This is the first model I ever did for a bubble popping:
I worked that out in March 2008 and after a bit of fluffing around I published it in September/October.
That was after I had tried to get it published in “The Journal of Economics and Business”. But they refused to put it up for peer-review on account of they said it was about “accountancy and valuation”, and “real” economists have MUCH more important things to worry their pretty-little heads about.
Like most models, this one works perfectly explaining the past, but then like Niels Bohr once said, “prediction is difficult, particularly the future”
I made two mistakes:
The first was that in early 2008 I hadn’t imagined that the US Banking system was in such bad shape. Although in my defence I wasn’t the only one; remember that was before Hank Paulson stood up (in July 2008) and declared “The US Banking System is a Safe and Sound One” (was he clueless or was he a liar?), and all the Great Economists and all the Kings Horses were lined up singing in four-part-harmony “don’t worry, we can put Humpty back together again”.
There again if banks had been obliged to value their assets using International Valuation Standards and to honestly report those valuations to shareholders and counter-parties then simple-minded people like me would not have been fooled.
My mistake was dumb innocence. In that respect, nothing has changed; banks, and banking regulators still don’t have a clue what the assets on their balance sheets are worth and the name of the game as spelled out in the New Financial Regulations is still to keep the public in the dark and feed them on bull-manure…in case there is “a crisis of confidence”, (the Stress Tests were a good example of that).
The difference for me is “once bitten – twice shy”.
The red line shows where that model would have ended up if I’d considered what actually happened, which was that nominal GDP grew by an average of 0.7% over those two years.
The second mistake I made was to under-estimate how hard the US Government would try and “socialize” the problem, i.e. share the pain amongst society in general rather than letting those who had made the “malinvestments” get wiped out.
That was done by allowing banks to “extend and pretend”, tax credits, and a massive injection of public funds into the pockets of “God’s Workers” and the mortgage machine (these days over 90% of all mortgages written in USA are underwritten by the state-owned mortgage companies).
If they hadn’t done that, then according to my calculation the Case-Shiller 20 City Index would be about 130 now, so I guess they “achieved” something with all that frenetic activity, although I’m not quite sure what, or what the cost was to “achieve” whatever it was they achieved?
But that’s the past…what about the future?
1: The main driver of (nominal) economic growth in USA for the next five years will be house prices.
That’s not a completely unreasonable notion since arguably it was the main driver for the past ten years. First as a huge amount of liquidity was pumped into the system via the “My House is an ATM” great-minds-economic stimulus strategy, and second, after the ATM broke down, via the “Oh dear, NOW you tell me I’m supposed to pay that money back” un-stimulus economic strategy.
Do the arithmetic and it’s not hard to build a model with a 80% R-Squared on that, which (historically) explains what happened a lot more accurately than the “consensus” economic forecasts for example in The Economist. Currently the “consensus” is predicting 4.8% nominal GDP growth for 2010 year on year although there is no reason to suspect that they will be any closer to the mark this time around than they were in the past (“The Consensus” were predicting 5% for 2009 in 2008).
So in that sense Nobel Prize Winning Economist Professor Paul Krugman was spot-on the button when he urged Alan Greenspan to “save the American economy” by creating a housing bubble in 2001.
He was absolutely correct (I suppose that’s why he got a Nobel Prize…he must be genius, well for an economist at least), a housing bubble most certainly creates “economic activity” (temporarily). Although whether that equates to long-term economic prosperity, is debatable; more like it orchestrates a transfer of wealth from one set of pockets (mainly the poor and the middle class) into another set of pockets (God’s Workers’ and “Public Servants” (of the self-service variety)).
Notwithstanding, the current administration and its agent (the Fed) are doing their best to “reflate” the popped balloon so that God’s Workers can get what they are justly entitled to, (although it looks like that’s turning out to be a lot easier said than done).
Regardless a model that works back to 2000 with an 80% R-Squared (on 30 points of data), might be a bit rough, but it’s a better single-line explanatory variable than the ones the “Great Economists” appear to be using, so that’s the one I’m going to use, for want of a better one.
2: Long-term interest rates (30-Year Treasuries) will be driven by nominal GDP, as they have been for the past hundred years.
There is a childish notion making the rounds that the Fed can control the yield on the 30-Year by helicopter drops…Err…dream on sweetheart.
3: Not a lot of new houses will be built.
I think Professor Paul Krugman said that? If he did then of course, he’s absolutely right….AGAIN!!
4: The US government and its agent the Fed will continue to do everything they can to re-inflate the housing sector, but ultimately they will fail.
That’s a bit controversial; it’s a bit like someone suggesting (in 2001) that there were no weapons of mass destruction in Iraq, and on top of that the Taliban had nothing to do with 9/11. So carpet-bombing 30 million people in the poorest and most impoverished country of the world, “Back into the Stone Age” (Donald Rumsfeld’s Big Idea), would be unlikely to “Win The War on Terror” (but it must have felt good (certainly looked great on TV), and $1 trillion later (and counting) a lot of people still think that was money well spent).
