Thursday, March 26, 2015

Inflation and the end(?) of the Zero Lower Bound

Inflation came in low again.  It will be interesting to see how this plays out over the next several months.  In 2 years, there has been 1 single month with core inflation above 0.2% and no months with Core minus Shelter inflation above 0.2%.

In the past 8 months, core CPI has risen by about 1.0% and Core minus Shelter has risen by about 0.3%.  Much of the Year-Over-Year inflation came more than 8 months ago.  As we move to June, YOY core inflation and core minus shelter inflation will have strong headwinds to overcome as months 9 through 12 time out of the inflation measure.  YOY Core inflation is very likely to still be well under 2% and core minus shelter well under 1%.

Shelter inflation has stabilized. Possibly if we are seeing the slightest whiff of a continuation in a housing recovery, this might slowly begin to decline.  That will either pull core inflation down even more, or credit expansion in housing might lead to inflation in non-shelter core categories.

In any case, it seems as though the Fed will have to conjure up some pretty strong forward expectations in order to justify a rate hike in the coming summer.  I'm just watching for now.  I suspect that there will be a window where expected short term rate movements are at their lowest and where nascent recovery in mortgage markets haven't triggered bullish expectations yet.  Maybe that point is now.  Maybe it will be in June.  At some point, there will be a profit in short forward Eurodollar contracts.  I might very well sit on the sidelines too long and miss it.  This is a tricky one.

Wednesday, March 25, 2015

Housing Tax Policy, A Series: Part 23 - Rent Inflation and Home Prices

Yesterday, I touched on the relationship between rent inflation and home price inflation.  Owner equivalent rent inflation has been above core inflation for 30 years and rent inflation in general has been higher than core inflation for 15 years.  I have made the point before that this is a very odd finding if we just saw a period of over building.  It's also an odd finding if the steep rise in mortgage debt was a product of median household desperation and stagnation.

Here is a graph of shelter inflation, core inflation, and the homeownership rate.  I would say that the general rate of inflation is a reflection of monetary policy.  The relative rate of shelter inflation is a reflection of tax policy, other public policies, and market trends which increase or decrease relative demand for housing.  The relative level of shelter inflation was low, briefly, in 1976, 1983, and 2010.  But, generally friendly policies and financial developments led to increased demand for owner-occupied housing in the late 1960s, late 1970, mid 1980s, 1990s, and 2000s.  These periods usually correspond to rising homeownership rates.  The high shelter inflation since 2007 has corresponded with sharply dropping homeownership rates.  As I showed yesterday, shelter inflation before this period came from owner equivalent rent, but this recent period has seen a rise in tenant inflation.  Earlier shelter inflation came from a shift right in owner-occupier demand, but this inflation is coming from a shift left in supply.  The shift in supply comes from the credit market, so the recent rise in rent inflation has been associated with very low home prices.  There is demand for housing, but there is no source of funds for it to be expressed in the owner-occupier market.

In any case, the direct relationship between rent and price only gets us so far.  Even using the Price/Rent ratio, home prices have risen from the mid 1990s levels by 47% to 100%, depending on the measure we use, and are from 22% to 68% higher than the previous high points seen in the late 1980s.

But, I think there is a more subtle interaction between rent inflation and home prices that has to do with homes as a financial security.  If we think of home ownership simply as a perpetual bond, which takes as its coupon payments the net rent on a particular house (after maintenance, taxes, and depreciation), a house is similar to a TIPS bond.  But, the inflation adjustment on a TIPS bond is based on the CPI.  On a home, the inflation adjustment is based on the specific local real estate market.

I think the required return of both homes and TIPS bonds begins at a level that reflects arbitrage with other investment alternatives.  With TIPS, this is relatively straightforward.  We can begin with the interest rate on nominal bonds and subtract expected inflation.  We usually go the other direction.  Since there is a market price for both TIPS and nominal bonds, we can infer expected inflation from the difference.


The sharp difference in real rates from 1978-1986 stems from the
sharp changes in inflation expectations, and the lack of a good
way to measure the effects of this on different durations. 
I submit that home prices operate in much the same way.  We begin with the nominal interest rate on very long term bonds, and we subtract expected inflation.  But, instead of inflation coming from the CPI, inflation comes from the specific expectation of nominal rent levels at that specific location.  This means that in areas where rent is expected to rise - growing cities, gentrifying neighborhoods, etc. - we should expect to see price/rent ratios much higher than average, because these homes will have a larger inflation discount.  And since all homes, no matter where they are located, should tend to provide the same expected present value of cash flows, the additional inflation discount on homes with higher expected future rents should lead to higher prices relative to the current rent.

Over time, I find that returns on homes, in the aggregate, do tend toward that non-arbitrage return level, relative to bonds.  Because they are perpetuities, there is much less cyclical fluctuation in home returns.  Also, they tend to have a premium (from liquidity, duration, and other complications of ownership) of about 1.5% compared to cyclically adjusted real 10 year treasury rates.

Comparing the nominal yield of 30 year mortgages to the real, implied yield of home ownership, we can perform the same inflation inference that we do with TIPS.  And, this measure produces an inflation premium very similar to the premium we see in TIPS and a real rate of return similar to what we see in cyclically adjusted real bonds, confirming that non-arbitrage pricing is effective in the housing market. (The real return on homes probably is approx. 0.5% higher than the real 30 year mortgage rate, because of the higher duration of the home, so this causes the inflation premium implied by mortgages and home returns to be understated by about 0.5%.)

