Housing Tax Policy, A Series: Part 6 - Interest Rate Levels over time

I used data from the BEA table 7.12 on rent income and mortgage interest expense, along with data from the Fed's Flow of Funds report on real estate values and mortgage levels, nonfinancial corporate income, interest expense, and equity and debt levels.  From these data, I can create estimates of aggregate effective interest rates and rates of return and compare levels of various asset classes.  I am looking at five asset classes, listed roughly in order from least to more risky:

• Treasuries
• Mortgages
• Home Equity
• Corporate Debt
• Corporate Equity

Over the long term, all but the owner-occupied home equity market are highly sophisticated and liquid markets, which should lead to arbitraged risk-adjusted, after-tax returns.  And, even though owner-occupied home equity does not share characteristics such as easy diversification, it appears to also tend toward no-arbitrage, risk-adjusted, price parity with the other asset classes.  So, changes in the relative prices of these assets should reflect changing risk attitudes, expectations, and tax rates.  In other words, the supply elasticity with these assets is very high with regard to substitutions of investors between the asset types.

So, for instance, I am considering the effect of tax changes on mortgages.  But, in terms of mortgage interest rates, the tax treatment of the lender will be the overwhelming influence on mortgage interest rates.  Whereas lenders are allocating a given capital base among these securities based on after-tax, risk-adjusted returns, mortgage borrowers are not allocating a given amount of debt among asset classes.  The mortgage level and rate they accept will be filtered through many factors, such as the size of the home, the amount of leverage used, etc.  So, tax treatment of the borrower will tend to affect quantities, while the interest rates on mortgages will reflect supply.

(One possible exception is that some of the split of returns on homes between the equity holder and the lender reflects duration exposure on the part of the homeowner.  After mortgages gained tax benefits, home owners might choose to accept more duration on the mortgage, since the after-tax premium on duration would be lower.  So effective rates would be higher, as a result of the changing risk exposure of the owner.  This effect is probably swamped by other effects.)

There have been changes in interest rate spreads over time, which I think do point to effects from the changing tax treatment of housing capital.

This first graph compares treasury, corporate, and housing returns over time.  (I have used the implied inflation rate from my effective mortgage rate figure to adjust corporate and treasury rates.  I know this isn't perfect, but I think it is better than using inflation or survey data.  In any case, all three methods give similar results for time-series analysis.)  Because of stickiness in housing markets and the very long duration of homes, effective home returns are more stable than corporate or treasury debt.  But, we can see that returns to housing have, more or less, tracked trends in treasury rates.  However, beginning in the mid-1960's (when the housing agencies were consolidated into HUD, and there was a build up in home equity ownership), corporate debt started to require higher spreads.  Then, the corporate spread really took off in the mid-1980's, when the mortgage deduction attained tax value.

This regime shift is very clear in this next graph that shows the effective corporate interest rate from Flow of Funds minus the 10 year treasury rate.  There is a jump of 1% from the 1960s to the 1970s, then, after 1986, a jump of 2%.

This is evident in this Fred graph comparing spreads, too.  Mortgages have remained in a range of 1% to 2% above 10 year treasuries.  But, Aaa corporate spreads before 1986 ranged from 0% to 1%, and since then have ranged from 1% to 2%.  The Baa spread has followed a similar pattern.

 

In the next graph, I have used the income information from BEA table 7.12 to compare pre-tax returns on owner-occupier homes to rented homes.  I don't have aggregate market value information that matches with these rented homes, so I used the capital consumption figure from table 7.12 as a proxy for home value.  And, what we find is that until 1986, owner-occupiers earned a consistent premium over renters.

This is a little difficult to work out.  I hope to tie together all of these factors by the end of the series.  But for now, I will simply note the intuition that if savers are arbitraging after-tax returns, then pre-tax returns for owner-occupiers would decline as they attained tax-preferred treatment.  So, this result should be expected, as far as that goes.  But, to be honest, I haven't fully put this all together.

Since 2007, credit markets have shut down in owner-occupied real estate and implied returns on homes have shot up.  In the graph comparing landlord income and owner-occupier income, my proxy for home values breaks down after 2007 because of the disequilibrium in this market.  The implied return for owner-occupiers follows a similar trajectory to landlords if we use home market values instead of consumption of capital as the denominator.  That is because many homeowners are sitting on homes that have seen marked declines in nominal value.  This problem doesn't affect landlords as much because so many of the landlord properties have been purchased in the cash market during the recent slump, resetting the depreciation at a lower level.  So, returns to home ownership are very high, but mortgage spreads have moved along about where they have been.

I think what we are seeing in these changing spreads is related to the effects of these tax changes.  As tax incentives pull more capital into housing, mortgages and homes are commanding a higher proportion of capital, and home equity is also providing additional returns from liquidity and non-diversification risk.  The advantages to these real estate securities are pricing corporate securities out of both the low-risk space and the high-risk space.  So we are seeing a decline in the quantity of corporate investments, less reliance by corporations on debt, and higher premiums paid for both corporate debt and equity, relative to risk-free rates.

Note that Commercial and Industrial Loans moved along at 32% to 40% of bank credit for decades, until the mid-1980s, when they suddenly began a long term decline.  And, note the sharp increases in real estate credit, after 1986 and 1996.  Now that real estate is not taking in new capital, commercial credit is pushing up above its previous peak.

Maybe the causation runs both ways here.  Low risk free rates have pushed home prices up.  But, possibly current risk premiums themselves are a product of housing tax policy, to an extent.  I have previously suggested that the significant reductions in corporate leverage over the past 30 years has been a result of corporate capital management under falling nominal interest rates.  This housing analysis suggests that the lower corporate leverage has come from a kind of crowding out.  But, all of these trends are probably inter-related.

Further, there is the oddity that, given the shifts in capital allocation outlined above, corporate enterprise value (equity + debt) has not declined as a portion of GDP.  (This graph is of non-financial corporate enterprise value, adjusted to domestic levels by using proportion of foreign profits, as a share of GDP.  It shows some rise over time, but this is generally due to the transfer of assets from proprietorships to corporate ownership over time.)

What does this mean?  Well, we must remember that housing values are anchored in rent levels.  So, when price/rent levels rise, housing expenses remain basically the same, but nominal prices of houses rise.  Prices have risen because interest rates have declined, and I believe that they also have risen because of these tax incentives.  To the extent that the increase in owner-occupied housing stock (see the fifth graph above) has increased as a percentage of GDP, what we are seeing is the nominal value of the tax transfers from renters to owner-occupiers.  Owner-occupiers are, in effect, expressing the value of these tax incentives through higher nominal home values.

I'm not sure that any of this has much effect on the non-housing economy.  In nominal terms, it makes it look like there is a lot more debt and capital than there used to be.  But, housing capital is kind of funny.  It kind of feeds itself because the higher values lead to credit creation.  If we didn't have all of this extra nominal real estate capital, the non-real estate economy would still operate just as well.  It would just need a little more currency to keep everything moving, to make up for the lost home equity that currently serves as a savings vehicle.  I think the largest effect might be that real incomes of renters are being decreased by these policies.  They are being taxed through their landlords, via higher rents.

