Tuesday, October 10, 2017

Housing: Part 260 - The gorilla on the court

There is an old psychological test where subjects are told to count the number of times some basketball players pass a ball around.  During the test, a person in a gorilla suit waltzes through the middle of the players.  Only about half of the subjects even see the gorilla, because they are concentrating on the basketballs and their selective attention causes them to miss the gorilla even though it is right in the middle of the scene.

I feel like I am watching a nationwide re-enactment of that test when I see people talking about low-tier housing demand.  I have touched on this weird development previously.  The latest round has come from reactions to comments made by Svenja Gudell, chief economist at Zillow:
affordability – at least on paper – looks good, thanks largely to very low mortgage interest rates; and home prices themselves show no signs of declining any time soon. But on the ground, the situation is much different, especially for younger, first-time buyers and/or buyers of more modest means. Supply is low in general, but half of what is available to buy is priced in the top one-third of the market. This only stiffens competition at the entry and mid-level segments, which pushes prices up faster and actually contributes to quickly worsening affordability for these buyers.
This is a case of mistaking the symptoms for the cause.  But the root problem is because the actual cause is the gorilla on the court.  Everyone is on the lookout for predatory lending, overbuilding, a new bubble.  They have been on the lookout for those things for at least 15 years.  And, there was certainly a period of strong building, borrowing, flexible and destabilizing mortgage terms and funding mechanisms.  While everyone was counting up all those things, a gorilla walked through the court - tight monetary policy, shifting sentiment, and an extreme shift to very tight credit standards so that a large number of potential first time buyers aren't potential first time buyers anymore and many homeowners are stuck in homes that they once borrowed money to purchase with mortgages they would not qualify for today.

There is nearly unanimous support for a massive regime shift in lending standards, yet few understand what we have done.  Tight standards are prudent.  Right?  You're going to argue against that in the middle of a financial crisis?

The gorilla on the court is that there is little funding for entry level home buying.  So it seems like a big mystery.  This CNBC piece on Gudell's comments considers that maybe investors are the problem.  "Supply on the low end is tight because during the housing crash investors large and small bought hundreds of thousands of foreclosed properties and turned them into rentals."  So, why don't builders come in to meet that demand?  "Homebuilders are simply not building enough inexpensive houses that the market needs."
The homes are there, they're just not selling, and it's not hard to figure out why."The recent home sales data has reflected a slower pace and I continue to believe it's due to more a push back on pricing," wrote Peter Boockvar, chief market analyst with the Lindsey Group, in a response to the data release.
The article quotes Gudell, "What's missing from the equation is a lack of homes actually available to buy at a price point that's reasonable for most buyers." and concludes, "The trouble is, even though the market is woefully mismatched, home prices will not come down as long as there are some buyers out there willing and able to spend more and more money for less and less house."

Honestly, this is amazing.  I don't really fault the CNBC writer, or Gudell, or the others.  There is clearly a mass hypnosis going on here that is more powerful than the an individual's sense of logic.  What exactly do they think is keeping those rising prices from triggering new supply?  I'd like to sit down with the entire country, give them some Lego figures and Monopoly pieces and have them walk through this step by step.

Here are some people.  Here is a bank, some homes, and some potential homes.  Homes are extremely affordable for mortgaged buyers, especially at the low end of the market.  Walk me through how this breaks down.

But, they simply can't say that there isn't enough lending in that market.  The truth is too far outside the acceptable narrative.  That can't be a reason, and they are left with strange reasons, like homebuilders with inventory that doesn't match their customer base.

We limited access to ownership (and supply) compared to previous standards.  This means that returns rise for the remaining owners.  And, since we heap subsidies on the "haves" through the tax code, there are two distinct markets.  Top tier markets where the "haves" buy larger more expensive homes, and low tier markets where the "have nots" downsize as rents rise.

With all these "haves" and "have nots" it must be industry consolidation, or real estate investors, that are the problem.  All agree that we "solved" the problem of predatory lenders.

Here is a graph of real estate value as a proportion of GDP (scaled for comparison) and mortgage debt service.  Closed Access real estate is the toll booth to opportunity in the current economy, so its value will relentlessly rise.  That value (the red line) is the cost of holding a limited asset - the cost of preventing others from accessing opportunity.  It will continue to rise.  We have a sort of chimera free market/banana republic economy where only certain citizens have access to property.  That property provides economic rents to its owner.  In a banana republic, those rents come purely through income.  The market price of the property remains low because it is the lack of access to ownership that provides the rents.  You own the property because of who you are.

In our chimera economy, there is limited access property that provides economic rents to its owners.  But, its ownership isn't limited to who you are.  It is available to all, as long as you have the means to pay for it.  So, in our economy, the value of the property can fully account for its value as an obstruction preventing others from living in our gated metropolitan areas.

Before 2007, this was moderated by migration.  Those without means moved away from the Closed Access cities to less prosperous places.  Those with means, or at least with bright prospects, moved in, frequently financing the move with mortgage debt.

We have ratcheted up this process since 2007 - moving more into banana republic territory by severely limiting property ownership through mortgage regulation. So, now, prices of real estate are lower, because there are few potential buyers, especially among the "have nots", but the income and the economic rents that property pays out are higher than ever.

Here are Zillow's measures of rent and mortgage affordability.  But, this is really not even half the story.  Homes in low-tier markets have price/rent ratios much lower than homes in high-tier markets.  For marginal homebuyers who are the CFPB's "have nots" (for their own protection!), the difference between mortgage and rent affordability is huge.

