Sunday, March 4, 2018

Housing: Part 286 - Upside Down CAPM and the Housing Bubble

One of the over-riding themes and lessons about the housing bubble was the realization that we weren't as wealthy as we thought we were.  That we drove up the prices of American assets with debt and then took out more debt using that inflated collateral in a doomed attempt to live beyond our means.

I have discovered that all of that was wrong.  The truth is really more the opposite of that.  We have hung a weight around our collective economic neck, consisting of restricted ownership that requires transfer payments to the politically protected owners.  Home prices during the bubble were a reflection of the value of their restricted ownership.  Debt was a product of attempts to buy those restricted assets.  And debt-fueled consumption was mainly consumption smoothing by the owners of those assets, who could liquidate their real estate by sale or through credit, to consume today from their future claims on ownership.

An idea central to the conventional story is the idea that debt and leverage can be used to increase the total market value of asset classes, and thus creates a sort of false growth.

Part of the foundation of the Upside Down CAPM idea I have been developing is that this is largely false.  It comes from thinking of borrowing from the perspective of a consumer.  But, thinking in terms of a national balance sheet, it is more accurate to think of the nation's assets as the anchor - the left side of the national balance sheet.  The right side of the balance sheet shows us how ownership is divided - between creditors and equity owners.  It is more accurate to think of rising debt generally as a shift in ownership between equity and creditors, with a stable amount of assets.  Debt levels are a pretty slow moving animal, and I like to point out that the frothy markets of the late 1990s happened through rising equity values and rising growth expectations.  Interest rates at the time were high because there was a bias then for equity ownership to have a claim on that growth.  Creditors weren't bidding down interest rates in an effort to avoid risk.  They wanted risk.  And savers looking for risk want to be equity holders, not creditors.

So, how does this hold up if we look at the housing bubble?

This first graph is a graph that has been an emblem of the American spending problem.  Debt keeps rising relative to incomes.  This is unsustainable, it would seem.  Households were dealing with stagnant incomes and they were borrowing in order to keep afloat.

The first problem with that story is that the borrowing was heaviest among the households with the highest incomes.  They represent the vast majority of borrowing and they also represented most of the new borrowing during the bubble, in absolute dollars.

The conventional thinking about this shifts upon this evidence to say that, well, the debt was used to bid up housing in a frenzied bubble, so while the evidence that the bubble was built on lending to households with low incomes may not hold up, the use of debt to push up home prices still sits at the middle of the story.

Of course, I have written, ad nauseam, about how the debt was mostly funding access to Closed Access labor markets, and that rising rents explain rising prices better than credit.  But, what about those crazy high debt levels?  How can I explain that away?  Households taking on new debt amounting to half a year's income, over the course of a single decade?

But, that graph shouldn't bother us because of what's on it.  That graph should bother us because of what's not on it.  We should view the economy as a complete balance sheet, where debt is just one form of ownership.  This is a partial picture.*  Debt is the least important part of the balance sheet.

In this next graph, debt is the yellow line.  In thinking about household net worth, I want to walk through these items one step at a time.  All measures are as a percentage of disposable personal income.

Step 1: Blue Line
Step one is the value of all financial assets.  This is stocks and bonds, etc.  Not housing.  This is the value of capital held by households, except for housing.

Step 2: Red Line
In Step two, we subtract debt from the total value of financial assets.  This is how we should think about household balance sheets.  The blue line is the total (non-housing) balance sheet and the ownership is divided between debt and "equity".  (Some of the "equity" may be in the form of fixed income securities, but here, those are assets on the left side of the balance sheet.  In terms of the household's balance sheet, those are part of the household's net worth, similar to a corporations equity, or market capitalization.)

Step 3: Black Line
Most household debt is used to buy real estate.  In step 3 we add the value of real estate to the total.  If we assume for the sake of simplicity that all household debt is secured by real property (most is), then we can roughly think of the distance between the blue line and the black line as the value of household equity in their real estate.  The distance between the blue line and the red line is the value of real estate funded by debt.

Since debt has already been subtracted from the total, the black line represents American households' total net worth.**

I apologize that I have made this a bit more complicated than it needs to be.  It would make more sense to add up the real estate and financial assets and then subtract the debt from that.  You would still end up at the black line as a measure of household net worth.  But, gross household asset ownership would be at a line higher than the black line, representing the total amount of assets, before accounting for debt.  I have done this because I want to make a point.

Let's look at 2005 with the full perspective of American household balance sheets.  The credit bubble story says that we were borrowing from foreigners in a housing bubble, where that borrowing was propping up the value of that real estate.  If an American household borrowed from foreign savers to bid up the housing stock, then that would leave the blue line where it was, it would lower the red line, and it would raise the black line.

So, let's not give American households any credit for the value of those homes.  Take a look at 2005 to 2007.  In terms of gross financial assets, without housing, American households were in a better financial position than at any time in recent history - roughly on par with the peak of the internet bubble.

