Wednesday, July 25, 2018

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.

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  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.)

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 na├»ve 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.


  1. Another amazing post.

    I am beginning to notice that the orthodox macroeconomic profession does not handle structural impediments or institutional frictions well, especially if such market-imperfections throw a monkey wrench into theories or set-pieces.

    By and large, conventional macroeconomists seem blind to housing issues that have macroeconomic impact.

    My own bias is that global trade issues present similar challenges to the profession.

    It is not a left-wing or right-wing split. It is just that the theories are losing their traction.

  2. - Another misconception that simply won't die: Paul Volcker DID NOT tame/kill inflation !!! It was the corporate sector that killed inflation in the early 1980s. One has think WAGES. Does the FED determine wages ? No, it's the corporate sector that determines wages.
    - In the 1960s and 1970s workers still would receive big wage increases. If inflation was say 5% then workers would receive a increase of say 6%, 7%, 8% or even 10%. If workers have a 8% wage increase then those workers also can spend 8% more. And that allows producers to increase their prices with 8% as well. That puts an upward pressure on inflatiion, pushing it from 5% to(wards) 8%.
    - That changed from the early 1980s onwards. Then employers kept a lid on wage growth. If inflation was say 5% then workers would only receive a say 2% wage increase. But this is the REAL inflation killer because every producer that raises it prices by 5% (the inflation rate) is guaranteed to lose (2% - 5% =) 3% in revenues because the worker can only spend 2% more. This "moderate wage growth" (in this example) of 2% actually FORCES producers to limit their price increases to 2% as well. And then inflation drops from 5% down to(wards) 2%.
    - How many times did I use the word "FED" in the story above ?

    1. There are so many things wrong here I'm not sure where to start, but how about:

      > it's the corporate sector that determines wages.

      Of course this is not true. Wages are determined by market forces.


    2. Wages are pruned by the Fed. Always results in a recession of some sort. Wages are pruned, credit tightens, and at the end of the cycle companies fail to raise wages. It is a function of the Fed, though.

  3. There certainly appeared to be a bubble in SoCal. Here's why.

    Lack of supply in the early-to-mid 2000s caused house prices to rise above incomes. The response to this problem was to lower lending standards in order to enable people to buy houses they really couldn't afford. Specifically, loans had a low "teaser" rate for several years that would subsequently be adjusted upward, and the hope was that buyers would by then have substantially greater income, or at least be able to refinance. Some of the buyers were flippers, but I think many of them just wanted to buy a house before things became even more unaffordable. And the greater availability of loans drove up demand, which drove up prices further. Of course, since the scheme was only sustainable by ever-rising prices, a crash was inevitable. That's why I view it as a bubble.

    Once the crash happened, there was a perverse incentive to limit supply so that prices would not fall further. And not surprisingly, much less housing was built from the mid-to-late 2000s and onwards, and what is built is largely for the luxury market.

    So rather than deal with lack of supply and unaffordability by making loans to people that they can't pay back, we deal with lack of supply and unaffordability by doing nothing. Nevertheless, prices are sky-high again because so few houses are on the market, and even though few people can afford them, the limited demand matches the limited supply.

  4. And I should add, that by making widespread loans to people that they couldn't pay back, at least that had the beneficial result of inducing more housing to built. That's why I don't buy the "SoCal ran out of land to build on" explanation. How can it be possible that we just happened to run out of land at the same time the crash occurred? No, the still land there, but instead there is just less incentive to build now for whatever reason.

    1. Anonymous, you are closer to the truth than most people. You are almost there. I think everything else will fall in place for you if you remove this part:
      " by making widespread loans to people that they couldn't pay back, at least that had the beneficial result of inducing more housing to built"

      In hindsight, we can see that the new buyers in the expensive cities were generally qualified borrowers. Households with median or below incomes account for an insignificant portion of the housing market in those cities, and they move away from those cities by the tens or hundreds of thousands every year. It is implausible that they had anything to do with the housing boom in those cities. It was more a case of households with healthy incomes, who were still spending 40% or more of their incomes on rent, finding ways to buy homes, which would naturally fall outside conventional measures.

      And, in those cities, there are tight political limits to building. You are right about that. And, so there was little or no inducement to new building. Those new homebuyers had to bid up the existing stock, which led to a spike of outmigration during the boom. From 2004-2007, the cities I call the Closed Access cities actually saw declining populations.

    2. I don't have the data, but in 2003-2004 I remember a lot of talk of negative amortization loans, teaser rates, etc. that would be impossible to pay off come adjustment time. I don't know how widespread these actually were, but they got a lot of media attention. But most of the problem was in inland SoCal, not coastal SoCal.

      And I do think it is a fact that substantially more housing per year was built back in 2000-2005 in coastal SoCal than in subsequent years. I don't think there has been any change in the tight political limits, so whatever the economic situation was back then, more housing was built. I certainly don't believe we "ran out of land" in coastal SoCal in 2006.

    3. Subsequent research has tended to find that falling prices had more to do with defaults than rate changes. Most defaults happened in 2009-2012 when rates were low, and by then the problem was that borrowers couldn't refinance because either (1) they couldn't qualify under new standards or (2) they had significantly negative equity.

      The coastal metro areas permitted housing at much lower than the national average during that time, at levels that barely maintained their population levels. You are correct about the political barriers to building. They prevented there from being much of a quantity reaction to rising prices.

    4. Kevin, Scott Sumner keeps saying there are no bubbles. But in Las Vegas, houses changed from being illiquid assets to becoming liquid assets. Houses went on the market at the hight of the bubble and were claimed before 24 hours. The liquid housing market was not normal, it was a bubble. Scott is wrong. He is wrong about tulips too.

  5. KE-

    This report from IMF may be worth pondering, Or, you may disagree with it.

    The IMF says “Large and sustained excess external imbalances in the world’s key economies—amid policy actions detrimental to external balances—pose risks to global stability.” Specifically, “Over the medium term, sustained deficits, leading to widening debtor positions in key economies, could constrain global growth and possibly result in sharp and disruptive currency and asset price adjustments.”


    Egads, it sounds like they are saying capital inflows into debtor nations (the US) are boosting asset prices, until you get the Minsky moment for some reason.

    As for currency, who knows, but they issue a dark warning. The long-lost dollar debacle?

    Well, 2008 all over again--unless the Fed does an Aussie, and keep assets values rising.

    PS: It would nice if the IMF would speak in plain language what they mean, instead of foggy obfuscations.

    1. Is that what I covered here?

    2. Ha!

      Yes, as I have said before, it is nice getting old, as every day is fresh and one forgets what has happened recently. I read and enjoyed your excellent post on the IMF the day you posted it. Which, evidently, was in the distant past, as far as I am concerned.

      I enjoyed your post, but my take-away is that the Fed will look at asset prices and say, "A Hyman Minsky moment is pending," and then act to ensure we in fact have a Hyman Minsky moment.

      Your post somewhat corroborates my point of view, when you cite IMF scolding about "loose financial conditions." (There is always a hint of morals in these tight-money sermons, as if "loose women" are an analogy.)

      So, says the IMF (and no doubt many inside Fed) we must curtail loose morals and easy money.

      Of course tighter money might bring that Hyman Minsky moment to fruition, as house prices now (like 2008) are high in closed-access cities, and US equities are trading at 25 times earnings.

    3. I feel you. And, some good points here too.

  6. - A house is NOT an "Asset", it's something that's being "consumed".