Friday, December 13, 2019

November 2019 CPI inflation

Inflation remains in a holding pattern - about 2.3% core inflation, which consists of 3.3% shelter inflation and 1.6% non-shelter core inflation.

The yield curve is, similarly, in a holding pattern.  How this plays out will depend on unanticipated real shocks over time and the future bias of the Federal Reserve.  My inclination is to continue to believe the short term outcome will mostly accrue to declining Treasury yields and the depth of that decline will greatly depend on the willingness of the Federal Reserve to support short term NGDP growth.  The slow moving train wreck (or not) continues.  As long as non-shelter core inflation remains below target and the yield curve remains effectively inverted, my expectations will be somewhat bearish.

Wednesday, December 11, 2019

Momentum in equities when reputational risks are high

This blog originally was supposed to mostly be about investing tactics, but I got sidetracked when I discovered the housing issue that has ended up taking over.

Here is a post on the topic I used to dwell on - tactical investing for high returns by being insensitive to reputational risk. A recent example of this issue is Hovnanian Enterprises, a major homebuilder that is still so down on its luck as a result of the housing bust that as recently as July, it was being threatened with delisting from the NYSE.

All along, they have mostly just needed the market in new housing to recover.  They need revenue to fully regrow back into the financial and organizational framework that had developed under the Hovnanian name in 2005.  They have so much organizational and financial leverage that small increases in revenue will translate into large increases in market capitalization.  This will further be enhanced by knock-on effects of recapturing the value of tax assets and written down developments, and paying or refinancing debt at more favorable terms.

After the July delisting notice, Hovnanian released results of two quarters which have provided strong evidence that revenues will be growing and these positive developments will be coming.  Normally, efficient markets would internalize these developments immediately, and a firm's share price would immediately jump to a level reflecting the new expectations.  Financial research has shown a momentum effect.  In other words, a trend in share prices doesn't happen 100% at once.  It mostly happens at once, but there does appear to be some predictable serial correlation.  A recent trend shift or a recent positive or negative shock to a share price will tend to continue in the short term, to a certain extent.

But, in unusual positions where reputational risk has become acute, this momentum effect can become very large.  I am sure there were some institutional holders who were forced by their own rules to unload shares when Hovnanian received the delisting notice.  At some point, the reputational danger of having owned a stock or of recommending a stock, can overwhelm the objective value of it.  In these cases, the market for that equity becomes very tepid.  It's sort of like very thirsty wildebeests coming upon an oasis.  They very understandably approach it carefully at first, not sure if it is safe.  But, almost inevitably, the whole herd will be lined up at the shore, sucking up water vigorously.  To someone who happens to have been at that oasis when the herd showed up and recognizes already that there are no crocodiles, this process can seem excruciatingly slow.

Here is the Hovnanian stock chart from the past 6 months.  The positive shocks are noticeable after each quarterly announcement, but even those shocks took place over several days.  Following the initial quarterly shock, there was further upward drift for some time.  The more recent positive shock also took several days to play out.  It will be interesting to see if a positive drift follows this shock also.  If revenues do climb from here, the share value is likely many times the current market value.  Getting from here to there will reflect a combination of objective results, expectations, and changing reputational risks.  It is the implicit position on reputational risks that can provide very high returns over time, but it comes with the occasional risk of losses, and those losses will necessarily be devastating and embarrassing.


Saturday, November 30, 2019

Great Review of Shut Out in the Economic Record

Declan Trott, an economist with Australia's Department of the Treasury, has written a very nice review of Shut Out for Economic Record, a journal of the Economic Society of Australia.  It offers a concise and well-written overview of the book's thesis.

Unfortunately, there is a pretty hefty paywall.

