Saturday, March 21, 2020

An article at Politico about letting banks help pump some cash into the pandemic scarred economy

Here is the Mercatus Center version:

https://www.mercatus.org/publications/covid-19/get-cash-more-families-need-it-now-give-banks-more-discretion-make-home-equity

Here is the Politico.com version:
https://www.politico.com/news/agenda/2020/03/21/how-mortgages-can-ease-the-downturn-140317

An excerpt:
Certainly, the 2008 financial crisis has created some reasonable fear about mortgage lending. But the dangers that were present in 2008 are not present today. There aren’t millions of recently purchased homes in cities where prices have suddenly doubled in a short period of time. Most borrowers will be long-time homeowners who braved the worst housing market in nearly a century and managed to hold on. In other words, unlike the housing bubble, these borrowers won’t be na├»ve new buyers speculating on a frenzied market; they will be established homeowners seeking financial safety during a pandemic. If ever there was a time to suspend the post-crisis regulatory framework, that time is now.

Thursday, March 19, 2020

The current issue of the National Review focuses on housing.

I have the cover article in the current issue of the National Review.  The issue includes a few good articles on the housing affordability topic.


Here's the conclusion:
The best solution to the entire problem is greater access: freer and more-open markets, in both mortgage-funding and urban land use. 
The financial return on owning a house should come mainly from its rental value, not from excessive capital gains. That should be enough to make owning a home worthwhile. If it isn’t enough, more people will choose to rent, rents will rise, and so will the rental value of homes and the financial return on homeownership.
Today, families are not necessarily choosing to be renters. Many are renters even though it would be worthwhile to them to own their home if they could. Rents are rising just about everywhere today because we have eliminated choices. 
Solve the problem of access, and affordability will follow. Choices are the key to the goal of affordability and fairness. We need to make more of those choices legal again. 

Friday, March 13, 2020

Long Term Yields as a call option

A long time ago, I played around with the idea that when yields are near zero, forward yields act more like call options on future interest rates than unbiased market expectations of future rates.

The second half of this post.

And here I discuss the idea.


What this means is that there is an unreliable relationship between long term yields and uncertainty.  That is because there could be uncertainty about the business cycle, or rising concern about a contraction, which would normally cause rates to decline.  But, there could also be uncertainty about the various potential states of the future.  For instance, let's say that the marginal expectation for 5 year forward rates is 0.5%, with a standard deviation of 0.5%.  What if there is a change in uncertainty that, somehow, leaves the marginal expected rate the same, 0.5%, but increases the standard deviation of that expected rate.  Since all of the expected future rates that were already below zero would still all just be truncated at zero, this would actually raise the market rate, because in those future scenarios where rates are higher, they wouldn't be truncated at zero.

In the chart here, think of each forward rate as the expected value of a range of potential rates, shown here as normally distributed expectations.  But, those distributions are truncated at zero.  The expected value of all potential scenarios would be higher than the median value because every value below zero would only count as zero.

Basically, this is just like a call option.  Call options can rise in value because, either (1) the expected future price of the underlying security increases or (2) the variance of expectations about the future price increases, making expected positive outcomes more valuable.

Yields have had some strange behavior this week, and I wonder if this could be part of it.  In options speak, maybe long term expected rates have been falling but with higher implied volatility this week.

I have been wondering when the right time is to sell long bond positions.  Earlier this week might have been the best time.  But, I suspect, because of this effect, when there is a positive shock from a Fed announcement or something that signals optimism to the market, the initial effect may be that interest rates decline quite a bit because there will be more certainty about the future economy.  I doubt that there will be a strong force pushing actual rate expectations much higher in the near term.  The net effect may be that the first move in long term rates will be to settle at a lower level that is actually more in line with what expectations are now, but which market prices are now biased away from due to uncertainty.

Treasury markets seem a bit unable to perform price discovery this week, and I assert that that is evidence in favor of my hypothesis.  If the Fed can get Treasury markets to calm down, long rates might decline.

One side effect of this would be that, if the Fed announces some big stimulus that calms markets, that should trigger declining long-term rates, and that will make it look like the Fed creates stimulus by lowering rates all along the yield curve.  I think that is not a useful way to think about Fed policy.  Stimulative Fed policy should cause the long end of the yield curve to rise.  In this case, it could very well cause median expectations of future rates to rise from 0% to 0.4%, but simultaneously reduce uncertainty so that the market rate falls from 1% to 0.6%, or something.  That would give a false statistical signal about how Fed policy affects the yield curve.


