Some Thoughts on Kevin Drum's Housing Supply Post

 A few weeks ago, Kevin Drum wrote a blog post that expressed skepticism about "America’s housing crisis."  He got quite a bit of pushback against that, so he has followed up with a new post, doubling down on his skepticism.

It is a very interesting post, mostly because Drum does such an impressive job at convincingly feeling the parts of the elephant that make his point. The post is a study in rhetoric and in the limits of empirical debate to inform a conversation.  I would take some issue with most of the specific points of fact, but in a way that I suspect a skeptic would consider pedantic.  And, those points of fact are wrapped in a broader assertion that is expressed as a generality - a feeling - that hampers pedantry, and so the whole argument is somewhat protected from criticism.

I suspect that for a reader, this comes across much like my own work does.  My books are full of empirical reinforcement of a core idea, and so for the reader, they are either deeply argued concepts or Gish gallops, and the problem for those kinds of arguments is that they present a skeptic with a lot of work. The skeptic will require a deep engagement with the long line of points in order to have their mind changed, or to confirm their skepticism. The other choice is to write it off as a Gish gallop without doing that work. The problem is that that work is not free! Writing off the full argument can be a rational response! So, I find that with my work, many of the readers are in two categories: (1) those who weren't skeptical or for whom something about the work overcame their skepticism, and they either do deeply engage in it with a sense of self-directed discovery or they accept it as basically true, either in whole, or with some minor remaining potential caveats, and (2) skeptics who don't engage with it deeply. I'm not sure that there is a single skeptic that has deeply engaged with my work, and I can't blame them. It is necessarily a complex web that I have tackled and it would take a lot of work.

It's a bit of a paradox. If my work is worthwhile, it is essential. But, if it isn't worthwhile, then anyone who engages with it skeptically will find at the end that they wasted a lot of effort.

Anyway, back to Drum, the generality I take issue with is comments such as this:

But beyond that there are always individual places that are popular and expensive, and there are individual neighborhoods within those places that are even more expensive. These areas change from decade to decade as different cities get hot, and there's really no way around this. This doesn't indicate a housing shortage any more than high prices for Gucci bags indicates a shortage of purses.

It seems like folksy wisdom, and surely there is a basic truth to it. New generations tend to have it better than older generations, and frequently cry foul at conditions that their grandparents would have embraced or accepted. The current generation is no different than any other generation in this regard. But, this point is simply wrong. This is a new era in American housing. The most economically dynamic cities have been shedding domestic migrants by the hundreds of thousands for years now. That is anomalous. One can see this both within the history of those cities and in other cities. NYC and LA are dominant because when they originally were ascendant, they were magnets for the working class. Of course they grew so large because, given their economic draw, they were affordable!  Looking elsewhere, the norm until recent decades was for metro areas to grow when they are economically ascendent and to stop growing when they struggle.  During the early and mid-20th century, the Detroit metro population grew by nearly 3% annually. Back then there weren't individual cities with incomes far above the norm, like there are today. Over the early 20th century, people moved to opportunity and regional incomes were converging as a result. Today they can't, so some metro area incomes are skyrocketing away from the norm.  This is new!

Also, it isn't the nice neighborhoods that are getting expensive. It's the cheapest neighborhoods in the most housing constrained metros.  Here is a graph of home prices in the LA metro since 2000.  The pressure here is to trade down on the socio-economic status of a neighborhood in order to get into the LA metro. Young Americans aren't complaining that they can't move straight into Beverly Hills. They are actually bidding up home prices in Compton to try to get into a massive metro area that refuses to grow. Population growth of American cities with the most buoyant local incomes has been recently countercyclical. They barely ever grow, and when the economy starts to do better, they actually start shrinking.  This is really weird!  In fact, a decent portion of their ascendent local incomes is really just a side effect of the poorest residents systematically being forced to other cities. This is something that I would expect Kevin Drum, of all people, to be really bothered by. This isn't just the way it's always been.

On his more empirical claims, I will just lay out one of my pedantic points.  He highlights two facts that appear to downplay the supply crisis narrative.  First, he compares cpi housing inflation with cpi inflation excluding shelter.  He finds that housing inflation is up 7% more than non-shelter inflation since 2000. He says that of the data he highlights, this is only one of two metrics that point to a housing shortage, but they are "very tiny ones". I have a pedantic sub-point here. He uses "cpi housing" here, which includes furniture, utilities, etc.  There is a better metric - "cpi shelter", which only includes the actual shelter. But, even that includes things like lodging. You can even dig down deeper and look at "cpi rent of primary residence".  Here's a chart.

The measure he uses shows 7% excess inflation since 2000. "Shelter" excess inflation is 10%. "Rent of primary residence" excess inflation is 21%.  Is that still "very tiny"?

Then, he highlights "rent as percent of household income" from 2000 to 2020, which increased from 22% to 25%.  He counts this as a lack of evidence that rents are skyrocketing.

But, think about this for a minute. If rent inflation is high (and in fact, much higher than his "housing" metric suggested), and yet total spending on rent is relatively level, then that means that American households are greatly decreasing their relative real housing consumption.  Here are a couple of graphs showing how the long term trend in gross rent/GDP started rising in the late 1970s.  Before 1980, there was generally below-average rent inflation and growth in real housing consumption, which averaged out to a level 8.5%ish of GDP being spent on shelter. After 1980, rent kept taking more of US incomes, but after 1980, this was a combination of high rent inflation and below-average real housing consumption. The real consumption hasn't receded fast enough to make up for the inflation, so total spending on housing has increased.

There is one period where the 5 year rolling average in real housing expenditure growth was faster than real GDP growth - 2009-2012.  That isn't because we were building lots of housing then.  Ironically, that's because in 2007-2008, the Fed was convinced that we had too much housing, and as I described in "Building from the Ground Up", they basically lowered American incomes until Americans were willing or able to purchase less housing.  Since Americans were actually lacking in adequate housing and already spending more of our incomes on it than we would like to, this was catastrophic. That error - the same error Drum is still making about the supply problem - was basically the cause of the financial crisis and recession.

Since the crisis only worsened the housing supply issue, Americans have spent the last decade growing real housing consumption at the lowest relative rate since WW II because we have no other choice. Yet, as long as we continue to be deprived of adequate housing supply, this will only partially offset rising rents.

There are several implications of this. First, this certainly doesn't sit well with Drum's general assertion that younger generations expect to hit the ground running, increasing their housing consumption more and earlier than their parents and grandparents had. They are increasing their real housing consumption at a lower relative rate than any previous recent generations did.

Some people will try to suggest that the reduction in real housing consumption is voluntary - smaller families, the norm that as real incomes rise real consumption of housing tends to grow at less than a 1:1 ratio with income, etc. But, if that was the case, rent inflation should be lower. The fact that rent inflation is above average, even though real housing consumption has been low for decades, points to a substantial supply problem.

So, this is a case of Drum highlighting two "parts of the elephant" that look like they push against the housing supply narrative, when, in fact, taken together, they point to a supply problem.

Where I would like to conclude, however, is something that Drum gets right that many people don't.  He closes with:

What about all those investors snapping up houses so the rest of us can't buy them? Isn't that killing off the housing supply?

No. Housing supply is the same regardless of who owns the homes. Besides, corporate and real estate investors buy a small fraction of all the houses sold in America. There are a few specific areas where they're very active, but that's it.

The real lesson from this trend is not that housing supply is tight, but that in certain areas starter homes are selling too cheaply and apartment rents are too high. That's why it's profitable to buy low-end homes and turn them into rentals. This suggests that in certain places there's an imbalance of what's being built and what people want, but that's likely to balance out before long.

This is correct (except for thinking that it isn't evidence of tight supply)! And, I find this interesting for two reasons.