A couple of brief excerpts:
But what if this fall in prices were not the inevitable bursting of a bubble, but an unnecessary and self-inflicted panic? This is Kevin Erdmann's contention. . . This is a provocative thesis, not to be accepted lightly.  Yet Erdmann has assembled a formidable battery of data and argument to support it.
. . .
It is the detailed documentation of the (housing bust), and the treatment of the entire episode as a panic rather than a bubble, that is Shut Out's key contribution relative to the academic literature. 
. . .
And, I was flattered by his closing comment.
As a member of the PhD tribe, I occasionally found myself wishing for more equations and regression coefficients, and simpler charts.  But still, somebody should give him an honorary degree. 

That sounds just like my editors and internal reviewers.  Why does everyone hate complicated charts so much? Anyway, this review was a pleasant Thanksgiving surprise.

Saturday, November 16, 2019

A postscript on the review of the crisis

Upon re-reading my summary of the housing bubble and financial crisis, I suspect some skeptical readers might find my summary lacking because it may seem as if I am writing off what was clearly a boom in residential investment and home building.  It may be worth a clarification.

There certainly was an increase in building from the mid-1990s to the mid-2000s.  But, in terms of either the number of homes per capita or the rate at which they were being built, nothing was outside of historical norms.  Residential investment seemed high, but part of what is accounted for as residential investment is brokers commissions, which don't really add to the housing stock.  Brokers commissions were high, however, because the shortage of urban housing made existing homes too expensive.  Subtracting commissions out of residential investment reveals a long term decline that was briefly interrupted with rates of residential investment similar to the 1970s.

There wasn't really a national building boom.  There was a moderate rise in building.  The reason it seemed so disruptive is that the Closed Access cities can't allow a sustainable amount of building.

That means that any time Americans try to increase our real consumption of housing at the same pace that our incomes are rising, a disruptive migration event must occur, because if the consumption of housing expands and some cities cannot expand their local stock of housing to accommodate it, those cities must depopulate.  That's what happened before the financial crisis.

Policymakers since then, whether they understand it or not, have been trying to avoid this disruption by either keeping incomes low (through tight monetary policy) or by reducing demand for housing (through tight lending standards).  That has reduced the migration out of the Closed Access cities, but it has come at the expense of living standards for Americans everywhere.

Friday, November 15, 2019

A review of the crisis narrative

Over at econlog, a commenter has asked me for a comprehensive review of the standard narrative and my objections to it.  His summary of the standard narrative is clear and concise, but thorough, and I thought it might make a nice template for posting a summary of my new narrative.

His description of the standard narrative is indented, and my responses are not.
A variety of factors (securitization introducing a principal-agent problem, organizational changes in banks/GSEs, regulatory encouragement, etc.) led to much looser standards for lending. This included:
No-documentation loans.
A growth in subprime lending.
Shrinking requirements on down payments.
These factors were all definitely at work.
This led both to an increase in for-occupancy home purchases by people who used to be renters, and in speculative home purchases (which were now easier to finance, and looked profitable as home prices were rising).
The private securitization boom, which is associated with all of these developments, lasted from roughly the end of 2003 to mid 2007.  Homeownership rates had been increasing since the mid-1990s, but they peaked near the beginning of that period, and then declined.  The relatively high level of homeownership was generally due to age demographics.  Homeownership rates for all working-age groups were about the same they had been in the early 1980s, at the high end of their recent ranges, but not unprecedented, and by the end of the subprime boom they were back in the middle of the long term ranges.  American Housing Survey data suggests that this was because, both, the rate of first time homebuyer activity declined, and an increasing number of existing owners sold out.

Of course, someone has to own every home, so this means that investor ownership increased.  In some volatile markets, some of that activity was speculative and ill-considered.  It probably hastened the early defaults in those markets because investors are more likely to default when equity becomes slightly negative than owner-occupiers are.  But, the investor activity was more of an effect of volatile markets than a cause of them.  Prices were nearly topped out by the end of 2005, and most speculative activity happened in 2006 and 2007.

In short, it is implausible to blame speculating investors for the rise in prices from 1997 to 2005 and it is implausible to blame rising homeownership from 1997 to 2004 on the loosening standards of the subprime boom.

