Wednesday, February 18, 2015

Housing Tax Policy, A Series: Part 8 - The crisis didn't happen the way you think it happened.

As far as I can tell, just about everyone agrees on the following series of events:

1) House prices driven up by predatory lenders, or public pressure to expand home ownership, or both, pushed low income households in homes they couldn't afford.

2) As rates rose, low income households with unsustainable ARM mortgages couldn't afford their mortgage payments.  Delinquencies started to pile up.  Home prices started to collapse as a result of families losing their homes in foreclosures, and the wider economy and labor market finally collapsed under the weight of it.

Let's check this narrative:

1) House prices driven up by predatory lenders, or public pressure to expand home ownership, or both, pushed low income households in homes they couldn't afford.

The first culprit in this step of the plot is the new Community Reinvestment Act of 1994 that is said to have pressured expanding banks to make more loans to marginalized neighborhoods.  And, the data suggests that this rule may have been significant in pushing up homeownership rates.  Beginning in 1994, there is a marked increase in homeownership rates, which had moved in a tight range around 64% for 10 years.

But, the timing just doesn't fit the story.  The ownership rate maxed out at a temporary spike of 69.4% in 2Q 2004.  A total rise of 4.3% from the flat trend of 1984-1994.  But, half of the rise had already been realized by 4Q 1998, when the ownership rate was at 66.5%.  And, as of that point, there had been no rise in inflation adjusted home prices.

Then, between 4Q 1998 and the peak of ownership in 2Q 2004, the Case-Shiller 10 city index rose 86 points.

But, prices didn't peak until 2Q 2006, by which time the Case-Shiller index had risen another 51 points.

So, half of the rise in home ownership came with no effect on home prices, and more than 1/3 of the rise in prices came after home ownership rates peaked.  In fact, the steepest period of rising homeownership rates came with no rise in prices and the steepest period of rising prices came with no rise in homeownership rates.

Now, there was a period of 5 years where homeownership rates rose along with home prices.  It is certainly plausible that some portion of the rise in prices is related to this portion of homeownership expansion.  But, considering there were a total of 6 years before and after that where there was no connection between these trends at all, the proportion of the price movement related to pressing marginal first-time homeowners into questionable mortgages is highly suspect.

I would have even believed very easily that desperate mortgage brokers might have been bottom feeding to keep their business plans intact as the boom stalled.  But, even that notion is betrayed by the data.  No net marginal households were purchasing homes for two entire years before prices peaked.

I would like to make two more points here, also.

First, we are talking about a rise in homeownership from 64% to 69%.  Or, put conversely, the marginal non-homeowning household at the beginning of the period was at the 36%, and by the peak, was at the 31%.  This is a marginal change.  While I don't doubt that many anecdotes about reckless mortgage brokers are true, the notion that the boom was built on wide-spread new ownership by households far outside the typical range of home-owning households doesn't seem to pass the smell test.  In 2011, the 36th percentile household income was about $35,000 and the 31st percentile household income was just over $30,000.  Households don't line up cleanly by income to be the marginal homebuyer, but this gives a sense of scale regarding the relative incomes associated with this expansion of households.

Secondly, between 1994 and 1999, about 3 million marginal households (on net) became home owners.  Those households experienced extremely profitable gains on their new homes.  Even today, their aggregate home values are more than double what they were at the times of their purchases.  For half of the new marginal home owners, homeownership was an extremely profitable decision.  I wonder if there are any stories in the Washington Post where these homeowners gush about what a great service their bankers provided for them.

In fact, today's housing price level is higher than the price level was in 2004 when the last net marginal household became a homeowner.  And, except for the last 1% of net marginal owners in the last year before the peak, aggregate nominal home prices never declined below the level at the time of the original purchase.

2) As rates rose, low income households with unsustainable ARM mortgages couldn't afford their mortgage payments.  Delinquencies started to pile up.  Home prices started to collapse as a result of families losing their homes in foreclosures, and the wider economy and labor market finally collapsed under the weight of it.

