Thursday, June 21, 2018

Upside Down CAPM: Part 5 - Returns on real estate investments

To review: upside down CAPM is the idea that CAPM models should start at the expected rate of return on diversified at-risk capital and the rate of return on risk free savings is the at-risk rate of return minus the premium savers pay for the service of protecting savings for deferred consumption.  Changes in actual returns for at-risk capital come from cyclical changes in profit and from changes in expected long term real returns, but expected real returns at any point in time tend to remain fairly stable at 7-8%.  Fluctuations in real risk free returns come from shifts in the premium savers are willing to pay to avoid risk with deferred consumption.  The equity risk premium doesn't come from changes in expected at-risk returns. It comes mostly from changes in the premium for safety that determines the risk free rate.

This model has led me to realize that I have probably been approaching real estate markets with some misplaced hubris.

Mortgage rates generally follow risk free rates with a small spread, so that mortgages basically fall in the category of low risk saving - deferred consumption.  To the extent that we can measure returns on home equity systematically, real rates of return seem to generally follow risk free rates. Owned home equity is also basically a low risk fixed income security.

But, that doesn't seem to be the case on institutionally owned real estate.  Equity REITs seem to have a fairly stable cap rate and dividend rate.  I had chalked this up to an undeveloped marketplace, where there aren't aggregate market measures that change everyday like in bond markets.  So it seemed like this asset class was like a fixed income asset class, but with a real yield that didn't fluctuate as much.  That didn't seem rational.

However, thinking with an Upside down CAPM framework, having a more stable expected rate of return is a characteristic of equity.  There isn't a mystery here. Institutionally owned real estate is basically a low-beta equity, and it has a low and stable expected rate of return, just as we would expect low beta equity to have.  Its risk comes from cyclical and long term shifts in real returns.

Keep in mind that I am talking about the entire market, so that cap rates are similar to expected returns on all equities, conceptually.  For developers, expected returns on individual projects, or even on all new projects at a given time, may fluctuate more, just as the market for IPOs or private equity seems more volatile and cyclical than the equity market as a whole.

The reason it is more equity-like than owned real estate is because it comes with management costs and vacancies.  This makes net margins lower and more cyclical than owner-occupied real estate.

So owner occupied real estate acts more like low risk fixed income, and the level of debt on a property is mostly related to the owner's need for capital.  Young owners tend to be more leveraged and older owners are less leveraged. Investor owned real estate is like low beta equity and the use of credit is more a product of the market and the property. To the extent that a property can offer the service of safe savings because of relatively certain cash flows, equity holders can optimize profit by using credit as a source of capital.  In fact, market forces will cause profit to be bid down to the point where real estate equity holders have to use credit to achieve a market rate of return.  This is similar to the utilities sector.

This would mean that real long term interest rates would moderate real estate activity between owned and rented properties.  When interest rates are low, at the margin some households would be induced to ownership. There are several ways to think about this. Low real rates reflect demand for low risk savings and deferred consumption. Owner equity serves this function in a way that investor owned equity doesn't. Another way to think about it is to think in terms of cap rates. Cap rates on investor owned properties, being more equity-like, remain stable.  But "cap rates" on owner occupied properties fluctuate with long term real interest rates, so as rates decline, owner-occupied property is worth more than investor-owned property.

It happens that homeownership rates (controlling for age demographics) were high in the late 70s and the 2000s.  In the 70s, inflation (and nominal rates) was high, so rising ownership was explained as an inflation hedge.  In the 2000s, inflation (and nominal rates) was low, so rising ownership was explained as a result of cheap and easy credit.  (Most of the rise in homeownership happened in the late 90s when rates weren't particularly low, so that's not a great explanation.)

Low long term real rates can explain why price/rent ratios were high at both times, but I haven't felt that comfortable explaining why that would lead to higher ownership rates.  Maybe this relationship between owned and rented properties, and the difference between equity and low risk savings, could be part of the explanation for why ownership rates rise when long term real interest rates decline.  (This isn't the case today because housing markets are dominated by credit repression which keeps millions of households out of the market.)

This framework also suggests that multi-unit building should have been much stronger in the 1990s when long term real interest rates were relatively high.  The bias toward equity exposure at the time should have translated to a bias for investor owned real estate.  Maybe some of the increase in homeownership rates in the 1990s was already coming from limits on multi-unit developments in the Closed Access markets, which was blocking this natural shift to rented property when real interest rates were high.

This is all still speculative.  Please provide conceptual or factual criticisms in the comments.

Tuesday, June 12, 2018

May 2018 CPI

More of the same this month.  I think this month might accelerate the slow motion train wreck, because it is being widely reported as accelerating inflation.  But, non-shelter core prices really haven't risen at all since February.  The only reasons year-over-year core CPI inflation has risen to 2.2% are (1) shelter inflation is at 3.5% and (2) the three months that just fell off the back end of the year-over-year range had cumulative deflation of non-shelter core CPI of 0.34%.  So, three months which had cumulative inflation of 0.02% caused the non-shelter core inflation rate to rise from 0.9% to 1.3%.  And shelter inflation adds the other 0.9%.

This will add confidence for maintaining an aggressive schedule of rate hikes.  Households are already into the territory where rent expense is taking a larger portion of personal budgets than is normal.  That suggests that consumption of shelter is already into inelastic territory, so that there won't be a cyclical reduction in shelter consumption.  That suggests to me that shelter inflation will remain high if the Fed overtightens, which will continue to push them to tighten more.

In today's context, I'm not sure that non-shelter inflation at 0.5% or even 0% leads to any sort of acute crisis.  But, it seems like that is where the risk lies.  One problem is that the obsessions and biases that developed during the housing bubble led to a canonized belief that the net effect of rising mortgage levels, home prices, and housing starts is consumer inflation.  But, that is wrong.  To the extent that consumption was fueled by mortgage credit, the source was rising rents in Closed Access cities where housing starts are persistently low, and Closed Access homeowners were spending some of their capitalized future rental income.  Except for the foreclosure crisis in 2008-2011, 2005 was the only time in the last 20 years when rent inflation finally reverted back to general inflation.  The housing boom was moderating inflation.  Closed Access homeowners were spending from their ill-gotten rentier profits, but the Fed is perfectly capable of countering that - and they were throughout the boom, with unusually low currency growth.  The Fed could do that today too, and obviously would, given the general hawkish atmosphere.  But, in the meantime, ironically, the first order effect of opening the floodgates on housing credit markets would be significant disinflation because of falling rent.


