Tuesday, July 17, 2018

Housing: Part 311 - The Premise Determines the Conclusion

Bill McBride has a post up today at Calculated Risk remembering testimony from Alan Greenspan in 2005.  This strikes me as a good example of the premise determining the conclusion.  The Fed held a meeting in the summer of 2005 where they looked in depth at housing.  Greenspan's comments here, that there could be some contraction in some local housing markets, but that it would be manageable, reflect the conclusions of that meeting.  And, those conclusions were basically correct.

Here's part of the excerpt at Calculated Risk:
The U.S. economy has weathered such episodes before without experiencing significant declines in the national average level of home prices. Nevertheless, we certainly cannot rule out declines in home prices, especially in some local markets. If declines were to occur, they likely would be accompanied by some economic stress, though the macroeconomic implications need not be substantial. Nationwide banking and widespread securitization of mortgages make financial intermediation less likely to be impaired than it was in some previous episodes of regional house-price correction. Moreover, a decline in the national housing price level would need to be substantial to trigger a significant rise in foreclosures, because the vast majority of homeowners have built up substantial equity in their homes despite large mortgage-market-financed withdrawals of home equity in recent years.

Whether you see his comments in 2005 as obtuse and foreboding or as reasonable completely depends on your premise.  If the crisis was inevitable, these comments are foreboding.  If the crisis was avoidable, then it is 2005 Greenspan that was reasonable, and it was the FOMC members in late 2007 who saw their jobs as being disciplinarians enforcing catastrophic losses who are chilling.  It was federal regulators who cut off lending to millions of households after 2008 who are chilling.  The premise does all the work here.  And, unfortunately, we had and have the political means to impose the premise of inevitable collapse on ourselves.

Because the premise itself holds so much power in the stories we tell ourselves about the crisis, nearly everyone has developed a strong sense of certainty about their conclusions. But that certainty is a mirage.  And, that certainty led us to impose the policies that created the conclusions that only reinforced the premise and the conclusion.  Rinse and repeat.

Everything in Greenspan's comment above was true.  The national housing price level did need to decline substantially to trigger a significant rise in foreclosures.  The foreclosures that impaired the value of AAA rated securities at the center of those markets happened after 2008.  Believing that those foreclosures were inevitable, even as the public and policymakers explicitly recognized our ability to avoid them and chose not to, allows one to turn the truth Greenspan spoke into an untruth.

Friday, July 13, 2018

June 2018 CPI Inflation

Not much to say this month, but I have been tracking this lately, so I am posting updated graphs.  There was a bit of a reversal in shelter vs. non-shelter inflation rates this month, which is probably mostly noise, although there have been reports of declining rents in some cities.  Trailing 12 month core inflation is at 2.2%.  The recent bump has mostly been because the months falling off the back end were low or negative.  Even though 12 month core inflation has been rising lately, annualized core inflation from the last four months has been about 0.6%.

So, the upward trend from the 12 month measure is sort of a false signal, but whether it goes up, down, or sideways from here is still to be seen.  I continue to watch the flattening yield curve, but I admit that this show has been playing for longer than I had expected it to.

Thursday, July 12, 2018

Housing : Part 310 - The premise determines the conclusion, a continuing series

Here is an interesting symposium at the NBER on the financial crisis (HT: MR).  Previously, I have written about how the crisis and its presumed causes were predetermined.  When the question is asked, "What caused the financial crisis?"  The answer always comes in the form of "This is what caused the housing bubble."  The inevitability of the crisis is canonized.  It doesn't even need to be asserted.  This can be seen throughout the slides that are provided at the NBER link.

A set of slides from Nicola Gennaioli and Andrei Shleifer discusses the difficulty of seeing bubbles and preventing them from blowing up.  It includes this graph, which all reasonable people are supposed to agree is part of the "the banks did this to us" story, where banks got all leveraged up with irrational exuberance and short-term greediness.

Can I suggest that this seems a bit underwhelming?  I mean, there are legitimate debates to be had about the most systemically safe ways to fund investment banks, but I think if you showed this graph to anyone that didn't have priors that there was a massive financial crisis caused by risk-taking, nobody would look at this and say, "This is clearly the picture of a financial system ready to blow up in 2007."

Morgan Stanley is the only bank shown here that had leverage in 2007 that was significantly higher than previous levels.  Maybe you could argue that leverage had been too high for the entire decade shown on the graph.  But, then this is just axiomatic.  It's a plausible condition that is lying in wait to explain any crisis.  Really, in that case, you could remove the y-axis, or change the numbers to half or to double the numbers shown here, and the argument wouldn't fundamentally change.  I mean, if Morgan Stanley had been leveraged 20 to 1 or even 10 to 1, and a financial crisis struck, it's not like economists would all look at this graph, with that different scale, and say, "Well, leverage clearly didn't cause this crisis.  Now, if they had been leveraged 30 to 1, then leverage would be important."

No. Leverage is a plausible cause of financial crises, and so any level of leverage, in hindsight, can be called out as the cause of the crisis.  The premise is overwhelmingly the source of the conclusion.  And, certainly leverage is a plausible cause of financial crises.  That's what makes it such a compelling culprit that the premise itself seems sufficient to reach a conclusion.

Here's another slide from that deck.  Here, referring to Lehman and what appear to be optimistic expectations in 2005, they say, "Analysts at Lehman Brothers understood the consequences of home price declines. However, they severely underestimated the probability and magnitude of these declines."

Again, this is hardly new ground.  This is consensus stuff.  But look at those scenarios.  There is nothing wrong with them.  There is a 50% chance of home prices rising by 5% per year, and a 5% chance of a shock to home prices worse than anything we have seen since the Great Depression.

And, who is to say that those probabilities are wrong?  Who is to say that if we could relive the 2000s a hundred more times that 95 of those times would turn out just fine?  Oh, and by the way, this scenario analysis would be pessimistic if it was applied to Canada, Australia, or the UK over the same time period.  We do have several versions of economies entering 2006 with very high home prices, and the evidence suggests that having a generation-defining housing bust is highly unusual.

This is such a deep and ironic example of how the premise that a severe contraction was necessary actually caused the crisis, and then served as its own confirmation when that crisis happened.  This error of looking back at scenario analyses and judging it based on a single outcome only seems reasonable because the premise that the crisis was inevitable is so strongly held.  (And, I don't mean to single out these authors.  This is the consensus treatment.)

This forecast was made in the summer of 2005.  From August 2005 to August 2008, the national Case-Shiller price index dropped by about 7%.  That part of their worst case scenario was actually too pessimistic.  It was their expectation of stability after that which was too optimistic.  From August 2008 to the end of 2011, prices fell another 14%.  And, it was during that later period where nine out of ten of the mortgage defaults happened.

Now, I'm not going to spend paragraphs here walking through the entire timeline again.  Surely we can all agree that by the end of 2008, public policy itself is implicated in the eventual outcomes.  Public policy can even be implicated in the declining prices before August 2008.  But, the irony here is so deep.  What was the overwhelming reason for holding back on stabilizing policies throughout that time?  It was that we had to let prices drop to avoid moral hazard.  To impose discipline.  They had done this to us because of their optimism, greed, and riskiness, and they needed to learn a lesson.

It's fitting that Lehman failed in September 2008, right when the first three years of that pessimistic scenario ended.  Their pessimistic scenario covered the outcomes that had occurred up to then.  In September 2008, the Treasury took over Fannie and Freddie and cut off lending to entry level borrowers, creating a late collapse in low tier home markets that nobody seems to have noticed (because the premise accepted, even demanded, collapse) and the Fed implemented disastrously tight monetary decisions by holding the target rate at 2% and then implementing interest on reserves that sucked hundreds of billions of dollars out of the economy.

I see slides in these programs bemoaning the role of pro-cyclical financial markets in creating a boom and bust, but I don't see much about public demands for pro-cyclical regulatory and monetary regimes.  There is no doubt that the Fed and the Treasury could have avoided the post-2008 price collapse with earlier and more accommodative actions.  The premise was that contraction was necessary.  The premise was the reason we allowed or insisted on instability.  And the premise is why that subsequent instability can be blamed on the market that we imposed the premise on.

