Value Judgments

House prices can be fickle but debt is loyal to the end. 


Listener: 22 September, 2007. 


Keywords: Business & Finance; Macroeconomics & Money; 


What is the value of your house? 


You might quote the “rateable value” given by Quotable Value for local authority tax (rates) purposes. Or you could go to a land valuer, who will use a similar procedure to estimate the amount that would be paid for the home if it were sold on the open market. 


Actually you do not get a “value”, but a market price. We’ve all heard the joke about economists knowing the price of everything and the value of nothing. But at least they know the difference. 


It explains why the real value of your house, with all its conveniences, memories and comforts, may not change much, whereas the price can rise as people bid more for housing. 


Typically they don’t pay that price themselves. Instead, they chip in some of their own money and a financial institution provides the rest by way of a loan. So lenders too are involved in setting the price. When they’re flush with funds, as they have been recently, they are willing to lend more, and, as we’ve seen recently, house prices rise. 


Economists have long struggled with the conundrum of the meaning of price. We have a theory, which I shall spare you, but sometimes it seems circular. Why did the value of your house increase from $400,000 to $600,000? Because people were willing to pay more for it. Why were they willing to pay more? Because the price of housing went up. 


The point of the last few paragraphs is that there is no absolute meaning to the price (or market value) of your house. On the other hand, there is an absolute dollar meaning to the debt secured on it. That $300,000 mortgage means that you have promised to pay off the debt according to an agreed plan. If you don’t, the lender is entitled to sell your house, pay off the debt (and associated expenses) and give you anything left over. That is the agreement you made when you accepted the mortgage. 


But if the debt is absolute and the price relative, could not the price of the house fall below the mortgage? That can happen, and not just for housing. In the financial system there are myriads of deals where a money debt is secured on an asset whose price is not as absolute. They too depend on asset valuers, including credit rating agencies, who are not always as reliable as house valuers. Sometimes they get their prices dramatically wrong, or market conditions change. 


So sometimes the value of the debt ends up exceeding the price. Not very often – well, not usually. But sometimes, and now seems to be one of those times, it happens. 


The most obvious local cases are the ones where some finance companies have found that the market value of the assets in which they have invested is less than the debts they have secured on them. In such cases the depositors who placed money in these institutions have lost all or part of their investment. 


Nobody need have stolen the missing money. It typically disappeared in a manner not very different from the way in which the price of your house went up. Except that, this time, the price went down. 


The possibility of the debt exceeding the market price does not apply just to housing, although the US (sub-prime) housing market is currently the main worry. As I said, there are myriads of transactions in which an asset’s “value” based on the market’s willingness to pay is balanced against a debt with an absolute monetary value. Usually there is a margin between the two, but because market prices fluctuate, the margin can be squeezed or even go negative. 


At which point things get uncomfortable for the investor, and, if it happens widely enough, for the entire financial system. As I fear this column may one day have to report.