Recession watch: Attribution error and inadvertent self-flagellation as policy and social norm

Here is a scary looking graph.  (HT: NickatFP)

Leverage is out of control, apparently.  We need some macro-prudential oversight, it seems.  This is a pretty common worry, and the comments at the link, as of now, are pretty common too.

"well rates are so low why would you not?"

"This is not going to end well."

Even the apologists seem to accept the premise.

"doesn't seem too worrisome, optimal capital structure altered by rate enviro. Not overly leveraged, could raise equity if need b"

Even though we've been hearing for years now that corporations are using low interest rates to leverage up, nobody seems to notice that leverage, according to this measure, has been very low for years while rates have been low.  Attribution error and confirmation bias are strong enough not to notice that this graph tells an improbable tale of corporations suddenly increasing their debt levels by 50% over just a few months after being very tepidly leveraged for a decade.

It is true that huge spikes in leverage appear to presage contractions.  On that I can agree that this chart is useful.  If we take a deep breath, though, what we see is a relatively flat level of leverage through the 1980s.  Then, at the onset of the 1990 recession, leverage shot up.  It moved back down to that typical level of about 1.2x EBITDA until it shot up again during the internet boom, with a second spike in the 2001 recession.

After that, leverage fell to practically half the 1980s levels, after which it moved back to about 0.9x.  Then it spiked again during the 2008 recession.  Then it dropped again, first to about 0.8x, then recovering to about 1.0x, before the recent spike to 1.6x.

Source

What's going on here?  What's going on is that debt levels are a pretty boring, stable factor, but profits are volatile and dependent on nominal national income levels.

What we are seeing here aren't surges of debt.  We are seeing collapses in profit.

The first graph here compares corporate debt ("credit market instruments") to corporate equity values.  The second graph compares corporate debt to corporate profit.



Source

In every case where leverage surged, it was falling profit that was causing it.  What causes profit to fall sharply?  This is almost entirely a monetary phenomenon.  Other factors, like debt levels and income shares, tend to evolve at a glacial pace.

So, every time nominal incomes start to disappoint, the first incomes to be affected are profits.  And, when this causes leverage to rise, the broad response is, "Oh, look.  Corporations are taking on too much risk.  This is going to be bad.  We better pull back the reins before they go any farther."

Is it possible to find a middle ground, where we counter softness in corporate profit without leading to high inflation, like in the 1970s?  I don't know.  What I do know is that what we are doing is a misidentification and a mistake.  The question here shouldn't be, "How hard do we pull back?"  The question should be, "How much can we accommodate before we risk inflation?"

The questions that guide policy now aren't even pointing in the right direction.  This was catastrophic in 2006-2008.

This is one of the advantages of NGDP level targeting.  It naturally pulls us in the right direction.  Not because it is some brilliant and difficult targeting scheme, but because it keeps us from doing so much damage.  It's like investing with passive rebalancing.  Literally doing nothing is better than what you would have done if you were trying to pay attention.  There isn't anything incredible about passive investing.  It effectively trades you a bottle of water for the Molotov cocktail you were reaching for.  If that is a benefit to us regarding our own hard-earned money, imagine how much we need it regarding our public positions about what other people are doing with their money.



We don't need a wall. The solution to too many immigrants will include more immigrants.

It is ironic that in 2016, it is the anti-immigration candidate who won the surprising election.  Immigration has been dead for a decade.  The unavoidable irony here is that animus toward immigrants will always tend to happen when there aren't many immigrants.  That's because economic stress is the root cause of that animus, and immigrants aren't particularly attracted to places with economic stress.

If you work in a working class industry and live in a town where 2% of the population are immigrants, and the local economy is stagnant, you are apt to see the immigrants as disruptive competition.  If that same town was thriving with an 8% immigrant population, you would be less likely to be concerned.  This is one of many reasons why growth is fundamentally important.

We solved the migration problem in 2008 by killing the economy.  It was a bipartisan effort, and it was very successful.  On one side of the aisle or the other, we made sure that mortgage originators failed, that MBS defaulted, that middle and lower-middle class households didn't have access to mortgages any more.

In any case, we succeeded in killing the economy.  And, we can see the effects from IRS data.  This is data that measures migration and adjusted gross income, from tax returns.  Here, we can see that immigration collapsed after 2008.  (Closed Access cities are California and Northeastern urban centers.  Contagion cities are the "bubble" cities.  Open Access here refers to the rest of the country.)  The concern about immigration that Donald Trump has tapped into is related to this collapse.  The same stresses that have caused migrants to stay away cause the few that remain to especially meet anger.

Here is an estimate of the average incomes of immigrants.  We can see here that the collapse was mainly focused on low income immigration.  High income immigrants still come, especially to the enclaves in California and the northeast.