Disclosure: long UBT

Monday, March 2, 2020

February 2020 Yield Curve Update

Well, this month appears to have presented the triggering event that will tip the Fed's hawkish bias over the tipping point.  It seems likely now that the Fed will chase the natural rate down to zero from here and there will be some sort of traditional contraction or recession related to the cycle.  In other words, in the second chart, we should have hoped for the dots to move up, but instead, they will likely move sharply to the left.  That chart uses monthly averages, so the 10-year yield is already well below the February point (in red).  The Fed is expected to announce an emergency rate cut.  Obviously, they should.  But, unless sub-1% short rates somehow leads to the 10 year moving up to 2% or 3%, there will likely be some period of economic contraction before rates increase again.

That means there probably still are some gains to be wrung out of a long bond position.  Regarding the other asset classes, however, housing looks increasingly bullish, and is relatively defensive in the current context, so I don't think there is much to fear in real estate.  And, equities certainly could decline, maybe even enough to become a legitimate bear market, but it is possible that they won't decline precipitously.  I think the jury is still out on that, though whatever the indexes do, this will likely be a trader's market for a while.  At some point, beaten down stocks will present long opportunities.

That relates to one bright spot in this month's update.  The yield curve has been inverted at the short end since early 2019.  The date of the expected rate low point had been September 2021 for a while.  As the last chart shows, we seem to have been moving toward that date, suggesting that there has been enough momentum in the economy to get back to a normal yield curve eventually.  But, the curve has been flattening lately, and it looked like it might tip back to December 2021 or even March 2022, which would suggest that we aren't really moving closer to a normal yield curve and that, as with the periods between QEs, more Fed loosening would be necessary to kick rates up over time.

But, with the corona virus dust up, even though yields have dropped down significantly, much of that has been at the short end.  In other words, markets expect the Fed to react.  So, even though most indicators in the past week have been negative, the yield curve has actually tilted up a little bit, and now the rate low point has moved to June 2021.  In other words, the negative thesis has probably been confirmed (We will proceed through a standard yield curve related contraction.) but as we proceed through the contraction, the market expects the Fed to be nimble enough to prevent it from being too deep or long-lasting.  I hope that's the case.






Disclosure: I have long positions in HOV, VNQ, and UBT.

Wednesday, February 26, 2020

Housing: Part 362 - All residential investment flows to consumer surplus

There is a hypothesis that I would like to dig deeper into in the long term.  Looking at the long-term data on residential investment and personal consumption expenditures on rent, I would argue that all residential investment flows to consumer surplus.  This makes real estate somewhat special as an asset class.

For example, if investment into communications technology increases, we would expect that to be related to a shift in more spending on communications tech.  More investment in railroads vs. airports would be related to more subsequent spending on rail travel vs. air travel, etc.  You build stuff and then people use it.

But, the odd thing with real estate is that our consumption of it is highly sensitive to our incomes.  We will tend to spend x% of our incomes, on average, on rent expenditures (both imputed and cash) regardless of whether, in our time and place, that spending gets us 3,000 square feet or 1,000 square feet.  In fact, spending on housing is a bit inelastic, so that, if anything, in times and places where x% gets us 1,000 square feet, we spend more for it than we do in times and places where x% gets us 3,000 square feet.

In terms of national accounting, residential investment and rental expenditures appear not to have much correlation at all.  For instance, we are spending more of our domestic incomes on rent than ever today, but we are at the end of a decade with basically no net residential investment after accounting for depreciation of the existing stock of homes.  We spend more because we invested less.

This has important implications for how we think of real estate vs. other assets.  All residential investment leads to consumer surplus.  That doesn't mean that new units are given away for free.  It means that when profitable new units are built, they reduce the rental value of the existing stock by at least as much as the added value of the new unit.

Take a look at San Francisco over the past 20 years or so.  Basically, compared to other areas, its real estate values have doubled.  This clearly is the result of restrained supply.  At some level of new supply, prices there could have been maintained at their 1997 levels, relative to other places.

Compare San Francisco to Austin. The population in Austin from 1997 to 2019 roughly doubled from about 1 million to 2 million.  San Francisco went from about six and a half million to just under eight million.  The relative median home price in Austin stayed about the same while San Francisco doubled.

