Friday, April 25, 2014

The Peculiarities of the Mortgage Market and More Financial Villains

Many of the problems in the housing market are a product of peculiarities that we take for granted because of mental benchmarking.  One problem that I have mentioned before is that homes are different than most other investments, because we don't tend to treat them as divisible investments.  If you want to purchase a home, it is unusual to be able to buy shares of partial ownership.  Instead, you enter into hedged financial instruments - a home and a related mortgage - and so your personal financial leverage balloons.

We also take for granted the way mortgages are owned.  They have a built in call, generally, where, if rates go down after you take the mortgage, you can just pay the mortgage back at face value (even though its market value, absent the call provision, would be higher than face value) and institute a new mortgage at a lower rate.

But, strangely, this doesn't tend to happen in the other direction if rates go up, the bank also can demand face value.  If rates go up, the mortgage is worth less to the bank.  If they originally had a $100,000 mortgage that earned $6,000 a year when $6,000 was the going rate, now they have a $100,000 mortgage earning $6,000 when $8,000 is the going rate, which means they really have a mortgage that's worth more like $80,000.

But, as far as I know, it is not typical for homeowners in that position to go to the bank and say, "You know, I'm selling the house, and so I'll be paying off the mortgage.  I see the market value is $80,000.  I'll pay you $85,000, and we'll call it a day."  The bank would just say, "Either make the payments or don't, but if you don't we'll just foreclose and pay ourselves face value."  So, a transaction that would be perfectly normal in most financial markets becomes difficult, and leads to all sorts of dislocations.

This is perfectly understandable, and I don't have an obvious way to fix it.  If the bank sold that mortgage to another bank, it would sell at the discounted price.  Corporate bonds can be bought back at a discount because their ownership is diffuse, and there is a marketplace for them.  But, mortgages are either owned by a single bank, or if they are split up into smaller shares, it is as part of a pool of mortgages, so that even though the pool of mortgages could sell at a discount, the individual mortgage can't be removed from the pool for this purpose.

This is especially a problem now, when very low long term interest rates are pushing up the value of homes, and making the price of homes more volatile, like a long-duration bond.  There are plenty of reasons why home prices could reasonably move up 30% - 50%, if we compare them to alternative low risk investments.  The problem is, if the prices do get bid up to those levels, then a homeowner who purchases a home with a large mortgage, will be faced with this dilemma.  If interest rates rise, the intrinsic value of homes will decline.  But, if the homeowner has to move, she will be stuck selling a home with a lower nominal value, but paying off a mortgage at the original face value.  The mortgage does not work as a hedge against a declining sales value of the home when interest rates go up.

(Note that the public programs involving mortgage renegotiations coming out of the recent crisis are not products of the same issue.  Interest rates are still low, so those mortgages would only have impaired value because they are in default and the homes are impaired.  If those mortgages were being paid dependably by the homeowners, they would still have a value near the original face value as marketable securities.)

Institutional Investors

My working theory on the high number of institutional investors in the home market has been that the real estate market was so hobbled by the damaged credit market that home prices have fallen low enough to be valuable, even to buyers without the mortgage tax deduction.

But, I wonder if institutional investors have an advantage in this market.  If low interest rates lead to volatile home values, institutions can raise money on the corporate credit markets, and buy the homes with that capital.  If rising long term interest rates end up pulling home prices down, and the investment firms need to liquidate any real estate holdings at a loss, they will use the proceeds of the sales to buy back some of their bonds at a discount.  To the extent that home values are a product of interest rates, they will have a relatively useful natural hedge.


For mortgaged homeowners, this set of conventions creates a kind of no-win situation when real interest rates are low.  In a high inflation environment, home buyers must commit to buying a large portion of the equity in the house in the early years.  (The real value of the house will tend to grow slowly, while the real value of the outstanding mortgage will decline steeply, because the mortgage payments will be very high and its nominal value will be stable.)  In a low inflation environment, home buyers will be able to qualify for mortgages more easily, but they will be vulnerable to potential drops in nominal home values.

There isn't any organic reason for these risks to exist.  I would expect market conventions to evolve to solve these problems, but I suspect that there is a strong level of inertia because many of these conventions are enforced legally, either through banking regulations or through conventions enforced by the federal mortgage support agencies (Fannie, Freddie, etc.).  These kind of scleroses in contract conventions are a subtle product of standards imposed through public regulation.  I suspect that the costs of this sclerosis are not generally accounted for, if ever, when reviewing the costs and benefits of these regulations, but it isn't difficult for me to imagine that the costs far outweigh any benefits, especially because the costs aren't direct costs, but instead are risks or transactional obstacles that are difficult to manage or quantify.  What would the benefit have been to homeowners, let alone the economy in general, if in 2006 & 2007, mortgages would have been packaged in such a way that they could easily be paid off at market value?


Looking at it this way, the surge in all-cash institutional home buyers could be viewed as a sort of regulatory arbitrage.  Institutional investors are able to capture the excess future expected cash flow of homes without the irregular risk profile that is imposed by the regulated mortgage market.

So, market dynamics are solving a regulatory problem.  Homebuilding is a powerful way to pull production back in time as baby boomers age through their prime productive years and transition into retirement.  Institutional investors are able to step in and help pull home prices up to levels that incentivize that production, where these peculiar risks and recent memories of collapse are dampening homeowner demand.  Home construction still needs to rise.

But, generally, people look at these same facts, and they intuit that homes are not necessarily a safe investment for households, and they see home prices being bid up by institutional investors, and they interpret this to mean that speculators are hurting households by creating a housing bubble.  And, again, we see what a difference a paradigm can make in creating a picture of the world as it is.  Good guy/bad guy framing balances on a knife's edge.  Tyler Cowen says when you use good guy/bad guy narratives, imagine subtracting 15 points from your IQ.  I say that's conservative.  For starters, shortcomings in mental framing don't just create normally distributed errors around a stable ideal.  As with this topic, a slight tweak in the mental framing means one version of this story is really, really wrong.

One reason I tend to dwell on these issues is that the bad guy narrative is so prevalent in financial contexts.  There are so many issues where a slight tweak in the framing creates a substantial speculative opportunity.  I will bet against the bad guy framing every time - I figure a 15 point IQ advantage should be very profitable.  Even in individual stocks, this is fruitful.  If a firm is set up for a highly variable pair of possible binary outcomes, the opportunities that offer huge profit possibilities are frequently those where you take the position of giving management the benefit of the doubt.  If you're wrong 50% of the time, the cynic will hold on to a lot more assets than the naïf will.  So, the trusting positions tend to pay off very well for investors without agency issues, but not for money managers.  I think this explains, partly, why even finance professionals tend to be cynical about finance - it's survivorship bias.

See, there?  With just a slight tweak in framing, and a ready explanation, I just said something that really either has to be insightful and clever, or really, really dumb.  That's why you can build speculative models where you can frequently safely fill in all your ignorance with an EMH assumption, but still expect to capture gains from large disconnections.  Even if inefficiencies are few, they can have unstable equilibria.

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