Tuesday, January 20, 2015

From the comments, on housing. A stream of consciousness primer on my view

I have had an extended discussion with "baconbacon" in the comments of this post.  He has used this URL to post extended comments.  I decided that responses to his latest post might be worth putting into a new post.  And this is it.

On Conceptualizing Homes as a Financial Instrument


I will summarize Kevin's position here- ... with very low nominal rates of interest it makes sense to borrow large amounts (to lever up) in exchange for the cash flow (in this case the implied rent)... This is a major point of disagreement for me.  By treating home ownership as an all-cash investment he eliminates the roles of banks, and banks and homeowners have very different risk profiles, and it is this risk profile where his analysis falls short.
There is a distinction to make here, which I think is very important when thinking about homes in the recent unusual context.  My point about thinking in terms of cash is that there are two separate figures with any asset - the intrinsic value and the market price.  We expect most markets to be relatively efficient so that most of the time, we might reasonably assume that these are the same price.

When valuing the intrinsic value of a stock, an analyst restricts her value to the characteristics of the firm.  As a first order effect, we don't change our estimated value of a stock depending on whether we are investing with cash or on margin.  Homes are no different.  Their market values are independent of the financing source of any individual buyer.

Now, there is some interdependence between the two, but it is subtle, and it is important to keep the conceptual effects of demand side credit issues separate.  In equities, the financial condition of an individual buyer would affect her personal risk aversion, and would change her optimal allocation of capital.  And, cyclical and monetary factors might influence aggregate risk premiums and capital flows, which would change the relative values of equities in different markets.

So, when I say we should conceive of homes as all-cash investments, I am not saying that banks have no effect on home valuations.  But, as a first step, homes have an intrinsic value based on future cash flows, as a stand-alone, unlevered asset.

This is a difficult point for me to make, because it is so common for home price fluctuations to be conceived of through the mortgage market's effect on demand.  It seems that when interest rates decline, everyone describes its effect on home prices as coming through demand, because households will be able to afford more house with the same mortgage payment.  I think this adds needless confusion.  It is also not a realistic portrayal of the market.  Average LTV generally hovers around 50%, and many home owners have substantial equity.  All-cash buyers are part of a significant portion of transactions.

When real interest rates decline, home values go up, mortgage or no mortgage, because far-future cash flows have a higher present value.  In fact, homes as a long-term financial security have very long durations - longer than the duration of a 30 year mortgage - so when real interest rates decline, the breakeven mortgage/rent ratio actually goes up.  (So, a period like the 2000's with very low long term real interest rates can look like a bubble if you view the mortgage/rent ratio as a conceptual constant.)  On the other hand, when the inflation premium (expected inflation) declines, it doesn't affect the intrinsic value of a home, but it does do exactly what the conventional narrative says.  It lowers the monthly payment, and lowers the barrier to mortgage qualification, decreasing obstacles to demand for home ownership.  This lowers excess returns available to owner-occupiers, so it can cause home prices to rise.

These factors, always moving up and down stochastically, look enough like the mortgage demand story that our minds find easy to conceptualize, so that's the narrative.  But, you have to detangle these effects to explain why Price-to-Rent ratios were rising in the late 1970's when mortgage rates were well over 10% and why they were rising sharply in 2012-2013 with no new mortgage credit and when many buyers were all-cash.  Real rates have a tremendous effect on intrinsic home values, especially when they are very low.

Now, banks come into play.  But, if we look at it this way, we might see intrinsic value as the starting point, and, due to the constraint we impose on real estate - that it is usually purchased as a whole unit, and not as partial shares - issues of financing usually reflect a discount from intrinsic value.  The lack of access to owner-occupancy, due to financing obstacles, limits demand and usually pushes home prices below intrinsic value.  Or, stated differently, there are usually excess returns to home ownership.  (Note, much of this comes about from tax advantages we give owner-occupiers.)

This is where I usually get the response that home ownership is not financially beneficial compared to renting.  While it is impossible to argue this definitively, because of the complexity and long life of the asset, I will make two points here.  First, there are many non-financial benefits to owner-occupancy, including the elimination of several principal-agent problems, cultural status markers, personal control, etc.  These are part of the equation, though they are difficult to quantify.  But, also, because there is a tendency to conceive of home ownership as a full mortgage vs. rent decision, we tend to compare mortgage payments to rent payments in our mental estimates of cost.  30 year fixed mortgage payments can actually serve as a reasonable proxy for the relative value of ownership.  But, the problem is that mortgage payments are inflation protected but rental payments are not.  So, at the outset of a purchase decision, the mortgage payment will always be higher than the breakeven rent payment.  At high inflation rates, it will be much higher.  The value to home ownership comes when 30 years later, you make your last $2,000 mortgage payment on a house that by then can fetch a $4,000 rent.  It is very hard to fully intuitively appreciate this huge benefit to owning.

