Real Estate and its Consequences

April 7, 2010 Leave a comment

One of the interesting things about thinking about finance in terms of cognitive bias is that you suddenly see how pervasive certain biases are. In real estate, confirmation bias seems pervasive. For young professionals in their 20s or 30s, the thinking goes something like this: My parents bought real estate in the late 1970s or early 1980s and have made a lot of money on paper (or have sold real estate multiple times); therefore, it’s a great investment over the long term. Or, real estate flippers reason: My friend acquired multiple pieces of property and put his kids through college with the proceeds; surely, I am smarter than him.

The problem with this kind of thinking is that it ignores the underlying economy. If the economy does not grow, then real estate prices don’t grow. Real estate prices, over the long term, are a good proxy for an economy’s trajectory. If real estate prices are increasing, the economy is growing because personal incomes are growing and capital is cheap.

The other problem with the real-estate-is-a-good-investment thesis is that bankrupt municipalities and state governments do not make for places where people want to live. Or, rather, owning real estate in states and municipalities that can’t pay their bills is a troublesome concept. Just think of what happened to New York City real estate prices during its fiscal crisis of the late 1970s.

So, there are a lot of problems with owning residential real estate. The most important of these problems, and the one least in control of the homeowner, is the fiscal stability of the local and state government.

But, beyond those factors, about which much more could be written, lie a number of other troubling aspects.

Felix Salmon writes eloquently:

Homeownership is, if anything, a drag on the economy, since it funnels resources into unproductive overconsumption, and helps to impede labor mobility. There is absolutely no reason to believe that countries with high levels of homeownership, like the U.S., have better economies than those with low levels of homeownership, like Germany.

The survey just gets more depressing from there. Americans think now is a good time to buy a house, largely because they think it’s always a good time to buy a house. And they reckon — even now — that house prices are going up, or will at least stay stable.

Of course, free marketers will argue that people ought to be free to spend money on whatever they please, and if real estate pleases people, so be it. This is true. But it’s also important to remember that the real estate market is neither a free market nor a liquid one. One’s real estate follies can’t as easily be reversed as one’s foolish investment in overpriced Apple stock. The real estate market is also manipulated by the government, firstly by allowing homeowners to deduct interest from their taxes, and secondly by serving as a backstop in the form of Freddie Mac. Indeed, it has been the explicit social policy of the United States government over several decades to encourage homeownership, especially among the poor. While its origins have a laudable goal–encourage access to responsible use of credit–the practical realities of expanding homeownership to ever-greater numbers of people has been that many people who are not able to parse the terms of a mortgage document, or build a loan amortization table, or earn enough money on a monthly basis to service the debt inherent in taking on a mortgage, have become homeowners. Not all of these people should own homes. We’ve moved from being a society where housing is seen as a civil right to where homeownership is seen as a civil right. The former makes sense; the latter does not.

Finally, a note on rentals. Megan McArdle notes that rental prices in many metro areas have been increasing recently. Arguably, this bodes well for the economy: if rental prices are picking up, it means that tenants feel that they can pay more because they are more secure in their jobs. However, she also notes that rental price increases may also be a consequence of the government’s intervention into the housing market, which intervention has kept housing prices artificially high. This of course raises the question: if the government’s explicit policy is to encourage homeownership, why does the government also intervene to keep market prices high? The answer to this is obvious: the government likes to have its cake and eat it, too.

Update: Matthew Yglesias makes some very perceptive comments about how Greenspan & Bernanke egged the housing bubble on.

Offshoring Jobs and the Myth of a Static Economy

April 6, 2010 1 comment

It has become a commonplace that American jobs have been eliminated in favor of cheaper labor overseas. To some extent, this is true, but it misses the real story. Most of the jobs that have moved overseas, and which are not coming back to the United States, are jobs for which educational requirements are minimal. The poorly trained and uneducated are the victims of structural changes in America’s economy.

(Other victims of structural changes in the American economy are the overeducated who pursue education in fields for which there is very little demand, such as humanities PhDs. But there is little sympathy for naive academics who find themselves unemployable.)

But, there’s nothing new about this. When elevators went from manual to automated, the people who lost out were elevator operators, who, of course, did not need much in the way of education to do their jobs. Likewise, when sock or textile manufacturers move their operations from, say, the Midwest, to China, it is the employees of American textile mills, who, by and large are relatively uneducated, who lose. Other Americans gain.

