Friday, August 24, 2018

Housing: Part 317 - Unsold inventory during the financial crisis

To follow up on the previous post, here is a Fred graph comparing various measures of homebuilding.


 Sorry, it's a bit messy.  The orange line at the bottom is homes built speculatively which have not been started yet.  The dark blue line at the bottom is completed homes that have not been sold.  This is one source of the "overbuilding" story.  Speculative building increased, basically in line with general growing sales.  The trend in speculative buying reversed soon after general sales started to decline, but it wasn't enough, and so homes that were completed without a buyer started to rise.  The green line is speculative homes under construction, and it begins to decline in 2006, but not quickly enough.  That is the extra inventory that might be blamed on overbuilding.

But (You knew there would be a "but"), notice the scale of the problem.  Even at 200,000 units, the level of unsold inventory should have amounted to just a few months' sales.  The only reason they amounted to much more than that was because sales had collapsed.  It was the collapse in demand that was the shock, not an oversupply.

In the next graph, the blue line (left scale) is months of inventory of new homes.  The red and green lines (right scale) are new homes sold (red) and inventory of vacant homes among existing homes.  Notice that the inventory of vacant homes also shot up at exactly the same time that sales began to collapse.  There was an event at the end of 2005 that led to a sharp collapse in demand for homeownership.  Remember, though, there was no shift in demand for the service of housing (relative to supply) because tenant vacancies remained low and rent inflation was high and increasing.
Or, maybe, this was the result of all those buyers who had been suckered into buying homes they couldn't afford.  Maybe they were getting foreclosed on and that was the source of vacancies.  But, again, notice the timing.  Vacancies started to rise in 2005.  They were already at the top of the range, over 2 million units, by the 4th quarter of 2006.

Here is data from the New York Fed Report on Household Debt and Credit.  When the vacancy level of units for sale had already reached more than 2 million units, in the 4th quarter of 2006, there were about 220,000 foreclosures.  That compares to an average of about 176,000 foreclosures from 2003 to 2006.  The foreclosure crisis mainly happened from 2008 to 2010, when every quarter more than 400,000 units were foreclosed.  When the vacancies developed in 2006, foreclosures had just barely begun to rise.

By the time the foreclosure crisis happened, builders had already contracted to practically nothing.  New building had contracted so much by the time foreclosures were happening in large numbers, that the number of unsold new homes was actually declining back toward normal levels by then.  Builders were actually quite responsive to the shock in demand.  The flooding of foreclosures onto the market didn't eat into builder sales.  Their sales were already collapsed by the time that happened.

But, here's the kicker.  The Census Bureau doesn't track cancelled orders.  So, many of those homes in the first graph that are measured as new houses sold and completed were actually homes that were sold, completed, and then cancelled.  Cancellation rates are normally about 15-20%, and they roughly doubled over the course of 2006.  So, a little more than a million homes were sold in 2006, but about 400,000 of them turned into unsold inventory instead of new, occupied stock.

Where the Census Bureau showed 200,000 finished but unsold homes in 2007, it was actually probably more than double that amount, if cancelled contracts are included.  Now, that inventory really doesn't have anything to do with subprime lending terms, etc., because new home buyers generally just have to put down a small escrow, and the mortgage isn't closed until the house is finished and the buyer takes ownership.

The homebuilders were quite disciplined, really.  From peak to trough, annual sales declined by about 1 million units, twice the change of the housing contractions of the 1970s.  Yet, months of inventory didn't rise much above the months of inventory that had developed back then, and it quickly declined from its peak, even though there were also hundreds of thousands of units of shadow inventory from cancellations were also on the market.

It would be interesting to see detailed research on this.  Was the rise in cancellations because the buyers were tactically cancelling or because their lenders were pulling out before the homes were finished?  In either case, the point is that the rise in cancellations, just like the other measures, predated the rise in foreclosures by at least a year, and was responsible for most of the rise in new home vacancies.  There has been research showing that falling prices generally led to defaults, and not the other way around.  But, here we can see that cancellations were creating hundreds of thousands of new vacancies before prices declined significantly.  A demand shock led to a change in sentiment which led to vacancies which eventually led to price declines, which led to defaults.