So, what did cause rising prices?  In at least 2/3 of the country, prices weren't outside of historical norms relative to rental values.  They were slightly high, which can be explained with low long term real interest rates, but not unusually high.  In 5 primary cities [NYC, LA, Boston, San Francisco (+ San Jose), and San Diego] prices were high because rents were very high and were rising.  Fundamentals fully account for high prices in those cities, and this is more obvious with every passing year.  Their rents are high because they allow an astoundingly low quantity of building.  I call them the Closed Access cities.  Loose lending may have added demand to the buyer market in those cities beyond what was previously possible, but it was generally allowing borrowers with high incomes to buy in cities where rental expenses are also outside historical norms.  Households with lower incomes were flooding out of those cities at the time by the hundreds of thousands each year. 

A smaller set of regions had something more akin to a true bubble - prices that were likely to retract at some point in the natural course of things: Arizona, inland California, Florida, and Nevada.  I call them the Contagion cities.  They were the primary landing ground for the Closed Access outmigrants, and the primary cause of their brief positive spike in home prices was that they were generally overcome by in-migration.  The demand was for actual shelter.  Families were moving to these places, in droves, specifically to drastically lower their housing expenses.  Recently, I have been working on preliminary evidence that during the periods where prices were rising in the Contagion cities, there was no unusual rise in borrowing.  That happened after prices and rates of new building in these regions had peaked.  Borrowing at the state level tends to lag both the building booms and the price spikes.

It would be very difficult for these cities to overbuild because they natural have heavy in-migration, and at the time it was higher than normal.  In fact, at the metropolitan area level, in the 2003-2006 period, rates of building were especially correlated with population growth.  Population growth in Contagion cities suddenly collapsed when the migration event out of the Closed Access cities collapsed.  This was happening by the end of 2006.  By then, the Fed should have been trying to stabilize housing markets, not slow them down. Yet, even in late 2008, the main criticism they faced was that they weren't destabilizing housing and financial markets enough.

The shortage of homes in these cities is the fundamental cause of the housing bubble and ill-informed policy reactions to it caused the financial crisis.
This rise in home prices was not sustainable (80% increase in 6 years, much faster than inflation), and eventually slowed/ended, this happened concurrently with raises in the interest rate (and thus in the rates of adjustable mortgages)
This would not have created a crisis by itself (housing markets have had downturns in the past) except for the fact that many homeowners either:
Couldn’t afford their mortgages and could no longer refinance them using new equity from price appreciation.
Had “negative home equity” and lived in no-recourse states, making it cheaper to default than to keep paying their mortgages.
The Fed had inverted the yield curve by the beginning of 2006.  To the extent that monetary policy is communicated through interest rates, the peak of the housing boom coincides with them.  Adjustable rates have little to do with the default crisis.  Defaults were highly sensitive to cohort (how soon after you borrowed did prices begin to collapse).  2007 was the worst, followed by 2006.  The yield curve was inverted and the short term Fed Funds rate was at or near the 5.25% high point throughout the period when those mortgages were taken out.  Rising rates on adjustable mortgages have nothing to do with the default crisis.

