Principles of Circular Valuation

Asset Valuation 101 (or why just about everything we own is over valued.)

In an earlier post, I suggested that the US was perilously close to “technical” bankruptcy.  By this I meant, that we have approached and, possibly, surpassed the “point of no return” in regards to servicing our debt obligations. 

Now, I am not a bankruptcy expert, however, to my thinking, this critical threshold has been crossed when either of two following conditions is met:

1.  It becomes necessary to borrow the funds necessary to meet the debt service obligations, or

2.  Aggregate liabilities are greater than the underlying value of the assets on the balance sheet.

Arguably, both of these conditions have already been met, but today’s focus is primarily on the second of these issues, namely just how our collective balance sheet is looking at the moment. 

As before, a very good reference article for this discussion has been presented by John Rutledge, which concludes that total US assets might reasonably be valued in the range of $188 trillion, being comprised of roughly $142 trillion in financial assets (75%) and the remainder of $46 trillion in “tangible” assets.  In that earlier post, I noted that current liabilities might be valued in the range of $164 trillion….which, at 87% of Rutledge’s $188 trillion asset value estimate, is a bit too close for comfort.

As I’m sure you recall, the spiraling collapse of the housing market was (or is being) fueled, in large part, by the rising number of home owners that have found themselve in a position of “negative equity”, meaning that they owe mortgage debt that is greater than the value of the underlying asset.   As we have all discovered, a great many of these home owners have abandonded their debt obligations (and their homes), which has had a cascading effect on the value of banks assets (the loans themselves) and of real estate assets generally. 

What should be reasonably clear in this single example is the degree to which all of these “line items” are  interconnected.  The linkage between financial and tangible assets, for instance, is so interwoven that it is virtually impossible to accurately isolate and measure a single layer of “cause and effect” in what is, effectively a “feedback loop” of rather significant proportions. 

Rutledge states, that “almost any analysis of the economy that focuses on spending or saving or budget deficits alone, to the exclusion of the balance sheet, is almost certain to be wrong because balance sheet changes are so big.”  He goes on to note evidence that household assets declined in value by some $13 trillion between Q3-07 and Q4-08, ostensibly a 16% decline over five quarters.  And, though he’s mostly pointing to the relative insignificance of even large budgetary measures, he’s also highlighting the volatility and magnitude of shifts associated with the balance sheet itself. 

What hasn’t yet risen to much notice, however, is the effect that treasury yields have on how we value assets, which, as it happens, I consider to be the “mother” of all feedback loops.  Notably, many economists, who focus solely on the potential inflationary effects of “loose monetary” policy are usually looking at how the expansion of credit and/or the supply of money in the economy will facilitate spending.  What they tend to miss, however, is the manner in which treasury rates are indirectly utilized in the valuation of assets generally.

In effect, the artificial suppression of interest rates in the market has an indirect, but virtually immediate, “inflationary” effect on asset valuation.  This is because treasury yields are most frequently used to establish the “rock-bottom” or “safe rate” for all other yield rates in the market.  Thus, the  market’s valuation for virtually all other financial instruments or income producing assets, whether they are bonds, mortgages, corporate stock, or real property, are calibrated according their investment risk as compared to the “full faith and credit of the United States of America”.  

As treasuries are typically presumed to be the safest investment possible, the pricing of all market risk tends function in concert with treasury yield rates.  Thus, riskier junk bonds, stocks, or shopping malls, will be priced on the basis of yield expectations that are adjusted higher than treasuries by a premium appropriate to the market’s perception of the relative risk of these investments.

What should be obvious, but is nonetheless rarely discussed, is that artificially low treasury rates ripple out through the market to produce generally lower yield expectations for virtually every income producing asset under the sun.  If treasuries are 200 basis points lower than they might be without intervention, then most other assets are likely to exhibit a similar degree of distorted pricing.

