Housing: Part 253 - Great new paper on subprime lending

Scott Sumner found a great new paper that looks at lending during the housing boom.

I have been working with various sources of information that demonstrate how there was no marginal increase in homeownership during the private securitization boom, rates of first time homebuyers were actually declining in 2004-2007, and mortgages throughout the boom were going to young professionals with college degrees and high incomes.

Frankly, this information isn't a secret.  It's clear in basic Census Bureau data, Survey of Consumer Finances, etc.  But, since a flawed premise regarding the housing bust was broadly accepted early, all of this data is generally simply ignored.  It's kind of absurd that I have any business being associated with its discovery.  It's unfortunate that it has been left to me to complete this new narrative of the boom and bust, and I do not have the full set of statistical skills and knowledge to make the best case for some of this work.  I am grateful that others have been filling in these gaps in knowledge.

In any case, this paper, from Stefania Albanesi, Giacomo De Giorgi, and Jaromir Nosal, digs into mortgage data with various methods to control for the effect of age among homebuyers, and finds some direct corroboration for these other sources.  There was no shift in risk-taking to homeowners among mortgage lenders.  And, in fact, they find that much of the rise in delinquencies was among financially secure investors.

Now, the consensus has coalesced around the idea that everything was reckless.  So, rising homeownership and expansion of lending to financially insecure buyers can be the reckless cause of the bust.  Or, falling homeownership and expansion of lending to financially secure investors can be the reckless cause of the bust.  Heck, in the decade's worth of a housing depression we have imposed on ourselves since then, many people have convinced themselves that there is a new housing bubble fed by institutions paying all cash for existing homes.  At this point, I'm convinced that if there was a surge of new housing units being built, by hand, by the owners cutting down the trees on their own land with hand saws, and thatching their own roofs, the Wall Street Journal and the Financial Times would post articles about how this calls for tighter monetary policy.

This paper provides support that the crisis had little to do with reckless lending, but detractors can still argue that investors tend to default more in the face of collapsing prices, so that even that lending was reckless.  That's all well and good.  We can have that debate.  But, we need to be clear that this was not the story that filled newspapers in 2007 and 2008 when everyone was standing blithely aside as home prices dropped by 1% per month, for months on end.  The story that led us to accept a crisis was that millions of buyers never had a chance at making their mortgage payments, and that was the cause of the inevitable collapse.

What really happened was that new homeowners were already in decline, long before we got serious about imposing a collapse on ourselves.  We determined that speculators and lenders needed some discipline.  There were a large number of recent young new owners and investor buyers who tend to be more prone to default when prices collapse, and we engineered that collapse, all the while complaining that they did this to us.  And, as time passes, the idea that lenders were throwing caution to the wind seems to be losing to the evidence.

To be fair, there is clearly much evidence that in 2006 and 2007, in some respects, there were sharp shifts in underwriting.  But, if you look closely at many of these complaints, they are complaints about a lack of documentation or complaints about investor buyers engaging in various sorts of misstatements.  This was a strange period, though.  The number of buyers was collapsing, which is a strange thing to see if underwriters are being extremely lenient.  I think, oddly, what we were really seeing was an exodus of previous owners out of the market, and the buyers that remained tended to be more leveraged and more likely to be investors.  This should have been obvious, since, by the time prices were collapsing, housing starts were already at recession levels.  The reason prices collapsed after mid-2007 is because the housing market had already absorbed as much decline as it could without breaking.

Selections from the paper:

Our analysis also reconciles the pattern of borrowing at the individual level and at the zip code level, showing that though mortgage balances grows more in areas with a larger fraction of subprime borrowers, within those areas, debt growth is driven by high credit score borrowers.

Using zip code level data, Mian and Sufi (2009) show that during the period between 2001 and 2006, the zip codes that exhibited the largest growth in debt were those who experiences the smallest growth in income. They argue that the negative relation between debt growth and income growth at the zip code level over that period is consistent with a growth in the supply of credit to high risk borrowers. We show that this negative relation does not hold for individual data. The differences in credit growth between 2001 and 2009 are positively related to life cycle growth in income and credit scores. Moreover, debt growth for young/low credit score borrowers at the start of the boom occurs primarily for individuals who have high income by 2009, and the growth in income is associated in a growth in credit score.

 

The positive relation between income growth and debt growth during the credit boom casts doubt on the notion that there was an increase in the supply of credit, especially to high risk borrowers. Instead, it is more likely that the rise in house prices caused an increase in mortgage balances. This is confirmed by the fact that the fraction of borrowers with mortgages did not rise for any quartile of the credit score distribution(.)