How much building would it take in San Francisco to get rid of the excessive rents that are due to supply constraints?  What if we doubled the size of San Francisco?  What if it was now home to almost 16 million people?  That would have been a massively different 20 years.  That's building and growth at roughly 6 times the growth rate San Francisco allowed.  Would that be enough to eliminate the supply constraint and take two or three percentage points a year off of rent inflation?  Would it even take that much building?  Maybe only adding enough units to grow by 4 million would be enough to bring prices back down to the initial norm.

The simple math here is that if doubling the size of San Francisco would mean that prices drop back to normal, that means that trillions of dollars in residential investment would have no effect on the total value of all residential real estate in San Francisco.  They would have twice as many homes but they would all be worth half as much. So, the total value would be the same.  All those trillions of dollars would be claimed as consumer surplus in the form of lower rents.


In markets with elastic supply, there is a fairly steep decline in marginal utility.  The 3,500 square foot house just doesn't add that much value compared to the 3,000 square foot house. In those markets, that is probably the most important factor that creates an equilibrium between the cost of building and the willingness of buyers to build more.

This is a reason why real estate makes a useful tax base, and why property taxes have the potential to be an effective public revenue producer while homeowner income tax benefits are not very useful.  Those tax benefits basically induce homeowners to live in 3,500 square foot houses that they don't really value much more than they value 3,000 square foot houses, and property taxes leave total rent expenditures about the same, but those expenditures only buy 3,000 square feet instead of 3,500 square feet - again, a difference that doesn't amount to much for consumers with steeply diminishing marginal utility.

On the other hand, if the location of a unit in San Francisco makes it worth $5,000 per month, then tax effects that provide a 20% subsidy to that spending will just mean it is worth $6,000 per month.  Subsidies to housing in Austin would have to work through added residential investment while subsidies to housing in San Francisco simply flow to the bottom line of the real estate cartel members.

I am just spitballing here, thinking about this idea.  Input is welcome.

Monday, February 24, 2020

Housing Part 363 - Did increasing debt cause rising home prices?

I've been playing around with some data on home prices, debt, and construction employment, by state.  First, here is a graph covering 4 distinctive periods of time, comparing changes in home prices to changes in construction employment. (The construction employment measure I am using is the proportion of state employment that is in construction. So if at the start of the period, 5% of the state employee base is in construction, and at the end of the period it is 6%, that registers here as a 20% increase in construction employment.)

Note that there is a surprisingly stable relationship here, throughout the different phases of the boom and bust.  This includes states like California and states like Texas. (Here, I am using the 11 states for which the New York Fed publishes quarterly per capita debt statistics.) There is truly a supply response to rising prices that appears to be generally universal across geography and across time.  The problem, of course, is that in the Closed Access areas, the base level of construction employment is very low and prices are very high, so these relative changes unfortunately are heavy on price changes and light on construction changes.

Source
This is all well enough as it is.  What I would like to reconsider today is the role of debt in this relationship.  Generally, this relationship is taken to be obvious.  Here is a graph comparing home prices and mortgage levels.  Before the crisis the relationship seems unassailable.  Before moving on, I suppose I should point to the obvious divergence after 2011.  Should that give us pause regarding this relationship?

If I was to, say, suggest that, rather than having had a housing bubble, we had a moral panic about lending, which created a one-time 30% or so drop in home values because the new lending standard added a sort of liquidity premium to home equity investments, so there was a one-time price shock then prices continued upward reflecting fundamental value.  Wouldn't a graph of that event look exactly like this?  I have added Canadian data here for a counterexample.

One problem here is that there is no controversy about the potential for a lack of liquidity to push prices lower.  Home prices would go even lower if we made mortgage lending completely illegal. But that doesn't generalize to prices above a reasonable, liquid equilibrium.  The fact that more generous lending today would cause prices to rise (reducing the liquidity premium on the yield earned by real estate owners) doesn't mean that more generous lending would lead to an irrational increase in prices.

Given current interest rates, US home prices are clearly very cheap compared to rents in most places.  Here is a graph of construction employment, mortgage affordability, and rent affordability in Atlanta.  In 2008, a bunch of construction workers were laid off, and homes went on a 30%-off sale.  At the same time, the FICO score of the average borrower shot through the roof.  Lending tightened dramatically.  These market shifts are so extreme, the only reason that the shift toward affordable ownership vs. renting isn't the most talked about issue of our day is because when the body of canonized wisdom is incorrect, it literally blinds us to reality.  You can't see things that you can't look at.  An example I use is that we don't question gravity after watching a magician levitate.  Gravity is canonical. That's fine. Gravity appears to be a true concept. Making it canonical saves us loads of time and effort. But, if we believed that some people had special powers to call on angels to lift us into the air - if that was canonical - we would leave the magic show with a deeply confused and dangerous confidence about how the world works.  Why bother looking to see if there were ropes or hidden platforms? Obviously the guy called on some angels.  You could be like, "But, mom, I saw a cord attached to a harness.  That's how he did it." And your mom would get angry. "What an insulting thing to say about a man who has power over angels."

