Sunday, March 4, 2018

Housing: Part 286 - Upside Down CAPM and the Housing Bubble

One of the over-riding themes and lessons about the housing bubble was the realization that we weren't as wealthy as we thought we were.  That we drove up the prices of American assets with debt and then took out more debt using that inflated collateral in a doomed attempt to live beyond our means.

I have discovered that all of that was wrong.  The truth is really more the opposite of that.  We have hung a weight around our collective economic neck, consisting of restricted ownership that requires transfer payments to the politically protected owners.  Home prices during the bubble were a reflection of the value of their restricted ownership.  Debt was a product of attempts to buy those restricted assets.  And debt-fueled consumption was mainly consumption smoothing by the owners of those assets, who could liquidate their real estate by sale or through credit, to consume today from their future claims on ownership.

An idea central to the conventional story is the idea that debt and leverage can be used to increase the total market value of asset classes, and thus creates a sort of false growth.

Part of the foundation of the Upside Down CAPM idea I have been developing is that this is largely false.  It comes from thinking of borrowing from the perspective of a consumer.  But, thinking in terms of a national balance sheet, it is more accurate to think of the nation's assets as the anchor - the left side of the national balance sheet.  The right side of the balance sheet shows us how ownership is divided - between creditors and equity owners.  It is more accurate to think of rising debt generally as a shift in ownership between equity and creditors, with a stable amount of assets.  Debt levels are a pretty slow moving animal, and I like to point out that the frothy markets of the late 1990s happened through rising equity values and rising growth expectations.  Interest rates at the time were high because there was a bias then for equity ownership to have a claim on that growth.  Creditors weren't bidding down interest rates in an effort to avoid risk.  They wanted risk.  And savers looking for risk want to be equity holders, not creditors.

So, how does this hold up if we look at the housing bubble?

This first graph is a graph that has been an emblem of the American spending problem.  Debt keeps rising relative to incomes.  This is unsustainable, it would seem.  Households were dealing with stagnant incomes and they were borrowing in order to keep afloat.

The first problem with that story is that the borrowing was heaviest among the households with the highest incomes.  They represent the vast majority of borrowing and they also represented most of the new borrowing during the bubble, in absolute dollars.

The conventional thinking about this shifts upon this evidence to say that, well, the debt was used to bid up housing in a frenzied bubble, so while the evidence that the bubble was built on lending to households with low incomes may not hold up, the use of debt to push up home prices still sits at the middle of the story.

Of course, I have written, ad nauseam, about how the debt was mostly funding access to Closed Access labor markets, and that rising rents explain rising prices better than credit.  But, what about those crazy high debt levels?  How can I explain that away?  Households taking on new debt amounting to half a year's income, over the course of a single decade?

But, that graph shouldn't bother us because of what's on it.  That graph should bother us because of what's not on it.  We should view the economy as a complete balance sheet, where debt is just one form of ownership.  This is a partial picture.*  Debt is the least important part of the balance sheet.

In this next graph, debt is the yellow line.  In thinking about household net worth, I want to walk through these items one step at a time.  All measures are as a percentage of disposable personal income.

Step 1: Blue Line
Step one is the value of all financial assets.  This is stocks and bonds, etc.  Not housing.  This is the value of capital held by households, except for housing.

Step 2: Red Line
In Step two, we subtract debt from the total value of financial assets.  This is how we should think about household balance sheets.  The blue line is the total (non-housing) balance sheet and the ownership is divided between debt and "equity".  (Some of the "equity" may be in the form of fixed income securities, but here, those are assets on the left side of the balance sheet.  In terms of the household's balance sheet, those are part of the household's net worth, similar to a corporations equity, or market capitalization.)

Step 3: Black Line
Most household debt is used to buy real estate.  In step 3 we add the value of real estate to the total.  If we assume for the sake of simplicity that all household debt is secured by real property (most is), then we can roughly think of the distance between the blue line and the black line as the value of household equity in their real estate.  The distance between the blue line and the red line is the value of real estate funded by debt.

Since debt has already been subtracted from the total, the black line represents American households' total net worth.**

I apologize that I have made this a bit more complicated than it needs to be.  It would make more sense to add up the real estate and financial assets and then subtract the debt from that.  You would still end up at the black line as a measure of household net worth.  But, gross household asset ownership would be at a line higher than the black line, representing the total amount of assets, before accounting for debt.  I have done this because I want to make a point.

Let's look at 2005 with the full perspective of American household balance sheets.  The credit bubble story says that we were borrowing from foreigners in a housing bubble, where that borrowing was propping up the value of that real estate.  If an American household borrowed from foreign savers to bid up the housing stock, then that would leave the blue line where it was, it would lower the red line, and it would raise the black line.

So, let's not give American households any credit for the value of those homes.  Take a look at 2005 to 2007.  In terms of gross financial assets, without housing, American households were in a better financial position than at any time in recent history - roughly on par with the peak of the internet bubble.

You might respond that this is an average and that there is gross inequality.  But, remember, the borrowers were households with high incomes.

You might respond that the stock market was still in a bubble, but PE ratios were under 20x and declining.  Bond rates were at cycle highs (so that valuations were low).

Now, subtract all that debt that Americans used to buy those homes.  The red line.  Even after subtracting debt worth 130% of disposable income, American balance sheets were as healthy as any time in modern history, except for a brief time during the internet bubble.

And, I have been arguing that the CDO boom at the end of the housing bubble was actually the beginning of the bust - part of the shift out of home equity because sentiment was already changing - even though American balance sheets were in great shape.  Notice that household net worth (the black line) was level from late 2005 to late 2007.  But, outside of housing (the blue and red lines), household balance sheets were still growing strongly.  Again, give Americans no credit for their real estate, but saddle them with the mortgage debt.  Even after that, from late 2005 to late 2007, when housing starts were collapsing and the Fed hiked the target rate to 5.25%, American balance sheets were expanding - even relative to incomes.