First, it would be easy for a skeptic to produce an empirical retort to his closing statement very similar to his retort here against the housing supply narrative.  They could show that low tier prices have been increasing along with rising institutional ownership. They could argue that when corporate owners buy up more of the housing stock, they ruthlessly raise rents, and that they are raising rents even though new construction has been growing for a decade.  They could point out that homeownership rates are lowest in the places where home prices have been bid up the highest. They could point out that prices are, in fact, rising the fastest where rents are rising the fastest.  Drum is right on this, and they would be wrong, yet there are many empirical points just lying in wait to support a number of sets of premises.

I suppose that means you should be skeptical of all of us. Or, unfortunately, it means that before you can really settle on a point of view here, you're going to have to put in a lot of difficult work parsing the various empirical assertions.

Second, this is a very good example of how mortgage suppression since 2007 has completely muddied the rhetorical waters on this issue, and made it very difficult to do that parsing.

Drum is right that the prices are too low and rents are too high in many places. The reason that is the case is because we killed off low-tier mortgage lending in 2008, which is part of what has made housing supply even worse.

Here's a chart of home prices from 2002-2015, by ZIP code income. The myth about 2002-2006 was that loose lending drove up the prices of low-tier homes to unsustainable levels, and busting the hobgoblin at the center of that myth was part of what we tried to do in 2008. We did it disastrously well.  Over the entire period from 2002-2015, low-tier home prices rose much less than high-tier prices. And, in fact, for the most part, they rose together from 2002-2006, and then we shit all over low tier mortgage lending and created a low-tier housing bust in the shadow of the primary housing bust that people are still making excuses for today. The crappy outcome of sucking 30% out of low-tier home prices relative to high-tier prices is bad enough. We should talk about that. But, that's not the end of it.

At the end of the day, though it's complicated, prices of homes are going to tend toward the cost of alternative new homes. So, you can't just push home prices around to wherever you want. If you push home prices unsustainably low, like we did to low-tier prices with suppressed mortgage lending, they will eventually want to rise again. And, the way they will rise is through rising rents.

As even Drum must agree, based on the charts he highlights, the housing bust did little to bring down rents.  So, now, the next chart, is a scatterplot where the 2002-2015 price appreciation is on the x-axis, and the subsequent rent inflation from 2015-2021 is on the y-axis.

Quite systematically, where a lack of mortgage financing drove prices down, rents increased excessively, until prices rose back up.  The graph (not shown) of price changes from 2002-2021 (rather than 2015) is flat. Prices at the low end and high end have increased similarly. But, to get there, low end rents had to skyrocket, because we made it extremely difficult for low-tier owner-occupiers to create demand as buyers (as opposed to renters), and so supply in the most credit constrained cities has been in the crapper for a decade.  With price/rent ratios still pushed down because of a lack of owner-occupier buying power, the only way for prices to rise back to their natural level was for rising rents to make up for low prices.

(Notice how the recent rise in low-tier rents and prices would seem to bolster the argument of people who falsely believe that the institutional buyers are the cause of all of that!)

Given all of this, if we aren't willing to stop suppressing mortgage lending, then institutional buyers funding build-for-rent neighborhoods is the only solution left for "balancing out" those markets, as Drum suggests they will.  There is a budding movement to stop that from happening, which is just one more step down the road of creating supply constraints and then trying to solve the damage of those supply constraints with more supply constraints. At least on this issue, it seems, Drum will be on the side of allowing new supply.

Or maybe, he'll take the same approach he takes about current supply conditions, when he writes:

Why are you willing to force people to move away from the places they were raised just so you don't have to look at an apartment building near your home?

I'm not. As far as I'm concerned, you may build as many apartment buildings as you want near me. I'm not trying to prevent higher density, I'm just gathering data about the amount of housing in the United States.

So, maybe he'll just watch as all his neighbors fight to block to build-to-rent neighborhoods so that the price and rent levels can't come back into balance, continuing to feel like his conscience is clean, and that the problem isn't severe enough to worry so much about his neighbors' consciences.  In the meantime, we are at quite a crossroad, because, if we find ourselves in a position where working class families can't get mortgages to build their own homes, cities keep fighting multi-unit infill developments, and now we start blocking the single-family build-for-rent developments that are one of the dwindling number of options for reversing our housing shortage, things are gonna get real dark.

The Divergence in Incomes and in Resource Usage

Recently, I was listening to Russ Roberts at EconTalk interview Andrew McAfee.  The topic was the surprising change in trends in resource use.  It appears that as economies grow, at first resource use increases, but eventually economic growth comes from more efficient use of resources instead of through the brute force of added resources.  Surprisingly, the use of many resources has been declining for some time in the developed world.  Not just in per capita terms, but in total.  Now, getting richer seems to mean using less.

They mentioned that the divergence seemed to happen around 1970.  Here is a graph of real GDP growth, iron and steel, and cement use, all indexed to 1970, using data from McAfee's website.

Although I don't think they mentioned the parallel in the program, I immediately thought of this graph that is frequently cited in the income inequality debate.  The source of this graph has made it quite clear what they think caused the divergence.

It seems likely to me that these issues are linked.  As economic growth became decoupled from the Malthusian quest for more resources, it became associated with rising services and status competition.  There could be a number of things going on here.  First, if it is easier to meet basic physical needs, there may be less motivation to increase income above a certain threshold.  Also, the real economic value of services and status items may be more difficult to track because it isn't based on the blunt measure of a physical quantity of inputs.  Variable inflation rates may be more difficult to track.  Think of the difference in rent between San Francisco and Little Rock, or groceries at Whole Foods vs. Wal-Mart.  Or, the price of a last-minute business class airplane ticket vs. an economy ticket.  Or, the vast number of services created by the internet that are commonly provided for free.  Think of the cost of Bloomberg financial services vs. the huge amount of data sites like Zillow make available for free.  The value of things versus the price of things has become highly variable.

In any event, these developments seem certainly to be related, and the transition away from a resource based economy seems like a much more relevant trigger than President Reagan.  I suspect there is a combination of mismeasured well-being and variance in well-being that is largely played out in status seeking services.  Thus, measured inequality seems high even though most households can purchase basic goods at real costs that are far below what they were in 1970.

I wonder if those who give Reagan such an important role in relative measured income growth after 1980 would feel such a strong intuition about the first graph, and hail Reagan as the president who curtailed resource usage.

Housing: Part 358 - Sometimes the answer is simple

Elizabeth Warren:

"From our trade agreements to our tax code, we have encouraged companies to invest abroad, ship jobs overseas, and keep wages low."

Bernie Sanders:

"Since Trump was elected, multinational corporations have shipped 185,000 American jobs overseas. That is unacceptable."  

City of San Jose:

San Jose has taken the rare step of publicly opposing the project, saying it would add far too many jobs, exacerbating the region’s housing shortage.  

New York City:

It’s only natural that Amazon saw its promise to create 25,000 jobs as a blessing, for creating jobs is most of what we have ever asked of American companies. But given the realities of our economy — an economy that Amazon is relentlessly and ruthlessly transforming according to its narrow self-interest — it’s also only natural that many New Yorkers wanted nothing to do with it.  

These days, things don't make sense.  Things are said in one context that sharply contradict things said in other contexts.  There is confusion and stress.

It is natural to view this confusion and to conclude that things are complicated.  But, sometimes, things are simple.  Sometimes, things seem complicated because we are blinded to the simple nature of the problem.

To Ptolemy, the solar system was very complicated.

If you walked into an elevator with a simpleton and told them, "You know, the reason the sun moves across the sky is because we are spinning on a sphere.", the simpleton would have said, "Huh. Cool.  I did not know that." and happily exited at his floor.

