Tuesday, January 01, 2008

A Banking Christmas Carol Part 3

A continuation from part 2

When you are borrowing money, in essence what you are doing is going to a group of strangers that have deposited their life savings in a bank and asking them if you can have their money to pursue your own idea or venture. Of course you don’t go directly to the people, you go to the banks which are presumably the guardians and stewards of their money. But that still doesn’t change the fact you are effectively asking to borrow other people’s hard earned money.

Additionally, should you fail to generate the cash flow necessary to pay back the loan, it is ultimately the responsibility of the US taxpayer to guarantee the loan. Of course, hopefully the bank has made enough good loans to compensate for your bad one. But if the banks are poor stewards of their depositors’ money and enough of their loans go bad, it will ultimately be the taxpayer through various governmental agencies such as the FDIC that will bail them out.

You would think this would humble you enough to make extra certain that you would be able to pay back the loan. That you would do everything in your power to eliminate all the risks and uncertainties in the venture you’re about to embark on. That you would run projections, study the market, look at your competitors and have the most comprehensive and thorough business plan possible all in an attempt to make sure you could pay back the loan. And if you were a real estate developer, you would think one of the most basic, most simple and most important things you would do is measure the current level of supply and demand in the housing market to see how likely it was your houses would sell. That before you’d go and ask for $15 million of other people’s money you would make sure that you could sell those houses and pay them back in the first place.

You would think.

It was mid 2005 and my boss came into my office and put a file on my desk. It was a loan we had done for this real estate developer about a year ago and not only did he want to refinance the original loan but take out a new one for a new development he was proposing. The original loan was for a 36 unit town home development in a small suburb of Mankato. The new loan was for a 120 unit development in a much smaller town called St. Peter.

I immediately knew something was amiss for while I had heard of Mankato I had never heard of the town of St. Peter. Mankato was a sizeable town of 50,000 people whereas (upon some research) I found out that St. Peter was a town of only about 3,000 people.

Now basic 3rd grade mathematics would tell you something was wrong. For each town home would house roughly three to four people. This guy wanted to build 200 of them, suggesting roughly a 700 person increase in population. This implied that St. Peter’s population was going to grow by 23% in just one year.

When I brought this to the attention of my boss I was told that St. Peter was one of the fastest growing communities in Minnesota, that demand for housing was skyrocketing and the developer wanted to take advantage of this growth. I went to the state demographer’s web site and looked up what population growth information I could and found out that while St. Peter was growing, there wasn’t quite the rush to move there. The state demographer had estimated St. Peter would grow by only 8%, not the 23% that would warrant demand for these newly proposed town homes.

“Not to worry,” I was told. This developer was the 8th largest real estate developer in the state with over 20 years experience. Besides which he personally had over $30 million in net worth and could easily guarantee the loan. So it might take a little while longer to sell those town homes than previously expected. So what!? He could afford it!

A year later his company had gone under and the two developments had cumulatively sold a paltry 11 town homes. The banks had taken a large hit and he was no longer the 8th largest real estate developer in the state.

The same story repeated itself a year later. This time I was driving to the town of Wyoming, Minnesota to conduct a site visit on another (you guessed it) town home development. The developer was nowhere near as aggressive as the now defunct 8th largest real estate developer in the state building only 12 units in the town of 3,900 people. This seemed more reasonable, but for some reason his town homes weren’t selling either. When I asked him why, he speculated “Might have something to do with some of the other developments in the area.”

“Developments? What other developments?”

We spent the next hour driving around Wyoming where I counted no less than 400 brand new town homes, twin homes and single family homes being built by various developers. In other words, real estate developers as a group were expecting the town to grow by roughly 38% in one year.

Of course nobody was expecting Wyoming’s population to explode by 38% in one year. Nor was anybody expecting St. Peter’s population to grow by 23%. But what happened in both instances was a grave, incredibly stupid mistake;

Nobody did their homework.

How stupid these real estate developers had to have been to not bother to at least estimate the demand for housing in these areas is beyond me. To not even bother to see how many other developments in the area were being planned or were under construction to gauge the level of supply. And to have the hubris and arrogance to go and ask for millions and millions of dollars of other peoples’ money to build something they literally had no idea whether it would sell or not was bordering criminal negligence. As much as I wanted to believe it was relegated to just these two developers, I had been in the business long enough to know this was the norm. For in just two short months, the same situation repeated itself again.

This time I received a request for a $6 million loan to build (what else?) town homes. This was early 2007 when the housing crash was in full swing and there was already a glut of housing on the market. Even in a housing slump projects like this were doable, but it placed an incredible amount of importance on the pricing of the town homes. If priced too high, they wouldn’t sell. They had to not only be priced at the market, but probably below the market if they were to sell in any reasonable length of time.