This is especially the time when American households were supposedly loading up on debt to live beyond their means, and now that home values had stopped rising, the end was supposedly inevitably near.  If we think about the equity and mortgage components of real estate, then, during this time, the distance between the red line and black line shrunk.  In other words, total real estate value was shrinking as a portion of household incomes.  And the equity portion was shrinking while the debt portion was rising.

Household balance sheets were healthy, but they had lost faith in housing markets, and they were disinvesting in home equity.  They still had plenty of net assets, and those net assets, seeking safety that no longer seemed available in home equity, they funded things like MBSs and then CDOs.  If, on net, that activity was the result of a global savings glut, then non-real estate net worth would have been declining.  But, on net, American net worth was rising.

When we only looked at the debt component, we missed all of this.  Part of that debt component is due to the Closed Access problem, that some urban real estate contains a capitalized claim on future political exclusion.  But, when we only focus on the level of debt over time, we miss the broader important factor.  Who borrows?  Rich people borrow. (See chart above.)

The reason debt has increased is because American balance sheets are healthy.  The reason there was a frenzy for AAA securities in 2006 and 2007 was because Americans were wealthier than they had ever been and they were scared about the housing market.  The most expensive housing markets, by far, were markets that we now know, with a decade's hindsight, were not destined for a bust.  Prices in the most expensive cities have performed as well as anywhere.  Yet, even in 2004 and 2005, homeowners were selling out of those markets and moving to other cities in large numbers - disinvesting in equity.

Were households borrowing out of home equity in order to consume?  Many surely were.  To the extent that they were, household net worth would have declined.

Today, American net worth as a percentage of disposable income is well into record levels by all of these measures.

* Oddly this selectivity is...selective.  For some reason, when talking about capital's claim on national income, economists seem to always use corporate profits - ignoring the part of corporate operating profits claimed by creditors.  When talking about household balance sheets, economists seem to only look at debt and ignore equity.  In both cases, the partial view is not very useful.

** There are also a small amount of non-financial assets amounting to about a quarter or a half of disposable income over time, so total net worth is slightly higher, but I have left that out for simplicity here.

Thursday, March 1, 2018

Henry George and Affordable Housing

Philip Bess has an article in American Affairs about the benefits of a land value tax (LVT), which was the idea that led to the fame of 19th century thinker Henry George.  There are a lot of interesting thoughts on urban development in the article, and I generally agree with the points made.

Reading the article triggered some thoughts regarding the land tax and housing affordability.  One of George's conclusions, which Bess refers to, is that having a near 100% land tax (which, effectively, is confiscation of unimproved land, but not the improvements and structures, by the government) would prevent speculative bubbles and would improve housing affordability by removing speculative value from the property.  Here is an interesting description, from the article, of how land ownership would look under a comprehensive LVT:
Land speculation would be impossible because only the use of land would have economic value. In turn, though, an LVT would also benefit land titleholders who would not pay tax on improvements to their land or productive activities undertaken thereon. And why would anyone sell land? One would not sell land to make a profit from the sale (which would not be possible), but rather to relieve oneself of a tax liability. That which one cannot or will not use one cannot own save for a fee. “Ownership” of land extends no further than an entitlement to the use of land, and that which an “owner” cannot use he must pay for or “sell” to someone else. “Buying” and “selling” land under a single tax regime therefore assume slightly different meanings than in ordinary discourse because what is really transferred is a land liability equal to land value—a liability virtually no one would accept if they did not plan to use the land.
George focuses on land banking and speculative ownership which is based on expectations of capital gains.   Here, I think my recent work on the housing bubble might add food for thought to this topic.  The point I have frequently made about analysis of the bubble is that there is a sense of attribution error in human nature deep enough to infect the academy. ("I bought a house in Phoenix in 2005 because I was tired of having my rent jacked up every year in LA, but I had to overpay for it because there were thousands of greedy speculators in the market at the time.")  I rarely see homebuyer expectations framed in terms of the present value of future rents.  Usually, especially during the bubble, they were framed in terms of expectations of future home prices.  Removing rental income from the mental framing of home values causes us to exaggerate the effect of speculation as a process unmoored from intrinsic present values.  I think this is the case regarding the idea that a LVT would eliminate land speculation or price volatility.

First, in terms of affordability, I would like to point out that ownership, first and foremost, is a rent hedge.  A Georgist tax would be a pretty harsh Darwinian imposition on homeowners.  California has Prop. 13 because rising home prices meant that older owners with limited incomes were faced with rising property taxes.  A Georgist LVT would impose that tax at a maximum level.  There would be no rent hedge.  It would be the antithesis of tenants rights.  If you couldn't pay the rising tax on a valuable property, you would have to move out.  George sees this as an advantage, and there are benefits to it.

One benefit would be, as a second order effect, that more housing development would be induced because developers would outbid less productive owners and build more improvements on the land, which they could profit from.  So, maybe where current building restrictions are the cause of high prices, this would solve the affordability problem, and little old ladies wouldn't be faced with rising taxes in the first place.

But, the first order effect would be to remove an important source of stability that is fundamental to ownership in our current system.

So, back to my point about speculation and price volatility, if price volatility is unmoored from the fundamentals, then it would be reduced.  However, if price volatility is related to fundamentals (the rental value of a home) then it would not.

Imagine an owner in an untaxed system vs. one in a system with 100% LVT.  Let's say the structure is worth $200,000 and the land is worth $200,000.  It has an annual rental value (after expenses) of $20,000 - $10,000 from the structure, $10,000 from the land.

