Although the article is long, if you stick with it there is an interesting surprise at the end. This article has been slightly edited for illustrative purposes.
An Article on Real Estate Speculation
A wise prophet observed many years ago that “when the blind lead the blind, both fall into the ditch” - a maxim which accurately describes our situation in both business and government today. In this respect the real estate field is no exception, unless it be in the extent of its mishaps and the number of people affected by them. It behooves us, therefore, to give some serious thought to the manner in which we have arrived in our present unhappy situation.
This situation, to tell the truth, is not entirely a novel one. The economic history of this country is colorful with recurring speculative epochs and episodes, growing out of varying conditions and with varying effects upon our economic structure and welfare.
Our latest speculative movement differs from all previous speculative eras in the United States in the fact that it has been distinctly an urban field of speculation, based primarily upon one specific phenomenon; namely, the growth of urban population and wealth. The rural sections of the country have been in a state of depression throughout most of this period, and the very cities in which active real estate speculation has been carried on have been surrounded by rural populations in acute distress. The agricultural depression in reality contributed substantially to the urban inflation by forcing the movement of millions of people from the farms and small towns to swell the population of the larger cities. This spectacular growth of urban population and wealth provided the basis for a period of sensational real estate speculation.
But the facts are sufficiently well known; and throughout the remainder of this paper we will confine our comment to (a) the results of this speculation, (b) the conditions which led to its excesses, and (c) the possible means of preventing its repetition.
What has been the impact of all this upon our business and financial organization?
Its first impact has fallen upon the very heart of our financial organization; namely, the banks and financial institutions. We have no fully developed system of real estate mortgage banking, under legal auspices and supervision, and that is a part of the story; but all the financial resources of existing banking and financial institutions were utilized to the full in financing this speculative movement. The insurance companies bought what were considered the choicer mortgages; Conservative banks loaned freely on real estate mortgages; and less conservative banks and financial houses loaned on almost everything else that represented real estate in any form.
A particularly ominous development was the expansion of the banking system itself for the specific purpose of financing real estate promotion and development. Real estate interests dominated the policies of many banks, and thousands of new banks were organized and chartered for the specific purpose of providing the credit facilities for proposed real estate promotions. In the extent to which their deposits and resources were devoted to the exploitation of real estate promotions being carried on by controlling or associated interests, these banks commonly stopped short of nothing but the criminal law-and sometimes not short of that.
In addition to this dangerous alliance of banking and real estate promotion, a third and more ulterior element was often included in the combination, that of local government officials and political groups. The purpose of this combination was sometimes to facilitate securing a charter, sometimes to secure the deposit of public funds, at other times to insure favorable treatment in tax matters and to exploit the projection of streets and highways and other public improvements. A fourth element frequently found in these banking institutions was represented by the contractors’ and construction groups, whose interests are obvious; and a fifth element was frequently made up of local public utility interests, who were able to combine the extension of surface and rapid transit lines with large real estate promotions.
Now, when it is recalled that these were not mortgage banks, organized on principles of long-term financing, investing their own capital funds, and free from deposit liabilities, but that they ordinarily purported to be commercial banks, engaged in accumulating and carrying large deposits, and that their operations were financed largely through the funds of their depositors, it will be realized in what a highly overextended position this segment of our banking system has placed.
Eventually we reached a point where most of the city and outlying banks of the country were loaded with real estate loans or real estate liabilities of some sort. Not all of these loans were speculative; many of them were intrinsically sound and conservative. But a large, probably a major, portion of this loan structure depended for its solvency upon a continuation of the rate of absorption and turnover which had characterized the real estate market, and on a continued advance of real estate values. When the rate of absorption halted and the price movement stopped, one of the largest categories of bank collateral in the country went stale, and the banks found themselves loaded with frozen assets, which we have been trying ever since to thaw out.
We do not have all the facts and figures, and in the nature of things probably will never have them. But it would seem that we can safely say this much: that real estate, real estate securities, and real estate affiliations in some form have been the largest single factor in the failure of… banks that have closed their doors during the past three years and in the “frozen” condition of a large proportion of the banks whose doors are still open; and that as the facts of our banking history of the past three years
Throughout this period there was another form of real estate speculation, not commonly classified as such, but one that has had disastrous consequences. This was the real estate “speculation” carried on by municipal governments, in the sense of basing… their revenues upon real estate and then proceeding to erect a structure of public expenditure and public debt whose security depended largely on a continuance of the rate of profits and appreciation…
During this period of prosperity real estate taxes were paid with little complaint. As a matter of fact, they were paid to a large extent neither out of capital nor earnings, but out of increment. Under these conditions, public expenditures expanded and taxes were increased without protest; and public officials exploited the real estate groups as systematically and thoroughly as the real estate groups had exploited the rest of the public. The result was a structure of public expenditure which it has been difficult to curtail, and a volume of indebtedness whose solvency is now seriously jeopardized on a large scale.
