I think everyone has generally assumed that the collapse of hedge funds and investment funds in 2007 was due to the combination of (1) high default rates on collateral and (2) high leverage in the funds that left no room for error. Default rates were rising at the time, but they weren't outrageously high yet. But, these were securities with market prices. Actual cash flows on securitizations from 2006 and 2007 would have been low because of defaults. But, because the defaults were being triggered by unprecedented widespread nominal drops in home prices instead of by more typical causes of defaults, the effect on securities prices may have been especially pernicious. Potential buyers of an MBS experiencing high defaults because of a poor labor market would price in an expected recovery. But, in mid 2007, someone valuing an MBS with high defaults would look at home prices off 10% and accelerating downward, and they may have modeled very high future default rates into their valuations. Markets are forward looking. So, even before defaults reached their high levels, the market values of MBS's may have been collapsing because of expectations of the ongoing collapse in home prices.
There has been extensive discussion about how the models used to rate securities backed by subprime loans were flawed because they didn't account for the potential for correlated defaults. But, I suspect that the collapse in the market values of those securities happened before most of the actual defaults. And, if that was the case, then an expected recovery in home prices in mid 2007 would have had tremendous benefits.
And, here we reach the circular problem with the crisis. If we don't assume that home prices required a massive correction, then large-scale monetary and credit market support in 2007 seems reasonable, even obvious. Markets in 2007, in effect, may have pulled the imminent collapse in home prices back in time from the near future to the present, reflected in the collapsing prices of MBS's, and a change in those expectations would have been significantly helpful. But, if we do assume that home prices required a massive correction, then that support seems dangerous. And, in this way, the crisis became self-imposed.
At the August 2007 FOMC meeting, after many bankruptcies and fund collapses, including the Bear Stearns subprime hedge funds, the FOMC statement was still reporting to anyone who might have been valuing an MBS that "the housing correction is ongoing" and the "Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected." Home prices were nearly 10% from their peak in nominal terms, already unprecedented in modern American financial experience, the Fed Funds rate was still pegged at its high of 5.25%. And the 2.1% core CPI inflation that the Fed was worrying about consisted of 1.2% non-shelter inflation and 3.4% shelter (i.e. rent) inflation, which had jumped up in 2006, apparently in reaction to the supply shock when homebuilding collapsed.
|The legend is incorrect. The scale for housing starts is noted on the axis.|
Now, keep in mind, this period does look like a boom in single family homes, because in order to meet aggregate housing demand, the SFH market had to expand enough to accept all of the households who have been locked out of metropolitan multi-unit housing.
In 2006, housing starts collapsed and rent inflation shot up. This looks like a clear indication of a supply shock, and the trend shifts are sharp. This also happened to coincide with the inversion of the yield curve, which correlates negatively with bank credit growth and has been a leading indicator, with about a 1 year lag, of recessions.
In 2007 and 2008, housing starts continued to collapse, but now so did rent inflation. This suggests that demand was suddenly collapsing more strongly than supply. During this period, renter inflation pushed far above owner equivalent inflation as the breakdown of mortgage credit and home ownership markets pushed many households back into rental housing.
Since 2011, we have the worst of all these factors. Housing starts remain at extremely low levels, and shelter inflation is again somewhat high. But, extremely low demand is keeping rent inflation from exploding. If demand recovers, I think we should expect single family home construction to recover with it, keeping owner equivalent rent from jumping. The significant expansion of a rental market in single family homes is helping to keep renter income low and is probably causing more of the renter inflation to be reflected in owner equivalent rent, but continued supply constraints in the major metropolitan areas are continuing to put upward pressure on renter inflation.