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Appraisers and the credit crunch.

Beginning in January 1990, profuse ad hoc evidence has surfaced in the popular media professing the existence of a credit crunch in the United States.(1) The popular press has indicated that this credit crunch was partially responsible for the economic recession beginning in the third quarter of 1990.(2) One can ask many questions about the media's coverage of the credit crunch: not the least of which is whether it truly does exist. If so, when did it start, what and who caused it, and what influence has it had on the economy? Were appraisers co-conspirators in the causes of the credit crunch? To try to answer these questions on the basis of how the media presented the situation, this article analyzes over 150 recent business media articles that discuss the credit crunch.(3)

The authors first examine the obvious signs of the credit crunch and then present and discuss apparent causes of the credit crunch, examining the roles that appraisers have played in it.

REPORTS OF A CREDIT CRUNCH

Several authors define and analyze the start of the credit crunch. In April 1990, the first report of a credit crunch in any region of the U.S. appeared in the Southwest with a report in The Dallas Business Journal, "Credit Crunch Still Slowing Texas Recovery," claiming that the credit crunch started in north Texas four years earlier.(4)

The next region to mention a credit crunch was the Northeast. Two 1990 reports mention initial credit problems in the Northeast: one article, "Financial Institutions, Glauber, Congress Support Credit Package As Step in the Right Direction," appeared in April in the Daily Report for Executives, and the other, "Regulators Are Wielding Ax When Finer Tool Is Needed," appeared in May in The American Banker.(5)

In the Southeast, credit crunch reports began with an article in July 1990 called "FDIC Choking Local Economy."(6) The article states that the start of a reduction in available capital in the Southeast may be pegged at mid-1989 with the announcement of the arrival of examiners from the Office of the Controller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) at middle-Tennessee banks.

The last region to report a credit crunch was the West. There, the first article to report its existence, "Housing Permits in Orange County Fall to an 8-Year Low,"(7) appeared in January 1991 in the Los Angeles Times. The appearance of all these initial reports spanned approximately a nine-month period from April 1990 to January 1991. At least one pegged the beginning of the crunch at as early as 1986.

OBVIOUS SIGNS OF THE CREDIT CRUNCH

Three obvious signs of a credit crunch are a change in bank attitudes toward lending, an inability to secure funds for real estate, and a lack of demand for loans by consumers. The potential magnitude of a shift in attitudes toward lending, especially among regulators and bankers, is better understood when seen in the context of the lending environment of the 1980s. Under President Reagan, deregulation and laissez-faire economics led to the removal of interest rate ceilings and to freer lending restrictions, both of which allowed banks and savings and loans (S&Ls) to venture into a larger variety of markets, including high-risk loans. When the economy slowed in the late 1980s, however, and regions such as the Southwest lapsed into recession, banks faced a high rate of defaults on loans, especially in the real estate areas of their portfolios. Operating on the assumption that, historically, financial institutions have survived business downturns and subsequent upturns, many wrote off their losses and continued making loans. In the process, though, institutions found themselves undercapitalized.

At this point regulators became stricter with financial institutions, especially in light of a growing number of lending institution failures. Bankers and other lenders fortified their portfolios with more secure financial instruments, such as government securities, in essence moving away from lending and toward investing.(8) The cause of this behavior seems to be the government regulators' tests of collateral for loans and the emplaced expectation by regulators of repayment by real estate borrowers only from lender repossession or forced sales. In acting on these government rules, lenders in essence ask for "safe" but low appraisals of real estate. This change in lending attitudes on the part of the lending industry may have helped cripple the real estate industry.

The growth of the real estate market in the 1980s included some projects that were not justifiable or viable. The result has been high vacancy rates in commercial markets--20% or more--along with overbuilt residential markets. With falling project values and declining asset prices, developers and home builders face difficulties in securing loans for new projects and in refinancing their existing loans. This stagnation of the real estate market is perhaps the most obvious sign of the credit crunch; reduced numbers of loans made to real estate projects may be evidence that the credit crunch truly exists.

