Reinvent the credit boom for businesses

First published in the Financial Times on 18th December 2012.

Banks must end their reliance on property and lend against other assets to help industry

Probably my biggest career mistake has been to not borrow enough. If you are in business and ambitious, then you need to learn how to obtain debt: ideally lots of it. Loans are required to develop companies and buy assets without dilution – unless you are lucky enough to own a self-financing business.

The period leading up to 2008 saw the greatest credit boom in history, when banks seemingly lent money against almost anything. And those who made the most money were those who employed the most debt. I largely missed the party, but at least I didn’t suffer too much of a hangover.

The leading borrowers were, as ever, in the property businesses. Real estate is usually the core of any bank lending book, and property developers and investors understand that half the secret of success is leverage. And in turn, the banks that had to be rescued were the ones with greatest exposure to property.

Banks don’t just lend to property companies – they use property as security even when the facility is for something else entirely. It might be funding working capital, the marketing costs of a launch or even a personal holiday. The banking profession falls back on bricks and mortar as security for at least two-thirds of its loans if residential mortgages are included.

There is historical logic in lending against a tangible asset such as property, but in many countries that unchallenged belief is taking a battering. The US, Spain, Ireland, Portugal and Greece have all suffered unprecedented property slumps in recent years. Property in Japan is still substantially below the price it commanded 30 years ago – even in nominal terms. And the rot is spreading. For forced sellers in most of France, Italy and Britain, excluding cities such as London, home values have also tumbled. Millions of home mortgages around the world are underwater, while tens – perhaps hundreds – of billions of commercial property loans are in trouble.

Not only can property prices fall significantly, but buildings can also go from being income producers to cost burdens. A friend recently bought a substantial office block in southern England in reasonable condition at perhaps a quarter of its build cost – with the land for free. It is partly occupied – but unless he manages to find more tenants in the coming years, he will lose money. The present rents are the same as they were 15 years ago – and it is a struggle to find new occupiers.

Incredibly low interest rates have propped up real estate values everywhere. But one day rates will rise – and that will put more downward pressure on property prices.

Meanwhile property valuation remains a dark art, and with few transactions, owners and lenders can get away without marking prices down to honest levels. No doubt many banks, funds and companies would be bust if they did. This is the “extend and pretend” game, where everyone in the daisy chain carries on the charade – because to admit default would declare the participants insolvent and throw the staff out of work.

More than half of all institutional property value in Britain is represented by shops. Landlords and banks appear in denial about the earthquake ripping through the retail sector. The digital revolution means many more chains will go bust in the next few years. Dozens – perhaps hundreds – of malls and retail parks will become redundant. What of retail yields then?

Banks were lazy and property lending seemed easy during the boom. This bias crowded out other borrowers. Now bankers must switch their emphasis, and reduce their focus on real estate. They should become more sophisticated about lending against cash flow, intellectual property, receivables, equipment and the like. Lending to productive industry helps create jobs and exports, and might well provide better collateral than supposedly reliable assets such as houses and shopping centres.

Regulators too must realise the world has changed, and adjust their rules to reflect new realities about asset classes. The global property bubble has burst, and many of the tired assumptions about what is a modern repository of value have been proved wrong. Banks should reinvent themselves, and find ways to finance innovation and the future, instead of relying on broken lending models.