Wisest of the crowds

I keep getting asked what will happen to home prices with the Federal Reserve lowering rates to banks. The question implies:

1. What is the relationship of cost of money to prices?
2. Can we identify trends and/or turning points based on this macro-economic variable?

The sub-prime crisis was not born of a real change in cost of money. Rather, it folded under its own weight as artificial borrowing conditions expired and came head-on with artificially inflated home prices. The recovery, on the other hand, may very well be born of a change in cost of money (at least the Fed Reserve is hoping as much).

I believe the past relationship of cost of money and prices is fairly strong and so we should probably consider it. However, the mortgage market is based on long-term MARKET rates (5 year, 10 year, and 30 year US Treasuries) and not DIRECTLY related to the short-term cost of money. Having said that, banks typically borrow short-term and lend long-term and so decreases in their short-term borrowing costs generally will lower mortgage rates - particularly if they WANT TO BE COMPETITIVE. Recently they have not wanted to lend and so lower rates just means increased banking profits. In essence, the Fed is using rates to improve the capitalization of banks. This will eventually flow back into the economy and hence to mortgage borrowers but the immediate impact is less clear.

The US Commerce Department reported various housing data this morning that confirms the poor state of affairs in the US housing market. Specifically:

- Building permits for single-family homes in December were 10.1 percent (±1.6%) below the November figure and 25.3 percent (±0.8%) below the December 2006 figure.

- Single-family housing starts in December were 2.9 percent (±8.7)* below November and 24.8 percent (±1.3%) below the December 2006 level.

- According the AP, it will take 9.6 months to eliminate the backlog of unsold new homes at the December sales pace, the longest stretch of time since the month’s supply stood at 10.3 months in October 1981.

You can see the data and release at this Commerce website.

What’s really interesting is that the markets are shrugging this off. Take a look at this mornings prices of home builders, complements of Google Finance:

Ths homebuilders have been rallying since the market low reached the day the Fed lowered interest rates 75 basis points on an emergency cut with another 50 basis points expected TOMORROW.

Having said all this, markets ALWAYS move further and harder than expected. More problems seem likely without some extreme structural (read fiscal) or economic stimulus. The Fed seems to be doing its part. Will the Government in the midst of an election year?

The National Association of Realtors reported that their “Pending Home Sales Index” for July fell to its lowest level since the post Sept. 11, 2001 period as a result of tightening credit for Jumbo mortgage loans (loans over $417,000).

So what is this index? Directly from the NAR release:

“The Pending Home Sales Index is based on a large national sample, typically representing about 20 percent of transactions for existing-home sales. In developing the model for the index, it was demonstrated that the level of monthly sales-contract activity from 2001 through 2004 parallels the level of closed existing-home sales in the following two months. “

It seems that Three Stooges of the mortgage ecosystem, lenders (Curly), Wall Street mortgage underwriters (Moe), and mortgage buyers (Larry) all woke up after a night of drinking and decided never again (well, at least for a few weeks!) ! These Jumbo loans are NOT purchased by the quasi-government agencies Fannie Mae or Freddie Mac whose job it is to purchase loans from lenders so that lenders have the funds to make more loans - a mechanism to facilitate home ownership for average and lower income home buyers. Jumbo loans do not qualify so they must be either held by lenders or sold to investors via wall street. Since Fannie and Freddie have continued to support loans at the low-end while the high-end has lost free market support, Jumbo’s have shut down for the minority and have gotten MUCH more expensive for the majority. Not surprisingly, the Western part of the US, which has the highest home prices and presumably the most Jumbo loans, got hit hardest being down a whopping 20.8% to 82.3 versus 89.9 nationally.

Will this last? No way. This is a temporary disruption as people reorient their perspective to risk. Will the cost of jumbo’s (as a spread to treasury securities) increase? You can bet on it!

Yesterday the NYT’s David Leonhardt wrote an interesting piece covering new research from Christopher Malloy of London Business School, Andrea Frazzini from University of Chicago, and Lauren Cohen of Yale. Entitled “The Small World of Investing: Board Connections and Mutual Fund Returns,” the research basically finds that mutual fund managers are more likely to buy stocks and take larger positions in companies that are in their academic network. Further, these money managers perform substantially better than funds that dont buy stocks in their network.

The data:

Yowza! Over 8% per annum difference! These guys beat themselves up for small fractions of a single percentage point return.

The authors conclude thats its either insider trading, ease of information gathering by being in the network, and better manager selection by investors due to network relationships. Intuitively all seem correct but the split is, of course, the rub. (I blog about this some more here.)