Another sign of the credit crunch has been the apparent lack of demand for loans by consumers. Lenders say funds are available for such loans, but there are no customers for these funds. This explanation shifts emphasis from the supply (the lenders) to the demand (the customers). Potential borrowers have faced recession by trying to avoid more debt. Builders who have not been able to remain afloat have exited the loans market, and those who are still solvent are reluctant to borrow to start any new projects in a depressed market. The lenders, on the other hand, claim they have money to lend, but they are slow to invest in the risky real estate market and in a recession-burdened economy.(9)

REPORTED CAUSES OF THE CREDIT CRUNCH

When analysts discuss the credit crunch, they cite several variables as potential causes. Invariably, government intervention plays a role in their analyses as does the economic climate, which affects both the demand for loans and willingness to supply loans. When regulators clamp down on banks so as to prevent a repeat of the S&L failures, analysts note a resultant change in bank attitudes toward lending. Other analysts attribute the change in attitudes to self-monitoring by banks as they tighten credit standards and restrict lending activities. At least one article terms appraisers "unrealistic" in a dysfunctional market, saying they are acting in such a way as to push real estate values down unjustifiably.(10)

For the most part, the media claim that appraisers have played minor roles in the reported causes of the credit crunch. In the Northeast, one developer seems to accuse appraisers of revaluing land to the point where holdings have no worth.(11) Few articles pinpoint this cause with such emotion and directness; most analyze the causes of the credit crunch on a much broader basis.

The following sections discuss the most frequently cited causes of the credit crunch, including failed S&Ls and the formation of the Resolution Trust Corporation (RTC), the banking industry, government regulations, and pessimism about the economy.

Failing S&Ls and the formation of the RTC

The S&L crisis and establishment of the RTC play a central role in any analysis of initial causes of the credit crunch. With the liquidation or merging of 20% of the nation's S&Ls out of the lending market, fewer builders are using thrifts as a primary source of loans, according to the National Association of Realtors.(12) The RTC serves as the government holding company for failed S&Ls, acting to liquidate assets of closed S&Ls, usually at a loss. Appraisals done before foreclosure tend to be lower than fair market value. The sheer size of the RTC's portfolio threatens the value of current assets and worsens the collapse in value of real properties, thus depressing an already depressed market.

The RTC, moreover, is not a lending institution; it is not bound to honor commitments made by the failed S&Ls and will not rollover construction loans into permanent financing. Yet commercial banks have not offset the reduction in S&L financing. The fact that so many S&Ls have been weakened by real estate loans has made banks reluctant to provide loans unless a project meets rigid underwriting requirements. This process has changed the rules that govern builder/lender relationships to the point that little new lending activity is occurring.

The banking industry

Banks play multiple roles in the credit crunch. The industry, reflecting its new conservatism, has reduced lending levels, adopted strict underwriting, and spawned skepticism about government policy. Coming out of the S&L crisis and operating under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), bank managers, appraisers, attorneys, and accountants exhibit a "general paranoia" according to the article "Industry Officials Support Moves by Regulators to Address Credit Crunch."(13) Bankers' refusals to lend have been cited by Alan Greenspan, the chairman of the Federal Reserve Board, as the cause for the continuation of the credit crunch.(14)

Strict underwriting curtails lending because capital is more expensive, loans need to be highly collateralized, and market conditions need to be justifiable. The FDIC has worked with lending institutions to draw up new lending guidelines, especially for refinancing real estate projects.(15) Passage of FIRREA brought about new limits on borrowing: only 15% of the previous maximum of the thrift's capital can be loaned to one borrower, with the exception of a higher cap of 39%, made only at the discretion of the Office of Thrift Supervision. According to a Federal Reserve Board study, 53% of domestic banks report they have tightened covenants for middle-market borrowers, and 43% of bankers have set more stringent credit standards for middle-market borrowers.(16) Along with tightening lending standards, bankers have indicated an unwillingness to make new loans.(17)

Government regulation

Regulations have been proliferating steadily in recent years, placing new constraints on banks. The new regulations have resulted in inconsistent examination standards, capital rules that discourage certain types of lending, artificial barriers to expansion, and often burdensome rules.(18) An excessive audit process has been described as having a paralyzing effect on the banks, and according to an article by Alison Rea, "FED May Change Bank Reserve Rules, but Analysts See Small Boon," "New policies and procedures are being implemented before they have been properly thought out."(19)

Bankers exhibit little confidence in the effectiveness of sometimes capricious government policy, citing the Tax Reform Act of 1986, which reversed those tax incentives instituted in 1981 that encouraged real estate growth and lending. This reversal in policy left many banks holding failed real estate projects.(20) Bankers point to the government plan to lessen reserve requirements on non-personal time deposits while at the same time raising premiums on bank insurance funds as an example of inconsistent government policy.

