Tuesday, June 20, 2017

Financial economics is hard.

I saw this on twitter today.



The natural equilibration of a free economy is so difficult for people to understand that even most traders and practitioners seem to fail to wrap their heads around it.

In this comic, we have the banks and the GSEs.  The effect of "bailouts" or safety nets for these firms is generally understood, as far as it goes.  The effect is explicit in most complaints about those safety nets, but then gets forgotten when applied to social criticism.

I'm not particularly a fan of the private/public GSE model or of the capital requirements and public deposit insurance that form the foundation of public support of banks.  This post is not a defense of those regimes.  But, if we are going to critique them, let's critique them for the right reasons.

What is the primary effect of the public safety net under banks?  The primary effect is to protect lenders to banks.  Who are lenders to banks?  Depositors are.  Public support means that depositors are less sensitive to bank financial instability, because they are protected.  Equity holders aren't protected.  They are generally wiped out when public support is used to save these institutions.  And, what is the effect on those depositors?  The effect is that, because their deposits have a public safety net, they have lower systematic risk, and thus, they earn lower yields.

Look in any description of the low risk investments available to savers, and it will describe bank deposits as one form of very low risk saving, then it will describe any number of similar savings options that have higher yields because they don't have insurance.

It's almost like these markets are highly efficient and things like rational expectations overwhelmingly guide markets in ways that we universally take for granted.  (But, if you want to be a sophisticated fish, you publish articles casting doubt on the naïve theories about "water".)

Similarly, the complaints about the GSEs always center around the "implicit guarantee" that GSE debt always carried.  And, how did we know that there was an implicit guarantee to complain about?  Because yields on GSE debt were low!  Again, the mathematical relationship between risk and return is explicit in the complaint!  The complaint itself is based on a rational expectations, efficiency assumption!

Then, we move to social commentary and we act like none of that happened.  Bailouts help the capitalists and cost the taxpayer, don't ya know.

But, every action has an opposite and equal reaction!  If you made the complaint, you had to know this!  Those safety nets meant that bondholders and depositors earned lower yields.  In other words, those safety nets meant that capital incomes were lower - capitalists earned less.  Do I need to go all caps on this?  Because I will, if I have to!

We can argue about exactly what forms of stabilization are appropriate.  And, believe you me, you don't need to twist my arm to convince me that the stabilizing policies of summer 2008 were not exactly optimal.  But, this idea that financial safety nets mean capital gets its cake and eats it too is just wrong.  The only way to have it both ways is to regulate away potential competition.  Markets with reasonably free entry can't help but pay it back.

And, in the meantime, there seems to be near unanimity about maintaining instability and keeping out competition in the housing market.  "Oh, no!  It's time to tighten again!  There are homeowners who still think real estate is a safe investment.  When will they learn?"  And, gee, guess what investment has yields well above the alternatives and far above the pre-crisis norms?  Rent income is through the roof.  No comics about that though, because for those yields to go down, prices and supply would have to go up, and a sophisticated fish knows there can never be not enough, only too much.

Monday, June 19, 2017

There is never not enough. Only too much.

Calculated Risk has a new post: Lawler: Single-Family Housing Production ‘Shortfall” All In Modestly Sized, Modestly Price Segment

with the following graph.


If we put a time capsule in the ground for archaeologists to dig up in 200 years, and I was asked to put one item in the capsule that best described our time, it would be those scare quotes.

Sunday, June 18, 2017

The flattening yield curve

This is a great article from Josh Brown.  It's an article I'd like to think I would normally write.  He basically says to calm down about the flattening yield curve.  Economies can have years of healthy growth with flat yield curves, even if inverted yield curves are a sign of a coming correction.  This is an excellent point, and normally I'm more than happy to fight the perma-bears and the bubble-mongers.  But, at the risk of being shown a fool, "This time it's different."  (Maybe it's safe to use that phrase in defense of being a bear.)

First, the most significant reason long term rates are low is because we have constructed barriers to long term residential investment.  This is why GDP growth has been anemic, why the labor recovery was somewhat weak, and why there have been headwinds for consumption and balance sheet recovery.  Especially in working class neighborhoods, home prices are still 20% or 30% too low because we have destroyed owner-occupier demand in those neighborhoods, which creates real losses and introduces agency costs to tenancy while also harming working class balance sheets.

Source

So, the reason for the flat curve is a lack of investment, and its already putting both real and nominal economic growth on crutches.

Second, real bank lending is already stagnant.  It has been for about 3 quarters.  This is usually a lagging effect and it points to my third point.

Third, the yield level may have a significant effect on the slope of the yield curve.  The zero lower bound creates non-normal distributions for expected future interest rates, which prevents the long end of the curve from flattening as much as it normally would.  In other words, there is option value in long term interest rates.  I know I am certainly much more willing to take speculative short positions on bonds when rates are very low.  There is a lot of skew here.

Notice how inverted the yield curve became in the late 1970s, when rates were high.  1990 and 2000 were pretty shallow recessions and in both the inversion was also pretty shallow.  But, the 2008 recession was more akin to the 1980-82 recessions, yet the yield curve inversion was much more shallow.  In the late 1970s, rates were around 10% to 15%.  In 2007, they were about 5%.  Today they are 1%.  I think it is pretty clear that a contraction will happen without a true inversion here.  The question is how much slope will we have when the natural short term rate starts to fall without a response from the Fed.  We could be there already.  If we get a couple of bullish head fakes, which is certainly possible in the inflation indicators over the next couple of months, the Fed might even push another rate hike.

I think the Fed's general stance, the broad demands for destabilizing monetary austerity, and these yield curve distortions make a contraction within the year probable.

Wednesday, June 14, 2017

May 2017 CPI and our benevolent monetary overlords

Well, here we go.

CPI less food, energy, and shelter, is down to 0.6%, TTM.  It looks like shelter inflation might have peaked too.

The three month drop in the non-shelter core measure is the worst drop since the BLS began tracking it in the 1960s.  Down about 0.5% since February.

And the Fed raised rates.

This is different than the last recession, though.  Things aren't lined up the same.  We're still raising rates, so rate-sensitive things may still be similar to a 2005 or early 2006 time frame.  That has me a little confused.  I'd like to take some positions that would benefit from falling rates, and the yield curve is already moving down.  But, if the Fed will push short term rates up one or more times, it muddies the water a bit, because the entire curve tends to react to those moves, if only temporarily.

Employment still seems relatively strong.  Flows are holding up pretty well.  That also looks like 2005 or 2006.

Inflation looks like the middle of 2007.

General credit is still growing, it seems.  But, bank credit is flat as a pancake, which is usually a coincident indicator.  Even without these inflation indicators, I would be a little nervous to see rates being pushed up with bank lending so weak.

I think the Fed is committed to recessionary policy at this point.  If (when) they push rates up to much, I don't think they will be quick in reversing their decision, either.  It's a matter of when the various moving parts affect different markets, though.  When do interest rates decline?  When does the labor market turn sour?

I don't think we will see much downward movement in home prices, housing starts, or equity prices unless things get really bad.  And, I still am having a hard time coming up with a detailed forecast for some of the other markets.

If signals turn south over the next couple of months, maybe the Fed will hold off.  But, the Fed sees this softness as temporary, and if some inflation measures have been temporarily down and bounce back, the Fed might see that as cover to raise again, maybe even in September.  I would expect that to lead to a fairly immediate flattening of the yield curve, after which it would be a matter of time before the Fed relents and lowers rates.  It used to be common for rates to peak and fairly quickly be lowered again.  But, lately, the Fed seems to like to sit at the peak rate level for a while before they are willing to lower rates in reaction to economic softness.

I think that's because Closed Access creates a sense among the public that nominal stability only benefits existing asset owners, so there is a strange demand for instability.  I don't see that changing in this cycle.

Friday, June 9, 2017

Housing: Part 235 - Tight Money caused the Great Recession which caused the Housing Bust

This will probably be a long post.  And I may be totally out to left field here.  This is sort of a stream of consciousness post.  I apologize in advance if it is hard to follow.  I've been editing to try to be readable for the book.  I feel like just puking out some ideas on the blog for a change.

