Monday, October 31, 2016

Housing: Part 184 - Intrinsic value trumps supply and demand

A common way of thinking about asset markets is to think in terms of supply and demand - factors that will change the number of buyers and sellers.  A good quarterly report from a corporation will bring in new investors from the sidelines.  More credit will increase the number of home buyers. Etc.

In some areas, this can be technically true, where quantities can change.  For instance, rising and falling credit access can lead to rising and falling housing starts, where there really is some change in the relative numbers of buyers vs. sellers.  But, in many areas, like equities, by definition, most of the time, there has to be exactly the same number of buyers and sellers.  It is still tempting to think about changing values as being a product of new buyers who have been induced by new information to buy, pushing the price up above the reservation price held by some sellers, leading to transactions and rising prices.  Certainly, this can describe almost all markets.

But, this is a case where the technical accuracy of the observation hides the broader, conceptual inaccuracy.  These transactions represent marginal liquidity issues and have relatively little to do with the broader reasons for changing values.  If Apple issued a positive quarterly report for the next quarter that increased the expected value of future production by 10%, their share price would immediately rise by 10%.  It would certainly be accompanied by an increase of buying and selling, but this activity would have nothing to do with that change in value.  The change in value could increase without a single transaction.

This is obvious if we think about Apple as a private firm.  Imagine that same quarterly report for private Apple.  The intrinsic value would move just the same with no transactions.  Sure, private firms shopping for buyers will consider buyer interest and liquidity when they position themselves for sale.  And, this will have some effect on the margin.  But, the reason Apple is worth $600 billion and Big Lots is worth $2 billion isn't because Apple has more buyers.  It's because Apple is expected to earn higher profits.  Intrinsic value moves markets.

One place where the housing bust drives this point home in a way that I think has not been widely appreciated is in the collapse of the private securitization market in the summer of 2007.  I have generally referred to this as a liquidity panic, which I think is more or less the norm.  And, in a way it was.  But, that's a strange way to talk about it, if you think about it a little bit.  There was no shortage of liquidity.  Everyone knows that at the time there was a massive demand for AAA related securities.  The entire CDO market had basically risen up to meet that demand.  That demand is at the center of the accepted narrative of the period.

In other words, there were many, many motivated buyers for those AAA securities.  If we think about this in the supply and demand mode that I described above, then how can we explain the collapse?  There was no collapse of demand.  The collapse was in the intrinsic value.  The collapse happened because there was a collapse in expectations about home values.  This had set off a series of self-perpetuating trends where lenders were less eager to lend, home sellers were less likely to repurchase new homes, home values were expected to fall, and the market expected high levels of future defaults as a result.

There were billions of dollars worth of potential buyers, desperately looking for safe assets to invest in, and those buyers would not pay more than 70% or 80% of face value for the AAA rated private MBS securities.  The differences here, between the extreme decline in market values and the extremely high number of potential borrowers, is....well...extreme.  Intrinsic value dominates supply and demand.

What happened in 2007 was that there weren't enough buyers for home equity.  The liquidity crisis wasn't in AAA rated debt securities.  It was in home equity.  The reason was that homeowners were fleeing the market through the back door.  First time home buyers continued to be strong, because the decision to buy is dominated by life cycle effects.  But, there developed a tactical outflow of homeowners from the existing stock of owners.  There weren't enough willing home buyers.  And, those home sellers, selling their old, lightly encumbered homes to the naturally highly leveraged new buyers took all those capital gains out of the home equity market and stuck it in the low risk capital market, where much of it ended up funding mortgages.  But, the problem is, you need a homebuyer to fund a mortgage, and since there weren't many, financiers started creating various forms of CDOs in order to create low risk debt for those former homeowners to invest in.

This began to happen as early as 2004.  But, intrinsic value rules.  It didn't matter that there weren't as many buyers.  For a year or two, prices continued to rise along with housing starts.  In fact, the sharpest rise in home prices was during the initial decline in homeownership.

Eventually, by the end of 2005, housing starts began to collapse, and home equity levels began to fall at the same time, because of that transfer of old homeowners out of the market.  But, intrinsic value still ruled.  For nearly two years after that, the decline in homeownership and in home equity accelerated, yet home values remained steady.

In the 3rd quarter of 2007, home prices were still within 3% of their highs, nationally.  But, home equity had already dropped by 20%!  Then, we finally broke the housing market so much that liquidity became the dominant factor in price.  Before the 3rd quarter of 2007, the housing market was like the New York Stock Exchange.  There could be debates around the edges regarding efficient markets.  Differences in prices of 5% or 10%, or differences in relative returns of a percentage point or two, could be debated, regarding the difference between efficient prices and market prices, or regarding the effect of credit and liquidity on market values.  After the 3rd quarter of 2007, the housing market had a regime shift.  Now it was defined by the lack of efficiency.

The entire country, it seems, mistook this to be exactly the opposite.  We thought that the housing market had been inefficient before the 3rd quarter of 2007 and that it was now returning to efficiency.  We were disastrously wrong.  And, we were wrong because we make the mistake of thinking supply and demand are more important than intrinsic value.  We assumed that forms of mortgage credit that had been ascendant were bringing in new buyers and that new buyers would naturally move prices higher.  We didn't account for the fact that intrinsic value rules.  To the extent that credit expansion had some hand in moving home prices higher, it was by providing liquidity in markets that previously were lacking in liquidity.  It turns out that this was largely in markets where high income households were buying access to Closed Access labor markets, where housing expenses in general have moved above our longstanding norms, making conventional mortgage funding inadequate.

