Friday, February 20, 2015

Housing Tax Policy, A Series: Part 10 - The crisis narrative

Just a quick follow-up to Part 8.

Looking at this chart again:

This is the narrative I see in all the papers:

2Q 2007: The reckless banks have finally pushed the subprime mess too far, and the damage is unavoidable.  The Fed will do what it can, but it may be too much to deal with.
Home Price Index:        219
Delinquency Rate:          2.3%
Unemployment Rate:     4.5%
TTM Currency Growth: 2.0%
TTM Bank Credit Growth: 10.3%

3Q 2008: The Fed must slow down its massive accomodation, since inflation is the primary concern.
Home Price Index:        174
Delinquency Rate:         5.2%
Unemployment Rate:     6.0%
TTM Currency Growth: 2.4%
TTM Bank Credit Growth: 7.7%

3Q 2014: We must end QE3 and start planning for interest rate hikes, since asset and wage inflation and financial instability are the primary concerns.
Home Price Index:        185
Delinquency Rate:         7.0%
Unemployment Rate:     6.1%
TTM Currency Growth: 7.5%
TTM Bank Credit Growth: 6.1%

It may seem like I'm trying to deny that there were some dislocations afoot in the housing market.  There were clearly excesses in some cases, especially in some MBS toward the end.  But, it's like we were crossing the street, and we tripped and cut our forehead on the pavement.  It was a bad cut.  It might have even needed stitches.  Forehead cuts can bleed badly.  It was disconcerting. But, while we were standing there, regarding our cut, we got hit by a bus.  That bus is still barreling down the road, dragging us behind it.  And, we're still saying, "Boy, that was one hell of a cut."  Scale is what rules, and scale is about dollars, not provocative anecdotes.  The anecdotes are provocative, and scale rules.  Both.


  1. Hi Kevin,

    Here is the reaction from a sophisticated friend of mine. I was curious about your thoughts.



    Not his best work. I think he's ignoring some relevant data and some identifiable system latency that explain the timing that bothers him. Subprime origination jumped from a historically normal 8% of the market to 20% of the market between 2003 and 2004 and stayed that way through 2006. That matches the bulk of the home price index increase. Many of those mortgages were delinquent within 90 days and that only got worse as 3 year ARM resets took place in 2007 and 2008. Those delinquencies tore up CDO insurers (like AIG) and led to blowouts in counterparty risk spreads. With 50x leverage it doesn't take much to ruin an investment bank (i.e. Lehman. ps don't ever be on Hank Paulson's enemies list).

    More thoughts/data: Mortgage delinquency rates didn't peak until 2010 and are still above the level they were in 2007. See

    1. Kenneth, thanks for the input. That is certainly a reasonable argument, and I don't doubt that, to some extent, it is the case. Even with accommodative monetary policy, there would probably have been some more growth in delinquencies after 2007.

      Of course, part of my narrative is based on the idea that home prices in the 2000's were quantitatively justifiable. Just looking at a Case-Shiller graph, that idea is a bridge too far for some people, and if they can't follow me there, we may be arguing over details explicitly, but really we would just be arguing over priors implicitly.

      My response to the fact that subprime mortgages were 20% of the market between 2003 and 2004 is that this sort of framing is part of the problem that leads us to overstate the scale of the problem. 20% of the market in originations is only a miniscule portion of all mortgages outstanding. By the end, let's say 5% of mortgages outstanding were subprime, and since they would tend to be smaller, let's say that amounts to 2-3% of mortgage dollars outstanding. Even if 25% default in a counterfactual, that amounts to less than 1% of mortgages, in dollar terms.

      And, the subprime story has so convinced everyone that they are sure it is the source of the price volatility. But a few million mortgages to low income households just can't begin to explain a 300% price boom and bust among homes across the market. Not even close. But, the sense of scale has been lost in the picture of what happened.

      I think part of it is that in 2007, everyone was thinking, "Man, delinquencies could get to 3% because of this subprime thing." And subprime was fingered as the culprit. Then, when delinquencies hit 10%+, we kept the culprit in our narrative, but didn't account for the fact that when it was the culprit, what we thought was bad was nothing like what was to come.

