John L. Davidson on Resolving the House Mystery: The Institutional Realities of House Construction

A Manufactured Home from  Manufactured Home Source

A Manufactured Home from Manufactured Home Source

John L. Davidson, is a Missouri lawyer who has an interesting blog, The Law of Drones, UAVs, UASs, and sUASs and is a frequent correspondent. You can find him on Twitter here. John had this intriguing response to my storify post  "A House Mystery: Why Does House Construction Go Up in Booms and Down in Recessions?“ He was generous enough to agree to share this. 

I have attached an article I wrote in 2005 for the South Carolina Bar which implicitly answers your questions. It has to do with banking law and LTV values.

Anyone in the housing or banking business should have give you an answer in 3 minutes. The answers collected in you series of tweets are wrong.

Understand that I have been representing homebuilders since 1980 and at one time represented one of the largest 10 private builders in the US.

While it may finally have changed with the Dobb Frank (law to new to know how it is being applied), before the latest Depression, there was no “equity or capital” in home building.

While nominally there was bank lending, in substance what we actually had was merchant banking with banks using construction loans to builders to give the appearance of lending, as I explain in my article.

This was accomplished by a manipulation of the LTV ratios. If you knew what you were doing, and had a good appraisal, a builder only needed 25% of the cost of the raw ground and could borrow all the rest. And by using “presales,” etc. the builder didn’t even need 25%.

In order to give the appearance of actually lending money, banks would monitor builders cash on hand and retained earnings. If a slow down appeared likely, banks would demand this cash be used to make greater down payments on renewal (home all LAC loans were 12 month, renewed in Sept., based on sales in spring and closings during summer).

My very large client failed in 1990 under this system. It was ironic. Its tax year was 8/31. It closed its tax year, making profits and paying income taxes. In September its lenders refused to renew loans unless all cash on hand was used to increase LTV ratios.  The cash was paid and on 10/1 the firm failed. Since all lots and homes were subject to bank’s security interests, my client could not sell a home or lot and collect any money at a closing. The banks foreclosed and then found new builders, using same plans etc. to sell homes, when things picked up.

In economic substance, the developer was merely an employee of the bank, albeit the highest paid employee. The loan documents also gave the bank complete control over cash, who was paid, when, etc.

The bank acted to call for more cash merely for appearance sake for its regulators.

The entire system has nothing to do with interest rates, wages, material prices, etc.  It was strictly a function of bank willingness to take risk. They could expand the inventory of homes or decrease such at any time. As they controlled all the lots—it takes 24 months, at best, to move from raw ground to finished lot and 30 months to a finished home—their actions controlled supply and prices.

Miles: Very interesting. But the question remains, why the banks don’t build more houses during the recession when it is cheaper to build houses?

John: Now that we have the right question, I have three or four answers, which kind of blend together to explain.

1)Banks do not make their money on the cost of the house. By law, they don’t share in profits. Banks make money on fees for loan origination and interest. Since they do not share in upside potential of build low, sell high, why take the risk?

2)Banks have minimal capital, so when economy dives and they have to take loan loss reserves, they don’t have capital to put into housing inventory.

3)Denial and appearances. Bankers do not think like merchant bankers. Lots of them think they are lenders. My good, look at denial elsewhere (even here in my one person law firm ;<) And, then you have what bankers think about all the time, What would the regulators think? If Bankers had financed new home construction in 2009 they could have been charged with bank fraud.

I am very serious on this point. The Bank fraud statute has been interpreted to make it a crime to make a “foolish” loan. Of course, true, when it comes to whether a loan is good or bad, is like art, in the eyes of the beholder. Read this case and consider whether if you represented a bank you would have told them to build homes in 2009?

US v. Ely, 142 F. 3d 1113,72,73,78,79,80,86,88,93,114,129,134,135,141,142,143,149,151,156,258,259,260,261,310,311,321,322,323,324,373,374,383&case=16038856462378403756&scilh=0

In part the case says:

Reckless disregard equally satisfies the intent required under § 1344. See Willis v. United States, 87 F.3d 1004, 1007 (8th Cir.1996). What is charged in the indictment is not mere breach of the duty of a fiduciary to act honestly and prudently but a breach of that duty resulting in the reckless disposition of $2.7 million of Statebank funds. The defendants are adequately apprised of the charge of crimes committed in violation of § 1344(a).

We take the district court’s point that if the world price of oil had not fallen, all the troubles that befell the defendants might not have occurred. They might be today rich and respected citizens of Anchorage. They were unlucky in the extreme. Many financial irregularities come to light only in bad times. If the irregularities are criminal, as those charged here are portrayed as being, the defendants cannot excuse criminal conduct by the plea of bad luck.

4)No home equity of developers. I mentioned the LTV cash down issue. Well developers in fact never put any $$$ down. Most of the time the “cash” part of the LTV comes from a guaranty on a home (with equity) and a second mortgage.  When homes sales drop, prices drop, available “equity” drops and capacity of banks to lend contracts. This was mentioned a lot by community banks, post 2008.

So, there you have it. A very detailed explanation about how the real world works.

Would appreciate you letting me know if you see any oversights in my thinking.