Housing: Part 314 - Costs will rise to meet price

I recently saw some research that suggested that the cost of building in the San Francisco area was high - that the typical new unit costs about $600,000, and most of that is construction costs.  Unfortunately I have lost the link.  But, I want to address this idea.  The conclusion this would lead to is that building in San Francisco is just naturally expensive, and that it is those natural costs that create high rents and prices rather than zoning or political obstructions.

But, I think that is incorrect.  Here, I think the comparison to Detroit is useful.  Building cars used to be very profitable in Detroit.  Detroit had natural advantages which were magnified as supply chains developed around those advantages.  The natural evolution of the industry led to a context where certain firms who had survived within the marketplace captured excess returns from these path-dependent advantages.  But, those advantages were geographically captured, so they could be siphoned off by local governments, unions, etc.  Eventually, an hour of labor in an automotive factory in Detroit cost more than an hour of the same labor in other locations.

That wasn't disruptive as long as the advantages of operating in Detroit were strong enough to share some of the economic profits.  But, the problem was that other places - notably Japan - developed their own economic advantages, and eventually the costs of operating in Detroit outweighed the advantages compared to other locations.  Now, it is to the point where automotive production is expanding in many areas other than Detroit, in spite of Detroit's previous advantages.  That is because claims on economic rents are more difficult to minimize than natural costs are.

But, it's not like those costs are separated out nicely.  It's not like you can easily look at the cost of building a car in Detroit and say, "OK, this $100 is natural, this $100 is economic rents." etc.  All those costs are bound up together with natural costs.  Who can say, with precision, what portion of local taxes are legitimate and what portion were due to wasteful spending that grew because the availability of excess profits could fund it?  Some of the cost of building the car is due to high wages.  But, much of those wages may also have been claimed by a myriad of other local costs, so that, even if workers were willing to give up their portion of the fading economic profits, they wouldn't be able to because their costs would be higher, and it would be difficult to determine which of those costs were reversible.

So, it would seem reasonable to say, "It is expensive to build cars in Detroit."  But, that would sort of be the opposite of the truth.  It was never naturally expensive to build cars in Detroit.  Yet, once a geographically captured source of economic profits develops, costs will inevitably fill the gap.  In fact, one could say that the reason Detroit has become less competitive is because it was too economical to build cars there, and sticky rent seeking filled in the gaps where production costs were low.

This is how it costs $600,000 to build a housing unit in the San Francisco area.

It really only costs, say $200,000, just as it would anywhere else in the country.  But, political obstruction has created an oligopoly in San Francisco housing, boosting the market price to $600,000.  That difference would go to land, some might be claimed in development taxes and fees, some would go to queuing and financing costs, etc.  Many of those costs would get rolled up into the actual cost of construction.  Local laborers require higher wages to pay for their own housing, for instance.  And, in addition to adding fees and taxes to new developments, local governments can add requirements which make building more expensive.

There is no natural impediment to adding those costs because it doesn't affect the incentive for developers to build or the market price.  It comes out of queuing costs or the cost of the land.

I sort of half jokingly wrote about California requiring solar panels on new homes, concluding that while that might be a dumb policy in most places, in California, those solar panels might produce some benefits, whereas the capital that would go toward the solar panels would otherwise have just been wasted in queuing or would have been transferred to land owners.  That is an instance where these costs get folded into building costs.  It is an example of how none of these issues reflect a Machiavellian collective policy structure.  There are just various groups with various forms of ideology or self interest who are vying for access to these economic rents.  On this case the solar panel interests plus some ideological environmentalists got a piece of the rents for their own purposes.  And, those rents now are reflected in construction costs instead of taxes or queuing.

If none of these costs were imposed, the difference between price and cost would all be waste or inefficient transfers, as I argued in the solar panel post.  So, in a way, fees and taxes, and even regulatory demands, are an improvement over the status quo at any point in time.  But, the nice thing about queuing costs and land prices is that they aren't sticky at all.  If added supply brought prices down, queuing and land costs will adjust quite easily.

So, if these economic rents have been changing the local landscape for long enough for these economic rents to have been rolled into costs, that is really bad news for the San Francisco area.  That means that there is now no functional way for new supply to bring costs down to a functional level.  It means that "market rate" supply, and even publicly funded units, really can't bring down high rents.

Housing: Part 313 - The boom and bust through a "safe asset" lens

I'm sure I have covered some of this before, but I thought I would just walk through the financial crisis purely from a "safe asset" frame of reference, focusing on housing.



Source

First, here is a chart measuring the year-over-over percentage change in home equity value (total owned real estate minus mortgage debt).  The annual gains from 1998 to 2005 were similar in magnitude to the gains from 1967 to 1986.  In both cases, "demand" side factors were given a large place in the causal story.

But, "demand" side factors were really only a foundationally important factor in the earlier period.  In 1970s period, the rise in home equity was roughly divided between declining real yields which increased price/rent ratios, and rising general price levels.  So, rising home prices were somewhat paralleled in rising prices across the economy at that time - because rising home prices then were actually a result of demand-side factors.  High inflation, high NGDP growth, etc.  Since that period truly was broadly a demand-side event (punctuated by some supply-side shocks in petroleum markets), there was never social pressure to induce a decade of deflation to counter it.  That would be dumb, and everyone recognizes that.  So, Volcker's task was simply to tame inflation.  Nobody was demanding "market discipline".  I am not aware of a movement at the time pushing for broad nominal capital losses.

