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The Deflating Bubble

June 22, 2009

Tags Booms and BustsBusiness CyclesInterventionismPrices

There is an epidemic of bankruptcies: Circuit City, Sharper Image, Goody's, Gottschalk's, Comp USA, Levitz Furniture, Chrysler, GM. Not to mention all the local businesses that don't make the news when they close up shop. And the rash of corporate bustouts is far from over according to consulting firm Bain & Company, who predicts nearly 100 large ($100 million or more in assets) corporate bankruptcies by next year.

We're in a period of severe losses — a cluster of errors, as Murray Rothbard described it — with thirty-seven banks having failed already this year, and many more to come.

But as gruesome as the economic news sounds, Rothbard explained that this is the recovery.

The liquidation of unsound businesses, the "idle capacity" of the malinvested plant, and the "frictional" unemployment of original factors that must suddenly and en masse shift to lower stages of production — these are the chief hallmarks of the depression stage.

Many would like the boom to continue "where the inflationary gains are visible and the losses hidden and obscure," Rothbard wrote. "This boom euphoria is heightened by the capital consumption that inflation promotes through illusory accounting profits."

But the boom is where the trouble happens — when resources are directed into malinvestments and distortions occur — and trouble we've had this past decade with a Capital T. The M-2 money supply increased 53% since year 2001, while at the same time total bank loans doubled and bank real-estate loans increased over 150%. The mistakes of bad entrepreneurs have been hidden, employment was directed to wasteful and unneeded occupations, unsound projects were built and business risk was ignored.

"The boom produces impoverishment," wrote Ludwig von Mises in Human Action.

But still more disastrous are the moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse.

Many bankers continue to contend that their banks are sound, protesting that they didn't make any subprime loans like those big Wall Street banks. But the cluster of errors doesn't contain itself to one asset. Houses don't suddenly appear. First, land is purchased. Then that land must be entitled — permission from local government must be obtained to build what the owner wants on the property. This is a lengthy process than can in the best case take months and in the worst cases take decades. Infrastructure improvements are then made and finally houses can be constructed.

So, low interest rates spur consumers and investors to buy houses — in some cases creating housing shortages and exploding prices, which, in turn, cause developers to buy land and begin the lengthy development process just described. After money supply increases by way of credit expansion, businesses malinvest by "overinvesting in higher-stage and durable production processes," Rothbard explained in Man, Economy and State.

Real-estate developers by and large use debt financing every step of the way from when they buy the land to when they start construction. In the past, banks traditionally shied away from making land loans. But as the market overheated, more and more banks got in the land-loan business. Land lending is inherently risky because land doesn't produce income and gaining government approvals in a timely manner is often problematic: land is many months from being converted to a use that is salable to the typical consumer. Lending for the construction is the least risky, but still the homes must be sold to pay off the loan.

Guaranty Bank of Austin recently demolished 16 new and partially built homes in Victorville, California. The cost of finishing the development exceeded what they could sell the homes for despite four of the homes already being complete. In early 2008, these homes were selling for $280,000 to $350,000 in the bedroom community 50 miles from LA.

The Victorville demolition is one of the most dramatic ends to a bad bet made during the housing boom, but abandoned developments have become an all-too-common sight in California. Nearly 250 residential developments totaling 9,389 homes have been halted across the state, according to one research firm.

And the residential meltdown is nowhere close to being over. There is reportedly a million-house overhang in the market nationwide. But misguided attempts by government are keeping home prices from correcting to affordable levels. "If an investor could purchase a home and rent it out for close to breakeven," real-estate broker Mike Morgan writes in Barron's, "we might be getting close to the bottom. But we are nowhere close to that level in most critical markets."

Morgan points to a California program that offers a $10,000 tax credit for buyers of new homes. Thus, encouraging the building of redundant houses, at the same time homes are being bulldozed in Victorville. The annual sales pace is 300,000 homes, yet 500,000 new homes are being started that will just add to a bloated inventory.

"All of this government intervention will only spawn new malinvestments and later depressions."

What Morgan calls the back half of the residential-real-estate hurricane will destroy bank balance sheets. "Our experience with banks' selling REOs is they realize about 50% — 75% of what they initially think they will get," explains Morgan.

But the current crisis doesn't end with residential real estate. Commercial-real-estate developers follow roof tops. When they see homes being built, they forecast that those homeowners will need places to shop and places to work — so the residential-construction boom inevitably leads to a commercial-property boom: office and industrial buildings as well as shopping centers. All those new homeowners will need to buy everything from groceries to garden hoses. Plus, new title company, mortgage loan, construction, and other real-estate-dependent jobs are created, meaning more office and industrial space will be required.

And lenders were there to embrace their developer customers' dreams and supply the credit. Commercial mortgages and construction loans exploded in the boom years. "Tiny cap rates, feckless lending and willful ignorance were par for the course in those years when the market could hardly seem to walk a straight line," writes Grant's Interest Rate Observer.

But with the finding of new tenants difficult and the rash of bankruptcies of current renters, commercial-property values are plunging. The Moody's/REAL Commercial Property Price Index has fallen over 21 percent since it peaked in October 2007. And the folks at Deutsche Bank see price declines of 35 to 45 percent and maybe more in commercial property, due to the large number of loans coming due between now and 2012 that will not be able to be refinanced. Not only are loan delinquency rates up and rents down, but the go-go years of aggressive loan underwriting are gone. The interest-only, high-loan-to-value-ratio loans that drove capitalization (cap) rates to the five percent range are history. Property buyers who are required to put more money down will offer significantly less for the same net operating income to achieve the required return on investment.

"Volume [of real-estate transactions] in the Americas has fallen hardest with the first quarter 2009 sales down 84% year-over-year and 56% from the fourth quarter of 2008," according to REAL Capital Analytics.

This spells further trouble for the small community banks that make up just 28% of the banking industry's total assets but are responsible for about 60% of the nation's commercial-real-estate lending.

So while many bankers contend their institutions are sound, bank attorney Gerald Blanchard told US Banker, "Across the U.S. right now there are still a fair number of community and regional banks with significant problems."

"There are banks in the sunbelt and other areas sitting on developed lots — lots that have been bulldozed, wired, and paved but not built on — worth 15 to 20 cents on the dollar," Blanchard says. "Those institutions with heavy investments are suffering big losses and big hits to capital. So yes, we will continue to see failures." Blanchard went on to say that newer banks will not be lending to builders and depending on brokered deposits to grow their banks, as they did in the boom.

A contraction of credit and liquidation of assets is exactly what would complete this recovery. Failing real-estate prices, business failures, and high unemployment signal that the economy is desperately trying to heal but the Fed is fighting valiantly to re-inflate, increasing its balance sheet 140% just to generate a 14% increase in the M-1 money supply. The folks at Grant's estimate the federal response to the current downturn to be 12 greater than that to the Great Depression, which prolonged that recovery for a decade.

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However, all of this government intervention will only spawn new malinvestments and later depressions. "It should be clear that any governmental interference with the depression process can only prolong it," explained Rothbard "thus making things worse from almost everyone's point of view." Further delay of the readjustments will only lengthen the depression, postponing complete recovery indefinitely.

"The larger the scope of malinvestment and error in the boom," predicted Rothbard, "the greater and longer the task of readjustment in the depression." Government intervention on all levels guarantees that this will be a very long, bumpy recovery.

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