Nostradoofus

A recent Wall Street Journal article’s claim that gas prices will make Riverside real estate worthless is exciting but exaggerated.

Paraphrasing the argument: imagine you are the canonical Riverside resident, commuting to LA in a flag-draped SUV. That’s 12mpg, $4.80 per premium gallon, 120 miles per day, 210 days per year: over $10,000 per year in gas, requiring at least $12,000 in pretax earnings or 20% of the median family income. (The WSJ article concludes about $14k after tax, using different assumptions.)

Accurate so far. But then the article quotes a Deutsche Bank analyst claiming such homes could become “effectively worthless” because of the cost of sustained higher gas prices.

Obviously ridiculous. 30mpg regular-gas used cars are readily available for $5,000. The return on investment of changing from SUV to high-mileage beater is over 100%. So even if people don’t behave rationally in the short run, eventually the cost per mile will drift down, using the existing stock of technology and vehicles.

So WSJ and Mr. Deutsche Bank are wrong. Yet these houses may still become nearly worthless, because overbuilding during the bubble was concentrated in marginal locations. Gas prices are not the only thing going the wrong way for Riverside county.

Unlike tradable securities, homes have a fixed location. The cost/benefit assessment of buying in a given neighborhood includes not just gas prices, but taxes, commute time, weather, crime rates, etc.

Comparatively, Riverside County is not a nice place to live. It is the smoggiest location in the nation, brutally hot in summer, yet also expensive, crime-ridden, far from economic centers, and with poor access to good schools.

As a result, when housing supply far exceeds demand, this is logically one of the first places to be abandoned. Gas prices are only one reason.

For historical precedent, consider the Antelope Valley northeast of Los Angeles, which includes the cities of Lancaster and Palmdale. The area lies within Los Angeles County, but is geographically part of the Mojave Desert: baking heat, high winds, dust storms, etc.

The Antelope Valley was marginal to begin with, held together by a local postwar aerospace industry. When that declined, the area was decimated. A double-digit percentage of homes there were abandoned, and Palmdale Airport closed for decades. It can happen.

Riverside is a huge county, stretching from the Arizona border to within 30 miles of the Pacific Ocean. Parts of it (e.g. Corona) are not far from LA, and may recover quickly. But I sure wouldn’t want to own a 4,000-square-foot home in, say, Indio right now.
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The Economist writes in “From buy-backs to sell-backs” that the slowdown or reversal of share repurchases is an ominous harbinger for stock markets.

The article seems to miss the central reason for the change: the cost of risky debt was historically, monumentally low before August 2007, leading everyone (corporations, individuals and governments) to increase their debt/equity ratio.

The academic model cited in the article, with tax effects, argues for a 100% debt, zero equity structure. In the real world, this is usually moderated by a nonlinear increase in the cost of debt as the debt/equity ratio increases: lenders simply won’t go that high. But just how high they may be willing to go is a moving target. Before last summer, lenders were eager, so many public companies dutifully issued debt and bought back stock, increasing firm value by increasing debt/equity ratio, as in the academic model.

Suddenly in August, the price of risky debt skyrocketed, dramatically reducing the optimal debt/equity ratio. Companies are frantically trying to delever in response.

The best CFOs recognized all along that the cost of risky debt, and the cash flow available to service it, change through time. As a result, the true optimal debt level was much lower than implied by the prevailing cost of capital during the go-go years of 2005-2007.

The article also mentions rights issues by banks. These are a related matter, but not in the way implied. Banks were on the other side of the leverage table before 2007, providing the aforementioned monumentally cheap risky loans. The results of this are well known, and banks need to rescue their now impaired balance sheets. Few will lend to them, so one of their only financing options is to issue stock. A rights issue is the least expensive way to do so.

The really ominous harbinger for stock markets is neither the slowdown in buybacks, nor the increase in rights issues, but rather the underlying reason for both: inability to borrow. This cannot be resolved until the root cause of the credit crunch — a crisis of confidence in credit rating agencies — is corrected. This problem lays outside the realm of monetary policy, and thus cannot be fixed by the central banks.

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Here’s an interesting cluster of headlines.