Well, wait a minute.  The homeownership rate topped out because ARM mortgage rates started to rise, causing borrowers to default on unsustainable mortgages.  Right?

Here is a graph of the Fed Funds Rate and the Real Estate Delinquency Rate.....

Short term rates began to rise in 2Q 2004, topped out in 3Q 2006, and remained there until 2Q 2007.
In 2Q 2007, the single family home delinquency rate was at 2.3%.  Please note how starkly the consensus narrative differs from reality.

In 2Q 2007, at 2.3%, single family home delinquency rates were still at the level we saw throughout the 1990's, which ranged between 2% and 3.4%.  Short term interest rates had been rising for 3 years and had been at this level for 1 year, so rate resets would have been well-baked in by this time.

At this point, the relationship between single family home delinquencies and interest rates was typical.  In 2Q 2000, the yield curve inverted, and delinquencies began to rise.  By 2Q 2001 delinquencies hit 2.4% and leveled out.  In 1Q 1989, the yield curve inverted, and delinquencies began to rise.  By 4Q 1990, they topped out at 3.4%.

In 2007, at the supposed end of the biggest, baddest housing bubble since the tulip craze of 1637, at the end of the rate tightening cycle, the delinquency rate was 2.3%.  By 3Q 2007, both the Fed Funds Rate and long term rates were in free-fall.  There is no question that by this time, the liquidity crunch was in full swing.

Home prices were still near their peak at this point.  Homeownership rates were down to 68.3%.  Home prices, even now, were 44% higher than they had been in 3Q 2003, when homeownership had last been 68.3%.  Can we attribute home prices in 2Q 2007 to loose monetary policy, a year into the yield curve inversion, and on the cusp of a demand collapse?

The next few graphs looks pretty clear to me.  Note that in the rates & delinquencies graph, the home price index is inverted to help see the parallels in the trends.  I have also added unemployment, which bottomed in 4Q 2006, after the yield curve inverted - just like it had in 1989 and 2000.  In 4Q 2006, when unemployment bottomed, delinquencies were at 2.0% and home prices were still at their peak.

So, the consensus narrative is that loose money, greedy bankers, and enthusiastic bureaucrats combined to create a housing bubble.  Despite these policies, the unsustainability of dicey mortgages caused millions of households to default because they couldn't keep up with rising rates, and this led to the crash of the bubble, despite efforts by the Fed to prop up this pretend economy.

The actual order of events is quite the opposite.  (1) Tight monetary policy.  (2) Rising Unemployment & Collapsing prices.  (3) Delinquencies.

In the 18 months after 2Q 2007, to 4Q 2008, home prices dropped by 25%!  In those 18 months, delinquencies rose from 2.3% to 6.9%.  Unemployment also rose to 6.9%.  In the following year, while home prices would find their bottom, unemployment would top out at about 10%.  Soon after, delinquencies on single family homes would top out at 11.3%

Here is one last graph, comparing delinquencies on single family homes, all real estate loans, and all loans at commercial banks.  We don't see delinquencies on single family homes rising, leading to problems in other areas.  We see all three measures rising at once, as if moved by some singular exterior force.  The only difference in behavior is after 2010, when policies regarding bank regulation, foreclosure processes, continued timid monetary policy, and persistent unemployment  continue to create frictions in the owner-occupier home market.  Again, the problems distinct to single family homes are, if anything, the lagging factor.

Two last graphs.  This is a graph of currency and bank credit.  Currency began to fall from trend as early as 2003 & 2004.  This might be reasonable because households were sitting on a lot of home equity, although total bank credit was not outside the typical range of its long term trend in the 2000s.  And, nominal home values had topped out by the end of 2005.  But, currency continued to fall from trend until late 2008.  The rise in bank credit doesn't line up with the housing boom.  It looks to me like it is more of a reaction to the Fed's tight money policy at the end of the housing boom.  Household equity % had been steady for a decade, and had been growing since 2003.  Home prices topped out at the end of 2005, and homeowner's equity began to fall precipitously while home prices held steady.  At this point, after currency had been growing at 8% annually for decades, it was now growing at less than 3%.  At this point, households were desperate for liquidity.  They had held equity steady throughout the boom.  In early 2006, they were done bidding on real estate, but they were desperate for cash.  This was happening by 1Q 2006.  As late as April 2008 - more than two years after this clamoring for liquidity began - the Fed had pushed the YOY change in currency down to 0.6%!