So I find this really interesting because it assigns dollars to the value of networking. We all know its important but who would of though that the difference was so large? Sure some of this data includes illegal activity but I think we now have a solid benchmark of networkings value. How does 70% more money sound to you? Its easy to see why social networking sites have been all the rage and why it is imperitive that all you old-schoolers who think your physical network is all you need, need to think again - especially if you are selling lofts to hipsters and not mansions to grand ma. Come on, get connected and get rich!

Who you ask? Banksy is a UK based artist that has largely used the streets of London as his canvas. Yes, it is graffiti. But really it is so much more. His manifesto gets to the point. It is political and social satire simply executed. The process of having to create a piece of art in a handful of minutes means that the art has to be direct and to the point. Nothing is wasted or indulgent. Banksy is, I guess, reminding us about the state of things and the state of our humanity. Or he is just another opportunitist media whore and I am a sucker.

Banksy was the subject of an article in the New Yorker entitled “Banksy was here” by Lauren Collins. My favorite quote:

“Imagine a city where graffiti wasn’t illegal, a city where everybody could draw wherever they liked,” he once wrote. “Where the street was awash with a million colors and little phrases. . . . A city that felt like a party where everyone was invited, not just the estate agents and barons of big business.”

So the question is why am I saying be like Banksy? Well, his art is simply reminding us, if I may be so bold, to be ourselves again and to take back the world from the stories we are told by people we don’t care about. People, typically, that run crap brands that make promises like “eat me and you will be happy (but fat)” or “buy me and you will be beautiful (but poor)”. We own the world and we will think for ourselves. Bring a point of view and decide for yourself. Look around and see what is happening. Do you approve? Feels somehow like I am just waking up and feel like the one guy who wasn’t in on the joke.

Okay so I am not some lefty anarchist. In fact I am the opposite. I believe markets are an underutilized gift (clearly). I also believe certain institutions and government have a key role. But my hope is that the artificial value being extracted by incumbent businesses based on false promises - promises that most people have been brainwashed to believe in - are over. The internet is changing the way we do business and everyday people will benefit. Will you be a force of change or will you help enslave another generation of suckers?

No not what you are thinking - not social, ethnic, or racial discrimination. Redfin discriminates on price. PRICE! The 60 minutes piece was a yawn for me personally but it does give Americans the right to start to push back. See the posts and comments at TechCrunch, Redfin, Inman, BloodHound for an early read. Whether it becomes a consumer zeitgeist or fades will be seen but the open question is this: will price variation become mainstream in american residential real estate?

There is an old economic idea called price discrimination that is popular with every micro-econ 101 student, and their professors, that says you reach more customers and make more money by offering variation in pricing. Its sort of definitional for anyone who believes in supply and demand. It works like this: when you go to see a baseball game, there are a 100 variations in pricing to meet everyones needs and to tap into every possible cross section of demand. For example, there are ticket prices for corporations who entertain in luxury boxes and ticket prices for those who mostly prefer a beer and some sun in the bleechers. Ticket prices for season holders and ticket prices for last minute shoppers. In short, EVERYONE can have their demand met for baseball. A small example with the mighty SF Giants here.

What would happen if every ticket was the same price? Mayhem and lost profits. Some people willing to pay more for MLB tickets will transfer their money to an underground marketplace that will use price discovery to allocate tickets. Meanwhile, people at lower price points will be shut out resulting in further lost revenues to MLB. Thats why we have pricing variation. Its better for everyone because everyone gets an allocation and the business folks maximize their revenues.
People might argue that the price variation exists is in the underlying house price and not in the intermediary execution price (brokers & agents). If that were true, then why did trading volume in financial markets explode when electronic execution came into acceptance? (For a slightly more technical explanation {very slightly!}, see my earlier post here).

Redfin discriminates. So do I. It makes sense and it is better for everyone. Many people have commented that Redfin basically passes their work load to external agents to facilitate their transactions and to make their business model work. I can certainly see how that might play out. But if the consumer is footing the work load “bill”, don’t they deserve to get a rebate? Don’t consumers deserve the right to choose their level of service? In the end I believe that consumers will still depend on full service agents because housing is complicated and its something we do rarely. But by offering price variation, we get to grow the pie. Anyone else out there a discriminator? Anyone else want to make more money?

The Washington Post has a hilarious (but real) article discussing the inside of New Century Financial - the sub-prime mess to end all messes that is now bankrupt. I first read about the article at Inman blog, entitled You WILL play ball. Below is a WP sampler:

“The stress in that place was ungodly. It was like selling your soul,” said Hardiman, who worked for New Century in 2004 and 2005. “There was instant notification to everyone as soon as you rejected a loan. And you dreaded doing it because you paid for it. Two guys would come with a bat, and they were all [ticked] off because you cut their deals.”