You might respond that this is an average and that there is gross inequality.  But, remember, the borrowers were households with high incomes.

You might respond that the stock market was still in a bubble, but PE ratios were under 20x and declining.  Bond rates were at cycle highs (so that valuations were low).

Now, subtract all that debt that Americans used to buy those homes.  The red line.  Even after subtracting debt worth 130% of disposable income, American balance sheets were as healthy as any time in modern history, except for a brief time during the internet bubble.

And, I have been arguing that the CDO boom at the end of the housing bubble was actually the beginning of the bust - part of the shift out of home equity because sentiment was already changing - even though American balance sheets were in great shape.  Notice that household net worth (the black line) was level from late 2005 to late 2007.  But, outside of housing (the blue and red lines), household balance sheets were still growing strongly.  Again, give Americans no credit for their real estate, but saddle them with the mortgage debt.  Even after that, from late 2005 to late 2007, when housing starts were collapsing and the Fed hiked the target rate to 5.25%, American balance sheets were expanding - even relative to incomes.

This is especially the time when American households were supposedly loading up on debt to live beyond their means, and now that home values had stopped rising, the end was supposedly inevitably near.  If we think about the equity and mortgage components of real estate, then, during this time, the distance between the red line and black line shrunk.  In other words, total real estate value was shrinking as a portion of household incomes.  And the equity portion was shrinking while the debt portion was rising.

Household balance sheets were healthy, but they had lost faith in housing markets, and they were disinvesting in home equity.  They still had plenty of net assets, and those net assets, seeking safety that no longer seemed available in home equity, they funded things like MBSs and then CDOs.  If, on net, that activity was the result of a global savings glut, then non-real estate net worth would have been declining.  But, on net, American net worth was rising.

When we only looked at the debt component, we missed all of this.  Part of that debt component is due to the Closed Access problem, that some urban real estate contains a capitalized claim on future political exclusion.  But, when we only focus on the level of debt over time, we miss the broader important factor.  Who borrows?  Rich people borrow. (See chart above.)

The reason debt has increased is because American balance sheets are healthy.  The reason there was a frenzy for AAA securities in 2006 and 2007 was because Americans were wealthier than they had ever been and they were scared about the housing market.  The most expensive housing markets, by far, were markets that we now know, with a decade's hindsight, were not destined for a bust.  Prices in the most expensive cities have performed as well as anywhere.  Yet, even in 2004 and 2005, homeowners were selling out of those markets and moving to other cities in large numbers - disinvesting in equity.

Were households borrowing out of home equity in order to consume?  Many surely were.  To the extent that they were, household net worth would have declined.

Today, American net worth as a percentage of disposable income is well into record levels by all of these measures.

* Oddly this selectivity is...selective.  For some reason, when talking about capital's claim on national income, economists seem to always use corporate profits - ignoring the part of corporate operating profits claimed by creditors.  When talking about household balance sheets, economists seem to only look at debt and ignore equity.  In both cases, the partial view is not very useful.

** There are also a small amount of non-financial assets amounting to about a quarter or a half of disposable income over time, so total net worth is slightly higher, but I have left that out for simplicity here.


  1. Great post.

    BTW, the many people who become successful in real estate investing look at your way….

    it is not debt payments that lead the conversation, it is assets acquired that lead thinking….

    Sure, sometimes when the economy tanks, then buying real estate looks bad (in hindsight).

    Right after a bust is a great time to buy…..

    1. The average person cannot buy after a bust by definition. If no one is selling there is no collapse in prices and no bust to buy at the bottom of.


    Aussies face housing costs…in a once affordable nation

  3. The definition you are using of balance sheet health cannot go down while 'secured' debt rises. You are using an artifact of the balance sheet system to draw a conclusion of health. According to your approach the balance sheet of a person who walks into the bank and borrows $100,000 to buy a house that the bank agrees is worth $100,000 is the same as that same person walking in and borrowing $500,000 to buy a $500,000 house, or $10,000,000 to by a $10,000,000 house. In all 3 cases his net change in individual wealth is zero. Further it is impossible to 'see' bubble activity through such a lens, as asset prices rise they pull up the net value of everyone who bought at a lower rate. Unless 100% of assets are sold simultaneously any price increase in a bubble will lead to an increase in 'net assets' and thus a 'healthier' balance sheet under this definition.

    "The credit bubble story says that we were borrowing from foreigners in a housing bubble, where that borrowing was propping up the value of that real estate."

    This is the Jim Kramer talking head definition of the housing bubble, very easy to knock down.

    1. On your first point, if you didn't include the value of houses, but did include the mortgage liability, household net worth would decrease in your scenario. Even in those terms household net worth was strong.

      What housing bubble stories aren't based on that description? Mian and Sufi? Bernanke? Shiller?

  4. "Even in those terms household net worth was strong."

    Only if you assume the value of other financial assets is independent of the value of housing prices during that time period.

    "What housing bubble stories aren't based on that description?"

    Austrian Business Cycle Theory for one.