Brief Housing Bubble 2.0 explanation

Reference

Housing Bubble 1.0, created in part by Basel II risk-weights of only 20% to AAA rated securities backed with mortgages to the subprime sectors, exploded, and a lot of liquidity was then injected with Tarp, QEs and other means.

Much of that liquidity was channeled through banks with not much capital and which, because of lower capital requirements (risk-weights sovereign = 0% and residential housing = 35%), channeled that liquidity into financing the government (low interest rates) and housing. The SMEs and entrepreneurs, with a risk-weight of 100%, had no chance to access loans at correct risk premiums.

If there is no change we all end up in houses with mortgages, but no jobs to pay the utilities and service the mortgages with.

Crony bank regulations got us into serious problems

For the purpose of setting the capital requirements for banks…

To our bosses, the infallible sovereigns, the governments, let’s give them a zero percent risk weight,

To that house financing politicians want to favor, let’s give them a 35 percent risk weight.

To that AAArisktocracy that we meet in Davos, let’s give them a 20 percent risk weight.

But to the SMEs, entrepreneurs and citizens, so that we seem prudent and conservative, let’s give them a 100 percent risk weight.

And for better measure, to the below BB- rated, let us assign them a 150 percent risk weight

And so banks earned higher risk adjusted returns on what was perceived, decreed or concocted safe, than on what was perceived as risky.

And so banks held too much AAA rated securities, loans to Greece and residential housing finance… and we got us the 2007-08 crash.

And so banks hold too little loans to “risky” SMEs and entrepreneurs… and so we can’t get ourselves out of the doldrums.

Anyhow let us pray Per Kurowski does not insist in explaining to others that, with respect to the real risk assets can pose to the banking system, these risk weights could be just 180 degrees the opposite.

Prioritizing the financing of residential property over the financing of job creation is not the smartest thing to do

Based on Basel II’s standard capital requirements for banks, these are required to hold 2.8 percent in capital when lending secured by mortgages on residential property and 8 percent when lending to SMEs and entrepreneurs. 

That means that the adjusted for risk net margin paid by a residential borrower can be leveraged 35 times by the bank (100/2.8), while the same margin can only be leveraged 12.5 times (100/8) if paid by SMEs and entrepreneurs.

And that means banks can obtain much higher risk-adjusted returns on equity when lending secured by mortgages on residential property than when lending to SMEs and entrepreneurs. 

And that means that banks will find it much more interesting to finance residential property than to finance those who can help to create the jobs to help residential mortgages and utilities to be serviced.  

That definitely sound skewed the wrong way. If I was the regulator I would much rather prefer banks financing more the creation of jobs, so that people could better afford to buy their homes with less financing… but that’s just little me.

“But building homes creates jobs?” Indeed, but once everyone has a home, and a mortgage to service, which diminishes their available income, where are our grandchildren to work?