Primer: real estate & finance

A few weeks ago I had the opportunity to speak with Stanbic Bank's credit department about real estate and finance. This essay is a summary of the main elements of that talk.

When people think about finance, more often than-not the image that may be conjured up in their minds is one of a Bloomberg terminal displaying all manner of graphs and prices. Whilst that is certainly one aspect of finance, the foundations of most financial systems are rather quaint. For the most part they start with very familiar things like farms and houses, and extend to things like supply chains (e.g trucks, trains, ships and warehouses), and even things like loans for furniture, phones, and the sort of credit you the reader may use from time to time. Those fairly innocuous and familiar things from every day life make possible the sort of high finance we typically associate with Wall Street. However, all of this is typically only possible in circumstances where two fundamental things exist--savings and productivity.

Financial systems are the means through which surplus users of capital transmit that value (through intermediaries) to deficit users of capital. As such, when a person goes to a bank to apply for a loan they (the deficit users of capital) are hoping that the bank can lend them money to buy a home. The would-be buyer isn't really thinking about where the bank's money is coming from--they're mostly thinking about the utility they're hoping to gain from the bank. The bank mostly doesn't use its own money to finance the mortgage the individual desires; approximately 10% of the total value of the mortgage would be from the bank--the rest will be from savings held at the bank by depositors. In the absence of intermediaries like banks--individuals would have to use their own money to purchase or build their home. For most, this would mean waiting a very long time before owning their home.

Mortgage providers typically require borrowers to provide at least 10-20% of the value of their desired home via a deposit; the lender then provides the balance (as already mentioned; typically 80-90%). This deposit represents the buyer's equity in the house. Without the use of a mortgage, the borrower would have to either have the full value of the purchase or save towards it. That might mean that the borrower would have to save for a decade or more before they have the resources to purchase their home. Consequently credit allows people to purchase a home earlier than they otherwise could. This might seem boring and innocuous--but it wasn't always possible.

In the past land was primarily held by feudal lords. Dukes or chiefs would own land by virtue of their title (Dukes, Earls, etc), and everyone else would have to rent their use of land from the nobility. Typically this was done through a form of share cropping whereby the tenant (usually a farmer) would give a fixed percentage of their annual harvests to their Duke. In addition to this, the tenant farmer might be required to take up arms when called for by the Duke; fighting in his militia on demand. As you might imagine, this wasn't the most secure of arrangements.

With time, security of occupancy, and participation in ownership were democratised. Individuals could formally lease their land from a landlord; with tenancies of anything from 10 years to 999 years. The leases allowed for a clear understanding between the occupant and landlord as to what rights each held--the tenant had a specific annual rent; and could own all improvements to the leased land e.g. their house was theirs--whilst the landlord could expect a defined cashflow and legal ownership of the land only. The landlord could sell their land--but the new owner would not have any rights to improvements owned by the tenant. Likewise, the tenant could sell their house or houses, but the rights of the landlord with regards to cashflow would remain the same. This allowed both parties to be secure. Alternatively individuals could purchase land from their nobleman or county/district/municipal authority. The creation of formal land tenure (as these arrangements came to be called) changed how financing of assets worked.

The history of banking and finance is intertwined to the development of cities, trade, and agriculture. As people transitioned from being nomadic hunter-foragers, they begun to settle in fertile zones--and to farm. Agriculture gave human beings more control over their lives. Previously human effort had capped returns. A hunter of even the greatest skill could only kill so many

There is evidence that banking started as far back as 2000BCE. Money lenders based in temples would lend to farBanks in their current form were "invented" in the middle-ages; initially servicing wealthy clients like royals, the nobility and the Church. Banks favoured these types of clients because (a) they had substantial capital resources (b) earned a steady cash flow from taxes/tithes (c) were relatively cheap to maintain [they didn't require an extensive retail distribution network]. Most people didn't have access to banks during that time, they were expensive to service [requiring a retail network], didn't have significant savings [potential deposits],  didn't own the land they farmed--and mostly used it to a) subsist b) pay rent to their feudal Lord.

Retail use of banking started to grow once people begun to be able to own the land they farmed, and were farming professionally as opposed to for subsistence. The ability to finance a cashflow was important; typically via off-take from an agricultural trader (the likes of a Louis Dreyfus). The farmer would execute a contract to sell their harvest to a trader, then finance the crop using a loan from a bank secured against the order from the trader. As international trade begun to grow during the renaissance period, banks were increasingly financing these voyages. A similar model was adopted, the ship's voyage would be equity financed by limited partners putting up the money, with a general partner managing the voyage itself. The trip might have a specific goal e.g. buying spices from "East India" and selling them to merchants in Europe. A purchase order would be made with the merchants, and a bank may finance a portion of the voyage using a loan with the order as security. These were early iterations of order finance.