December 2014 JOLTS

Still lookin' good.

Hiring, job openings, and quits are not only all rising.  They are all accelerating.  The labor market is looking great.

My back of the envelope estimate is that the baby boomer effect (the large number of older workers) probably causes the job openings rate to be about 0.25% higher than in previous cycles, and the quits and hires rates to be about 0.25% lower.  That puts the labor market cycle at about where we were in mid-to-late 2005, when the unemployment rate was around 5%.

The baby boomer effect should be pulling down the unemployment rate, because older workers tend to have less unemployment churn.  Again, looking at the back of the envelope, insured unemployment correlates to about a 4.3% unemployment rate, compared to recent cycles.  My simple estimates attribute about 0.8% of the additional unemployment to the very long term unemployed that appear to have mostly timed out of extended unemployment insurance before the program had ended, and another 0.5% to persistence in unemployment that appears to be typical of more frequent or extended downturns.  So, I think the current labor market, accounting for these effects, does resemble the 2005-ish labor market, whether we are looking at JOLTS, insured unemployment, or unemployment durations.  But, these comparisons are moving targets because of the unusual demographic situation.

Here is a Fred graph, which I think makes for interesting perusal.  I think we can compare where we are now to where we were in about 2005 and 1995.

First, I would note that in 1995 when the unemployment rate levels out for a while, the Fed Funds rate topped out at about 6%, and the Fed pulled it back to 5.25%, avoiding a yield curve inversion.  I think that could have something to do with the expansion that continued for another 4 years.  If the Fed would have pulled back from 5.25% to, say, 4.5% in 2006, I think that 2007-2010 would have looked more like the late 1990's.  Home prices would have moderated, but not collapsed.  There would have been a slight hump in unemployment, then a continuation of the expansion.  Note that following the small decline in the Fed Funds rate in 1995, real wages rose, but inflation didn't.

Also, notice in 2005 when real wages started to rise, they were not accompanied by rising inflation.  Actually, despite the frequent framing of current Fed policy in terms of "wage inflation" there is no evidence of this sort of relationship over the past 50 years.  We are at a point in the cycle where real wages should see a healthy rise.  Inflation will be related to other issues.

If lending doesn't loosen up, inflation will come from a supply shock in housing, and, ironically, this looks like it will be widely attributed to wage inflation, with tighter monetary policy the cure.  That will be completely wrong, but it will appear as if it is right.  Considering how little evidence there is now in the historical data for "wage inflation", I doubt that it will take much for that narrative to be widely seen as confirmed.

Somebody should write about this housing problem.  A long time ago, this one blogger started a fascinating series on the topic, but he's gone AWOL.  He was last seen in the alley behind the local mall, a bottle of gin in his hand, his hair disheveled, filthy, a wild look in his eye, mumbling something about effective rates of return to frightened passersby.

Keystone Pipeline: Politics is not about policy

(I had written this out, but I was sitting on it, debating whether to soften it up, and I saw that Menzie Chinn made a post this morning that is, unfortunately, a perfect example of the problem.  Our central bank treats success as failure, and our academic economists treat costs as benefits.  So, I decided to post this.  I promise I will get back to my housing series.)

I was listening to NPR this morning, and they were talking about the Keystone Pipeline.  Politics is about imposing our factional collective will on others.  So, the point of engaging in politics is to stubbornly refuse to acquiesce to reasonable opposition.  That being the case, the way to win in politics isn't to engage in thoughtful dialog.  If anyone disagrees with you to begin with, in the political realm, they will be engaging with you specifically to avoid that.  So, you win by appealing to whatever misconceptions or biases they have already committed to, which happen to support your policy preference.

So, when I happen upon political dialog, what is striking to me is how often basic truths are avoided by everyone involved in the discussion.

And so it is with the Keystone XL Pipeline.  Regarding the economics of it, there is really only one significant measure of value, and that is the consumer and producer surplus it will provide.  On the margin, the consumer surplus will only come about indirectly and will be difficult to measure.  But, by the conventions of modern finance and accounting, we tend to keep a precise record of producer surplus - profit.  The economic profit the owner expects to reap from it is really the only measurable point of clarity here.  This point appears to be stridently ignored by all involved.  In a sane public debate, instead of arguing how many jobs it would create, we would ask the intended owner how much they were going to make on the pipeline, and the higher the number, the more support we should give it.

The jobs created by building and maintaining it and the materials and capital used will presumably be slightly more valuable as a result of this additional opportunity for their application.  But mostly, on the whole, it will simply divert labor and capital from some similarly valued activities that are competing for our limited resources.

So, here's a test.  Tell someone that you like the pipeline, but you would really love it if instead of creating all these jobs, the owner simply had a state of the art machine that would quickly lay down the pipeline with little cost, and could reap millions in profits without hiring more than a handful of workers or spending more than a small amount of capital.  That would really be great.

If the person looks at you like you have cottage cheese coming out of your ears, then they are operating with a morally perverse frame of reference.  They are making an ascetic imposition on the rest of us based on a preset determination of who they morally favor.  It is the moral equivalent of a segregationist or a tyrannical monarch who forces women out of school.  They are explicitly willing to harm the whole society if it seems to harm a particular group proportionately more.  If cash is transferred to the group they favor (labor), they go so far as to treat costs as benefits.  If cash is transferred to the group they disfavor (capital), they will treat benefits as costs.

It's disappointing to me how foundational this sectarian status battle has become in American politics.  I see so many otherwise good, intelligent people proudly calling for the rights of other Americans to be curtailed - people who are keenly aware of these human tendencies when it comes to race, gender, and sexual orientation, and who actively fight for a better society in those realms, yet they engage so explicitly in motivated reasoning and ad hominem regarding economic matters.  Get-out-the-vote rhetoric like, "Help make sure the voice of the 1% isn't heard this Tuesday."  Profit as a reason to oppose something.  Explicit calls to roll back Bill of Rights protections for commercial associations.  I trust that the pendulum will swing back at some point.  But it is a little frightening and disappointing to see how easily people can believe harm is a virtue.

This bias against capital is so built into our public consensus that introducing the idea in a conversation like this is generally met with bewilderment.  It should be patently obvious that we are better off if some new service can be provided with less effort and material.  Sadly, for most people, it is not.  This is one of those cases - much like with, say, someone in a creationist community who is confronted with the evidence of evolution - where, on the facts, it seems like it should be very easy for people to see something.  But, we are human.  Community matters a lot to us.  Affiliations give our lives meaning.  Having villains, and sharing those villains with a group of like-believers, is powerful.  If acceptance of a simple fact challenges that, it is most definitely not an easy thing to do.  It could, in fact, be rational for that person to concoct a story that ignores the fact, but saves their personal identity.  That doesn't mean it's good.  Local optimums are not global optimums.