Monday, June 11, 2018

Housing: Part 304 - The problem of the displacement of long-term renters.

One of the dilemmas of in-fill housing expansion is that some existing tenants are usually displaced.  That can happen directly because units are taken down to make room for new development, or it can happen indirectly because rents will rise in a "hot" area, leading to a reconstitution of the local population - "gentrification".

A primary cause of this problem is the existence of long-term renters.  These are households who have deep roots in the local community and ties related, very locally, to place, who do not own the properties they reside in, and therefore lack control over these changes.

Frequently, tenants rights policies are advocated for to try to solve this problem, but those sorts of frictions in the dynamics of local housing markets are a big part of the problem that has prevented urban housing markets from shifting to meet new demand for urban tenancy.  The better solution would be for these households to be owners in the first place, and the fact that they are not owners is a sign that our financial and housing markets are underdeveloped.

Landlords provide two sorts of liquidity services.  First, they provide liquidity for frequent movers.  Many frictions exist in the market for transacting real property, which make it quite expensive.  Thinking of homeownership as an ownership stake in a flow of rental income, this makes homeownership unprofitable for tenants who cannot commit to a long tenancy.  This service is very valuable.  Landlords allow tenants to move without incurring all of the costs of buying and selling real property, so that households who might move often are not burdened by the cost.

Second, they provide liquidity through access to capital.  Some households might be able to commit to a long-term tenancy, but they don't have the access to capital markets that would allow them to purchase a property.  In the real estate market that exists, this is a valuable service, also.  But, the goal of housing and financial public policy should be to eliminate the need for this service.  In a fully functional market, households that can commit to long-term tenancy should be able to be owners.  There should be financial products available to them that allow that to happen.

So, the fact that there are long-term tenants in some urban neighborhoods who can be evicted because they are not owners is a sign of a suboptimal system.  If there are a large number of residents in an area who have developed a sense of endowment about the area, but who are renters, then the solution we should seek for them is to find a way for them to be owners.

This is why I really don't like the focus on affordability, whether in terms of debt payments to income or price to income.  If a household can afford to rent a home, they can afford to own a home.  The transactional frictions may be harder to solve, so it is reasonable at this point in time for short term tenants to opt out of ownership.  But, that isn't really so much of a problem, because short-term tenants will not tend to have as much of an endowment effect about the neighborhood they currently live in.

On the other hand, there should be a financial product that allows a long-term tenant to own their home, and the fact that some can't is a problem, because they do feel more of a spiritual ownership of their location.  It does hurt them more to be forced to move.  But, many long term tenants can't be owners because the only financial products we have for ownership involve down payments, amortization, and a mismatch between the asset, which is real, and the typical mortgage product, which is nominal.

Actually, since the crisis, even with the inflation premium embedded in mortgage payments, most tenants - especially those for whom affordability is most difficult - could purchase their homes with a mortgage that would have a monthly payment that is less than their rental payment.  In many cases, it is much less.  This is the case, because in our errant haste to solve what was presumed to be a credit-bubble induced affordability crisis, we have done the opposite of what we should have done.  Instead of finding more ways for households to access ownership, we have eliminated the option of ownership for a large portion of the country.

Our financial system has failed, but the failure wasn't in making too many households homeowners before 2007.  The failure was in preventing households from becoming owners after 2007.

The problem that tenants in gentrifying neighborhoods have is that the financial market has not developed enough to give them a true ownership stake in their properties, so some advocates try to give them second-best ownership stakes through tenants rights.  It would be better if those households could benefit by selling into a hot market, or by borrowing from rising home equity, and choose individually how to capture those gains.

That doesn't solve all of the problems.  From white flight in the 20th century to NIMBYs in today's coastal urban centers, homeowners have never reacted well to any sort of change in their neighborhoods.  And, why should they?  Change is difficult, and when change encroaches on an area, it induces the need for compromise which is a sort of bad luck for those who would prefer that their neighborhoods remain the same.  Some of the reasons for disliking that change may be more morally justifiable than others, but all of those households are reacting to the same human desire - that the world we live in should stay just the way we like it.  But, these compromises are a fact of life.  We currently are missing some dear neighbors who recently have moved away.  Isn't it funny how flexible our sense of political privilege can be?  In this case, it would be absurd of us to demand that our neighbors remain in this house in order to keep our neighborhood intact.  Our sense of political assertiveness comes mostly from our sense of who are outsiders and, thus, who we can boss around.  So, of course it would be ludicrous of us to demand that our dear neighbors stay.  But, it doesn't seem so ludicrous to try to stop strangers from some other social class from moving into our neighrborhoods.  The reason that doesn't seem ludicrous is because they are outsiders and so we feel more comfortable asserting control over them.*

So, even neighborhoods full of owners frequently prefer stability over change, and are willing to assert control over outsiders in order to maintain it.  But, if we focused on access over affordability, and developed tools and products that provided that access, at least we would marry actual ownership with the legitimate sense of ownership that households feel about their long-term homes.  Next time you witness a debate about how new developments will displace longtime tenants, instead of wondering how to protect that class of households, you should wonder why they exist at all, and think of solutions that make them owners, in law, in a way that matches their sense of ownership, in practice.

Edit: a commenter makes the great point that in cities where prices reflect political exclusion, ownership carries more risks and isn't such an obvious improvement in today's environment.

* This is not entirely explanatory.  While there is a strong social norm against preventing our neighbors from moving away, there are many cases of neighbors preventing each other from making aesthetic changes to their properties.  So, there are selected contexts where legal or social norms allow us to obstruct the activities of our existing neighbors.

