Seminar on Real Estate Driven Risk

2013-01-15

Korea Development Institute Seoul, Korea December 13-14, 2012

Keynote Address:

Cycles, Crashes, Contagion, Cygnus, and Complexities: The Future of Global Real Estate

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Fundamental Condition:

Real Estate is a Derived Demand

Real Estate Cycles, in General, are Intertwined as Part of the Larger Economic and Financial System

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Real Estate Market Activity is Dependent Upon: 1. Availability and Cost of Capital 2. Aggregate Demand (Income)

Figure 1: Real Estate is A Complex Derived Demand

Technological Social-Cultural Factors Developments

Preferences Materials Internet

Real Estate

Global Changes Prepayment, Defaults

Economic Changes Changes in the Financial System

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Issues Pertaining to Real Estate Cycles

• “Trigger” Events: Cause Confidence Crisis • Over Confidence: déjà vu all over again – This time is different – Nothing can go wrong • Financial System vs. Real Sector • Contagion vs. Fundamental • Black (Cygnus) Swan vs. Cooked Goose

Historical Review: Real Estate Assets Cycles are Mutually Reinforcing Part and Parcel of:

• Banking Crises • Inflation Cycles • Sovereign Debt Crises • Economic Contractions • Confidence Instability

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History of Economic Cycles, Credit Crunches, & Contagions

• Selective Overview of U.S. Financial and Economic Crises: A Hardy Perennial • Special Attention to Crisis of 1873, 1907, 1914, 1929, 1981, 1987, 1991, 1997, 2001, and 2007

Globalization and Volatility: Booms and Busts

• U.S. History of Financial and Real Sector Volatility: 1800-1940

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A US History of Booms, Busts and Panics

Crashes Recessions, Preceding GDP Peak Trough Real Stock Major Booms, Stock Banking Contraction, Price Change Causes Price Changes Panic % (%) %

1809 1814 –37.8 War –1.6 1804 1835 1842 –46.6 Bank war –9.4 57.2 1837 1853 1859 –53.4 Railroad boom –8.6 1857 1863 1865 –22.5 Civil war –6.2 20.5 1875 1877 –26.8 Railroad boom 50.5 1873 1881 1885 –22.2 Railroad boom 51.3 1884 1892 1894 –16.4 Silver agitation –3.0 1893 1902 1904 –19.4 Rich man’s panic 29.9 1906 1907 –22.3 World financial crisis –6.9 1907 1916 1918 –42.5 War 1919 1921 –24.5 Disinflation, disarmament –8.3 1929 1932 –66.5 Roaring 20s and policies –29.7 201.8 1930–33 1936 1938 –27.0 Tight monetary policy –4.5

Panic of 1873 • Started an international Great Depression (the Long Depression) • The U.S. downturn was deep and long 1875-1879 • In Great Britain 1873-1896 had an extraordinary duration Trigger events: Bismarck's decision to de-monetize silver in 1871 • Significant property losses because of Chicago (1871) and Boston (1872 fires (see Christine Rosen) • Banking reserve crunch in NYC, September 1873 Brief Events Study • In U.S., Railroad investments “exploded” between 1868-1873 – Land grants – Subsidies to railroads (perhaps the original corporate welfare Program) – Overbuilding of ports, factories, and ancillary facilities – Coinage Act of 1873 (De facto gold standard) – September 18, 1873, Jay Cooke and Company declares bankruptcy – Government refuses to finance 300 million loan to Cooke – Failure of Cooke to raise equity capital for Northern Pacific parkway – Many bank failures followed Cooke’s demise, including a closing of the NYSE for 10 days! – 55 railroads failed; 60 railroads entered bankruptcy! – Silver mining crumbled!

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Panic of 1873 In Germany and Austria • Grunderjahre (founders years) • Deutsche Bank • Military victory over France (1871) • Speculative industrial expansion (railways, factories, docks, steamships) • In 1873, introduction of the gold mark, drying up money supply! • Vienna Stock Market crashes on May 9, 1873 (bubble from unsustainable expansion, insolvencies, and dishonest manipulation – nothing new under the sun) • Collapse of foreign lending • Recovery in Europe was relatively rapid; wages did not decline and industrial production picked-up quickly

Panic of 1873 In Great Britain • Suez Canal “folly” ushered in set of bank failures • Long Depression, with unemployment rate growth, halt in public works, and trade slump (through 1896) Other Parts of the World Felt substantial ripple effects from the Depression to various degrees. Paradox of 1873-related long Depression • Deflation, with GDP growth! – Firms were able to reduce costs (via productivity growth), and increase production! – 1873-1896: Great Britain industrial output increased 40% – 1872-1896: Germany industrial output increased by 100%.