      Then, of course, there is the problem of believing that the Fed was tight when they were dropping rates precipitously. That's another thing baked into the narrative, that if it creates doubt in someone's mind, means they just aren't going to believe my story.

    2. It's a bit humbling when I occasionally look back and see something, like this comment, where I confidently asserted something that was factually wrong. I'm very lucky that you've hung on with me through the entire study, Kenneth. NOW, I'm very confident that I have corrected ALL of the mistakes. ;-)

  2. TravisV here.

    Kevin, I'm curious whether you agree with the following comment by Joe Leider:

    "Any owner of assets whose value is determined by interest rates will have benefited tremendously from Fed policy. House prices have reflated because mortgages cost less. Stocks are up because bonds return practically nothing.”

    1. Well, I hate to say that I think that post is full of conceptual errors. I realize my view is idiosyncratic (it's in the title!).

      Home prices are high because they are worth more, due to low discount rates. The rise in home prices since the crisis has come from all-cash buyers. Thinking in terms of mortgage rates as the driver is a common problem.

      Stocks are up because aggregate demand is up. Stocks don't go up because interest rates are low. There is a subtle distinction between earnings (or, specifically, required returns) and asset values. They move inversely to one another. When real interest rates decline, it is usually coincident with a rise in risk premiums. This means that earnings rise, but valuations remain stable.

      Imagine $100 revenues, with $5 profit and $5 interest expense. Rates decline, and now we have $8 profit and $2 interest. But, the rate decline was associated with a rise in the equity premium from 5% to 8%. So the share price would be unaffected. I believe this is typically the main relationship at play.

      Now, it happens that when rates are low due to cyclical variations, we tend to see a recovery, which is associated with higher growth rates and higher revenues, so share prices do tend to rise at these times, but not because of the low rates themselves.

      It is tough to pull anything statistically significant out of the data, but I think that what you end up with during low real risk free interest rate periods is higher income for equity holders, but with a lower growth rate. This should be intuitive. Since firms require higher returns to justify investment, they invest less and return more to shareholders. There is a misconception that firms would invest based on the cost of debt. But, they invest based on their total required returns.

      People tend to say, "Look, interest rates are low, and corporations still aren't investing. We need to do something about that." But, what needs to be done is to make the economic landscape safer for capital. This will be associated with higher interest rates, higher investment, and higher wages. This seems ironic if one doesn't account for these subtleties.

    2. Here's a comparison of real interest rates and real growth in corporate enterprise value. These are such messy, cyclical series. But, I think we can see the secular co-movement.
      Of course, this is made even more confusing by the way we account for share buybacks, so that now, for public firms, the higher income looks like higher capital gains rates.

    3. Kevin/TravisV - I definitely agree that the reason companies aren't investing is that the economic landscape isn't quite there yet. I also agree that lower rates/looser policy now will result more quickly in a return to "normal" interest rates & health wage growth (an NGDP level target would be great).

      As an investor, I simply judge the returns available. Now we have a stable (non-deflationary), low-interest rate environment. And I think the low rates themselves will influence the prices of assets --- maybe it's not the first cause, but definitely a feedback loop where investors search for return.

      Even Buffett is reacting to low treasuries:

      His economics might not be 100% spot on, but I'd have to agree with him on pure market psychology.

      BTW - Kevin, great blogging overall. I really enjoy your stuff (especially when I understand it :-)

    4. Thanks Joe. I've seen some thoughtful stuff you've written. Considering that, instead of calling them "errors", I should have said that I had conceptual disagreements with your post. :-)

  3. TravisV here.

    Good stuff, thanks Kevin!

    (1) In November, you disagreed with me and didn't seem to think that a bit higher NGDP and interest rates would be good for stock prices. Now it sounds like you agree with me. Hooray! I'm discussing the simple model in my mind with Joe Leider here:

    (2) Interesting recent observation by Larry Summers that you might want to comment on (Krugman highlighted it in his latest column):

    "One of the puzzles of our economy today is that on the one hand, we have record low real interest rates, that are expected to be record low for 30 years if you look at the index bond market. And on the other hand, we have record high profits. And you tend to think record high profits would mean record high returns to capital, would also mean really high interest rates. And what we actually have is really low real interest rates. The way to think about that is there's a lot of rents in what we're calling profits that don't really represent a return to investment, but represent a rent."

