The current credit crunch will last quite awhile, if past periods of similar conditions are any guide. One reason is that the U.S. banking system has been seriously hurt by capital losses from real estate loan write-downs. Consequently, the capacity of banks to make real estate loans has been drastically reduced and will recover only slowly.

Ironically, the current credit crunch had its origin in a massive flood of financial capital into real estate around the world, especially after the stock market crash in 2000. The resulting “Niagara of capital” into real estate markets caused intense competition among capital suppliers to lend on, or buy, real properties. This drove interest rates down and encouraged investors to skimp on underwriting. Cap rates were pushed downward, driving property prices upward.

One of the resulting innovations was large-scale expansion of the subprime mortgage market. Low-credit borrowers were encouraged to buy homes with little or no money down, very low initial interest rates, no verification of incomes, and rapid securitization of their loans to investors scattered worldwide.

After initial low “teaser” rates were reset, subprime borrowers had to pay interest rates about three percentage points above prime borrowers. Such loans attracted investors from all over the world, since most other interest rates were unusually low.

A jolt to the system

But when subprime default rates soared, alarm bells went off. Lenders suddenly realized they had not been getting paid enough to offset their risks, mainly because of their own poor underwriting.

So the lending community decided it had better make three calculated changes: charge higher interest rates, add more covenants to their loans, and conduct more due diligence. If they could not get those terms from borrowers, they would stop lending on real estate.

That shift to more stringent loan underwriting means property owners have to pay higher borrowing costs, which reduce the net incomes of properties and cause prices to fall.

Most owners won't accept lower prices, even though they recently profited from the heightened competition among capital suppliers that drove up property prices. A standoff between capital suppliers and property owners ensued. Property transactions ground to a virtual halt globally, but especially in the U.S.

Banking fallout

A key factor in this standoff consisted of immense financial losses by both major and regional banks in the U.S. due to defaults and foreclosures, especially in the subprime mortgage business.

Although most of those bank loans had been securitized, many banks found themselves having to take back or write down many such loans. Bank stocks have plummeted as the extent of bank write-offs has been recognized.

Among the 12 largest U.S. commercial banks in terms of market capitalization in 2006, 11 have suffered severe declines in stock prices from June 2007 to June 2008. The average stock price decline was 44.6%, and five banks posted declines of more than 50%. Washington Mutual's stock price fell 89%.

Even banks gaining capital infusions from foreign sovereign wealth funds have sustained a huge drop in their stock prices. Wall Street investment banks also suffered from plummeting stock prices, though less than the big banks.

These losses have weakened the ability of the U.S. banking system to continue providing credit to real estate borrowers. From 1990 through 1999, real estate loans accounted for about 25% of total bank assets. By early 2008, that figure had risen to 33%. As a result, many banks do not want to make any additional real estate loans.

This situation means real estate owners, operators, and potential buyers are going to have a hard time borrowing the money to make deals or pay for capital expenses. And this credit drought could last for several years, based on the similar situation in the early 1990s.

The result will be lower-priced properties, higher interest rates and stronger loan covenants. Owners will have to cut capital needs to a minimum in order to survive in this environment.

Anthony Downs is a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California. He can be reached at anthonydowns@csi.com.