Business Law Prof Blog

Is there a housing bubble?

The debate over whether there is a housing bubble in the United States has taken up a significant amount of print lately. The debate involves three central questions: (1) is there, in fact, a housing bubble; (2) is the bubble national in scope or regional, and; (3) if there is a bubble and it bursts, will the fallout be as great as was the case after the Nasdaq bubble burst? For some perspective on these questions, here are a few recent articles:

1) The Economist cover story for the week of June 16 explored the issue of whether or not there is a global housing bubble (see article here if you have an online subscription). By comparison, housing prices over the period between 1997 and 2005 have increased by: 73% in the U.S.; 47% in Canada; 87% in France; 154% in Britain, and 192% in Ireland (while falling by .2% and 28% in Japan and Germany, respectively). According to the Economist, the price/rent ratio in the U.S. is 35% of its average level over the period between 1975 and 2000. One study found that 23% of all homes purchased in the U.S. in 2004 were purchased for investment purposes. Finally, interest-only loans have gone from 8% of all mortgages in California in 2002 to 60% in 2005. The article discounts the arguments that demand far exceeds supply and that housing prices have never fallen in the United States since the Great Depression and even casts doubt on the argument that real estate has posted significant real annual returns over the last century. Finally, the article points out that two-fifths of all private sector jobs created since 2001 have been in construction, real estate and mortgage brokering.

2) The IMF reports that at least 15 states are vulnerable to a housing market correction. At least one Merrill Lynch analyst estimates that a slowdown in the housing market could reduce GDP growth by as much as 1%. (see article from CNN/Money here).

3) Some private equity funds are creating pools of capital to buy up depressed assets after real estate prices do fall, calling such a fall a "self fullfilling prophecy." (See WSJ "After the Fall," 6/29, B4 or here).

4) On the other hand, in a recent commentary in the Wall Street Journal (6/22, A10, or here) Lionel Tiger argues that housing prices are not subject to bubbles because people have an emotional attachment to their homes that they do not have to other assets, implying a hedonic pricing structure for real estate that defies rational expectations models of economic behaviour. And Howard Gold of Barron's argues that even if there is a bubble, it is regional and unlikely to reverberate across the economy (Online exclusve dated 6/23, available here).

CNOOC and CFUIS Review

CNOOC, the China controlled company attempting to buy Unocal has great press.  The New York Times ran a story favorable to the bid.  It makes two points:  First we let Venezuela buy Citgo (so why not?) and second Unocal has no refineries in the United States and limited production and reserves in the United States (so why worry?).  On the first point, Venezuela is not China.  China threatens to take the resources off the market whatever the price, Venezuela is a oil exporter not a dominant consumer.  Second,  refineries are important but they must have something to refine;  China, as an owner of Unocal, can choose to remove all Unocal's production from United States markets.  Finally, no American company can purchase control of any Chinese oil company.  We can engage in joint ventures but the Chinese owners and authorities alway retain effective control.

    Buy some top notch American legal talent and some top notch American investment banks and China gets some very positive press.

Justice Souter's House Could Go in Eminent Domain Proceeding

   The Kilo case lets local governments trade up for tax revenue, taking low tax revenue properties and turing them over to developers whose projects will pay higher taxes.  A local company has petitioned to condemn Justice Souter's home, promising to replace it with a hotel.  The press releases are below.

Slashdot story:
http://science.slashdot.org/article.pl?sid=05/06/30/197250&tid=167&tid=160&tid=123&tid=103

Slashdot comment:
http://science.slashdot.org/comments.pl?sid=154472&cid=12956003

Press release: http://www.freenation.tv/hotellostliberty2.html

New Public Offering Rules: Relaxing the "Quiet Period"

    Chairman Donaldson's second to last day on the job produced a contentious meeting on the mutual fund rules.  They have been discussed in earlier posts.  The new Chairman may revisit this matter. 

     In any event, the SEC at the same meeting passed the new public offering rules (the vote was unanimous).  The public offering rules will stick.  The rules marginally are positive.  Companies can more easily communicate will investors about securities offerings before registration statements become effective, indeed, in some case, before they are even filed.  Companies can use electronic "raodshows" in the waiting period and can post prospectuses online.  The rules are complex, varying by company type and history.  The new public offering rules also allow established companies to act with more speed in bringing their new offerings to market.  These are all good changes. 