First, let me preface this by saying, I am not talking about whether the Fed was hitting their targets or meeting their mandates, as measured, our whether NGDP growth was above or below some threshold.  I am trying to get at something more subtle that maybe is only clear in hindsight.  This isn't a post about second guessing what was done as much as it is a post about what some of the subtle effects of Closed Access could be, and how they might undermine our basic methods for recognizing economic cycles.

Some observers believe that the Great Recession was more a product of tight monetary policy decisions from late 2007 and 2008 than it was a product of the housing bust.  I agree.  But, I tend to push that tight money problem back to early 2007 or even 2006, and I would suggest that the mortgage bust, as we have come to know it, was really a product of the Great Recession.

First, clearly there was a panic that began around August 2007 which destroyed the cash-like character of trillions of dollars worth of securities.  Regardless of one's opinion about Fed policy up to that point, this was a massive dislocation in the market for near-cash securities (Gary Gorton has written about this) which the Fed never countered, at least until the QEs kicked into gear in 2009 and after.  This was followed by policies in late 2008 which were explicitly contractionary, both during and after the crisis events at Lehman Brothers, the GSEs, and other institutions.


Source
Now, considering this, what do we consider to be the defining characteristic of the housing bust?  Defaults?  Defaults overwhelmingly happened after 2007 - even after 2008.  If we define the housing bust by defaults, then clearly tight monetary policy caused the housing bust.  There really is no question about this.  Many anecdotes about defaults filled the papers of 2006 and 2007, but in terms of scale, defaults were overwhelmingly caused by the economic dislocations in late 2008 and 2009.  (Like so many issues regarding the housing boom and bust, the scale is alarming.  This is mountains and mole hills.  Defaults in 2006 and 2007, which were blamed on bad underwriting and supposedly triggered the collapse are a mole hill next to the mountain of defaults that happened when unemployment shot up and NGDP growth collapsed.)  Defaults accelerated after the August 2007 event and accelerated again after the September 2008 event.  More than 90% of the excess foreclosures happened after August 2007, more than 80% after September 2008.

(Even if you believe that prices had to collapse and that monetary and credit policies before September 2008 were appropriate, then, still, an economy full of homeowners with negative equity creates an even more important need for stability of employment and purchasing power.  So, really, even when it comes to the 2007 collapse in private securitizations, monetary and credit policy is endogenous, because those AAA securities broke below face value because of expectations of future defaults.  And those future defaults were bad enough to justify that collapse in valuations only because we explicitly chose public policies that allowed them to happen.  There is little controversy about whether we could have stabilized the economy and the mortgage market more.  The controversy is whether we should have.  The idea that the private securitization collapse caused the Great Recession is circular.  If it did, it is because we chose to allow it.)


Source
How about prices.  Is the housing bust defined by collapsing home prices?  At the national level, the collapse clearly kicks into gear after August 2007.  Prices had been flat from the end of 2005 to August 2007, moving within a 2% range for that entire period.  The national price collapse happened after the August 2007 panic.  The private securitization market had completely collapsed, banks were defensive, and pressure was being applied to the GSEs to pull back.  The only mortgage conduit capable of filling the gap was the FHA/VA conduit.  Funding for homebuyers collapsed, and prices collapsed with it.

GDP growth began its steady decline around then (NGDP growth began to decline in mid-2006, but the decline accelerated in 2007.), the recession officially began in December 2007, unemployment started to shift up, etc.  Except for some commodity inflation, signs are pretty clear that monetary policy was too tight at this point.  So, if we either identify the housing bust by defaults or by prices, in either case, the housing bust happened after monetary policy became contractionary.  As with defaults, the price collapse accelerated after August 2007 and again after September 2008.

How about housing starts?  Housing starts and residential investment began to collapse at the beginning of 2006.  This is a little more subtle.  Before I get into this, though, I would point out that I think defaults and declining prices would be the most common characteristics associated with the housing bust, and that generally those things happened later, relative to the general economic decline, than is generally appreciated.  This is mostly because the small rise in delinquencies and defaults in 2007 was reported on with much more intensity than the many, many defaults that happened later.  The housing bust, as a proposed cause of the recession, is rarely described in terms of housing starts.  So, nothing that is commonly associated with the housing bust was really happening before August 2007.

As I have argued before, I think this early phase of the bust, where contraction was mainly manifest in declining investment, is actually the first sign of economic contraction, it was a development that was generally encouraged because of the mistaken idea that there were too many houses.  Fed members generally saw this as a positive development.  Mortgage growth continued through 2007.  I think this is generally because the rate of new first time homebuyers is more stable than other segments of the market, and these tend to be more leveraged buyers, so there is a natural stickiness to mortgage growth.  But, mortgage growth rates kinked down at the beginning of 2006, just like investment, housing starts, and home equity levels did.  It just took a little longer to adjust down.

This is the period where equity as a percentage of real estate values really started to collapse.  Prices were still relatively stable, but mortgages outstanding continued to rise, thus the rise in aggregate leverage.  Homeownership was falling by then.  I have argued that much of this shift was due to an exodus of capital out of home equity, much of it in the form of owners selling and not repurchasing new homes.  By 2006, first time homebuyers were in decline and exiting owners were increasing at the same time.  In addition to that shift, there was a shift of households out of the Closed Access cities.

Data from American Community Survey
During the boom, these were households selling out of the high priced cities and repurchasing in lower priced cities.  During the boom, some of those homes were purchased by households who were moving into the Closed Access cities, but most of them were purchased from existing Closed Access households who had been renters.  In both cases, this was a shift in ownership from lightly encumbered households (because they generally had significant capital gains) to more leveraged households.

This is where the interpretation is a bit subtle.  Generally, the housing bubble idea is based on the idea that the unsustainable supply of credit led to capital gains which would inevitably be lost, and that households were spending those capital gains on consumption.  But, what if prices reflected reasonable valuations of future rents, and credit supply was simply facilitating the purchase of what were really economic rents from exclusionary local political policies regarding housing?  Then, that consumption wasn't unsustainable.  It certainly wasn't unsustainable for those Closed Access outmigrants who realized their capital gains.  And, the new homeowners that purchased those homes weren't using those mortgages to fund non-housing consumption.  They were using the mortgages to fund the purchase of those expensive homes, and they were, in fact, probably crimping their other non-housing consumption as a result.

We can really think of other homeowners the same way.  Even if a household retained their home and got access to their gains by taking out home equity loans instead of selling their property, they were still accessing economic rents, just like the households that sold or moved.  The value of the homes were just as permanent.  They just chose to continue to hold those homes as unrealized gains instead of selling them and realizing those gains.

http://www.nber.org/papers/w15283Mian and Sufi estimate that during the boom these home equity extractions amounted to at least 2.8% of GDP.  We can see this simply by comparing residential investment with mortgage growth.  Generally mortgage growth runs slightly below residential investment, but during the boom, mortgages outstanding were growing by about 2% more annually than residential investment was (as a % of GDP).


Source
The Fed, trying to maintain low inflation, was countering this by reducing currency growth.  I'm not saying they were targeting currency growth.  I'm just saying, if mortgage growth was leading to increased bank deposits that were related to rising consumption, a central bank targeting inflation will naturally limit currency growth.  We can see that PCE core inflation was generally at target during this time, even though currency growth was very low.

Note, by the end of 2006, much of the excess mortgage growth was gone.  Since then, households have had to fund residential investment from other sources.  But, currency growth continued to fall until the summer of 2008.

Now, a reasonable response to this is that, while the Fed might have been a little tardy in reacting to the collapse in mortgage growth in 2007 and 2008, it was perfectly reasonable for them to counter the inflationary pressures of mortgage growth before then.  In terms of viewing monetary policy through the Fed's stated targets and mandate, this is certainly true.  Even in terms of NGDP growth, in late 2006 and early 2007, nominal GDP growth was sort of on the cusp of growth rates that would normally be considered recessionary, and it was subsiding, but it wasn't at a rate that is undeniably recessionary.


