A falling inflation premium can increase demand by making mortgages more affordable, in nominal terms. When I first started thinking about the housing bubble, this was my assumption. I thought about it through a finance framework, that the obstacle to nominal financing meant homeowners had earned "alpha" in previous times when interest rates had been high. Since both real rates and the inflation premium were low in the 2000s, I thought that what had happened was that more open access to homeownership had reduced "alpha", and that higher prices weren't so much a sign of excess, but a reduction in the benefits that used to accrue to those with access to credit.
Ironically, that is the story today, in 2016. A lack of broad access to mortgage credit means that homeowners are earning significant "alpha" today. But, since first looking at the issue, I have changed my mind. The housing boom wasn't so much the result of more access to credit as it was the combination of access to credit and a lack of access to building. In many valuable areas, homes can't be built, but for those who want to buy them, credit is available. The difference between 2005 and 1995 wasn't so much the access to credit as it was the lack of access to building.
|From BEA table 7.12, with home values from Federal Reserves'|
Financial Accounts of US (implied by Consumption of Capital before 1950)
But, this excess return appears to have been mostly bid away by the mid 1960s by access to ownership that was facilitated by government programs. This graph shows net total returns to homeownership (green line) and the net returns after nominal interest expense (blue line). We can see that once debt financing became widespread, real total net returns remained in the 2.5% to 4% range that long term bonds generally yielded during that time.
One difficulty is that we don't have market rates for real yields on treasuries before the late 1990s. So, especially during the volatile period of the 1970s and 1980s, it is difficult to confirm these trends. But, in the late 50s, early 60s, and 90s, when inflation expectations were calm enough to roughly estimate real rates, real long term rates and implied housing yields appear to have all ranged in the 3.5% to 4% range. So, alpha from homeownership seems to have been capable of being low for some time.
Here is a chart of mortgage affordability, over time, for Houston (an Open Access city) and San Francisco (a Closed Access city). There were already some supply constraints in the San Francisco metro area (MSA) by the late 1970s, and we can see that here. This graph concurs with these intuitions about home values.
On the other hand, between 1995 and 2005, real interest rates fell by close to 2% while the inflation premium remained fairly stable, or declined slightly. In Houston, this had little effect on mortgage affordability. From 1979 to 1995, falling inflation brought down mortgage payments with little effect on home prices. From 1995 to 2005, falling real rates pushed up home prices with little effect on mortgage payments.
In San Francisco, the operable effect on mortgage affordability during the 1995-2005 period was sharply rising rents. From 1979 to 1995, mortgage affordability followed roughly the same pattern as it followed in Houston, because the primary cause of the decline was the same in both cities - falling inflation premiums on mortgage payments. But, from 1995 to 2005, there was a divergence. The cause of the rising mortgage payments in San Francisco was a local phenomenon, coming from rising rents.
I think it is interesting to compare the 2000s to the late 1970s. In the 2000s, home prices were rising by close to 10% per year, sometimes more. As households kept taking on larger mortgages, observers complained that those gains were unsustainable, and that those households were overspending for their homes based on unrealistic expectations. But, how is this any different than what happened in the 1970s? Home prices were going up just as strongly then. And, homeowners were taking on mortgage payments that were a large portion of their incomes in order to fund them. So, what was the difference between these two periods?
The difference is that the price increases of the 1970s were part of the broader monetary inflation we had at the time. In that period, mortgage rates were high because inflation was imbedded in the interest rate. Since mortgages can be pre-paid, the mortgage terms also had an imbedded hedge against falling inflation.
But in the 2000s, the price increases came from localized supply constraints, and broader monetary inflation was low. So, in the 2000s, the inflation that affected the housing market was not embedded in the mortgage inflation rate, it was embedded in the price of the house. This difference meant that there was not a natural hedge embedded in the mortgage terms that could ratchet down the cost of the mortgage when home rents stopped climbing.
Of course, as I have pointed out, the local constraints that drive up rents are still operable, and the collapse in home prices was something we engineered at the macro level. After 2007, real interest rates collapsed along with home prices and mortgage affordability, which, when we carefully assess the factors involved in home affordability, we can see is the sign of a significant disequilibrium.
But, thinking about the difference between the 2000s and the 1970s, how should we have expected housing markets to behave? Should they have ignored the persistent rent inflation in the high cost cities? That's the thing about markets. They don't ignore things. And, the policies behind those rising rents are much more entrenched and persistent than the inflationary policies of the 1970s. Homebuyers in coastal California and urban New England in the 2000s were at least as justified when they took on those mortgages as the homebuyers in the 1970s were.
The macro-instability inherent in the housing market of the 2000s was fully a product of the local policies that constrained supply. The instability wasn't caused by the homebuyers that were bidding up prices to reflect those constraints. It wasn't, at its base, caused by the banks that were funding those purchases. It was caused by decades of errant policy development in city halls and regional development committees.
Now, it is true that we can curtail lending enough to counter that instability. That is what we are doing now. Creating stability through credit contraction means falling home prices and rising rents. It means the most financially secure 1/3 or 1/2 of households that are able to secure credit or buy with cash earn excess returns on their imputed rent - the rent they avoid by owning. And landlords can earn excess returns through higher rents from tenants who are locked out of homeownership. And, in the way that we have imposed those credit constraints, that applies in Houston as well as San Francisco. That is why (looking back at the first graph) even though homeowners are as leveraged now as they were in the 1990s, they are now earning returns, after interest expenses, as high as homeowners in the 1950s did with much lower leverage.
On the topic of real interest rates, it occurred to me that one proxy for real interest rates is the Equity Risk Premium (ERP). ERP is a measure of the difference between risk free rates and expected returns on equities, and it is a real (as in, without inflation) measure. This is an estimate, not a market price, but it is a measure for returns to another real asset - corporate equities. Since total real expected returns to equities appear to be fairly stable over time, ERP tends to be an inverse measure of real risk free interest rates.
So, I have graphed here, the implied return on housing (orange), the recent market rates on 30 year real bonds (maroon), 20 year nominal treasury rates minus inflation for the years where inflation expectations should have been somewhat close to actual inflation (purple), and the inverted ERP (green). The 20 year rate measure here probably adds more heat than light. The real rate in the late 1960s was probably slightly higher than the rate estimated by the 20 year rate here. But, sometime during the 1970s, real long term rates probably were as low as the inverted ERP implies.
And, the inverted ERP does seem to be a good proxy for real long term interest rates, as they might apply to housing - until the disequilibrium that began after 2007.
The very high ERP and very low 20 year treasury yield (minus inflation) in the 1970's suggest that home yields should have been lower (home prices should have been higher). This is counter evidence to my speculation above that the high inflation wasn't a drag on home prices at the time. Equities were fetching mysteriously high premiums at the time, which could partly be explained by the tax effects of high inflation. Homeowners would be immune from the tax effects on imputed rent, and some of the tax effects on capital gains, so some of the separation of yields in the 1970s could be from those factors. But, maybe the effect of high mortgage payments on demand did keep home prices down and yields up, relative to other assets, during that period.