FIRREA, enacted in the wake of the S&L crisis, appears to have created unpleasant side-effects that are contributing to the credit crunch. FIRREA has been blamed for shrinking assets in those institutions that are trying to meet capital requirements; for halting the flow of outside capital; and for causing the so-called paranoia among managers, appraisers, attorneys, and accountants. It has forced thrifts and banks to sharply reduce loans to builders, thus possibly triggering a credit crunch. According to a survey by the National Association of Home Builders, by late 1991 36% had received notice that their thrift would reduce the amount it could lend to them in the future.(21) Values influenced by expectation of foreclosures play a central role in this trend. The determinate cause, however, appears to be rooted in governmental policy rather than in the secondary roles played by appraisers who apply the regulations. In essence, some voices claim that regulators forced real estate writedowns.(22)

In reality, this chain of causation seems to have historic, regulatory sources. The government's deregulation of financial institutions in the early 1980s has been named as the major initial cause of the S&L crisis, of bank failures, and of the credit crunch. Laws such as the Garn-St. Germain Act changed the industry radically, giving thrifts powers to invest up to 40% of their assets in nonresidential real estate lending and to offer money market funds free of an interest rate ceiling, insured up to $100,000. After 1981, government tax policies also encouraged banks to lend.

FDIC chairman William Seidman argues that the 1982 relaxation of lending rules for construction and development loans was the major cause of the banking crisis of 1990. An FDIC analysis of the First Republic Bank of Texas finds that the three billion dollars in losses that led to its collapse all resulted from real estate loans that would have been illegal before 1982.(23) According to Seidman, the Bank of New England loaned 40% of its monies for real estate construction and development, and most of this lending would have been illegal before 1982.

Subsequent policy interpretation indicates a "green-light/red-light" attitude toward lending traffic on the part of regulators. This regulating behavior seems to support the idea that governmental action contributed to the credit crunch and to the eventual reversal of the government's own policy.(24)

Pessimism about the economy

Pessimism on the part of bankers about the future of the economy has contributed to their conservatism and belt-tightening behavior. The Fed's August 1990 survey indicated that "By far the most important reason domestic respondents gave for tightening their credit standards in the last three months was a less favorable economic outlook and industry specific problems."(25) As company ratings are downgraded, so are the portfolios of banks who lent them money. Because the recession hurts the bottom lines of these companies and their financial ratios, the risk of lending to them increases pressure on capital positions of banks and forces bankers to reduce lending to protect their own portfolio risk exposure.

The recession has also reduced the amount of money companies are willing to borrow. Reduced cash flows discourage taking on further debt. Instead, companies find it necessary to reduce debt in order to improve their ratios as well as to reduce expenses and downsize. Therefore, the demand for loans falls. This reduction in demand cannot be surveyed by objective data. Such surveys don't show the borrowers who decided not to even ask for loans or those who asked for smaller loans, assuming a larger amount would be impossible to obtain.

Faltering money growth and the reduced velocity of money, attributed to the banking crisis, may have contributed to the credit crunch. The recent (in 1991) lack of activity in M2 combined with record-low interest rates indicate that credit is neither available nor desired, even at low prices. That both the money multiplier and velocity are much lower than what they should be for this level of interest rates indicates a disruption in the flow of capital through lending institutions.

Further, credit limitations on the international markets have reduced the supply of foreign credit flowing into the U.S. economy, thus contributing to the falling levels of lending and capital availability. Demand for funds in Eastern Europe, in the Middle East, and in developing nations is increasing as traditional suppliers of cash such as Germany and Japan respond to greater domestic needs.