If you walked into an elevator with Ptolemy, you would have a lot of work to do and many things to explain.  When the door opened, he would have exited unconvinced.  Ptolemy simply knew too much.

Here is a good rule of thumb: When things are complicated, inputs are messy, running at cross purposes, and many factors cancel out other factors.  Complicated contexts don't tend to move to extremes.  What tends to move to extremes is a context dominated by a single factor.  (This also works in equity investments.  Finding small cap stocks with large upside potential usually involves finding firms that have some very large single variable at work.  That is why you can outmaneuver professional analysts.  Professional analysts are paid to know everything.  Their job is to understand complexity.  To paint a picture of all the pieces.  Since overwhelming single factors are rarely certain, and speculators must expect to lose frequently, it is reputationally difficult for analysts to predict extreme valuation moves based on single factors.  If the stock they follow is likely to soon quadruple in value, their intuition will be to say, "It's complicated.")

So, the fact that markets and the economy seem to have some really extreme problems and incoherencies is a signal that the problem is not complicated.  The problem is overwhelmingly due to one factor.

In a sentence, that factor is:  The economy and the housing market of 2005 were what a highly successful economy looks like if our leading economic centers refuse to build more houses, and that economy is almost universally feared and actively avoided.

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.

Housing: Part 349 - Homeownership rates

The Census Bureau recently published the 2019 first quarter numbers on the housing stock.  Homeownership rates had bottomed out in 2016 at 62.9%.  That was one quarter which was probably an anomaly.  Generally, the bottom appears to have been about 63.5%.

It had generally risen since then, up to 64.8% last quarter.  However, this quarter, it moved back down to 64.2%.

I have been watching this number because there have been mixed signals on the housing market.  As the analysts at AEI point out, by some measures, mortgage standards have been easing.  However, according to the New York Fed, there hasn't been any loosening to pre-crisis standards in terms of originations by FICO score.

At the same time, the low rate of building has been levelling out along with prices and resales in some markets.  It seems unlikely to me that homeownership can continue to recover without easing in terms of borrower quality.  My interpretation of this mix of data is that the various factors that are causing a shortage of housing supply are pushing up housing costs, which leads to the use of riskier mortgage terms, and that part of the problem is that the constraints on lending to financially marginal households who would have been buyers in previous generations is one factor that is causing the shortage.  Looser lending would help pull up prices in low tier markets, back to price points that make new building profitable.  That's what needs to happen to lower housing costs in general.

However, my hypothesis would need to be reconsidered if homeownership continued to rise while borrower-based lending standards remained tight.

This quarter is an interesting number, because it presents the possibility that my point of view is correct.  On a noisy measure like homeownership, it is hard to tell what is noise and what is signal until some time has passed.  It could be that the 62.9% number and the 64.8% number were just noise, and that homeownership bottomed out at about 63.5% and only very slightly rose to about 64.2% where it will remain.  If it is still in this range in a year, that is plausibly the case.  If this quarter turns out to be the outlier, and homeownership is up to 65% next year, then perhaps a recovery is possible in homeownership without expanding lending to more marginal borrowers.

Time will tell.


On High Tier vs. Low Tier Prices

I want to discuss tier price levels for a moment.  There has been some recent recovery in low tier prices vs. high tier prices, which appears to lend credence to the idea that lending is loosening substantially, in spite of the FICO score data.  There are a couple of caveats to note here.

First, there is a bias in the way some analysts use Case-Shiller indexes.  As with so many factors on this topic, it is purely a function of priors.  It isn't a bias at all if the conclusion that credit markets were the main cause of rising low-tier prices before the crisis is already taken to be true when the data is analyzed.  However, it does appear to be a bias if you question that conclusion.

Case-Shiller has 20 city-specific indexes, which includes all 5 Closed Access cities.  Be careful looking at analysis of low- versus high- tier prices that uses those indexes. If the data is heavily populated with Closed Access data, it will not be indicative of national markets.  Low-tier vs. high-tier prices act differently in those cities than in other cities.  I go into that a little bit here.  Or, better yet, buy Shut Out to read about it(using code 4S18MERC30 for a discount).

Furthermore, even in national stats there is a bias here.  The problem is the extreme nature of the walloping we handed to low tier housing markets.

Imagine a city where high tier markets bottomed out at a 20% decline and low tier markets bottomed out at a 50% decline.  As a proportion of the peak price, that's a 30% additional decline in the low tier.  In spite of conventional wisdom to the contrary, in most cities, that wasn't undoing anything.  Low tier prices hadn't risen significantly higher than high tier prices had.

The bottom came around 2012.  Now, if someone uses 2012 as a baseline, they may find that high tier prices have recovered by 25% since then, while low tier prices had recovered by a whopping 40%.  If one treats the 2012 market as the benchmark, it would seem that low tier prices are 15% overvalued.  But, if we treat the pre-crisis level as the benchmark, then there has been no catch up.
  High Tier 80% x 1.25% = 100%
  Low Tier  50% x 1.4% = 70%

In other words, low tier prices are still 30% undervalued compared to high tier prices, and there has been no catchup at all.  Because conventional wisdom has been so blind to the fundamental causes of the crisis, this sort of bias is very common among academic papers, policy papers, and general journalism.  It's fascinating how an innocent shift in priors can create these self-fulfilling biases in the analysis.  There are clues about these biases though, once your frame of reference moves to a place where useful questions aren't obscured by priors.  On this issue, for instance, it would seem to be a mystery why low tier building rates are still dead if prices are 15% inflated.  But, it isn't really a mystery at all if those prices remain relatively low.

Keep in mind, this is a hypothetical example, although it is a realistic number for many cities.  There has been some low-tier recovery. Maybe the post 2012 appreciation rates have been more like 50% compared to 20%.  But, in this example, for instance, to completely re-attain previous norms, low tier prices would have to double from their lows while high tier prices only rise 25%.  Even though this is arithmetically the case, it would be quite a difficult point of view to sell to someone who is convinced that excess lending or speculative buying is the ever-present monster under the bed that needs to be thwarted.  As Russ Roberts of EconTalk fame frequently laments, data isn't as powerful as we would like it to be in these debates, because the issues are just too complex and too bound up by differing premises.  Isn't it striking?  There is a stew of ever evolving priors informed by data, informed by priors, etc. etc. which leads us to a point where it isn't possible to come to agreement about whether low tier prices are overvalued at  a 100% appreciation level vs. 20%.  How do we ever come to know anything?

Yield Curve Update

I have written previously about the yield curve.  It appears to me that as interest rates get lower, there is an option value embedded in long term rates because of the zero lower bound.  That means that it is harder for the curve to invert at lower rates.

I suspect this comes from my "Upside down CAPM" way of thinking.  There is a relatively stable expected return on at-risk assets like corporate equity, and fixed income is a way to trade off some of those expected returns in exchange for cash flow certainty.  So, a real 10 year yield of 1% is really a payment of about 6% subtracted from the expected real yield on corporate equities of 7%.  Low real rates are a sign of risk aversion.  They are not stimulative.  It seems that others view them as stimulative.  They are wrong.  And, this gives them a false signal about the yield curve.  It makes it look like an inverted yield curve is less dangerous at lower interest rates, because the low rates are seen as stimulative.  But, an inverted curve at low rates is actually more dangerous, not less dangerous.

Here is a graph of the yield curve slope, my adjusted slope, and forward changes in the unemployment rate.

We have been treading right along the edge of "adjusted" inversion since 2016.  It seems to me that at this point in the recovery, the long term interest rate is a simple and important signal.  If the Fed can keep the yield curve spread between 0% and 1% (or, if my claim that an adjustment is necessary is accurate, then the spread now should be between about 0.75% and 1.75%), then that seems like a great first step in thinking about monetary policy through an interest rate lens.

