Monday, October 31, 2016

Housing: Part 184 - Intrinsic value trumps supply and demand

A common way of thinking about asset markets is to think in terms of supply and demand - factors that will change the number of buyers and sellers.  A good quarterly report from a corporation will bring in new investors from the sidelines.  More credit will increase the number of home buyers. Etc.

In some areas, this can be technically true, where quantities can change.  For instance, rising and falling credit access can lead to rising and falling housing starts, where there really is some change in the relative numbers of buyers vs. sellers.  But, in many areas, like equities, by definition, most of the time, there has to be exactly the same number of buyers and sellers.  It is still tempting to think about changing values as being a product of new buyers who have been induced by new information to buy, pushing the price up above the reservation price held by some sellers, leading to transactions and rising prices.  Certainly, this can describe almost all markets.

But, this is a case where the technical accuracy of the observation hides the broader, conceptual inaccuracy.  These transactions represent marginal liquidity issues and have relatively little to do with the broader reasons for changing values.  If Apple issued a positive quarterly report for the next quarter that increased the expected value of future production by 10%, their share price would immediately rise by 10%.  It would certainly be accompanied by an increase of buying and selling, but this activity would have nothing to do with that change in value.  The change in value could increase without a single transaction.

This is obvious if we think about Apple as a private firm.  Imagine that same quarterly report for private Apple.  The intrinsic value would move just the same with no transactions.  Sure, private firms shopping for buyers will consider buyer interest and liquidity when they position themselves for sale.  And, this will have some effect on the margin.  But, the reason Apple is worth $600 billion and Big Lots is worth $2 billion isn't because Apple has more buyers.  It's because Apple is expected to earn higher profits.  Intrinsic value moves markets.

One place where the housing bust drives this point home in a way that I think has not been widely appreciated is in the collapse of the private securitization market in the summer of 2007.  I have generally referred to this as a liquidity panic, which I think is more or less the norm.  And, in a way it was.  But, that's a strange way to talk about it, if you think about it a little bit.  There was no shortage of liquidity.  Everyone knows that at the time there was a massive demand for AAA related securities.  The entire CDO market had basically risen up to meet that demand.  That demand is at the center of the accepted narrative of the period.

In other words, there were many, many motivated buyers for those AAA securities.  If we think about this in the supply and demand mode that I described above, then how can we explain the collapse?  There was no collapse of demand.  The collapse was in the intrinsic value.  The collapse happened because there was a collapse in expectations about home values.  This had set off a series of self-perpetuating trends where lenders were less eager to lend, home sellers were less likely to repurchase new homes, home values were expected to fall, and the market expected high levels of future defaults as a result.

There were billions of dollars worth of potential buyers, desperately looking for safe assets to invest in, and those buyers would not pay more than 70% or 80% of face value for the AAA rated private MBS securities.  The differences here, between the extreme decline in market values and the extremely high number of potential borrowers, is....well...extreme.  Intrinsic value dominates supply and demand.

What happened in 2007 was that there weren't enough buyers for home equity.  The liquidity crisis wasn't in AAA rated debt securities.  It was in home equity.  The reason was that homeowners were fleeing the market through the back door.  First time home buyers continued to be strong, because the decision to buy is dominated by life cycle effects.  But, there developed a tactical outflow of homeowners from the existing stock of owners.  There weren't enough willing home buyers.  And, those home sellers, selling their old, lightly encumbered homes to the naturally highly leveraged new buyers took all those capital gains out of the home equity market and stuck it in the low risk capital market, where much of it ended up funding mortgages.  But, the problem is, you need a homebuyer to fund a mortgage, and since there weren't many, financiers started creating various forms of CDOs in order to create low risk debt for those former homeowners to invest in.

This began to happen as early as 2004.  But, intrinsic value rules.  It didn't matter that there weren't as many buyers.  For a year or two, prices continued to rise along with housing starts.  In fact, the sharpest rise in home prices was during the initial decline in homeownership.

Eventually, by the end of 2005, housing starts began to collapse, and home equity levels began to fall at the same time, because of that transfer of old homeowners out of the market.  But, intrinsic value still ruled.  For nearly two years after that, the decline in homeownership and in home equity accelerated, yet home values remained steady.

In the 3rd quarter of 2007, home prices were still within 3% of their highs, nationally.  But, home equity had already dropped by 20%!  Then, we finally broke the housing market so much that liquidity became the dominant factor in price.  Before the 3rd quarter of 2007, the housing market was like the New York Stock Exchange.  There could be debates around the edges regarding efficient markets.  Differences in prices of 5% or 10%, or differences in relative returns of a percentage point or two, could be debated, regarding the difference between efficient prices and market prices, or regarding the effect of credit and liquidity on market values.  After the 3rd quarter of 2007, the housing market had a regime shift.  Now it was defined by the lack of efficiency.

The entire country, it seems, mistook this to be exactly the opposite.  We thought that the housing market had been inefficient before the 3rd quarter of 2007 and that it was now returning to efficiency.  We were disastrously wrong.  And, we were wrong because we make the mistake of thinking supply and demand are more important than intrinsic value.  We assumed that forms of mortgage credit that had been ascendant were bringing in new buyers and that new buyers would naturally move prices higher.  We didn't account for the fact that intrinsic value rules.  To the extent that credit expansion had some hand in moving home prices higher, it was by providing liquidity in markets that previously were lacking in liquidity.  It turns out that this was largely in markets where high income households were buying access to Closed Access labor markets, where housing expenses in general have moved above our longstanding norms, making conventional mortgage funding inadequate.

So, as with the private firm positioning itself for a new buyer, that added buyer interest did have a marginal effect on market prices in some places, but it was only pulling prices toward the liquid, efficient price level.  Big Lots might tweak their market capitalization by a few hundred million by announcing their entrance into an exciting new market that investors are excited about.  But, they aren't going to get to Apple's market capitalization by attracting new buyers.

This is why the housing markets that were especially hot during the 2000s continue to have relative values higher than the rest of the country, even though we killed the non-conventional mortgage market.  Intrinsic value.*  Even though those markets are still reaching for intrinsic value, they are still underpriced, because we have eliminated sources of liquidity for those markets.  So, a rejuvenated private mortgage market would cause those home prices to jump again, and a rejuvenated conventional mortgage market would cause low priced homes across the country to rise.  But, they would rise toward efficiency, not away from it.  Because intrinsic value rules.  The number of buyers is a deceptively weak explanation for market inefficiency.  Millions of new home buyers couldn't make home prices rise above their intrinsic values any more than those trillions of dollars of savings in 2007 could keep private MBSs at face value.

Tomorrow's post will explore this general idea a little more.

* By intrinsic value, I don't mean natural value.  Those homes are only valuable because of a political stranglehold on supply.

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