The main issue is whether the artificial resuscitation of the housing market that is currently being attempted will continue to produce a denial of reality (Option A), or whether the valiant sub-contractors of God’s Workers will run out of breath (Option B).
In the short term that’s about whether house prices do a “Dead Cat Sigh” and fall down to where they would have been without the artificial respiration (i.e. to about 130 on the Case Shiller 20 City Index), the rest is arithmetic.
With regards to Option A, I give-up when it comes to trying to second guess how hard people will try to shoot themselves in the foot; about the only thing I can say on that score is they might be running out of ammo.
This is how Option B pans out:
Interesting the model spits out an average 5.1% growth in nominal GDP over that period (assuming of course that my thesis that the ONLY thing that drives US nominal GDP is house-prices (which might be a bit of an over simplification)). But at least I’m pretty much in line with the “Consensus-Seekers” for a change!!
How much of that is going to be “real” and how much will be “inflation” (whatever that’s supposed to be), is something that the “real” economists can argue about, personally I think that argument is about as pointless as watching a crowd of Medieval Monks arguing about how many “God’s Workers” you can fit on the end of a pin, but each to his/her own.
So is that “Good News” or “Bad News”?
Well I suppose the good news is that according to that calculation a “doble-dip” economic recession is probably not on the cards (depending of course on the outcome of the debate about perceptions of reality).
The “Bad News” is that the model says there will be another 12% drop in house prices (per the Case Shiller 20 City Index), but that’s not really news, foreclosures are not letting up, HAMP has failed, and there is only so long you can extend and pretend without looking ridiculous.
One thing is that the 30-Year ought to start to tick up a bit from here on in, driven by nominal GDP, it might even get back up to about 5% by 2015, which is something to look forward to, although personally I would hesitate to go out and put all your savings into shorting it like Nassim Taleb was recommending last February.
What “Should” the Administration and it’s agent the Fed “DO”!!
My advice is take a long holiday, you’ve done enough over the past ten years!!
The way I look at house prices is as follows:
1: Long-term the amount of money people are willing (or able) to pay for “shelter” as a proportion of their disposable income is constant.
2: Divide that by the number of houses and you get an “income per house”
3: The “fundamental” price of houses (on average in an economy) is that number divided by a yield which has got something to do with long-term interest rates (i.e. a “function” of the 30-Year Bond), times a constant. You can have a go at finding out what the constant is and the algorithm for the “function” by doing multivariate regression analysis on 100 years of data.
(Turn that around and the “correct” way to work out the cost to someone of living in a house he owns is exactly equal to the mark-to-market value at the beginning of the year, multiplied by the yield on the 30-Year, anything else (what he might make or lose out of holding the asset or gearing that profit or loss, is irrelevant ).
4: How people finance that has got nothing to do with the “fundamental”. When you buy a commercial property the amount of debt the property has, has no bearing at all on the valuation of the property (outside, in the case of a distressed property, on your assessment (as the buyer) of how desperate the seller is to sell, but that’s not a “fair” (i.e. representative) market transaction).
5: The propensity of people to “invest” or “gamble” another (separate) part of their disposable income (or even worse, borrowing money to go and play in the casino), betting that house prices might go up, and the amount of gearing they take on to make that bet, is irrelevant to the fundamental; although that kind of behaviour can lead to bubbles.
6: Bubbles burst, the first people “in” who got “out” make a fortune (George Soros’ speciality), and the ones left holding the baby get wiped out, the dynamics of bubbles create no economic value, they just transfer wealth from one set of pockets to another.
In the case of housing in USA, loans were made to buyers not based on an assessment of the Debt Service Coverage Ratio ((DSCR) how much income the borrower could reasonably be expected to muster to pay the loan back, with interest), but on the anticipated future value of the asset that was collateralized (the future house price).
Note: The “value” that matters in such speculation, is not what you could have sold the house for yesterday (that’s the number that was written down on the mortgage application and it’s also the one that is still used by many banks to calculate the value of their “assets”), the value that matters is what you will be able to sell the house for when whoever borrowed the money from you, decides he’s not going to pay it back (with interest).
That is a distinction that many bankers forgot, to their cost. That “lapse of common-sense” is speculation, not banking, and that was always dumb; recent events have illustrated quite clearly that what was dumb in the past; is Err….still dumb.
7: When a bubble bursts the extent of “under-valuation” that follows and the period of time of that under-valuation (below the “fundamental”) is a mirror of the bubble.
That’s when what the Austrians call the “debt-induced malivestments” get washed out of the system in the spin-dry cycle. Look-see, all those bankers going round and round “extending and pretending”…don’t forget to wave, sweetheart!
By Andrew Butter
Twenty years doing market analysis and valuations for investors in the Middle East, USA, and Europe; currently writing a book about BubbleOmics. Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( firstname.lastname@example.org ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.
© 2010 Copyright Andrew Butter- All Rights Reserved
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