Evidence of the Real Estate Credit Problem

Normally, around the perimeter of Phoenix, you see signs like this:

For the first time ever, today, I saw this sign:

This is a single family home neighborhood where new homes are being built specifically for the rental market.  Builders want to build.  But, if they build, they can't find very many households that can buy them.  So, a builder has realized that they can use their access to credit to find a way to build homes.  They build them to rent.  This is what you get in a housing market where households that can afford your home can't get a mortgage.

This isn't about affordability.  The rents on these homes are in the ballpark of what mortgage payments would be for buyers of the same homes.  But, since they don't have access to credit, the households moving into these homes won't gain equity as nominal real estate values increase, and they won't have rental payments that are perpetually protected from inflation.  The difference is huge, and we are seeing the echoes of those benefits to home ownership in the high rent inflation in the CPI and in the high returns to real estate in the national income accounts.

On the topic I touched on the other day, I think that if we didn't have the mortgage interest tax deduction, we might see more of this sort of thing.  And, it would be ok.  But, that would be in a context where households were choosing to be renters because of their individual circumstances.  In today's context, households are choosing to live in these homes because they are locked out of the credit markets.  And, many of the households that are well-off enough to get over the hump to get a mortgage and buy a house - households that are usually financially more secure - get a government subsidy.

I believe that home prices are currently below the values they would have in a context where mortgage credit was being generously distributed, even if we didn't have the mortgage tax deduction.  And, on top of that advantage, we have the government basically writing those households a check.

The mortgage tax deduction amounts to an annual payment nearing $100 billion made from renting households to owning households.   That's about 1/2 % of the economy, paid from the bottom half to the top half of economic households.  Those owning households enjoy another tax break, relative to renters, that is probably even larger than the mortgage tax break, when they sell their homes with capital gains exemptions.  (edit: The total between the two might be 1 1/2% of GDP annually. Please let me know in the comments if you have a source for the scale of the capital gains tax exemption.)

Lots of self righteous ink is spilled these days about inequality and a "rigged" system.  But, a lot of this kind of stuff enjoys wide bi-partisan support.  When you think about it, of course it would.  Easy self-righteous indignation aimed at the bogeyman of the day is a heck of a lot more fun than trying to understand something as complex and counterintuitive as an economy.  I am not holding my breath, waiting for my politically active friends to invite me to an angry march to the capital building against the mortgage interest deduction.  And certainly there isn't going to be a march to eliminate corporate and capital gains taxes (which, among other things, is a tax on renters.)

December Employment Preview

I don't have much to say about this anymore.  Here is the comparison I have been using between insured unemployment and total unemployment.

It looks like my simple forecast for total unemployment has been a little optimistic for the past 6 months.  I suspect that the employment gains we saw coming out of the end of extended unemployment insurance at the end of 2013 were mostly played out by about June, and that very long term unemployment and some of the unusual shorter term unemployment will be somewhat persistent, which seems to be a pattern in the insured vs. total unemployment relationship over the long term.  I thought that the trend in very long term employment would continue its linear fall, but this may have leveled off.

Insured unemployment also seems to finally be leveling out.  It had declined to very low levels.  At this point in the pattern, in the past 3 recoveries, insured and total unemployment rates have declined very slowly for several more years.  (Visually, in the graph, they continue to follow the same trajectory, but with less decline.  The dots, representing months, are closer together.)  So, the signal from the employment market is that the recovery is at the early stages of maturity.  I would expect the unemployment rate to meander around down through the mid-5%'s through 2015, with some noise along the way.

The first graph here is my regular graph.  The second graph is a close up view.  I have added a second forecast line, which assumes that the unusual decline in unemployment from the end of EUI ends in June.

The third graph is the longer view, smoothed.  The relationship has a counterclockwise movement through the business cycle.  The slope of the relationship is fairly consistent during downturns.  After the counterclockwise movement through the recovery, insured unemployment rises in the next downturn.  The level of unemployment when that rise ensues appears to be related to the scale and timing of previous cycles.

I don't expect to see any sudden movements or speculative opportunities coming out of employment numbers for a while.

Zero Lower Bound and Yield Curve Distortions

It's crunch time, and the signals are not comforting.

Interest rates have taken a dive recently.  Declines this week appear to be from lower inflation premiums in the first 10 years of the yield curve and from both lower real and nominal rates at the long end of the curve.  The declines are not coming from a delay in rising rates in 2015.  The declines are coming entirely from lower rates at the long end and a lower slope during the rate recovery period.


This first graph shows the expected date of the first rate hike and the expected subsequent rate of rate increases (from Eurodollar futures).  The expected date of the first hike has actually moved back in time recently (blue line, inverted right scale).  But the slope of rate hikes has dropped sharply down to 22 bps per quarter.

The next graph shows the Eurodollar curve at several points in time.  In Sept. 2012, when QE3 was just getting under way, short term rates were very close to where they are now.  Then, by the summer of 2013, both the date of the first hike and the rate of those hikes had taken bullish directions, with the first rate hike expected as early as 2014 and the slope hitting around 35 bps per quarter (which is still low relative to previous recoveries).  But, as QE3 has been tapered and then terminated, rates fell back to the previous level, and now long term rates are even lower than they had been after QE3 began.

