Wednesday, October 18, 2017

Housing: Part 263 - The correct answer is not in the set of choices.

Actual footage of economists answering IGM Questions
The IGM forum polled  economists about Factors Contributing to the 2008 Global Financial Crisis.

In order of importance, the choices are:

  1. Flawed financial sector
  2. Underestimated risks
  3. Mortgages: Fraud and bad incentives
  4. Funding runs
  5. Rating agency failures
  6. Housing price beliefs
  7. Household debt levels
  8. Too-big-to-fail beliefs
  9. Government subsidies: Mortgages, home owning
  10. Savings and investment imbalances
  11. Loose monetary policy
  12. Fair-value accounting

Some of these are actual problems, or at least policies which are arguably not optimal and feed instability.  Numbers 1, 2, 4, 5, 8, and 12 are basically issues that will always be up for debate and that will always appear, in hindsight, to be the cause of financial crises.  When there is a run up in defaults or a run on assets at financial intermediaries, for any reason, in hindsight, it will appear wise to suggest that financial intermediaries took too much risk, held too few assets, or underestimated risk, and balance sheet accounting that forces pro-cyclical buying and selling will make those things worse.  All of these things could possibly be addressed to help avoid future instability, and they certainly count as contributing factors, as posed in the question.  But, they don't really help much in terms of finding foundational causes of a financial crisis that occurs after national real estate markets have lost a quarter or more of their nominal value.  In the respondents' defense, the question was about "Factors Contributing to the 2008 Global Financial Crisis", so these answers aren't wrong regarding the question at hand.

Numbers 3, 7, and 10 are outcomes of the bloated housing market.  These outcomes are the result of bloated asset values, regardless of the cause of the bloat.  Again, as "factors contributing" to the crisis, they aren't necessarily wrong.

Number 9 legitimately contributes to the capitalization of real estate asset values, and thus higher prices, and also contributed to price volatility, though in a way that I don't think is widely appreciated.

The problem is in the list of questions.  In all of these cases, there is a presumption that the cause of both the boom and bust was the financial sector.  And, there is a presumption that the bust was inevitable.  Some of the respondents note that some of these factors are mechanisms or effects more than causes.  Of 74 respondents, only one noted that the list was tilted toward issues in the financial sector, but even that respondent, Nicholas Bloom of Stanford, makes clear that he considers home prices to have been too high, presumably making the bust inevitable.

Numbers 6 and 11 reflect the confusion that comes from the presumptions behind the rest of the list.  Loose monetary policy is given low importance, which is heartening.  What is interesting about that is that tight monetary policy isn't even presented as a potential cause, and none of the respondents seem to have a problem with that.

That leaves Housing Price Beliefs.  This one little factor in the heart of the list.  The rest of the factors really hinge on this factor.  Surely, limiting ourselves to this list of potential factors, none of the other factors would have been notable if we hadn't started with the core problem of overpriced housing that was bound to collapse.

Here, I present a series of scatterplots.  Each point represents the median home price of a given metropolitan area.  The x-axis is the price at the beginning of the time period.  The y-axis is the change in price over the given time period.

The graph these economists appear to have in mind is the first graph, of home prices from 2006 to 2011.  During the specific period of the crisis, there was a clear negative correlation between home prices and subsequent changes in home prices.

This period of time does appear to suggest that beliefs about home prices were optimistic.  It was also characterized early by an inverted yield curve, which is a broadly accepted sign of tight monetary policy, followed by a collapse in investment and GDP growth, a rise in unemployment, and a persistently low rate of inflation - also all signals of tight monetary policy.  It was also characterized by a near nationalization of the mortgage market and probably the single most extreme publicly imposed tightening of credit standards in US history.  Also, not available as an option on the poll.

Regarding those home price expectations and credit standards, we might take a step back and look at the broader picture.  What if we step all the way back to 1998 and all the way forward to today?  I think that it can be stated uncontroversially that, regardless of how one regards credit standards in 2006, in the time since then standards have remained tight - tighter than in any recent period of time.  After all, the private securitization market that funded subprime and Alt-A loans is basically non-existent.  So, I hope we can agree that home prices in 2017 are not part of a credit-fueled housing bubble.  Surely, collapsing rates of homeownership and a decade-long period of depression level residential investment are confirmations of this fact, if confirmation is required.

So, how about price expectations of home buyers back in 1998?  How did buyer expectations pan out?  In this case, there is a strong positive correlation between starting price and subsequent price growth.  Keep in mind, this period of time includes the period shown above.  This period of time concludes with a decade of public policy explicitly aimed at limiting access to mortgage credit where real estate is expensive, keeping home prices low.  Yet, for each 10% premium homebuyers paid in 1998, they could expect to earn about 4% in additional profit over the next 19 years.

