Case-Shiller Revisted

Case-Shiller Revisted

Over the weekend I commented to a relative that the worst seemed to be over.  Just to confirm, take a look at the Case-Shiller Index depicted graphically since 1987.  (Note year 2000 is the base value of 100 for all markets.)

And the composite number looks like this:

Yep, it appears the worst is over. 

 

The Strategy of Modular Construction

It’s been a long time since my last blog, and I am a bit weary of commenting on the vagaries of the economy and their effect upon the industry. Suffice it to say the economy is roiling and will eventually smooth out. In the meantime, we must move forward.

Let’s talk about the economics of the industry beginning with competitive strategy. Going back to Porter’s seminal work on strategy, the four industry influencers are:

• Customers – we immediately think of homebuyers, but they are not necessarily the direct customer. Our industry often serves the homebuilder who then serves the homebuyer. There are other channels such as direct retail, retail lots, etc., but most have been tried and found wanting. For the purpose of our discussions, presume the customer is the homebuilder. (I welcome other opinions.)
• Suppliers – we all know the supply chain; the only challenge is moving back far enough in the chain to secure good pricing. This is a function of either volume or market position, but smaller shops pay top dollar.
• Substitutes – there are plenty of substitutes, but that is hardly a major issue. The issue is how modular companies become the substitutes in the site-built industry.
• Entrants -- volume homebuilders may backwards integrate into the business by setting up their own modular shops; thus one of the competitors/entrants is large customers. Suppliers are unlikely entrants into the market; it could put them into competition with some of their customers and might not increase margins enough to be worthwhile. But entrants are not limited to these groups; virtually anyone can enter this business. The primary barrier to entry is knowhow, and some folks choose to charge in whether they know what they are doing or not. Other classic barriers-to-entry – capital, specialized equipment, etc. – are relatively low hurdles.

In later blogs I will comment on constraints and scalability.

What a Week

While the market was riding the roller coaster, we were setting and selling.

First, we had a great set – one of those that makes you want to come back for more. Granted it was 116 degree heat index, but the set went wonderfully. The best part of the day was the customer, who has purchased homes from at least four other modular companies, say this was the best modular home he has ever received. Nice!

Secondly, we got orders. A deposit for two single family homes and a commitment for a duplex. Way nice!

Is there any concern? Absolutely. Banking for our customers is a major hurdle. The lack of understanding of modular structures makes it even more challenging. But not to fear. We are about a week away from having a great video presentation showing homes, construction and – most importantly – customer testimonials. After all, it’s all about the house.

Now about that market….

Spin Recovery

We’re not talking political spin today; we had enough of that from Washington lately. We’re talking about economic spin.

The analogy is a spin in flight. A plane enters a condition where one wing is ‘flying’ slower than the other, the slow wing loses its ability to generate lift and the plane begins to fall. Physics causes the plane to turn downward and inward, and this further slows the problem wing. It also accelerates the non-problem wing which speeds and tightens the spin. The spin tightens to the point where the plane may no longer have the aerodynamic control and the result is catastrophic. (For inquiring minds, the solution is immediate power back, nose down, full opposite rudder. Don’t forget it! Don’t let the spin go more than three revolutions even in practice! Change your diaper.)

Our housing economic situation has been spinning. The disabled wing -- housing values -- no longer provides support. In fact, values have weakened as the spin tightens. The other wing – mortgage financing -- still has lift but only if it can fly faster; i.e., stiffer credit requirements, greater collateral, tighter bank regulations, etc. Four annual cycles have come and gone, but the fundamentals hold:

• Power back – if we think more stimulus will carry the day, think again. Data consistently show the poor multiplier effect of government expenditures, and more losses in Fannie and Freddie won’t put Humpty Dumpty back together. Pulling back the throttle on federal spending will let natural economic forces take over. All good.
• Nose down – spins eat altitude; successful recovery occurs before all altitude is eaten. Housing values to date, excluding the disaster areas of Phoenix, Las Vegas, Detroit and Florida, have dropped 10-30%. This is scary but recoverable. Also, the rate of value diminution is declining; i.e., the worst appears to be over. Clear Capital, reported today in Bloomberg, said, “The moderation of the projected price changes generally reflects a flattening market.”
• Full opposite rudder – lower housing starts, lower rates of home ownership, private capital nipping at the edges of the securitized mortgage market, investors bottom fishing for rental/ultimate sale (but flipping is not back), bank accommodation (capitulation?) on valuations of REO, etc. All are clawing to stabilize the ship.

The bottom line – hang on; we’re coming out of it.

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P.S.– it could be tougher. Check out ‘pitch up’ in the aerodynamic sense. Nothing like tumbling end over end through the air.

The Good News of the US Debt Standoff

In case you didn’t notice, the yield; i.e., implicit interest rate, on US Treasury Bills – 10 and 30 year maturity -- dropped yesterday to the lowest rate since November 30, 2010. The closing rates were 2.80% and 4.12%, respectively.

