Housing: Part 247 - The elasticity of causation

Here is Matt Taibbi on the Fannie and Freddie lawsuit in Rolling Stone.  This is an interesting piece.  Taibbi is a compelling writer, and I give him props for recognizing the apparent abuse of power here.  It would probably be easier for him to take the position against the dreaded speculators and hedge funds who have sued the government.

I don't spend a lot of time reading popular assessments of the financial crisis, so it is always eye opening for me to step out of my conceptual shell and to be reminded of the things most people have come to confidently take for granted.

Here are a couple of excerpts regarding the GSEs and the crisis:

They had gone bust during the crash years for a variety of reasons, mostly due to incompetent and corrupt management. But by the summer of 2012, with the real estate market in recovery, the companies weren't bust anymore. On the contrary, they were about to start making money again – enormous piles of it, in fact...

...It should be noted that despite legends to the contrary, Fannie and Freddie's affordable housing mission did not cause the 2008 crash.

In fact, the Financial Crisis Inquiry Commission concluded that delinquency rates for GSE loans were "substantially lower" than those of the private banks and mortgage companies that were lending subprime loans to anyone with a pulse during that era.

The crash was caused by greed, not social policy...

...probably because Fannie and Freddie were so unpopular after the crash – deservedly, in part, because of numerous scandals involving its executives – the companies were treated very differently than other bailout recipients.

I think this is a great example of how flexible our collective sense of morality can be.  And, I don't think there is anything unusual, here.  Taibbi is a great journalist, in part, because he has an intuition about the audience's contradictions.

Notice how easily he floats here between certainty that every problem the GSEs had was due to mismanagement and corruption and how no problem is explained by the affordability mandates.  "The crash was caused by greed, not social policy." is an axiom.  Even within paragraphs of each other, when mentioning social policy, we should note that the GSEs were quite well managed.  When mentioning management, we should note that the GSEs were managed incompetently and corruptly.

In fact, neither of these factors has much to do with anything.  The GSEs were designed to be vulnerable to one thing, and one thing only, and that is a massive, multi-sigma downturn in the housing market.  There is no other context where they would ever have failed, and there was no way for them to avoid failure in that context if the government decided to strictly invoke capital requirements.  They faced a multi-sigma downturn, the government invoked strict capital requirements, and they failed.  Everything else is noise.  Taibbi and his readers share a set of axioms, so these axioms are repeated ad nauseam until the repetition itself creates a sense of empirical fact in their minds.

Other audiences reverse this axiom and blame social policy.

The fact that, given the context and the position of the treasury in 2008, failure was inevitable, allows all axioms to be acceptable to their respective audiences.  One could argue that the cause of the collapse was a happenstance where the axioms of a plurality of Americans caused them to support liquidationism in 2007 and 2008.  This is obvious in hindsight, when the bulk of criticism toward federal officials is related to their attempts at stability rather than at the instability itself.

--------------------------

One other quote from the paper:

In most versions of GSE reform currently winding their way through Congress, the same too-big-to-fail banks that blew up the mortgage markets in 2008 would assume most of the responsibilities of Fannie and Freddie. Crucially, securitized mortgages would continue to enjoy government backing under many of these proposals.

Privatized profits, socialized losses. Who doesn't love that formula?

I note this excerpt as an example of the sorts of little errors that slip into our common discourse which allow us to mend and protect our axioms.  Again, there is nothing unusual or special here.  We all have these.

Did you notice what he ignores here?  It is an uncontroversial fact that yields on these securities that have federal backing are lower because of the backing itself.  In free markets, it could be no other way.  It is impossible for markets to privatize these profits.  First, because the guarantee earns a profit over time, through fees, which Taibbi implicitly understands when he notes that the GSEs have returned to profitability.  Over the long term, they have been profitable, even after having taken nearly a quarter trillion dollars in credit losses during the bust.  (When their incompetent and corrupt management managed, somehow, to maintain those strikingly low default rates.)  Secondly, because investors bid down the yields on those guaranteed MBSs to reflect the value added of that guarantee.

"Who doesn't love that formula?"  The formula is a figment of Taibbi's imagination.  This subtle mistake, along with many others, serve to support the axiom.

You can see a similar sort of convenient error in the way everyone talks about CDOs.  The way they are always described is that they were creating AAA securities that really had hidden embedded risks.  Bankers trying to boost their yields were buying them up because they were too stupid and too greedy to understand that.  And that greed is what done us in.

Now, I have written a lot about how this is entirely wrong, anyway, because the CDOs, and especially the more exotic CDOs that had more exposure to systematic risk, were a late phenomenon that happened almost entirely after home prices and housing starts peaked, and certainly happened well after homeownership peaked. (In fact, falling home ownership was the reason they ever needed to be created in the first place).

But, ignoring all that, this way of describing CDOs is wrong in much the way Taibbi's comment above is wrong.  Yield is a reflection of risk.  If yields on the AAA securities from the CDOs were higher, it is because the market clearly recognized the potential for added risk.  The yields weren't bid down to a riskless yield level.  The mis-statement about the CDOs is usually described as "reaching for yield" which is one of those phrases I wish we could just blast from the lexicon.  That phrase really only serves one purpose, and that purpose is to promote this lie, that perceived risk and yield are somehow unconnected - that yields are just independent variables out their in the market, and greedy investors chase them up in a short-sighted attempt at capturing more income than is sustainable.

It just doesn't work that way.  All yields are codetermined with perceived risks.

This axiom is so deeply ingrained, that few noticed the severity of the dislocation in the summer of 2007.  By normal standards, things like monetary policy weren't wildly off the mark, but by August 2007, even though there were billions of dollars of savings, madly in search of safe assets - a "bubble" in AAA securities, in the common and perverse usage of that term - those securities were trading at deep discounts.  There was a massive demand for safety, and the securities meant to be safe were failing.  Then even auction rate securities markets started failing.  Again, despite billions or trillions of dollars in search of safety.

This is recognized as a regime shift from greed to fear.  That's truish, as far as it goes.  But, what if the description of reality was closer to having moved from normalcy to fear.  Even if one concedes that 2005 could be characterized by "greed", certainly that hadn't been the case for some time by 2007.  In fact, the regime shift in 2007 was probably from fear to crisis.  We had already passed clean through normal.