Another example of the strength of the premise, from the same set of slides is a reference to the work of Case, Shiller, and Thompson, who surveyed homebuyers for several years, and found that their long-term expectations for home price appreciation are unrealistically high.  This has been blamed for fueling the crisis.  The Shiller real housing chart that was so popular during the boom is referenced, which I have addressed before.  That chart is based on national average numbers, which completely erases the localized nature of the housing supply problem that caused the bubble.  Treating the housing bubble as a national phenomenon helps to feed the false presumption about its cause, because it is a lot easier to blame the bubble on national excesses if it is a national phenomenon.

Along this vein, the panelists reference the survey work of Case, Shiller, and Thompson, and note that during the years from 2003 to 2008, the average long term annual gains homebuyers expected in four different counties were:
11.6% Alameda County (San Francisco)
8.1% Middlesex County (Boston)
9.5% Milwaukee County (Milwaukee)
13.2% Orange County (Los Angeles)

They note "Forecasts were roughly in line with extremely rapid home price growth witnessed prior to the surveys but were way off from future realized growth."  Treating the bubble as if it was a national phenomenon and treating the bust as if it was inevitable means that we can ascribe (false) meaning to this result.  But, here is a graph of the median home price in each metro area (from Zillow).  These cities have very different stories.  Nothing in Milwaukee was outside of historical norms.  As with most of the country, prices were somewhat buoyant in 2004 and 2005, but that is understandable given the low long term real interest rates of the time.

So, how much of the "bubble" is explained by these expectations?  If Milwaukee buyers had high expectations but home prices were about $200,000, then did the expectation of 11.6% price appreciation explain $700,000 homes in San Francisco?  It seems more likely that there is some bias in the response to this question that has little effect on prices.  Let's say there is some effect.  Maybe 15%?  Maybe without these high expectations, San Francisco home prices would have only been $600,000 at the peak instead of $700,000.  What if home prices in San Francisco had stopped at $600,000.  Would we then have looked at the housing data and said, "Oh, expectations can't explain that.  Now, if homes were selling for $700,000, then we might be looking at a bubble, because then San Francisco prices would be 15% too high, and that would be a reason to suspect these biases in expectations."?  No.

Since the premise that demand, unmoored from rational value, exists prior to the analysis, this bias in buyer expectations can explain everything from $200,000 homes in Milwaukee to $700,000 homes in San Francisco, and everything in between.  And, when the "inevitable" bust comes, those high expectations will be sitting there, ready to fill in the narrative.  The reason it seemed like there was a bubble was that home prices in Boston, LA, and San Francisco were double or triple the price of homes in Milwaukee.  But, the false premises about its cause led us to watch the median home price in Milwaukee decline by 15% over the next five years - an incredible loss by any historical standard - and consider that reasonable, even though there was never a reason for homes in Milwaukee to lose a penny of value.

Another presentation by Aikman, Bridges, Kashyap and Siegert asks "Would macroprudential regulation have prevented the last crisis?"  But macroprudential regulation caused the crisis.  In their presentation, the first step to achieving macroprudence is identifying the buildup of risks in the economy.  The first item in their list of examples of challenges to achieving this is the recognition of a housing bubble.  While many of the tasks of achieving macroprudential stability are difficult and were not done well, according to the presenters, this first step was achieved, because the Federal Reserve noted correctly in 2005 that home prices were overvalued by 20%.

But, that was the problem.  Home prices didn't need to fall by 20%. As the housing market started to collapse, the Fed signaled that if home prices did fall by 10% or 20%, it wasn't going to do anything to counteract it.  That was a "correction".  The initial drops in housing starts were enough to buffer the sharp drop in demand that naturally followed.  But, when housing starts fell as far as they could, ratings agencies started to forecast unprecedented declines in prices, and the Fed continued to see instability as a necessary medicine for enforcing discipline and avoiding moral hazard, prices collapsed.  The more they collapsed, the more that the false premise led us to demand discipline and to rail against moral hazard.

Step 4 in their action plan is to "Take action to reduce the build-up in household debt".  The macroprudential action here, surely, should be local, since the rise in these balances was local.  And, the clampdown on lending to borrowers with low incomes and low credit scores, which seems like the obvious macroprudential response, has killed low tier markets, and it has nothing to do with what happened during the boom.  All of the rise in debt payments that were over 40% of income was among households with high incomes, because those are the households bidding up home prices in the Closed Access cities.

I don't see anything in these slides that seems to acknowledge the importance of supply constraints in rising debt levels.  The entire discussion happens within the premise that credit supply is the cause of both the boom and bust.

Another presentation also discusses leverage and over-reliance on short-term borrowing in the financial sector.  Here is a chart from that presentation:

I would point out here that most of the increase in home prices had happened by the time short term repo financing began to rise above the level of long term financing.  By late 2005, the Fed had raised the short term rate to nearly 5%, and the yield curve was inverted.  Banks weren't saving on interest expense when they increased their reliance on short term financing.  This wasn't a matter of "borrowing short and lending long" and pocketing the difference, while creating an externality of systematic risk.

It is certainly useful to consider ways in which a financial system can be more resilient, but these discussions are like a group of doctors standing around a patient who is repeatedly hitting his head with a mallet, and discussing the importance of avoiding headaches by staying hydrated.  Staying hydrated is important!  This is true!  But, it isn't the problem at hand.

Friday, July 6, 2018

Upside Down CAPM: Part 6 - Leverage before a crisis

I recently saw these graphs, from the IMF:

Here is text from their Global Financial Stability Report (Chapter 2),  "The prolonged period of loose financial conditions in recent years has raised concerns that financial intermediaries and investors in search of yield may have extended too much credit to risky borrowers, potentially jeopardizing financial stability down the road. These concerns are related to recent evidence for selected countries that periods of low interest rates and easy financial conditions may lead to a decline in lending standards and increased risk taking."

It seems to me that there is a strong and common presumption that complacency or risk-taking lead to borrowing, and that this presumption really does all the work here.

In the text above, there are several red flags.  Has there been a prolonged period of loose financial conditions?  I don't think so.  There is that phrase, "in search of yield".  People who want yield buy equity.  High yield bonds may be somewhat like equity on the gradient from low yield/low risk securities to high yield/high risk securities.  This horrible phrase is central to my "Upside Down CAPM" framework.  Low yields for fixed income securities aren't a signal of risk-taking, and investors complacent about risk wouldn't push yields down, even in high yield bonds.  If expected returns for equities are around 7% plus inflation, then investors funding bonds that pay 5%, nominally, aren't searching for yield or risk, because there is a better source for both of those things in equity markets.

I'm not sure we can even conclude how attitudes about risk might influence the relative level of high yield corporate debt.  And, household debt, which is mostly associated with mortgages, should grow inversely with risk-taking, as it would signal a bias toward real estate with stable cash flows over corporate investments with highly cyclical cash flows.  It seems plausible that the relative amount of risky debt securities could either rise or fall with attitudes about risk.

This seems like a simple counterfactual to consider.  What if the level of risky debt outstanding wasn't positively correlated with systemically dangerous attitudes about risk.  What would these charts look like?  Wouldn't they look just like this?  When a contraction hit, wouldn't we see disequilibrium in the market for high risk debt and a surge in low yield safe securities?  And, then, as cash flows stabilized and markets healed, wouldn't we see markets for riskier securities recovering?  In other words, the drop in risky lending and the initial recovery reflect the market dislocations that come from uncertain and volatile cash flows, not from attitudes about risk.  This is movement into and out of dislocation, not a shift in a steady equilibrium.

So, the top graph is a spurious correlation.  Of course risky debt outstanding is highest right before economic contractions.  There is no reasonable counterfactual where this wouldn't be the case.  And, the second graph shows that (in the years before a financial crisis), risky debt levels first rise as markets re-attain normalcy, and then the level of risky loans actually levels out in the years before the crisis.