The period of the 2000s was not a demand side event.  It was caused by localized supply constraints.  So, in that period, rising equity was roughly split between declining real yields which increased price/rent ratios (just like the 1970s) and rising rents in constrained locations (not like the 1970s).  Those rising rents were the product of political obstruction.

And, this brings us to the topic of safe assets.  In the actual demand-side boom of the 1970s, homes were considered a safe haven from inflation.  In that context, homes were a safe asset - maybe even "safer" than normal.  Aggregate home prices were never far from replacement values.  There was no reason to worry about aggregate home prices collapsing in a functional economy.

In the 2000s, regardless of what specific causes you might assign to the housing boom, I think everyone can agree that rising home prices became unconnected to replacement value.  Homes in San Francisco don't sell for $1 million because of high lumber prices.  In other words, because the housing bubble of the 2000s was not a demand-side event, homes had become less of a safe asset.

So, thinking in terms of safe assets, from 1998 to 2005, real estate in the Closed Access cities (NYC, LA, SF/SJ, Bos., SD) went from less than $3 trillion to more than $7 trillion in total value.  (Data generously provided by Zillow.com.)  In terms of total assets, the American economy gained $4 trillion in value.  But, the very act of gaining that value meant the loss of safe assets, because those properties now have a very real danger of quickly losing much of their value.  So, really, during that time, speaking with a broad brush, the US gained $7 trillion worth of risky assets and lost $3 trillion worth of safe assets.

Now, it is true that in any time or place, real estate can lose value.  Former homeowners in a city like Detroit experienced the risk of loss as values declined, even though values there had never been stratospheric.  But here it is important to recognize the importance of income (imputed or cash) in real estate markets.  Frequently, because owners only experience income as an opportunity cost (opportunity profit?) through the rental payments they didn't have to make, the income factor in real estate values is forgotten and capital gains are treated as the only reason for ownership.  But, in real terms, income is by far the most important factor in real estate returns.  A house selling at a price/rent ratio of 10x can still be a decent long term investment even if it is razed in 30 years.  That is not so much the case for a home selling at 20x rent.

Real long term interest rates, measured by 30 year inflation protected treasuries, dropped from about 4% in the late 1990s to about 2% in 2005.  It was considered a conundrum that long term real interest rates didn't rise along with short term rates in 2004-2005.  But, already, there had been a loss of safe assets because a portion of the American housing stock had ceased to be safe.

Then, after the Fed started raising interest rates in an attempt, in part, to slow down residential investment, in the face of this shortage, the idea that home equity in Closed Access cities was not safe was intensified.  You can see this in the migration patterns out of those cities.  Hundreds of thousands of homeowners were selling and moving to other, less expensive, cities.  They sold their homes to more leveraged buyers who had less equity on the line.  A high LTV owner - especially an investor owner - holds something more like a call option than a fully at-risk equity position.

In a way, the private securitization markets clarified the new context of asset safety, because the old Closed Access owners took their capital gains and plowed them into AAA rated securities, which were more safe than their home equity had been.  And the mortgage securities that funded the new buyers were actually divvied up into risk classes.  Some of those risk classes were rated as risky bonds and some were even called "equity tranches".  Some of the investors in those mortgages rightfully considered their investments to be "equity".  So, in a way, the market incorporated this new reality into its structures.  (In the end, of course, the risk obviously reached beyond the equity tranches, but as I have written elsewhere, that was the product of a series of policy catastrophes that continue to today.)

Source

Most of the homeowners in LA who were selling and moving somewhere like Phoenix probably considered the market to be in the midst of a credit-fueled bubble.  It doesn't really matter why they thought their home equity was in danger.  It only matters that they did.  And, thinking in terms of portfolio construction, we can see that when they traded their million dollar home in LA for a $250,00 home in Phoenix plus $750,000 of money markets, CDs, bonds, etc., they were explicitly reconstructing their portfolios in order to remove an asset class that had ceased to be a safe asset and replaced it with other safe types of assets.  This is what was going on when the CDO market was blossoming in order to meet rabid demand for AAA-securities.

This is what was happening from early 2006 to late 2007.  Prices were fairly level, but there was a mass exodus from home equity.  This shows up both in collapsing housing starts and in falling outstanding levels of home equity.

By 2007, the entire real estate asset class - $25 trillion in terms of total value or $13 trillion in terms of home equity after mortgages - ceased to be safe.  This step in the process was largely due to expectations.  A national consensus that the acknowledgement and enforcement of a lack of safety in home equity was a signal of prudence, wisdom, and sophistication.  Of course, we all know better, but those other people are always greedily chasing after profits and forgetting that losses can be very real.  This is the story that you can find being told explicitly in the dozens of books that line the shelves of your local library about the boom and bust.  And there were highly leveraged unsophisticated investors, especially in the Contagion cities like Phoenix.  We weren't lacking in anecdotes to fill the narrative.  Narratives never lack for anecdotes.  There are always naïve speculators, greedy bankers, violent immigrants from disfavored ethnic groups, mal-informed leaders from the opposing political party.  In all political topics, whatever popular narratives might lack, it is never supporting anecdotes.

So, the second wave of lost safe assets came from a consensus acceptance of collapse.

