Friday, September 13, 2019

Yield Curve mid-September 2019 update

There has been quite a lot of movement in yields since last month, so I thought it would be useful to look at an update.

During the last half of June and July, the long end of the curve came down while the short end moved up a little bit.  I wish we had an NGDP futures market to check these intuitions against, but I think the best interpretation is that in June the Fed had reversed track a bit and signaled more dovish policy going forward, but then some compromises in that posture began to arise, so while they certainly are more dovish than they were several months ago, some of the optimism that was pressing long end rates higher in June has receded.

The slope of the curve from two years onward has remained relatively stable since then and the movements have mostly been movements in the estimated low point of yields in 2021.

At first glance, rising rates since the end of August are bullish.  But, that is entirely due to rising short term rates.  The long end has actually flattened slightly compared to the beginning of August (the blue line compared to the pink line).  There are obviously a mixture of factors here, and continued strength in the labor market is probably one reason for optimism.  But, it seems to me that the net movement of the past two weeks is probably bearish.  Less faith that a dovish commitment by the Fed will prevent a bit of a downturn.  That would lead me to suspect that the coming decline in the target short term rate will be somewhat tepid and will be associated with a sympathetic decline in the long end of the curve at first, back toward or below the levels of late August.

Thursday, September 12, 2019

August 2019 CPI Inflation

Here are the monthly inflation updates.  It will be interesting to see if the Fed treats 2% as a symmetrical target or a ceiling.  There might be an argument for treating it as a ceiling at this point in the business cycle, because employment is so strong.  But employment is a lagging indicator.  At this point, I think the Fed has reduced the potential of worst case scenarios, but I don't think they will loosen up monetary policy aggressively enough to avoid a bit of a contraction.  And the depth of the contraction mostly depends on future decisions.

In addition to the problem that these measures are backward looking, of course, there is the issue, which is always the focus of these posts, that the shelter component is not particularly related to monetary policy, since it mostly measures the estimated rental value of owned homes, and even in the case of rented homes, frequently is measuring the growth in economic rents from the ownership of a politically protected asset, which is really more of a political transfer of wealth than an effect of monetary policy.

All of these questions about monetary policy discretion would be unnecessary under an NGDP futures targeting regime.  Hopefully, we can continue moving in that direction.

The last couple of months have seen an upward movement in non-shelter core inflation.  This puts core CPI at 2.36% and non-shelter core CPI at 1.68%.

Monday, September 9, 2019

Part 16: The conclusion to my series on housing affordability

A conceptual starting point for housing affordability and public policy

Here is an excerpt, but the post is short, so please click the link if you're interested.

Understanding this value and the systematic returns that homes provide leads to a somewhat paradoxical conclusion that (1) homeownership is usually a good investment, and (2) the smaller the investment, the better. In other words, an owner-occupied home with a low rental value can be a great investment, but the downside is that it requires living in a home with a low rental value.

The various posts in this series have considered housing affordability with a focus on rent. This focus has led me to the following policy suggestions: we should (1) maintain relatively high property taxes, (2) reduce or eliminate income tax benefits of homeownership, including the non-taxability of the rental value of owned units, (3) eliminate urban supply constraints, (4) reduce regulatory barriers to mortgage lending, especially in low tier markets, and (5) encourage innovation in real estate markets that reduces transaction costs.

I hope you have found some interesting ideas in the series.  I found it useful and enjoyable to systematically lay out a conceptual review of these ideas.

Here is a link to the whole series.

Wednesday, September 4, 2019

August 2019 Yield Curve Update

I had a brief flirtation with optimism, but the last couple of months have seen a bearish turn. 

This first graph is a graph comparing the Fed Funds Rate and the 10 year Treasury yield.  The orange line is the effective inversion line.  The zero lower bound means that long term yields have a kind of option value, biasing the yield curve upward.  This is my attempt at adjusting for that effect.  The yield curve is highly inverted.

In the meantime, the Fed seems to be tepid about their recent dovish turn.  It would take quite an aggressive posture for them to get ahead of this.  For this to become less bearish, the 10 year yield would need to rise substantially.  It's unlikely to do that without an aggressively dovish move, which the Fed would signal with a sharp decline in the Fed Funds Rate.

I expect the long term rate to bounce around a bit, but it seems unlikely that it will push back away from inversion.

The second graph shows the yield curve at various dates over the past few months.  It has flattened even as short term rates have declined.

Tuesday, September 3, 2019

Part 15 of my Housing Affordability at Mercatus

As the series nears a conclusion, I question the notion that homeowners are more leveraged than renters, or that, all things considered, the housing boom was associated with a rise in household liabilities.
The idea that paying $700 in rent is preferable to a $300 mortgage payment comes from the idea that a potential home buyer would be adding a new liability to their household balance sheet. It would involve leverage, and leverage is dangerous.
But this idea is, itself, a product of mental framing. There are assets and liabilities that we explicitly include on balance sheets, like the value of a home and a mortgage, or the market value of a corporation’s future profits. And there are assets and liabilities that we don’t explicitly include, like future rental expenses or the market value of a laborer’s future wages.
The explicit financial engineering that spread before the financial crisis has taken on a lot of criticism over the past decade.  That financial engineering, ironically, created risks and costs that were more transparent and visible than the implicit financial engineering that has been an unwitting side effect of deleveraging Americans’ explicit balance sheets.
A significant part of corporate financial analysts’ academic training is to properly account for the liability of the rents corporations have committed to paying.  Wouldn’t it be prudent for mortgage regulators to account for this liability also when evaluating the benefits and costs of the lending standards applied to households?

Tuesday, August 27, 2019

Coming to terms with discretion

The development of such a strong canon regarding what caused the housing bubble and what we should expect the economy to do during the recession has led to a subtle issue regarding causes and consequences.

The strength of the canon - that excessive lending and speculating had to be beaten down - and the passion for approaching it, meant that the entire episode has an air of inevitability, even where it was completely discretionary.

I mean, really, take any version of what happened in 2008.  It will have the pretense of inevitability.  Ask, "What caused the financial crisis?" and the answer will contain an implicit transitory property so that the answer will actually be the answer to "What caused the housing bubble?"  The FCIC report is basically entirely built on this premise.

Basically, a=c (things that might have caused a housing bubble = a crisis happened) was so universally accepted, that nobody has paid much attention to the second part of a=b and b=c (things that might have caused a bubble = did cause a bubble) and (the development of a bubble = a crisis).  Of course, much of my work debunks a=b.  This naturally means b=c is essentially a meaningless relationship.  A bubble that never really was could hardly be said to have caused anything.

Now, as far as a=b goes, there are library shelves full of claims about that connection.  Even though one might disagree with them, at least they exist.  But b=c was essentially presumed.  Yet, it wasn't inevitable at all.  In fact, once one is led to doubt whether a=b, one realizes that regardless of whether credit, speculation, etc. caused a bubble, the question of whether a collapse is inevitable isn't settled at all.  The collapse was completely under our discretion, and it was simply the universal agreement about that discretion that made it seem inevitable.  Like an abusive parent hitting a child and exclaiming, "Well, he broke the rules.  What would you have me do?"  The answer to that question was obviously to accept the abuse 100 or 200 years ago, simply because its acceptance was canonized.  It isn't acceptable today.