But, in a paradigm that sees only two regimes - greed and fear - fixing the fear problem necessarily means creating a greed problem.  We didn't fix the problem because that meant we'd go back to the greed regime, and that's what caused all our problems, right?  Reaching for yield.  Privatized gains and socialized losses.  We had to avoid those things.  And, weren't those incompetent and corrupt managers the source of the problem, anyway?  We're just supposed to let them off the hook?  Our axioms demanded, "No way."

Housing: Part 246 - Funny Real Estate Quote from 3 Days Ago

This recent post at Calculated Risk is a good example of Our Problem.

He links to a quote from 10 years ago, June 2007 when home prices in most places were still pretty stable but sales and starts had been in steep decline for more than a year:

Ten years ago, NAR's senior economist said: "It is too early to say if home sales have already passed bottom," said Lawrence Yun, the senior economist for the group in the report. "Still, major declines in home sales are likely to have occurred already and further declines, if any, are likely to be modest given the accumulating pent-up demand."

That silly senior economist!  Didn't he know that the future was already written?


Here is a graph of housing starts.  Housing starts (which trend with existing home sales) had been in decline for about a year and a half when he said that, and they hit and fell through the bottom of the long term range around the end of 2007.  (And, by the way, even in 2005, housing units per adult or per capita were similar or lower than at any time since the 1980s.  Outside of some depopulating Rust Belt cities, no city had too many homes.  No city needed a collapse in homebuilding.)


Source

If only Mr. Yun could have been the senior economist for the realtors of Canada or Australia, which also have had a housing "bubble".  Then, he could have been a brilliant prognosticator.  But, alas, he was the senior economist for the US National Association of Realtors, which means he was a silly, silly man, because the US housing collapse was years from turning back up.  And, this was already pre-determined.  Smart people know that.  The coming collapse of the private mortgage securities market, the federal takeover of the GSEs and its extreme tightening of credit standards, the decision by the Fed for 6 months after this prediction to continue to refer to housing market trends as an ongoing "correction" and to broadcast fears of inflation, its discretionary tightening in September 2008 because of inflation fears - two weeks after the feds forced the GSEs to take massive write downs in anticipation of future foreclosures.  None of those things had anything to do with the continued collapse.  Those were simply reasonable policies enacted because smart people should have known in June 2007 that the worst was yet to come.  It would have been irresponsible of us to expect anything else.  And, you and me, we're not silly like that senior economist.  We know a bubble when we see it.  Policies based on an expectation and acceptance of a collapse are simply the only prudent response.  The witches were triggering hallucinations.  I suppose you wouldn't have burned them at the stake?  It's easy for you to complain after we solved the problem.

We never had too many houses.  That's not our problem, by a long shot.  You know what our problem is?  Our problem is that we've got a country full of smart people - not those silly people.  A country full of people that know the value of things.  A country full of people who feel a smug self-satisfaction when markets collapse, prices decline, and those irresponsible, silly speculators, lenders, and builders go bankrupt.  Bill McBride at Calculated Risk is a smart guy.  Most of my neighbors are smart.  Most economists (unlike that NAR guy) are smart.  The Fed is smart.  Teachers and doctors and plumbers - smart people all over.  So many people are so smart that when I suggest all of this mess wasn't inevitable to strangers on a plane or acquaintances at school functions, I usually get a slightly confused look and then a comment about those terrible bankers that did this to us.  I think they just think they misunderstood me, and they assume if they reply with something that smart people all know, the misunderstanding will clear up.

A country full of people ready to claim "I told you so" whenever everything breaks is a country destined to break.  How can it be any other way?

Hey, you working class families in New York and San Francisco, and Los Angeles!  Remember in 2007 when that silly economist claimed there was pent up demand for housing?  Remember that silly guy?  You know better, don't you!  You know they're practically giving houses away!  Got so many, they don't know what to do with them!  Silly economists.  "Pent up demand."  What planet was he on?  We hadn't even begun to enforce the correction.  Good thing we've got some smart people in charge to keep these things from getting even more out of control than they did.  We'd be like that green line or that red line in the graph instead of the black line.  In Canada and Australia - countries apparently full of silly people - they literally are buried in houses by now.  Opening a checking account?  Here, have a house!  Oh, you want 4 scoops of ice cream?  That comes with a house!  That's what it's like in those countries.  That's what you get when you don't let the smart folk keep things honest and prudent.  They are soooo going to feel dumb when they realize they've got waaay too many houses.  They'll probably beg us to take them.  But, we're not chumps.  We're prudent.  We know the value of things.  Things are too expensive.  Have been as long as I can remember.  We don't want their bubble houses.  Prudent people go without.  Prudent people make others go without.  If you don't, next thing you know the silly ones are running the show.

-------------

Imagine what a world it would be if instead of thinking "I told you so." we had a country full of people who, upon seeing that quote from June 2007 and the graph of housing starts since then, thought, "Good Lord, what have we done?"

Housing: Part 245 - Foreign buyers

There is a lot going on in this New York Times post "When the (Empty) Apartment Next Door Is Owned by an Oligarch".

This struck me:

Anger at who is causing that harm can stray uncomfortably close to xenophobia. But politicians and anxious residents often add that their real grievance is with foreign money, not foreigners. And maintaining that distinction is important if cities that have long prided themselves on being cosmopolitan want to continue embracing immigration while curbing speculation. 

This really is a window into our time.  At a time when so many forms of prejudice are becoming cardinal sins, all is forgiven if prejudice can be framed in terms of money.  Since this is the case, it is striking how explicit and unapologetic prejudice in these terms is stated.  Here, we can see it stated in the positive.  "We're not engaging in the cardinal sin of prejudice against foreigners.  We're engaging in the acceptable prejudice against money."

This prejudice has infected the humanities.  An example I noticed a while back was in a Slate.com review of the book "Empire of Cotton: A Global History", where the reviewer wrote:

Less than a decade ago, a historian interested in the rise of capitalism would have a difficult time finding a job in a history department. The closest thing scholars wrote about capitalism was called labor history, the story of the working class. Almost no one bothered writing about the flip side, elite capitalists; to do so suggested sympathy for the enemy.

Imagine being so blind to your own prejudices that you would say such a thing - as a historian, no less.  (Of course, none of us is immune to this, and we are all most ignorant of our personal prejudices where they are the strongest.)  It is understandable, given the statement above, that something like Nancy MacLean's "Democracy in Chains" could be published.  I'm sure she felt quite justified and professional while she was writing.  Tyler Cowen has said the use of villains in our narratives about the world lowers our IQ by 10 points or more.  This is an understatement.  It saddens me to think of the potential insights about economic history that are missed because the academy has become so blinded by this sort of Marxian sectarianism.