The third wave of lost safe assets came after the crisis, when mortgage markets were tightened up sharply.  As a result, housing starts have remained at depression levels for a decade.  A couple trillion dollars worth of physical assets have not been created because of this.

So, when thinking about the safe asset shortage that keeps real long term interest rates low, housing plays an important role here, in three steps:

1) The loss of a few trillion dollars worth of safe assets when the value of Closed Access real estate rose to far above replacement value.

2) The loss of more than ten trillion dollars of safe assets when the value of most real estate in the US was expected to and allowed to collapse.  The fact that fixed income securities associated with housing lost their "safe" status has been the focus of public attention, and the false sense of inevitability has led most people to act as if those securities were never actually safe.  But, the losses in those securities are a secondary effect that only came about because of the much larger loss of "safe" status in the home equity asset class.  The Case-Shiller index fell nearly 40% in Atlanta from 2007 to 2012.  Losses associated with securities funding mortgages originated in Atlanta are surely a small fraction of those equity losses.  This phase of the safe asset shortage problem is, by far, the most significant, and it is also associated with the sharpest and most persistent decline in real long term interest rates.  But activity in fixed income markets only captures a portion of what has happened.  The ubiquity of comments along the lines of "people forget history and they naively thought real estate never loses value." makes it clear what happened.  There was a public hysteria committed to removing the real estate equity asset class from the set of safe assets.  You may balk at calling it hysteria.  If prices in a few cities like Phoenix had dropped by 20% or 30%, then a defensiveness about that would be merited.  But, when that consensus view is so widely used to excuse and justify a nearly 40% drop in home values in Atlanta, which, like many cities, didn't even see much of a shift in Price/Rent ratios until they collapsed after the crisis, it is quite clearly hysteria.

3) The loss of $2 or $3 trillion more in potential safe assets in the homes that have not been built and the continued suppression of home values in properties that are at or below replacement value because of mortgage market dislocations that prevent households from buying or selling units, especially in low tier markets.

Housing: Part 312 - An introductory slide deck to my new view of the housing boom and financial crisis

Here is a slide deck introducing my work on the housing bubble and the financial crisis.  I will keep a version of this in the page links in the right margin, for future reference.

Housing: Part 311 - The Premise Determines the Conclusion

Bill McBride has a post up today at Calculated Risk remembering testimony from Alan Greenspan in 2005.  This strikes me as a good example of the premise determining the conclusion.  The Fed held a meeting in the summer of 2005 where they looked in depth at housing.  Greenspan's comments here, that there could be some contraction in some local housing markets, but that it would be manageable, reflect the conclusions of that meeting.  And, those conclusions were basically correct.

Here's part of the excerpt at Calculated Risk:

The U.S. economy has weathered such episodes before without experiencing significant declines in the national average level of home prices. Nevertheless, we certainly cannot rule out declines in home prices, especially in some local markets. If declines were to occur, they likely would be accompanied by some economic stress, though the macroeconomic implications need not be substantial. Nationwide banking and widespread securitization of mortgages make financial intermediation less likely to be impaired than it was in some previous episodes of regional house-price correction. Moreover, a decline in the national housing price level would need to be substantial to trigger a significant rise in foreclosures, because the vast majority of homeowners have built up substantial equity in their homes despite large mortgage-market-financed withdrawals of home equity in recent years.

Whether you see his comments in 2005 as obtuse and foreboding or as reasonable completely depends on your premise.  If the crisis was inevitable, these comments are foreboding.  If the crisis was avoidable, then it is 2005 Greenspan that was reasonable, and it was the FOMC members in late 2007 who saw their jobs as being disciplinarians enforcing catastrophic losses who are chilling.  It was federal regulators who cut off lending to millions of households after 2008 who are chilling.  The premise does all the work here.  And, unfortunately, we had and have the political means to impose the premise of inevitable collapse on ourselves.

Because the premise itself holds so much power in the stories we tell ourselves about the crisis, nearly everyone has developed a strong sense of certainty about their conclusions. But that certainty is a mirage.  And, that certainty led us to impose the policies that created the conclusions that only reinforced the premise and the conclusion.  Rinse and repeat.

Everything in Greenspan's comment above was true.  The national housing price level did need to decline substantially to trigger a significant rise in foreclosures.  The foreclosures that impaired the value of AAA rated securities at the center of those markets happened after 2008.  Believing that those foreclosures were inevitable, even as the public and policymakers explicitly recognized our ability to avoid them and chose not to, allows one to turn the truth Greenspan spoke into an untruth.

June 2018 CPI Inflation

Not much to say this month, but I have been tracking this lately, so I am posting updated graphs.  There was a bit of a reversal in shelter vs. non-shelter inflation rates this month, which is probably mostly noise, although there have been reports of declining rents in some cities.  Trailing 12 month core inflation is at 2.2%.  The recent bump has mostly been because the months falling off the back end were low or negative.  Even though 12 month core inflation has been rising lately, annualized core inflation from the last four months has been about 0.6%.

So, the upward trend from the 12 month measure is sort of a false signal, but whether it goes up, down, or sideways from here is still to be seen.  I continue to watch the flattening yield curve, but I admit that this show has been playing for longer than I had expected it to.