Even in early 2008, after 2 years of liquidity starvation and home prices down 15%, delinquencies were under 4%.  Yet, after all of this, in the infamous September 2008 FOMC meeting, the Fed held rates steady to signal that inflation was their primary concern.  They soon dropped rates to the zero lower bound.  Delinquencies in 3Q 2008 were still at 5.2%.  Two-thirds of the rise in delinquencies happened after that meeting, with short term rates (presumably including ARM rates) near their lower bound.  However, equity as a proportion of real estate began rising again in 1Q 2009, when the Fed finally reversed course and implemented QE1.


  1. 'The first culprit in this step of the plot is the new Community Reinvestment Act of 1994 that is said to have pressured expanding banks to make more loans to marginalized neighborhoods.'

    The CRA, around since the Carter Administration, was amended in 1995. It was preceded by the GSE Act of 1992 and the HUD Best Practices Initiative of the new Clinton Administration in '93-94.

    The criticism isn't that these changes led to more lending in marginal neighborhoods, but that they changed the underwriting standards of all home loans. I.e. increased leverage.

    1. I'm totally with you, Patrick. I think we should reduce barriers to homeownership, but CRA is not the ideal way to do it. I agree that WAMU, Countrywide, etc. and HUD were engaged in a mutual enterprise that was creating risky mortgages. I'm willing to believe that all 5% of the new homeowners were due to the subprime push.

      But, what's interesting is it doesn't really show up in the numbers. There is no price appreciation in the 1990's. There is no increase in leverage coming out of those initiatives in 92, 94, and 95. But, there is a sharp increase in homeownership starting in 94, which I think was probably the most important change in CRA, regarding the push up in owners.

      I think a lot of it comes down to scale. We hear a lot of big numbers about what was happening, but those numbers have to be put into context. By the 2000s, there were maybe 1 million extra subprime sales a year, compared to normal. That's a big part of the sales market. But, for the whole period, it really only adds up to about 5% of total households. So, let's say that the entire 5% of new owners were subprime, on the margin. I'll buy that. But, those are going to tend to be smaller homes. So, in terms of the housing market and the bank balance sheets, we're looking at more like 2-3% of the housing market, in $ terms. And, even if 1/4 of them end up defaulting, now your down to less than 1% of the housing market. I just think it doesn't scale up to enough of an issue to be the overriding factor.

      I think when you scale it out, the sub-prime issue can be blamed for that little movement up in delinquencies from 1 1/2% to 2% in 2006 and early 2007. But that isn't nearly as large an issue as everything else.

      Now, in the counterfactual, where the Fed moves rates back down to 4% in 2006 and lets the money supply expand a little bit, then I think we might end up with a much better economy, but with more of a subprime problem, because now those ARMs that were sold at a 1% FFR are resetting at 4%. But in that case, I think the problem is more compartmentalized among the subprime households, and we see some minor adjustments in housing without the massive collapse. The subprime issue isn't going to cause $4 million homes in Silicon Valley to lose half their value.

    2. Home prices begin to diverge from historical trend in late '96 to early 1997, approximately two years sooner than the point you've identified in your post (keep in mind the new trend through collapse appears to be exponential). Given that the change in home ownership rates occurs in late '94 to early '95, this gives us a two-year lag between average home prices as reflected in the Index, and the rightward shift in demand.

      This is not, to me, an implausible lag, considering the various structural hurdles between realizing the effects in a massive, national index like the CS-HPI and upstream changes in the dyanmics of the indexed market. It takes time to clear properties, and home prices tend to be sticky.

      I interpret your figure 1 as buying a 5% increase in the homeownership rate by doubling home prices and nearly breaking the financial economy. Will need more time to digest the balance of the post.

