The looming global property crisis
Property is the collateral upon which all credit ultimately depends.
MACLEOD FINANCE
As collateral securing credit, tangible property values are the underpinning of credit upon which a modern economy depends.
If there are serious credit problems in the private sector, they usually radiate from property.
Property secures credit for not just property itself, but directly or indirectly influencing almost all other finance.
As we saw in 2008 when excessive lending through securitisation backed by liar loans were unwound in the US, the potential for a great financial crisis emanating from a sectorial property crash in just one jurisdiction, let alone a global one, should not be underestimated.
We face such a crisis today.
Here is a brief summary of the elements:
· Commercial real estate (CRE) is in crisis, not just in America but also in all other advanced economies where oversupply has been compounded by higher interest rates.
· When there is a high element of fixed rate term mortgages involved, residential property is on a longer fuse.
But this market is already stagnating and can be reasonably expected to decline further, if only because affordable mortgage credit is becoming unavailable to prospective buyers.
· Property is the basis of collateral for Main Street activities, with consequences for bank credit generally.
Savills estimated global real estate was worth $326.5 trillion in 2020, more than twice current assessments of global financial asset values.
· If a crisis is to be avoided, interest rates must decline.
Unfortunately, they are set to rise instead as I explain later in this post.
When markets awaken to it, the anticipation of rising interest rates and bond yields will undermine all asset values.
· US inflation is on the rise, with the monthly rate having increased five months in a row, which is why interest rates cannot decline.
· Credit defaults across all economic activities will increase this year due to bank credit being withdrawn as lending risks increase.
· Led by the US, G7 economies face not just a recession, but a deepening slump from a debt crisis.
This will add to government funding requirements, driving bond yields higher still.
In the face of these verifiable facts and the reasonable projections based upon them, it seems extraordinary that otherwise rational investors turn a blind eye.
Here they are, happily creating wealth, oblivious to the mounting dangers to debt, and therefore the existence of all forms of credit:
It really is a case of see no evil, hear no evil, and say no evil.
It has, perhaps, all the ingredients of a case study in wishful thinking ex post facto.
The purpose of this article is to warn those prepared to listen to reason about the enormous dangers the world of fiat currency and bank credit faces.
And this understanding must come from a full appreciation of the role of collateral, how its values are tied to interest rates, and how and why those values will almost certainly decline.
The threat to credit from falling property values
There has been much commentary about the state of the commercial real estate sector in the US, and how office blocks mostly held as loan collateral at the banks have become unsaleable.
But the factors undermining the US’s CRE sector are also evident throughout the G7.
Post-pandemic, demand for offices has declined sharply, particularly in the developed world because of a greater propensity to work from home.
Leading into the current decade there has been a massive expansion of commercial property supply world-wide.
Consequently, demand is nowhere near clearing this overhanging supply — supply which was further stimulated by ultra-cheap finance until recently.
The elements of this crisis are not just visible in the US, but in the EU and the UK as well, exacerbated by the sharp rise in interest rates from 2021 when it was widely thought that interest rates would never rise again.
Furthermore, rental values have declined.
The last property crisis in 2007—2009 didn’t involve interest rates but commercial property did take a 30% dip in the US, from which it rapidly recovered aided by the super-easy monetary policies of the Fed and the continuing decline of interest rates.
This time is different, with significant monetary inflation still in the pipeline — don’t forget that the US Government budget deficit is running at over 12% of GDP, and that is on optimistic economic assumptions, feeding the dollar’s debasement at an increasing pace.
Furthermore, the effect on residential property is an additional concern, with higher mortgage rates only gradually filtering through and suppressing house price values perhaps not so much as CRE initially, but for longer and ultimately as deeply.
As collateral securing credit, tangible property values are the underpinning of any modern economy.
If there are problems in the private sector, they radiate from property.
Property secures credit for not just property itself, but directly or indirectly influences almost all other finance.
The root of the problem is the cost of borrowing relative to rental income when the former rises sharply, which together with oversupply is what has collapsed the CRE market today, even taking down a few of the US regional banks.
Coincidently, the Fed’s assistance for banks caught out by higher interest rates is over, with its bank term funding programme having ended last Monday.
But to think these problems are confined to US regional banks and the CRE sector is a huge mistake.
The extent of the related crisis extends to all forms of credit, from government borrowing to the entire private sector, and even to the humble credit card user.
There is a precedent for today’s CRE crisis in the 1970s
To understand what happens when a CRE crisis is triggered by rising interest rates you have to go back to 1972—1974 in the UK.
In early 1972, the Bank of England’s interest rate was 5%, and long gilts (government bonds) were yielding 7.9%.
The inflationary consequences of the Barbour boom had fuelled the stock market bull which peaked that May.
The Bank of England’s minimum lending rate (MLR) was raised to 6% and the yield on long gilts had begun to rise the previous month.
At the stock market’s peak in May/June 1972, having already begun to discount rising interest rates and price inflation long gilts yielded 9%, finally undermining the stock market which declined a whopping 75% in just eighteen months.