So, as with the private firm positioning itself for a new buyer, that added buyer interest did have a marginal effect on market prices in some places, but it was only pulling prices toward the liquid, efficient price level.  Big Lots might tweak their market capitalization by a few hundred million by announcing their entrance into an exciting new market that investors are excited about.  But, they aren't going to get to Apple's market capitalization by attracting new buyers.

This is why the housing markets that were especially hot during the 2000s continue to have relative values higher than the rest of the country, even though we killed the non-conventional mortgage market.  Intrinsic value.*  Even though those markets are still reaching for intrinsic value, they are still underpriced, because we have eliminated sources of liquidity for those markets.  So, a rejuvenated private mortgage market would cause those home prices to jump again, and a rejuvenated conventional mortgage market would cause low priced homes across the country to rise.  But, they would rise toward efficiency, not away from it.  Because intrinsic value rules.  The number of buyers is a deceptively weak explanation for market inefficiency.  Millions of new home buyers couldn't make home prices rise above their intrinsic values any more than those trillions of dollars of savings in 2007 could keep private MBSs at face value.

Tomorrow's post will explore this general idea a little more.

* By intrinsic value, I don't mean natural value.  Those homes are only valuable because of a political stranglehold on supply.

Sunday, October 30, 2016

Housing: Part 183 - A measure of the shortage

Here is a graph of housing units per adult in the US, quarterly.  Unfortunately, there is a sizeable discontinuity in 2002 where the count of housing units was adjusted as a result of the decennial census.  But, even with that discontinuity, the trends are sharp enough that we can see pretty clearly that housing units peaked in the late 1980s and have been generally declining since then.

During the big, bad 2000s, we just barely started to reverse the trend before we busted the housing market in 2007.  (That little bump up in units per adult happened in 2008 after housing starts had collapsed, and is partly related to a slowdown in population growth.)  So, when we had a moral panic about housing, when we were supposedly overbuilding, and when capital was supposedly being unsustainably misallocated into housing, we were near secular low points in units/adult, hovering, as far as we can tell, around the level last seen in 1986.

Of course, the misallocation didn't come from where capital was allocated.  It came from where it couldn't be allocated - the Closed Access cities.

In any case, we can use this ratio as a first estimate of how many housing units we are short of some stable level that might have been built if we hadn't had the moral panic.

Oops.  Obviously, that y-axis is in thousands, not millions.
Next, is a graph of the number of housing units that would be required to just get us back to the same ratio of units/adult at the end of 2006, or alternatively, the number of units required to get us back to the nadir of the housing stock in 1991.  We need somewhere around 5 million housing units.

Eventually, as the baby boomers age into very old age groups, there might be some decline in housing units/adult, but we aren't anywhere near that now.  I don't think there is any current demographic trend that would lead us to expect the demand for housing units/adult to have shifted materially, as it did in the 1970s and 1980s when household size declined for a number of reasons.

This basically matches the gap suggested by housing starts.  Adding about 1/2 million units per year since the bust would put housing starts at near historical norms, and would roughly have given us those 5 million units.

How many hundreds of thousands of men without college degrees have been unemployed for the past decade while we patted ourselves on the backs for making this happen?  But we blame trade with China, because construction employment was unsustainable.  Right?  0.55 housing units per adult was just masking the loss of manufacturing jobs.  Right?  We had to do this.  It was inevitable.  Necessary, really.  Right?

Friday, October 28, 2016

Liberal society depends on the presumption of rights.

The core liberal ideal at the heart of the American experiment is the presumption of rights.  It was imperfectly instituted at the founding, and has, miraculously really, expanded and become more universal since then.  But, in the past century or so, that presumption seems to have waned with regard to our rights in the realm of commerce.

I wonder if this has something to do with the persistent influence of Marx.  In a way, the fundamental challenge to the sustainability of liberal, civil society is our natural tendency toward tribalism.  The endurance and success of market economies is certainly related to the way in which markets undermine tribalism by building on impersonal exchange.  Every day we transact, directly and indirectly, with thousands, or millions, of others, who, in other contexts, would naturally greet us with vitriol.  The political season is a window into what human nature looks like in contexts where it isn't moderated by the utilitarian temperance of markets.

When those Trump and Clinton supporters put down their placards and shut off their Facebook pages, they all go out into the world and buy hamburgers, sell Halloween candy, repair plumbing, and hail taxi rides with each other without much thought about their moral differences.

It's actually kind of funny that such a big commotion is made about the occasional situation that arises where, say, a baker refuses service for a gay wedding, because in commercial settings, the interaction tends to have to be pretty peculiar in order to create controversy, as with the cake, where the baker is forced by the transaction to directly consider and affiliate with some moral sentiment.  Those bakers generally happily take the cash from, not only gay customers, but even from genuinely bad people, for the cakes they bake.

