Where did all the money channelled into property-backed lending go? Post author By Philip Lane Post date February 2, 2015 Patrick Honohan provides an accounting of the gains and losses from the property boom-bust cycle here. Categories In Uncategorized 17 Comments on Where did all the money channelled into property-backed lending go? ← Lamfalussy was right: independence and interdependence in a monetary union → Ideological Differences between Economists 17 replies on “Where did all the money channelled into property-backed lending go?” Bigger question is where has all the QE money gone now, how much of it is chasing yield in illiquid assets and what’s the plan for it if interest rates rise. There is so much hanging on CBs getting their timing right. Julia Black of LSE says the financial system is a risk distribution mechanism. She’s very good on the system weaknesses that lead to panics. The fact that the prof only knows now where the 08 era mispriced poison went shows how little sight CBs have today over the imbalances that will drive the next panic. A very welcome amplification of the guvnor’s statement to the BE where he singled out construction workers as beneficiaries of the huge re-distributitive effects of the boom/bust. He surmises that Ireland the nation is in a net zero position. That 40bn in taxpayers money for the banks, all the losses on negative equity etc. are by and large in the hands of a small minority of Irish people who made windfall and economically unjustifiable gains during the boom. Note that bondholders, German or otherwise, were not beneficiaries, they simply got their money back. To have defaulted on these would have been tantamount to a massive fraud by the Irish nation taken as a whole. I am surprised that with the superfluity of budding Syrizistas in the country no-one has targeted this windfall minority. It seems that retrospective taxation is the ultimate taboo. I am less impressed by the guvnor’s counterfactual. It is the redistribution in the factual which should get far greater coverage. Re: Apparent Problem in the Governor’s Narrative The narrative presented by the Central bank governor, is indeed a very intelligent and useful one. This idea of a factual, and counter-factual Irish economy, is exactly how we should try to view things in retrospect. But there is one huge mistake in the middle of the Central Bank governor’s formulation of his narrative (as useful a tool as it certainly is, by which to understand Ireland’s mistakes as a nation), and furthermore, it is even contained in the first line of the Irish Times article. The Central Bank governor continues, as many who do not understand or appreciate real estate finance, to argue that the banking system in Ireland, tried to engage itself in ‘property-backed lending’. That is not what the Irish banking system tried to do. We really need to become aware of that fact. What the Irish banking tried to do, was not engaging in ‘lending’, but instead, engage itself in commercial real estate ‘funding’. They are two totally different animals. And it is no where near acceptable for the most sophisticated economics and financial minds, that Ireland has, to continue not to exercise the distinction. It is just not acceptable, on almost any level. In the aftermath of the financial collapse of 2008, around the globe, what we witness are conversations and arguments over what constitutes ‘too big to fail’, and why modern day financial institutions are too big to fail, or are not too big to fail, and so on. What we do see in the financial system, when we look at it calmly and rationally, are institutions, which were always big, . . . and despite being so big, . . . there were never any careers in journalism made, by publishing books about the fact that such institutions were so big. Even in Ireland today, when the population of the island is paying a ‘levy’ for one large insurance financial institution, no one in journalism has made fame, by writing about this. There are institutions which are larger than banks, and no one makes a career in journalism, from writing about those. The people who do make names for themselves in journalism though, from writing about things that are ‘too big’, are those who write about banks. Clearly there is something about the manner in which banks need operate, which means that ‘size’ is not a good thing for banks. Clearly there is something in which the way that other financial institutions operate – insurance companies, pension funds, sovereign wealth funds – which means, that size isn’t as big of a problem for those. In fact, they are so large and boring, that the journalists don’t even bother publishing books, to describe all about their tremendous scale. There are some kinds of financial institutions, for which ‘size’ is a much bigger problem, than it is, for others. Re: Funding institutions are big and boring. It is the charter, mission statement and license of large funding institutions, to behave as ‘big and boring’. Banks, which attempt to operate as funders, tend become ‘big and exciting’ (worthy of the story telling capabilities even, of our best authors). Exciting, is not to be desired, in finance. Not to be desired, one bit. Even in countries such as Ireland, where excitement can be plentiful. Funding institutions have not, or tend not to, blow up entire economies, in the manner in which banks, who try to behave like funders, very often too. What Ireland’s banks attempted to do in the boom, was not to lend. What they attempt to do, was to fund. This is why, the very first line of the Central Bank governor’s article in the Irish Times newspaper, displays the inability on the part of the economics profession