The tone of books like MacLean's, or of others like Naomi Klein, remind me of my youth when certain evangelical preachers would write or give sermons about how, say, Dungeons & Dragons was a tool of Satan.  Their description of the supposed vice was so tainted by their fundamentalism that it was humorous to anyone with a passing familiarity of it.  It is similar with Klein's and MacLean's work for anyone with a passing familiarity of Milton Friedman or James Buchanan.  In Klein and MacLean's case, it's a little less funny because they are attacking actual people, both soon after their deaths, who whether one agreed with them or not, were clearly engaged in a sincere attempt to make the world a broadly better place to live.

In any case, these works are so fevered, and so defined by their propagandist techniques, that, as with those sermons about D & D, they leave the realm of criticism or argumentation.  There is little chance that their authors will adjust to reasoned criticism.

The universality of this prejudice is really at the heart of our self-destructive policy choices during the housing boom and bust.  Money was to blame.  Hunting season was on.  The Wall Street Journal could literally ask for a financial panic with no sense of shame.  Across the political spectrum in 2007 and 2008, the only acceptable position to hold was that somehow markets needed to be stabilized without stabilizing the financial positions of speculators and lenders.  Even after the series of panics and collapses, public officials have to pepper their memoirs with apologies about "bailouts" and self-defense along the lines of, "Ya gotta believe me.  We stabilized financial markets because we had to, not because we wanted to."

In Geithner's memoir, he says,“Nothing we did during the financial crisis was motivated by sympathy for the banks or the bankers. Our only priority was limiting the damage to ordinary Americans and people around the world.”  And, Geithner is considered to be among the more aggressive policy makers regarding stability.

Think of how bizarre this is.  Imagine describing your policymaking approach regarding any other group by insisting - in your defense - that you had no sympathy.  "No, really, you shouldn't be so critical of me!  I'm a good guy, just like you.  I don't have sympathy, you see!"  I am especially sensitive to this because when I looked at the evidence, I concluded the unthinkable - that "money" in a broad sense, really had little to do with the housing boom.  Once I came to that conclusion, all of the sanguine attitudes about collapsing home equity and failing investment banks, all of the explicit demands for "Wall Street" to suffer for their sins, have become shocking.  Is it really that different than, say, being sanguine about the AIDS epidemic because it arose from "sinful" behavior?  I suspect many readers will blanch at that comparison.  How dare I compare a prejudice that is a cardinal sin to an acceptable prejudice?

One prejudice might have slowed the development of a cure.  The other prejudice might have led to a generation defining financial crisis and recession.  If you can see the fingerprints of prejudice in one, you should be able to see it in the other.  If your response to that is, "The difference is that Wall Street really did cause the recession because of the sin of greed." are you sure that your conclusion is independent of your prejudice?  Don't take this as an attempt to sway you.  I realize this would be counterproductive.  You don't win people over to a point of view by calling them prejudiced.

-----------------------------------

Back to the issue of foreign buyers, the post mentions a paper that tries to model the effects of non-resident real estate buyers.  The authors estimate that out-of-town buyers in New York City have increased New York home prices by a whopping 1.1%.

The post suggests a tax on foreign buyers, as has been implemented in Vancouver, which might seem harmless enough.  We might be able to agree that the priority in housing policy should be to provide residential units over vacation homes or second homes.  I would agree that this would be far from the worst policy we have implemented in housing markets.

But, I think this is a good example of the depth of the problem of unintended consequences.  Let me preface this by saying that there are many cities that have many foreign buyers and that don't have a problem with out of control prices - places like Houston and Dallas - and they don't have to tax foreign investors.  They manage to build some blanking houses to meet demand.  Crazy, I know.

But, I think this unnecessary housing bust is really damaging because a housing boom is actually one of the more effective ways to deal with the demographic bulge.  The problem with the coming bulge of retirees is that, in any given period, most of what we consume must be produced.  If a large proportion of the population is out of the labor force, then there are many more consumers than there are producers.  You can't solve much of that problem by saving in preparation.  Whatever you do, when the time comes, you're still going to have "x" people vying for "y" consumption goods.

Housing is one very effective way to shift consumption over time because, as consumed, it is almost purely capital.  It doesn't have to be produced in the same period that it is consumed - in fact very little of it is.  That means that secular shifts in construction employment could really help to smooth consumption as baby boomers retire.  A lot of homes can be built now, when boomers are still in the labor force, and consumed later when boomers are retired.  Some of that macro-level consumption smoothing might even come in the form of multiple properties - homes that are vacation homes or second homes today, but that could become primary residences in 30 years when retired boomers lead workers to shift to consumption goods instead of durable goods.  The household today with a vacation home may be indirectly helping workers in 30 years to maintain a stable amount of consumption.

Prices are information, and so things like interest rates naturally feed these sorts of self moderating trends in a way that we can't really ever fully appreciate.  So, while we have been in a housing depression for a decade, one could argue that in an unencumbered economy, we would naturally be building too many houses - and that would be a good thing.  Unfortunately, in finance, we can play God.  We have the apparatus in place, and we have given ourselves broad moral authority to impose our will.  We will not be enjoying a housing boom any time in the near future.  We will make sure of it.

Housing: Part 244 - Moral hazard in securitizations

Here is an interesting working paper from John Krainer and Elizabeth Laderman at the Federal Reserve Bank of San Francisco. (pdf)

The abstract:

We compare the ex ante observable risk characteristics, the default performance, and the pricing of securitized mortgage loans and mortgage loans retained by the original lender. We find that privately securitized fixed and adjustable-rate mortgages are riskier ex ante than lender retained loans or loans securitized through the government sponsored agencies. We do not find any evidence of differential loan performance for privately securitized fixed-rate mortgages. However, we do find evidence that privately securitized adjustable-rate mortgages performed worse than retained mortgages, even after controlling for a large number of risk factors. Despite the higher measures of ex ante risk, the loan rates on privately securitized adjustable-rate mortgages were lower than for retained mortgages.

