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.

Little Graph, Big Picture

Today I am going to shamelessly steal data and give it my own spin. First, the data on housing starts from the National Association of Home Builders (NAHB). As shown in the graph below, the rate of housing starts since 1994 has been well above one million per year up until the Crash. After that it has dropped into the 400,000 to 600,000 per year range.





But what is normal? I took the liberty of inserting a ‘normal’ line at the one million starts level and then shadowing out the period prior to 1994. This then begins to show us something – the downturn in housing starts of the past few years has yet to offset the glut of housing built in the prior periods. In other words, don’t look for the upturn as early as 2012 as shown by the NAHB graph.

But what if the normal line is wrong? According to Harvard’s Joint Center for Housing Studies:

     While estimates vary widely, the Current Population Survey indicates that household    growth averaged about 500,000 per year in 2007-10. This is not only less than half the 1.2 million annual pace averaged in 2000-7, but also lower than that averaged in the 1990s when the smaller baby-bust generation entered the housing market.

So should the ‘normal’ line be 1.2 million?  Given historic rates of household formation AND the upward pressure from the Echo generation, this seems plausible.  And changing the line make the graph look like this:



Under this scenario, the upturn is upon us, even if multifamily housing absorbs some of the household formations.
The next question is what type of housing stock will serve the coming market. We’ll hold that for another day.

Lighter Weight, Shorter Life

We’re talking about the GDP here. GDP, or Gross Domestic Product, is the total of all goods and services for a defined economic unit – usually a state, country or region. Alan Greenspan, one of my favorite economists, has determined GDP per dollar is getting lighter and shorter lived. So what does this mean?

Several decades ago our GDP was comprised of things like steam locomotives and industrial facilities; today it includes software and services. As the proportion of software, the average weight of GDP declines. (How many Tweets fit in a McDonald’s bag? Would you like some likes with that?) Similarly, locomotives and factories lasted a long time but internet news updates are gone tomorrow.

In good times this all works great. (Hey, I’m gonna get a backrub and increase the GDP!) The question is what portion of this lighter, more temporal GDP endures throughout economic cycles. And this brings us to the murky boundary between needs and wants.

Needs are warmth, water, shelter and food. (If you don’t buy that definition, I invite you to backpack a mere three days with me. I WILL keep you alive.) Wants are anything else, and it is this reality which is now slowing our economy. Add to this the rising prices of commodities driving up the real cost of warmth (energy) and food (grain, corn) and wants are even more crowded out in the marketplace.

So what is the solution? It appears the precursor signals are already showing in economic reports. First, our currency has to decline. For those who have been hiding under a rock the past few years, this has already occurred and may likely continue. Secondly, manufacturing must move back into the US. Why? Because we are currently using our wealth for two things – ephemeral, short lived items and imported manufactured goods. If this continues ad infinitum, the US expends all of its resources on imports. The good news is the manufacturing index unexpectedly increased last month. While the overall economy may not seem to be robust enough to drive this increase, I believe the declining dollar is beginning to pull manufacturing back onshore.

And by now you are asking “What does this have to do with housing?” The answer is twofold. First, a real increase in GDP will stimulate new household formation or relocation. Pent up demand for new household formation already exists; all it will take is enough available purchasing power to release this demand. Relocation will occur as people move to the sites of new manufacturing.

Secondly, this stimulation of housing will create a reinforcing effect for US manufacturing. Much of the materials used in a home – lumber, shingles, etc. -- are produced in the US. Granted my toilet was made in Brazil, but ….

Guess I will have to wait for Greenspan’s next analysis for confirmation of the trend.

Look at the Numbers

A professor counseled us to determine what the numbers say for ourselves instead of listening to the opinions of others, and I encourage you to do the same. The Case-Shiller composite index just came out so... I took the liberty of converting to a more understandable format – the actual price during each period assuming each area’s price started at $100,000 three years ago. This makes it easy to really see what has happened.