There is much moral similarity between strident moralists - think of angry marchers with anti-gay signs or anti-Wal-Mart signs.  These are both working from sectarian impulses, yet thoroughly convinced that they are morally compelled.  They are both working from a pre-determined set of good vs. bad, with a determined refusal to consider any of the constraints or needs of the chosen villain, a demand that you, nonetheless, bend your lives to their moral code, and a complete ignorance about what that would realistically entail created by a refusal to engage you with even the slightest empathy or understanding.  And both insist on acting as if there is some damage being done to hetero families or workers, with reasoning that is highly motivated.  I think that, even though there is a lot of discomfort still in our society regarding sexual identities, there is generally a consensus about the shamefulness of those protesters.  Economics is a complex subject, so there will always be ignorance about it, but I would like to think that we will someday have the same consensus about both sets of protesters.

Human nature wants to make everything moral.  We used to think that droughts and famines were the gods' punishment for our moral failings.  We have shed those tendencies in so many ways, but we retain them in the realm of finance and economics.  In the Wal-Mart or Keystone examples above, people are still imposing moral biases, consciously or unconsciously.  Or, think of the Great Depression and the Great Recession.  How many people believe that these events were payback for the "excesses" of the preceding decades?  The inevitable falls from grace resulting from our greed.  We make this error, and we end up destroying ourselves, as humans always have.  We've come a long way, but we have a hell of a long way to go.


PS.  I don't want to debate the pipeline itself.  There may be other reasons to oppose it.  I am speaking only about how the distribution of its economic effects would affect someone's support.

PPS. (added)  One character of prejudice is that we impose a moral framework on our targets where we would allow ourselves to operate more pragmatically, and we ignore the constraints that our targets have in  meeting our moral demands.  The striking thing about this regarding anti-capital prejudice is that we have this remarkable, real-time measurement of the constraints on capital - the stock market.  A butterfly flaps its wings in Bangkok, and the next day GE stock is down three ticks.  Literally by the second, we can measure the constraints on capital.  So I am blown away by the level of self-imposed obtuseness that leads to those back-of-the-envelope geniuses who figure out that Wal-Mart could raise wages or improve working conditions without losing profits, or better yet, gaining profits.  Can you believe the $280 billion worth of capital trading up and down every second because of those wing-flapping butterflies missed this one?  Stop watching those butterflies, people!  That guy with the dreadlocks, the venti fair trade latte, and the necklace with the artisanal aboriginal pendant that's been out yelling at passersby in front of your store just made you a ton of money.  He's got the basic idea scribbled out on a napkin in his back pocket.  Do this before the guys on Shark Tank find out and steal the idea first!

We are the 100%...

I really want to get back to the housing stuff, but I just have to rant a little more about the current self-destructive mood of this country.  I'm getting myself a little worked up.  I want to go back to William Dudley's speech from yesterday's post:

The expectation of [a "Fed put"] is dangerous because if investors believe it exists they will view the equity market as less risky.  This will cause investors to push equity market values higher, increasing the likelihood of an equity market bubble and, when such a bubble bursts, the potential for a sharp shock that could threaten financial stability and the economy.

Look, lazy cynics (which, frankly, on the topic of finance covers a lot of people) think the Fed sits around watching the ticker tape every day to cover the backsides of Wall Street cronies.  Which, just right off the bat should strike everyone as a %*#($ing stupid thing to believe, coming out of a decade that saw two separate equity market contractions of 50%.  If they are trying to cover the butts of Wall Street cronies, they are pretty freaking bad at it.  So, as one fledging member of "Wall Street", let me go on record and say to the FOMC, if the last 15 years have been a secret attempt by you to line my pockets, please, for the love of Pete, stop.

But, I don't think any serious people think they do this, or that they should do this.  In fact, I don't even think they can  do it.  When you think about it, the inflation hawks are haunted by a spectre of the high inflation of the 1970's because excessively loose monetary policy was not good for capital.

ERP Source

Look at this graph of the unemployment rate and the equity risk premium.  William Dudley thinks it's a real problem if equity holders start investing more in at-risk ventures.  We need to be risk averse, to be saved from ourselves.  He is literally describing a policy where if the equity risk premium falls too low (which apparently is anywhere close to the historic average), it is his job to push the risk premium back up!  Because when prices are high, he says, why that could be a bubble!  He is literally treating one of the clearest signals of optimal Fed policy as a contra-indicator.

But, why stop here.  So many people think we have a bubble now and think the Fed is too loose now.  Maybe we need an equity risk premium of 10%.  Who says that 5% is safe enough?  The S&P500 is up to 2000 points.  That means it has 2000 points to fall.  Maybe we should get that risk premium up to 10%, then the S&P 500 would only have 1000 points to fall.  There would be a lot less bubble risk.

For that matter, we're in the range of full employment.  People could get too used to having plentiful work.  They'll start spending all their wages like the proverbial grasshopper.  It's a labor bubble.  Better to get unemployment back up to 9% or 10%.  It builds character.  You let people see a little sunlight and they just get soft.  They've got no sense.  Save them from themselves.  You've heard of people who grew up in the Great Depression, and to their dying days they hid all their savings under the mattress and refused to spend money on trifles?  That's what a good monetary policy can do.  It's like a structural reform that is built in for a generation.

Even many people who are calling for more Fed accommodation bemoan the booming stock market.  All the gains are going to Wall Street, they moan.  It seems that 90%+ of this country is convinced that success is failure.  Those bemoaning Wall Street's success are wrong in about 1,000 ways.  I will describe two.

First, in an age of heavy share buybacks (which is not a problem), using the published stock market indexes is not a good measure of equity market growth over time.  Buybacks are a return of capital, like dividends, but over time they are accounted for as capital gains, not capital income.  So, historically, equities tended to throw off about 5% annually in dividends, but today, only about 2% is paid as dividends, and the rest goes to buybacks.  (And, no, this doesn't somehow secretly line the pockets of the CEO.  If that's what you think, you've been listening to lazy cynics.)  So, that 2-3% adds to the level of the index, whereas dividends do not.  Here is a graph showing what the S&P 500 index would look like if all cash was still returned to shareholders via dividends.  These are annual numbers, ending in 2013.  At the current level, just above 2000, the adjusted S&P 500 level would be just over 1200, about where it was at the peak 14 years ago.  So, subtracting out the return of capital, which was not significantly different, in total, than its century-long total level, equity owners have not seen any nominal capital appreciation in 14 years!  (But, all the gains in this economy are going to Wall Street!  Right?)


And, secondly, if the stock market is rising because of falling equity risk premiums, then that is literally the result of capital owners demanding less cash in return for their investment.  It's not "trickle down".  It's math.  A low equity risk premium means that the stock market will be higher and that more corporate returns will be going to laborers and creditors.  When (if) the equity risk premium falls, real wages will be rising when it does.  This is true even over the longer term, shown in this graph, which is kind of another version of the first graph, above.

In fact, this graph will probably show up in one of the upcoming housing posts, because this issue with risk premiums gets tied up in home values in an interesting way.  I'm still working out exactly how.  But, clearly homes have pricing behavior similar to low risk, inflation-protected securities.  Home prices have been high when the risk premium has been high.  And, the Fed is treating high home prices as a sign of risk taking!

