Friday, May 29, 2015

Housing Tax Policy, A Series: Part 35 - The effect of limitations to building in the coastal cities

I've been using data from the BLS and the American Community Survey (ACS) to try to gauge the relative effect of limits to building in the major cities.  I've been using the 10 cities from the Case-Shiller index as the representative basket (hereafter, "CS10").  This isn't a perfect match for the problem.  Denver, Chicago, and Las Vegas don't exhibit excessively abnormal rent inflation and price levels.  Boston and Miami are worse.  But, New York City, Washington, DC, San Diego, Los Angeles, and San Francisco are in a class by themselves, and they are all on the list of 10.  The Case-Shiller 10 is a pretty good proxy for the cities behind the housing supply problem.  (I don't have full CPI data for Las Vegas and Washington, DC, so some of this analysis is limited to data from the other 8 cities.)


Shelter Inflation reflects a supply problem

As I have looked at housing data and monetary policy over the past several months, I have come to the conclusion that there are two general components of inflation over the past 20 to 30 years.  There is a Shelter component, which is generally high because of supply side issues, and there is Core Inflation minus Shelter, which I think we can use as a proxy for the demand side (monetary policy).  As a rule of thumb, I treat Rent inflation above the Core minus Shelter level as a supply issue.  (I welcome feedback regarding any technical criticism anyone has about this treatment, but please read the series of housing posts first, if you have conceptual criticisms.)

In the mid-1980's, Shelter inflation briefly rose, but this was limited to owner-occupied properties.  I suspect that this largely reflects tax arbitrage in single family homes by homeowners due to the new importance of the mortgage interest tax deduction in the mid-1980's.  Single family homes for rent are subjected to a less favorable tax treatment, so owner-equivalent rent for owners, which reflects pre-tax expenditures, rose.  But, after the brief rise in owner imputed rent, shelter inflation followed core inflation until the mid-1990s.  Since the mid-1990s, shelter inflation has been consistently high (except for the brief post-2008 shock), and it has been highest for renters.

We can see in the Fred graph that since the mid-1980s, multi-unit housing has had very limited growth during recovery periods.  In fact, I have come to believe that this was one of the important factors at play in the housing boom of the 2000s.

Note that total housing starts were not unusually high in the 2000s.  But, limitations to multi-unit building, which are largely occupied by renters, caused rent inflation to rise, and drove households into single family homes.  So, total new units was fairly normal, but all the extra growth had to come through new single family homes.

Home price appreciation was concentrated among the CS10 cities, and I have argued that this reflected rents that were rising especially sharply in those cities.  ACS data, which only covers 2005-2013, gives us some additional detail on this picture, and helps to estimate the scale of the BLS inflation data that goes back to 1982 for many of these cities.  Keep in mind that these data sets cover entire metropolitan areas, including the suburbs, so in some ways, the data showing housing supply problems in these cities understates the problems that are specific to the city centers and to limits on multi-unit housing.

Source
We can see from the first graph, above, that rent inflation was worst during the housing boom, and was especially bad in the 2006-2008 period, after home prices and new building leveled off and began to fall.  During this time, national vacancy rates were somewhat elevated, but they remained low in these high-rent coastal cities.

I think, when we put all of these things together, what we see happening is limited multi-unit building in our metropolitan core cities driving up rents there, pushing households out to the suburbs.  Sticky prices and other frictions in the housing market prevented single family housing growth from fully meeting demand in real time, so rents continued to climb during the housing boom.  Then, beginning in 2006, the Fed began to pull back on the money supply and the mortgage market dried up. Housing supply was already struggling to meet demand, but this new limit to single family home construction completely undermined the market.  Now housing starts collapsed and rent inflation accelerated.

Notice in the Fred graph above that multi-unit housing starts and single unit housing starts had always moved roughly in sync.  But, notice how single unit starts collapsed in early 2006, but multi-unit starts continued apace until the summer of 2008.  Also, note that home vacancies rose in 2006 (even while new building collapsed) but rental vacancies remained level until 2009 (even while building continued).  The money supply and the mortgage market collapse are what led to the housing collapse.  There was still demand for housing, but there was no cash or credit for it any more.

Now, rental vacancies are at new lows, and multi-unit starts have recovered back to pre-recession levels.  But, it's like there is a cap at about 400,000 units per year.  And, in the 20 years during which it looks like there is a 400,000 unit lid on multi-unit housing, we have had persistently high rent inflation.  And this supply problem is coming from our coastal cities.


Rent Inflation among the Case-Shiller 10 and the rest of the country

"Core minus Rent" (CmR) inflation from 1995 to 2013 averaged an estimated 1.8%.  Rent inflation for all households since 1995, in all the areas outside the CS10, has averaged 2.4% - that is 0.6% higher than CmR inflation, suggesting a small housing supply issue.

But, for these 8 cities on average, while CmR inflation was similar to national CmR inflation, at about 1.9%, Rent inflation for all households was 3.2%, and Rent inflation for renters in these cities averaged 3.6%.

The Case-Shiller 10 cities account for 21% of the US population and 31% of residential real estate, by value, but during this period, they were responsible for 55% of the nationwide excess owner-occupier rent and 62% of the nationwide excess renter rent (above the CmR inflation level).*

In the decade before 1995, rent inflation in these cities was no higher than core inflation.  There was a previous period of relatively high shelter inflation, in the 1970s and early 1980s, but I don't have city-specific data for that period.

These cities create a sort of triple-whammy.  Renter inflation has risen more than owner-occupier inflation, these cities have a higher proportion of renters, and rent in these cities tends to claim a higher proportion of household income.

There isn't particularly a reason why these cities need to have perpetual rent inflation.  High density cities aren't that expensive (HT: OB), and many large US cities have grown without unusual rent inflation.

Using rent inflation figures and median rent expenses for the 8 cities with BLS data, I have constructed an estimate of median incomes in a counterfactual world where rent inflation was in line with Core minus Rent inflation since 1995.