(T)hough the fraction of investors with prime credit score is very similar across quartiles, in quartiles with high share of subprime, investors exhibit larger increases in mortgage balances during the boom and a more severe increase in foreclosures during the crisis. This difference in behavior for prime investors may be driven by the behavior of real estate values.

(KE: In other words, investors who were prime borrowers were a large source of delinquencies in zip codes with a high proportion of subprime credit scores.  So, more volatile prices probably were the cause of higher default rates in those zip codes.  My work has shown that those zip codes were located in specific areas, and the volatility comes from a systematic behavior of Price/Rent that is probably unrelated to credit markets.)

We find that most of the increase in mortgage debt during the boom and of mortgage delinquencies during the crisis is driven by mid to high credit score borrowers, and it is these borrowers who disproportionately default on their mortgages during the crisis. The growth in defaults is mostly accounted for by real estate investors.  

The premise determines the conclusion

One of the features of my recent research that I find fascinating and frustrating is the reality that, when it comes down to it, just making a few subtle shifts in our priors can completely flip our conclusions.

This is the problem I have with behavioral explanations for recent phenomena.  Behavioral explanations are basically explanations that presume inefficiency of some sort - mispricing that an omniscient or reasonably rational collection of traders would avoid.  But, how do you falsify that?  So, there is a certain amount of presumption involved in those explanations.  But, once you accept that presumption, then explanations fall into place.  Mortgage debt is bound to scale with real estate values, so if there is a presumption that mortgage credit can lead to inefficient or unsustainable prices, then it can always appear to be causal.

So, then, every sign of rising prices is taken as a signal of unsustainable demand, whether it is or not.  I think this reached an extreme in 2006 and 2007, when, amid a sharp downturn in housing starts, mortgage growth, homeownership rates, and residential investment, the consensus view was that the economy was characterized by excess.  And, the heavy demand for AAA securities, of all things, was taken to be evidence for risk taking.  That's because, by that point, these presumptions had taken so many people so far down the road toward that conclusion, in a way that wasn't really justified by the evidence, that it was difficult to square evidence of extreme risk aversion with the consensus that had already developed.

So much analysis of the business cycle falls into this category.

Here is a recent Financial Times article by John Auther that is an example of this.  He claims that rising equity prices are being propped up by easy money.

From the article:

"The central bank has bought bonds to try to push down their yields and so push up the valuations that people will put on stocks - and they have been phenomenally successful."

I would question whether Fed bond buying pushes yields down over this time frame and scale and I would also question the effect that long term yields have on equity prices.

Here is the main chart he references:

My question is, What's the counterfactual?  Let's say that we had gotten ourselves into a case where interest rates had fallen to zero because monetary policy had been too tight, so that the QEs were a move toward a more optimal policy.  The economy needed cash, and to a certain extent, the QEs led to some money creation.  If that's the case, then what would this chart look like?  Wouldn't it look just the same?

So we have competing priors. Auther's prior, which seems to be commonly held, is that the values of homes or long term bonds or stocks can be regularly pushed far from any normalized value by central bank activities even while consumer prices move along at roughly 1-2% inflation rates.  My prior is that at this scale, prices of all of those assets are much more influenced by real economic factors.  The stock market moved higher because our collective economic future had improved.

Is that naïve? Maybe.  But, let's say either of us is wrong.  In that case, which premise is more of an offense?  Can I suggest that if you will only be satisfied with contraction and deprivation, that you might require a higher standard of confirmation?  If core inflation hasn't even touched 3% for more than two decades, can we shelve the endless complaints of Fed largesse?

More about leverage and the business cycle

What is the actual evidence for the Austrian business cycle/Minsky idea that businesses are induced to leverage up during expansions, which becomes unsustainable, and eventually must lead to a disciplining contraction?

The evidence seems to me to loudly proclaim the opposite.

Here is a chart of corporate leverage and changing profit margins.

Source

The red line is nonfinancial corporate debt as a proportion of operating profits, net of tax.  The grey line is the YOY percentage change in real operating profits.

It seems clear to me that firms tend to deleverage through expansions.  Where leverage rises, it is generally associated with falling profits that are usually a leading indicator of a coming recession.  The explanation for this seems obvious.  Firms confront negative profit shocks, which cause their balance sheets to shift out of equilibrium.  They cut back on investment in order to try to pull leverage back down to the comfortable level, which over time seems to have moved between about 4x to 6x operating income.  After the contraction, profits rebound, and firms use that expansion to finally allow their leverage to decline.

Here is a graph of these same two series.  Here I have converted the leverage measure so that it also is a measure of the YOY change.  Then, I created a scatterplot of these two series.  Could this be more clear?  Firms clearly deleverage when profits rise.

