The term hybrid government-private mortgage finance model is widely associated with the US agencies Fannie Mae and Freddie Mac. However, government support for mortgages is reaching beyond that specific form of credit provision and is not limited to the US.

Government actions also affected to the demand side of privately securitized mortgages in the US. The GSEs, as government sponsored entities, themselves invested in private label subprime MBS during the housing boom. Furthermore, state sponsored European banks, such as the German Landesbanks or Pfandbriefbanken were an important factor in the demand for those products.
In Europe it is widely common that state backed banks are directly providing mortgages to individuals. In Germany and France government guaranteed banks were an important element of the credit provision even before the crisis.
So the term hybrid government-private mortgage model needs not only to encompass the GSEs but also the direct supply of mortgages by government backed banks and their demand for privately issued MBS.

Increased role of governments in the mortgage markets a longer term story

While some people call the last twenty years the period of unfettered banking capitalism, it is also true that the involvement of governments increased in mortgage markets in the same period. In the figure below I plotted the evolution of the US residential mortgage outstanding categorized by two segments. In red you see the level of US residential mortgages outstanding that involve any sort of a government guarantee or ownership. These are predominantly mortgages being held on the balance sheet or being securitized by the GSEs or other near government bodies. The blue line shows the private mortgages outstanding.
You can see that the “government mortgages” gained already on importance during the 80ies, when their share (plotted in green) sharply increased to about 50% of mortgage outstanding. In the early nineties they overtook the private sector and then grew till 2004 about the same pace as the private mortgages.

The subprime bubble: not a story about the failure of  markets but of the hybrid model

Some might point out that just at the point when the share of private label mortgage markets increased and the agencies shares diminished (after 2004) mortgage origination standards broke down blaming that specific private market segment for the crisis. I would not refute that observation. LTVs increased after 2005 and appraisals became very often too optimistic. It is true that the market included some elements of greed or even fraud and certainly we had observed herding behavior of home-buyers, lenders and investors. Herding is one aspect of market failure, as – to put it in the terms of a behavior economist – market participants are not communicating via the channel of market prices but by direct interaction between each other. The latter is a thing that economist don’t like. In order to achieve the best aggregate result, market participants are supposed to act as individuals in the pursuit of their rational self-interest.

But there are several points to make with regards to my point that this was not just a typical private market failure but the involvement of governments in mortgage markets aggravated the weaknesses of private markets.
First, while the subprime securitization market was the vehicle that made the bubble to inflate, it was only the culmination of a trend that started long before: the provision of low cost mortgages that reduced the credit requirements for potential homeowners and led to continued growth of the mortgage universe. To put it into other words: It was a mortgage ponzi scheme. And a ponzi game sponsored by government agents. When half of the mortgages are guaranteed by the government you certainly cannot speak of a private market.

Second this market not only involved private players. Government bodies heavily participated in that boom. In a market with involvement of government the process of the pursuit of the rational self interest – that would lead to the rational market results- is skewed in the several ways. Look at some of the investors: Some managers of state backed European banks that invested in subprime a) were not qualified to judge the market in which they invested and only relied on ratings b) they benefited from low funding costs due to the state guarantees and c) were sheltered at home from competition and were not afraid from any consequences for their personal career, as these are safe government jobs…

When players in the market are not on the path of the rational pursuit of the self-interest one should not expect the rational market result. I am not ruling out that private investors haven’t acted irrationally. There were serious principal agent problems also on the private side. But as anecdotic evidence shows the state bank were the first to be rescued which suggest that such problems were more severe on this side. If you have not-informed investors on the one side and issuers and originators on the other side who anyway have an information advantage due to normal course of business the asymmetric information problems gets worse. As behavioral research shows you then don’t need the whole market but just a few to act irrationally and you can have a race to the bottom (in the sense of credit quality) and the bubble gets inflated.