But, maybe I'm being too hard on the Fed and Mr. Dudley.  These nutty positions are basically consensus positions right now.

A brief rant on monetary policy

I'll take a small break from my housing series today for a rant.

I recently saw the transcript of this speech by William Dudley, President and CEO of the New York Fed. (HT: Tim Duy via EV).  Here is an excerpt:

First, during the 2004-07 period, the FOMC tightened monetary policy nearly continuously, raising the federal funds rate from 1 percent to 5.25 percent in 17 steps.  However, during this period, 10-year Treasury note yields did not rise much, credit spreads generally narrowed and U.S. equity price indices moved higher.  Moreover, the availability of mortgage credit eased, rather than tightened.  As a result, financial market conditions did not tighten.  As a result, financial conditions remained quite loose, despite the large increase in the federal funds rate.  With the benefit of hindsight, it seems that either monetary policy should have been tightened more aggressively or macroprudential measures should have been implemented in order to tighten credit conditions in the overheated housing sector.
Second, during the financial crisis, especially during the fall of 2008, financial market conditions tightened dramatically even as the FOMC was cutting its federal funds rate target to zero.  Monetary accommodation turned out to be insufficient to produce an easing of financial market conditions, and the economy fell into a deep recession.

Later:

The third implication that stems from the fact that financial market conditions matter in the conduct of monetary policy pertains to the so-called “Fed put” with respect to equity prices.  The notion here is that because the Federal Reserve cares about unanticipated and undesired changes in financial market conditions, the Fed will respond to weakness in equity prices by easing monetary policy—essentially providing a put to equity investors.  The expectation of such a put is dangerous because if investors believe it exists they will view the equity market as less risky.  This will cause investors to push equity market values higher, increasing the likelihood of an equity market bubble and, when such a bubble bursts, the potential for a sharp shock that could threaten financial stability and the economy.

So, these are the lessons the President of the New York Fed and Vice Chairman of the FOMC has learned from the crisis:

• Monetary policy was too loose in 2004-2007
• A signal that it was too loose is that long term interest rates were very low.
• Another signal that it was too loose is that equity price indices moved higher.
• Financial market conditions tightened dramatically in 2008, in spite of (I guess) the loose posture of Fed policy in 2007.
• The collapse in 2008 happened because monetary accommodation was impotent.
• The Fed should view low equity risk premiums as dangerous.

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

Here are some Year-over-Year changes in the S&P 500 Index

2004     8.6%
2005     3.0%
2006     13.7%
2007     3.2%

Here are some valuation metrics:
                                     1976-1979     2004-2007
Avg. PE Ratio              11.8 - 7.9       22.7 - 17.4
Equity Risk Premium   4.6% - 6.5%  3.7% - 4.4%
Avg. Inflation Rate     5.5% - 8.3%   2.8% - 2.7%
(GDP deflator)

Higher risk premiums mean lower stock prices, relative to fixed income investments.  Aswath Damodaran at NYU tracks a measure of the Equity Risk Premium.  It has averaged 4% since 1960.  In 2004-2007, it was 3.7%, 4.1%, 4.2%, and 4.4%.  (Higher premiums mean that investors are more risk averse.) Mr. Dudley's memory is quite fuzzy.

Monetary policy wasn't loose in the 2000s.  It was in the 1970s.  The supposed evidence that it was loose in the 2000s is that home prices and equity PE ratios were high.  Here is one big reason why PE ratios are high today compared to the 1970s, even though equity risk premiums are as high now as they were then.  It's because corporations in the US have massively de-leveraged over the past 40 years.

Here's a scatterplot of inflation and the S&P 500 Price/Equity ratio from 1948 to 2007.  In 60 years of post-WW II monetary history, there literally is not a single instance where excessively high inflation triggered high equity valuation multiples.  High PE Ratios are a signal of optimal monetary policy.  I'd expect this sort of error from some gold-bug newsletter.  But, how can the Fed think this way?  Our explicit monetary policy regime right now is to miss the dual mandate.  Equity risk premiums are currently at the top end of their long-term range, over 5%, and Mr. Dudley is poised to hit us sooner and harder if the Fed can manage to bumble into the range of optimal policy long enough for risk premiums to get back down to the long term average.

Just a reminder:  The pressing concern of the Fed even after the Lehman failure in September 2008 was inflation.  They held the Fed Funds rate at 2% in September as a stand against phantom inflation, and then, even after that, began paying interest on excess bank reserves.  The idea that they were pushing desperately for accommodation is quite revisionist.  This revisionism is especially surprising, since Mr. Dudley was the Manager of the System Open Market Account for the FOMC at the time, and said this to the committee at that September meeting:

So I think the consensus view still in the marketplace is that the Fed probably will not cut rates today. That would be a disappointment to a degree because there’s some probability placed on the idea that the Fed might do 50, but that’s how I would interpret what’s priced into the markets today........But I think it’s hard to interpret because it’s really not about 25 versus zero. It’s really about zero versus 50 or maybe even 100 as you look out longer term. Either the financial system is going to implode in a major way, which will lead to a significant further easing, or it is not.

And the response from the FOMC at that meeting was to hold interest rates at 2%.  And now Mr. Dudley says, "Monetary accommodation turned out to be insufficient to produce an easing of financial market conditions, and the economy fell into a deep recession."

The day of the meeting, the Reserve Primary Fund broke the buck.  The next day, the Fed bailed out AIG, the day after that Bernanke told Congress that without TARP we "may not have an economy on Monday", a week later WAMU fell, and two weeks later, the Fed finally lowered the Fed Funds Rate by 50 basis points, but also implemented interest on reserves.  At the October 8 meeting, the revisionism had already begun.  Tim Geitner comforted the committee, "The argument that makes me most uncomfortable here around the table today is the suggestion several of you have made... which is that the actions by this Committee contributed to the erosion of confidence—a deeply unfair suggestion."  And, now that very same Mr. Dudley tells us that there was just nothing the Fed could do.

Statements like this coming out of the FOMC make me very pessimistic about the near-term downside scenario.  If the mortgage market loosens up, long term interest rates should move higher.  In that case, the decline in shelter inflation and the Fed's down-is-up point of view might actually give us a couple of years before the clamps come down.  But, if mortgages don't recover, interest rates will remain low.  And, the Fed apparently will interpret this as a sign of loose money (!).  Now, I think that the economy might be ok with a percent or two of rate hikes, which makes me somewhat sanguine about the immediate damage.  But if real interest rates remain low because of the lack of demand coming through mortgages, and equity premiums manage to drop a little bit in that context, equity PE ratios could get pretty high if the non-housing economy can manage to grow in the face of rising short term rates, and the only way to bring them down will be to destroy some portion of the capital base through monetary mismanagement.  And, apparently, annual returns in equity markets of 3%, 8%, and 13% are signs of a speculative fever to the FOMC.

