Struggle Four

In a good, healthy market, where supply matches demand, prices change very slowly.

But when there’s too little supply of something in a market, prices can change very fast.  Think of what happens to ticket prices for sold-out concerts.  Or what happened to tulips in the 1600’s, or Beanie Babies in the early 90’s, or tech stocks in the late 90’s, or housing this decade, or gasoline last year.  Just a few people willing to pay more for something makes the price of the good skyrocket.  The market then collapses when more of that good is produced or when the excess demand subsides.

Likewise, when there’s too much supply of something, prices plummet.  If a concert doesn’t sell out, a seller might only be able to get a few dollars for an extra ticket.  If a few too many shirts are made by a designer, prices could fall 75% just to sell the excess inventory.

For most goods, excess supply is consumed or destroyed quickly.  But what happens to markets when the excess supply can’t be destroyed?  Cheap stuff sticks around!

Yankee Tickets:

Judging from the amount of tickets for sale on StubHub, I’d estimate that about 10,000 of the 50,000 Yankee tickets per home game were bought by those hoping to resell the tickets.  If there were 15,000 people that wanted to buy those tickets, prices would skyrocket.  But when there’s only 5,000 people that want those tickets, many resellers have to settle for getting just a few dollars, or else they get nothing.

Yankees versus A’s, Tuesday 4/21:

• Tickets available on StubHub on 4/19: 5591
• Best price for $375 Field Dugout on 4/19: $177 (53% Off)
• Best price for $95 Field Outfield on 4/19: $21 (78% Off)
• Best price for $120 Terrace Suite on 4/19: $44 (63% Off)
• Best price for $30 Grandstand Dugout on 4/19: $9 (70% Off)

Yankees versus Angels, this Thursday, 4/30: (updated 4/29)

• Tickets available on StubHub on 4/27: 6849 (3730 on 4/29)
• Best price for $375 Field Dugout on 4/27: $183 (51% Off) ($95; 75% Off on 4/29)
• Best price for $95 Field Outfield on 4/27: $31 (67% Off) ($25; 74% Off on 4/29)
• Best price for $120 Terrace Suite on 4/27: $48 (60% Off) ($27; 78% Off on 4/29)
• Best price for $30 Grandstand Dugout on 4/27: $15 (50% Off) ($10; 67% Off on 4/29)
• I bet they’ll be even cheaper tomorrow! (The direction of the market is easy to predict when there’s oversupply)

Hotels:

If 10% of the hotel rooms in this city were suddenly destroyed, there’d be much less excess supply. No one would wish for that. Since hotels are better off getting a few dollars than nothing, prices are plummeting:

Midweek hotel prices:

• 2 star: Holiday Inn Express near Park Slope Brooklyn, $70 including fees on Priceline.
• 3 star: Park Central, across from Carnegie Hall, $100 including fees on Priceline.
• 4 star: Various Hiltons and the like, about $130 including fees on Priceline.
• 5 star: Tribeca Grand, $235 plus fees on Hotels.com.  Cheaper on weekends.
• No real point in having that pied-a-terre or that guest room these days.

This is where bankers should stay until our loans are returned. Closer to Wall Street than Midtown.

1BR Tribeca Apartments:

For just $3500 a month, you can rent an apartment that would sell for $1 million and has $1200 monthly maintenance fees.  That’s a tremendous bargain.  Just a couple thousand dollars more a month and you don’t have to invest or borrow a million bucks.  But I bet rents get even cheaper.  Let’s keep track of Tribeca 1BR rents going forward because they dictate the eventual equilibrium prices of condos and co-ops:

• Number of 1BR Tribeca apartments for rent on Craigslist, 4/24: 55
• Average listing price: $3345
• Renting is so much cheaper than owning, and you don’t have to lose hundreds of thousands of dollars.  Still, it’s going to get even cheaper.