So I drove out to the site where the town homes were going to be built to get a feel for the neighborhood and an idea of what kind of price they would command.

I looked to my east and saw a sea of town homes across the highway.

I looked to my north and saw a sea of town homes across the other highway.

But when I looked to the south I saw a gas station…nestled within a sea of town homes across the highway.

As far as the eye could see there were town homes.

So I drove through these developments and counted no less than 27 town homes that were for sale. When I returned to my office I conducted my own little market study, pulled the market data for the area and found that there were actually 47 town homes for sale in the area and the pricing for the average town home was around $120 per square foot (they price on a per square foot basis so you can compare prices of different sized properties).

“Surely,” I opined to myself, “the men asking to borrow $6 million of other peoples’ hard earned money have conducted similar such research and their pricing will be slightly below $120 per square foot.” “Surely” I postulated, “the men asking to borrow $6 million of other peoples’ hard earned money have conducted similar such research and are fully aware there are already 47 similar town homes for sale in the immediate area.”

Surely indeed. For when I looked at their proposed town homes, their prices and their square footage, their pricing came in at $172 per square foot. In other words, they had overpriced their town homes by 43%. If the average town home was selling for $200,000 they would charge $286,000.

Naturally I figured I must have missed something. If my figures differed by 5-10% in pricing, then it was likely they were just greedy and slightly over pricing their units and could be bargained down. But 43% suggested to me I had missed something completely. Perhaps these town homes were particularly special. Perhaps these town homes came with a built in Jacuzzi or had their own private vineyard. Perhaps a free F-16 fighter plane came with the purchase of a new town home. Or perhaps there was a squad of cheerleaders that would cheer you on as you parked your car, watered your grass and did other mundane tasks. And sure enough there was. After talking to the banker who brought me the deal, I found out these town homes would have access to a clubhouse. And this clubhouse not only had a pool but also had…

conference rooms!

No Jacuzzi.

No personal F-16 fighter plane.

Not even my own personal squad of cheerleaders.

No, just a lousy pool and some conference rooms in a clubhouse, and it would cost me an extra 43%.

Obviously these town homes would not sell. Obviously, these men had not done their homework. Obviously the bank would lose its money on this loan.

However there was good news. This loan differed from the other two in that this loan hadn’t been made yet, it was just a proposal. Meaning this loan and the problems that would come with it could thankfully be avoided. All the bank had to do was turn it down. You would think that it would just be a matter then of showing management the 43% overpricing of the town homes, not to mention the already existing 47 town homes that were already on the market, and the bank would promptly decline the loan.

You would think.

For the ensuing battle was more lengthy and contested than the Battle of Somme. On one side was the banker and the broker who brought this deal to our bank. On the other side was myself and all the research I had done. The banker contested and questioned every number and statistic I had. He made me show him where I got the data and how I pulled it thinking somehow I had a bias or vendetta against him and was trying to sabotage his career. Upon satisfying that request the broker then pulled his own “market study.” And surprise, surprise, the broker (who coincidentally was vested in a 1% commission should this deal go through) found that the town homes were “fairly” priced and that although 47 other town homes may be for sale in the area, they were not comparable to the larger, more “luxurious” town homes that were proposed.

True, the proposed town homes may be superior, but I showed them that my pricing had been done on a per square foot basis, which bypassed the need to find similarly “luxurious” comparable town homes. I also pointed out that even if the proposed town homes were more luxurious it didn’t warrant a staggering 43% premium over similarly sized town homes. Pushing the limits (and perhaps a bit smugly) I pointed out his study consisted of cherry picked town homes from neighborhoods that were in more affluent zip codes and picturesque, which then begat accusations of questioning his integrity and the use of the hurtful epithet, “young punk.”

Regardless, the biggest point of contention I came to find out wasn’t the location, the pricing or the current supply of housing, but rather the club house. The banker, visibly frustrated now said, “Look, you are completely ignoring the largest selling point of this development and that is the club house! What about the club house!?”

I thought to myself, “You have got to be kidding me?”

Six hours arguing over pricing per square foot, valuation techniques, comparables, housing inventory and zip codes and I come to find out that their whole argument, their whole reasoning for a 43% premium in pricing, their whole rationale for lending out $6 million of other peoples’ hard earned money was that stupid club house.

“What about it?” I asked.

“It’s a really great club house.”

And that’s when I realized that I was not dealing with rational people. No matter what I would say, they would still argue for the funding of this loan.

The land could be sitting on an old nuclear waste dump.

“But it’s got a club house.”

The land could border the tarmac to the international airport.

“But it’s got a club house.”

The land could buttress an active volcano, erupting at this very moment.

“But it’s got a club house.”