in Ireland as a whole, to grasp the whole thing. Irish economists have failed, there, unfortunately so. Because they have succeeded in devling into the crisis, and explaining it so well, along so many other dimensions. By having real funding institutions present, in something such as the commercial real estate industry, what it achieves is too three things. Firstly, it ensures that banks do not have to grow out to gross scale and proportion, relative to the size of the economy in which they trade in. Secondly, it means that beyond a certain point, when the funders’ ‘belly is full’, so to speak, they tend to operate as a natural brake upon real estate speculation, and output of production. Thirdly, when the inevitable ‘crash’ in the commercial real estate market happens, real funding institutions are not all rushing for the exit, at the same time. What occurred when the Irish banks in the 2000’s, tried to operate in the commercial real estate industry, as funders, instead of as lenders, is they deprived the country, known as the republic of Ireland of all the above features, in its financial system and economy. Worse than that, because the parties who were creditors to the Irish banks, had ‘Emergency Liquidity Assistance’, they could all run out through the exit door, to Ireland’s financial system, much faster and practicality at the same time. That is, instead of ‘ELA’ helping the problem, it increased it. In other words, Ireland was surrounded by the wreckage of a global financial crisis, . . . and at the same time, all of the air flew out of the tyre, which was its own banking system. This is really why lenders don’t become funders, or if they do, their banking charters should be revoked. That is why funders do what funders do. And anyways, lest it not become too simple, for the economics experts who might need to read this, . . . the important deal that happens in commercial real estate development, . . . in any country, where commercial real estate supports and underpins, a proper functioning, first world type of economy, . . . the important deal, is not that which happens is not between a ‘bank’, and a ‘developer’. Instead it is between a ‘funder’ and a ‘developer’. Everyone in real estate finance knows that. Everyone, except economists. In the Irish situation, banks were not prevented from exceeding the terms (and basically walking them into the mud), of their own banking charters and licenses. This is what our parliamentary banking inquiry, must investigate. This is where, it must go. It is just unfortunately, that it will not have the great assistance and abundant talent from Ireland’s economics community, to help to carry it, there. BOH. @ BOH You obviously feel passionate on the point but could you explain to me, a non economist, the substantial difference between lending and funding. Re: Explanation of the substantial difference It is confusing. Because in the context of residential mortgage lending, the bank does offer a lot of longer term loans, with terms of up to twenty and thirty years. That is, the bank has its risk, on that lending, diversified across a very large portfolio of borrowers. Commercial real estate loans, are much, much larger. There is more risk, concentrated in the one borrower. You do not have large numbers of borrowers, in commercial real estate lending. The trade off, which banks make is, they lend on much, much shorter terms to this customers. The banks, also charge much higher interest rates, on commercial real estate loans. But because, the term, is no more usually, than the short duration of the commercial real estate construction project – the borrower – the commercial real estate developer, doesn’t worry about the high interest rate, that they are paying. The construction, loan, which a developer obtains from a lender, is repaid, before it has a chance to accumulate. That is why the funder, is required, in order to close the loan, with the developer’s lender, in order to prevent that high interest rate from accumulating too much. I.e. The most important deal, which a developer, does before, getting involved in commercial real estate at all, is the deal that they make with their funder. The funder, effectively releases the ‘lender’, and ‘developer’ from any financial involvement with the finished product, and extracts the major amount of income, or rent, which can be extracted throughout the life span of the commercial real estate asset. But the funder, is entitled to do so, because they are the only one’s, who arrived ‘to the party’, with any real, hard cash that needed to be invested in the first place. ‘Funders’, as I said, are large to begin with, stuffed with real cash, that needs to flow somewhere. But that is not the job, which banks are supposed to do. It is the job and duty, of lenders, to remain like athletes – working with less, and not more – but recycling the less, in order to generate it’s income. That’s not what happened in Ireland. Former ministers for finance in Ireland, helped the banking and real estate industry in Ireland, by describing what the banks did in the boom, as reckless lending. The Irish banking industry, couldn’t be happier than to be accused of reckless lending. Because it puts whatever activity which they tried to engage in, firmly back within the charter, and license, for the lending institutions in Ireland. The way, that you know that Irish banks, were funding, instead of lending, is you look at each commercial real estate project, and you find out if the ‘developer’ had established a deal with a funding organisation, prior to obtaining lending, or not. The reason, that you know that Irish banks, were operating far outside of their mandate, is