Nationwide, the median home owner would have real income 3.0% higher if we did not have this scarcity in housing.  In non-CS10 areas, median owner real income would be 2.2% higher, and in CS10 cities, it would be 5.3% higher.  Owners do earn this income back, to the extent that they have equity in their homes.  But, in terms of asset values, this income is reflected in unusual capital gains captured by existing home owners.

For renters, the median national renting household would see 4.9% higher real income.  The non-CS10 median renter would have 7.5% higher income and the CS10 median renter would have 12.6% higher income.

This loss of real income is basically paid as capital income to real estate owners, as returns on their unusual capital gains.  Homes in the CS10 cities have cumulative excess rent inflation since 1995 of 27%.  Homes in non-CS10 areas have cumulative excess rent inflation since 1995 of 10%.  The national average is 16%.  In 2013, gross rent paid and imputed for housing amounted to 10.5% of GDI.  So, I would estimate that real estate owners are capturing about 1.4% of GDI from the capital gains they have accumulated due to this imposed scarcity.  This is split roughly in half.  About 0.7% goes to property owners in the CS10 cities and about 0.7% goes to property owners in the rest of the country.


The Effect of Housing Scarcity by Income

I can also use real estate and income data from the Survey of Consumer Finances, the CPI rent inflation data, and BEA data on rent expenses to estimate the effect across incomes.  By this measure, for home owners, housing scarcity claims 1.7% of mean family income, ranging from 1.3% of the top decile to 2.9% of the bottom quintile.

Here the effect on income distribution is muted, because home ownership is not that low in the lowest quintile (37% in 2013), and the lowest quintile has the highest proportion of equity among all income levels (reported at 80% in 2013).  So, most low income home owners are probably older households who have pocketed the capital gains from these 20 years of housing scarcity.

Please give me a link in the comments if anyone knows where I can get data on household income and rent for renting households, by income quintile.  The ACS has some data, but the data I have found is not broken out like the SCF data where I can calculate mean levels of expenditures as a proportion of income.

But, if the median renting household spends more than 30% of their income on rent, the poorest households must reach something around half of their incomes.  That means that the renters who make up 63% of the lowest income quintile probably have real incomes reduced by around 10% because of these housing issues, and renters in the CS10 cities - especially New York, Washington DC, and the California metro areas - might see real income cuts of around 20%.  And that is for entire metro areas.  In the core cities, where the limits on multi-unit housing are most severe, real incomes for the poorest households could have taken an even larger hit, although, for this group, the effect of public subsidies, rent controls, etc., must be complex.

Since high income households spend less on housing and capture some of the gains of ownership, they will only see minor declines in lifetime incomes from this problem.  This could be a major factor in the apparent stagnation of lower incomes.  Actually, I think that this spread in income growth between income quintiles would be in addition to measured increases in income inequality, because these household-specific costs would not be captured by average national inflation statistics.



*This is based on stable nominal expenditures at 2013 levels, so it doesn't include any compounding effects from cities with persistently higher inflation.

Wednesday, May 27, 2015

Adjusting PE ratios for cash.

Aswath Damodaran uses his extensive database to do, in practice, what I attempted to do, here, in theory:  adjust PE ratios for cash balances.



Here is the key graph, regarding the application of this issue to current valuations.  PE ratios on actual, productive assets are much lower than they appear.



I would take this a step further.  Corporations also have much lower debt levels, and a similar adjustment should also be made regarding debt.  Damodaran addresses this indirectly in his recommendation to use Enterprise Value instead of equity valuations.



Relative PE ratios are much lower than they seem and Equity Premiums are much higher than they seem, when they are adjusted for cash and leverage.  This is especially interesting, given that even unadjusted Equity Premiums have been very high.

If loving finance is wrong...

David Glasner joins the chorus against the finance sector with "Is Finance Parasitic?", mostly with true stories of information asymmetry.  This seems to be a point of view that unites observers from all perspectives.

Think of the international capital flows that I have been looking at lately.  Developing market savers invest in low yield US assets, and US corporations invest in developing economy operations.

This trade is largely facilitated by the liquidity of US equity and debt markets.  Here is my attempt at passing an ideological Turing Test.  Let's look at all the damage finance does through this simple trade.

1) Developing market capital is pulled out of markets that could desperately use it.

2) That capital is parked in Western markets, funding unproductive public debt and inflating real estate values, creating unsustainable asset bubbles.

3) US households binge on this cheap capital, selling their financial futures by borrowing against these bloated assets to spend more than their incomes would allow.

4) Much of this spending goes to imports, so all of this debt goes to killing US jobs and supporting jobs overseas.

5) In the meantime, US firms keep moving operations abroad, selling out the American worker for an addiction to cheap foreign labor.

This is the bubble economy, and it has been facilitated by parasitic finance, who takes its cut at every step in the process.  Does the typical household have higher income because of any of this financial crapulence?  No.  Finance just leaves a trail of debt and excess.

</end of test>

David also references this post with thoughts from Timothy Taylor and Luigi Zingales   These guys are all much smarter, better read, and more reasonable than me.  And, clearly there is as much (maybe more) rent seeking, unfair practices, influence peddling, etc. in finance, as there is in many sectors.  But I am struck by the apparent lack of concern with the difficulty of measuring the social gains of financial activity and the tendency to generalize from specific problems with little concern for scale.

I suspect that a lot of potential readers would read my five steps above without objection.  Isn't that a good description of what is happening?  It's frustrating to me to see so many respectable intellectuals seeming to support the common narrative.  This is a subtle, complex subject, and the subtleties need supporters.

The output of finance frequently can't be measured in spending or production.  Finance is the management of risk.  Sometimes, when finance adds value, it adds value by reducing the denominator in the present value of future cash flows.

When developing market capital flows into the US, driving down interest rates, the owners of that capital earn much lower income on those US assets than US corporations earn on the foreign assets that they purchase in return.  Is the US financial sector actually destroying the potential income of those foreign savers?  If we simply measure the value of finance through the top line income it produces, then the answer is yes.

Or, maybe, Western financial institutions are providing value that surpasses that apparent loss of income, and this is one factor that attracts that capital to Western securities.

