patrick.net

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".

I’d also make an argument that it’s capitalism at it’s finest, when a small group of employees can start their own company and take ownership through options, and build a great company from nothing.

Fine, I agree.

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

For most public corporations (all that I know of), this is forbidden by your ESO and employment agreements. Further, there are explicit SEC restrictions against this for virtually all employees who'd have a big enough stake to want to really do this. Remember, equity-option premiums are very expensive and not worth it for small open-interest positions...unless you know something the market doesn't. And then, you'll be risking a much bigger problem. The SEC loves to investigate options-trades.

"Assumption #2: Pro-RE Congress soon to pass mortgage income tax CREDIT (covering 100% of mortgage interest & prop tax)"

Has this credit ever been suggested in Congress?

This would make me sick.

Remember, equity-option premiums are very expensive and not worth it for small open-interest positions…unless you know something the market doesn’t.

It used to be so expensive that it is difficult to lose selling options. Now it is quite different actually.

The market does not know the future, unless enough psychics are in the game ;) . Money is made when you are in disagreement with the market, and you turn out to be right.

test post

---Money is made when you are in disagreement with the market, and you turn out to be right.

True enough, lol. But, unless your system produces "you're right" more than "you're wrong", then you'll be at best out $0 minus the premiums, which is a net loss. And we can blame the efficiencies of the options market on Messers Black and Scholes, et. al. At least some of them are now indicted criminals due to the LTCM fiasco. "Hedge funds are evil. Long live hedge funds!"

True enough, lol. But, unless your system produces “you’re right” more than “you’re wrong”, then you’ll be at best out $0 minus the premiums, which is a net loss.

Also, "how right" and "how wrong" are important. :)

At least some of them are now indicted criminals due to the LTCM fiasco.

I thought there was no crime committed in the LTCM fiasco and most outside investors did not end up losing money.

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).

Was it about MACRO securities? Or was it about HedgeStreet?

Thanks.

Mainly HedgeStreet and their hedgelets. But also some interesting stuff about how you can create a sometimes safer synthetic hedge using short-term, variable financing and buying other things like TIPS and STRIPS.

Basically, if you are pretty sophisticated, and know what you're doing, and are comitted to making rebalancing moves when you see the signals you set (all big assumptions for most folk), you can hedge your RE cheaper with adjustable mortgages and treasuries than using a derivative. In fact, if you have enough wealth, because the expected future RE volatility is extremely high right now in bubble-markets, you can do quite well buying now if you know how to hedge AND you get a little bit of luck in the timing.

My guess is that almost 0 people will be able to really do this, unless they're already super-sophisticated RE investors (not flippers). The timing is the killer. The cost of hedging, even with financing, will only mount as you wait for the market to turn. And the window will close very fast on all this once sentiment does turn.