that hardly none of their borrowers, had ever talked with funding organisations, at all (indeed, the borrowers to Irish banks, were aggressively instructed, that if they talked with funders, they would not get the loans, which they needed, to construct, Irish real estate projects). It was all a power struggle, which should have been stamped out, and not allowed to develop, to the extent which it did do. Funders, also find out very quickly, if the real estate project is defective in some way, because they own the real estate project, and discover whether it is viable or not. So if the ‘developer’ has done badly, by a funder in the past, that commercial real estate ‘developer’, will find it difficult to get funded, in the future, never mind, about the construction loan. I.e Funders, ought to be the one to hold a bit more power in it all, and not so much, the lenders, as happened in Ireland. The former government ministers in Ireland, was very careful, at the time of the crisis in 2008, 2009 etc, to stick to exact language. At any and every opportunity in the media, for government ministers in Ireland, castigated the banking and real estate industries in Ireland, for something they describe as reckless lending. And it shows really, how public relations, really works. Because after a while, even those who should no better, began using the vocabulary adopted by government ministers, to try to explain what happened during Ireland’s economic bubble. Very soon, the National Asset Management Agency, was established. It’s mandate and mission, was, you’ve guessed it, . . . to sell the loans. But the ‘NAMA’, as it is known in Ireland, doesn’t sell loans at all. Rather, it sells funds. The institutions which purchase the funds, from NAMA, are funds. They customers of NAMA, are not other banks. Banks create loans. Banks don’t create funds. Funders create funds, and buy or sell funds to one another. Banks, create, buy and sell loans, to one another. It is within their corporate mandate and mission statement, their charter and their license, to do so. The largest errors of financial management, that were committed by the two industries of real estate development and banking lending in Ireland, in the boom, were those mistakes, that happened firmly outside, of their charter. But as long, as everyone (including economists who write in Saturday’s Irish Times, it would appear), blame the Irish banking and commercial real estate industry, for lending, and not funding, then both of those industries are ‘home and dry’. They are prevented entirely, from owning their own particular slice of the total mistakes, committed in Ireland. Because all the experts, all the best and the brightest brains, said so. It makes one wonder, why someone along the line, didn’t pick up the ‘A, B, C’ guide to commercial real estate finance. Or even ask someone, other than an economist, to share their analysis. We know that those in banking and real estate industries, don’t need to be taught all of the above. What we don’t know, is the extent to which those who ‘try’ to regulate, know the same (or do not wish to know?). BOH. @ the Second I would say it is about the obligation on bankers to be prudent in lending, because they have (or should have) a duty in that regard. That’s such an old-fashioned word….. I would suggest that the distinction is easily established i.e. any bank that accepts “personal guarantees” as collateral is in the business of funding an activity – mainly construction – rather than lending against an arms length assessment of risk based on proper banking criteria. Of course, I await the definitive view of BOH. @thesecond I think the shorter BoH is that banks strayed into the roll of quasi-equity financiers in terms of their exposure to projects. Analogous to leveraged fund equity at that. It is often under-appreciated. @ ufc I think I get that. All the same in colloquial terms the Guvnor can be excused for describing it as “lending” to the property sector @UFC/the Second Irish banks strayed away from sensible senior lending structures in many ways, to mention but three: 1) Personal guarantees (and in a situation where banks had no sight on the true extent of a borrower’s debt stack this was effectively outsourcing the a key element of the credit analysis (i.e. the core competence of a bank) to the borrower) 2) Quasi equity financing – financing the riskiest slice of property transactions 3) Financing property development transactions without a credible off take covenant in place While I am keen to hear BOH’s thoughts on the lending/funding distinction, in my view item 3 above is closest to the banks accepting the “funding” risk, i.e being left with a completed building with no tenant in place. Re: Translation Sometimes, you get an instruction manual, which began in Mandarin, was made into Korean, ended up in Japanese, then into German, and somewhere along the way, via a Spanish translation, ends up written in English. It can happen. It’s happened here in Ireland, with policy making and banking resolution, unfortunately. There is a comment above, awaiting it’s moderation, but I could use this comment to bring up another point – and it has far less, to do with the notion of analyzing the financial wreckage of the past, to find answers, and it has an awful lot more to do, with the creation of policy making for industries like commercial real estate and banking in Ireland, in the immediate and near future. What we need in Ireland, to be honest, is a couple of dictionaries, to translate better between different languages, used by different disciplines. There is a translation needed between real estate finance lingo, and economics lingo. There is also