Writing has been very light. Who am I kidding? It’s been nonexistent. Part of it is that I’ve been very busy with projects, but the other part is that there really hasn’t been much of interest that I haven’t written about over and over before. Enjoy the silence, I figure.
I break that silence because world events intrude on my peaceful focus.
As everyone knows by now, the U.S. (which means the world) is undergoing a crisis in banking. As of this writing, three major regional banks have failed (Silvergate, Signature, and of course, Silicon Valley Bank), four others were at the verge of failing until “rescued” by the Feds, and one international giant is teetering (Credit Suisse).
Since this is not a finance blog nor a banking blog, I urge you to go check out all of the commentariat on finance and banking. I know I have. The three I found the most useful are Rebel Capitalist, Blockworks Macro, and InvestAnswers channels on YouTube. So go check those out, as well as others. Here are a few I found the most useful that you can watch:
But I am going to address how these events and more importantly the government’s response to them will impact real estate. TL;DR: We are going to party like it’s 1999 in real estate, as the overall economy and the global financial system heads towards the cliff.
Bank Failures, the Fed, and Government Response
It seems like there is wide agreement about most of the bank failures to date: incompetent managers did not hedge their risks enough. The main risk — the one that brought down SVB — is that their assets decline in value as the Fed raises rates. Lots of complicated reasons why, but government regulations incentivize banks to buy government debt: treasury bills, treasury bonds, and agency MBS (which are backed by the government). Funny how that works.
There is widespread agreement that the Fed and the government caused the problem with their idiotic response to COVID: printing some 40% of all US Dollars in existence in less than a year. All of those checks sent to individuals and companies ended up in some bank because people have to deposit a check to some sort of bank account.
Most of us tend to think of banks like a vault: it’s just this building with big-ass safes, and banks just hold our money in these safes. Hollywood bank robbery movies certainly encourage that view. But the truth is that banks are more like middleman businesses. We loan them our money (aka, deposit funds into our accounts at the bank) and then the bank invests that money elsewhere to earn a spread. The classic way that banks invest that money, of course, is lending it to some borrower to buy a house, to buy a car, to start a business, to pay for college, etc. etc. The important point is that our deposits are liabilities of banks, and they are “on demand” meaning the bank has to pay back our money when we ask for it.
So the classic risk is the mismatch between liabilities (short-term and on-demand) and assets (long-term and not on-demand). All those bankers who work in fancy offices make beaucoup bucks managing that mismatch.
Plus, a bank isn’t going to invest in crypto or startup companies; that’s too risky. It’s unlikely to invest in stocks; that’s also too risky. Plus, most bank charters require that banks only invest in very very safe assets. So banks invest in bonds, which are the safest and most boring investments imaginable. And out of bonds, government debt is the safest and most boring of all. In fact, US Treasuries and agency MBS are considered cash-equivalents because of how liquid and how safe they are. (That’s one of the regulations that impacted the situation. I know, details that don’t truly matter to us.)
Except they’re not. Government bonds and agency MBS are subject to interest rate risk: when rates go up, the value of your bonds that pay lower rates go down. Your $1 billion bonds paying 1.56% over 10 years aren’t worth $1 billion when one can spend the same $1 billion and get bonds that pay 5% over 10 years. They’re also subject to duration risk, where the long-dated bonds don’t pay off for years and years, while the bank’s liabilities are on-demand (or short-term CDs and such).
The Fed seeded the problem with money printing, which led to huge increases in deposits at banks (aka, liabilities) and then they ignited things by raising rates to fight inflation, which led to huge decreases in the value of bonds those banks owned (aka, assets).
Anyhow, for a variety of reasons, depositors at these banks asked for their money back. The banks could not make those payments because most of the money was tied up in liquid, safe, cash-equivalent assets… which had nonetheless declined in value. SVB sold and took massive losses, which made it insolvent.
So far, that’s just the story of banking. And to be fair, it looks like SVB was uniquely mismanaged. As Stephen Miran put it in the Blockworks Macro podcast, a summer intern wouldn’t have made the mistakes that the senior executives at SVB made. It’s possible that the other banks (Signature, Silvergate, First Republic, Credit Suisse, etc. etc.) were also mismanaged in some fashion. Mismanaged banks fail all the time. There’s nothing new about a badly managed bank failing.
What is new however is the government’s response, which then leads to the market reacting.
The government’s response was (1) bail out SVB and Signature by guaranteeing all depositor funds in clear violation of the FDIC’s $250K limit, and (2) setting up a new facility for “emergency loans” to banks: the Bank Term Funding Program.
Say Hello To My Little Friend Moral Hazard
The proper name for these two actions might be “Incompetent Rich People Protection Program.”
Now, every depositor at every bank in the United States is guaranteed by the FDIC and that $250K limit simply does not exist in practice. So if you’re Roku, and your moron CFO has left $487 million in SVB knowing that the FDIC limit is $250K… you’ll be made whole by the FDIC. I see no reason whatsoever that the same wouldn’t apply to some construction company in Iowa who left $25 million in the bank instead of doing basic treasury management stuff. What is the rationale for making Roku whole, but other rich people and companies not?