Here are the data:

	3-years earlier	2-years earlier	1-year earlier	3-months earlier	1-month earlier	Apr-11
Washington DC	$ 100,000	$ 83,105	$ 89,176	$ 90,199	$ 90,059	$ 92,770
San Francisco	$ 100,000	$ 71,954	$ 84,904	$ 81,010	$ 78,859	$ 80,200
Atlanta	$ 100,000	$ 85,276	$ 85,497	$ 81,179	$ 81,131	$ 82,470
Seattle	$ 100,000	$ 83,188	$ 80,829	$ 75,411	$ 74,053	$ 75,260
Denver	$ 100,000	$ 95,067	$ 99,229	$ 95,515	$ 93,830	$ 95,200
Cleveland	$ 100,000	$ 89,519	$ 95,635	$ 90,537	$ 88,121	$ 89,170
New York	$ 100,000	$ 87,659	$ 86,730	$ 85,119	$ 83,666	$ 84,310
Dallas	$ 100,000	$ 94,899	$ 98,114	$ 94,727	$ 93,700	$ 94,140
Minneapolis	$ 100,000	$ 77,921	$ 85,639	$ 81,354	$ 75,749	$ 76,090
San Diego	$ 100,000	$ 79,994	$ 89,387	$ 86,970	$ 85,229	$ 85,570
Los Angelos	$ 100,000	$ 78,719	$ 84,845	$ 83,911	$ 82,865	$ 83,080
Portland	$ 100,000	$ 83,982	$ 83,640	$ 77,663	$ 75,871	$ 75,970
Phoenix	$ 100,000	$ 64,748	$ 68,220	$ 62,940	$ 62,154	$ 62,210
Boston	$ 100,000	$ 92,292	$ 96,774	$ 95,902	$ 92,866	$ 92,680
Miami	$ 100,000	$ 72,736	$ 72,366	$ 70,500	$ 68,494	$ 68,350
Charlotte	$ 100,000	$ 90,038	$ 88,034	$ 84,454	$ 82,514	$ 82,250
Tampa	$ 100,000	$ 78,661	$ 76,802	$ 72,281	$ 71,135	$ 70,850
Chicago	$ 100,000	$ 81,342	$ 80,052	$ 76,964	$ 73,501	$ 73,200
Las Vegas	$ 100,000	$ 67,832	$ 62,055	$ 59,885	$ 58,648	$ 58,220
Detroit	$ 100,000	$ 74,579	$ 72,330	$ 72,135	$ 68,926	$ 66,920

The bad news, most of the lows have occurred in the subject month or one month prior. Translation: it isn’t the bottom until there is an uptick.
The good news is the declines are diminishing which usually portends a bottom.
The other good news is diminishing declines portend smaller declines going forward. I wouldn’t put much credence in the Chicken Little “another twenty percent drop to go” theorists.
But don’t take my word for it. Draw your own conclusions. My professor would be proud of you.

Light at the End of the Tunnel

There are a lot of tunnels in the vicinity of my East Tennessee home town, and often we romanticize the phrase light at the end of the tunnel. Today I want to talk about the reality of tunnels and what the other end looks like for the housing market.

First, long tunnels take us from one place to another and the landscape is often different at each end. The housing landscape parallels this. We left the realm of easily financed McMansions and are going to the land of optimized housing decisions – from Crazytown to Rationality. Those who expect to see the same housing market on the exit end of the tunnel will be surprised.

Secondly, even the climate can be different from one end of a long tunnel to the other; sunny going in and cloudy on the other side of the mountain. The financial climate fits this description. On the exit end, the financial climate is overshadowed by weakened asset values, greater banking restrictions, tightened lending standards and a hurricane of sovereign debt on the distant radar. I even hear rumblings of eliminating the interest deduction for housing. Not exactly fair weather.