Thursday, June 7, 2018

Housing: Part 303 - The Fed Balance Sheet

Scott Sumner shared my recent Mercatus papers over at EconLog.  Scott generously supports much of my push-back against the bubble story.  Economist Bob Murphy saw the post and reacted with some chagrin that Scott or I could question the idea that the pre-crisis housing market should be broadly characterized as a bubble, or that the crisis could be blamed on tight monetary policy.

Source
In support of his chagrin, he uses the measure of the Federal Reserve's balance sheet (the blue line in this graph).  The Fed balance sheet shot up in late September and October of 2008, and then continued to grow with the QEs.

I have probably gone over all of this before, in some form, but this seemed like a good excuse to look at it again.  First, it is worth taking a closer look at this graph.  Here is a close-up look at the Fed balance sheet in 2008 along with the Fed Funds Rate.

Source
By mid-November, the Fed had added more than $1 trillion to its balance sheet.  Half of that rise came in September and October when the Fed Funds Rate was sitting at 2%.  Even Ben Bernanke admits that holding the rate at 2%was a mistake.  The initial burst in the Fed balance sheet was due to interest on reserves, which the Fed began to pay because the 2% target rate was so far above neutral at that point that they would have had to sell every single Treasury they had in order to hit their target.  As crazy as this sounds, this was the actual reason for the policy (see here and Bernanke's memoir).

Most of the rest of the increase came when the target rate was still at 1.5%, and the target rate was still at 1% when the balance sheet topped out.  Until QE3, most of the increase in the Fed balance sheet dates to this period that was before QE and was even before the Fed Funds rate hit the zero lower bound.  Heck, half of it happened while the Fed was maddeningly trying to keep the Fed Funds rate at 2%.  They couldn't keep the rate at 2% because they had induced a financial panic, so interest on reserves was intended to force a rate floor by sucking funds out of the banks.  So the initial increase in the Fed balance sheet has nothing to do with loose monetary policy.  It seems as though many people who use the monetary base as a measure of monetary policy haven't accounted for this at all.

QE1 really didn't add much to the balance sheet.  It was mostly swapping Treasuries and MBSs for emergency loans to banks.  The short hand that I use for what happened is that the Fed had policy so tight it was running out of ways to suck cash out of the economy, so instead it started sucking credit out of the economy by offering to borrow cash from the banks and then stick it in a vault so it couldn't be used (excess reserves).  And, looking back at the first graph, we can see that happening.  From September 2008 to the end of QE1, bank lending dropped way off while deposits continued to grow at somewhat normal rates.  So, the gap in bank lending roughly equals the amount of excess reserves.  The banks "loaned" cash to the Fed so that it could hoard the cash and do nothing with it instead of loaning it into the private economy.

Clearly the growth of the Fed balance sheet ceased to be a good measure of monetary accommodation at this point.

Considering conditions today, it seems as though what we should see happen as the Fed reduces its asset base is that bank lending should re-converge with the level of deposits.  There is a bit of a delicate balance here for the Fed, because if they reduce the balance sheet size too fast with monetary policy that is otherwise too tight, the net effect will be for that convergence to happen through declining deposits.  If they reduce the size of the balance sheet while being too accommodative (for instance, this might policy happen if they stopped paying interest on reserves and returned the Fed Funds Rate back to zero, though even then I'm not sure the net effect would be accommodative if it coincided with a reduction in the balance sheet) then possibly banks would lend at such a pace that deposits would start to grow more quickly.

Source
Unfortunately, it appears that they may be erring on the side of reducing the balance sheet while maintaining policy that is too tight.  Here are the 1 year rates of change in deposits and bank lending.  Both are growing at less than 5% and are decelerating.  Lending had looked like it was stabilizing, but over the past 4 weeks, levels of Commercial and Industrial Loans and Closed End Residential Real Estate loans have both declined.

But, the more important story here is that clearly the monetary base is not a good measure of monetary policy under the current regime, and certainly it wasn't in 2008.

Tuesday, June 5, 2018

Housing: Part 302 - Austan Goolsbee was right

I saw a link to this March 2007 New York Times Op Ed by Austan Goolsbee, titled "‘Irresponsible’ Mortgages Have Opened Doors to Many of the Excluded" on Twitter. (HT: NT*)  The point of the tweet was that it isn't fair to judge people with gotcha's about things they said before the crisis, because most people were caught off guard, and this op-ed is an example of something that Austan Goolsbee, a respectable economist, wrote that everyone now knows was horribly wrong.

The interesting thing is that the op-ed that is used as an example of something obviously wrong was presciently correct.  It is something Goolsbee should, and I hope someday will again, be proud of.

Goolsbee wrote (in 2007):
Almost every new form of mortgage lending — from adjustable-rate mortgages to home equity lines of credit to no-money-down mortgages — has tended to expand the pool of people who qualify but has also been greeted by a large number of people saying that it harms consumers and will fool people into thinking they can afford homes that they cannot. 
Congress is contemplating a serious tightening of regulations to make the new forms of lending more difficult. New research from some of the leading housing economists in the country, however, examines the long history of mortgage market innovations and suggests that regulators should be mindful of the potential downside in tightening too much.
This is exactly what happened.  And we have paid dearly for it.

Compare this to statements from Case & Shiller in their 2004 paper "Is there a bubble in the housing market?":
(J)udging from the historical record, a nationwide drop in real housing prices is unlikely, and the drops in different cities are not likely to be synchronous: some will probably not occur for a number of years.  Such a lack of synchrony would blunt the impact on the aggregate economy of the bursting of housing bubbles. 
This is not what happened.