Many cite the lack of funds circulating throughout the economy as the cause of the credit crunch--and the recession. Insufficient capital in the banking system may be argued as a cause. For those who assert that lending has dropped, however, the fact remains that the flow of capital has been disrupted and thus lending has been reduced, a phenomenon they say has shifted the supply-and-demand-for-loans curve downward to a new equilibrium point. This new equilibrium point, which reflects reduced lending, is a cause of the credit crunch and the recession as well.

In addition, the downturn and collapse of the real estate market have contributed to the credit crunch. Asset price inflation followed by price collapse make it difficult to place a value on an asset; in dysfunctional markets, buyers are hard to find even when price values are low. Sellers enter the market, most often under duress, to realize capital need rather than value received for their real estate.(26) When banks reappraise properties held in their portfolios they downgrade projects and the equity owners hold in them, a practice called marking to market (currently, a market that is undervalued) and often decide to foreclose for lack of collateral. Subsequent court battles between builders and bankers may often result, causing borrowing to come to a halt. Such deflation of value fuels recession.

The lack of confidence in the economy seems to be self-fulfilling: the public at large has expected a recession, behaved as if a recession exists, and therefore has exacerbated the recession. Similarly, when real estate is down, appraisers tend to reflect the pessimism and to conservatively place value low.(27) In general, national surveys have revealed that consumer confidence has been shaken by uncertainty over jobs, declining U.S. competitiveness, and the crisis in the U.S. financial service industry.(28) Alan Greenspan called it the "most confidence-sensitive cycle I've seen in decades."(29) Lack of confidence in the economy causes people to neither borrow nor spend, and thus the economy contracts.

Interestingly enough, the most recurring proposals offered as cures for the crunch seem to revolve around relaxation, if not change, in governmental regulation. Specifically, sound federal guidelines are sought to reduce the unnecessary volatility in asset valuation. For appraisers this could mean that values could be estimated based on predicted worth, not on the depressed current market.

John D. Benjamin, PhD, is assistant professor of finance at the American University in Washington, D.C. He received a PhD in finance from the Louisiana State University, an MS in finance from the University of Houston, and a BA in history from the University of North Carolina. Mr. Benjamin has published numerous real estate-related articles.

Janette M. Deihl taught composition and rhetoric at Pennsylvania State University for many years and is currently a free-lance editor. She earned her BA at Goshen College and her MA at University of Pennsylvania, both in English.

The authors would like to acknowledge the assistance of Mark Polani in the collection of background information for this article.

1. The first popular report of a credit crunch appeared on January 27, 1990. See Jacqueline L. Salmon, "Credit Crunch Puts Squeeze on Builders; Bailout of Nation's S&Ls Causes Scramble for Funds," The Washington Post (January 27, 1990): E-1. Appearing in the real estate section, the article places the responsibility for the credit crunch on the savings and loan bailout bill, the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA). After months of denying the existence of a credit crunch, except in the real estate development industry, Federal Reserve Board chairman Alan Greenspan acknowledged the "reduced availability of credit" on July 18, 1990. See Peter G. Gosselin, "Greenspan: Interest Rates May Ease; Fears Credit Crunch May Fuel Recession," The Boston Globe (July 19, 1990): 33.

2. Even the Fed chairman, Alan Greenspan, has cited the credit crunch as one of the major causes of the 1990-1991 economic recession. See Bailey Morris, "Elixir of Confidence Eludes Hard-Pressed White House," The Independent (February 17, 1991): 8, for more information.

3. The authors employ Lexis/Nexis news retrieval services to identify media reports on the timing, causes, and influences of the credit crunch.

4. Huntley Paton, "Credit Crunch Still Slowing Texas Recovery," The Dallas Business Journal (April 23, 1990): 18.

5. "Financial Institutions, Glauber, Congress Support Credit Package as Step in the Right Direction," Daily Report for Executives (March 5, 1991): A-9; Karen Shaw, "Regulators Are Wielding Ax When Finer Tool Is Needed," American Banker (May 2, 1990): 4.

