Saturday, 26 July 2014

Economic myths: Building more houses will bring down prices, part the umpteenth.

In my local town there is a quite pleasant development of flats with a good view of a spectacular castle, even if the castle does tend to shade the flats somewhat. They are right by the water in the centre of town and even have parking available, after a fashion, yet the majority are unsold. The law of supply and demand says that since the demand is not there, the price will fall until the flats reach a price where the demand is there and they sell. This has not happened.

Today, as I was strolling past the flats along the river, it occurred to me that one reason why so many of the flats are still empty could be that the developer borrowed heavily to finance the development and that the loan is secured against the value of the flats. Reducing a single unsold flat reduces the value of all the unsold flats and thus reduces the value of the collateral against which the money has been borrowed.

In these days, it is "cheaper" to go on paying the interest on the loan than it is to devalue the collateral by reducing the value of the flats, plus there is always the chance that land prices will start to go up again and the flats will sell. Added to which, if the reduced collateral puts the borrower in negative equity, the lender will get nervous that the borrower will simply go bust and so will try and get their money back early, which the developer equally doesn't want.


paulc156 said...

This is similar to the story I heard some time back that shops on the high street often sit empty for extended periods rather than getting tenants in on a reduced rent, for the reason that it would imply a lower yield [say 9K a year instead of 12] which in turn would imply a lower value for the property [25% lower]. Those properties that were part of larger chains would then have to face up to reality and reduce the value of their property holdings as stated on their books and the implications that that would entail made it easier to simply leave the properties empty and suffer the loss in income.

Lola said...

B & P156. E.G. Pubcos.

Mark Wadsworth said...

Yes, the way the system works is that "developers" are actually encouraged to be highly leveraged land speculators, so their whole business model is a delicately balanced house of cards which depends on finding a greater fool.

Lola said...

MW. Yup. It's the same corrupt nexus of banking / government / Financial regyewlayshuns that drives all levels of speculation throughout the economy. Developers and banks are not naturally corrupt

Lola said...
This comment has been removed by the author.
Blissex said...

«the developer borrowed heavily to finance the development and that the loan is secured against the value of the flats. Reducing a single unsold flat reduces the value of all the unsold flats and thus reduces the value of the collateral against which the money has been borrowed.»

That is part of what I call the "debt-collateral spiral" which has been since Thatcher and Reagan the favourite economic policy of anglo-american central banks and governments.

Boosting asset prices generates tax-free (or very low tax) capital gains for the vested interests that sponsor right-wing parties, and the way to boost them in what is claimed is a totally safe way is to lend buyers of assets the money to buy the assets using the asset itself being bought as collateral. A form of vendor financing in effect.

A bit like Tom and Dick owning bicycles they bought for £50, but that they both value at £400,000, and Harry being their friendly bank manager. Dick buys Tom's bicycle for £400,000 with a loan from Harry collateralized by the £400,000 bicycle, and Tom buys Dick's bicycle in the same way. Now both Tom and Dick have bicycles with a market price of £400,000 each, plus each has now £400,000 in cash, and Harry has given himself a huge bonus for having sold £800,000 worth of loans which are entirely safe because they are collateralized by assets worth £800,000.

At this point, given how easily the bicycles sold for £400,000 and the huge profit they made selling them, and thebease with which they could cash the profit, both Tom and Dick put on sale their bicycles at £500,000 to each other and both each other's bicycle at the new valuation, both netting a £100,000 capital gain, and both remortgage their bicycles from Harry getting an extra £100,000 cash each. Harry gives himself another bonus for having sold and extra £200,000 of loans, and is sure that the outstanding loans of £1,000,000 are fully collateralized by 2 assets worth £500,000 each because that was the last recorded mark-to-market price.

In any case the Bank of England guarantees the loans too, because Harry's lending business is too big to fail.