The main difference (comparing the white line to the green line) is that the slope in late 2012 had been as low as 15 bps per quarter.  So, now, compared to late 2012, long term rates are lower, but the slope of the recovery period is somewhat higher.  My intuition here is that market participants are more confident that rates will rise at all than they were when QE3 began, but they now expect the long term posture of the Fed to be more hawkish.  But, I will address this further.  I think this may be a difficult thing to read.

My model of the expected date of the first hike, the uncertainty about that date, and the slope of the curve during subsequent hikes has been based on the notion of the short end of the yield curve at the zero lower bound (ZLB) as a sort of call option, where the ZLB is like the strike price, and the yield curve is the current "price" of forward rates, which includes an expectation of future rates and a premium created from the ZLB and the level of uncertainty about future rate movements.  A futures contract well into the future is like a call option far in-the-money.  Its price generally reflects the present value of future prices.  But, a futures contract near the expected date of the future rate hike includes a premium because the ZLB limits losses, just like a strike price does for a call option.

We are close enough to the expected rate hike that there isn't much "premium" curvature in the yield curve anymore.  And, at the very short end of the curve, Fed discretion can be as important as movements in natural rates.  So, I think the ZLB could be causing distortions now in the yield curve in a slightly different way.

We should think of the price of each forward interest rate as the price settled by the marginal investor in each contract.  The neutral final price that comes from a variety of different expectations.  So, each forward rate is the product, itself, of a distribution of expectations.

The recent decline in the slope of the yield curve has been roughly proportional to the decline in the expected long term interest rate.  So, compared to 4 months ago, I think there has been an increase in the expectation that we will, in fact, not escape the ZLB.  I have been thinking of this in terms of a bifurcated set of expectations, where some portion of the market expects rates to climb quickly to, say, 3% or 4%, and another portion expects us to remain at the ZLB or to leave it only temporarily.  Thinking of it that way, the ZLB traders would be pulling the yield curve down proportionately across the curve.



But, I am wondering if this is the right way to think about it.  Here, I have graphed the yield curve as if short term rates were at 3%.  We might imagine that at each point along the curve, there are a range of relatively non-skewed expectations around the market rate.  As the yield curve moves out into the future, the uncertainty about the expected rate would increase, but the market rate would still be an unbiased reflection of a range of expectations.

But, if the rates are at the ZLB, then it is possible that the lower bound will affect the shape of expectations.  At very short term rates, this is basically how I have been modeling the convexity of the yield curve.  I had assumed that this factor was not important at the longer end of the yield curve.  But, as long rates have declined, the probability that there are some ZLB expectations at the long end of the curve seems undeniable.

If instead of thinking of it as consisting of a two-humped distribution, as I had above, what if we think of it as a normal distribution where the ZLB acts as a lower limit, much as a strike price does on a stock option?  This reverses the effect on forward market rates.

Now, what we have is what would normally be the mean, median, and mode rate expectation.  But, the low end of the expectations distributions would be truncated by the ZLB.  We could presume that this would lessen the speculative weight these market participants would place on taking a position on lower rates, since the potential profit is limited by the ZLB.

If this is the basic shape of market expectations, then the ZLB would push the mean expected rates above the median expected rates - and presumably to some degree the market rates would also be pushed above the median expected rates.

In this scenario, the rate curve we are seeing now would actually be an overstatement of expected rates.  After walking through this, I think this is very likely to be the case.  If we take the scenario to the extreme, where expected future short term rates are expected to be at 0% indefinitely, we would clearly expect the long end of the curve to rise above zero, even if there was no maturity premium and we had a pure expectations context.  Because, there would be an option premium there, just as is with a stock option at the money or the recent short end of the yield curve.

The scale of this distortion would be a product of the level of uncertainty.  And this, ironically, might be good news.  The long end of the curve is about 3/4% lower than it was in September 2012 after the start of QE3.  While there are still some expectations of an enduring ZLB, there should be quite a bit less uncertainty about the near term economy than there was then.  GDP growth has remained steady.  Employment has been strengthening.  Commercial lending has continued to strengthen.  Households have continued to deleverage.

So, we should expect the tendency of the ZLB to push up the market rates at the long end of the yield curve to be weaker now than it was then.  Maybe the median expected long term rate level was, say, 2%, in September 2012 and is also at about that level now.  Maybe then the market rate was biased up by 1 3/4% and now it's only biased up by 1%, because there is a tighter range of expectations now.

Even if this is the case, the most recent drop in rates is probably the result of falling mean and median rate expectations and a higher probability of being stuck at the ZLB.

Also, the slope in the 2016 period is a monkey wrench in this hypothesis.  The expected date of the first rate increase has not changed.  If recent rate changes were a result of lower economic expectations, then I would have expected the date to move back in time.  It seems odd that the expected slope has declined while the expected date of the first increase has remained bullish.  This suggests the bifurcated expectations distribution I originally described.