Yet, here we are in 2018, and Austan Goolsbee is supposed to be embarrassed by what he wrote while Case & Shiller are commonly credited for calling the bubble.


idiosyncraticwhisk.blogspot.com 2018
Source: Zillow.com: Median prices by zip code, sorted by IRS income
Here is a chart comparing home prices for the entire period from 1998, before the price run-up, to 2013, when prices were near the bottom.  Does this look like the picture of a housing market where a few high priced cities finally fell back to earth?  Or, does this look like a market where we took a billy club to low-tier lending markets until they relented?  As I have pointed out previously, there is usually very little difference within metro areas between price appreciation of high tier and low tier markets, on average, over time, because, contrary to conventional wisdom margin shifts in credit access just don't have that much of an effect on prices in functional markets.


idiosyncraticwhisk.blogspot.com 2018
Source: Zillow.com: Median prices by zip code, sorted by IRS income
How can I say that?  Well, in most cities, during the boom, there wasn't much difference between high tier price appreciation and low tier price appreciation (here shown from 1998 to 2006).  So, either there was a credit bubble in the 2000s and it didn't have much of an effect on low tier prices, or there wasn't a credit bubble in the 2000s.  (The reason the rise in low tier prices is limited to the Closed Access cities likely has little to do with credit markets, which I explain here.  But we can infer that it has little to do with credit markets just by looking at these graphs, since it would be odd if only a handful of cities were affected by the credit bubble and those cities were the only cities where long term prices in low tier neighborhoods held up well.  You could plausibly explain that away by arguing that in the Closed Access cities, a credit bubble led to price increases while in other cities it led to oversupply.  But for oversupply to explain this scale of a price drop, surely tenant vacancy levels would be high while subsequent low tier rent inflation was low - and both would be extreme.  Yet, in most cities, there is nothing.  Rents are rising and vacancies never rose.)

My point here is to note that in order for credit markets to really move prices between market tiers, the shift in credit access has to be extreme.  The credit boom in the 2000s that appeared extreme had little effect within metro area housing markets.  To knock 30% off of low tier prices in a city, compared to high tier prices, you really have to apply Godzilla level shifts to the market.

Goolsbee referenced this paper from Kristopher Gerardi and Paul S. Willen from the Federal Reserve Bank of Boston and Harvey S. Rosen of Princeton.  They write, "We find that over the past several decades, housing markets have become less imperfect in the sense that households are now more able to buy homes whose values are consistent with their long-term income prospects."  In hindsight, this was absolutely true and continued to be true during the bubble.  According to the Survey of Consumer Finance, the rise in homeownership was focused on households with high incomes, college degrees, and lucrative careers.  And, even the rise in distressed levels of debt (debt payments greater than 40% of income) that happened at the end of the boom, was among households with top incomes.  Those were the households that accounted for much of the small, early wave of defaults in 2007.  Middle and lower-middle income borrowers who are the type of borrower that we might think of as credit constrained in a functional market, accounted for much of the later, much larger wave of defaults that happened well after we went and did exactly what Austan Goolsbee told us not to do.

"Also, the historical evidence suggests that cracking down on new mortgages may hit exactly the wrong people....When contemplating ways to prevent excessive mortgages for the 13 percent of subprime borrowers whose loans go sour, regulators must be careful that they do not wreck the ability of the other 87 percent to obtain mortgages."  I didn't say that.  Austan said that, in 2007.  And it's even worse than he feared.  Originations to borrowers with FICO scores above 760 have continued at at least the same pace since 2007 as they had been issued from 2003-2007.  Originations below 720 have been cut by two-thirds, even though there had been no increase in low FICO score originations during the boom compared to high FICO scores.  Even lending to FICO scores between 720 and 760 has dropped by more than half.  We didn't stop at 87% of the subprime market.  We killed half of the prime market.  That's how much life you have to stomp out of credit markets to get low tier markets to collapse.  There isn't anything subtle going on here.

Austan.  You were right.  Claim your crown.




* The original tweet isn't there anymore, but the tweets and replies to it remain.

Sunday, June 3, 2018

Housing: Part 301 - When the canon is wrong, there is little hope for constructive learning

It happened again.  I thought I'd been scooped.  The Mises Institute headline reads: "Housing: High Prices, Few New Units" (HT: JW)  They have noticed that a supply shock in housing is having important effects.  But, conventional wisdom has foiled them.  It is simply impossible to come to terms with the true state of our national housing problem with "bubble" colored glasses on.  This is why a new view on this is so important.  Until conventional wisdom about the housing bubble gets overturned, public consensus about the economy in general and the housing market in particular will be anything but wise.

Let me walk through the article.

First, the tags on the article - "Booms and Busts, Money and Banks" - give insight into the strength of presumptions in the conventional wisdom.  Housing quantities and prices fall under these categories.  Money, credit, fear, and greed.  Instability is inevitable, it is driven by money, and it begins with a boom.  The reason these are the tags is because this is canonical.

It starts by contrasting the current market with the bubble. "At the same time, home prices were increasing, driven up in part by fact that everyone was convinced that housing prices always go up, and real estate — any real estate — was a rock solid investment."

This is also part of the canon.  It doesn't need to be questioned.  And, thank goodness, because there isn't really any way to establish plausibility or causality here.  If you tried to use this sort of assertion as the foundation for a contrarian point of view, it wouldn't fly.  The nice thing about it is that, since it has become part of the canon, it could explain prices rising by 10%, 50%, 200%, or 400%.  And, the higher prices rise, the more we could conclude that people are irrational.

The author notes that building is not nearly as strong as it was in 2005.  This is true.  He says,"Now, some might think 'it's good we not going back to bubble levels.' True enough."

Again, this is an uncontroversial statement.  That there were too many homes is canonical.  So, here, the author exhibits unusual wisdom, by correctly noting that, adjusting for population, housing starts are much lower than they have ever historically been.  This has been the case for a decade.  Here is a graph he shares:

Do you notice anything funny about that graph?  That graph either displays a good measure of housing expansion, which supports the author's point, or it shows that there wasn't anything close to an overexpansion of housing in 2005, in which case it would seem to display a poor measure of housing expansion if the bubble story is true.

