Monday, 20 May 2013

The Great Property Market Conspiracy – A €55 Trillion Plus Problem! - Part 2

In recent days, Germany's Commerzbank has had to go to the markets to sell around €3.5 billion of additional shares to try to bolster its capital position. Its shares have already fallen by almost 40% over the last few months, and this share offering was put out, with a further discount of around 40%. But, the real fears surround Deutsche Bank. It is Germany's largest, private financial institution. The problem facing all of these banks now is not their speculative positions in gold, but their speculative positions in property! That applies at least as much to banks in France and Germany, and other Northern European economies, where a large rental sector means they have not suffered from house price bubbles, as it does to the southern periphery and UK, where they have.

In the UK, the latest casualty appears to be the Co-op Bank. It is not known for its recklessness and speculative activity, but a couple of years ago it merged with Britannia Building Society. The Britannia, like all other such institutions seems to have got carried away with the housing bubble. Just as years of falling gold prices led banks to believe that it was a forever one way bet, so years of rising house prices, as the bubble continued to inflate, seems to have convinced them that this was a one way bet too. Like the US mortgage lenders, like Northern Rock, and a multitude of other banks and financial institutions who thought they could lend out to people who might not pay back, because the value of the property, they were lending against, would always go up, so it seems, the Britannia has found itself with a lot of bad mortgage debt, on its books, debt the Co-op has now inherited.

But, these problems are dwarfed by the potential problems that could imminently manifest themselves amongst the bigger banks. The big UK banks, face the prospect that over 1 million people have borrowed from them, for property, but have no means of repaying the capital sum of their mortgages. Twenty or thirty years ago, that would be no problem. The bank would repossess the house, and invariably be able to sell it for more than the debt. But, today, outside London, house prices are falling by the week. Selling prices are around 30-40% below initial asking prices, and houses are staying unsold on the market for a year or more. Yet, even so, as unemployment rises, and real wages get hammered, even fewer people can afford to buy, and those who already have, hang on by their finger nails, only because of unsustainably low interest rates, and rising levels of other debt to cover their weekly spending. Osbourne's proposals will only worsen that situation, encouraging even more debt, but doing nothing to enable people to pay it back.

In fact, in Stoke, the Council has put up 35 houses for sale at just £1, and yet still couldn't get interest in eight of them!!! Under those conditions, its no wonder the banks are avoiding having to repossess properties, because to do so would mean not only that they would get back no monthly payments at all, but they would face having to sell these properties at prices way below the debt outstanding. That is if they could sell them at all!!! Instead the banks have engaged in a policy of “extend and pretend”.

But, as stated above, Deutsche Bank demonstrates the sheer scale of this problem, and why Governments and Central Banks are desperate to paper over the cracks, and stop the flood waters rushing in. German Banks, including Deutsche Bank, lent to other banks across Europe, including those in Greece, Ireland, Spain, Portugal and Italy. Those banks, in turn, engaged in a frenzy of reckless lending, to finance mortgages and to finance construction, that inflated a massive property bubble. In Ireland, that bubble burst and crashed the banks. Rather than let those foreign banks, finance houses, and investors pick up the tab, which is what Iceland did, Ireland, instead bailed out the banks with taxpayers money, thereby protecting all of those financiers and foreign banks. It then started to recoup that hole in its finances by massive cuts in state spending.

In Greece, a policy was adopted over several years, of letting those banks and finance houses get rid of their holdings of Greek debt, much of it bought up by the ECB and by the national central banks. One casualty of that seems to have been Cyprus, whose banks took a massive haircut on their Greek debt holdings. But, those European banks still hold vast amounts of debt in interlinked holdings that ultimately rests upon property that is effectively worthless across southern Europe, but which is still listed, on banks' balance sheets, at its bubble prices from several years ago. A good example is Spain where every month, now, banks hold “bank sales” of property, with villas being sold off for as little as €20,000. The prices of property in general in Spain has fallen by around 50% from the peak, so that on a like for like basis, you could buy a house on the Costa Blanca, away from the sea, for about a third of what it would cost in North Staffordshire. Yet, many analysts believe that Spanish property prices need to fall by another 50% from here. That would mean a 75% drop from their highs, to match what happened in the US and Ireland. The latest figures from the Bank of Spain show that banks bad loans ratio continued to rise last month, yet this official figure of nearly 11%, massively understates the real situation.