So, for the first time in the modern era, in the 2000's, real interest rates were really low (high intrinsic values) and inflation expectations were really low (unencumbered demand).  Market prices were high, and, for the first time, nearing intrinsic values.

"Baconbacon" writes:
Now you can tell a different story with the data shown- but it basically requires the claim that either a substantial portion of the population (3-5% percent of households) went from being a poor mortgage risk to a good one
But 3-5% of households did become better mortgage risks.  Inflation premiums dropped by several percentage points between 1980 and 2003.  A reasonable monthly mortgage payment in 2003, even at very high nominal home prices, was much lower than in 1980 or 1990.  That makes a real difference.  Lower real rates meant that home prices should be higher, and lower inflation premiums meant that more households could handle the upfront cash flow demands of home ownership.

"Baconbacon" later commented that:
I think you are underselling the costs here. You need a liquidity premium for owning vs renting, you need a discussion of upfront costs (closing costs, inspection, realtor costs) and insurance to start to get a more accurate picture of owning vs renting.
But, again, I think it is important to see the distinctions we need to make in estimating market values.  Liquidity premiums, closing costs, etc. are important for deciding individually what real estate purchasing decisions we should make, just like they are important in deciding whether we should invest in small cap stocks, annuities, or bonds.  But, when we are looking at the level of the stock market, these are all simply inputs into aggregate risk premiums.  Those risk premiums are basically an aggregation of the countless personal judgment calls that make a market.

We can get an estimate of all of these aggregate personal judgments as we look at home prices over time, and use this empirical data to analyze the current market and estimate how the aggregate risk premiums that arise from these uncountable individual judgments are changing.  If we look at housing this way, we don't need anything unusual to describe the boom market of the 2000's.  Lower real rates and inflation expectations, compared to the 1980s and 1990s, can explain the price appreciation.  The current market can only be explained by a very high level of excess profit above levels we would estimate from long-standing risk premiums, which clearly is coming from a broken down mortgage credit market.

This is where viewing home values as a rent vs. own decision, with a "breakeven" price is problematic.  The apparent "breakeven" price does not easily account for the present values of those far-future cash flows.  It is much better to value the homes as unlevered assets.  There is no breakeven level.  There is a current nominal asset price, and there is some series of expected future cash flows from rent (or implied rent).  The price is a product of changing discount rates on those future cash flows.  Those discount rates are always positive.  And, when they get very low, as they were in the 2000's, the nominal price of a very long duration financial asset skyrockets.

Many observers looking at homes through the "breakeven" point of view claim that they are rarely a quantitatively profitable investment.  And, they also tend to move easily into claiming that buyers in the 2000's were highly irrational.  But, these observers are simply refusing to develop any coherent model of home values, and are projecting this lack of a model onto the market.  In some circumstances, like the 2000s, the poorly specified simple heuristics that worked most of the time, in place of a coherent model, become less accurate estimates of actual models, and so they blame markets for being wrong instead of blaming their pseudo-models.

You may argue that I can't expect markets to be reasonable if most of the market participants are using pseudo-models.  But, I can.  That's what markets do.  Have you read Yahoo message boards?  Markets usually tend toward efficiency in spite of our individual errors.  (Housing could be strong-form IMH, in which a market has high potential profits because of regulatory issues.  So, my analysis could be correct.  I could take long housing positions when I see mortgages start to increase.  And, I could end up with losses because Americans are so universally wrong that the Fed is pressured into kneecapping the economy again in their Quixotic battle against "bubbles".)

This skeptical view of home values would be similar to saying that we can't model prices from US large cap stocks, because small caps have earned higher returns that seem to be persistent.  Investors in large caps are not breaking even, compared to small cap investors, much as investors in homes supposedly aren't breaking even compared to renters.  In stocks, we recognize that there are factors which create different levels of required returns among asset classes.  Homes are no different.  The long term pattern of discount rates of future implied rents is the appropriate breakeven rate, just like the equity risk premium is.  It is for each investor to decide how they should allocate, but the risk premiums are what they are.  They represent the unseen.

On the Banking Bubble

Next, baconbacon gives a great description of issues in banking.  I am generally in agreement with this, and I found the description interesting.  I do believe that there was a AAA-rated security bubble, I just don't think this had more than a minor effect on home values.  Housing is an efficient enough market that I would expect mitigating factors to counter some of the excess demand that might have come out of the AAA bubble.  Of course, I can't prove this.  But, I can look at the housing market and find relatively reasonable specifications that justify the price levels.