There are any number of models that could explain this pattern.  The conclusion comes from the presumptions, not the evidence.

This is where turning the model upside down seems useful.  In the IMF report, low yields are associated with easy financial conditions.  I think this leads to confusion.  Low yields are associated with demand for certainty in cash flows.  I realize it takes some hubris to stand up against an entire body of research, so that having this discussion is sort of unwise of me.  I'd love to see evidence that there is more to it than this.  But, from where I stand, it looks like low interest rates are a sign of difficult financial conditions, and that fact is so counterintuitive that we have just gone barreling along with economic models that are backwards.

Part of the problem is the unfortunate habit of equating low long term interest rates with loose monetary policy.  Using the financial sector as a measure for financial conditions might, itself, be part of the problem.  When the financial sector increases in size, this is generally treated as risk-seeking behavior.  But, the financial sector is generally in the business of being an intermediary for fixed income securities.  Investors didn't need the financial sector to invest in Pets.com.

Note, that Pets.com wasn't put out of business through bankruptcy, because the ownership was completely in the form of equity.  They simply liquidated and paid any remaining cash to the shareholders.  Notice that the collapse of the internet bubble is not associated with a financial crisis.  That is because there was little debt involved.  The IMF has it correct in this regard.  But the reason it wasn't associated with debt and the reason it didn't lead to a financial crisis is because it was associated with risk-taking!  And risk-takers had equity positions.

So, this is where the standard models go off the rails, because that error flips the story on its head, and it leads the IMF and most other observers to a position where they see signs of risk-aversion and their solutions are to limit lending and cut back on monetary expansion.  Then, the collapse in cash flows that ensues gets blamed on risk takers.  The correlations between debt - even high yield debt - and subsequent financial crises are correct.  The interpretations are suspect.  What leads to a crisis is when a large portion of the set of savers demands certain cash flows and then subsequent cash flows become so volatile that those demands are not met.

Zero is also part of the problem.  Zero looms large in the way we construct these models, and it shouldn't.  Take zero out of the equation.  Now, think of an economy where savers can expect yields of minus 2%.  Or, let's take that to an extreme.  Savers can expect yields of minus 50%.  These economies exist.  Would you associate these economies with "easy financial conditions"?

Thursday, July 5, 2018

What guides intuition about efficient markets?

Scott Sumner has recently been making the case for the efficient market hypothesis.  I'm basically with him on this, especially when it comes to public policy.  If a committee decides that they know the correct price level of something is different than the market price, they will be wrong much more often than they will be right.  And, if that committee has the power to move prices to where they think they should be, the results will be disastrous.  Furthermore, if the committee decides that prices, or God forbid, quantities of something are too high, then they will be imposing scarcity on their constituents.

That's what happened in the housing bubble and the financial crisis.  The model was wrong, but we have given the federal government enough power to impose its model on the economy, and it took a crisis to move prices to the place that they were aiming for.  Though, it's not really an issue of a state-imposed crisis, because the crisis was popular.  It was demanded.  To the extent that people like Ben Bernanke and Timothy Geithner used discretionary power, they used it to moderate the crisis in ways that were widely unpopular.  They partially saved us from ourselves.  Their memoirs can be seen, to a certain extent, as extended apologies for protecting us from our worst impulses.

The public treatment of market efficiency is strange to me.  It seems random.  Some markets are clearly prevented from clearing in a functional way, but people seem to have an intuition for making excuses for them.  Take 100 random people who haven't thought about the issue and present to them the idea that there is a politically imposed shortage of housing in Los Angeles, and they will respond with: Well, there just isn't any land left to build on.  Well, there are just too many people.  Well, the Chinese keep buying up the properties and leaving them sit idle.  Well, with all this income inequality, the rich just keep bidding up the home prices.  Well, all that QE cash keeps pumping up the market.  Well, California is a nice place, so of course it is more expensive.

These are all plausible, yet not significant, reasons from high home prices in Los Angeles.  With a little digging, it becomes clear that these factors aren't definitive, and that the problem is supply.  Even without going into detail about each factor, simply look at the process of development in Los Angeles.  If all these other factors were the reasons for high prices, housing authorities in LA would be running new projects through the system as ferociously as they could to make up for it.  The opposite is the case.

Similarly, mortgage markets are tied up in knots because of extremely tight lending standards.  But, seeing the dislocations, people respond: Well, incomes have declined and people can't afford homes any more.  Well, young families have student loans.  Well, homebuilders only want to build high-dollar properties because they are more profitable.  Well, families don't want to own any more.

All of these are, again, plausible sounding enough if you don't check to see if they are true.

So much of the development of our opinions comes from what we give the benefit of the doubt.  In these cases, for some reason, intuition tends to be that there must be a good reason for what is happening, and our minds search for plausible reasons.  When we find one, we are satisfied.

Sometimes, this intuition leads to conclusions that are extremely supportive of very strong efficiency.  The idea that public schools become segregated because higher quality schools cause home prices to be bid out of the reach of poor families supposes a sophisticated and extreme amount of efficiency in housing markets.  This supposes that quality of a school district gets capitalized into the prices of homes with a high correlation coefficient.

The idea that the various forms of income tax benefits create much higher home prices also supposes a sophisticated level of efficiency, where many far future benefits - some of them imputed - are capitalized into present prices.

But, then, there are times when, for some reason, the intuition flips.  So, if one points to fundamental causes for high home prices in the 2000s, the response is usually to push back and to find plausible reasons why markets weren't efficient.  Well, bankers make bad loans in a shortsighted attempt at padding their numbers.  Well, na├»ve speculators hop in the market at the top and keep pushing prices higher.  Well, mortgage originators could just dump garbage on investors who were too dumb to know.  Well, the Fed just keeps pumping money in so that this fake bubble economy just gets more and more bloated.

Again, all plausible if you don't look hard enough.  It's amazing to me, in hindsight, how many facts that contradict these stories are just sitting in plain sight.

What causes that flip?  What causes the intuition to support efficiency in some ways while it contradicts it in others?  What convinces the average person at the end of the bar that there must be a natural reason for the median home price in San Francisco to approach a million dollars but that we had to suffer through a financial crisis because home prices in Topeka were up to $120,000, and when they fell back to $90,000, that was when we were back to normal.

There is definitely an important role for attribution error here.  We do things because of the context we are presented with.  Other people do things because they are greedy, ill-informed, and short-sighted.  That explains the nuts and bolts of what happens when consensus forms against something.  This is clear in the current anti-immigrant political machinations.  But, we have been dealing with this problem for years, across the political spectrum in the mental models that people have about what caused the housing bubble and the financial crisis.  There are a lot of villains and dupes in the various stories about what happened.

But, this isn't a compelling answer to the question of where this intuition falls.  The housing regulators and NIMBYs in Closed Access cities could easily serve as the villain in stories about expensive urban housing.  In the just-so stories about the current shortage of entry-level housing, attribution error leads to stories of homebuilders who aren't willing to supply low tier markets.

I'm not sure that I have an answer.

And, I'd like to say that I wish that the public tended to support EMH, but even that doesn't help much.  The excuses that seem to plausibly explain million dollar urban homes, in defense of an efficient market, aren't much better than the excuses that seem to explain inefficiency.  I mean, I guess complacency is better than aggressive, passionate sabotage.  But, still what is the mechanism that steers public intuition?

I think the intuition is to search for defenses of the status quo and to see things that change quickly as aberrations.  This is probably not a bad heuristic if it's the best we can do. But this is where the efficiency of modern markets gets them in trouble.  Changes in prices can move quickly when valuations change for any reason. The natural proclivity to distrust financiers leaves us all too eager to blame them and their perceived excesses when change happens.

Even this intuition is biased, though. Our intuition is to explain why there are reasons for financial markets to retract but to push back against financial markets that expand.