Now, to a very large extent, this is blaming the victim for economic forces beyond his control. That is true. However, it is also true that if the American economy wants to continue to grow over the coming decades, there will be winners and losers in it. Egalitarianism is a false ideal upon which Stalin murdered tens of millions of people. That is what social safety nets are supposed to account for (in part). It is also incumbent upon people to realize the precariousness of their current employment and pursue opportunities to develop skills that are transferable. The United States’ deplorable educational system does not help in this regard.

But we can’t conclude from any of this, as some do, that the overall number of jobs in the United States has decreased because a lot of those jobs have been moved overseas. Neither the economy nor the number of jobs is a static thing. Buggy whip manufacturers were driven out of business by the development of the internal combustion engine, but in the decades since the internal combustion engine was invented, many more jobs than were ever lost by buggy whip manufacturers have been created.

The Municipal Bond Problem

April 6, 2010 1 comment

All of the sudden, a lot of attention is being paid to the municipal bond market. Rick Bookstaber writes:

Well, guess where we have a market that is (1) leveraged and opaque, that is (2) very big and tied to the credit markets; and is (3) viewed by investors as being diversifiable by holding a geographically broad-based portfolio; with (4) huge portfolios where assets and liabilities are apparently matched; and with (5) questionable analysis by rating agencies; and where (6) there are many entities, entities that may not approach default with business-like dispatch, and that have already mortgaged sources of revenue that are thought to support their liabilities?

Answer: The municipal market.

The problem, as always, is goverments spending more money than they take in. Except, unlike the US government, the nation’s municipalities can’t print money because they’re not sovereign entities with their own currency, and their ability to sell more debt is constrained by people’s willingness to believe that they will pay their existing debts.

David Merkel notes the similarities between ineptly run municipal governments and corporate crooks:

Governments that scam the asset markets (and their citizens) take all manner of half measures to defend failed policies before undertaking structural reform. (This includes defending the currency, some asset sales, anything that avoids true shrinkage of the role of government.)

The question I would pose to those who inveigh ceaselessly about corporations and capitalism is this: when do we, the citizens, become taxed enough by governments that can’t spend within their means? All the attention paid to fraud on Wall Street is for naught if it allows government to escape unscathed.

The Problem with Confirmation Bias

April 3, 2010 Leave a comment

Confirmation bias is endemic to financial markets because their participants have money on the line and those participants want to know that the bets they are making will be profitable. Therefore, investors, traders, financiers, and all other manner of market participant seek reassurance. This type of cognitive bias makes an appearance in other places, and it’s useful to consider how it harms those unaware of it.

The New York Times has an interesting article about Tiger Woods, his inner circle, and the loyalty he demands from the same:

Tiger Woods, a self-acknowledged control freak, insists on loyalty as a fundamental quality in employees, associates and friends. Just how much Woods values allegiance was summed up by his father, Earl, in an interview shortly before he died.

“Loyalty is No. 1 to Tiger,” Earl Woods said in a biography of his son. “You’re loyal or you’re history.”

The problem here is a lack of perspective. If all the people with whom you deal hew to the party line you have no way of understanding perspectives different from your own experience. (North Korea’s cult of personality is probably the most extreme demonstration of this cognitive bias.)

How does this type of bias manifest itself in finance? The always-invaluable Robin Hanson at Overcoming Bias writes:

We’d love for things to go well. So we’d love people to think that things are going well. So we want folks to hear news about how things are going well. But sometimes people hear bad news, about how things are going bad. Gee – why don’t we fix this by banning bad news? Then people will only hear good things, and so only good things will happen, right?

This argument is transparently stupid to most everyone, at least when they think of “bad news” as appearing in newspapers or TV shows. Sadly, that insight seems to disappear when it comes to financial bad news communicated via short sales.

Just as Tiger Woods seems to want to avoid any appearance of discord or disagreement within his empire, and so has suffered as a result, financial market players don’t want to contemplate news that doesn’t comport with their view of the world. It is likely true that most investors are a rather optimistic lot–else, why bet on the future outcome of an investment–and so don’t want to contemplate that maybe the future is not as rosy as the conventional wisdom.

Hedge Funds and Mystique

April 1, 2010 Leave a comment

One of the signs of a bull market is that hot money chases old ideas. Everyone wants to get into the most popular hedge fund, the one which is generating all the positive and glowing press about alpha generation. Popular hedge funds, though, have no reason to open the door to the masses (SEC prohibitions against doing the same notwithstanding), so so-called “funds of funds” popped up, promising retail and smaller investors a way to buy into these exclusive clubs. Fund-of-funds pool together your investment with hundreds or thousands of other random people, and invest that pool of money in James Chanos‘ latest fund. Suddenly, you are investing with the big boys.

