Wednesday, May 11, 2016

Housing: Part 147 - The terrible, rotten view that the Fed's error was providing stability

I was listening to Russ Roberts and George Selgin talk this morning about what bad policy bailouts are.  It hurts my brain to hear such nice and intelligent men go on about something so wrong.

They aren't wrong, conceptually.  Some sorts of bailouts are bad policy.

But, if we had only had more of the right kind of bailouts, then we wouldn't have needed the wrong kinds of bailouts, and Roberts and Selgin both treat firms like Bear Stearns and Lehman in 2007 and 2008 as if they were just recklessly taking advantage of the bad kind of bailouts, when in fact the defining truth of that period is that what they desperately needed were the good kind of bailouts.

Good bailouts = universal stability
Bad bailouts = targeted arrangements made in a panic

One of the unfortunate results of the recent crisis is that many observers seem to disfavor both types of policies because they see the collapse as confirmation of excess.  A disappointingly low number of people looks back on this misery and says, "Huh, we probably should have tried to stabilize prices, including home prices."  Instead, they take the collapse as confirmation of the necessity of collapse.  Even though a dozen other countries stand as examples of how preferable avoiding the collapse would have been.

Here is a graph of Total real estate value for the Closed Access cities and for the US excluding the Closed Access cities (this still includes Contagion cities, like Phoenix, Las Vegas, Miami).  I have expressed it as a proportion of total personal consumption expenditures to normalize it with the nominal economy.

Next is the annual growth rate of real estate values in these areas.  This includes both new building and capital appreciation.  Keep in mind, there is little new building in Closed Access cities, proportional to their existing stock, but new building in the other areas is healthy.

From 1998 to the end of 2005, the non-Closed housing stock had risen by 20%, relative to personal consumption expenditures.  Given the drop in real long term interest rates over that period from about 4% to about 2%, this is a mild rise in values.  Rates first stabilized at just over 2% from 2004 to 2009, and have fallen farther since then.  They have never sustainably moved up from those levels back toward 4%.

Yet, non-Closed real estate began to fall in early 2006.  By the time Bear Stearns fell, non-Closed real estate values had fallen by 11%, relative to personal consumption expenditures.  By the time Lehman fell, they had fallen another 5%.  They would eventually fall an additional 20% from that level, before finally leveling out in 2012.  They remain, to this day, nearly 20% below the levels of 1998 while real long term interest rates are now close to 1%.  Really, was it craven and irresponsible for investment banks to expect that 21st century public institutions charged with maintaining economic stability would prevent home prices in places like Topeka and Omaha from falling more than 30% relative to personal consumption?

Maybe before the next crisis we should settle, once and for all, exactly what banks can expect from our consensus policy, because as far as I can tell, unless they are just piling gold in the vault and lying in the fetal position in a pool of their own flop sweat, there is literally nothing they can expect from federal policymakers in terms of stability that won't lead to unanimous finger pointing at them when the bottom falls out.

PS.  I think we might be able to look at the second graph here for a clue regarding economic trends.  When the Closed Access real estate prices are rising more quickly than in other areas, this is a sign of the Closed Access migration pattern.  This tends to correlate with general economic growth, and it is the reason why it seems like our economy is addicted to debt and can't grow organically without creating asset inflation.  In 2005, when Closed Access real estate appreciation fell back to more general levels, that was the brief time where mortgage growth and new building were still strong enough to be sustainable.  When prices in all areas began to move in concert in late 2005, falling sharply along with housing starts, that is a sign that national, not local, factors were at work.

Note, that is the period where all the accusations of fraudulent securities are made.  That is when CDO squared and synthetic CDO's were being constructed.  Those were the securities that blew up when systemic defaults started happening.  Those securities were insignificant before 2005.  They had nothing to do with the "bubble".  The reason that there was such a demand for AAA securities wasn't because of banking excess.  It is because we had been systematically undermining the market for normal AAA securities.  By 2006, the yield curve was inverted, Fannie & Freddie had gone through a series of steps of removing liquidity from mortgage markets.  The Fed was starving the economy of cash.  What we needed was cash and credit.  What we needed was an institution that could support the mortgage market, so that normal, non-exotic AAA securities could be created.  Synthetic CDO's, falling housing starts, universally falling prices, bankrupt mortgage originators were all screaming for stability as early as 2006.

And, men as clear headed and upstanding as Russ Roberts and George Selgin are complaining in 2016 about how dangerous it is to have policies that lead to bankers expecting stability.  Like that's the problem.

