Should the U.S. ban real estate lending?
Oct 24th 2009 1:00PM
Updated Dec 4th 2009 5:11PM
Lending money to people to build and buy real estate is a risky business that periodically costs taxpayers huge amounts of money. Not only do taxpayers lose as a result of all the tax incentives associated with real estate, but they also pay when the banks that make bad real estate loans go bankrupt.
While there are clear benefits to owning real estate, the business of real estate lending costs America so much that I think we ought to let real estate prices drop to a level at which people can afford it without borrowing.
What prompts these thoughts is the news on Friday that the number of bank failures hit 106 so far in 2009, the highest number since 1992, when 181 banks failed. And more are on the way as 416 banks with $299.8 billion in combined assets are on the FDIC's list of "problem" lenders, according to Bloomberg.
The interesting thing is that what caused bank failures back then is the same thing that is causing them now -- real estate and construction loans that developers couldn't repay when they abandoned failing projects, as well as landlords who could not make their loan payments.
How much have these failed real estate loans cost us? The S&L bailout that wrapped up around 1992 took $293.3 billion from the American taxpayer. And the current real-estate-led collapse has cost the FDIC -- to which I consulted in 1982 -- an estimated $25 billion this year -- a cost expected to hit $100 billion through 2013. (As I posted, another major cause of those failures has been the use of brokered deposits -- which came from all over the world in search of higher returns -- to make those real estate loans).
The cost to the FDIC is a tiny proportion of the total. If you take into account the cost to taxpayers of keeping the biggest banks from collapsing -- which resulted from borrowing too much money to buy securities backed by real estate loans -- the cost to taxpayers this time rises to $23.7 trillion. Of course, that includes the costs to the U.S. of bailing out Fannie Mae and Freddie Mac. And let's not forget the $1.1 trillion in credit losses and writedowns that banks have taken since 2007.
But there's an entirely different set of costs we incur to worship at the altar of real estate. I am talking about all the tax incentives for building and borrowing to buy real estate. For example, people who borrow to buy a house can deduct mortgage interest, points, and real estate taxes on their tax returns, costing the U.S. Treasury $75 billion, according to the San Diego Real Estate Market Blog.
People who own rental properties can also deduct a portion of the value of the property as depreciation, as well as the costs of managing the property, such as transportation, insurance, repair, and maintenance. And then there's the tax-free exchange of one investment property for another. These incentives for real estate investment are just the tip of the iceberg, and I don't know how much they cost taxpayers.
While the first wave of the current financial collapse was caused to a large extent by subprime mortgages gone bad, there is another $6.7 trillion worth of commercial real estate loans -- bundled into $700 billion worth of commercial mortgage-backed securities (CMBSs) -- that further threaten the banking system.
Analysts estimate that by 2012, $153 billion worth of these CMBS loans will come due, and since the property values have declined so much, about two-thirds of those loans will not be refinanced, costing about $100 billion in losses when the CMBS cannot be refinanced.
When you take into account all the costs of bailing out bad real estate loans and couple them with the cost to the Treasury of tax deductions to encourage people to build and borrow to buy real estate, you realize that it might be cheaper for society to end real estate lending and let the price of real estate fall until people can afford to buy or rent it without borrowing.
Is it possible to imagine a world where people live within their means when it comes to real estate? Sure. But making it happen would require overcoming a firestorm of opposition from all the people who benefit from the perverse incentives we've created to turn what would otherwise be unaffordable for most into a mass market.
Peter Cohan is a management consultant, Babson professor, and author of nine books, including Capital Rising (due in June 2010). Follow him on Twitter. He has no financial interest in the securities mentioned.