The change in profit is on the x-axis and the change in leverage is on the y-axis.

Source

Notice where zero is on the x-axis.  There are only a few quarters where leverage as a proportion of operating profit increased moderately during periods of moderate profit growth.  Overwhelmingly, during expansions, firms deleverage.

Housing: Part 252 - The Deceptive Limits of Knowledge

One of the lessons that has really hit home for me in this housing research is how much our assumptions and priors affect our interpretations, and how much our conclusions really are simply a regurgitation of our priors after they have been run through a Rube Goldberg logic machine.  We make so many claims based on a mixture of facts, constructed information that may or may not be accurate, and assumptions that may seem perfectly reasonable but are not.

I can't say that I've applied much of this learning.  I regularly make bold claims based on my own versions of constructed information.  Very early posts I wrote about housing markets contain what I still consider to be clever and well-argued justifications for housing trends, which today I would say generally missed the most important points.  I don't know if anything I wrote was flatly incorrect, but in practice, coming up with the wrong answer to the right question isn't much worse than coming up with the right answer to the wrong question.  Yet, I find it very easy to be confident about my current conclusions, some of which are almost certainly wrong in some way that I will eventually realize.

One example of an assumption that doesn't explain as much as it seems like it should is the idea that cities where people want to live would naturally be much more expensive.  Another is that when mortgages outstanding grow at about the same rate as total real estate values, the growth in mortgages seems like it must have caused the rise in values.  In both of these cases, there really isn't a reason to believe that is the case without corroborating evidence, but it seems so reasonable, that these assumptions can become placeholders in a conclusion that end up doing a lot of the work.  They seem so reasonable, it doesn't seem necessary to vet them.

Yet, in so many cases, just a slight error in how information is constructed can turn our conclusions 180 degrees backwards.

In any case, here is a good example of the problem.  The authors post a chart of high and low tier housing markets, aggregated from 16 major markets.  They note that low tier homes rose higher in the boom years, fell lower in the bust, and now have overtaken high tier homes again.  They tell investors:

If you focus on lower-priced homes, beware that you are investing in a more volatile section of the market from a pricing perspective and beware that lower-priced homes have appreciated the most.

First, there is an assumption problem here.  It just makes sense that lower tier markets are more vulnerable, in the "World to end tomorrow.  Women and children to be hurt the worst." sense.  It makes sense that marginal markets would be most affected by economic contractions.  Defaults would be higher in low tier markets.  So, this conclusion rests easy.  It doesn't seem like it needs to be vetted.

Then, there is a constructed information problem.  Low tier homes were only more volatile than high tier homes during the boom in a handful of markets.  It shows up in their chart, because the 16 markets they aggregate contains all of the cities where that happened.  It didn't happen anywhere outside the 16 markets they reference, and it only happened in about half the markets they do reference.  There is a specific pattern that causes this to happen that is probably mostly tied to maxing out tax benefits on homeownership when homes rise above about $500,000.  Actually, this should provide a little bit of a positive skew to potential gains for investors in low tier homes and a negative skew for investors in high tier homes, because tax subsidies create an asymmetrical set of outcomes for investors that don't claim owner-occupier subsidies.

Source

The first graph here shows YOY high and low tier home prices in LA and Portland going back to 1987.  Notice that there is no systematic excess volatility among low tier homes anywhere until the mid 2000s.  In LA, low tier homes rose higher than high tier homes during the boom, and then dropped farther.  But in Portland there was only a short period, well after the bust had begun, where low tier homes dropped somewhat farther than high tier homes did.

So, there is basically one episode where low tier prices collapsed more than high tier prices, and that happened to coincide with a sharp public policy shift where we essentially made it illegal to make a mortgage to low tier owner-occupiers.  This coincided with a decline in working class homeownership rates in general and a decline of more than 10% in homeownership rates among families that typically used to be first time homebuyers - young families with average or above average incomes.

Recently, it appears that the collapse in homeownership may have finally stopped.  But, this was a one time shock.  You can't collapse a bridge twice.

Source: Zillow Data

So, if we deconstruct their constructed information, we really have two types of cities.  First, we have Closed Access cities, where low tier housing is more volatile than high tier housing, because of these owner-occupier tax issues.  And we have the other 80% of the country, where there never was a difference in volatility, except for that one-time shock.  In a few cities, like Phoenix and Dallas, it appears that population inflows have made up for the lack of low tier demand created by the mortgage shock, and low tier house prices may have recovered back to parity with high tier homes.  But in most cities, from Seattle to Detroit and everywhere in between, there is a very typical pattern.  Prices moved together until the end of 2008, then low tier prices take an extra step down.