My main concern is that if my adjustment is accurate, a positive yield curve of 0.5% or so is actually equivalent to an inversion, and even people on the lookout for an inversion won't notice it until it is too late.  The expected December rate hike puts us into inversion territory, in that case.  I have been early to this worry, and was surprised by rising long term interest rates, so you may want to take this with a grain of salt.  But, it seems like something worth watching.  If the unadjusted yield curve inverts, it seems unlikely that the Fed will accommodate nearly quickly or strongly enough.

Housing: Part 334 - Credit supply and the housing bubble.

Tyler Cowen links to a new paper today, with this note: "Credit conditions really did matter for the housing bubble." (HT: Tyler)

I haven't looked at the paper yet, but I have looked at a set of slides, here.

My basic point of view here is:

1) Of course credit conditions matter.  This is standard finance.  Credit provides liquidity, and less liquid securities sell at a discount.  But, this is an asymmetric relationship in standard finance.  Liquidity doesn't lead to over-priced assets.  It just leads to asset prices that reflect the market rate of return with a lower liquidity discount.  One reason that homes are a good investment for many households is that liquidity is very constrained.  Transactions costs are high and they must be purchased as a whole, not piecemeal.  Returns on homeownership are highly correlated with the length of tenure, where these costs can be amortized over longer periods.  Developments that reduce the costs associated with those problems should increase home prices.

2) The outcome of the housing bubble and bust matches standard financial expectations.  Prices during the boom were as sensitive to long term real interest rates as we should expect them to be, highly sensitive to local rent inflation trends that were the result of a supply shortage, and sensitive to credit supply where the supply shortage had pushed prices high enough to create obstacles to conventional funding.  Credit supply is an ingredient here, but it is secondary to supply constraints.

3) The problem with analysis of the housing bubble and the financial crisis is that the notion that there was an unsustainable bubble that was destined to collapse was canonized before it was established empirically.  So, evidence that explains the bust is taken as evidence that explains the boom, and vice versa.  But, if the bust was not inevitable, then correlations during the bust don't tell us anything about the boom.  This goes back to points 1 and 2.  The bust is certainly explained largely by a negative credit shock, but this is an asymmetric relationship.  From that, it doesn't necessarily follow that a boom had been created by a positive credit shock.

If I get a chance to see the full paper, I will be happy to retract my comments here.  But, these slides associated with the paper do not appear to avoid these issues.

Here is a graph of credit standards from the slides.

Not only is the relationship between liquidity and yields or prices asymmetrical, but in this particular case, the scale of the negative shock was far greater than the scale of any other shift in lending standards.  The relationship between credit standards and home prices from 2006-2010 will dominate any statistical analysis here.

So, given my priors, what I would like to see from an analysis like this is the relationship for the period up to 2005 or 2006 and the relationship for the period after 2006 or 2007.

Here is a table of results from the slides.  They run regressions from 1991-2017, 2005-2013, and 2007-2017.  Elsewhere, they use 2000-2010.  This is unsatisfying.  There is a clear trend break to a negative shock that starts in 2006.  There is no analysis of the relationship during the boom that doesn't include that period.  For someone who looks at this with the standard presumption that the boom and bust are necessarily related, this might seem like more evidence that a bubble was largely due to loose credit.  I would like to see the regression from 1991-2005.

Here is a chart comparing the one year change in real home prices to the trend in credit standards.  The asymmetrical relationship is clear here.  I have not precisely replicated the regressions shown in the slide.  I have simply done regressions of the two measures shown in my chart.  For the periods analyzed in the slide, I find similar, strong correlations as the authors do over the periods they use.  For the period from 1991-2005, I find no correlation.

When I see the paper, I will update regarding whether this is addressed there.  In the meantime, this seems like another paper that found that collapsing credit markets were highly correlated with the housing bust and concluded that loose credit caused the boom...which is a shame, because the conclusion that does clearly follow from this data - that a negative credit shock led to a housing bust and a financial crisis - is the conclusion that should be motivating current public policy and retrospectives about the crisis.

Housing: Part 333 - David Beckworth interviews Robert Kaplan

David Beckworth recently interviewed Robert Kaplan from the Dallas Federal Reserve Bank (transcript).  They discussed many interesting things regarding monetary policy.  There were a couple of items that I thought might be interesting to get into here.

Here is one spot:

Robert Kaplan: ...The nominal GDP targeting has a lot of appeal in that it takes into account inflation. It takes into account growth. The other thing is we are a very highly leveraged country. It's nominal GDP that services our debt.
David Beckworth: That's right.
Robert Kaplan: In other words, you need to generate nominal GDP to service the debt. There are some challenges though with this approach and others, which I actually would like to see us debate.
What's an example? How to explain nominal GDP targeting, in that there's a catch‑up mechanism in nominal GDP targeting and a lot of other aspects that I think are not going to be easy to communicate. The good news about the current framework is it's relatively straightforward to communicate.

This seems true, on the surface, but I think the more important point is that, in a way, NGDP targeting really wouldn't require communication.  How can I say that?  Well, what I'm thinking of is the countless conversations today about whether the Phillips Curve is useful, whether inflation trends will reverse or accelerate, whether expanding credit is feeding "overheating", etc.  Think of the millions of hours of debate and analysis that go into developing or forecasting Federal Reserve policy choices and their consequences.  The problem with the current dual mandate is that there is too much communication, and all the communication we could muster will never lead to consensus or certainty about near term economic activity.

With a functional nominal GDP targeting regime, there would be little to communicate.  And, what a relief that would be!

The following excerpt is more to the point of the focus of this blog - credit markets and the financial crisis.  As David points out, even this conversation would be less salient in an NGDP targeting world.  Management and regulation of credit markets wouldn't be so important if it wasn't an important ingredient in sudden negative NGDP shocks.  Kaplan's response to that notion is a window into the problem of seeing the housing bubble as a result of excess credit rather than a shortage of housing supply.

Robert Kaplan: If you look at the household sector in this country, the household sector was extremely leveraged. Meaning if you took household debt divided by gross domestic product for the households, there was a very high degree of leverage.
The reason we didn't notice it is if you looked at household debt relative to asset values, it actually didn't look excessive, back to home prices. What the housing crisis exposed is a lot of households were dramatically over‑leveraged, but they were comforted by the fact that there were easy mortgage conditions and home prices were very high.
Obviously, I don't need to remind people when the housing sector collapsed, all of a sudden, the household sector, it was clear, were very highly leveraged. They've spent the last eight or nine years deleveraging.
I think one of the lessons also, which relates to mortgage availability and so on, was we've got to watch the health of the household sector. Even with that, the aggressiveness on mortgage offerings were probably the tip of the iceberg.
It's all the securitizations upon securitizations upon securitizations of those mortgage obligations which magnified those excesses. If we didn't have all the securitizations on top of this aggressive mortgage lending, it still would have been painful, but it wouldn't have been anywhere near as painful as what ultimately happened.
David Beckworth: This goes back to the point you made earlier about nominal GDP targeting. Again, in a different world, a counterfactual world where we did have a nominal GDP level targeted, this would have made that crash a whole lot nicer or less severe.
Robert Kaplan: Truthfully, I wasn't at the Fed. I've been at the Fed only three years. I actually probably have a slightly different take. I think there's a number of things we do at the Fed. One of them is monetary policy, but another big one is macroprudential policy.
I think if you don't have good macroprudential policy, it's very difficult to run a sensible...It makes monetary policy harder. I think we need to do both. You could debate, and I've been part of those debates, to question monetary policy leading up to the crisis, approaches for monetary policy.
I think if you don't have good macroprudential policy for, again, stress testing, monitoring of the non‑bank financials, I think it makes it very hard to avoid instability.
David Beckworth: That's a fair point. If you did have those imbalances build up, let's say, for the sake of argument, you did have that leverage, I think the point you made earlier is that a nominal income target, a nominal GDP target that would make the unwinding of that leverage much more manageable. Is that fair?
Robert Kaplan: Listen, what I've learned is if the household sector gets over‑leveraged, you've got to accept it's going to take a number of years for households to deleverage. They're not like companies, who can sell assets, raise equity, restructure, restructure their debt. Households can't do that.
I think the trick is a little bit of prevention. I think we want to get into a situation where we monitor the household sector more carefully and try to take steps to maybe moderate excessive debt growth at the household sector relative to income. 

