Late last month an interesting analysis came out of the Bank of England. (Check out the Seeking Alpha news story about it here; I first saw it in a Wall Street Journal article by Mark Whitehouse.) In a discussion paper called "Optimal Bank Capital," three BoE economists argue that capital--in short, the equity part of bank balance sheets, and therefore the opposite of their leverage ratio--should be much, much higher than is currently required in the UK, the US, or anywhere else.
That idea doesn't sit well with banks, which typically carry only about 9% capital, meaning they're 91% leveraged. The bankers' point is that debt is cheap and equity is expensive, so the best way for them to earn profits is to use as much debt as possible.
There are two problems with this analysis. First, debt (leverage) is cheap precisely because governments subsidize it heavily in two ways: explicitly by making interest payments tax-deductible, and--perhaps more importantly--implicitly by bailing out those banks that go under, largely because they weren't holding enough capital. Second, equity (capital) is expensive precisely because the equity holders are the ones left out to dry whenever those highly leveraged banks go under. So, if banks were required to hold less debt (leverage) and more equity (capital), then equity would be cheaper because the equity investors wouldn't face such high risk of bank failure.
In fact, Miles, Yang & Marcheggiano, the trio of BoE economists, estimate that bank capital should be more like 19% to protect against moderate bank crises, and 52% to protect against even the most severe ones. They estimate that permanently reducing the probability of a banking crisis would be worth more than half the entire annual output of the economy, while increasing capital requirements would cost the equivalent of only about 6% of annual economic output.
I used to work for Alan Greenspan and Ben Bernanke at the Federal Reserve Board (where I tried to increase capital requirements for commercial and residential mortgage loans!), but I'm primarily a real estate guy rather than a banking guy. The reason I found this analysis so interesting is that publicly traded REITs use much less leverage than banks do, with the industry average only around 40%. Yet they produce terrific returns, averaging 11.82% per year over the last 20 years--and 10.46% per year even if you go back to August 1989 to make sure you cover every bit of that terrible downturn!
Even more important, publicly traded REITs generally ignored very loud advice that they should dramatically increase their leverage during the years in the last decade that turned out to be a commercial real estate bubble fueled by a debt bubble. In fact, there were even people saying that the REIT era had passed because they weren't willing to keep up with the private equity real estate funds that were grabbing debt as fast as they could and using it to buy properties--and whole REITs, in fact--at top dollar at what turned out to be the peak of the debt-fueled market bubble. (Sounds like the banks with their mortgage lending, doesn't it?)
Of course, those publicly traded REITs that resisted loading up on leverage are the same that are now the most active purchasers at the bottom of the market, while those private equity real estate funds that went he##-for-leather into la-la-leverage land are the same that aren't buying at the bottom of the market largely because they're too busy trying to stave off default or bankruptcy. (Again, sounds like the banks with their refusal to lend now, doesn't it?)
Actually, there's a sober lesson that could have been learned even without observing the debt bubble and the carnage that has come of it. If your business model is basically to grab as much debt as possible just because it's cheap and then to look for something to do with it before it burns a hole in your pocket (and your financial statements), then you'll have a tendency to make poor investments. That's what happened to banks, not just this time but periodically, and that's what happened to private equity real estate funds too.
In contrast, if your business model is to look for good investments, and then--only after you find good ones--look for the capital to pay for those investments while maintaining a sensible balance between debt and equity (leverage and capital), then (1) you're less likely to blow it on bad investments; as a result (2) your equity will be cheaper; and (3) your returns may well be superior on a risk-adjusted basis.
Sounds like maybe the banks, as well as the private equity real estate funds, could stand to learn something from the REITs.
Disclosure: I am long Vanguard REIT Index Fund and ING Global Real Estate Fund.
Disclaimer: The opinions expressed in this post are my own and do not necessarily reflect those of the National Association of Real Estate Investment Trusts ((NAREIT)). Neither I nor NAREIT are acting as an investment advisor, investment fiduciary, broker, dealer or other market participant, nor is any offer or solicitation to buy or sell any security investment being made. This information is solely educational in nature and not intended to serve as the primary basis for any investment decision.