September 30, 2007

The great credit contradiction

Posted in Banks · 5 comments ·
Share 

While ordinary house-buyers are paying high priced loans on average houses, the banks are falling over themselves to lend millions to super-rich developers.

Now that the great credit deluge is coming to an end, it’s time to take stock. Credit liberated the society in a variety of fantastic ways.

The old class system was blown apart by the injection of liquidity which, up until the early 1990s, had been the prerogative of a tight-assed middle class who did very little with the cash at their disposal.

When credit was made available to risk-takers the economy took off. But now that the cycle is turning, something distressing is emerging.

I have written before about how, when lucre gets divided up by the banks, it cascades into an economy like a champagne pyramid. When the banks go out and borrow money it is the equivalent of popping the cork of a jeroboam of champagne.

Credit flows initially into the top, triple-A assets, such as the major development sites.

Then this market overflows, so the excess cash finds its way into other, more risky assets. As these fill up with cash and yields fall, the speculative cash goes further afield looking for return. Eventually, a s long as the taps remain turned on, even the riskiest projects, regions and ventures get cash.

However, the price of that money, like the amount of champagne you get, depends on where your glass is in the pyramid.

If you are close to the top of the pyramid, like the oligarchs, your cup is constantly overflowing. However, if you are at the bottom you realise that there is cash everywhere, but it’s not quite reaching you, so you have to pay more to get your hands on it.

If you want to catch a glimpse of how this system works, to see who is getting all the cash they want and who is struggling, pick up a paper today. Look at the business section. Doubtless you will see details of some mega-deal proposed by some developers or other.

These days this is as much an exercise in PR for the flagging market. Then flick to the small ads, the ones that start by asking if you’ve been rejected by a bank or if you need to roll all your debts into one. You are down with the bottom-fishers now, the people who can’t get credit. The contrast between the two borrowers couldn’t be more stark.

Last year’s hotel deals involving Jury’s, the Berkeley Court and the Burlington saw sites change hands for between €70 million and €80 million an acre, making Dublin more expensive than New York when it comes to land. But how is the whole thing financed? How did the men involved stump up all this cash – €400 million here, €600 million there?

Well the simple answer is that they didn’t. In many cases, the developers buying these properties paid very little of their own hard cash for the pleasure of owning one of the most prized assets in the city.

So let’s examine how a mega-deal at the height of the property mania was financed. The key to all this was/is the banks. In many cases, the developers are just fronts for banks or for a stockbroking firm.

Consider a typical deal at the height of the boom in Dublin where a developer is seen to have bought a property for €100 million. The property, let’s say it’s a premium office block, has a good tenant and a strong stream of income. The rent is €5 million per year. The yield is therefore 5 per cent. But how does he get his hands on the €100 million he needs?

Remember the market was going up, so he was confident that he could sell on in a few years.

The bank, which knows him well, will finance 85 per cent, taking a charge over the property. So he has €85 million already in the bag. He negotiates with the bank to roll up the charges and interest into one lump sum.

Now he has to come up with €15 million of ‘his own’ cash. He calls his mates in the stockbroking company and says he needs €15million.By this stage, the deal is almost secure, and as the market is raging ahead, they can re-rate the asset the minute they have all the cash in.

The broker puts together a syndicate of ten investors to raise €20 million. The extra €5 million is to cover the broker’s ‘costs’, don’t forget. The broker may also negotiate what is called a ‘carry’, which is a bit of the equity for himself, which he can realise when the sale is completed.

However, the ten investors do not put in €2 million each of their own money. They put down €250,000 each in cash and borrow 90 per cent from a bank, usually the same bank that is financing the oligarch. The syndicate investors get shares in a new company which now owns the asset.

The shareholders’ agreement says that the oligarch owns 85 per cent of the building (all borrowed) and the syndicate owns 15 per cent of the building. However, their share is no longer valued at €15 million — which was the original price the oligarch negotiated with the seller and the bank – but €20million,thus revaluing the building at €133 million already.

As a result of this new price all the shares of the new company have to be rerated upwards.

The developer, without putting in any cash of his own, is already looking at a huge capital gain. The interest costs and arrangement and lawyers’ fees are paid for by the rental income. So everyone waits.

These types of deals were happening across the country, so prices were being bid up not by fundamental value but by the effect of the syndicate’s modest outlay which re-values the entire property. The developer is getting money for nothing.

At the bottom of the champagne pyramid, a non-conforming borrower – the Irish world for sub-prime — is paying close to 8 per cent interest for the pleasure of staying in his overvalued townhouse in the commuter belt, whose value is now falling. He is trapped.

This is the paradox of credit, the rich get money for nothing, while the poor pay through the nose for it.


  1. [...] wrote an interesting post today on The great credit contradictionHere’s a quick [...]

  2. Raymond Darling

    Very Good, Very Interesting!

