patrick.net

Why does FASB assume that an otherwise efficient market is somehow unable to factor in this one, singular aspect of capitalization?

Because the market is not as efficient as one would like to.

All it is is a socialist transfer of wealth from shareholders to employees who are getting a lucky deal and earning much more than they would command in a sane market.

Absolutely. It is a way of privatizing gains and socializing costs.

Effificent market is not a sufficient safegard against socialism.

The options are typically granted at the current market valuation at the time of grant, so the employees are not getting any guaranteed money.

Usually, options are granted at a discount to market valuation. Even if they are granted at market valuation, they still worth something because the employee has all the upside and none of the risks.

Today's Chronicle paints a very rosy pitcure of the Bay Area market and basically says the direct OPPOSTIE of Patrick's points on the main page of this site:

http://sfgate.com/cgi-bin/article.cgi?f=/c/a/2005/09/20/BUGA7EQCSS1.DTL

Thoughts? Is the rent & price ratio really not as bad now as in years past like the article claims, for instance?

1. Somebody posted a link to a graph of inventory somewhere in Cali and wrote . . .
"Second graph down the page showing increasing inventory."

Good spot, inventory is taking off.

How about the third graph? Showing properties "removed" from the listings? That's taking off too. But inventory is not decreasing. Makes you wonder if Realtors are doing the "take it off and put it on again as new"? Yeah, you know it. Oh look, this one's only been on the market for 2 days (months).

2. Hey Patrick, I never did give you my props. When I first got the bug that their was a bubble in DC, I came online and searched "housing crash". I turned up your site. Reading your site, among others, corroborated what I though was going on in DC. I immediately went into emergency mode to sell the house.

It was about the 4th best decision I have ever made.

If you're ever in CT, let me know, dinner on me.

For the rest of you bums, I really enjoy this blog. Most of the people on here are well educated and have reasoned points to make. I even enjoy the ranting, stream of cons. type crap.

If this all blows over, which it won't, I'll have to come out to the Bay Area and go to some open houses. I'll tell them an Investor from Alabama.

Jack wrote -
"No crash. A non-event. 10 to 20 per cent TOTAL correction (at most) and spread over 4 years."

So let me get this. If some poor slob buys a "house" in San Fran for 1 million today, and it loses about 50,000 dollars a year in value every year for 4 years, you would not consider that a "Crash"? Particularly when you consider that virtually everybody who got into the market in the last 20 months would be underwater?

Well, I gues if a plane hitting the ground is not within the scope of the definiiton of "crash," then I'd have to agree with you - no crash.

And some are undoubtedly holding time-bomb loans, (which they have no doubt had a chance to reconsider in the light of the possiblity of declining future prices.

Yes, I sure do wonder...if the US faces a credit crisis, and banks will find themselves with far too much exposure (or no loan default reserves at all), won't easy loans will be a thing of the past?
Therefore, purchasing a home in a flat or negative market that severely strains one's income won't be a possibility--banks won't allow it, and the speculative fervor won't be there. Those factors could severly limit demand, while "late to wake" investors flood the market with inventory. And, if a recession hits, that will further dampen RE demand around SF bay. People are already moving due to above factors, and I have noticed price drops too. I'm not positive, but for the above reasons, I suspect a steeper correction coming.

Today’s Chronicle paints a very rosy pitcure of the Bay Area market and basically says the direct OPPOSTIE of Patrick’s points on the main page of this site

I remember reading it earlier on Inman News. The study was probably sponsored by the real estate industry. The business school has no academic integrity nowadays.

BTW, studies like this one were very common in 1929.

How about a highly acclaimed Yale professor? Does Irving Fisher ring a bell?

Today’s Chronicle paints a very rosy pitcure of the Bay Area market...

Boosterism isn't unheard of in the Bay Area; local businesses and media have a vested interest to pump up the economy, it makes them look good to their clients. The hype permeats as far as the social consensus: many people here believe we have a bulletproof economy, therefore RE carries a premium. Let's just say that's been said throughout history. I'm sure I can guess what the article says already, but I'll give it a read.