Source
Unemployment was also stable, although I would argue that employment growth was actually beginning to weaken substantially, and that the first phase of contraction led to a reversal of the Closed Access out-migration surge, which was a buffer against rising unemployment.  This caused the early signs of cyclical dislocation to be hidden, so that by the time unemployment became a signal of contraction, there had been many months of internal stresses within the economy.  Even having said this, though, the rise in unemployment in the US predates the rise in other countries.  Something unusual was happening here by early 2007.

Setting Fed mandates and targets aside, though, what does this mean simply with regard to stability itself.  What if much of that new housing wealth was the capture of economic rents?  These were largely future potential economic rents, which will eventually be earned through excessively high rental rates on those properties.  Those future rents are capitalized in today's home prices.  This added consumption wasn't being financed by using unsustainable capital gains to borrow from financiers.  It was financed by those future economic rents.

This was basically consumption smoothing by rentiers.  The rentiers were consuming today out of their capitalized future economic rents.  And, on net, we would expect non-rentiers to lower consumption as they suffer from the losing side of the surge in rentier incomes.  Rentiers explain the increase in borrowing.  Non-rentiers explain the increase in low risk investments, such as AAA securities.

Current consumption was being claimed by non-producers.  That isn't controversial.  My tweak to the story is just that this consumption wasn't unsustainable.  So, this means that there would be inflationary pressures.  This means that the rentiers were claiming current consumption from the non-rentiers - they were outbidding them.

What if those gains were sustainable?  Then we have an economy composed of rentiers and non-rentiers.  According to Zillow, from 1998 to 2006, total value of Closed Access residential real estate increased from $2.9 trillion to $7.4 trillion - most of that after 2002.  Even in real terms, this was an increase of about $4 trillion.  Mian & Sufi estimate extracted home equity, nationally, from 2002 to 2006 at $1.45 trillion.  If that is a transfer from non-rentiers to rentiers, that is a major economic dislocation.

Mian & Sufi's 2.8% represents all borrowing through this channel, so consumption would only be a portion of that.  On the other hand, this measure does not include capital gains captured by households either selling homes into the boom or selling high priced Closed Access homes to move to lower priced cities.  Adding all of these sources of current consumption together, it seems that this transfer of rents accounted for much of the growth in personal consumption during the boom.

Real GDP growth per capita was significantly higher in the Closed Access cities during the boom than it was elsewhere, by the way.

Taking all of this together - the low level of currency growth, the significant rise of credit fueled spending, and the moderate levels of total spending and of inflation - suggests that there was a shift in consumption toward households who were harvesting capital gains from housing.  All else equal, without that shift, inflation would have been negligible and nominal GDP growth would have been very low.

Again, I don't think I really need to assert anything here.  This is not controversial.  The idea that debt was fueling consumption is universally accepted.  But, the difference between irrational, unsustainable capital gains and harvesting of permanent economic rents is pivotal here.  What would happen if the source of consumption was from the harvesting of permanent economic rents?  Imports would rise.  Savings would increase.*  Debt would rise.  Everything that happened would happen.  And, if the central bank didn't counter all of this, then inflation would rise, too.  But, the central bank did counter it.

We are an open economy, so when the central bank countered the inflationary effects of this consumption smoothing, at first, it didn't create a problem.  We purchased imports - which, again, were seen as unsustainable overconsumption from debt, but really were consumption smoothing from the owners of our increasingly exclusive asset base.  Inflation is basically a product of monetary policy, and as long as it isn't disruptively high or low, it shouldn't matter that much.  Eventually it mattered because policy became disruptively tight - first leading to extremely sour expectations in real estate markets, then a breakdown in mortgage markets, then finally a sharp downturn in consumer inflation and NGDP growth.

But thinking about inflation in this way, the question arises: how exactly was monetary policy to blame for the housing bubble?  And, how was tightening it supposed to be the cure?  Even in the conventional telling, that this was all reckless and unsustainable debt fueled spending, how was lowering the inflation rate supposed to help?  I mean, if housing debt was allowing households to claim an extra 2% of current consumption, why would that be any different if inflation was 5% or 0%?  Those households were using access to nominal spending power, but they were claiming real output.  Why would a change in inflation change that?

The only way monetary policy could change that is by lowering expectations so much that it induced a crisis of confidence in the housing market by causing home price expectations to collapse - to fall into negative territory.  And, this is clearly what had happened, in a pretty extreme way, by no later than mid 2007.  The Fed's response to these collapsing expectations was to say "the housing correction is ongoing", and to continue to use that term - "correction" - through the end of the year, even after the collapse of private securitizations.

To this day, this is explicitly and widely supported.  The problem, the story goes, with the economy in 2006 was that all those starry-eyed speculators thought that home prices never go down, and that if there was any mistake about how we handled it, it was that we didn't set up markets for those prices to fall earlier.  I am making a damning accusation about the policies that were widely demanded and enacted in this country at that time.  This is awkward, because it should require some contentious claim about what was being demanded.  It's awkward, because the claim itself is not contentious at all.  The explicit demands to create negative expectations in the housing market were broad and loud then, and they are still broad and loud.

Data from Zillow
The reason my criticism is so damning is because the premise was wrong.  The reason my criticism is so damning is a boring little scatterplot which shows that the capital gains funding that consumption were from permanent economic rents.  While the country was fretting about how home prices were becoming unmoored from rational value, rent was becoming a more and more important factor.  It still is.

Notice in the graph how most metro areas basically fall on a line that intersects the origin.  In other words, prices and rents were fairly proportional.  (In 2007, the Contagion cities were causing a bit of a bulge at the top end of the mass of less constrained MSAs, pulling it slightly above the proportional line.)  But, in the Closed Access cities, and generally only the Closed Access cities, the relationship is not proportional because the price also reflects future rent expectations - a cash flow growth premium.  By 2015, even with a basic, linear, unweighted regression between median rent and home prices among MSAs, r^2 is above .85.

Notice one thing that nobody ever expected.  Nobody expected the rents in those high priced metropolitan areas to decline.  We aren't about to see a correction there, even though that is where the correction is needed.  This would require a resurgence in housing - at least in terms of building and lending.

This realization should create a wholesale shift in how we view monetary policy at the time.  Monetary policy was countering this housing-fueled consumption.  But, this wasn't coming from a widespread dissemination of debt to marginal households.  This was coming from a minority of households who had become quite wealthy by obstructing access to opportunity through repressive housing policies.

This seems like the classic problem of a non-optimal monetary regime.  There were two distinct types of Americans - those who were consuming gains from economic rents and those who were not.  The first set didn't need monetary accommodation.  The second set did.

But, in the end, this problem is dwarfed, I think, by two more important factors.
  1. The consumption fueled by housing gains had nothing to do with monetary policy, except that before 2007 we were within a range that allowed the economy to function.  And a functioning economy that contained these pockets of Closed Access was bound to have high home prices.  When we left that range in 2007 and 2008, that source of consumption was undercut.  But, of course, this catastrophe was applauded, not derided.  "If only we had done it sooner."
  2. The effect of the expectations channel overwhelmed any negative effects of the more conventional damage tight monetary policy might have caused for the have-nots.  As I review the data, even the decline in migration out of the Closed Access cities that began to happen in 2006 was mostly due to the decline in migration among homeowners.  The disruptions were targeted to recent homebuyers in Closed Access and Contagion markets.  When those disruptions took hold, the Fed didn't discontinue its tight policy, and since policymakers thought working class borrowers were the source of that extra consumption (They weren't.), they severely clamped down on lending to those markets in 2008 and after.  And, it was late - in 2009 and 2010 - that those households were hit.  But, even there, the hit was largely through housing, as working class neighborhoods really took a beating as a result of those late policy choices.
But, even though this was related to expectations specific to housing, it is still intertwined with monetary policy and the problem of rentier and non-rentier needs.  Some neighborhoods in places like Dallas started to see slow price declines in 2006 and 2007, accelerating in 2008.  Dallas was non-rentier territory.  An extra 5% of inflation over that period might have done wonders for sentiment in places like Dallas where home prices were never particularly high.