Housing : Part 310 - The premise determines the conclusion, a continuing series

Here is an interesting symposium at the NBER on the financial crisis (HT: MR).  Previously, I have written about how the crisis and its presumed causes were predetermined.  When the question is asked, "What caused the financial crisis?"  The answer always comes in the form of "This is what caused the housing bubble."  The inevitability of the crisis is canonized.  It doesn't even need to be asserted.  This can be seen throughout the slides that are provided at the NBER link.

A set of slides from Nicola Gennaioli and Andrei Shleifer discusses the difficulty of seeing bubbles and preventing them from blowing up.  It includes this graph, which all reasonable people are supposed to agree is part of the "the banks did this to us" story, where banks got all leveraged up with irrational exuberance and short-term greediness.

Can I suggest that this seems a bit underwhelming?  I mean, there are legitimate debates to be had about the most systemically safe ways to fund investment banks, but I think if you showed this graph to anyone that didn't have priors that there was a massive financial crisis caused by risk-taking, nobody would look at this and say, "This is clearly the picture of a financial system ready to blow up in 2007."

Morgan Stanley is the only bank shown here that had leverage in 2007 that was significantly higher than previous levels.  Maybe you could argue that leverage had been too high for the entire decade shown on the graph.  But, then this is just axiomatic.  It's a plausible condition that is lying in wait to explain any crisis.  Really, in that case, you could remove the y-axis, or change the numbers to half or to double the numbers shown here, and the argument wouldn't fundamentally change.  I mean, if Morgan Stanley had been leveraged 20 to 1 or even 10 to 1, and a financial crisis struck, it's not like economists would all look at this graph, with that different scale, and say, "Well, leverage clearly didn't cause this crisis.  Now, if they had been leveraged 30 to 1, then leverage would be important."

No. Leverage is a plausible cause of financial crises, and so any level of leverage, in hindsight, can be called out as the cause of the crisis.  The premise is overwhelmingly the source of the conclusion.  And, certainly leverage is a plausible cause of financial crises.  That's what makes it such a compelling culprit that the premise itself seems sufficient to reach a conclusion.

Here's another slide from that deck.  Here, referring to Lehman and what appear to be optimistic expectations in 2005, they say, "Analysts at Lehman Brothers understood the consequences of home price declines. However, they severely underestimated the probability and magnitude of these declines."

Again, this is hardly new ground.  This is consensus stuff.  But look at those scenarios.  There is nothing wrong with them.  There is a 50% chance of home prices rising by 5% per year, and a 5% chance of a shock to home prices worse than anything we have seen since the Great Depression.

And, who is to say that those probabilities are wrong?  Who is to say that if we could relive the 2000s a hundred more times that 95 of those times would turn out just fine?  Oh, and by the way, this scenario analysis would be pessimistic if it was applied to Canada, Australia, or the UK over the same time period.  We do have several versions of economies entering 2006 with very high home prices, and the evidence suggests that having a generation-defining housing bust is highly unusual.

This is such a deep and ironic example of how the premise that a severe contraction was necessary actually caused the crisis, and then served as its own confirmation when that crisis happened.  This error of looking back at scenario analyses and judging it based on a single outcome only seems reasonable because the premise that the crisis was inevitable is so strongly held.  (And, I don't mean to single out these authors.  This is the consensus treatment.)

This forecast was made in the summer of 2005.  From August 2005 to August 2008, the national Case-Shiller price index dropped by about 7%.  That part of their worst case scenario was actually too pessimistic.  It was their expectation of stability after that which was too optimistic.  From August 2008 to the end of 2011, prices fell another 14%.  And, it was during that later period where nine out of ten of the mortgage defaults happened.

Now, I'm not going to spend paragraphs here walking through the entire timeline again.  Surely we can all agree that by the end of 2008, public policy itself is implicated in the eventual outcomes.  Public policy can even be implicated in the declining prices before August 2008.  But, the irony here is so deep.  What was the overwhelming reason for holding back on stabilizing policies throughout that time?  It was that we had to let prices drop to avoid moral hazard.  To impose discipline.  They had done this to us because of their optimism, greed, and riskiness, and they needed to learn a lesson.

It's fitting that Lehman failed in September 2008, right when the first three years of that pessimistic scenario ended.  Their pessimistic scenario covered the outcomes that had occurred up to then.  In September 2008, the Treasury took over Fannie and Freddie and cut off lending to entry level borrowers, creating a late collapse in low tier home markets that nobody seems to have noticed (because the premise accepted, even demanded, collapse) and the Fed implemented disastrously tight monetary decisions by holding the target rate at 2% and then implementing interest on reserves that sucked hundreds of billions of dollars out of the economy.

I see slides in these programs bemoaning the role of pro-cyclical financial markets in creating a boom and bust, but I don't see much about public demands for pro-cyclical regulatory and monetary regimes.  There is no doubt that the Fed and the Treasury could have avoided the post-2008 price collapse with earlier and more accommodative actions.  The premise was that contraction was necessary.  The premise was the reason we allowed or insisted on instability.  And the premise is why that subsequent instability can be blamed on the market that we imposed the premise on.

Another example of the strength of the premise, from the same set of slides is a reference to the work of Case, Shiller, and Thompson, who surveyed homebuyers for several years, and found that their long-term expectations for home price appreciation are unrealistically high.  This has been blamed for fueling the crisis.  The Shiller real housing chart that was so popular during the boom is referenced, which I have addressed before.  That chart is based on national average numbers, which completely erases the localized nature of the housing supply problem that caused the bubble.  Treating the housing bubble as a national phenomenon helps to feed the false presumption about its cause, because it is a lot easier to blame the bubble on national excesses if it is a national phenomenon.