IW readers know that this is a good chart, and that it correctly shows moderate housing expansion in 2005 and very low housing expansion since then.  But, the author just breezes right past this oddity in his presentation.  I don't really fault the author, per se, because the bubble is canon.  It resides in a different part of the brain than ideas that require confirmation.  There is no motivation and no point in even paying a moment's notice to whether this chart supports the bubble story, because the bubble story isn't a story that needs support.  It is something we know.  It might be worth pondering why housing starts per household in 2005 aren't higher than they are in the graph here, but surely there are more useful things to do with our time.  That's the point of the canon.  You can't spend half your day confirming that gravity still exists.

But, when the canon is wrong, the truth trolley goes off the rails.

The author notes that the Kansas City Fed has also noticed this problem, and the Kansas City Fed lists the following possible reasons: (1) shortage of qualified construction workers, (2) small builders having trouble funding lot acquisitions and construction, (3) limited availability of lots.

All of these problems would be solved with more money and looser credit.  And, since credit conditions in the mortgage market have tightened to extremes, especially in low tier markets, you might think this would merit a mention.  But, too much money and credit is what caused this mess, according to the canon.  That's like suggesting that birds can fly because gravity doesn't apply to them.  The answer can't contradict the canon.  For the most part, in our daily lives, it wouldn't (and shouldn't) even occur to us to do that.

The author wonders if lower Mexican immigration is a cause of this.  Or "finding inexpensive financing for land acquisition and construction has been difficult as money has been siphoned off to other forms of bubble investment as central-bank produced asset inflation continues."  And, "nowadays, as Brendan Brown has often noted, other investment "narratives" have directed many investors' attention elsewhere. It's no longer assumed that housing prices will always go up. Meanwhile, lumber costs, labor costs, and regulatory costs at the local level continue to push up production costs."

As for rising costs of lumber, regulations, etc., those are plausible, and they might even be true.  But, then low tier housing would be selling at a premium.  Instead, in every city during the bust, low tier housing took on a large discount, and for the most part those discounts remain.  If higher cost was what was keeping supply mysteriously low, wouldn't that make prices move up?  Rents are up, but prices are what builders are concerned with, and prices are very low, given current rents and interest rates.

What could possibly cause relative prices to remain low in low tier markets after a decade of depressed supply?  That answer contradicts the canon.

The author concludes by noting that homeownership rates are lower than they were before the bubble started.
Vacancy rates are down and housing prices in both rental housing and in single-family housing continues to head upward.
Nearly a decade out from the last financial crisis, one is tempted to wonder if we'd have all been better off without constant federal "help" designed to increase homeownership rates and build an "ownership society."
Originations for 720<FICO<760 are also down.
When the canon is wrong, this is how bad it can get.  Without the canon, one might suggest that at the end of a decade when mortgage lending to borrowers with FICO scores of less than 760 has been made especially difficult through public policy (the average FICO score is around 690) that maybe the lack of federal help might have something to do with the fact that there was an unprecedented collapse in homeownership during that actual decade.
And this lackluster production is all happening during a period of expansion. Presumably, it should be easy to find financing to build housing right now, and to find buyers who can pay a price that will cover expenses for homebuilders. That doesn't seem to be happening. 
One would presume, wouldn't one.  One might presume that there would be easy financing to plant strawberries in a healthy economy, too.  But, if the CFPB decided that only people with college degrees should be able to eat them, strawberry farmers might find themselves in the odd position of finding it hard to rent acreage where they could profitably grow strawberries.  High school educated cooks would be forced to only buy more expensive processed foods that used the strawberries.  College educated cooks would be rolling in an abundance of relatively cheap strawberries.  And, the country would be united in castigating strawberry growers for only serving the educated.  (Ain't that how it always is.  You can only make profit selling to the high end, you know. Or by selling expensive pies to people who really can't afford them. Typical late-stage capitalism.)

Related imageAs I said, I can't blame everyone for not seeing something that any reasonable person, by now, is allowed to consider a settled issue.  But, it is amazing how deeply blinded and wrong the consensus can be because of this unavoidable need to ignore information that contradicts the canon.

I feel like Indiana Jones in the Last Crusade, at the leap of faith.  There is a bridge across the chasm between the canon and the truth that nobody can see.  Sane people don't just step off into chasms.  I get it.  Maybe if I scatter enough pebbles, we can all walk across it.  There is a room across the chasm that contains a chalice that can heal our ailing economy and make late-stage capitalism young and vibrant again.

Saturday, May 26, 2018

Housing: Part 300 - The Global Bubble Hypnosis is a Larger Problem than NIMBYs

Here is a recent article at the Financial Times.  The headline:
New York property jitters herald declines elsewhere
 The first line:
Clouds are hovering over New York’s housing market.

This is a great example of the mass hypnosis that has infected the public consensus on housing.

There is a broadening realization that the lack of access to urban labor markets and the lack of access to affordable urban housing are the prime challenge of early 21st century economics.  The problem is, solving that problem requires economic dislocation and upheaval of urban housing markets.  If you see falling real estate prices in urban centers should your reaction be to worry about "clouds hovering" over urban real estate markets?  I say, celebrate.

If our primary economic problem is that a lack of housing in urban centers causes it to be overpriced by a factor of 2 or more, then the DIRECT solution to that problem is that urban real estate needs to lose 50% or more of its value.  This article begins by noting that the median price per square foot in New York City has declined by 18% from last year.  Your reaction to that should be, "That's a great start!"  Full stop.  If that's not your reaction, then what are you doing?  What's your purpose?

Further, the article argues that global capital markets are leading to a new synchronization of urban real estate markets, so that additional supply is such a strong factor in bringing down urban housing costs that new units in New York City can bring down prices in London.  Your reaction to that should be, "Wonderful news!  Supply is a much more powerful factor than we thought."  Full stop.  If that's not your reaction, then what are you doing?  What's your purpose?

Reasons given in the article for this drop in New York prices include: (1) removal of tax benefits, (2) "glut" of luxury supply, (3) globalization, (4) "financialization", (5) "ultra-loose" money.  Your reaction to that should be, "Oh.  OK.  Those must all be good things.  Let's do more of those things."   Full stop.  If that's not your reaction, then what are you doing?  What's your purpose?