Nov 2007: Wells Fargo Bank: worst housing crisis since Great Depression.
Feb 2008: US govt: Ohio job losses worst since Great Depression.
Apr 2008: Soros: worst financial crisis since Great Depression.
Apr 2008: Stiglitz: worst recession since Great Depression.
Apr 2008: IMF: worst financial crisis since Great Depression.
Apr 2008: IMF: US in worst economic crisis since Great Depression.
May 2008: Moody’s Economy.com: worst housing crisis since Great Depression.

The bad part of the above is the high credibility of the sources.

The silver lining, if any, is a reasoning error that occurs when reading headlines like these. One infers “as bad as the Great Depression,” when in fact they merely say “worse than everything except the Great Depression.”

Those statements are very different. If today’s situation is only slightly worse than the 1970s, then we can cheerfully look forward to a decade of falling real asset prices and standard of living. Why cheerfully? Because it does not automatically imply the starvation, revolution and global warfare that are conjured up by invoking “Great Depression.”

That said, notice also that the 1970s and 1930s were nothing alike, and this one will likely be yet again something else.

My thinking cannot help being influenced by Nassim Nicholas Taleb, whose excellent book I’m currently reading.

The financial press observes correctly that Time Warner’s recently announced cable spinoff reflects a more general surge in corporate spinoffs in 2008. Why would this be happening now?  Like everything else these days, it results from the credit crunch.

The first reason is the collapse of private equity.  Before August 2007, if a public company even hinted about splitting off an attractive division, the division was immediately swallowed up by Blackstone, Cerberus or their peers.  This is now impossible, because private equity firms cannot obtain cheap debt financing for acquisitions.

The second reason is slightly more complicated.  Most stocks are priced as a multiple of their earnings per share.  Many such stocks have been going down in recent months, for three reasons:

1. Corporate earnings have stalled as consumers and businesses feel the pinch of reduced borrowing power.
2. Pessimistic investors will no longer pay so large a multiple of earnings as before.
3. Stocks compete with bonds.  The credit crunch has increased the amount you can earn from a bond investment, making stock yields less attractive by comparison.

How does this result in spinoffs?  Because corporate management and investors constantly seek ways to increase share value.  If the normal solution — increased profits — doesn’t work, they look for other ways.

Spinoffs fill the bill nicely, because they address two of the three issues above:

1. Corporate earnings have been shown to grow faster post-spinoff.  This is believed to result from better management incentives:  if you increase profits as a division head within a company, you get a pat on the back, but if you do it as CEO of an independent firm, you get millions of dollars in incentive pay.
2. Investors have been shown to pay higher earnings multiples for more easily understandable businesses.  Spinoffs increase understandability.  For example, Time Warner is a complicated conglomerate, but Time Warner Cable is simply a cable company.

Activist investors are increasingly aware of the spinoff effect, and have been pushing for breakups at well-known companies.  For example, Nelson Peltz appears to have been instrumental in spinoffs Cadbury Schweppes in 2008 and Wendy’s in 2006;  Carl Icahn pushed for the spinoffs at Time Warner and Motorola in 2008.

There are two barriers that prevent a real flood of spinoffs.  

• Some conglomerates tend to receive higher debt ratings than would their component businesses. As a result, and again because of the credit crunch, some spinoffs may be prevented by the inability to issue bonds as an independent company.  For example, there was some question whether the Dr. Pepper Snapple spinoff from Cadbury several weeks ago would be delayed by debt issuance problems.
• The compliance costs of the Sarbanes-Oxley Act of 2002 make it prohibitively expensive for companies under about $100m market capitalization to go public.  This would not affect larger companies like Time Warner Cable.

Both these barriers may be removed, as corporate debt issuance settles down and the SEC provides an exemption (proposed) for smaller firms from the most onerous parts of Sarbox compliance.

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I like Google.  They are brilliant, non-evil, I use their various services daily, my best friend from college works there, etc.  No complaints.  The following is merely an academic exercise in business strategy.  

If you were a loser in pay-per-click search advertising (e.g. Microsoft), how would you fight back?  Taking Google’s customers is too hard, because there’s no real reason to switch.  Instead, why not just destroy the entire PPC ad market by open-sourcing the web search industry?