The most conspicuous example of wholesale governmental speculation in real estate was that of Florida; but striking examples of the same thing are afforded by the financial difficulties of Chicago and other cities. In Chicago, it is true, there were some special circumstances; there are always special circumstances in the neighborhood of a shaky structure. But the essential elements in our financial difficulties in Chicago are an extreme concentration of tax burdens on real estate and a volume of expenditure and indebtedness which assumed a continuation of real estate profits and appreciation. Hundreds of other cities and local governments in the United States are now in default or on the verge of insolvency for substantially the same reasons. The impairment or collapse of their finances and credit has seriously impaired the credit situation in their various communities.
The final impact of deflation and loss in any field of industry falls upon the purchasing power of the individuals and groups directly and indirectly dependent upon this industry; and so the final impact of the successive inflation and deflation of real estate has fallen upon the individual owners of real estate. In this case, it has somewhat special significance on account of the wide distribution of real estate ownership. Indeed, one of the results of the speculative activity itself was to broaden the distribution of real estate ownership in this country. The wide distribution of losses meant a violent contraction of established purchasing habits, with disastrous results in retail and wholesale commercial channels.
In consequence of these various impacts of the real estate inflation and deflation we find ourselves in a depression, in which, while real estate is only one among many factors, it is nevertheless a major factor, and one whose ramifications and influence in the situation assume larger proportions, as the underlying facts of the depression come more and more to light. And the writer hazards the conjecture that when the history of the past decade is finally written in economic terms, it will be apparent that our spectacular urban expansion, with the reckless speculation based upon it, has been one of the dominant aspects of the whole somewhat bizarre period. And while speaking of the character of this speculation it will not be amiss to offer some comment upon the factors which contributed to its excesses and its ulterior aspects. One of these is the fact that much of the real estate business of the past few years has been more a merchandising business than a field of speculation; and it is a mistake to confuse the two things. It is the writer’s conviction that the unfortunate conditions in the real estate field today are due quite as much to vicious merchandising methods as to unwise speculation. Real estate merchandising performs certain highly useful services, analogous to the functions of the middleman in other fields. But there are certain fields of merchandising which, on account of the nature of the commodity handled, the character of those engaged in it, or other circumstances, have developed particularly vicious methods of merchandising.
One of these, for example, is the field of patent medicines and medical quackery; and another is real estate. In both fields the explanation lies, in part, in the nature of the commodity. No one knows but that a certain combination of roots and rattlesnake oil may happen to contain the particular ingredient that will relieve his pain; and no one knows but that a particular lot out in the sticks may happen to be the center of a future suburb. In both fields, the explanation lies in part also in the nature of the clientele appealed to. The medical fakir appeals to the large body of suffering humanity in need of relief; the real estate fakir appeals with shrewd salesman’s instinct to those large classes who cannot anticipate financial security unless through the medium of some fortunate investment of the small surplus they can command. This is illustrated by then wholesale victimizing of teachers, preachers, salaried people, women, and people of small means in general. And in both fields the explanation lies, further, in the character of those who engage in them. I have known medical quacks, and at the present time I have the honor of including some real estate quacks among my personal acquaintances. Of the two, the real estate fakir is the more unscrupulous type, quite frequently the racketeering, crooked-politician type. If anyone is inclined to think this overdrawn, concrete evidence of it is afforded by the notorious extent to which successful racketeers have gone into real estate, as a field of respectable business into which they can graduate with the least readjustment of previous business habits. The truth is that much of the real estate activity of the past few years has been as devoid of speculation as anything could be, so far as the promoters and operators were concerned. The operator who drove his stakes in the swamp and moved his electric light posts from one temporary subdivision to another had no intention of speculating-at least not in his own properties. He was merely a peddler, relying on highly developed merchandising methods to dispose of his wares quickly and move on to the next countryside. Many real estate and building promotions did not represent even devices for selling real estate primarily, but for merchandising various types of securities, for selling materials and equipment, for marketing contractors’ supplies and services, and for still more remote emoluments. To call this “speculation” and ascribe its unhappy results merely to “excessive speculation” is applying a conventional terminology to a situation which it no longer describes. And when the bank subsequently finds itself loaded with “frozen assets,” to ascribe its difficulties merely to “excessive speculation” is a misplaced euphemism. The writer has thus far felt obliged to use the conventional terminology, but takes this occasion to point out that much that was called speculation in the period we are discussing was actually something very remote from speculation. In the second place, the real estate business has for years been conducted in more complete detachment from any relation to the facts that underlie it than any major line of business or industry of which the writer has knowledge. Much of it has had no discoverable relation to facts. Yet facts of the type to which Professor Fisher has referred and scores of other equally pertinent and concrete facts could have been known at the time that policies were being determined, if real estate operators had cared for facts or cared to base their policies on them. Their refusal to ascertain or to face the facts was one of the factors that made collapse inevitable. The more important question now is whether anything can be done to prevent a recurrence of this whole episode in our next period of prosperity; or shall we, like the popular character in the play, merely make the most of the depression while it lasts, resigned to the prospect of an inevitable return of prosperity, when we shall have the whole thing to go through again?