(Admittedly, this shows up more clearly in Zillow data.  Low tier markets, in general, seem to have an upward bias and high tier have a downward bias in the Case-Shiller data, compared to Zillow, over time.  This seems to be the case across cities.  Case-Shiller follows individual properties while Zillow takes a market snapshot of all properties at a point in time.  But, I'm not sure how that would create this difference.  So, the volatility is basically the same in Case-Shiller vs. Zillow, but Case-Shiller makes low tier properties look like better long term investments.  The authors use Case-Shiller data, which should make low tier properties look better, but since there has been this z-shaped boom, bust, and recovery, that only makes it look like an unsustainable boom in a volatile market segment.  Another example where a simple difference in a data set of constructed information leads to totally opposite conclusions.)

So, basically the exact same data with a couple of assumptions or facts switched out, and you get two completely different conclusions.  If you account for the mortgage market shock and you use the long term drift in Zillow values, then you're buying up low tier homes in cities across the country with great risk/reward profiles.  If you don't account for the mortgage market shock, you make some reasonable assumptions about market behavior, you aggregate the data among various cities, and you use the long term drift in Case-Shiller values, then you're bracing for a contraction in low tier housing markets that look especially perilous.

These are not massive errors of judgment.  These are tiny little shifts in data with some very reasonable assumptions filling in some harmless looking blanks in the narrative.  And you've got one investor long and the other short - one investor looking at markets always swinging to extreme equilibriums that must correct and another looking at some stable and boring market equilibriums with occasional policy shocks.

Greenspan on interest rates

Here is a recent Bloomberg article, quoting Alan Greenspan. "By any measure, real long-term interest rates are much too low and therefore unsustainable... We are experiencing a bubble, not in stock prices but in bond prices.”

The article goes on more about the Greenspan and the Fed's view, which seems to also be shared by Goldman Sachs Group Inc. Chief Economist David Kostin.  It seems to include the following points:

• Rising rates hurts stock valuations.
• High inflation hurts stock valuations.
• Rising rates are a sign of tight monetary policy.

These three points manage to be both wrong and contradictory.  I suppose one could construct ways that they could all be true.  If inflation shot up to 8%, and the Fed tightened as a reaction to that, then I suppose, inflation would be high, rates would be high, the Fed would be tightening, and equity values would suffer, as in the 1970s.  So, there is some context where these factors would be true.  But, the fact that this is the particular context we are talking about right now, to me, is a sign of our current problem.  Should we really be worried about this?

And, while that hypothetical might salvage the frame of view they are using, it seems clear to me that they do not limit their framework to that specific context.  In the article, even shifts in interest rates and inflation back toward moderate levels are referenced as if they would cause price contractions in equities.

The article does mention that there could be doubts to this view, and that brief peaks in bond rates in 2013 and 2016 didn't cause equities to decline.

This shouldn't be surprising.  This is an example of how an upside-down CAPM model helps to think about these things more clearly.  There is little relationship between expected returns on equities and bond rates.

One reason that it seems people think there is a relationship is because frequently nominal bond rates are compared to implied equity yields.  Equities are a real asset - their values increase over time with inflation.  Most bonds are nominal - their face values are fixed at a nominal value.  I frequently see nominal rates compared to equity returns, and most of the time, this is an incoherent comparison.  To Bloomberg's credit, in the linked article, they refer to TIPS bonds, which are also real assets - adjusted for inflation over time.

But, even using real rates, I just don't see any reason for this view.  Over the nearly 20 year period of time that we have real TIPS rates on long term treasuries (20 and 30 year maturities are what I use here.), there is little relationship between expected equity returns and TIPS rates.

Here, I will use Aswath Damodaran's estimate of the equity risk premium (ERP) to estimate expected returns on equities.  Expected real returns on equities are equal to ERP plus the long term real TIPS rate.  On a quarterly basis back to 2008, after a brief jump in equity yields during the crisis, total real expected equity returns have remained around 6% to 7%.

We can see this even more clearly with annual data, which can take us back to 1999.  Here, again, total real expected returns to equities remain around 6% to 7%.  This is in spite of real rates falling from 4% to less than 1%.

This is the upside down CAPM model.  Start at about 7% real expected returns on equities.  That is stable over time, with some noise.  When TIPS are at 4%, that means investors are willing to give up 3% for safety.  When TIPS are at 2%, investors are willing to give up 5% for safety.  It's as simple as that.  Firms are price-takers when it comes to interest rates.  Interest rates reflect risk aversion.  When they are low, risk aversion is high.  Firms are price-takers in capital markets, so there is no reason to expect them to leverage up and take financial risks when risk aversion is high.  And, in fact, I don't think we see that.  In equilibrium, I'm not sure that leverage is a particularly cyclical factor.