There is a lot of talk about how the securitization boom created moral hazard, how you used to go to the bank and get a mortgage and the bank giving you the loan was the one you would be paying, but now they sell the mortgage off and it gets sliced and diced among a million investors who have no idea how good of a credit risk you are, and so the bankers are willing to underwrite garbage, and this caused the whole system to collapse in a heap of greed.

Great story.  Very plausible.  It just didn't happen.  There was no significant increase in securitization as a whole during the housing boom.  The private securitization boom largely happened after prices peaked.  There is a brief period - lasting months really - between the rise of private securitization and the implementation of Fed rate hikes where some markets appeared to have some extra price appreciation.

In the Krainer and Laderman paper, which is based on a large data set from California, from 2000 to 2007, they find some evidence that privately securitized mortgages tended to have somewhat riskier characteristics, but it really doesn't amount to that much - certainly not enough to be the defining development of a massive bubble.  They report: "Indeed, observable risk factors such as current LTV and the subprime and documentation status are estimated to have a much much larger effect on the default hazard than investor type." (page 23)

Here is a graph of defaults, from the paper.  The blue line is retained mortgages, the red line is privately securitized mortgages, and the black line is mortgages securitized with the GSEs.  The GSEs had default rates much lower than either retained or privately securitized mortgages.  And, while privately securitized mortgages defaulted at a faster rate, by the end of the period analyzed here, default rates of retained and privately securitized loans were similar.

This doesn't look very promising for the "moral hazard" view.

In fact, I wonder if one effect of the GSEs is to provide a securitization market for the least risky loans, which would, ironically, leave the banks worse off, because there are many mortgages which can be reasonably made which don't happen to conform to GSE standards.  Those loans could be reasonable, and yet, they will inevitably be more risky than conforming loans.  What we have here is the opposite of moral hazard.  The banks are left with a riskier retained portfolio because of the GSEs.

Might we speculate that this would have led to constrained lending among more marginal borrowers, and private securitization provided an outlet for banks to realign their retained portfolios to be more like the neutral portfolios they would have been in a market without the GSEs?

--------------------------
Richard K. Green and Susan M. Wachter have a paper with some international comparisons.  Now, clearly, if you limit access to liquidity for a given asset, the market price of that asset will decline.  This is conventional financial theory.  Where I part ways which so much analysis about the housing bubble is the universal knee-jerk reaction to blame growing mortgages and expanding credit for rising prices, with little accounting for scale, alternative hypotheses, etc.

Green and Wachter briefly describe the mortgage markets of several nations.

United Kingdom, Canada and Japan do not have significant securitization markets.  Two bubble markets and one market that did not have a bubble.

The US, Denmark, and Germany have significant securitization markets.  Two bubble markets and one market that didn't have a bubble.

The funny thing is, some of these countries tend to have strict down payment requirements while others do not.  Some have recourse loans others do not.  Some tend to have fixed rate.  Others do not.  Some have balloon payments, others have long amortizations.  Some allow pre-payments without penalties.  Others do not.

Now, there are some correlations, like countries with higher down payments appear to tend to have lower prices.  But, there is no obvious pattern with these mortgage market characteristics and housing bubbles.  This was true within the US, too.  There were some areas where private securitizations might have tweaked the market a bit, but for the most part the US market has relatively uniform characteristics.  Yet, homes in a few cities became much, much more expensive than homes in most cities.

Everyone understands that those high prices are triggered by supply constraints.  Yet, in all of these countries, from the US, to Canada, to Australia, debates rage about how to curb lending or keep out foreign investors, etc., as if the mortgage market is the causal factor, and prices are rising, unmoored from rational rental value, because of it.  Yet, if we look at Germany and Japan compared to the UK or Australia.  Or, if we look at Dallas vs. San Francisco.  Clearly supply constraints are a universal factor.  Strange that there are many articles about all that China money flowing to Australia or San Francisco, or Vancouver.  Why are they flying over Seoul and Tokyo to get to those other cities?

(This NAR report suggests that there are as many buyers in places like Florida and Texas as there are in California and New York.)

I don't know about Japan, but Germany and Switzerland appear to have tax policies that don't favor homeowners.  In the US, I find that the monetary value of the GSE subsidy is basically a rounding error compared to the income tax benefits.  So, of the three major sources of price inflation, the order of importance seems to be - supply, taxes, and lending policies.  Securitization is a single factor within the factor that is of least importance.

June 2017 CPI

The story continues.  Shelter inflation (YOY) remains at 3.3% and core minus shelter inflation remains at 0.6%.  Core minus shelter inflation has been in a fairly steady decline since the first rate increase in December 2015.  It seems increasingly plausible that the target Fed rate is above the natural rate so that inflation will continue to decline unless the target rate is decreased.  That isn't going to happen.  The available choices appear to be either raising the Fed Funds rate or keeping it at about 1%.  If it needs to be decreased, the Fed will be behind the curve.  I continue to tentatively expect a slow-motion contraction, although without much movement in prices of the major asset classes.  Bond yields don't have much room to fall, housing is being held in depression mode by credit policies, and I don't see any reason at this point for equities to collapse, although that would depend on global economies, future NGDP shifts, etc.

Hsieh and Moretti have made several attempts at estimating the loss of economic activity due to Closed Access housing policies, ranging from around 10% to much higher estimates.

It seems to me that simply comparing consumer inflation with and without shelter inflation gives a good first estimate of the lower range of this cost.  There was a jump in the late 1970s of about 10% in consumer costs due to rent inflation and since the mid 1990s, there has been another rise of 10% to 15%, with a brief pause from 2008 to 2012 because of the foreclosure crisis.  Considering that this doesn't reflect any particular rise in building costs, this seems like a decent estimate of the payment of economic rents to Closed Access real estate owners.

That is just the measure of the extra costs to workers and firms that reside in those cities.  There are additional costs to the US economy due to the exclusion of workers from those cities - workers that didn't have the opportunity to earn additional income which would then be funneled to urban real estate owners because the high cost led them to remain in other cities.  Maybe the higher estimates from Hsieh and Moretti of something like 50% since the mid 1960s aren't out of line.

Housing: Part 243 - A Brilliant Argument for More Regulation

I finally got around to watching "Inside Job", the documentary that putatively is about the danger of financial deregulation.  The show was surprisingly effective.