Banks operate in a market with several important distortions.  There is a static regulator regime that gives value to AAA-rated securities, so there is a demand among banks for those securities which can fluctuate dangerously, without a robust set of mitigating responses.  Where a market is like a rainforest, a regulated institution with unmoving values regulated by capital controls, Federal deposit insurance, etc. is like an agricultural monoculture.  So, there are AAA-rated securities, which the banks were buying, based on some of the mortgages, which do appear to be clearly mis-priced in hindsight.  And it seems that some mortgages were issued carelessly because the AAA-rated securities they would fuel had excess value in that monoculture.  (Although, new research even casts doubt on this. <HT: TC>)

This problem extended beyond the commercial banks.  I suspect this is partly because, even though the shadow banks didn't have FDIC, they did have overnight repos.  Both of these legal factors create a large liability on balance sheets which is immune from pricing signals.  I think overnight repos are an accounting fiction that should be dropped along with FDIC.

I doubt that I would be able to convince anyone who is currently skeptical that the banking bubble didn't have much influence on home prices.  I haven't really tried very hard.  I could be wrong.  But, I'm not in politics.  I'm in finance.  So, I'll place my bets.  And, I could very well see tremendous gains even if I'm completely wrong about this.  That's probably why finance guys are so infuriating.

I hope this isn't getting repetitious for IW readers.  Thanks to baconbacon for posting thorough, thoughtful replies.


  1. > I hope this isn't getting repetitious for IW readers.

    Not for this one, probably because I'm slow to grasp the models you work with and their implications. I find it fascinating. I haven't seen this depth of analysis in finance anywhere else. Thank you Kevin.


    Kenneth Duda
    Menlo Park, CA

    1. I would also like to compliment you on this blog, an it is now a part of my daily reading.

    2. Thanks. And, welcome to the conversation.

    3. Frankly, Ken, I tend to be surprised and impressed by my return readers. Sometimes, I go back 6 months to review some of my stuff, and I can't figure out what the hell I was talking about....

    4. Well at least being a reader here wont be boring!

  2. Hi Kevin! There is a ton of really great stuff in this post, so don't take my disagreements as indicative of the whole piece.

    ". . . Their market values are independent of the financing source of any individual buyer."

    I think we can both agree that the market price of a bond relates to two things- the stream of payments and the likely hood of default. My major disagreement with you right now is that my position is that because of financing the holder of the bond (the mortgage holder) doesn't hold 100% of the risk. Banks have obviously known that they are exposed for eons and so they have rules on down payments that are designed to shift enough of the risk to the buyer that this wont matter. My contention, in brief, is that these rules (the banks models) fail during a price spike- even if that spike is justified by lower interest rates. We can throw in FHA loans and all the other stuff to discuss how and why the specifics of the past 15 years happened the way that they did but let me sum up the point with this example:

    When you buy stocks on margin there is an agreement that should your stocks decline in value you will either put up more collateral or you will be forced to sell. Imagine the stock market with margin but heavily limited downside for the buyers of stocks on margin, that is basically how I see the housing market over the recent past. Previously (from 1945-1975ish) price volatility was low enough that this didn't cause any crazy incentives.

    1. baconbacon, this is a great comment. I agree with you completely, and I probably do tend to understate this problem in my analysis. I will push back a little bit, though. First, the convexity problem isn't unique to homes. It's a problem with all of fixed income. So, to the extent that price volatility becomes more problematic at low discount rates, it should be baked into the rates themselves. Rates would be even lower if this wasn't an issue.

      That being said, the way homes are financed, you are right that they are probably more susceptible to systemic risks from that issue.

      But, even given that, I would attribute, maybe, the first 5% to 10% of the housing collapse to this problem, and the other 40% lies at the feet of the Fed. In fact, shouldn't we have expected the Fed to consider this peculiar issue as a factor that should have mitigated their hawkish stance in 2006-2008? But, there was a lot pressure on them to be hawkish because of all of those other misunderstandings about nominal asset values.

    2. I think we have (and it would be an interesting discussion to have) different viewpoints on how accurate risk pricing not only is but how accurate it can be. My (admittedly simplistic) view is that models won't be accurate for events that haven't occurred in that industry. The decline in the price of housing that we saw after 2006 hadn't occurred since WW1, and your typical banking executive isn't someone that spent 30 years trading high default foreign bonds (and even if he was he would have entered that industry that already had a long record of dealing with large price movements and wouldn't automatically know how to apply those risk lessons). If I walked into a banking meeting in 2003 and said "hey- our models have no value in case of a 30%+ price decline" would I be listened to at all even if I was right? And EVEN IF THEY DID LISTEN that would only be 1 bank, and that 1 bank that would be pricing risk appropriately (according to me anyway) would start losing market share because I haven't convinced the other banks of the need to scale back. I would probably be fired or reassigned before 2006 rolled along.