The housing market has not been in equilibrium since 2007 (in other words, homes provide excess profit compared to fixed income alternatives - see the graph above with the output gap), so the inflation premium cannot currently be estimated in the housing market.  Even though real interest rates were low in the late 1970s, I originally thought that the high inflation rates must have dampened effective demand for housing by making mortgages unaffordable, which would depress Price/Rent (increase real returns).  But, real returns on homes did fall below 3% during that time, and the implied inflation premium is about where we would expect it to be for that period.  As I have looked at the data, it has begun to look as if low real interest rates were still incentivizing households into homeownership.  The homeownership rate rose in the late 1970's, and shelter inflation was strong.  But, imputed rent was falling as a portion of GDI until the Volker recession in 1980.  It looks as though households were moving into owner-occupied homes, but prices remained at the approximate no-arbitrage levels.  Normally, households would increase their housing consumption when they buy a home, because of the tax advantages of owning.  In the late 1970s, high mortgage payments were the obstacle to those excess gains, so marginal households had to downsize to capture it.  We can see in this graph that the average home price moved up relative to the marginal home price.  This downward shift for marginal home buyers created a positive skew in the homebuyer market, causing this shift.  (This may be a sort of just-so story, but I think that the market would have readjusted back to a less skewed market.  But beginning with the mortgage deduction in 1986, high income households were incentivized to consume more housing.  So, as nominal mortgage rates declined, marginal owner households consumed more shelter, but higher income households also consumed more shelter because of the mortgage tax deduction.)


Implications for Case-Shiller Home Price Indexes

I'm getting off track here.  The point of this post is that localized home prices, in theory, should be related to the local expectations of rent inflation, which could come from local development, zoning limits, or other local sources of shelter demand or obstacles to shelter supply.  As I laid out in yesterday's post, rent inflation has been higher in the 10 cities included in the Case-Shiller 10 city index than it has been in the rest of the country.  So, this would naturally cause prices to rise in proportion.  But, what I am describing in this post is a more subtle effect.  Persistently higher localized rent inflation would also increase the equilibrium Price/Rent level.  And, this is what we see in the indexes.

From 1985 to 2013, core CPI inflation averaged 2.8%, national Owner Equivalent Rent for Primary Residences averaged 3.2%, and OE Rent for Primary Residences in the 8 cities that have CPI measures from the Case-Shiller 10 city index averaged 3.5%.

So, simply using the rent level, the YOY rent inflation, and a very long term mortgage interest rate, implied from 15 year and 30 year mortgage rates (which ranges from 0.3% to 0.9% higher than the 30 year mortgage rate, depending on the steepness of the yield curve), I have a simple model of expected home prices to compare to actual prices.  Here, I am using the Case-Shiller indexes, so I have simply calibrated the modeled prices to roughly match the Case-Shiller indexes in the 1993-1994 time period.

I use the rent levels specific to the index (national OE rent for the National Index and average OE rent for 8 of the 10 cities in the 10-City Index).  I am simply using the rent inflation rate for a given year as my inflation rate adjustment.  In order to minimize noise from single-year rent inflation fluctuations, I have limited home price increases to a maximum of 15% per year.  I am valuing the homes as perpetuities, so the formula is very simple:
(CPI Rent Level) / (Estimated very long term Nominal Mortgage Rate - YOY Rent Inflation) * Constant
Here is a graph of the modeled prices corresponding to the National Index and to the 10-City Index.

At current interest rates, modeled home prices would be much higher, but they are limited by the 15% maximum gain.  In order for the modeled prices to fall back to today's market prices, long term real rates would need to rise by about 2%, which is about where they were in the late 1990's and at the high point in 2006-2007.  Long term rates are less volatile than short term rates.  It would be unlikely for long term rates to rise that high unless the Fed Funds Rate rises above 4%.

A reasonable scenario where the Fed Funds Rate rises to 3-4% by, say, early 2017, with nominal 10 year treasuries at 4% and 30 year mortgages at 5.5%, with typical 2.5% implied expected inflation, would put mature recovery home prices a little bit above where they are now - may 10-15% higher - with real implied returns on home ownership of 3-3.5%.  But, if the natural level of interest rates at full recovery rate levels ends up lower than that, there might be more room for home prices to rise before they settle in to a more typical, inflation level rate of annual appreciation.

A couple of implications from this projection:
1) Fed Funds forward prices are currently less than 1.5% in early 2017.  I wonder if there is a good hedged position to be taken here by pairing a short Eurodollar or Fed Funds contract with some sort of position that has long exposure to home prices.

2) Since long term real interest rates have been low and volatile, and since the effect of low real long term interest rates on durable real assets becomes stronger at lower rates because of the convex relationship between rates and asset prices, I think it would be much safer in this context to target 2-4% inflation instead of 1-2% inflation we have seen since the turn of the century.  Even in the early 1990's, Price to Rent levels declined by around 20% over a number of years.  Since inflation was around 4-5% at the time, nominal home prices remained stable and we avoided a mortgage crisis.  Eventually, secular real rates will rise.  A slightly higher inflation rate will probably create more stability when they do.

Higher inflation might dampen home demand slightly because of the higher mortgage payments that are required in a higher inflation context.  But, the inflation premium itself may create more stability than any dampened demand does.  Because, as I have outlined, since mortgages are a nominal security and homes are a real security, the inflation premium portion of the mortgage interest expense is really a pre-arranged purchase of home equity by the owner, from the lender.  In effect, because of our current conventions in home buying, higher inflation forces home buyers to increase their real equity positions in their homes at a faster pace.

Tuesday, March 24, 2015

Housing Tax Policy, A Series: Part 22 - Different Measures of Price/Rent (updated)

Over the past 30 years, rent inflation has outpaced core inflation.  From 1986 to 2000, this largely was from owner equivalent rent inflation, and from 2007 to the present, this was from tenant inflation.

The period of high owner equivalent rent inflation coincides with tax advantages to home ownership that would have moved the demand for housing from owners higher, relative to renters.  The period of high tenant inflation coincides with the housing bust, which has led, generally, to a shortage of housing and to attrition of households out of ownership.  I hope this state of affairs changes.  I am not particularly concerned with the absolute level of home ownership, but simply that the market should reflect a stable level of access and demand, reflecting efficient prices and returns relative to other asset classes.  If that happens I would expect to see tenant rent inflation move back below the trend in OE rent inflation, unless homeowner tax benefits are reversed.

