Real Estate Booms and Banking Busts: An International Perspective

Real estate cycles and banking cycles may occur independently but they are correlated in a remarkable number of instances ranging over a wide variety of institutional arrangements, in both advanced industrial nations and emerging economies. During the recent Asian financial crisis, the most seriously affected countries first experienced a collapse in property prices and a weakening of the banking systems before experiencing their exchange rate crises. Countries where banks play a more dominant role in real estate markets and hold a greater percentage of assets are the most severely affected during such a crisis. In this paper, the authors develop an explanation of how real estate cycles and banking crises are related and why they occur. The authors first discuss how real estate prices are determined and why they are so vulnerable to deviations from long-run equilibrium prices, paying special attention to the role of the banking system in determining prices. Increases in the price of real estate may increase the economic value of bank capital to the extent that banks own real estate. This then increases the value of loans collateralized by real estate and may lead to a decline in the perceived risk of real estate lending. For these reasons, an increase in real estate prices may increase the supply of credit to the real estate industry which is then likely to lead to further increases in real estate prices. The opposite is also true. A decline in the price of real estate will decrease bank capital by reducing the value of the bank's own real estate assets as well as reduce the value of loans collateralized by real estate. This may lead to defaults, thus further reducing capital. A decline in the price of real estate is also likely to increase the perceived risk in real estate lending. All of these factors reduce the supply of credit to the real estate industry. Supervisors and regulators may also react to the resulting weakening of bank capital positions by increasing capital requirements and instituting stricter rules for classifying and provisioning against real estate assets, leading to even further decline in prices and supply of credit to the real estate industry. In order to explain how real estate cycles begin, the authors turn to a model of land prices developed by Mark Carey that details the role of optimists in the process. They then bring in the role of non-financial variables as well as of banks and then turn to the part played by "disaster myopia" -- the tendency over time to underestimate the probability of low-frequency shocks -- in determining cycles. Other factors that contribute to cycles are inadequate data and weak analysis by bank managers as well as "perverse incentives" -- one result of "disaster myopia" that occurs when lenders believe that they can accept higher loan-to-value rations, weaker commitments or guarantees and looser loan covenants without increasing their risk of loss. Using this framework of the interactions between the real estate market and bank behavior, the authors interpret recent examples of real estate booms linked to banking crises in Sweden, the United States, Japan and Thailand. They then discuss measures that can be taken to limit the amplitude of real estate cycles and ways to insulate the banking system from real estate cycles. They believe that the heart of the problem is the structure of the real estate market and that cycles can be avoided by taking measures that counter: The bias towards optimism; Excessive leverage; Disaster myopia; Inadequate data and weak analysis; Perverse incentives. The authors detail their recommendations for avoiding these problems in the future. These include the development of an options market for commercial real estate, greater reliance on equity financing, changes in supervisory policy that allow the identification of vulnerable banks before they become weak banks, better publication of information relevant to the valuation of commercial real estate projects, and refraining from providing full protection to all bank creditors, especially sophisticated creditors such as corporations, banks, and institutional investors.

The housing finance revolution

Housing ; Housing - Prices ; Mortgages

Panel Data Unit Roots Tests: The Role of Serial Correlation and the Time Dimension

We investigate the influence of residual serial correlation and of the time dimension on statistical inference for a unit root in dynamic longitudinal data, known as panel data in econometrics. To this end, we introduce two test statistics based on method of moments estimators. The first is based on the generalised method of moments estimators, while the second is based on the instrumental variables estimator. Analytical results for the IV based test in a simplified setting show that (i) large time dimension panel unit root tests will suffer from serious size distortions in finite samples, even for samples that would normally be considered large in practice, and (ii) negative serial correlation in the error terms of the panel reduces the power of the unit root tests, possibly up to a point where the test becomes biased. However, near the unit root the test is shown to have power against a wide range of alternatives. These findings are confirmed in a more general set-up through a series of Monte Carlo experiments.Dynamic longitudinal (panel) data, Generalized method of moments, Instrumental variables, Unit roots, Moving average errors