But, that's not the direction the article takes.  The article notes that sales volume is also down, and, as is the convention, it treats this downturn as the inevitable end of a boom bust cycle.  So, instead of seeing the drop in sales as a sign that all these good things might come to an end - as something we should counter - the article treats the boom that preceded it as the problem, and the solutions proposed are all policies aimed at stopping the real estate expansion before it develops!

This is an explicit defense of a monetary and credit regime that is specified to ensure rising urban real estate costs.

Now, admittedly the problem of solving urban costs is difficult, because normalized, unconstrained urban housing markets would require building with few unnecessary obstructions and low costs.  And, part of what happens in these regimes is that the bridge between basic costs and market value gets filled with all sorts of "limited access" rent seeking.  Developer fees, concessions to advocacy and neighborhood groups and municipal powers, queuing, etc.  These added costs emerged.  They didn't develop as some sort of plan.  So, if supply actually starts to increase enough to bring rents down to a reasonable level, these extra costs will have to be reduced in order to allow new development to come online profitably. Since the cost of queuing is pure waste, the first step here is "easy".  Just keep pushing through more projects for approval that are bringing in those "clouds".  There are a few trillion reasons why local planning boards aren't going to do that to existing owners and developers.

But, for activists and researchers who want to solve the urban housing problem and for global financial journalists who cover these markets, the reaction to that political problem should not be to kill any booms in their infancy.  The reaction should be, "How do we entice these urban planning departments to keep pushing through new supply when it looks like a downturn is coming?"  Because, to refer to any supply in these cities as anywhere close to a "glut" is a laugh.  A horrible, dark, depressing laugh.  There will be a glut of supply when rent in New York City is similar to rent in Atlanta, or even Chicago.  Until then, any use of the word "glut" to describe New York City housing should be met with laughter.

The reason we are engaged in this odd public rhetorical house of mirrors is because we all have a virus in our brain.  It's a cultural meme.  And it's a received canonical premise that there was a housing bubble, and that bubble was caused by loose money and loose credit.

The housing bubble, such that it was, was caused by an extreme shortage of urban supply.  Because of that shortage of supply, the process of meeting the public need for housing requires a "bubble" and the availability of credit that is flexible enough to allow for ownership where rents regularly take 50% or more of a household's budget.  Since supply in those cities barely responds to price, prices in those cities have to be bid up to high enough levels to induce outmigration so that new housing can be built in the rest of the country where supply can react to high prices and high demand.  At the peak of the US housing "bubble", credit markets were just beginning to push market prices to a level that induced that new supply.

Now, it would be better to build ample units in the urban centers.  But, since that doesn't appear to be close to happening, this was a second-best solution.  And, in terms of rent - which is the appropriate measure for considering housing affordability - 2005, briefly, was the one point since 1995 where supply at the national level was abundant enough to moderate rising rents.

Unfortunately, the Closed Access cities in the US are such a problem that in order to create enough housing at the national level, we had to induce a mass migration event out of those cities, and that mass migration event was the source of the dislocations in places like Phoenix that drove the country to demand a credit and monetary contraction.

This is the first step to fixing the problem.  We need to get that virus out of our heads.  The problem, all along, was supply.  Trying to pop the bubble before it inflates is the opposite of what we need to do.  I think the first rhetorical step to beat this virus is to stop thinking about housing affordability and housing markets in terms of price.  Price is a secondary function.  Affordability is about rent.  And, in the end, price is also about rent.  And, in the past 25 years, there have been two successful means for moderating rents.  (1) build like it's 2005, or (2) pull back on the money supply and credit so severely that a good portion of the country is foreclosed upon.

If we had committed to (1), today rents would be lower, prices would be higher, homeownership would be strong, and American balance sheets would be healthy.  It would be nice if a lot more of those American households could also live in the coastal cities.  I don't know if that can happen, but it sure as heck isn't going to happen if there is a consensus reaction to protect those precious urban real estate values every time the solution actually starts to play out by worrying about a "glut" of supply, and then by accepting pro-cyclical credit and monetary policies in order to "pop" the "bubble".

In that counterfactual, where the urban supply problem isn't solved and the rest of us commit to abundant supply, there would be gnashing of teeth about how the Federal Reserve is feeding bubbles and they are at fault for making home prices too high.  We have indulged that intuition for a decade now.  Now we know how wrong that is.  This was the darkest timeline.  Let's roll the dice again and proceed with the knowledge that doing it wrong has provided us.

New York real estate is getting cheaper and is pulling housing costs down in other cities, says the Financial Times, because (1) removal of tax benefits, (2) "glut" of luxury supply, (3) globalization, (4) "financialization", (5) "ultra-loose" money.  OK.  Those must all be good things.  Let's do more of those things.  What's your purpose?

Wednesday, May 23, 2018

Housing: Part 299 - Construction, health, and education employment. Which is unsustainable?

One of the most popular themes you hear about the bubble/bust is that there was massive over-investment into real estate.  This meant that lost manufacturing jobs were temporarily masked by overemployment in construction.  It also meant that Americans thought we were wealthier than we were because we had built a bunch of homes that weren't worth what they were selling for.  When the inevitable bust came, there was a double whammy.  First, all those unsustainable construction jobs disappeared.  And, second American household net worth dropped back down to reasonable "real" levels.

This is one of countless cases where the premise determines the conclusion.  At the center of all conventional explanations of the bubble and bust, there is the presumption that home prices can be pushed wildly above fair value by generous lending and/or speculation.  The problem is that in an asset class like real estate, prices that rise for any reason will be accompanied by rising debt and riskier borrowing.  And, if prices collapse for any reason, the most leveraged owners will fail first and most often.  The fact that these things correlate with price fluctuations tells us deceptively little about the power of credit to move markets.

But, since housing (the service) is related to housing (the asset) that is frequently funded with debt, those correlations are treated as evidence of causation, and the public discussion about housing markets takes off running with presumptions that are rarely questioned, and can't practically be falsified.

