patrick.net

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.

My husband just returned from the Bay Area yesterday. He was glad to be home. He got a ride to SJC airport from Campbell and it took him over an hour in bumper to bumper traffic @ 10:00am. He used to commute 1.5 hours each way to work when we lived there - 16 years - it reminded him of how much he hated traffic. Of course, he heard all of the stories about how all of our friend's homes have gone up so high (we sold two years ago because of a job transfer and are now in the Midwest).... anyway, I thought it was funny how everyone was so proud of themselves for 'making so much money' and they can't fathom that prices will ever go down - they all insist that prices will never drop. I thought it was interesting the same people just got new next door neighbors in Morgan Hill - Four sisters and their husbands and kids from Mexico - 4 families moved in together after purchasing the house for nearly one million dollars - house is 2800 sq ft. I thought it was sad that these people are having to live in such circumstances and probably took on a horrible loan as well.

Yes, I'm bothered that we sold at the 'wrong' time even though we did make a nice profit on the house at the time but I don't miss the traffic and congestion and horrible schools. The weather was nice in CA but what's interesting about other parts of the country is that everything is climate controlled - people in Vegas turn on the air, people in the midwest turn on the heat - it's comfortable - you learn to cope. I thought it was interesting that people would pay more than a million dollars for a shack because of the weather. You wouldn't believe the types of homes and lifestyles you can get elsewhere. It's not for everyone but there are other places. I'm glad I'm raising my kids here. The schools are wonderful, the parents are so involved. We can't find parking at any of the school functions because the parents are extremely interested in their children's education - the parent teacher conferences are 98% attended. When I was in CA, we had about 10 parents who showed up. I'm not trying to knock CA because I was born and raised there but I want those who feel hopeless about ever owning a home to know that you do have choices - sometimes those choices can give you a better life than you ever dreamed possible. Figure out what is important in your lives. I wanted to raise my children in a small town with family values and parks and trees and room to roam. Sure, I miss the possible equity loss because homes don't go up as much in the heartland -but I do think at the end of the day, our lives will be happier because of our choices.

Re: housing declines in "unbustable" BA markets.
Just for a bit of historical perspective, here's something from OFHEO.gov on house prices in SF:

1990 4 -2.56
1991 1 -4.79
1991 2 -4.95
1991 3 -4.72
1991 4 -1.67
1992 1 -0.96
1992 2 -1.05
1992 3 -0.85
1992 4 -2.27
1993 1 -2.63
1993 2 -2.34
1993 3 -2.74
1993 4 -2.11
1994 1 -1.33
1994 2 -1.71
1994 3 -2
1994 4 -2.97
1995 1 -1.55
1995 2 -0.19
1995 3 1.12

So, a hypothetical home "worth" $1M @ 1990 (4), may drop to roughly $675K by the end (-32.5%). Should we suppose this can't happen again?

“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

Not that I know of, but I wouldn't put it past them ;-)

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.

HedgeStreet? OMG. It choked after I placed a $500 order. I think the "ask" side was exhausted after absorbing $200.

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.

I am probably too unsophisticated to handle the tracking risks. Using 5+ contracts of TY/US to "hedge" a mortgage can incur 5-digit losses in hours. These losses are marked-to-market and one needs a large capital base to meet margin requirements.

How would you hedge real estates? If you can convince me, I will call my agent this week.

I completely give up on the idea of hedging the RE market about 12 months ago. It appeared to me that the hedge is more dangerous than the thing being hedged.

Randy, can you post the reprint (or a summary) anyway?

You are an important source of economic theory and information. Without you the blog will be at the mercy of my half-truths. ;)

Always a little bit too late Says, I think quality homes that are reasonably priced and still selling. Fewer people are willing to pay unrealistic amounts now.

What type of property is that? Where is it located?

I think those numbers are year over year not quarter to quarter so the decline is actually a lot less.

Really? While dqnews compares prices from Y-to-Y, I haven't read anything that states quarterly numbers from ofheo.gov are doing that calculation. If anyone can source that directly, please post it. Of course, I may have missed something, even if those stats appear plausible. That said, I think the stakes are higher this time.