Simply questioning the premise reveals the dissonance.  The reason the crisis happened wasn't because there was nothing we could do about it.  The reason it happened was that, going as far back as 2006, or arguably even earlier, turning points just kept piling up where policymakers chose contraction, panic, decline, and collapse because to do otherwise would be coddling risk takers, bailing out wrong-doers, letting those who did this to us off the hook.  I don't even think I need to establish the point.  The public record is so saturated with that idea that it is undeniable.  It covers practically every page of every review of the period, every criticism of the Fed and the Treasury.  It's the story we have told ourselves about what happened.

Anyway, I am treading again over this territory, because I came across this graph today (here).

And, it really drives home the damage that those discretionary decisions did.  The places that are hurt much, much worse by cyclical dislocations are the places that are struggling already.  Successful places bounce back.  If not for the recession, "distressed Americana" in this graph would at least still be treading water.  Instead, there is a gash in its flesh in 2009 that isn't going to heal.  And, rest assured, the parts of the country that suffered that gash were not in the throes of a speculative frenzy.  They certainly didn't need to be taken down a notch so that those reckless people that did this to us had to be punished.

If you are concerned about the bifurcation of economic growth in this country, then there is a big giant elephant in the room regarding that issue.  We walked that elephant into the room, and it took a big, elephant-sized crap on the places that really needed stability.

Even if you think there was an unsustainable bubble and excesses had to be painfully purged from the system, consequences be damned:  THIS is the consequence.  Oh, by the way, it didn't need to be done.  a<>b .  But, even if we save that debate for another day, the imposed "discipline" that so universally was hoisted on the economy to knock it down to size had downsides that should be faced honestly.  a<>b, but even if a=b, there are a lot of questions we should have asked about, really, how committed we should have been to b=c.

Monday, August 26, 2019

Housing Affordability, Part 14

Here is my latest post at Mercatus: "Because of Housing, All Taxes on Capital Tend to Be Regressive".  Here is the conclusion.  Go to the link for the details.

 (T)he income tax code, as it exists, has regressive effects regarding housing affordability.Given those effects, it is inaccurate to treat capital taxation in general as a progressive tax. Corporate taxation, in general, creates a regressive rent subsidy. A different tax regime that focused on property taxation rather than generalized capital taxation could plausibly produce public revenue in a way that would be more progressive than a tax code that taxes capital income more generally. This should cast doubt on common presumptions about how and why to change the tax code.

Friday, August 16, 2019

July 2019 CPI Inflation

Core inflation has recovered a bit in the last two months, but we remain in the context of relatively low non-shelter inflation and high shelter inflation, averaging out to roughly on-target total core inflation.

I will probably continue to do these updates for a while, but I suspect the context is set, and specific shifts in inflation won't affect things much in the near term.  Inflation isn't likely to shift sharply in either direction, and in the time frame that is important for the Fed right now, noise dominates information.  So, effectively, Fed discretion will rule, although it will frequently be cast in language of inflation or interest rate control.

The context in place seems to be that the Fed will loosen.  Not so much to avoid a bit of a contraction, but not so little as to be greatly disruptive.  Excess shelter inflation is part of that context, but other factors will come into play, too.

Here, I think the 2008 event is informative.  The Fed is somewhat forgiven for allowing NGDP and inflation expectations to drop so sharply because at that time inflation was slightly above target.  This makes inflation seem like an important short term element in Fed decision making.  But, I disagree with that analysis.  Inflation wasn't anywhere near a level that would have led any sane regulator to sit aside as one panic after another struck the economy.  And, even as the Fed did that, the overwhelming criticism of them was that they were even daring to try to stabilize financial markets.  Even today, many commentators explicitly complain that selected economic agents weren't made to suffer enough.  The financial crisis in late 2008 happened because it was popular.  Slightly above target inflation is simply one of several justifications that were used to allow it to happen.  For any reasonable observer with a straightforward goal of maintaining economic stability, none of those justifications were plausible excuses for allowing such economic dislocations to occur.

The reality in late 2008 was that any reasonable monetary or fiscal policy would have caused a rebound in housing prices, as a side effect.  That would have been taken as indefensible.

We don't have the same dramatic setup today, so the stakes aren't as high.  But, similarly, inflation and interest rates will be used to communicate short term monetary shifts even though those shifts will have little to do with either.

Wednesday, August 14, 2019

Part 12 of my Housing Affordability series at Mercatus

Are Property Taxes Regressive?

The conclusion:
A region that allows ample new supply and imposes higher property taxes is friendlier to households with lower incomes than a region with obstructed housing supply and low property taxes.

Thursday, August 8, 2019

July 2019 Yield Curve Update

The yield curve has taken a sudden turn for the worse.

The Fed's tradition of using interest rates to convey their monetary stance is such a constant source of confusion.  The conversation about yields so often seems to hinge on the idea that the central bank is in full control of interest rates and uses them to make it more or less profitable to borrow and invest.  It baffles me how ubiquitous this sort of idea is in both professional finance and economics.

Recent movements in yields are a great case in point.  It is common to hear this shift described in terms of expectations about Fed rate cuts.  But the whole yield curve shifted down.  This is not a sign that the Fed will be loosening monetary policy more aggressively.  This is a sign that they won't be loosening aggressively enough.  The neutral rate just changed, leaving the Fed behind as a victim of institutional inertia.  That is in contrast to recent times when yields did react to clear signals from the Fed that it was going to be more aggressive.  In those cases, short term rates fell and long term rates increased.

I only update my graph of the adjusted yield curve inversion monthly, so the red dot for July is at about the same spot as it was at the end of June.  Of course, the 10-year rate has dropped 25bp since then.  So, unless some sort of economic or political development greatly improves economic prospects in spite of a tight monetary posture, raising 10 year yields back up, then we are already at a point where, even with short-term rates at zero, the yield curve will be effectively inverted.  This will likely lead to complaints about how the Fed is using QE4 to keep long term interest rates low to boost investment and asset prices, including from many otherwise sensible people who are generously paid to manage other people's assets.

Monday, August 5, 2019

Part 11 of my housing affordability series at Mercatus

Low Property Taxes and Obstructed Housing Supply Are a Bad Mix
"It would seem that raising property taxes would make housing more expensive.  They are, effectively, a tax on materials to build homes.  But the binding constraint to affordable and reasonable housing in twenty-first century America isn’t material.  It isn’t a lack of affordable physical space.  It is the political obstruction to placing those materials in dense urban centers."

With a universal expected market return, lower property taxes and just a small expectation of persistently rising rents can lead to much higher housing prices.  That's the first order effect.  But, as a second order effect, the value of homes as assets that are speculative claims on local political cartels, might mean that lower property taxes will be associated with higher rents.  It seems that higher property taxes might lead to lower quantity demanded, but also lower supply, with a net effect of less housing at higher cost, with cartel real estate owners pocketing the profits.  The political implications of that might change when the oligopolists would otherwise have been middle class pensioner grandparents, but the economic implications don't.

Tuesday, July 30, 2019

Part 10 of my Housing Affordability series at Mercatus

Property Taxes Can Be a Tax on Monopoly Power.

"If politically maintained monopoly power is going to remain, claiming monopolist profits through taxes is an improvement. The fact that the tax doesn’t affect rents is a sign of efficiency. If rents must be elevated, better that they go to local public services than to the real estate cartel."