To the extent that very high inflation in the 1970s seemed to increase (decrease) expected equity returns (prices), this may be mostly due to de facto tax rates.  When inflation is high, firms are taxed on booked profits that are really just inflationary.  In other contexts, if PE ratios are changing, we should interpret that as a shift in growth expectations.  Thinking about equities in terms of premiums to treasury yields is a red herring.

More on the "Real Growth" Phillips Curve

I have been trying to build a case for a "real growth" Phillips Curve, where low unemployment leads to rising wages.  Normally, this is associated with rising inflation or with rising labor share of national income.  But I think it mainly equates with higher real growth.  (I think there is a case to be made for labor share of domestic income rising during extended periods of stability.  But, I think this has more to do with capital requiring a lower risk premium than it has to do with things like negotiating power.)

Conor Sen has been noting on Twitter how restaurant margins are getting squeezed by rising labor costs.  It looks like what we have here is a battle between inflationary or labor share versions of the Phillips Curve.  Either restaurants will raise prices and stay in business or they can't raise prices, and their profits will suffer.

But, if we think one more step here, we can see that this is economic growth.  This is sorting.  Wages are rising because workers have better things to do.  In other words, the economy has moved to a new regime where more value can be added somewhere than could be added in the restaurant that used that labor in yesterday's economy.

Sen notes: "We have too many restaurants and a lot are going to close over labor costs and an inability to raise prices."

What will happen, if growth continues, is that the better restaurants will have pricing power, the worst restaurants won't.  Or, more generally, the weaker firms will naturally be the firms that fail.  There will remain a restaurant sector of some size, where wages will be higher and profits will remain at normal sustainable levels.

Interestingly, restaurant employment is growing as a proportion of total employment.  So, this may not even require a contraction in the industry itself.  Weak firms might be forced out by shrinking margins, even as the category remains healthy.

This is creative destruction.  And, we can see quite clearly that this is happening during an expansion.  It is happening because of expansion.  This is the sort of pressure that we need to apply to weak firms in the restaurant industry.

A contraction would also cause weak firms to fail.  But, why would we choose that?

It seems to me that many people see rising wages and they expect that to be inflationary, so they decide that this is unsustainable, and a contraction will pull us back down to earth.  Then, on the other hand, some employers see rising wages and they find their profits being squeezed - in other words, it's not inflationary.  And, they decide that this is unsustainable, and we need a contraction that will pull us back down to earth.

What is really happening is that wages are rising, and this is unsustainable.  We are approaching a better tomorrow.  It is unsustainable in the same way that blacksmithing, film developing, and candlemaking were unsustainable in the past.  Our reaction should be, "This is unsustainable.  Let's keep it up!"

Counter evidence to the consolidation story

The idea that industry is getting more consolidated has been getting a lot of play lately.  In some ways, this does seem to be true.  Clearly, there are network effects, etc., in tech and finance that might lead to consolidation with just a few firms, at least temporarily.

One reason I am skeptical of the notion is that I think it has grown out of the idea that corporations are capturing more income at the expense of labor.  That idea is greatly overblown.  What decline there has been in labor share of income isn't attributable to firms capturing more income.  Of course, I attribute much of it to income going to real estate owners.

I think the mystery this increase in concentration is supposed to solve is that shift in income share.  Since the shift in income share doesn't really amount to much, there isn't much of a mystery to be solved.

To the extent that there has been some consolidation, I suspect that it just hasn't had that much of an effect on the labor/capital income balance.  To the extent that there are higher margins in terms of variable costs (and, taking everything into account, I'm not sure net margins are as high as all that), much of that is flowing to human capital, and since human capital has to buy access to lucrative labor markets through constricted housing markets, much of that flow on to real estate owners.

Anyway, here is another piece of evidence that seems contrary to the consolidation story.  For the past 20 years or so, it is midcap stocks that have led the way, not large caps.  If there is consolidation, this would suggest that it is consolidation that is related to creative destruction and market reorganization.

Source

Leverage is not a sign of risk seeking, a continuing series

I have written in the past about how the typical treatment of debt levels in the business cycle tends to treat it as purely a demand phenomenon - that risk-seeking investors seek out debt in order to leverage their dangerous investments.

But, as with most things financial, there is a supply and a demand side.  And, if we think broadly about the two types of ownership - equity and debt - from a saver's point of view, debt is actually a sign of risk aversion.  Risk averse savers invest in debt.  Risk seeking savers invest in equity.

There are a lot of moving parts here.  For instance, in an economy saddled with systemic risks, debt levels will tend to be lower because the debt itself is considered riskier.  This may be part of the reason for the global finance trade, where developing market savers seek out developed economy debt for safety while developed economy firms invest in developing economy equity.