Clearly, all else equal, we would expect home prices to rise with rents.  Here I have the Owner Equivalent Rent on Primary Residence, from the Fred graph above, along with Core CPI.  In addition, the BLS maintains metropolitan-specific CPI indexes, and I was able to find OE Rent indexes for 8 of the 10 Case-Shiller cities that covered the period I am looking at.  In the analysis here, I use the simple average of the levels and the growth rates for those 8 cities.

The 8 city series rises more quickly than the national rent level.  This probably is due to a number of factors - inadequate housing stock because of rent control and zoning restrictions, the growing value of city real estate as development spreads, etc.

After the rise and fall of home values, in the boom, Price/Rent levels in 2012 fell to a level similar to 1987.

By this measure, the 10 city index rose by 68% from 1987 and doubled from the low in 1997 to 2006.

By the nationwide measure, the rise was 45% and 64%.

In the next graph, I show the Case-Shiller indexes, relative to rent, and I add the Price to Rent ratio given by using Household Real Estate from the Flow of Funds report and Imputed Rent from the BEA.  By this measure, home prices, relative to rent, only increased by 22% and 47%.  And, this measure reached a low point in 2011, even below the lows of the 1990s.

Over the long term, I would expect the Flow of Funds and BEA Imputed Rent numbers to be the most representative, because it represents two measures that are independently tracked each year in nominal dollars.  I don't think there is a rent measure that cleanly compares to the Case-Shiller price indexes.  Since the indexes track individual homes, they may catch changes in home values that reflect real values and not inflation.  So, the Case-Shiller Indexes may be causing us to overstate relative changes in home prices.  If the Federal Reserve and the BEA measures are accurate (and these are the measures that feed GDP numbers, etc.) then home prices today, adjusted for rent inflation, are back at the levels where they were at the low point in the mid-1990s.

I think rent has at least one other interesting effect on home prices, but this is enough for today.  I will save that for tomorrow's post.

UPDATE:

Since I can take the BEA data back to 1929, and Flow of Funds back to 1950 (and infer it back to 1929 by using the BEA data on homeowner capital consumption), I thought I would include that graph for historical perspective.

Friday, March 20, 2015

Housing Tax Policy, A Series: Part 21 - More about the Crisis Timeline

I laid out a timeline of the financial crisis in this post.  I followed up in this post.  But, I tend to throw a bunch of stuff at these graphs, so for clarity, I thought I'd revisit the timeline, simply showing home prices (inverted) and mortgage delinquencies, with max & mins roughly lined up, to get a sense of scale and time.

Here it is.  From early 2007 to the present, delinquencies have followed price with about a 6 to 12 month lag, even falling with the same lag and scale as prices have rebounded.


Source: Calculated Risk
We can see in the Calculated Risk graph of real home prices, that in 2 of the previous 3 dowturns, real home prices fell in the range of 10%.  There is this mythology about the 2000s housing boom that everyone suddenly got stupid and thought houses could only go up.  But, by the end of 2007, nominal house prices had dipped by about 10%, and delinquencies were at 3.1% - less than they had been in 1991.  When real home prices dipped, in 1982 and 1992, YOY currency growth bottomed out at about 6%, and the Fed started pushing the money supply back up.  In the 2000s, currency growth hadn't been as high as 6% since 2003, and by April 2008, was down to 0.5%.

So, during previous housing downturns, inflation was around 5%, so nominal home prices remained level.  Yet, in this downturn, the Fed wouldn't give us any inflation.  Core minus shelter inflation (estimated here by treating shelter inflation as 40% of core CPI and subtracting it) had not been persistently above 2% since 1997.  By the fall of 2007, it was down to 1.0%.

In the next graph, there are more general real estate delinquency measures that go back far enough to compare to the 1991-1992 episode.  They didn't reach the peaks of that period until the end of 2008 or 2009.

Yet, we describe this period as one where reckless lenders were bailed out by the Fed?  This narrative was already in place.  It would have been the Fed's job to create stability.  But, the country basically has the position (and here I can really say "we" - practically everyone seems to feel this way) that, "If the Fed does it's job, how will we ever learn?".  And, again, I truly mean "we".  Several people I know who firmly believe this bought homes in the 2004-2007 time frame.  These are smart people.  And, as I have tried to show in other posts, the prices they paid were reasonable, given their investment alternatives.

So, first, delinquencies didn't come any faster than they had come before.  And, second, home prices were orders of magnitude outside any previous experience before banks began to have widespread problems.

Bear Stearns had to extend credit to two subprime mortgage hedge funds in June 2007.  By that time, nominal home prices were down about 3% - about the worst of any housing corrections in previous decades.  They would fall more than 10% more in the following 6 months.  They would, by some measures, eventually fall by 40%.

In theory, there are systemic risks from lending with low downpayments.  If we had seen 10% delinquencies in 2007, after nominal home prices had bottomed out at 3% or even 10%, this episode might have lent evidence to that theory.

In theory, there are systemic risks from securitizing loans with low down payments and less documentation.  (Although, (1) typical FICO scores did not decline during this period, and (2) as the rough measure in this graph shows, banks were still holding plenty of real estate loans on their books.  The notion that banks were suddenly giving out mortgages without any standards and unloading them on the MBS market, in some sort of frenzy, is greatly overstated.)  If nominal home prices had bottomed out at 3% or even 10%, and some other funds had followed those Bear Stearns funds into trouble, this episode might have lent evidence to that theory.

But, this episode saw real home prices fall by 40%!  What this episode proved - the only thing this episode proved was that when home prices fall by 40%, bad things are going to happen.  This was beyond unprecedented.  Standard deviations can't even really describe the Fed's failure here.

Oh, so you think that the formulas for the CDO securities "devastated the global economy"?  Please, Mr. Hindsight 20/20, please show me where you, or anyone, was saying that these models needed to be able to take a 40% hit to real home prices.  Don't give me any nonsense about how these greedy speculators thought home prices could never go down.  That is not remotely a description of what happened.  Show me any skeptic who, before 2007, said models should be able to handle a 40% downturn.  How about 20%?