a translation needed between what lawyers call things, and what they actually are, in the world of real estate finance. The major problem is, is that in the height of the crisis periods, in Ireland, the language used by each discipline, gets bend-ed beyond it’s breaking point. And that ‘broken’ faulty language, then, wreaks havoc when it is used for future policy making efforts, in Ireland. Simply put, commercial real estate finance, is part of the mechanism, that is used to generate the ‘supply’, which is the term, which economists use. Remember that. On the demand side, in economics linguistics, it equates to things like residential real estate finance (home owner borrowing), on the real estate linguistic side. Then, to make matters even more confusing, banking started to do funding, or projects (and entire portfolios of real estate projects/assets/land), and call it lending. Lending, being the term adopted by lawyers in Ireland, who were racing ahead, trying to write into legislation, a national ‘bad bank’ institution, to accept all of the busted ‘funds’, which the banks had tried to carry on the ASSET SIDE, of their balance sheets. Note: Irish banks, had funding, from creditors on one side of their balance sheets, whilst they were giving out funding, to their debtors, on the other side of the balance sheet. Irish banks, had not one, BUT TWO, gigantic funding operations happening, at the same time, within the same institutions. When economists come along in Ireland in 2015, and talk about generating supply (adopting their lingo, for a moment), they seem to care less, that such supply is going to be generated using a defective real estate financing structure. We don’t have a tradition of good funding institutions, moving into Irish real estate, owning it and managing it over its life time, it would appear from my investigation. That’s a whole big subject, over what had happened there. The ownership of items of commercial real estate, doesn’t have to be clear cut either. There could of course, be a pension fund that owns a part share holding of an office park, or shopping center. There could be a REIT, which owns another part, and a private equity fund, leveraged or otherwise, which comes it too. Think of it, like in terms of the ‘debate’ about ownership stakes of Ireland’s national airline, at the moment. Here is the real, real, real problem. Irish economics is an orthodoxy, which really knows no opposition, in the current public debate. I’m not saying that Irish economists are wrong in anything, that they say, . . . but their lack of experience, at the level of ‘commerce’, prevents those Irish academic economists from perceiving whole chunks of the real narrative. Which in turn leads Irish economists, to construct very well thought-out, and impressive policy for industries like real estate, but mix up the cake, all the wrong way. They leave out the eggs, the sugar or the sultanas, whatever. Having worked very hard on the ‘cake’, something big, ends up getting missed. And the tragedy is, no one calls them up, because the Irish economics profession, knows no real formidable ‘opposition’, to it. Irish economists are never happier (and neither are they alone, in that company), than when they are diagnosing problems, as a lack of supply, and going on television, telling us about this diagnosis. The reason, that I have rattled on, to the extent that I have, about Irish ‘commercial’ real estate industry, is because it is the means, though which this supply, which economists love to rattle on about, is created. Residential real estate, is about the demand, side of that equation. Probably Irish economists, have got a better handle on that side of the ball game. What we have been doing in Ireland, for several decades now (and the Irish economics profession, is just as bad in this, is to try to generate supply, into the Irish real estate markets, of various flavors, by creating policy, that helps the bank (lenders), to stray far beyond their mandates, into what a commentator has described above, as leveraged fund equity behavior. And this is how, the Irish economy, continually gets smashed, and broken, and busted. The broken language of policy making, that was needed, to accelerate things like asset resolution corporations through legislation, in the crisis, then gets carried forward, and total pollutes, the language and the conversation, which ends up becoming brand new policy! Economists, understand supply and demand. What they don’t seem to understand, is to generate supply, in a way, that is safe for Ireland’s economy. The economists, do seem to be able to work well on policy for the demand, side of the equation, but not the supply one. As a commentator above states, it is too often, under-appreciated. BOH. Re: Funding or Lending Instead of waiting for the above comment, to appear, I will carry on the train of this argument here. There is one thesis, which in Ireland should be proposed, in the wider debate, in Ireland, to do with the question: what did happen, which directly led in to a spectacular economic crash? The question can be stated, why does one require three parties in commercial real estate enterprise (i.e. generation of this much needed supply), at all? Why not, continue to operate with the two-party, commercial real estate model, which Ireland had used to an overwhelming extent, prior to its real estate crash. One possible reason, is perhaps, we should avoid practices, that occurred before the crash. But let’s, attempt to dig a little further than that. What we do witness, in Ireland, after the crash, are the granting of additional capabilities, under legislation, to entities that are called banks, whom are