Kaplan's comments reflect what I think is considered an uncontroversial set of stipulations:

• Excessive credit led to home prices and household debt that were bloated.
• When home prices collapsed, households were left with the excessive debt.
• Deleveraging from that debt slowed down the recovery.

The solutions to these stipulated risks are:

• Prevent household debt from rising.
• Prevent excessive use of multi-level securitizations and financial derivatives.

First, I'll point out a bit of a contradiction here.  Multi-level securitizations and credit default swaps on those securitizations were developed in order to create securitizations that didn't require new mortgages.  High household debt and excessive complex securitizations and derivatives are substitutes, not complements.  They didn't additively lead to a more acute crisis.  In fact, the rise of complex securitizations and mortgage-based derivatives came from having more savers looking for safe assets than there were investors taking the primary risk positions on either securitizations or home equity, itself.  The reason complex securitizations were profitable for their underwriters was because investors were willing to pay a premium for securities with lower expected risk.

I have discussed this many times, so I won't go into it here again in more detail, but this is an important, if subtle, correction to the credit-fueled bubble narrative.  Synthetic CDOs, CDO-squareds, etc. were the first stage of the bust, and they came about because the core cause of the bubble was a lack of housing supply, but the bubble was addressed as if it was due to a lack of fear.  Investors in the CDO AAA-securities were risk-averse.

Regarding the other points, what if high home prices are generally due to an urban supply shortage, and rising mortgage levels are a side-effect of that problem?  Then, what will happen as a result of the proposed solutions?

• Home prices will remain somewhat elevated because of high rents.
• Since credit is a side effect of high prices, there will be natural pressures pushing up demand for household debt.
• To reduce that demand for household debt, taxes or non-price constraints will need to be implemented to reduce the quantity of household debt.
• In order to keep household debt at a normal level as a percentage of income, debt will have to be held low as a percentage of home values and/or homeownership will have to be lowered.
• Regulatory obstacles to home ownership will raise the yield on home equity - to some extent through lower prices and to some extent through higher rents.

So, the policy that seems like the prudent policy for the Federal Reserve to follow is a policy that will create high yields for a set of households who meet regulatory approval and that will create high costs for households who do not meet regulatory approval.  Over the past several years, this has been the case.  Using BEA data on housing value added and Fed data on mortgage and real estate values, the past few years have been unique in providing real returns on home equity that are higher than nominal yields on mortgages outstanding.

And, it is highly likely that regulatory approval will fall sharply along socio-economic status lines.

I am not arguing here that high debt levels are not systemically destabilizing.  I am not arguing that we shouldn't be concerned about them.  I am simply pointing out that the only realistic way to enforce this macroprudential policy is to enforce higher-than-market returns for select Americans while limiting access to those returns.  To be honest about that means being clear-eyed about the cause of high levels of household debt.

Or, to put this another way, there are many sources of value in an economy.  A marketable college degree creates value, in the form of human capital, but it is difficult to have liquid markets in human capital.  So, there isn't a ZillowPeople.com where you can see the current market value of college graduates and their current market wage.

Yet, in a way, housing sort of serves as a substitute for the market in human capital.  If a banker feels confident enough in your earning ability, she will allow you to take out a mortgage to commit to transferring some of the high wages you can earn to future payments.  The potential to foreclose on the house serves as a financial tool that facilitates this trade in human capital.  The banker serves as an intermediary, using the liquidity of the mortgage market and the stability of the housing market to facilitate trading activity in the human capital market.

That is what was happening before the crisis.  In most places, the mortgage and housing markets have developed to the point that more than 80% of households can complete that trade at some point in their lives.  This is a testament to the development of human capital (broad access to above-subsistence wages) and of real estate and mortgage markets.  But, our economy was hamstrung by a political limit to urbanization, which created a dichotomy: places that were exclusive and places that weren't.

That exclusivity is rationed through housing, and by happenstance there is a liquid market that measures the value of that exclusion.  There is a Zillow.com for houses.  Before the crisis, this trade in human capital and housing was still functioning, but in the Closed Access cities, this meant that only those with a large excess of human capital could engage in that trade.  They had to transfer a large stake in their future earnings over to the existing real estate owners to claim their place in exclusive labor markets.  In order to fully accrue the full potential of their human capital, they had to pay the toll to access the markets where wages were highest.

Home prices reflected the value of that exclusion, and homes traded at a value at reflected their claim on that earning power.  Certainly, the existence of these credit markets facilitated the market that revealed those values.

By focusing on credit as the cause of high prices, these transactions between human capital and the housing stock have been hobbled.  The undiscounted total value of future rents on properties has not been reduced.  "Macroprudential" management on mortgage markets has just added a significant premium to the discount rate that is applied to those future rental incomes.  This has lowered home prices in Closed Access markets from where they would have been, and it certainly has reduced household debt from where it would be in this Closed Access context.  But, because this is a misdiagnosis of the problem, where its effect has been the worst has been to block access to low tier housing markets in cities across the country that were never out of whack.  (I touched on this in the previous post.)

Macroprudential management has effectively been a step backwards to a less sophisticated economy, where access to ownership of real property requires a pre-existing stockpile of wealth, and those who have wealth earn higher returns on it.

Housing: Part 332 - The problem in a picture

I came upon some old data recently that I thought was worth sharing.  Sorry, this isn't updated past 2014 data, but the story hasn't changed that much since then.  Maybe real estate values have recovered another 10% or so, compared to personal income.

Here is the problem.  There are two housing markets in the US.  A closed one and an open one.  The closed market gives you access to the best economic opportunities in NYC, LA, Boston, and San Francisco (Closed Access cities).  It's limited to about 50 million people.  You want in, you gotta pay.

Sources: BEA and Zillow

Here is a graph of total real estate value as a percentage of total personal income.  In 1998, in the Closed Access cities and in the rest of the country, the ratio was about 2:1.

Then, as we entered the post-industrial economic era, competition for access to the Closed Access cities pushed real estate there up to close to 350% of income.  In the rest of the country (which includes the Contagion cities, Seattle, Washington, etc.), it didn't break 250%.  Even that increase can be effectively explained with low long term real interest rates.

By 2014, in the Closed Access cities, it was 248%, while the rest of the country was down to 166%.  Now, this is with very low long term real interest rates, so, if anything, it should be above 250% even outside the Closed Access cities.

Keep this in mind when you read countless articles complaining about affordability.  Homes are more affordable than ever, really, for owners.  It's just that some homes have a premium attached to them that is unrelated to the value of shelter.  Imagine how backwards economic and monetary policy is right now, that it is not unusual to hear people call for or accept contractionary monetary or fiscal policy because home prices are getting too high again, and macroprudential policy is called for.

Also, consider the countless articles and conversations that complain about how we bailed out the banks but left regular households hung out to dry.  You know what really killed those households?  Maybe it was the fact that they lost wealth, on average, that amounted to nearly a year's income.  When real estate value outside the Closed Access cities collapsed from 236% or incomes in 2006 to 157% in 2012, how many of these moral crusaders were demanding more monetary support because home values had clearly fallen too low?

