The real estate standard

At the height of the 2008 financial crisis, the U.S. government seriously considered nationalizing a large chunk of the American banking system. Instead, what it did was take effective control of the massive U.S. mortgage market. Without Federal guarantees and full government support, the U.S. real estate market (already under critical pressure from the subprime crisis) would have suffered a disastrous meltdown. This Federal control was implemented through the nationalization of both Fannie Mae (FNMA) and Freddie Mac (FHLMC), the two giant government-sponsored enterprises that provide the necessary liquidity in the secondary mortgage market. As a result, today these two entities guarantee approximately 65% of new mortgage loans in the U.S., compared to 27% in 2006! Moreover, the Federal Housing Authority (FHA) and the Department of Veterans Affairs (VA) guarantee about 20% of new mortgage loans, against just 3% in 2006. Therefore, as 9 out of 10 new home loans are now guaranteed by the U.S. taxpayer versus 3 of 10 new loans in 2006, the U.S. real estate market has effectively been nationalized!

It is crucial to identify and understand these issues. It is important not to be misled by recurring real estate ‘bubbles’ in both the United States and Europe. The support and promotion of home ownership were the easiest vehicles for banks and governments to ‘’create money’’ in order to give us the illusion of material comfort while our wages declined. The process is simple because the money created by the banks is used for all of our daily transactions, without us even thinking about the big picture. In fact, the housing market substantially affects our economic cycles. And its economic activity accounts for most of the money in circulation. Therefore, since the real estate sector is our fundamental growth engine, any real estate crisis has devastating effects throughout the economy. The real estate market’s multiplier effect on the economy is positive when the sector does well but especially negative during downturns. Eight of the last ten recessions in Western countries were caused by real estate crises. Despite the diversification of our economies, their technological advances and their enormous size (like the U.S.), a real estate crisis almost invariably escalates into a generalized recession. This is because real estate massively affects money creation and contraction.

The financial system as well as government authorities is very much aware of the dangers of sharp drops in real estate markets. This situation causes distortions in the valuation methods. There are three main methods for estimating the value of a property: cash flow, cost of replacement and comparative sales. However, since cash flow (rents) and replacement cost obviously do not justify current market prices, the comparison valuation method prevails. The banking system depends primarily on real estate for money creation and no mechanism can today replace the wealth effect created by this sector. It is what sustains consumption in our economies. As a result, we find ourselves in absurd situations like the one that prevails today in the United States where it is the Federal government that ‘de facto’ controls real estate market valuation.

At another time in our history, it was gold and the gold standard that defined the convertibility value of banknotes. Today, the dollars and euros in our pockets are indirectly convertible against property because most of the money created by banks derives from the growth of the real estate market. As banks and “shadow banking” create money based on real estate valuations (which are known to be artificial), we end up living not under a gold standard but under a “real estate standard”, where most of our money only exists to encourage property price appreciation.