All the participants of pyramid schemes seem to win as the scheme expands, even though every investment into the scheme is a bad investment.  Eventually, every late entrant into the scheme loses as the scheme unwinds. Only the early participants who exited while the scheme was intact benefit.

The real estate market of the past 8 years was the largest pyramid scheme in history.  Profits to previous investors were paid with the funds of additional participants.  Real estate investors were not profiting because they made the correct long-term decisions but because an increasing amount of people were making the same wrong long-term decision as they were.  For awhile, the profits from this pyramid scheme were supporting the entire world economy.  Now, the losses from the scheme are devastating the economy.

Of course, the unwinding of this pyramid scheme is a good thing for the country, but all the unwitting participants will suffer great losses.  There is no escaping this reality.

However, there’s one giant bonus to this pyramid scheme for those who didn’t participate: All those homes and apartments that should have never been built will bring rents below equilibrium for the foreseeable future.

Losers from The Great Real Estate Pyramid Scheme:

• Estimated 20% of the population that were first time home buyers over the last 7 years or significantly upped their real estate holdings, and didn’t sell at the top.  These people thought they were either getting free money for doing little of value or miscalculated real estate risk.  These people will be much more careful with their money going forward.
• Banks who loaned money to people wanting to participate in the real estate pyramid scheme.  Many of these loans won’t be paid back.  These institutions will suffer now but will assess risk much better going forward.
• Those who borrowed money against their temporary real estate gains and spent that money, assuming the gains were permanent.  Perhaps an additional 5% of the population.

Winners from The Great Real Estate Pyramid Scheme:

• Those who lowered their real estate holdings over the past 7 years.  Perhaps 5% of the population. These people assessed risk properly.
• Those who don’t own real estate.  30% to 40% of workers. These people will see rents fall considerably over the next few years due to the oversupply of housing.  These people will also be able to buy real estate at fair prices in the future.

In all, there are more winners than losers, though each loser will lose more on average than each winner will win on average.  Those who don’t own real estate will be better off at the expense of real estate owners.

As money is destroyed in the real estate market, real estate owners will have much less money to spend on other goods. Meanwhile, the lower rents will slowly allow those who don’t own real estate to begin spending more money on other goods.

The short-term losses from the unwinding of the Great Real Estate Pyramid Scheme are large, but there are also long-term gains for the non-participants.

The $1400 1BR apartment in downtown Manhattan will become a reality once again, and those renters will have plenty of money with which to buy things and invest in the stock market.

Over the last 100 to 130 years, the stock market has appreciated about 6% to 7% above inflation annually while the housing market has appreciated about 0% above inflation.  The 6% to 7% figure for the stock market includes dividend payments, while the housing market return does not include dividends.  Why does this matter? Because housing pays an awesome dividend! We can live in them! We don’t have to pay rent when we own a house.

Over the long-term, housing values might rise only with inflation, but if you rented out a house you owned, you would make about a 7% return each year.  If you lived in your house, you would not have to pay rent, which should average to 7% of the cost of a buying a house.  So you get a 7% return above inflation if the house price only appreciates with inflation.

In other words, in the long-term, the housing market and the stock market both return about 7% a year above inflation.  For the stock market, this comes mostly in the form of stock price appreciation above inflation, though some of the return comes from dividend payments.  For housing, some of the long-term return comes from house price appreciation at the inflation rate, and the rest of the return comes in the form of rental income or rental payment saved.

Both assets are risky year-to-year.  That’s why they both perform better than risk-free assets and bonds, which return about 1% to 4% a year above inflation, depending on the length of maturity and risk of default.

So when asset markets are about in equilibrium–the stock market and housing market were both close to equilibrium in 1995–investors can expect to make about 7% a year above inflation in both markets over the long-term.  Our economy left equilibrium in mid 1990’s as stock prices began to appreciate much faster than what was sustainable.  Housing prices followed a few years later.  Now, both assets are trying to return to equilibrium, but the big question is what are the equilibrium prices?