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Panic of 1873

Causes (debated) of Long Depression • Post-war (U.S. Civil War and Franco-Prussian War) inflation • Speculative investments in railroads, ports, and so forth • Large trade deficits • Ripples from economic dislocations in Europe caused by Franco-Prussian War (1870-71)

Panic of 1907

The Shadow Banks Fail: Knickerbocker Trust and Trust Company of America “Bank of Last Resort” J.P. Morgan saves the day, but not all banks

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Japanese Malaise and 1997-1998 Asian Real Estate Experiences

Efficacy:

1997 Asian Financial Crisis & Failure of Traditional Monetary & Fiscal Policy Options

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Strains of the Asian Flu

• Thailand and Malaysia • Indonesia • South Korea • Hong Kong • China • Japan

External Debt of Asian Countries: Ratio of Short-Term to Long-Term

22 21 20 19 % 18 17 16 15 14 89 90 91 92 93 94 95 96

Source: IMF; EIU Country Reports 20

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Private External Debt of Asian Countries As Proportion of Total External Debt

60 58 56 54 52 % 50 48 46 44 42 40 89 90 91 92 93 94 95 96

Source: IMF; EIU Country Reports 21

An Economic Vicious Circle

Living Standard Balance of Currency FDI Expectations Payment Problems Declines Exceeding Growth Problems

Negative Negative Impact Change on In Growth Growth Prospects

Financial System Asset Value Decline Instability

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The Policy Dilemma

Negative Impact Restrictive on Banks

Fiscal Policy Stimulus Negative Impact On Currency No Traditional Answer for a Non-Traditional Crisis Restrictive Negative Impact On Banks Monetary Policy

Negative Impact Stimulus On Currency

Successful Policy Prescriptions

Banks Currency •Banking System •Foreign Investment Rehabilitation Incentives •Assets Disposition •Legal Reforms •Securitization •Currency Exchange •Fiscal Policy •Political Risk Reduction

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Causality:

Does Banking System Failure Cause Real Estate Market Crunches?

The Case of Japan (Dokko, Edelstein et al Research)

• Japanese Evidence Indicates that Stock Market Decline “Causes” Real Estate Market Decline, Not Vice Versa • Hidden Reserves Mechanism had Special Impact • May Not be Same Mechanism in Other Countries?

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Japanese Bubble & Asian Financial Crisis •Japanese land prices grew for 40 consecutive years (tripling between 1986 and 1991) •Nikkei peaked at 38,915 yen in 1989 •Since 1991 through 2005, land values have fallen by 75%

2,500

2,000

1,500

1,000 INDEX: Y1997=100 500

197019711972197319741975197619771978197919801981198219831984198519861987198819891990199119921993199419951996199719981999200020012002200320042005

Land Price Index for Six Major Cities Nikkei Average Stock Price Real GDP 4YMA

Contextual Overview of Crises and Current U.S. Economy: The Prolonged Contraction

• All Asset Markets, Global Involvement • Anatomy of Financial-Economic Meltdown: Credit Crunch and Economic Weakness • Shorter-run versus Longer-run • Update for Investment in U.S. Real Estate

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Shorter-Run Complexities

• De-leveraging and Aggregate Demand • Financial Re-regulation and Restructuring • Euro-land and BRIC’s • The Role of the Lender of Last Resort • Lynchpin for Sustained Growth: Public Sector Needs to Restore Confidence and Stability

Policy Perspective • No Single Policy is the Silver Bullet • Complex Benefits-Costs Analyses Require Multi-faceted Solutions • International and Intra-national Differences May Require Locally Differentiated Approaches • Reinvigorate Securitization Process • Triage “Bad” Loans (Zombie Banks)

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Why Are Crashes Prevalent?

Common Elements of Meltdowns: – Exuberance (irrational optimism; nothing can go wrong; this time is different) – Leverage (private and public) – Low interest rates and easy credit availability – Mushrooming deficit (recognized and implicit) – Regulatory insouciance and laxity – Regulatory arbitrage – Greed (especially in short-term financing for long-term assets – spreads) – Financial “wizardry” – Service provider orgy – International correlation

• Globalization and worldwide securitization of real estate markets is inevitable – Diversification is dead. • U. S. & Europe “models” are useful, but not perfect prototypes for the rest of the world. • Legal, transparency and capital market development issues are non-trivial barriers to globalization and market integration. • Economic and financial stability are pre-requisites for long term success.

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Longer-Run Complications and Future Risks • World Demographic Drivers – Retirement – Health Care • International Resource Competition – Energy Supply and Demand – Protein Upgrade – Pollution Control – Clean Industry – Inflation Scenarios • Technology Improvements • Unwinding Bailouts

Longer-Run Complications and Future Risks (Continued) • Black Swans and Quasi-Black Swans – The Cygnus Effect – Pandemics – Global Warming – Energy Resources – Political Unrest – Arab Spring, Iran, North Korea, China-Japan – ?

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• Globalization has always been a multi-edged sword! • How does the global opening of real & financial markets change the interactive stability of the world-wide political economy • How will the technological revolution impact location, location, and location? • We need a better understanding of the “economic dynamics and structure” of the world economy