But, in the US economy, which generally is stable and which is built on the long term establishment of institutional trust, debt is generally associated with risk aversion.  And, corporate debt isn't particularly sensitive to interest rates.  Firms are price takers when it comes to risk premiums.  When interest rates are low, this is a sign of risk aversion, which means that when interest rates are low, equity investors aren't particularly interested in leveraging up.  This is also true cross-sectionally.  It is the least risky firms that tend to carry the most debt.

Here is a graph of corporate debt (credit market liabilities issued by non-financial firms) as a proportion of operating profit ("operating surplus" as defined by the BEA).  That's the blue line.  Then, the bar chart superimposed on that is a measure of the trailing 12 month change in non-financial operating surplus.

What we see here is that, in the aggregate economy, firms tend to want to settle at a debt level of about 4x to 4.5x operating income.  To the extent that things like growth expectations affect the enterprise value of firms, that generally accrues to equity values.  There appears to be a pretty stable limit to debt/income levels in equilibrium.

Now, what we see, since the mid-1980s, is debt/income that settles in around 4-4.5 during expansions, and then it shoots up above that level during contractions.  The reason debt/income shoots up is because these are unexpected income shocks.

Debt levels don't rise because risk-seeking savers get careless as an expansion ages.  Risk-seeking savers bid up equities, like they did in the late 1990s.  Debt levels rise because firms are reeling from a contraction.  And, once the contraction subsides, firms retrench until debt levels settle back at 4-4.5x.

Where in the world did we get the idea that we have to draw back the economy because firms will get too risky and borrow too much?  What data is that story based on?  It looks to me like we are actually creating the leverage problem, not solving one.

What would happen if instead of engineering contractions in corporate profits, we tried to engineer a continuation of positive profit growth?  What if that actually led to rising interest rates for savers, improved negotiating power for laborers, solid returns to pensions, and robust tax revenues?  Recently, profits have not been great, and leverage has increased as profits have declined.  And, a reason the Fed is giving for tightening is to prevent some sort of push in wage inflation...

Housing: Part 251 - Elements of our current cycle

I have been critical of the Fed's current stance.  I think they are destined to over-tighten because of Phillips Rule thinking and because rent inflation induced by throttled housing supply causes them to overestimate the inflationary effects of monetary policy.  I expect the yield curve to eventually decline to a lower level.  And, stocks might move around a bit, but I suspect they will eventually be lower than the current level over the next couple of years, though not necessarily too much lower.

In the meantime, I had been waiting for a convergence between interest rates and home prices.  There has been a divergence since 2007.  Yields on real estate (especially low tier real estate where credit constraints have cut off demand of owner-occupiers) have been at long term highs while long term TIPS yields have been very low.

I don't know how much trading there actually is on the relationship between housing and interest rates, but the colloquial take on it is that rising rates make affordability harder, and cut into homebuilding.  I don't see any reason in the historical data to consider that relationship important.  Rising real long term rates could reduce the intrinsic value of homes, causing price/rent ratios to moderate.

However, there is a divergence now.  So, I think it will take a resurgence in residential investment to pull real long term interest rates higher again.  That resurgence either needs to come from loosening the supply constraints in the Closed Access cities or from loosening entry level mortgage standards, which have been quite tight.  So, rising rates would likely be related to surging homebuilders.  Like I said, this is contrary to the colloquial take on this, but I'm not sure it's that contrarian to past experience.

Yields aren't the binding constraint in housing, so I don't think rising rates will pull down intrinsic values in housing.  I think this will make homebuilders more positively correlated with interest rates than normal over the business cycle.  Also, at current levels, homebuilders are fairly defensive, because there is so much pent up demand.

Data from Zillow (ZVHI)

I think we are starting to see a resurgence of low tier housing.  Here are 12 month price changes in Miami.  This is pretty typical of today's market across MSAs.  By my count, in 17 of the top 20 MSAs, low tier prices are rising faster than high tier prices.

We need this.  Cumulatively, since the late 1990s, low tier prices have lagged high tier prices in most cities - by 15% on average (more than that outside the Closed Access cities).  This is because in most cities, low tier prices didn't behave much differently than high tier prices during the boom, contrary to common reports.  But, when we clamped down on lending, low tier prices collapsed.  So, they have a lot of ground to make up in the return to normalcy, if it ever comes.

We have also seen moderate very recent rises in mortgage lending, according to some measures.

In the meantime, though, Fed policy might be pulling interest rates down by causing economic contraction.  So, I'm not sure we will see an immediate convergence of housing yields and interest rates (rising home prices and falling bond prices).  On the other hand, there could be some interesting ways to create defensive hedges that also have upside potential as these markets evolve.

