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.

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.