Imagine that MSFT and other also-rans funded a truly independent, nonprofit, open-source-based search site, which ran no ads. Computer makers could easily be convinced to use it as their default search engine, because it would reduce their dependence upon Google, without increasing their dependence on Microsoft.

This strategy would steal page views from Google.  It is not necessary to kill Google to end its dominance:  a 30-point loss in market share could drive Google into the red, throwing its virtuous cycle (earnings, stock options, recruiting) into reverse:  share collapse, layoffs, reduced retention, etc.

There are no anti-trust concerns — this would be a truly independent entity, jointly funded by a consortium, rather like Mozilla.

The technical hurdles are low.  Search engines long ago reached the “good enough” stage.  The insights of Page and Brin in the mid-1990s were so great that little has changed in the past several years.  There already exist reasonably good open-source modules for web search.  

The main hurdle is the capital expense of a big server farm.  Assuming a consortium pays for this, all that’s needed is to plug some GPL modules together, scale them up, and set this as the default search engine on all new HP and Dell computers.

Such a service would not work as well as Google.  But it would be good enough, and would be the default on every new computer.  By thus sucking revenue out of pay-per-click, MSFT could sustain the Empire for a few more years.

Why would I write this, if I love Google?  First, because it’s the truth, and second, because there is no risk that paralyzed, rudderless Microsoft would actually do it.

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Solutions suggest themselves when you state a problem precisely.

The phrase “credit crisis” is unusably general.  The precise problem is that no one trusts their own estimates of default risk, so they’re afraid to lend.  It’s that simple.

Here are some key tools used to estimate default rate, and why they are no longer trusted.

1. Credit rating.  In 2007, it emerged that thousands of AAA ratings granted by the three rating agencies (Moody’s, Standard & Poor’s, and Fitch) were completely wrong.  
2. Extrapolation.  The economic environment has changed so abruptly, and so many unregulated financial instruments have been introduced in such a short time, that extrapolation of past default rates is increasingly recognized as a fallacy.  As an easy example, exotic mortgages mostly didn’t exist 10 years ago, so there is no historical basis to estimate default rates.
3. Financial statement transparency.  Previously, you could estimate the default risk of a company by looking at its books.  Today, increasing use of complex derivatives and off-balance-sheet liabilities make this more difficult.  For example, since many derivatives are illiquid, their market value cannot be estimated from current prices;  derivatives face their own counterparty risk (aka clearing risk) that is hard to estimate;  etc.  Worst, everyone knows the big financial institutions are holding out on us — whatever their books say, everyone knows they still have yet to write off all the junk.  As long as everyone believes that, they will be afraid to lend.

Note we have not mentioned monetary policy at all.  That’s because it doesn’t help.  As written here in January, short-term rates could go to zero, and lenders would still be afraid to lend, because they cannot estimate default risk from credit rating, nor balance sheets, nor extrapolation from the past.

The solution — the only solution — is to restore confidence through transparency.  At minimum, this would require:

• Major central banks to agree on disclosure standards, and force all banks to air the dirty laundry.  
• A very noisy, very public government oversight campaign to restore confidence in bond rating agencies.
• FASB standards to require public disclosure of the maximum exposure of a company’s derivative instruments, rather than just the market value of those instruments.

These and other steps would begin to restore a rational basis for estimating default risk, which in turn would permit rational pricing of bonds, which in turn would restore the bond market, which would cause bond yields to fall, which would restore the stock market.

The financial press and powers that be are weirdly silent on all these issues, exactly those required to mitigate the damage.  How strange that some civilian in southern California would even find it necessary to write a post like this one.

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The essence of our economic predicament is that the cost of debt has risen dramatically on instruments the Fed can’t control: longer durations and riskier issuers.

This happened to corporations and consumers simultaneously. Both rises were essentially unexpected, i.e. not priced in. Now we’re getting whipsawed as realization of the new cost of capital is priced in.

Other things equal, disinflation or deflation is the logical result of an uncontrolled, unexpected, sustained, large increase in the cost of capital.