This isn't just a refutation of the idea that price expectations were too optimistic.  In high priced markets in 1998, home price expectations were extremely pessimistic.

Now, let's move up in time, to the peak of the boom at the end of 2006.  Here is the scatterplot of home prices and subsequent changes from then until today.  Remember, again, during this period of time there was an extreme directional shift of tightening mortgage credit market standards that included the collapse of an entire conduit for mortgage originations.  In fact, today, total mortgages outstanding have still not grown to a higher level than they were at the end of 2006.

There is a bit of a V-shape here, because the Contagion cities, which tend to fall in the middle of the valuation range, did experience a bit of a bubble and bust as a result of the housing refugees fleeing the expensive cities, which I have addressed at length.  But, the notable thing here is that there is little relationship between home prices in 2006 and subsequent price changes, between MSAs.  A $690,000 home in San Francisco gained about the same as a $130,000 home in Lincoln, Nebraska.

The difference, overwhelmingly, between 1998 and 2006 is that price expectations in 2006 appear to be much more accurate across MSAs than they were in 1998, because home prices in the highest priced MSAs had been finally bid up to levels that would make future price gains insensitive to the starting price.

Maybe the 30% lag in relative valuations among those mid-range cities is the tell-tale sign of a generation defining bubble?  Then, what does that say about the 100%+ gap in relative valuation shifts after 1998?  Can someone please point me to the section in the library with 50 books explaining how extremely underpriced housing in coastal cities was in 1998?  Or, maybe price expectations in every city were too optimistic in 2006.  Maybe the $130,000 buyer in Lincoln was just as blinkered by optimism at a Price/Rent ratio of 14x as the $690,000 buyer in San Francisco was at a Price/Rent ratio of 28x?

Or maybe, none of this was inevitable.  It is a shame that tightening credit standards and tight monetary policy were not available as choices.  A few respondents did apply a low score to price beliefs and monetary policy.  I count 6 from the US panel and 9 from the European panel that gave both a score of 2 or less, on a scale from 0 to 5.

Robert Hall of Stanford and Chair of the NBER Business Cycle Dating Committee applied a 1 to loose money, home price beliefs, debt levels, underestimated risks, fraud, and savings and investment levels. (He gave himself a confidence score of 1.)  On the European panel, Lucrezia Reichlin of the London Business School gave monetary policy a 0 and price beliefs a 1, with a confidence of 8. Richard Portes of the London Business School gave them a 0 and a 2, and noted that not being the lender of last resort for Lehman would get a 4, with a confidence of 9.  Per Krussell at Stockholm University and Rachel Griffith at the University of Manchester gave both a 1.

I wonder what these respondents would have answered to the missing questions.  The correct understanding of the financial crisis lies outside the Overton Window.  The correct answer to the poll was not an option.  Would any of these respondents have given tight money or tightening credit a high score?  We can't know if we don't ask them.  I suppose that's why the question has been left for a doofus like me to answer.  Not that anyone asked.


  1. Why don't people look at the system dynamics anymore?

    Fact: Any feedback control system (supply/demand on housing where increased demand increases the supply) will go unstable when the response time to demand changes is the same as the natural oscillation frequency of the system. This is true for all system with proportional feedback like markets provide. Control theory gets around these natural instabilities. (you can't drive a machine whose response time is the same as your response time: why we not have computers between the pilot and the controls on modern jet fighters that can go unstable and crash -- F105 for example).

    Half a century ago in LA, when the market ticked up, new cities were created in less than a year response time while the market oscillation was on a 5 to 10 year basis of business cycles. This system stayed withing narrow price ranges in real dollars.

    Now we have Zoning and regulators that add years to the planning/development time schedules. This change in response time will create unstable systems that cause any small change to grow into a crash.

    This is just physics and control theory. This will show up in dynamic programing economic models of the 60's, but that isn't in favor.

    However, blaming it on regulatory delay wouldn't be PC as the regulator system becomes a great transfer of wealth from Joe Median to the educated elite who run and operate the regulatory system.

    1. Thanks for the interesting point, in general. And, this probably does apply to individual developers. But I'm not sure this has much effect at the macro level. These cities don't go through boom and bust cycles. There is never an oversupply. I think the volatility comes more from sensitivity to credit markets, long term expectations, and interest rates. It's not like the Closed Access cities had pipelines of new units growing the housing stock by 4% a year when the bust hit.

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