But, let's leave that all aside.  Let's look at the bubble period.  This graph compares rising debt levels and rising prices between states.  Similar to the first graph above, but the y-axis now is the change in debt rather than the change in construction employment.

Before the crisis, there was only one 2-year period (from the end of 2003 to the end of 2005) where there was any relationship at the state level between debt and home prices.  From 1999 to 2003, debt rose at about the same rate in all eleven states.

One intuition we might have about that correlation is to say, well, sure, we should expect that.  There was a mortgage bubble, and in places with inelastic supply, prices went up, and in places with elastic supply, they built too many homes.  But, remember the first graph.  The change in construction was positively correlated with rising prices, not negatively.  Debt in states like Ohio and Michigan was not related to a significant rise in construction or prices.  The only state that is an outlier from 1999-2003 was Texas, which saw debt rise at a lower rate than most other states, even though Texas had a healthy building market.

One problem is that the canonized narrative is a hodge-podge of different stories.  They all make sense as individual parts of a broader narrative that properly puts supply constraints and rising rents at the center of the story. But, they really don't fit together well within the canonized narrative.  The idea that households were both desperately cashing out housing ATMs and also engaging in a bidding war on entry level housing is a tough pair of assertions to pair up.  I think there is some truth to both stories, but the true version makes more sense if we remove the presumption that the "big story" here is debt leading to an unsustainable price bubble.  The price bubble was largely an equity bubble.  Where mortgage debt increased, it was generally where there was a combination of available home equity and declining rates of local economic growth that caused demand for liquid assets.  So, until the end of 2003, prices were unrelated to levels of debt.

From the late 1990s until 2008, mortgage debt increased from about 43% of GDP to 73%.  From the end of 2003 to the end of 2005, that figure increased by about 8%.  So, 8% out of 30% of the rise was associated with rising home prices, at the state level.  Even there, that doesn't mean that the entire increase in home prices during that time was caused by expanding mortgage issuance, but at least it's plausible that some of it could be.  Now, it could be that the 6% increase in mortgages/GDP after 2005 was recklessly underwritten and ultimately destabilizing, but it had nothing to do with rising home prices.  And, much of the 16% increase that happened before 2004 happened in places with neither unusually rising prices nor rising rates of construction.

It is likely that much of the correlation even in 2004 and 2005 between debt and price growth is a lagged reaction to the price growth of the previous few years.  Buyers requiring more debt to buy more expensive homes and homeowners having more access to home equity.  That makes debt a lagging factor.

That clearly is the case during the period from the end of 2005 to the end of 2008, which was characterized by declining prices while debt was still increasing.  During that period, the relationship between changes in prices and changes in debt became negative.  That is because both declining prices and increasing debts were largely the product of prices having been driven higher before.  Prices had more room to drop and homeowners had more equity to draw on during the early recession period.  At least, until prices collapsed so much and lenders pulled back, so that they didn't have access to equity any longer.

Then, after 2008, there really was a highly positive correlation between rising prices and rising debts, or, more to the point, declining prices and declining debts.

The subsequent events and the policy postures that they called for take on a much different hue if causation largely goes from rising prices to rising debts than if causation largely goes from rising debts to rising prices.  Unfortunately, we went all in on the latter when the case for it was not necessarily strong.

Thursday, February 20, 2020

Housing: Part 362 - The Odd Case of the Elites vs. the Masses

It is strange that a rant from Rick Santelli delivered from the floor of the Chicago Mercantile Exchange, where he was being cheered on by a bunch of securities traders, is referenced as the founding moment of the Tea Party.  Wall Street style trading floors aren't usually associated with populist anti-Elite moments.