What does this mean? First, no one really expects the US to default on its debt. Granted some short term notes ticked up to reflect that payments may be delayed, but the world still believes the US will pay 10 and 30 year notes when due. On the other side of the Pond, Greece 10 year debt was 14.81% Thursday – implying a loss of about 40%. Translation – holders of Greece debt expect a haircut.

Secondly, it implies slow economic growth and a flight to safety. Why put money at risk if the economy is going to slow? At least put it somewhere; i.e., US Treasuries, where the principal is safe. This is somewhat of concern, but is more driven by near term expectations.

But take a longer view. Although growth may slow in the near term, the low rates for US debt indicate continued faith in the strength of the US… and this faith can only come from the belief the US is getting its house in order. If investors felt the machinations on Capitol Hill are just another partisan spat on the way to business as usual, they would be running for the exits. As is, they are hanging in and signaling belief the US is going through a sea change event for the better:

• Lower deficits,
• Reduced government spending as a percentage of GDP, and
• Reduced payments to individuals as a percentage of government payments.

It appears adult supervision has reached Washington. We are waiting to see, but it could be a great thing for the economy overall. Since the overall economic lethargy appears to be holding back housing formations, an uptick to release this pent-up demand would be a huge boost. Would it require increased liquidity in the private sector? Yes, but that is another issue.

Let’s just hope the market’s expectations become reality.

Equilibration

Equilibrium is a wonderful concept. To know that conditions will come into balance gives us a sense of stability and reassurance. Whether it is dissolved concentrations on either sides of a membrane (think ‘kidneys’), buoyancy forces acting upon a ship or supply/demand market forces, we are calmed by the knowledge such forces work with little intervention required.

It is this very supply/demand equilibrium which is now beginning to, figuratively, right the housing ship. The supply/demand forces were examined in the July 14 blog and I touched on the financial challenges in the previous post. Today we are going to look in more detail at the financial equilibration taking place.

First, prices have declined. Home prices have dropped in response to the supply of financing available and this has resulted in increased transactions, compared to a base case of no price decline, and reduced supply; i.e., fewer housing starts.

Secondly, private equity is moving to fill the market void created when credit standards were tightened and financing became scarce. On July 15, the Wall Street Journal reported that money managers and REITs are exploring lower rated mortgage securities carrying higher yields. As reported:

Bond issuers, faced with meeting rating firms’ triple-A stringent guidelines or trying to sell bonds with not ratings at all, are considering a middle ground – one that produces profitable deals and could help expand credit that is scarce in today’s housing market.

Thirdly, the rate of housing formations is destined to rise. The Echo generation will drive increased future demand, and that demand may already exist in the pent-up state.

Is there any good news? Yes, equilibration works. Just hang on.

Utility and Intrinsic Value

I was always fascinated by the economists’ definition of utility – the relative fulfillment that comes from ownership or consumption of a good. Given that different goods can have different values to different people at different times, the concept of utility drives economic interactions to optimize fulfillment. The classic question – what is a glass of water worth to a man dying of thirst in the desert?

Money is an exchange of universally agreed value against which all other financial transactions are compared. This works, except…. Recent events surrounding the Greek sovereign debt crisis have eroded this concept of money, or at least for the Euro. Today, rates are rising for the sovereign debt of not only Greece but Ireland, Portugal, Italy and Spain. The Euro is sliding. As reported July 12 by Bloomberg:

"Contagion is running amok," Bill Blain, a strategist at Newedge Group in London, wrote in a research note. "A sovereign default is now being discussed openly. We seem to have crossed that moment when chaos theory takes over and we get a price breakout into unknown territory."

And today, Suki Mann, senior credit strategist at Societe Generale SA in London, wrote:

As another D-day looms on Thursday, we have few soothing words. Greece appears beyond repair, Italy is on the brink and the chances are that the euro might be no more very soon.

Translation – things are going to [insert your favored pejorative]. The Brits always did have a way with words.

But what does this have to do with housing? The US could tip over into such contagion if we don’t get our fiscal house in order. Our debt ceiling crisis could result in the dreaded “self inflicted wound” if not resolved. While few expect the US would fail to rapidly cure any default conditions, the shock to the financial system would be frightening. With the preponderance of all mortgages backed directly or indirectly by the full faith and credit of the US government, mortgage origination would hit a wall.

Looking back, it is precisely this eroding concept of money which tanked housing values in late 2007 and beyond. Pre-crash values were based upon the availability of money, albeit at times recklessly available, to support high valuations. The reduced availability of funds, not the intrinsic value of a house, drove the price declines. (If the intrinsic utility of home ownership had declined, we would see a wholesale migration out of single-family housing independent of available financing. This is not the case. People still want to buy houses but cannot.) Further, the decline has produced a self-reinforcing ‘pain avoidance’ response from those who fear further declines.

The bottom line – the housing industry has EVERYTHING riding on the debt discussions unfolding in Washington. Erosion of faith in our sovereign debt would undermine both the value and availability of US dollars. Regardless of the intrinsic value of homes, the financing mechanism would be heavily impaired.

We thirst for housing in the US, but there is no funding to buy in the desert. Is there any good news? Yes….tomorrow.