(Follow up post)

Housing Tax Policy, A Series: Part 5 - Mortgages ARE savings

I've written about how the Mian & Sufi style narrative about debt fueled instability gets it all backwards.  Before, I have noted that increases in mortgage levels were not a sign of unsustainable consumption.  They were an artifact of middle class Americans deferring consumption by investing in real estate.  When a household buys its first home, with say a 20% down payment, they are making a significant saving decision.  In the process, for each dollar they save, $4 of debt are created.  But that debt isn't due to consumption.  It is an artifact of our conventions around real estate ownership.  It's due to saving.

But, in thinking about returns to real estate, I've realized that their error is even worse.  Mortgages aren't just an artifact of saving.  They, in part, are savings.

We think about these things in nominal terms, so we think of the homeowner as capturing capital income on imputed rent.  If he has a mortgage, we think of the claim on that income being split between equity and debt holders.  This split is represented by the interest payment.  So, as I framed it in the previous post, we start with the total return to the home, and then we subtract the interest payment to find the residual return to ownership for the homeowner.

We can see from the graph that there is some distortion in this way of thinking, because the returns to the homeowner are too volatile by this measure.  The error made by this framing becomes more clear if we think in real terms instead of nominal terms.  The returns in the graph are real returns, because homes are an inflation-protected security, with the inflation adjustment coming through rent inflation.

To think of home returns in real terms, we need to think of the mortgage interest rate as having two parts - the real rate and the inflation premium.  The interest payment, then, is divided between a payment for the real cost of credit and a payment for inflation.

So, the real total return is still the total of net rental income to the owner and total interest expenses.  But, to find the true real returns to the owner, we only subtract the real portion of the interest expense.

The inflation portion of the interest expense simply reflects the change in the value of money and assets over time.  Inflation will cause the home to increase in nominal value, which is a capital gain for the owner, and it reduces the real value of the mortgage repayment, and the mortgage provider takes the inflation premium payment in cash.

In national accounts, this is treated as interest income for the lender and interest expense for the homeowner.  But, thinking about it in real terms, that is not an accurate portrayal of the transaction.  In effect, the homeowner has committed to a saving plan, where each year he agrees to purchase a portion of the equity in the house, equal to the expected rate of inflation x the outstanding mortgage, from the lender.  So, this is more accurately portrayed as capital income earned by the homeowner, which is then saved by the homeowner through the purchase of additional home equity, in real terms.

It's important to be clear about the difference in expected earnings and realized earnings.  Clearly this income isn't earned in such a clean, stable fashion.  But, that is a product of the different exposures the lender and the homeowner are taking as the market prices of the mortgage and home fluctuate.  This is about expected earnings and income, not experienced capital gains and losses.

Note that with the current tax treatment of owner-occupied real estate, mortgage financed home ownership has the advantages of both a regular IRA and a Roth IRA.  The contributions (interest payments) are tax deductible and the distributions (realized capital gains) are mostly untaxed.

The Public Policy Implications

Before I move on to look at how this effects the reported numbers, let's think about the public policy implications of the "unsustainable debt" narrative.  It takes as its motivating fact the sharp rise in household debt.

Note when those rises in debt levels occur.  The mortgage tax deduction advantage was created in 1986 and the capital gains tax advantage was strengthened in 1996.  What a coincidence, huh?

But, the narrative interprets this as an unsustainable attempt by low-to-middle income households to make up for stagnant incomes.  These bar graphs show some numbers, by income level (from 2004).  Keep in mind that 35% of households rent.  So looking at the debt levels of these households, by income, we see that essentially the entire mortgage tax benefit goes to the top 50%.  And the bottom half of households hold a very small portion of this debt.  The debt that adds up and makes scary looking graphs like this one comes from upper income households.

I have included the homeownership rate in the line graph, also.  Notice that the tax incentives for mortgages and home ownership don't seem to correlate with higher homeownership.  Homeownership rates did stop declining when the mortgage deduction advantage was instituted in 1986, but it settled at the same level it had been in the 1960s.  And home prices and real estate values also didn't move up after 1986.  Then, homeownership levels increased coincidentally with the new CRA in 1994.  But, note that the homeownership rate had already moved from 64% to 67% before mortgage levels started to increase in the 2000s.  (Don't get me wrong.  I think increased access to homeownership from initiatives like the CRA might be a good thing.)  So, it appears that the increases in mortgage utilization and real estate investment that were related to these tax policies did not result in new households getting access to homeownership.  They simply provided new tax benefits to the households that already owned homes.

And what is the "unsustainable debt/income stagnation" narrative proposal for fixing their misdiagnosed problem?  The proposed solution is to raise marginal tax rates on high income households.

Now, what effect do you think higher tax rates will have on the supposed debt problem?  There will be more incentive for these households to move assets into tax advantaged investments - like homes and mortgages!  So, upper middle class houses will buy larger homes and take out larger mortgages.  And in the New York Times, we'll read articles on the homes of the rich, and how obnoxiously extravagant they are.  And next to those articles will be articles about indebted households and how they just keep getting further and further underwater.  "The system is rigged!", they'll say.  And how could you deny it?  And, I suppose the solution then will be to raise taxes even higher?


The Numbers

First, I am going to compare effective nominal mortgage rates (BEA table 7.12, line 159, divided by Household Home Mortgages Level from Flow of Funds report) to the total return on owner-occupied homes (rental income + net mortgage interest expense / market value of homes).  I will assume that the required real return on the home is equal to the required real return on the mortgage.  Obviously, there are many factors that differ between these two assets, but I think that in the aggregate, it is a decent proxy.  Correcting the 30 year mortgage rate for inflation gives a similar result.

First, look at this relationship.  Until 2007, the inflation premium implied by the difference between mortgage rates and total returns to homes was a decent reflection of inflation expectations.  Based on this long-term relationship, returns to homes were close to their reasonable value (and, thus, so were prices).  It is the relationship since 2007 that is completely off-track.  Starting in 2007, home prices collapsed due to the liquidity crisis, so returns to homes, as a proportion of home prices, have been way too high.  Clearly, it is home prices in 2008-2015 that are out of order, at a much greater scale than home prices of 2005 could have been.

Now, by allocating returns to debt between real returns and the inflation payment (which is a de facto equity purchase by the owner) we can use this information to re-allocate imputed returns on the home between the owner and the lender.  This looks much more reasonable than Net Rent/Price did in the first graph.  We can see that most of the dip in net Rental Income in the 1970s and 1980s was the result of homeowners capturing very large real gains in equity ownership from their lenders because of the high inflation rates of the time.  Then, after 1986, the real gains in equity came from the higher Loan to Value levels, as households took advantage of the tax subsidies.  (At 2% inflation, a household with 40% LTV would only expect to gain 0.8% of equity through their mortgage arrangement.  But, a household with 50% LTV would gain 1%.)