When US firms buy foreign productive assets in markets with high local risks, even if those assets don't produce more than they would under local ownership, their nominal values may rise due to the fact that they are pulled into a diversified asset base of a corporation traded in sophisticated and liquid financial markets.  So, there is no increase in production, but American corporations capture increases in nominal asset values due to diversification and liquidity.  American finance, just moving stuff around on paper to create fake paper profits.  Right?

Or, put another way, the owners of those foreign assets are now demanding fewer profits for each dollar of productive assets, and capital inflows into those markets will push up the future wages of local workers as a result.

This is conceptually very difficult to understand.  Even if financially literate intellectuals put on a full on offensive effort toward public education on this issue, it would be a tough assignment.  But, in a world where misplaced concerns about trade deficits and asset bubbles keep steering public policy in damaging directions, it's disappointing to see these concerns supported.

One specific reaction I have to the Glasner piece is regarding his paragraph about active trading.
In earlier posts, I have observed that a lot of what the financial industry does is not really productive of net benefits to society, the gains of some coming at the expense of others. This insight was developed by Jack Hirshleifer in his classic 1971 paper “The Private and Social Value of Information and the Reward to Inventive Activity.” Financial trading to a large extent involves nothing but the exchange of existing assets, real or financial, and the profit made by one trader is largely at the expense of the other party to the trade. Because the potential gain to one side of the transaction exceeds the net gain to society, there is a substantial incentive to devote resources to gaining any small, and transient informational advantage that can help a trader buy or sell at the right time, making a profit at the expense of another. The social benefit from these valuable, but minimal and transitory, informational advantages is far less than the value of the resources devoted to obtaining those informational advantages. Thus, much of what the financial sector is doing just drains resources from the rest of society, resource that could be put to far better and more productive use in other sectors of the economy.
It seems to me that he is doing a rhetorical flip-flop here.  It seems as though he is counting the gains of the winning trader as gains to finance and the losses to the losing trader as social losses.  But, isn't it more accurate to say that, if active trading is a zero-sum game, and passive investing on average earns higher returns, that all the gains are social?  The active investors who are making markets more efficient capture none of the gains of their efforts.  In fact, after costs, they lose. But, the benefits clearly accrue to the passive investor and to consumers who enjoy the products of newly funded firms.

Did Apple, Microsoft, Google, Amazon, etc. just spring from our passive conscience?  Aren't we taking for granted that the internet economy sprang from the American VC industry?  I suspect there are some subtle rhetorical biases going on here, where we separate active asset management into categories.  Where it was highly socially beneficial, as with Apple, the result is (1) huge gains to some traders and (2) unseen consumer surplus.  So, we count the trading gains as a sort of unearned income that leads to economic inequality.  Where it failed, the result is (1) losses to some traders and (2) missed potential consumer surplus.  So, we count the losses as a sort of outcome of information asymmetry - finance luring unsuspecting savers in with false tales of potential gains, pocketing the trading fees in a heads-I-win, tails-you-lose parlor game.

In the model in the Hirshleifer paper that Glasner links to, markets are assumed to be perfect.  So, active trading doesn't add any social value in a model that assumes away the social value of active trading..  And, we make a different category for describing capital that creates permanent changes in productive capacity.  When we describe these activities as earning rents off of "private information", it's easy to underestimate how ethereal information is.  Until the singularity comes, things like "foresight", "intuition", and "courage" are scarce kinds of information.  We are much more willing to credit people who created PC's in their garages with creating a new world than we are willing to credit the people who bankrolled them.  It seems ok that the tinkerer got rich.  He was out there working days and nights, getting his hands dirty, doing real work - innovating.  The financier behind him just got lucky, and her gains are parasitic - rents from private information.

Partly what is going on here is the Ant & the Grasshopper problem.  Is someone who invests savings with the assistance of a financial advisor a consumer of the finance sector or a part of the finance sector?  I think what people tend to do is move the agents around, depending on their place in the narrative.  So, there is a narrative that investors trade too much and are overconfident about active investing.  In this narrative, the financial intermediary plays the part of the finance sector and the saver is a customer - outside of finance.  So, overtrading is a cost finance imposes on others.

But, what if the narrative is that corporations have some sort of monopolistic power and profits keep climbing while wages stagnate?  In this narrative, the saver is a part of finance.  They are accruing gains on their investments at the expense of others.

Finance is parasitic because we define it as parasitic.  And the definition is fluid and self-contradicting where it needs to be.

In any system that is too complex to easily understand, we have a tendency to import our biases as a satisfying source of explanation.  Parasitic financiers are an ancient source of explanatory satisfaction.  I think we would do better to check ourselves.  It is very important for us to undermine and correct specific areas of corruption and influence peddling in an area as important and difficult as finance.  But, a comment like, "a lot of what the financial industry does is not really productive of net benefits to society." which is sort of vaguely defensible while feeding corrosive social misunderstandings, is sort of a rhetorical parasite feeding on our existing biases.  I'm not sure this points us in the right direction.

"Mood affiliation" is very tempting here.  I want to make it clear, the point of this isn't to make a category - "finance" - and to form two teams of arguing advocates and opponents.  My point is that finance, in the current public context, contains (1) a lot of highly regulated, complex, and politically charged activities that are ripe for rent-seeking and abuse by providers and (2) a lot of complex and politically charged activities that are very beneficial - crucial, even - to a world of progress and abundance, and whose benefits are subtle, difficult to measure, and frequently at odds with our dreadful intuitions.  Confusing activities in group number 2 with those in group number 1 is inevitable, because emergent phenomena are too complicated to understand.  This confusion is usually met with mass approval, because of our rotten intuitions and the moral dissonance we feel about deferred consumption - the ant.  Avoiding this confusion may be one of the most important and difficult tasks public intellectuals can undertake.

Tuesday, May 26, 2015

Housing Tax Policy, A Series: Part 34 - Volatility Risk Premiums in Homes and Bonds

Friday, in my post about inflation, I included versions of this graph.

