Thursday, February 12, 2015

Housing Tax Policy, A Series: Part 6 - Interest Rate Levels over time

I used data from the BEA table 7.12 on rent income and mortgage interest expense, along with data from the Fed's Flow of Funds report on real estate values and mortgage levels, nonfinancial corporate income, interest expense, and equity and debt levels.  From these data, I can create estimates of aggregate effective interest rates and rates of return and compare levels of various asset classes.  I am looking at five asset classes, listed roughly in order from least to more risky:
  • Treasuries
  • Mortgages
  • Home Equity
  • Corporate Debt
  • Corporate Equity
Over the long term, all but the owner-occupied home equity market are highly sophisticated and liquid markets, which should lead to arbitraged risk-adjusted, after-tax returns.  And, even though owner-occupied home equity does not share characteristics such as easy diversification, it appears to also tend toward no-arbitrage, risk-adjusted, price parity with the other asset classes.  So, changes in the relative prices of these assets should reflect changing risk attitudes, expectations, and tax rates.  In other words, the supply elasticity with these assets is very high with regard to substitutions of investors between the asset types.

So, for instance, I am considering the effect of tax changes on mortgages.  But, in terms of mortgage interest rates, the tax treatment of the lender will be the overwhelming influence on mortgage interest rates.  Whereas lenders are allocating a given capital base among these securities based on after-tax, risk-adjusted returns, mortgage borrowers are not allocating a given amount of debt among asset classes.  The mortgage level and rate they accept will be filtered through many factors, such as the size of the home, the amount of leverage used, etc.  So, tax treatment of the borrower will tend to affect quantities, while the interest rates on mortgages will reflect supply.

(One possible exception is that some of the split of returns on homes between the equity holder and the lender reflects duration exposure on the part of the homeowner.  After mortgages gained tax benefits, home owners might choose to accept more duration on the mortgage, since the after-tax premium on duration would be lower.  So effective rates would be higher, as a result of the changing risk exposure of the owner.  This effect is probably swamped by other effects.)

There have been changes in interest rate spreads over time, which I think do point to effects from the changing tax treatment of housing capital.

This first graph compares treasury, corporate, and housing returns over time.  (I have used the implied inflation rate from my effective mortgage rate figure to adjust corporate and treasury rates.  I know this isn't perfect, but I think it is better than using inflation or survey data.  In any case, all three methods give similar results for time-series analysis.)  Because of stickiness in housing markets and the very long duration of homes, effective home returns are more stable than corporate or treasury debt.  But, we can see that returns to housing have, more or less, tracked trends in treasury rates.  However, beginning in the mid-1960's (when the housing agencies were consolidated into HUD, and there was a build up in home equity ownership), corporate debt started to require higher spreads.  Then, the corporate spread really took off in the mid-1980's, when the mortgage deduction attained tax value.

This regime shift is very clear in this next graph that shows the effective corporate interest rate from Flow of Funds minus the 10 year treasury rate.  There is a jump of 1% from the 1960s to the 1970s, then, after 1986, a jump of 2%.

This is evident in this Fred graph comparing spreads, too.  Mortgages have remained in a range of 1% to 2% above 10 year treasuries.  But, Aaa corporate spreads before 1986 ranged from 0% to 1%, and since then have ranged from 1% to 2%.  The Baa spread has followed a similar pattern.

In the next graph, I have used the income information from BEA table 7.12 to compare pre-tax returns on owner-occupier homes to rented homes.  I don't have aggregate market value information that matches with these rented homes, so I used the capital consumption figure from table 7.12 as a proxy for home value.  And, what we find is that until 1986, owner-occupiers earned a consistent premium over renters.

This is a little difficult to work out.  I hope to tie together all of these factors by the end of the series.  But for now, I will simply note the intuition that if savers are arbitraging after-tax returns, then pre-tax returns for owner-occupiers would decline as they attained tax-preferred treatment.  So, this result should be expected, as far as that goes.  But, to be honest, I haven't fully put this all together.

Since 2007, credit markets have shut down in owner-occupied real estate and implied returns on homes have shot up.  In the graph comparing landlord income and owner-occupier income, my proxy for home values breaks down after 2007 because of the disequilibrium in this market.  The implied return for owner-occupiers follows a similar trajectory to landlords if we use home market values instead of consumption of capital as the denominator.  That is because many homeowners are sitting on homes that have seen marked declines in nominal value.  This problem doesn't affect landlords as much because so many of the landlord properties have been purchased in the cash market during the recent slump, resetting the depreciation at a lower level.  So, returns to home ownership are very high, but mortgage spreads have moved along about where they have been.

I think what we are seeing in these changing spreads is related to the effects of these tax changes.  As tax incentives pull more capital into housing, mortgages and homes are commanding a higher proportion of capital, and home equity is also providing additional returns from liquidity and non-diversification risk.  The advantages to these real estate securities are pricing corporate securities out of both the low-risk space and the high-risk space.  So we are seeing a decline in the quantity of corporate investments, less reliance by corporations on debt, and higher premiums paid for both corporate debt and equity, relative to risk-free rates.

Note that Commercial and Industrial Loans moved along at 32% to 40% of bank credit for decades, until the mid-1980s, when they suddenly began a long term decline.  And, note the sharp increases in real estate credit, after 1986 and 1996.  Now that real estate is not taking in new capital, commercial credit is pushing up above its previous peak.

Maybe the causation runs both ways here.  Low risk free rates have pushed home prices up.  But, possibly current risk premiums themselves are a product of housing tax policy, to an extent.  I have previously suggested that the significant reductions in corporate leverage over the past 30 years has been a result of corporate capital management under falling nominal interest rates.  This housing analysis suggests that the lower corporate leverage has come from a kind of crowding out.  But, all of these trends are probably inter-related.

Further, there is the oddity that, given the shifts in capital allocation outlined above, corporate enterprise value (equity + debt) has not declined as a portion of GDP.  (This graph is of non-financial corporate enterprise value, adjusted to domestic levels by using proportion of foreign profits, as a share of GDP.  It shows some rise over time, but this is generally due to the transfer of assets from proprietorships to corporate ownership over time.)

What does this mean?  Well, we must remember that housing values are anchored in rent levels.  So, when price/rent levels rise, housing expenses remain basically the same, but nominal prices of houses rise.  Prices have risen because interest rates have declined, and I believe that they also have risen because of these tax incentives.  To the extent that the increase in owner-occupied housing stock (see the fifth graph above) has increased as a percentage of GDP, what we are seeing is the nominal value of the tax transfers from renters to owner-occupiers.  Owner-occupiers are, in effect, expressing the value of these tax incentives through higher nominal home values.

I'm not sure that any of this has much effect on the non-housing economy.  In nominal terms, it makes it look like there is a lot more debt and capital than there used to be.  But, housing capital is kind of funny.  It kind of feeds itself because the higher values lead to credit creation.  If we didn't have all of this extra nominal real estate capital, the non-real estate economy would still operate just as well.  It would just need a little more currency to keep everything moving, to make up for the lost home equity that currently serves as a savings vehicle.  I think the largest effect might be that real incomes of renters are being decreased by these policies.  They are being taxed through their landlords, via higher rents.


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