Ahhhh, I see you are back to your old self today Peter P, at least judging by your comment. (One line to refute a whole story!) Hope you are feeling better.

Thanks Jack. I still have a headache, but I am feeling better otherwise.

The Chronicle article had a lot of assumptions in it

Yes, they probably assumed that real estate prices never go down.

Give me any conclusion you want and I can usually prove it.

“Studies like this one were very common in 1929.” (Classic Peter P.)

Well Jack, it is not a crime to attack bad arguments with more bad arguments. ;)

“Perhaps they looked at the percentage of interest-only loans used each year, and adjusted their affordability based on that?”

Business schools are more about industry connections than knowledge and truth. I doubt that they have conducted a study at all. It is more like:

"I want to conclude that the real estate picture is rosy, prove it."

It’s not the article you should critique. It’s the actual oped and research pieces by the Columbia & Wharton professors.

Yes, if we can laugh at a Yale professor for "permanentaly high plateau" we can surely do the same to Columbia and Wharton professors too.

I want to wait and see if Marin reacts differently to all those signs than Contra Costa or Sacramento does though.

yeah--you're right in that Marin hasn't seen any major downturn before (at least what I see w/median prices). I wish I had more individual property history to know for sure...
It's good to hear the other side to keep my predictions in check. In all honesty, the BA may possibly have stickyness in RE, and perhaps that has attracted investment too.
Wouldn't it be a wild possibility if RE just flattened for a while, then took off again? I sure wish my salary did that! ;)

Microclimates--yeah, another "intangible" for the list. Someone who moves here can pretty much choose the climate they like...that is if they can afford to live here!
My surprise was to find my new home gets ~ 50% more rain than Seattle--who would've thought that?!

The rise in inventory and interest rates will slow price growth to normal or flat levels for a bit, perhaps even slight isolated reductions, but absent a economic recession significant statewide (CA) reductions won’t occur.

We will see how reflexivity plays out this time.

Just saw this in MarketWatch. Evidently S&P believes that it’s going to be a fizzle, and not a pop.

If they say there is going to be a pop, they will cause one. How many companies have they downgraded before the tech bust?

We will see how reflexivity plays out this time.

Another wild card this time: the number of properties bought by investors--and what will be done with those when the market goes sour.

So how will the bubble be popped--excess inventory plus lack of buyer confidence feeding a downward pricing spiral? Or, an invetibable tightening of credit and loans, large-scale investor pullout, leading to a precipitous dropoff in demand?

Jack -
"By your reasoning, are YOU not in fact “underwater” at this very moment DC, should you have to sell your house immediately?"

Jack, that wasn't my reasoning. My point was only that the percentage of owners who will be underwater after a 5% decline is higher than ever, which, in my opinion, makes a current 5% downturn more of a "crash" than a downturn in a market where everbody has at least 40% equity.

Regarding your analsis of the previous downturns through which you lived, I think now is much different from then.

Now, we have little or no cushion. We have no fallback position.

For us, this is Waterloo. We are the Roman garrison. If we lose here, there is nothing else for which to fight. In other words, without spewing all the detail, we have one straw's worth of mass left to carry.

In 1988, despite many issues and Reagan's deficit spending, there was plenty of fall back space.

Hellboy -
The Wharton school uses imputed annual rent as their cost of housing. Now what’s wrong with that picture? Anybody?

The rent/buy ratio is out of whack, thus resulting in a low imputation of homeownership cost.

If by “downgraded” you mean pointed out the fact that operating capital would run out in a matter of weeks for companies that had never turned a profit, the answere is MANY. Is that the case today?

If you refer to some recent marginal homebuyers and inves-culators, it is the case. ;)

Jack, that wasn’t my reasoning. My point was only that the percentage of owners who will be underwater after a 5% decline is higher than ever, which, in my opinion, makes a current 5% downturn more of a “crash” than a downturn in a market where everbody has at least 40% equity.

