Friday, November 15, 2019

A review of the crisis narrative

Over at econlog, a commenter has asked me for a comprehensive review of the standard narrative and my objections to it.  His summary of the standard narrative is clear and concise, but thorough, and I thought it might make a nice template for posting a summary of my new narrative.

His description of the standard narrative is indented, and my responses are not.
A variety of factors (securitization introducing a principal-agent problem, organizational changes in banks/GSEs, regulatory encouragement, etc.) led to much looser standards for lending. This included:
No-documentation loans.
A growth in subprime lending.
Shrinking requirements on down payments.
These factors were all definitely at work.
This led both to an increase in for-occupancy home purchases by people who used to be renters, and in speculative home purchases (which were now easier to finance, and looked profitable as home prices were rising).
The private securitization boom, which is associated with all of these developments, lasted from roughly the end of 2003 to mid 2007.  Homeownership rates had been increasing since the mid-1990s, but they peaked near the beginning of that period, and then declined.  The relatively high level of homeownership was generally due to age demographics.  Homeownership rates for all working-age groups were about the same they had been in the early 1980s, at the high end of their recent ranges, but not unprecedented, and by the end of the subprime boom they were back in the middle of the long term ranges.  American Housing Survey data suggests that this was because, both, the rate of first time homebuyer activity declined, and an increasing number of existing owners sold out.

Of course, someone has to own every home, so this means that investor ownership increased.  In some volatile markets, some of that activity was speculative and ill-considered.  It probably hastened the early defaults in those markets because investors are more likely to default when equity becomes slightly negative than owner-occupiers are.  But, the investor activity was more of an effect of volatile markets than a cause of them.  Prices were nearly topped out by the end of 2005, and most speculative activity happened in 2006 and 2007.

In short, it is implausible to blame speculating investors for the rise in prices from 1997 to 2005 and it is implausible to blame rising homeownership from 1997 to 2004 on the loosening standards of the subprime boom.

So, what did cause rising prices?  In at least 2/3 of the country, prices weren't outside of historical norms relative to rental values.  They were slightly high, which can be explained with low long term real interest rates, but not unusually high.  In 5 primary cities [NYC, LA, Boston, San Francisco (+ San Jose), and San Diego] prices were high because rents were very high and were rising.  Fundamentals fully account for high prices in those cities, and this is more obvious with every passing year.  Their rents are high because they allow an astoundingly low quantity of building.  I call them the Closed Access cities.  Loose lending may have added demand to the buyer market in those cities beyond what was previously possible, but it was generally allowing borrowers with high incomes to buy in cities where rental expenses are also outside historical norms.  Households with lower incomes were flooding out of those cities at the time by the hundreds of thousands each year. 

A smaller set of regions had something more akin to a true bubble - prices that were likely to retract at some point in the natural course of things: Arizona, inland California, Florida, and Nevada.  I call them the Contagion cities.  They were the primary landing ground for the Closed Access outmigrants, and the primary cause of their brief positive spike in home prices was that they were generally overcome by in-migration.  The demand was for actual shelter.  Families were moving to these places, in droves, specifically to drastically lower their housing expenses.  Recently, I have been working on preliminary evidence that during the periods where prices were rising in the Contagion cities, there was no unusual rise in borrowing.  That happened after prices and rates of new building in these regions had peaked.  Borrowing at the state level tends to lag both the building booms and the price spikes.

It would be very difficult for these cities to overbuild because they natural have heavy in-migration, and at the time it was higher than normal.  In fact, at the metropolitan area level, in the 2003-2006 period, rates of building were especially correlated with population growth.  Population growth in Contagion cities suddenly collapsed when the migration event out of the Closed Access cities collapsed.  This was happening by the end of 2006.  By then, the Fed should have been trying to stabilize housing markets, not slow them down. Yet, even in late 2008, the main criticism they faced was that they weren't destabilizing housing and financial markets enough.

The shortage of homes in these cities is the fundamental cause of the housing bubble and ill-informed policy reactions to it caused the financial crisis.
This rise in home prices was not sustainable (80% increase in 6 years, much faster than inflation), and eventually slowed/ended, this happened concurrently with raises in the interest rate (and thus in the rates of adjustable mortgages)
This would not have created a crisis by itself (housing markets have had downturns in the past) except for the fact that many homeowners either:
Couldn’t afford their mortgages and could no longer refinance them using new equity from price appreciation.
Had “negative home equity” and lived in no-recourse states, making it cheaper to default than to keep paying their mortgages.
The Fed had inverted the yield curve by the beginning of 2006.  To the extent that monetary policy is communicated through interest rates, the peak of the housing boom coincides with them.  Adjustable rates have little to do with the default crisis.  Defaults were highly sensitive to cohort (how soon after you borrowed did prices begin to collapse).  2007 was the worst, followed by 2006.  The yield curve was inverted and the short term Fed Funds rate was at or near the 5.25% high point throughout the period when those mortgages were taken out.  Rising rates on adjustable mortgages have nothing to do with the default crisis.

Falling prices (negative equity) were by far the largest factor leading to defaults.  Lending standards were tightened sharply during 2007, so it is true that it was harder for borrowers to refinance.  The drop in homeownership in 2007-2008 was mostly among homeowners with high incomes in the "bubble" areas where prices were collapsing the most sharply.  Declining middle income and lower-middle income homeownership rates were a very lagging event, really not happening until after 2008, after lending standards had been sharply and permanently tightened, which caused a largely unacknowledged second housing collapse that was focused mainly on low tier neighborhoods, and which affected nearly every city in the country.  The bottom of prices around 2012 was not a return to normalcy, it was a self-inflicted collapse in credit constrained markets that were now locked out of mortgage access.
This led to a snowballing increase in delinquency rates which started prior to the crisis and lasted through the recession. It was also unique in that it happened in a correlated fashion across the country, unlike prior downturns which tended to be local.
This then impacted the financial sectors as many instruments built on securitized mortgages were discovered to be worthless, and entire companies went bankrupt.
The fact that it was correlated across the country is a solid signal of how wrong the standard narrative of its causes is.  Cities have huge differences in prices, rents, rates of building, vacancy, etc.  It is implausible that overbuilding or unsustainable prices could have done this. It was the result of national policy choices aimed at doing it, first by tight monetary policy that began to limit liquidity and change sentiment (leading to collapsing new building rates beginning in 2006) and continued to push markets into further disequilibrium as it remained too tight until the end of 2008.  By the end of 2008, lending standards had been tightened (average FICO scores of approved borrowers moved from around 710 to 750 over the course of 2008, a huge shift, which largely remains today). So, from the end of 2008 onward, high tier home prices stabilized but low tier prices had their worst declines after that.

A postscript.


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