The series will continue each Monday with discussion of the effect of various regulations and taxes on housing costs.

Sunday, July 28, 2019

Housing: Part 356 - Black Homeownership

Here is a new Bloomberg article on black homeownership.  The title is:
"Black Homeownership Falls to Record Low as Affordability Worsens"

The headline, and the article, are wrong.  Affordability isn't bad and that isn't why black homeownership is falling.

Here is a graph in the article, which also has an incorrect headline.  It says, "Over 25 years, the gap between blacks and whites has widened."  What the graph really shows is that from 25 years ago to 15 years ago the gap was narrowing, and then for the past 15 years it has been widening.

Here is a graph that combines old decennial Census data with the more recent quarterly data to provide a little more historical comparison.

From the Great Depression to the late 1960s, white homeownership rose as a result of Federal programs that explicitly excluded black families.  Then homeownership for black families increased, but then fell back again in the 1980s, for reasons I am not familiar with.  Then, in the late 1990s, it recovered back to the levels of the late 1970s, relative to aggregate US homeownership rates.

Then, homeownership peaked in 2004 for black families as well as for the US in general.  And the drop in ownership since then has been stronger among black families than among others.

To describe these trends with "Over 25 years, the gap between blacks and whites has widened." obscures what is important.  Black homeownership was recovering and expanding when mortgages were more available.  Note, however, that the recovery in ownership peaked near the beginning of the private securitization boom that lasted from roughly 2004 to 2007.  Since then the relative homeownership rate collapsed.

The disparate impact of the recession, the crisis, and the subsequent sharp tightening of lending standards on black households has been strong.  But, who would dare to claim that the pre-crisis housing market was good and that post-crisis lending market has been detrimental?

Here are the Zillow measure of mortgage and rent affordability - the portion of the median household's income required to pay the rent or the mortgage on the median housing unit.  It would be more accurate to say that it has been especially unaffordable not to be a homeowner in recent years.

Wednesday, July 24, 2019

Housing: Part 355 - Homes and population growth

I noticed that housing units per adult has actually started to level off.  This is interesting because total permits and total starts are still below past averages.

So, maybe the new neutral run-rate for new units is less than 1.5 million annually.  Maybe the need for new units is less acute than I have been saying.

But, there is a problem of causation here.  More people means we need more homes, but also, a lack of adequate housing can lead to less people - both by limiting migration and by limiting family formation.

And, it is true that population growth has slowed.  Before the financial crisis, it tended to run at 1-1.2%.  Since the crisis, it's more like 0.7%.  So, in a way we solved the housing shortage, in part, by reducing population growth.  If this is the new normal, then maybe 1.2 million units a year isn't an unsustainably low peak.  But, if population growth, either through immigration or through family formation, returns to anywhere close to historical norms, then housing starts probably need to catch up a bit and then settle at something closer to 1.6 million units annually.  (Ignore the big drop in housing/adult in 2000.  I haven't taken the effort to try to account for the discontinuity in the data there.  I suspect that mostly that discontinuity comes from an overestimate of the housing stock in the late 1990s, but it isn't central to the main trends I am discussing here.)

Certainly an argument can be made that population growth through family formation has been naturally slowing, so that we shouldn't expect population growth to continue at historical norms.  On the other hand, there are many good reasons to counter that decline with more generous immigration policies.  And, while there is a long term down trend in natural population growth, there was a sharp downshift that appears to have been related to the economic turmoil of the crisis and to the lack of housing growth since then.  Even without immigration, it seems likely that natural population growth has declined more than it otherwise would have after the crisis.

Also, there is always the important signal here of rent inflation, which has persistently run high for the past 25 years and returned to high rates during the post-crisis recovery.  That is not a signal we would see in a country where housing was being depressed by natural declines in population growth.

Tuesday, July 23, 2019

The latest posts in my Mercatus Housing Affordability Series

The last two posts in my series were:

"Tight Lending Regulations are a Wealth Subsidy".  An excerpt:

Thinking in terms of rental value, public policies and market innovations that lower mortgage interest rates can be broadly beneficial to consumers, even if those benefits don’t accrue to the actual borrowers who use those low rates.  That is because higher mortgage interest rates have a similar effect on price as exclusionary lending standards.  Downward pressure on price creates a rental subsidy for home buyers who don’t require a mortgage.

"Property Taxes Are Rent to a Public Landlord" An excerpt:
If there is concern that the net effects of government policies, in total, favor housing and lead to market volatility, a return to higher levels of property taxation can be a useful tool for countering it.

Writing the series helped clarify my thinking on several issues.  I hope you find some nuggets of interest in it too.

Thursday, July 11, 2019

June 2019 CPI Inflation

Here is my monthly inflation update.  We continue along in the same pattern.  This month there was a bit of a bump in non-shelter inflation, but the trailing 12 month rate remains about 1.1% and shelter inflation remains about 3.4%.

Going forward, I think inflation may become a less important indicator.  The Fed has shifted to a more dovish posture and they are not insisting on holding the target rate at a plateau.  It would be a shock if they don't lower rates this month.  So, I am happy to say that my worst fears appear not to have come to pass.  Monetary policy is on the margin of neutral.  Unless the Fed reverses course, I suspect there will either be a slight contraction or a continuation of the expansion.  For now, I will call that a tentative prediction, but it seems to be where we have moved.

We are probably near the point in time where a tactical long position in fixed income should shift into more of a long position in equities and real estate, either now or over a few months as this plays out.

In terms of broader influences, I'm more worried about nominal growth rates in Australia and Canada than things like the tariff issue, but I'm no expert on those issues.  That's just my hunch.

Monday, July 8, 2019

Squeezing "Unqualified" Borrowers

The latest post in my Mercatus bridge series.

More on how recognizing the key importance of rent as the measure of affordability - for both owners and renters - helps clarify the issue.  Tight lending is making housing less affordable for renters.

Considering this set of circumstances, the idea that housing affordability is getting worse because prices are high and that the solution is even higher interest rates or tighter credit access is a disastrous misreading. It will lead to a vicious cycle of segregation between households that can qualify under today’s standards (and who then can buy ample units at favorable terms) and households that cannot qualify (and who must keep economizing while a large portion of their wages is transferred as rent to the ownership class).

There are two options. Re-opening credit markets to entry-level buyers will return the market to a more equitable equilibrium. Maintaining the market as it is will continue down the path of settling at a new equilibrium where certain households live in smaller, less adequate units, either because of size, amenities, or location.
Please read the whole thing.

Here is the link to the full series.

Sunday, July 7, 2019

Housing: Part 354 - Nashville follow up

I wanted to revisit one graph, because I think it tells the story so well about what's happening in many US cities while lending standards are tight.

In the process, I realized that I should have adjusted for inflation, and in the process of doing that, I realized I had a minor excel worksheet error.  Here is the chart with the error fixed and the dollars constant.

In the last post, the linear trendlines were pretty nearly lined up.  But, the things that would affect the price/rent relationship should generally scale with inflation, so this is probably a more accurate portrayal of the Nashville market.  There has been some recovery of price/rent ratios in the low-to-mid part of the market.

At the top end of the market, P/R ratios are up about 5 points since the bottom, which was around 2011.  The bottom should be up at least that much too.