Third, the indirect effect of the longer term commitment of governments to mortgage market might have also have increased the moral hazard on the side of market participants (This argument is just speculation from my side but as I believe an educated speculation). Consider two markets which both are labeled as MBS, one with government guarantees (though implicit) and the other without government guarantees. Just think out of the box about this point. What make a GSE securitized mortgage look different from a privately securitized mortgage? Sometimes the LTV and the credit quality of the borrower, but this does not necessary need to be so. But in my view the only big difference is the government support. So the conclusion from side of the investor that the government will also help in the private market and bail you out seems to be likely. A same reasoning can also applied to other markets in Europe where you have in the mortgage provision by private and government guaranteed banks as players. Whether a mortgage is provided by a government backed bank or a private institution does not matter much. The major takeaway for a speculative investor is that there is a government commitment for both and the government will come to help if something bad happens.

I am not making any judgments here whether this government involvement is good or bad. That would require a longer term cost benefit analysis that needs to compare that system with any feasible alternative. Here, I am only laying out the facts that A) when we talk about the present state of mortgage markets we are not talking about unfettered capitalism but a hybrid system that involves private and government players and B) the crisis was not the result of the failure of private markets but the failure of the hybrid private government mortgage finance model. Hybrid means that this system combines elements of private markets together with government guarantees and intervention. This can create at times an explosive amalgam, when the weaknesses of both systems reinforce. Herding and private market moral hazard can be amplified in the presence of government guarantees.

Here I am giving you an advance warning that some of the content will be politically biased. I personally endorse individual freedom rights and prefer systems and outcomes that are the result of voluntary interaction. Or put in another words: Variables of housing and mortgage markets – such as house prices, volume of home sales, construction numbers, mortgages approvals, mortgage conditions etc. – should in my view be the result of market forces rather than of actions to achieve politically desired outcomes. One could debate that there exist such a thing as a social desirable outcome. But even if you accept it as a goal, there are problems.  Actions that try to achieve new allocations on markets, often have unintended consequences. Just take the subprime debacle that can also be seen as a bad consequence of mixing social policy with finance.

When we look back at the history of housing and mortgage markets, the subprime mess was not an isolated case. The housing and mortgage market was never the thing that economist consider a free market. Since the dawn of human mankind real estate markets have been subject to constant interference by local chieftains, government administrators or elected officials. There are plenty of examples in our daily lives: You can start by how building permits are granted on the local level or highlight the fact that politicians appoint the CEOs of regional or state-led banks in order to influence the financing of their pet projects.

Whenever you as an economist try to analyze housing or mortgage markets you need to develop a judgment about the political dimension.  If you  want to forecast house prices in the US or some European countries in the current environment, you need to consider the effects of the different government programs and their exits. Some might counter that this is just because of the financial crisis and the consequence of reckless lending. But there is abundant evidence of market distortions created by intervention or guarantees before the financial crisis. Just to give one example: Even in the free market oriented USA in the 90ties around 50% of the residential mortgage outstanding was financed by some sort of government guarantees (most part was due to the GSE securitizations).

It seems that governments remain an important player in real estate and mortgage markets for the future, as there are misconceptions about the source of the financial crisis. Free market principles are blamed for causing the crisis. But looking at the boom years, there was not such a thing as a free market but a market that was subject to political goals and there existed a bunch of implicit and explicit guarantees. I try to emphasize in subsequent contributions that there are better alternatives to this hybrid type government-private real estate funding model.

Last week’s special report in The Economist described how the structure of the US economy has started to shift away from consumption and debt towards manufacturing and exports. That excellent report laid out the current structural shifts in the US economy, like the implications from the reversal of the regulators attitudes towards credit card debt, regions that might benefit from new technologies (like Pennsylvania from shale gas) or the necessity for American manufacturers to look abroad for opportunities. Such changes are also taking place in the European economies. Countries in Latin Europe (mainly Spain, Portugal and Italy) that built their economic model around an extraordinary large housing and consumption sector are realizing that they need to tackle issues of fiscal austerity, productivity and to foster innovation. At the other end a competitive, strong export oriented German manufacturing sector is also hit by the weakness of those consumer economies and needs to find new markets or create a higher domestic demand. At the same time emerging markets are becoming more and more dominant in the global economy and are grabbing for a higher share of world trade. It’s important to recognize that the latter is not a zero sum game, as the global economic pie is getting larger. The rising incomes in emerging countries are also creating a higher demand for goods and services produced in the developed world.