Opting to waste no more time I said, “Fine, let’s submit it for approval, see what the higher ups think.”

Thankfully in the end cooler heads prevailed and the loan was declined, but what was most disturbing about this episode was just how close this loan got to being approved. The most basic and simple common sense would dictate this loan be thrown out the window immediately. But the political pressure to make sales quotas was so high that management insisted we explore every possible way to make the deal happen, resulting in myself, the banker and various members of management wasting nearly 20 labor hours on something that should have taken no more than 20 minutes.

Sadly, while this particular development may have had a happy ending, the truth is the majority of real estate developments were never turned down, no matter how bad they were. At every bank I worked at and across the industry the story was the same. Real estate development deals that had little to no hope of being repaid were being made left and right. As long as somebody owned the land and had put together some nifty blue prints and an “artist’s conception” of what the finished town homes would look like, they were approved. And as long as the appraisal, no matter how inflated of bogus, showed a high enough value, they were approved. In my entire banking career I had seen no more than four real estate development deals turned down and all of this in the face of growing and damning evidence that a historic glut was forming.

What is potentially going to be the largest irony in the entire housing scandal, the secret that nobody is going to let you in on is that these deals, and to a large extent, the entirety of the housing crisis could have largely been avoided had the banking industry required one simple thing;

Absorption studies.

Absorption studies are simple reports or formulas that calculate how much a local market can “absorb” in housing. You look at various variables including the increase in population, housing permits issued, jobs added to the area, etc., and infer how much demand versus supply there is for housing. From this you can deduce, rather accurately, how many new units of housing the area will need in the foreseeable future.

The only problem is despite their obvious use and value not once, NOT ONCE in my years in banking did I ever see an absorption study. I had heard of them. I had studied them. I even composed some myself to internally analyze some proposals we received. But after all my years working in the banking industry and literally hundreds of real estate development proposals I had seen, not one of them included an absorption study.

Had an absorption study been required of all real estate developments it would have immediately paralyzed the forces that were contributing to the housing bubble at their source. Not only would the housing crisis been averted, but hundreds, if not thousands of real estate developers would have avoided filing for bankruptcy. The study would have shown them, quite clearly, that there was already an excessive amount of housing in most markets, that their properties would not sell and that they would lose money. Their plans would be taken off the table and demand would be allowed to catch up to supply.

Furthermore scores of mortgage lenders would have avoided bankruptcy not to mention legions of employees and contractors related to the housing industry would have avoided being laid off altogether.

But the consequences for refusing something as simple as an absorption study go beyond the developers, mortgage lenders and their employees. There is also a severe consequence to the banks and society at large.

In continually approving real estate loans that had no hope of ever being paid back, the banks effectively did two things that undermined their future financial health.

One, they made bad loans. It naturally follows that if you make bad loans, you will have losses. The properties won’t sell, the developer will not be able to pay you back, and not only do you lose out on interest, but if and when the houses do sell, you’ll probably only get a fraction of the money you lent out. This has already begun to happen.

Two, they impaired their own collateral. In theory to lower their risk and ensure they don’t lose their money, banks require that you pledge your house or real estate as collateral. That way should you fail to make your payments, the bank can repossess your property, turn around, sell it, and get their money back. But because of the sheer volume of real estate deals that were being made, banks flooded the market with housing, driving the market value of their collateral down to the point it was worth less than what was owed on it. So even if the banks did repossess these developments and try to sell them it is unlikely they’d ever recoup the full amount they loaned out.

These two things combined pose a serious threat to the banking industry. Because of the business they’re in, banks are naturally highly leveraged, meaning they have a lot of debt and very little equity. And it doesn’t take a lot in losses to wipe out the equity they have and send them into bankruptcy. Furthermore, as property prices drop and the banks repossess their failed real estate developments, the value of their collateral drops as well. This decreases the value of their assets, but does not change the value of their liabilities, forcing them to write off some or part of their loans, further eroding their net worth.

The end result is that many banks are facing the very real and increased prospect of bankruptcy. Unable to recoup the money they lent out, some banks will have to admit they do not have the money to honor and fund the deposits of all of their customers. Normally in the past this would have triggered a bank panic, people would have rushed to their local bank to get what money of theirs they could. But we no longer have bank panics because through various governmental entities, your deposits are guaranteed by the US federal government, otherwise known as the US taxpayer. And this is the other consequence of the stupidity and ignorance of the banking community.