Source
Yet, even by the end of 2009, when that 40% drop in home prices had already come to pass, look at the impairment levels of these securities.  AAA tranches on Subprime MBS did remarkably well.  Even a decent amount of CDO's, which had the infamous Gaussian copula function and whose main weakness was a nation-wide correlation in defaults, were still hanging on without impairment.  After a nationwide collapse that was 10 times the magnitude of anything we had seen since the Great Depression?

The blame game here is absurd.  This Wikipedia article on the "Causes of the Great Recession" would be funny if it wasn't so sad.  Among dozens of causes discussed, monetary policy is barely mentioned, and then, only to blame it for being too accommodative (!) before the collapse. (Who knew that 6% NGDP growth was the path to hell?  Is the 20th century completely expunged from the economic history books?)    And one sentence about how increased interest rates might have contributed to lower home prices.  The 40% fall in home prices is simply treated as inevitable.  This is especially outrageous, considering that home prices are climbing back to the pre-recession levels, without any credit growth whatsoever.  People just refuse to believe that home prices could be efficient.  Our intuition regarding prices is useless, yet we insist on believing it.  Here we have a black swan the size of an elephant, and it's in the room.

Next is a graph from the Richmond Fed that breaks out delinquency rates for subprime and adjustable rate loans.  Even adjustable rate subprime loans didn't have a delinquency rate higher than delinquency rates in 2001 until 2Q 2007.  But, keep in mind, look at the home price graph again.  There was no housing slump in that cycle.  Delinquency rates booked at domestic banks, as shown in the graph above, topped out at 2.4% in that recession.  The Richmond Fed graph doesn't go back far enough to compare to the 1982 or 1992 housing dips, but clearly, none of these delinquency rates reached the levels we would see from those earlier corrections in home prices until the end of 2007.  The behavior of delinquencies doesn't appear to have been different than it had been in those cycles.



PS.  I was trying to find a paper I had seen that discussed the finding that FICO scores for mortgage borrowers didn't really fall below typical levels during the boom.  I didn't find the one I was looking for.  But, google has page after page of this kind of nonsense:
July 8, 2014—Mortgage bankers fear another real estate bubble, according to the latest quarterly survey of North American bank risk managers conducted for FICO (NYSE:FICO), a leading predictive analytics and decision management software company. In the survey, 56 percent of respondents directly involved in mortgage lending expressed concern that “an unsustainable real estate bubble is inflating.”
That is a survey of mortgage bankers, by FICO, in July 2014!  Here's a graph of the YOY growth rate of mortgages held by US households.  And bankers are reporting to FICO that we are in a mortgage lending bubble!  Can we, for the love of all that is holy, at this late date, please, please, I'm begging you, at least let something stop freaking declining before industry insiders start speculating about a bubble?

Thursday, March 19, 2015

The Problem with Corporate Social Responsibility

Milton Friedman famously argued:
There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.
This position is frequently derided.  However, I believe that if we deconstruct this a bit, we see that Friedman's position is the only truly cosmopolitan, liberal position.

The confusion comes from the fact that social responsibility is often confused with conspicuous social responsibility.  Our public postures and signals of identity and loyalty tend to capture an undue amount of our attention, because these are the activities that define us within our social communities and among antagonistic factions.  So, while the viewers of MSNBC and Fox News agree on 90% of how we live - things that may make modern Americans different than ancient hunter-gatherers or Middle Eastern nomads, or African peasants, or Japanese workers - the things we talk about are the 10% of things we disagree about.  And, we are impassioned about those things.  We get angry about the people that disagree with us.  For the most part, we don't even notice the 90%.  It takes real effort to notice it.

That 90% is what Friedman is talking about when he says "so long as it stays within the rules of the game".  That is all that we can expect of them.  In fact, they could do no more and no less.  The natural equilibrium of the relationships a firm will establish with its owners, its employees, and its customers will have to incorporate that 90%, or problems will tend to erupt.  The firm will have legal or public relations problems.

This 90% isn't a universal standard for local firms, because Americans do differ by the other 10%.  So, the equilibrium level of social responsibility is different for a food co-op in Berkeley than it is for a gun shop in Bismark.  But, it generally holds for national firms.

There are many examples of firms doing more than the equilibrium amount of social responsibility.  The owners of Chick-fil-A and Hobby Lobby surely thought that they were being especially socially responsible.  But, that meant that they chose issues that are in the 10%.  And, what did it get them?  Protests and boycotts.

There are many endowments and funds that now engage in conspicuous social responsibility.  Avoiding investments in fossil fuels or vices, for instance.  These are also issues that tend to fit in the 10%.  They play well for identity politics, but they frequently are based on decisions that even their backers wouldn't want to see applied universally.

The advocates of corporate social responsibility really are asking for corporate conspicuous social responsibility.  Corporations are already engaged in social responsibility - just as you and I are.  We all accept many standards of behavior and compromise in order to be a part of modern, cosmopolitan, liberal societies.  We are, and most firms are, the true cosmopolitans - the true liberals.

Advocates for conspicuous social responsibility don't actually want corporations to follow their own consciences in being conspicuously socially responsible.  That would get them boycotted.  What these advocates want is for corporations to act out the advocates' preferred conspicuous social responsibility.  The advocates are not liberal at all.  Quite the contrary.  The advocates are sectarian.  They want control over other people.  They want to deny firms the right to their own idiosyncratic moral notions, while pressuring firms to act on the advocates' idiosyncratic moral notions.  Like all sectarians, the advocates don't accept the distinction between their own moral notions and universally accepted moral notions.  They make the mistake of assuming that imposing their moral framework on everyone else is a moral advancement for everyone.  They vastly underestimate the importance of the 90% of agreed upon norms, and focus unhealthily on that other 10%.  Yet, obviously, that 10% applied universally and coercively is almost never appropriate. (Though we hold firmly in our hearts those rare times when it was.)

A second order effect of sectarianism is that sectarians develop an unrealistic view of the validity and practicality of their impositions, and thus develop negative caricatured opinions of those who are imposed upon.  So, for instance, firms which provide some opportunities for low skilled workers, but do not single-handedly and completely counteract the imperfect set of opportunities of those workers can be an eternal source of self-satisfying indignation.  Willful ignorance, together with angry demands, is its own reward.