It only got worse after early 2008.  Regarding working class homeowners, one might properly conclude that the housing collapse did cause the recession.  But, in that case, it was tight credit policies from the GSEs and Dodd-Frank, in 2008, 2009, and 2010, that caused dislocations in those communities.  Low tier home prices didn't collapse across the country in 2009 and 2010 because of bad underwriting or excess prices in 2005.  So, for those communities and neighborhoods, it was the credit-policy induced housing bust of 2009 and 2010 that exacerbated recessionary conditions in 2009 and after.

Because the exodus of homeowners that had been growing throughout the boom and accelerated in 2006 and 2007, home equity levels collapsed much more strongly than valuations, both the growth of mortgage financing and the harvesting of equity continued to boost consumption after expectations in the housing market had soured.  In addition, sanguine attitudes about the collapse in housing starts meant that there was no natural buffer for declining investment by the time of the first panic in August 2007 and by the time the recession officially began.  Housing starts were already at levels normally associated with the depths of a recession.  Prices began to collapse, in part, because the shift in quantity supplied that could come from changing rates of new building had already been mostly exhausted.  This was met with indifference because of the mistaken notion that we had too many homes.  Ben Bernanke still thought there were too many homes in 2011, and he was far from alone.

For many of these reasons, the collapse was felt first in changing expectations about home prices.  Obviously, negative expectations about values create a natural dislocation in ability to use an asset as collateral.

Here is where you might scold me and explain that it isn't the Fed's job to keep home prices from declining.  I certainly agree, with regard to idiosyncratic price movements.  But, these were nationwide.  As a start, we should have a strong presumption that broad changes in sentiment and price have a systematic or monetary source.  And, obviously my contention that prices are mostly capitalized economic rents from future political exclusion is important here.  But, even setting all that aside, let me suggest that all of our measures of monetary policy effectiveness - inflation, output, NGDP growth, etc. - are not the end goal of monetary policy.  They are proxies.  They are proxies in the service of stability in the business cycle.  In the end, regardless of what we think those proxies were signaling to us, they are only proxies.  If every tactical target the Fed has is on the nose, and an imminent collapse in housing sentiment is going to lead to a generation defining recession, then proxies be damned.  We shouldn't let tactics take the place of the mission.

I don't blame the Fed for looking at those proxies.  It's not their "fault" in that sense.  But, just because the proxies failed doesn't mean that the any of these series of developments were not, in some sense, monetary issues.

But, even saying that, the horrible truth is that we imposed three (really four) stages of collapse on ourselves.  (1) the housing exodus in 2006 and 2007 that coincided with collapsing investment and the retrenchment of migration that had been flowing away from the high cost cities, (2) the August 2007 securitization panic, (3) the wider panic of late 2008, and (4) the federal denial of credit and the late crash of working class housing markets from 2008 to 2011 (and really to this day).  The initial collapse in sentiment might not have even been catastrophic if we had stopped after #2.  Maybe a generous lending policy from the GSEs in 2008 would have been enough to stabilize the economy even with a very tight monetary policy.  Surely the lack of mortgage access had something to do with the sharp drop in low tier prices, and the sharp drop in low tier prices was the root of rising defaults, collapsing securities valuations, etc.

The counterfactual that would be interesting to know would be whether systematic support of generous conventional lending in 2007 and 2008 and after would have been enough to counter any cyclical effects of the repricing in the Closed Access and Contagion cities that might have come from the collapse in private securitizations.  That repricing had happened by the tragic late 2008 episode.  I don't think that most of that repricing was necessary, but in any case the credit repression that happened after that and is still happening - after monetary policy finally became more accommodative (over much public consternation) - was egregious and unnecessary by any measure.




* Much of the savings was from foreign sources.  And much of it was unmeasured because capital gains on those homes are not counted as savings, even though they really are savings if they are permanent, and they certainly are savings for the many households that sold and realized those gains.

Saving rates look low throughout the Closed Access era because the capital gains are received as savings by the rentiers, but they are not recorded as savings.  Whether these are properly considered savings or not depends on if the gains are sustainable.  They are if they are capitalized rents.  They aren't if this was just an irrational credit-induced bubble.  This is the trouble with this topic.  Our interpretation of events affects the causal inputs.

Thursday, June 8, 2017

A radical proposal to eliminate the FDIC

OK.  This will probably brand me a hopeless radical - a naif - someone with such an absurd fundamentalist faith in markets that it's just not worth talking to me.  But, here goes.  I propose we get rid of the FDIC.  Just get rid of it.  Let savers fend for themselves.

What could happen?  Well, there was a time, I believe, when bank CFO's would actually be accountable for losses and they would take out private insurance policies.  Or maybe, a private deposit insurance market would develop for banks.  Or clearinghouses that would backstop failing banks.  Or, maybe banks would publish their balance sheets and depositors would consider the riskiness of their portfolios before depositing their cash.  Maybe banks will actually end up being less leveraged, and the system will be more safe.  It seems like all of these developments might be better than the system we have.  In a way, I think many of the major issues in banking today come down to public deposit insurance that misprices its policies so that banks can get too leveraged or too big, etc.  It seems like a lot of problems could be solved simply by pricing deposit insurance more efficiently.

I don't think any of that needs to happen.  In fact, I suspect that in an unregulated market, there wouldn't be any deposit insurance, because there would be no demand for it.  Depositors would only give the slightest attention to the books of the banks where they made their deposits, mostly just depending on brand reputation as a signal.  And, I think this would lead to a market that you might call a sort of crazy Wild West.  I think you'd end up with banks that were highly leveraged - not 10 to 1 or even 20 to 1 or 30 to 1 - but, basically with no equity at all.  Depositors would be drawn to deposit in those banks.  Some might say duped.  But, I say we should try it.  Even if that happens, I think we'll be alright.  I think things will work out just fine.  I've been thinking about this, and I even have come up with a name for this proposal.  The name for these new banks would be "money market funds".

Wait.  Maybe you object.  We already have a thing called money market funds, and they are exactly the opposite of this.  They aren't leveraged at all.  They are generally very safe.  Don't they basically meet my description, though?

Oh, the leverage thing?  Well, a bank is 90% leveraged because they have 10% in equity capital and 90% in deposits (which are liabilities to a bank).  A money market fund has 100% deposits.  The only reason we call it unleveraged is because money market funds don't have FDIC insurance.  FDIC is a magic formula that turns equity into liabilities.

Safety?  How many failed banks required FDIC actions after 2007?  Hundreds?  How many money market funds?  As far as I know, just one, at the height of the crisis when CPI prices collapsed by 2% in a single quarter - the Reserve Primary Fund.  It came up short in the amount of one or two billion dollars.  I believe savers received 99.1 cents on the dollar.

There is about $2.5 trillion parked in money market funds.  And, they invest in reasonable short term investments.  How is this not proof of concept?  What am I missing?  How is FDIC insurance and the complex web of regulation surrounding it in order to maintain safe deposits at commercial banks anything but a kludge intended to maintain an anachronistic set of financial institutions which keep creating systemic risks by mismatching assets and liabilities?

It seems like there is a place in the economy for financial intermediaries that take on credit risk with local entrepreneurs, commercial real estate investors, etc.  It seems like there is the potential for a bank with operational capital to capture a decent profit in that business.  What's the point of having that institution also take in deposits just to buy MBSs, sell and retain long duration mortgages, buy treasuries, etc.?  In a world with money market funds, why does this still exist?  Why shouldn't we have banks that take credit risks, with liabilities and capital that match the maturities and risks of that business, and banks that don't take credit risks, and meet the demands of depositors with short maturities?  Instead, it seems like we are mixing these mismatched assets and liabilities and we are cobbling together a bunch of capital requirements which are determined by the bank's assets, but which really are aimed at meeting the demands of liabilities that really have no business being involved in the funding of those assets.

Is there something I am missing here?