Along this vein, the panelists reference the survey work of Case, Shiller, and Thompson, and note that during the years from 2003 to 2008, the average long term annual gains homebuyers expected in four different counties were:
11.6% Alameda County (San Francisco)
8.1% Middlesex County (Boston)
9.5% Milwaukee County (Milwaukee)
13.2% Orange County (Los Angeles)

They note "Forecasts were roughly in line with extremely rapid home price growth witnessed prior to the surveys but were way off from future realized growth."  Treating the bubble as if it was a national phenomenon and treating the bust as if it was inevitable means that we can ascribe (false) meaning to this result.  But, here is a graph of the median home price in each metro area (from Zillow).  These cities have very different stories.  Nothing in Milwaukee was outside of historical norms.  As with most of the country, prices were somewhat buoyant in 2004 and 2005, but that is understandable given the low long term real interest rates of the time.

So, how much of the "bubble" is explained by these expectations?  If Milwaukee buyers had high expectations but home prices were about $200,000, then did the expectation of 11.6% price appreciation explain $700,000 homes in San Francisco?  It seems more likely that there is some bias in the response to this question that has little effect on prices.  Let's say there is some effect.  Maybe 15%?  Maybe without these high expectations, San Francisco home prices would have only been $600,000 at the peak instead of $700,000.  What if home prices in San Francisco had stopped at $600,000.  Would we then have looked at the housing data and said, "Oh, expectations can't explain that.  Now, if homes were selling for $700,000, then we might be looking at a bubble, because then San Francisco prices would be 15% too high, and that would be a reason to suspect these biases in expectations."?  No.

Since the premise that demand, unmoored from rational value, exists prior to the analysis, this bias in buyer expectations can explain everything from $200,000 homes in Milwaukee to $700,000 homes in San Francisco, and everything in between.  And, when the "inevitable" bust comes, those high expectations will be sitting there, ready to fill in the narrative.  The reason it seemed like there was a bubble was that home prices in Boston, LA, and San Francisco were double or triple the price of homes in Milwaukee.  But, the false premises about its cause led us to watch the median home price in Milwaukee decline by 15% over the next five years - an incredible loss by any historical standard - and consider that reasonable, even though there was never a reason for homes in Milwaukee to lose a penny of value.

Another presentation by Aikman, Bridges, Kashyap and Siegert asks "Would macroprudential regulation have prevented the last crisis?"  But macroprudential regulation caused the crisis.  In their presentation, the first step to achieving macroprudence is identifying the buildup of risks in the economy.  The first item in their list of examples of challenges to achieving this is the recognition of a housing bubble.  While many of the tasks of achieving macroprudential stability are difficult and were not done well, according to the presenters, this first step was achieved, because the Federal Reserve noted correctly in 2005 that home prices were overvalued by 20%.

But, that was the problem.  Home prices didn't need to fall by 20%. As the housing market started to collapse, the Fed signaled that if home prices did fall by 10% or 20%, it wasn't going to do anything to counteract it.  That was a "correction".  The initial drops in housing starts were enough to buffer the sharp drop in demand that naturally followed.  But, when housing starts fell as far as they could, ratings agencies started to forecast unprecedented declines in prices, and the Fed continued to see instability as a necessary medicine for enforcing discipline and avoiding moral hazard, prices collapsed.  The more they collapsed, the more that the false premise led us to demand discipline and to rail against moral hazard.

Step 4 in their action plan is to "Take action to reduce the build-up in household debt".  The macroprudential action here, surely, should be local, since the rise in these balances was local.  And, the clampdown on lending to borrowers with low incomes and low credit scores, which seems like the obvious macroprudential response, has killed low tier markets, and it has nothing to do with what happened during the boom.  All of the rise in debt payments that were over 40% of income was among households with high incomes, because those are the households bidding up home prices in the Closed Access cities.

I don't see anything in these slides that seems to acknowledge the importance of supply constraints in rising debt levels.  The entire discussion happens within the premise that credit supply is the cause of both the boom and bust.

Another presentation also discusses leverage and over-reliance on short-term borrowing in the financial sector.  Here is a chart from that presentation:

I would point out here that most of the increase in home prices had happened by the time short term repo financing began to rise above the level of long term financing.  By late 2005, the Fed had raised the short term rate to nearly 5%, and the yield curve was inverted.  Banks weren't saving on interest expense when they increased their reliance on short term financing.  This wasn't a matter of "borrowing short and lending long" and pocketing the difference, while creating an externality of systematic risk.

It is certainly useful to consider ways in which a financial system can be more resilient, but these discussions are like a group of doctors standing around a patient who is repeatedly hitting his head with a mallet, and discussing the importance of avoiding headaches by staying hydrated.  Staying hydrated is important!  This is true!  But, it isn't the problem at hand.

Upside Down CAPM: Part 6 - Leverage before a crisis

I recently saw these graphs, from the IMF:



Source

Here is text from their Global Financial Stability Report (Chapter 2),  "The prolonged period of loose financial conditions in recent years has raised concerns that financial intermediaries and investors in search of yield may have extended too much credit to risky borrowers, potentially jeopardizing financial stability down the road. These concerns are related to recent evidence for selected countries that periods of low interest rates and easy financial conditions may lead to a decline in lending standards and increased risk taking."

