Friday, August 12, 2016

Housing: Part 170 - Is Housing Difficult to Short?

This is frequently cited as a reason why the housing market is supposedly inefficient and prone to bubbles - that it is difficult to short housing.  One of the things I find odd about the academic economic treatment of housing is how often rent is ignored.  In the debate between the credit supply school and the passive credit school about what caused the "bubble" (Was credit expansion a cause or an effect of the "bubble"?), whole articles can neglect to even mention rent.  Frequently, home buyers in hot markets will be associated with speculative fervor or with "self control problems".  Generally, these characterizations are part of ad hoc constructions of interpretations of the data, basically suggesting that no other justification for their behavior can be found.  This is common across schools of thought and political points of view.  And, frequently, these explanations will be used in the interpretation of the data in papers that literally do not mention rent as a motivation for ownership.

Wouldn't you know it?  In a national conversation about housing that ignores the entire fundamental basis for home values - the value of rent cash flows - a consensus has developed that home buyers are irrational.  How in the world could you conclude that they are rational if you ignore the sole source of reason in their decisions?

The issue of the inability to short housing is a part of this bias.  The idea that this is the case - that we can't short housing - presumes that our positions on housing are entirely positions taken for capital gains.  But, let's think about this.  Every single one of us comes out of the womb with a lifelong short position on a non-marketable perpetuity on housing.  By far - it isn't even close - the single largest financial "holding" of the average American is a short position on housing they will use.  And that position can certainly be adjusted.

In fact, you could consider the housing bubble to be a short squeeze.  It was a strange short squeeze.  We are used to thinking of short squeezes as the result of short positions covering capital losses.  But, our short position on housing is like a short position on a floating rate perpetual bond.  The face value remains at par, but the coupon payments change.  So, hundreds of thousands of housing shorts were squeezed out of the Closed Access cities during the "bubble", "covering" their short positions by reducing their short exposure to housing, moving to cities with lower rents and less rent inflation.  Some of them even managed to hedge their short positions by taking a long position.  Those households were famously, and summarily, screwed over, even if we have not (and may never) come to terms with what we did to them through public policy.

The way to prevent the short squeeze would have been to introduce liquidity into the housing system - to issue stock, as it were.  We did precisely the opposite.  So, the sharp rise in rent inflation in 2006 and 2007 along with the unprecedented decline in housing starts during the same period, can be seen as a massive short squeeze perpetrated on American renters.  When home prices finally collapsed in late 2007 because of the liquidity crisis in mortgage securities, those households who had tried to hedge their natural short positions with matching long positions (ownership) now faced the worst of both worlds - they were squeezed on their floating rate short positions at the same time that they were squeezed by a massive liquidity discount on their long capital positions.

More houses and more mortgages would have fixed both squeezes.  A decade later, the squeezes are largely still in place - a decade later.  And many observers, infuriatingly, are calling for macroprudential governance in order to refrain from too much housing and mortgage growth while our leaders publish books about that time in 2007 & 2008 when they courageously saved the world.

In fact, the shorts of "The Big Short" fame, who had short positions on housing, were not that different from the typical American.  Their short position on mortgages was a sort of floating rate short, where they had to continue to make coupon payments to the long positions in the synthetic CDOs as long as the housing market remained functional.  The reason they fared well while the typical homeowner fared poorly is that they paired that short position with a position that was long on a liquidity crisis.  Those traders pocketed most of their gains by autumn 2007, before more than 90% of defaults happened and before most of the decline in home prices.

The difference between those shorts and the Americans who had hedged their short positions by becoming owners was that homeowners were vulnerable to a liquidity crisis while the "Big Shorts" depended on one.  Ironically, it was the inability of American households to take long positions on housing that led the market to become catastrophically inefficient.


  1. Fascinating post. I think I agree.

  2. I really like the way you characterize everyone's need for shelter as being short housing. We're short food and transportation too. With some luck, we're long on human capital. Thanks.