It's not like we would be in some sort of unknown universe without FDIC insurance and capital requirements.  And the downside seems to be that once in a lifetime, if we learn nothing about creating a more stable macro economy, a few savers lose a penny.

Tuesday, June 6, 2017

Housing: Part 234 - Liquidity is a Public Good

Reader Chuck Erickson pointed me to this article, which I had missed.  The article engages in the sort of framing that baffles me regarding the housing market.  I think, at the heart of this problem, is a public confusion about the difference between owning a home and utilizing the services of a home (consuming housing services, or making housing expenditures).

I think this confusion comes, in part, from the fact that homeowners do not make regular rental payments to themselves, but all homeowners have expenses for maintenance and upkeep, and many owners make monthly mortgage payments.  The only difference between owner-occupiers and renters is the fact that there is no cash rent payment.  Both owner-occupiers and landlords have upkeep and financing expenses.  But, these represent a fairly complex set of expenses, including depreciation, which owner-occupiers mostly replace with very imperfect heuristics about cash expenses.

This is exacerbated by the fact that ownership carries with it real value.  First, there are the various tax benefits.  But, secondly, there is real value in having ownership control over such a personal asset.  So, the act of taking ownership represents a form of consumption that is separate from renting the property.  The owner-occupier gets value from control, and in this way, buying a home really does represent a different type of consumption from renting - it gets placed in a different mental category.  For many households - those with a settled lifestyle and the means to become owners - renting would be a very poor substitute for owning.  So, financial advisors and families generally tend to balk at the notion that homeownership is a financial decision, similar to investing in something like bonds.

At the personal level, this confusion may work fine.  The fact that financial advisors seem to pretty universally treat homeownership as something different than other financial allocations speaks volumes here.  There must not be that much value for most households to be careful about these distinctions, so we tend not to worry about them that much.

But, the problem is, these distinctions are important when it comes to analyzing macro-level markets.  And, since few people have been bothered to think about these distinctions at a personal level, there is no channel through which these distinctions materialize into macro-level discussions.

So, there is an obvious central factor in housing markets that seems to be easily forgotten:  homeowners are housing suppliers.

The article quotes the National Association of Realtors (NAR): ".... contract activity is fading this spring because significantly weak supply levels are spurring deteriorating affordability conditions."

This is technically true.  But, if we think about the difference between owning and using a home, it's a little more complicated.  The affordability problem right now is wholly and completely a rental problem.  It's a problem from lack of supply that is raising the cost of utilizing housing services.  There is no affordability problem for homeownership.  Practically any house you view at Zillow will have a much higher rental value than a mortgage expense - especially at the low end of the market where home buyers would have marginal credit.  There is absolutely no affordability obstacle to homeownership right now.*

You can spend 40% of your income on rent and Elizabeth Warren isn't going to demand that heads roll, but if you and many of those other renters spend 40% of your incomes on mortgages and then a cyclical downturn leads to defaults on those mortgages, then just turn on C-SPAN and watch out.  There is a natural demand for housing.  We aren't going to force families to live under a bridge to meet some sort of affordability standard.  But we are happy to force them to rent.  We are quite proud of it.  Macroprudence, we call it.  But, there can't be a natural supply of housing if we legally obstruct it - either in real terms in the Closed Access urban planning departments that block actual building, or in nominal terms in the national mortgage market that blocks funding.

There is a source of supply from landlords, which has been quite active.  But, since shifting from owning to renting means that a household loses that control value, and since we rain largesse down on owners, we have two markets - an owner-occupier market, where the demand curve shifts right, and the renter market, where the demand curve shifts left.  And, we have added an additional rightward shift in owner-occupier demand because the obstructed mortgage market means that interest rates are low and true returns to homeownership are kept high.  Owner-occupiers might have higher imputed rents, but they never pay themselves that rent, and they get a boost in the yield of their investment because regulators are keeping the riff-raff out of the ownership market.  In this way, they are kind of like the banana plantation owner without the liquid market.  They have high returns, but those returns can only come from ownership.  They can't be realized as capital gains.  Those who bought when the market was liquid, just before the bust, thus, have capital losses.  (And, of course, the investor buyers get blamed for driving up prices, even though the thing keeping buyers out is clearly the ability to get any mortgage, not the cost of a mortgage that has been offered.)

In addition to bemoaning the lack of supply and "affordability" problems, the article blames a shortfall of buildable land in the high priced cities.  You know, those cities where the planning department is just begging developers to come in a create supply, and the builders just shrug and say, "Sorry, there's just no place where we can build."  Those cities.  (It seems like it must be true, though doesn't it?  It seems so plausible.)

The article ends:
Whatever happens, it is apparent that housing dynamics (price and quantity) is not supporting a growing population living in the traditional array of housing arrangements. More unconventional housing arrangements (compared to history) appear to be operational, either by economic choice (housing affordability) or some other combination of reasons.
The answer to this problems is clear, and it has nothing to do with affordability, from an ownership standpoint.  The answer to the problem is that liquidity is a public good, and since we determined to learn all the wrong lessons from the housing boom and bust, we have insisted on imposing a liquidity crisis on ourselves.  This happened in acute form in 2007 and 2008 as credit market dynamics and the money supply were shifted to the point of panic.  And, it has happened since then in mortgage markets in more chronic form as regulatory pressures and federal control of the GSEs has pushed average approved FICO scores up by 40 to 50 points above any previous standard.**

Now, real estate has never been a particularly liquid market, so that the main reason a household would choose to buy instead of renting is how long they intend to stay in the home.  If it is long enough to justify the transaction costs, then generally you should own.  To the extent that there was ever an issue with affordability, it had to do with the fact that leveraged ownership required high cash outlays because mortgages generally require the inflation premium to be paid in cash while homeownership earns its inflation premium as unrealized capital gains over time.  There is a natural savings to ownership because of the control premium and because much of the expense is in the form of depreciation, which allows for some deferred costs.  Because of the confusions mentioned above, this has gotten filtered through public perception as if the affordability problem somehow comes from owning being inherently more expensive than the alternative.  This is just not the case in a low inflation environment, and it certainly isn't the case when implicit returns to homeownership are excessively high because of policies that limit access and liquidity in housing markets, like what we have now.

In effect, what we have done is analogous to closing down the stock exchanges as a matter of public policy.  Equity values would obviously drop like a rock in that scenario.  That is because liquidity is a public good.  Equities are worth more now because liquidity has real value.  We have private and public financial institutions that provide that liquidity, so equity owners demand lower returns on their investments, which means that prices for equities are higher.

Now, imagine if we closed down the stock exchanges and took away that liquidity, and if we were oblivious to the effects of what we had done.  Many people who might own a few shares of Amazon today would be locked out of equity ownership in that context.  We might complain that equity ownership was unaffordable for many people.  It would be.  Even though the market value of Amazon would be lower.

While equity owners would be earning higher profits for their investments, there would be an affordability problem for consumers - those using the services provided by those firms.  Those higher profits would come from higher prices for their goods and services.  There would be an "affordability" problem.  Consumers would be worse off.

We would all simply be worse off in that world.  Except that those who had the wherewithal to make private equity investments in equities would earn much higher returns on their investments while everyone else would be stuck in more accessible securities with lower returns.  (Huh, fixed income returns since the end of the housing boom have been mysteriously low.  What a coincidence.)  As ubiquitous as the complaints about bubbles and hot markets are, I'm afraid we are at a point in history where this would be considered an improvement.  In fact, I think this is basically our problem.

In this analogy, homeowners are like the equity owners, and tenants (both owner-occupiers and renters) are like the customers.  Our confusion about homeownership does such a number on our understanding of the housing market, that the way we talk about housing markets is the equivalent of seeing high prices for corporate goods and services and complaining that there is an affordability problem for shareholders.

The solution to that problem in equities would be to open the stock markets back up.  This would democratize ownership, bring in competition, bring prices on goods and services down, bring profits down, and raise equity prices.  This is what needs to happen in housing.

