The Anatomy of a Banking Crisis
Since real estate has become such an important part of these secular trends, these quarterly updates always have a real estate bias, and this report will be no different.
In this update, we’ll look at how real estate, both residential and commercial, has transitioned from a stable asset to a speculative asset and how that has destabilized the US banking system.
A rapid increase in debt accompanied rapid price appreciation in US real estate over the last 30 years. The combination of price appreciation and debt accumulation is one of the core elements of any debt/banking crisis.
In the book “Manias, Panics, and Crashes”, Charles Kindleberger expanded on ideas put forward by Hyman Minsky and outlined the anatomy of a crisis. Going back over two hundred years, all of the banking crises followed a pattern of shock > overtrading > revulsion > discredit.
Some of the dynamics in US real estate today fit the anatomy of a crisis.
Troubled assets and bank insolvencies will lead to another fork in the road, and the question is whether the country will increase its debt to bail out bad banks and questionable real estate investments, thereby suffering worse economic conditions over the long term.
Alternatively, we can choose to accept a period of deleveraging for a better and more prosperous economy in the long term.
From 1890 to 1990, a one-hundred-year period of American history, real home prices increased by 0.2% per year.
For most of modern American history, home prices perfectly kept up with inflation, most likely due to the land value.
Starting in the early 1990s, real estate prices exploded and transitioned from a stable asset to a speculative asset.
Transition From Stability to Speculation
From 1997 to today, real home prices have exploded, rising an average of 2.4% per year, while real GDP growth has declined by 30%, averaging just 2.3%.
From 1997 to 2006, real home prices increased by 75%. This rapid home price growth period was accompanied by a rapid increase in debt for households and large financial institutions, ultimately leading to the largest decline in residential home prices since the Great Depression.
After the pandemic hit in early 2020, real home prices increased nearly 30% in 24 months.
Real home prices have declined roughly 7% from their 2022 peak, which is on par with past recessions and substantial once you consider there has yet to be a significant disruption in the labor market.
The rapid price appreciation in the residential market is a cause for concern, but the more significant pressure for the economy and the banking sector is developing in the commercial sector.
In the mid-2000s, real commercial real estate prices increased by 60% before collapsing and reversing all the real gains.
Interestingly, real commercial real estate prices flattened out before the COVID crisis as struggling sectors like malls and retail space suffered.
Prices started to decline sharply during the COVID recession, but as a result of the bailouts and government relief, prices surged back to new all-time highs.
Price Appreciation + Debt Accumulation
The problem with the commercial sector, more so than the residential sector, is the rapid increase in debt. Rapid increases in prices and rapid expansions in debt form the anatomy of a crisis.
Most often, multi-family residential apartments are considered commercial real estate – but the debt statistics treat them separately. The level of debt in the multi-family residential sector has exploded over the last 30 years, rising from 3% of GDP to almost 8% of GDP.
"Revulsion"
If we focus on commercial, which includes multi-family apartments, we have a situation where there was rapid price appreciation, accompanied by rapid increases in debt and now large and precipitous price declines.
I like to use real prices or inflation-adjusted prices when comparing declines in real estate across time, but if we look at the raw data from Green Street Advisors, we can see that all properties are down 15% in nominal terms, with office buildings down 25% from the most recent peak. Interestingly, apartments, an area with rapid debt accumulation, is down 21% from the peak, the second most after office.
If we follow the Kindleberger blueprint, a debt crisis should follow a pattern of shock > overtrading > revulsion > discredit.
Minsky said that a shock, displacement, or innovation is the origin of any crisis. The shock should be sufficiently large that it increases the profit opportunities of at least one specific sector.
If a shock is combined with an increase in the supply of credit, a boom is fueled. It’s clear the stimulus efforts of 2020 rapidly increased the supply of credit and easy money while a massive disruption impacted the real economy.
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