In practically every other context, we take for granted that people make moral judgments about each other in important and even unreasonable ways.  Even supporters of LGBT rights basically have a consensus that, as sad as it is, those cake buyers will have to deal with reactions from families, friends, and acquaintances.  In those contexts, we look to change hearts.  We pass laws to force the baker to provide a cake for the wedding, yet we wouldn't think for a moment to pass a law forcing the couple's parents to support the wedding.  And, yet, gay couples have surely faced much more despair about how their parents would react to their sexuality than they have about how their bakers would react.

The sharp difference in our reactions is due to the fact that we have lost the presumption of rights in commercial settings.  Liberalism is not the natural resting place of human nature - tribalism is.  Liberalism is sort of tribalism's opposite.  And it has to be learned and practiced.

Where Marx comes in is that, at its base, Marxism is popular because it manages to sneak tribalism into markets and undermine markets' natural tendency to reduce tribalism.  The way this happens is that the division between owner and laborer creates a dichotomy of in-group and out-group that provides us with a satisfying and unbreaking David vs. Goliath mental framework.  As with all forms of divisive community building, whether in traditional ethnic or racial relations or in lighter forms like team sports, we are provided with a template where we can persistently identify with the "David" team with little need for compromise.

This intuition is so strong that it even generally defines academic work.  How often do papers simply treat rising labor share of income as a positive outcome, a priori.  Surely there is some level of capital income that would be too low.  Surely there are contexts where falling labor share of income would be reasonably favored.  It seems obvious that there are distinct periods in the business cycle where that is clearly the case, in fact, since equity owners take nearly all of the shock of nominal contractions.  (Here is an old post about labor share of income.*)

For better and for worse, modern market economies undermine our sense of belonging.  Fewer outlets for divisiveness and moral control also means fewer sources for belonging.  I am afraid these two sides of the coin of human community are inseparable.

But, the Marxist framework allows us to divide this big, unmanageable, unknowable stew of human interaction into teams.  We know who to root for.  We can usually assume that our team got the bad calls, America is on the right side of the war, and workers (or customers) deserve better.**

This leads to a switch turning off in the part of our minds where we consider public postures about capital.  The American legacy of the presumption of rights, which informs our moral intuitions in so many other contexts, is disarmed.  Note, it is that American (or maybe more broadly, the British) legacy that is odd in the history of human interaction.  The strong tendency of tolerance instead of control is what makes us strange.  This is what always makes the lack of a presumption of rights seem so easy and natural, and why it has been such a miracle that the breadth of this presumption has grown over time.

Judged against the natural lack of a presumption, the liberal ideal is strange, and vice versa.  If the switch is turned off, our behaviors can change drastically.  How many political arguments revolve around the difference between people about where the switch is turned off and where it is turned on?  We can think of the sharp differences about race, sex, gender, etc. in this way, obviously.  But, it seems that where this happens with increasing frequency and universality these days is in this divide between capital and labor/consumer.

Much of my effort recently has been toward an empirical and conceptual reimagining of the housing bubble and bust, where I think there is a strong argument that the bust was the problem, and that it was certainly not necessary or inevitable.  Now, as I read memoirs about the early bust period, it is striking how explicit, universal, and ubiquitous the calls for ruin were - even among the bankers and homeowners themselves.  The country and its policymakers were basically in agreement in 2007 that, while price stability would have been very helpful for everyone, it was unacceptable because it would also help capitalists.  Every policymaker from the period bemoans the problem that they couldn't find a way to avoid crisis that would simultaneously maintain a crisis for lenders.  They clearly avoided obvious sources of stability.  And, their most vocal critics complain that they did too much.  One of the most vocal critics for not imposing enough pain on Wall Street has been the Wall Street Journal, which has pretty consistently been liquidationist.

For two years, we avoided the obvious solutions to the problem as we desperately tried to find some way to manage the economy that would hurt capitalists while it helped everyone else.  We never found it, because there is no out-group.  The enemy is us.  It's easy to scoff at this as apologetics for the powerful, because we have managed to create an out-group that seems comfortable and powerful.  But, accepting that caveat, is the mistake we have been making really that different than the mistake a culture makes that insists on preventing a gender or an ethnic group from becoming educated or legally whole at the expense of remaining poor and backward?  Forsaking a global optimum in order to capture an inferior local optimum is the more common human behavior.  Of course we aren't immune to it.

Many will be skeptical of my story regarding the housing bust and the recession.  But, considering the stark shift in moral form that comes from pivoting away from a presumption of rights, how certain do you need to be of your version of the story in order to take responsibility for demanding the imposition of "discipline" over stability for some specific segment of your community?  How certain do we need to be about our macro-understanding in order to risk the moral monstrosity of insisting on ruin?  In every instance where Ben Bernanke or Hank Paulson relented and decided that support was necessary, they were peppered with one demand.  The way this is set up, the capitalists will be ruined, right?  The shareholders will be wiped out, right?  The executives will be pushed out, right?  And, yet, even with that, time after time, when what amounted to bankruptcy proceedings were implemented, they were referred to as "bail outs".***

Consider the idea of corporate inversions and attempts to stop them.  Basically, some corporations are being acquired by foreign firms or are moving their headquarters to other countries to avoid onerous US corporate taxes.  One response, shared by both President Obama and Hillary Clinton is to try to prevent them from leaving and to impose punitive exit taxes on them.

