Mis-pricing Risk in the US Real Estate and Lending Markets
Back before the housing bust in the early 2000’s we were in the process of purchasing a new condo and wanted to put down a substantial amount of money, over 50% of the purchase price. The response from lenders at the time was a full cavity search of all assets we had across all dimensions, and we never could seem to satisfy them (i.e. after we had given them everything, there were even more questions).
Meanwhile, people were getting “liar loans” with virtually nothing down or “balloon loans” with floating interest rates that were extremely risky, and they were paying roughly the same interest rate that we were receiving, even though the bank stood almost no risk of default with us since we were willing to put down 50% as equity. In order to lose money, the price of our real estate would have to lose 50% before the bank was at risk at all.
How this SHOULD have been accomplished is that someone borrowing money and putting down very little equity would have to pay a substantially higher interest rate than someone putting down substantial amounts of equity, since the real risk to the bank was far lower. Instead, the lender went through a spurious cavity search of me and then let the other guy do a liar-loan at virtually the same rates. This seemed ridiculous to me at the time and you can see how that all turned out for everyone.
Today, this problem has been “fixed” in a different way – instead of varying the interest rate based upon the inherent risk of the project, people with good credit receive loans at very low interest rates and people with poor credit are effectively frozen out of the market entirely. They have no access to credit at all, in the first place. We have de-facto rebuilt redlining, albeit based on creditworthiness, with no “slope” for those with poorer credit. This same process works with businesses – banks are willing to lend to those types of businesses that essentially don’t need the money (strong cash flows, limited debt) and won’t even consider riskier companies and start ups, at any price.
Mis-Pricing Emerging Country Debt Risk:
Today the world is hungry for “yield” or interest / dividend income, a consequence of the “zero rate interest policy” or ZIRP that is effectively employed in most of the developed economies today.
Mexico is currently able to issue debt at a rate of 5.43%. The Mexican finance officials see that there is a hunger for their debt and are moving to respond to it by issuing 10 and 20 year debt.
Several analysts saw the increase in long-term bond issuance as a response to the recent strong demand for the paper, which has pushed secondary-market yields down sharply in the past month.
While Mexico has financially been running a sound ship, with a reasonable deficit, there are profound risks in buying ten and twenty year debt at under 6%. The first major risk is the Mexican currency, which has depreciated many times in the past. The second major risk is crime.
A recent (highly recommended, albeit terrifying) article called “The Kingpins” in the New Yorker describes the intense drug wars currently engulfing Mexico, which lays out the following facts:
1) over 50,000 soldiers have deserted the army while fighting the drug war
2) it only costs 1000 pesos ($80 USD) to have someone assassinated in Mexico
3) over 98% of violent crime goes unpunished
4) drug lords are now tapping right into the pipelines of PEMEX, the oil monopoly and cash cow for the government, in order to steal fuel
The article follows the drug gang battles between various factions, the powerlessness and corrupt nature of the governmental bodies, and the civilians caught in the cross fire. These drug battles are so epic that they would better be described as military campaigns, and the entire situation is close to that of a civil war. Other than the use of massive heavy weapons (tanks, artillery) and targeting by ethic group (rather than gang alliances), the situation is likely not far from the Syria civil war in terms of total casualties and deaths.
HOW does it make sense to buy 20 year Mexican debt at a rate near 6%? To the extent that you believe the Mexican currency will do better than your currency and want to earn 6% during the interim, I guess that makes sense. But in general I cannot see that 6% interest rates in a country engulfed in a virtual civil war with widespread lawlessness and epic corruption making sense as fairly pricing that risk.
Likely the outcome of lending money in local currency to countries with severe domestic problems and a history of devaluations will turn out as well as our policy of granting loans to home buyers with virtually no equity and without verifying their earnings in the first place.
Cross posted at LITGM