You want home prices to decline, lets get rid of the tax benefits that amount to a 25% premium on aggregate home values.  Maintaining that regime while we fret about bubbles, about the measly quarter point or so interest rate discount created by the GSEs, and about affordability, is dumb.  The causes of the problem here are right in front of our eyes, and they are not subtle.  We are doing this to ourselves.  And we have been casting blame and fear in all the wrong directions.


PS.  This may be a good post for feedback.  Am I starting to write in a sort of idiosyncratic language that is impossible to follow, or are the concepts above somewhat accessible?


* This isn't true in Closed Access cities.  In those cities, mortgage expenses tend to be higher than rental expenses, especially when you factor in cost of ownership.  That is because Closed Access houses don't just represent the ownership of existing shelter.  Rents there have a growth rate.  These are like buying an early stage growth stock.  Much of the value comes from owning future limited access to a prime location in an increasingly segregated country.  They are long positions in systematic political exclusion.  They are the result of marrying the value of land access as in a banana republic with the liquid markets of a developed economy.  A sort of meritocratic elitism available for sale to the highest bidder.  Heirs to banana plantations are local elites, but in return, they must be in the banana business because their ownership rights are personal, not universal (see North, Wallis & Weingast).  Heirs to Closed Access real estate can sell their little housing services plantations to aspirational young programmers and designers, venture capitalists and investment bankers, and invest their gains in other assets or retire to the mountains somewhere.

** Here's where you tug at your pipe and explain that back in your day, home buyers saved for years first, always put 20% down, walked uphill both ways in the snow, and there were never any financial crises.  And, you knew who you were then.  Girls were girls and men were men.  Mister, we could use a man like Herbert Hoover again.  Didn't need no welfare state.  Everybody pulled his weight.  Gee, our old LaSalle ran great.  Those were the days...  There was probably buildable land in the big cities then too.

Thursday, June 1, 2017

Housing: Part 233 - Is the Housing Bubble meme just one big Gish Gallop?

There is one irrefutable fact that we can all agree is true: Home prices were very high in parts of the US in the 2000s, and continue to be high in some cities, as well as in parts of several other developed economies.

We can ask the question, is this because of supply side factors (limited access to valuable real estate) or demand side factors (tax benefits to homeowners, loose monetary policy, frothy mortgage markets, speculative frenzy, etc.)  This is what is so odd about public consensus on this topic.  We have never really asked this question.  Yet, the supply side problem is embedded in all of the demand side explanations about housing bubbles.  I don't think there is any disagreement that for those demand side factors to cause a bubble, there has to be inelastic supply.  So, the supply side explanation for housing bubbles is imbedded in the demand side explanations, and then everyone goes galloping off with demand side explanations, as if those are the important factors.  The premise has been predetermined and the conclusion arises entirely from the premise.  This is begging the question.

Isn't it strange that there isn't any particular homogeneity in the demand side factors among the various places with housing price concerns?  Fixed versus adjustable rates, long term amortization versus short term with balloon payments, different central banks, public guarantee programs versus private markets, recourse versus non-recourse loans, etc.  So, in the US, Canada, Australia, UK, France, etc., a consensus builds around whatever the local set of demand side factors is, and blames those for the "bubble", even though they are different in every location.  Of course, those dastardly foreign buyers are always a demand-side factor.

The bias here is extreme.  The Financial Crisis Inquiry Report by the federal commission on the causes of the financial crisis (the FCIC) is a great example of this.  It's a great summary of the boom and bust.  There is a lot of information in there, presented well.  Yet, it simply treats the issue as a problem of excessive lending and speculation, a priori.  As far as I can tell, limits to urban housing supply are mentioned once, briefly, in one of the dissents at the back of the report.

Now, even if one insists on focusing on the demand side and on the brief spike in prices in the Contagion cities, where the argument for an unsustainable bubble is strongest, at the center of that story are millions of Closed Access housing refugees flooding out of the Closed Access cities and into the Contagion cities.  A lack of urban housing is the core causal factor even in the Contagion bubble.  The report makes no mention of this.

What we get, instead, is just a litany of anecdotes and descriptions of lending and speculating activities, with various amounts of recklessness or fraud, and it is simply assumed that these anecdotes add up to foundational causation.  The report is similar to many of the popular books about the crisis, which are collections of narratives about the various players and agents in the crisis.  These books treat every action from developments with the GSEs a half century ago to the last desperate CDO packages in 2007 as "another brick in the wall".  The table of contents of these books look something like this:

"A Report on the Failed Harvest"
Chapter 1: Witches Throughout History
Chapter 2: Recent Carelessness about Witches in Our Midst
Chapter 3: Why the Gods are Angry with Local Dissidents
Chapter 4: What the Heretics Have Wrought for All of Us

One assumption at the heart of this bias is that debt can largely be described as a tool for leverage, so that increased use of debt is a sign of recklessness.  As with so many issues in finance, this conventional treatment turns reality 180 degrees on its head.  It is true that a buildup of debt creates systemic risk.  But, debt builds up because debt buyers are seeking safety.  Banks aren't leveraged because of demand for high risk capital.  They are leveraged because there are trillions of dollars worth of cash that demand risk free low returns in the form of deposits.  It wasn't demand for the residual  piece of private securitizations that drove that market.  It was demand for AAA securities.

We can see this clearly in industries that do not have capital regulations.  The relationship between risk and leverage is quite clear.  The most leveraged firms are the safest firms - like regulated utilities.  They don't issue debt because equity buyers invest in utilities looking for risk.  They issue debt because they are in a position to offer debt with very low risk, and the demand for that is great enough that they can earn profits by being a source of fixed income for low risk investors while their equity continues to be fairly low risk.  This seems obvious to me.  The difference between how debt arises in private markets and how leverage is described in our conventional macro-level narratives is stark.

A small example of this broad sense of question begging is in the FCIC report, on pages 9-10.
One of the first places to see the bad lending practices envelop an entire market was Cleveland, Ohio. From 1989 to 1999, home prices in Cleveland rose 66%, climbing from a median of 75,200 to 125,100, while home prices nationally rose about 49% in those same years; at the same time, the city’s unemployment rate, ranging from 5.8% in 1990 to 4.2% in 1999, more or less tracked the broader U.S. pattern. James Rokakis, the longtime county treasurer of Cuyahoga County, where Cleveland is located, told the Commission that the region’s housing market was juiced by “flipping on mega-steroids,” with rings of real estate agents, appraisers, and loan originators earning fees on each transaction and feeding the securitized loans to Wall Street. City officials began to hear reports that these activities were being propelled by new kinds of nontraditional loans that enabled investors to buy properties with little or no money down and gave homeowners the ability to refinance their houses, regardless of whether they could afford to repay the loans. Foreclosures shot up in Cuyahoga County from 3,500 a year in 1995 to 7,000 a year in 2000.  Rokakis and other public officials watched as families who had lived for years in modest residences lost their homes. After they were gone, many homes were ultimately abandoned, vandalized, and then stripped bare, as scavengers ripped away their copper pipes and aluminum siding to sell for scrap.
Pretty damning stuff, huh.  Same ol', same ol'.  Of course an economy filled with this sort of predation is asking for comeuppance, right?

Source
Here is a graph of home prices among cities that aren't Closed Access or Contagion cities, compared to Cleveland.  Cleveland is the thick black line.

You could use the index for Cleveland home prices from 1989 to 2005 as a straight edge.  It is difficult to find a single major housing market that was more subdued during this period than Cleveland.  This is exactly the effect we should expect from demand side factors where supply isn't a problem - "flipping on mega-steroids" as the report describes it.

Think about it.  Take any stochastic market that might be described as a random walk in various ways.  Look at the history of that market.  There will be times where prices or quantities will be higher or lower, lending will be looser or tighter, foreclosures will be higher or lower.  The way this issue is treated, all of those markets are taken as evidence of the predetermined premise and conclusion.

See?  In this random market, there was a point in time where there were more foreclosures than there had been at another point in time!  Ergo, changing foreclosures caused the thing we are concerned about.