Now, as you might expect, the surface content itself was not particularly moving.  The documentary format made it difficult to go into the details of various regulatory regimes, so this complex topic was diluted down to a simple binary ideal of "regulation" versus "deregulation" that is essentially devoid of meaning.  There was no mention of the importance of housing supply constraints, which is to be expected in such a production.  The focus on CDOs as the core trigger of the housing bubble is obviously problematic since almost all mortgage-based CDO activity happened after home prices had peaked.  And apart from the introductory focus on Iceland, no attempt is made to explain how these deregulatory trends could have happened simultaneously in Canada, the UK, Australia, etc. and would apparently continue to be important factors in those countries.  No mention is made of CDO markets in those countries, though one must assume that its explanatory power in the US is such that it would surely be paralleled in those markets.

But, that is what was brilliant about the documentary.  In spite of all of those weaknesses, the material was compelling and convincing.  The material about sex and drugs on Wall Street effectively packaged the villains of the production for an audience who would already be prone to accept them as villains.  This allowed the effective use of the visual medium to imply causation by mentioning activities of the villains over time alongside selected economic data.

As the viewer proceeds through the production, the subtle brilliance of the director's framing becomes more clear.  Documentary filmmaking is a nearly completely unregulated industry.  We don't even have a regulatory body charged with the review of the content in these sorts of productions.  Yet, clearly, this is a dangerous and powerful medium, capable of molding the consensus of an electorate that understandably will not be able to check the veracity of the information that has been presented.  Documentaries of this type clearly do need to be regulated.  In fact, considering the potential power of the imagery, and the difficulty of dealing with subtle or deep facets of the subject matter, it is probably advisable to simply ban the medium altogether.  Do I even need to mention the famous problem of the abuse of sex and drugs in the film industry?

The weaknesses of the film, then, becomes an ironic defense of regulation that is an even more powerful argument than the actual content of the film.  Brilliant.

I had to check imdb to see if Charlie Kaufman was involved.  It should not go unnoticed that Kaufman has little or no credited professional activity in 2010 when the film was released.  I suspect that he was intimately involved with the project in an uncredited capacity.

A classic signature of Kaufman's handiwork is that the near universal praise for the film among critics and viewers actually ends up serving the ironic point of the film.  This may be his best work, taking the meta-irony even deeper than "Synecdoche, New York" or "Adaptation".  It's enough to make you wonder if Kaufman found a secret portal into credited director, Charles Ferguson's, psyche on the 7½ floor of the Mertin-Flemmer Building.

Economics Detective Podcast

Garrett Peterson over at the Economics Detective kindly asked me to be a guest on his podcast.  We had a great conversation.  I think Garrett managed to help me hit most of the main points of my housing research.

Podcast at the link.

Housing: Part 242 - Incomes and inequality over time

Arguing about policy that tamed and then drove inequality since 1950s? Here's one pretty obvious line to draw (Piketty/Saez/Stantcheva). pic.twitter.com/kaj8fOmk34

— Mike Konczal (@rortybomb) July 9, 2017

I saw this recently on Twitter, and it always strikes me as odd when this data about tax rates is used to comment on income inequality.  If this is true, then it is a confirmation of the Laffer Curve.  In fact, for tax rates to have had such strong effects on relative incomes, elasticity of supply of high skilled labor and high return capital must be very high.  We see the same thing at the bottom end of the income spectrum.  Strengthening the safety net in the 1960s and after effectively increased marginal tax rates on poor households, when both taxes and subsidies are accounted for.  And, after these shifts in marginal tax rates, we saw this amazing reversal from the entire history of human economic activity.  Leisure time has flip-flopped.  Now, workers with high incomes work more and workers with lower incomes work less.

So, it seems to me that those who might argue for more progressive income taxes based on these trends must make that argument from a labor supply elasticity presumption.  They must presume that the Laffer Curve is relevant here.  And, the argument, it seems to me, would be that the extra production is somehow being captured by the highly skilled and connected workers, and isn't flowing out to the rest of the labor force or to consumers.  The argument would have to start with the idea that, with higher taxes, those high earners would work or invest less.

Now, to me, that seems like a bit of an uncomfortable position.  And, I think the housing story helps to allay that discomfort.  There seem to be two baskets of countries - those that still have strong manufacturing sectors, trade surpluses, and less income growth over the past two or three decades, and those that have shrinking manufacturing sectors, trade deficits, and more income growth over the past two or three decades.  The former countries tended to not have housing bubbles and the latter group did.

Source

According to Mike Konczal's scatterplot above, it appears that we can add one more characteristic to these two baskets of countries.  The former group has not lowered tax rates on high earners and the latter group has.

The larger story here is that the post-industrial economy requires urbanization.  And, the urban housing problem is obstructing that transition.  Countries with a growth orientation are the countries butting up against that obstruction.

This does leave one mystery though, because housing supply is clearly central to this story.  Japan and Germany clearly have fewer obstacles to housing expansion.  So, which way does the causality run?  Do countries moving more aggressively into post-industrial production also happen to develop obstacles to urban homebuilding?  Or do countries that are still more focused on the manufacturing economy also happen to have fewer limits to urban housing supply?  I don't see any satisfying reasons why this correlation should be true with either direction of causality.  Yet, the pattern is there.  The pattern is even there within the US.  Cities at the center of post-industrial economic growth have high incomes and extensive limits on new housing while the other cities do not tend to have those limits to housing expansion.

Strange.  But, the correlation is striking.  Every time I look at these sorts of measures, like in the Fred graph above, they seem to line up quite nicely into these two groups.

Maybe this is an example of trade management.  An argument is sometimes made that the Asian economic success stories developed with the help of some managed protectionism.  In an age built on human capital, maybe housing constrictions serve as that protectionism, limiting competition among the firms that utilize that labor.  Maybe post-industrial firms are attracted to these protected markets.  Maybe this problem of income inequality and housing affordability is a confirmation of the idea of managed protectionism for nascent industries.

Housing: Part 241 - Home Prices compared to wages

Bill McBride at Calculated Risk has a recent post that gives a glimpse into how important understanding the housing supply problem is.  This isn't meant to pick on McBride.  His post will seem quite obvious and reasonable to practically any reader.

In the post, he tracks a ratio of home prices to wages.  This ratio had a range of about 20% from peak to trough before the bubble.  At the turn of the century, it was down at the bottom of that long term range.  Then, it rapidly increased by about 50%.  Then it collapsed, and has slowly risen back toward the top of the long term range.

McBride comments, "Going forward, I think it would be a positive if wages outpaced, or at least kept pace with house prices increases for a few years."