The current proportions are the result of a disequilibrium in the housing market.  Until 2007, I believe that these proportional returns reflect relatively efficient prices.  But, since 2007, home prices have collapsed due to the inoperable mortgage credit market, so homes have been earning higher returns than mortgages have, distorting the share of rental income split between owner and lender.  I have previously taken a stab at real returns to home ownership, with a more simple approach, which also found excess returns to homeowners in the current market.  When I first began thinking about this, I had thought that homeowners earned excess returns in general because of the limited access to home ownership that results from limited access to mortgage credit.  As I work through the data, and think about the details, I am coming to a more detailed understanding of what might be happening here.  I will be getting into those issues in later posts.

So, homeowners are currently capturing equity in their homes through nominal expected capital gains.  It's just not showing up in the graph as a cash transfer to the lender because they are getting it for free.  If the housing market were functional right now, home returns would be similar to those of the mid-2000's. Homes would be earning a little under 3% real returns.  (The lower returns would generally be a function of homes having higher nominal prices than they currently do.)  But, there has been a lot of deleveraging since the mid-2000's, so the owner's portion of the real return to the home would be higher and the lender's would be smaller now than they were in the mid-2000s.  And owners would be making positive payments to the lender for the inflation premium.

Housing Tax Policy, A Series: Part 4 - Real Interest Rates are important

David Beckworth had an interesting post recently, where he pushed back on the Secular Stagnation thesis.  He included this chart:

He attempts to fully pull out both the inflation expectations and the term premium for inflation uncertainty, which has the effect of flattening the 10 year yield over time compared to the yield that only adjusts for inflation expectations.  I'm not sure I'm completely on board, though.  Any time you do a nominal time series that includes the 1970s, that big inflationary hump swamps everything else.  So, everything looks flat compared to the inflation.  But, the real interest rate line here still looks to me like it has a bit of a downward slope.  Even less than a 1% change in a measure that is at such a low level can be significant.  The cyclical noise makes it difficult to see.

He also includes this graph, comparing the 10 year real yield to the output gap.  At this time frame, I agree that there isn't much of a downward slope until 2008.  So, it may be true that there isn't a long term downtrend in real risk free rates.  But, I think there are some interesting patterns here, and I think we can start here for a check on the importance of real risk free interest rates in housing markets.

My attempt at a real risk free 10 year interest rate only goes back to 1969, and it doesn't quite match David's, but it has the same basic shape.  I can get back to 1949 with the output gap.


There appears to be a relationship between the output gap, real rates, and housing returns (these graphs reflect owner-occupant returns only).  This first graph is the comparison of annual numbers.  The output gap and interest rates are very noisy.  So, in the second graph, I compare housing returns to the centered 10 year moving average interest rate and output gap.  This makes the co-movement more clear.

The disconnect between bond yields and home returns after 2007
is due to the very high excess returns going to home owners
currently because access to mortgage credit is so shut down.

It is interesting how much more stable real returns to real estate are than 10 year treasuries (2% has been added to the real treasury yield for comparison in the graphs).  The steep drop in home yields in the 2000s was much less volatile than typical bond movements.  From a volatility point of view, homes should have lower returns compared to long term bonds, based on these numbers.  The factors that lead to this apparent return on investment are part of what I want to think about in this series of posts.

But, here, I think we can see that home prices really do react to long term real interest rates.

Note that in the past 60 years, we did have previous periods where long term rates rose and returns on houses rose with them.  Real home price/rent ratios would have fallen.

I will submit this as yet one more piece of evidence that the 2000s weren't some aberration in history regarding home prices.  This was a normal market.  The new aspect was the tight monetary policy and relatively low inflation that failed to buffer the real capital losses of home owners, which eventually became ruinously tight.  It looks to me like the rate increases in the 1950's coincided with a building boom coming out of the 1940's.  Going into the 1950's it looks like there was a housing surplus because of the swoon in population during the Great Depression and World War II.  As the parents of the baby boomers moved into single family homes, helped by New Deal home ownership initiatives, owner-occupied home building boomed, buffering the drop in Price/Rent.  And again, between 1990 and 1993, according to the Case-Shiller 10 city Index, nominal home prices fell by 8 1/2%.  From 1989 to 1996 there was a 26% drop in Price/Rent.  From March 2006- March 2007, home prices leveled off in a typical way.  A Fed doing its job in 2007 makes this a very different graph.  We have learned all the wrong lessons from this.

I did wonder if this relationship was partly an artifact of BEA imputations.  Capital consumption appears to be generally a function of real estate values.  I think this would be distortionary, because changes in real estate values that are related to interest rate fluctuations would be related to the underlying property value.  The added nominal price would not be a depreciating asset.  I think it would be more accurate to make the capital consumption adjustment proportional to rent instead of price.  In the relationship I outline above, the BEA treatment of capital consumption could cause returns on homes to fluctuate more widely because, as home prices increase, the capital consumption adjustment would also increase, leading to an inflated volatility of measured returns.  So, as a test, I replaced the capital consumption figure used by the BEA with a capital consumption estimate that is a stable 22.5% of rent.

This doesn't change the return profile significantly.  But, it does narrow the range of returns to home ownership a little bit.  In this graph, I have included the returns to equity, the returns to debt + equity, and the returns to debt + equity with the stabilized capital consumption adjustment.  In addition to seeing the small effect of the stable capital consumption this graph also shows how debt captured a much larger portion of housing returns, first from the high nominal interest rates of the 1970s and 1980s, and then because of the mortgage interest deduction after 1996.  (Remember, part of that exchange between debt and equity is a swap of cash income for deferred capital gains, so the sum of the two as the total return on the home is fairly straightforward, but the division of the return between them is complicated.)

The last graph gives more detail to the relationship of major housing tax policies and some housing market measures.  The trends in these measures seem to point to definite effects on the market as a result of these policies.  (Changes in the CRA in 1994 may also be significant, although it appears to have triggered a rise in homeownership rates, but not prices.)  But, we might have expected more generous tax policies to pull down the rate of return on home ownership, and the graphs above don't show an obvious decline in home returns over time, relative to real risk free rates.  But, a 10% increase in home prices from tax incentives would only pull net returns down by around 1/2%.  So, it wouldn't take much of a change in the measured return to homes to create a significant de facto transfer to home owners through tax policy.  I will probably revisit some version of this graph as I think through these factors.

Housing Tax Policy, A Series: Part 3 - Total Returns to Capital is Conceptually Important.

There is so much to consider here, I'm kind of getting strangled in the weeds at the BEA.  I hope to have some follow-up posts soon.  In the meantime, I want to float an idea that I haven't seen addressed elsewhere.

In macro-economic discussions, profits seem to be frequently treated as the return on capital.  But, interest is just as important when looking at returns to capital.  I touched on that here.  Even in finance, we tend to start with the risk free rate and then add an equity premium to that, which, also leads to a viewpoint where debt is a step to take to get to profit.

I have gotten into the habit of looking at total unleveraged return as the baseline value.  Then within that total return, there is a swap where equity holders exchange fixed income to debt holders for a premium.  So, we start with a total return, and the equity premium becomes a fixed income discount.  I like this framing better for several reasons.  One reason is that total return appears to be more stable than equity return, and this framing helps to see how the changing risk free rate is mostly a product of debt holders adjusting the discount they are willing to pay to avoid manageable volatility.