Financing purchases of assets using as collateral the assets themselves is claimed to be totally safe as it has a truly stupendous advantage: when buyers given easy financing collateralized by the asset itself bid the asset price higher, its value as collateral is also implicitly pushed higher, so there is never a gap between the price of a the asset and its valuation as collateral for the loan used to pay that price.

Therefore a beautiful debt-collateral spiral soars into ever greater asset prices: more debt-financed purchases push up asset prices, but higher asset prices are also higher collateral valuations, so more debt can be collateralized by the same assets.

«In these days, it is "cheaper" to go on paying the interest on the loan than it is to devalue the collateral by reducing the value of the flats»

That's why interest rates are kept so low: because if borrowers could not afford to pay interest, they would have to sell the assets, this would push down their valuations as collateral, and all the banks that have lent against those collateral valuations would then go bankrupt, collapsing the entire financial system, not just Northern Rock, RBS etc., as well as 50% of voters.

The debt-collateral spiral can only go forward, never backwards.

Mark Wadsworth said...

Blissex, I agree to all that apart from the second to last paragraph.

The Homeys pretend that everybody's livelihood depends on house prices going up and staying up, but it is simply not true.

The whole bubble could be unpicked and reversed in exactly the same way as it arose (only in the other direction).

And nearly all of us would be much better off after doing it.

Bayard said...

Back in the late '80s several scamsters made small fortunes out of this process. Mr A would set up a false identity, and borrow, say, £200,000 to buy a large house. This he would then sell for £250,000 to Mr B (also a false identity), who would borrow the money to buy it. Messrs A & B would then disappear, never to be seen again, leaving the bank with a repossessed house worth £200,000 to set against a loan of £250,000.

Roger said...

Surely hope - or expectation - come into this. Your developer expects capital values to go up sometime and will not crystallise a loss. But suppose houses were build on a big scale - big enough to make a dent in the huge pent up demand. Then your developer would be confounded and see capital values go down. But so would everybody else, those without mortgages or with small mortgages might ride the apparent loss but recent buyers would face big problems. Worse, there would be political fallout and the banks would see balance sheets damaged, the British wealth illusion would be over, the Treasury would be frightfully alarmed but as you say after the pain we as a nation we would probably be better off and a rather different country. But as things stand Generation Rent is paying a huge tax to keep the illusion going - until things change.

DBC Reed said...

I very much admire the skill of Blissex's explanation and agree with all of it including the paragraph Mark disagrees with.
Collapsing the debt collateral vortex is likely to leave the banks with big voids where their mortgage collateral used to be and is going to skewer all the Homeownerist cannon fodder with negative equity .That is the argument Martin Wolf makes re LVT
every time he recommends it (not in quite such bitter terms but the same substance ).
As land taxers we should be wary of being put on the hook for threatening another collapse of the global economy (it would not be our fault but look how Gordon Brown and the Labour Party got the Goebels' big lie treatment of causing the 2008 crash pinned on them!)
This is why I favour the from-here-on version of LVT ,drawing a line at today's valuations and taxing future land price inflation over a year not digging into existing values and collateralised valuations.
I would point out in my own defence that not only Martin Wolf but Merryn Somerset Webb of Moneyweek follow this from-here -on only line, the latter in response to a letter I wrote in the FT ( they don't all disappear without trace)

L fairfax said...

But if you have enough developments like that (as in Spain) then they all go bust as they cannot afford to pay the interest (they can't sell so many flats) and prices crash.

Lola said...


Nice analysis. Saved me the bother. But I agree with MW it is perfectly possible to unprick this bubble without causing a whole load of grief, broadly because there are lots of people (like me!!!) who don't have a mortgage. And even for those that do who'd be in neg. eq. MW has posited a way round it that I cannot for the nonce recall.

Ben Jamin' said...

@DBC Reed

LVT is a means to an end. That being economic justice.

If we'd applied the "here on" approach to the abolition slavery, we'd still be living in a not very nice place.