But, the strangeness doesn't end there.  He's complaining about a new Obama proposal to modify mortgages for struggling homeowners.  Now, I'm not necessarily a huge fan of the modification idea.  What really would have been better would have been to stop the horrendous combination of tight monetary policy and newly very tight lending which would have helped to stabilize housing markets.  It's a very distant second-best plan to keep pounding down on housing markets and then to construct some sort of program contrived to help and/or hurt various actors affected by the process.  It's like tying concrete blocks to a guy's ankles, pushing him off a boat, and then throwing him a lifesaver.

But, it's just so odd that there was so much anger toward speculators and banks that it was considered populist to wish that people would lose their homes.  The elites didn't dare to suggest that home prices should stabilize or that part of the solution should be stabilizing the lending market so that people who could have been borrowers for much of the past few decades could still get loans.  But, they did dare to suggest finding ways to keep families in their homes, which caused Santelli's ire.

Here's the kicker.  Most of the damage done to working class home equity was done after the Santelli rant.  Since punishing homeowners and tying the hands of lenders was the rallying cry of the day, low tier home prices crashed in the years after the Santelli rant.  From February 2009, when he made his appearance, to early 2012, home prices in low tier Atlanta neighborhoods, for example, lost about 30% of their values - about twice the decline they had experienced before February 2009.  None of that drop, especially after February 2009, was inevitable, natural, helpful, or an unwinding of anything unsustainable that had happened before.

What percentage of the homeowners in those neighborhoods had bought their homes in 2006 and 2007 with inappropriate mortgages?  A couple percent?

Santelli and his trader friends were very concerned about moral hazard.  "Don't throw the lifesaver to the guy with the blocks around his ankles! If you do, he'll never bother to learn how to swim!"

What's the opposite of moral hazard? Sadism?

Jim Cramer also had a famous rant on CNBC. It was more timely, prescient, and would have been helpful to those Atlanta homeowners.  About the same time that Santelli was ranting, Cramer was being hounded by Jon Stewart and others for being one of the elites that caused this mess.

If only we were better at choosing our populist champions.  Instead, American populists are complaining about what big paddles the elites have, after spending a decade bending over and yelling, "Thank you sir, may I have another."  It seems to me that a reason that a crisis happens every now and then is because every now and then a crisis becomes inexplicably popular.

Thursday, February 13, 2020

January 2020 CPI Update

Nothing to really say here.  Shelter inflation continues at 3+%, non-shelter core inflation keeps muddling along at about 1.5%.  There is nothing particularly unsustainable about this, regarding the business cycle.  It's just a continuation of the sign that the Fed is erring toward hawkish.  There is room to loosen and avoid contraction. But the odds are probably on the side of eventually having some real shock that pushes us into recessionary conditions, or at least falling yields.

Thursday, February 6, 2020

Housing: Part 361 - Homeownership by age doesn't show much recovery.

Last quarter, I posted an update on homeownership rates at Mercatus.  Recently updates for the 4th quarter came out from the Census Bureau.  This is noisy data, so it's tough to get much out of quarter-to-quarter changes.  You sort of need to wait for trends to be established.

For what it's worth, the homeownership rate increased slightly this quarter.  It could be the beginning of a trend, but for ages above 44, homeownership has been pretty flat for a while.

One way to look at this is how homeownership grows with each cohort.  For instance, comparing the homeownership rate of 35-44 year-olds from ten years ago to the rate of 45-54 year-olds today can tell us how many of that age cohort have become homeowners over the past decade.  Here is a chart for 45-54 year-olds and 55-64 year-olds, based on annual data the Census Bureau has published since 1982.

The good news is that, within age cohorts, the rate of new buyers has begun to recover.  The net effect on the homeownership rate for those age groups is flat, because while there are an increasing number of new owners, the homeownership rate of those cohorts 10 years ago was dropping like a stone.

This suggests that the homeownership rates of the middle-aged groups will remain flat at their current low levels for a while.  The housing bust created a big, gaping wound in the life plans of a generation or two of Americans, and it looks like that wound will continue to be visible for a while.

Looking at the next graph, which just shows the annual homeownership rate of each age group since 1982 highlights something interesting.  In 1992, when only 5% and 3% of 45-54 and 55-64 year-olds became owners over the course of a decade, that is because about 70% of 35-44 year-olds had already been owners in 1982.  So, in 2004, after a decade where these cohorts really increased their rate of buying as they got older, their total homeownership rate wasn't that different than it had been in 1992.  By retirement, about 80% of households tended to become homeowners, and the difference over time was that some generations became owners earlier than others.  This is a point I made in "Shut Out".  It isn't really the case that there were suddenly a bunch of "unqualified" buyers in the late 1990s and early 2000s buying homes.  It was really just a matter of households buying homes they would have eventually bought anyway, but just buying them a couple years earlier. A return to the homeownership trends of the early 80s.