I feel that the answer to this question is simple.  If we add 6% to 7% plus inflation annually to stock prices in 1995, we will have a good estimate of equilibrium levels.  This would be about double the current stock market prices.  If we adjust 1995 housing prices to account for inflation, we would have a good estimate of housing prices. Equilibrium levels for housing would be about 30% below where they are now nationwide, and about 60% below where they are now for 1BR Co-ops in downtown New York City.

I first want to say that I don’t think the economy is going to hell.  It just needs some rebalancing.  Prices were way off kilter.  Houses had risen to prices where new purchasers could not and should not buy.  Stocks have fallen because these purchases have sapped the buying power of consumers.

Nationally, houses only have about 30% further to fall.  Considering the low interest rates, long-term buyers can soon begin buying again in most markets.  That is, mortgage payments on 30-year loans are just about at their bottom in most markets.  As interest rates for 30-year loans return to average levels–7% a year from the current 5% a year–houses will fall in value that last 30%, but mortgage payments will be about the same. If you wait for houses to drop further, you will find that you won’t be saving much money on your mortgage because interest rates will be rising by the end of the year.  Now is the time to refinance.

Downtown New York City 1BR apartments have fallen about 20% already, trailing the rest of the boomtowns in losses, and will fall another 60%, leaving them about double 1995 prices.  However, after they fall another 30% to 40%, which will happen by the end of the year, long-term buyers can once again return.  Prices will fall further, but mortgage payments on 30-year loans will be just about at their bottom.

Stock market returns for the year could be well over 50%.  Super-low interest rates, combined with expense purging at major corporations, will yield much higher profits for corporations when they return to the revenue levels they had in the past.  No, they won’t be making the same revenue as they did two years ago by the end of the year, but Wall Street will see the profits returning and will be able to project very high profits for the next few years.  The stock market was just about at equilibrium levels before the crisis began, yet dropped nearly 50% last year because of the projected short-term losses.  Once these short-term losses recede, the equity of many companies could double or triple in price before resuming their long-term growth rates as interest rates return to average levels.

Before I get into the headier stuff, here’s something simple..

The consumer stimulus package recently passed puts an additional $40 a month into our bank accounts.  There’s an easy way to add $10 to $20 more.  Abolish ATM fees for all the major banks getting bailout money.  Deli ATM’s can still charge whatever they like, but don’t force us to pay $3 to use a Chase ATM with a Citibank card.  This will hurt bank profits and benefit Americans.  Just part of the payback we deserve.  Banks are supposed to add value to society, not extract value.

This is the right way to start gaining back our trust.

Amazon.com Review
“Why do otherwise intelligent individuals form seething masses of idiocy when they engage in collective action? Why do financially sensible people jump lemming-like into hare-brained speculative frenzies–only to jump broker-like out of windows when their fantasies dissolve? We may think that the Great Crash of 1929, junk bonds of the ’80s, and over-valued high-tech stocks of the ’90s are peculiarly 20th century aberrations, but Mackay’s classic–first published in 1841–shows that the madness and confusion of crowds knows no limits, and has no temporal bounds. These are extraordinarily illuminating, and, unfortunately, entertaining tales of chicanery, greed and naivete.”

I first read this book as a junior in high school.  I was researching the Crash of 1929, focusing on the effect the media had on misleading the public as the Depression began. As part of that project I read the front page and business section of the New York Times for the weeks following the Great Crash.  You know what the tone was?  Optimistic.  Every story was about the buying opportunities that had been created.  Bankers, CEO’s, and the media all thought a complete recovery was likely.  They advised people not to panic and not to sell.  That was terrible advice.

In 1624, when tulip bulbs cost more per ounce than gold, people bought them because they saw the wealth that others had earned from buying them, not because they were greedy.  They thought they had to buy the tulips in order to maintain their lifestyle.  The riches others were earning was making them relatively poorer.  The “madness” was perhaps rational in the moment, but history can easily judge the foolishness.