That certainly would be a positive, but it would only be a positive if that happened because we solved the supply problem.  If we don't solve the supply problem, then in most reasonable scenarios of economic growth, this ratio will inevitably grow.  That is because economic growth will be centered in our innovation centers, which now have limited access so that workers must bid up the housing stock to access those labor markets.  Economic opportunity is arbitrarily limited, so payment for access to that will naturally scale up as the American economy expands.

This is like saying, "Going forward, I think it would be a positive if wages outpaced, or at least kept pace with taxi medallion prices for a few years."  That is actually happening now because of disruptors like Lyft and Uber.  And that is why it is a good thing that wages are outpacing taxi medallion prices.

But, if there wasn't disruption, then the value of taxi medallions would simply scale with the amount of activity happening in places like New York City.  It would simply be an asset that is correlated with economic activity at more than a 1:1 ratio.

Since we have incorrectly blamed housing on credit and money instead of on supply, there is this bi-partisan reaction now to basically any organic economic development.  Imagine if Manhattan had a policy of maintaining a fixed supply of taxi medallions and tracking their value.  Then, every time their values began to rise, Manhattan would implement "macroprudential" policies known to slow economic growth and employment.

We're afraid of our own shadows, and we will continue to be until we get this right.

The strange thing is that nobody seems curious about why this is happening.  It's bubbles, bubbles everywhere, and the idea that lenders or speculators in our midst are enticed into madness is apparently so satisfying that observers rarely seem motivated to ask "why?".

The Phillips Curve is real.

There are many subtle ways in which we have an intuition to think in terms of competing factions instead of cooperating factions.  Generally, where labor and capital are not artificially constrained, our interests are much more aligned than otherwise.

I think this is partly why the Phillips Curve idea is so persistent.  There is this idea that when the economy is growing and unemployment is low, this will lead to inflation, because workers will be able to demand higher wages from employers.

Of course, the problem is that this hasn't shown up in the data for decades.  Some argue that the Phillips Curve is now flat because the Federal Reserve targets a level inflation rate.  That's certainly true.  I would argue that the Phillips Curve is a measure of monetary policy.  If the monetary regime is pro-cyclical, the Phillips Curve will tilt down.

That is in nominal terms.

In real terms, there does seem to be a persistent Phillips Curve that slopes down.  Wages were unusually high in 2008-2009, but generally, before and after the recession, real wage growth and unemployment have moved within a long term relationship.  Real wage growth is a little low, but it has generally moved up the trendline since the bottom of the recession as unemployment has declined.

I noticed that John Hussman beat me to this.  His post from April 2011 has some interesting details about it.  His take on it is that the nominal Phillips Curve is wrong, and on top of that, even if it was operational, the Fed has the causality backwards.  Inflation won't lead to less unemployment.  If anything, less unemployment would lead to inflation.  But, even that is wrong.

The funny thing is that his point in 2011 was that inflation wasn't going to be helpful.  He thought the Fed was too loose and asset prices were too high.  And he didn't want them to keep policy loose in a quest to lower unemployment.  I would say that this point of view has not aged well.  There was a brief dip in the stock market in 2011, but in the six years since that post, total returns on stocks have averaged more than 10% annually and inflation has remained subdued.

I think he has some great points about the Phillips Curve, but I would argue that this is why the Fed shouldn't worry about tightening today.  Low unemployment won't lead to inflation.  I think we can both be right, here, though.  In either case, tightening or loosening, a Phillips Curve justification seems wrong.

Source

I do have a quibble with Hussman - maybe a speculative quibble, but a quibble nonetheless.  He basically makes a supply and demand argument: "very simply, when a useful resource becomes scarce, its price tends to increase relative to the prices of other goods and services."  So, this still has a lot in common with the basic intuition of the Phillips Curve.  These higher wages are coming from a position of negotiating strength.  A nominal Phillips Curve would suggest that those higher wages are being paid for by consumers through higher prices.  A real Phillips Curve suggests that those higher wages are being paid for by employers.  Viewed as a proportion of income, it certainly appears that there is a trade-off between labor compensation and profits.

But, this inverse relationship doesn't show up in absolute measures of income growth.  However, there is a strange relationship of the second derivative.  If the growth rate in corporate profits increases, about two quarters later, labor income will also tend to increase.  On the other hand, if the growth rate in labor compensation increases, profits tend to decrease over the next few quarters.

Yet again, though, this could be a result of monetary policy.  If the Fed manages the business cycle based on a nominal Phillips Curve model, then monetary policy would be creating this correlation between rising wages followed by declining profits.  And declining profits would still lead to declining wages.

This would be ironic, but it makes sense.  Wages tend to be sticky and employment rates are a lagging economic indicator.  Equity owners hold the residual interest.  When economic shifts happen, they feel it first.  So, if the Fed thinks low unemployment is inflationary, and implements contractionary policy with an idea that this will lower inflation, they may be doing the opposite of what they think they are doing.  Instead of moderating wage inflation, they are moderating profits.

And, why would they expect contractionary policy to lower wage inflation?  What mechanism would be at work that would cause shifting monetary postures to play out initially and primarily in wage levels?  The mechanism would have to be falling profits, wouldn't it?  Isn't that the reason firms would be less willing to increase wages?

In this next chart, I compare the unemployment rate (inverted) with a scaled and detrended measure of the real total return on the S&P 500.  There is a clear cyclical relationship here.  In addition, there even appears to be a relationship over time in levels.  This only involves a couple of trend shifts since 1950, so it could be spurious.  But, when secular unemployment rates have been low, corporate valuations have been high and vice versa.

This suggests that there is a sort of Phillips Curve, but higher wages aren't being paid for with higher prices.  And higher wages aren't being paid for with lower profits.  Higher wages are being paid for with higher growth.  And there is enough growth to go around, so that profit expectations are rising as real wages rise.

This makes sense, too.  Quits rise when unemployment is low.  Employment flows into the labor force rise when unemployment is low.  This is not about us vs. them negotiating power.  This is about growth vs. stagnation.  When unemployment is low, workers might have negotiating power, but more importantly, they have the power of exit.  They can more safely test out alternative sources of income.  This is the real power.  Negotiating power is a fixed pie mechanism.  This power to leave is the power to sort better - the power to search more confidently - the power to become more productive.