Low tier prices have risen as much or more than high tier prices.  But, as I pointed out in the previous post, this is because of low tier rent inflation, and the positive feedback of units with higher rents moving up to higher price/rent ratios.

That is still evident in this corrected graph.  At the high end, adjusted for inflation, price changes since 2011 are generally due to a recovery in price/rent levels.  That is the part of the market where building is taking place.

At the low end, little building is taking place, and rising prices are largely from rising rents.  Here, we can see that, even adjusted for inflation, the bulk of zip codes have moved from rents typically around $1,100 per month to rents more like $1,300.  P/R ratios in that part of the market have risen by around 2x and the rise in rents led to an additional P/R expansion of another 2x or so.  So, the low-to-mid part of the Nashville market moved from $1,100 rents at a P/R of 10x to $1,300 rents at a P/R of 14x.  The combination of those things was enough to cause those areas to appreciate in price faster than high end Nashville where rents have remained about the same in real dollars and P/R has increased by about 5x.

Some of the increase in rents is due to gentrification and in-fill capital improvements, but the tendency to blame those capital improvements for the increasing problem of unaffordable rent completely misses the point.  Rents won't come down until those segments of the market get as much capital as the top end is getting.  And, the top end is getting a lot.

Friday, July 5, 2019

June 2019 Yield Curve Update

Rates have continued to dip.  Forward markets have already moved much of the way back toward zero.  This has been somewhat surprising to me.  I expected the Fed to maintain the Fed Funds rate at a plateau level, as they did in the last two cyclical reversals.  But they are almost certain to start to lower the target rate this month, and that is great news.

There is still some potential for trading gains in forward rate markets, I think, because short rates are highly likely to return to near zero.  I hope the newly dovish turn by the Fed is enough to give that move some oomph.  I think an important signal will be the long end of the curve.  If it remains low as the Fed lowers the target rate, this is a sign that the Fed is following the neutral rate down, and isn't really inducing nominal growth.  It will be a bullish sign if the long end of the curve moves up.

In fact, using the adjustment I make to the yield curve, at today's levels, the 10 year treasury yield would still be effectively near inverted rates even if the Fed lowers the target rate to zero.  My worry is that mistaken associations between low rates and loose money will prevent the Fed from being aggressive enough.  But, recent Fed communications have been more promising.

The first graph here shows the 10 year rate vs. the Fed Funds rate, and shows my modeled inversion indicator.  By this measure, the curve has been inverted for many months and moved much farther into inversion territory this month.  In some ways, that is a good sign, because it reflects expectations of near-term Fed rate cuts.  But, ideally, it would be better if long term rates held firm.  The fact that long term rates are declining along with short term expectations is a sign that frictions in credit markets were keeping long term rates high.  To me, this is the best way to think about yield curve inversion.  Some set of frictions in the market prevent long term yields from declining to unbiased forecasts of future short term rates when the yield curve is inverted.  I suspect that this causes problems with credit allocation that may be a causal element in the contractions that tend to follow inversions.  If long term rates decline when short term rates are lowered, that suggests that lowering rates has removed those frictions and allowed long term rates to move to a less biased level.  So, the good news is that Fed dovishness is helping to offer relief to markets, but the bad news is that this means an inversion is in effect and that usually leads to a contraction.

The market is currently priced to expect the dots on my scatterplot to move sharply to the left as short term rates are lowered.  But, the key to avoiding a recession is for the upcoming dots to also move up.  If they don't, then I suspect that we will be playing catch-up and economic growth expectations will remain subdued, which will continue to lead capital to safer assets instead of into riskier investments that can trigger productivity and employment strength.  It is hard to tell in real time, but it is beginning to look like real GDP growth peaked a year ago and that the 4 quarter real GDP growth rate will move back down below 3%.  One might expect real growth to level off as unemployment bottoms, but employment growth has been pretty stable since 2012 at 1.5% to 2%, and continues to move in that range as workers re-enter the labor force, so changes in employment growth don't point to a GDP slowdown yet.

The best thing that could happen is the Fed lowers the target rate aggressively, long term rates rise with new real growth and inflation expectations, and then FOMC members and pundits who incorrectly view lower rates as a stimulus to risky investments will interpret higher rates as less stimulative, and they won't pressure the Fed to stop lowering the target rate.

Wednesday, July 3, 2019

Housing: Part 353 - The Seemingly Strange Case of Nashville

There are two core constructed details that have formed a basis for much of my analysis about the 21st century housing market and the financial crisis.

  • Price/rent ratios tend to rise as rents rise, but at some point in each metropolitan market they reach a ceiling.  This means that (1) excessive price appreciation in low tier homes during the housing boom in cities like LA and NYC was mostly a product of rising rents. and (2) The core error of the FCIC and most analysis of the crisis was missing this fact and blaming rising prices on aggressive credit markets instead.
  • In most cities, rents were moderate enough that there was not an unusual rise in low tier home prices from this effect, but after the boom, when credit was greatly tightened, low tier prices were decimated, frequently falling more than 20% compared to high tier prices.
This first graph basically tells that story (PS: Many thanks to for making so much price and rent data public): 2019
Data from Zillow

LA is highly unusual, both for having such high price appreciation and for having such a divergence between the high and low end during the boom.  These are related.  They both come from the extreme shortage of supply relative to demand for housing in LA.

Seattle is more expensive than Atlanta because incomes are higher there and supply of housing is more constrained, though much better than LA.  So, you see a bit of difference between Seattle and Atlanta during the boom, but little difference between the top and low tier of each city.

Then, during the bust, bottom tier home prices in both Seattle and Atlanta collapse, to the point where low tier prices in Seattle had total appreciation that was no more than high tier appreciation in Atlanta. 2019
Data from Zillow
I recently had occasion to look up data in Tennessee.  I have gotten so used to seeing this pattern that running the numbers has become rote.  Almost every city looks something like Seattle and Atlanta.  So, I was quite surprised when Nashville looked like this:

Nashville looks like Atlanta before the crisis and Seattle after the crisis, and it doesn't have the lagging low tier price appreciation of either of those cities.  In fact, it is high tier prices that have been lower in recent years.

What gives?

It turns out that in recent years, Nashville has been on fire, economically.  Population growth, in-migration, rising incomes.  Things are going really well there.  Things are going so well that housing supply pressures are making it look more like a Closed Access city.  Well, it's more the case that there are two Nashvilles.  The top half of the housing market operates like an open access city before the crisis.  The bottom half of the housing market operates like a closed access city because new tighter lending standards are preventing owner-occupiers from buying homes in those sub-markets.  This has compressed price/rent ratios so that yields are high enough to induce buying by landlords.  This can happen through lower prices or by rising rents.  In practice, it can be a little bit of both.  In Nashville, it appears that economic success has led especially to rising rents, because pressure for residency in Nashville is pushing up demand for Nashville housing.  At the top end, this leads to more supply.  But, that demand pressure also appears to be seeping into the low tier, where it can only push up rents, because buying pressure is limited mostly to landlords and they are still mostly just buying up the existing stock, apparently at price points that still can't induce much new supply.