The fact that the slope is higher now than in September 2012 also points to bifurcated expectations, since lower variance of expectations would have lowered the slope if expectations were normally distributed.

There is also the possibility that expectations about the way the Fed manages the rate of hikes in 2015-2017 has changed, and the changing slope simply reflects these changing expectations.  But, I'm already having trouble keeping this all straight without bringing in another vague and moving variable.

The ramifications for speculation are problematic here, because I would have been looking for a flat yield curve as a signal for declining short term rates.  This effect could mean that the next downturn begins when short term rates are near zero and the yield curve is distorted so that even if median expectations are for a flat yield curve, the market prices of forward rates could have a decent positive slope.

I hope that all of this becomes moot when we start to see mortgage credit flow and inflation expectations are re-invigorated.  But, there has been no sign of that happening yet.

Multi-part Topics from 2014

Here are the topics I looked at with series of posts in 2014:


11 Part Series on Risk, Valuations (and Leverage)

3 Part Series about how compensation is declining because of housing, not corporate profit (1, 2, 3)

5 Part Series on Stock/Bond (and Real Estate) Allocation (1, 2, 3, 4, 5)
(I found that bonds are a terrible hedge for stocks, although they might be a decent hedge for your mortgage.)

The Absurdity of Blaming Capitalism for Inequality (1, 2, 3, 4)


I've been meaning to complete a multi-part series on the idea of beta in CAPM which I think has some fun implications.  I hope to get it out soon, but it's been on the to-do list for a few months.

IW in 2014 (and a little from 2013)

Here are some of the IW posts that were most popular over the past year (and a little of 2013):


Housing

I have arrived at a contrarian position in housing.  I don't think homes were significantly overpriced in the 2000's and I think further increases in home prices are an important signal of continued recovery.  I don't care what home prices are.  I just think they have been held well below their intrinsic value during the crisis.  I don't have a well-organized list of posts for this topic.  The most popular posts are below.  Click on the "Housing" tag for others:

Real Interest Rates and the Housing Boom
Housing policy - please do the opposite.  (And the follow-up)
http://idiosyncraticwhisk.blogspot.com/2014/04/new-home-sales-and-prices.html


Posts on Finance

Rant about risk and recovery (Follow-up rant) (Compensation and risk premiums)
You should invest passively because markets are Inefficient (Follow-up)
Reshorings aren't happening - and that's a good thing
P/E Ratios, Equity Returns, and Interest Rates
Naïve Market Maker Strategy in Forward Interest Rates
Austerity in Recessions (Follow up)
Required Returns, P/E Ratios, and Wealth Illusion
Risk Premiums, Reputation, and Actively Managed Mutual Funds
The Yield Curve is a Call Option


Posts on Anti-Finance Cognitive Bias and General Nonsense

Policies are for Identifying Outsiders
Regulatory Predestination and the Right to Exit
The Allure of Design (Follow-up)
Extremely positive news on economic mobility
Villains have incredible power to make us stupid.
If we are the 100%, then who will be the scapegoat?
Median Incomes (also: Skewness in Lifecycle Incomes) (More)
Evidence is Optional with Finance Cynicism
Family Structure and Income
Abundance Requires Real-Time Knowledge of Scarcity


Distortions in the Labor Force

I have many posts on the relationships between unemployment insurance, demographics ,and employment.  Like with housing, I don't have a well-organized set of posts.  Here are the most popular:
http://idiosyncraticwhisk.blogspot.com/2013/12/labor-force-participation-trends-and.html
http://idiosyncraticwhisk.blogspot.com/2014/08/eui-homeownership-and-wages.html
http://idiosyncraticwhisk.blogspot.com/2013/07/demographic-distortions-in-unemployment.html
http://idiosyncraticwhisk.blogspot.com/2013/08/its-all-demographics-again.html
http://idiosyncraticwhisk.blogspot.com/2013/08/more-on-duration-demographics-and.html
http://idiosyncraticwhisk.blogspot.com/2013/09/1970s-vs-2000s-gender-effect.html
http://idiosyncraticwhisk.blogspot.com/2013/12/a-natural-experiment-on-emergency.html
http://idiosyncraticwhisk.blogspot.com/2013/12/a-couple-more-thoughts-on-emergency.html


Minimum Wage

I've written a lot about minimum wage.  This post has been, by far, the most read on my site:
http://idiosyncraticwhisk.blogspot.com/2014/01/teen-employment-and-minimum-wage-60.html

I received a lot of feedback, and I spent several posts tweaking it.  Federal MW hikes tend to come in groups.  So, instead of treating each hike as a separate event, I treated each group as an event.  In the last post, I found what seems to be a systematic disemployment effect from minimum wage hikes, adjusted for the beginning level of RGDP growth.:
http://idiosyncraticwhisk.blogspot.com/2014/01/review-of-60-years-of-minimum-wage.html
http://idiosyncraticwhisk.blogspot.com/2014/01/total-and-teen-employment-minimum-wage.html
http://idiosyncraticwhisk.blogspot.com/2014/01/a-couple-more-minimum-wage-regressions.html