  3. “This is the paradox of credit, the rich get money for nothing, while the poor pay through the nose for it.”
    A truism really.The rich are less likely to default on loans I imagine.! the higher risk taker wants a higher premium as ever goog economist knows.

  4. Paul McKenna

    I’m a low/mid earner working in N.I. from Donegal in I.T. Ireland should have the seeds to the new Industrial / business and INVENTIVE culture for the world, look at our repressed (any irish) imagration laws, you have captured what i’ve thought for many a long time, i.e. the dispara of the irish, bring as many home, from all displines, and the students, we have had them, we’ve trained them, why not employ them?????
    I wish i could follow my comments with a change in career……

  5. MK

    Hi David,

    Another good article.

    I agree that there are different ‘terms’ for people with more assets than others, but it was ever thus (think of the Romans!), and it is appropriate for money lenders to apply different rates depending on risk, etc. This is the only way a lender can cover the costs of the estimated bad debt for a particular risk-class. As we have seen with the sub-prime “contagion”, a problem can be that as debt products get more exotic, the real risks are hidden (rating agencies can only estimate) and lenders and people involved in some of these leveraged products get stung.

    I dont subscribe to the premise that the rich get money for nothing, while the poor pay through the nose for credit. There is a difference of what ‘rich’ and ‘poor’ pay, that is true, but the ‘rich’ or larger projects can come crashing down just as easily as the smaller ones, and we are seeing some of that of late with leveraged hedge funds going ‘bang’ in a major way as well as financial businesses losing billions on purchased debt bonds, etc. But people with little money will always pay some more. Their only recourse is to save, save, and save and then invest wisely, build some assets up before borrowing only what’s necessary. Many dont or cant.

    > The developer, without putting in any cash of his own, is already looking at a huge capital gain.

    ‘Flipping’ property or any other asset, such as a business (eg: private equity buys), whether a 1-bed 25k flat in Bulgaria or a 100m plot in Ballsbridge or an 11b co such as Boots, may not require that much cash, but it is the same for small and large and there is equivalent risk involved, both for the borrower and the lender. As you correctly point out, lenders have been jumping over themselves to lend to such projects, and projects, whether the 20k or the 100m or the 11b can end up being leveraged to nearly 100%. So small and large can make sizeable gains without putting much cash in. The availability of credit stretches across all project sizes.

    > These types of deals were happening across the country, so prices were being bid up not by fundamental value but by the effect of the syndicate’s modest outlay which re-values the entire property. The developer is getting money for nothing.

    No, the paper value of any project is only a paper value. It only gains real value when it is sold on, or if the known demand matches the paper value (ie: someone is willing to bid that amount for it). In a rising market for these large projects, yes, the developers/investors/syndicates were making a gain, but the value was driven up by the demand, not by the syndicates outlay and re-pricing of the project. The developer in this case wasnt getting any money for nothing. They only get the money if there is a demand for the asset at that price valuation. This is the same for small or large projects. But a 10% gain on a 100m project is a lot more than a 10% gain on a 25k project (although exactly the same as 4000x 25k projects). And investors could double their money on both projects with leveraging which is cheap.

    > At the bottom of the champagne pyramid, a non-conforming borrower – the Irish world for sub-prime — is paying close to 8 per cent interest for the pleasure of staying in his overvalued townhouse in the commuter belt, whose value is now falling. He is trapped.

    The non-conforming borrower probably has a reason why they are paying a higher rate – ie: their risk. They most likely have either had some type of ‘financial history’ of not being able to pay debt, or else their income stream is not stable, at least as it can be perceived by the lending industry, the measurement of which is far from perfect. But they are not trapped necessarily as they can sell and rent elsewhere, perhaps in a more frugal property. They are only trapped if they bought at the wrong time and the valuation of their asset is less than their loan, so-called negative equity, but that is the same problem for low-risk borrowers as well as high-risk sub-prime borrowers.

    Ironically, as a group, the US example has shown that the sub-prime sector there has been supported by the less risky sectors and as a whole they have gained, ie: by getting access to funding that they really shouldnt have, and evidently the extra cost of their risk was not enough to cover the paying back problems they undoubtedly did have. The lending ‘agents’ in this case lent too much and lost out, but the receivers of those loans gained.

    Overall, with Bretton-Woods and the breaking of the value of money with real assets and work, and the availability of central banks to ‘create’ as much money as they want, isnt it any wonder that the world is awash with cash/capital, which are all competing to find a ‘home’? Is this a global experiment that will all come crashing down one day, when we all decide to take our money out and pay off our loans but find out that we ALL cant do it. Like a champagne tower or a house of cards, we need to trust the system. Its implicit tust in the stucture which keeps the tower or house up. If all the bottom cards or glasses should move ……

    Time for a Dom Perignon …..

    MK

You must log in to post a comment.
× Hide comments