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 naïve 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.


  1. It is interesting that an intelligent apartment-investor does not share your conclusions about national housing markets and the economy.

    What bothers me is that most professional macroeconomists have probably never considered your point of view.

    Or that the Federal Reserve Board has never explicitly stated that much inflation in the United States today is caused by artificially constrained housing markets.

  2. Benjamin, have you looked at Why Wages Don't Fall during a Recession? See for an intro. You might like it. The book has exactly that empirical approach you like here.

  3. Matthias: Before I read something, I want to know if it confirms my biases. If I am wrong, I want to at least be comforted in my wrongness.

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