We are the 100%.  "You go, we go."  When the Fed begins with the opposite presumption, their contractionary impulses hurt us all.  They should let it rip.  I'm not saying that they should aim for high inflation.  I'm just saying, they should stop worrying about things that are just not useful.  There are many reasons why a "hotter" economy might not be inflationary.  I wish we could give that a chance.

Housing: Part 240 - It's great to see some movement in the right direction.

One of my worries is that when my story gets a wider audience, there will be too much defensiveness about the conventional narrative, and my story will just have too many new re-interpretations of the data for many people to accept.

So, it delights me that over the past several months, there seems to have been a lot of positive movement in the direction of YIMBYism, even in California at the state level.  One of the oddities of discourse on this topic is how rent clearly is an important factor in rising Closed Access prices, yet in debates about whether the bubble was caused by credit supply or credit demand, there is rarely any mention of rent at all.  This leaves academics to simply argue about whether it was irrational bankers or irrational borrowers that caused the bubble.

But, among all the factions in post-recession Closed Access cities, there is no debate or question.  Rising rents are the problem.  And, increasingly, the role of supply constrictions is becoming too obvious to deny.  Once that pillar is knocked down, the façade of a credit-fueled bubble destined to collapse crumbles.

Similarly, important people like Narayana Kocherlakota are coming around to key factors in the crisis.  He recently tweeted:

When u look at other countries, u have to ask: why did US house prices *fall* so much from 06-10? https://t.co/8BcFIcRoj5 via @TheEconomist

— NRKocherlakota (@kocherlakota009) July 3, 2017

And, the replies, to my mind were weak.  This issue has been astoundingly ignored.  The reason is that we generally came to agreement that the causes of the bubble were almost all forms of American exceptionalism before we fully addressed the empirics.  This tweet is basically the foundational question of an important early chapter in the book.  I'm am very happy that Kocherlakota is already there.  The rest of the story should be more palatable to him now that he's already a few steps in the right direction.

Leverage is not a sign of risk seeking.

Building on this post about JW Mason's paper from the other day, I want to discuss debt and business cycles a little more.

Source

It's strange to me how much space debt takes up in our discourse about business cycles.  These don't look like cyclical measures to me.

I think we get closer to something cyclical if we look at equity values.

Something is wrong with the legend.  This is corporate nonfinancial equities / GDP ... Source

Even this is a little hit and miss, but at least we do tend to see some cyclical behavior here.  And this makes more sense.  When you seek risk in your savings, do you invest in fixed income or do you invest in equities?  And, part of what is happening here is that, on an Enterprise Value basis, firms tend to deleverage during expansions, mostly because the value of equities is rising.  Now, if you were a firm, and equity prices were high, and you wanted to raise capital, would you issue more high priced stock or would you issue more debt?  Why would you leverage up in this context?  You might respond that if interest rates are low, then bonds are basically fetching high prices too.  But, at the end of economic expansions, interest rates tend to be high.  They are low now, but that is because savers are risk averse now.  (There is also an upward drift in equity/GDP because equities increasingly reflect the value of foreign operations.)

How weird is it that in 2006, after a few years of middling stock market returns, when there was a massive influx of savings into AAA securities, we associated that with risk seeking behavior?  Why do we do that?

There is a recent example that might illuminate this issue.  Recently, many people noted that Tesla had a larger market capitalization than Ford. I was pretty amazed by that, so I looked up their financials.

Ford has a market cap of $46 billion plus $143 billion in debt. Tesla has a market cap of $58 billion and $7 billion in debt.  In other words, Ford is 3 times the size of Tesla ($189 billion vs. $65 billion), but claims on their assets are mostly in the form of debt instead of equity.

Now, do you suppose risk-seeking investors choose to invest in Ford over Tesla because they like how the high level of leverage gives them higher returns even though that leverage is dangerous?

Do you think a risk-seeking, over-optimistic market would have more Fords or more Teslas?  And, thus, do you think a risk-seeking, over-optimistic market would have more debt or less debt?  Would it have more equity or less equity?

Investors in Ford are mostly seeking a safe, certain cash flow.  They see some big giant buildings with expensive equipment and they figure that, even if Ford doesn't make a profit for its shareholders, its likely to earn back most of that investment, in any case.

If investors in Tesla are the risk-takers, then why don't they demand that Tesla sell a bunch of bonds to leverage their investment?  Because that's not what motivates leverage!  What motivates leverage is savers looking for certainty.  And, given the choice between loaning cash to Ford or Tesla, they have a clear preference for Ford.

Think of the madness we engage in when we see a potential approaching economic contraction, and we see rising debt levels, and we react by deciding that sentiment needs to be tamped down.  And, lo and behold, if we do it boldly enough, like we did in 2007 and 2008, lending actually does decline when we tear up the financial system.  And we pat ourselves on the back.  "See.  All that risk-seeking debt led to an inevitable collapse, and now those borrowers are finally deleveraging in the way smart people like us knew they needed to."  And, library shelves fill up with articles about the mystery of why interest rates remain so low after the crisis.

Then, debt wants to grow again, because we are afraid to let the economy grow, so nobody wants to own the residual stake (equity).  And, when debt does grow, we fret that it looks like those risk-taking investors still haven't learned their lesson, and we need to have another contraction to get all that excess borrowing out of the system.


Debt in the housing bubble

Now, think about how this played out in the housing bubble.  I have written before about the CDOs, CDOs-squared, synthetic CDOs, etc.  These are all seen as part of excess borrowing and leverage.  But, the problem was that they couldn't find any borrowers to take the mortgages.  That is the only reason those products developed.  If they could have found mortgage borrowers, they would have just packaged them into new basic RMBSs.  The mortgages would have been sliced and diced into new AAA-securities.  But, since they didn't have any new mortgages, they had to slice and dice the B-rated tranches from the existing mortgage pools to create new AAA-securities.

There are two contradictory claims about the period.  One is that spreads were low because the investors were too sanguine about the potential for falling home prices.  The other is that the portfolio managers who were investing in the AAA-rated securities from those CDOs and the exotic CDO products thought they were getting a free lunch, because they had higher yields, but they had a AAA rating.  So, they bought them, not understanding that they were riskier.

Well, what is it?  Were spreads too low or were spreads higher on those securities than they were on normal AAA-securities?  It can't be both.  This is typical of stories about the time.  It's like the facts don't matter.  If portfolio managers really were systematically fooled, then they would have bid those spreads down.  But, they didn't.  How do I know that?  Well, I really only know that because the people that tell this story always claim it, even though it undermines the story.