Dark lines are in-migration.  Light lines are out-migration.

The same has happened within the country too.  In-migration rates tend to be fairly stable, but migration in general has fallen across the country - especially in the Contagion cities.

Until 2006, the rest of the country was building houses for the Closed Access households who had to leave for want of housing.  We closed that avenue down, and it has continued to remain closed down for a decade.

And, here's what has happened to incomes in the meantime.  Between that first graph of immigration levels and this last graph of relative earnings, is there any question about what the true source of stress is regarding feelings about immigration?  The Closed Access areas went for Clinton and most of the other areas went for Trump.

The way to reduce anxiety about immigration is to help all of the parts of the US develop economies that will attract more of them.

I harp a lot on the problems of limited housing in the Closed Access cities.  But, the story these graphs tell says that the damage we have done to ourselves since 2005 is worse than the damage the local Closed Access policies were inflicting on us.  The Closed Access cities imposed deprivation on us, and we responded to that deprivation by adding more.

By analogy, it is like a drought caused rice prices to soar, and we responded by salting the fields in order to prevent greedy new homesteaders from getting in on the rice craze.

None of this requires detailed debates about economic policies or programs.  We get most of the way there simply by not salting the fields.  We need to go back to 2005.  In 2005, we were in the midst of a long-term drought in housing.  If that drought bothered you, then we solve the drought by fixing policy in the Closed Access cities.  In the meantime, let's stop salting the fields in Topeka and Columbus and Charlotte.  The big giant red flag in those cities has been the collapse in mortgages and homebuilding and the collapse in home prices at the bottom half of the market, where they had never really been excessive, in those cities.  Let's stop salting the fields.  If, after we do that you're still bothered by the effects of the drought, then, sure, let's fix that problem.  In the meantime, let's stop salting the fields.

October 2016 Inflation

I am a bit frozen in place as to whether we are looking at a bullish continuation or a bearish turn.  Rising treasury yields are a good sign, both because they suggest an improving economic outlook and because they imply a passive loosening of monetary policy in a way that the Fed seems not to usually counter in real time.

On the other hand, the inflation doomsday scenario is building, as the Fed talks up rate hikes while non-shelter inflation falls to well below target.  I'm a bit surprised that long bonds have been as strong as they have been.

My suspicion is that we will tend to see a lot of sideways movement across asset classes and that sometime during 2017, yields will turn back down if the Fed continues to read shelter inflation as a monetary phenomenon.

The divergence between shelter and non-shelter inflation continues this month.  In five of the last six months, Shelter inflation has been over 0.3% and non-shelter core inflation has been under 0.1%.  The CPI now lists unadjusted year over year core inflation at 2.1%, consisting of 3.5% shelter inflation and 1.2% non-shelter core inflation.

A reminder that loyal readers probably don't need at this point - most shelter inflation is imputed and has nothing to do with cash transactions.  We are tightening monetary policy to counteract a price level that probably has little to do with monetary policy and much to do with supply.  Supply of this particular asset tends to react positively to monetary and credit expansion.  At this point, I don't think housing starts are particularly sensitive to interest rates.  But, inflation would be helpful in continuing to raise nominal home values and incomes, to help heal the damage we have wrought on the bottom half of the housing market and rebuild equity.  (Note, this isn't because rising prices are always good.  This is because prices where they currently stand are unusually low because we inflicted a credit crisis on the low end of the housing market that pushed implied yields on investment up for the few investors who could tap into the market.  Advantages of home ownership include both the natural advantages of control and arbitrary tax advantages.  The tax advantages largely accrue to the high end of the market, and control advantages accrue more strikingly to the low end of the market.  We have perversely created a post-"bubble" housing market that has maintained the high end tax advantage while undermining ownership at the low end, and this is reflected in relative prices.)

If homebuilding drops a bit, it will be blamed on rising interest rates cutting into demand.  I declare this, pre-emptively, to be a spurious correlation.  That actually gives me some hope, because if the regulatory obstructions to mortgage lending can be loosened a bit, then in this battle between the neutral rate and the inadvertently hawkish Fed, the neutral rate might have a chance to get out ahead of the curve, and then I think we would see rising interest rates, an accelerating homebuilding market, and a rejuvenated recovery.

As a speculator, I think it would be easier to position for a predictable Fed over-reach, but as a citizen, I'm pulling for the more complicated potential for a recovery, despite ourselves.

Housing: Part 187 - The solution to our problems is urban

I've seen several articles suggesting that, instead of expecting workers to move to urban areas for employment, we should be providing more support in areas with stagnant labor markets - jobs programs, social services, etc.  It isn't just people that are struggling.  It is places.  And, depopulating those places doesn't solve that problem.