Falling prices (negative equity) were by far the largest factor leading to defaults.  Lending standards were tightened sharply during 2007, so it is true that it was harder for borrowers to refinance.  The drop in homeownership in 2007-2008 was mostly among homeowners with high incomes in the "bubble" areas where prices were collapsing the most sharply.  Declining middle income and lower-middle income homeownership rates were a very lagging event, really not happening until after 2008, after lending standards had been sharply and permanently tightened, which caused a largely unacknowledged second housing collapse that was focused mainly on low tier neighborhoods, and which affected nearly every city in the country.  The bottom of prices around 2012 was not a return to normalcy, it was a self-inflicted collapse in credit constrained markets that were now locked out of mortgage access.
This led to a snowballing increase in delinquency rates which started prior to the crisis and lasted through the recession. It was also unique in that it happened in a correlated fashion across the country, unlike prior downturns which tended to be local.
This then impacted the financial sectors as many instruments built on securitized mortgages were discovered to be worthless, and entire companies went bankrupt.
The fact that it was correlated across the country is a solid signal of how wrong the standard narrative of its causes is.  Cities have huge differences in prices, rents, rates of building, vacancy, etc.  It is implausible that overbuilding or unsustainable prices could have done this. It was the result of national policy choices aimed at doing it, first by tight monetary policy that began to limit liquidity and change sentiment (leading to collapsing new building rates beginning in 2006) and continued to push markets into further disequilibrium as it remained too tight until the end of 2008.  By the end of 2008, lending standards had been tightened (average FICO scores of approved borrowers moved from around 710 to 750 over the course of 2008, a huge shift, which largely remains today). So, from the end of 2008 onward, high tier home prices stabilized but low tier prices had their worst declines after that.

A postscript.

Wednesday, November 13, 2019

Comments on the Quarterly Report on Household Debt and Credit (2019 Q3)

Here are a few updates on the data.

 First, mortgage originations by FICO score.  This continues to remain near levels it has been since 2009.  In fact, the average FICO score of borrowers started moving up in the second quarter of 2007, just before home prices started to collapse.  They basically hit the new plateau in the second quarter of 2009.  As I have shown, much of the devastating loss of equity in entry level homes happened after 2008.

This is the actual cause of the housing bust (and the financial crisis). The general collapse in home prices came after credit tightening, and the continued additional collapse focused on low tier housing came well after credit tightened, after it settled permanently at the new normal.  To this day, the consensus response to that claim is that it had to happen in order to bring credit standards back to normal.  But, borrower standards were normal.  The typical FICO score of borrowers in 2006 was the same as it had been in 1999.  The squeeze continues.

Total mortgages outstanding seems to be settled at about 3-5% annual growth.  And total number of mortgage accounts outstanding fell from about 98 million in 2008 to 81 million in 2013, where it remains.  That would be a bit laggardly in a fully recovered market, but it is very laggardly in a market with a severe shortage of housing and a rent expense problem.

Second chart shows the balance of debt of different types.  Good job America!  We have managed to push all that borrowing out of HELOCs and into credit cards, because the lesson we all learned from the financial crisis was that unsecured debt is preferable to secured debt. I read the terms on my credit cards and I can't help but shout "Stability! Prudence!"  We're so much wiser now.  Kudos everyone.

Remember, if you sell your house short because you're 30% underwater, that's really bad.  But, if you have to sell your house because you hit a rough patch and nobody will lend on more than 80% LTV and/or perfectly documentable income, that's just being reasonable.  If that happens to you, try being a little gracious about it.  It was for your own good, silly.

Third, debt outstanding by age (adjusted to per capita). Some analysis of the crisis sets it up as rich (savers) vs. poor (borrowers).  But, really, the only reason it looks like that is because the crisis was more a matter of old (savers) vs. young (borrowers).  Borrowing was moving up as much for the old as it was for the young, but older borrowers tend to be less leveraged. The older groups have increased their borrowing since the crisis.  That is because they didn't tend to own homes with high leverage during the boom, so they escaped the housing collapse with less damage.  And, that has allowed them to continue borrowing after the boom, because borrowing scales with wealth and income, to a certain extent.  The younger borrowers took a hit in the foreclosure crisis and are now catching up.

Unless there is a return to looser lending, though, it seems like there is a limit to how much catch up can happen.

Tuesday, November 12, 2019

Housing: Part 358 - Sometimes the answer is simple

Elizabeth Warren:
"From our trade agreements to our tax code, we have encouraged companies to invest abroad, ship jobs overseas, and keep wages low."