I have commented before on the perverse self-destructiveness of public sentiment in 2007, where stabilizing policies were routinely avoided specifically because stabilization would have prevented some people from taking devastating capital losses.  But the perversity is even deeper than that.  Consider the homebuilders.

I looked at annual SEC filings from Meritage Homes to collect sales and cancellation data from the Arizona market.  Actually, in hindsight, I'm not sure if Arizona looks much different than the rest of the country on this matter.  Oddly, it appears as if sentiment shifted downward to the extreme, in some cases well in advance of actual price shifts.  For instance, for Meritage, in Arizona, cancellations jumped to 37% in 2006.  From 2006 to 2008, the average sales price in Arizona dropped by more than 40%.  By 2008, Meritage cancellations were declining back to the norm in Arizona because nobody was bothering to sign a contract in Arizona in the first place, by 2008.

In Texas, the cancellation rate was 35% in 2006 and it increased to 40% by 2008, but the average price of Meritage homes over that period was basically flat.  Finally, from 2008 to 2010, Meritage home prices in Texas declined by a little bit less than 10%, but Texans had been getting cold feet for several years before that happened.

Maybe this is because buyer quality had become so bad that suddenly nearly half of potential buyers realized by the time the house was completed that they couldn't possibly afford their mortgages? But, after 2005, when this was happening, sales were declining - first time buyers were declining pretty sharply.  It doesn't make sense that the period of time where borrower quality was deteriorating was the period where the number of buyers was dropping like a stone - unless the decline in borrower quality was from a liquidity shock.

Here are the Meritage numbers for Arizona.  In 2006, they had new contracts for 2,910 units.  Of those, 1,833 were built and sold and 1,077 were cancelled so that Meritage had new, unplanned inventory.  Then, in 2007, net orders after cancellations were 1,203.  So, after accumulating 1,077 unplanned vacant units in 2006, total net sales in 2007 were only 1,203.  In the meantime, they accumulated another 642 cancelled units, and 2008 net sales were only 884.  For years, in Phoenix, there were developments full of empty homes.

I was planning on ending this post with a discussion of systemically risky terms on subprime loans and how, even if there wasn't an oversupply of housing, those type of loans by investors were likely an important part of the panic.  And, they probably were.  But, this is a part of the story few talk about.  These cancellations have nothing to do with lending terms, or owners vs. investors.  In all cases, they would have created a small escrow fund to initiate building.  In all cases, they would have been likely to tactically put the home back on the builder.  Neither owner nor investor would have had an emotional history with the property at that time, and the size of their down payment or their interest rate terms were irrelevant to the decision.  However, lower interest rates in 2006 would have probably helped to reduce this problem, because buyers would have been more optimistic about housing markets and they would have been able to close the sale with better terms.  Surely, that would have improved the cancellation rate.

But, here is where I ask you to think about the perversity of public sentiment in 2006 and 2007.  The public discussion was all about subprime borrowers and homeowners who were in over their heads.  The public discussion was all about overbuilding and oversupply.  It was about corporations using predatory tactics against regular people.

And, the primary initial shock in 2006 and early 2007 was among homebuilders.  What were homebuilders doing?  First, in Phoenix, they couldn't get permits fast enough to meet demand.  So, rather than overbuilding, in 2005 they were holding lotteries at the new developments to determine which buyers could order a new house.  They were clearly not able to build at a fast enough pace to meet demand.  Then, they got signed contracts from qualified buyers who ordered new homes.  Only after they had a contract and an escrow account for a new home did they begin to build.  And, at that time, it was probably generally several months before they even broke ground, since they were running at capacity.  Far from being predatory, builders take a generous approach.  They take the construction risk.  They finance the construction, and they generally give buyers an easy out to walk away if there is some reason why they don't want to complete the transaction in several months when the house is ready.  Even in good times, cancellations frequently run over 10%.