Monday, July 2, 2018

Housing: Part 309 - The Closed Access cities should double or triple their minimum wages

Here is a story about rising minimum wages leading restaurants in San Francisco to automate or use self-service features. (HT: MR)  Recently, I argued that a rule requiring solar panels on homes in California, which would normally be inefficient, might actually be somewhat useful in the upside down world that develops when your economy is characterized by obstacles to capital allocation.  I think this might be a better example.

Now, the best solution to the problem of high cost cities is to find ways to expand housing in those cities until costs decline to roughly the unobstructed cost of building.  When reading this post, please don't lose sight of that fact and that, given the choice, that is the policy I would clearly support.  And, it is the policy that would clearly lead to more equitable economic outcomes.

Since that solution hasn't been achieved yet, we are faced with the problem of having a handful of cities, with a population that is basically capped at around 50 million, who have a geographical monopoly on certain kinds of productive labor markets.  In order for those labor markets to grow, or for more Americans to tap into those cooperative networks, we have to engage in a bidding war on the local housing stock.  This leads to rising rents and prices until some marginal household who isn't in a position to leverage those cooperative labor networks can't pay the bills any more, and they move away to a less expensive city, to make room for the more productive worker.

This leads to all sorts of conflict.  Complaints about gentrification, etc.  But, for the country as a whole - again, if we have to accept that the optimal solution is unavailable - this conflict is a necessary adjustment that inevitably will happen with any economic growth.  In fact, accelerating this adjustment and this conflict will help strengthen economic growth because it will match workers better with the locations where they can be most productive.

But, whether we encourage this transition or not, it will happen.  This is clear today, after we have spent a decade putting the federal thumb on the mortgage market in an attempt to prevent households from bidding up the price of housing.  Yet, the conflict and the pressure continues.  Rents continue to rise.  Local populations are forced to move away.

Before we imposed regulatory brakes on the segregation process, loose lending in 2004 and 2005 was helping to accelerate it.  The economy was strong.  But, accelerating the process that way created a major side-effect.  There are two types of Closed Access residents who don't belong there, and who need to move away in order to allow productive workers to move in.  First, are workers who are earning lower wages and who are usually renters.  Second, are long time residents - frequently older households - who are shielded from the high costs because they bought their homes years ago and they are living in homes that would fetch thousands of dollars a month in rent.  This is a level of rent that these households would never entertain if they had to pay it in cash each month.  But, they are insulated from it because they own their homes and they are sitting on unrealized capital gains from years of appreciation.  When young, aspirational borrowers bid up the prices of homes in Closed Access cities, it triggered a massive out-migration of these households, who now took advantage of the hot market to realize those capital gains.  When flexible lending markets allowed young households to bid those homes up to prices that truly reflected the value of their future rents, the owners were more likely to sell and reap their profits.  Hundreds of thousands did.

This had a positive effect of accelerating the segregation process, allowing more productive workers into the Closed Access cities.  But, this came at a tremendous cost.  Because in order to induce that segregation, we had to create trillions of dollars worth of transfers to those real estate owners.  They made space by leaving town, but they took a huge chunk of change with them.  In fact, to the extent that workers are willing to pay the entry fee to get into those cities and earn higher incomes, the productivity of those workers went to the former homeowners.  The country, as a whole, was more productive and richer, but the riches were mostly claimed by rentiers.

Long ago, I spent many posts looking at minimum wage laws, and concluded that at the national level, there seems to be a systematic loss of employment that is associated with rising minimum wages.  Normally, that would be a reason to oppose it.  But, in the upside down world that is created when we oppose the allocation of capital to its highest use, bad becomes good.

In this case - again, if we are resigned to the fact that these cities will not simply allow more homebuilding - raising the minimum wage is the best alternative to that option.  These cities should triple their minimum wage levels.  A commenter at the Marginal Revolution link to the original story noted that workers making $50/hour would qualify for housing subsidies in San Francisco.  Unless San Francisco can commit to expanding its housing stock, if you need housing subsidies, then you should live somewhere else.  You are blocking the process of segregation.  The unemployment that would be triggered by a $50 minimum wage would accelerate the process without triggering the trillions of dollars in transfers to real estate owners.  Unemployed workers would move away.  Maybe some would be able to earn the higher wage level locally, which minimum wage proponents would naturally support.  This would be a positive development for the workers that remained.

Maybe, if it was successful enough at triggering unemployment, it would actually lead to lower local rent levels and prices, reducing the transfer of economic rents to existing real estate owners.  This might just be an effective way to moderate the housing market again.  Just keep raising the local minimum wage until home prices in LA or San Francisco are, say, within 50% of prices in other cities.  In the upside down world of Closed Access, the minimum wage would be a boon to productivity and equality.  Let's see how high it can go.

In the upside down world of Closed Access, marginal increases in the minimum wage that don't lead to significant employment loss would be bad, because the extra income would simply have to be deployed in the never-ending bidding war for housing. So marginal increases in the minimum wage would probably increase the transfer of economic rents to real estate owners.

In the upside down world of Closed Access, the minimum wage would only be useful if it was high enough to trigger significant unemployment and reduced the demand for local housing.  Let's say that a minimum wage of $50/hour was enough to price out a few million workers who would leave those cities to find work elsewhere, driving rents down so that decent apartments were available for $1,000 per month.  Surely there would be some wage level that would induce such an outcome.  The Closed Access cities would be utopian.  Everyone there would be comfortable, from the custodian to the CEO.  It would be a clear improvement from today's condition.  And it would be basically a free lunch.  Sure, several million residents will need to move to find gainful employment. But this would arguably be less painful than the process of several million residences gradually moving away as their cost of living slowly grinds higher.

So, I will carve out an exception for minimum wage policy. In most places, minimum wages are questionable. But in the Closed Access cities, the minimum wage should be high enough to bring down home prices.

Thursday, June 28, 2018

Housing: Part 308 - Why is inventory so low?

One facet of the housing market that gets a lot of attention is the very low level of inventory, especially in low-tier markets.  It looks like a strange market.  Prices seem high on a price-to-income basis, and they continue to rise.  Low inventory tends to correlate with a seller's market, and it is frequently treated as a sort of causal element.  Prices will rise because inventories are low.  I don't find that sort of framing very helpful.  But, the mysteries about the current housing market go beyond that.  If inventories are low and prices are high, why aren't buyers just moving into new stock?  Why aren't homebuilders filling this market?

Timothy Taylor has some comments on this today, here.  He covers some of these issues.  He references a study that mentions rising costs, limited lot supply, builder caution coming out of the crisis, etc.  I think all of these are false flags.  They appear to be important issues, but until a full reconsideration of the housing boom and the crisis is undertaken, it would be impossible to solve the mystery of low inventory.  The truth is that, relative to high tier home prices, low tier prices are very low.  And, taking into account very low long term real interest rates, prices are also low.  There are many regulatory barriers to new lot development, so it appears that this is the constraint.  It is a constraint, but it's not binding.  On the margin, builders are being outbid for land because the use of the land that they are trying to develop is underpriced by 20-40%.  Is there any doubt that lots would be widely available if home prices were 40% higher and builders could double their bids for lots?

But, if inventory is so low, then why don't prices rise until that happens?

The reason is that we have imposed a regime shift in regulatory barriers to home ownership, and probably more than a third of households live in homes that they would not currently qualify for.  We have created non-price barriers to ration housing through mortgage regulation, so now about half the country are housing have-nots, who must rent.  Renting comes with higher costs for management, vacancy, tenant conflicts, etc.  So, supply for rented units tends to be lower, rents relative to unit value tend to be higher, and so the quantity demanded by renters is lower than it is by owners.  This is only made worse by income tax benefits targeted at owners.