Bernie Sanders:
"Since Trump was elected, multinational corporations have shipped 185,000 American jobs overseas. That is unacceptable."  
City of San Jose:
San Jose has taken the rare step of publicly opposing the project, saying it would add far too many jobs, exacerbating the region’s housing shortage.  
New York City:
It’s only natural that Amazon saw its promise to create 25,000 jobs as a blessing, for creating jobs is most of what we have ever asked of American companies. But given the realities of our economy — an economy that Amazon is relentlessly and ruthlessly transforming according to its narrow self-interest — it’s also only natural that many New Yorkers wanted nothing to do with it.  

These days, things don't make sense.  Things are said in one context that sharply contradict things said in other contexts.  There is confusion and stress.

It is natural to view this confusion and to conclude that things are complicated.  But, sometimes, things are simple.  Sometimes, things seem complicated because we are blinded to the simple nature of the problem.

To Ptolemy, the solar system was very complicated.

If you walked into an elevator with a simpleton and told them, "You know, the reason the sun moves across the sky is because we are spinning on a sphere.", the simpleton would have said, "Huh. Cool.  I did not know that." and happily exited at his floor.

If you walked into an elevator with Ptolemy, you would have a lot of work to do and many things to explain.  When the door opened, he would have exited unconvinced.  Ptolemy simply knew too much.

Here is a good rule of thumb: When things are complicated, inputs are messy, running at cross purposes, and many factors cancel out other factors.  Complicated contexts don't tend to move to extremes.  What tends to move to extremes is a context dominated by a single factor.  (This also works in equity investments.  Finding small cap stocks with large upside potential usually involves finding firms that have some very large single variable at work.  That is why you can outmaneuver professional analysts.  Professional analysts are paid to know everything.  Their job is to understand complexity.  To paint a picture of all the pieces.  Since overwhelming single factors are rarely certain, and speculators must expect to lose frequently, it is reputationally difficult for analysts to predict extreme valuation moves based on single factors.  If the stock they follow is likely to soon quadruple in value, their intuition will be to say, "It's complicated.")

So, the fact that markets and the economy seem to have some really extreme problems and incoherencies is a signal that the problem is not complicated.  The problem is overwhelmingly due to one factor.

In a sentence, that factor is:  The economy and the housing market of 2005 were what a highly successful economy looks like if our leading economic centers refuse to build more houses, and that economy is almost universally feared and actively avoided.

Monday, November 11, 2019

Mid month Yield Curve Update

Enough has happened in credit markets that I figured it was time to update charts.  The long end of the curve has moved up a bit, which has led to some expressions of relief.  I'm not sure we're totally out of the weeds.

The entire curve has moved up from its lows by about 1/2%.  That's mildly bullish.  It suggests that the market doesn't think the Fed has to react quite as strongly to maintain stability.  But, what would really be bullish is if short term rates were at more like 1% and the long end of the curve would be at 3%+ (circa 2003).  That was a yield curve of a marginally neutral central bank creating stability.  But, because of the housing bubble, very few people believe that about 2003, so it still seems to me that the pressure will be to take a hawkish posture, and eventually, the yield curve will move back down.

The second graph here compares the Fed Funds rate and the 10 year yield from 2004 to the present.  The diagonal lines are my estimation of a functionally inverted yield curve.  While the recent uptick is reassuring, for it to really signal that we are out of the woods, the 10 year yield needs to move up to 3% or more without being followed up by the Fed Funds rate.  Until then, I consider these recent movements to be noise while we are still basically inverted (circa 2006-2007).

One thing to check is housing markets.  The more recovery we see there, the more likely we are to be safe.  That is growth in price, sales, and borrowing.  Rising prices and rising borrowing would signal that the channel for capital to react to low yields by flowing into real estate is operating (though it is hobbled at best in today's regulatory environment).  Rising new sales would signal that financial capital is capable of funding real investment.  In other words, strong home prices would show that prices can react to fundamentals, strong housing starts would show that real investment can react to changing prices, and rising borrowing is the connective tissue for these market responses.  I suspect that an inverted yield curve reflects a breakdown in those mechanisms, which is why it is a good predictor of recessions.

