Saturday, June 23, 2018

Housing: Part 305 - If only we could burn all the extra houses down.

From Andrew Ross Sorkin's "Too Big to Fail"(pg. 190), from the summer of 2008 before Fannie and Freddie were taken over by the Treasury.
Paulson and a half dozen staff members huddled over the Polycom on his desk to hear the former Fed chairman's faint voice through the speaker.
Rattling off reams of housing data, Greenspan described how he considered the crisis in the markets to be a once-in-a-hundred-year event and how the government might have to take some extraordinary measures to stabilize it.  The former Fed chairman had long been a critic of Fannie and Freddie but now realized that they needed to be shored up.  He did have one suggestion about the housing crisis, but it was a rhetorical flourish befitting his supply-and-demand mind-set: He suggested that there was too much housing supply and that the only real way to really fix the problem would be for government to buy up vacant homes and burn them.
After the call, Paulson, with a laugh, told his staff: "That's not a bad idea.  But we're not going to buy up all the housing supply and destroy it."
IW readers know there weren't too many homes.  The only things the American housing market and the economy needed were sufficient money and credit.

I have the same feeling reading these retrospectives as I do hearing debates about the market today. It's like we're a tribe that shares a religious origin story in which the spirit of spring floods plays the devil's role. We're in the midst of a terrible drought, but it is simply part of our cultural DNA that water cannot be part of the solution.  So the elders desperately engage in plans and discussions about dealing with the drought in which they cannot reference water as a solution.

Dig a well? Build an irrigation canal? It's not that arguing for these things would be fruitless. It's that it wouldn't occur to a respectable person to mention them.  To mention canals would only serve one purpose - identifying yourself as a heretic.

To suggest that Fannie and Freddie should seek to expand their balance sheets in the summer of 2008 would only serve to besmirch one's own character.  (Look who's the first to pray to the spirits of the flood when things go bad.)

In effect, the entire country became taken with some version of what Robin Hanson would call "far thinking".  Far thinking is where we can impose our ideals on a map of the world that is clean and easy, where our ideals don't have to be moderated by messy reality.  In far mode, the Wall Street Journal can talk about the virtues of a financial panic. FOMC members can talk about letting the market discipline risk takers.  The President can explain that it's not his job to bail out speculators. Elizabeth Warren can ask why aren't more bankers in jail.  In far mode, we can know that they did this to us.  In far mode, just deserts keep us on the straight path.

In effect, Greenspan and Paulson are dealing with the cognitive dissonance of far mode here.  Burning down homes is an obvious solution to the problem in far mode.  Unmoderated by messy reality, far mode can get pretty absurd.  They recognize the absurdity of it. That's why the suggestion is funny.  If only they had taken it seriously enough to force them to confront the "near" - to confront the cognitive dissonance that made it funny - their plans might have been moderated by messy reality.

I wish I could travel back and take them to some townhouse in Brooklyn whose family was moving out of the state because they couldn't afford to spend half their income on rent anymore.  Here's some lighter fluid and a match, Al.  Should we start with this one?

As the crisis wore on, others echoed Greenspan's sentiment.  Frequently the concern was about old working class neighborhoods in rust belt cities, which were devastated by foreclosures.  Now, isn't it strange that in a country that had supposedly just built millions of unneeded homes in Arizona, Forida, etc., that the excess supply was in 80 year old neighborhoods in Cleveland?

Here is an article from Cleveland in 2010 about their program to tear down homes.  Now, in cities that have been depopulating, it may be the case that there are parts of town that call for demolition programs.  But, my point here is that we have conflated this problem with the subprime lending crisis in ways that have led us astray.  From the linked article: "Blame our region's economic stagnation and the nation's recession; blame lenders who bent and broke old rules to make loans to people who couldn't afford them; blame Wall Street speculators who bundled and resold those toxic loans, poisoning the economy. Or blame our drive to expand, leave the old neighborhoods and make new suburbs out of countryside."