Here is a Fred chart of housing permits in Nashville.  The red line is single family homes and the blue line is multi-unit homes.  Both are very healthy.  Pre-crisis Nashville had strong rates of new home building.  It may be unique among cities where building was well above the national average before the crisis and has recovered to those pre-crisis levels.  You just don't see this in other cities.

I presume that eventually, rents will rise high enough to trigger even more building at the low end, putting a stop to excessive rent inflation.  But, it hasn't happened yet.  Though, multi-unit starts are very strong.  To the extent that investors will build new stock, it will tend to be multi-unit. 2019
Data from Zillow
Here is a graph of median rent and mortgage affordability in Nashville and in the US over time.  (Again, all hail Zillow.)  The national story here is that rent affordability has been high (though it has moderated recently) but that mortgage affordability has never been better.  There has never been more reason to loosen lending standards.  This is basically why the low tier of most cities is lagging in price and supply with rising rents, because we have financial gatekeepers preventing potential low-tier buyers from closing this financial arbitrage gap.  Price is not the moderating factor keeping mortgage expenses so low.

But, note what the Nashville story is here.  It has traditionally been an exceptionally affordable city, in terms of rent.  But during the housing boom and after, that gap has closed, and Nashville isn't particularly affordable any more. 2019
Data from Zillow
Because of these high-tier vs. low-tier supply issues, this affordability problem is especially pronounced in low-tier Nashville neighborhoods.  Zillow only has rent data from 2010, but here is a graph comparing aggregate median rent levels in each zip code in Nashville from 2011 to 2019.  The x-axis measures the starting median rent and the y-axis measures how much rent has increased in that zip code since then.

More affordable areas have experienced rising rents much higher than more expensive areas.  So, the median rent affordability measure above really splits a divide between top-tier areas where rent affordability has remained low and low-tier areas where it has moved up more.  In Nashville, this has been strong enough factor to swamp the compression of price/rent ratios. 2019
Data from Zillow
And, this brings us back to the bullet points at the beginning.  The counterintuitive issue at the core of the question of rising home prices is that rising rents cause price/rent ratios to rise.  Here is a comparison of rents and price/rent ratios in zip codes in Nashville in 2011 (blue) and in 2019 (red).  As we can see, the typical pattern holds.  Price/rent ratios rise as rents rise, up to a point, where they level out.  At the top end of the market in Nashville, price/rent ratios have increased since the market bottomed, and top end price/rent ratios now average around 17x or so, up from around 14x in 2011.

One would think that price/rent ratios at the bottom end would have to have expanded at least that much, because prices have appreciated at least as much at the bottom.  I have added linear trendlines here, reflecting the portions of Nashville that are not at the peak price/rent level.  As you can see, that relationship hasn't changed much since 2011.  A typical unit renting for $1,200 has a price/rent ratio that is right at the same level it would have been in 2011.  But, rising rents have pushed all housing units up this price/rent ratio incline.  This is basically the same effect that was happening in places like LA before the financial crisis.

The long and short of it is that there are zip codes in Nashville where rents might have been $1,000 per month and looser lending may have pushed price/rent ratios up from 10x to 12x.  The trend line in this graph would have moved up.  Instead, because of tight lending, rents in those zip codes are more like $1,200 with price/rent ratios around 12x.  The trendline hasn't moved at all, yet this doesn't make housing more affordable.  This is one of many reasons why the focus on affordability should be on rent, not price.  Rent is the coherent source of information for that question.

I have concluded that the relative rise in low-tier prices in cities like LA during the bubble was unrelated to loose lending markets.  That is a tough argument to make, because it coincided with loose lending markets, and it just seems to make sense that loose lending would create new buyer demand that might push prices up.  But, here, in Nashville, we can see the same effect, and here, the effect coincides with tight lending.  In both cases, however, rising rents and rising price/rents coincide with limited supply.

Tight lending standards have created the same context in the rest of the country that supply constraints in Closed Access cities had created before the crisis.  Any positive economic developments will create a side effect of pushing up the cost of living for families with the lowest incomes.  Eventually, I presume, Nashville will hit a rent level that pushes prices high enough to induce enough investor building to level off rent inflation.  There will be a new normal, where the level of rents will be higher for low-tier tenants relative to where they used to be, but once we hit that level, the rate of change in rents should level out.

There is no rule here that points us to the correct place.  Maybe access to mortgages should be tightly regulated and housing should be more expensive than it used to be for low-tier tenants.  An advantage of that market norm would be lower rates of mortgage defaults, etc.  It would be a safer equilibrium with less volatility and less punctuated distress.  But, the cost of that safety comes at the expense of low-tier tenants.  They replace less punctuated distress with more chronic distress.  And, if prices are going to be depressed by limiting access to capital, then that means, mathematically, that we are enforcing a system of inflated returns to those who happen to have capital.  Again, maybe that's ok.  We just need to be honest about the implications of these lending norms.

If this is the new normal, then most cities have a few decades to look forward to that look like Nashville today.  Economic success will mostly simply mean rising cost of living for households with lower incomes.  This will be blamed on all sorts of supposed problems with laissez-faire markets, but most of it lays at the feet of a national consensus that has supported an extreme regime shift meant to make real estate markets less volatile.  Supporting an economic structure that benefits all Americans will require coming to terms with the pros and cons of that consensus.

Follow up.

Monday, July 1, 2019

The next post in my Mercatus series on housing affordability

Here is where you can see the entire series as it is posted:

Here is the latest:
"The Myth About Bubble Buyers"

A lot of this particular post will probably be familiar to long-time IW readers.
(F)or households 45 to 54 years in age, the homeownership rate in 1982, when the Census Bureau started tracking it annually, was 77.4 percent. It bottomed out at 74.8 percent in 1991 and then recovered to 77.2 percent at the peak in 2004. By 2017, it was down to 69.3 percent!
Rental expenses as a proportion of incomes (Figure 1), belie the conventional wisdom. The rental value of owned homes was more stable as a portion of owner income than the rental value of rented homes from the late 1990s to the mid-2000s. In other words, if there was an increase in relative spending on housing, it was among renters. The rental value of homeowners was rising in line with their incomes. There is no sign of marginal homebuyers being induced into homeownership and overconsumption.

Tuesday, June 18, 2019

May 2019 CPI Inflation

Sorry I'm a few days late on this.

Core CPI continues to ride along the 2% target range, bifurcated between shelter and non-shelter prices.  CPI shelter inflation is at about 3.3% over the past 12 months.  The non-shelter core components are now down to 1.0% over the past 12 months.

Inflation isn't that great of a short-term signal.  After all, non-shelter inflation was at or above 2% in 2008 and 2009 while nominal GDP growth was collapsing.  But, the period leading up to that, in 2006 and 2007, had a similar character - high shelter inflation and low non-shelter core inflation.  Yet, when that signal appeared in 2017, it reversed in spite of Fed postures that continued to signal tightening.

All that being said, it certainly seems as though maintaining an inverted yield curve with non-shelter inflation at 1% is clearly too hawkish.  It appears as though the Fed is looking to reverse course, which is very good news.  A couple rate reductions is prudent at this point.  Unfortunately, that is likely to meet the howls of those who claim a low target interest rate inflates prices in capital markets.  But, it seems the FOMC has become more immune to that, which is great.