There has been a long-standing relationship between home Net Rent / Price levels and cyclically adjusted real long-term bond and mortgage yields.  There are several ways to adjust nominal bond yields for inflation.  In this version of the graph, I have adjusted the mortgage yield with Rent Inflation instead of Core CPI Inflation.  Mortgage rates move in a fairly tight range with 10 year treasuries.  Here, the persistently high rent inflation we have seen since the 1980s pulls the real mortgage rate below the real 10 year treasury rate (plus a 2% premium).  If I used the same inflation adjustment, they would be very close throughout this period.

The yield adjusted by Rent Inflation is the more appropriate adjustment, if we are looking at the non-arbitrage yield level here, because persistently high Rent Inflation acts as an income boost to home ownership, pushing the equilibrium real yield of home ownership down to compensate.

I have dismissed the lack of a tight relationship in the 1980s by averring that there was a high premium on nominal bonds at the time for inflation uncertainty.  This premium was very high until about 1985, then there appears to be a small premium that slowly fades until the early 1990s.  (The premium in the late 1980s could also reflect the larger benefit of the mortgage tax deduction in a high inflation environment, which would reduce the required pre-tax return on homes.)

So, maybe the recent divergence in relative returns reflects an uncertainty premium in homes, resulting from the recent volatility in home prices.  I think this is a theoretically sound point, and if we had been in an equilibrium environment, I would agree that this effect could be in force.  But, I don't think it is the constraining factor at work, for the following reasons:

1) The uncertainty in bonds in the 1980s was a direct result of changing real returns.  A bond bought in the 1970s, with a coupon rate of 8% (3% real and 5% inflation) was now being paid off with inflated dollars, so that the effective 8% payments were 10% inflation and -2% real.  There was a loss in the real value of the cash flows.  This is what caused the inflation uncertainty premium to rise and the market value of those bonds to fall.

But, for homes after 2007, there was no income shock.  A $200,000 home receiving $6,000 in imputed net rental income in 2005 has continued receiving about $6,000 in imputed rent (adjusted for inflation), with just a temporary lull in rent inflation that would have a very small effect on housing income.

So, the shock in 1980s bonds came from the changing real value of coupon payments while the shock in 2000s homes was purely a price phenomenon.  You could say that the changing yield on homes reflected a liquidity shock.  But, then, that is my point.  A liquidity shock could be mitigated by reintroducing liquidity.  There might be some residual liquidity uncertainty premium, but that will be much smaller than the premium created by the lack of liquidity itself.


Source
2) When bonds fetched an uncertainty premium, they were still being issued.  There were still buyers and sellers.  They were simply settling at a higher yield to reflect the uncertainty.  But, after 2007, the market for home finance collapsed.  The fundamental supports of an arbitrageable market had broken down.  We can see in the graph to the right that mortgage levels still really haven't begun to grow and new home building languishes.

3) Even in the case of 1980s bonds, there was still convergence over the following decade, as uncertainty receded.  In the last graph, here, we can see that volatility in bond market values declined around the same time as the uncertainty premium in the 1980s, sharply at first in the first half of the decade, then slowly for the last half of the decade.  And, we do see a similar pattern in home price volatility in the recent period, with higher volatility for about 5 years, which now looks like it is slowly declining.  So, if the uncertainty premium has been the binding factor, it should be aging out of market expectations as homes continue to re-establish non-extreme price behavior.

In any case, returns to homes should be converging with bond returns so that, if we re-establish non-arbitrage pricing, bond yields, with the typical risk adjustments, at the top of this cycle should approach or pass imputed home returns.

Monday, May 25, 2015

Unemployment by Duration and Interest Rates

Here is a graph of unemployment durations over the past several years, as of December.  For durations under 27 weeks, we are back to 2007 levels (which were similar to 2005, 1999, and 1995 levels).  (The unusual approx. 1 million remaining in the unemployed workers in the "over 26" category have an average duration of over 100 weeks.  The normal approx. 1.5 million workers in that category should have average durations of around 56 weeks.  The remaining additional workers are marginally attached to the labor force, and likely have little effect on general trends in the labor market.  That is not to minimize their challenges or to ignore that they will probably slowly re-enter the labor force.  But, they should have a very diminished influence on things like interest rates and wage growth.)  In other words, employment is back to levels we would normally see at the end of an economic recovery, with high short term interest rates and a flattened yield curve.

What the Fed does with short term interest rates between here and 2% isn't going to matter much, as long as we can keep out of a highly deflationary context.  What will matter for the business cycle (besides attracting capital back into the housing market) is how the Fed manages the money supply when the yield curve flattens.

The year 2017 could be the year 1997, or it could be the years 2001 or 2007.  Whether they begin raising rates in September 2015 or in 2016 shouldn't have much bearing on that.  Right now there is more than enough liquidity for everything, but just not enough ways to employ it as housing capital.

Friday, May 22, 2015

April 2015 CPI and the Treasury/Housing trade

Inflation came in strong again.  This is interesting.  On a monthly basis, core CPI is growing almost as quickly with Shelter as it is minus Shelter.  Will this persist?  Could we be seeing the beginning of a trend back to 2% inflation?

I have lost confidence in the short Eurodollar/long homebuilder position for now.  There was a brief glimmer of growth in mortgages and home prices after the slowdown associated with the taper of QE3.  But, for now, that seems to have subsided.

Yet, CPI data suggests that we might see an uptick in inflation.  I think real long term interest rates will remain very low until real estate values recover.  I had expected to see inflation, home prices, and real rates all recover together.  But, if the current trend in inflation persists while mortgages and home prices remain stagnant, maybe we will see higher nominal rates while real long term rates remain very low.  This complicates a speculative interest rate position.

It also means that the Fed could begin raising rates before we see a substantial recovery in new home building.  That could lead to an outcome where short term interest rates, more or less, follow the path of the current yield curve, with a very slow climb relative to recent recovery periods.  Maybe the yield curve doesn't reflect a thick tailed distribution of expectations, after all.  But, it would mean that if the housing shortage continues to push on shelter inflation and the Fed treats that as a demand issue, we could see stagnation or a new recession before we see any improvement in housing supply.