For "Wall Street" to be implicated as a source of unneeded homes, those loans would have had to have been associated with a building boom.  Here is the rate of new housing permits (compared to civilian labor force for scale) in the US as a whole and in Cleveland.  I show a long time frame here, just as a reminder that even at the national level, there was nothing unusual about the rate of building in the 2000s.  But, Cleveland didn't have any part of the 2000s housing boom, such that it was.  The rate of building in Cleveland was low and steady, until 2006, when it fell off a cliff along with the rest of the country.

The reason home building fell off a cliff in 2006 in every city across the country is because buyers lacked money and credit.  Cleveland didn't build a bunch of homes and then suddenly discover that they couldn't afford them.  In fact, in Cleveland, as in just about every city in the country, rent inflation rose in 2006 and early 2007 because of the shock to supply created by tight monetary policy.

By 2010, when neighborhoods were devastated by the blight of foreclosed properties, those neighborhoods suffered from one problem: not enough money.  This was not a supply issue.  Even today, homes in those neighborhoods generally fetch rents of around $1,000 a month.  The collapse was purely a nominal issue.  2018
Here, I compare home prices in the three most expensive ZIP codes in Cleveland (blue, right scale) with the three least expensive ZIP codes (orange, left scale).  Cleveland is like most other cities.  During the boom, prices across the city increased at similar rates.  Then, after we pulled the rug out from under low tier mortgage markets, prices diverged.  After mid 2008, low tier markets collapsed.

Low tier homes have prices that are similar to prices in 1996.  High tier prices have risen in the range of 50% over that time.  Working class balance sheets have been devastated.  Low tier homes in Cleveland lost half their value after 2008.  This is not because rents have suddenly been cut in half, because this isn't a supply issue.

When Hank Paulson and Alan Greenspan jokingly wished they could burn down some homes, what those homeowners needed was some cash. Cash that the Federal Reserve, Fannie Mae, and Freddie Mac were in prime position to provide.  The thought didn't even occur to them.  It couldn't have.  It would have been heresy.  2018
Here, I have graphed mortgage affordability for the median home in ZIP code 44137, Maple Heights, OH.  It's the yellow line in the previous graph.  There was no affordability crisis in Cleveland.  The monthly payment required to buy those homes with a conventional loans was similar to what it had been for at least 10 years, after adjusting for inflation. (This graph is in current dollars.)

Foreclosures in Cleveland had been rising throughout the boom, and they spiked from late 2005 to 2007, and then remained high.  Maple Heights continues to have many foreclosed properties.  In the "bubble" cities, foreclosures tended to be a lagging factor - after prices collapsed.  This is the case in Cleveland, too.  Clearly, after 2008, foreclosures were a function of household income shocks in properties that had lost all of their equity, so that the owners couldn't make payments and couldn't tap equity as a rainy day fund.  But, Cleveland did see a rise in foreclosures before the collapse.  This suggests that there was a market in risky mortgages in Cleveland during the boom that called for some moderation.

But, this is the important yet subtle point: The mortgage boom didn't have any significant effect on home prices or supply in Cleveland.  It had little effect on aggregate demand for housing.  The sloppy way in which housing affordability is commonly equated with home prices instead of with rents and the sloppy way that price booms in places like San Francisco or Phoenix have influenced our image of housing markets in places like Cleveland have led to disastrously wrong consensus in policy.  So disastrously wrong that when working class households in Cleveland just needed some cash, the public officials who could have provided that cash were wishing they could destroy real assets.

This over-reaction caused home values to collapse.  By 2010, when the over-reaction was codified in the terms of Dodd-Frank and the Consumer Finance Protection Bureau, the affordability of homes for buyers was unprecedented.  Actual affordability (in terms of rent) was worse than ever, because of the supply shock.  But, in Maple Heights, where the median home required monthly mortgage payments of about $600 for the decade leading up to 2008, it had fallen to less than $400.  And, the further collapse in home values that followed Dodd-Frank eventually pulled the median mortgage payment down to $200.