It's a compelling point of view, and would that it were so.  But, I'm afraid it is unrealistic.

Imagine the previous period of urbanization, when technological advances in agriculture reduced agricultural employment, freeing up those workers for other productive activities and creating the dislocations that always come with growth.  The technological era of mass production meant that the new jobs were in the cities because production was centralized.

It didn't have to be that way.  It was determined by our technological context.  If communications had been the next wave of human innovation, maybe those former workers would have stayed in their little towns and would have worked on semaphores scattered across the countryside.  But, in the world where we lived, centralized mass production arose as the path to progress.

What if we had taken this position during that phase of urbanization?  What if we had agreed that tenements filling Manhattan island had more downside than upside, that the stresses of urban life were worth avoiding, that the way to approach falling agricultural employment across the country was to support those towns and work on policies that would bring jobs to those areas?

Can we all agree that this would have been a disaster?  That the results of this policy would be very similar to the stagnation and frustration that we see across the country today?  The available policy choices for a nation are those choices that fit the technological context that we have.  Ignoring that is costly.  Norway could decide tomorrow that the negative externalities of fossil fuels are too great, and that they can't justify taking income from that sector anymore.  Maybe you agree with that assessment.  But, we can all agree that if they made that choice, Norway would pay a high price for it.  It would be a mighty sacrifice.

Today, the globe is undergoing a new wave of urbanization.  I attribute this to the combination of two factors.  First, the frontier economic growth of developed economies is coming through highly networked and highly skilled information workers.  These workers clearly gain great value from being located in tight geographic clusters.  Whether this is expected or surprising is beside the point.  Their choice of location and the evolving prices associated with those locations are stark empirical confirmation of this development.  The fact that practically all the major new tech. firms are headquartered within a few miles of one another is not an accident.  There is no fear that Goldman Sachs will be moving their headquarters to Cincinnati in order to save on costs.

Second, the transition out of manufacturing, due mostly to automation, but clearly associated with the rise of developing economies, is leading to a transition into new sectors.  These generally are the non-tradable sectors - local services, construction, health care, etc.  These sectors have to be centralized, not because production is centralized, but because they have to be near their customer base - by definition, really.  And, the customer base happens to be this subset of information workers who do happen to be highly centralized.

Again, you can debate the cause as I have outlined it here.  But, the rise of a handful of cities where those centralized sectors are located and the extreme costs workers are willing to accept to be within commuting distance of them, tell an extreme story that must be true, regardless of the details that fill it in.

This wave of urbanization is pressing up against a political framework that has evolved which is not capable of accommodating high density development.  We have put roadblocks in front of the path to progress.  This has not been the product of a conscious public conversation.  Citizens in Pittsburgh and Cleveland didn't vote on referenda where they agreed that the downsides of urbanization are too great, and it would be preferable to take a second-best path toward a different technological solution.  The current equivalent of funding a semaphore network.

In effect, what has happened, just because of an accident of politics, is that the citizens of New York City, and Boston, and San Francisco, and Los Angeles (and London and Toronto and Sydney...) have decided that they like their cities just the way they are, thank you very much.  Modern democratic polities have increasingly evolved to accommodate these demands.  They vote for the pros that come from stability.  And, they happen to capture economic rents that come from stagnation where you get to be grandfathered in to the prime location.  (Of course, the millions of workers from the most economically vulnerable households who have been forced to move out of those cities over the last couple of decades don't get to share those gains.)  Americans in Pittsburgh and Cleveland suffer the externalities.  They are denied the natural salve that would moderate their economic dislocations - the ability for some portion of the community to migrate to places with more opportunities.  This is a human right and a process that is ancient.  It predates humanity itself.  It was, in fact, a factor in the creation of humanity.  More than ever, the free migrations of birds and caribou and butterflies are sacred to us, but not those of our fellow humans.  Sure, we argue about the right to cross that line that runs along the banks of the Rio Grande.  We need to address the line that surrounds San Francisco and New York City.  The first step is seeing the line.

And, consider the families who have been most exposed to the dislocations of today's technological shift.  They are stuck between that line along the Rio Grande and the line around the northeastern and Pacific cities.  Is it any wonder that they are mad about trade and immigration?  If we actually had a universally consistent policy in favor of the right to migrate, they wouldn't be so mad.  They have selectively been forced to take on the negative externalities of these accidental restrictions on freedom.  And the collective response of many of the citizens of those enclaves of economic privilege is to march and protest, to label those people who are locked out of their cities as sorts of heretics because of the forms of their frustration.