Untaxed, a buyer pays $400,000 cash and there are no further transactions.  Under the LVT, a buyer pays $200,000 plus an annual $10,000 tax.  We might  imagine that they invest their other $200,000 in a long term fixed income security that pays $10,000 annually.  So, for the buyer, the transaction is essentially the same.  They need $400,000 to own the house.

Now, what if there is a market expectation that the land rental value will grow by 2% annually because of its location?  All the numbers above are the same, but in year two, the tax would be $10,200 instead of $10,000.  So, now, in order to perpetually control the property, the buyer would need enough savings to pay the initial $10,000 tax, and to grow by 2% each year.  So, the buyer would need to pay $200,000 for the house and save $280,000 to cover the taxes.  So, the total "price" would be $480,000.

Now, since rising rent is a liability for the owner, owners would still want to hedge that risk, just like they do today.  So, we might imagine that banks would offer a service.  They might develop a security that they sell, sort of like an annuity.  They would say, "Pay us a set amount, and we promise to make the LVT payments on a property in perpetuity."  So, now, the buyer would go to the bank, pay them $400,000.  The buyer would own the home and the bank would handle the LVT, so the owner would have no further expenses.

And, if the local housing market became valuable, and there was an expectation that land values would rise 2% annually, the bank would still sell the same security, but they would require a payment of $480,000.  And, if someone wanted to buy the property, they would have to purchase that annuity from the current owner, also at $480,000.  If we think of speculators betting on future rental value rather than betting on short term price increases they expect to reverse (presumably after they sell), then there is no difference in that changing value.

(edit: Changing interest rates would also affect the value, just as they do today.  And, of course, we could further imagine that buyers fund their initial payment for the annuity by getting a loan with a 30 year fixed amortization.)

(edit #2: Upon further thought, even unmoored speculation could happen with those annuities.  So, maybe my distinction between fundamental and unmoored speculation isn't that important.  Everything would basically be the same, except that since the government has taken a long position in the land, which it doesn't have in the untaxed version, for these instruments to work, the bank has to have a short position on the land, which is what the promise to pay the tax is, which it doesn't have in the untaxed version of the story.)

So, we can imagine that, to the extent that home values reflect capitalized future rental value, there really is no difference between the taxed and the untaxed market.  I differ from George on these two points.  (1) I think he, like most observers do, overestimates the significance of unmoored speculation on home prices, and (2) by removing a device for capitalizing future rental values, he can imagine that the value doesn't exist.  But, future rent or tax changes have an effect on current owners whether we imagine that they can hedge them or not.

Friday, February 23, 2018

Housing: Part 285 - There was always a shortage of housing, Phoenix Edition

Phoenix.  The poster child for the boom and bust housing market.  Built so many homes in the developers' lust for profit that it took years to burn off the inventory.

Sources: IRS,
S&P/Case-Shiller and Census data via FRED at St. Louis Federal Reserve Bank
Here's the latest in a long line of graphs that I should have thought to make months ago.  If you are new to this blog, you may be surprised to hear that that is all wrong.  If you are not new, you probably aren't surprised any more by this stuff.

I have combined housing permit data with migration data to review the timeline.

First, a couple of notes:

(1) The migration data is based on IRS estimates of tax filers.  This only covers about 3/4 of Phoenix households, so the total number of migrating households is larger than the numbers shown here.

(2) There is some level of housing expansion that is required to cover natural local population growth and the replacement of old units.  For this exercise, we can assume that the level of building (the black line) from 1995 to 2001 roughly reflects the level needed to meet this need, which during that period appears to have been about 1.5 units per 100 existing households, annually.

From 2002 to 2004, there was a rise in housing units that roughly paralleled the rise in in-migration that was coming due to California's housing shortage.

In 2005, the gross inflow of households continued to rise, but Phoenix builders were already pulling back.  Permits in 2005 were lower than permits in 2004.  Now, notice what happened in 2005.  Net in-migration topped out along with housing permits.  So, how did net migration top out if in-migration was still rising?  The only way it could.  Out-migration had started to rise.  In 2005, in Phoenix, there was a shortage of housing.  And, as a result, home prices in Phoenix in 2005 sky-rocketed.

One explanation I hear in Phoenix for why builders didn't build more in 2005 is that new units were just being bought up by speculators, and they didn't want to feed that bubble.  Another explanation I hear, which is more plausible to me, is that local municipal permitting offices were working at capacity.  The only reason that may not be plausible is that I have not heard builders complain about it.  And, maybe the first explanation is the reason why they didn't complain.  Maybe they would have individually applied for more lots, but they were satisfied with having the entire market constrained for supply because they were convinced that it was a collective action problem and keeping the entire market from developing more lots was beneficial.

It looks to me like that constraint was a significant cause of the spike in prices and of the development of a speculator market, since speculators could put their name in a hat to buy a home one month, knowing that the 10 other buyers in that development who were turned away would be back next month willing to pay more.

In any event, what is clear is that supply started to moderate even when in-migration was strong.

In 2006, in-migration began to fall, because the Fed had engineered a decline in residential investment, employment growth was declining, and the mass migration event was subsiding.  But, note what happened in 2006 in Phoenix.  Permits for new housing units again dropped more sharply than in-migration was.  And, so, because the shortage remained, prices remained elevated and outmigration continued to climb.

These trends continued in 2007. In-migration declined and out-migration increased while new units declined.  The only change was that by the end of 2007, prices were collapsing.  By 2008, out-migration and in-migration had converged so that there was hardly any in-migration into a city that regularly sees net migration rates of above 1% per year.  Prices continued to collapse and building was at a standstill.