But, there are millions of households who are have-nots in the current regime who were haves in the previous regime, and they still live in homes that they own.  Given the current regulatory regime, they are over-consuming housing.  They are living in homes that are more valuable than the homes they would be allowed to live in today if they were starting out fresh.  This is one basic way to think about it.  Inventory is low because there are millions of homeowners who are sucking up more housing supply that the FHFA and the CFPB would let them if they could.  Households who were foreclosed on have reduced their housing consumption, but households that managed to maintain ownership are grandfathered in to previous levels of housing consumption.  If the current regime remains in place, then real housing consumption will be lower, rents will be higher on existing properties, and prices will be relatively lower.  In this regime, we don't need to build that many more homes.  But, in the meantime, these households are grandfathered in, and the process of shifting down real consumption of housing will be very slow.  So they have a temporary claim on a portion of the housing stock that will slowly be cured by reduced housing consumption rather than by new building.  While this transition takes place, there is less housing left for other households to claim, but no means or incentive to build new housing to make up for it because it is a temporary disequilibrium.

Thinking of their homes as financial securities, the grandfathered owners are earning very high yields on their investments based on current market values.  Partly that is because rents have generally risen after a decade of crimped supply.  But, mostly, it is because the new regime pulled prices down.  These are sunk costs.  The existing owners didn't benefit from it.  The high yield comes from their unrealized capital losses.  But, the oddity here is that the reason the prices of their homes is low is because owner-occupier demand is being arbitrarily constrained by mortgage regulators.  The reason their homes are underpriced is because buyers are being held out of the market - including them!

The great and comprehensive annual report from the Joint Center for Housing Studies of Harvard University, cited by Taylor, notes that length of tenure has risen for both owners and renters. American Housing Survey data I have seen also shows this, and the AHS data shows length of tenure that is flat until the crisis, then climbs. The reason is that households are stuck in their homes. They are grandfathered in. And, the reason that length of tenure for renters has also increased is that people who intend to remain in a unit for many years generally should be owners, but the current regime locks them out of ownership.  So, the marginal households that have become renters over the past decade are naturally stable households with longer tenures.

So, let's walk through what the market looks like for a grandfathered owner.  If they want to downsize, they probably can do that, because they would be reducing their expenses, and they might even be able to swing a mortgage, since any home equity they have would go farther toward a smaller home.  But, higher regulatory costs and limits on fees have made small loans very difficult for lenders to make.  If they want to upgrade, they are unlikely to qualify.  A home in 2002 that sold for $140,000 might have rented for $1,000 and had a monthly mortgage payment of $750.  That family would still have a monthly payment of $750 (or slightly more or less if they refinanced along the way), but now rent would be more like $1,300.  So, a move to a similar property would entail an increase in their monthly cash outflow from $750 to $1,300, and it would only get worse if they tried to trade up to a better unit.

Homeowners get a tremendous deal today because home prices are being held down by repressed lending.  Moving out of a home that is owned to a rental unit is a terrible deal, right out of the gate.  The same factor that prevents this household from moving into another owned property is the reason that the deal they have for remaining in the property they own is so great.  No marginal shift in price is going to overcome that.  The only way to break this logjam is for prices to rise significantly, and the only way that will happen is for mortgage markets to loosen up significantly.

This is why "low inventories will lead to rising prices" is not a useful framing.  If prices rise, it will almost certainly be associated with rising inventories.  And, if the public understanding of the housing market remains mired in its current form, that will be accompanied by dire calls for economic contraction, because rising prices in the face of rising inventories will look like a market top that is leading to oversupply.  Intentional contraction will lead to....well, contraction....and the contraction will be blamed on loose lending and oversupply.

If your model for managing the macro economy calls for contraction, then model error and model confirmation both look exactly the same.  That is the problem with models from the Minsky school or the Austrian business cycle.  If their calls for cutting the boom off at its knees are wrong, they actually create unnecessary instability, and that only leads to calls for doubling the dose of poison.  That sort of conclusion infects much of the thinking about the housing boom and bust.  As long as Fed policy is viewed as a function of interest rates, it will be an infection that is difficult to cure.  We can see how difficult it is to cure, since low tier markets tied up in knots with very little activity or building don't seem to have dampened the idea that loose money is the cause of high prices.

Wednesday, June 27, 2018

Housing: Part 307 - Apartment Supply and Rent Inflation

I have been seeing reports of falling rents in various cities.  Zillow data generally shows a decline in rent inflation over the last couple of years. Here is a report from SeattleApartmentlist.com has a nice report out with data for many cities that also generally shows declining rent inflation.
This is generally attributed to rising supply because of strong multi-unit building.  I don't doubt that this is true to a certain extent.  Seattle seems like an especially good case for this.  Here is a chart of permits issued for multi-unit and single family unit homes, and the Case-Shiller home price index in Seattle.

Single family home building remains low in Seattle while multi-unit building expands at strong rates.  Meanwhile, according to the Seattle Times and Apartmentlist.com, above, rent inflation is declining and according to Case-Shiller, single family home prices are rising.

Looking at the zip code level data from Zillow for either multi-unit or single family, rent inflation appears to be strong in low-tier zip codes and moderating in high-tier zip codes.  But, the rise in single family home prices appears to be concentrated in the high tier zip codes.

I'm not sure what is going on in Seattle, but I think there is more substitution between these markets than is frequently assumed, especially in today's context.  I'm not sure that even in Seattle this is a simple story of apartment supply leading to rent deflation.  Across Seattle, it seems that high end rents are leveling out while low end rents remain strong, yet high end prices are rising more than low end prices.  I haven't spent the effort to get to the bottom of it.

Thinking more broadly, it is interesting that the decline in rent inflation that is showing up at places like Apartmentlist.com isn't showing up in CPI or PCE data.  Here is a graph of the growth in real and nominal tenant housing expenditures.  I have also included the measure of the number of new multi-unit permits here (black dashed line, right hand scale).  Notice that there isn't much of a relationship between the growth in tenant-occupied real housing expenditures and the growth of multi-unit permits.  I think that is because, at least for the last 20 years or so, the growth in tenant-occupied housing expenditures has been largely determined by the shift of single family units between rented and owned.  From 1994 to 2004, the shift was from tenant-occupied to owner-occupied, so while there was a decent growth in multi-unit permits, the rate of tenant-occupied housing expenditures was flat, even though rent inflation was stable and high.  Then, after 2004, there was a shift of single family units back to tenant-occupied, because we killed the mortgage market as part of the moral panic against the housing boom.  So, for several years, new unit growth was low, but tenant-occupied housing expenditures rose.

Now, we have switched back to the pattern that was in place during the boom.  And, it so happens, homeownership rates have begun to rise again.

There are a couple points to consider here:

  • Whether this rise in homeownership will persist remains to be determined.  The level of mortgages outstanding has been growing slowly for a few years, but there hasn't been any shift toward more lending to households with FICO scores below the mid-700s.  If that doesn't happen, then there is a limit to how much homeownership could rise.  There just aren't that many households with FICO scores over 760 who don't already own homes.
  • Rent inflation has been high for the last several years, but one reason it hasn't been higher is that households have been contracting their housing expenditures in the aggregate in order to try to moderate rising housing costs caused by the shortage of housing.  This should put a floor on rent deflation, because even if homeownership expands and single family homebuilding increases as a result, much of that expansion will be accommodating pent up demand.  That isn't a guarantee against declining rents.  Certainly, a fully functional housing market should equate to rent levels on existing units that are relatively lower than they are in today's constrained market. But, while intuition would tell us that rising supply will pull us down the demand curve to a lower price level, in today's context, rising supply will be associated with a demand curve shifting out.  The net effect on price may not be positive, but it will be much higher than it would be with a static demand curve.
In sum, what this suggests is that (1) it is the shift in single family units that will probably affect multi-unit rents more than the direct supply of multi-unit building, (2) for that shift to be significant enough to lower rents, the increase in single family building would probably have to be very large, and (3) an effective hedge against multi-unit rentals would therefore probably be exposure to single family home builders or to prices on owner-occupied units in either single family or multi-unit markets.