Wednesday, March 18, 2015

Housing Tax Policy, A Series: Part 20 - Never reason from an asset allocation change.

I was reading this conversation between William Sharpe and Robert Litterman, and I came across this exchange, which considers the problem of market-matching asset allocation:
Sharpe:   ...Let’s say you believe that you’re an average person and that you want to take as much risk and get as much expected return as the average investor. The theory says to hold a market portfolio. To keep it simple, assume that the current market portfolio consists of stocks and bonds with weights of 60% and 40%, respectively— the fabled 60/40 portfolio. Now, imagine that down the road, you look at the values of stocks and bonds in the market as a whole and, for whatever reason, it’s 70% weighted in stocks and 30% in bonds. If you want to be like the market because you’re an average investor, then you should be 70/30 as well. However, if you look at the investment policy statement of, say, a typical defined benefit pension fund, it will state that the policy is to be 60/40 or some other combination of relative values. Should the pension fund follow that policy? Most of them don’t, but imagine if they were to. If stocks were to go up and thereby make the proportions 70/30, pension funds would have to sell stocks and buy bonds. Almost all policy statements that I’ve seen are stated in terms of percentage by value for each asset class. Those policies are all contrarian. They all recommend a decision to sell winners and buy losers, and not everybody can do that. In any event, for the investor who wants to be average in risk and return, the adaptive asset allocation formula says that if the market is 70/30, you’re 70/30, too, and that’s how you write your policy statement. It goes on to say that if you want to be x% riskier than the market, then you use a formula that tells you how to adjust your desired proportions when the market moves in a particular way, in terms of stocks and bonds. Even then, you don’t do a lot of trading, which is a good thing. 
Litterman: Why did the market go from 60/40 to 70/30?  
Sharpe: That’s not in my range of expertise. Predicting things and making probability assessments of what the future outcomes may be is your job, not the job of theoreticians. 
Litterman: Presumably, either the expected returns have gone up to justify this or the risk aversion has changed. 
Sharpe: Or risk has changed.
There are several problems to consider here.  First, is the equilibrium vs. disequilibrium problem.  If firms or home owners are temporarily over-leveraged because of a demand shock, then an optimizing, tactical investor with access to credit should utilize that credit to capture excess gains in corporate or real estate equity.

But, assuming equilibrium, Litterman and Sharpe seem to be assuming that changes in allocation are products of investor demand.  But, what if the move to 70/30 is due to corporate deleveraging?  What if it is due to rising treasury debt and real estate allocations, which serve to meet the demand for fixed income securities?  There are a lot of moving parts here.  The conceptual question of how to match the market portfolio does not have an easy answer.

Thinking about the topic, I decided to look at asset values in the US over time, from the Flow of Funds report.  This is difficult, because different types of agency and ownership methods are difficult to categorize.  I have used the equities and bond levels from Tables L212, L213, and L228 and household real estate levels from Table S.3.  Please let me know if you believe that this is an incomplete or incoherent treatment.

The first graph is as a proportion of assets.  The second graph is as a percentage of GDP.  I was surprised to see that, in the first graph, real estate levels were not unusual in the 2000s.  They were mostly rising from very low levels in the 1990s.

In the second graph, we can see that these levels have risen as a percentage of GDP, from about 250% in the mid 20th century, to about 400% now.  This 150% increase is roughly described in thirds of roughly 50% each:

1) Foreign profits for firms, which add to firm valuations, but not to GDP.  As I have argued, this, in effect, pays for the trade deficit.  I think subtracting the trade deficit from GDP probably understates our national production because this is consumption that has been paid for with our foreign capital gains.  More precisely, we reinvest those gains in high return foreign corporate assets, and foreign savers must export goods and services to us in order to fund an even larger basket of low risk/low return capital in the US.

2) Additional real estate value.  This is essentially deferred consumption.  Values have probably been bid up because of the high demand for deferred consumption among baby boomers.  As I work through my housing series, I will also treat this as a sort of tax arbitrage, and I hope to estimate how much of the added real estate value since the mid-1980's is simply the added value of the tax advantages given to home ownership.

3) Additional firm value, mostly in the growth of financial corporation bonds.  I think I am double counting here.  Many of the mortgages held against household real estate would be corporate assets related to the corporate debt and equity shown.  So, some of the increase probably comes from an increase in mortgage levels, which also have increased corporate capital levels.  I have not made the complicated adjustments required to avoid double counting that.  And, some of the added real estate value ends up in proprietors' balance sheets.


In these last two graphs, I show capital incomes as a proportion of GDI.  These are from BEA tables 1.11 and 7.12, so they don't match up exactly to the previous charts, but I think they basically give us the profit side of the story.  These numbers are for domestic income, so the foreign source of corporate valuations has been removed here (point number 1, above).

The first graph shows profit to proprietors and firms and interest income.  This has been fairly flat over the entire period.  The second graph shows returns to homeownership.  This has risen over time.

As above, the interest income in the first graph includes mortgage interest, so there is some double counting.  This may be adding confusion, but since it reflects debt holder interest in real estate, it sort of fits in both categories.  So, I haven't done the detailed work it would take to carefully cull it out of corporate asset and income measures.

Keep in mind that part of the income to bond and mortgage holders is an inflation premium.  In real terms, this is more accurately described as a purchase of capital by equity holders.  So, the treatment of interest as income is somewhat incoherent.  In this regard, some of the interest income is really equity income and some of the mortgage income is homeowner income.  But the effect on total corporate or homeowner returns would not be affected by this transfer.

I think, except for the growth in foreign profits, the gains in capital as a percentage of GDP are mostly coming from the issue of interest rates.  Since homes are a relatively fixed income type of asset, and since rents tend to be a relatively stable portion of GDI, home prices increase as a percentage of GDP when real interest rates are low.

This effect has recently been inflated by higher housing consumption (which has pushed returns to housing capital to new highs).  Owner-occupied housing consumption has increased because (1) it is a useful form of deferred consumption for baby boomers, (2) tax advantages implemented in the 1980s and 1990s increase owner-occupier housing demand, and (3) low real and nominal interest rates have increased demand for owner-occupier housing.