If the our financial system relies on non-productive assets i.e immoral earnings to exist, the quicker it implodes the better.

Then they can go back to adding value, instead of parasiting on it.

Bayard said...

"This is why I favour the from-here-on version of LVT ,drawing a line at today's valuations and taxing future land price inflation over a year"

If you take that approach at the top of the market (which is where we are now), then the tax will raise bugger all, as interest rates rise, prices decline and there is no gain to tax.

Mark Wadsworth said...

DBC, negative equity is purely a psychological thing.

So a plan would be e,g, for example, write off all the mortgage debt that is in excess of values so that nobody is in nequity.

But if they could afford £150,000 mortgage at 4% they can afford a £100,000 mortgage at 6%. So in exchange for mortgage write down, they pay a higher interest rate.

And if "savers" end up losing some of their deposits in the radical debt for equity swap (shareholders and bondholders being wiped out first), then at least they are getting a higher interest rate (higher than RPI or CPI inflation).

So everybody wins, and people with a "balanced portfolio" will make gains on their non-banking shares and bonds more than equal to their losses on banking shares and bonds.

Senior bankers meanwhile can be sent to prison or into exile until they repay all their bonuses.

Job done.

Bayard said...

"DBC, negative equity is purely a psychological thing."

Quite, it hurts the lenders far more than it hurts the borrowers, but the Banks don't want you to think that, in case you move out to an undisclosed location and post them the keys. It's not the cannon fodder who will be skewered, it will be the elite.

DBC Reed said...

Not sure I get the slavery analogy: slavery was not ended by punitive taxation. In fact Brit slaveowners were compensated by the taxpayers for the loss of their productive assets post 1833 to the sum of circa £1.7 trillion (current values; £20 million then) by my shaky estimate.Slaves were speedily replaced in the Caribbean by Indian indentured labourers who were sold into slavery for set periods of time.The "apprentices" in "The Mill" at Quarry Bank on telly were not paid hence were slave child labourers.Slavery was not so much abolished as bribed out of sight.
@B The from here-on tax may very well not take in any money.This is a virtue in my opinion.I can never understand some land taxers' enthusiasm for taking people out of income tax and simultaneously requiring them to pay an equivalent amount of LVT. This is not a selling point.
As I have said before it would be better if government spending came from, not tax reform but monetary reform, as adumbrated by Positive Money; let the gov create money instead of the banks
and spend it into existence.

Ben Jamin' said...

@ DBC reed.

The privatisation of land rent is economic slavery.

At the heart of both issues is one of property rights.

Bayard said...

"The from here-on tax may very well not take in any money."

Well, what would be the point of it then? If it is designed to act as a damper to house price fluctuations, then it still needs to be introduced mid cycle, not at the top. As an example, think how useless the dampers (shock absorbers) on your car suspension would be if they only controlled downward movement of the wheel from the rest position.

DBC Reed said...

It would not take in very much money if land prices remained steady.But that's a virtue in itself.If production increased and the economy grew while land prices remained pegged we would be doing pretty well.
( In addition smart money would quit speculative land holding because of its nill yield. With the datum line re-set year on year it would become a downward ratchet with a negative compound interest).
It is also the only form of LVT that stands any chance electorally
though Mark's method is very feasible.
I admit that it is pretty much an anti land price inflation measure but that's not to be sniffed at in the present permacrisis.
@BJ of course . Its the solution that's the problem to both forms of enslavement . Silvio Gesell believed in the land reform / monetary reform route. He would nationalise all land and compensate the landowners the way the slave owners were compensated. But not with taxpayers' money. I believe (I am talking from memory) he would compensate the former landowners with par bonds which would have a yield from the rent that he charged the new land users.Then by raising the rents somewhat he could buy out the bondholders.Somehow ??
Its actually his velocity money system that's very interesting. Keynes thought so and ripped it off comprehensively as he acknowledges in his General Theory.