Ricardo's Law of Rent Accelerated
by the Credit Economy

Edward J. Dodson

[March 2009]

Ricardo did not extend his analysis of ground rents to locations in cities, but he provided keen insights that (for the most part) have been given little attention by modern economics.

What Ricardo understood is that credit acts as an accelerant on the natural tendency of investors to speculate in locations. Far better to use leverage and risk someone else's assets in speculation than one's own. The use of credit by investors in the property markets is normal. What was not normal in this land market cycle were the aggregation of externalities -- most importantly the bypassing of the GSEs as the core secondary market controls over the quality of collateral going into mortgage backed securities. Wall Street packaging of loans and investors looking for high normal rates of return stimulated the production of mortgage loans made without verification of income, employment or even creditworthiness -- often with fraudulent property appraisals. A high percentage of second mortgages were originated under predatory terms with even greater incidences of fraud.

What happens whenever the pool of potential borrowers or homebuyers expands is that market forces capitalize the change in equilibrium into higher land prices. The mortgage lenders responded by a combination of raising maximum loan limits, reducing down payment requirements, extending mortgage terms, creating interest only mortgages, permitting negative amortization and offering ARMs with low "teaser" rates for the first six months or year of the loan.

Those of us in the industry who say all this developing and feared the worst observed that on a higher percentage of property appraisals the land-to-total value ratio skyrocketed in many markets. By the early 2000s, the loans we were purchasing involved financing for more and more land and less and less housing.

Similar problems were operating in the commercial real estate sector. Here, investors ignored current cash flows and entered into bidding contests for properties they expected to flip after a few years to take advantage of rising land prices. Banks accommodated their speculative investments by making poorly underwritten loans and passing on the default risk to investors who purchased CMOs.

What economists ought to immediately understand is that at some point the accumulative financial stress on businesses and residential property owners will bring on a collapse in property markets (with bank failures as collateral damage).

Business profit margins are reduced by rising land acquisition costs (pushed forward to increases in the cost of leasing space in office buildings, retail shopping centers, etc.). So, businesses look for ways to reduce costs of doing business. When business relocations begin and vacancy rates increases, this is a clear indication that a crash in the property market is on the horizon.

In the residential property markets, the end comes when property (i.e., land) prices become too high for first-time homebuyers to enter the market even with the exotic mortgage offerings provided by lenders. The continuation of the cycle depends on the ability to pass on rising land costs to others. By 2004-2005, the capacity of millions of U.S. households to carry housing debt on top of other debt and expenses had reached its maximum. Household incomes were stagnant or declining, household savings had disappeared to many, and interest rates could not be lowered (in part because the U.S. government needed to offer foreign investors some level of return to attract sufficient funds to meet government expenditures).

It is too late to prevent the economic crisis. At best, what governments around the globe will do is mitigate the depth and duration of the depression.

The land market cycle will begin again when businesses see the opportunity to invest (to borrow and invest?) in new capital goods creation and once again generate profitable sales.

Among the numerous reforms we need is regulation that prohibits banks from extending credit for the purchase and/or refinancing of land. This will require investors and homeowners to come up with cash down payments from savings or other sources that do not put the financial system at risk. Removing credit as the accelerant for land speculation will not solve the problem, but it is an important first step.