This third point is important and contrarian.  Rising supply will be associated with rising price/rent multiples.  If rents decline or stagnate because of rising supply, prices will necessarily be rising, because the lack of single family home expansion has been the result of credit repression that has pushed prices of existing properties below replacement value.  To builders, this looks the same as a market where costs have risen.  In either case, they are unable to compete with existing stock on price.  But, unless interest rates rise significantly, this divergence will have to be solved with rising prices.  And, interest rates are unlikely to rise until trillions of dollars of pent up demand for new homebuilding are unlocked to suck up the low risk savings that are pushing interest rates down.  So, while this may be counterintuitive, the hedge against falling rents now would be a long position on rising prices.

Monday, June 25, 2018

Housing: Part 306 - The boom was good. The bust was bad.

The Federal Reserve has a new article (HT: Noah Smith) posted that is a great example of the problem of trying to develop new understanding in a context where canonized wisdom is wrong.

The main point of the article is that, "The rise in rent-inclusive PIRs for below-median income households suggests that many of these households are about as vulnerable as near the onset of the financial crisis, as more of their income is committed to rent payments, possibly at the expense of saving for down payments for home purchases."

PIR's are payment to income ratios.  They are saying if we estimate housing expenditures only using mortgage payments, then it looks like housing costs have declined since the housing boom, but if we include rent payments in that measure, then households with lower incomes actually have more precarious housing expenses than they did during the boom.

This is the correct conclusion.  What's fascinating is that the data they use to come to this conclusion also contradicts the idea that the housing boom was associated with unsustainably high housing expenditures.  But, the idea that there was an unsustainable housing bubble is canonical.  So, the fact that this data contradicts that presumption is not important.  The canon does not require empirical confirmation.

I don't blame the authors of the article for this.  We have to have a canon.  We can't require that the canon be reconfirmed every time we try to learn something new.  But, it still fascinates me to see a single data set that is used to confirm some new idea within the canon of accepted facts, even while the fact that the data disputes the canon itself goes unnoticed.  As long as the canon is wrong, this will be inevitable.

We can see what is happening in the graphs from the article.

Here (figure 2 from the article), the portion of households with debt payments (which are mostly mortgage payments) above 40% of income is shown in blue.  The portion of households who spend more than 40% of income on the sum of debt and rent is shown in red.

The point that the authors try to make here is that debt payments are an incomplete measure of distressed housing costs.  But, this graph supports an interesting point about the housing boom.  There was a lot of concern expressed about that rising debt-to-income ratio from 2001 to 2007.  This rise in high levels of debt was completely from increased debt among households with high incomes.  And, notice what we see in the graph here.  If we add rent payments to mortgage payments, there was little change from 2001 to 2007.  In other words, households were not increasing their total housing expenses.  They were simply substituting mortgage payments for rent payments.  The households who were taking on mortgage payments greater than 40% of their incomes had been making rental payments that were more than 40% of their incomes.  These mortgages were rent hedges being taken out by households with high incomes who lived in housing deprived cities.

From 1995 to 2007, there was a housing boom, and that boom was associated with a reduction in rent payments.  Since 2007, mortgage repression has lowered the prices of homes, so that households that own homes spend less, but renters are spending more.

If we could expunge the error-plagued canon from the public consciousness, then the obvious lesson to be learned from this graph is that the housing boom greatly reduced the number of households with distressed levels of housing expenditures.

Here, I will compare Figure 1 and Figure 4 from the article.  Again, the blue line is for debt payments.  The red line is for debt payments plus rent payments.  (These are rough approximations of the measures shown.  See notes in the article for details.  Some other minor payments are included in some of these measures.)  Figure 1, on the left, shows the portion of all incomes going to these payments.  Figure 4, on the right, shows the portion of incomes going to these payments for households with below median incomes:

For all households, we can see that total payments (in red) were fairly stable throughout the boom, and have declined since then.  As described above, the boom reflected mostly a substitution of mortgage payments for rent payments.  But, take a look at payments for households with below median incomes.  Remove the terrible, distorting, wrong canon from your head so that you can actually see this graph in full.  There is one overwhelming point that this graph makes clear: The housing boom was associated with a significant decline in total housing payments for households with low incomes.  The housing boom was reducing economic distress of households with low incomes, and that process was halted in 2007 when the housing boom was interrupted.

The authors do not note this because even though the idea that low income households were especially vulnerable at the cusp of the financial crisis is wrong, it is canonical.  It is not a point that can be disputed with a single data point.  So, the most significant piece of information that this graph makes clear is not noticeable.  I would suggest that it is effectively invisible to the naked eye, even though it lies in plain sight.

I will point out a couple of other details from Figure 4.  As with the broader measure I described above, the rise in debt payments in 2004 is completely countered by a decline in rent payments.  There was no net increase in housing expenditures.  But, note that this measure peaked in 2004 (which is when homeownership rates peaked).  The so-called subprime bubble happened from 2004 to 2007.  Mortgage payments for households with low incomes peaked before the subprime and Alt-A markets exploded.  That is because the rise in private securitizations was mostly associated with the households with high incomes buying homes in housing deprived cities while households with lower incomes migrated to less expensive parts of the country.

The housing bubble was the acceleration of the national segregation by income that is set in motion by localized housing deprivation.  Households with high incomes were taking on the expense of claiming their piece of limited residential space in order to claim high incomes in the Closed Access cities.  Households with low incomes were fleeing from those cities and making compromises in order to reduce their expenses.  The public obsession with predatory lending has blinded us to the primary social development of our time.  And, for a decade we have been poisoning our economy as a result.

Here is Figure 6 from the article.  The general reaction I see to this graph from most audiences is that (1) the period since 2007 is just another example of the common American getting screwed - that things keep getting harder for those with less power and easier for those with more power - and also (2) the most important thing we must do is to avoid going back to the policies that were in place from 1995 to 2007.

What is happening here is that we "solved the problem" of high home prices by kneecapping the mortgage market - especially mortgages for households with lower incomes, FICO scores, etc.  This has reduced home prices across the board, and it has especially reduced home prices in entry level markets.  Since entry level prices are so low, homebuilders can't compete with existing homes on price, and new entry level supply has been curtailed.

So, for households with high incomes who can qualify for a mortgage, housing is cheap.  For households with high incomes who can't afford a mortgage, rents are high, but they can make adjustments in their real housing consumption to bring payments down (smaller unit, longer commute, etc.)  Households with lower incomes have less elastic demand for housing because they already tend to spend more of their incomes on housing that is smaller or less convenient than they would prefer.  Few of them can qualify for a mortgage, so they don't get to take part in the housing sale.  And, as renters, they must eat much of the rising costs.

The data is all there.  There is no need to argue about the details.  I take no issue with the facts in this article.  That is the good news.  The facts can be stipulated.  The bad news is that the canon needs to be erased and rewritten, and as the old saying goes, you can't easily reason people out of something they weren't reasoned into.  Yet, it seems like there is room for optimism when there are so many pieces of highly informative and accurate research out there about this topic, such as this article, which simply need to believe their own findings.

Saturday, June 23, 2018

Housing: Part 305 - If only we could burn all the extra houses down.

From Andrew Ross Sorkin's "Too Big to Fail"(pg. 190), from the summer of 2008 before Fannie and Freddie were taken over by the Treasury.
Paulson and a half dozen staff members huddled over the Polycom on his desk to hear the former Fed chairman's faint voice through the speaker.
Rattling off reams of housing data, Greenspan described how he considered the crisis in the markets to be a once-in-a-hundred-year event and how the government might have to take some extraordinary measures to stabilize it.  The former Fed chairman had long been a critic of Fannie and Freddie but now realized that they needed to be shored up.  He did have one suggestion about the housing crisis, but it was a rhetorical flourish befitting his supply-and-demand mind-set: He suggested that there was too much housing supply and that the only real way to really fix the problem would be for government to buy up vacant homes and burn them.
After the call, Paulson, with a laugh, told his staff: "That's not a bad idea.  But we're not going to buy up all the housing supply and destroy it."
IW readers know there weren't too many homes.  The only things the American housing market and the economy needed were sufficient money and credit.