Here are a couple of graphs showing the regime shift that I think we have seen in housing and long term interest rates.  Until 2007, there was a long-standing relationship between housing and long term real interest rates.  (Bond yields tend to be more cyclical, and they carried unusual inflation premiums in the 1980s.)  But, since then, we have been in disequilibrium.  So, before 2007, rising home prices were associated with falling real interest rates.  But, since 2007, falling home prices have been associated with falling real interest rates.  Unless we see renewed growth in housing, I expect real long term rates to stagnate or fall.

These graphs have proxies for housing returns using (1) Case-Shiller and (2) BEA data, and proxies for long term real interest rates using combinations of mortgage rates, 10 year treasuries, U. of Michigan inflation expectations, and core CPI, for periods pre-dating TIPS bonds.  It looks to me like equilibrium rates would correspond to 10 year TIPS rates about 2% higher than they currently are and real home prices about 25% higher than they currently are.  In equilibrium, interest rates lower than that would need to correspond with sharply higher home prices.

I think one simple rule of thumb here might be to expect the yield curve to invert at Fed Funds rates similar to today's 10 year rate (plus maybe a 1/2% added inflation premium from today's levels), but that if we allow the mortgage market to recover, then long term rates would recover, real incomes would rise with less inflationary pressure, and the yield curve would not invert until the Fed Funds rate reached 4%-5%.

Thursday, May 21, 2015

Housing Tax Policy, A Series: Part 33 - Higher Home Prices can lead to Larger Homes

In the comments of the previous post, baconbacon brought up a topic that I realize I haven't touched on yet.  That is the counterintuitive relationship between home prices and square footage.  If the supply of homes is constricted through building limits, or if home prices are rising because of long term real interest rates, then the rising cost of home ownership will be mostly reflected in land prices.  That is because if the cost of building remains relatively stable, the marginal cost of the total property will have to manifest itself through the land price.

In the case of supply limits, rents will rise because the implied rent of the unimproved lot will rise.  In the case of lower long term interest rates, rent will remain the same, but the price of the entire property will rise.

In the case of supply limits and rising rents, households will purchase or rent relatively less lot and more home (the blue line) of a property with a lower real value.

In the case of lower real long term interest rates and higher price/rent, since the cost of the improvements will be relatively stable, the higher price must be attributed to the lot.  This means that with lower rates, the lot comprises a larger portion of the total value of the property.  This will have the same relative effect as rising rents.  Households will purchase or rent properties with less lot and more home.  Here, I don't think that total utility will change.  The house will still have the same real and nominal rental value.  It will just have a different mix of home and lot.

If the lot is already a sufficiently large portion of the total cost, it is possible that rising rents could lead households to buy homes with larger square footage, or at least higher value (on less valuable lots).


Source
There is data on square footage of new single family homes and lots, so we can use square footage as a proxy for value.  Over the past thirty years, we have had an overriding shortage of housing supply and related rent inflation.  And, over that time, homes have had steadily rising home square footage relative to lot sizes.

Next is a graph of the ratio of Home Square Footage to Lot Square Footage.  In the chart, I also show home Price/Net Rent (this is the inverse of real long term interest rates) and the telative price level of Owner Equivalent Rent / Core CPI over time.  We can see that all of these measures tend to move together.  Regressing the square footage ratio against the other two, inflation has the strongest effect.

Rent Inflation & Lot/Home ratios - left scale
Rent/Price - right scale
I would have expected Price/Rent to have the stronger effect.  But, even if we look at detrended Lot/Home Size compared to Year-over-Year relative Rent Inflation and Real Long Term Returns to Real Estate (Net Rent/Price, which is similar to long term real interest rates), we still see a strong correlation.  A regression of these measures still shows a strong influence of relative Year over Year rent inflation on the deviation of Lot/Home Square Footage from trend. There is also a weaker correlation between Rent/Price and deviation of Lot/Home Sq. Ft. from trend, but not statistically significant.

It's important to keep clear the difference between all of these measures.  My proxy here for a housing shortage is housing inflation.  This has nothing to do with home prices.  This is the relative change in the rent of a property over time.  Housing consumption (which is different than home ownership) and home supply are both slow moving variables over time, having to do generally with the number of households and the stock of housing.  Real housing consumption (measured as rent or imputed rent) has been declining for three decades, while nominal housing consumption has remained flat (both as a portion of personal consumption expenditures).  This suggests a supply constraint.  Housing is becoming more expensive (in terms of rent, not price) because this shortage has led to above normal rent inflation.

Counterintuitively, larger average square footage of single family homes does not contradict the housing shortage hypothesis or the home-as-real-long-term-security model.  It confirms them.  Believe it or not, I had not even looked at this data on lot sizes until after my exchange with baconbacon.

The suggestion from this data is that rent inflation has a larger influence on the changing size of homes and lots than long term real interest rates.  I am beginning to convince myself that building constraints are a larger influence on housing costs (and consequently, real incomes) than either tax issues or low interest rates.  I am beginning to think that by the time I am done with this, I will have an explanation for a large amount of the stagnation in low quintile household incomes.

This is a real shame, because, if we did not have these constraints on housing supply, the effect of this global context of low real interest rates should have been to entice investors into building, lowering rents instead of raising them.  Between this factor, and the imposition of taxes on renters, I think these housing supply and tax issues could explain a decline in real incomes of 20% or more among the lowest income households.  That's my guess now.  I should be able to eventually come up with more detailed numbers, but this has become a larger project than I ever expected.

Wednesday, May 20, 2015

Housing Tax Policy, A Series: Part 32 - Macroprudential regulations will continue until morale improves

I was depressed to see this headline today (FT, Reuters): "Banks calls for global coordination of bubble-busting measures".

While the banking executives did include warnings about the need to be careful in implementing these measures, the very first sentence of the Financial Times article kicks off with the typical, if unlikely, interpretation that high demand for low risk assets is a sign of high risk taking:
A group of leading financial executives have urged authorities around the world to bolster their crisis-busting arsenals amid fears that ultra-low interest rates have increased the risks of financial instability. 
One of the proposed regulations would be a limit on mortgage levels relative to incomes.  It is common for banks to use guidelines for debt expenses relative to income.  But, this would limit the size of the mortgage. The FT article says, "Authorities in countries ranging from the UK and Switzerland to Israel and Hong Kong have been making greater use of these regulatory levers to curb rising asset values, especially in the housing market."