In the first place, it may be observed that there is nothing in all this unfortunate development to indicate that there is not still a field for the useful functions of speculation in land and real estate, as in other fields of legitimate speculation. Speculation widens the market, increases the salability and fluidity of real estate, broadens the distribution of property, and frequently provides somewhat specialized resources for carrying the peculiar risks of land ownership and utilization. Especially in a country like the United States with its vast area and resources, its broad movements of population and industry, and its rapidly changing industrial structure, there is need for all the speculative capacity that can be developed for discerning these movements beforehand and providing facilities for their orderly development. And in many periods in our past history courageous and intelligent speculation in land and real estate has played a strategic part in shaping our economic progress.
It is not necessary to go to extremes; we need not feel obliged to justify every form of speculation in land or hunt for far-fetched grounds on which to justify legitimate speculation… But while avoiding all such extremes, it is still true that there is an important field for intelligent real estate speculation; and our problem is, if possible, to preserve this field while avoiding the disastrous results of our recent episode. To this end we shall enumerate four general lines of possible action, all of which grow directly out of the facts and conditions already described.
In the field of subdivision development, particularly on the periphery of our larger cities, we have reached an intolerable situation. Subdivision, as it has been practiced in the past, has destroyed thousands of acres of valuable agricultural land and has surrounded our larger cities with a “no-man’s land” of devastation and desolation. I am unable to discover any element in the real estate business, as now organized and practiced, that promises to prevent a repetition of past experience as soon as normal times return. I am coming to the conviction reluctantly that we are going to be compelled to subject this field of activity to positive public regulation in the form of requiring a certificate of public necessity and convenience before a new subdivision can be developed, with requirements insuring specified standards of lay-out, transportation facilities, public utility services, and the financial responsibility of the company undertaking the development. The one consideration that would still make me hesitate is the character of our municipal governments, upon whom in most cases this regulative authority would have to be conferred. If our city governments in the next decade, as they have been in the past, are going to be turned over to our “Big Bills” and “Dapper Jimmies” and their numerous associates it is worse than futile to talk of conferring any additional powers upon them. In that case, we are between the Devil and the sea and it is useless to try to choose between them. But if we should be able, by the grace of God, to pull our municipal governments out of the slough of incompetence and corruption into which many of them have fallen, one of their worth-while functions may well be the supervision of their own planning and development.
The collapse of our banking system under the weight of real estate financing was due in part to the inflated character of real estate securities; but it was due in part also to the character of the banking
system. We were trying to finance a real estate movement through the agency of a commercial banking system. The results have demonstrated a new the need for a fully developed system of mortgage banking, subject to the same type of control and supervision as our national bank system. Feeble and somewhat muddled steps have been taken in that direction in the form of the Federal Land Banks, Joint Stock Land Banks, and our Home Loan Banks; but certainly our experience in the field of real estate financing for the past decade demonstrates the urgent need for a fully developed system of mortgage banking under government control and supervision. The financial difficulties of local governments in consequence of both the inflation and deflation of real estate values demonstrates strikingly the un-wisdom of a revenue system concentrated so heavily upon real estate, or upon any other one commodity. A tax system that rested on a broader base, that drew its revenues from a greater number of categories of tax-paying ability, would have weathered the period of adversity with less wreckage to itself and less demoralizing effects on private credit and investment.
In the fourth place, something can be accomplished by the concentration of more scientific study upon the field of urban economics. When speculation dealt with western lands, oil and mining exploitation, railroad promotion, and similar fields, there may have been little field for scientific study. Fortunately the urban field of real estate speculation is one in which there are wide areas capable of scientific exploration.
Such problems as population trends, influence of the agricultural situation, geographical movements of industry, population densities, absorption rates, housing and residential trends, building height and traffic problems, obsolescence, taxes and special assessments, and influence of public improvements on land values are all capable of scientific exploration. And while in none of these fields will the facts alone afford an answer, a real estate business based on recognition of these facts will
be a very different thing from most of the real estate business of the past decade. Now, none of these things, nor all of them put together, will prevent speculative excesses from time to time. But if during the past decade we had had even a half-way intelligent public regulation of subdivision development, if we had had a fully developed system of mortgage hanks under legal supervision, if we had had a tax system that rested to a substantial extent upon other categories of ability than real estate exclusively,
and if we had had more intensive research and a wider dissemination of the facts affecting urban growth, it is safe to say that one of the major factors in the present depression would have been considerably minimized.
Title: Real Estate Speculation and the Depression
Author: Herbert D. Simpson
Journal: The American Economic Review, Vol. 23, No. 1
Date Published: March 1933
Now that you read that take a look at what Yale professor Robert Shiller had to say about the housing decline. The article was written after The Great Depression started. Will we be looking forward to that scenario in 2010?
Share This
April 29th, 2008 at 3:45 am
[...] of my first articles was on Non Borrowed Reserves, which Wall Street mocked as crazy. Why was I looking at “aggregate amounts” of capital [...]