Now, imagine any other groups or associations of Americans.  Imagine that they have decided that conditions are bad enough in the United States that they have to leave.  And, imagine that the government issued a proclamation that they would be stopped at the border so that the government could appropriate some of their valuables.  Has there ever been an instance where a government that did that sort of thing met your approval?

When we remove the presumption of rights, we are capable of a wholesale change in our public behavior.  When we act on that lack of a presumption of rights, our actions tend to be illiberal.  And our solutions tend to require coercion and an imposition of control.  This can end up affecting both the targets of our coercion and the targets of our protection.

Consider the impending expansion of overtime rights, which I previously discussed here.  This, like rising minimum wages, seems to be popular with the public.  But, it seems that the main effect here will be to switch a bunch of salaried workers to hourly, which will not only create a less steady income for them, but will also remove a sense of status and control over their working lives.  I suspect the popularity in the polls for this sort of thing comes from the idea that this is a free lunch for workers - that everything else will remain the same, but with a 50% bonus extracted from the firm at those times when hours go over 40 hours.  In the aggregate, this simply cannot be the case, as I argued in the previous post.  Clearly, these are generally jobs that have terms above any legal minimums.  These terms are the product of market forces, and on the margin, new demands on the employers will be balanced by new concessions from the workers.  Nothing here is changing the market forces that led to existing contract terms.  Even if you think the terms are abusive, time demands are hardly the only way that abusive terms can be imposed.

Clearly this will not be a winning change for some portion of the labor force.  But, whatever the outcome, consider the illiberal imposition that is being made here.  This is not a choice.  A worker who values the status and income stability of being salaried will lose it.  A policy that is premised on the idea that its beneficiary lacks agency will require, in the end, that its presumed beneficiaries give up any agency they had actually maintained.

This leads to awkwardness, again, when viewed from a presumption of rights.  This is similar to how rules from the 19th or early 20th century, that seemed perfectly reasonable to their supporters strike us a obviously sexist, racist, etc.

Imagine, for instance, if, in response to a problem of husbands being demanding or abusive of their wives, demanding that dinner be ready right at 5pm, we made a rule that, if a wife has had to do more than 2 loads of laundry during the day, she has a right to delay dinner until 6:30.  This is kind of what we are doing to salaried workers.  It looks, on the surface, like we are supporting them, but we are actually reinforcing and locking them in a lower status.  If you were against my dinner rule, I might respond, "Oh, well, I guess you don't understand that we have a problem with dictatorial husbands." just as someone might respond that opposing the overtime rule means that you don't appreciate the problem of abusive employers.  But, the rule itself is demeaning.  And, not only would it be demeaning to some of the wives.  It would be demeaning in a more persistent, stultifying way than the status quo was.

But, the illiberal approach tends to presume that everyone has their place and needs to remain there.  And my dinner rule, as a first order effect, is, after all, imposing a control on the husbands.  It is addressing a place where they might be asserting asymmetric power in a way that I might find inappropriate, and coercing them to give up that power, just like we are doing with these employers.  The presumption of rights is replaced with a whole set of other presumptions that end up demeaning everyone.  When we don't have a presumption of rights, it sure feels like we have the power to solve problems, though, like kibitzers over a chess board.

The rule on overtime imposes a lot of insults on workers who will be affected:
  • You aren't the kind of worker than can be trusted to set your schedule.  Your employer needs to have a record of your arrivals and departures.
  • You aren't the kind of worker who can be paid according to your general value to the firm.  You need to be paid like a machine, by time.  The work you do only has value as a rote task measured in time.
  • When there is excess work to be done or an unusual problem to be solved, you are not the kind of worker who represents dormant value the firm will look to.  You are a burden that must be minimized until the schedule can return to normal.
Clinton also frequently mentions programs to encourage profit sharing.  Here is an article where profit sharing and inversions are both mentioned:
Host Mark Halperin asked Fallon, "She would support economic policies which would take money from the people who are currently well off and doing well and move it to people who are lower down the economic ladder?" "That's what the profit -- the tax proposal to incentiv(ize) profit-sharing by corporations is all about," Fallon said. "It's a carrot, not a stick, but it's -- we think it would be a significant inducement toward more responsible -- we think it's smart corporate behavior."
Notice that Marxian underpinning.  Workers deserve more.  In a way, these two policies are similar in that they purport to force firms to share temporary gains with employees.  In a way, they are contradictory - one making workers more like the risk-taking owners and the other insulating them from the status and stresses of ownership.  What both policies have in common is the false notion that they can sustainably create a transfer of value from the out-group to the in-group.

Probably most successful political players have to utilize this sort of setup.  It isn't realistic to win an election among 300 million people by appealing to reason.  In this election, Trump seems to use foreigners as the out group and the Democrats seem to use capitalists in various forms as the out group (bankers, employers, etc.).  What the millions of workers who have been forced away from opportunity, or locked out of it, because of illiberal housing policies, need is a liberal party.


* Today, I would attribute much of the decline in labor share of income, and the related trade deficit and wage variance issues, to urban housing constrictions that raise wages of skilled information workers and block the natural, ancient migration responses of distressed working class households.  But, that is a very complicated story.