And, this could happen sort of under the radar.  The entry level markets don't amount to much in total dollars, because the home values are low.  So, I think we could see healthy improvement in entry level homebuilding while credit markets look meager because a lot of these homes might be purchased without moving the total dollars borrowed that much.

In the meantime, if these trends lead to a pick up on the margin of homebuilding in these markets, finally, it could really perk up some homebuilders, even if the macro-economy doesn't look that exciting.

Housing: Part 250 - Interest Rates and Home Prices: Open Access, Closed Access, and Canada

Before I really started to dig into the details of the housing boom and bust, I used to excuse the run-up in home prices simply by using real long term interest rates.  Long term real interest rates declined by about 2%.  That's a sharp decline for real rates at the long end of the yield curve.  This is the rate that should dominate intrinsic values of homes, because homes are real assets. (Their values and cash flows shift with inflation.)

A basic rule of thumb in fixed income is that the value of a cash flow will shift in proportion to its time in the future.  The present value of a cash flow one year from now will decline by 1% for each 1% rise in the one year discount rate.  The present value of a cash flow 30 years from now will decline by about 30% for each 1% rise in the 30 year discount rate.  For a bond, this sensitivity is called its "duration".

If we think of home ownership as a claim on all future rent value, then homes clearly have a very long duration - something similar to a 20 or 30 year bond.  That means that, hypothetically, a 2% drop in real long term interest rates could justify something around a 50% increase in home prices.

It so happens that Price/Rent ratios did increase by about 60% from 1997 to 2005.  So, it seemed possible to me that interest rates could explain that rise without requiring any influence from credit access, speculation, etc.

But, I was making a fundamental error, as I now know.  There was no American housing market, per se.  There were cities where Price/Rent ratios increased by maybe 20%.  There were other cities where Price/Rent ratios more than doubled.  That can't be explained by interest rates.  And, in fact, I have come to the conclusion that local supply effects are a primary factor in rising home prices in the US and abroad.

It so happens that Edward L. Glaeser, Joshua D. Gottlieb, and Joseph Gyourko have estimated that home prices are not that sensitive to long term interest rates.  They have a sensitivity of about 8% for each 1% change in long term interest rates.  And, it so happens, if we apply that sensitivity to home prices among the major US metropolitan areas (MSAs), that sensitivity can justify home prices in cities where Price/Rent ratios only increased by about 20%.

In other words, with Glaeser, Gottlieb, and Gyourko's sensitivity, interest rates basically explain all of the changes in home prices from the 1990s to the peak of the boom in cities that didn't have supply constraints.  That leaves most of the price increase in the Closed Access cities unexplained.

It also happens that there is a strong correlation between rent inflation and the unexplained rise in MSA home prices.  In other words, where supply is limited, rents increase and are expected to continue to increase.  Rents in cities like Dallas and Atlanta have risen at about the rate of general inflation, and home prices in those cities never depended on expectations of rising rents.  On the other hand, excess rent inflation in the Closed Access cities has averaged about 2-3%, annually since the 1990s, and a basic cash flow valuation model for homes in those cities can justify their peak 2005 home prices with rent inflation somewhat lower than that for the next 20 years or so.

But, I still wonder if this sensitivity to interest rates is still a product of treating the national market as a single entity.  I wonder if there may be a correlation between rent inflation and interest rates that is dependent on local supply constraints.

Here is a basic equation relating rent to the price of a home.  (Rent here is after expenses and depreciation.)

This is just a specific version of a standard Gordon growth model.  Cash flows are in the numerator and the discount rate is in the denominator.  Here "C" is a multiple to reduce the sensitivity of home values to long term real interest rates.  Using the estimate above, we might set this equal to the rate on a 30 year inflation protected treasury, with only a 40% sensitivity to changes in that rate.

Here's the tricky thing, though.  In a city where supply can respond to price signals, we should see two mitigating forces.  First, lower rates should increase the value of homes and this should induce more building.  That new building - a rightward shift in supply - should reduce rents.  In the equation above, "Growth rate" means the expected rate of future rent inflation, above general inflation.  So, in a city with elastic supply, when the interest rate declines (lowering the value of the denominator), this should directly effect rent inflation.  Rents should decline.  And, since the growth rate is subtracted from the denominator, this should raise the value of the denominator.

In other words, in an open city, when homes have higher values because of declining interest rates, they should also have lower values because of decreasing rent expectations.

And, that would look a lot like a housing market where home prices were just less sensitive to interest rates.  In fact, to the extent that this should happen pretty mechanically in an unencumbered market, I don't see how we would tell one from the other.  Expected future rent would be an unmeasurable value.  How could we determine this relationship quantitatively?  I don't think we could very easily.