Long term real interest rates were low in the late 1970's, but at the time, rental income was only 3% of GDI, so the rise in home values was hidden.  If rental income had been 5% of GDI, total real estate would have been worth another 75% or so of GDP.  Total capital, shown above, would have been around 325% of GDP.

In the late 1970's, high inflation made mortgage payments very high.  I had originally assumed that this led to decreased housing demand because households were blocked from ownership by the high hurdle for mortgage access because of those high payments.  But, curiously, homeownership rates bumped higher in the late 1970's, and low real interest rates, which have a strong effect on home values, seemed to be pushing home price/rent ratios up at the time.  How could all of these things be true?  I think the graphs here may give us a clue.

Low real interest rates were making homes more valuable.  In order to capture the benefits of homeownership, which included significant tax savings due to the high nominal capital gains homes were earning as inflation drove their prices higher each year, households were reducing their housing consumption (rent) in order to match with a house in which they could afford the mortgage payments in nominal terms.  So, there was a dampening of demand because of the high inflation premium, but the lower demand wasn't manifest through fewer homeowners; it was manifest through smaller homes (or at least, homes with lower rents).  So, the prices of homes as a security (Price/Rent) were still relatively efficient.  The adjustment in demand was made through reduced housing consumption more than through a decline in home buyers or in the Price/Rent relative to intrinsic value of forward cash flows.

In the 2000's, the inflation premium wasn't a binding issue, so the households incentivized into home ownership by the low long term real interest rates didn't reduce their housing consumption.  Rents remained stable, and the full effect of low interest rates on the nominal value of real estate expanded the value of capital, both in terms of real estate, and in terms of corporate holdings of mortgages.

Ironically, this nominal increase in capital values, which I expect to see again as the housing market continues to recover, would be reduced by looser monetary policy (which would produce higher inflation, and probably somewhat higher real long term interest rates).  I don't personally think the high capital values, in and of themselves, are a problem.  But, those who do think it's a problem, and who blame accommodative monetary policy, have the story exactly backwards.  There will be great pressure for tight monetary policy as these valuations expand, and they will be brought back down in the only other way possible - by creating a demand shock.  Money will be tightened until it is catastrophic.  This will only serve to keep real long term rates low, because savers will be reasonably risk averse and growth expectations will be muted, which will mean that these capital valuations will return to high levels as the economy recovers again, and the Fed, after once again kneecapping capital will be painted as the capitalist's handmaiden as nominal capital valuations move higher again.

I sure don't want that to happen, but I don't see how we avoid it, given the current zeitgeist.

Tuesday, March 17, 2015

The road to a housing recovery

Since the mortgage credit market has been stagnant since 2007, changes in US household equity levels have been almost purely a product of home market values.  Here is a chart comparing home prices and equity.  QE3 facilitated the flow of cash into the real estate market, through institutional and all-cash buyers.  But, as QE3 was tapered, and eventually ended, this source of demand in the housing market diminished.  The extreme level of excess returns to home ownership continue to attract institutional and foreign capital into real estate, but the pace has slowed.

I had hoped that relaxation of regulatory pressures on banks late last year would begin to allow mortgage levels to grow again.  It has, somewhat.  But, the growth is still very slow compared to previous periods of economic expansion.  It looks like closed end real estate mortgages at commercial banks are growing at up to about 5% annually, similarly to the period between QE2 and QE3.

It is common for real estate loans to expand at a rate of 10% plus inflation during expansions, especially when interest rates are low.  That should be the case now, more than ever, since relative income levels from homeownership are unprecedented, relative to the alternatives.

So, it looks to me like there is only so much supply of mortgage credit (as opposed to demand) can do.  What I hear from folks in real estate is that households just can't afford homes.  But, the thing is, rents aren't falling.  There isn't a lack of household demand for housing.  If this was a problem of incomes, rents would be falling.  The problem is that households can't come up with the downpayment.  Households don't have the net worth they need to purchase homes.  I suspect this might have something to do with $20 trillion in missing home equity.

Fortunately, households have been deleveraging, so we don't need to return completely back to trend to re-establish demand.  Owners' Equity as a proportion of Real Estate Market Value was about 59% at the end of 2005, before the liquidity crisis began to push us out of equilibrium.  This fell to as low as 37%, but it has recovered back to 54.5%.  And, at the current slow rate of housing appreciation, it is growing by about 1/2% per quarter.  That means that we are about 2 years away from normalcy, at the current rate of growth.

Now, I don't think equity will grow at 1/2% per quarter until it hits 59%, and then suddenly the mortgage market will open up and home values will suddenly appreciate by 15% per year.  There should be some acceleration as home prices appreciate, and more homeowners, on the margin, are capable of initiating transactions in the housing market.  So, we are probably looking at 12 to 18 months of slowly rising housing growth.  For speculative purposes, I'd prefer a sharper tipping point.  The process I am expecting makes the dilemma of entry points and triggers more difficult to gauge.

Until this expansion happens, I think we are looking at a bifurcated fixed income market, where bonds earn very low returns, and homes earn 5% or more, plus capital gains.  I think the Fed Funds rate could be anywhere from 0% to 2% in this context without affecting monetary expansion that much, one way or the other.  Because, the industrial economy is a high rate economy right now, but there is a surplus of capital, because there are too many frictions preventing it from getting into real estate quickly enough.  But, when real estate can expand - probably early to mid 2016 - look out.  Natural interest rates will be flying - both real and nominal.

I suspect that everyone will crap themselves when home prices start rising by 15% per year, and we'll put a stop to it to spite ourselves.

I haven't thought this through before, but if this is true, then the equity risk premium right now is a bit of a mis-specification.  If risk free bond rates are sort of out of equilibrium because of this housing problem, and could just as easily be 2% (real 10 year), then equilibrium equity premiums are probably under 4% - a more typical level.  That is potentially good news for real profit and wage growth, especially if a diminished housing shortage stops pushing up core inflation.

