Financial Institutions holding billions in 'paper money'

The 'bubble burst' 'price correction' 'normal cycle' currently unfolding in the upper middle income apartment market poses a systematic risk to the Kenyan financial system.

While the actual amounts involved are not easy to figure out, a rough estimation points to billions being held by banks in the form of ‘paper money.’

That is to say ‘money that is only existing in the books of accounts but not in the bank vaults.’

I will explain.

Most of the property construction that has been happening in this real estate segment in the last ten years has been funded largely through loans.

It is loans on two fronts—construction loans (to build) and mortgage loans (to buy)-mostly.

There are also arrangements where an owner of a plot gets into an agreement with a bank to advance some money for construction of the plot and then share the proceeds on an agreed formula when ‘a sale happens.’

(Then there is of course equity release on property for those who have already bought and have to use their houses as collateral for a loan which is a story for another day.)

First things first.

The above works perfectly well when business is booming and not during a dip, a price correction, a bubble burst like we are currently witnessing.

Property sales have significantly gone down in these areas due to a number of reasons I explained in my earlier post. Property prices are coming down. Some of these things are just not announced on a newspaper or TV but the range is 20%-40%--some as high as 50% (due to a number of reasons I explained in my earlier post.)

It is taking longer and longer to conclude sales—meaning a rise in cost of doing business (due to a number of reasons I had explained in my earlier post).

The gap between the asking price, closing prices and offer prices is getting bigger by the day. In fact the difference will have moved a few millions by the time I finish writing this piece.

This trend means one thing for the banks—increased defaults on mortgage/loan repayments and a slowdown on their revenue projections.

The catch here is that even if the bank reposes a property in these areas, first it cannot sell it immediately. The rate of converting these assets into liquid cash becomes an issue. Two if a bank finally manages to sell such a property, it will be at a significantly discounted price.

(I currently have offers, if you contact me on [email protected] I will get back to you. Both for those who have been having trouble selling and are willing to quietly give great discounts and those that are looking to buy but have not been lucky through mainstream agents *they work under orders you know.)

Meanwhile, the asset valuation on the books of accounts at the bank remains the same as of the time of inception of the construction project or at the time of dishing out mortgages.

The difference in the value of property in the books of account (and the revenues) and the reality on the ground is what banks are holding as ‘paper money.’ It runs into hundreds of billions.

The financial institutions are hush about it. In fact they will go: ‘ouch, there goes MA again’ after reading this article.

Here is the relief.

Having ‘paper money’ is ok. It happens from time to time. Revaluation here, re-adjustments there and an additional provisions to bad loans and it is sorted—of course at the cost of a drop in profitability.

The problem comes when the value of ‘paper money’ becomes a common feature in a number of banks as the crisis spreads. This way it poses a systematic risk to the financial system.

It is something like this that caused the subprime mortgage crisis in the US (only that the foundation causes where different.)

What is making the current scenario dangerous is that nobody actually knows how widespread this ‘paper money’ issue is.

(OR we can play safe and say that it is not that widespread but let us find out the actual reality on the ground.)

How many banks are currently affected by this and what is the actual amounts involved? Compared to capitalization is it something that needs to be looked at? Loan to Value ratios are they ok? What of debt-to-income ratios?

Do the amounts involved pose a systematic risk to the entire financial system? What of a section of the financial system?

These are the questions that the Central Bank of Kenya should be asking (someone make me the governor already…LOL)

(A year plus ago when I asked Ann Waiguru this question at a function at KICC called to re-base the Kenyan economy she seemed unsure. I offered to do a research to establish the extent—at a fee of course--and we were to discuss later but clearly as things turned out I didn’t get to meet her again.)

But probably it is not that serious.

As explained in a paper by By Kosuke Aokiy and Kalin Nikolov, Bubbles, Banks, and Financial Stability, the scale this phenomenon is what is of key concern here.

What are the dangers going forward?

If it is widespread then our goose is cooked. A financial crisis baam. CBK has ways and remedies to with this. A couple of bail outs. Panic in the market. Deep losses. Cries of i wish i knew--who knows, a financial crisis in each country receives different reactions. In Japan they mostly commit suicide.

Any price correction in an overvalued property market can easily be magnified by fire-sales especially so if the original investors got into it after buying ‘prices will continue to rise’ slogan.

This is so like the upper middle income apartment market in Kenya.

It is clear that quite a number of people are stuck in negative equity in these areas As explained in the previous post, negative equity happens when the value of the property is less than the price it was paid for at the time of securing a mortgage or a loan.

Increased awareness or talk on negative equity is bad for the economy because it discourages the populace from borrowing with their houses/property as security. On the other hand, it is good because it encourages savings (meaning new investments) which is also bad in the short term because in the short term it lowers consumer spending which lowers economic growth.

Ok-that was mixed but that is just the way economics is.

As property prices fall—as is happening in the upper middle income apartment market although landlords are stubborn to admit it--equity withdrawal slows down which is not good for the economy…for so many reasons—brah brah brah, hutakikusikia…..

The effects are many and lined up if you factor the multiplier effect.

But it is not all bad.

One benefit of falling house prices is that it reduces the cost for those who are planning to buy a house for the first time.

Now is the time to buy—only if the property owners are man enough to say that the situation is bad and lower prices.

The only concern here is that the writing was on the wall all this time. (A story for another post which will come after the post on the investment tragedy that is The MALL CONCEPT.

So long…