     The sad side of the new rules is that they are not nearly enough.  The Internet should radically change our system for issuing stock, which originated in a document-through-the-mail time.  The rules stayed the same through the development of faxes, through the development of e-mail, and through the development of the Internet. 

    We need a public offering system designed for the Internet, not modified to make a slight accomodation for the Internet.  The SEC spent huge amounts of time to get these incremental changes in place when much larger changes are in order. 

Reverse Mergers Into Shells Become ... Legitimate?

A well-hidden but interesting article in today's Wall Street Journal discusses the increased use of reverse mergers of privately held companies into publicly held shell companies by firms that are legitimately seeking access to the capital markets without the cost and delay of a proper IPO pursuant to the 1934 Act. (see article here if you have an online subscription; otherwise it is on page C3). This trend, like so many in the markets today, has an interesting hedge-fund/private equity twist with fund managers using the reverse merger process to get into and out of an investment quickly.

The SEC and Congress

    Those who follow the SEC have been stunned with Chairman Donaldson's high handed exit, pushing through in emergency fashion a package of mutual fund rules after the D.C. Circuit remanded the rules for more careful consideration.  This is carefull??  Donaldson had not vision;  he lurched from crisis to crisis with to much reliance on the SEC staff.  The staff (well-meaning but often very idealistic and young) should not control SEC decisions.

     Congress, in Sarganes-Oxley, delegated a great deal of new power to the SEC and Congress must stay involved, making sure that the SEC does not overreach.  The new Section 404 rules are a case in point.  The rules are a mess and now the SEC is getting defensive;  Congress needs to keep its hand in, through hearings and letters, to fix this regulatory train wreck.  We cannot assume the SEC will do it on its own.

Scrushy's Acquittal

     The Justice Department yesterday lost one of its strongest cases of financial fraud.  The jury, after a 21 day deliberation, acquitted former Health South CEO Richard Scrushy on all counts, despite the testimony of five (!!) former CFOs that he had lead an elaborate and lengthy scheme of accounting lies and distortions.  A stunned national press is interviewing jury members whose offhanded comments are contributing to the second-guessing of how the prosecutors lost the case.  The jurors' mild comments on race and religion are feeding a press frenzy and the talk shows are running them hard. (Scrushy, on his indictment, joined an African-American church, gave sermons at others, and had African-American pastors and members show up consistently to sit behind him at trial.)

     The better analysis is an older one (see Oesterle, Ohio St. J. Crim Law 2002).  Juries in financial fraud cases have trouble with the sophistication of the evidence, get bored, and look for tangible bits (the "smoking gun").  They are not content in "swearing contests" to make normal inferences against the defendant -- they do not have a business context to make the inferences.  Sophisticated business people would say, given the context and their understanding of how things normally work, the inferences were solid;  regular folks are less confident of their ability to make such an inference at the beyond a reasonable doubt standard.  Prosecutors have to be sensitive to the problem from day one, in their first words to the jury.

    Sarbanes-Oxley was supposed to help by providing new criminal offenses that were easier to prove.  In particular, SOX asks CEOs to certify the firm's financials and makes him criminally liable if the certification is false.  Like some many thins in SOX, the provision did nothing.  Defenders of SOX have been quick to claim that the acquittal does not affect SOX.  Of course it does.  The new criminal provisions have the same difficulty as the old ones;  the prosecution must prove criminal intent in financial fraud cases.  The schemes are elaborate and tricky and usually rest on inferences from testimony and financial data.

    Scrushy also showed us a very clever defense, the scandal was clever and his defense was clever.  It is very hard to convict smart, wealthy CEOs whose intelligence does not desert them at trial.   

The Supreme Court Term: Business Cases

     The Supreme Court ended its term with two intellectual property decisions, MGM Studios v Grokster and National Cable v Brand X Internet.  In the former case, the Supreme Court ruled unanimously that file-sharing companies may be liable for copyright infringement when their products encourage customers to illegally download songs and movies.  In the later case, the Supreme Court ruled 6-3 that the FCC had the prerogative to not require cable-TV companies to share their lines with rivals (unlike local phone companies).  Stock traders are handicapping the winners and losers.

    The Grokster case involves one of the law's toughest areas, secondary liability.  When is a bar tender liable for selling drinks to a known drunk driver, a gun shop owner liable for selling a gun to a known distressed and angry husband, a car owner liable for lending a car to a known reckless driver, a lawyer liable for giving advice on tax shelters?