  2. The important question is who comprised the "excess" 5.4% of homeownership.

    1. Undoubtedly, those in the upper part of the FICO distribution are underrepresented in the 5.4%. Instead, these were primarily sub-prime and Alt-A borrowers.

    2. When you look at statistics across the entire mortgage population it will necessarily wash out what is happening with the 5.4%. As it happened, there was no tipping point across the entire mortgage occurred in stages. Looking just at the subprime sector, by Oct. 2007 the actual monthly default rate, not just a delinquency rate, exceeded the previous high in the subprime sector (November 2000) and was accelerating higher. Alt-A remained manageable a little longer, only inflecting up the exponential curve in about Mar 2008 and surpassing the previous subprime default high in August 2008. Prime never was just a slow and steady clime.

    3. Home prices don't need to increase from a specific price level for them to be unaffordable at certain percentiles of the population. Everything is at the margin. At the point of the 5.4%, they were likely previously out of the market for a reason...insufficient income (to simplify). This is why one of the primary underwriting defects on subprime and alt-a loans is misstated income and DTI.

    4. As part of Clinton's implementation of CRA and his initiative on homeownership, he sent his hit teams to all the big banks and threatened red-lining suits unless they made certain levels of loans to "underrepresented" populations, i.e. minorities. I'm not clear on the correlation between skin pigmentation and default rates, but I'm thinking it's not an economically valid underwriting criteria.

  3. A possible cause of price increases without home ownership increases: flipping. I'm not sure it's a sufficient explanation for widespread (ie. national) market effects. But, you might expect a surge in flipping to follow an initial run-up in prices (whether driven by increasing homeownership or not).

    1. Anon,
      The flippers making prices more efficient, not less. Speculators generally become more active when market frictions cause delays in price discovery. The idea that speculators are a sign of a bubble is a colloquialism that comes out of the fact that one of the frictions in the marketplace is mental benchmarking by buyers and sellers when prices are rapidly changing. This error is also what leads people to think that the Fed is being accommodative when it begins to lower interest rates.

      The momentum effect is one of the more enduring pricing anomalies, even in highly liquid equity markets, because price discovery tends to lag intrinsic value rather than overshoot.

    2. Keven,

      All of this detail is interesting, but were the reports that sub-prime mortgages that multiplied with Fannie and Freddie snapping them up as the bubble inflated, and those sub-primes being the "toxic asset" that popped the housing bubble-were those reports wrong?

    3. DDNC, yes, I believe they were wrong. It's complicated, though. I wouldn't disagree with the idea that there was a "bubble" in AAA rated securities, but I've become more sanguine even about that as I have looked at this issue. I'm up to about 44 parts in the series now. If you are reading in order, or have just come aboard here at part 8, please check out the rest. As I have looked at the data, my conception of what happened has changed - generally away from the conventional viewpoint. The data is in defiance of practically everything we think we know.

  4. Making loans in designated census tracts was not the only criteria for banks to pass their CRA test. Some banks made no, or minimal, loans in CRA tracts and were still able to pass their CRA test.

    Countrywide was involved in quasi CRA lending long before it became a bank and was required to do so, and long before it became involved in subprime lending.

    All CRA loans required full and verifiable documentation of the borrower's income, assets and credit worthiness. However, some of the documentation and sources of income and assets did meet FNMA/FHLMC guidelines for so called A paper. Therefore, many of these CRA loans were held in portfolio - they were not sold on the secondary market. Some were made to fit bond pools issued by cities, counties and states, and were either funded by issuing entity or funded by the bank and sold to the issuing entity.

    To assign any casual effect to CRA loans, with respect to the housing bubble and its collapse, one would have to look at these loans specifically and not conflate them with subprime or so called alt-A loans. I do not believe anyone has done this.

    1. Thanks for the information, Charlie.

    2. To assign any casual effect to CRA loans, with respect to the housing bubble and its collapse, one would have to look at these loans specifically

      No, that doesn't really follow. Banks could meet CRA obligations by buying subprime MBS from mortgage companies that were not themselves subject to CRA.

      It's true there might have been lax lending standards and a crisis without the CRA, but CRA existed to make them more lax.