This is not to say that home prices have to move in an ever-rising cycle in order to maintain economic growth.  The problem with housing is constrained supply, through local regulations and now through disastrously tight federal mortgage regulation.  These factors drive up rents, and I suspect also put downward pressure on interest rates, since residential investment should, but can't, be a moderating influence on long term real yields, keeping them from being persistently too high or low.  Building lots of homes would bring down home prices. 

The third graph shows the Fed Funds rate and 10 year yield from 1994 to 2002.  In 1996, the curve flirted with inversion, and the Fed responded by lowering the Fed Funds rate, which was followed by recovery in long term rates.  This happened again in 1999, and at first, the Fed stayed put as long term rates rose, but then it followed them up too aggressively.  By 2000, the recessionary signal was starting to develop.  First, a rising Fed Funds rate pushed the curve to inversion, which became stronger as long term rates declined.  Then, the tepid response meant that the Fed Funds rate declined over the next couple of years, remaining contractionary enough to keep long term rates from rising.  The same thing happened in 2007-2008.

It seems as though, in the 1970s, the Fed generally erred on the dovish side, inflation was getting too high, and the long end of the curve would rise while the Fed deeply inverted the curve.  Since 1980, the Fed has generally erred on the hawkish side, inflation has remained moderate, and recessions have been avoided when the long end was allowed to rise, but have followed when the long end has remained level during inversions.

Of course, this whole tightrope could be avoided if the Fed abandoned interest rates as a communication device and policy tool and instead targeted forward domestic income growth.

Going forward, if the 10 year doesn't rise much from here, then I would expect a typical descent into a contraction, with the Fed following the yield curve back down to zero.  If it does rise from here, up to something above 3%, then either 1996 or 1999 will be a good guide, and either we will avoid contraction altogether or yields will follow the clockwise path similar to the 1999 to 2002 path, and a contraction will eventually happen, but we will get another year or two of expansion first.

I continue to fear that a misunderstanding of the causes of the financial crisis will create pressure both on and off the FOMC to be too hawkish, but I must admit that the Fed was more willing to reverse their recent rate hikes than I had expected them to be, to our benefit. There is some hope that the Fed might continue to be responsive.

Tuesday, November 5, 2019

A look at trends in homeownership.

Here's a new post I have up at the Bridge, at Mercatus.

Here's a chart from it:

The brief summary is that there hasn't been any recovery in homeownership rates at all from the bottom of the housing bust for middle aged households.  The small amount of recovery we have seen recently is all among young households - generally households that were young enough to miss the crisis.

And, of course, I revisit the basic point that it is a myth that there was excessive or unsustainable homeownership during the housing boom.

Here is a Jed Kolko piece at Trulia that adds some interesting details to the story.

Friday, November 1, 2019

October 2019 Yield Curve Update

The yield curve still seems to be following the bearish timeline.  My axioms here are:

1) The true measure of inversion isn't a slope of zero.  At the zero lower bound, it is a slope of a little more than 1% (10 year minus Fed Funds), which declines as the base yield rises.  (At about 5%, meaningful inversion happens at a slop of zero, and higher than that, the slope will tend to become more negative the higher yields are.)

2) The neutral rate is a moving target.  If the Fed drops its target rate too slowly, long term rates will tend to stabilize but not rise, and this usually ends in some sort of contraction.  If the Fed gets ahead of the dropping short term rate, then long term yields will pop up like they did a couple times in the 1990s, and contraction will be avoided.  So, if the scatterplot keeps moving to the left as it did this month, that's bearish.  If it moves up, that's bullish.

The second graph is the Eurodollar yield curve, which continues to move up and down a bit but with a negative short term slope and a pretty flat long term slope.  I expect the short end of this curve to eventually drop below where it was in late August.  It will be good news if it doesn't.