I have been suggesting that long bond positions would be profitable, and expecting that an inertial Fed would create marginal buying opportunities in other assets as that opportunity played out.  The long bond position is mostly finished because of the zero bound. Mid-to-long term rates aren't able to go much lower.  If the Fed gets ahead of things here, maybe they will curb any pullbacks in equity markets or housing markets.  I'm happy to see that tactical opportunity disappear if it means the Fed doesn't encourage unnecessary contractions.  In fact, maybe that would make those opportunities even more fruitful, without waiting on a pullback, if the economic expansion is allowed to continue, chipping away at risk aversion.

But, the story remains.  Inflation is very low.  To the extent that real wage growth continues to disappoint, this is largely a structural supply issue that creates a transfer from tenants to real estate owners, which is measured as inflation.

Monday, June 17, 2019

Mercatus Series on Housing Affordability

I have a blog series on housing affordability that is slowly rolling out (1 per week) at The Bridge.

I find discussions about housing affordability to be frequently frustrating.  One reason is that homeownership is generally treated as if it is a wholly different type of consumption than tenancy is.  This is odd, because in national accounts, the BEA treats tenancy the same for both owners and renters.  I find it useful to disaggregate our economic activities regarding shelter so that every home has an owner, a financier, and a tenant, regardless of whether those agents are all different or are all the same individual.

There is certainly a risk that comes from becoming an owner-occupier and taking ownership of a single large asset that can frequently be much larger in size than your total net worth.  On the other hand, there is also value that comes from getting rid of the principal-agent problems that come from having various stakeholders who all have competing interests on a single asset.  For owner-occupiers, those conflicts are erased, which seems to lead analysts to act as if these three different relationships to a property disappear when those agency conflicts disappear.

In this series I maintain these three roles as factors for all homes - financier, owner, and tenant - and consider various aspects of housing markets and housing policy.  This process has led me to new points of view regarding these issues, and I hope you find something to think about in each post, also.  In hindsight, I find that the posts have a veneer of dryness, but they are short, and I am hopeful that each one has at least one new idea that will shift you in your seat a bit and help you to take a few moments to deepen your own sense of how these factors play out in the marketplace and in the various public policies that affect that marketplace.

The tl:dr on the first four parts:

  1. Thinking Clearly About Housing Affordability:  "Here is the core analytical error: housing affordability should be measured in terms of rent, but our understanding and policies have erroneously focused on price—to disastrous ends.  From monetary policy to credit policy to regulations on local development, responses to the housing bubble have consistently and explicitly aimed for less residential investment, fewer buyers, and fewer homes.  Limiting the supply of homes has had a predictable effect of increasing rents.  In other words, the problem of affordability, in terms of price, was “solved” after 2007.  Affordability in terms of rent was not.  Understanding the difference between these two measures will be an important factor in correcting the policy errors that led to the crisis and creating better, more equitable, more stable economic outcomes in the future.
    I argue in my book, Shut Out, that the housing collapse and the financial crisis were not inevitable.  They weren’t even useful.  In fact, their very purpose was mistaken.  The fundamental measure for housing affordability is rent, not price.  And, trying to bring down prices instead of bringing down rents inevitably will fail on its own terms.  In the long run, prices will be determined by rents anyway."

  2. What Are Landlords Good For?:  "More efficient markets lead to higher real estate transaction productivity. The resulting higher prices convey that information: owning a home is more valuable now, because it can be done with less hassle. Landlords would be less necessary because transaction costs would be a smaller problem, making homeownership more valuable.  Only focusing on price might tempt one to suggest that transaction cost-reducing innovation should be avoided because it would only increase prices."

  3. Homeowners Make the Best Landlords:  "When considering the benefits of home ownership on the margin, the focus should be on capturing the excess yield that seems to be widely available to owners.  It is this yield that is most important to marginal potential owners, not capital gains... It may be more accurate to think of that excess yield as a form of patronage.  A lucrative wage available to those with access to ownership.  The wage is earned by performing the duties and taking the risks of a landlord. Upon becoming the owner, the wage remains, but the duties of the job can be shirked.  There is no problem tenant to evict.  No vacancies to fill.  No complaints to manage.  It’s a cushy job you can get because your Uncle Sam pulled some strings down at the bank."

  4. Real Estate Investment Doesn’t Increase Spending:  "The housing bust is creating more excess capital income than a housing bubble ever could have."

Sunday, June 9, 2019

May 2019 Yield Curve Update

Good news on the monetary policy front.  The Fed has been signaling a willingness to ease, and currently, futures markets are predicting a 25 basis point rate deduction in July (with some probability even of a 50 bp deduction!).  Initially, this brought the yield curve down out to several years, but in the days since then, the short end of the curve has remained lower while the curve from 2020 onward has recovered back to late May levels.  That's a great sign.  Maybe the Fed will ease enough to avoid a contraction.

The primary thing to look for in the yield curve, I think, is reaction of the long end.  I think we are clearly in inversion territory now, which means that there has been some distortion in long term yields.  As short term yields decline, that distortion will be eased, and long term yields will initially decline along with short term yields.  Eventually, the positive signal will be a divergence between short and long term rates, with a flattening of the short to mid term curve and a slight upward slope.  It seems as though the Fed is willing to be aggressive enough to make that happen.  This is a positive surprise to me.

Expectations have changed so sharply that already, if you look at the December 2020 contract on the Eurodollar curve, half of the gap between the November peak rate of about 3.2% and 0% has already been filled.  In terms of taking a long position on forward rates, the horse is already mostly out of the barn.  If the Fed is aggressive, forward rates may not have that much farther to fall.

In the second chart here, I would expect the typical pattern to happen, where, as the Fed Funds Rate declines, the 10 year rate will decline along with it along the inversion trend line.  At some point, the 10 year will stabilize.  A rule of thumb I would expect to look for is if the Fed has gotten too far behind the 8-ball, then the economy will deteriorate and the Fed Funds rate will continue to decline.  Or, if they get ahead of the ball, then the 10 year will recover.  So, I suppose I would expect the inversion to eventually reverse.  The scatterplot will cross back over the trendline.  It would be a bad sign if the scatterplot crosses the trendline horizontally and it would be a good sign if it crosses it vertically.

It moved vertically in 1996 and 1999.  But, in those cases, the curve wasn't inverted, or the inversion hadn't been in place quite as long.  In cases where it has been inverted for at least this long, recession followed.  In 2001, the inversion was reversed by lowering the Fed Funds rate, so it crossed horizontally.  It seems as though we could go either way.  I have been prepared for the mania about asset prices to drive the Fed to a too hawkish position, but the fact that the market thinks there is a chance for a 50 basis point move in July suggests that the Fed is no longer as hawkish as I thought.

Friday, June 7, 2019

Housing: Part 352 - Building market rate homes helps make housing more affordable

Nolan Gray has a great write-up at CityLab about a new working paper that attempts to empirically measure the process by which substitutions across housing markets work.  This is one process by which new high-end units can help create broad affordability.

Gray's piece is about a new working paper by Evan Mast.

The take-away:
Building 100 new luxury units leads 65 and 34 people to move out of below-median and bottom-quintile income neighborhoods, respectively, reducing demand and loosening the housing market in such areas. These results suggest that increasing housing supply improves housing affordability in the short run.
Keep in mind that the status quo in the Closed Access cities is that tens of thousands of households of lesser means move away each year because of affordability issues.  This work only measures moves up-market, not the cessation of outmigration.