In the stock market, for instance, the common Price/Earnings (or P/E) ratio is essentially an implied yield rate.  If the long-term average P/E for the S&P 500 is in the range of 15x, this implies a yield capitalization rate of roughly 6.7%.  Since 1953, the average 10-year treasury rate has been in the range of approximately 5.3%, which might suggest a “risk premium of roughly 140 basis point for the S&P. 

Now, here’s the deal:  Everybody knows that treasury rates have been artificially suppressed for a long, long time.  Just how much remains open for debate.  However, mere reversion to the mean from a current 10-year yield of 3.6% or so would constitute a whopping 47% upward adjustment in this one measure of the market’s rock-bottom “safe” yield expectations. 

Extended to the whole of the market, such an adjustment in of itself would reduce the value of all income producing assets by a significant degree .  For example, a financial asset that pays us $1 at a yield of 3.6% would have a value of $27.78.  If we require a 5.3% yield, however, we could only pay $18.87 for the same asset.  This adjustment in yield expectations, then, directly results in a 32% decline in the value of the asset. 

This “reversion to the mean” perspective, by the way, does not reflect the higher risk premiums typically required to offset longer periods where rates have been well below the mean.  In other words, the “mean” reflects periods where rates have been both higher and lower…..reversion to the mean always requires a corresponding adjustment to the other side of the line.

What should be obvious here is a recognition that current market yields continue to be distorted by artificially low interest rates.  These rates are unsustainably low and will, at some point correct.  The unavoidable conclusion that the Fed is now monetizing some – if not the majority – of our debt in order to suppress rates should remind us just how much force is being utilized to keep them low and, not coincidentally, how much risk is associated with their rising.

Regardless, even without going “off the deep end” of the risk equation, mere reversion to the mean would imply that, in all likelihood, the underlying value of all our collective assets is still 30+% lower than we think it is.  If so, Rutledge’s $188 trillion, could just as easily be $132 trillion, or less, which to my way of thinking puts us well past the “bankruptcy” threshold.


5 responses to “Principles of Circular Valuation

  1. Pingback: We Owe it to Ourselves « A Reasonable Life

  2. Pingback: “The Enemy is Us”: Principles of Circular Valuation, Part 3 « A Reasonable Life

  3. Pingback: From One Sinking Ship to Another: Principles of Circular Valuation, Part 2 « A Reasonable Life

  4. HDW:

    Yes, well, we’ll get around to your purported meliorism shortly.

    In the meantime, the “technical” part of the phrase is intended to reflect the aggregate nature of the data presented and, of course, the fact that that no one from the Federal or State government system has (or can) actually file for bankruptcy.

    For them, I guess we’ll just have to wait and see about their default option. And, as there are no “official” court proceedings for bankrupt sovereigns, perhaps the only court that will matter for them, in the long run, will be the “court of the market” to rule on the issue. In the case of states like California, that court has already ruled.

    The calculations presented, however, include the whole of the economy – public and private sectors – and, as might have guessed:

    – YOY bankruptcy filings through June 09 were up 35% in the Federal courts.

    – According to Realtytrac, home foreclosures in 2009 were up 21% over 2008 and 119% over 2007.

    – The SBA reports that small business loan defaults, as low as 2.4% in 2004, had risen to 8.4% in 2007 and 11.9% in 2008.

    You see, the “technical” part of the also denotes the aggregate nature of the data. Clearly, some rising portion of the economy is “actually” bankrupt and the implication is that we might expect more.

    Finally, in most bankruptcy proceedings, the balance sheet is the “last recourse” to repayment. When there is inadequate income, assets are typically sold to satisfy creditors. The “negative net worth” metric is still a useful reference both to creditor risk and borrower motivation. As we’ve seen, negative equity situations tend to produce more defaults.

    Welcome back H Dex.


  5. Being “technically” bankrupt is like being “technically” pregnant. Bankruptcy occurs when a legal entity lacks the ability to pay it’s bills as they come due.

    Condition 2 is simply a negative net worth. This is not bankruptcy. You can actually have a positive net worth and be bankrupt if your assets are not liquid enough to pay the bills “as they come due.”

    Everything will be fine.

    Go USA!


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