So, the thing is, looking back at the previous graph of the two cohorts, the ownership rate of 35-44 year-olds today is only about 60%.  Way below any previous range.  For 80% of them to become homeowners by the time they retire, as their parents and grandparents had, their homeownership rate will need to increase by 20% over the next couple of decades.  That's a rate of rising ownership for 45 to 64 year-olds that is much higher than the peak rates of 2004.

The good news is that those cohorts are finally buying again.  But, the rate of buying required to make up for the lost decade is sizeable.

Wednesday, February 5, 2020

January 2020 Yield Curve Update

Interest rates have declined back toward the August lows (though they have bounced back up a bit over the past couple of days).  Generally, this month has continued the trend that suggests the Fed will be a bit behind the curve, long term rates will remain low, and eventually they will have to lower their target overnight rate in an attempt to expand the money supply.

In the second graph, the bullish signal would be a 10 year yield pushing far above the regression lines.  Those lines are my estimation of a de facto yield curve inversion.  The pattern of recent recessions has been (as in 2006-2008) that the plots move to the left.  Where we have avoided recession, the plots move to the left for a relatively short time, then move up significantly as long-term rates reflect improved sentiment.  Either is still possible, but with each month below the inversion line, a move to the left is more likely.

The last graph is an indication of Fed posture measured as the expected low point in Eurodollar rates.  The further into the future the expected date of the last rate cut is, the more likely it is that the Fed has been too slow to react to poor sentiment.  It remains at September 2021, and looking back at the first graph, one can see that, if anything, it is more likely that the low point will move to a later date rather than to an earlier date, compared to the similarly low August yield curve.

Unless another Fed cut or a significant unexpected positive shock improves sentiment, it seems like there might still be some room for bonds to go higher before this turns.

Tuesday, January 28, 2020

When will interest rates bottom?

Back in the days of QE, I noticed a pattern that during QEs, the expected future date of the first rate hike would remain relatively level, but when QEs were stopped, the expected future date of the first rate hike would move ahead in time.

In other words, if the first rate hike was expected to be in December 2012 when a QE round began, it would still be about December 2012 when QE ended.  Then, after QE ended, five months later, the expected date of the first rate hike will have moved back to May 2013.

I never put this observation to intensive statistical scrutiny, but it was a pattern that I saw.

Today, we might look at another pattern.  Since the short end of the yield curve inverted in late 2018, one way we could think about the Fed's posture is to infer from Eurodollar futures markets what the expected last rate cut will be.  The further into the future that expected last cut occurs, the longer we can expect the Fed to have taken a somewhat too-tight posture.

It's not actually that easy to measure, because the curve has more of a bowl shape than a V-shape, so there are several quarters that could be called the bottom.  But, I thought it might be worth seeing.

The first graph shows the quarter with the lowest rate in Eurodollar futures markets.  The second graph shows how many days we are from the quarter with the lowest rate.  So, we could be on a trajectory with a lot of noise that is basically headed for a bottom around the middle of 2021.

But, the bottom is about the same as it was about 6 months ago.  If the bottom happens to jump up another quarter, we could be in a situation similar to the QEs.  Maybe if the Fed holds rates steady, the date of the future rate bottom will move forward in time, and if the Fed drops rates enough, maybe we will continue on that trajectory to mid-2021.

Wednesday, January 22, 2020

Housing: Part 360 - New Homes vs. Existing Homes

When the federal government made it effectively illegal to originate mortgages to many families after the financial crisis, the effect of that development was clear in the prices of homes.  Low tier home prices collapsed and sales of new homes at low prices collapsed.  The combination of those effects meant that the median price of new homes moved much higher than the price of existing homes.  The median new home has long had a price about 30% or 40% higher than the median existing home, and that ratio was slowly declining during the housing "bubble" because the "bubble" was mostly facilitating the construction of more affordable homes and the mass migration of Americans out of the expensive, housing-deprived cities.  New homes were being built, mostly, where they could be built, and that means they were built where they were cheaper.

