Since last week, there’s been a lot of talk and debate about Obama’s recently unveiled “Volcker Plan,” which seeks to place aggressive limits on bank size and activities. Peter Wallison, a senior economist at the free-market focused think tank American Enterprise Institute, has an interesting op-ed in the Wall Street Journal today criticizing the plan. Most of the points he makes are those I’ve heard before, and some are even similar to my own worries. But towards the end, he picks up on an interesting subtlety involving banks’ addiction to real estate. Is it a problem?
Wallison writes:
There is one more factor to consider. Banks have been committing themselves increasingly to financing real estate. The reason for this is simple. Because they cannot underwrite or deal in securities, they have been losing out to securities firms in financing public companies–that is, most of American business other than small business. It is less expensive for a company to issue notes, bonds or commercial paper in the securities markets than to borrow from a bank.
Where, then, can banks find borrowers? The answer, unfortunately, is commercial and residential real estate.
Real-estate loans rose to 55% of all bank loans in 2008 from less than 25% in 1965. These loans will continue to rise in the future, because only real-estate, small business and consumer lending are now accessible activities for banks.
This is not a good trend, because the real-estate sector is highly cyclical and volatile. It was, indeed, the vast number of subprime and other risky mortgages in our financial system that caused the weakness of the banks and the financial crisis. Requiring banks to continue to lend to real estate, because they have few other alternatives, virtually guarantees another banking crisis in the future.
Since banks can never be let out of these restrictions as long as they are government-backed, one solution for banking organizations is to center their activities in the bank holding company which–because it is not government-backed–does not have to limit its range of activities. The fact that Mr. Obama now proposes to close off this one avenue through which banking organizations can be profitable is strong evidence that neither he nor his advisers, in attempting to lash out at banks, have thought through the long-term prospects and needs of the banking industry.
That might make good populist politics, but it is not responsible policy. Instead of trying to punish the banking industry, Mr. Obama should try to understand why banks have become so heavily invested in real estate.
First, when Wallison says “banks” I believe he means deposit-taking institutions — not bank holding companies with investment banking arms. I assume he’s calling them “government-backed” because he means that they have federal deposit insurance. As oppose to bank holding companies that have no explicit government guarantee, despite what recent events might suggest.
I bolded a sentence of the excerpt above, because that’s his crucial point. He worries that the Volcker plan would actually make banks’ reliance on real estate even worse. They would no longer be able to engage in prop trading. In the unquoted portion of his essay, he explains that prop trading, while risky, has been highly profitable for banks — unlike real estate, which has been less profitable and also surprisingly risky.
I have a few comments here. First, Wallison likely already knows the answer to the challenge that Wallison sets out for Obama in the final paragraph above. Banks have a love affair with real estate because it had been seen as overwhelmingly safe. They developed an absurd view that real estate would always be profitable. But more importantly, Wallison would likely point out that much real estate, particularly residential mortgages, had come with an implicit federal guarantee from the government-sponsored entities like Fannie Mae. That, I suspect, is what Wallison would like for President Obama to discover — and correct.
My second observation, however, is that the Obama administration probably wouldn’t be too troubled by Wallison’s analysis. I can imagine Volcker or others who support the plan responding, “So what you’re saying is that banks might have trouble being as profitable if we create these limitations? Hallelujah! That’s exactly what we want!” Wallison sees this as a problem, but those who think banks are making too much money would probably invite a situation where they have trouble profiting as greatly. And they’ve also convinced themselves that Wall Street’s complex securities — not real estate — caused the crisis.
Still, no matter your view on the cause of the financial crisis, banks reliance on real estate might be a legitimate problem for other reasons. If you consider the statistic that Wallison uses, that 55% of bank loans are now real-estate driven, while only 25% were in 1965, I can’t help but think about industrial and business growth. In recent years, especially the last decade, a lot of U.S. business growth was replaced with real estate-related growth. Is it a coincidence that banks have also shifted to catering more to real estate? It could be, but I think it’s more likely that the government’s insistence on promoting real estate has crowded out other industries and made those loans appear safer, and more consequently more desirable, to banks, which shied away from underwriting more loans for business endeavors. That’s not smart long-term economic policy if you want a nation to exhibit strong industrial and technological growth.