The bank stress tests were supposed to cover this, and the new Basle III regulations were supposed to ensure that banks increased their capital to ensure they could cope with such bad property loans. The Co-ops' downgrade, by Moody's, and its need to add capital, and Commerzbank's share sale, are part of that process. Yet, Commerzbank's need to offer its, already depressed, shares at a 40% discount, shows the problem banks face in raising this capital. Italian banks faced a similar problem in recent months, having to offer them at similarly huge discounts.

In fact, this is just one element of the development I have referred to recently of the fall in the supply of capital relative to demand. The banks are in this position for specific reasons. From the onset of the Long Wave Winter around 1986-7, the global rate of profit began to rise. From the onset of the new boom in 1999, that rise in the rate of profit was accompanied by a rise in the global volume of surplus value. More surplus value was produced than could be productively consumed. Huge corporations accumulated it as money hoards on their balance sheets. States in various parts of the world that ran huge trade surpluses, as a result of it, accumulated huge sovereign wealth funds – massive money hoards that sought a home across the global economy. This massive pressure of money in the money market, found a home as the provision of credit to governments and individuals in the west, and forced down global interest rates. Western central banks, were thereby able to print masses of money tokens, and extend credit without causing inflation, because the other side of this process was the huge volume of additional, cheap commodities pumped into those western economies from China and elsewhere, which soaked up the additional money. In fact, the additional money printing avoided what otherwise would have been an inevitable deflation of commodity prices. Instead, it inflated all those prices of things that could not be imported cheaply from China – houses, shares, bonds.

But, now the global long wave Spring has turned to Summer. The rate of profit, will begin to fall. Yet, global firms will continue to need to invest. In fact, the causes of the fall in the rate of profit may mean they need to invest even more, in an attempt to raise productivity and maintain or increase market share. The demand for capital will continue to rise, whilst the supply of capital will fall. The consequence will be a secular rise in global interest rates. Central Banks can print money tokens, and credit, but they cannot print capital. As soon as interest rates begin to rise, then as Mervyn King said a few days ago, asset prices will fall. But, under such conditions, they never fall in an orderly manner – they crash. Printing more money under such conditions will only raise inflation, and push nominal interest rates even higher.

The problem seems to be such that the European banks are engaging in various manoeuvres to hide the amount of debt they actually hold, so as to avoid having to obtain additional capital, or to reduce how much they have to obtain. One of these is once again to utilise derivatives. The banks argue that this is all fine, because these derivatives are hedged. In other words, they have insurance that, if any contract goes bad, some other financial institution will compensate them. The means by which that occurs are complex, such as holding one instrument that will rise in value if another falls etc.

But, this was precisely the problem that arose with the credit crunch in 2008. It is the problem with counter party risk. Nobody knows who is likely to go bust, who is likely to pay up, or who is able to pay on any of these contracts should the need arise. But, once some big event occurs, it becomes apparent that the Emperor has no clothes. A claims from B, who can't pay, because they have claimed from C and D who could not pay, who in turn had claimed from A, who couldn't pay, because they were waiting to be paid by B. And ultimately, none of them could pay, because they had themselves borrowed and lent huge sums of money, to people who could not pay them back, to buy property, that had no real value, that was anything approaching what it had been sold for, and which, in a fire sale, was reduced to prices even below what it might reasonably have been worth!

Its reported that Deutsche Bank's total global exposure to derivatives is €55 Trillion!!! To put that in perspective, Germany's annual GDP is only €3 Trillion. That is an exposure equal to 20 times German GDP. By contrast, the Cyprus Banks assets were 8 times annual GDP. Deutsche Banks exposure to these derivatives is on the same scale as the Luxembourg banks ratio of assets to GDP, and Luxembourg is likely to be one of the next economies to go the way of Cyprus.