We could choose, like the hypothetical Norwegians, to sacrifice for some higher cause.  What exactly is the cause?  That a few lucky real estate owners get million dollar windfalls while the screws turn ever tighter on renters?  That the highest income workers get an income boost because there is a moat around their cities that prevents potential upstarts from competing?  That the little shady suburb full of $2 million dollar cottages doesn't have to have that 20 unit condo building next to the train station that would just totally ruin the local vibe?  That the 200 unit skyscraper downtown would charge market rates that offend our sensibilities?  (By the way, what a strange phrase - "market rate" - to describe the price of a new building that amounts to about 1/3 actual construction costs and 2/3 fees, kickbacks, taxes, etc.  Interesting how that phrase creates a sort of rhetorical lie that buildings sell for three times their cost because of the market.)

What exactly are we sacrificing for?  There isn't another choice here.  We either sacrifice or we urbanize.  If we deny ourselves the benefits of the natural technological pathway that lies before us, we give those gains up.  There isn't some nearly equivalent alternative.

And, let's not act as boiled frogs here.  There are a few cities where incomes are much higher than in the rest of the country.  This doesn't happen naturally.  There are significant patterns of migration away from those places.  Human beings don't behave this way without coercion - even if that coercion is unappreciated and hidden in a complex set of political restrictions.

What would a trade war look like today?

One of the many risks of a Trump presidency is a disruption in trade.  But, in thinking through the issue, I can't quite imagine what would happen in today's context.

The large trade deficit today is peculiar.  Part of the reason it is so large is that many of our most productive corporations operate in frontier information and financial sectors that don't involve the movement of goods across a border.  So, if Google makes a profit in Australia, it is more likely to register as the revenue and profit of a foreign subsidiary than as an export.  Part of the trade deficit is simply the result of this semantic distinction.

But, the trade deficit is the mirror image of the capital surplus.  We send a lot of dollars overseas to buy goods, and instead of using those dollars to buy goods from the US, foreigners save a lot of those dollars and invest them in the US.  Funny thing is, though, after decades of this - after trillions of dollars of excess investment - the income US investors make on foreign investments outpaces the income that foreigners make on their US investments by a wider margin than ever before.  Foreigners are running to stay still, at best.

I think the reason for this is that the US has many global corporations who are earning above market returns.  (I have come to attribute that to the role of urban housing in the information economy, but that's a complicated story.)  Whatever the cause, the implications of this are interesting.  US firms are reinvesting our foreign profits in high return operations.  If we reinvest $100 billion that will earn 10% returns, then if foreigners can only earn 5% returns, they have to invest $200 billion in the US just to maintain a stable net international capital income.

This is why we have a sustainably large trade deficit.  Foreigners have to keep selling us stuff in order to maintain a capital income.  If they stopped selling us stuff to invest it, our net foreign income would balloon, and our firms would end up owning an accelerating portion of their capital.  Currency values, interest rates, trade levels, etc. adjust to an equilibrium that draws foreign capital to the US.

So, given this context, what would happen if the US imposed a policy with the aim of reducing the trade deficit?  The causal factor for the deficit - the need for foreigners to save - would not go away.  It wouldn't be that difficult for foreign markets to enact tariffs, etc. to instigate a trade war.  But, they would need to stop our corporations from getting revenues through their foreign subsidiaries.  That is a little more difficult and intrusive.  It would involve some sort of capital repression, nationalization, etc.  Would they be willing to go that far?

If they didn't go that far, and there was still pressure to gather dollars in order to invest in US assets, then what would give?  Would the trade deficit remain, and US tariffs would end up being a revenue source for the US government, with little effect on trade?  Would production move back to the US?  If it did, and the trade deficit declined, then would our foreign assets and income balloon?  Would the dollar rise in value?

I'm having trouble imagining all the moving parts.  Anybody have any ideas?

The Real Anti-Immigration Party

Just a friendly reminder that those voters marching against the anti-immigration President-elect live in states that have forced, on net, more than 3 million of their own residents out over the past decade - generally the poorest and least educated.

These are, across the board, our richest, most aspirational, cities, and they have already built magic walls around themselves that only allow in the educated and most well-off residents from the rest of the country.  Everyone else is locked out of their economic fortresses while soaking up those 3 million housing refugees.

Oh, look, now the folks in the Capitol are upset about the lousy attitudes of the proles out in the districts.  How precious.

JOLTS, Sept. 2016

It's been a while since I posted JOLTS data.  Generally, the data continues to follow the pattern of an aging recovery.  I continue to believe that we are at a place where monetary policy can be important.  If the Fed pulls back too much, we will contract.  If they accommodate rising wages, then recovery can continue for a long time.

I think the association of rising wages with inflation is a virus.  Wages are rising because a healthy economy reduces the frictions that allow firms and workers to adjust and shift.  If corporate profits are leveling off while wages rise, then monetary policy needs to accommodate enough nominal activity to prevent corporate profits from falling enough to disrupt these healthy economic trends.  If that becomes inflationary, then we can moderate, but to pre-emptively pull back is going to trigger contraction by cutting into corporate profits.