Homes are no different than corporate assets, and the same behavior seems to be in place with them.

The red line in this first graph is the Rental Income to Persons after Capital Consumption Adjustment.  (All of these graphs are for owner-occupiers only.)  This red line is similar to the income I have discussed in earlier posts.  This is real income accruing to households that isn't showing up as compensation, because it represents the profit they gain from being home owners.  The red line is the important line for that analysis.  (edit: Although, even there, the total return is important in the long run.)  But, for analyzing the value of the homes themselves, we should look at Rental Income to Persons plus Mortgage Interest.  This is the total return on the asset.  And, it is much more stable over time.

Here it is shown as a portion of GDP.  Here we can see that the dip in Rental Income in the 1980s was the result of high interest mortgages.  But, this still doesn't quite give us the right comparison, because spending on imputed rent and home ownership rates change over time.  So, we need to look at these returns to real estate capital as a portion of real estate market values.

And, as with corporate returns, here also we find that the total return level is much more stable than the "profit" level.  Here we can see that returns to real estate have remained within a range of 2.5% to 4% of market value for nearly a century.  I think this will be an important reference point for my analysis in this series of posts.


A Difference Between Real Estate and Corporate Assets

There is an important difference between real estate and corporate assets regarding this debt-equity trade.  The main factor in this trade on corporate assets is a risk premium.  When the risk premium is high, more of the return is retained by equity as profit.  When the risk premium is low (interest rates are high, equity premiums are low), more of the return goes to debt as interest.

But, with real estate, both the house and the mortgage are relatively low risk assets.  They both tend to have relatively stable income returns (either through interest or through rent).  Both of those income streams are much more stable than the net income stream to corporate equity.  So the trade here isn't a risk swap.  It's an inflation swap.

But, this gets really complicated, and I haven't completely figured out how this affects reported incomes and production.  The BEA doesn't account for capital gains on existing assets because they are not the result of production.  But, when homeowners engage in this trade, especially in a high inflation context like the 1970s & early 1980s, they are exchanging a cash expense for a capital gain.  That is how net returns on housing (Rental Income) could actually dip into negative territory.  Homeowners were earning returns on their homes that were about as high as they have always been.  But, when inflation was 8%, part of their interest expense was an exchange of an 8% cash interest expense which they paid to the bank, in exchange for ownership of the home, which would provide them with an 8% unrealized capital gain.

With the increasing level of spending on housing and the high inflation of the 1970s, this has been a significant effect on the way incomes are reported.  Maybe it just amounts to a fairly arbitrary exchange between income reported as financial corporate profits vs. capital income to persons.  But, I wonder if stated national incomes are somehow being distorted.  I wonder if there could be some distortion related to this that is coming through the capital consumption adjustment.  I haven't fully wrapped my head around this problem, because it's a conceptually complex exchange through time, mixing changing asset values and income.

Housing Tax Policy, A Series: Part 2 - Outline of the model

<Update:  These estimates are bound to change some more as I continue to review data and concepts.  I am purposefully kind of thinking aloud.  So please check on follow-up posts in the series if you are interested in these estimates.>

Here is the very simple model I am using in excel.

Colored cells are user input.  The model is simple, but I think the implications will be interesting and useful.  I'll walk through it briefly:

Tax Rates: The landlord is my baseline, so these represent tax exemptions for owner-occupiers.  Tax policy, especially in real estate, is complex, so I am open to boot-on-the-ground input on how steep the de facto taxes are for the marginal landlord.  These seem like a good starting point, partly based on some commenter input from the last post.

Rent Adjustments:  Property Tax, Insurance, and Maintenance apply to net rental income for all owners.  Property Tax would be more accurately portrayed as a portion of home price, but putting it here helps me to avoid circularity in the model.  This means that I need to be careful with this measure if I test values much higher than current levels, because I lose some of the feedback loop between taxes and home values by putting it into the formula here.  The Owner Benefit premium is the added value of having control over one's homestead.  The data might steer this one way or another, but I am starting in the ballpark of 30%.  This is in the range of a control premium in a corporate ownership context.  That is a slightly different context, obviously.  Actually, I suspect this premium is very household-dependent.  It is clearly nearly zero for, say, a college student, but could be much higher than 30% for a very high income middle class family.  This is a factor I might try to think through as I move through the issue.

Equity % is the equity percentage of the owner.

I am simply estimating the mortgage benefit based on the aggregate effect.  This would not be very accurate for individual households, since the usefulness of this tax deduction would vary with the size of the mortgage and the tax characteristics of the household.  But, I think it is a decent estimate for aggregate effects.  The Mortgage Interest Benefit comes from the leverage level and the Mortgage Benefit Factor, which will be 0 before 1986 and .06 after 1986.

I am pegging rent at $1,000 per month.  Rent is the baseline figure here, so Price to Rent will be the home price measure that will be most relevant.  Where I use home prices as a comparative measure, they will tend to be adjusted for rent inflation.

Owner Net Rent Value is the net adjusted rent income, either imputed or paid, of the homeowner, after accounting for all the adjustments above.

Capital Gains Usage reflects the ability of owner-occupiers to use the capital gains tax exemption.  I have it set at 25% before 1996 and 75% after 1996.  But, again, boots-on-the-ground input here is welcome.

Owner risk premium is the added return on investment that owner-occupiers would require because their ownership cannot be diversified and would tend to have some correlation with personal risk attributes, such as the local employment market.

The Capital Gains Exemption Premium is a product of the capital gains exemption, the usage of that exemption, and future inflation.

The intrinsic home value (Home Price) is based on a discount rate that includes the real rate, the owner risk premium, and the capital gains exemption premium (which is negative).  I can ignore inflation here because of my assumptions about home price appreciation and inflation expectations.  I have based intrinsic value on the DCF value of 100 years of rent.

The mortgage rate is the sum of the real rate and the inflation rate.

Here is the update of my basic estimates of the subsidies, before digging into the conceptual details of how they might work through the housing market, based on comments from part 1:



The Cap Gains levels are affected by other factors, and I might tend to find
that they are even lower in many contexts where the other specs change.

I am interested in how these factors might influence home owning decisions and home prices.  I will begin to review these issues in the next post.

Housing Tax Policy, A Series: Part 1 - I was wrong. The mortgage deduction is just the tip of the iceberg.

I've been yammering on about housing policy lately.  I referenced this study that claimed mortgage tax deductions amount to nearly $100 billion annually.  Additionally, the capital gains exemption for owner-occupiers is worth probably even more.  But, I have been missing the full implication of the largest tax benefit - the fact that owner-occupiers don't have to claim imputed rental income as taxable income.  I can't believe that I didn't think about what that means.  I'm going to model this out, because I think this is going to be significant.  What I am finding is that this is very complicated, and the magnitudes of many of the implications dwarf the mortgage interest deduction.

To begin, we basically have three tax advantages to home ownership.