The only thing preventing this house of cards from collapsing is the ability of governments and central banks to keep these property bubbles inflated. That is why they are engaged in such a massive conspiracy to portray property markets as stable. In Britain, the Government has plenty of reason to do that. On the one hand the property bubble here has been inflated for more than 30 years, and is well beyond the point where it should have burst. On past experience of such crashes in Britain, that would mean prices falling by around 75-80%. That would also be a fall on a similar scale to those seen elsewhere in the last few years, but less than the 90% fall that happened after 1997 in Japan. British banks are some of the most indebted and exposed to this property debt, but also to the debts of other banks across Europe. Moreover, the Government's natural support comes from those middle class pensioners whose property has inflated grotesquely since the 1960's when many of them bought it, and who are deluded into believing that it in some way makes them better off, rather than the truth, which is that higher house prices, like higher prices for any other commodity, only impoverish workers.

The wholesale collapse of those prices in Spain and other parts of Europe, let alone in Britain, has not happened yet, but, just as it did in the US and Ireland, it most certainly will. Whether that happens because some crisis sparks a run on the banks, or because interest rates rise, as the supply of capital falls relative to demand, or the run on the banks is sparked by a collapse in those house prices is only a question of what comes first the chicken or the egg.

Back To Part 1


George Carty said...

Isn't property in Britain in short supply though (which is why the prices have stayed up) due to draconian planning restrictions, unlike in the United States, Ireland and Spain, where vast amounts of speculative construction caused oversupply and a price crash?

The only way to push prices down significantly would be to build roughly 500k new homes a year for a decade (increasing stock from 27 to 32 million), of which 70-80% would have to be social housing funded by government (or local government) borrowing. Don't hold your breath.

Despite populist gestures like Help to Buy, the future is therefore less about mortgages and more about outright ownership for both occupation and renting out, with homes becoming cherished legacies and mobility from renting to buying grinding to a near halt. The musical chairs of the last 30 years has now stopped, which is why the government is trying to jump-start the market with cheap loans. Another way of looking at this is that we're seeing a gradual unwinding of historic property debt, which is likely to last for at least another decade and possibly two. A large scale house building programme would jeopardise this orderly liquidation, so it is likely that supply will continue to be constrained in order to keep asset holders and developers happy (and we'll blame restrictive planning regulations instead). That does not look like much of a recovery.

From Arse To Elbow: Happy Days are Here Again

Boffy said...


There is no shortage of supply! I set out why some time ago here.

In 2009, when credit became hard to obtain, prices crashed by 20% overnight. Have houses suddenly become in short supply since then? No, clearly not, which is why outside London, prices are falling by around 30%, and why huge numbers of houses are remaining unsold for more than year.

David is wrong in his analysis about it needing 500k houses a year to send prices down. In 1990, prices fell by 40% within a few months. It certainly was not because the supply suddenly increased. The same is true in pretty much every other instance of a house price crash following a bubble.

The only one that doesn't follow that is probably the one that arose at the end of the 1940's. In 1947, when my dad came out of the army, like many other people at the time, he and my mum were desperate for somewhere to live. Eventually, they paid £1,000 for a terraced house. Could they have waited just over two years, they could have bought a new semi-detached house in the same village for just £250!!!

Its that kind of consequence that makes me very concerned that many people are being set up for a life time of debt that they will never escape from as prices crash.

In fact, there is 50% more housing provision per head of population today than there was in the 1970's. What, in fact has changed is that the structure of households has changed with more single people being convinced they should go into debt to buy their own house. It is really an increase in demand sparked by low interest rates and easy credit that is behind the speculation not shortage of supply.

In fact, private housebuilding is not much different than it has been historically. The difference in building is almost exclusively public, but public house building has been sporadic, historically.

Finally, its not particularly planning that restricts supply, by land hoarding. As house prices crash, land prices will crash too, and the hoarders will quickly turn in to anxious sellers.