Here are a couple other of the more popular MW posts:
http://idiosyncraticwhisk.blogspot.com/2014/07/the-latest-in-minimum-wage-politics.html
http://idiosyncraticwhisk.blogspot.com/2014/01/minimum-wage-bad-luck-policy.html
Menzie Chinn included the "Bad Luck" post on his year-end list of "Fantastical Pseudo-Economics".  Those last two posts were probably a bit too snarky.  But I find this whole thing pretty funny.  There were a lot of reactions to the first post.  One of them, which I thought was a bit ironic, was to say that (1) this one graph was way too simple to be able to come to any conclusions without doing some $600 statistical analysis, and also (2) you could tell just by eyeballing it that what was happening was that recessions just coincidentally had come on the heals of the MW hikes.  Looking more closely (in the three middle posts above), I found that the timing of recessions wasn't that regular, relative to the MW hikes, but I ended up trying to control for RGDP growth to account for any changes in economic trends.  As a kind of joke, I posted about what bad luck the MW had, because, time after time, there was either a recession, or for some other reason, workers kept dropping out of the labor force.  Menzie Chinn saw that post, and to show that MW hikes don't lead to labor crises, Dr. Chinn actually did a Granger causality test to show that recessions don't reliably come after MW hikes.  But, it was the critics of the original post, who were trying to minimize the finding, who were claiming that all of the minimum wage hikes were followed by recessions.  Maybe Dr. Chinn can let  Arindrajit Dube and Kevin Drum know what he found.

In the end, while I realize that my analysis isn't that sophisticated, I think it is clear that these episodes of serial MW hikes need to be treated as single events.  Employment demand is forward-looking.  Employment behavior has a pattern over the entire series, with job losses starting before the first hike and then recovering after the last hike.  Analysis that treats each hike as an individual event will treat the job recovery that begins after the last hike as if it is a result of the MW hike, when it is more likely to be the result of MW hikes coming to an end.

Other ways I think we get housing wrong

(Previous post)

I.  Nominal real estate asset and debt levels are unique and not comparable to other assets.

First I see a problem in the way household debt is frequently described as a sign of middle class stagnation and of a housing "bubble".  I have discussed this before.  Very short version - most middle class debt is mortgage related.  In other words, most middle class debt is related to savings - deferred consumption, not debt-fueled consumption.

The manifestation of many recent market trends is interest rates.  With regard to housing, the most important factor is very low long term real rates.  Emerging market savers and developed market baby boomers (and their pension managers) have a tremendous demand for long term safe cash flows, so that long term real interest rates have been bid down to very low levels.  (Real rates were very low in the 1970's also.)  Changing interest rates have different effects on different securities, depending on what is held constant.

1) Treasuries.  As treasuries mature and are re-issued, face values are reset.  So, coupon payment levels change over time, but the changing asset value of, say, a treasury ETF reverts to a stable mean over time, even if interest rates don't reverse.  And, government debt is the product of various political factors that are not related to interest rate levels.  So, the quantity of government debt and the market value of that debt do not have a systematic relationship to interest rates.  In futures markets that use a stationary bond maturity as the basis, bonds trade based on a premium or a discount to a stationary interest rate, but this is not a factor in the public image of bond values or in the total nominal quantity of bonds over time.

2) Corporate bonds.  Corporate bonds have many of the same characteristics as treasuries.  It is usually assumed that corporations would sell more bonds when rates are low.  I have not found that to be the case.  But, even if it were the case, a change of 1% or 2% would only be expected to change corporate debt levels marginally.  Corporations don't borrow to target a set interest expense level.  They borrow to fund a set nominal investment level.

3) Corporate equities.  It is frequently asserted that the stock market is fueled by Fed-induced low rates.  Risk premiums for corporate equities tend to move counter to risk free interest rates, so equities also don't react systematically to interest rate changes.  Most capital gains in equities come from growth in economic activity and stabilizing aggregate demand during recoveries.

4) Real estate.  Real estate is different than all these other categories of assets.  The "coupon" on a piece of real estate is the rent.  Rent tends to track income, more or less.  And, there is no reset on real estate face values - real estate is like a perpetual bond with no maturity reset.  So, real estate in the real world, and in our collective consciousness, acts like those bond futures contracts.  And since real estate has a very long life, it's nominal value is very sensitive to changes in real interest rates, especially when they are very low.  This doesn't only increase the nominal value of real estate assets.  Since rents tend to change very slowly, relative to interest rates, this has a similar effect on real estate debt.  In a low real long term interest rate context, it can be reasonable to purchase leveraged real estate with very high levels of nominal debt, because the cash flows will compare favorably to renting.

So, when real long term interest rates are very low, like they have been this century, the only nominal asset value they really affect is real estate.  I don't have a precise suggestion for adjusting for this fact.  But, given that it is a fact, any analysis that uses the changing levels of mortgage debt and real estate values as the signal for some broad social issue is simply baseless.  They aren't measuring what they think they are measuring.

But, it's a problem for all of us.  I am saying that, if real long term interest rates change over time, the nominal value of assets at a given point in time is not a reliable or useful piece of information.  And I don't have a suggested replacement.