Finally, in 2009, out-migration declined.  In-migration also continued to decline, but the decline in out-migration suggests that finally locals weren't being pushed out.

Now, take a look at vacancies in Phoenix.  In 2006, vacancies among owned homes increased.  Homeowners were having a hard time selling houses.  Normally, this is chalked up as the first sign of a market dealing with overbuilding.  But, look at rental vacancies.  There weren't too many units in Phoenix.  Rental vacancies remained low until late 2007.  The reason owned vacancies increased was because we purposefully sucked money out of the economy in a concerted attempt to cool off housing markets.  Rental vacancies were low and households were still having to move out of town, but the market for homebuyers was weak.

By the way, in my 4 categories of cities, this pattern only shows up in the Contagion cities.  The Contagion cities are the cities that had a mass migration event.  In the Contagion cities, as a group, owner vacancy increased in 2006 and renter vacancy increased in 2007.  For years after the crisis, federal policies were based on the idea that there was an national overhang of housing inventory to work off.

None of the other types of cities showed any systematic shift in either rental or owned home vacancy rates.  There was a rise in the "other" category, which was largely due to Detroit.  I will concede that Detroit has an oversupply of homes.

Monday, February 19, 2018

PCE Inflation

I usually update CPI inflation, since it is updated monthly.  Detailed PCE inflation is only updated quarterly, so I haven't tended to review it as often.  But, I thought it was worth checking up on.

Here is PCE (personal consumption expenditures) inflation through the end of 2017.  It follows a similar pattern as CPI inflation.  PCE core inflation is about 1.5%.  But, this consists of housing inflation above 3% and non-housing inflation of about 1%.*

It's always worth a reminder that Taylor Rule based complaints about monetary policy in the 2000s have to ignore the fact that PCE inflation never strayed far from 2%, and that non-housing core PCE inflation was below 2% for the entire period.  It is stunning to think that we live in a regime that has both (1) a central bank that explicitly runs an inflation targeting program and (2) a large contingent of economists who claim that for several years, a fundamental feature of the economy was a central bank that held the target interest rate several points below the neutral rate, creating a massive asset bubble, and the inflation rate averaged less than the consensus target rate for that entire period.  In fact, taking housing out of the measure, inflation has been below target for more than 20 years.

Why should we take housing out of the measure?  It's mostly imputed rent.

To make this easy to imagine, let's imagine a zero inflation target and zero growth.  In year 1, the average household has $50,000 income and $20,000 in cash expenses.  Additionally, the BEA notes that the household owns a home that has $15,000 in rental value, so that, while the household doesn't realize it, they have $65,000 in income and $35,000 in expenses.

In year 2, the central bank accidentally hits its target.  The household still has $50,000 income and $20,000 cash expenses.  But, the central bank notes that the household also owns a home that has $15,500 in rental value, so that, while the household doesn't realize it, they have $65,500 in income and $35,500 in expenses.

The central bank determines that they have erred by $500.  They need to pull back the amount of cash in the economy so that the household returns to a level of $65,000 and $35,000 in expenses.

Now, the problem is that the rental value has nothing to do with cash, so that the central bank can only reduce spending in other areas.  This means that when the central bank tightens policy, the household has $49,500 in income, $19,500 in cash expenses, and still has $15,500 in rental income and expense.  The central bank had to deflate the cash economy in order to meet their target.

The kicker is that the reason rent inflation is above target is because there isn't enough money to fund new construction!

*This is technically a "Housing and utilities" category, so a small part of the housing category itself is "energy", which probably adds a slight imperfection to my "PCE less food, energy, and housing" measure, which I have estimated manually.

Friday, February 16, 2018

Housing: Part 284 - No Bubbles, Only Busts

Timothy Taylor has a post up today on homeownership rates around the globe.

One of the key pieces of information that is a clue about what happened in the US is that US housing markets were not international outliers until 2007.  We had two markets - the Closed Access cities and the rest of the country.  The Closed Access cities looked like places with housing supply problems like the UK and Canada and the rest of the country looked like places that don't have housing supply problems, like Germany and Japan.

After 2007, prices in the US, along with just a couple other small countries, collapsed relative to those other places.  The Closed Access cities collapsed relative to Canada and the country's interior collapsed compared to Germany and Japan.

Benchmarking to the rest of the world, we didn't have a bubble.  We just had a bust.

Well, it turns out that this is the case if you look at homeownership rates, too.  From 1990 to 2005, homeownership here increased from 64% to 69%.  But, that was actually a slower increase than the typical country experienced over that time.  Then, after 2005, homeownership rates collapsed here, along with prices.  In the rest of the world, homeownership rates are still about where they were in 2005.

No bubbles.  Just a bust.

Side note.  Taylor's post includes this interesting bit:
Interestingly, anecdotes suggest that many German households rent their primary residence, but purchase a nearby home to rent for income (which requires a large down payment but receives generous depreciation benefits). This allows residents to hedge themselves against the potential of rent increases in a system that provides few tax subsidies to owning a home.
We have a lot to learn from Germany.  They are one of the countries with stable home prices.  The reason, broadly speaking, seems to be that we subsidize ownership relative to renting and then we put up policy gatekeepers against ownership and obstructions to new supply.  Germany taxes ownership and has fewer obstructions to supply.  We induce a bidding war on limited stock and they discourage consumption of an abundant stock.

But, this seems like it's a bit too far.  I don't think it makes much sense to have two neighbors renting to one another for a tax arbitrage.  We should do away with the subsidies to ownership, but the goal should be a neutral field.

This is one reason why I think low taxes on capital income are beneficial.  If other capital is lightly taxed, then these potential tax incongruities in housing become less important.  And, in the US, those tax incongruities are regressive and destabilizing.  They subsidize high end housing, and they force households to take out large amounts of debt to finance imputed future tax benefits.