Don't get me wrong.  It isn't the job of the Fed or the government to prop up home prices.  But, it is their job to allow markets to function.  The "bailouts" were only a very poor substitute for reasonable federal macroprudential and monetary policy.  But, any reasonable policy would not have led to such drops in real estate values, especially after 2007.  How many bailout critics would have supported those policies?  That would have created moral hazard.  Right?  Because everyone knew that homes were too expensive.

One more thing about that graph.  It shows less recovery than some other measures of price/income do.  I think the main reason is that normally, price/income is based on the price of the median home compared to the median income.  Since we have been in a decade-long housing depression, the aggregate value of real estate has risen less than the value of individual properties.  This is an important part of what is happening, but it is difficult to understand it with "bubble" thinking.  Bubble thinking presumes that more building is triggered by money and credit, so that more building equals rising values.  That has it backwards.  The red line rose much higher than the blue line precisely because that relationship is very strongly in the opposite direction.

Closed Access real estate rose in value so much because there are not as many new Closed Access homes.  And, even on a national level over time, aggregate real estate value has little to do with the rate of building.  The reason that real estate value has declined along with lower rates of building since 2007 is that credit and monetary policy pushed home values well below the value that could trigger new building in many markets.  The decline in value led to lower rates of building, not the other way around.

The way to reduce things like median price/income levels so that homes become affordable again is to build many, many new homes.  That will have very little effect on the aggregate value of real estate.  In fact, if we do it well enough, it will reduce the aggregate value of real estate.  But, it will be hard to trigger new supply until credit is loosened enough and prices rise enough that more new construction can be justified.

There seem to be many macroeconomic issues that have this strange, contradictory type of causation.  In this case, rising prices cause more building, but more building causes declining prices.  Clearly, more building could cause prices to decline so sharply that more building would cause total value to decline, even after adding new real supply to the housing stock.

Housing prices need to rise so housing prices can fall.

Housing: Part 331 - More on Mortgages and Homeownership

Here are a couple more graphs on mortgages and homeownership.  The first one is from the Survey of Consumer Finances, which is conducted every three years.

From 2004-2007, homeownership declined somewhat, but mortgaged homeownership increased.

The second graph has the number of mortgage accounts from the New York Fed and the number of owner-occupied homes from the Census.  Owner-occupiers topped out around the end of 2005 when housing starts peaked.  But, oddly the number of mortgage accounts shot up in 2006 and 2007.

It appears that there were three factors at work in 2006 and 2007:

1) An increase in the number of unmortgaged owners selling their homes and transitioning to renting while a declining but somewhat stable flow of first time buyers that were naturally leveraged continued.

2) Unmortgaged owners - mostly older households - taking on new mortgages.  (Most homeowners under 55 already have a mortgage.)

3) Increasing investor activity.

It is interesting that the sharp increase in mortgages in 2006-2007 is not associated with rising ownership or rising prices, and it is associated with sharply falling housing starts.  For all of those reasons, I think it has been incorrect for so many people to treat the late rise in mortgages, which performed terribly, as if they were responsible for the housing bubble.  They had nothing to do with it, and if anything, they were propping up a housing market that would have otherwise been in unnecessarily deep decline.


In my feistier moments, I wonder if this was actually a sign of a need for liquidity.  Interest rates were at their cyclical peak.  These weren't mortgages taken out at low rates.  Currency growth was very low at the time.  This was expensive debt taken out when cash was relatively scarce.

Source

Would it be too crazy of me to say that there was already a liquidity crunch, and that the only reason nominal GDP growth was still limping along at rates that were only marginally recessionary was because households sitting on recent real estate gains tapped those properties for cash?  Were those households, on net, speculating, or were they getting cash wherever they could get it, and currency from the Federal Reserve wasn't where they could get it?

Maybe I'm wading into waters that are over my head here.  Please tell me if I am.  But, it seems to me that causation could go either way here.  Mortgage debt could rise in a search or liquidity, or the Federal Reserve could contract the growth in the money supply as a way to counter excess liquidity coming from a speculative bubble.  Wouldn't one clue about the direction of that causality be the direction of housing starts.  If the causal trigger was a flood of debt into hot housing markets, then housing starts would be rising.  If the causal trigger was a lack of liquidity, housing starts would be collapsing.  It seems like the evidence is pretty clearly stacked against the idea that the Fed needed to be counteracting the rising mortgage levels.  Housing starts and currency growth were both contracting.

In the narrative that treats everything as excess, each step along the way is just one more facet of the bubble.  So, the mortgages originated in 2006 and 2007 were just the last gasp of that process - a continuation of the excesses that preceded them.  It seems perfectly reasonable to say, "They did this to us.  They caused this to happen.  They created the bubble, and the bust was inevitable."

But, what if the "bubble" was primarily the result of a supply shortage?  There were still trillions of dollars of home equity to be harvested, even if those trillions weren't unsustainable paper profits created by a credit bubble.  So, that wealth was available to tap for liquidity as nominal economic activity contracted.

Instead of saying, "They did this to us." we should say, "They delayed the tragedy we imposed on ourselves, but we would not relent, so the tragedy happened eventually anyway."  Those borrowers in 2006-2007 might have saved us.

Source

Rentiers - Closed Access real estate owners who were capturing monopoly profits - were claiming an outsized portion of new production.  In order to use their property values to claim that production they either had to sell them (to a new owner that was likely more leveraged) or they had to take out debt that was collateralized by them.  This accounted for more than 100% of new personal consumption expenditures during the boom.  Eventually, the collapse of sentiment and, eventually, property values, in real estate, caused that debt-funded consumption to collapse, and there was little monetary accommodation until the end of 2008.  Nominal consumption collapsed until that happened.

The borrowers and investors were maintaining the growth of the nominal economy until they couldn't anymore.  This is a good example of how fundamental our priors and presumptions are about what happened.  Priors that say debt is unsustainable, lender and speculator driven, and reckless, would lead to a conclusion that collapse would bring discipline.  That bad things are good.  But, changing those priors, recognizing that debt-funded consumption was the product of a deep inequity in our economy, that it was sustainable and natural as long as that inequity remains, leads to a conclusion that what Americans needed was relief.  Discipline was abuse.

The homeowners with growing equity are the monopolists that need to be tamed.  But, in 2006-2007, the borrowers were the only thing keeping us afloat.

Housing: Part 329 - Construction Hiring

I happened upon an interesting post by Jason Smith at "Information Transfer Economics".  He suggests that a crackdown on immigration in 2006 was a causal factor in the housing bust and recession.  This echoes speculation from Scott Sumner.

I think there is something to what they both are saying.  There definitely has been a downshift in immigration, and as Smith points out, there was some anti-immigrant legislation passed in 2006.  But, I don't think there is much to it.  Smith tries to argue that this is a causal factor in the housing bust.  But, he's stretching quite a bit to come to that conclusion.  Here's the case he tries to build:

Again, this is speculative. However it is not implausible that the anti-immigrant sentiment of the mid-2000s ended the "housing bubble". Employers continued to look for workers in construction, but suddenly were unable to hire as many starting in 2006 due to declining immigration

That it "is not implausible" puts it on par with many other proposed causes of the crisis, and as with most of the others, that is probably the most you can say for it.  Smith points to construction-specific JOLTS data.