Such a structural change in the global economy is nothing new, as we have been living in a dynamic world for quite a while and the structure of the economies is constantly changing. But the financial crisis seemed to have corrected some trends that were unsustainable like the ponzi game of leverage in many countries.

However why should real estate investors care about these high level macroeconomic issues? Traditionally many real estate investors only apply an opportunistic logic behind investments and hit bids that seem reasonable according to their experience. That can make sense if you consider your properties as single investments and if you think you have an edge in your local markets. But at the same time the macro perspectives for that region need to be ok as well. You can buy good objects which you think are cheap in your region and still lose your whole stake if industries in that region are suffering and need less space. So from a portfolio view you would want a diversified portfolio in order to reduce idiosyncratic risks but at the same time overweight regions and sectors that you think will outperform. And this outperformance and underperformance is heavily driven by macro factors and structural shifts in the economy.

That’s why you need a disciplined investment approach. For every market you invest you need to model demand and supply dynamics (qualitatively or quantitatively). The highlighted structural shifts can go into your demand forecast: There you can account for issues like whether retail spending will decline or the regional banks balance sheet are shrinking or small businesses that specialize on export will thrive. Your macro CRE models then translate these economic trends into forecast of market rents and prices.

Consider for example two regions: Region A is characterized by an oversupply of shopping malls and is home to overleveraged mid income households. Region B comprises of a dynamic cluster of SMEs that are focusing on exports. If you think that exports are going to boom and retail spending is going to decline you rather buy land for industrial development in region B than a shopping mall in region A. While the shopping mall in region A will face higher vacancies and declining rents, the land for industrial development will strongly appreciate due to its option like nature as the export oriented SMEs are able to increase their incomes and need more space for their production.

Unfortunately the situation is not so crystal-clear in reality like in this idealized exampled. But our complex background of such investments even strengthens the case for a disciplined investment approach that relies on a strong macro based real estate research.

CRE caused in many episodes in the past trouble for parts of the financial sector. CRE was to blame in Switzerland in the early nineties when several small banks had to be bailed out. While residential real estate prices for owner occupied properties increased sharply during the eighties, it was the collapse of the CRE market that brought down several institutions. CRE also took the center stage in the US at that time. The Resolution Trust Corporation (RTC) was set up to manage and liquidate real estate and financial assets that it inherited from insolvent thrift institutions. Between 1989 and 1995 747 thrifts with assets of around 400 bn. USD were liquidated. Commercial real estate was here the predominant issue. CRE and land loans played also a role in the Asian crisis. Real estate developers financed their land bank with foreign currency denominated loans. With the depreciation of the Asian currencies the debt could not be serviced and this had led to a wave of defaults.

The link between CRE and banking failures

In the light of the past experience it is somewhat surprising that this time it was the residential real estate market to trigger the financial crisis (I will address the US residential market in my next article: “Why this time residential real estate?”). However, the collapse of CRE values puts currently a heavy burden on banks’ balance sheets in the US and in some European countries. Problems with CRE and construction loans were last year the most important factor behind the collapse of more than one hundred financial institutions in the US. That’s why I would like to shed light on the important link between commercial real estate values and banking failures. In my view the commercial real estate credit is the credit class that can put the survival of financial institutions at some points in time most at risk when its addressed improperly from a risk management point of view. This is due to the following points:

➢ Strong pro-cyclicality of CRE

➢ Attractiveness of CRE loans during the boom leads to negligence of risk management

➢ Effect of the default of large undiversified positions on banks’ balance sheets

Strong pro-cyclicality of commercial real estate or why is commercial real estate prone to bubbles