The election has presented a bit of a surprise, though.  I have been focusing on monetary policy because I assumed no relief was going to come to the mortgage market from GSE expansion or regulatory easing on the banks.  After everyone took a deep breath last night, Trump didn't act like a monster when he gave his speech, and markets rebounded this morning.  Banks are up in the 5% range as I type this.

Could it be that Trump will govern as a sane person, and that also some of the Dodd-Frank regulations that have cut low income households out of homeownership will be retracted?  I don't have the feeling that Trump explicitly understands the connection between the banks and the condition of his rural voter base.  But, he does seem to have a bias toward lighter banking regulations.  Does this mean that we will meander our way into finally healing the housing market?

The yield curve has also steepened significantly today.  Up by 25 basis points or so at the long end of the Eurodollar curve.  This is exactly what I would expect to happen if mortgages were going to expand and the housing market was going to heal.

Wouldn't that be funny if Trump ended up being our rescuer?

Housing: Part 186 - Where do credit constraints kick in?

Building on the last couple of posts, I want to think a little more about the idea of credit constraints and how they can affect prices.

In sort of the same vein as Scott Sumner's frequent complaint that it seems like in 2007 everyone suddenly forgot all the macroeconomics that they had learned over the previous 50 years, it seems to me that some basic finance has been forgotten, too.

Given a certain market rate of return on highly liquid at-risk assets, investors seem to be able to earn excess returns over time for holding assets with similar risks, but with less access to ownership or less liquid markets.  Price is the inverse of yield.  So, small cap stocks, assets which cannot be easily purchased on liquid markets, small private businesses, etc., tend to sell for lower prices (higher implicit expected returns).  This is why back-testing might suggest higher risk-adjusted returns in some alternative asset class, and then when the financial sector responds by creating a bunch of ETFs and other mechanisms that provide access to that asset class, the returns disappoint.  Once the asset class becomes liquid, it loses its excess returns.  This is a common problem in finance.  Return anomalies frequently disappear after they are exploited.

So, traditional models of finance would predict that, once all factors are accounted for, owner-occupied housing should have a higher rate of return than investments with similar risks, because there are obstacles to ownership.  As those obstacles are removed, required returns will decline to normal levels, providing a temporary price boost, and leading to future returns more in line with similar assets.

Most neighborhoods were never credit constrained, so taking the general context of housing markets as a given, those neighborhoods would reflect equilibrium prices without an additional liquidity discount.  In neighborhoods that are credit constrained, we might expect lower prices.  And as those constraints are lifted, as they might have been in the 2000s when new mortgage products were widely marketed, we might expect those prices to rise to levels similar to the neighborhoods that were never constrained.

There is no reason to believe that the new price levels will be above a reasonable level.  That is the case, even if the removal of credit constraints causes low priced homes (presumably more credit constrained) to rise more than high priced homes.  Our presumption should be that access to credit makes the market more efficient, not less.

Zip code level rents in 1998 and 2006 are inferred
from MSA median rent changes for years before 2010

Here are graphs of Dallas and Los Angeles, comparing home prices and price/rent ratios, by zip code, over time.  It seems logically unassailable that credit access would have something to do with rising prices in the expensive cities.  Yet, if that was the case, I think we should see the slope of these relationships flattening.

Instead, Dallas shows little change at all.  Los Angeles, which has a pattern similar to the other Closed Access cities, has rising Price/Rent at the top end of the market.  This naturally pulls prices higher, pulling all P/R levels up along with it.  The slope of the relationship doesn't change much.  It's just that all zip codes kind of climb the P/R ladder as prices rise in general.  In both Dallas and Los Angeles, P/R stops rising around $400,000 or so, suggesting that this is related to the ability to capture tax benefits.

When I create the same graph with incomes on the x-axis, however, we do see a pattern that suggests credit expansion.  In low income neighborhoods, the P/R ratio did rise slightly more than in the high income neighborhoods, in Dallas.  In Los Angeles, it rose substantially more.  By 2006, the slope of relative P/R by zip code income had flattened substantially.

In San Francisco, where all zip codes had reached that $400,000+ range where Price/Rent seems to flatten out, the P/R trendline completely flattened out by 2006, even going slightly negative.

In Boston, where top end valuations didn't move that much during the boom, the rising P/R levels at lower incomes show up clearly, too.