    3. That's a great point, and it seems to be confirmed by a lot of anecdotal evidence from the big banks at the time.

      I agree. My main disagreement is that the 30% decline wasn't a product of market fluctuations. It was a product of Fed policy. As they say, you can't fight the Fed, and that is especially true when policy is extreme. In September 2008, a couple days after Lehman failed, after home prices had already fallen by more than 20%, the FOMC's public stance was prioritized around a concern about inflation. There is no model that can support profitable credit allocation and hedge against a central bank that is that focused on value destruction.

    4. Honestly this is where my ability to analyze the situation stalls out. If you asked me what should happen in a bond market where there was underpriced risk- the bondholders should take a haircut and the new interest rate should be "higher" (lots of ambiguity there) to compensate for the now better understood risk. Higher interest rates would push housing prices down further, so the Fed "should have" gone to lower interest rates to make the spread higher, but we are near zero in terms of the Fed's interest rates and the interest rates banks pay depositors. I think QE is in general doomed to be marginally effective (I am working on a post about why) so why not negative interest rates? I think you can make 3 different cases- the pessimistic case is that negative interest rates are contractionaryhe

    5. Opps, a tiny finger hit publish.
      Negative rates imply the fed is taking deposits out of circulation, and will make depositing less attractive. The positive case I think you know. The third case goes back to pricing risk for me. Functionally we have never seen negative rates big enough to know what would happen if we had gone down to say -3% as I think were implied at the bottom. If you take the Scott Sumner view and say that the only way for the Fed to get 2-3% inflation and full employment would be for easing on that scale, then the Fed made a mistake in not trying. If, on the on the other hand, you look at the Fed's responsibility as promoting stability- which is how I think the Fed views itself- then pushing that hard would be a big mistake.

    6. Rates have been low since 2008 because the Fed was too tight, not too loose. You have to be careful about thinking of monetary policy through interest rates. Rates would be higher and their balance sheet much smaller if they had been looser.

    7. When should they have loosened and what mechanism should they have used?

    8. I think they were too tight all the way back to 2006, when the yield curve inverted.

      My advice has the benefit of hindsight and a counterfactual world that works according to my assumptions. But, if they had bought a few more bonds in 2006 or 2007 and signaled an intent to have liquidity as a priority, the Fed Funds rate might have been 4% in 2006 instead of 5%, but it probably would have still been at 4% in 2009, and their balance sheet would barely have grown.

  3. "But 3-5% of households did become better mortgage risks. Inflation premiums dropped by several percentage points between 1980 and 2003. A reasonable monthly mortgage payment in 2003, even at very high nominal home prices, was much lower than in 1980 or 1990. That makes a real difference. Lower real rates meant that home prices should be higher, and lower inflation premiums meant that more households could handle the upfront cash flow demands of home ownership."

    From a stream of payments view- yes, from a defaults view not automatically. Defaults are generally expensive for banks (even with down payments), with foreclosures selling at a discount, the lost payments, legal fees, months sitting on the market, and defaults are generally not associated with people simply taking on a mortgage they can't currently afford the payments on. The literature on bankruptcies shows that they usually occur not due to wild overspending but due to the combination of a one time event and low savings. A lost job or a medical event "cause" the default, but the lack of a backstop is what separates those that go bankrupt from those that can weather the events. The marginal home buyer is generally not someone that got a raise from $14 an hour to $15 dollars an hour and can now afford that stream of payments, they are generally someone with a spotty work history or a low savings rate.

    1. Good point. I wish we had different conventions regarding real estate ownership. The conventions we have now seem especially vulnerable to unnecessary economic dislocations.

    2. By this do you mean federal interventions?

    3. Well, these things do tend to become set by the regulatory framework. But, I just mean that in an alternate universe people might buy real estate through proportional shares or some other method other than a highly leveraged full equity exposure in a single property. There must be ownership structures that would be less problematic, but these things tend to be path dependent.

  4. Hey Kevin.
    Nice discussion. I have nothing to add, really. But here's a totally off topic question:
    Following the BoJ yesterday/today my extremely informal reading of ECB / BOJ / FED projections has oil somewhere around 70 USD in 2015. Does this sound reasonable to you as a survey of opinion? As a projection?

    1. I don't have any insights into oil prices. It seems to me like it could stay low for a while, too, but I probably know less about it than you do.