Ponzi Finance II: quid pro quo

The real story revealed by the New York Times Trump tax returns bombshell is not that Donald Trump paid no taxes in 10 out of 15 years or that he paid $750 in 2016 and 2017. The real story is that he doesn’t have net income to service his debt. There is nothing inherently illegal about that. He did it before in the 1980s and when real estate prices stopped rising in 1990, his creditors were left holding the bag.

Hyman Minsky wrote about Donald Trump’s investment strategy in a 1990 talk, “The Bubble in the Price of Baseball Cards.”

One of the puzzles of the 1980s was the rapid rise in the financial wealth of Donald Trump, author of The Art of the Deal, and what else. Trump’s fortune was made in real estate. Many large fortunes have been made in real estate, since real estate is highly leveraged. Two factors made Trump somewhat unique — one was the he developed a fortune in the period of high real interest rates, and the second was that the cash flows on most of Trump’s properties were negative.

Trump’s wealth surged because the market value of his properties — or at least the appraised value — was increasing faster than the interest rate. Trump obtained the funds to pay the interest on his outstanding loans by increasing the draw under what in effect was a home equity credit line. The efficiency with which Trump managed these properties was more or less irrelevant — hence Trump could acquire the Taj Mahal in Atlantic City without much concern about the impacts on the profits of the two casinos he already owned. Trump was golden — he had a magic touch — as long as property prices were increasing at a more rapid rate than the interest rate on the borrowed funds.

The puzzle is that the lenders failed to recognize that the arithmetic of his cash flows was virtually identical with that of the developing countries; in effect Trump was Brazil in drag. In the short run Trump could make his interest payments with funds from new loans — but when the increase in property prices declined to a value below the interest rate, Trump would become short of the cash necessary to pay the interest on the outstanding loans.

The increase in U.S. real estate prices in the 1980s was regional, and concentrated in the Northeast and in coastal California; for the country as a whole, real estate did not increase relative to the price level. The regional dispersion in the movement in real estate prices more or less paralleled the changes in personal income. Real estate prices dipped in the oil patch, climbed modestly in the rust belt, and surged in those areas that benefitted from the rapid increases in incomes in banking and financial services — sort of a derived demand from the financial success of Drexel Burnham. In effect, those individuals with high incomes in financial services — and with the prospect of sharp increase in incomes — set the pace for increases in real estate prices

 

Trump’s cousins were alive and well and flourishing in Tokyo, Taipei and Seoul especially in the second half of the 1980s. The prices of equities and real estate were increasing because they were increasing — the “greater fool theory” may have been relevant, in that the recent buyers believed there was a greater fool to whom they could sell these assets before the bubble imploded.

In any market economy the price of real estate will tend to reflect both its rental return and the rate of return on the riskless bond. Real estate is a riskier investment than bonds and even public utility stocks, so the anticipated return should be higher. But the real estate offers investors a more effective hedge against inflation. The cliché, “land is a good investment, the price of land always increases is right, wrong and irrelevant. The price of land rises and the price of land sometimes falls — the relevant question is whether the anticipated increase in the price of land is sufficiently higher than the interest rate on bonds to justify a riskier investment.

To make a long story short, when the interest rate on bonds rose above the rate of increase in real estate prices, Trump’s real estate stopped being a “good investment.” He could no longer pay off his old loans with the proceeds of new loans. Since his properties were money losers, there was no question of paying off his loans from his negative cash flow. That was Trump Ponzi Finance I.

The mystery of Ponzi Finance II is who would be “stupid” enough to loan hundreds of millions of dollars to a guy who had a track record of defaulting on hundreds of millions of dollars of loans and was recycling the same old racket? I’m sure you’ve all heard the expression quid pro quo? 

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