I think what we are seeing here is the difference between the extensive margin (new buyers) and the intensive margin (spending among existing buyers).  I have shown that there was much less correlation between rising homeownership, non-conforming mortgage growth, and price increases than it seemed.  Most of the rise in ownership came before the unusual rise in prices, and the rise in non-conforming mortgages was actually associated with a sharp decline in homeownership.  Homeownership peaked in early 2004, just when the big jump in non-conforming loans was getting started.  By 2006, and especially by 2007 when prices began to really tumble, homeownership was on its downward path.

Yet, clearly, when looking at zip codes by income, there was a strong rise in prices, negatively correlated with incomes.  All of this together suggests  the bulk of the expansion was at the intensive margin - higher prices and more debt even though ownership didn't seem to be expanding in these areas.

But, even here, the data balks.  There isn't evidence in the broader survey data, such as the Survey of Consumer Finances, of an unusual rise in debt levels of households in the mid and lower income quintiles.  And, the most extreme peculiarity about the cities where low income zip codes had the largest price increases is that, during that time, low income households were moving away from those cities by the hundreds of thousands.  Such a strange juxtaposition.  A massive outflow of households from the places where home prices were rising the most.  Where was the demand coming from?

It seems clear that, to some extent, changes in population composition were important.  But, in the end, I think it may be a distraction to think of this through a supply and demand framework.  What caused what?  Who was buying, and how much money did they have?

As I mentioned in the previous couple of posts, intrinsic value rules.  And, this is where these Price/Rent to Price Level graphs come in.  What caused the rise in prices?  Supply constraints?  Migration patterns?  Expansion of credit access?  These all probably played a part.  But, when we note this relationship between P/R and Price, we don't actually need a special explanation for why low priced homes increased by more than high priced homes.  Anything that leads to rising prices will trigger this positive feedback effect.  Whatever the root causes of rising prices, those causes simply became strong enough in the Closed Access cities to make this effect noticeable.

Because what started me down this path was noticing the lack of evidence for mortgage growth and homeownership among low income households during the boom, I have tended to be more amenable to the passive credit school (the school of thought that believes credit expansion was more of an effect than a cause of the housing "bubble").  But, I think that is really the wrong question to ask.  And, since it is the wrong question to ask, it leads both passive and active credit proponents to the wrong conclusions.  They mostly disregard rent as an input to price, which seems defensible because prices were so volatile while rents tend to change slowly.  So, prices, almost by definition, reflect irrational expectations.  (If you disregard the sole source of income for a financial asset, by what basis could you even construct a rational model?)  Then, they end up just arguing about whether it was mostly low income buyers, flush with new credit, who were irrational, or whether everyone was irrational.

Intrinsic value rules.  What actually happened was that the market was ruthlessly rational in spite of us.  Intrinsic value pushed these prices up that P/R ladder as the various influences on rising prices in the Closed Access cities became increasingly extreme.  The only way we could have prevented this from happening would have been to implement extreme economic dislocation and financial repression.  Oh, look!  That's what we did!

If we pull the fetters off the mortgage market without fixing the Closed Access supply problem (or, alternatively, getting rid of the corporate income tax* or the owner-occupier tax benefits) low priced homes would naturally start climbing that ladder again as those markets heal.  This would finally begin to heal the balance sheets of working class homeowners who have survived all that we have imposed on them.  And, I don't see how that will happen without leading to a new chorus for macro-prudential regulations or monetary suffocation to shut it down.


* The largest owner-occupier tax benefit is the non-taxability of imputed rent.  It seems to me that the most feasible way to eliminate this relative benefit would be to eliminate the corporate income tax.

Housing: Part 185 - the phases of the bust

 I want to look at the graph from yesterday's post some more, because I think that graph highlights the turning points of the housing bust well.

We can roughly divide the period into 6 sections:

1) Normal market, with Closed Access supply problem.

2) GSEs and FHA in decline while private securitizations rise.  Since the GSEs and FHA tend to serve first time buyers, this exchange of market share coincided with a decline in homeownership.  But, private securitizations, probably helped by both a loosening of regulations regarding marginal lending and by the decline in the public conduits, grew to take their place.  The less stringent limits on terms for the private securitizations allowed home prices in credit constrained markets of the Closed Access cities and Contagion cities to rise, though these loans were generally to households with high incomes.  The change during this time was in the terms, not in buyer incomes.  So, even though homeownership was beginning to decline, price increases during this time were at their strongest.  First time buyers were as strong as ever here, so we can presume that tactical selling out of ownership was strong.  During this time, there was strong out-migration from the Closed Access cities - weighted toward low income households, but not necessarily weighted toward renters.  During this period, there was probably some profit taking among existing homeowners in the Closed Access cities, who, because the private securitization boom was pushing their home prices up, were incentivized to take capital gains, even where they had been enjoying artificially low property taxes.