The tech boom and then the housing boom were no different.  They are tales as old as free market economics.  Housing prices have fallen about 40% in Los Angeles, Phoenix, Miami, and Las Vegas over the past two years.  Boomtowns no longer.  Downtown New York City 1BR Co-ops fell 10% in the first quarter of 2009.  It may seem that prices are low, but they’re not.  Those Co-ops are still four times the price they were in 1997. The losses will continue.

You can hope that hundreds of thousands of people will appear in New York willing to pay more than current prices for housing, but that’s very unlikely. You can hope that prices fall no further, but few can afford apartments at their current prices while many will be forced to sell. You can hope for a rebound, but the whole time you’ll be holding a tulip and not a piece of gold. Rational people avoid making the mistakes others have made.  Bubbles do not reinflate once they pop.

The grave error made by economists during the 25-year economic boom was that their research focused solely on figuring out how to incorporate more and more people into the boom that they had helped create.   When I was getting my graduate degree a few years ago, the professors were writing papers about ways to trick workers into contributing more to their 401k.  They wanted more people to behave like they behaved.  They had faith that they were right and that they would always be right.

Very few economists thought about what would happen if the premises their peers thought true turned out to be false.  Good scientists should always question the assumptions of their science.  The history of science from Descartes to Darwin to Einstein and beyond is dominated by events that proved the prevailing paradigm to be incorrect.  Great scientists expose and correct flaws in their sciences.

Yes, there were a few people who pointed out that the risks we faced were much greater than most of us thought. Robert Shiller (Irrational Exuberance) and George Soros (Bubble of American Supremacy) come to mind.   But their opinions were marginalized by society and their peers, even though they had shown tremendous accuracy in successfully assessing risks in the past. Faith in the current system was chosen over dissent because it made people feel more secure. No one wanted to hear that the path was unsustainable.  Not even the economists, whose job it was to assess this risk.

If bankers had incorporated the risks that these marginalized yet successful intellectuals spoke of into their models, assets would have been priced correctly in the first place and all this chaos would have been avoided. If banks had considered that there was some chance that the credit bubble could pop, they would have behaved quite differently.

While I agree that the bankers in power in the 2000’s displayed poor judgment—a failure to consider the risks of their actions—the banks are not to blame for allowing these bankers to rise to the top.

The Fed is to blame.

Time and time again the Fed reassured banks, and the American public, that they would not allow the economy to suffer a major downturn.  The Fed told everyone they would do everything in their power, always, to prevent economic malaise.

Yesterday’s bankers did not completely believe the Fed.  In the mid-1990’s, there were still many bankers who assumed some chance—be it 2% or 5% or 10%—that the economy could go into a deep recession where a significant amount of loans might not be paid back.

But the Fed kept telling all these bankers not to worry.  They had everything under control.  Instead of encouraging bankers to assess the odds of a potential meltdown, the Fed told bankers to just consider the odds to be zero and forget about the potential downside.

Huge amounts of money were made by accepting that the risk of a downturn was zero.  Banks could loan money to almost anyone, and almost all loans would be paid back if the economy remained meltdown-free.  Bankers who still thought there was a risk of meltdown were pushed out by bankers who saw that risk as zero.  These new bankers were making all the money by listening closely to what the Fed told them. They were not free thinkers. They were zombies.

There was always some risk that the Fed would fail to prevent a collapse.  It was never zero.  Fifteen years ago that risk might have been really small, so the zero estimate was a decent estimate of actual risk.  Few errors were made when risks were assessed fairly. But as time passed without a meltdown, the errors made due to the zero estimate were not addressed and began to multiply.  Soon, the chance of a meltdown began to increase as the errors in the economic system increased.