Excellent point!

Peter P is a real estate BULL. Can you prove this statement Peter?

Peter P is a real estate BULL because he believes that housing is a good investment in the long run. However, being a bull does not oblige one to being bullish at all times. :)

That Wharton article does have one thing correct–the amount homedebtors are paying per month is lower than prior to the 1989 downturn (in inflation-adjusted and percentage terms).

But inflation was a lot higher back then. I believe real interest rate was higher too.

If they say there is going to be a pop, they will cause one. How many companies have they downgraded before the tech bust?"

I was watching CNBC this morning (market watch), and they were interviewing a real estate mogul who attended a real estate convention yesterday. At this convention, they had a survey asking what 2006 would bring for the housing market. The clear majority said no bust and no boom, but rather the market would be flat. This sounds to me like an admission that things can't go on as they have forever, which is a far cry from what I was hearing from some of these same people earlier in the year. If I could time line it, it would go something like this - There is NO housing bubble and prices will continue rise at staggering pace for the unforeseeable future, there are some pocket areas that might be experiencing a bubble but supply and demand will continue to cause prices to rise for many years to come, (NOW) the market will be flat for 2006. It's amazing how attitudes can change within a year's time.

The clear majority said no bust and no boom, but rather the market would be flat.

I wonder what caused the lowered expectation. ;)

"I wonder what caused the lowered expectation."

Hahahaha, lol.

On a side to note, I just heard an expert on CNBC say that the fed will have to raise rates in order to keep real estate in check (so to speak). Could it be true that the fed is raising rates with the housing market in mind because they see trouble on the horizon? Naaaaaaa, Alan said there was no evidence of a housing bubble, oh wait only pockets of froth, oh wait.....

So if you believe that house price in SF Bay Area will increase nominally by 5.3% a year, then there is no bubble.

See, chewbacca defense! The conclusion is part of the assumption.

Well, science is objective, but the presentation of science is not.

User Cost in SF jumps from 2.4% to 5.7%
Justified price multiple down from 42 to 17.5

This illustrates how sensitive prices are with regard to the underlying assumptions, which are themselves questionable. Their study is at least non-robust. It will probably get a C as an undergrad term paper.

This Wharton study is just another “CPI” trick. They just figured out a whay to lower the cost of owning a home through the use of hedonics. I can tell you for a fact that a $1million dollar house would not cost me $2k a month to buy it with a conventional mortgage( even with a 20% down ).

Well, throw in some "intangibles" and your cost will be $0 per month. (Sorry, Jack)

Any house can justify any price.

I think the User Cost formula presented in the study is actually a good measure of the cost of owning a home (instead of using a straight Price/Rent or Price/Income multiple). I would give it a B+.

Perhaps. I think it is as good as the black-scholes model. Determining future appreciating is like determining future volatility. It is probably useful as a tool to determine the implied appreciation expectation of the market. (IMHO B/S model is useful only to determine the implied volatility of the market)

---Usually, options are granted at a discount to market valuation. Even if they are granted at market valuation, they still worth something because the employee has all the upside and none of the risks.

I can't let this lay. That statement is categorically false; most ESOs are issued at the money, not in the money. Further, issuing of ESOs in the money, for a public company (which is the only relevance), has always resulted in a P&L expense. So this argument is invalid.

Your other argument about externalities and market efficiencies: it is dangerous business to make general statements like "the market isn't efficient, so we have to expense ESOs". You must quantify this. Why are equity-options price efficient and common stock for a firm with ESOs not? And, if the ESOs cause market asymetries, then shouldn't we fix the other much much much bigger asymetries? How about real-estate (a favorite topic here), which is never adequately represented on the balance sheets or P&Ls of companies? Is the market somehow able to digest this, which is much mroe complex and opaque, but it can't figure out a simple dilution?

Quite contridactory to your supposition that somehow expensing ESOs protects against socialism, I speculate that putting neverending market "helpers" and controls in place because you think people can't do simple 5th grade math leads to socialism much faster. I had a CSR class some time back. I shudder to think what kind of "market fixes" that gang of populists would force on the capital markets.

