Saturday, October 11, 2008

Financing and prices

A while ago I asked: to what degree should financing impact the price of an asset? Should I be willing to pay more for a share of Amazon.com because my broker offers me a generous margin account?

The answer is: to the degree that the price of the asset is determined by financing, financing can effect it a great deal. As we are seeing, the value of a 30 year debt instrument depends monumentally on whether it's being financed by rolling over short term debt, or whether it acts as a very long CD. Similarly, we saw how mortgage financing drove up the price of housing, even us underlying rents barely moved. George Soros, of all people, makes this point in an interview with Bill Moyers:
And that actually was based on a false idea. This namely, the markets self-correcting because the market moods have a way of affecting the fundamentals the markets are supposed to reflect...

Banks give you credit based on the value of the houses. But they don't seem to somehow understand that the value of the houses can be affected by the amount of credit they are willing to give. Now, we've developed these fabulous new ways of securitizing mortgages, which has made credit much more amply available.
Also a while ago, I wondered how the Treasury would act, as I understood the people who made up the Fed (academic economists) but did not understand the Treasury. Now I know -- it's ex-bankers, so you should expect them to do what they can to save banks. This explains why the original Paulson Plan was such a stinker, and the shift to Plan B: (partially) nationalizing banks etc. Zingales his a Plan B here:
Congress should pass a law that makes a re-contracting option available to all homeowners living in a zip code where house prices dropped by more than 20% since the time they bought their property. Why? Because there is no reason to give a break to inhabitants of Charlotte, North Carolina, where house prices have risen 4% in the last two years.

How do we implement this? Thanks to two brilliant economists, Chip Case and Robert Shiller, we have reliable measures of house price changes at the zip code level. Thus, by using this real estate index, the re-contracting option will reduce the face value of the mortgage (and the corresponding interest payments) by the same percentage by which house prices have declined since the homeowner bought (or refinanced) his property. Exactly like in my hypothetical example above.

In exchange, however, the mortgage holder will receive some of the equity value of the house at the time it is sold. Until then, the homeowners will behave as if they own 100% of it. It is only at the time of sale that 50% of the difference between the selling price and the new value of the mortgage will be paid back to the mortgage holder. It seems a strange contract, but Stanford University successfully implemented a similar arrangement for its faculty: the university financed part of the house purchase in exchange for a fraction of the appreciation value at the time of exit.
I didn't think much of Zingales' Plan A and have mixed feelings about his Plan B. The key problem is that it tries to prop up house prices, which are still too high. As we learned in the Great Depression, keeping a market from finding its clearing price is the best way to halt economic activity, which extends and deepens recessions. The Stanford University plan was put in to protect the University in case prices declined -- they wanted the owners to have some skin in the game, which a traditional debt subsidy did not give them. One of the broader issues in the economy is that the American consumer is finally tapped out, has stopped taking on debt, and is working to rebuild the household balance sheet. Keeping the price of housing inflated at current unaffordable levels will be as beneficial in this environment as adding a $10 tax to every gallon of gasoline.

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