I have the same feeling reading these retrospectives as I do hearing debates about the market today. It's like we're a tribe that shares a religious origin story in which the spirit of spring floods plays the devil's role. We're in the midst of a terrible drought, but it is simply part of our cultural DNA that water cannot be part of the solution.  So the elders desperately engage in plans and discussions about dealing with the drought in which they cannot reference water as a solution.

Dig a well? Build an irrigation canal? It's not that arguing for these things would be fruitless. It's that it wouldn't occur to a respectable person to mention them.  To mention canals would only serve one purpose - identifying yourself as a heretic.

To suggest that Fannie and Freddie should seek to expand their balance sheets in the summer of 2008 would only serve to besmirch one's own character.  (Look who's the first to pray to the spirits of the flood when things go bad.)

In effect, the entire country became taken with some version of what Robin Hanson would call "far thinking".  Far thinking is where we can impose our ideals on a map of the world that is clean and easy, where our ideals don't have to be moderated by messy reality.  In far mode, the Wall Street Journal can talk about the virtues of a financial panic. FOMC members can talk about letting the market discipline risk takers.  The President can explain that it's not his job to bail out speculators. Elizabeth Warren can ask why aren't more bankers in jail.  In far mode, we can know that they did this to us.  In far mode, just deserts keep us on the straight path.

In effect, Greenspan and Paulson are dealing with the cognitive dissonance of far mode here.  Burning down homes is an obvious solution to the problem in far mode.  Unmoderated by messy reality, far mode can get pretty absurd.  They recognize the absurdity of it. That's why the suggestion is funny.  If only they had taken it seriously enough to force them to confront the "near" - to confront the cognitive dissonance that made it funny - their plans might have been moderated by messy reality.

I wish I could travel back and take them to some townhouse in Brooklyn whose family was moving out of the state because they couldn't afford to spend half their income on rent anymore.  Here's some lighter fluid and a match, Al.  Should we start with this one?

As the crisis wore on, others echoed Greenspan's sentiment.  Frequently the concern was about old working class neighborhoods in rust belt cities, which were devastated by foreclosures.  Now, isn't it strange that in a country that had supposedly just built millions of unneeded homes in Arizona, Forida, etc., that the excess supply was in 80 year old neighborhoods in Cleveland?

Here is an article from Cleveland in 2010 about their program to tear down homes.  Now, in cities that have been depopulating, it may be the case that there are parts of town that call for demolition programs.  But, my point here is that we have conflated this problem with the subprime lending crisis in ways that have led us astray.  From the linked article: "Blame our region's economic stagnation and the nation's recession; blame lenders who bent and broke old rules to make loans to people who couldn't afford them; blame Wall Street speculators who bundled and resold those toxic loans, poisoning the economy. Or blame our drive to expand, leave the old neighborhoods and make new suburbs out of countryside."

For "Wall Street" to be implicated as a source of unneeded homes, those loans would have had to have been associated with a building boom.  Here is the rate of new housing permits (compared to civilian labor force for scale) in the US as a whole and in Cleveland.  I show a long time frame here, just as a reminder that even at the national level, there was nothing unusual about the rate of building in the 2000s.  But, Cleveland didn't have any part of the 2000s housing boom, such that it was.  The rate of building in Cleveland was low and steady, until 2006, when it fell off a cliff along with the rest of the country.

The reason home building fell off a cliff in 2006 in every city across the country is because buyers lacked money and credit.  Cleveland didn't build a bunch of homes and then suddenly discover that they couldn't afford them.  In fact, in Cleveland, as in just about every city in the country, rent inflation rose in 2006 and early 2007 because of the shock to supply created by tight monetary policy.

By 2010, when neighborhoods were devastated by the blight of foreclosed properties, those neighborhoods suffered from one problem: not enough money.  This was not a supply issue.  Even today, homes in those neighborhoods generally fetch rents of around $1,000 a month.  The collapse was purely a nominal issue.

idiosyncraticwhisk.blogspot.com  2018
Here, I compare home prices in the three most expensive ZIP codes in Cleveland (blue, right scale) with the three least expensive ZIP codes (orange, left scale).  Cleveland is like most other cities.  During the boom, prices across the city increased at similar rates.  Then, after we pulled the rug out from under low tier mortgage markets, prices diverged.  After mid 2008, low tier markets collapsed.

Low tier homes have prices that are similar to prices in 1996.  High tier prices have risen in the range of 50% over that time.  Working class balance sheets have been devastated.  Low tier homes in Cleveland lost half their value after 2008.  This is not because rents have suddenly been cut in half, because this isn't a supply issue.

When Hank Paulson and Alan Greenspan jokingly wished they could burn down some homes, what those homeowners needed was some cash. Cash that the Federal Reserve, Fannie Mae, and Freddie Mac were in prime position to provide.  The thought didn't even occur to them.  It couldn't have.  It would have been heresy.

idiosyncraticwhisk.blogspot.com  2018
Here, I have graphed mortgage affordability for the median home in ZIP code 44137, Maple Heights, OH.  It's the yellow line in the previous graph.  There was no affordability crisis in Cleveland.  The monthly payment required to buy those homes with a conventional loans was similar to what it had been for at least 10 years, after adjusting for inflation. (This graph is in current dollars.)

Foreclosures in Cleveland had been rising throughout the boom, and they spiked from late 2005 to 2007, and then remained high.  Maple Heights continues to have many foreclosed properties.  In the "bubble" cities, foreclosures tended to be a lagging factor - after prices collapsed.  This is the case in Cleveland, too.  Clearly, after 2008, foreclosures were a function of household income shocks in properties that had lost all of their equity, so that the owners couldn't make payments and couldn't tap equity as a rainy day fund.  But, Cleveland did see a rise in foreclosures before the collapse.  This suggests that there was a market in risky mortgages in Cleveland during the boom that called for some moderation.

But, this is the important yet subtle point: The mortgage boom didn't have any significant effect on home prices or supply in Cleveland.  It had little effect on aggregate demand for housing.  The sloppy way in which housing affordability is commonly equated with home prices instead of with rents and the sloppy way that price booms in places like San Francisco or Phoenix have influenced our image of housing markets in places like Cleveland have led to disastrously wrong consensus in policy.  So disastrously wrong that when working class households in Cleveland just needed some cash, the public officials who could have provided that cash were wishing they could destroy real assets.

This over-reaction caused home values to collapse.  By 2010, when the over-reaction was codified in the terms of Dodd-Frank and the Consumer Finance Protection Bureau, the affordability of homes for buyers was unprecedented.  Actual affordability (in terms of rent) was worse than ever, because of the supply shock.  But, in Maple Heights, where the median home required monthly mortgage payments of about $600 for the decade leading up to 2008, it had fallen to less than $400.  And, the further collapse in home values that followed Dodd-Frank eventually pulled the median mortgage payment down to $200.

Excessive lending had little effect on mortgage affordability in 2005.  But, the over-reaction against lending had such a devastating effect on home values, that mortgage expenses declined by 2/3.  While pundits and critics blamed the Fed for saving Wall Street instead of Main Street and while they demanded cram downs, forced refinancing, and subsidies to borrowers, and while Greenspan and Paulson wondered how to get rid of all those houses, what those neighborhoods needed was for someone to just offer them some run-of-the-mill mortgages, of the type that they had successfully been paying for decades.  Not only the existing borrowers, but the potential new borrowers.

We were so upset about mortgages that stretched some borrowers too thin when mortgages in Maple Heights required monthly payments of $700 in 2005 that we were bound and determined to prevent mortgages from being made in 2010 that required payments of $200.  And we did it in the name of affordability.

This is a crazy disconnect.  The idea that homes were too cheap because of oversupply was consensus.  Greenspan and Paulson were hardly staking new ground here.  Consider the scale of the religious zeal against lending that had to be in place for them to think this was a problem.  Even if oversupply had been a problem, sane people would not have wanted to destroy the extra homes.  The obvious solution would be to buy them for pennies and then give them away to working class households.  If there was an oversupply, then working class households could just double the square footage of the homes they were living in at no extra cost.  The reason this wasn't happening in reality was because there was, in fact, a shortage of homes, and rents were rising.  But, if oversupply was the "problem", then the obvious solution at any time from 2009 on would have been for Fannie and Freddie, under federal control, to open the flood gates, and to spread our overabundance of homes to working class borrowers, who could now have twice the house at half the expense by shifting from renters to owners.  This is still, basically, the case today.  And, today, we still maintain a religious zeal against letting that happen.