      From the link below:

      "A study put out by the Treasury Department in 2000 found that the CRA was encouraging the mortgage servicers to provide loans to low-income borrowers, in part because the CRA loans had been so successful.

      What about "No Money Down" Mortgages? Were they required by the CRA?
      Actually, yes they were. The regulators charged with enforcing the CRA praised the lowering of down payments and even their elimination. They told banks that lending standards that exceeded that of regulators would be considered evidence of unfair lending. This effectively meant that no money down mortgages were required. A Treasury Department study published in 2000 found that the CRA had successfully lowered down payments not just for CRA loans, but for all mortgages.

      Explain the shift in loan to value away from the traditional lending requirement of 80%.
      Again, the regulators told banks that much higher LTVs was an appropriate way to meet the CRA obligations.

      What about the elimination of payment history? How about income requirements?
      Regulators instructed banks to consider alternatives to traditional credit histories because CRA targeted borrowers often lacked traditional credit histories. The banks were expected to become creative, to consider other indicators of reliability.

      Similarly, banks were expected by regulators to relax income requirements. Day labors and others often lack reportable income. Stated-income was a way of resolving the gap between actual income of borrowers and reported income. The problem, of course, comes when the con-artists and liars come into the game.
      The government pushed for greater mortgage securitization in an effort to increase CRA lending. At the behest of HUD Secretary Andrew Cuomo, Fannie and Freddie promised to buy $2 trillion of “affordable” mortgages.
      Finally, the Clinton adminstration threatened to subject the mortgage companies to the CRA if they didn't comply voluntarily. They promptly agreed to increase their CRA-type lending in order to escape the kind of public scrutiny that comes with official CRA regulated status."

  5. 1 seems fatally flawed by the unknowability of the counterfactual "no CRA" homeownership rate at any point in time, and the obviousness of the fact looser lending standards increase borrowing.

    The CRA was a major cause of the problems -- a necessary, if not sufficient precursor to the collapse. They spread looser lending standards throughout the industry. Borrowers reacted rationally. Recession shook out the weak hands. People who bought mispriced the risk got burned. The effect was large enough to bury major players.

    The definitive summary of exactly how and why:

    1. Dave, thanks for the thoughtful input. All of our facts from this comment and the comment above are reasonable. I agree with you about all the problems with how the CRA was utilized and the dangers it created. But, while I agree that it was a potential problem, in the end, I have come to the idea that, in fact, it was not a necessary nor sufficient cause of the collapse.

      One point, from the post, is that this stuff had been going on since the mid-1990s. (It accelerated in the 2000's, but given the very low real interest rates and low inflation, homes should have been increasing in nominal value and more households should have been buyers.) The 64% level of ownership is a very long term baseline, so I don't think we should have expected ownership rates to fall. So, something up to 5% of increased ownership could be related to CRA. But, as I point out, the vast majority of this happened before 2004. And, nobody who bought a house before late 2003 has ever seen home prices fall below their purchase price. I agree that very low down payments could be a problem, but they weren't a problem for any but a very few marginal buyers after 2003.

      The CRA narrative is very compelling, hypothetically, so it is tempting to accept it, but I just don't think the data bear it out.

    2. sorry - first sentence "your facts" , not "our facts"

  6. 64 percent to 69 percent was not a marginal change because it was centered in a few bubble states where it actually drove prices up. And securitization allowed the easy money. And securitization was permitted because the risk of MBSs was mispriced. BAC said the Fed does mispricing and I believe you have to include the housing bubble. And no, the CRA was not the main culprit. The private mortgage pools were the main culprit, and bogus AAA rated mortgages. That bubble was real, Kevin. Sorry, that history won't be rewritten. This most important chart proves the private sector goosed the real bubble until late 2007, when LIBOR went wild.

  7. The real problem with home ownership is not so much predatory loaning as it is poor borrowing habits by consumers. I don't want to say that people don't have the right to own a home, but should anyone ever try to own something that will come with a nearly endless debt for many years?

    Henry Hansen @ Ethica Private Wealth Specialists

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