Wednesday, February 14, 2018

January 2018 CPI

Non-shelter core CPI does continue to show some recovery.  The noisy month-over-month measure was strong and year-over-year is now up to 0.8%.  Shelter inflation remains at 3.2%.

Maybe the parallel to where we are is the late 1990s, but now a little more extreme.  Core inflation then was about 2%, which really consisted of 1.5% core non-shelter inflation, plus a 1.5% annual increase in the transfer of economic rents to real estate, which was expressed as shelter inflation.  Today, we have 0.8% core non-shelter inflation, plus a 2.5% annual increase in the transfer of economic rents to real estate, which is expressed as shelter inflation.

In both cases, the policy rate is rising, and I suspect will rise too much.  In 1999, the Fed had been hiking rates slowly, and they accelerated the hikes in 2000 when inflation moved higher.  The 2000 recession coincided with a hard equities crash.  I'm not sure we will see that.  But, it might be reasonable to expect a drop in yields and only a slight drop in employment and housing starts.  In fact, housing starts have already leveled off, as they had in 1998 and 1999.

On the other hand, I think capital repression has pushed low tier home prices down, making it difficult to trigger new building.  It appears that credit conditions have loosened ever so slightly, which may be allowing low tier credit to expand.  The initial effect of this may be to raise prices.  Possibly prices will need to rise 10% to 20% before they are high enough fund the development of new lots.  Maybe that means that the initial expansion of credit has more of an inflationary effect than a real effect because of household balance sheet recovery and credit creation.  That may be necessary, but on the other hand, it would probably create a negative Fed reaction.

This still seems like a race between the Fed's policy rate and the neutral rate, and if long rates can continue to stay ahead of short rates, maybe the expansion can continue.  If long rates reverse back down, that calls for defense.  And, a careful position somewhere in the real estate or construction sectors probably is useful.

In the meantime, I hear the usual talk about how deficit spending is inflationary and how the increase in Treasury supply will drive interest rates higher, etc.  It really does make sense, and it would move me if I saw any evidence of it in historical data.  Yields will mostly reflect monetary policy and sentiment.  Intrinsic value trumps supply and demand.

Tuesday, February 13, 2018

Mortgage growth

The New York Fed's Household Debt and Credit Report is out for 4Q 2017.  Mortgage growth is building.  This is in spite of rising rates and low lending growth from commercial banks.

Homeownership rates seem to have bottomed and there are some signs that home price growth has lately been stronger in low tier markets than in high tier markets.

I have been waiting for both of these things to happen - a Fed tightening cycle and a loosening of credit standards.  I think both of those things will make interest rates rise.  If loosened credit standards can lead to rising rates (from more borrowing, increased building, etc.) faster than the Fed raises the policy rate, then de facto monetary policy may not tighten so much.  The Fed would be facing a rising neutral rate.  We can hope.

But, if that is the case, home prices, borrowing, and buying by households on the margin will increase.  All of those things will trigger the same moral panic that happened in 2007, to some degree.  Will that lead to over-reaction?

This is bullish for some homebuilders.  But, if low tier home prices grow by 10% this year and entry level homebuilders start to see rising sales, the question is what will the policy response be?  There shouldn't be political risk here, but unfortunately, the public and policymakers have decided that this is an area where we should impose our will on markets.  If there is an over-reaction, interest rates will fall and homebuilders will have to wait longer for recovery.  If there is not an over-reaction, then interest rates might rise and homebuilders will see bright prospects.

There is potential for a hedged position there, between interest rates and homebuilders, and a carefully created one might provide net expected gains.  The relationship is the opposite of what we might normally think of.  Rising rates will be related to rising home sales.  But, the secret is in the timing and the choice of securities.  The last couple of weeks have not been friendly to this theory, as homebuilder stocks tumbled while interest rates rose.  The question, as always, is whether that is a rejection of the hypothesis or a buying opportunity.

Thursday, February 8, 2018

Upside-down CAPM, Part 3: Capital Growth

There are problems with the way we talk about capital and leverage.  Frequently, leverage is discussed as if it is a way to multiply the amount of capital we have in some unsustainable way.  During the housing bubble, it is homeowners taking out equity LOCs or investment banks using high levels of leverage in their business models when they were underwriting MBSs and CDOs.  But, leverage doesn't really do that.  Maybe we talk that way because we are thinking in terms of a household taking out consumer debt, or a small business owner getting a loan to make a capital investment, so that for the protagonist in the story, there is some sense of magnifying their economic ownership and risk.  Or, maybe, we are thinking of how banks can make loans, which are re-deposited in the system, seemingly creating capital out of mid-air.

But, none of those things actually increases the real stock of capital.  None of it makes a building appear or stocks a store's shelves.  To do that, capital must bid on the same stock of real inputs that existed before those loans were made.

We might think of the stock of capital something like this:

For this exercise, let's think of public debt simply as deferred taxation.  It might fund some public capital that provides public benefits, but it doesn't have to, and its value is just a claim on future taxes in either case.  So, I am not going to address public debt here.

Private capital might be broadly divided into four categories: Two debt categories that generally have nominally fixed claims and income streams, and two equity categories that generally have nominally flexible claims and income streams based on constantly changing residual income streams to the full basket of income-producing assets.