PPS. When 30 year tips yields are back to 2%-3% and home prices in flyover country have risen by 30% relative to personal consumption expenditures, that is when you will know we have returned to some sense of normalcy.  There is an angry, unified consensus in this country to literally, actively, prevent that from happening.  The policies that prevent it from happening will continue to pin interest rates at near zero levels, and, thus, the roars will continue that the Fed is just propping up asset prices with low interest rates, when in fact we are doing the opposite.

21 comments:

  1. I simply disagree. I'm not saying that the Fed did everything right in 2007/08...they didn't, but hindsight is easy.

    On the other hand, maybe you should ask why the financial system is so fragile. Asset prices fluctuate - we know this. Things happen that haven't happened in a very long time - we know this. Equities fluctuate by significantly more than home prices and yet private equity was basically Ok in the crisis. So why is the banking sector a fragile mess?

    I believe two of the major culprits are Fed policy and bailout policy. Starting with Greenspan, we essentially began targeting NGDP to ensure short, shallow recessions. The Fed successfully reduced the volatility of the business cycle. Banks knew this and so they added financial leverage. Reduce cycle volatility and you'll simply get more financial leverage such that ever-smaller deviations from target produce ever larger-crises. Second, banks are aware that they are crucial to the system and had a chance of being bailed out - that, plus short-term incentives (unlike private equity) created a disaster.

    I don't want to live in a world where a 30% move in any given asset class means we are on the verge of a depression. Let's treat the root cause, not the symptom. Bailouts and a naive approach to "smoothing" business cycles will simply make things worse.

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    1. Ahhhh. Nooo! Stop!!!!

      This is the broken windows fallacy, but instead of just breaking them, you're just making credible threats to break them so that everyone is too afraid to accomplish anything.

      There was no reason for a 30% decline in non-closed real estate values. None. Zero.

      You're right that hindsight is easy. Sometimes, it even helps us to see the truth of the matter! To have hindsight and insist on doing the same thing is insanity.

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    2. And, you don't reduce leverage with damaging monetary policy. That's insane. You reduce it by removing all the fiscal policies that encourage it.

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    3. You're missing my point. Yes, I think the Fed was too focused on backward-looking inflation and was too tight in 2008. Agree with you there. However...

      Was there a "reason" for equities to skyrocket in the late 90s then crash? Was there a reason for oil to do the same? Bonds have had their own crazy periods. Even given "perfect monetary policy" it is simply unacceptable to have a 30% fall in assets destroy your banking system. Assets do this..they rise and they fall, sometimes sharply. Sometimes there seem to be reasons, sometimes there doesn't, but truth is we never really know...it's simply supply and demand. For all we know, if the Fed had been easier in 2008 it would have flowed into equities and housing still would have fallen...no way to know.

      Any other asset class rises/falls by a massive amount and the system is ok. But not housing. Why? Because banks have been told they are protected and the asset class has a backstop. Well, in my opinion that's silly. The financial system needs to be prepared for sharp rises and falls in housing just like any other asset class. To do that we need to make it clear there are no backstops.

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  2. "(A)s far as I can tell, unless they are just piling gold in the vault and lying in the fetal position in a pool of their own flop sweat, there is literally nothing they can expect from federal policymakers in terms of stability that won't lead to unanimous finger pointing at them when the bottom falls out."--KE

    And not only that. New money enters our economy through bank lending. When banks stop lending on property, you get a recession.

    I do think it is time to seriously consider so-called helicopter drops or money-financed fiscal expansion any time property lending drops.

    Lord Adair Turner may have used some prejudiced language in his piece, but the core of his insights is very valuable.

    Kevin, you are onto something yuuge.

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    1. Benjamin, that's what we did in 2008.

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  3. Housing is historically much less volatile than other asset classes....for a reason. The volatility had nothing to do with markets or animal spirits. As I've said before, if home prices dropped by 5% and this happened, you'd have a good point. Before the year 2000, nobody would have thought to suggest that any financial system should be engineered to handle a 30% national decline in home prices. I'm a lone voice on this, but the fact that the financial system held together until mid to late 2008 is a testament to how incredibly resilient it was.

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    1. If before that you had told me that housing might have a quick 30% fall after a quick 20-30% rise I would not have blinked an eye. Volatility works both ways.