Or are you?

Fund-of-funds’ promise has always been access to an exclusive club. But access comes at a price. Not only do you pay for Chanos’ management and his fee, you also pay for the fund-of-fund’s management and its fee. The New York Times reports:

Funds of hedge funds are rightly getting a dose of reality. Justifying their extra fees was always a tall order. Unremarkable returns and investor defections have made it harder. And the traditional fees — 1 percent of assets plus 10 percent of gains, known as 1-and-10, are fast becoming 1-and-zero.

Hedge funds’ frequently mediocre middlemen eked out an average return of just 13 percent last year — just half the rate for the average multistrategy hedge fund, according to Morningstar. The average fund of funds has performed less well than the average hedge fund in all but two of the last 20 years.

Also note that the Morningstar performance data cited above suffers from survivorship bias, and so cannot be relied upon as a measure of hedge fund managers’ talent. Most hedge funds fail, and most hedge fund managers never generate alpha over a sustained period. This is why the successful ones make billions of dollars for themselves and their investors.

Productivity, Debt, and Taxes

March 31, 2010 Leave a comment

A Reuters blogger, James Pethokoukis, claims that the United States is about to enter into a 20-year period of slow growth. He cites as evidence for his claim a paper written by Robert Gordon, an economist at Northwestern University. However, Pethokoukis doesn’t provide a link to the original paper; therefore, it’s hard to judge how much of this is an accurate interpretation of the economist’s conclusions.

But the argument presented is a rather stark one:

Gordon’s argument is simple: The productivity surge starting in the 1990s was driven primarily by the Internet, though drastic corporate cost-cutting in the early 2000s helped, too. Going forward, though, Gordon thinks the IT revolution will be marked by diminishing returns. He concludes, for instance, that most of the product innovations since 2000, like flat screen TVs and iPods, have been directed at consumer enjoyment rather than business productivity. (Also not helping are a more protectionist trade policy and a tax code where the penalties on savings and investment are about to skyrocket with rates soaring 60 percent on capital gains and 200 percent on dividends.)

All this dovetails nicely with research showing financial crises are followed by negative, long-term side-effects such as slow economic growth and higher interest rates. Lots of debt, too. Indeed, researchers Carmen Reinhart and Kenneth Rogoff find advanced economies with debt-to-GDP ratios above 90 percent grow more slowly than less-indebted ones. (Japan is the classic example.) America is on track to hit that level in 2020, according to the Congressional Budget Office.

Categories: Current Affairs, Debt, Economy, Jobs

Loss Aversion

March 31, 2010 Leave a comment

Felix Salmon has a rather interesting blog post about loss aversion and sovereign investors:

Much has been written on the behavioral economics of loss aversion, where the pain of losing a certain amount of money is nearly always greater than the pleasure of gaining an identical amount. And what’s true of a country’s citizens is often true of its government, which is why the question of whether or not governments are making a profit on their bank bailouts is an interesting and important one.

He continues:

But the point is that if Treasury continues to speculate now, it’s mere speculation. When it was underwater on its investment, it at least could say that it was holding on to its stake until the share price rose enough that it could get its money back. Yes, that’s a form of speculation too. But it’s somehow a more acceptable form of speculation to hold onto an investment in the hope that you won’t lose money than it is to hold onto a profitable investment in the hope that you’ll make even more money.

Indeed, the whole argument about whether or not banks should mark their assets to market is at heart an argument about this very question. If banks hold loans on their books at par, even if they could never get 100 cents on the dollar for those loans in the secondary market, they’re essentially speculating that the value of the loans will return, over time, to more than they lent out in the first place. But they don’t call it speculation, they call it “commitment to our valued clients through thick and thin”, or something like that.

This is all very interesting, and I think Felix (and the behavioral economists) are correct when they say that the pain of a loss exceeds the pleasure of a gain. At least, intuition suggests that that is how man thinks. But, this makes me wonder: if man is so averse to losses, why is there such a clamor for short sales and mortgage cram-downs? Those are nothing if not recognition of losses made on a crappy investment.

A side question about real estate: Given that debt-financed assets lose value as interest rates increase, and most residential real estate is financed with debt, why do people claim that real estate is an inflation hedge? The likely answer is that most people who acquire real estate don’t really know what they’re buying and don’t understand its underlying economics.