Fed rate cuts can mitigate that, but not as much as desired, because most of the problem is concentrated at the other end of the risk and duration spectrum, e.g. 30 year mortgages or BBB corporate debt.

This essentially all resulted from a loss of faith in the judgment of the rating agencies, and in the solvency of the debt insurers. The Fed rate could go to zero, and banks would still be afraid to lend to a BBB credit, because they can’t be sure it’s really BBB any more, or that they can insure reliably against a default. So restoring faith in the ratings agencies and debt insurers is probably a prerequisite
to flattening both the yield curve and the risk premium.

As long as it stays like that, we appear to be facing an era in which asset prices are falling and cost of servicing debt is rising, so that seems deflationary. The alternative, which I prefer, is to cut Fed
rates so aggressively that things go the other way, i.e. dollar falls, durables prices rise, etc. But keep in mind that fewer people have much equity left to buy things with, no matter where rates go.

That’s how it looks from this armchair.

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Wall Street Journal, January 24, 2007:

“The package is also likely to temporarily raise the conforming loan limits for Fannie Mae and Freddie Mac, beyond the current $417,000, which would allow the government-sponsored companies to buy bigger loans in areas with high housing costs. Rep. Barney Frank, the Massachusetts Democrat who chairs the House Financial Services Committee, said the new limit would be 125% of a metropolitan area’s median housing price, up to a cap of about $700,000.”

Exactly as predicted here five days ago. However, I failed to predict that the desire to subsidize political donors would be bipartisan.

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Americans — and especially English-language media — commonly confuse wealth with prosperity. A primer:

• Prosperity is how much you make. Wealth is how much you have.
• Prosperity is revenue. Wealth is assets minus liabilities.
• Prosperity is what America has (high GDP per capita). Wealth is what America doesn’t have (we’re a net debtor, i.e. negative equity).

Once you make this distinction clearly in your mind, you see the error everywhere. For example, consider this Reuters article about subprime lending in expensive neighborhoods. Reuters mistakenly refers to overleveraged owners of expensive homes as “wealthy.” This is obviously wrong, since the source of their problem is insufficient equity, i.e. insufficient wealth. They are prosperous, but spendy, and hence not wealthy enough to stay in their homes.

Discovering a reasoning error is often enough to change behavior. If the wealth/prosperity distinction were clearly understood by more Americans, we would grow rapidly wealthier. China’s government and citizenry understand the distinction, which is a big reason they are advancing so fast.

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The GSE conforming mortgage limit, which went unchanged for 2008 — and which regulators currently insist is immutable and untouchable — will be raised or eliminated within 90 days.

How could an about-face occur so quickly? Because it is the style of this presidential administration to recognize emergencies late, initially deny their existence, then respond abruptly in a way that (i) benefits wealthy patrons and (ii) has no regard for future consequences.

The White House mortgage bailout plan of December 2007, for example, mainly bails out mortgage servicers, not mortgagees. By incentivizing hapless homeowners to continue paying teaser rates on homes with negative equity, defaults are spread over a longer period, allowing servicers to manage them more profitably. The loser is the mortgagee, who is led to believe he will somehow recover an investment that is already lost, when in fact his most logical action is to default or do a workout with the servicer.

With that in mind, the basis for today’s prediction is that subprime fallout has reached the prosperous (note: the Reuters article referenced here confuses “wealth” with “prosperity,” a common error in America). There was a brief window during 2005-2006 in which a family with an income of, say, $250,000 could “afford” a $2m home with no money down. Their situation is now every bit as untenable as that of a blue-collar family in Cleveland: they cannot qualify for a fixed-rate refi, because their income is too low; they cannot sell, because they have no equity; but they cannot stay where they are, because the payment reset will kill them.

Suddenly, election fundraisers are no doubt hearing, “I can’t donate to your campaign because I can’t afford my mortgage.” This is a problem the currently broken GOP can understand. We should expect White House-controlled regulators to drop everything and look for a quick fix. Allowing Fannie to hold mortgages on homes in Greenwich, Palm Beach and Newport Beach, which would drive fixed rates down on large mortgages, is such a fix.

Should it be done? Probably not. Will it? Yes. There are few other options. You heard it here first.

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