Furthermore, the BTFP means that banks no longer have to care that much about interest rate risk as long as they’re buying government bonds and agency MBS. The Fed will just value your devalued bonds at par, as if nothing had changed. Risk management? Whatever for?
Private gain, public loss: that’s the definition of moral hazard. And our betters at the Fed and Treasury and FDIC and elsewhere just made that a government program.
Rate Cuts Incoming
Then there is the market expectation for a halt to the rate hikes by various central banks, including the Fed, and even an expectation for rate cuts in the not too distant future. The Pivot is straight ahead, boys and girls!
I’ve been arguing (following Luke Gromen’s logic) that the Fed has to pivot because of our national debt of $31 trillion. Higher rates means government’s borrowing costs go up, and our federal government already spent a record $736 billion just on interest payments in 2022. That’s even more than they spent on Ukraine! It’s more than the Feds spent on everything that wasn’t a transfer payment of some kind or weapons and the men to wield them.
Turns out, the Fed might have to pivot because all of its member banks (remember, the Federal Reserve is a private entity owned by a group of banks) might go under if it keeps hiking rates. Small businesses suffer and people can’t buy houses because of higher rates? Keep hiking to kill off inflation! Banks start going under because their bond portfolios are now worth half par value? Systemic risk! To hell with inflation; reverse course immediately!
More than one finance expert is now thinking that we’ll see mortgage rates at 5% or lower by the end of the year. The bond market certainly appears to think that the central banks are done raising rates. (Follow Jeff Snider for a fuller, if very dense, explanation on that.)
That the housing market will benefit is beyond dispute. That home prices will reverse course and start to rise is to be expected. Home prices track money supply, and we have just signaled that money supply will be going up. Because bank bailouts (or bailouts of their idiotic rich depositors) is by definition adding money to the economy.
We in the real estate industry are going to party like it’s 1999. Lower rates will juice demand, of course, but perhaps more importantly, it might unlock some inventory as homeowners decide that going from a 3% mortgage to a 5% mortgage to move up is a far better deal than going from a 3% mortgage to a 7% mortgage to move laterally or down.
With the BTFP, banks are heavily incentivized to buy agency MBS since that’s one of the bonds that would be valued at par if SHTF no matter what the actual value might be in the marketplace. That increases liquidity for residential real estate, which means easier terms, easier to qualify, and lower rates for mortgages.
The result should be more transactions at higher prices.
Bank Failures + Moral Hazard = Investor Activities
There is also the real possibility that the extremely close calls with SVB and others serve as wake-up calls for a lot of rich people and companies, even banks themselves.
Banks invest in the safest of safe securities: government bonds and agency MBS. But those are long-dated. Mortgages are 30 years, for cryin’ out loud. Now that they’re awake to the possibility that investing in safe bonds with interest rate risk could mean the end of the bank, I imagine quite a few will be looking for investments that aren’t 10+ years out to maturity, and aren’t fixed rate if possible.
For wealthy depositors who have over $250K in one bank, even if they dodged a bullet with the Fed rescue of depositors, I imagine most of them are in talks with money managers and accountants about diversification. And since it turns out that holding “cash” is not actually holding cash unless you have pallets of $100 bills in your garage, I imagine quite a few rich people will be thinking they need investments that don’t have counterparty risk. And oh yes, your bank is not a vault; it is most definitely a counterparty.
Real assets, not just pieces of paper, are going to be much in demand in the weeks and months ahead. I heard one finance YouTuber going on and on about how your money isn’t safe in banks, and how you need to own real assets: real estate, gold, silver. What all of those have in common is that they do not have counterparty risk. You don’t need someone living up to their contractual obligation if you own land; you just own land. Same with gold, wheat, pork bellies, or oil. (Assuming you have the actual physical atoms in your possession.)
Combine the two and you have the prospect of wealthy people and funds borrowing money from the bank at lower (but floating!) rates with shorter terms, then using that money to buy real assets like real estate. Banks should be happier to make those loans since they are shorter term, will pay more than government bonds, and the collateral could be real assets. Borrowers should be happy to take those loans to put into things like real estate, which cash flows and could appreciate in value.
If those don’t work out and you end up with a bank run? Well, the government will make depositors whole, so bank runs are highly unlikely, but if it should happen anyway, you got paid, got your bonuses, and you can move on as long as you didn’t do something criminal. But if it does work out, then fabulous profits all around. Moral hazard, yes, but smart business.
Oh, we gon’ party for sure. Demand from consumers will be juiced by lower rates and more inventory, while demand from investors will also go up because of fear, uncertainty and doubt about our financial system.
The Counterpoint
There is one very valid counterpoint to this line of thinking. The idea is that the Fed will actually raise rates and keep on raising rates to kill off inflation. They can do this because of the extraordinary and probably extralegal moves made in response to the bank failures.
By guaranteeing all depositors at all banks, and by providing liquidity to banks that have government paper, the Fed is now freed up to keep on hiking rates without worrying about member banks going belly up.