But, this isn't even really my main point.  My main point is that actually spreads weren't low.  They were high.  There was all this money chasing AAA-rated securities.  But, they couldn't find mortgage borrowers to take the money.  Normally, if this was the case, how would that problem get solved?  The problem would get solved by lowering the spreads until more borrowers were willing to take the mortgages!

Notice how outrageous it is that, among all the stories of stupid investors who didn't know their risks and unqualified borrowers who were duped into borrowing at predatory rates, it seems that nobody has noticed that the overriding problem of the time was that the market for mortgages wasn't settling at a market clearing yield.  Somehow, the spreads demanded by the investors couldn't go low enough to entice new mortgage borrowers, so that they needed to create the securities with other bonds.

This is because the market was already in disequilibrium.  The reason exotic CDOs were spreading was because lenders were too nervous about home equity to lower their spreads and borrowers were too nervous about it to take on new mortgages.  This was because, already, expectations of future home values were negative enough that expectations of negative equity drove a wedge between lender and borrower too large for a price to settle where all the supply of credit could be utilized.

In the midst of this dislocation, prices held fairly steady through 2006 and the first half of 2007.  How?  In 2005, about 2% of homeowning households were selling and leaving Closed Access cities, on net.  Prices were rising even with that selling pressure.  When mortgage markets started breaking down in 2006, which is when exotic CDOs really took off, that migration stopped.  Buying pressure dropped significantly, but at the same time, so did selling pressure.  Households stopped selling and moving away.  And, of course, housing starts were dropping sharply, which also took pressure off of collapsing demand.

PS. John Cochrane finds a particularly explicit example of this type of thinking regarding debt.

Housing: Part 239 - Homes in Contagion Cities during the housing bubble were Inferior Goods

The motion chart from the previous post really helps to visualize the difference between the Closed Access cities and the Contagion cities.  The bubble in Phoenix happened entirely after the Fed began to hike the Fed Funds rate.

The out-migration from the Closed Access cities had been growing since the late 1990s, and peaked in 2004 and 2005.  This surely was facilitated by nonconventional mortgages which helped households living in the Closed Access cities with high incomes to purchase homes and spread their elbows a bit.  But, you would think this would show up in gross migration flows.  You would think that during this time, more potential in-migrants would be able to buy Closed Access homes, so that there would be an increase in both in- and out-migration among the Closed Access cities.  But, according to IRS data, this wasn't the case.  Closed Access in-migration was low and flat throughout the housing boom.  This is one of several oddities that I think creates some doubt about the centrality of the private securitization boom as a cause of bubble prices and migration patterns.  ACS data, which only goes back to 2005, suggests maybe Closed Access in-migration in the top income quintile increased by about 10,000 households during the peak boom years, with little change among other income quintiles.  This compares to net out-migration at the peak of more than 200,000 households, annually, from the Closed Access cities.

One of the interesting things that I think the motion graph helps to show is that as soon as the Fed began to hike interest rates, price appreciation in LA - especially in the top tier markets - moderated.  And, it was after this moderation that Phoenix prices shot up.  But, we can also see that prices in Phoenix are much lower than in LA.  Here is a line graph of home prices over time, by price quintile.  In 1999, the top quintile of prices in Phoenix were similar to the 4th quintile of prices in LA.  By 2004, top quintile prices in Phoenix were lower than 2nd quintile prices in LA.


We can see the downshift in price appreciation in LA here in 2004, when rates began to rise.  And, at the same time, prices in Phoenix shot up.  But top quintile prices in Phoenix peaked at the end of 2005, still below the median quintile in LA.

Of the more than 200,000 households, net, that migrated out of Closed Access cities in 2005, about 85,000 were homeowners from the top two income quintiles.

Technically, we can call what happened in Phoenix a bubble.  It had the classic ingredients of a bubble - temporarily inelastic supply and demand.  But, this had nothing to do with "easy money" and I'm not sure that it really had much to do with easy credit.  The bubble in Phoenix, ironically, was the very early first signal of the bust.  Homes in Phoenix were inferior goods.  As counterintuitive as this is, this should be uncontroversial when one thinks about it for a moment.  That massive inflow of homebuyers in Phoenix in 2005 were buying downmarket.  They were buying way downmarket.  For the migrant households as a whole, it would have been mathematically impossible to do anything else.

Homeownership and rate of first time buyers were declining at the time.  But, how does this square with prices that continued to rise and mortgages outstanding that continued to rise?

Mortgages continued to rise because those Closed Access sellers were very lightly encumbered.  If your home increases in value from $450,000 to $1,000,000 in just a few years, it would be very difficult to be leveraged even if you tried really hard to be.  So the sellers were mostly claiming equity in those sales.  But, the new buyers would have naturally been more leveraged.  When those 85,000 homeowners left town, they had to be replaced by about 85,000 new homeowners.  Homeownership rates were starting to drop, but they weren't dropping by that  much.  About 2% of homeowners were leaving the Closed Access cities annually.  Homeownership rates shift by fractions of a percent.  Those new homeowners are naturally more leveraged.  That is why mortgage levels continued to grow.

Prices continued to rise in Phoenix because there was a migration surge of buyers massively reducing their housing expenditures.  Prices continued to rise in LA because prices in LA were a rational reflection of future rent values.  Today, it is easier to say that, because as we see in the graph, the most expensive homes in one of the most expensive cities in the country, have risen to new highs, even as mortgage markets have remained suppressed.  Those homes in top tier LA markets in 2006 turned out to be decent investments over the following decade.

This is because it is only in extreme and temporary circumstances that a shift in the number of buyers and sellers will move market prices.  Intrinsic value rules.  In Phoenix, briefly, the number of buyers might have pushed prices out of sustainable levels.  That was not the case in Los Angeles.  Consider that, if mortgage expansion could create a sustained increase in prices at the scale we have seen in the Closed Access cities, that the expansion had to have been so far outside normal ranges that it still pushed prices out of rational valuations, even though before that could happen, it first had to make up for those 85,000 fleeing homeowners.  That seems highly unlikely to me.  That's the jab to the credit fueled explanation for Closed Access home prices.  And the uppercut is the strong price trends in those cities in the decade since the mortgage market collapsed.