It seems to me that there is a strong and common presumption that complacency or risk-taking lead to borrowing, and that this presumption really does all the work here.



Source

In the text above, there are several red flags.  Has there been a prolonged period of loose financial conditions?  I don't think so.  There is that phrase, "in search of yield".  People who want yield buy equity.  High yield bonds may be somewhat like equity on the gradient from low yield/low risk securities to high yield/high risk securities.  This horrible phrase is central to my "Upside Down CAPM" framework.  Low yields for fixed income securities aren't a signal of risk-taking, and investors complacent about risk wouldn't push yields down, even in high yield bonds.  If expected returns for equities are around 7% plus inflation, then investors funding bonds that pay 5%, nominally, aren't searching for yield or risk, because there is a better source for both of those things in equity markets.

I'm not sure we can even conclude how attitudes about risk might influence the relative level of high yield corporate debt.  And, household debt, which is mostly associated with mortgages, should grow inversely with risk-taking, as it would signal a bias toward real estate with stable cash flows over corporate investments with highly cyclical cash flows.  It seems plausible that the relative amount of risky debt securities could either rise or fall with attitudes about risk.

This seems like a simple counterfactual to consider.  What if the level of risky debt outstanding wasn't positively correlated with systemically dangerous attitudes about risk.  What would these charts look like?  Wouldn't they look just like this?  When a contraction hit, wouldn't we see disequilibrium in the market for high risk debt and a surge in low yield safe securities?  And, then, as cash flows stabilized and markets healed, wouldn't we see markets for riskier securities recovering?  In other words, the drop in risky lending and the initial recovery reflect the market dislocations that come from uncertain and volatile cash flows, not from attitudes about risk.  This is movement into and out of dislocation, not a shift in a steady equilibrium.

So, the top graph is a spurious correlation.  Of course risky debt outstanding is highest right before economic contractions.  There is no reasonable counterfactual where this wouldn't be the case.  And, the second graph shows that (in the years before a financial crisis), risky debt levels first rise as markets re-attain normalcy, and then the level of risky loans actually levels out in the years before the crisis.

There are any number of models that could explain this pattern.  The conclusion comes from the presumptions, not the evidence.

This is where turning the model upside down seems useful.  In the IMF report, low yields are associated with easy financial conditions.  I think this leads to confusion.  Low yields are associated with demand for certainty in cash flows.  I realize it takes some hubris to stand up against an entire body of research, so that having this discussion is sort of unwise of me.  I'd love to see evidence that there is more to it than this.  But, from where I stand, it looks like low interest rates are a sign of difficult financial conditions, and that fact is so counterintuitive that we have just gone barreling along with economic models that are backwards.

Part of the problem is the unfortunate habit of equating low long term interest rates with loose monetary policy.  Using the financial sector as a measure for financial conditions might, itself, be part of the problem.  When the financial sector increases in size, this is generally treated as risk-seeking behavior.  But, the financial sector is generally in the business of being an intermediary for fixed income securities.  Investors didn't need the financial sector to invest in Pets.com.

Note, that Pets.com wasn't put out of business through bankruptcy, because the ownership was completely in the form of equity.  They simply liquidated and paid any remaining cash to the shareholders.  Notice that the collapse of the internet bubble is not associated with a financial crisis.  That is because there was little debt involved.  The IMF has it correct in this regard.  But the reason it wasn't associated with debt and the reason it didn't lead to a financial crisis is because it was associated with risk-taking!  And risk-takers had equity positions.

So, this is where the standard models go off the rails, because that error flips the story on its head, and it leads the IMF and most other observers to a position where they see signs of risk-aversion and their solutions are to limit lending and cut back on monetary expansion.  Then, the collapse in cash flows that ensues gets blamed on risk takers.  The correlations between debt - even high yield debt - and subsequent financial crises are correct.  The interpretations are suspect.  What leads to a crisis is when a large portion of the set of savers demands certain cash flows and then subsequent cash flows become so volatile that those demands are not met.

Zero is also part of the problem.  Zero looms large in the way we construct these models, and it shouldn't.  Take zero out of the equation.  Now, think of an economy where savers can expect yields of minus 2%.  Or, let's take that to an extreme.  Savers can expect yields of minus 50%.  These economies exist.  Would you associate these economies with "easy financial conditions"?

What guides intuition about efficient markets?

Scott Sumner has recently been making the case for the efficient market hypothesis.  I'm basically with him on this, especially when it comes to public policy.  If a committee decides that they know the correct price level of something is different than the market price, they will be wrong much more often than they will be right.  And, if that committee has the power to move prices to where they think they should be, the results will be disastrous.  Furthermore, if the committee decides that prices, or God forbid, quantities of something are too high, then they will be imposing scarcity on their constituents.

That's what happened in the housing bubble and the financial crisis.  The model was wrong, but we have given the federal government enough power to impose its model on the economy, and it took a crisis to move prices to the place that they were aiming for.  Though, it's not really an issue of a state-imposed crisis, because the crisis was popular.  It was demanded.  To the extent that people like Ben Bernanke and Timothy Geithner used discretionary power, they used it to moderate the crisis in ways that were widely unpopular.  They partially saved us from ourselves.  Their memoirs can be seen, to a certain extent, as extended apologies for protecting us from our worst impulses.