As I mentioned on a recent post, while we tell ourselves there isn't generally widespread support anymore for explicit price controls, this sort of thinking really is a softer version of the same thing.  And, this is so wrong-headed.  I have outlined here many times how home prices, more or less, behave like a very long term real financial asset - because that is what homeownership is.  We shouldn't expect anything else.  Yet, everyone seems to simply accept the idea that prices in the 2000s were crazy - "exuberant" - because nominal prices were high.

Let's apply that logic to bonds.  Here is a graph of the price of a 10 year bond, with a $100 face value and a 10% coupon rate.  Why, look at that!  The market price doubled between 1985 and 2010.  This is the price for a certificate with a fixed level of income - $10 per year.  This must be irrational exuberance!  Why would sane investors pay twice as much for the same income?

So, what would be the best policy here?

1) Don't do anything.

2) Correct the irrational exuberance with a tight money policy.

3) Make a rule that banks can't sell these bonds for more than $140.


Unfortunately, #2 is exactly what we did from 2006 to 2008.  Imagine if we had done policy #3 instead.  Bond issuance would collapse if we did that to the bond market.

So, I would expect new home building to dry up if this rule became constraining.  But, housing has a stable existing stock.  I suppose in the housing market, the market reaction on existing homes would be to treat them as if there was a rolling call option at the price level that would tend to trigger the loan limit rule.  If long term interest rates remain low enough to make this policy constraining, then housing supply would continue to be inhibited, and rent inflation would continue to climb.  But, before I think through this more, I want to look at a few graphs to show how misplaced this entire concern is.

First, here is a measure of the mortgage payment required to buy the median new home, as a portion of median household income.  This was not particularly high in the 2000s, and it has been extremely low since then.  Since home prices in the 2000s were mostly a product of low real long term interest rates, they didn't require large mortgage payments, because mortgages also had low rates.  This is basic asset/liability matching.  The funny thing is, we have this whole set of controversial quasi-public institutions set up to create this asset/liability match, and now we ignore the fact that we have it when we interpret activity in the housing market.

Using Federal Reserve and BEA data, we can compare estimated rent and mortgage payments all the way back to at least 1950.  Mortgage debt service was much higher in the 1970s.

Here we can see that the way to lower home prices is through very loose monetary policy.  If housing was a problem that needed to be solved (it didn't), then the solution would have been to create expectations for 5% inflation.  Mortgage payments for new homes would have been higher, so there would have been less pressure on home prices.  And, for households with variable mortgages, their nominal home values and incomes would have gotten a 5% annual boost to help alleviate any difficulties.


But, I want to go back and think about what effect a loan size to income limit would have on the housing market if it was a tighter constraint than debt service to income ratios.

One of my running themes here has been that housing does tend toward a no-arbitrage price level - the aggregate market is relatively efficient.  In the late 1970's and 1980s, real long term interest rates were almost as low as the 2000s, (although very high inflation and inflation uncertainty muddy the picture). This would justify a high Price/Rent ratio.  It appears that home prices still found an efficient level in that period, and that households tended to downsize in order to settle at a debt service level that was manageable.  This makes sense.  There would have been tremendous incentive to own property that would appreciate along with inflation.

But, if a loan size limit becomes the constraint, households buying with leverage won't be able to bid the prices of homes up to the efficient level.  So, when the efficient price moves above the level that regulators would allow a mortgaged purchaser to fund, wealthy households would have an advantage, because they would be able to use cash equity to bid the prices of homes higher.  Households without a large pool of savings would need to downsize in order to buy homes at the market price (because the price would reflect some demand from cash buyers).  Homeowners in general would earn excess returns because limited mortgage availability would limit demand and prevent the efficient price from being reached.

It would like a combination of today's housing market and the early 1980s market.  There would be less new homebuilding because of the artificially low price level, which would cause rents to continue to climb.  That would possibly be mitigated by the downsizing among new owners.  But, just as there now is, returns to ownership would be very high, so owning a home would be lucrative, especially for institutional owners who could obtain outside financing.  So, there would be a tendency for homeownership rates to fall and for institutions and households with high net worth to capture above-market returns.

If the inhibition of supply was strong enough, this would lead to a vicious cycle of rents rising faster than incomes, so that marginal households would qualify to buy smaller and smaller homes.  This would further erode the ownership rate and produce high returns for well-funded owners.

Marginal households that did manage to purchase highly leveraged homes would see especially large returns because they would reap the excess returns on home ownership but their interest expense would not reflect a premium, since there would not be a constraint on the banks themselves to issue mortgages.  But, I think an end result of these trends would be to push back toward a pre-HUD context where ownership was less mortgage-dependent and less owner-occupier based.  Eventually, landlord funding and organizational foundations would be available for landlord owners to earn those leveraged excess returns.

To the extent that the landlord market developed and housing prices were bid to near-efficient levels, there would be lower rent inflation and lower homeownership rates.  To the extent that this didn't happen, marginal households would tend to purchase downsized homes, rents would tend to rise over time, and real estate owners would earn excess returns.

I wonder if these possible trends, themselves, (stagnant housing stock, less credit expansion and more equity ownership) would tend to have a downward influence on real long term interest rates, adding to the vicious cycle of pushing home prices above the loan constraint.





Tuesday, May 19, 2015

Revisiting Labor Force Participation

Tyler Cowen, linked to a post today about unemployment, which made the common insinuation that the unemployment rate has been lowered by a bipartisan conspiracy to hide the true level of unemployment.  From the post:
Before the latest recession, the proportion of people who "want a job" has been around 63% for a very long time. During the recession, this proportion plunged to below 59%.
This looks plausible next to a graph truncated in 1994 when female labor force participation was peaking and falling into a slight long term declining trend similar to male labor force participation in a post that makes no reference to these gender trends or to the significant aging issue.  But, the idea that the aggregate Employment-Population Ratio (EPR) has had some longstanding level stationarity which has suddenly failed is false.  Labor force participation (LFP = employed + unemployed, so it is less cyclical than EPR) does have longstanding linear trends for gender specific age groups.  But those trends have been slightly negative for generations among males.  So, where there are trends, they don't support the author's case.