6. Ken Larish, "FDIC Choking Local Economy," Advantage (July 1990): 1-12.

7. John O'Dell, "Housing Permits in Orange County Fall to an 8-Year Low," Los Angeles Times (January 31, 1991): D-1.

8. See, for example, Pierce Paley, "Reaction to Bank Difficulties Adversely Affects Real Estate," The New York Law Journal (November 14, 1990): 41.

9. See "Industry Officials Support Moves by Regulators to Address Credit Crunch," BNA's Banking Report, v. 56, no. 10 (1991): 449.

10. "SEC, Bank Regulator Talks Underway on Revising In Substance Foreclosure Test," The Thrift Accountant (July 19, 1991): 4.

11. For more information, see Micky Baca, "A Developer's Nightmare: Project Appraised Value Drops by 50 Percent in 15 Months," New Hampshire Business Review (September 7, 1990): 1-2.

12. National Association of Realtors, "NAR Survey Confirms Credit Tightening In Commercial Sector," PR Newswire (March 6, 1991).

13. "Industry Officials Support Moves by Regulators to Address Credit Crunch."

14. As reported by David E. Rosenbaum, "The only misjudgment |Greenspan~ might have made, he indicated, was that he did not recognize how long banks would maintain tight lending policies. Bank lending gives consumers and businesses more money to spend and thus generates economic growth." See "Greenspan Warns of Deep Recession If War Lasts," The New York Times (January 31, 1991): A-1.

15. "U.S. FDIC Works with Builders, Banks on Loan Rules," Reuters (May 12, 1991).

16. Robert Trigaux, "Deals: Fed Survey Confirms Banks Have Tightened Loan Terms," American Bankers (August 28, 1990): 1.

17. Ibid.; Gosselin, "Greenspan: Interest Rates May Ease; Fears Credit Crunch may Fuel Recession."

18. William W. Streeter, "Biting the Hand That Feeds," ABA Banking Journal (March 1991): 104.

19. Alison Rea, "FED May Change Bank Reserve Rules, but Analysts See Small Boon," The Reuters Business Report (November 28, 1990).

20. Janet M. Pavliska, "Pessimism Is Not the Source of Lending Cutbacks," American Banker (March 21, 1991): 4.

21. See Salmon, "Credit Crunch Puts Squeeze on Builders; Bailout of Nation's S&Ls Causes Scramble for Funds."

22. See "Financial Institutions, Glauber, Congress Support Credit Package as Step in the Right Direction."

23. See "U.S. FDIC Works with Builders, Banks on Loan Rules" for more information.

24. A current discussion that indicates another government policy reversal is that of the proposed change from a $50,000 de minimus threshold for licensed appraisals to $100,000. Three federal agencies (OCC, FDIC, and RTC) have issued this proposal, the Office of Thrift Supervision is considering the change, and an aggressive letter writing campaign to OCC is running 4 to 1 in favor of the change. The goal would be to lower the cost of a small residential loan to below the usual $375 fee. Opponents agree that the time is not right for loosening underwriting standards (see "Rep. Barnard Charges Federal Regulators with Attempt to 'Gut' Appraisal Provisions of FIRREA; Warns Significant Losses to Taxpayer," PR Newswire |November 4, 1991~) and that an aggregate of small, bad loans that were not based on appraisals could total multimillion dollar losses similar to the ones that caused the S&L crisis (see "Barnard: Regulators Watering Down Appraisal Requirements," The American Banker |October 29, 1991~: 5). Critics also complain that FIRREA intended that most properties be appraised because accurate evaluations of real estate values by independent qualified appraisers protect lending institutions.

25. Trigaux, "Deals: Fed Survey Confirms Banks Have Tightened Loan Terms."

26. For a thorough discussion of the "fair market price" of real estate, see Anthony Downs, "Appraisal Practices Need Revision," National Real Estate Investor (June 1991): 30. Downs defines the term in four ways specifically contrasting the low-market liquidity value with the realistic long-term earning power value.

27. Ibid.

28. For more information, see Morris, "Elixir of Confidence Eludes Hard-Pressed White House."

29. As reported in Rosenbaum, "Greenspan Warns of Deep Recession If War Lasts."
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Author:Benjamin, John D.; Deihl, Janette M.
Publication:Appraisal Journal
Date:Jan 1, 1993
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