By recklessly and irresponsibly lending money to questionable real estate developers various banks have pushed themselves to the brink of bankruptcy and in doing so have dramatically increased the chance of a government bailout. And what is particularly appalling is how these loans ever got made in the first place. It is inexcusable that bankers would advance the funds to these developments with absolutely no clue as to whether or not these developments would sell. It is unforgivable that with absolutely no absorption study, how they found nothing wrong with being so free with other people’s money to the tune of $8, $10 or even $15 million. And because of such stupidity it really forces one to think whether they consciously knew what they were doing and were just in it for the commission, or if they truly were that inconceivably stupid. Regardless of whether it was criminality or stupidity, it’s the taxpayer that will pay for their mistakes.

Of course the question is just how much are these mistakes going to cost the taxpayer? The last time renegade bankers ran unchecked was during the Savings and Loan crisis in the late 1980’s. That scandal cost the US taxpayer $150-$200 billion depending on whose estimates you prefer. This current housing scandal, although too early to tell, some estimates by varying economists put the potential cost of the housing scandal up to $1 trillion.

Poor taxpayer just can’t get a break.


justacoolcat said...

Thanks for the read of this very insightful post.

Anonymous said...

Politicians don't really get to keep their jobs if another depression occurs. But to a certain degree, we need one for some time now. Many people need to be taught to save money instead of spending every dime on something that they themselves barely want. Afterall, some people complain about all the fees and costs of cell phones, but continue to keep using them. Only when their financial security is destroyed will they learn. Learn to be responsible.

Plus it would destroy the growing threat of growing Chinese power. Their piggy backing on our consumer demand.

Anonymous said...

WOW, this reminds me of the Dot Com bubble, when you could go to Silicon Valley and without a business plan of any kind and just a great idea, with no real research whatsoever, you could get venture funding, and then have you company that was not even generating revenue (no profit is one thing, no revenue is another!) go public, and people were then buying stock in all these non-revenue-generating companies going IPO, etc...

Then the same thing happens with the real-estate market, propose real-estate ventures without any real business plan or research, get the money, and build!

I swear as an entrepreneur, I am NEVER making mistakes this stupid!

BTW, Capt, do you have an e-mail for people to send you economic news we receive from other places that you may not be aware of?

For example, I don't know if know or not, but just in case, the LA Times reported that China's GDP is 40% smaller than thought, here's the link: http://www.latimes.com/news/opinion/sunday/commentary/la-op-mead30dec30,0,1035099.story?coll=la-sunday-commentary

Anonymous said...

Capt, give me your mailing address or PO Box. I'll buy "Book Proposals That Sell" and mail it to you.


Steve said...

Still a great read! As I read the 3 parts I'm reminded of a relative who purchased a home. Of course this isn't a million dollar housing development but I think it shows how quick and easy it was to get a loan. The bank included all of his overtime in calculating his income. Overtime comes and goes and in the year he's been in the home, he had to get helped out several times to make his house payment as his overtime decreased. I wonder how many other loans like this the bank made.

Anonymous said...

A sad, but valuable tale, Captain. I place the finance industry on the same dung heap as the legal and political entities. Imagine how much better off this country would be if these groups actually functioned with integrity and performed in the manner with which they were intended? I told my kids years ago that I'd disown them if they joined one of these professions and behaved like its membership!! Thankfully, they listened!

Captain Capitalism said...

HA! Bucktown, always the eternal optimist.

If you guys want to shoot me an e-mail, and Buck you want my mailing address the e-mail address is;


Ensure to copy and paste it, it is CAPTcapitalism@yahoo.com

Anonymous said...

Moral hazard.
As someone before me said we need a depression, but we also need to let banks fail so these greedy bastards that are encouraged to take excess risk because of a social safety net get punished big time.
Eliminate fractional reserve banking(by lifting government guarantees) and you all but kill inflation. People would be safer holding on to a currency backed by a hard asset then to put money in banks just to keep up with the inflation the banks are creating.

Anonymous said...

"As someone before me said we need a depression, but we also need to let banks fail so these greedy bastards that are encouraged to take excess risk because of a social safety net get punished big time.
Eliminate fractional reserve banking(by lifting government guarantees) and you all but kill inflation. People would be safer holding on to a currency backed by a hard asset then to put money in banks just to keep up with the inflation the banks are creating."

Quoted for truth. Back in the day when banks weren't sitting on a government safety net, they were careful not to let their liabilities get out of control relative to their assets, or they risked being bought down by other banks who would purchase other people's deposits and withdraw them all at once.

The threat of a bank run, even one intentionally triggered, works wonders for keeping greedy bastard in line and doing their jobs with some responsibility and prudence.

Anonymous said...

The funny thing is something I've always been aware of dealing with banks: they've always been ready and willing to lend me much, much more than I realistically thought I could pay back. After years of living in a smaller house than what I could have had, I made double and triple payments and I now own it and have zero debt. People really need to sit down and read their loan contracts and be realistic about what they think they can borrow and pay back. Enough of my reamblings...