Tuesday, March 17, 2015

The road to a housing recovery

Since the mortgage credit market has been stagnant since 2007, changes in US household equity levels have been almost purely a product of home market values.  Here is a chart comparing home prices and equity.  QE3 facilitated the flow of cash into the real estate market, through institutional and all-cash buyers.  But, as QE3 was tapered, and eventually ended, this source of demand in the housing market diminished.  The extreme level of excess returns to home ownership continue to attract institutional and foreign capital into real estate, but the pace has slowed.

I had hoped that relaxation of regulatory pressures on banks late last year would begin to allow mortgage levels to grow again.  It has, somewhat.  But, the growth is still very slow compared to previous periods of economic expansion.  It looks like closed end real estate mortgages at commercial banks are growing at up to about 5% annually, similarly to the period between QE2 and QE3.

It is common for real estate loans to expand at a rate of 10% plus inflation during expansions, especially when interest rates are low.  That should be the case now, more than ever, since relative income levels from homeownership are unprecedented, relative to the alternatives.

So, it looks to me like there is only so much supply of mortgage credit (as opposed to demand) can do.  What I hear from folks in real estate is that households just can't afford homes.  But, the thing is, rents aren't falling.  There isn't a lack of household demand for housing.  If this was a problem of incomes, rents would be falling.  The problem is that households can't come up with the downpayment.  Households don't have the net worth they need to purchase homes.  I suspect this might have something to do with $20 trillion in missing home equity.

Fortunately, households have been deleveraging, so we don't need to return completely back to trend to re-establish demand.  Owners' Equity as a proportion of Real Estate Market Value was about 59% at the end of 2005, before the liquidity crisis began to push us out of equilibrium.  This fell to as low as 37%, but it has recovered back to 54.5%.  And, at the current slow rate of housing appreciation, it is growing by about 1/2% per quarter.  That means that we are about 2 years away from normalcy, at the current rate of growth.

Now, I don't think equity will grow at 1/2% per quarter until it hits 59%, and then suddenly the mortgage market will open up and home values will suddenly appreciate by 15% per year.  There should be some acceleration as home prices appreciate, and more homeowners, on the margin, are capable of initiating transactions in the housing market.  So, we are probably looking at 12 to 18 months of slowly rising housing growth.  For speculative purposes, I'd prefer a sharper tipping point.  The process I am expecting makes the dilemma of entry points and triggers more difficult to gauge.

Until this expansion happens, I think we are looking at a bifurcated fixed income market, where bonds earn very low returns, and homes earn 5% or more, plus capital gains.  I think the Fed Funds rate could be anywhere from 0% to 2% in this context without affecting monetary expansion that much, one way or the other.  Because, the industrial economy is a high rate economy right now, but there is a surplus of capital, because there are too many frictions preventing it from getting into real estate quickly enough.  But, when real estate can expand - probably early to mid 2016 - look out.  Natural interest rates will be flying - both real and nominal.

I suspect that everyone will crap themselves when home prices start rising by 15% per year, and we'll put a stop to it to spite ourselves.

I haven't thought this through before, but if this is true, then the equity risk premium right now is a bit of a mis-specification.  If risk free bond rates are sort of out of equilibrium because of this housing problem, and could just as easily be 2% (real 10 year), then equilibrium equity premiums are probably under 4% - a more typical level.  That is potentially good news for real profit and wage growth, especially if a diminished housing shortage stops pushing up core inflation.

As we can see in these last two graphs, there has been an uptick in mortgage supply since late 2014, in terms of standards.  But, demand has been soft.  I expect to see demand increase along with rising prices, but probably slowly.


  1. Kevin, at the risk of just repeating myself, I wanted to thank you again for taking the time to lay this stuff out in a way that a normal person can (usually) understand. By far the smartest investment analysis I've seen anywhere.


  2. The good news about the slow housing recovery is that we can expect housing to be less of a problem in the next crash, so we may not see as much fallout as the last one.