There is a consumption vs. saving decision that is important on the margin.  But, over time, the growth to the capital base largely comes from growing equity, not new saving.  (I saw a great graph on this recently that I have lost track of.  Please post in the comments if you know what I'm talking about.)  Now, here is where there is a bit of magic.  Let's say Amazon makes some transformative consumer electronics announcement tomorrow, netting $5 billion in new market capitalization.  This means that equity value grew by $5 billion above any investments that Amazon will make in new tangible assets.  I contend that this is an increase in the real capital base, even though it is intangible value.  Amazon might reinvest cash, borrow, or issue stock in order to make that investment, and those activities will affect the stock of capital in the way we normally think about it.  Yet, those are all just reinvestments and shifts in ownership claims.  One could say that the only real increase in the capital stock from that initiative is the new intangible equity value it created.

And that value comes from the real intangible value that Amazon's organizational capital creates.  In the aggregate, this is the primary source of capital growth, and the funding comes from future broad growth in incomes.  Over the long term, the division between capital income and labor income is quite stable.  This means that the added value to business equity that comes from future profits is a reflection of broad-based future economic growth.  In that sort of time-travel hocus pocus that modern capital markets create, the capital base largely grows from its own future intangible value.  The investment Amazon makes has to outbid some other potential use.  It is the intangible increase in value that grows the base of measured capital.

Debt has little to do with this growth.  Changing levels of debt are generally simply changes in the ownership of those future intangibles, between residual owners (equity) and owners with nominal claims and income streams that are fixed in some way (debt).  So, when economic progress happens, some of that accrues to equity.  When equity increases, that actually means that the total capital base increases.  But, when debt increases, that is simply a balance sheet decision by the firm.  The total level of capital remains the same, but the proportions by which it is divided up change.

This is the opposite of how capital seems to be generally understood.

Real estate is no different.  Changing mortgage debt levels are simply a reflection of shifting ownership between equity and debt.  Changing equity levels actually change the total level of capital.  But, the source of value in housing capital is a little tricky.  Business equity value comes from growing future real production.  But, the rent we pay for shelter appears to track pretty closely with about 19% of total personal consumption expenditures, regardless of how much real capital we invest in real estate.  In other words, demand for housing is overwhelmingly mediated by the income effect.  Future income levels are largely a product of investments outside of housing.

If we look at past consumption of housing, there was a great housing boom after World War II, where both real and nominal expenditures on housing grew.  The capital base was growing, part of that was through deferred consumption creating new real housing stock.  When housing expenditures reached about 18% of PCE, that leveled out, and both real and nominal spending on housing remained flat for 20 or 30 years.

By the 1990s, though, we had entered the age of Closed Access, and so, while nominal spending on housing remained level, the real housing stock declined.  This is the period of time where households segregate into metropolitan areas by income.  High income frequently means high rents in a Closed Access city and low income means moving to other cities.  Nominal spending on housing remains level, but Closed Access households are spending a portion of those high incomes on a stagnant housing stock.  Their real housing expenditures (size, commute, amenities) continue to grow at a slower pace than their real incomes.

We can see the shadow of this in the measure of operating surplus to housing.  This is the net income to all homeowners (equity and debt investors, for both owned and rented units) after expenses and depreciation.  Even though nominal spending on housing has been level for 40 years, income to real estate owners has captured an increasing portion of that spending.  That is because Closed Access real estate owners capture income from political exclusion instead of from building new and better units.  Notice that net operating surplus to real estate owners was starting to decline during the big, bad housing bubble.  That's no accident.  The housing bubble was largely the acceleration of the great American housing segregation event, where builders were investing in new real housing stock and households were moving out of the Closed Access cities to other cities where their rent actually paid for shelter instead of transfers to politically protected owners.

During the boom, real estate equity grew substantially - the real stock of capital grew.  But, unlike what happens when business equity grows, this wasn't because future real incomes were growing.  This was a combination of three factors.  First, finally, after decades, new housing stock was being built at a rate that maintained real housing expenditures as a proportion of real incomes.  (That maintained the size of the housing portion of the capital stock.)  This meant that the nation's interior had to build enough homes for its own population and for the Closed Access housing refugees.  Second, low real long term interest rates caused home values to rise.  (I see this mainly as a shift in proportions, similar to the shift we might see if creditors take a larger portion of the balance sheet.  Real estate equity and mortgages grew, but at the expense of business equity, in a complex mix of investment and valuation shifts.)  Third, the capitalization of future rents into Closed Access home prices increased the capital base.  (This did increase the capital base as a portion of domestic income.  But, whereas business equity grows because future incomes will grow, in this case, real estate equity - and debt - grew because they were claiming a larger portion of domestic incomes, which we see in the upward trend in housing operating surplus.)

Because of the way we tend to think about capital, consensus descriptions of the housing bubble get this all wrong.  The conclusion we came to about the bubble was that banks were creating capital by increasing the level of mortgage debt outstanding, and households were using that newly created capital to consume.  This is wrong because lending doesn't create capital, it can only reallocate it between classes of owners.  What was actually happening was that real estate owners were capitalizing their future, bloated rental claims.  The rising levels of housing equity and mortgages outstanding weren't creating capital, and on net they weren't funding unsustainable consumption.  Early in the boom, real estate owners were mostly tapping debt markets to use their capitalized rents to consume.  Non-owners and foreigners provided that capital by shifting it from other capital or by curtailing consumption.  (Foreigners were doing it by maintaining a trade surplus with us.)  But, those netted out.  For every owner shifting consumption to the present, there was another household who was consuming less.  There had to be, in the global sense.  So, real estate owners held politically exclusive assets, this raised future rental income in selected cities, which raised home prices, which raised the value of home equity, and eventually some of that equity was shifted to debt ownership because we don't have a developed system for liquidating home equity to other equity holders.  Partial liquidation of real estate holdings is typically done in debt markets.

The net effect of these shifts was a drag on long term real income expectations, which is why the marginal effect was to keep real long term interest rates low rather than high.

