Tuesday, August 16, 2016

Housing: Part 172 - A Bubble both rational and unmoored

Some more quotes from Hank Paulson's "On the Brink":
 Government policies, from the implicit support of the GSEs to tax preferences, had pumped up the housing bubble and exposed the financial system - and taxpayers - to far too much risk. (p. xix)
Fannie and Freddie were the most egregious example of flawed policies that inflated the housing bubble and set off the financial crisis.  It is absolutely crucial that we now end the time out and tackle GSE reform.  We need to dramatically rein in their missions and shrink their size by sharply reducing their ability to hold mortgages on their balance sheets, and by limiting the mortgages they can insure.  This can be done by limiting guarantees to first-time borrowers or restricting the size of qualifying mortgages or the income of borrowers, or some combination of all three.  Government guarantees should always be explicit, and the government should charge any user of its guarantee a fee large enough to create room for a robust private mortgage market.  Without the discipline provided by a private mortgage market, we will be at risk of another binge with government-provided incentives leading to yet another housing bubble.
To be sure, housing subsidies are not restricted to the GSEs.  Other government incentives, from the mortgage interest deduction on person income taxes to programs run by the Federal Housing Administration and various state agencies, have contributed to a systemic bias toward overinvestment in housing. (p. xxxiii)
I don't really have a strong opinion of the GSEs.  In the book, I will recommend reining in their missions and treating them as a utility within the Federal Reserve.  I will argue that the mortgage guarantee function is a purely monetary function.  I agree that government guarantees should be explicit and that this was a problem.

But, I honestly can't figure out what Paulson is getting on about here.  Estimates of the effect of the GSEs usually point to something like a quarter percent reduction in mortgage rates.  The most egregious example of policies that inflated the housing bubble?  The GSEs barely expanded during the height of the home price boom.  But, even if they had, the GSE subsidy amounted to a single digit percentage boost to market home prices.  And, that subsidy had been in place for decades, so the attempt to blame it on the rapid price increases of the 2000s is weak.

But, I have a broader problem with the implications of these paragraphs, and this is something that is not unique to Paulson.  Here, he is talking about how tax and subsidy policies boost the values of American residential real estate and encourage leverage.  This is true.

Yet, he refers to this episode as a bubble.  A bubble suggests something temporary and bound to correct.  And, Paulson seems to have seen the decline in home values as a correction, as does almost everyone.

But, taxes and subsidies wouldn't lead to an unsustainable boost in prices.  They would lead to a permanent boost in prices.

Think about this a little bit with me.  Almost everyone agrees that either speculative fervor or reckless availability of credit led home prices to be bid up to levels that were unmoored from economic reality.  Households were bidding up real estate with small down payments and risky terms, with little regard for the downside.

But, that's a regime shift from what Paulson is talking about above.  Tax and subsidy policies depend on rational valuations.  If the GSEs caused real estate to be over-consumed because households would spend more where there were marginal declines in interest rates that were combined with long term tax benefits on the back end, then those are hyper-rational households.  Talk about homo-economicus.  Isn't it funny how nobody minds using homo-economicus when it is used as a presumption of bubble behavior?

Households that bid up the price of the housing stock by 20% because of tax policies and subsidies are an entirely different animal than households rabidly bidding prices up to the stratosphere if you let them get their hands on a little credit.  These are polar opposites.  A story that presumes to be characterized by both at the same time simply doesn't make sense.

Homo-economicus seems to explain most of what happened, as far as I can tell.  But, if that's the case, then the bust was due to policy changes.  There weren't policy changes in taxes or supply obstacles.  There were policy changes in credit and money.  It would be nice if there were policy changes in taxes and supply obstacles instead.  That would create a "bust", but it would be a bust related to healing rather than needless suffering.

If that isn't the case - if this was a bubble based on irrational exuberance - then taxes and interest rates have little to do with it.

Of course, there is the Austrian business cycle version of events that claims while ABC proponents can see the dangers of low interest rates, the rest of the world can't.  Other than being tricked by the central bank, the rest of the world does act as homo-economicus and bids prices up to the levels that seem reasonable when the central bank pushes interest rates down.  So, in that story, buyers were rational, but naïve.  Of course, nearly all of the synthetic CDOs, CDO squareds, even most of the regular CDOs, and even a large portion of the privately securitized mortgages themselves were issued after late 2005, when the Fed had pushed short term rates up sharply.  By January 2006, the Fed Funds Rate was up to 4.3% with a flat yield curve, and the Fed didn't stop until it hit 5.25% with an inverted yield curve.

Any argument based on the idea that all those exotic mortgage securities were induced by low interest rates and loose money would literally be the most wrong argument made in the history of arguments.  It literally couldn't be more wrong.  Did I mention that I mean that literally?  It would be like arguing that the Dust Bowl era Okies were seeking refuge from a multi-year flood that hit Oklahoma in the 1930s.  Literally, it is that wrong.

I wonder how many ABC proponents were complaining in 2006 that a central bank with interest rates pegged too high might cause rational but naïve savers to catastrophically under-invest.  The reason those synthetic CDOs filled a market niche is because so few Americans were willing or able to take the equity position in real estate - even in the 2/3 of the country where mortgages were still quite affordable by any historical standard.  So the "Big Shorts" manufactured a synthetic equity position where, in exchange for making part of the payments that homebuyers would have made, they would capture a huge pay day if the underinvestment continued until it became catastrophic.

PS. I agree with the prescription that we should eliminate the income tax benefits of home ownership and that relatively higher property taxes would be good for places like California.  But, as it stands, we do tend to have a significant tax focused on real estate - the property tax.  I'm not so sure that, all told - property taxes, income tax benefits, and subsidies - it adds up to much of a net subsidy for housing.  The idea that real estate is heavily subsidized seems popular, but is it really true?


  1. I like this addition to your last post. Paulson really wants the GSE's for Wall Street. That is what this is about. There was an article at the NY times that said exactly that, years ago. The banks could then issue loans, and guarantee them themselves! I kid you not, Kevin. One of my first articles on Talkmarkets at my name expresses my view that the banks cannot be trusted with the GSE business.

    Also you point out that loans were made with little down, and that it was not particularly rational behavior. Well, people were promised the option of refinancing later. I remember those promises when I went to open houses. I thought they were crazy. But they were promising refi, almost with a certainty. You had David Lereah promising that RE's climb had not stopped. I think he was abandoned by the Fed, but I think he knew people were at risk. I really have mixed feelings about David Lereah.

    And of course the rates were not that low. The teaser, beginning rates were low. Yes, some people who held out did see the adjusting rates diminish. But I think big investors cashed in big at the foreclosure auctions. A lady who invests in foreclosures said big money brought suitcases of money. I assume she would know as she owns multiple properties. I can't confirm that.

    And about the rational/irrational part. It became easier for people to move into a house, no money down, than to pay first, last and deposit on a rental. Yeah, the financial system knew exactly what it was doing to people.

  2. Another irony of the Big Short - the main characters seemed to think that their positions would pay off when interest rates ROSE on those ARMs and forced defaults due to rising monthly payments.

    1. Yep. And, they got their payouts when the market for the AAA securities collapsed in late 2007, before the actual number of defaults was that high. The securities collapsed because of expectations. Those expectations became true, but only because of credit and monetary policies that caused defaults to keep rising in 2008 and 2009.