Below is a graph I recently noticed in this great Griffin and Maturana paper.  Of all the work I have read, I think they do the best job of counting the passes of the basketball players, as it were.  Of all the "credit supply" school research, I think they make the most compelling case.  They frame the cause of some rising prices in terms of "dubious" mortgages - mortgages with poor documentation and false information.

This graph is of home prices in cities with elastic housing supply, what I would call "open access" cities.  In Closed Access cities, new mortgage access might cause prices to rise, because supply is limited.  But, in Open Access cities, it is hard for prices to rise far above the cost to build, so new credit is more likely to lead to new homes.

They find that prices in zip codes with dubious lenders didn't rise more than prices in other zip codes in the Open Access regions.  But, prices in the dubious zip codes did fall much farther after the bust.  They take this, understandably, as a sign that dubious mortgages induced oversupply, which led to a collapse.

This is an understandable conclusion because they can't see the gorilla.  As the others I quoted above have noted, rents have been increasing.  That is odd.  If prices were falling because of oversupply, you'd think you would see that in rents.  Griffin and Maturana follow the standard practice of academics arguing about the role of credit in the housing boom and bust.  The word "rent" does not appear in the paper.  (Well, it appears once regarding "economic rents", but not regarding rental income of a homeowner.)  So, it is understandable that they didn't notice that oddity.  Rent just isn't part of that conversation.

The graph is interesting because the initial shock affected both areas - those with more dubious lending and those with less.  By the third quarter of 2008, the mortgage origination industry that had grown up around private mortgage securitizations had been dead for some time.  There really are two distinct periods here where home prices fell more in the areas with dubious lending and diverged from the other areas.  The first was in the third quarter of 2008, when the financial crisis hit and the GSEs were taken over and lending tightened.  The second was after the third quarter of 2010, when Dodd-Frank passed.

The collapse in the bubble cities was of a scale so much larger than other areas, it sort of drowns out what was happening in the bulk of the country in 2008 and 2009.  But, here, where Griffin and Maturana have isolated the Open Access parts of the country, it looks like Dodd-Frank had more of an effect on these home prices than the GSE takeover did.

G&M look at the change in prices over the entire period after 2006, and conclude that when the dubious lenders collapsed those zip codes had a supply overhang because of all the unqualified homeowners, and that led to inevitable decline.

But, first, there never were too many homes.  Second, by 2010, when most of the divergence happened, homebuilding had been dead for years.  There is no way that the divergence that happened then was the result of supply overhang.

G&M counted all the passes.  But, the gorilla on the court is that after 2007 lending standards were tightened extensively.  G&M, like most people, seem to just account for any contraction after 2006 as if it is simply an unwinding.  But, the pendulum swung far in the other direction.

We can see here how, as is so often the case in this story, the presumption determines the conclusion.  G&M do a lot of interesting work in that paper.  But, some of their conclusions come down to an implicit presumption that whatever happened after the bust was inevitable and that lending norms at the end of the bust were roughly similar to lending norms that pre-dated the boom.  That presumption is incredibly wrong.

In fact, in their chart that I show above, if we were looking for gorillas, it would seem quite obvious to us that the discontinuity was in 2008 and after.  Let me be clear - it would seem obvious.  Maybe that presumption is wrong too.  I don't think it is wrong.  But, the change in presumptions so that we were looking for a time when credit standards tightened, would lead us to view that graph with high confidence as confirmation that in 2008 and after, there was a devastating collapse of marginal credit markets.  That's the gorilla.  Once you see the gorilla, you stop paying attention to the basketballs.  You say, "Holy cow! There's a gorilla on the basketball court!  That is something!"

This doesn't mean there weren't basketballs.  Surely some housing outcomes in 2004 and 2005 were facilitated by peculiar mortgage market developments.

But, Dude!  There's a gorilla on the court!


  1. I'm an economist and I can't understand what you're saying. Could you restate this in standard economic & financial language without analogies or references to third-party comments with which you disagree?

    Specifically, who exactly is ignoring what you consider obvious in terms of risk-adjusted returns and why? Also, describe your solution and explain who bears the economic and financial risk if you're wrong. Finally, tell us what you personally are doing to capitalize on what apparently everyone else is missing.

    1. Regulatory limits to borrowing have created non-price rationing in housing markets combined with subsidies for buyers who meet the threshold for buying. The shift toward this is pretty extreme and it shows up in falling homeownership among the young and middle class, prices in low tier markets that have lagged high tier markets in most cities. So costs rise for consumers and incomes rise for owners in low tier housing markets.
      I would say, for those with the means and the ability, buy leveraged SF rental properties. But that takes some skill.

  2. Great post.

    Just for fun, I did a word search on the Griffin and Maturana paper. The words "property zoning" do not appear, even the word "zoning" does not appear. Not even in a footnote. Not even to be dismissed as a topic.

    (This reminds of a joke from my dating days: "I would like to say I was snubbed, but first she would have had to even notice me.")

    The orthodox macroeconomics profession cannot think about housing markets in a way that is meaningful.

    Moreover, just look at housing production. It has been a pathetic weakling industry for 10 years. Yet the Census Bureau says there will another 100 million USA'ers by 2050.

    But we find the macroeconomics profession jibber-jabbering about interest rates, or too much credit to some borrowers.

    There will be 100 million new Americans (from 325 mil to 425 mil, round numbers) in 33 years.

    This makes the China one-child policy look viable, along with a dose of xenophobia.