But, shouldn't the fact that nothing happened in Cleveland regarding price levels mean that this example is a mitigating piece of evidence?  It would be if we were actually engaged in a review of the evidence.  But, we are not.  The commission is simply galloping through a set of anecdotes in defense of our priors.

Thursday, May 25, 2017

Housing: Part 232 - Credit supply, housing supply, and financial crises.

Credit causes financial crises.  How do we know?  Because that is our set of possible outcomes.  Mian, Sufi, and Verner have a new paper out, titled, "Household Debt and Business Cycles Worldwide". (HT: John Wake)
We group theories explaining the rise in household debt into two broad categories: models based on credit demand shocks and models based on credit supply shocks.
They find that when household debt rises, this is associated with a temporary rise in consumption that is followed by a drop in GDP growth.

They dismiss a rational expectations credit demand shock cause because this would mean that higher debt levels are based on optimism about future economic growth, and that doesn't jibe with the predictable decline in GDP growth that happens after household debt grows and the low interest rates that tend to coincide with these periods of rising debt.

What if we expand the set of possible causes to include supply constraints?  Supply constraints lead to rising home prices in cities with productive employment.  The debt is a result of households buying access to constrained future production.  This is why rising household debt is related to low interest rates, rising home prices, and subsequent declining growth rates.

The bidders on restricted housing do have rational expectations for their own rising incomes.  Incomes are rising in those cities.  It is their countrymen who are denied access to those local economies who have stagnant incomes.

Since the credit demand shock story fails this test, MS&V can attribute these results to credit supply shocks, which they attribute to behavioral biases among lenders.

They also note that the relationship is non-linear.  Higher debt/GDP ratios lead to falling GDP growth but lower debt/GDP ratios don't lead to rising GDP growth.  This, again, comports with a housing supply cause.  Elastic housing supply simply allows housing to continue to expand at the cost of construction.  There is a floor on home prices in a functional economy.  Inelastic housing supply where potential incomes are high causes prices and debt to rise and crimps economic opportunity and growth.

It is odd that the supply issue is so invisible in these academic discussions, because, first, it is such an obvious problem right now.  This is not an unknown issue.  And, second, it is generally accepted that for home prices to rise excessively, supply needs to be inelastic.  Even these credit shock models can only cause these results when housing supply is inelastic.  The supply problem is built into the models, at some level.  It's really a sort of rhetorical issue that it isn't allowed to be causal.

Of course, as is the norm on these papers, amid extensive discussions of the role of price expectations in borrower behavior, rent is simply not mentioned as a determining factor in home prices or expected future home prices.  A text search for rent comes up empty.

This leads to a fundamental difference in thinking as the business cycle proceeds.  If we think of the debt as a product of a credit supply shock and overly optimistic lenders and speculators, then their optimism is the source of the problem.  In the Great Recession, this reached outrageous levels by September 2008 when the Fed was still bracing against inflation after home prices had dropped by more than 20% and were still falling by about 1% monthly, nationwide, and the public was beside itself because we were "bailing out" the ones that did this to us.  But, the key period is really back in the 2006-2007 period.

The sharp decline in housing starts and residential investment was welcomed, because obviously the lenders and speculators were overfunding new building.  The initial declines in GDP growth were accepted because, obviously, all that credit had led to overconsumption which needed to calm down.  And, eventually the collapse of the private securitization market - a massive hit to nominal growth - was seen as medicine well-taken, and the GSEs were castigated for attempting to make up for it - just more greedy lenders, and weren't they the problem to begin with?

Long term interest rates which remained very low throughout that series of events, because there was already a flight to safety, and already home equity was not considered safe.  Since we are so strongly led to see credit as causal, this looked like a credit supply phenomenon, and those low rates were interpreted to be stimulative.  It's the central bank and our collective notion of acceptable public policy that has a behavioral bias.  Those low rates were shouting that bad things were on the horizon.  Some will find this unbelievable, but I think that if the Fed had lowered rates in late 2005, and kept the Fed Funds rate at, say, 4%, long term rates would have moved higher, residential investment would have stabilized, buyers would have returned to the housing market, and the CDO boom would never have occurred.  The CDO boom was a product of the flight to safety, both by investors and by home owners fleeing the housing market.  A credit supply shock view meant that we saw a flight from the housing market as a positive - a correction.  But, a negative housing supply shock view would have properly led us to notice that was a sign of severe dislocation.

It seems to me that, in practice, behavioral finance is simply collective attribution error.  We were convinced that there were these massive forces of irrational actors in the marketplace, and given any support, they would re-enter the housing market and push everything out of whack.  MS&V attribute the end of the boom to changing sentiment.  Surely this is true.  The difference in interpretation here is whether we encourage that change in sentiment to disastrous ends or work to counter it and stabilize it.  At that point, monetary and credit policy become endogenous, and our interpretations of these cycles become self-fulfilling prophecies.  They note, by the way, that these crises tend to be worse in economies with constrained monetary policy.  Yet, since the cause of the crises is determined to be excess credit, this interpretation of the cycle leads us to put self-imposed limits on monetary and credit policy.  With that interpretation, it would seem like madness to try to provide stability if that is only going to encourage more borrowing.

MS&V note that GDP forecasts tend to be too optimistic going into the bust, in that they don't reflect what MS&V find to be predictable declines after the boom in household debt.  To the point above, it seems that forecasts which did shade lower would also become endogenous, because this would encourage more growth oriented monetary and credit policies.  I wonder if forecasts in 2006 had been lower, would we have accepted looser monetary policy?  I'm not sure we would have.  The drop in growth comes from this paradigm that views credit as a disease and stability as dangerous.  The drop in growth was a choice, even if it was a choice we didn't admit or understand we were making.

It is telling that the howls of protest in late 2008 weren't complaints that stabilizing monetary policy had been tardy.  The complaints were that policy should have been tighter in 2004 or 2006 or 2008.  And the chorus of ad hoc inflation phobia that claimed inflation was actually high in 2004 and 2005 if you counted home prices as part of the basket of consumer prices suddenly turned to silence when home prices were dropping by double digits.  To do anything about that "deflation" would be a "bail out" don't ya know?  And it would only encourage that dangerous credit supply that leads to crises.  The credit supply thesis has an endogeneity problem.

Maybe you could say the housing supply thesis has an endogeneity problem too, and that Canada, Australia, etc. are just kicking the debt can down the road.  At least their result has option value.

Wednesday, May 24, 2017

Housing: Part 231 - Bloomberg to Canada: Time to Party Like It's 2008!

The article's title is "Canada Must Deflate Its Housing Bubble", from the editors.  And it is a panoply of the errors that led us to our 2008 debacle.

The problem is home prices.  Period.  There is no other reason to demand tight money in Canada.  Inflation has been moderate for years, unemployment has basically been flat at around 7% since 2012 (still 1% above the pre-2008 bottom), and, since 2012, annual nominal GDP growth has ranged between 0% and 5%.

High home prices are blamed on "foreign money, local speculation and abundant credit".  No mention of supply constraints.  It would take a decline of 40% for Toronto home prices to fall back to historical norms relative to incomes, according to the article.

Just as in the US, in practice what Bloomberg is calling for is to kneecap the economy until they get the housing collapse they think they need.  A 10% or 20% or more collapse in housing prices will be seen as success - a "correction".

"Granted, the bubble bears little resemblance to the U.S. subprime boom that triggered the global financial crisis." says the article.  Except that it does.  The resemblance is just in the place where Bloomberg isn't looking.  There is little resemblance from a demand side (credit) perspective because this is a supply problem, and in every country people collectively view what is going on and blame it on whatever happens to be the credit and monetary regime in place at the time.  Homes always require a healthy credit market, and when home prices are high, unsurprisingly, credit markets are always active.  You would think the lack of a resemblance would be a clue that credit and speculation aren't the fundamental causes of the price boom, but the blinders are just too strong on this issue.

That being said, the structure of the private securitizations market in the US was especially primed for a vicious cycle once expectations turned south.  Canada has a better banking system, so a financial crisis is less likely.  If they go down this path, it will be interesting to see how different it will be from the US contraction.