As the boom aged, more owners were tapping those capitalized rents by selling out and moving or renting.  During the later period, there was a transfer of homes from old owners to new owners (either new buyers or investors.)  By then, total value of real estate had peaked, so that the increase of capital in mortgages clearly wasn't increasing the capital base.  There was a large transfer of ownership from housing equity to housing debt.  Much of that transfer was from previous homeowners, tactically reinvesting away from home equity, which had ceased to be considered a safe asset class, and in that search for safety, moving down the array of asset classes, mortgage debt seemed a reasonable resting place, even if that decision was filtered through financial intermediaries rather than being a direct decision of the savers themselves.  For the households taking out that debt, there was nothing stimulative about it.  The debt was simply funding the transfer of their wages to the previous real estate owners.  Those mortgages were a reflection of the reduction in real wages created by Closed Access, manifest through higher rent expenses.

PS. The show Shark Tank is a good example of how this capital creation happens.  Someone with a good idea and little else walks onto the set.  They have very little capital.  They connect with a "Shark" that has the means to capitalize that good idea, and now, suddenly, they have hundreds of thousands of dollars in capital.  If execution of the plan goes well, they will soon have millions of dollars in capital.  That capital appeared as if out of thin air, but it really was created out of the execution of the plan that creates future consumer surplus from their good idea.  That's why it's hard to think about the offers and valuations that are given in a simple mathematical framework, because even if the presenters give up a lot of equity based on their existing business, the payoff really comes from the creation of capital, not from divvying up existing capital.  In that context, one of the "Sharks" may offer a deal that has a debt component, but their shift from an equity stake to a debt stake has little or nothing to do with the capital that will be created from their partnership.  It is just a reallocation between equity or debt forms of ownership.

PPS. These models, along with my narrower viewpoints regarding the housing market and the financial crisis specifically, lend themselves to a coherent and unique asset management process, both strategically and tactically.  I have been gauging interest in that sort of thing among some readers.  If you know of someone or if you have clients that would also be interested in a fund run on these principles, please contact me via the e-mail address in the right margin.

PPPS. So I have this conceptual framework, and I can use to it tell a story about capital.  But, I haven't debunked the other story, have I?  What if everyone else thinks mortgage lending did cause home prices to rise, increase the base of capital, make everyone feel richer, and lead to overconsumption?  Why should you care if I came up with a story?  In the end, this is all rooted in the empirical evidence I have found regarding the financial crisis and the housing bubble.  And, the core empirical evidence that confirms the conceptual model here is the realization that rents explain everything.  The empirical presumptions underlying the other story are wrong.  Not only does my conceptual framework make sense, but it rose out of the array of empirical evidence that I discovered which contradicted the presumptions of the other framework.

Tuesday, February 6, 2018

Housing: Part 283 - Lot size and construction cost

The National Association of Home Builders has a lot of great resources.  I was poking around some of their reports recently, and I think I can connect some dots regarding lot sizes, construction costs, etc.  I recently posted on the noticeable post-crisis trend in Phoenix of very small lots.  The story I told there, that credit repression in home buyer markets was the source of the trend, is borne out in NAHB survey data.

It is useful here to consider the natural regulators on home prices.  We can think of home prices as having a ceiling and a floor.  The ceiling is the present value of net future rental income on the home.  The floor is the cost of building a new home.  If the ceiling is below the floor, housing starts will be low, because existing homes would be selling at less than the cost of building.  If the ceiling is far above the floor, housing starts will usually be strong, because new homes can be built for less than the net present value of their expected rental income.  The net present value of future rents is determined by (1) real long term interest rates and (2) expected future rents on the property.

The difference between the ceiling and floor levels accrues to the value of the lot.  In Closed Access cities, starts can't increase to sustainable levels, so the lots become increasingly valuable.  In cities that allow sustainable building, the ceiling price declines when new construction brings new supply to the market, reducing future rents.  In cities where supply is unobstructed, the ceiling doesn't tend to climb very far above the floor.  Prices tend to reflect the cost of building, with relatively minor fluctuations over time.

Here is a recent special study by the NAHB on costs of construction.  Builders have been complaining about rising regulatory costs, and that shows up in the survey.  Costs associated with fees related to permits, etc. have risen substantially, but they only amount to a few percentage points of total cost.  As I have argued, while rising regulatory costs may be a valid complaint, they aren't the binding constraint in housing markets now.  If they were, then low tier housing would be selling at higher prices, relative to high tier housing.  But, low tier housing in most cities still is selling at a discount to pre-crisis prices, compared to high tier markets.  Possibly, because of new regulatory costs, it would take some extra price appreciation to trigger new building in low tier markets, but the reason there isn't more building today is because of a lack of demand for low tier housing, and that lack of demand is being created by credit market repression.

Keep in mind, the survey will be weighted toward moderately priced areas where lot prices aren't as high as in Closed Access cities.  That is because, even though Closed Access real estate represents about a quarter of total residential real estate, by value, it only accounted for about 7% of housing starts during the boom.  It is the lack of building that maintains high prices.  So, builder costs reflect cities where building happens.  And, during the boom, the extra building in affordable places was bringing down rents, as we should expect it to.  In this Fred graph, we can see the localized nature of the housing bubble, and how areas where building isn't politically obstructed followed classical economic models.  In Dallas, Atlanta, and Phoenix, new building was lowering rents, which was lowering the floor and ceiling of home values.  (Rents in Phoenix bumped up in 2005 and 2006 at the same time prices there peaked, as it was overwhelmed by Closed Access housing refugees.) 2018 - Data from USDA and NAHB
The NAHB survey confirms that homes have become larger while lots have become smaller.  Tracking costs over time, the survey indicates that lot value increased as a proportion of total building costs until 2004, then declined until 2015, and then pushed back up in 2017.  Here, I compare the finished lot cost from the NAHB survey to farmland prices from the USDA (pdf) and to real long term interest rates (30 year TIPS, inverted).  Farmland has followed the pattern we would expect, climbing as long term real interest rates decline.