This is a difficult condition to accept.  But, if you accept the most common story in defiance of my position, then you have to believe that American middle class households have been stumbling under the weight of stagnating incomes and taking on debt to mask the effect on their lifestyles.  And this problem has been coincident with an unprecedented and relentless bidding war on owner-occupied middle class housing.  That's simply unbelievable, notwithstanding the widespread belief in it.

II. It was not unreasonable to model MBS's based on historical experience.

I come here today to ("gulp", straightens tie nervously) defend David X. Li and the widely derided risk models that were applied to MBS's during the housing boom.

There are many legitimate arguments to be made about assuming normal distributions, continuation of historical trends, etc.  These arguments can be made about MBS's as well as many other types of investments.  And, to be honest, I am not enough of a statistician to get too far into the weeds on the topic.

But, the point I would like to make is that there is nothing exceptional about MBS's that make the models in use in the 2000's especially bad.  The breakdown in the models basically arose from the fact that correlations all rose toward unity.  There were admittedly securitizations that, in hindsight, seem to have been made up of especially flimsy mortgages.  And, around the margins, we could second-guess some of the ratings that were applied to those securities.

But, in the end, the universal collapse in asset values was a product of Fed policy.  My point is that, if you have a self-inflicted black swan - if the Fed is bound and determined to suck liquidity out of the economy - then how can you model that?  The only way to be prepared for that is to....I don't know, bury a bunch of gold coins under your porch?

I mean, how'd your house do in 2008?  How about your stocks?  Even inflation protected bonds dipped in the chaos of late 2008.  All these assets fell right along with MBS that had been designed with those models.  Nobody needed an actuarial model to lose a substantial sum in 2008.  It was a pretty easy thing to do.  There were speculators who had the right side of some trades when the bottom fell out.  You might have done quite well if you were long volatility.  But is there someone out there who had a better risk model, who sailed right through 2008?

Homes lost 30% of their value - in the aggregate - in 2 years.  Home prices were stable as interest rates rose.  The losses began approximately 1 year after the yield curve inverted, when short and long term rates started to collapse.  So, we shouldn't pin responsibility for this on monetary policy?  We should blame the MBS models because they weren't robust in the face of 30% aggregate losses and a massive liquidity crisis?

So, can you get caught with your pants down if you own leveraged assets?  Of course.  Could we have an economy that was based on more robust forms of investment?  You bet.  Could the Fed give us more stability?  Certainly.  Our answers to all of those questions matter a lot more than whether or not there were some simplifying assumptions in some asset construction.

I suspect that MBS risk models that are based on historical correlations of defaults - even in MBS with relatively risky mortgages - will perform relatively well in the future.  There will be times where they don't perform well.  But in those times, it won't be the model that killed you.  It will be a war or a pandemic, or a Fed that hasn't accounted for the topic of the first half of this post.

Housing policy - please do the opposite

I recently saw this column by Robert Shiller, where he made this comment:

since 1890, the average appreciation of inflation-corrected home prices in the United States has been only a third of 1 percent a year. That’s why housing hasn’t been a great investment. And in 10 years, it may be almost equally likely that real home prices will be higher or lower than they are today.

That is kind of a shocking statement to me.  That's like saying bonds are a terrible investment because the redemption value will be the same as the initial face value.  You don't buy bonds for capital gains.  You buy them for income.  Likewise, you don't buy a house for capital gains.  You buy it for the rent.

Some people do buy bonds or houses as speculative activities, but of course speculation is a zero sum game.  That doesn't have anything to do with whether they are good investments.  How can Shiller make this statement?  The question is, how much does the house cost, how much would rent be (corrected for homeowner expenses), and how does that compare to alternative investments?

In fact, the fact that home prices in the US have roughly tracked inflation suggests that thinking of a home as an inflation-adjusted bond is a pretty good first step for looking at aggregate home values.  There is no way that 30 year TIPS bonds are paying a higher return now than the average rental home is.  This has nothing to do with what home prices will do in the next 10 years.

------------------------------------------------

In that column, Shiller also argues against the mortgage tax credit deduction.  This is an interesting issue.  I agree with Shiller about this.  And, I think this would be the perfect time to phase it out.  Affordability is not the binding constraint in housing right now.  Access to capital is.  Households with capital or credit can purchase homes.  The homes are underpriced, so for the few that can buy a home with a large mortgage, they are earning excess rents.  The mortgage deduction is just adding to those rents.  Normally, there would be a fear that ending the mortgage deduction would lead to a drop in home prices that was steep enough to cause an economic dislocation.  But, real estate credit has been too hobbled for the mortgage interest deduction to lead to higher prices.  Home prices are low enough to be profitable for investors, and at least until very recently, cash buyers have been dominant, so if the mortgage deduction was ended now, cash and institutional investors would keep prices from declining significantly.

But, public housing subsidies are interesting to think about.  According to Modern Portfolio Theory, a tradable asset or security that is widely accessible should be bid up to a market price where there are no risk-adjusted excess profits.  Optimized portfolios will be diversified, so they will still be exposed to market risk.  But any exposure to idiosyncratic risk related to individual securities will not have any excess returns in the aggregate, because that risk can be diversified away.

