Economy, stupid...

The following is an email exhange I had with a gentleman I serve on a public (county) advisory board about the economy and banks, lending and the finance industry.

Him:
"For what it's worth, my personal predictions for the next four quarters are as follows: I anticipate the second and third quarters of 2009 will see an improvement from what we've seen the past six months. Much of this improvement will be seasonal. The last quarter of 2009 will see a seasonally adjusted improvement. In other words, I anticipate a more positive outlook for the building industry and a more robust economy in general, but we will be entering the seasonally slower period for actual job starts. I anticipate the first quarter of 2010 will see an even more improved economic outlook with the bottom of the recession behind us. The catalyst for any improvement, in my opinion, will be a friendlier lending environment for businesses and home buyers."

Me:
Most likely, the lending environment will not get any friendlier for the foreseeable future. The lending environment we have experienced since the early part of this decade is one of the most significant contributing factors to this economic downturn. Good businesses with capable management and adequate financial stability will always have plenty of good lending institutions across the country to seek financing. Weakening credit standards is not the answer to an economic turnaround. Neither is rampant government spending and increased taxation. Loosening credit standards is especially not the answer in residential or other consumer types of lending. Consumer lending has run far too long without an appropriate level of safeguards and a high level of availability to both the creditworthy and un-creditworthy in all facets of the market; credit cards and other unsecured lending, auto loans and residential financing. Coupled with overbuilding or oversupply creating negative trends in real estate values, high instances of rapidly increasing property taxes and declines in rents, the residential real estate market has a long road of recovery ahead. Our economic foundation over the past decade has been built on debt rather than cash. In fact, a significant portion of our economic growth in commercial and residential real estate was based on retail consumer spending of borrowed funds rather than household earnings. I do not see a significant improvement in our economy until the balance of our economic foundation returns to sound fundamental consumer spending of earned dollars, not borrowed funds. The same holds true for our myriad of governmental arms and agencies and their spending habits, especially our federal government, in my opinion.

Him:
"With all due respect to your banking background, and in light of the fact that banking is not my profession, I would like to respectfully disagree with a portion of your response. No doubt the lending habits of the past ten years were unwise, however, currently, it is very difficult to get financing on vacant property. Of all of the valuable commodities on earth, in my opinion, vacant land is a cornerstone more stable than the bulk of other investments.

"Many lending institutions are loaning money using collateral much less solid than real estate. I understand that, in light of the current situations, many banks find themselves in, they will be unable to do land loans anytime soon, however, I can't help but think that at some point, these institutions will decide to loan on raw real estate again."

Me:
The world would be a pretty boring place if we agreed on every subject all the time. It is very difficult to get financing on vacant property because lending practices in the past ten years were unwise.

Land is certainly a valuable asset. Lending money on unimproved land, however, is among the highest risk lending practices in the market, now or at any time in the past. The reason is because the vast majority of loan repayment dollars will come from the sale of the completed land and/or other sources of financing (like a home construction loan). The repayment rarely comes from internally generated cash flow by the borrower. Land values are instable and have relatively short periods of significant fluctuation. I do agree that in the long term, land values increase and at times are good investments, but not for a bank. It is not sound lending practices to lend money on an asset (unimproved bare land) that has no internally generated cash flow to repay the loan. It is much different to lend money secured by a property that has a house or apartment that generates income to the borrower.

Right now, in many markets across the country, there are huge surpluses of for sale improved land. The inventory is well beyond what the market can absorb in a year or possibly two years. From a bank’s perspective, there are no incentives to add more to the supply. A repayment scenario that is more than a year out on land acquisition and development loans has been proven many times over to increase default rates beyond acceptable levels. Many banks have the capacity to lend in this area, but due to the market conditions and the risk, most will not.

I hope that clears up your questions.