Wednesday, January 23, 2013

Real Estate Monetary Standard: the New Wildcat Banking?

Michael Sankowski at Monetary Realism suggests that we may be on a "real estate monetary standard." He writes:
Much like how we can use assets like gold to create a commodity money system, it seems like we operate our current monetary system as a real estate standard.
Banks create money against real estate assets. We use this money in our day-to-day transactions, without much thought about what stands behind this money, but most loans are for residential and commercial real estate.
He makes the comparison to a gold standard, but I suggest another analogy: the Free Banking Era. The Free Banking Era refers to the period from 1837 to 1863. Prior to free banking, opening a bank was a difficult process that involved obtaining a charter from a state legislature, and the Second Bank of the United States required state banks to keep an adequate supply of specie on hand, thereby limiting the amount of notes that they could issue. When the Second Bank closed, states needed to make bank entry easier to fill the void in banking services. New York and Michigan were early adopters of free banking laws, which allowed anyone to operate a bank as long as notes were redeemable on demand and backed by state bonds held at the state auditor's office. Eventually, 18 states adopted free banking laws. I would like to compare the state bond-backed monetary system to what Sankowski calls our real estate monetary standard.

With the passage of the free banking laws, many new banks opened and a plethora of different kinds of banknotes circulated as currency. An expansion of the banking sector in that era has its analogue in the expansion of mortgage lending, including subprime lending, from around 2003-2007, when there was also large growth in non-bank independent mortgage originators. (See Joshua Wojnilower's post on how tax policies created a real estate monetary standard.)

The Free Banking Era is notorious for a large number of bank failures, which often resulted in losses to noteholders. The conventional explanation for the problems of free banking is also a common explanation for the bank failures of recent years: fraud and greed. The evil bankers of those days were called “wildcat bankers." In a well known 1974 paper, Hugh Rockoff explains the link between wildcat banking and free banking laws. Some states allowed banks to issue notes equal to the face value, instead of the market value, of the bonds backing. So wildcat bankers could buy state bonds that had depreciated, deposit them with the state auditor, and issue currency amounting to the face value, rather than the depreciated value, of the bonds. They could then circulate these notes to the public, in exchange for specie and investments worth more than what they paid for the state bonds, forfeit the bonds and run off with the bank’s assets. Sound familiar? Consider Felix Salmon's description of the "enormous mortgage bond scandal."
This is where things get positively evil. The investment banks didn't mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren't going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker. In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors. 
However, as the Economist notes, there has been "a lot of debate over whether blame [for the recent financial crisis] should be assigned to deliberate fraud by financial-industry actors, or whether the whole phenomenon was simply an unfortunate catastrophe based on systemic miscalculations. General opinion settled on the unfortunate-catastrophe thesis." Likewise regarding the free banking era, later authors such as Gerald Dwyer and Arthur Rolnick and Warren Weber argue that most bank closings and noteholder losses were not caused by fraudulent wildcat banks, but rather by capital losses due to drops in state bond prices. There were systemic miscalculations concerning state bonds like there were with mortgage-backed securities. And in fact, they were eerily similar.

State governments at the time were in the business of building roads and canals, running up big debts to do so. It seemed like a great investment, given New York's success with the Erie Canal. States expected to be able to service debt with the revenue proceeds of an expanding tax base; the land boom of the 1830s seemed to promise growing property tax revenues. Plus, the roads and canals that they were borrowing to build were expected to bring in even more revenue. So state bonds were presumably extremely safe assets. It was very similar to the subprime loans made during the housing bubble: even though borrowers didn't have the income they would need to pay their mortgages, they were allowed to borrow because home values were expected to keep rising. But just as AAA-rated subprime-mortgage-backed securities were downgraded to junk status when borrowers started defaulting, the state bonds also sunk in value when many states went into default.

Then as now, leverage mattered. Nine of the ten states with the highest per capita debts defaulted; none of the states with below median per capita debts defaulted. The defaults of course caused financial turmoil and also adversely impacted the real economy. And although the pros and cons of free banking were not well understood until well over a century later, policymakers were fairly quick to impose new regulations. The Free Banking Era came to an end with the passage of the National Bank Acts of 1863 and 1864, which set up a national system of banking with federally issued charters and a uniform national currency backed by Treasury securities. The Comptroller of the Currency was established as a supervisor in 1863; the Federal Housing Finance Agency was established in 2008 to supervise secondary mortgage market components. The parallels are so interesting--this is why I love economic history!