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    2. One of the better ways to prevent the quick fall of an asset would be to lean against a quick rise. It seems as though we're only interested in the latter. There are always "reasons" when assets go up and "policy mistakes" when they go down. It is any wonder that bad practices are prevalent in our banking system with beliefs like that ingrained?

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    3. That's the central point of my project. Prices and housing starts collapsed even in places that had healthy relatively stable prices even though they had strong housing demand. Monetary policy can't push home prices 20% above intrinsic value.

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    4. Monetary policy can only affect prices negatively?

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    5. Mp can certainly affect prices. I said it can't push housing prices 20% above intrinsic value. 20 years ago would anyone have even claimed it could?

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  4. It is certainly understandable I think that one would see bailouts as encouraging banks to take on more risk than they otherwise would, at the taxpayers' expense. Bailouts may have limited efficacy if they became a matter of policy, just inflation stopped reducing unemployment once markets learned to anticipate it back in the '70s.

    Relatedly, there's the issue of the need for bailouts; the financial system should not be so sensitive to a few big firms. If one views this 'too big to fail' phenomenon as central to the occurrence of financial crises, then one might contend that bailing out these banks only props up an unnecessarily fragile system.

    Personally, I would be more at ease with a bailout if it were followed by reforms in financial regulations, so that we might see more competition and a more robust banking system.

    Incidentally, the Sanders type idea of 'breaking up the big banks' by force wouldn't work either. We tried that before the Great Depression by outlawing interstate banking and limiting branch numbers and creating a bunch of little monopolies, which is no better than the big oligopoly of today. But I think a more competitive banking industry with greater ease of entry into the market would make it less dependent on the big established banks, and, one might dream, render this discussion moot by making bailouts less necessary.

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    1. I agree with all of this, conceptually. In this day and age, with deregulation, I'm not so sure we would even have as much of a banking industry, as we know it. I think people might keep deposits with money markets and long term investors would fund long term lending. I'm not sure we need to even have this problem of banks borrowing short and lending long.

      I agree that targeted bailouts are a problem and TBTF is a problem. I just don't think this crisis has much to teach us about that, and I don't think either of those issues has much to do with the development of the crisis.

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    2. At one time, I did. But, I don't any more. Even the clamoring for AAA securities that I used to say was a bubble, even after I stopped believing in the housing bubble, now looks to me like it was due to the early stages of the Fed's and treasury's liquidity starvation, mostly through mortgage markets, because they were convinced prices had to fall, so they refused to act to counter a series of significant negative demand shocks.

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    3. I don't think it had anything to do with prices "having to fall." The Fed was responding to well-above-target inflation. And then even when they realized they needed to ease they simply could not react quickly enough probably due to the sheer complexity of what was taking place and political constraints.

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  5. If shareholders and bondholders get wiped out in a bailout of a TBTF, I have no problem. In fact, the faster and bigger the bail out, the better.

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    1. That's all good. I think letting Lehman fail was ok and didn't really play that big a part in the crisis. Although, they failed because of terrible public policy, which in any other context would engender sympathy. But my main point is just that TBTF isn't really a lesson to take from this crisis. There was nothing about being big that had anything to do with it. Everyone is ok with cramdowns, helicopter drops, tax rebates, etc. Bailing out TBTF firms makes them like everyone else, not different. And we all should have been bailed out. We should have been bailed out 2 years earlier with a couple hundred billion $ worth of treasury purchases. It wouldn't have been called a bailout because a bailout is just the term we use to describe crappy too-late half measures. And the things we call bailouts end up being 10 times the size with all sorts of moral hazard. By all means, let's get rid of public deposit insurance, etc. But the TBTF talk mostly just seems to me to be another bs way to make Wall Street boogeyman stories. It's a much tinier issue than the shelf space it's taking up.

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  6. Kevin you said this: "Note, that is the period where all the accusations of fraudulent securities are made. That is when CDO squared and synthetic CDO's were being constructed. Those were the securities that blew up when systemic defaults started happening. Those securities were insignificant before 2005. They had nothing to do with the "bubble"."

    They had a couple of impacts on the bubble. They allowed more financing at easier rates. Investors buying them provided more lending ability. And they undermined the bubble and helped crash the commercial paper market. The Fed could have bought that paper, but didn't. And then the Fed allowed mark to market on top of that! So, the Fed made things worse. But clearly, securitization of bogus AAA bonds made it even easier to qualify for a toxic loan.

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    1. And before those bogus MBSs were spread widely in 2004.

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