The answer is transparancy, not ad-hoc P&L manipulations.

And...you never answered my question about how does one accurately value a ESO? In one exercise I did a $50 at-the-money ESO with a 5 year term, which was priced by Black-Scholes at roughly $5.00 (based on implied volatility of publicly traded equity options), would be worth less than $0.90 were you to factor in all the liquidity restrictions and legal surrender clauses.

Just to let you know, Fed hikes another quarter.

An illustration in the paper shows a 5% user cost based on the following assumptions:
4.5% (Risk Free Rate) + 1.5% (Prop Tax) + 2% (Depreciation)+ 2% (Risk Premium) = 10.50%
OFFSET by
1.75% (Tax Deduction based on 25% tax rate, 5.5% mortgage rate & 1.5% prop tax rate) and 3.8% (long-term appreciation in the US for the last 25 yrs) = 5.55%

How can one claims a low risk-free opportunity cost (assuming cash purchase) and mortgage deduction at the same time?

What if I invest at a higher rate, say 8%? My opportunity cost woul be much higher. Usually, BA people are hit with AMT, so no prop tax deduction.

Let's see...

8% (opportunity cost) + 1.5% (Prop Tax) + 2% (Depreciation)+ 2% (Risk Premium) = 13.50%
OFFSET by
1.4% (Tax Deduction based on 25% tax rate, 5.5% mortgage rate) and 3.8% (long-term appreciation in the US for the last 25 yrs) = 5.2%

Cost = 8.3%!

I can’t let this lay. That statement is categorically false; most ESOs are issued at the money, not in the money. Further, issuing of ESOs in the money, for a public company (which is the only relevance), has always resulted in a P&L expense. So this argument is invalid.

And…you never answered my question about how does one accurately value a ESO? In one exercise I did a $50 at-the-money ESO with a 5 year term, which was priced by Black-Scholes at roughly $5.00 (based on implied volatility of publicly traded equity options), would be worth less than $0.90 were you to factor in all the liquidity restrictions and legal surrender clauses.

Fine.

Why are there so many ChickenLittle’s like me on this board?

I do not know.

Why does MarinaPrime has so many screen names? Why does he call himself ChickenLittle?

I do not know.

One other point of data on stock options:

Before 1997 (I think it was 97), it was allowable for employees with large option positions to enter into OTC contracts (with their options as the asset) in an attempt to hedge their positions against dowside. This quite effeciently created a real, price-efficient market for ESOs, although it was fairly narrow. Many insiders at places like Netscape, Excite, etc. took advantage of this to either monetize or "buy insurance" against their over exposure to their own company's stock.

Very few of these hedges paid off. In the end, the cost of the hedge was more than the value of the options. This suggests that the value gained from volatility of future price movements is less than the costs of liquidity and legal constraints.

Randy H, even now, employees can in theory sell calls, but puts, or short stocks to hedge against their vested options.

On the theme of this thread, I have a reprint of the WSJ article, New Tools to Hedge Your Home if there's somewhere here I can send it, in case anyone's interested in how you'd set up a hedge using either derivatives or leverage (or both).

The reference was (for anyone who has the paper or an account):
By JAMES R. HAGERTY
Staff Reporter of THE WALL STREET JOURNAL
September 17, 2005; Page B1

Proposed assumptions for new Whoreton Bay Area RE "study":

Assumption #1: Long-term annual appreciation rate = 20-30% ("at least")
Assumption #2: Pro-RE Congress soon to pass mortgage income tax CREDIT (covering 100% of mortgage interest & prop tax)
Assumption #3: Maintenance & depreciation negligible in the BA (this is Cali --"bad stuff" doesn't happen here!)
Assumption #4: "Owning" intangibles are worth a multiple of 3X rents.
Assumption #5: 1% NAAVLP "teasers" will soon go negative -- lenders will pay YOU interest to live there, turning your home into a true "ATM".