When Americans vote in the US presidential election in seven weeks’ time, they will implicitly judge the incumbent on his track record. Four years ago, when they first elected Donald Trump, they had little more than his rhetoric and business career to go on.
To many at the time, the pre-politics Mr Trump was above all a wealthy media personality with business interests in everything from vodka to beauty pageants.
Unsurprisingly, given his divisiveness, his acumen and track record as a corporate entrepreneur have long been debated. But one lesser-known period in the president’s life before the White House stands out as an important lesson about asset bubbles.
It starts in the mid-1970s, when Donald Trump was looking to strike out on his own, after watching his father Fred build a real estate empire focused on federal-subsidised housing in New York city’s outer boroughs. Donald instead envisioned the family business as a luxury property brand centred on Manhattan, where things had recently turned very sour.
As Mr Trump explains in his memoir-cum-business advice book The Art of the Deal, the inner city had been badly hit by a federal government-issued moratorium on housing subsidies just as interest rates started to rise, stoking inflation and construction costs. Few developers would touch it.
“The biggest problem by far was with the city itself,” he wrote. “The city’s debt was rising to levels that started to make everyone very nervous. For the first time you heard people talk about the city going bankrupt. Fear led to more fear. Before long New York was suffering from a crisis of confidence. People simply stopped believing in the city.”
Helped by some very generous tax breaks from local authorities, Mr Trump then made a series of contrarian bets on Manhattan, wagering that his investments would precede and even inspire a rejuvenation. “I like the inner cities, I see the inner cities as being sort of a wave of the future now,” he told an interviewer in 1980.
In a sense, he was proved right. During the coming decade, his wealth rose from $100m to as much as $3bn in 1987, according to one 'Trump-approved' estimate. One person who became intrigued in this extraordinary streak was the economist Hyman Minsky, whose work on financial crises later became a go-to source during the Great Recession. In a series of talks given in 1990, Mr Minsky described the rapid rise in Mr Trump’s financial wealth as “one of the puzzles of the 1980s”.
“Two factors made Trump somewhat unique,” claimed Mr Minsky. “One was that he developed a fortune in a period of high real interest rates, and the second was that the cash flows on most of Mr Trump’s properties were negative.”
A third, it might be stated, was that Mr Trump made his initial real estate fortune during a period when inflation outstripped average property prices across the US. What actually happened in this period was real estate prices rocketed in places that benefited from rising income in the financial services industry, New York chief among them.
Mr Trump’s real estate bets didn’t share in this rising income, at least in terms of cash flows. His wealth surged because the appraised value of his properties increased faster than the interest rates he was being charged by the banks. To pay off the interest on these loans, he instead remortgaged or tapped the banks for credit loans secured against his personal equity.
In his telling, Mr Trump did this through savvy awareness of his own leverage and an ability to convince others they needed him. Counterparties and city officials were strong-armed into thinking he was the only developer willing to create jobs and take a bet on developments in a dying city. With the banks, Trump reminded them of their “moral obligation to finance new developments to help get the city back on its feet”.
That New York did – incidentally – get back on its feet in the 1980s meant property values rose dramatically. But without this ingredient, Mr Trump’s developments could not have survived, given that they could not even cover interest payments.
Mr Minsky called this type of speculation “Ponzi finance”, which he described as borrowing that requires an asset’s value to rise high and fast enough for its refinancing, let alone its repayment. This in turn breeds asset bubbles, and increases the risks to the broader economy when borrowing can no longer be rolled over. It is, in a sense, a debt-fuelled version of the ‘greater fool’ theory of investing, which states that investors can always make money buying and selling assets, whether or not they are overvalued, because there will always be someone (a greater fool) who is willing to pay a higher price. As Minsky puts it: “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.”
Mr Trump took enormous risks in his early business career, and rode out on a rising bubble in New York property values. The questions for today’s landlords and investors is how much property and asset values are propped up by the implicit guarantee of refinancing, what they might be worth if interest rates should ever again hit levels seen in the 1980s, and – should you fear a post-bubble crash – whether you can convert your equity into cash as fast as the billionaire Donald Trump was apparently able to.