But, with housing, there is limited access, due to the all-or-none form of ownership that is typical, and there are potential gains from idiosyncratic risk, since such large portions of the market are not, and cannot, be diversified.  Also, high transaction costs create a liquidity premium.  So it is likely that there are excess returns from home ownership, especially when a home is held for a long period of time, minimizing trading costs.

But, this issue, as is often the case, gets turned on its head.  Since home ownership provides excess profits, and these profits tend to go to households with the most access to capital, we tend to think, wouldn't it be fair if everyone could get access to those profits?  This is wrong-headed.  Profits (accounting for liquidity and idiosyncratic risk) only exist because there is limited access to the market.  If everyone gets access, the profit goes away.  The solution is to get rid of the profit.  But the irony is that, if we get rid of the profit, then moving households into home ownership is not necessarily a benefit.  The only equitable outcome for housing policy isn't to subsidize more home owners, it's to make all households indifferent to home ownership.

This is a very difficult distinction for the consensus to accept, because in social policy, we tend to associate middle class behaviors with social improvement, and it is natural to assume that social progress comes from nudging the lower economic classes into that behavior.  If middle class behavior involves the accretion of economic rents, universality of middle class behavior is a mathematical impossibility.

A more universal and equitable housing market would come from lower transaction costs, more access to credit, more pathways to ownership, etc.  This is a good example of how hard it is to have good public policy in an IMH world.  The housing market of the 2000s was a great example of a context where the housing market was more universal and equitable.  Low interest rates, low down payments, investor diversification through securitization - all of these trends were pushing down excess returns in housing and expanding the pool of potential home owners.  All great things!  In a world where rent payments will be fairly stable, how will lower excess profits (economic rents) be manifest?  Through higher asset prices!  And, what kind of reputation do the housing market and the financial industry of the 2000s have?  Public views of the housing market are definitely an example of strong form IMH.

On all sides of the political spectrum, there seems to be a consensus that the Fed is the lap dog of Wall Street, making sure the financial elite earn economic rents.  And there also seems to be a consensus that the era of equity and universality in housing was a monstrosity that had to be beaten down.  And the consensus complaint is that the financial intermediaries who made that housing market possible, who for the most part are bankrupt, reorganized, or a fraction of their former selves, have been "bailed out" because the Fed dares to inject some liquidity into the chasm that used to be a credit market.

The mortgage tax deduction really made everything worse.  For those who could capture excess profits, the deduction increased those profits.  And, on a macro level, it creates a two-tiered market, where there is a general price level for landlords, and a higher price level for owner-occupiers who can benefit from the deduction.  This means that supply and demand forces for landlord owners will translate into higher rents.  This also means that the market for single family homes, especially homes with higher nominal values, is much thinner than it would normally be.  There is a market of non-diversified, owner-occupiers with equilibrium prices above the equilibrium price for landlords.  When that market broke down in a context where (1) excess profits had been bid down because of wider credit access and (2) the mortgage deduction continued to provide added profit for owner-occupiers, prices had to fall significantly before landlord investors were willing to add support.

So the mortgage deduction creates a less stable, less equitable market.  I wonder what the counterfactual would have been if, during the 2000's, we hadn't had the mortgage interest deduction, but we still had low interest rates, securitization, and all of the other accommodations that came out of low real interest rates, low inflation, and financial innovations.  Home prices would have been somewhat lower.  Home ownership rates would have been lower.  There would have been much broader landlord demand for homes.  Rent inflation would have been lower.  And, I think that it is plausible that there would have been more supply of homes as a result of all of these factors.

Partly, what was going on in the 2000's was that very low long term real interest rates were pushing up the intrinsic value of homes - the value of homes as an investment.  This was pushing up the landlord owner equilibrium price of homes.  The equilibrium price for owner-occupiers was naturally above that price, at least partly because of the mortgage deduction.  And, low nominal mortgage rates pushed that price even higher, as low monthly payments meant that constraints on demand coming from mortgage credit access were much lower than they had ever been in the modern era. (This is a separate effect from the effect of low rates on the actual nominal value of homes as a durable asset.) But, liquidity issues, transaction costs, the microstructure of the realty market, and the inability for buyers in the owner-occupier market to expand their holdings, meant that there were a lot of frictions and price stickiness in the owner-occupier market.  This created the opportunity for a lot of speculative activity.  But, it also might have kept supply from rising quickly enough to meet demand, because home builders were generally limited to finding buyers among that thin, friction-filled market of owner-occupiers.

If we hadn't had this two-tiered market, there might have been a more robust market for home builders to build for the renting market.  The relatively lower amount of frictions in the market might have allowed quantities to more quickly rise to meet demand, even as average prices would have remained lower without the mortgage deduction.  Landlord buyers would have been able to build large numbers of homes at prices they could profit from.  With the mortgage tax deduction, home builders could hold out for price levels higher than the landlord price level, but they had to find buyers one at a time from the owner-occupier market.