The public treatment of market efficiency is strange to me.  It seems random.  Some markets are clearly prevented from clearing in a functional way, but people seem to have an intuition for making excuses for them.  Take 100 random people who haven't thought about the issue and present to them the idea that there is a politically imposed shortage of housing in Los Angeles, and they will respond with: Well, there just isn't any land left to build on.  Well, there are just too many people.  Well, the Chinese keep buying up the properties and leaving them sit idle.  Well, with all this income inequality, the rich just keep bidding up the home prices.  Well, all that QE cash keeps pumping up the market.  Well, California is a nice place, so of course it is more expensive.

These are all plausible, yet not significant, reasons from high home prices in Los Angeles.  With a little digging, it becomes clear that these factors aren't definitive, and that the problem is supply.  Even without going into detail about each factor, simply look at the process of development in Los Angeles.  If all these other factors were the reasons for high prices, housing authorities in LA would be running new projects through the system as ferociously as they could to make up for it.  The opposite is the case.

Similarly, mortgage markets are tied up in knots because of extremely tight lending standards.  But, seeing the dislocations, people respond: Well, incomes have declined and people can't afford homes any more.  Well, young families have student loans.  Well, homebuilders only want to build high-dollar properties because they are more profitable.  Well, families don't want to own any more.

All of these are, again, plausible sounding enough if you don't check to see if they are true.

So much of the development of our opinions comes from what we give the benefit of the doubt.  In these cases, for some reason, intuition tends to be that there must be a good reason for what is happening, and our minds search for plausible reasons.  When we find one, we are satisfied.

Sometimes, this intuition leads to conclusions that are extremely supportive of very strong efficiency.  The idea that public schools become segregated because higher quality schools cause home prices to be bid out of the reach of poor families supposes a sophisticated and extreme amount of efficiency in housing markets.  This supposes that quality of a school district gets capitalized into the prices of homes with a high correlation coefficient.

The idea that the various forms of income tax benefits create much higher home prices also supposes a sophisticated level of efficiency, where many far future benefits - some of them imputed - are capitalized into present prices.

But, then, there are times when, for some reason, the intuition flips.  So, if one points to fundamental causes for high home prices in the 2000s, the response is usually to push back and to find plausible reasons why markets weren't efficient.  Well, bankers make bad loans in a shortsighted attempt at padding their numbers.  Well, naïve speculators hop in the market at the top and keep pushing prices higher.  Well, mortgage originators could just dump garbage on investors who were too dumb to know.  Well, the Fed just keeps pumping money in so that this fake bubble economy just gets more and more bloated.

Again, all plausible if you don't look hard enough.  It's amazing to me, in hindsight, how many facts that contradict these stories are just sitting in plain sight.

What causes that flip?  What causes the intuition to support efficiency in some ways while it contradicts it in others?  What convinces the average person at the end of the bar that there must be a natural reason for the median home price in San Francisco to approach a million dollars but that we had to suffer through a financial crisis because home prices in Topeka were up to $120,000, and when they fell back to $90,000, that was when we were back to normal.

There is definitely an important role for attribution error here.  We do things because of the context we are presented with.  Other people do things because they are greedy, ill-informed, and short-sighted.  That explains the nuts and bolts of what happens when consensus forms against something.  This is clear in the current anti-immigrant political machinations.  But, we have been dealing with this problem for years, across the political spectrum in the mental models that people have about what caused the housing bubble and the financial crisis.  There are a lot of villains and dupes in the various stories about what happened.

But, this isn't a compelling answer to the question of where this intuition falls.  The housing regulators and NIMBYs in Closed Access cities could easily serve as the villain in stories about expensive urban housing.  In the just-so stories about the current shortage of entry-level housing, attribution error leads to stories of homebuilders who aren't willing to supply low tier markets.

I'm not sure that I have an answer.

And, I'd like to say that I wish that the public tended to support EMH, but even that doesn't help much.  The excuses that seem to plausibly explain million dollar urban homes, in defense of an efficient market, aren't much better than the excuses that seem to explain inefficiency.  I mean, I guess complacency is better than aggressive, passionate sabotage.  But, still what is the mechanism that steers public intuition?

I think the intuition is to search for defenses of the status quo and to see things that change quickly as aberrations.  This is probably not a bad heuristic if it's the best we can do. But this is where the efficiency of modern markets gets them in trouble.  Changes in prices can move quickly when valuations change for any reason. The natural proclivity to distrust financiers leaves us all too eager to blame them and their perceived excesses when change happens.

Even this intuition is biased, though. Our intuition is to explain why there are reasons for financial markets to retract but to push back against financial markets that expand.

Housing: Part 309 - The Closed Access cities should double or triple their minimum wages

Here is a story about rising minimum wages leading restaurants in San Francisco to automate or use self-service features. (HT: MR)  Recently, I argued that a rule requiring solar panels on homes in California, which would normally be inefficient, might actually be somewhat useful in the upside down world that develops when your economy is characterized by obstacles to capital allocation.  I think this might be a better example.

