Wednesday, August 22, 2018

Housing: Part 316 - The phases of the bust.

There was one answer from my podcast interview with David Beckworth at Macro Musings that I feel like I sort of flubbed, so I am clarifying the issue in this post.  David asked me about the early shifts in the migration event and what caused it to stop.

I have covered the timeline before, so some of this might be a repeat, but I think my thinking has evolved a little bit on this as new information comes in, so there might be subtle differences and additions to previous posts.  For this topic, my moving chart of home prices over time is helpful.

1990s to 2003:
For this period of time, supply constraints dominated.  Cities that were more expensive to start with were generally becoming even more expensive over time, because the reason they were expensive was that they lack sufficient housing and so rents are high and rising.

November 2003 to June 2004:
For this brief period of time, home prices in Los Angeles accelerated relative to other places.  It is plausible that the newly expansive private securitization market, which was especially active in California, was the source of this unusual price appreciation.  Added demand from new homebuyers in Closed Access cities created a surge in the out-migration that tends to come out of these cities.  Since the housing stock is relatively stagnant in Closed Access cities, more housing demand from one household means less housing stock is available for other households, and someone has to move away.  The price appreciation appears to have triggered a boost in the outmigration of homeowners, who were cashing out as prices increased.  So, there was an increase in migration among both owners and renters.

July 2004 to November 2005:
The Federal Reserve started to raise interest rates in July 2004.  This was probably appropriate purely as a monetary policy shift, and the economy, in general, was still clicking.  So, Phoenix had two forces pushing on its housing market.  Aspirational migration was strong.  In a typical year, about 50,000 households move into the Phoenix area from places that aren't "Closed Access".  During this time, the rate of migration from other places moved up slightly to about 60,000 by 2005.  Those were probably mostly households moving up from less expensive places or moving to Phoenix for retirement, as is typical.  That increase was due to a strong economy, flexible lending, etc.

From 2002 to 2005, migration from Closed Access and other Contagion cities increased from about 12,000 to 21,000.  These were households moving down-market.  They were moving to Phoenix to lower their housing expenses.  There would have been several forces at play with this group of movers.  Loose lending in California was a force that was inducing the outflow.  The high prices that had developed in California were inducing more selling and migration from homeowners.  And, rising interest rates were likely adding to that selling pressure as homeowners expected rising rates to eventually be a drag on rising prices.  So, there was an extended period of time where continued economic growth and changing sentiment in the California housing market were both putting upward pressure on the Phoenix population and on its housing market.

This is clearly visible in the moving chart, as Los Angeles price appreciation moved back down to the national norm, even though private securitization mortgages were very active there.  At this point, the added demand those mortgages created in California was mostly creating new local housing supply by inducing out-migration and selling by existing owners.  Rising rates probably had something to do with that.  So, rising interest rates and selling pressure were pulling down prices in Los Angeles, where credit-fueled demand might have otherwise pushed prices a little higher and they were pushing prices up in Phoenix because of the migration that ensued.  (Note that any effect here was purely from expectations or sentiment, because 30 year mortgage rates and long term interest rates in general did not actually rise until the Fed had flattened the yield curve in late 2005.)

November 2005 to August 2007
By November 2005, the Fed had increased the Fed Funds Rate high enough to flatten the yield curve.  I would argue that at these levels (about 5% at the time) that is basically an inversion.  As is clear in the moving chart, there was a uniform national reaction in the housing market.  All measures began to collapse everywhere.  Sales, housing starts, etc., and inventory of homes for sale rose.

Now, from this new perspective, which says that there were never too many homes anywhere and that home prices in 90% of the country generally reflected fundamental factors like rising rents and low long term real interest rates, this is a huge red flag.  Clearly, the economy was already in a state of dislocation.

This was clearly a monetary event.  I don't even think that is a point that is open to debate, for several reasons.  First, as I said, the premise is doing all the work here.  If the premise changes so that we don't presume that there were too many houses selling for too many dollars, then the shifts in the housing market were extreme and moving in unison across the country in an extreme contraction that wasn't called for.  This was not a subtle shift.  Second, the Federal Reserve, itself, considered the downturn in the housing market to be a product of their policy choices, and they were pleased by the downshift at the time.  They were very focused on housing markets at the time and mentioned them in nearly every FOMC press release.  Third, many economists who have commented on Fed policy at the time attribute high home prices to loose monetary policy, they attribute some power to the Fed to be able to pull prices down, and many of them argue that the Fed should have targeted home prices earlier and tightened policy earlier in order to do it.

There is a question as to what mechanism was at work.  Sentiment? Money supply? The effect of yields on valuations or lending?  (One interesting facet here is that mortgage growth was a fairly late factor, still growing slightly even when the 2007 panic hit.  But, home equity had been declining for some time, and much of that decline appears to have come from unmortgaged owners selling and exiting the market.  According to the Survey of Consumer Finances, in 2001, 23.1% of American households owned homes with no mortgage.  That declined to 19.9% by 2007.  So, even though there is an abrupt shift in price trends when the yield curve flattened, it appears that sentiment and money supply were more important than lending in the early phases of contraction.  I consider an inverted yield curve to be an important forward contractionary signal, but what exactly causes the signal and what the inversion itself causes to happen remain a mystery.  The 2005-2007 period, to my mind, both confirms the importance of yield curve inversion and adds to the mystery of what is actually happening.  Maybe these flows out of home equity as an asset class and into other forms of long term fixed income are an important part of that puzzle.)  But, as to whether those mechanisms were related to monetary policy, there is no argument left here.  Once the premise changes, the conclusion changes with it.  The Fed put a stop to the migration event as a side effect of causing a housing contraction.  That is stipulated.  The argument is whether they should have.  Before blaming the Fed too much, keep in mind that in 2007, nearly everyone thought they should have.