Asset managers, insurance companies and pension funds usually own commercial real estate due its relatively stable and high income yields. This long term passive hold strategy is in my view however not the value maximizing approach to commercial real estate investments and can even be a very value destroying strategy at some points in time. Commercial real estate has very pro-cyclical total returns and has to be actively managed (cyclical timing necessary). A strong decline of CRE values can also come without an economic depression. CRE prices usually fall in normal downturns by 20-40%. The volatility of commercial real estate is the result of two factors: Volatility of incomes and the effect from leverage. Income volatility is the consequence of economic volatility. Vacancy rates and rental incomes vary during the economic cycle. If you own undiversified real estate portfolios the income backdrop in your portfolio during a recession can be much more pronounced as for the market as whole. Volatility of commercial real estate values also arises from the leverage applied to investments. Commercial real estate transactions involve usually debt financing. This increases potential returns and risks for investors. Not being able to service the debt can lead to default and the loss of the full equity contribution to such investments. If you have bad luck you need to liquidate parts of the portfolio in very illiquid environments. The effect from this leverage can create a much higher volatility for this asset class than seen on paper…

Commercial real estate is also prone to bubbles. Bubbles can be seen as the result of illusions combined with leverage. Commercial real estate can provide in a benign economic environment income and rent growth illusions to investors. As investors become more and more optimistic they increase their debt loads, as they can leverage returns this way. The physical nature and the local presence of CRE can also give a false comfort to investors that there simply must be a value in such objects/projects. E.g. when assessing business plans of investments or construction projects and they see how great the building will look like they can fall into what I call “value illusion”. So the rational decision is biased by (emotional) affection.

The other point is the usual high size of commercial real estate transactions. In the US the average sales price for commercial real estate deals is 25 mm$. This relative higher size of transactions makes CRE an attractive field for leveraged investors, especially when the cost of credit is low. That could not just be seen in the US and Europe during the boom years but actually currently in China with the government leverage leading to high inflows into commercial real estate. If you are following the commercial property market in Shanghai some trends there resemble to what has happened in the US in 2005/2006

The high size of the transactions combined with an explosive mixture of overly optimistic expectations and leverage can continue to inflate the CRE bubble as long as there is no trigger event to burst the bubble.

CRE loans as an attractive source of earnings during booms

CRE is linked to the banking system by means of commercial real estate mortgages, construction or mezzanine loans. Banks provide trough these instruments leverage to investors in CRE transactions.In a benign economic environment these instruments are an attractive source of earnings for lenders. Due to the large size of transactions the spread between financing costs and interest earned can lead to attractive income jumps for the lenders. A 100 million commercial real estate loan with 100 basis points margin for the bank generates net income of one million USD. Especially for smaller banks commercial real estate loans can increase the earnings and the manager can earn easily big bonuses. Disciplined credit risk management that relies on the principles of the MACRO REAL ESTATE Analysis Approach is here crucial, as all these earnings are at the expense of risks in the future. Lenders have to be aware of the risks if a loan defaults at a future date. As seen in the current crisis in a case of default the loss for the bank for the same 100 mm$ loan could be as high as 60 mn$. (I assumed a loss severity of 60%) For subordinate or mezzanine loans it can also be easily become a full loss.

The best risk tools for lenders are here the loan to value ratios (LTV), the debt service coverage ratios and personal guarantees of the borrowers. However there is a tradeoff for the lender. With a higher LTV a higher income can be earned on a deal. But with higher LTVs also the risks rise in the case the borrower defaults. However, in a bullish competitive environment usually the credit risk department loses out in arguments against the dealmakers and LTVs rise and loans are approved at higher risks. That happened also during the boom in the US and risks for the banking system from commercial real estate increased on the whole.

Effect of the default of large undiversified positions on banks’ balance sheets

A sharp decline of CRE values together with a high LTV basis on its loans can threaten the existence of bank involved in CRE financing. Two further conditions needs to hold further for such a worst-case scenario to come true.

First, the exposure of lenders to such loans has to be material relative to the capital and the equity position of the bank. This brings smaller banks at risk that granted relatively large loans, as per definition here a loan has a higher share of the bank’s balance sheet. But the same logic also applies to large players, who were aggressive lending at the late stage of the bubble. Late bubble vintage loans don’t have the time to accumulate enough equity and have usually higher LTVs and inflated appraisals.