22 comments:

  1. Hi thanks for the cool summary! Your work is listed over at:

    http://coppolacomment.blogspot.com.au/2013/01/misunderstanding-qe.html

    Kind Regards

    ReplyDelete
  2. In a busy and crowded world, space is the ultimate luxury; Vatika Inxt provides the space in Gurgaon to create the life you want.. Vatika primrose resale / Vatika Next plots / Plots for sale in Gurgaon

    ReplyDelete
  3. I am impressed with the effort you have so obviously put into this content. I am also impressed sell your house fast in NYC with your point of view on this topic, especially since you have made your points so clear.

    ReplyDelete
  4. To tell the certainty this is a kind post concerning this topic. I got an unpolluted solution from here. Also I can refer to you all pocket folders here to get educational helps. However will wait for more posts from the blogger. Thanks a lot…….

    ReplyDelete
  5. Wonderful information, I had come to know about your blog from my friend nandu , hyderabad,i have read at least 7 posts of yours by now, and let me tell you, your website gives the best and the most interesting information. This is just the kind of information that i had been looking for, i'm already your rss reader now and i would regularly watch out for the new posts, once again hats off to you! Thanks a ton once again, Regards,

    ReplyDelete
  6. Very informative post, but dose this help common people? Quick house sale

    ReplyDelete
  7. There are times when a client is flying in and may only be here in the morning. In those cases my day would start there, at my client’s choice of meeting place that accommodates their busy schedule the best. Thanks.

    ReplyDelete
  8. Thanks for this article! Especially now that I'm planning to move to one of these naperville illinois apartments, I learned so many from your post.

    ReplyDelete
  9. You completed a number of good points there. I did a search on the subject and found nearly all folks will go along with with your blog.

    ReplyDelete
  10. Nice post.it will be very interesting and informative to us.we have a news about real estate information.

    Real estate AZ

    ReplyDelete
  11. Very nice and interesting post. Thanks for the information you have provided.
    Real Estate Property

    ReplyDelete
  12. Take good care of things that will be effective in our Real Estate Investments Australia. Our efforts will lead our business into the success that we are targeting for our future. It is important that we create possibility towards our business in order for us to achieve our goals in life and for our business.

    http://property-investment-mackay.blogspot.com/2013/06/4-steps-to-making-money-with-real.html

    ReplyDelete
  13. "The property Finance Manager will lead the charge in planning and execution the financial tools needed to support the movement of the Holy Ghost..."real estate finance
    Implying that the Holy Ghost cannot move whereas not their financial tools? Is that blasphemy?

    ReplyDelete
  14. Get Your New Orleans Dream Home helps you find the best option in the city, community, neighborhood of your choice. We have the best real estate listings in New Orleans.
    New Orleans luxury home for sale

    ReplyDelete
  15. Find an affordable real estate for an average type of customer that has quality standard for a home. Make sure that we target all kinds of market to ensure that our business has lots of choices. Take control of the situation and continue to discover things that will be helpful for us to find a better stable position.

    Property Investment Portfolio

    ReplyDelete
  16. The investment banks didn't mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren't going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker. In fact, the banks had an incentive to buy loans they knew were bad. Milan Rubenstein

    ReplyDelete
  17. Don't advertise permanence when you have no plans to bring people on board. If you get on your bosses bad side once, New Lenox houses for sale you are already on your way out. All blame is placed on you when very little support is given from the people who are supposed to help you.

    ReplyDelete
  18. Saving costs are not the only reasons you might choose a vancouver furnished suites over a hotel- especially a furnished one. You have everything that you need right there and it will help you feel more at home than a hotel room. It can also be a good choice if you are traveling with a big family or with several people.

    ReplyDelete
  19. Thank for helpful Article post about Real state Services. Crown at Robinson Road (formerly Chow House) is a freehold commercial developement comprised of offices and commercial shops component. This mixed offices and commercial development is well located in Singapore’s most desirable address Robinson Road in prime District 01. At 140 Robinson Road, Crown at Robinson comprised of 80 Offices and 6 Shops within a state of an art iconic tower that stands out from the rest. Crown at Robinson

    ReplyDelete
  20. Great article. Very clear and well thought-out.
    And besides insurance against the small probability of loss of confidence in currencies (say dollar), real estate is also excellent in diversification. A simple way to push a portfolio towards the efficient frontier..
    African real estate

    ReplyDelete

Comments appreciated!