One of our persistent themes around here is that much of the banking crisis was the result in errors on the part of bankers, investors, portfolio managers and regulators.
In particular, most were convinced that investing in real estate backed securities was far less risky than they turned out to be and that the business cycle had been tamed.
Sometimes we get challenged on this by people who think the bankers knew all along that they were creating toxic mortgage backed securities but were incentivized by the compensation structure to take on too much risk. To counter these challenges, we’ve made habit of collecting evidence of the Great Delusion that accompanied the bubble.
Our latest find is this paper from the Journal of Portfolio Management by Jon Ruff, a director in the San Francisco office of Bernstein Global Wealth Management. From the abstract:
The spread of mortgage securitization and a decline in business-cycle volatility have reduced the traditional risks of holding commercial real estate. These secular factors, in turn, have contributed to record property valuations. Investors seem willing to pay higher prices for the same cash flows because they believe they can borrow at lower rates and count on stable cash flow from commercial rentals in a climate of comparative certainty. The result has been a sharp compression of the risk premium on commercial real estate. No doubt, this phenomenon will in part prove to be cyclical. However, the evidence suggests that, long term, the commercial real estate risk premium will remain below its historical average.
Wow. In retrospect, that’s basically the perfect summary of how the bubble in commercial real estate was inflated.