    1. Ugghh. Sorry. Those conversations are like nails on a chalkboard to me. Bla bla bla. The last thing people need is for me to decide what we have to do for them, robots or no. Thank god my life isn't organized the way the Larry Summers of 50 years ago were blathering on about. Workers 50 years from now will care as much about what we thought of their working arrangements as we care about what William Jennings Bryan would have thought of ours. Let them figure it out. People aren't as helpless as the busybodies pretend.

      I meant to post a full reply on that whole discussion. I've ended up just nibbling around the edges of it. If I recall correctly, the disagreement was about inflation. I still don't think that inflation will be that important for non-real estate employment over the next few years, because real wages will be rising. I agree that 2-4% would be better than <2%. But, I think the differences are swamped by the question of whether the Fed creates another crisis.

      I do think that inflation would help real estate immensely. So, the effects here are complicated. The lack of inflation has created a housing shortage. This means that current renters are experiencing negative real wage pressure specific to them. Because home prices are so low, a tremendous gain can be made by switching from renting to owning, but few can make the switch because the mortgage market is stuck.

      So, renters now have not only health care and education inflation eating up all their nominal wage gains, but now they have housing inflation eating it up too. But, since this is happening through a sort of targeted inflation, I don't think it will disrupt the labor market.

      For homeowners, they are getting 3% wage increases with 1.5% inflation. But all of that inflation is in imputed rent, so it feels to them already like they are getting 3% real wage increases. It's not like they are marking to market on their imputed rent.

    2. TravisV here.

      Thanks Kevin! Sounds like you're more reasonable. A few points off the top of my head:

      (1) There's still tons of slack in the economy. Therefore, faster NGDP growth should result in a lot more hours worked and therefore a lot more real growth.

      (2) If we had faster NGDP growth, wages would grow a lot slower than other prices. That's what needs to happen in order for businesses to hire more people (expected revenues grow a lot faster than expected expenses).

      (3) Under the current flawed regime, the odds of a crash are much higher if we have steady 0.5% inflation than if we have steady 1.5% inflation. Investors sense that, so equity risk premiums should be significantly higher if we have steady 0.5% inflation.

      (4) Remember the perverse logic of inflation targeting: if there's a big sudden oil shortage, then the Fed must slow NGDP and millions of people have to lose their jobs in order to bring inflation back down to target.

      (5) Therefore, if the Fed committed to a 3.0% NGDP target, that would be wonderful for stocks. It would be so much better than a 1.0% or even 2.0% inflation target.

      If the Fed committed to a 3.0% NGDP target, I think the odds of a crash would be much much much much lower than a commitment to a 2.0% inflation target.

      P.S.: Evidence supporting my story (and Sumner's): in January, the 10-year Treasury yield crashed to 1.6% and the S&P 500 fell significantly. And this month, the 10-year Treasury yield surged to 2.1% and the S&P 500 rocketed higher.

    3. 1 & 2) Don't get me wrong. I'd be ecstatic if the Fed announced tomorrow that they are targeting 4% inflation for 2 years. But, I think we may be past the point you describe. Real wages should continue to be strong. There may be a little bit of wage stickiness out there, but I'm not sure how much. Real wages are even stronger than they appear because the inflation is all from a supply shock in housing. So, I don't think wages would grow more slowly than other prices. Also, I wonder if we are near the limits of real growth. Here is a chart of inflation adjusted growth in Commercial & Industrial Loans. I'm not sure we can expect capital expansion to be much faster.

      I don't know why I'm arguing with you though. Higher inflation would definitely help real estate, which is definitely not growing at capacity.

      Sorry, I'm being pedantic. Of course higher NGDP couldn't hurt, and would probably help.

      3) I don't know. I'm not sure what to expect from the Fed over the next couple of years.

      4, 5 & PS) Well, of course, I'm on board with the NGDPLT. Why 3%?

    4. TravisV here.

      I mentioned 3.0% NGDP growth for the inflation hawks. I'd prefer 5% but we'd still prosper with 3%.

      Since 2009, NGDP has grown pretty consistently at around 4%/year. 3% growth would be slower than that but stocks would still rise upon news of the commitment due to more confidence in future stability.

      And of course, level targeting and futures targeting would be even more wonderful.....