Researchers like Mian & Sufi write about a transfer from high wealth to low wealth households, but in a lot of ways, wealth is a proxy for age.  If we think in terms of income, migration data from this period suggests that there might have been some profit-taking among low income households.  I suspect there was a bimodal distribution of migrants - poor renters forced out and low income owners taking profits - both induced by an expansion of housing consumption among young, educated, high income workers in the Closed Access cities, which was made possible by the lenient terms of the private securitization market.

3) In the spring of 2006, the Federal Reserve intentionally pushed the Federal Funds Rate high enough to slow real housing growth.  And they succeeded royally.  Mortgages held on banks' balance sheets had been strong, helping to counteract the relative decline in GSE and FHA lending, but banks predictably reduce lending in the face of an inverted yield curve.  We can see the effects of this policy choice.  So, at the margin of the market - new home sales - we see a sharp drop.  New home buyers were still relatively strong, however.  The continued entry of first time buyers begins to cause leverage to rise during this time, as the wave of tactical selling builds from existing homeowners exiting the market.

4) By 2007, the number of first time buyers begins to drop, but the exit from ownership continues.  This causes new home sales to fall even farther, and home ownership rates really begin to fall.  But, intrinsic value rules.  Rent inflation was rising sharply, and home prices remained near their peaks, because intrinsic value dominates supply and demand in asset markets that are not in disequilibrium.

5) In late 2007, disequilibrium hits.  Both buying and selling dry up.  Notice that the homeownership rate levelled off somewhat in 2008 despite the drop in first time buyers.  Tactical selling was strongest when prices were high.  That stopped after prices began to drop.

6) In late 2008, the GSEs were taken into conservatorship and the banks were in disarray.  The GSEs severely tightened credit standards, to widespread approval.  The Fed finally fully committed to stability.  So, prices and sales finally bottomed out and stabilized.  But, because the stabilization was targeted at the high end and left the low end out, the apparent stabilization of the housing market was a bit of a mirage.  This period was the worst period for the bottom half of the housing market.  And the continuing drop in homeownership was concentrated at middle incomes and the bottom.

Keep in mind that homeownership to begin with was already 80% to 90% for the top 40% of households, by income, so the rise in ownership among those groups, as a proportion of existing non-owners, was much stronger than in lower income groups.  And, today, compared to 1995, ownership rates are lower for the low income groups and higher for the high income groups.  We gave low income households a bust when they never had a bubble.

These last charts are annual changes in median home prices, by zip code (from Zillow Data).  Zip codes are arranged by price on the x-axis, on a natural log scale.

Across many cities, the same pattern developed in 2008 and 2009.  The aggregate market appeared to have stabilized, but we removed liquidity from the bottom half of the market.  The number of defaults that happened during this period is many, many times the number of defaults that had happened before the subprime market collapsed in 2007.

Housing: Part 184 - Intrinsic value trumps supply and demand

A common way of thinking about asset markets is to think in terms of supply and demand - factors that will change the number of buyers and sellers.  A good quarterly report from a corporation will bring in new investors from the sidelines.  More credit will increase the number of home buyers. Etc.

In some areas, this can be technically true, where quantities can change.  For instance, rising and falling credit access can lead to rising and falling housing starts, where there really is some change in the relative numbers of buyers vs. sellers.  But, in many areas, like equities, by definition, most of the time, there has to be exactly the same number of buyers and sellers.  It is still tempting to think about changing values as being a product of new buyers who have been induced by new information to buy, pushing the price up above the reservation price held by some sellers, leading to transactions and rising prices.  Certainly, this can describe almost all markets.

But, this is a case where the technical accuracy of the observation hides the broader, conceptual inaccuracy.  These transactions represent marginal liquidity issues and have relatively little to do with the broader reasons for changing values.  If Apple issued a positive quarterly report for the next quarter that increased the expected value of future production by 10%, their share price would immediately rise by 10%.  It would certainly be accompanied by an increase of buying and selling, but this activity would have nothing to do with that change in value.  The change in value could increase without a single transaction.

This is obvious if we think about Apple as a private firm.  Imagine that same quarterly report for private Apple.  The intrinsic value would move just the same with no transactions.  Sure, private firms shopping for buyers will consider buyer interest and liquidity when they position themselves for sale.  And, this will have some effect on the margin.  But, the reason Apple is worth $600 billion and Big Lots is worth $2 billion isn't because Apple has more buyers.  It's because Apple is expected to earn higher profits.  Intrinsic value moves markets.

One place where the housing bust drives this point home in a way that I think has not been widely appreciated is in the collapse of the private securitization market in the summer of 2007.  I have generally referred to this as a liquidity panic, which I think is more or less the norm.  And, in a way it was.  But, that's a strange way to talk about it, if you think about it a little bit.  There was no shortage of liquidity.  Everyone knows that at the time there was a massive demand for AAA related securities.  The entire CDO market had basically risen up to meet that demand.  That demand is at the center of the accepted narrative of the period.