** An example of the excessive nature of this bias, both to support labor or consumers over capital and to underestimate the power that lightly regulated markets have to actually provide that support, is the airline industry after Carter administration deregulation, of which Richard Branson has quipped, "If you want to be a millionaire, start with a billion dollars and launch a new airline."  Deregulated airlines have found it difficult to maintain sustainable profits as an industry, with many famous failures.  Our presumption should be that a higher level of profitability would probably be a step toward a more healthy equilibrium.  Has any article in a general periodical about labor relations, mergers and acquisitions, or product innovations ever taken that position?  When the FTC reviews airline mergers, do they ever decide to approve one because it will raise prices?  Isn't it possible that higher prices are beneficial if the industry has consistently had difficulty earning profits?

It isn't the case that we have considered the peculiarities of the airline industry and decided collectively that profits are still too high, in general, I don't think.  We simply haven't thought about it.  That's the point of community consensus.  It eliminates the need to think about important things when we present our public faces.  As social animals with language, we necessarily evolved the ability to intuit these automated conclusions.  This is the Deirdre McCloskey story, as I understand it.  Some set of circumstances led to the rhetorical acceptance of merchants and traders, which set in motion an era of abundance.  It seems as though this rhetorical acceptance is not a natural resting place for human nature.  There is something about our intuitions against powerful "others", and the place of capital within that web of impersonal exchange that seems to represent both "power" and "other".  Thus, a priori, it must be better for airlines to earn lower profits.

*** Please do not interpret my discussion of this particular lack of the presumption of rights as a denial of the numerous other areas where it is a problem.  There can be more than one problem at a time.  I am not picking a team.  This just happens to be a question that has grown out of the work I have been doing.  There are people doing work on war-weary refugees and marginalized ethnic groups.  They are important.  You should pay attention.  But, if there is a chance that we have created the largest economic upheaval in our country of a generation, and it was because of these out-group pressures, then it seems reasonable to talk about this too, even if it challenges our posture toward the out-group that we all love to hate.  No less so because our inter-connectedness probably means the most vulnerable citizens are hurt the worst in either case.

Thursday, October 27, 2016

The Obama administration sees its own nose.

Hey, look what the Obama administration discovered today! (HT: Andy Berner)

The impact of the financial crisis on current borrower access to mortgage credit is evident. (KE: The impact of borrower access to mortgage credit on the financial crisis is evident.  - FIFY) Today, the credit score of the typical new mortgage borrower is nearly 40 points higher than the typical borrower in the early 2000s. The average credit score for those obtaining a loan backed by Fannie Mae and Freddie Mac (collectively, the government sponsored enterprises, or GSEs) in conservatorship is nearly 750. The minimum credit score to qualify for a mortgage at the GSEs is 620, yet only 1 percent of all new mortgages originated across the industry are to borrowers with FICO scores below 665. While creditworthiness is certainly a critically important factor, this credit selectivity is especially sobering given the fact that more than 40 percent of all FICO scores nationally fall below 700. While a variety of factors contribute to these outcomes, it is clear that the GSEs and the secondary market can do more to reach a broader swathe of creditworthy households. Constraints on access to affordable credit have ripple effects across the owner-occupied housing market. When a large number of first time homeowners cannot buy a home, established homeowners may face a harder time relocating or moving up in the market.

If only the Bush administration had figured that out in the last year of their term, or if Obama had noticed in the first year of his.  The GSEs were taken over in 2008.

The curious thing about my project is many facts are slowly being accepted across the spectrum of observers.  But, will readers be willing to accept the conclusions that those facts point to when they populate a coherent narrative?  Will we admit that we fought an unnecessary war?  And, in the end, is that what the delay is about, even if that isn't a conscious choice?

It is the lack of credit what done us in, not an excess of it.  As this graph points out, and the White House memo seems to acknowledge, there was no excess to begin with.  Some try to concoct a story that FICO scores were somehow inflated by the housing boom.  But, an expansion of credit or real housing expenditures doesn't show up if we look at incomes or spending, either.  And, in any case, if the expansion of credit can happen with little discernible movement in FICO scores for nearly a decade, what does that say about the scale of a 50 point increase that happened during the bust.

The government took over most of the mortgage market, and supported the top half of it.  For the bottom half, the worst of the bust came after that - both in terms of defaults and in terms of lost equity.

If they actually follow through on this, prices at the low end of the housing market will rise significantly, which would be great.  Not because it matters whether prices are high or low, but because it matters that prices are free to reflect accessible markets.  The only reason those prices are low now is because we are killing the mortgage market, and locking middle income households out of the market, to keep them that way.  That's the rigged system.

Success might push us even more quickly into a recession, because there seems to be a consensus that we have to prevent markets from clearing.  But, at least there is are green shoots of statements of the obvious here.  Baby steps.

Wednesday, October 26, 2016

Housing: Part 182 - The Only Solution for Closed Access Cities is to Build Luxury Market Rate Units

A common complaint in the Closed Access cities is that they can't allow housing expansion at market rents because all the developers want to build is luxury apartments.  When they try "trickle down" housing policy, it just attracts more high income residents to the luxury apartments and just puts more pressure on working class tenants.