To get back to normalcy those low tier home prices in Cleveland would need to double from today's price.  This is fabulous news.  For working class homeowners who have managed to keep their properties, simply returning to a normal market would double the value of their homes.  It's amazing how easily one can attain new health simply by refraining from taking poison.

But, the problem with human affairs is that sometimes, when we are wrong enough, being wrong is an impediment to correction.  The disconnect between reality and the consensus view is so great that the truth seems too outrageous to entertain.  So, burning down houses makes more sense than giving them away and to suggest otherwise seems like madness.

In the meantime, working class homeownership is on a 50% off sale in Cleveland while many complain that homebuilders aren't building enough new homes for the entry level market.  And, homebuilders complain that labor, and lumber, and lots are all too expensive.  Everything is too expensive when you're trying to compete against a 50% off sale.  So, because the consensus is so wrong on this issue that it requires a religious conviction to maintain it, this leads many today to complain that those costs are too high because we have too much money.  The solution to homes that are undervalued by half is to raise interest rates and suck cash out of the economy to bring those other costs down.  An awful lot of bad things will happen before those costs are low enough to compete with the 50% off sale.

Thursday, June 21, 2018

Upside Down CAPM: Part 5 - Returns on real estate investments

To review: upside down CAPM is the idea that CAPM models should start at the expected rate of return on diversified at-risk capital and the rate of return on risk free savings is the at-risk rate of return minus the premium savers pay for the service of protecting savings for deferred consumption.  Changes in actual returns for at-risk capital come from cyclical changes in profit and from changes in expected long term real returns, but expected real returns at any point in time tend to remain fairly stable at 7-8%.  Fluctuations in real risk free returns come from shifts in the premium savers are willing to pay to avoid risk with deferred consumption.  The equity risk premium doesn't come from changes in expected at-risk returns. It comes mostly from changes in the premium for safety that determines the risk free rate.

This model has led me to realize that I have probably been approaching real estate markets with some misplaced hubris.

Mortgage rates generally follow risk free rates with a small spread, so that mortgages basically fall in the category of low risk saving - deferred consumption.  To the extent that we can measure returns on home equity systematically, real rates of return seem to generally follow risk free rates. Owned home equity is also basically a low risk fixed income security.

But, that doesn't seem to be the case on institutionally owned real estate.  Equity REITs seem to have a fairly stable cap rate and dividend rate.  I had chalked this up to an undeveloped marketplace, where there aren't aggregate market measures that change everyday like in bond markets.  So it seemed like this asset class was like a fixed income asset class, but with a real yield that didn't fluctuate as much.  That didn't seem rational.

However, thinking with an Upside down CAPM framework, having a more stable expected rate of return is a characteristic of equity.  There isn't a mystery here. Institutionally owned real estate is basically a low-beta equity, and it has a low and stable expected rate of return, just as we would expect low beta equity to have.  Its risk comes from cyclical and long term shifts in real returns.

Keep in mind that I am talking about the entire market, so that cap rates are similar to expected returns on all equities, conceptually.  For developers, expected returns on individual projects, or even on all new projects at a given time, may fluctuate more, just as the market for IPOs or private equity seems more volatile and cyclical than the equity market as a whole.

The reason it is more equity-like than owned real estate is because it comes with management costs and vacancies.  This makes net margins lower and more cyclical than owner-occupied real estate.

So owner occupied real estate acts more like low risk fixed income, and the level of debt on a property is mostly related to the owner's need for capital.  Young owners tend to be more leveraged and older owners are less leveraged. Investor owned real estate is like low beta equity and the use of credit is more a product of the market and the property. To the extent that a property can offer the service of safe savings because of relatively certain cash flows, equity holders can optimize profit by using credit as a source of capital.  In fact, market forces will cause profit to be bid down to the point where real estate equity holders have to use credit to achieve a market rate of return.  This is similar to the utilities sector.

This would mean that real long term interest rates would moderate real estate activity between owned and rented properties.  When interest rates are low, at the margin some households would be induced to ownership. There are several ways to think about this. Low real rates reflect demand for low risk savings and deferred consumption. Owner equity serves this function in a way that investor owned equity doesn't. Another way to think about it is to think in terms of cap rates. Cap rates on investor owned properties, being more equity-like, remain stable.  But "cap rates" on owner occupied properties fluctuate with long term real interest rates, so as rates decline, owner-occupied property is worth more than investor-owned property.

It happens that homeownership rates (controlling for age demographics) were high in the late 70s and the 2000s.  In the 70s, inflation (and nominal rates) was high, so rising ownership was explained as an inflation hedge.  In the 2000s, inflation (and nominal rates) was low, so rising ownership was explained as a result of cheap and easy credit.  (Most of the rise in homeownership happened in the late 90s when rates weren't particularly low, so that's not a great explanation.)

Low long term real rates can explain why price/rent ratios were high at both times, but I haven't felt that comfortable explaining why that would lead to higher ownership rates.  Maybe this relationship between owned and rented properties, and the difference between equity and low risk savings, could be part of the explanation for why ownership rates rise when long term real interest rates decline.  (This isn't the case today because housing markets are dominated by credit repression which keeps millions of households out of the market.)

This framework also suggests that multi-unit building should have been much stronger in the 1990s when long term real interest rates were relatively high.  The bias toward equity exposure at the time should have translated to a bias for investor owned real estate.  Maybe some of the increase in homeownership rates in the 1990s was already coming from limits on multi-unit developments in the Closed Access markets, which was blocking this natural shift to rented property when real interest rates were high.

This is all still speculative.  Please provide conceptual or factual criticisms in the comments.

Tuesday, June 12, 2018

May 2018 CPI

More of the same this month.  I think this month might accelerate the slow motion train wreck, because it is being widely reported as accelerating inflation.  But, non-shelter core prices really haven't risen at all since February.  The only reasons year-over-year core CPI inflation has risen to 2.2% are (1) shelter inflation is at 3.5% and (2) the three months that just fell off the back end of the year-over-year range had cumulative deflation of non-shelter core CPI of 0.34%.  So, three months which had cumulative inflation of 0.02% caused the non-shelter core inflation rate to rise from 0.9% to 1.3%.  And shelter inflation adds the other 0.9%.

This will add confidence for maintaining an aggressive schedule of rate hikes.  Households are already into the territory where rent expense is taking a larger portion of personal budgets than is normal.  That suggests that consumption of shelter is already into inelastic territory, so that there won't be a cyclical reduction in shelter consumption.  That suggests to me that shelter inflation will remain high if the Fed overtightens, which will continue to push them to tighten more.

In today's context, I'm not sure that non-shelter inflation at 0.5% or even 0% leads to any sort of acute crisis.  But, it seems like that is where the risk lies.  One problem is that the obsessions and biases that developed during the housing bubble led to a canonized belief that the net effect of rising mortgage levels, home prices, and housing starts is consumer inflation.  But, that is wrong.  To the extent that consumption was fueled by mortgage credit, the source was rising rents in Closed Access cities where housing starts are persistently low, and Closed Access homeowners were spending some of their capitalized future rental income.  Except for the foreclosure crisis in 2008-2011, 2005 was the only time in the last 20 years when rent inflation finally reverted back to general inflation.  The housing boom was moderating inflation.  Closed Access homeowners were spending from their ill-gotten rentier profits, but the Fed is perfectly capable of countering that - and they were throughout the boom, with unusually low currency growth.  The Fed could do that today too, and obviously would, given the general hawkish atmosphere.  But, in the meantime, ironically, the first order effect of opening the floodgates on housing credit markets would be significant disinflation because of falling rent.