So, the homebuilders were eating all of this inventory and taking it on the chin.  The Fed had steered the economy in this direction and had seen the decline in residential investment as appropriate, then in 2007, they held off on lowering rates because doing so would let speculators off the hook and would fail to discipline the marketplace.  At that point, even though prices in much of the country remained stable, new home sales had collapsed.  And, homebuilders were sitting on inventory of hundreds of thousands of homes.  Their sin was that they had built homes for paying customers who had signed contracts to order them.

What were they supposed to do?  Should we have a policy that homebuilders should refuse to build homes for paying, qualified customers who fund escrow accounts?  Should we have a policy that homebuilders must require buyers to put down escrow amounting to 20% of the home prices and wait for 9 months before they can move in, so that builders have more power over buyers during the construction process?

The only policy that fixes this problem is to provide accommodation sometime over the 18 months between early 2006 and the 2007 panic.  Lower rates to, say, 4%, instead of 5.25%.  Or, lacking that, in 2007, let people off the hookActually help stabilize markets that are panicked.  God forbid, maybe even allow some speculators and lenders to avoid financial ruin in the process.  By the time the Richard Fisher of the Dallas Fed told the FOMC in September 2007, "I’m very concerned that we’re leaning the tiller too far to the side to compensate risk-takers when we should be disciplining them.", the homebuilders had been disciplined for a good 18 months in the face of sharply declining nominal investment and sentiment.  To the extent that speculators were involved in that shift in activity, they had already taken their small losses by surrendering their escrow funds.  And, by September 2007, the homebuilders were far along passed the time where they needed to be reminded to be careful about speculative building.

PS.  Here is a chart from the Calculated Risk link that shows cancellations across several builders, which has the same pattern I found at Meritage.


  1. All of this is true...and YET...the dollar price of gold was shooting up by 15% per year (as was oil!), which sooner or later threatened another "revolt of the bondholders" like we had in the 1970s when the dollar's depreciation vs. gold made creditors hesitant to be repaid in dollar-denominated loans even at double-digit interest rates (why do that when hoarding gold is even better?) Even expanding the monetary base by double digits year over year and flooding the system with liquidity was not enough to bring interest rates down, and just led to more inflation and even more of a bondholder revolt.

    The Fed in the 2000s did not want to lose control again. So, what were they supposed to do? They could have changed the form of the crisis from the Great Recession to the Great Inflation Redux, but a crisis was unavoidable at that point...not due to any previous mistakes of the Fed, but due to insufficient world gold production which failed to keep up with the growth of the rest of the world economy, and which was increasingly putting undue strain on the dollar/gold exchange rate and which sooner or later threatened to place undue strain on the patience of bondholders.

    In other words, we needed a policy to spur the worldwide production of gold. Increasing the dollar-price of gold (i.e. lowering the dollar's exchange rate vs. gold) would have just spooked bondholders even more. So the only alternative was to cheapen the inputs to gold production (raw materials, machines, labor, the inputs to labor such as consumer necessities and homes...EVERYTHING). General deflation of the price level was unfortunately necessary and, in fact, did not go nearly far enough to really rejuvenate world gold production to the extent that was needed to set the stage for a really vigorous recovery in the world economy afterwards. Hence, our current rather pathetic "recovery."

    1. Gold responds to low real interest rates, not to inflation. Low rates were caused by the crisis. Gold was at $400 in 2005. High gold prices were the result of tight monetary policy, if anything.

  2. I agree that gold tends to go up when real interest rates are low. Sadly, the Fed has practically no control over real interest rates. An accommodative monetary policy does not necessarily raise real interest rates, as the Fed witnessed with declining or even negative real interest rates during the accommodative late '70s and the high real interest rates during and after the stringent Volcker Shock in the early '80s. I predict that attempts at an accommodative policy the next time around will be ineffective at preventing or addressing the next crisis and thereby keeping real interest rates positive and gold down.