Second, there must be an immediate risk of a default of the loan to create a loss or an impairment charge. Accounting practices play in this aspect a key role. Loans are usually hold to maturity assets and don’t have to be marked to market. So commercial real estate loans are usually accounted at 100% in the balance sheet. Banks only have to account for loan losses if there is the risk of an immediate default. So theoretically the current mark to market LTV for such loans can be even 150% or higher, but the bank does not have to account for a loss if it believes that values rebound till maturity or no default event occurs. There are several events of default. A term default occurs when the borrower defaults on its interest payments or LTV or DSCR trigger events are broken. Maturity defaults occur when the borrower cannot repay the loan at maturity.

So such default events are a necessary condition to affect banks’ balance sheet. And maturity matters, as it is an important trigger event for defaults and losses. If several loans on the balance sheet of a bank are maturing at the trough in a CRE price cycle this leads to large impairments or losses. And due to only few but large positions the losses don’t increase gradually but by leaps and bounds. This size effect is an important point that makes CRE financing for banks so risky. Compare a loss of one 100 mm$ CRE mortgage with 100 1 mm$ residential mortgages with identical loan criteria. The residential mortgage have to be perfectly correlated in any respect like credit score, maturity, inflation of the appraisal to create the same loss as the CRE loan.

Survival Strategies of Banks can lead to a restrictive credit stance


In an extreme case losses from CRE, construction or mezzanine loans can even threaten the survival of the bank in question. The only direct remedies- without a government bailout- that such a bank can follow are the extension of these loans or raising new equity. But also even after having secured its survival such a bank is still haunted by its actions in the past. Such banks are usually reluctant to engage into new business, as they try to earn their way out of insolvency. This can lead to a credit crunch not only for CRE loans but all sorts of loans as the bank tries to shrink and to deleverage its balance sheet.

Opportunities for new money in the current environment

While it is currently a very burdensome situation for the banks dealing with these balance sheet problems, a lot of opportunities arise for new money flowing into the sector. This new money has several opportunities from engaging into new lending, buying distressed debt to investing into commercial real estate properties. New money that targets lending can benefit from the current favorable environment:

➢ Risks for new lending have shrunk considerably due to the strong value decline and can be addressed by applying LTVs or DSCR.

➢ High negotiating power of lenders providing financing in the current environment

➢ Positive Selection borrowers which are still in the business, as bad borrowers have defaulted or will default and are losing their equity

➢ Free Field: The competition in lending decreased due to the paralysis of parts of the banking system. This leads to higher margins and lower competition

➢ Distressed Opportunities: Buying loans or properties from distressed sellers

However, there are no free lunches. A wrong operational implementation can lead also for sharp losses for new money flowing into the sector. A proper research based lending approach with extensive due diligence work and a strict credit risk control is a key for success.

• They show that property appreciation over the long term was just in line with inflation. Actually they point out that prices in 1999 were in real terms 30% below the level of 1899. That‘s noteworthy, as at the same time they demonstrate the high volatility of commercial real estate prices over the longer term. Theories of risk suggest that investor needs to be compensated for excess volatility. The result that buy to hold investors are not compensated for volatility over the last century challenges such an investment approach and would strengthen the reasons for a more activist approach to real estate. It provides a case for a tactical asset allocation for commercial real estate that tries to realize gains and identify attractive entry points into the sector. I argued at several occasions in the past that the most prominent characteristic of commercial real estate is its cyclicality. The paper shows that this cyclicality was not just a feature over the last thirty years but is an important lasting attribute of commercial real estate

• They are not directly addressing the inflation hedging characteristics of real estate but from their return estimation one can see that commercial property was not a good hedge against inflation in the first couple of years after the First World War. This is also in line with what Prof Shiller reported for US one  familiy home prices in his latest version of Irrational Exuberance. Between 1900 and 1920 commercial real estate prices in New York and residential real estate prices in the US fell by 35% resp. 25% in real terms. This is indeed striking as a broad majority of practitioners and academics argued recently for the inflation hedging characteristics of real estate. And the period between 1917 and 1921 was the period with the highest inflation over the last hundred years in the US. (CPI Inflation was 12% in 1917, 20% in 1918, 18% in 1919 and 17% in 1920.) This challenges the inflation hedging characteristics of commercial real estate. Commercial real estate is usually perceived as a hedge against inflation as rents are indexed to the CPI. My interpretation of these results is that the inflation hedging characteristics of commercial real estate only holds true if inflation is within a specific threshold. When inflation rises above certain percentage it can hurt the values of commercial real estate. Values are always a function of two factors: The expected income and the discount rate. So if inflation rises above a threshold the negative effect from the discount factor magnifies the income effect