Housing is one of three sectors, together with education and health care, that has tended to suffer from lower than average productivity growth, so that consumers tend to spend more on it over time, with much of that spending simply covering inflated prices.

Here, I compare housing (in green) to education and health care (in orange) in terms of percentage of total labor and percentage of GDP.  (Construction employment isn't a great metric here for labor used for housing, but creating a better metric would be time consuming.)


Source
My point here is to address the "keeping up with the Joneses" meme.  That Americans overspent on housing because they wanted a house as nice as their neighbors', even though they couldn't afford it.  The irony is that housing is the outlier here.  Americans have been doing the opposite of that.  Americans' reaction to low productivity in housing has been to maintain nominal spending on housing as a percentage of total consumption, which means that real consumption of housing has not kept pace with rising real incomes.  This has been the case for more than 30 years.  During the boom, the real expansion of housing was just barely starting to expand at the same rate as spending on other categories.

This is in contrast to education and health care, which, both in terms of labor and spending keep growing to larger and larger portions of the American budget.  Now, that's what a sector looks like when we are engaged in an arms race to "keep up with the Joneses".  Ironically, it is the stability of spending on residential housing that leads to this claim only being applied to housing.  Since residential investment has ranged between 4% and 6% of GDP for decades, then that is taken as normal, and an increase to the top of that range is seen as abnormal.

Why?  Why can't Americans decide that marginal new incomes will be spent on housing?  We spend it on education and health care.  Is that spending on education and healthcare unsustainable?  Are we less rich than we think we are because the country is full of overvalued hospitals and universities?  One might reasonably argue that they are overvalued, for similar reasons why housing is overvalued - limited competition.  But, we rightfully see that as a cost, and nobody suggests that the problem is too many schools and hospitals.

To further the irony, to the extent that status is involved in any of these forms of consumption, the status that is associated with housing is generally associated with not overinvesting in real new stock.  The pricey high status units are the units located where residential investment is very limited.

And, in the end, this whole error comes from the problem of associating the service with an asset that has a closely monitored market value which we over-attribute to credit access.  Because, if we didn't overlay all that baggage onto this form of consumption, we wouldn't have this intuition against it.  If Americans decided that their homes should be twice the size they were, who's to argue?  What does that have to do with unsustainability?  If our cars are twice as good as cars were 30 years ago, or our healthcare is twice as good, or our tech gadgets, etc. does that make them unsustainable?  It's an incoherent question.  We consume what we consume.  The way we approach housing consumption is the anomaly.

Let's say we had built millions of unneeded homes, or that we added improvements to our homes in 2005 that were more extensive than they had been before?  (By the way, we didn't.)  It's not like we had to wake up one morning in 2006 and say, "Oh, man.  We can't afford all this housing." and then all move back into smaller units and leave 10% of the housing stock empty until we could actually afford it.  It doesn't work that way.  We built it.  It was here to use.

At that point, any questions about whether we could afford it or not were purely nominal questions - how many dollars would we need to arbitrarily print in order for borrower collateral and ability to pay to remain functional.  Eventually, the public mania about housing became dysfunctional enough that there were widespread calls for making sure we didn't support the functional value of collateral and the ability to repay.  The strong intuition of people to take that position is mindboggling when you step away from it and question the presumptions behind it.  The routine and explicit calls for ruin, even today in hindsight, are a dark lens into the human psyche.

But, before the mania reached that level, the Federal Reserve was explicitly pulling back on nominal growth in order to reduce real residential investment.  And, this goes back to my earlier point.  Can you imagine treating any other form of consumption this way?  Would we slow the economy down to reduce real consumption of education or healthcare?

Housing is pure capital, so we are actually very limited in how much we can do that, because we have to sort of pre-pay for future consumption.  We have to build a unit that will provide housing for years into the future.  It would be like when the tech revolution happened in the late 1990s, if we would have had to pre-pay for all of our future smartphones when we bought our first one.  This makes it difficult to increase our housing consumption.  Yet, because that future consumption is capitalized and because we worry about how that affects our perception of wealth, this is the consumption category we get all tied up in knots about.

Sunday, May 20, 2018

Housing: Part 298 - FICO Scores

There isn't much new here.  I was just putting together a chart from the New York Fed Household Debt and Credit Report, which tracks mortgage originations back to 1999, by FICO score.  It just still amazes me how little there is here.  How an entire, passionate point of view about the housing bubble grew out of a supposition that has no backing in the data.

There was a boost in mortgage refinancing in 2003 because households with strong credit tend to tactically refinance when rates are low.  For the entire rest of the housing boom, there was no shift in lending, by FICO scores.  The general rise in the value of originations followed along with rising home values, but then it leveled off.  So, not only was the private securitization boom not associated with a rise in lending to low-FICO scores, it wasn't associated with a rise in originations at all.

idiosyncraticwhisk.blogspot.com   2018
Source: New York Federal Reserve
From the end of 2003 to the end of 2005, the value of residential real estate rose by about 40%.  We might expect mortgage originations to scale with aggregate value, even if it is rising value that is driving lending, not the other way around.  But, that didn't even happen.  While valuations increased by about 40%, originations remained flat.

There is a tiny bump up in originations to borrowers with FICO scores under 620 toward the end of the securitization boom.  The idea that this could form the basis for any noticeable shift in the aggregate market is a stretch, to say the least.

idiosyncraticwhisk.blogspot.com   2018
Source: New York Federal Reserve
Sometimes you hear hand-waving about this.  One explanation is that rising home prices were falsely bloating  FICO scores.  The problem with that explanation is that prices in the Contagion cities tended not to rise until 2004, so this wasn't the case there.  And, the housing stock in the Closed Access cities is overwhelmingly owned by households with high incomes while households with lower incomes were moving away from those cities in droves.  The Closed Access housing markets are not a good example of markets driven by low credit quality borrower activity.