Excessive lending had little effect on mortgage affordability in 2005.  But, the over-reaction against lending had such a devastating effect on home values, that mortgage expenses declined by 2/3.  While pundits and critics blamed the Fed for saving Wall Street instead of Main Street and while they demanded cram downs, forced refinancing, and subsidies to borrowers, and while Greenspan and Paulson wondered how to get rid of all those houses, what those neighborhoods needed was for someone to just offer them some run-of-the-mill mortgages, of the type that they had successfully been paying for decades.  Not only the existing borrowers, but the potential new borrowers.

We were so upset about mortgages that stretched some borrowers too thin when mortgages in Maple Heights required monthly payments of $700 in 2005 that we were bound and determined to prevent mortgages from being made in 2010 that required payments of $200.  And we did it in the name of affordability.

This is a crazy disconnect.  The idea that homes were too cheap because of oversupply was consensus.  Greenspan and Paulson were hardly staking new ground here.  Consider the scale of the religious zeal against lending that had to be in place for them to think this was a problem.  Even if oversupply had been a problem, sane people would not have wanted to destroy the extra homes.  The obvious solution would be to buy them for pennies and then give them away to working class households.  If there was an oversupply, then working class households could just double the square footage of the homes they were living in at no extra cost.  The reason this wasn't happening in reality was because there was, in fact, a shortage of homes, and rents were rising.  But, if oversupply was the "problem", then the obvious solution at any time from 2009 on would have been for Fannie and Freddie, under federal control, to open the flood gates, and to spread our overabundance of homes to working class borrowers, who could now have twice the house at half the expense by shifting from renters to owners.  This is still, basically, the case today.  And, today, we still maintain a religious zeal against letting that happen.

To get back to normalcy those low tier home prices in Cleveland would need to double from today's price.  This is fabulous news.  For working class homeowners who have managed to keep their properties, simply returning to a normal market would double the value of their homes.  It's amazing how easily one can attain new health simply by refraining from taking poison.

But, the problem with human affairs is that sometimes, when we are wrong enough, being wrong is an impediment to correction.  The disconnect between reality and the consensus view is so great that the truth seems too outrageous to entertain.  So, burning down houses makes more sense than giving them away and to suggest otherwise seems like madness.

In the meantime, working class homeownership is on a 50% off sale in Cleveland while many complain that homebuilders aren't building enough new homes for the entry level market.  And, homebuilders complain that labor, and lumber, and lots are all too expensive.  Everything is too expensive when you're trying to compete against a 50% off sale.  So, because the consensus is so wrong on this issue that it requires a religious conviction to maintain it, this leads many today to complain that those costs are too high because we have too much money.  The solution to homes that are undervalued by half is to raise interest rates and suck cash out of the economy to bring those other costs down.  An awful lot of bad things will happen before those costs are low enough to compete with the 50% off sale.


  1. Amazing post.

    A quibble here or there.

    Housing prices in Cleveland fell after the region stopped producing and exporting as much as it formerly did, so there was less income to the region. That seems roughly true.

    I think lower living costs and commercial rents could have saved a Cleveland or possibly even a Detroit, had human behavior been better.

    But no one who is a productive-type, that is they show up for work every day etc., wants to live in a crime-ridden neighborhood. So some neighborhoods went downhill and ultimately depopulated. Valuable housing stock was lost, a real shame. In a sense (a real one in Detroit) they were already burning down houses.

    I love your flood-myth analogy, and possibly you know there were in fact great, periodic and scouring super-floods that ravaged the Plains after the last Ice Age. Interestingly, Death Valley CA was a large fresh-water lake only a few thousand years back. And there are still visible stone fishing-traps in the Mojave.

    Okay, I am a little OT.

    But back on point. You describe the mythology of housing in the US. In many ways, I agree that it is a mythology.

    But who are myth-makers?

    As I often say, "Like efficient market theory, vulgar Marxist analysis answers in about 95% of situational reviews. However, Marxist medicine is poison, while efficient markets are the solution 95% of the time."

    1. Thanks Ben. You are right about the regional economic downturn. That probably explains much of the pre-crisis rise in foreclosures. In 2007, the Great Lakes area in general had high foreclosure rates.