But on the positive side, we do generally exit tunnels. (Anyone who has not, raise your hand. Oh, you're not here!) We begin to see light and glimpses of the landscape. In the last ten days , the Wall Street Journal cited three encouraging glimpses:
• Home sales in the $50,000 to $100,000 range actually rose! While this is somewhat propelled by foreclosures falling into this price range, I believe it also foreshadows a trend to smaller, more rational housing decisions. (See the previous blog about Europe.)
• Lewis Ranieri, the "godfather" of mortgage finance for his role in pioneering securitization and mortgage-backed securities, is exploring the creation of funds to provide higher interest rate mortgages to less qualified applicants – which may be darn near all of us. This is a great sign that the financial market sees an opportunity in housing and may step in, albeit slowly, to fill the current void of mortgage availability.
• An article appeared stating that lack of availability of mortgages was hurting the housing market – duh! While this is not a revelation, the magnitude of the problem is. An example given was an applicant with an 800 credit score and 50% downpayment being denied. Makes Ranieri seem even more prescient, eh?

So are these lights at the end of the tunnel? Highly likely. They show a changing landscape (home prices), a responding financial market and pent-up demand. I can’t help but like it. We just have to keep moving forward.

Lessons from across the Pond

Often our blog is a one way communication but today is different. Today is simply a question – what is the home of the near future? Over the past several decades America has moved from simple flats to small suburban homes to McMansions and then a crash. Taking the long view, we must ask ourselves what is the ordinary home in America’s future.

To help us with this question, we can look at other countries and how they have evolved. While our situation is different, we can get some good ideas from beyond our borders.

There are a number of lessons from Japan, but that model may not be applicable. Japanese systems of finance, land use and intrinsic value are vastly different from the US. A better model may be Europe where the culture is more similar to ours. Given this huge assumption, I will venture some thoughts:

• European cities developed different land use patterns due to transportation. Although autos and open spaces beckoned, most people remained close to the cities and used public transportation. As such, they became more immersed in the urban culture with ‘living areas’ other than their homes.
• Europeans never drank the Kool-Aid of 30 year mortgages with tax advantaged interest, so there was no artificial stimulation of home investment. Instead, home investments were weighed against all other spending and investment decisions and optimized in that context. This resulted in smaller, more durable dwellings which delivered greater value over the life cycle. In fact, many European homes seem to have almost endless life cycles due to refurbishments and upgrades (as opposed to replacement).
• Lastly, US land investment may also have been skewed by the above factors. Expansive subdivisions with relatively large lots make sense only if they can be easily financed. Otherwise, the investment in roads, water lines, sewer systems, power distribution and communication distribution appears excessive. Case in point -- the available subdivisions throughout the nation which have been stranded by the recent downturn.

So what will homes in the US look like going forward? Maybe that is the subject of another blog. I’m thirsty and need some Kool-Aid.

Supply Lines and Quality

Usually a title such as this is an introduction to an esoteric discussion of supply chain theory and its relationship to quality; today’s blog is much simpler.

This past week we had a water supply line under a vanity come loose and flood a new home that had been in place, with water connected, for about a week. It was a mess but fortunately no major, permanent damage was done. I visited the site and the builder handed me the culprit – a polymer line which relies upon a compression fitting to seal and provide pullout resistance. Evidently the fitting was tight enough to hold but worked its way loose over the week.

As a company, we could respond in different ways to this situation. We could ignore the matter and hope it was an isolated instance, we could reprimand our plumber (who regularly does a good job) or we could reexamine our materials and processes. As you may guess, the first two options are insufficient. Ignoring the matter just continues the chance of another problem and reprimanding focuses upon the person and not necessarily the problem. Instead, we looked at our material and processes.

Immediately, we changed away from compression fittings. Yes, the new lines cost more but we know they won’t have the specific problem because the line is attached to the fitting in a more positive fashion. We didn’t hem and haw about; we just did it. Secondly, we reexamined our processes to determine if additional checks were needed. The bottom line – we focused on continuous improvement.

While this may sound like a simple and silly example, I am reminded of a phrase from my high school Latin teacher:

Inch by inch, life’s a cinch; yard by yard, life is hard; mile by mile, life’s a trial.
We are working to continually improve inch by inch. It will put us far ahead of our competitors.