The key point here is that the existence of a cash flow was an important pre-requisite for banks to forward credit to potential borrowers. That was true in the distant past, and it remains true today. Banks aren't really interested in physical collateral. They require it as a last measure to recover a defaulted obligation, however what is more important to them is the existence and reliability (quality) of cashflow from a potential borrower. As economies became much more formal, and people begun to earn reliable incomes through wages from formal organisations; the number of potential credit users begun to grow. The growth in the population of wage-earning-workers expanded the potential number of would be depositors and borrowers. Allowing for banking to go from something reserved for the ultra wealthy nobility of former years, to something anyone in a formal job could use.

As this was happening, the nobility in Europe begun to find that they were losing tenants. People were migrating to cities, and fewer and fewer people were involved in farming. Instead they were becoming factory workers, clerks, and professionals. This reduced their earnings and put stress on their ability to finance their lifestyles. This is famously shown in the TV show Downton Abbey. This pressure was net positive in that it forced land owning gentry to sell excess land/property, giving farmers the ability to maximise their earnings, and also created investible capital for the land owning gentry that could be invested into the financial system via bonds and other instruments issued by banks. Increasingly more and more people wanted to own the homes they lived in, so they used mortgages to purchase homes from the Landed gentry who were selling. The increase in formal employment created new savers, who alongside the land selling nobility were financing these mortgages through deposits sitting in banks.

As more and more people joined the formal sector, and as the industrial revolution pushed forward creating a surge in wealth from factory exports; capital accumulation rose sharply. This capital was sitting in banks.

Banks used this growth in capital to finance new factories, as well as mortgages for the growing population of wage earning people who sought to own the homes they lived in. At a system level, the growth in capital formation also had the effect of lowering the cost of capital.

The history described above largely remains true in Zambia--except that its all happening today. The larger part of the country's land is held by customary leaders, the number of wage earning individuals is limited and so the number of potential depositors and borrowers is also very constrained. Zambia (like much of Africa) is yet to properly experience an Industrial Revolution (which China has only now experienced). Consequently the potential for capital formation funded by growing factory exports is limited. This has the effect of making capital scarce, and expensive. As was the case for early banks, most commercial banks in Zambia (Africa) do the bulk of their business with governments, and the limited number of large businesses that operate in here.

The scarcity of capital is such that the cost of capital is higher than it ought to be, even on a risk adjusted basis. This has the effect of making long term project finance rare, and expensive. A mortgage in Zambia can cost upwards of 23% per annum--whereas in South Africa (more industrialised than Zambia) mortgages typically price around 10% per annum, and in the USA they price around 5% per annum. The difference comes down to capital scarcity and productivity per person.

How do poor countries overcome this? Part of the solution is that the lessons of history are worth learning. During the British Industrial Revolution, banks not only provided credit in the form of debt to factory developers or mine operators; they often also took equity positions in the companies to which they lent money. Merchant banks took on equity risk alongside the credit risk they underwrote. This had the effect of de-risking their loans because the banks participated in the governance of the companies they backed. Banks also used multiple strategies to underwrite credit to their clients, sometimes book-running commercial paper issuances, placing senior loans other times issuing bonds for clients, buying equity or all the above. This flexibility allowed companies to use a mode of financing that best matched their specific needs. This sort of dynamism has been absent in Zambia and much of Africa; with South Africa being a notable exception.

Failure to match this historical development of banks elsewhere is a limiter to the growth of the financial system. However the amount of global capital being invested in financial technology globally, and the pace and diversity of these investments is such that financial technology firms are extremely incentivised to create solutions that solve these problems. If banks do not match the pace of innovation in the financial technology space they may find that they are increasingly disintermediated. It is already happening with mobile network operators and the near ubiquity of mobile money in several African countries, and more recently with payment gateways, remittance startups, neobanks, and card issuers. It's a matter of time until credit products, vcDAOs, and savings products offered by web3 startups potentially replace key aspects of business lines currently offered by banks.

For the average person it might seem that a lot of this stuff is academic. A person in their early 30's in Zambia might think a mortgage is something an older person in middle to senior manage would think about. What would be lost on them is that their view is a direct consequence of credit pricing. If a mortgage was priced at 8-10% per annum instead of >20% per annum, they might afford that house they want. In the absence of that credit, that individual has to first buy a plot of land (likely with vendor credit provided by the land seller), and thereafter save towards building their house--which they may construct over several years.

An individual observing the real estate market in Zambia and most African countries might not that property prices never really fall. They might be confused by this. However, considering that most people who own a home likely built it with equity alone, it's understandable that they are under little pressure to dispose of these assets when the economy suffers. In contrast, individuals who own mortgaged homes in more developed markets may be incentivised to sell the home when economic performance declines. They could sell to protect their equity in the home--selling in the hopes of preserving their deposit plus any gains on asset value they accrued. Or they could sell because they fear that interest rates might be rising and they would not afford to service the mortgage. Either way, this creates opportunities for price discovery and allows the property market to actually reflect the true nature of its vitality or lack thereof. The lack of liquidity in the housing market prevents properties from being as productive as they otherwise might. A farm remains undeveloped for longer than it might otherwise have. A house that could be earning rents and distributing value to various stakeholders (owner and financiers) remains half constructed.