In other words, there were many, many motivated buyers for those AAA securities.  If we think about this in the supply and demand mode that I described above, then how can we explain the collapse?  There was no collapse of demand.  The collapse was in the intrinsic value.  The collapse happened because there was a collapse in expectations about home values.  This had set off a series of self-perpetuating trends where lenders were less eager to lend, home sellers were less likely to repurchase new homes, home values were expected to fall, and the market expected high levels of future defaults as a result.

There were billions of dollars worth of potential buyers, desperately looking for safe assets to invest in, and those buyers would not pay more than 70% or 80% of face value for the AAA rated private MBS securities.  The differences here, between the extreme decline in market values and the extremely high number of potential borrowers, is....well...extreme.  Intrinsic value dominates supply and demand.

What happened in 2007 was that there weren't enough buyers for home equity.  The liquidity crisis wasn't in AAA rated debt securities.  It was in home equity.  The reason was that homeowners were fleeing the market through the back door.  First time home buyers continued to be strong, because the decision to buy is dominated by life cycle effects.  But, there developed a tactical outflow of homeowners from the existing stock of owners.  There weren't enough willing home buyers.  And, those home sellers, selling their old, lightly encumbered homes to the naturally highly leveraged new buyers took all those capital gains out of the home equity market and stuck it in the low risk capital market, where much of it ended up funding mortgages.  But, the problem is, you need a homebuyer to fund a mortgage, and since there weren't many, financiers started creating various forms of CDOs in order to create low risk debt for those former homeowners to invest in.

Source

This began to happen as early as 2004.  But, intrinsic value rules.  It didn't matter that there weren't as many buyers.  For a year or two, prices continued to rise along with housing starts.  In fact, the sharpest rise in home prices was during the initial decline in homeownership.

Eventually, by the end of 2005, housing starts began to collapse, and home equity levels began to fall at the same time, because of that transfer of old homeowners out of the market.  But, intrinsic value still ruled.  For nearly two years after that, the decline in homeownership and in home equity accelerated, yet home values remained steady.

In the 3rd quarter of 2007, home prices were still within 3% of their highs, nationally.  But, home equity had already dropped by 20%!  Then, we finally broke the housing market so much that liquidity became the dominant factor in price.  Before the 3rd quarter of 2007, the housing market was like the New York Stock Exchange.  There could be debates around the edges regarding efficient markets.  Differences in prices of 5% or 10%, or differences in relative returns of a percentage point or two, could be debated, regarding the difference between efficient prices and market prices, or regarding the effect of credit and liquidity on market values.  After the 3rd quarter of 2007, the housing market had a regime shift.  Now it was defined by the lack of efficiency.

The entire country, it seems, mistook this to be exactly the opposite.  We thought that the housing market had been inefficient before the 3rd quarter of 2007 and that it was now returning to efficiency.  We were disastrously wrong.  And, we were wrong because we make the mistake of thinking supply and demand are more important than intrinsic value.  We assumed that forms of mortgage credit that had been ascendant were bringing in new buyers and that new buyers would naturally move prices higher.  We didn't account for the fact that intrinsic value rules.  To the extent that credit expansion had some hand in moving home prices higher, it was by providing liquidity in markets that previously were lacking in liquidity.  It turns out that this was largely in markets where high income households were buying access to Closed Access labor markets, where housing expenses in general have moved above our longstanding norms, making conventional mortgage funding inadequate.

So, as with the private firm positioning itself for a new buyer, that added buyer interest did have a marginal effect on market prices in some places, but it was only pulling prices toward the liquid, efficient price level.  Big Lots might tweak their market capitalization by a few hundred million by announcing their entrance into an exciting new market that investors are excited about.  But, they aren't going to get to Apple's market capitalization by attracting new buyers.

This is why the housing markets that were especially hot during the 2000s continue to have relative values higher than the rest of the country, even though we killed the non-conventional mortgage market.  Intrinsic value.*  Even though those markets are still reaching for intrinsic value, they are still underpriced, because we have eliminated sources of liquidity for those markets.  So, a rejuvenated private mortgage market would cause those home prices to jump again, and a rejuvenated conventional mortgage market would cause low priced homes across the country to rise.  But, they would rise toward efficiency, not away from it.  Because intrinsic value rules.  The number of buyers is a deceptively weak explanation for market inefficiency.  Millions of new home buyers couldn't make home prices rise above their intrinsic values any more than those trillions of dollars of savings in 2007 could keep private MBSs at face value.

Tomorrow's post will explore this general idea a little more.



* By intrinsic value, I don't mean natural value.  Those homes are only valuable because of a political stranglehold on supply.