For many reasons, there has been a deluge of capital searching for low-risk investments, and the housing market served as a useful conduit for that capital.  In a more landlord dominated market, there would have been a much more robust set of saving opportunities through real estate.  There would have been a much larger industry of REITS and mutual funds placing investments in landlord institutions.  Savers would have been able to utilize real estate to meet current savings demand without trying to stuff so much of it through the conduit of owner-occupiers and small-time real estate investors.

Put another way, the equilibrium price of houses is the Price to Rent ratio that creates a return equal to other investment opportunities (including non-financial considerations).  In a normal real estate market, taking away the mortgage deduction means the average Price to Rent ratio will decrease.  This will lead to more quantity supplied from landlord owners, and rents will decline.  The declining level of rent, with a stable Price to Rent ratio, will mean that prices would decline further.

In addition to the lower prices this change would encourage, the mortgage market should allow low income households to establish ownership with few obstacles.  Down payments should be low, and various payment options should be available.  There is no reason to publicly subsidize these things.  Anyone who does establish ownership will likely already be earning profits relative to renting households.  Private mortgage insurance and securitization were available in the 2000's.  There is no reason why we need to bring in the moral hazard problems of public subsidization.  Deregulation would suffice.  In effect, housing policy should be a policy of creating lower housing prices and then not encouraging households to be home owners.

The main problem with this prescription is that there will still remain this deep cultural association of home ownership with the middle class.  As long as we have that association, on the margin, there will probably be households that establish a real estate position when they probably shouldn't.  That would subside over time, and, in fact, may already be less of an issue after the collapse of 2008.  Generally, the positive cash flows from mortgaged home ownership come after years of rent inflation, so there isn't generally a short-sighted incentive to switch from renting to owning.

So, please, take your mortgage interest deduction and give us back the real estate market of the 2000's.  There may never be a better time to do it.  This is what so-called consumer rights activists and working class political heroes should be pushing for.  So, Who's with me?....I said, Who's with me?!.....

...I think I have one more post worth of this nonsense, for those of you still hanging with me....

The first half of 2015 will be a tipping point

This is an interesting period of time, coming out of QE3.  Inflation expectations and real interest rates rose during the QEs, and then declined coming out of the QEs, and in hindsight, QE3 seems to have created the same basic pattern.  Short term treasury rates are distorted by the curvature at the short end of the yield curve.  This first chart is the 5 year, 5 year forward real interest rate (approx.) and expected inflation.  This shows the tendency for both real rates and inflation expectations to have risen during QEs and fallen afterward.  Long term real rates are lower now than after QE1 or QE2, even though it still appears as though a rate increase might happen.

All of the QEs stabilized the forward yield curve, bringing us closer to the point where short term rates might rise above the zero lower bound.  The length of QE3 was helpful in this regard, since we are now back to within six months of the expected date of interest rate increases for the first time since the beginning of the crisis.  (I think this is the case, but my data prior to QE3 isn't as precise, so I'm not certain.)  With the pullback in October, it looked like the expected date of the first rate increase might start moving forward in time again.  But, this has recovered, and as of Friday, the expected first rate increase was less than 6 months away for the first time in a long time.

QE3 seems to have improved near term expectations enough to firm expectations for the eventual rate increase, but at the same time, long term forward rates have declined.  Here we can see the yield curve for Eurodollar futures over time during QE3.  The time frame for rate hikes has remained fairly stable.  By the end of 2013, the timing of the first hike had moved back somewhat, but most of the effect was to increase the slope of the yield curve after hikes began, and to increase the expected final level of rates after rate hikes would have ceased. The expected rate hike remains in mid-2015 now, but the slope of the yield curve is fairly flat again, and most strikingly, the long end of the curve has moved even lower than it had been at the start of QE3.  This suggests that Fed Funds rates are expected to top out at around 2.5%.  (Some of the Eurodollar rates after about 2017 would reflect the TED spread and a maturity premium over the expected future Fed Funds rate.)

Markets seem to expect that we will have a very hawkish Fed, but that we will escape the zero lower bound in spite of it.

We now have two countervailing forces working on inflation and interest rates.  Commodities prices are in steep decline.  The broad decline in dollar terms suggests a monetary source for this, although there may be some supply influences, also.  So, this should be related to a decline in inflation along with some increase in real consumption.  In the meantime, real estate prices are leveling out, which looks like it is mostly the result of less supply, due to credit market constraints (stagnant bank lending, which may soon improve) and the premature exit from QE3 (household leverage still too high).  (edit: This is decreasing the supply of new homes, which is causing rent inflation.) This is increasing inflation at the expense of real incomes.  But, since most households are also home owners, the negative effect of the housing supply problem on incomes may be muted.  Beyond its effect on nominal incomes, I am not sure of the effect of the housing constraint on interest rates, since expanding mortgage markets will effect both investment supply and demand.