As we can see in these last two graphs, there has been an uptick in mortgage supply since late 2014, in terms of standards.  But, demand has been soft.  I expect to see demand increase along with rising prices, but probably slowly.

Saturday, March 14, 2015

Just a minute, honey. Someone on the internet is wrong.

I.

The other day Paul Krugman compared the post-1981 recovery to the post-2007 recovery.  He links to an earlier post, where he claims to have "predicted this in advance".  From that post:
Post-moderation recessions haven’t been deliberately engineered by the Fed, they just happen when credit bubbles or other things get out of hand.
And while they haven’t been as deep as the older type of recession, they’ve proved hard to end (not officially, but in terms of employment), precisely because housing — which is the main thing that responds to monetary policy — has to rise above normal levels rather than recover from an interest-imposed slump.
The recent years of the 10 year centered moving averages only
include the years to date, so these measures are likely to move
up somewhat if the economy continues to recover.
Of course, this is completely wrong, unless housing, suddenly as of 2008, demands a 2% premium above its 60 year long range.  Krugman can be forgiven for failing, along with practically everyone else, to acquiesce to my view.
Krugman's Chart


But, in the recent post, he includes the following chart, with the following comment:
In practice, Reaganomics was far more Keynesian while Boehnernomics — which is what it ended up being, in practice — was anti-Keynesian.
This seemed strange, since Boehner was not the Speaker of the House until 2011 (quarter 13 in the graph, I think), and since total federal spending has been notoriously high since 2007.  So, I added some information to that graph.

I will leave as an exercise for the reader the questions of whether Krugman is suggesting that House Minority Leader is the new power center in Washington, whether Boehnernomics includes massive increases in transfer payments, whether Krugman is saying that Reaganomics succeeded because it focused on expenditures instead of transfers, or whether the post-2008 recovery was relatively slow because of policies implemented after 1985 and 2011.

Here is a graph of the unemployment rate for these same two periods, with the 2008-2015 period again partitioned into the "Minority Leader Boehnernomics" period and the "House Speaker Boehnernomics" period.


II.

It is interesting to me how tipping points in interpretation can lead to highly divergent points of view.  Here's a short article I came across the other day.  I don't mean to pick on this author.  I am not aware of her other work, and I only reference this because it is so typical.
Lower asset values are a key part of the cure needed to fix global imbalances and restore rational investment math and consumption ability once more for the middle class.  But for bankers…this is a nightmare of their own foolish, greedy design. Rate-cutting powers now gone, and future consumption already spent as demand the past few years, the next global recession is advancing to force a much needed cleansing of reckless policies and players. Couldn't happen to a more deserving bunch of folks…
She, like Krugman, knows the correct price of everything, notes that it differs from the market price, and sees economic pain as the only cure.  Especially pain for bankers.  And, the comments on that article, as they always are for such articles, are very supportive.

Now, I, being a demon speculator, while I don't know the price of everything, I do act as if I know the prices of a few things.  And, as speculators are wont to do, I put my money on the line in a hubristic attempt to profit from my special knowledge.

What is interesting about the overwhelming population of people who seem to know what happened in the 2000's - the banks did this to us -  it is not unusual for them to have purchased homes during the "bubble" period.  These are generally high income households.  (Of course they areThat's who was buying homes.)  And, these people explain to me how the banks did this to us and deserve to be punished.

What is interesting to me is that, while it seems that the Fed policy that actually created much of this mess was responsive to these widespread interpretations, these mal-informed households were still managing to participate in highly efficient markets, even while they did, and continue to, consciously espouse viewpoints that contradict their investing behavior.  It seems to me to be a monumental example of how markets aggregate widely irrational individual participants into an efficient market, and how, in non-market settings (like currency management) subtle biases in interpretation can lead to catastrophic mis-calculations.

I speak to people who are so angry about the crisis.  They are angry at speculators and bankers.  And, how can you blame them?  Who else pushes prices to levels that everyday folks know are wrong, but speculators?

And, they meet so many families who couldn't make ends meet any more.  Truly tragic stories.  And in the middle of every one of those stories is a banker that had approved a home equity line that the family had used to get by for a few years, but which just pushed them further behind.  A banker making demands.  A banker pushing them out of their homes.

And they go to their friends, and they seethe, "These damn bankers."  And their friends say, "You know it.  Devils, they be."  The narrative isn't far fetched.  It is served right there on a platter for us.  All that is required to believe it is a willingness to accept the obvious facts.  And, this subtle whisper that says, "No need to check this one.  We know how they operate."  It takes no effort at all.

Now, if it looked like we should blame the crisis on good, wholesome Americans, like teachers, or farmers, or public servants (pending a review of their allegiances), or "working families" - you know, people that do honest work to make the country better, not profiteers (shudder) - we might say, "Wait a minute.  There must be more to the story."  This is a subtle trigger.  It is understandable that so few bother.  I can understand why they are so upset, even if I think they are so wrong.  There is nothing I can say.

So, I put my money down.  They put their money down, too.  But, then they vote.  And therein lies the problem.

Thursday, March 12, 2015

Some interesting graphs from the White House on Gender and Income

Here is a slide show from the White House with some interesting graphs (HT: UYSIT).

Here are a couple of interesting ones.  Several more are at the link.  Many of these raise as many questions as they answer.

I think these two charts point to the strong role of female empowerment in the shape of incomes over the past 40 years.  I linked to an interesting paper about that (here).

  • Since the early 1970's, most of the gains have gone to high income households.
  • Since the early 1970's, most of the gains have gone to women.

Both of these things are true.  In fact, they are both probably largely describing the same phenomenon.

Unfortunately, the first version is both more rhetorically exciting and  more likely to lead to poor policy choices than the second version.