In the extreme, where high-end housing demand is inelastic and low-end housing demand is very elastic, one might expect new supply to lead mostly to an expansion of high-end quantity demanded with little or no expansion of low-end quantity.  That is effectively what is happening on the margin today.  As high-end demand continues to grow, demand at the low end is reduced by substituting out of the metro area.  The migration data tells us this is the state of demand.

So, functional substitution between housing sub-markets could still lead to better affordability even if there was not an expansion of quantity demanded among low-tier tenants.  It would still be an improvement if lower rents simply allowed them to remain in the units they have.  It would be an improvement simply to stop that distressed outflow.

Mast's findings are a bonus.  Not only can the new supply stop the outflow.  It can even lead to low-tier increases in quantity demanded.

Wednesday, June 5, 2019

The popularity of the nationalistic rhetoric of Trump, Warren, and Sanders is a failure of economics

Elizabeth Warren posted "A Plan for Economic Patriotism" this week.  It begins like this:
I come from a patriotic family. All three of my brothers joined the military. And I’m deeply grateful for the opportunities America has given me. But the giant “American” corporations who control our economy don’t seem to feel the same way. They certainly don’t act like it.
Sure, these companies wave the flag — but they have no loyalty or allegiance to America. Levi’s is an iconic American brand, but the company operates only 2% of its factories here. Dixon Ticonderoga — maker of the famous №2 pencil — has “moved almost all of its pencil production to Mexico and China.” And General Electric recently shut down an industrial engine factory in Wisconsin and shipped the jobs to Canada. The list goes on and on.
These “American” companies show only one real loyalty: to the short-term interests of their shareholders, a third of whom are foreign investors.
As with her other proposals, there is a mixture of good and bad, and a lot of details.  Maybe the rhetoric isn't that important, in the end, to the actual policies.  But, the rhetoric here is chilling.  The history of public movements calling out groups for their supposed divided loyalties is a long and disgraceful one.  Considering the starkness of the rhetoric, and the parallels between Trump, Warren, and Sanders regarding their use of the form, it is interesting to consider how, for all of us, our reactions to each of them differ so much.  The bridge between Warren and Trump voters seems to be increasingly noted.  It seems plausible that this new press release is part of a plan by Warren to build on that.

But, I want to step back from that for now, and just consider the practical issues raised in Warren's statement.  Economics, at the least, should serve as an inoculation against this sort of rhetoric, and in this, it seems it has failed.

Consider the global economy as it might be, full of functional, productive societies with wealthy residents.  In that world, the places we currently consider developed might produce 20% of global goods and services.  Instead, today we produce something more like 70%.  At some previous point, it was more like 80%, and developing economies have been catching up.

That process of catching up is fabulous.  It is all to the good.  The only sustainable way of becoming a developed prosperous place that we know if is to move toward a system of a universally applied rule of law, human rights protections, personal freedom, and self-determination.  With that foundation, people engage in the process of specialization and trade that is the source of economic abundance.

This is the key - specialization and trade.  So, imagining this fabulous development - the whole world becoming civilized, humane, and wealthy until our part of it only produces 20% of that abundance - exactly how does one expect that shift to happen?  As the developing world moves from 20% to 30% of global production, they will necessarily specialize in some additional portion of world production.  It might be apparel or pencils.  It might be something else.  But it will be something. And much of it will be items that used to be produced in the developed economies.

The idea that the Dixon Ticonderoga company has much of a say in this is obtuse.  And, furthermore, the idea that their acquiescence to this global transformation is the result of "the short-term interests of their shareholders" is ludicrous.  There is nothing short term about this.

The reason that this rhetoric doesn't destroy Warren's public credibility is because of the failure of economics education.  The reason this can be construed as a short-sighted decision is that it is almost universally seen as a way to take advantage of the low wages of developing economy workers.  As if this is just a heartless example of exploitation rather than a reaction to epochal shifts in global productivity.

I propose a simple statement as a starting point for remedying this problem: "Production doesn't move to where wages are low.  It moves to where wages are rising."

That is the story of economic development.  This doesn't mean there aren't growing pains that sometimes hit some workers the hardest.  But, it does mean that in the end, all of those gains, on net, go to workers.  Returns to global at-risk capital are about 8% plus inflation.  They were 8% a century ago, they average about 8% today, and they will likely be 8% or less a century from now, if the world continues to grow with a capitalist framework.  But, workers today earn ten times or more what they did a century ago, and in another century - especially in places that are catching up - they will earn at least ten times what they earn today.

It really is ironic that Warren uses the Dixon Ticonderoga company as an example here.  Leonard Read, the founder of the Foundation for Economic Education was perhaps most famous for writing the essay, "I, pencil".  An excerpt:
I, Pencil, am a complex combination of miracles: a tree, zinc, copper, graphite, and so on. But to these miracles which manifest themselves in Nature an even more extraordinary miracle has been added: the configuration of creative human energies—millions of tiny know-hows configurating naturally and spontaneously in response to human necessity and desire and in the absence of any human masterminding! Since only God can make a tree, I insist that only God could make me. Man can no more direct these millions of know-hows to bring me into being than he can put molecules together to create a tree.
An interesting aspect of that essay is that it contains several practical references to geographical locations of production, many of which I am sure have become dated as global production and specialization have evolved.  The essay is at once a timeless conceptual reminder of the profoundness of the invisible hand and a record of the fleeting nature of its operation.

I found this with a quick google search, which is a nice educational aid used in some New York state elementary school classrooms.  The education is being done.  But, the continued popularity of its absence is a call for ever more.  Godspeed, New York elementary teachers.

(PS; Karl Smith weighs in here with some interesting supporting details about the history of Dixon Ticonderoga.  He also discusses currency manipulation, but I think that is an overstated factor in the American trade deficit.)

Housing: Part 351 - The downfall of "Pick-A-Pay" loans

Here is a great article on the history of Golden West Financial Corporation and the development and downfall of option ARMs. (Pick-A-Pay or option ARM refers to mortgages where the borrower can choose their monthly payment for some period of time - sometimes at a rate that doesn't even cover the interest, so that the principal amount grows rather than declines.) An excerpt:

Five months after the Times’s “pariah” story ran, the paper’s Floyd Norris wrote a column about Golden West’s loans. The business columnist had entirely missed the original piece on the Sandlers, he says, and knew little about their bank’s history. Like other option ARMs, Norris wrote, Pick-a-Pay loans were racking up big losses. But when reading Wells Fargo’s first-quarter earnings report, he noticed that less than one-third of 1 percent of Golden West’s loans were expected to recast before the end of 2012, meaning that borrowers wouldn’t see large payment increases for many years. “That struck me as an amazing number,” he says. “How the hell could that be?”

It was the ten-year option at work. Over the next few days, Norris researched the terms of Pick-a-Pay loans, and concluded that the loans’ ten-year option and high loan-to-value cap were remarkably generous, and an attempt to do right by borrowers. Yet in a catastrophic market decline, those terms stripped the bank of leverage. Homeowners could pay less than interest-only in the hope that the market would recover, restoring their equity. If prices stayed depressed, however, they didn’t have much to lose, as their payments “could well be less than the cost of a comparable rental,” Norris wrote.