     The Brand X decision is one of deferring agency authority and highlights the importance of agency chairs.  These appointments are no longer mere political favors; they mean something.  The Supreme Court said, in essence, that the FCC's distinction between phone and cable lines may not make any sense but it is the FCC's call.

    The stock trader handicapping also provides a window into the effects of the Supreme Court's earlier Kilo v City of New London decision.  Jim Kramer on Mad Money said buy the real estate developers' stocks.  Real estate companies, he said, can now get land at below market prices from poor people (I am not making this up) and this will be good for their bottom line.  Defending his realism he says, make money on the stock and then donate it to whatever good cause you want -- like the Socialist Party.  His honest projections reveal how bad this decision is.   

Donaldson: Consistent to the End

     Departing Securities and Exchange Commission Chairman William Donaldson has scheduled a vote on his controversial mutual fund rules package for his final week in office (indeed, one day  before he leaves).  The rules require mutual funds to have an independent chairman and to increase to at least 75% the number of independent directors.  A federal appeals court had rejected the rules, holding that the SEC had not adequately considered the costs of the new rule or whether less costly alternative rules were available.  The rules package has passed 3 to 2, with both Republican Commissioners voting in dissent.  Donaldson sided with the two Democratic Commissioners to favor.

    Donaldson's response?  To tinker with the staff report on the new rules and identify more accurately the technical out-of-pocket costs of the rule (mutual funds may have to fire directors and hire new ones and so on).  What is missing?  All the important analysis:  First, a proper analysis of the benefits -- Will the changes led to better managed funds?  (Why was a board of 50% independent directors insufficient?)  We are given only pie in the sky assumptions and speculation here.  And second, a proper analysis of the potential hidden costs -- Will the changes hinder the management or retard the flexibility in evolution of the management structure of mutual fund companies?  There is no analysis here.  Intuition is no substitute for analysis. 

   His reformer's zeal has turned to desperation. 

Cnooc and Unocal: The Wall Street Journal Editorial

   On the Opinion page of the Wall Street Journal for Friday, June 24, 2005, the Editors of the Wall Street Journal encouraged the President to approve the Cnooc acquisition of Unocal.  "Open Capital Markets Work Both Ways"  Try buying a Chinese oil company. 

CNOOC's Bid for Unocal: CFIUS Approval

    Hong Kong based CNOOC, Ltd, China's largest offshore oil producer made a bid last week for Unocal Corp. CNOOC is 71 percent owned by state controlled China National Offshore Oil Corporation.  The acquisition falls under of the interagency Committee on Foreign Investment in the United States (CFIUS).  CFIUS, a committee that has worked in relative obscurity (it is the last chapter, never covered, in my Mergers & Acquisition casebook), will now be in the bright lights.  The Unocal acquisition appears to be the first of many attempts by China and Chinese companies to buy American companies.

    CFIUS has its origins in the Exon-Florio Amendment to the Omnibus Trade and Competitiveness Act of 1988.  A Japanese company, Fujitsu had attempted a takeover of Fairchild Semiconductor Corporation in 1987 and the Exon-Florio Amendment was Congress's response.  The President now has the authority to block foreign acquisitions of American companies if the acquisitions "threaten to impair the national security."  The President delegated authority under the Act to CFIUS to investigate and advise the President on whether foreign acquisitions threaten national security.  CFIUS is chaired by the Secretary of the Treasury and has eleven members -- representatives of the Departments of Treasury, State, Defense, Commerce, and Justice, and the Office of the Trade Representation, the Office of Management and Budget, the Chair of the Council of Economic Advisors, an Assistant to the President for Economic Policy and the Director of the Office of Science and Technology Policy.  National security is not defined but Congress included a list of "factors"  that include a focus on national defense requirements.  Oil would clearly meet one of the factors;  oil production is necessary for the "capacity of domestic industries to meet national defense requirements."

    The Unocal acquisition will be a test case for CFUIS and our response to China's efforts to buy major American companies. I suspect that CFUIS will recommend that the President block the acquisition and that the President will agree to do so.  In so doing, of course, the President will make Chinese officials very unhappy.  China, however, does not let Americans buy controlling stakes in Chinese companies and in international affairs, reciprocity is the name of the game.