Charles Kindleberger
Brian Trumbore
President/Editor, StocksandNews.com

"I can calculate the motions of the heavenly bodies, but not the madness of people."
--Sir Isaac Newton

A few weeks ago in my "Week in Review" column I noted the thoughts of a private equity / hedge fund type as he toured California and took in the real estate scene. The fellow quoted Charles P. Kindleberger, who authored the Wall Street classic "Manias, Panics, and Crashes: A History of Financial Crises."

Well, I went back to my own copy to see what Kindleberger found in his research when it came to property bubbles and while he admits his interest has never really lied in the field of real estate, Kindleberger couldn't help but note the relationship between bubbles in the sector and those in other objects, such as stocks.

Kindleberger refers to a 1933 book by Homer Hoyt titled "One Hundred Years of Land Values in Chicago: The Relationship of the Growth of Chicago to the Rise in Land Values, 1830-1933. In it Hoyt "linked the boom in the stock market in 1928-29 to one in raw land, residential sites, commercial building, and the like, downtown and in the suburbs, on the rise, but especially in decline."

Regarding the upside, Hoyt quotes from a Chicago Tribune editorial of April 1890.

"In the ruin of all collapsed booms is to be found the work of men who bought property at prices they knew perfectly well were fictitious, but who were willing to pay such prices simply because they knew that some still greater fool could be depended on to take the property off their hands and leave them with a profit."

It turns out that Chicago's reputation for real estate booms was such that a bubble in Berlin in 1870, following victory over France, was called "Chicago on the [river] Spree." Booms in Berlin and Vienna around this time were also related to the bull market on Wall Street. Speculative markets rise together. One writer in Chicago, 1871, noted that "every other man and every fourth woman had an investment in house lots." [Kindleberger]

Charles Kindleberger:

"The spread of euphoria from one market to another is readily understood. The bandwagon is under way: climb aboard. The compelling analytical point deals with the downside. When the stock market collapses, shareholders, especially those on margin, know they are in trouble, and have to get squared away. Speculators in real estate initially feel no such compunction. Their debts are not day-to-day brokers' loans, but come from banks on extended terms. They have real assets, not just paper claims. They can wait out recovery which will come soon, or so they think."

As Homer Hoyt wrote in 1933, as a downturn leads to a drying up of demand for real estate, taxes and interest on loans are still due. The speculator is "ground down," as is the bank. "In Chicago in 1933, 163 out of 200 banks suspended payment. Real-estate loans, not failed stockbrokers' accounts, were the largest single element in the failure of 4,800 banks in the years from 1930 to 1933." [Kindleberger]

Kindleberger cites Hoyt's 1933 work as laying the groundwork for any analysis of both the Wall Street crash of 1987 as well as the troubles in the Japanese stock market, January 1990.

"The stock market's troubles of Oct. 1987 were cleared up brilliantly as the monetary authorities poured money into the banking system to forestall trouble from brokers' loans. Margin requirements of 50 percent doubtless helped; portfolio insurance did not. But the agony in real estate was drawn out. Construction was slowed down to the rate of buildings being finished, as new starts halted. Vacancy rates in office buildings rose sharply?.

"A classic illustration of the Hoyt insight comes from the Rockefeller Center Properties, Inc. which had a $1.3 billion mortgage on Rockefeller Center in midtown Manhattan, after the complex had been sold to a Mitsubishi entity as an investment. The mortgage was held in a Real Estate Investment Trust. A detailed newspaper account notes that in 1987 the trustees sought to increase the income of the trust by taking out short-term credits to buy back bonds which were selling at a discount. The gains were paid out as dividends. In 1989 as the deterioration in the real estate market progressed, the trustees decided to take out a letter of credit and pay off the short-term debt?.After prolonged agony, the REIT crashed."

Then there was Japan. The economy here boomed in the late 1950s and through the 1960s, establishing Japan as a place for investors of all stripes. The Nikkei stock market index, which started at 100 in May 1949, was at 10,000 by 1984 and 12,000 in 1986. Then the bubble came and by the end of 1989 the Nikkei was at a staggering 39,000.

At the same time as stocks were soaring, so was Japanese real estate. A price index for residential properties in six large cities, starting at 100 in 1955, reached 4,100 in the mid-1970s, 5,800 around 1980, and then rose to a peak of 20,600 in 1989. As Kindleberger writes, "The land bubble brought forth remarks such as the value of land in Tokyo exceeded that of the state of California, which happens to be larger than all of Japan, or that the value of Japanese land as a whole was four times that of the United States."

Meanwhile, the consumer price index in Japan during this time rose from 100 in 1983 to just 103.9 in 1989, while wholesale prices actually fell to 93.6 over the same period.

Deregulation was a major culprit in the twin stock and real estate bubbles, owing to pressure from foreign governments to loosen up. Interest rates were also falling; from 5 ? percent on the Bank of Japan's discount rate in 1982 to 2 ? percent in 1987. But then while the Federal Reserve in the United States and Germany's Bundesbank began inching rates back up in 1987 and '88, the Bank of Japan waited until December 1989 to change direction, precipitating a crash in January 1990. "The crash when it came was abetted by revelations of scandals in which some major banks made good losses on loans to favored customers, and hid these actions by imaginative accounting."

"Real-estate prices leveled off when the Nikkei index dropped, and later started down but slowly, largely, one gathers, because the volume of transactions dried up."

Kindleberger published the edition of his book that I have in my hands in 1996 and by then, 1,000 commercial and industrial enterprises in Japan were going bankrupt each month. The estimate of bad loans on the books of Japanese banks and financial institutions was $550 billion. In an effort to stem the tide, the Bank of Japan lowered its discount rate to ? percent in September 1995 and would go on to essentially keep the key rate at zero until just last year. With banks lending out at around 3 percent, this was a surefire way back to profitability. [And something foreign investors made gobs of money on as well? the yen carry trade.]

It's interesting to note Kindleberger's thoughts on central banks and monetary policy during periods of speculation, in light of the current debate on this topic.

"Most central bankers choose price stability as the main target of monetary policy; whether it be wholesale prices, the consumers' price index or the gross domestic product deflator is not a critical issue. If, however, the explosion of a bubble in stocks and/or real estate can affect bank solvency in general, there is a basis for saying that central bankers should keep an eye on asset prices too. In one view, asset prices should be incorporated into the general price level because, in a world of efficient markets, they hold a forecast of what future prices and consumption will be. But this assumes that asset prices are determined within a narrow range by fundamentals, as they often are to be sure, and will not be affected by herd behavior, leading to a bubble which will ultimately burst."

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Next week, the Edsel.

Brian Trumbore