“I understand it makes some people feel better to know that they have identified someone who acted outrageously,” Norris says. “But sometimes it’s more interesting when nobody acted particularly outrageously and things blew up anyway.”

Thursday, May 30, 2019

Housing: Part 350 - Perceptions of reckless lending

I like to get feedback on my work from real estate investors, developers, etc.  Most of the time, they simply see me as na├»ve or silly.  Some doofus with a theory sitting next to you on an airplane isn't going to cause you to stop believing your own eyes.  And, real estate is still mostly local.  Knowing the up and coming parts of town, the best corner for a new building, etc. are still more important than having a fine-tuned perspective on macro trends.  Whatever is driving the macro-level, there will still be apartment buildings sitting half empty in one part of town while they can't get built quickly enough in another.

It is a difficult conundrum, because macro-level work needs to be able to withstand a critique from on-the-ground market experience.  Yet, success on the ground doesn't necessarily require having a coherent interpretation of the market.  The guy with the bustling bagel shop on the corner might be able to do just fine even if he sees the world through a collection of layman's fallacies.  If he makes a decent bagel and manages his staff well, it probably won't affect his livelihood if he thinks the Federal Reserve is controlled by the Rothschilds and that the economy is just being pumped up in a series of fake inflationary bubbles.

So, I try to hear what strangers have to say, even though I realize it is a bit dangerous that I am capable of being stubbornly immune to their criticisms.

Recently, I had a conversation with a woman who is a small-scale landlord.  The kind of street-wise investor that you typically see in that market, who knows how to put their money to work.  It is interesting to talk to people like this because they operate from a different framework than I do.  I have shown how there is a systematic relationship between price and rent within each metro area, and I have hypotheses about why that is - costs of management, access to capital, income tax benefits, etc.

It is rare for people who actually invest in local real estate to have thought about these things, even though you would think it would be important.  Usually they just have some personal rules of thumb: only buy properties with a gross return above x%, don't rent to x, y, and z types of people, don't buy properties in x, y, and z parts of town, etc.  These rules of thumb effectively come to the same result as a quantitative analysis of returns would do.

Typically, these investors simply dismiss out of hand the possibility of investing in high tier single family homes, because they are too expensive.  That will happen in either case, whether looking at the market systematically and quantitatively from a macro level, or using their rules of thumb.  If you recognize that something is too expensive to pay off as an investment property, you don't necessarily need to spend a lot of effort to explain why it is.  But, since they use their rules of thumb, they never confront the oddity that their single largest investment is exactly the investment they dismiss out of hand - the very home they sleep in every night.  To them, that is simply a different category of activity.  That is consumption, not investment.

It is perfectly reasonable that they own their home.  Part of what they are consuming is the act of ownership - control.  But, not fully confronting these conceptual issues leaves many functionally successful investors in a position of misunderstanding macro-level issues and policy issues.  For a start, I think it is common to underestimate how pro-ownership public policy goals unlock value for other households that current homeowners frequently take for granted without having really thought about it.  In other words, it is perfectly rational that they paid more for their house than they would ever have dreamed of paying for an investment property, yet creating markets or public programs that would allow other households to do exactly the same thing seems reckless and dangerous - using public subsidies to feed speculation and over-consumption.

Aaaaanyway, I digress.  The woman I struck up a conversation with had some pointed reasons for dismissing my broad theory of the housing bubble.  One reason, which she explained to me, was that her son bought a house in Wyoming during the bubble while he was finishing college.  As she explained it, she and his father had agreed to co-sign on the mortgage so he could qualify.  But, when it came time to close on the sale, they were out of the country on a trip.  They were preparing to come up with a way to sign the proper documents when her son informed her that the banker said it was unnecessary.  They would approve the loan without requiring a cosigner.  She was aghast.  Her son had very little income at the time.  It was outrageous that the bank would approve the mortgage.  Furthermore, this was during the bubble.  Home prices were elevated, precisely because this sort of recklessness was moving the market.

This is the sort of feedback that I consider interesting.  I have to acknowledge these sorts of excesses properly in order to arrive at a truthful explanation of what happened.  At first blush, this seemed like feedback that I should chew on as a source of caveats.  But, the more I chew on it, the more peculiar it seems.

First, here is a chart of median real home prices in Wyoming, with real home prices in California included for a reference point.  Also, I have included an estimate of conventional mortgage payments on the median Wyoming home.  (Data from Zillow and Fred)

There are some interesting things going on here.  First, I think this is a good example of how the bubble idea has infected our perceptions of the time.  I am sure that her memory of prices in Wyoming isn't technically wrong.  The unit her son was buying was probably 10% or 20% higher than it would have been a few years earlier.  A frugal investor would notice such a thing, and would think twice about buying in such a market.

Yet, prices in Wyoming just wouldn't have led to any sort of notions about a special market that was bloated by recklessness.  Those notions have been planted in our perceptions because of places like California.  As the chart shows, the scale of the market just isn't in the same ballpark.

And, here is a chart of foreclosure sales in California and Wyoming. (Data from Zillow)  This perfectly reasonable woman has a picture in her head of something that happened that just didn't happen.  It was even convincing to me until I sat on it for a while.  If, indeed, there was a rash of reckless lending in Wyoming before 2007, then we should conclude that reckless lending had nothing to do with either a housing bubble or a foreclosure crisis, or at least was far from sufficient as an explanation.

She was explaining to me why lending was responsible for a boom and bust by using a market that didn't have a boom and bust.

Yet, this isn't even the half of it.

What she is perturbed about is the fact that the bank was engaging in such reckless underwriting.  Yet, her son didn't have trouble making the payments.  He ended up doing fine.  I mentioned to her that this was interesting, because even though there was an expansion of lending, in hindsight, it was focused on more qualified borrowers - those with college educations, professional career tracks, higher incomes, etc.  And, Stefania Albanesi, Giacomo De Giorgi, and Jaromir Nosal found that, even where loans went to borrowers that appeared to be less qualified, they were borrowers who had bright prospects.  Their incomes, FICO scores, etc, improved after getting their loans.  And, her son seemed to fit that profile.

No, she replied.  Underwriting isn't based on wishful thinking.  It's based on whether the borrower can make the payment today.  It was reckless.  Not only is this good advice, but she has built a sizable and durable nest egg by being careful about the prices she pays for investment properties and the tenants she fills them with.  To suggest otherwise would be foolish and, really, offensive to everything she identifies with.

But, notice, she isn't upset that he got the mortgage.  She expected him to get the mortgage.  She was willing to vouch for him in order that he could get the mortgage.  She was in the best position to decide if he was worthy of the loan, and she was willing to take financial responsibility for the loan in order to help make it happen.  She is just upset that the bank's underwriting came to the same conclusion she did using methods that were not conventional.  And, after all, the bank was right to make that decision.

Yet, understandably, considering the way that perceptions have developed concerning the bubble, there is no way I could ever convince her that conventional wisdom about the bubble is wrong.  She has personal experience that clearly seems to confirm the conventional wisdom.  Reckless lending led to bubble prices that were bound to collapse.  And the evidence for this is that a bank agreed to make a loan that she, herself, having more information than the bank had, would have made.

I wish I could have been a fly on the wall when she described the ravings of this fool to her husband that night.