Differentiate between your home, asset

By DAVID MOON, Moon Capital Management, LLC
January 4, 2009


You've likely read (or chosen not to read) many different lists of the best or worst or most surprising something from 2008.

My list is shorter. It contains only one item: the single most important and far-reaching business revelation from 2008.

Any guesses?

Your house is not an asset; at least not in the traditional investment sense.

I know that's not what your real estate agent said, but listen to your grandfather about this one. A house is a place to live, not part of your retirement plan.

If the Wizards of Wall Street had listened to their grandfathers, we wouldn't have been on the edge of financial meltdown last August.

It all started with the creation of a seemingly benign little investment, the mortgage backed bond.

A bond is simply an IOU that is backed by something: maybe the assets and revenues of a company, FDIC insurance or the taxing power of a government.

The asset backing a mortgage backed bond is (surprise!) a mortgage. So far, so good.

A mortgage is a pretty simple asset. It's just a stream of monthly cash flows that a borrower promises to pay. But other than the word and honesty of a mortgagor, what really backs the mortgage?

A house.

Therein lies the problem.

An owner-occupied house has no intrinsic value. Other than replacement cost or the incredibly esoteric (and subjective) rental equivalency value, there is no way to determine the true value of a house. It has no earnings, pays no dividends and has no alternate use value. In a liquidation, very few houses can be converted into milk factories or airline call centers.

Yet Wall Street used residential houses as the ultimate backing for trillions of dollars in loans that financed businesses in every imaginable industry.

A house consists of some land, raw materials and labor. Anything that a person pays above these costs is simply a preference premium.

In accounting terms, this is called an intangible asset.

In grandfather terms, we call this hocus-pocus.

Intangible assets can be created out of thin air by successively higher sales prices and the issuance of more debt. This system works as long as everyone agrees that this 'preference premium' will always both exist and increase.

Absent its use value, a house is a lot like an ounce of gold. It doesn't do anything. It requires annual storage/insurance expenditures.

Unlike gold, however, houses don't have to be discovered. We can create as many houses as we want, functionally limited only by the availability of raw materials.

With limited functional value and the possibility of limitless supply, exponential price increases in the aggregate housing market are unsustainable.

Those expected price increases are also a terrible basis for supporting trillions of dollars of business capital.

We may not yet realize it, but a permanent change in the mortgage securitization market will be the most far reaching business event of 2008.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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