Source

When Mexican immigration slows in 2006, he notes that hires decline while openings remain strong.  But, those shifts are pretty minor.  There is some early decline in construction employment, relative to other employment but, as I have shown, the shifts in construction employment were mostly very late.  Here is JOLTS data for total employment:

Source

So, there is a small dip in construction hiring in 2006, and there is an earlier decline in construction employment growth in 2007 compared to total employment.  But, here we can see the late factors too.  First, the spike in layoffs in construction come after the September 2008 crisis.  And, hiring and quits decline in late 2008 and don't really recover.  Those measures for total employment are back to highs, but in construction, they remain basically where they were in 2008.

Even though Mexican immigration declined along with the bust, domestic migration also declined in the Contagion cities.  In Phoenix, for instance, migration from both the Closed Access cities and the rest of the country peaked in 2005 and continued to fall sharply through the crisis.  Domestic outmigration from Phoenix was increasing at the same time.  It seems more plausible that all of those trends in migration are due to declining sentiment, the end of the "inferior good" boom of Closed Access households moving away to lower costs, declining employment growth and production in general, the inability of Phoenix to meet housing demand during the migration event, and the eventual collapse in sentiment and demand that reduced the Closed Access tactical outmigration.  As with domestic migration, international migration seems like more an outcome than a cause here, though it may have played some small role.

Furthermore, housing starts were declining, and by 2006, homebuilders were facing many cancellations, leaving empty homes to sell.  It seems unlikely that by mid-2006 labor constraints in construction were the driving force in the collapsing markets.

One thing the decline in immigration might be a factor in explaining is how 12 month employment growth in Phoenix could have gone from 6% in 2005 down to 1.4% by August 2007, yet the unemployment rate dropped from 3.9% to 3.1% during that time.

Oddly, Smith is basically making a supply side argument here - that a lack of construction labor triggered the end of the housing boom, and even agrees that the debt crisis was more of an outcome than a cause of the contraction.  But, he dismisses my supply side explanation out of hand.  Scott's immigration story is more of a demand side story, that there are millions of households who would have needed homes today if immigration had continued at previous levels.  And, again, while that is a reasonable inference, it depends on the notion that the decline in construction activity was due to an oversupply of homes.  But, the decline in activity has been due to mortgage suppression.  There are many households who are "overconsuming" housing today because they live in homes they would not qualify to buy, and they would likely downsize if they had to be tenants in today's housing regime.  Certainly, if a few million additional immigrants had come here, there would be added pressure on rents, and it would have had some effect on construction markets.  The question is, given mortgage markets as they exist today, how much would that added demand just put more pressure on rent inflation and how much would it trigger new supply.  I suspect it would have done more of the former than the latter.  Especially in low tier markets, prices are still below replacement cost, so many markets, especially in entry level housing, need quite a bit more rent inflation before the price ceiling for new supply (discounted value of future rents) moves back above the price floor (construction costs). Mortgage suppression has created this outcome by raising the discount rate, lowering the value of future rents.

Housing: Part 328 - Bank Capital and the Crisis

John Cochrane has an interesting post up today about the role of bank capital in the financial crisis.  He is referencing some recent work from Laurence Kotlikoff.

Larry puts it all together nicely by starting with the 2011 Financial Crisis Inquiry Commission report:

"There was an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread reports of egregious and predatory lending practices, dramatic increases in household mortgage debt, and exponential growth in financial firms’ trading activities, unregulated derivatives, and short-term “repo” lending markets, among many other red flags. Yet there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner. "

Larry then takes apart each of these non-culprits, as below.


In my view, the understanding that the crisis was a run, that without a run there would have been no crisis, somewhat like the 2000 tech stock bust, and that lots and lots more capital is the only real answer, has emerged slowly over the last 10 years. Larry's essay is good for putting all the others to rest.

The point of this is to suggest stronger capital requirements for banks, and I basically agree with all of that.  In an age where there are money market funds, securitized mortgage securities, fintech, etc., is there a reason to subsidize and support a banking system built around a mismatch between assets and liabilities?  I don't think so.  There are a number of potential ways to change that system, and people with much more expertise than me will debate what the best way is.

The two-cents I will add here is simply that, in order to get to the conclusion that a systemically unstable banking system was the cause of the crisis, Kotlikoff and Cochrane dismiss many of the same supposed causes that I have also dismissed.  They have already basically come to the same conclusions I have about the causes of the crisis, but their focus is on bank capital rather than on what caused the stresses on bank capital.

Eighty percent of my job is done here, I think.  I would only ask them to take one step back and to consider that if so many of the supposed causes of the financial crisis are not particularly compelling, then maybe the stresses on the banking system were not inevitable.

Sure, given the stresses that the banks ended up taking on, a better banking system would have responded better.  But, those stresses should have never happened.  Both can be true.  It can be true that those stresses revealed weaknesses in the banking system, and it can be true that reasonable attempts at broad stabilization in 2007 and early 2008 would have prevented those stresses from ever developing.

I fear that for those who are advocating for a more stable banking regime, the idea that a fragile regime was a root cause of the crisis is a powerful point to promote, and that it would feel like making a rhetorical compromise to agree that the crisis could and should have been averted, even with the banking regime we had.  Yet, they already have come to conclude that the evidence underlying the presumption of inevitability is weak.  It will be interesting to see how they respond to a new narrative.

Housing : Part 310 - The premise determines the conclusion, a continuing series

Here is an interesting symposium at the NBER on the financial crisis (HT: MR).  Previously, I have written about how the crisis and its presumed causes were predetermined.  When the question is asked, "What caused the financial crisis?"  The answer always comes in the form of "This is what caused the housing bubble."  The inevitability of the crisis is canonized.  It doesn't even need to be asserted.  This can be seen throughout the slides that are provided at the NBER link.

A set of slides from Nicola Gennaioli and Andrei Shleifer discusses the difficulty of seeing bubbles and preventing them from blowing up.  It includes this graph, which all reasonable people are supposed to agree is part of the "the banks did this to us" story, where banks got all leveraged up with irrational exuberance and short-term greediness.

Can I suggest that this seems a bit underwhelming?  I mean, there are legitimate debates to be had about the most systemically safe ways to fund investment banks, but I think if you showed this graph to anyone that didn't have priors that there was a massive financial crisis caused by risk-taking, nobody would look at this and say, "This is clearly the picture of a financial system ready to blow up in 2007."

Morgan Stanley is the only bank shown here that had leverage in 2007 that was significantly higher than previous levels.  Maybe you could argue that leverage had been too high for the entire decade shown on the graph.  But, then this is just axiomatic.  It's a plausible condition that is lying in wait to explain any crisis.  Really, in that case, you could remove the y-axis, or change the numbers to half or to double the numbers shown here, and the argument wouldn't fundamentally change.  I mean, if Morgan Stanley had been leveraged 20 to 1 or even 10 to 1, and a financial crisis struck, it's not like economists would all look at this graph, with that different scale, and say, "Well, leverage clearly didn't cause this crisis.  Now, if they had been leveraged 30 to 1, then leverage would be important."

No. Leverage is a plausible cause of financial crises, and so any level of leverage, in hindsight, can be called out as the cause of the crisis.  The premise is overwhelmingly the source of the conclusion.  And, certainly leverage is a plausible cause of financial crises.  That's what makes it such a compelling culprit that the premise itself seems sufficient to reach a conclusion.

Here's another slide from that deck.  Here, referring to Lehman and what appear to be optimistic expectations in 2005, they say, "Analysts at Lehman Brothers understood the consequences of home price declines. However, they severely underestimated the probability and magnitude of these declines."

Again, this is hardly new ground.  This is consensus stuff.  But look at those scenarios.  There is nothing wrong with them.  There is a 50% chance of home prices rising by 5% per year, and a 5% chance of a shock to home prices worse than anything we have seen since the Great Depression.