I have posted several times about the conflicts between the appraisers, lenders, and agents here, here and here. Bottom line is that it may be time for buyers to hire their own appraisers. This doesn’t represent a new expense but rather a disaggregation of a current expense. If a buyer uses cash, rather than having the costs buried in other transaction costs, than the buyers can control quality and appraiser can get on with their jobs with conflicts.

Also, we might consider the conflicts from the lending side as to communicating affordability to consumers. Does it make sense to expect a lender, who is commissioned based on the number of closed transactions, to actually protect the customers side of the equation? I suppose the logic is that its the banks money but in truth, lenders sell loans and loan agents get new jobs. So the buck gets passed, Wall Street just play the odds (and gets a commission), and the financially illiterate get stuck holding the bag. Nothing new from “big business” but certainly NOT something part of the new business models powered by the internet - including ours.

The solutions to these and other vexing consumer problems are being addressed by market forces. Entrepreneurs like us see this problems as opportunities to add value to people by being open and transparent about our businesses. We put people at the center of our model and drive everything to satisfy this focus. Gone will be the days when trapping and or tricking a customer into a piece of business is THE model. Gone will be the oligipoly’s upon which many incumbent industries are based. Power is being pushed down to people and the economics will follow. Selling your soul in sub-prime, or any other industry, is a dinosaur waiting to happen. A lot of other charts will look like the one below over the next few years.

Yesterday, Russel Shaw at Bloodhound Blog posted a note he received from a young person sniffing the real estate industry. Entitled “I’ll bring you a big basket of cash if you’ll let me sell your house for free” Shaw responds to the young persons overt question whether the industry is crowded and the covert question as to whether pricing can be used as a competitive weapon. Shaw tells the young person not to use pricing to differentiate (and yes there are too many agents). This got me thinking. If EVERY industry has price discrimination, why doesn’t housing? (yes there are firms like Redfin and FSBO’s but traction is light) This is not whether orange people get better prices than purple people. Not that kind of discrimination. This is you using e-trade for stock execution rather than Morgan Stanley. Does variation in transaction costs make sense for housing?

I am not an economist but here goes.

The graph above is what Shaw is saying. There is one price for transactions (or something like that) and that you should stick to it. An economist would say that given the demand at that price, sales will be S1. Lets see if we add new prices…..

So by adding new prices, we tap into a larger amount of the total demand. From an industry perspective, price discrimination (price variation) yields HIGER total number of transactions. This is why airlines use it. This is why software companies use it. This is why EVERYONE uses it. Ever clipped a coupon? Ever cashed in on frequent flier miles? This is price discrimination at work.

So the one thing to consider that might debunk this basic economic notion is whether the demand curve (in blue) is in fact oddly shaped. Lets take a look….

So if demand is the same regardless of price then Mr. Shaw is correct. In fact, if demand in the real estate industry is oblivious to transaction costs than Mr. Shaw and all the other realtors are bloody idiots for not raising prices. So I guess the question is this: is demand for housing sensitive to transaction costs or not? If it is, like most things, then everyone stands to be better off by offering differing levels of pricing (and service). If demand for housing is not sensitive to transaction costs…then put your orders in for those new german cars because margins are about to get much better.

Giddy up little doggy!

More news from the Commerce Department (pdf) yesterday - the number of homes sitting empty has increased fairly dramatically. Homeowner vacancy increased to 2.8% from 2.1% and rental vacancy increased to 10.1% from 9.5% versus the first quarter of 2006. That means that there are now almost 4 million units for rent, 2.2 million houses for sale and 7.3 millions units vacant for no apparent reason (dead cities?). When looking at homeowner data by area, cities increased 60% to 4% occupancy, Metropolitan Statistical Areas increased 45% to 2.9%, and suburbs increased 33% to 2.4%. Regionally, the South has both the highest rental and homeowner vacancy. The data below:

The Commerce Department released more data and analysis confirming what we know - that housing is dragging the economy. The economy grew just 1.3% (preliminarily) for the first quarter of 2007. From the press release:

The increase in real GDP in the first quarter primarily reflected positive contributions from personal consumption expenditures (PCE) and state and local government spending that were partly offset by negative contributions from residential fixed investment, private inventory investment, and federal government spending.

Here is a chart of GDP going back a few years:

As you can see, things haven’t been this bad since Q1 2003. The markets largely shrugged this off but home builders took it on the chin:

Most of the big names down around 3% but the index as a whole finished down just 1.52%