Mr. Market's Gone Schizo

Benjamin Graham must be chuckling in his grave. Believers in semi-strong and strong efficient markets must be rationalizing away. We have witnessed some of the largest inter and intra-day pricing movements in history, violent waves on the surface of the economic ocean, yet as is often the case with short term price movements, the prices (perceptions of the fundamentals set on the margin by fearful/greedy investors) and the fundamentals (the actual reality of the economy) are completely out of proportion. Problems can emerge when the perception of reality affects reality itself, when irrational price change behavior starts to influence economic decision making, but that is a different topic for a different post.

The core issue of this financial crisis is housing prices. The structure of assets that many financial institutions have on their books can be thought of as a huge bet that housing prices in the US would continue to rise or, if they fell, the fall would be shallow at worst. This has obviously not been the case. Witness the Case-Shiller index data on housing prices:

http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/0,0,0,0,0,0,0,0,0,1,1,0,0,0,0,0.html

The most recent data available is for July 2008; using a CPI-esque methodology to measure home prices, the index assigns a value of 100.0 to prices on January 2000. Prior to January 2000, prices slowly rose through the years through a combination of inflation and perhaps a bit of real appreciation as the US economy (and hence the assets within the economy) gained in value. However, it would take a retardedly high amount of economic growth coupled with inflation to justify the extreme price movements we witnessed over the last half decade. Consider...

From January 2000 to July 2006, the ENTIRE NATION's houses more than doubled in value on an aggregate basis. The index went from 100.0 on January 2000 to 206.52 in July 2006. That's a bubble if I've ever seen one! Now consider that many of our financial institutions own assets whose value depends largely on housing prices keeping or continuing to rise in value. NOW consider that they levered up these assets to really high amounts. Bear Stearns had a leverage ratio of 33:1. When house prices were increasing and mortgages could be repackaged and sold abroad easily, this meant massive profits for investment bankers and massive amounts of resources in our economy diverted to more housing production. Witness the huge amounts of empty condominiums and "for sale" signs in many of our metropolises Enough about that though, let's look at where we are today and where we may be going.

As of July 2008, the Case-Shiller index has a value of 166.23. Let's be quite generous and assume that the fair market value of these houses on an aggregate basis is 115.0, despite the massive amounts of new home construction (find out how much new construction) which may have sent home prices below 100.0 And let's also assume that housing prices won't overshoot on the downside (as so often happens when a bubble turns into a crash). What does this mean?

Housing prices still need to fall by about 30% from their current levels just to reach fair market value with very generous assumptions. This means that the toxic mortgage assets banks hold on their books will only become more toxic as housing prices continue to fall. Combined with the insane level of leverage banks used to purchase these assets... it's no wonder that Paulson and Bernanke are asking for huge sums of money to recapitalize our financial institutions. Because while bailing these institutions out is deplorable and has huge opportunity costs (think of all the children who could be given health insurance with $700 billion), having our banking system fail would be even worse. Businesses would not be able to expand (or in some credit-hungry industries, operate at all...), people would not be able to take out loans, economic activity as we know it would slow tremendously and a repeat of the 1930s could very easily set in. The natural human reactions of fear, xenophobia, and political upheaval would rear their heads and it would be an ugly situation.

The national media has a rather limited attention span, and I haven't seen too many people who really grasp the 'big picture' of what's really going on in the financial press, the way that home prices have driven this entire crisis. It's euphoria one day and panic the next. If any of the few people who might stumble across this could point me to someone who really 'gets it', please let me know.

Given:

• Consumer confidence is so highly driven by house prices (when peoples' home values go up, they 'feel richer' and spend more)
  
• House prices are downward sticky (people are extremely reluctant to sell their home for less than they bought it)
• The large amount of debt the average American consumer has already accumulated through reckless spending combined with the consequent tightening of credit (insert data here about average consumer's debt)
  
• The fall that still needs to occur in housing prices
• The large decline in consumer spending, which constitutes 70% of our GDP, that will occur as a result of the above
  

We may be in for a long and nasty recession. The problem could be compounded if President Obama (yes, he will be president) over-regulates the economy and raises taxes too much. I think a tax increase is needed and obviously more regulation is needed in the financial sector, especially with regards to accounting transparency, but the temptation exists to go too far in the direction of higher taxes and more regulation, which would only add fuel to the recessionary fire.

On the bright side, this means if you have a lot of cash, there exists a tremendous potential for profit by buying cheap companies which will only become cheaper and undervalued as our economy deteriorates.