And, who is to say that those probabilities are wrong?  Who is to say that if we could relive the 2000s a hundred more times that 95 of those times would turn out just fine?  Oh, and by the way, this scenario analysis would be pessimistic if it was applied to Canada, Australia, or the UK over the same time period.  We do have several versions of economies entering 2006 with very high home prices, and the evidence suggests that having a generation-defining housing bust is highly unusual.

This is such a deep and ironic example of how the premise that a severe contraction was necessary actually caused the crisis, and then served as its own confirmation when that crisis happened.  This error of looking back at scenario analyses and judging it based on a single outcome only seems reasonable because the premise that the crisis was inevitable is so strongly held.  (And, I don't mean to single out these authors.  This is the consensus treatment.)

This forecast was made in the summer of 2005.  From August 2005 to August 2008, the national Case-Shiller price index dropped by about 7%.  That part of their worst case scenario was actually too pessimistic.  It was their expectation of stability after that which was too optimistic.  From August 2008 to the end of 2011, prices fell another 14%.  And, it was during that later period where nine out of ten of the mortgage defaults happened.

Now, I'm not going to spend paragraphs here walking through the entire timeline again.  Surely we can all agree that by the end of 2008, public policy itself is implicated in the eventual outcomes.  Public policy can even be implicated in the declining prices before August 2008.  But, the irony here is so deep.  What was the overwhelming reason for holding back on stabilizing policies throughout that time?  It was that we had to let prices drop to avoid moral hazard.  To impose discipline.  They had done this to us because of their optimism, greed, and riskiness, and they needed to learn a lesson.

It's fitting that Lehman failed in September 2008, right when the first three years of that pessimistic scenario ended.  Their pessimistic scenario covered the outcomes that had occurred up to then.  In September 2008, the Treasury took over Fannie and Freddie and cut off lending to entry level borrowers, creating a late collapse in low tier home markets that nobody seems to have noticed (because the premise accepted, even demanded, collapse) and the Fed implemented disastrously tight monetary decisions by holding the target rate at 2% and then implementing interest on reserves that sucked hundreds of billions of dollars out of the economy.

I see slides in these programs bemoaning the role of pro-cyclical financial markets in creating a boom and bust, but I don't see much about public demands for pro-cyclical regulatory and monetary regimes.  There is no doubt that the Fed and the Treasury could have avoided the post-2008 price collapse with earlier and more accommodative actions.  The premise was that contraction was necessary.  The premise was the reason we allowed or insisted on instability.  And the premise is why that subsequent instability can be blamed on the market that we imposed the premise on.

Another example of the strength of the premise, from the same set of slides is a reference to the work of Case, Shiller, and Thompson, who surveyed homebuyers for several years, and found that their long-term expectations for home price appreciation are unrealistically high.  This has been blamed for fueling the crisis.  The Shiller real housing chart that was so popular during the boom is referenced, which I have addressed before.  That chart is based on national average numbers, which completely erases the localized nature of the housing supply problem that caused the bubble.  Treating the housing bubble as a national phenomenon helps to feed the false presumption about its cause, because it is a lot easier to blame the bubble on national excesses if it is a national phenomenon.

Along this vein, the panelists reference the survey work of Case, Shiller, and Thompson, and note that during the years from 2003 to 2008, the average long term annual gains homebuyers expected in four different counties were:
11.6% Alameda County (San Francisco)
8.1% Middlesex County (Boston)
9.5% Milwaukee County (Milwaukee)
13.2% Orange County (Los Angeles)

They note "Forecasts were roughly in line with extremely rapid home price growth witnessed prior to the surveys but were way off from future realized growth."  Treating the bubble as if it was a national phenomenon and treating the bust as if it was inevitable means that we can ascribe (false) meaning to this result.  But, here is a graph of the median home price in each metro area (from Zillow).  These cities have very different stories.  Nothing in Milwaukee was outside of historical norms.  As with most of the country, prices were somewhat buoyant in 2004 and 2005, but that is understandable given the low long term real interest rates of the time.

So, how much of the "bubble" is explained by these expectations?  If Milwaukee buyers had high expectations but home prices were about $200,000, then did the expectation of 11.6% price appreciation explain $700,000 homes in San Francisco?  It seems more likely that there is some bias in the response to this question that has little effect on prices.  Let's say there is some effect.  Maybe 15%?  Maybe without these high expectations, San Francisco home prices would have only been $600,000 at the peak instead of $700,000.  What if home prices in San Francisco had stopped at $600,000.  Would we then have looked at the housing data and said, "Oh, expectations can't explain that.  Now, if homes were selling for $700,000, then we might be looking at a bubble, because then San Francisco prices would be 15% too high, and that would be a reason to suspect these biases in expectations."?  No.

Since the premise that demand, unmoored from rational value, exists prior to the analysis, this bias in buyer expectations can explain everything from $200,000 homes in Milwaukee to $700,000 homes in San Francisco, and everything in between.  And, when the "inevitable" bust comes, those high expectations will be sitting there, ready to fill in the narrative.  The reason it seemed like there was a bubble was that home prices in Boston, LA, and San Francisco were double or triple the price of homes in Milwaukee.  But, the false premises about its cause led us to watch the median home price in Milwaukee decline by 15% over the next five years - an incredible loss by any historical standard - and consider that reasonable, even though there was never a reason for homes in Milwaukee to lose a penny of value.

Another presentation by Aikman, Bridges, Kashyap and Siegert asks "Would macroprudential regulation have prevented the last crisis?"  But macroprudential regulation caused the crisis.  In their presentation, the first step to achieving macroprudence is identifying the buildup of risks in the economy.  The first item in their list of examples of challenges to achieving this is the recognition of a housing bubble.  While many of the tasks of achieving macroprudential stability are difficult and were not done well, according to the presenters, this first step was achieved, because the Federal Reserve noted correctly in 2005 that home prices were overvalued by 20%.

But, that was the problem.  Home prices didn't need to fall by 20%. As the housing market started to collapse, the Fed signaled that if home prices did fall by 10% or 20%, it wasn't going to do anything to counteract it.  That was a "correction".  The initial drops in housing starts were enough to buffer the sharp drop in demand that naturally followed.  But, when housing starts fell as far as they could, ratings agencies started to forecast unprecedented declines in prices, and the Fed continued to see instability as a necessary medicine for enforcing discipline and avoiding moral hazard, prices collapsed.  The more they collapsed, the more that the false premise led us to demand discipline and to rail against moral hazard.

Step 4 in their action plan is to "Take action to reduce the build-up in household debt".  The macroprudential action here, surely, should be local, since the rise in these balances was local.  And, the clampdown on lending to borrowers with low incomes and low credit scores, which seems like the obvious macroprudential response, has killed low tier markets, and it has nothing to do with what happened during the boom.  All of the rise in debt payments that were over 40% of income was among households with high incomes, because those are the households bidding up home prices in the Closed Access cities.

I don't see anything in these slides that seems to acknowledge the importance of supply constraints in rising debt levels.  The entire discussion happens within the premise that credit supply is the cause of both the boom and bust.

Another presentation also discusses leverage and over-reliance on short-term borrowing in the financial sector.  Here is a chart from that presentation:

I would point out here that most of the increase in home prices had happened by the time short term repo financing began to rise above the level of long term financing.  By late 2005, the Fed had raised the short term rate to nearly 5%, and the yield curve was inverted.  Banks weren't saving on interest expense when they increased their reliance on short term financing.  This wasn't a matter of "borrowing short and lending long" and pocketing the difference, while creating an externality of systematic risk.

It is certainly useful to consider ways in which a financial system can be more resilient, but these discussions are like a group of doctors standing around a patient who is repeatedly hitting his head with a mallet, and discussing the importance of avoiding headaches by staying hydrated.  Staying hydrated is important!  This is true!  But, it isn't the problem at hand.