But, really, someday, I think people will look back and wonder how such widely held and extreme beliefs developed from empirical conclusions that were built entirely from modifications to data that, in its raw form, provided little or no basis for the conclusion.  This data is collected in a fairly timely fashion.  When the broad consensus formed in 2006 and 2007 that collapse was inevitable and curtailing lending at the margin was an important part of the process that we needed to enforce that collapse, this data was available.  Did anyone dare point that out at the time?

There is a lot of latent potential lending out there. (Averages are quarterly.)


 I am sure that many readers might think that lending was excessive throughout the 1999 to 2007 period, so that I can't really treat the average originations for that period as a normal baseline.  Let's say they are correct.  Then, my question for them is, what explanation do you have for borrowing that rose evenly across FICO scores from 1999 to 2007, but then only dropped for FICO scores under 720 after 2007?  Was lending too generous, and were prices too high, for all types of borrowers before 2008, but for some reason lending and relative prices only needed to decline for low FICO scores and low tier housing markets?  Can someone explain that to me?

Wednesday, May 16, 2018

Housing: Part 297 - A Review of the Soon-To-Be New View on Housing

As I prepare parts of this project for wider dissemination later this year, it is nice to see several schools of thought which inform this new view gaining favor. My project is the puzzle piece that solves some of the remaining mysteries and pulls these schools of thought into a coherent whole.

There are three movements or focal points of research that have become building blocks for this new view:
  • Market Monetarism:  This is a school of thought based on the idea that central banks should focus on stabilizing nominal incomes rather than focusing on inflation and unemployment. This seems to be gaining momentum, and it seems like it would lead to better central bank policy outcomes. The important point for my project is that, since market monetarists tend to measure de facto central bank outcomes with nominal income growth, they tend to conclude that the financial crisis was created by tight monetary policy in 2008, the crisis was not inevitable, and there was no direct, inevitable link between the housing bust that had been building in 2006 and 2007 and the recession in 2008 and 2009.

  • The Passive Credit School: Researchers like Demyanyk or Adelino, Schoar, & Severino, or Albanesi, De Giorgi, & Nosal, or Foote, Loewenstein, & Willen have been building a set of research that questions some of the presumptions of the popular accounts of the housing bubble. Borrowers during the boom didn't have particularly low incomes, low credit scores, or less education than usual, the crisis wasn't triggered by defaults that followed rate resets (as many had predicted), systemically destabilizing mortgage products were mostly being used by sophisticated borrowers who defaulted because home prices collapsed rather than because of affordability problems. Etc.

  • The New Urbanization:  Richard Florida has been describing this phenomenon for years. Hsieh & Moretti have done some interesting work. I would put the work of Autor, Dorn, & Hanson in this category. The YIMBY movement is building steam. Even though many urban housing activists tend to seek regulatory solutions rather than focusing on supply, there is a budding consensus that a lack of affordable urban housing is a really big problem

There are several blind spots and false premises which keep these movements from seeing that an endemic shortage of urban housing is the connective tissue that binds them all together.
The broad consensus that the housing boom was, fundamentally, a credit bubble prevents market monetarists from taking the leap to realizing that even the housing crisis was caused by destabilizing tight monetary and credit policies, which date back to as early as 2006 and continue in many ways to today. It's hard enough to try to claim that the housing bubble and bust didn't cause the recession. It would be crazy to try to argue that a recession caused the housing bust, but that is essentially what happened.

That broad consensus also prevents the passive credit school from pushing to a strong conclusion, because since they still tend to believe what happened can be described as a bubble, that there has to be some ad hoc explanation for why a bubble developed. This increases the confidence that the credit supply school has in the competing theory that unsustainable credit supply was the causal factor in the housing bubble and bust. The passive credit school would be on much firmer ground to conclude that there was no (or only an isolated) housing bubble. But, they cannot reach that conclusion based on currently accepted presumptions.

The new urban movement also is limited by the consensus presumptions about the housing boom. If your motivating principle is that we need more housing, it's a pretty big obstacle to have this idea that only a dozen years ago our big problem was that we had too much housing. So, again, their voices are weakened whenever policies that would solve the problem would seem, as a first order effect, to increase lending, home prices, or building development. All of their work is much more coherent once that false presumption is removed.

New evidence, which help to see that the consensus presumptions are wrong, include:
  • The flight from homeownership, and from living in the urban centers with constrained housing markets developed before the most aggressive price inflation happened, before the private securitization markets boomed, well before the CDO market that started the series of financial panics.  First time home buyers were declining as a portion of all households by 2005.  The private securitization boom was not associated with any increase in lending to first time buyers.
  • The peak bubble period was associated with a massive migration event from cities with high home prices to cities with lower home prices.
  • Taking all types of units into account, there was never an oversupply of housing in any city with a strong housing market. The rise in construction employment was not unsustainable.
  • The cities where low tier home prices rose more sharply than prices in high tier markets were an anomaly, and the source of that price differential was not credit supply.
  • The anomalous collapse in low tier home prices was universal across cities, and it happened after late 2008. It was not due to a supply overhang or to a lack of qualified borrowers. It was due to the regulatory imposition of extremely tight lending standards through the federally controlled GSEs and standards set by Dodd-Frank.
  • The time after the extreme tightening in credit standards is the time when the US market deviates from international comparisons. US-specific monetary and credit policies aren't likely explanations of boom period home prices because boom period prices followed international patterns.
  • The primary factor influencing home prices during the boom was location, and when comparing locations, changing rent levels explains nearly all rising prices.
In sum, rising prices during the boom were due to deprivation of supply, not excess credit and money. Once this realization is allowed to inform our presumptions about the market, the importance of the three schools of thought above, and the over-riding problem that connects them - an endemic shortage of housing - becomes clear.

Increased housing supply is what would have fixed the housing bubble. The myth that there was an oversupply overwhelmed our collective sense about what was happening. The Fed was never too accommodative. Home buyers, for the most part, were never too optimistic or speculative. There were never too many homes.

Once those conditions are accepted, the bold conclusions that the three movements above should lead to become obvious, and those seemingly unrelated movements reinforce each other.