The surprising thing is that, if you think about it for a bit, they are actually making an arguable point.  Or, at least, it would appear to be an arguable point to anyone who was simply trusting their own experiences and observations about what was happening.

But this is one of those Bastiat things, where the good stuff is all happening outside our field of vision.  Here's why.

As a city's housing supply becomes constrained, the first response of households is to reduce their real housing expenditures.  We can see this effect, really, in just about all cities, in the "drive until you qualify" distribution of home values.  As you move into the city core, more amenities and shorter commutes mean that you get less house for the same money.  The same adjustment happens across the board in a city as the entire city develops constrained housing.  The house has to get smaller or the drive longer in order to keep costs manageable.

In cities like Seattle, Washington, DC, Minneapolis, etc. where there are supply constraint issues, but not to the level of the Closed Access cities, households generally can make those adjustments across the income spectrum.  The median household tends to feel comfortable with rent in the 20% to 30% range.  This has moved up to 25% to 35% because we have imposed a housing shortage on the entire country by killing the mortgage market.  But, as the first graph here shows, up until 1995, rents settled around a common range.  After 1995, cities with especially high incomes (which can only be maintained by exclusion) also developed very high rents - even as a proportion of those high incomes.  This is because housing became so constrained that households couldn't downsize any more, and for households that valued remaining in those cities, they had to allow housing expenditures to rise as a portion of their incomes.

Washington retains normal rents, as do Seattle and other cities that are regarded as expensive because they still are functional enough that most households can downsize enough to keep housing in that comfort range, even if the home itself is not as physically comfortable as they would prefer.

Here was my attempt at graphically describing this effect.  As housing becomes constrained, households begin to allow it to take on more of their household budget.  Demand becomes inelastic.  But, at some point, income effects become too strong, and demand becomes elastic again for the current residents.  At some level, there is a maximum amount that households can spend on housing, where demand maxes out.

This is why Closed Access cities have a peculiar migration pattern of low income households moving away in such large numbers.  At some point, there is potential in migration, and these in-migrants have less elastic demand for housing the current residents.  In other words, they have higher incomes, so when rents rise, they can accept the higher rents on the given housing stock, so they can bid up rents, forcing the previous residents out.

Across the distribution of incomes, households move along that demand curve to the right.  The higher their incomes, the less they need to spend on rent as a portion of their incomes.  They achieve this by reducing their real housing expenditures, as households in many cities do.

This is another old graph of mine that describes this phenomenon.  At low incomes, rent pulls in a large portion of Closed Access incomes.  As incomes rise, households in Closed Access cities spend a similar amount as households in other cities do, on rent.

So, at the two extremes, there are households with very elastic housing demand, in terms of the proportion of their incomes - but convex at one end and concave at the other.  If we imagine an expansion of supply in the graph above, rents will decline.  For low income households, they will tend to remain in the same unit, and will allow their rental expenses to decline from 60% to 50% of their incomes.  For high income households, their rent spending is already at a comfortable 20% of their incomes, so falling rents will allow them to increase their real rent expenditures until they can once again spend 20% of their incomes on rent, but for a more comfortable unit.

Thinking about this in the aggregate, notice what this means regarding the effect of new supply on housing consumption.  The pent up demand for housing is focused within the high income households.  They are naturally the households that will expand their real housing consumption.*

So, if a Closed Access city manages to expand the supply of units, the overwhelming natural demand for those units is going to come from high income households.  The measure of how much that new supply helps low income households isn't going to come from seeing low income households move into new units.  It has to come indirectly.  First, by seeing that they have more money to spend on non-housing consumption, because that's what they have been cutting back on.  Second, by seeing that they stop fleeing the city by the thousands for lack of affordable housing.  Closed Access cities are so dysfunctional that expanded real housing consumption among low income households is way down the road in any scenario that addresses the problem.

Since the direct effect of new housing - what the locals see - is high income households buying them up - expanding their real housing consumption, it looks to any reasonable observer like "trickle down" economics.  Then, they react by obstructing new market-rate units.  And, ironically, it is the obstruction that continues to make their city dysfunctional.  It is the obstruction that makes those units "luxury" units.  It is the location.  The reason the location makes those units status goods is because of the constricted supply.  So, again, Bastiat might point out to us that across the city, low income households are forced out of existing units that have now become a little more "luxury" because of the obstructed supply.

The irony is that many of those forced out households move into units in Phoenix or Dallas with higher ceilings, more square-footage, etc. than those "luxury" units in the Closed Access cities, because in cities that don't obstruct building, developers have an abundance of choices for all types of households.

* In fact, the opposite of this is what happened in the housing bubble.  More flexible mortgage terms allowed high income households in the Closed Access cities to expand their real housing consumption.  In the Closed Access cities, where home prices were by far the highest, this was not a phenomenon focused on low income households.  Low income households were being forced out of the Closed Access cities by the hundreds of thousands during the bubble, because high income households were able to use those mortgages to outbid them.

Tuesday, October 25, 2016

September 2016 Inflation

Sorry I'm a little late on this.

Trends continue.  The housing shortage continues to push rents up and the money shortage continues to push other inflation down.