  3. Great blogging. Richard Fisher, egads.

    I understand that when people invest in a venture capital fund they can expect to take loss.

    It is unsettling when government policy becomes that people who bought houses should take a loss--- especially when housing shortages are the norm.

  4. It's not the government's whim, but the Law of Value which occasionally forces homeowners to take a loss and some to go without a house at all. Houses and all other commodities (except for gold) were overproduced in 2007, not in the sense that nobody wanted a house or a car or an iPhone, etc., but rather in the sense that there was not enough aggregate purchasing power to purchase these things at existing prices. They were overproduced relative to an underproduction of purchasing power. Kevin Erdmann's school of thought is correct on this point.

    The kicker is, neither the Federal Reserve nor the fiscal authority was in a position, in the mid-2000s, to create new real purchasing power. The dollar money supply needed to be accelerated, but this must be accompanied by a similar expansion in the world gold stockpile or else it will provoke a creditor strike as creditors witness the dollar's depreciation vs. gold.

    In such situations when world gold production is lagging, increasing the dollar money supply causes not a rise in real purchasing power, but simply a rise in nominal prices.

    The Quantity Theory of Money is correct when applied to the relationship between fiat money and commodity-money. A doubling of dollars without a similar doubling of the world gold stockpile will lead to a doubling of prices in dollars. A doubling of the world gold stockpile without a doubling of dollars in circulation will lead to a halving of prices in dollars.

    However, the Quantity Theory of Money is not correct when applied to the fundamental basis of purchasing power, which is always commodity-money. A doubling of both dollars AND the world gold stockpile, all other things being equal, will not lead to higher prices, but instead to lower interest rates and good times for business and consumers. A stagnant supply of both dollars AND the world gold stockpile when housing and all other commodities are being produced in greater numbers will not lead to lower prices, but instead to higher interest rates and a bad time for business and consumers.

    In this sort of situation where the world gold stockpile is not expanding vigorously, as we saw in the mid-2000s, there will remain a troublesome aggregate shortfall of purchasing power, regardless of what the Federal Reserve or the fiscal authority does. More dollars will translate into higher prices, and the shortfall in purchasing power will persist now that everything must be purchased at higher prices. There will also be irresistible upwards pressure on interest rates. If the monetary authority resists this upwards pressure on interest rates by expanding the dollar money supply faster than the expansion of the world gold stockpile, the result will not be an increase in real purchasing power and a permanent decline in interest rates, but instead inflation and interest rates that will eventually be higher than they otherwise would have been. The 1970s decade attests to that.

    The only way to address an aggregate purchasing power shortfall, as we witnessed in the mid-2000s, is to spur on greater world gold production. And the only way to do that without spooking creditors (i.e. without simply allowing the dollar price of gold to skyrocket) is through general price deflation so that the inputs to gold mining are made cheaper. The solution to the crisis is the crisis itself. No pain, no gain.

    See this article for further explanation of my viewpoint:

    1. I should mention that there is one other possible solution: financial repression. If you have access to creditors' money at gunpoint at any interest rate that the State wants, like China does, then you don't really need to worry about your currency's depreciation vs. gold, and you can print money, bail out bad loans with this printed money, etc. all you want. This assumes that China can actually enforce its financial repression and keep money from seeping out of the country for greener pastures or out of productive investment in favor of gold hoarding.

      Assuming that China can actually enforce its financial repression, it becomes effectively exempt from the Law of Value and the need for periodic crises.

    2. It seems you have a heterodox theory of monetary policy. I'm afraid I have enough of a job explaining my own heterodox theory as an alternative to conventional wisdom. I'm not going to be able to address you heterodox theory too.

    3. Heh, true, fair enough. I do find your work interesting and appreciate the opportunity in your comments section to promote my views.

    4. Matthew: keep in mind that silver predated gold as a monetary metal. What do trends in silver production tell you?