Now, the best solution to the problem of high cost cities is to find ways to expand housing in those cities until costs decline to roughly the unobstructed cost of building.  When reading this post, please don't lose sight of that fact and that, given the choice, that is the policy I would clearly support.  And, it is the policy that would clearly lead to more equitable economic outcomes.

Since that solution hasn't been achieved yet, we are faced with the problem of having a handful of cities, with a population that is basically capped at around 50 million, who have a geographical monopoly on certain kinds of productive labor markets.  In order for those labor markets to grow, or for more Americans to tap into those cooperative networks, we have to engage in a bidding war on the local housing stock.  This leads to rising rents and prices until some marginal household who isn't in a position to leverage those cooperative labor networks can't pay the bills any more, and they move away to a less expensive city, to make room for the more productive worker.

This leads to all sorts of conflict.  Complaints about gentrification, etc.  But, for the country as a whole - again, if we have to accept that the optimal solution is unavailable - this conflict is a necessary adjustment that inevitably will happen with any economic growth.  In fact, accelerating this adjustment and this conflict will help strengthen economic growth because it will match workers better with the locations where they can be most productive.

But, whether we encourage this transition or not, it will happen.  This is clear today, after we have spent a decade putting the federal thumb on the mortgage market in an attempt to prevent households from bidding up the price of housing.  Yet, the conflict and the pressure continues.  Rents continue to rise.  Local populations are forced to move away.

Before we imposed regulatory brakes on the segregation process, loose lending in 2004 and 2005 was helping to accelerate it.  The economy was strong.  But, accelerating the process that way created a major side-effect.  There are two types of Closed Access residents who don't belong there, and who need to move away in order to allow productive workers to move in.  First, are workers who are earning lower wages and who are usually renters.  Second, are long time residents - frequently older households - who are shielded from the high costs because they bought their homes years ago and they are living in homes that would fetch thousands of dollars a month in rent.  This is a level of rent that these households would never entertain if they had to pay it in cash each month.  But, they are insulated from it because they own their homes and they are sitting on unrealized capital gains from years of appreciation.  When young, aspirational borrowers bid up the prices of homes in Closed Access cities, it triggered a massive out-migration of these households, who now took advantage of the hot market to realize those capital gains.  When flexible lending markets allowed young households to bid those homes up to prices that truly reflected the value of their future rents, the owners were more likely to sell and reap their profits.  Hundreds of thousands did.

This had a positive effect of accelerating the segregation process, allowing more productive workers into the Closed Access cities.  But, this came at a tremendous cost.  Because in order to induce that segregation, we had to create trillions of dollars worth of transfers to those real estate owners.  They made space by leaving town, but they took a huge chunk of change with them.  In fact, to the extent that workers are willing to pay the entry fee to get into those cities and earn higher incomes, the productivity of those workers went to the former homeowners.  The country, as a whole, was more productive and richer, but the riches were mostly claimed by rentiers.

Long ago, I spent many posts looking at minimum wage laws, and concluded that at the national level, there seems to be a systematic loss of employment that is associated with rising minimum wages.  Normally, that would be a reason to oppose it.  But, in the upside down world that is created when we oppose the allocation of capital to its highest use, bad becomes good.

In this case - again, if we are resigned to the fact that these cities will not simply allow more homebuilding - raising the minimum wage is the best alternative to that option.  These cities should triple their minimum wage levels.  A commenter at the Marginal Revolution link to the original story noted that workers making $50/hour would qualify for housing subsidies in San Francisco.  Unless San Francisco can commit to expanding its housing stock, if you need housing subsidies, then you should live somewhere else.  You are blocking the process of segregation.  The unemployment that would be triggered by a $50 minimum wage would accelerate the process without triggering the trillions of dollars in transfers to real estate owners.  Unemployed workers would move away.  Maybe some would be able to earn the higher wage level locally, which minimum wage proponents would naturally support.  This would be a positive development for the workers that remained.

Maybe, if it was successful enough at triggering unemployment, it would actually lead to lower local rent levels and prices, reducing the transfer of economic rents to existing real estate owners.  This might just be an effective way to moderate the housing market again.  Just keep raising the local minimum wage until home prices in LA or San Francisco are, say, within 50% of prices in other cities.  In the upside down world of Closed Access, the minimum wage would be a boon to productivity and equality.  Let's see how high it can go.

In the upside down world of Closed Access, marginal increases in the minimum wage that don't lead to significant employment loss would be bad, because the extra income would simply have to be deployed in the never-ending bidding war for housing. So marginal increases in the minimum wage would probably increase the transfer of economic rents to real estate owners.

In the upside down world of Closed Access, the minimum wage would only be useful if it was high enough to trigger significant unemployment and reduced the demand for local housing.  Let's say that a minimum wage of $50/hour was enough to price out a few million workers who would leave those cities to find work elsewhere, driving rents down so that decent apartments were available for $1,000 per month.  Surely there would be some wage level that would induce such an outcome.  The Closed Access cities would be utopian.  Everyone there would be comfortable, from the custodian to the CEO.  It would be a clear improvement from today's condition.  And it would be basically a free lunch.  Sure, several million residents will need to move to find gainful employment. But this would arguably be less painful than the process of several million residences gradually moving away as their cost of living slowly grinds higher.

So, I will carve out an exception for minimum wage policy. In most places, minimum wages are questionable. But in the Closed Access cities, the minimum wage should be high enough to bring down home prices.