energy merchant sector' was collapsing at the same time and again, the banks carefully managed the process, letting just one of these huge players fail per month, from Oct '01 to Nov '02. A masterpiece of market management !

There are important lessons in all of this - I wrote about some of them here back in Feb.

Tom P said...

Thanks Nick - very interesting stuff! will check out your previous post.