There are a host of factors feeding these income trends.  The technology boom has fed the tremendous income gains at the very top.  (I've seen somewhere, but I don't have the link handy, that the entire climb in inequality over the past few decades goes away if you exclude a handful of counties around Seattle and San Francisco.) (Edit: if this is the paper I was remembering, then my counties are slightly off -NY instead of Seattle- and I have somewhat overstated the effect.  These counties explain most inequality during the dot Com boom of the late 1990s.) But, also, as referenced above, we can also explain all of the growth in inequality with the changing incomes of women within households.  We can also explain some of it with changing lifecycles and demographics (more low income students in early adulthood and more low income retired households).  We can also explain some of it with housing.  Imputed rent is not included in household income, and this is becoming a larger portion of the median household's true income.

So, it looks like inequality is explained many times over.  I don't think this is an error.  I think all of these things are legitimate explanations.  The counterbalance is that a rising tide lifts all boats.  These factors have all been balanced out by the natural equalizing tendency of capitalist markets and the tendency of economies with rising incomes to expand their social safety nets.

We can lower measured household inequality by supporting undistorted free markets, halting the technology boom, reversing the empowerment of women, replacing support for post-secondary education with support aimed at other forms of human capital development, reducing incentives for overinvestment in housing, or increasing the social safety net.  The low hanging fruit here includes the removal of barriers to entry (technology is doing some of this, reversing things like occupational licensing would help also), transformation of education subsidies, and housing policy.  These aren't necessarily political feasible, but they would be helpful.

The continuation of the technology boom and empowerment of women are clearly far more important than the issue of income inequality.  This is one of many reasons why poverty is a much more coherent issue to focus on than inequality.  Feminine and technological advances are clearly beneficial, even while making measures of inequality worse.  We wouldn't even think of reversing course on these issues in order to reduce inequality.  That is because inequality is not, legitimately, a concern, so it tends to conceptually collapse in the absence of strawmen and boogeymen.

If someone is concerned about inequality when thinking of CEO's or hedge fund managers, but he isn't so concerned about it when thinking about households of married physicians or married lawyers, then he is really just pretending that his bitter attitude toward CEO's and hedge fund managers is a concern about poverty.  This is especially egregious in moralistic complaints about globalization as a cause of income inequality, where corporations and developing economy workers have joined together in an equalizing revolution of global economic improvement.

How about the concern that the internet and pirating are preventing musicians from capturing income from their recorded music.  Is there a group of people with a more extreme level of income inequality than popular musicians?  Why do we bemoan their falling incomes, but cheer for moderation of CEO and financier incomes?

The inequality meme joins a long list of rhetorical emblems that have served to seemingly transform being against something into being for something.  These rarely serve the greater good.  If something is worth being against, then it's worth being against.  The use of the rhetorical device is, itself, a sign of weak moral backing.

Wednesday, March 11, 2015

The Equity Mystery in the 2006-2008 Liquidity Crisis


I expressed some confusion about how, given my narrative that the liquidity crisis has roots going back as far as 2006 or earlier, equity values could continue to grow in 2006 and 2007. (The dark green line in the graph is the market value of nonfinancial corporate equities from the Flow of Funds report as a proportion of GDP. Its behavior follows a similar cyclical pattern to the S&P 500.)

Note, first that returns were good but not stellar after a brief recovery in 2003.  Political Calculations notes that both equity prices and dividends were growing stably right up to the end of 2007, even as profits were falling and GDP growth was weakening.  In fact, dividends and buybacks were both strong.

Source: Political Calculations
American corporations were a significant source of liquidity.  Powerful sources of demand could scale up their investments, unlike in the owner-occupier housing market.  Plus, corporations were (and are) very deleveraged.  Debt to equity ratios are half what they were in the 1970's and 1980's.  And, corporations have extensive overseas operations and sales.  These were large sources of liquidity.

Additionally, investors were tapping margin debt by late 2006 and 2007.  As we moved from 2007 to 2008, short positions were spiking (noted by Credit Balances in Margin Accounts).


Source: NYSE
Firms were holding up operations with sources of credit and foreign cash.  And, to a certain extent, some of that credit was coming to investors in the form of dividends and buybacks.

This is what frightens me about talk of the Fed focusing on financial stability and macroprudential management.  This debt was a sign of tight monetary policy.  A shortage of money was pulling down nominal asset values and nominal production.  Without cash, firms and households will use credit.  What are they supposed to do?

But, here is Ben Bernanke in April 2009:
Unfortunately, our economy still has a significant number of very serious imbalances that need to be resolved before it can grow at a healthy pace. Just to list five. First, the leverage issue of both the financial and the household sectors. Second, wealth–income ratios are well below normal, and therefore more saving is needed to rebuild those ratios. Third, we have dramatic fiscal imbalances, which have to be reconciled at some point. Fourth, we have current account imbalances, which are at least temporarily down, but the Greenbook forecast for the medium term is that there is probably some worsening in that dimension. And fifth, as a number of people mentioned, the unemployment we are seeing is probably not mostly a temporary-layoff type of unemployment.
All five of these problems either would be solved by monetary expansion,  were caused by the previous disastrous monetary tightening, or both.  Yet, Bernanke seemed to be under the impression that these issues either rendered monetary policy powerless or made monetary expansion dangerous....in April 2009.

These ideas that somehow, on an aggregate level, we have to pay for past excesses, or that if the financial industry gets an extra dollar, they will somehow drive us off a cliff in a rabid binge of greed and predation, or that we weren't as wealthy as we thought we were, are so dangerous.  We were exactly as wealthy as we thought we were.  Those houses we were building weren't pretend.

There are debates about the problem of national debt, and whether it isn't a problem because we "owe it to ourselves."  That is a whole bag of worms.  But, if we look at the funding of national production, we really do owe it to ourselves.  This idea that we will somehow overproduce if we have too much cash, and somehow end up poorer for it, seems to me to create many more problems than it solves.

American corporations own a tremendous amount of foreign production, which is also consumed abroad.  We earn such high profits from those operations, that foreign savers have to sell us billions of dollars worth of imports each year and invest the proceeds in the US, just to keep from falling further behind than they already are.  We do not, in the aggregate, have a financial stability problem.  If the problem is that we shouldn't have so much debt and real estate, then the solution is in tax reform and monetary accommodation.  The solution surely isn't liquidity starvation.