1) The mortgage tax deduction.  This became more important after the Tax Reform Act of 1986.  Before that, all personal interest expenses were deductible above a minimum level.  After that, mortgages carried a tax advantage to other forms of debt.  The effect on the housing market is limited, however, because the marginal tax savings only kick in for a household once itemized tax deductions exceed the standard deduction.  Thus, most of the potential tax savings is unused.  The Reason.org study mentioned above references work that puts the effect on home prices of 3%-6%.  In my models here, I am using 3.5%.  That looks about right to me. This amounts to an annual transfer from renters to owner-occupiers of about 0.5% of GDP.  I won't get into this here, but if we broke out households more finely, we would find that within the homeowner group, most of that transfer would be going to upper-middle class households who have mortgages large enough to capture the benefit.  So, an unfortunate redistribution of income, but not a significant distortion in the housing market.


2) The capital gains tax exemption.  This was significantly strengthened in the Taxpayer Relief Act of 1997, which made the availability of exemptions on real estate capital gains much more universal.  I should have concentrated on this more in my previous posts.  I am surprised this isn't more of a focus in general.  Here is a comparison of home prices and homeownership rates in the US.  Note that while homeownership rates seem to have reacted to the 1994 passage of the Community Reinvestment Act, price appreciation kicks into gear in 1997 along with the capital gains tax exemption.

I have been defending home prices in the 2000s as being a reasonable reflection of the effect of low real interest rates.  I might have to walk a little of that back.  (I don't know.  This is going to be really complicated before I'm done.)  But, in general, this does still point to my general intuition that while home prices do react to changing demand from more universal access, most of the change in home prices is a reflection of the changing intrinsic value.

In terms of its effect on the housing market, if we assume a 20% capital gains tax rate and 75% utilization of the exemption, the value of a home increases by about 10% at today's interest rates.  Since owner-occupier rent represents about 14% of GDP, this amounts to an annual transfer of about 1.4% of GDP from renters to owners.

Keep in mind, in aggregate, the capital gains taxes on real estate are largely a tax on inflation effects.  My preference is to avoid this distortion by eliminating all capital gains taxes.  The effect here is to create a dislocation between owners and renters.  And the effect is very sensitive to inflation.  So, even though this effect may have been very strong, the low inflation environment we have been in has greatly diminished this distortion.  The 10% effect on home values is based on 2% inflation expectations.  In a 4% inflation environment, the capital gains exemption would create a 20% price distortion.


3) The tax exemption of  the rent income itself.  As far as I know, this has always been the policy.  This is surely a reason why homeownership rates were nearly 50% even before the mortgage deduction, capital gains exemption, and low income homeownership programs were in place.  In effect, this is the opposite issue that two-earner families face.  If a second parent joins the labor force, there is a tax penalty that arises from the fact that much of the household value that had been provided by a full time homemaker is now filtered through additional household cash income, which is taxable, to payments for child and home care services, which are frequently not tax deductible.  Homeownership is sort of the capital version of labor's household production.  Owning a house allows a household to consume its own production in a way that doesn't trigger a public transaction.

This is a case where it is important to separate forms of ownership (debt and equity) from the returns to the asset itself.  We need to start here with a comparison between a landlord who owns an unleveraged house and an owner-occupier that owns an unleveraged house.  When we keep focused in this way, this is a very simple concept.  Let's assume an income tax rate of 25%.  If a landlord has, say, a $300,000 house that has a market rental rate of $1,000, then his post-tax monthly return is $750 on that property.  Since an owner-occupier doesn't pay that tax, she would be willing to pay 25% more for the same property.  At those different prices, both home owners - the landlord and the owner-occupier - would be earning the same after-tax return on investment.

Now, I know, there are costs to owning the home that need to be deducted from the rent, etc.  I will make these adjustments as I work through this issue.  But, I think the value of this factor is pretty clear.  And, unlike the mortgage and capital gains tax factors, utilization does not mitigate this factor.  For most households, if imputed rental income was taxable, their taxes would rise with the first marginal extra dollar of income.  This factor is nearly 100% utilized.

If we assume that all homes are fully owned with no leverage, a model of home values that accounts for costs of ownership, with a 25% income tax rate, ascribes a 20% increase in the home value due to this factor.  That amounts to an annual transfer from renters to owners of about 2.9% of GDP.


The relationship between the income exemption and the mortgage tax deduction

This is where the mortgage tax deduction comes into play, and before I have thought through it this way, but I hadn't fully appreciated the value of the income tax exemption separate from the mortgage deduction.  A cash homeowner receives the full advantage of the income exemption.  But, if we assume that a homeowner is fully leveraged 100% on a home, with a perpetual interest only loan in a zero inflation environment, we can imagine that they might have $1,000 in monthly income that is untaxed, but also $1,000 in monthly interest expense that is not deductible.  They would have no net benefit from homeownership.  (Differences between rent expense and interest expense for actual homeowners are effectively a product of inflation and duration exposures they are taking due to the different characteristics of the mortgage and the home.)

So, in an economy where household real estate is leveraged to roughly 50% in the aggregate, this means that owner-occupiers claim roughly 50% of the income exemption benefit - which would account for a 10% increase in intrinsic home values and a 1.4% of GDP annual transfer from renters to owner-occupiers.  The mortgage tax deduction is, effectively, a way for leveraged home owners to also capture this benefit.  But, since the utilization of the mortgage deduction is so low, leveraged home owners only capture about 1/3 of the benefit.  (As stated above, the mortgage deduction might increase home values by 3.5%, compared to my estimate of an additional 10% increase that homeowners would see if they had 100% equity instead of 50%.)

Here is a summary of the effects.  (Keep in mind that these are broad estimates, which interact with one another and also change slightly in scale as interest rates and other assumptions change):

The capital gain exemption is proportional to expected inflation.
(assumed to be 2% here)

<**Edit: Vivian Darkbloom has talked me down a bit in the comments.  After considering her input, I would revise these numbers to: 3% + 5% + 7% = 15% of home values and 0.4% + 0.7% + 1.0% = 2.2% of GDP.  The Cap Gains numbers may still be high, but for a number of reasons having to do with the relationships of the factors in the model, the effect on the modeled price is higher than the effect we might estimate simply by accounting for this year's expected real estate gains.  This factor may turn out to be lower in many contexts.>

<Edit #2:  These estimates are bound to change some more as I continue to review data and concepts.  I am purposefully kind of thinking aloud.  So please check on follow-up posts in the series if you are interested in these estimates.>

Over the next few posts, I expect to show that the actual increase in home values may be much less than 23.5%.  But I expect to demonstrate that this transfer to owner-occupiers exists regardless of the total effect on nominal home prices.  The conclusions I have reached so far have been pretty shocking to me, and I may continue to be shocked as I work through the models to complete the remaining posts, so my conclusions may differ from what I currently expect.  (I am proceeding as I work this out, so you might see my errors as I proceed.  And, this will get complex enough that I might end up reaching the limits of my analytical tools.)  At the point where I am in my analysis now, I believe that if these factors are not manifest in higher nominal market prices for homes, then the potential increase in home values coming out of these policies is a sort of risk-adjusted deadweight loss on our economy.