A year after the stock market peaked, in May 1973 MLR was 7.75% and long gilts were yielding 10%.
Inflation was rising, and conventional opinion that summer was that with inflation beginning to spiral out of control, commercial office property was the best investment as an inflation hedge.
Equity portfolios rebalanced into property shares, driving up their value as collateral, which was then used by developers as backing for further bank finance.
With this demand, a relatively new category of banks began specialising in commercial property lending.
Most of these banks were small and had developed during the Barbour boom, funding corporate raiders dubbed asset-strippers in the popular press, who descended on old-school sleepy corporates.
When the stock market declined these secondary banks (secondary, that is, to the long-established large joint stock banks) shifted loan activities from declining stock-market dependent corporate finance into property finance and related development projects.
The commercial property bubble was primed and fuelled, cocked and loaded.
Gilt yields and interest rates continued to rise, with the Bank of England’s MLR rising to 11.5% in July 1973 — still not enough to break the back of the commercial office property boom.
But gilt yields were still rising, creating funding difficulties for the government.
In those days, the Bank operated interest rate policies under instruction from the Treasury whose permanent staff were accountants and Keynesian economists with little grasp of market realities.
At that time, the sterling dollar rate was $2.56, beginning to slide towards $2.20 in January 1974 and adding to inflationary pressures.
It was the beginning of a crisis that took the pound down to $1.60, only recovering after the IMF were called in and forced budget discipline on the socialist government of the day.
Sterling’s decline is shown in the chart below.
I remember well the treasury’s stubborn reluctance to embrace the market’s verdict.
Gilt funding would be paused for lack of buyers, and with the stand-off in the gilt market, excess government spending became unfunded by permanent debt, forcing the Bank into short-term markets to balance the government’s books.
Very quickly, a crisis would develop which could only be addressed with higher interest rates and gilt coupons.
[Note: There is a similar situation developing in the US today, with the Biden administration borrowing heavily in the Treasury bill market.
The Treasury has yet to properly test investment appetite for notes and bonds.
When it does so, we can expect the negative yield curve to flatten initially. After that, funding will be in the lap of the gods.]
Consequently, to resolve the government’s funding crisis the Bank was forced to raise MLR to 13% in early November, and the office property market imploded.
In the space of about a week, leading property shares on the stock exchange lost over 90% of their value, with many going under.
The collapse of this collateral took out the secondary banks, including the most pre-eminent of them, Slater Walker.
And the Bank of England launched what was termed the lifeboat to offer emergency assistance to the banks affected, while they were wound down in an orderly manner.
Despite the crisis which effectively wiped out the entire commercial property sector, the Bank and a reluctant treasury ministry were forced into paying even higher gilt coupons up to 15.5% on a twenty-five year maturity Treasury stock; and that was at a discount to get it away.
That marked the peak of long-maturity gilt yields of over 17% in December 1974.
People who argue that deflation leads to lower interest rates should take notice.
The UK’s experience in those years should alert us to the dangers ahead, this time on a global scale.
We should note that the common belief that central banks are always in control of interest rates could turn out to be an expensive error.
And we should also note that when a government finds itself having to fund rising deficits it must be prepared to pay a market rate, which rises the greater the funding demand.
The situation is potentially far worse today
The debt crisis which drove UK gilt yields as high as 17% in December 1974 was against a background of a debt to GDP ratio of less than 50%, and a budget deficit at 6% of GDP.
This fiscal year, the US debt to GDP starts at 120%, and the budget deficit will be about 12% so long as there’s no recession.
This is at least twice as bad as the conditions which drove a collapse in UK bond and equity values in late-1973 and all but destroyed the commercial property sector, taking down multiple banks with it.
The international dimension is grim as well, with estimates across a range of nations in the table below.
Inflation is rising again
According to the US’s Bureau of Labor Statistics, the annual consumer price index (which is its principal measure of consumer price inflation) fell to its lowest monthly level of 0.1% last October, since when it has been on a rising trend, hitting 0.4% in February, according to figures released on Tuesday.
Annualised, these are the equivalent of 1.2% and 4.8% respectively.
Now, I routinely disregard individual government-sourced statistics as being self-serving and irrelevant to economic analysis anyway.
But the trend to higher price inflation cannot be denied and is fully in accordance with accelerating currency debasement due to increasing budget deficits.
It will prove impossible therefore, for the Fed to suppress interest rates meaningfully against this trend.
Having nearly exhausted short-term finance provided by money funds shifting their deposits from the Fed’s reverse repo facility into short-term T-bills, shortly the US Treasury will find itself where the UK’s treasury ministry was in late-1973 — possibly even worse.
There is little doubt that rising interest rates and even greater increases in bond yields will come as an enormous shock to financial markets.
If you still think this is unlikely, then bear in mind that in terms of debt to GDP and budget deficit to GDP, the US position today is more than twice as bad as the UK’s was in the mid-1970s which led to the IMF’s 1976 rescue package to save the nation from economic collapse.
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