The next six months should lead to some important discoveries about the future path of the US economy.  The Wizard of Oz theory of the Fed is not helpful here.  Rates won't rise in mid-2015 just because the Fed decides that they will.  If the Fed decides to hike rates inappropriately, the yield curve will flatten, and we will be in for a nasty ride.  There will be no mistaking it.  If forward rates remain elevated when the Fed starts to increase Interest on Reserves and the Fed Funds Rate, we will know that the US economy had enough momentum to expand while at the zero lower bound.  Then the question will be whether the Fed manages the subsequent money supply in a way that keeps us off of the ZLB.  I am not hopeful about that, since it probably necessitates an inflation target above 2%.  But, it's a much better problem than the problem of never leaving the ZLB to begin with.

November Inflation, Housing, and Mortgages

Recent trends continue.  Core minus shelter (C-S) inflation turned negative again, so now we have deflation in 3 out of the 5 recent months, and basically no C-S inflation over the past 5 months, cumulatively.  If mortgage credit markets can expand as a result of recent regulatory adjustments, then I expect a domino effect of rising home prices, rising new home production, declining rent inflation, and recovery in Core minus Shelter inflation to follow.


If mortgage credit markets remain stagnant, then I expect this pattern to continue, and the question will be whether wage stickiness has diminished enough and real natural interest rates have risen enough to stop hampering economic growth.

This is a complicated outcome.  There will be shelter inflation, but much of that is simply an accounting transfer within households.  Households will see rising nominal incomes, but those incomes won't rise as much in real terms because they will be spending much of the extra income on rent...to themselves.  Since this is a transfer of income which doesn't involve any actual change in cash flows for home-owning households, it won't be a relevant issue regarding those households' economic decisions.  (Except, since this issue arises from a stymied housing market, household estimates of their net worth will be somewhat lowered by the low real estate prices.)

So real incomes will be rising faster than they appear among home-owning households, but households that rent will see stagnating real incomes, as their nominal income gains will accrue to landlords.  This is already happening, and we can see the market responses, one of which is a very strong multi-unit residential construction market, relative to single family homes.  In this scenario, if RGDP is our jumping off point for measuring economic growth, then households and landlords will have additional real discretionary income equal to about 1% of RGDP, compared to the official measure.  (This is because their imputed rent will rise due to rent inflation, which will be subtracted from nominal GDP growth.)  Since this is, at its core, a product of lower real estate equity, it is essentially the same economic effect that we would see if homes rose in value and households pulled 1% of GDP out of growing home equity value and used it for household consumption.  Except, in that case, the extra spending would be measured as NGDP growth.  If the rising home prices were a product of wider access to real estate credit, then it would also be associated with rising RGDP, since new home building would ease rent inflation.

So, while I see this Core minus Shelter inflation as a bad sign, it is mostly as a sign of potentially catastrophic deflation.  The odds of Fed policy becoming far too tight surely are higher in a context where most core spending is already deflationary.

But, if real wage growth rises, as it should with low unemployment rates, and if natural interest rates are above zero, as they should be in a mature recovery with low unemployment and solid NGDP growth, and if households, in effect, automatically are capturing and spending their real estate capital gains, inflation might not be as important as it is when NGDP, employment, and interest rates are plummeting.

I will look at some housing issues a bit more in the next post.

PS:  Commenter TravisV sees inflation as more important in the near term, and while my review of the topic has led to several posts nibbling around the edges of this topic, I still need to put together a post looking at near term Fed policy scenarios more directly.

Changes in Male Labor Force

These charts from the New York Times are just the kind of thing I've been looking for.

Here is the static version of the chart from the article.  It would be great to see a moving version of this over a longer period of time.

I'm not sure there is much to worry about on the age groups under 50 years.  Some blame the increase in young workers not working while in school on the minimum wage.  There might have been some of that after the 2007-2009 hikes, but the minimum wage is nearly back to insignificant levels, so I can't believe it would have had that much of an effect.  And, we saw this same trend between the MW hikes of 1996 and 2007.  So, I think this is largely a cultural shift.

Between 25 and 50 years, there has been a shift to unemployment, which is cyclical and should be generally temporary.  Otherwise, there have been small shifts to disability and caring for family.

I would also attribute much of the drop in rates of retirement to cultural changes, generally from people being more productive and active at older ages.  Some attribute this to older workers lacking retirement support, but as with the young, this represents a long term shift in behaviors that has persisted through business cycles.  There is a tendency to negativity in some of these interpretations, so that lower labor force participation in 50 year olds is blamed on stagnation and higher labor force participation in 60 year olds is also blamed on stagnation.

The largest problem is the disability issue, which affects the over 50 age groups the most.  This is clearly the product of bloat in a program that has devastating moral hazard issues, and it appears to be a significant input into the decline in US labor force participation compared to other nations over the past couple of decades.  Other public programs have the problem of creating a high de facto marginal tax rate for the poorest households.  But, this policy provides a meager support level and then explicitly directs recipients to self-identify as unproductive.  Local news teams expose frauds on disability who are filmed playing in softball leagues, etc.  This is trees and forests, people.  We're the monsters that put them in that situation.  (Of course, you could say the same for banks overleveraged on AAA securities.)  I predict that this problem will not be a topic in the political theater associated with upcoming elections.