First is the month-over-month graph.

Then is the trailing 12 months graph.

Notice on the monthly graph that the trend outside of shelter is down.  Now, trailing 12 month non-shelter core CPI is at 1.4%.  In the last 7 months, non-shelter prices are up 0.45%.  In the 5 months before that, prices rose by 0.95%.  In other words, annual inflation outside of shelter is unlikely to rise back up above 1.5% for quite a while.  It is probably more likely that it will move below 1%.

Forward inflation expectations implied by TIPS bonds have been moving up from low levels, but those are based on total inflation, which includes shelter.  Core CPI is above 2% now when shelter is included.  Five year forward breakeven inflation is under 1.6%.

Let's hope the hawks can be overcome quickly when this comes to a head.  Our perpetual recession is its own sort of macro-prudence, I guess, so we've got that going for us.

It will be interesting to see what happens.  If rent inflation continues to rise, it might encourage the hawks.  On the other hand, if rent inflation falls under these supply conditions, that is a really bearish signal (like in 2007).  I would take it as a signal of a potentially more severe contraction.

At the risk of sounding vain, I wish I could have gotten the book finished and in front of some faces 6 months ago.  A public conversation about this would be useful.

Monday, October 24, 2016

Signs of Recession, Part 2

I guess signs of recession will be a new series.  Whoop-die freakin' do.

Here are some apparently mixed signals from employment flows.

 Net employment flows between unemployment and employment have taken a sharp turn into recessionary territory.

But, on the other hand, flows from out of the labor force, into employment, are very strong - at least as strong as 2004-2005.

The flows in 2004-2005 were related to the huge migration flows out of the Closed Access cities during the housing boom.  In 2006, flows into employment dropped dramatically - from unemployment, and especially from out of the labor force.  This is because the Federal Reserve inverted the yield curve and purposefully slowed down real residential investment.  The beginning of the collapse of the mortgage markets that resulted, both reduced funding for new homes in Contagion cities and reduced the pressure on the housing stock in the Closed Access cities.  So, the first effect of the recessionary conditions of 2006 wasn't for unemployment to rise, it was for those migration flows out of Closed Access cities to dry up.

The interesting thing about that migration was that it wasn't a traditional migration to employment.  There were plenty of jobs in Closed Access cities.  It was migration due to cost, which is this super-duper way we have decided to run an economy these days, with a virtual wall surrounding our most dynamic labor markets so that we naturally segregate by income and skill, with a rent-soaked high income urban core and a deprived rural inland.

So, the decline in migration in 2006 didn't lead to unemployment.  Those households who were now staying in the Closed Access cities were employed.  They were just economically stressed by costs in spite of being employed.  Rent inflation shot up in 2006 and 2007 while housing starts collapsed and this migration pattern sharply declined.

So, I don't expect to see the same patterns as we move into this recession, because that migration pattern isn't in place today.  Households are already stuck in the high cost Closed Access cities because for a decade we have made sure to prevent housing and mortgage finance from recovering.

So, what do gross flows tell us about flows between employment and not-in-labor-force?  Here, the indicator is recessionary.  I'm not sure what forces are behind the net flow.  Normally the net flow would turn negative at the same time that gross flows began to downtrend.

I don't know if there are any home runs that can be hit in this context.  I'm not sure there are any obvious areas of excess valuation or systemic risk.  This could be sort of a mix of 1991 (relatively mild stock market shock) and 2001 (relatively mild pause in housing expansion) and there certainly isn't much upside in bonds to prepare for.  I'm not sure there is much to do but wait for the Fed to blame something else for the recession after they crimp the money supply too much and give themselves permission to do QE4.  I hope it happens sooner rather than later.

Friday, October 21, 2016

Signs of Recession

Bill McBride notices a cool down in the apartment market.  All four measures of market tightness from NMHC fell sharply in the 3rd quarter.  He seems to see this in real terms, as a trend shift in supply and demand, where supply has finally caught up to demand.  Multi-unit building has been relatively strong compared to the previous highly constrained couple of decades.  But, of course, housing starts in general are very low.  There is no way that the supply of homes has caught up to demand.

Here is the chart from Calculated Risk.

Rent inflation remains high, and appears to still be climbing, although the CPI rent measure can lag somewhat.  Mortgages outstanding are just barely growing and homeownership is still dropping, so there is no sign that the single family market is capturing any extra housing demand.

Maybe rent inflation will begin to wane.  But, if it does, I think this will be a sign of generally nominal contraction.

Notice that this level of looseness in the apartment market has previously been associated with the beginning of recessions.  I don't think this has as much to do with real housing supply as it has to do with money.  We are at the beginning of a nominal downshift, and this is one sign of it.  There is no lack of demand for housing.  There is a nascent decline in nominal activity.

Here, it may be worth revisiting BEA statistics on housing expenditures.  Nominal housing expenditures have run pretty close to 18% of PCE for 35 years.  It spiked in 2008-2010, because housing expenditures are sticky and nominal incomes dropped faster than households could adjust.  Consider this long-term flat trend.  Also, note that there was absolutely no rise in this measure from 2002-2006, during the supposed housing bubble, when Americans were recklessly overbuilding homes, as the story goes.