Few seemed to notice this increase in risk, and those who did looked the other way.  The data that bankers used from the past 25 years supported their zero-percent-meltdown-chance estimate, and the Fed continued to tell them that the risk was indeed zero.  By 2008, the only bankers who remained were ones who had been listening to the Fed the whole time.

Brain-washed zombies were leading the zombie banks, and it was the Fed who created the zombies.

Now that the zombies heads have rolled, real bankers can return to take their place.

Until recently, I thought a significant period of inflation would be the only way to help our economy get back on sound footing.  Real estate could still fall in relation to other goods, while it stopped going down in terms of dollars.  It would be easier to pay off the $400,000 house if you made $100,000 for doing what used to be $50,000 of work.  Of course, that home is now only worth the price of four cars, but you didn’t have to default on your loan.  Almost all loans would be paid back, the toxic assets would turn out to be profitable investments, and the economy could begin growing again.

The net effect of the inflation would be a transfer of wealth from savers to debtors, with the added bonus of a reinflation of the toxic assets and a healthy banking system, which would help us all.  What’s more, since we are a debtor as a nation, significant inflation would make those debts easier to pay back.  A few trillion dollars is half as much stuff now.  Nations that are savers, like China, would lose as we gained.

The Fed thinks they know the way to inflate a currency when monetary policy loses its powers: The famous helicopter money speech by Chairman Bernanke.  The reasoning is that as long as we can get more cash to the consumer, whether it’s through cheaper credit, tax cuts, or stacks of bills in your mailbox, we can get the currency to inflate.

The only problem with all this?  China isn’t going to let it happen.  Why should they?  If we begin inflating our currency, China will start selling our bonds.  Those bonds go down in value with inflation.  They’re forced to sell them.  If it’s harder to find anyone to loan us money, interest rates rise.

In other words, the helicopter money doesn’t even lead to inflation.  If we gave a few trillion dollars away to the public, just dropped it out of the sky onto their lawns, the value of the currency would be diluted and the currency would inflate.  China wouldn’t like this at all, and would begin selling our bonds before they became worth even less.  This would cause interest rates to rise, and all the inflation would be offset by the deflationary power of higher interest rates.  The helicopter drop of money wouldn’t cause inflation at all.  Just higher interest rates.  Uggh.  Foiled.

So we really are in a debt-deflation spiral that’s going to take some actual brilliance to escape.  The only real way to escape an economic slide is to create real value again.

Innovation and hard work is the only possible solution left.  Economics can’t do anything.

***Update*** I wrote this post the day before the Fed announced how they were going to try and create inflation.  If they buy the long bond to drive down rates, the market will react by selling enough bonds to negate the chances of overall inflation.

Just sell your apartment. There’s no way to stop a market from returning to its long-term equilibrium levels (or below, due to oversupply) because people are free to leave their apartments behind. Why realize a 75% loss when you can sell?

It took years for the mispricings to begin correcting themselves, as we’ve unfortunately found (the Fed used to think mispricings were impossible). But once people learn that the past prices were wrong, mispricings correct themselves naturally.

From the graph above, we can see that Detroit prices are already below 1997 levels and are likely to bottom within the year. Furthermore, prices for the 10-City composite and LA have already fallen substantially and are likely to bottom within two years, with about half the losses still to come.

But prices for the New York metro area are still three to four years away from approaching their bottom, and prices for co-ops in New York City have yet to realize most of their declines.

There are two ways New York City can avoid these potential losses:

1. Massive, 70’s-like inflation so that real estate prices can decline in relation to other goods but not fall much in dollar terms (what the Fed is unsuccessfully trying to do and is unlikely to succeed at doing, as I’ll talk about in my next post)
2. Current owners remain comfortable with the price they’ve paid, and new owners move into New York to absorb the excess supply.  If each new buyer is willing to spend as much money on real estate as those who bought previously, declines would halt. (Chance close to zero.)

[Data for NYC 1BR apartments based on average price per square foot]