Anyway, looking at that made me realize that it had been quite a while since I had reviewed Labor Force Participation (LFP).  We will continue to slowly converge on the long term trend, so it's not something I have been following recently, but it might be interesting to unpack it a bit to see what's been happening lately.  (My LFP label has many posts.  Here is a reaction to a previous Tyler Cowen link.  Here, I go into some more detail regarding errors in LFP analysis.)

Here is a graph of the aggregate LFP rate compared to a demographically adjusted trend.  I am surprised to see that the trend has begun to level off and that there has not been convergence between my demographically adjusted trend and actual LFP.  I had blamed the declining LFP on cyclical declines, demographics, and on the minimum wage hikes of 2007-2009, with a mitigating factor from Emergency Unemployment Insurance (EUI), since that should have been keeping some unemployed workers, who might otherwise leave the labor force, in the labor force.  There was about a 1/2% drop in LFP coincident with the end of EUI.  (This graph has a wide scale, but you can see the widening of the gap between actual LFP and trend LFP in 2014.)  But, I would have expected LFP to be recovering by that time from the cyclical and minimum wage issues.

So, the question is, why isn't there a stronger recovery in LFP?

As a first step, let's revisit the movement of LFP among the various age groups.  The 16-24 group is a bit of a wild card, because there has been significant movement over time.  I would attribute some of the 2007-2009 decline and subsequent recovery to the minimum wage hikes, but there has been a strong downtrend in this age group for many years related to trends in extended education.

The idea that 16-24 year old labor force participation is back to trend or slightly above appears to be reasonable, because 16-24 unemployment is also back to recovery levels.  Unemployment tends to be high in this group.  In April it was at 11.6%, which was the unemployment level in 1997 and 2005 when labor force participation was previously above trend.

So, the continued gap between actual LFP and my estimated trend is not coming from this age group.

Next, let's look at prime working ages.  The 25-34 group is 0.3% below trend, 35-44 is 0.8% below trend, and 45-54 is 1.3% below trend.  The gap widens as we move up through age groups.

I think the 25-44 group is straightforward.  The combined level of these two groups suggests a gap between LFP and trend LFP of around 0.5%, which, is slightly low, but not unusual for late recovery periods.

Moving on to the 55+ group, there has been a tremendous break from trend.  This group is 3.1% below trend, and the break happened around 2007-2009, which appears to be related to the cycle.

But, the 45+ age groups are a little strange.  The 55+ age groups have had sharply rising LFP trends for the past 20 years.  Part of this is due to rising LFP among men, which appears to be a cultural shift among baby boomers to work longer, unrelated to business cycles.

Part of this is due to the last remaining upward shift in female labor participation.  Female LFP for 35-44 year olds peaked in the 1990s.  It peaked for 45-54 year olds around 2000-2002.  And, we see here that it peaked for 55+ year olds in 2010-2012.

So, the leveling trend of 55+ female LFP was predictable.  So, both the leveling female trend and the recession happened at the same time that the trend of 55+ male LFP leveled.

It's hard to pin down the precise causes of the movements in this age group without much more detailed analysis.  But, the systematic behavior by gender and age, and the sharp differences between the marginal age groups and the core prime age groups, suggests to me that these changes are only tangential to the business cycle.

Here is a graph with the 55+ age groups broken out into 5 year subgroups.  This graph shows the change in labor force participation, in percentage points, from January 2000.  I think here we can see that there isn't a systematic kink in labor force behavior associated with the recession.  What we see is a peak in labor force participation that moves through the age groups roughly in line with the arrival of the baby boomers, who tend to work to older ages and tend to have higher female participation.  These tend to be very noisy data series.  But, generally, the 55-59 group peaked around the time of the recession (and some of this group's decline may be cyclical).  The older groups are still growing as life expectancy grows and as the baby boomers move into the older groups.

So, what is happening to the LFP of the aggregated 55+ group is a similar version of what is happening to the aggregate LFP across all ages.  The trends within each subgroup are continuing with a relatively normal behavior.  In these groups, the trends are actually rising.  But, as the baby boomers age through these groups, the total LFP of the aggregate 55+ group declines, because LFP declines sharply as workers age through these groups.  This is shown in the next graph.

And, this basic demographic issue also explains the behavior of the 45-54 group.  Here is that group, shown with the 5 year subgroups.  The 45-49 subgroup looks more like the 25-44 age groups.  And the 50-54 subgroup looks more like the 55-59 group.

Stepping back, the only significant factor here that looks especially out of the ordinary when we disaggregate, is the sharp dip in LFP for the 50-59 age range, which is probably explained by the rise in social security disability claims that tends to happen in this age range, and has especially been the case during the recent recession.

If this change in the trend of 55+ workers is not related to the recession, then there is no gap in LFP.  The next graph shows 55+ LFP and my original linear trend, with a new trend line added that follows the new flat trend since the beginning of 2011.

And the graph after that shows what the aggregate LFP trend looks like if we make this change in the 55+ age group trend.

Now, I haven't proven that there is no cyclical issue here.  But, if someone argues that trend LFP is some distance above the estimated trend that I show here, they would need to explain why the continued lag in LFP is limited to workers over 50 years old.

In the period from 2000 to 2014, social security disability rolls have increased from 2.4% to 3.6% of the adult civilian population.  New enrollees peaked in 2010, which is when baby boomers were at the heart of the 50-60 age group.  Disability rolls have stabilized since 2011, as baby boomers move into the 60+ age groups, so this issue is probably not as severe, going forward.  And, while there was some increase in disability enrollment that was related to the recession, this is not really a cyclical issue.  And, it's not a reason to describe the current labor market as deceptively weak.

