Posted by Leonard Steinberg on June 9th, 2014

As the DOW approaches the 17,000 mark, many are asking whether we are experiencing a repeat of the 2006-2008 bubble? One driving aspect of the financial crisis of 2008 was the volume of over-valued property loans held by banks.  Loans secured by real estate typically make up about one-third of U.S. bank assets, mostly in the form of home loans and commercial loans. Add in mortgage-backed securities, and the banking sector’s long-term average real-estate exposure rises to 42% of total assets. This climbed sharply in the years preceding the financial crisis, hitting a peak of 48.6% in 2006. Since then, banks have reduced their exposure to debt linked with real estate, due in part to write-downs of bad loans. The depth of this reduction and its persistence are striking and are critical to judging the valuations of big banks.

Real-estate-linked debt’s share of bank assets was just 38.6%, a level last seen in 1987. The retreat is most evident than in the decline in home loans. Residential mortgages on 1-4 family homes made up about 18% of bank assets from 1989 until 2006. This was relatively constant even as the housing bubble inflated, because many of the mortgages made back then were securitized. At the start of 2014, bank exposure to home loans stood at just 12.2%. One result is likely to be lower earnings and lower, but more reliable, stock returns in the sector. Rising real-estate exposure before the crisis led to higher returns, and banks that expanded mortgage lending generated higher earnings. The high returns of the pre-crisis era were earned by raising risk to dangerously high levels.

Today, banks are less exposed to both improvements in housing and any future deterioration. That helps explain why bank stocks rose so rapidly last year amid weak earnings growth. Investors saw the quality of earnings was rising. one would like to credit the banks for this prudence, but much of it has to do with tighter government lending standards. Making more mortgages, including riskier ones, produces profits investors can see easily. Meanwhile, there is likely to be diminishing returns to further reductions in real-estate exposure. This is harder to do anyway with the sector now far below historic averages. And at some point, banks risk overexposure to other asset types.

While all this is not great news for bank profits, it certainly speaks to a big difference between now and 2006-2008 when the volume of bad loans fueled bigger profits at the expense of the entire economy. And lets not also forget how much government encouraged those bad loans back then……they too have changed their tune.