So, the collapse in migration that led to an especially tough housing collapse in Phoenix was actually part of a national negative monetary shock.  Both nominal and real GDP growth were marginally at levels that have normally been recessionary.  And, as shown in the chart here, employment growth, which had not been particularly strong, started to decline in 2006.  Nationwide, it didn't decline sharply like it usually does in a recession.  There is a typical recessionary downshift in the Contagion cities in 2006. (Here I show the Phoenix metro area and the state of Florida.)  Because the economy had become so characterized by these inter-metro migration patterns, the initial result of this wasn't a rise in unemployment.  It really is quite striking.  With such a negative shock to employment growth in Phoenix in 2006, the unemployment rate didn't bottom out until June 2007!  All of the shocks to employment markets were buffered by a reversal in migration flows!  In Contagion cities, the shock didn't lead to higher unemployment.  It led to an end of the migration event.  In other cities, employment didn't collapse in 2006 the way it normally does at the beginning of a recession because at the same time that employment growth was slowing, population growth got a boost because households stopped moving to the Contagion cities.

In the Contagion cities, the inflow of households slowed down.  I would expect that the retrenchment among renters with lower incomes was related to declining employment opportunities.  The retrenchment among home sellers was likely related to the fact that home prices had levelled off.  As prices had been rising, on the margin, more homeowners had been selling, collecting their capital gains, and moving away from Closed Access cities.  But, when prices levelled out or started to fall slightly, that would have induced many fewer tactical sales.  The inflow of both households and capital to the Contagion cities slowed down as a result.

At the same time, the outflow of households out of the Contagion cities to other places that were now more affordable continued to rise, so net inmigration fell dramatically.  The reason for the outmigration is because the liquidity shock had thrown the construction market into disarray, and the Contagion cities, who already were struggling to build enough homes to meet the demand from in-migration now had a terrible shortage of homes themselves.  Inventories of homes for sale had shot up, because the liquidity shock had created barriers to home buying, and vacancies of owned homes increased in the Contagion cities, related to that.  But, rental vacancies remained low for some time after the shock in 2006.  In Phoenix, rental vacancies were low until 2008.

Prices, nationally, should never have declined at all, and when they finally did in the summer of 2007, it was only after this had been going on for a year and a half, housing starts had retracted as far as they could to buffer the decline in demand triggered by the disrupted buyers' market, and when declining sentiment led to the panic in privately securitized mortgages, the general mood of the country was that it wasn't anyone's job to right the ship.  Political sentiment made the unnecessary price collapse inevitable.

So, what specifically caused the migration event to end?  Monetary policy has a lot to do with it.  Essentially, a proto-recession had already been induced, and it hit the Contagion cities the hardest because their home prices had been driven up by that migration event.  For a year and a half, during that proto-recession, relative to previous trends, recessionary conditions were mitigated in the rest of the country because they were matched by a temporary population boost.  Whereas Austrian school economists might argue that loose money induces unsustainable demand that leads to a boom and bust, what might have been happening in 2006 and early 2007 was that money was relatively tight, but that non-Contagion markets were induced into unsustainable demand that kept them at the margin of recessionary conditions because they had a temporary boost in demand through population flows.

Home prices, even in the Contagion cities, remained relatively strong as housing starts collapsed along with those migration flows.  The reason is that the Contagion cities didn't have enough homes.  It is possible that if things had turned out differently, and the migration event had wound down without being induced by a monetary shock, that home prices in the Contagion cities would have dropped a bit.  It is clearly plausible that home prices there had been boosted by cyclical pressures related to the migration event.  And, it is plausible that if the Fed had been accommodative in 2006, home prices in California would have still peaked, cutting off the flow of wealthy home sellers into Phoenix, and plausibly, the economy might have grown while the Phoenix market corrected.  But, that isn't what happened.  The Contagion cities never had too many houses, so in 2007, rent inflation was high and gross out-migration was rising, and prices remained relatively stable until the country accepted the development of a series of financial panics.

Accommodative monetary policy in 2006 would have been very useful, and one important result of it would have been stabilizing the housing market in the Contagion cities.  Don't get me wrong.  I'm not saying that the Fed should be in the business of stabilizing prices in various asset classes.  The primary reason that it would have been important to see improvements in the Phoenix housing market wasn't to ensure that investors or lenders didn't have losses.  It wasn't even to create employment growth in construction.  The reason it would have been important is because the Contagion cities needed houses and the fact that they couldn't manage to build them and that buyers couldn't manage to fund them was already a signal of disequilibrium.  Given public sentiment at the time, it would have been impossible for the Fed to have seen this in real time, or to have acted on it.  But, in hindsight, we must understand what happened.

Given that in 2007, we had the premise wrong, and we thought that a credit bubble that was destined to bust was our problem, one can imagine how Federal Reserve officials could have read these signals as positive.  They had managed to slow down the housing boom.  They thought that was the right thing to do.  And they thought that their biggest challenge was going to be limiting the damage to the rest of the economy.  In May 2007, when Ben Bernanke was assuring the public that the subprime crash would be contained, he was looking at the economy in Phoenix that had just had a massive shock.  It's housing market was DOA.  And unemployment there was at 3.2%.

Follow up.

1 comment:

  1. Interesting post.

    BTW so few housing units are being built that the US housing stock is aging at nearly a one year to one year ratio. That is, each year the average age of US housing stock increases by about one year, shaved just a little bit.

    Buildings (in the First World) last a long time.

    Still, I think there will be a tremendous market in renovation, rebuilding and possibly new construction in the years ahead.