So, I continue to believe that the labor market is as strong as popular measures make it out to be.  I don't accept the notion that strong labor markets are inflationary.  I think we can expect strong real growth that comes from a highly functional economy.  This would normally also include high real interest rates.  But, I think it remains to be seen if high interest rates can materialize in the absence of mortgage expansion.  So, while I think labor markets are strong, I don't think this necessarily translates into a call for the Fed to raise their target rates.  But, if we can find some way to overcome the real estate shortage, secular growth rates could be quite strong.

Monday, May 18, 2015

Interest on Reserves during the Financial Crisis and Going Forward

Here is a graph of:

1) Bank Deposits

2) Bank Deposits, net of excess reserves

3) GDP

Notice that bank deposits grew fairly steadily throughout the crisis and recession.  They leveled off shortly in 2010, after the crisis.  (This lagged decline in deposit growth happened also after the 1990-1991 recession, where deposits were relatively flat from 1992 to 1995.  Here is a previous IW post on the similarities between 1990 and 2007.)

But, if we look at deposits, net of excess returns, there is an unprecedented volatility in bank assets, beginning in the fall of 2008, coincident with the sharpest fall in NGDP since the late 1940s.  Because of the zero lower bound and the role of reserves in current monetary policy, this measure has continued to be volatile.  But, since 2008, this volatility has not been associated with extreme and predictable variations in NGDP.

I think the reason is that, since the implementation of QE, changes in reserves have come from the injection of cash into the economy.  The Fed purchased long duration treasuries, and subsequently sold short duration securities back to the banks, that were in the form of excess reserves.  This was an exchange of liquid assets, and I think it facilitated an exchange of equity based real estate ownership that replaced debt based ownership.

But, the original shock to deposits minus reserves was not associated with this exchange.  That period was chaotic.  In this next graph, the red line is bank deposits, net of excess reserves, plus all federal reserve assets.  The purple line is bank deposits, net of excess reserves, plus conventional open market operation assets (in which I include treasuries and MBS).  The difference between these two measures (between red and purple) is the "lender of last resort" activity that the Fed engaged in during the crisis.  We can see that there was none of this before 2007, a small amount stemming from the failures earlier in the recession, and a sharp rise in September and October 2008, after the Lehman failure.  Since then, these assets have been slowly declining.

If we just look at Fed assets associated with a typical injection of currency as part of open market operations, (the purple line) we can see that in late 2008, until QE1 kicked into gear, there was a flight of cash from banks back to the Fed.  We can see here that, since then, reserves and QE injections have roughly matched, so that deposits minus reserves plus Fed assets has grown as steadily as deposits.

We should remember that when the bottom fell out of the economy in the fall of 2008, the Fed was far from the zero lower bound.  The recession, as defined now, had begun in December 2007, but that was not declared by the NBER until November 28, 2008.  So, we were not officially in a recession in September 2008, the Fed Funds rate was at 2%, and the FOMC decided to hold the rate steady in defiance of market expectations of a decrease, as a prophylactic against inflation.

It now seems clear that the Fed was taking an extremely tight stance at that meeting.  This has not been the case since the implementation of QE.  Or, at least, bank liquidity has not been the constraint on nominal economic expansion since then.  I have previously looked at interest on reserves during the crisis period.  Here is a graph from that post, comparing effective Fed Funds rate, target Fed Funds rate and the IOR rate.  When the Federal Funds rate was at 1%, and IOR was pegged at 1% also, in November and early December, the effective Fed Funds rate was well below the target rate.  And, it  was during this period that bank deposits were piling into excess reserves.

The IOR rate is a contracted rate, controlled by the Fed.  As far as I know, it remains fixed.  But, the Fed Funds rate is a target, which the Fed influences by buying and selling securities in open market operations.  Normally, the Fed would raise the effective Fed Funds rate by selling securities, sucking cash out of the economy.  But, clearly what we needed in late 2008 was not a sharp tightening of monetary policy.

What I think happened was that the Fed had set the Fed Funds policy above the neutral rate.  After the disastrous September 16 FOMC decision, even before IOR was implemented, banks were collecting reserves in an unprecedented way.  Since banks were hoarding cash, the effective Fed Funds rate was already pushing well below the target rate.

Once the IOR rate was pushed above the neutral rate, the only remedy would have been to push IOR back down.  But the Fed didn't do that, so while bank deposits grew at a normal pace on banks' liability ledgers, hundreds of billions of dollars were being put back to the Fed as reserves on the asset ledgers.

It seems to me that a big difference regarding the monetary base between using IOR and Fed Funds is that when the Fed uses the Fed Funds rate, it is generally in control of the quantity of cash it is injecting or pulling out.  But, with IOR, the banks are in control of the quantity of cash being exchanged.  The Fed's institutional inertia in the face of that problem in November 2008 was disastrous.

A further problem with an IOR based policy is that IOR below the neutral rate may have minimal effect on reserves and bank balance sheets.  Currently, expansion in bank credit is not encumbered by limited reserves.  (In modern banking, I'm not sure that it ever is.)  But, if IOR is pushed above the neutral rate, as it was in late 2008, there is a tipping point where reserves come rushing out of the banks.  It's like a lender-initiated bank run.

I wonder if this is a signal to look for if the Fed begins pushing the IOR rate up.  I suspect the neutral rate is currently above the Fed Funds rate.  But interest rates aren't the constraint on faster nominal expansion.  (Regulatory pressures on mortgage availability are strong.  Banks have assets of about $7 trillion in loans to businesses and households, and half of that is real estate.  So, any growth in credit is only coming out of half the balance sheet.)  Currently, banks are expanding their loans and leases and reserves are slowly being converted to currency.  But, if the IOR rate pushes above a tipping point, and reserves start to grow while the Fed's asset base remains level, that could be a real problem.

The Fed didn't react quickly to that problem in 2008.  Would they act quickly next time?  There are a lot of folks who see "asset bubbles" all over the place, who are impatient for the Fed to raise rates.  I suspect that if this problematic scenario plays out, bubbles will be blamed.