called ‘lenders’, to the Irish economy. You see it, in relation to the bank, in Ireland, and its relationship with residential mortgagee debtors. What one also has to realize, is that on the scale of commercial, real estate lending practice, that entities known as lenders, suppliers of ‘credit’, into the Irish economy, are similarly equipped with tools, to administer the relationship between the lender, and the commercial real estate ‘developer’ debtor. It is the lender, who is equipped, not the FUNDER, under Irish law, to cope with eminent default, or distress, which may be experienced by a real estate development company, in the course of its trading. A funding, organisation, though key to how commercial real estate works, and how supply, of product, may be generated, is not equipped with the tools, to exercise needed influence over a real estate development company, which say, . . . for the sake of argument, . . . decided to take a sabbatical, right in the middle of an important real estate construction schedule/program. It could happen. It does happen, unfortunately, as strange as it may sound. It’s a pure risk management, enhancement, that roles of funding, and lending, have to be more clearly distinguished from each other, . . in the endeavour, to create supply, which economists and so many others, . . . would love to have, to have a less dysfunctional operation, of a wider Irish ‘market’, in real estate product. BOH. Re: Simply put, the role of a funder Having established above, in the initial part of the ‘proof’, of a need for three, instead of only two, distinct parties in the operation of an industry, such as commercial real estate, to guarantee a safe supply of product, on time and on schedule, to a market, we will discuss briefly, the funding organisation, and its role in the ecosystem. The funder’s main function, is to ‘drive’ the finished product, off of the salesroom forecourt, just like a person would do purchasing a vehicle (new, or otherwise). The funder, generally speaking, is much better equipped, (that is the key word), to drive, the finished real estate product over the course of it’s useful life span – with all of the warranty, etc, which it needed to be granted from the real estate development company (and in turn from statutory regulation enforcement agencies), in order to do so. This is why, I go to lengths here, to emphasize the primary importance of the commercial real estate developer, and funding organisation, relationship, . . . well over and above, that relationship that may have to be managed, . . . between a developer, and a lender, in commercial real estate (supply generation side), enterprise and activity. Generally speaking, we can observe, that while the lender,may be equipped to handle a relationship with a troublesome, or not troublesome borrower, . . . the lending institution, is no where near well equipped, to drive the finished commercial real estate project, over longer distances. Securitization, or unit-ization, as it is sometimes called in commercial real estate, does present lending institutions, with some opportunities to ‘fund’ projects, as well as ‘lend’ to them. That is securitization, undertaken by banks in Ireland in commercial real estate, may have offered more alternatives in addition to that of going through traditional funders. But as successful as one may hope the securitization, of Irish commercial real estate to become, one can also conclude that it can never be, the entire picture. The simple fact is, is that commercial real estate (supply of real estate product, of whatever variety), has to be funded, before you can safely lend to the same. Irish commercial real estate securitization may offer a benefit, to gain some additional acceleration, in the process of delivering supply, straight off the blocks, when one is behind in the race. But it was never a silver bullet, . . . and probably, even did harm, it that it has helped to further obscure a helpful distinction between funding as an activity, and that of lending, in Irish real estate. BOH. Re: Filling in the gaps @ All, I’ll now allow all of you, to paint in the remainder of the picture, for yourselves. But you have to, at some point, in an analysis of the real estate lending, bubble in Ireland in the 2000’s, bring into that narrative, the conditions in regards to interest rates, that were present and effective during that time. You could understand, that in normal times, that it might be easier to distinguish between activities that are lending, as against funding, in the business of banking. Because interest rates of funding, is so much lower than that of lending (the funding taking over, from the lending, once the completed real estate project, begins to generate income of some kind). But because interest rates in the Irish real estate boom, were so low, right across the board, one could see, how the margin of interest rate between activities such as lending, or funding, became more difficult to distinguish. And this is how managers, who didn’t have a deep understanding, and overview of what they were doing, and be able to separate out different financial intermediation activities, from first principles, could no longer distinguish them. It’s a side effect of a low interest rate environment, like those which Paul Krugman talks about, in relation to monetary policy for example, which starts to have real consequence for finance (of which real estate, just happens to be a large consumer, during bubbles), and for economics. As if you do have questions, but I think you can begin to use your own imagination, training and knowledge, to paint in a lot of additional detail into the above. BOH. Comments are closed.