Modernizing real estate finance
I believe that real estate finance today is where corporate finance was a hundred years ago, and the current global financial turmoil is the beginning of its transformation into something similar to modern corporate finance. About a century ago, corporate finance adopted its modern form where equity is owned by large diversified pools of capital with low levels of leverage. Real estate as an asset class is of the same size as the equity market, but it is still dominated by small undiversified owners with large amounts of leverage.
Most houses are owned by individuals who finance them with mortgage debt. A high quality mortgage might have a loan to value ratio of 80% while very few modern businesses are run with 80% debt to total capitalization. In lower quality mortgages, the loan to value ratio could be in excess of 90%. This is a prescription for financial fragility. While modern economies can easily absorb the stock market dropping by 50% in a year, their financial systems are devastated by even a 20% drop in real estate prices.
This is also a problem from the investor view point. Since real estate is as large an asset class as equities, an institutional investment portfolio should ideally have a large holding of real estate, but this cannot be achieved because ownership interests in real estate are not available in sufficient quantity (see for example, Hoesli, Lekander and Witkiewicz, “Real Estate in the Institutional Portfolio: A Comparison of Suggested and Actual Weights”, Journal of Alternative Investments, Winter 2003.) Almost all real estate is user owned and therefore the only exposure that you can buy to real estate in the financial markets is mortgage debt (residential or commercial).
Corporate finance was also like this centuries ago. Bond markets existed long before stock markets, and for the first couple of centuries of their existence, stock exchanges like the London Stock Exchange traded bonds more than stocks. Apart from their own money and that of their friends, businessmen had to rely largely on debt to finance their businesses. But all this changed in the late nineteenth century as Mitchell has described in his fascinating book The Speculation Economy: How Finance Triumphed Over Industry, BK Currents, 2007. The joint stock corporation meant that anybody anywhere in the world could own a piece of any business.
The equivalent transformation in real estate has yet to happen. For most individuals today, their home is the most undiversified investment that they have (even more undiversified than their human capital), and it is a heavily levered investment. If an individual were to buy shares worth several times his annual income on margin, we would doubt his sanity. But when he does the same thing in real estate, governments encourage the imprudence by giving generous tax breaks.
This fragile financial structure where everybody buys real estate on margin with a downpayment of only 10% or 20% is a prescription for huge systemic risk. By contrast, in the equity market, pension funds and mutual funds have negligible levels of leverage; very few individuals buy stock on margin; and corporate investments in stocks (strategic investments) are also financed with relatively low levels of debt.
The fragility of real estate finance is less of a problem so long as people irrationally keep paying mortgages even when they have negative equity in their homes. Standard valuation models of mortgage securities (whether it is prepayment modelling or default modelling) assume that the home owner is irrational and will neither exercise the prepayment option (call option) optimally nor exercise the default option (put option) optimally. As financial systems get more sophisticated, these assumptions are bound to be falsified. As this happens and jingle-mail becomes more prevalent, the business of selling near money put options on real estate (which is what mortgages are all about) is bound to be less and less viable.
In the period of transition, large portions of the financial system will doubtless lose much of their capital. This is what one is seeing in the global financial turmoil. It is a necessary part of the process of creative destruction through which hopefully real estate finance will be transformed just as corporate finance was transformed a century ago.
Posted at 6:13 pm IST on Fri, 11 Apr 2008 permanent link
Categories: crisis
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