Are Home Prices Low – or Just Right?

Today the Case Shiller index is again released.  Woe is us say the pundits.  But are we again making the mistake of comparing to the wrong base?  Did any of the appreciation of the last 10 years make any sense?  Is there any reasonable expectation that homes will be going back to their values of 2007?

 

Looking at CPI inflation since home prices took off, we see that inflation has averaged about 2.5%.  And with 2.5% inflation in home prices since 2000, the index should be at 135.  Which is just about where it is. 

So maybe home prices are just right now.  Maybe they make sense for the first time in 10 years.  Maybe we just need to recalibrate our expectations. 

The same sort of analysis can be done with equities.  Much press was made off the fact that at some point in the last two years, equity markets stood at the exact same level as 10 years ago, or even slightly lower.  However, ten years earlier, equities were near the peak of the tech stock bubble.  So making any long term conclusions about the viability of equity investing based upon the prices at the top of a bubble is just wrong headed. 

Both houses and stocks are bad buys at the peak of a bubble.  Neither should be expected to beat inflation by 10% per year.   Long term returns should never be based upon bubble peaks but it may be the case that bubble troughs are simply bringing prices back to sensible levels. 

And since this is a blog about risk – it is necessary to point out that expectations for returns that were formed during bubble periods are very risky when the party is over.  

Wrong decisions come from unrealistic expectations.

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Risk Evaluation Standard

The US Actuarial Standards Board (ASB) recently approved proposed ASOP Risk Evaluation in Enterprise Risk Management as an exposure draft.

In March 2011, discussion drafts on the topics of risk evaluation and risk treatment were issued. The ERM Task Force of the ASB reviewed the comments received and based on those comments, began work on the development of exposure drafts in those areas.

The proposed ASOP on risk evaluation provides guidance to actuaries when performing professional services with respect to risk evaluation systems, including designing, implementing, using, and reviewing those systems. The comment deadline for the exposure draft is June 30, 2012. An exposure draft on risk treatment is scheduled to be reviewed in summer 2012.

ASB Approves ERM Risk Evaluation Exposure Draft – Risk Evaluation in Enterprise Risk Management.  Comment deadline: June 30, 2012

Old Risk Management Programs – 10 ERM Questions from Investors – The Answer Key (7)

Riskviews was once asked by an insurance sector equity analyst for 10 questions that they could ask company CEOs and CFOs about ERM. Riskviews gave them 10 but they were trick questions. Each one would take an hour to answer properly. Not really what the analyst wanted. Here they are:

1. What is the firm’s risk profile?
2. How much time does the board spend discussing risk with management each quarter?
3. Who is responsible for risk management for the risk that has shown the largest percentage rise over the past year?
4. What outside the box risks are of concern to management?
5. What is driving the results that you are getting in the area with the highest risk adjusted returns?
6. Describe a recent action taken to trim a risk position?
7. How does management know that old risk management programs are still being followed?
8. What were the largest positions held by company in excess of the risk limits in the last year?
9. Where have your risk experts disagreed with your risk models in the past year?
10. What are the areas where you see the firm being able to achieve better risk adjusted returns over the near term and long term?

They never come back and asked for the answer key. Here it is:

Every company has legacy risk management programs.  Some are being dutifully followed, some have been abandoned and some are actually still alive and well.  The best answer to this question would be that the company has a process for periodically assessing all of its ERM programs.  That there is an aging metric for risk treatment processes and whenever a risk treatment process has gone three years without any changes or updates, that triggers a review.  In that review, the risk staff assess whether the risk treatment is still needed, whether it is still effective and whether it can be updated to take advantage of new developments.

One particular concern is whether changes elsewhere in the company have created a need for major increases or decreases in the tolerance for the risk being treated.  It is quite possible that changes elsewhere in the risk profile of the firm means that there now may be natural offsets to the old risk and risk treatment can be reduced.  It is also possible that the risk treatment program was put in place assuming that the risk would grow to a size that would make it material to the risk profile of the firm.  If that growth has not materialized, or if growth elsewhere in the firm has changes the scale considerations, then the materiality of the risk and the resulting need for the risk treatment program needs to be reassessed.

Of course, it also could be true that the level of risk treatment activities that were put in place in the past may be found to be inadequate and need to be increased.  This could be because the understanding of the risk has changed and the risk treatment is less effective than initially thought.  Or it may be that the risk environment has heightened and the risk per unit of activity is currently higher than assumed in determining the approach to risk treatment.

The cost of the risk treatment program should also be assessed.  There may now be different alternatives for achieving the same effectiveness of risk treatment for a lower cost that were not available previously.

This is important because everyone tends to forget old risks.  They just assume that since they have not been mentioned for some time that they have gone away.  But in many cases, old risks of insurers tend to linger.  And if the risk treatment programs that are supposed to be controlling those risks are being handled in an autopilot sort of mode, those risks might erupt into a totally unexpected problem if there is any stress.