• Cap rates for New York office properties have traded in the last hundred years in the band between 5% and 10%. The point here is that cap rates seem to be stationary over the long term. This is  remarkable in the light of the recent cap rate declines. At the peak of the commercial real estate market in 2007 some properties in NYC were trading at cap rates of around 4%. Just a few years ago (2001) they were at  8-9% and almost at the higher end  registered within the last hundred years. So within ten years they fell from peak to trough. Now in the course of recession and the financial crisis cap rates increased again by 200-300 basispoints. The stationary property of cap rates and its quick reversal just in a few years provides also the case for a cyclical timing of commercial real estate in the context of a tactical commercial real estate asset allocation.

Residential real estate markets in the US, Europe and Asia saw a spectacular boom between 2000 and 2006. Prices more than doubled in this timeframe in many countries such as US, France, Ireland, Spain or most Asian countries.

The bubble in commercial real estate was masked by the yield or cap rate shift. In commercial real estate you usually not refer to prices but to cap rates, the ratio of rental income to the transaction price or the appraised value of an object. Commercial real estate yields or cap rates compressed between 2003 and 2007 mirroring the price increase in housing. Some people argued then, that this decrease in yields was justified by the structural change in financing or the generally lower interest rate environment. That might be true to some extent. But when prime yields decrease considerably below the level of government bond yields, one has to become skeptical.

So both residential and commercial real estate markets were then driven by a global factor: capital and abundant liquidity. The turnaround in the US housing market marked in autumn 2006 an end of this era. The falling house prices in the US triggered a series of events, which we know today as “the financial crisis”. These events had broad repercussion on real estate markets around the world, as the global liquidity bubble burst. There was the effect of the financial crisis on the demand for real estate, as the global economy slipped into a recession and employment figures started to rise. Some homebuilders, who had expanded the units under construction in previous years, were then caught on the wrong foot, as they expected a further increase in demand. They brought the projects to market despite the recession and vacancy rates spiked. Supply, especially in the US, was not only pressured by new buildings but also by foreclosures, as people defaulted on their mortgages. At the same time the weakness of banks’ balance sheets brought in some countries an abrupt halt to new lending to households and to commercial real estate investors. The mortgage markets that relied on the refinancing of mortgage lending from the capital market were additionally hit by the loss of investors’ confidence in securitizations. Issuance of new private label securitization dried up completely in 2008.

Inflated real estate prices came increasingly under pressure in one market after another. However, the speed of the downward adjustment has differed between the markets and countries. In the US, house prices already have corrected by more than 30% since peak. However, in some markets in continental Europe, like France and Spain, the decline of house prices has progressed very slowly so far. It is never a good sign, if the problems are not tackled and the solution of a problem is delayed. We Swiss remember that adjustment processes can take a long time. In Switzerland it almost took a decade till the real estate market recovered from the burst of the bubble of the late 80ies.

From both an academic and practical research point of view interesting times are ahead. Between 2000 and 2006 market selection did not matter much from a practical point of view, as real estate prices were inflated in practically all markets. Then risk assessment was (or would have been) important. The question was, when to leave the boat to cash in gains or to avoid a shaky see after years of sunshine.

Today the situation is different. Real estate markets are not all at the same point in their cycle nor just driven by one global factor, liquidity. So market selection, cyclical timing, an assessment of market fundamentals and longer term drivers should be crucial going forward. Not all markets will be able to quickly rebound. Residential and commercial prices in many markets and segments are unfortunately to decline further. For some markets the risk is that a recovery could take a decade. But there is also hope for markets that look fundamentally sound and are just suffering from a cyclical but not structural downturn. Local supply and long term demographic trends will be key. On the commercial real estate markets it is material, how the refinancing risk, which seems to be the most critical depressing factor, can be resolved.

I will address such questions in my Blog in future and if interested, please subscribe. (It’s free, see RSS or other means) Both positive and negative comments and inputs are always very welcome.