The Bank of Canada didn't take Bloomberg's advice, and signaled that they will keep the policy rate at 0.5% today.  Good for them.  As chatter about a housing bubble continues, it bears watching.

Tuesday, May 23, 2017

Housing: Part 230 - Supply and Demand during a housing boom.

One aspect of a hot real estate market that is thought to lead to cyclical volatility is the wealth effect of rising prices.  Existing homeowners get an income boost from rising capital gains in their homes.  This shifts the demand curve out because existing home owners can use their newfound equity to buy up into the hot market.  It also shifts the supply curve down because some households who might have had to sell their homes due to temporary financial stress can now tap home equity in order to continue making mortgage payments.

These are legitimate factors that might feed a bubble.  But, I think there is a significant mitigating factor - outmigration.  I think this factor might be overlooked, because we tend to model markets in a ceteris paribus framework, and the way that this factor mitigates the bubble is through a shift in the market itself, as former homeowners sell and move away from the local market.

This first chart is the estimate of population shifts from IRS data.  This is net domestic migration into and out of the Closed Access and Contagion cities since 1995.  This roughly matches the net domestic migration we see in the ACS data that begins in 2005, specifically for homeowners.  There was a buildup of migration, peaking around 2004 or 2005 at 1.5% or more of the local population.

In the Closed Access cities, this means that at the peak of prices and sales, there was selling pressure that amounted to more than 1.5% of existing units each year.  That's a hefty mitigating factor.

Usually, home sales volume runs about 5% of the existing stock.  (I'm not sure why the Zillow measure shown here shows such a decline in 2016.  NAR existing home sales haven't declined like this.)  That bumped up to about 7% during the boom.  Sales turnover was higher in the Contagion cities, but the Closed Access cities tended to run near the national average.


Data from Zillow
This means that about 1/4 of home sales in the Closed Access cities were from homeowners selling out of the market and moving out of town.  That's a lot of selling pressure.  This doesn't include households that might have sold properties and remained in the city as tenants.

There was a sharp jump in privately securitized mortgages in 2004-2006, and there was a jump in home price appreciation in 2004 and 2005, which leveled off in 2006.  We tend to attribute those 2004-2005 gains to the new, more flexible mortgages, and certainly they were a factor.

But, the degree to which that new demand from buyers flowed to price is dependent on how elastic this migration-related supply was.  Maybe prices would have gone up another 30% if this outmigration hadn't kicked in.  Or, maybe one reason prices accelerated in 2004 and 2005 was that the "low hanging fruit" had been picked out of Closed Access markets, and the homeowners who were easily induced to migrate had already sold and left, and supply shifted out less over time as the population of potential movers was tapped.  Or, maybe we overestimate the effect of demand on these markets in general, and home prices at the MSA level are more bound to the present value of future rents than we give them credit for.  The quantitative answers to these questions are beyond my abilities, but they seem to be questions that have not been asked nearly enough because changes in the mortgage market have taken center stage while the sharp shifts in migration during the boom were less directly visible.

In any case, it seems to me that the degree to which Closed Access prices remained close to a reasonable valuation vs. being pushed to unsustainable or irrational levels, depends more on the elasticity of supply coming from those existing owners than it does on the new demand that might have been facilitated by the new borrowers.

The Contagion cities are the mirror image of the Closed Access cities, so their markets were characterized more by new demand.  But, we can see this migration-supply factor coming along even there, beginning in 2005.  The first shift in migration in the Contagion cities in 2005 was an upshift in out-migration, even as migration from the Closed Access cities remained strong.  Then, in 2006, even while the private securitization boom remained strong, net migration really dropped in Contagion cities, and home prices leveled out there.

We can also see a mitigating factor across cities.  Portland, OR took in a lot of California migrants during the boom, like Phoenix, but its total population growth was more subdued and home prices there were less volatile.  This is mostly because home prices there started out higher.  They peaked about the same level in Phoenix and Portland.  This is what we would expect to see if migratory shifts on the margin, regulated by the cost of housing relative to the Closed Access source cities, were an important factor in finding an equilibrium price.

Added:  Another comparison we might make with the 1-1.5% rate of Closed Access out-migration is that first time homeowners tend to represent just over 1% of households per year.  (It has been lower than that during our decade of demand deprivation.)  And, during the housing boom, homeownership was rising by about 0.5% per year.  It has fallen at about that same rate since then.  The rate of out-migration from Closed Access cities during the boom was larger than either of those measures.

Friday, May 19, 2017

Housing: Part 229 - Public policy, behavioral finance, and attribution error

Robert Shiller has a new post up. (HT: EV)  He is discussing the housing bubble, how home prices are moving up again, and what a mystery it is:
The problem for economists is that these changes don’t correspond to movements in the usual suspects: interest rates, building costs, population or rents.
I happen to have a book or two coming out that explains how home prices were entirely explained by interest rates, building costs, population, and rents.  Anyone who reads this blog knows that the evidence in this regard isn't marginal.  In all these factors, the shocks were extreme.  (Regarding building costs, in most areas these were tame, and home prices were tame.  In Closed Access cities they mostly are related to political obstruction.  eg. How much would it cost to build a 40 unit condo in the Mission District in San Francisco?  Show your work.)

I hope this whole episode helps to bring real estate finance into the 21 century.  I have been treating housing, as an asset class, like an index.  There could be a real estate index just as there is an S&P 500 or a Dow Jones index.  Dr. Shiller, in fact, has introduced many indexes that move us in that direction.  Because we have these indexes in equities, it is very common to see that asset class treated as an entity with measurable aggregate behaviors.  The interesting thing is that we seem to need to have the indexes in order to help us think that way.

There are indexes for bond prices, so if I ask you what the going rate for 10 year bonds is, you look in the Wall Street Journal and say, "Looks like it's at 2.4% today."  Tomorrow will be different.

But, in real estate, you ask someone at a real estate fund what the current return is on new developments, they say, "Well, the investment committee has it at 5%."  Then, you see them 6 months later, and they'll say, "It looks like the investment committee will be moving the cap rate down to 4%.  This will lower our income, but it will open up a lot of new investment opportunities for the fund."  OK.

It will be a sign of progress if when I ask you what the current return on real estate is, you look it up in the Wall Street Journal.  Returns on investment aren't a policy decision in a developed market.  They emerge.  But, we are probably a long way from that possibility.  Now, many insiders would probably say this is ivory tower naivety.  But, before there was a Dow Jones Industrial Average, it would have seemed just as naïve to think that you could stick a restaurant group, a steel fabricator, and a hundred other firms into a bucket and come out with anything meaningful.  Now, there are massive parts of the investment market that hardly do anything else.

In the meantime, we have a bunch of economists looking at national data that doesn't capture any of the inter-MSA details that are defining our market.  And, the real estate sector itself is heavily focused on extremely local factors that largely determine the idiosyncratic returns of each individual project.  Localized public sentiment drives those markets, and the entry of pesky amateur investors is naturally seen as problematic.  It is very easy for those to groups, each missing the core part of the story - the difference between MSAs - to come to agreement that a bunch of speculators must be screwing up the buyers' market.

I suppose that having more developed measures of value doesn't stop every guy at the end of the bar and every Austrian Business Cycle proponent from calling the equity markets bubbles, too.  So, maybe this isn't the problem.  Although, I think the public sentiment created by attribution error in real estate markets is somewhat contagious, and is partly to blame here too.  Coincidentally (?) a favorite tool of the equity bubble mongers is Dr. Shiller's CAPE measure.

Tuesday, May 16, 2017

Housing: Part 228 - International and Domestic Migration

One reason we might excuse Closed Access cities for the large amount of migration outflows they produce is because they have long been entry points for international immigrants.  This is still true today.  But according to Census Bureau estimates, they are not much different than the other major cities.

Net international migration into Closed Access cities is about the same rate as the Contagion and Open Access cities.  What makes the Closed Access cities Closed Access cities is that they generally can't even manage to house their own offspring.