In a way, because bailing out the banks is inflationary, the Fed can pursue deflationary policies elsewhere without imperiling the global financial system. Not to put too fine a point on it, but the Fed can kill housing without killing banking now.
Since housing was a main driver of inflation in February, it would make sense to try to keep killing off the housing market if you can do it without killing off the banks.
The Cliff Ahead
It isn’t all sunshine and rainbows, however, even for us in the real estate industry.
First, there’s no guarantee that these moves by the government will work beyond the next couple of weeks. The evidence so far from the bond markets (again, read finance guys or listen to finance podcasts) is that they don’t believe any of this will actually work to stabilize the financial system. If the traders don’t believe the Fed and the government can contain things, then there’s very little the authorities can do.
Second, one possible (probable?) outcome of these moves is that the small banks and even midsized regional banks all go bust as people move their money to the TBTF (Too Big To Fail) banks. That’s great for those few big banks, but it’s not great for the economy as a whole and probably not great for housing either. Think about the mortgage market if the number of underwriters drops from dozens to four, and those four are the biggest banks in the country. Now apply the same logic to small business loans. Your local community bank might lend to some guy who wants to start a pizzeria; will JP Morgan Chase? This way lies economic recession… which many analysts are now predicting is closer than ever.
Third, I have to imagine that the 30 year fixed rate mortgage is not long for this world. Those worked for as long as they did because the government (implicitly) guaranteed them in a world filled with risk. Agency MBS is a cash-equivalent because of government backing. But that guarantee covers default risk, the risk that the borrower won’t pay the loan back. It does not cover interest rate risk, and it certainly doesn’t cover duration risk, but smart people would hedge those. The big risk was that you wouldn’t get your money back, and agency MBS covered that. That is why MBS was so popular and why liquidity for housing skyrocketed in the United States.
Thing is, the Feds just guaranteed that you would get your money back from any bank in the United States. And bank deposits are on-demand, not locked up for THIRTY years in a volatile rate environment. Going forward, why would some insurance company buy 30 year mortgage bonds for $500 million if they could just deposit $500 million into Bank of America and earn a few points of interest on that, knowing the entire $500 million is guaranteed by the government? And if you’re one of those big banks, why not take greater risks with those deposits since (a) depositors will be made whole, and (b) you can always take your government paper and get par value, and (c) you know you’re Too Big to Fail. The Fed will bend over backwards if you get into trouble; they did it for frikkin’ SVB — they’re going to let Bank of America fold up shop?
Speaking of Bank of America… combine points 2 and 3 and you get… Canada which is dominated by five big banks. You know what Canada doesn’t have? Long term fixed rate mortgages. Big Banks have very little incentive to be offering such things; most Canadians have 5 years or shorter terms on their mortgages. I don’t see BofA or Wells Fargo bemoaning that outcome; do you?
Fourth, the big big unknown for us (and for everybody else) is politics. Things like bank failures and bailouts tend to focus the mind, and they tend to focus the mind of lobbyists and politicians especially. Whatever plays out in the months ahead, that process will be intensely political as Dems and Republicans try to blame each other for whatever bad thing, while local Congresscritters do everything possible to save their local banks and local companies and local jobs and whatever else. The horse trading is likely to be intense. Do we benefit from that because housing is so local? Or do we get sacrificed because high housing prices is a political drag? I don’t think anybody knows. But I will say that having the DOJ and FTC pissed off at real estate because NAR kicked them in the nuts isn’t a big plus in our favor.
Last but not least (definitely not least), does anyone actually think the real economy is strong? I mean, forget all of the financial stuff, money printing, depositors, Fed action, Treasury programs, and the rest of it. Just the day to day on the street vibe. Are we seeing a strong job market, tons of production, new buildings going up, new stores opening, bumper crop yields? Do you feel like you could tell your boss to take this job and shove it, and find a new job in a week or two? Does 2023 feel like 2018 or 2019? Or does it feel more like 2008? If the real economy is weak, then eventually the financial economy will follow suit.
The End of the World scenario that some people who are hardly tinfoil hat conspiracy theorists are contemplating is the end of the fiat money system of the entire world. Bond traders are not, generally speaking, conspiracy theorists or idealists. They trade bonds to make money and they’re quite ruthless about what they do. It’s the end of the Age of the Dollar when American money backed by American muscle brought prosperity and growth to everybody not named North Korea.
We’ve been here before time and again, just not in most of our lifetimes. If you read any of Ray Dalio’s works, you know that we have had huge changes in the global monetary system from the Dutch Guilder to the British Sterling to the US Dollar. We don’t know what comes next, and we don’t know what disruptions we’ll have to live through as that change happens.
The good news for us is that we work in an essential asset industry. Financial disruption or not, people have to live somewhere. That means eating, drinking water, sexytime, protection, and sleeping under a roof. Housing isn’t an NFT. It’s not a gaming app. It’s not television, as essential as that seems sometimes. It’s actually essential.
The way things are lining up now after these unprecedented actions by the FDIC, the Fed and the Treasury, looks to me like we in real estate are going to party at the end of the world.
-rsh
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