When the feds quashed that process with draconian new lending regulations, the median price of new homes shot up to about 70% more than the price of existing homes.  For the past several years, that has been moderating.  Some of that moderation has been because low tier home prices have done some catching up over the last few years.  Some of it might have been due to some recovery in building, but sales of homes under $200,000 is still sitting near cycle lows. So, I don't think the decline in the median price of new homes is due to a compositional shift back toward entry level units.  It must be due to a pullback in buying among the existing, "qualified" buyers with high incomes.  The same basic group of buyers are buying the same number of units that they were a couple of years ago, but at slightly lower prices.  Maybe the intrinsic value of homes was knocked down a bit by the 2017 tax bill.  I would say that is a bearish development, even though homebuilding has such pent up demand that it's tough to be too bearish.  On the other hand, we just had this blowout number in housing starts for December.  Housing will be interesting to watch this year.

My comment to HUD on affordable housing.

Today, the Mercatus Center posted my response to HUD's request for public comments on how to achieve more affordable housing.  Here is the closing paragraph:

There are certainly many areas where regulatory barriers to building need to be eliminated in order to keep housing affordable throughout the United States. That should certainly be the priority of government at all levels. Yet today there are many areas in this country where those barriers aren’t the binding constraint that is blocking supply and pushing up rents. Those cities do lack adequate supply today, but it is because they lack suppliers. They lack potential home buyers. Potential home buyers frequently need mortgages. The most direct and immediate boost to housing supply that HUD could create today would be to increase suppliers, to broaden the availability of mortgages to households that have been locked out in one way or another from today’s market. Trends in prices, building, and borrowing suggest that many of those potential buyers would buy more affordable and more modest homes than the homes that are bought by buyers who can qualify today. The most important task for HUD today is to figure out what is preventing the construction of homes that would sell for less than $200,000. The answer to that puzzle is surely a bit counterintuitive, because it is clear that more broad-based lending and more residential investment will be required for that to happen. The families that would use that funding, for the most part, aren’t living under a bridge or in a car today. They are stacked into the existing housing stock, where they frequently spend much more on rent than they would need to spend on a mortgage to buy that very same house. Spending less on rent must begin with spending more on residential investment.

Here is the comment on the same question from my Mercatus colleagues, Salim Furth and Emily Hamilton.

Thursday, January 16, 2020

Housing: Part 359 - Recent shifts in housing may be related to GSE activity

There has been a bit of a mystery recently in housing markets.

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For a couple of years, the square footage of new homes has been declining.  This could be because of a decline in demand for housing, in general.  Or, it could be from a compositional shift to more entry level homes.  That would be bullish.


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Rent inflation remains high, suggesting that demand for shelter remains strong.  Residential investment has levelled off at really low levels.  Rates of homebuilding have levelled off, both in total, and specifically for single family homes.  This suggests that it is a decline in demand (at least for homeownership, if not for shelter) is the cause.  That would point to a retraction in lending markets, or sentiment, or an effect of the progressive housing elements of the 2017 tax law.

There has been a bit of a recent rise in homeownership among young families.  But they are flat among older families.  That calls for some optimism that there is rising demand for entry level homeownership and homebuilding, to meet the existing demand for entry level shelter.  But, the New York Fed's Quarterly Report on Household Debt and Credit doesn't really show any rebound in the number mortgages outstanding or in rising originations among buyers with low FICO scores.  That would suggest that the rebound among young homeowners is limited to those with very good credit.  Yet, if that was the case, why is the average new home size declining?  It could be that young families generally demand smaller homes, even if they are financially secure, because their families are still growing.

I think a clue to what is happening is here, in this AEI update on housing markets.  Here is a slide from AEI.  Notice that at the GSEs, there has been a recent clampdown on high Loan-to-Value and high Debt-to-Income lending.

I suspect that there is a combination of things happening:

1) Some continued tepid improvements in the ability of high-tier buyers to buy or trade-up as equity continues to recover, the economy grows, etc.

2) Still no compositional shift to low tier buyers that have been locked out of the market since 2007.

3) A decline in demand among some subset of those high tier buyers, as a reaction to new tighter standards at the GSEs.  These buyers might be somewhat reducing their demand for units. But the amount they can borrow with conventional loans has been capped by new GSE standards, so they may also be reacting by buying smaller homes.

If this is the case, then I don't think we should be particularly bullish about housing.  I don't think smaller new homes reflect a recovery of low tier borrowing.  But, we also shouldn't be particularly bearish.  The decline in new home size and the levelling off of housing starts may just be a temporary reaction to the change in lending standards to the existing pool of qualified buyers under the current regime.