Lot prices for homes were climbing before the crisis and then declined.  In the meantime, according to the NAHB, builders are facing a shortage of available lots.  But, this is strange.  With such low long term real interest rates, lots should be a larger portion of total housing costs than they ever were.  They should be following along with farmland prices.  The reason lot supply is low is because the price is low.  Why don't builders bid up the price, inducing more supply?  Because there is no demand for it.  The reason there is no demand for it is because of capital repression that prevents qualified buyers from getting mortgages.  The price of the physical home itself is not sensitive to interest rates, so the physical home is more affordable than ever for those who can qualify for a mortgage.  So, buyer money plows into the physical home, and builders put larger homes on smaller lots, and complain that there aren't enough lots available, because they can't make a profit if they bid the prices of lots high enough to trigger supply being shifted from other markets like farming.

This is why the key to near term economic growth is mortgage regulations.  If they remain where they are, interest rates will remain low, rents will continue to rise, and there will be a limit to how quickly homebuilding can continue to recover.  If regulations in lending could be relaxed, and if the public would be willing to allow lending to happen and to allow markets to equilibrate under those conditions, it would trigger a tremendous amount of pent up demand for homeownership, pushing up real interest rates, pushing lot prices up and farmland prices down, increasing housing starts and home prices, decreasing rents again.  It would be a win-win-win-win win, except for farmland owners.  But, the public wouldn't stand for it.  There would be near unanimity that the Fed and regulators were creating new asset bubbles with loose money and reckless credit, the Fed would be pressured into hawkish policy postures until prices and housing starts declined, and we would be left with a bubble in the one area that we actually have a bubble and where households are being squeezed - high rents.  This is basically what we did to ourselves in 2007 and 2008, and until we learn the right lessons about that, I don't see how that can change.

Monday, February 5, 2018

Housing: Part 282 - Borrower characteristics

The Urban Institute does some great work on housing markets.  Here is a link to their monthly housing update, which is full of great information.

These are old points that I have made before, but looking at the charts in the report, I think they may be worth repeating.

First, here is a chart of mortgages outstanding, by type.  What is important to note here is that Ginnie Mae is basically the public conduit for subprime mortgages.  A decent estimate of the size of the subprime market is the combined total of private subprime mortgages and Ginnie Mae (FHA) mortgages.  When we look back at the boom period, that category of total subprime was surprisingly level.  Adding private subprime and FHA together, there wasn't much growth.  The rise in private subprime basically came at the expense of FHA volume.

One of the responses to the crisis that I think is backwards is the idea that public mortgage conduits added to the amount of risk that was taken.  On the contrary, public conduits behaved counter-cyclically during the boom - especially FHA/Ginnie Mae.  It would have been preferable for FHA to have been more aggressive during the boom.  The privately securitized loans tended to have terms that added systematic risk to the market - loans that were set up to be frequently refinanced, MBS packages that didn't have public credit guarantees, etc.  There isn't any question that if those loans had remained in the Ginnie Mae conduit instead of the private markets that developed, the bust would have been less disruptive.

The correct lesson from the boom is that FHA and the GSEs should have been making more loans in 2004-2007.

Since the growth wasn't coming from subprime, where was it coming from?  It came from the sharp rise in Alt-A loans, which were being utilized by households with high incomes and the ability to pay, who lived in housing constrained cities where housing expenses are very high.

Here is another graph from the report.  It appears that working class/entry level housing markets have been showing some strength recently.  Prices in low tier markets seem to be rising at a slightly higher rate than in high tier markets.  I would expect this to be reflected in credit markets, but mortgage growth remains low.  And, according to the Urban Institute data, it doesn't look like there has been much of a retreat in FICO scores of average buyers.  DTI levels have risen recently, though.  So, recent market moves seem to be coming from improved sentiment from highly qualified borrowers, who are willing to take on more debt in order to purchase.  Maybe this is related to the continuing reversal of negative equity, and some qualified households who have been stuck in homes with negative or negligible equity are now escaping those homes, and taking out mortgages reflecting the high LTV they have been stuck with in homes that continue to be priced too low because of public credit policies.

One additional random tidbit:  One of the pieces of evidence regarding lending excess during the boom is that credit spreads were low.  But, if those spreads are measured as the difference between risky mortgages and conventional mortgages, really those spreads are a reflection of the lack of aggressive lending at the FHA and GSEs.

Here is a graph comparing 30 year conventional mortgage rates to the 10 year treasury rate.  This has bee relatively high since the 1990s.  Remember that the GSEs were under pressure in 2003 and 2004.  And, as shown above, FHA was in retreat throughout the boom.  Spreads between GSE loans and jumbo loans were low during the boom also.  This is because it was GSE rates that were unusually high.  That remains the case today.  Today, rates remain high largely because of guarantee fees.  The UI report notes that guarantee fees at the GSEs remain very high - more than 50 basis points, which is double what they normally would be.  This is a primary source of very high profits at the GSEs.  Banks should be raking in market share under these conditions, but they face pressure from the CFPB.

Especially considering the lack of significant pre-payment risk at current rates, mortgage spreads should be much lower than they are.  High guarantee fees and high spreads are a political outcome, not a market outcome.  If they were a market outcome, the outcry about greedy bankers would be deafening.  Since they are a political outcome, those profits get pocketed by lenders and the GSEs while activists and pundits nod in support of our wisdom and prudence.