Misaligned Incentives and Mortgage Lending in Asia

This paper provides a conceptual basis for the price discovery potential for tradable market instruments and specifically the development of mortgage securitization in Asia and the potential dangers of such markets. Nonetheless we argue for the potential importance of securitization in Asia because of its possible role in increasing transparency of the financial sector of Asian economies. We put forth a model explaining how misaligned incentives can lead to bank generated real estate crashes and macroeconomic instability, with or without securitization under certain circumstances. We examine the banking sectors performance in Asia compared to securitized real estate returns, to provide evidence on the contribution of misaligned incentives in the past. We discuss how the addition of liquid MBS could help to inoculate markets from the shocks arising from bank-financed mortgage lending. We conclude with a brief discussion of current MBS markets in Asia.tradable market instruments, price discovery, mortgage securitization, dangers, Transparency, MBS markets

Corporate Policy and the Coherence of Delaware Takeover Law

This Article presents a model that can be used to explain key elements of Delaware takeover law. By incorporating corporate policy as a key variable in the model, Delaware law’s management discretion rule can be shown to be best suited for maximizing the value of the corporation and the shareholders’ interest under a set of reasonable assumptions. By allowing for occasional market mispricing and the agency costs associated with managing to the market, we demonstrate that a shareholder choice regime would likely lead to suboptimal investment decisions. In our model, managers are assumed to have better information regarding alternative corporate policies than shareholders but may, in certain circumstances, act to maximize share price in order to insulate themselves from hostile tender offers, even at the expense of maximizing firm value. This theory explains the result in Paramount v. Time, and also why shareholder choice is allowed in limited instances that implicate Revlon duties such as Interco and Paramount v. QVC

Why Defer to Managers? A Strong-Form Efficiency Model

We compare the efficiency with which management discretion and shareholder choice regulate hostile tender offers. This is the first paper in a long running debate that rigorously compares these legal rules to analyze both the critical informational assumptions and the interplay of those assumptions with principles of financial market efficiency. A critical innovation of our model is its focus on an informed management’s choice among alternative corporate policies under the protection of the business judgment rule, but where agency costs exist. We assume that corporate assets and reinvestment opportunities are efficiently priced by financial markets, but that markets never learn the value of foregone investments. In this case, shareholder choice may create an agency problem whereby managers forego positive net present value investments that increase the risk of a hostile bid. We are able to determine analytic conditions under which the expected cost of this agency problem exceeds that of the standard agency problem usually identified with management discretion

The American Mortgage in Historical and International Context

Home mortgages have loomed continually larger in the financial situation of American households. In 1949, mortgage debt was equal to 20 percent of total household income; by 1979, it had risen to 46 percent of income; by 2001, 73 percent of income (Bernstein, Boushey and Mishel, 2003). Similarly, mortgage debt was 15 percent of household assets in 1949, but rose to 28 percent of household assets by 1979 and 41 percent of household assets by 2001. This enormous growth of American home mortgages, as shown in Figure 1 (as a percentage of GDP), has been accompanied by a transformation in their form such that American mortgages are now distinctively different from mortgages in the rest of the world. In addition, the growth in mortgage debt outstanding in the United States has closely tracked the mortgage market’s increased reliance on securitization (Cho, 2004). The structure of the modern American mortgage has evolved over time. We begin by describing this historical evolution. The U.S. mortgage before the 1930s would be nearly unrecognizable today: it featured variable interest rates, high down payments and short maturities. Before the Great Depression, homeowners typically renegotiated their loans every year. We next compare the form of U.S. home mortgages today with those in other countries. The U.S. mortgage provides many more options to borrowers than are commonly provided elsewhere: American homebuyers can choose whether to pay a fixed or floating rate of interest; they can lock in their interest rate in between the time they apply for the mortgage and the time they purchase their house; they can choose the time at which the mortgage rate resets; they can choose the term and the amortization period; they can prepay freely; and they can generally borrow against home equity freely. They can also obtain home mortgages at attractive terms with very low down payments. We discuss the nature of the U.S. government intervention in home mortgage markets that has led to the specific choices available to American homebuyers. We believe that the unique characteristics of the U.S. mortgage provide substantial benefits for American homeowners and the overall stability of the economy