The chart title is wrong.  This is a measure of housing PCE as
a proportion of total PCE, not the other way around.
Basically, what the data tells us is that, in an economy burdened with Closed Access housing markets, where housing is perpetually undersupplied, residential investment is a freebie.  It simply transforms inflationary housing expenditures into real housing expenditures.  Oversimplifying a bit, it means that households live in 2,400 square foot homes instead of 2,000 square foot homes, but their expenditures remain the same.  There is nothing unsustainable about that.

The next graph compares the BEA measure for real housing and utilities expenditures to the measure for real total PCE.  Even in 2002-2006, some of that flat nominal spending on housing was inflationary as real housing continued to decline.  The housing bubble was a moral panic about something that really wasn't even happening.  That is not uncommon for moral panics.

Notice that the jumps in real housing expenditures all happen during recessions, and are a result of falling total PCE, not rising real housing expenditures.  The softening of the apartment market appears to insiders like it is a product of their supply and demand factors, and at very local levels, those factors certainly dominate.  But, in the aggregate, softening demand for housing is probably a sign of softening nominal demand in general.  Growth in real PCE has never really even moved back up out of recessionary levels.  Past contractions have tended to drop at least 3%.  Will real PCE growth drop to sub-1% in the next 18 months?

Thursday, October 20, 2016

TBTF isn't the problem. TSTS is.

TSTS = Too Small to Save

The problem with Too Big to Fail, as generally described, is that we have let certain financial firms become so powerful that we were forced to save them in the crisis.  But, the crisis was a liquidity crisis.  The collapse of the housing market and the related collapse of the subprime mortgage market were products of contractionary monetary and credit policies.  This shouldn't be a controversial statement.  Policy makers at the Fed and the Treasury, plus just about everyone who either supports or questions Fed policies during the boom and bust, have explicitly stated that home prices had to collapse, that the Fed could not provide support for nominal economic activity in 2006 and 2007 because that would be bailing out irresponsible investors and lenders.  It is a matter of public consensus that policies in 2006 and 2007 could have lent support to housing markets and we chose not to, in order to impose discipline on the market.

I suspect that few readers will regard that last sentence as false.  Most will regard it as an obvious statement of wisdom.  At this point, just typing it sort of makes my blood boil.  Maybe a few of you join me on that.

Below the fold is an extended excerpt from Ben Bernanke's "The Courage to Act", about events in early 2008 (pg. 202-205):

Tuesday, October 11, 2016

Book step 1.

The first draft of the manuscript is done.  Blogging will be light this week, but I suspect as I decompress and look around, the next couple of weeks will be a flood of things I wish I'd included.  A couple have already occurred to me.  Like, concepts or visuals that seem like they should have come to me before, now that I've thought of them.  I'll post them when I can.

Thursday, October 6, 2016

Housing: Part 181 - Predatory Lending in the bubble

Here are a couple of old graphs from the Survey of Consumer Finances that I don't think I posted before.

First is homeownership by education.

Second is homeownership by occupation.

Remember all those stories in the papers back during the bubble about all those doctors and lawyers and accountants being duped into buying homes?  Remember all those poor souls who were tricked into mortgages that anybody could tell you were too complicated for someone with a Bachelor's Degree to understand?

Basically all the new homeownership went to professionals and owners with a college degree.

Homeownership has declined in the bust in every category.  But, really, it's such a small price to pay in order to teach those predatory lenders that you don't go around cashing checks on the backs of college graduates and doctors who can't properly manage their own affairs.

Those high school drop outs and service employees will be fine.  They'll bounce back.  They are powerful enough in this rigged system to come out on top in the end.  They kept themselves out of that nasty housing bubble, didn't they?  Let's just hope those college graduates don't start getting crazy again.  We'll have to do some macroprudence to keep them where they belong.

Here's another good one.
Income quintiles

Tuesday, October 4, 2016

Our peculiar housing problem.

I saw this op-ed by a Manhattan city council member. (HT:MY)  The op-ed mentions the recent report from the President Obama's Council of Economic Advisers about the urban housing problem.  The recent reports from the President's staff on housing and occupational licensing really have been unusually lucid and clear-headed.

The Manhattan City Council member, Helen Rosenthal seems to agree that the report is well done.  But, she adds this caveat:
But the White House’s toolkit falls woefully short in that it completely ignores a rapidly growing threat to affordable housing in New York City and across America: short-term rental of residences on platforms like Airbnb.
In his op-ed, Jason Furman succinctly points out that “basic economic theory predicts that when the supply of a good is constrained, its price rises and the quantity available falls.” Airbnb is the prime offender of this basic economic tenet in that it facilitates the widespread removal of housing from the New York City market, constraining supply and driving rent through the roof.
But, we also have the problem that developers only want to build new "market rate" units for the "luxury" market, so when supply increases, it simply draws in more luxury tenants, increasing local rents.

It appears that, from London to Los Angeles, the West's major cities have encountered a strange happenstance.  A v-shaped demand curve that just happens to be centered at the current level of supply.

What defines a "luxury" good?  My stab at a definition would be, "A luxury good is a good that confers high status because of limited supply."  We should probably put a moratorium on the production of new luxury goods until we can figure this mystery out.