This might mean that housing will return to a moderate level of growth.  A level of growth that isn't particularly vulnerable to a pullback because there is so much pent up demand for shelter.  And, also a level of growth that could really accelerate with any reasonable expansions in lending standards.  I would call that a bullish expectation in housing, but it's not as bullish as the context where smaller new homes were the result of already expanding the set of potential homebuyers.

PS. This also tweaks my expectations for the broader economy to a more bullish position.  I have posted about how the yield curve is effectively inverted, so that, at least, I expect yields to decline, and possibly some contraction in equity markets or GDP growth.  The pause in housing growth could be a sign of weakening demand, in general.  But, this suggests that it could just be related to a one-time shift in lending standards at the GSEs.

Tuesday, January 14, 2020

December 2019 CPI Update

Not much to say.  More of the same.  Shelter inflation tracking over 3%, non-shelter core around 1.5%, and core CPI about 2.2%.  I don't think short-term inflation fluctuations are very informative at this point, unless they veer wildly in one direction or the other.  I still think the most likely event in the near term is a decline in interest rates, so I am still mostly holding on to bond exposure and keeping powder dry on some potential tactical equity positions, except for positions with some defensive elements.  For instance, Hovnanian, a homebuilder, (HOV) that is highly leveraged, financially and operationally, and poised to recover because of the both defensive and speculative potential of that sector.  I actually consider that position a sort of hedge against a bond position, in part, because I think a primary factor holding yields down is the lack of residential investment.

Disclosure: I own shares of Hovnanian (HOV)

Monday, January 6, 2020

The 20th Century Equity Sine Wave

A while back, probably even before I started blogging, I noticed that US equities in the 20th century seem to follow a fairly steady sine wave.  This is data that Robert Shiller makes available on historical S&P 500 or equivalent values dating to 1871.  Equity returns were fairly linear before 1900, according to this data.  Here, I use total real returns, which includes dividends and is adjusted for inflation.  That's really the only way you should look at long term index returns.  (The values on the y-axis don't match the current value of the S&P 500 because this is in inflation-adjusted dollars, with re-invested dividends.  The trend is important.  The values are somewhat arbitrary.)

Here is a chart of the fitted wave.  This only uses 1900-1999 data, so the last 20 years are out of sample, yet still seem to be following the trend.  Of course there are lots of technical theories about predictable movements in asset prices, most of which are questionable.  There could be a reasonable explanation here, though, having to due with baby boomer types of generational fluctuations, for instance, which might create long-term shifts in real growth rates that are difficult to arbitrage because they literally cross generations.

Anyway, for what it's worth, the sine curve fluctuates from annual total real gains of about zero to about 10%, and we are currently right at the peak, where expected annual returns would be about 10%.  Make of that what you will, if anything.

There is still a standard deviation of close to 30% in the difference between market prices and the fitted curve, but if that means that in, say, 5 years, equity holdings after reinvested dividends would be expected to be worth around 15% to 75% more than they are today, that seems reasonably better than if (using a linear trend line instead) they were only expected to be worth 0% to 60% more.  With equities, it is still the holding period that should dominate one's allocation, because short term noise is the key risk factor.  But, this seems like something to consider on the margins.

Friday, January 3, 2020

December 2019 Yield Curve Update

The yield curve continues to press upward from the mid-year lows.  This is mildly bullish, but I would still say that the yield curve is in bearish, inverted territory (below the trendline in the second chart).  We may sit here for a while (several months?), but my guess is, per past patterns, that either 10 year yields will move up above 3%, and the Fed will keep the target rate low, and we might escape a contraction, or 10 year yields will remain close to where they are, and eventually the entire yield curve will move back down toward zero, and we will have some sort of contraction.  I don't think the contraction would be extreme, and it may not even bring much of a decline in equity markets.  The ingredients that made 2008 so disruptive aren't in place today.  The Fed appears to be ready to react to contraction without as much delay as they allowed in 2006-2008.  And, though perma-bears will always be with us, as are the poor (in the long run, maybe they are one and the same!), I don't get the sense that the same suicide cult mentality is so strongly shared as it was in 2008, when Americans would only be satisfied with some sort of financial meltdown.

So, in short, this month doesn't change my posture much.  I think the odds are greater than 50% that future near term yields will be lower than current forward yields, maybe a slight rise in unemployment and decline in equities if the inverted yield curve, as I see it, does signal some coming contraction, and housing that will probably look a lot like 1999-2001, at worst seeing a slight pause in growth.