But, guess what happened in places like Dallas and Atlanta?  When rates went down, housing starts went up, and rents went down.  It's like Econ 101 in those cities.


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So, could it be the case that in Dallas and Atlanta, home values are as sensitive to long term real interest rates as we would expect a durable asset to be, but they are also sensitive to changing rent expectations that would naturally come along with those changing interest rates?

What if that is the case?  Then, how would that change our model of home prices in the Closed Access cities?  It is surprisingly indeterminate.

Let's rearrange the equation above so that we solve for the growth rate.  In other words, given the rent and price in a given city, what rent inflation is required to justify prices in that city?

In the following scatterplots, I have plotted actual rent inflation from 1995 to 2005 for each city on the x-axis, and I have plotted the implied excess rent inflation from 2005 home prices on the y-axis.  The first graph uses the low rate sensitivity (only 40% of the sensitivity of 30 year treasury bonds).  The second graph uses a high rate sensitivity (the same sensitivity of 30 year treasury bonds, which is about 20 years, depending on rates).

These are all cities with both a Case-Shiller price index and a BLS rent measure.  I would say that these two scatterplots could both be realistic.

In the first version of the model, future rent inflation expectations are less in every city than the trailing 10 year average rent inflation had been.  So, there is nothing outrageous about the expected rent inflation implied by home prices in any city.

On the other hand, causation goes both ways.  There had been a sharp housing correction in the early 1990s, and real interest rates were high throughout the 90s, with moderate housing starts.  Rent inflation was high just about everywhere, and that shouldn't be expected to continue in a low rate environment.

In the second model, only the most expensive cities required any expectation of rent inflation.  In this version of the model, low long term interest rates are responsible for most of the rise in home prices in just about every city.  This also seems reasonable enough.  Expected excess rent inflation in Atlanta and Dallas, with this version of the model, is between -1% and -1.8%.  Well, during the boom, when rates were low and building was strong, excess rent inflation in those cities ranged from zero to -4%, as we saw above.  And, at the national level, after a decade of persistent rent inflation, by 2005, rent inflation had finally declined down to about the general level of inflation.

If we had allowed housing starts to continue to be strong, we should have expected rent deflation.

So, is the sensitivity of home prices in the range of 8% for each 1% change in long term rates, or is it more like 20%?  You tell me.  I think it could be either.  Either could be reasonable.  I suspect it is somewhere in the middle, but I think the sensitivity might very well be closer to the high version here.

What I find interesting regarding the housing bubble thesis I have been building, in terms of the causes of the bubble, it doesn't matter what the sensitivity is.  In either case, there is a strong relationship between rent inflation in a given city and home prices.  Clearly, the difference between cities - and the difference between cities is the most important factor of the housing bubble - is largely about rent inflation.  It is about supply.

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One reason I have slowly tended toward believing there is a higher rate sensitivity is the international data.  Since 2007, the US market has been broken.  Our supply problem is as bad as it has ever been, but we have sharply curtailed mortgage access, so we have created a regime shift in housing by creating a demand shock.

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In the other "bubble" countries - here I show the UK, Canada, and Australia - prices have continued to remain high or to rise higher.  It happens that during this time, long term real interest rates have fallen even further.

When I look at Canadian data, housing starts and rent inflation in cities like Vancouver and Toronto don't seem as extreme as they are in the US Closed Access cities.  There is some building - not nearly enough to meet demand, but some - and, at least as measured, rent inflation doesn't appear to be the reason for recent price appreciation.

Australia also appears to have boosted housing starts, but with little effect on prices.

This is what we would expect to see if interest rates were more important than expected rent inflation in explaining the high price levels.

Clearly, in the US, rent inflation has been correlated with price growth.  But, could it be that those high prices don't depend so directly on rent expectations?  Maybe, since homes are a low risk asset, and future rent expectations are an uncertain factor, homebuyers aren't willing to pay much of a premium for expected rent inflation.  Maybe, in a Closed Access context, homes represent two sources of value - the low risk source of value (shelter and location) which calls for a low discount rate (a high price/rent ratio), and the high risk source of value (future rent expectations) which calls for a high discount rate, and thus doesn't really affect the price that much.

If that's the case, then once we get past a certain threshold, all Closed Access cities will sort of look the same.  Once there are enough political limitations to housing growth that local housing starts just aren't that sensitive to shifting interest rates and rising prices, maybe it doesn't matter that much whether excess rent inflation might come in at 0%, 2% or 4%.  Maybe it's enough to simply block the moderating influence of rising housing starts, so that declining interest rates don't trigger rent deflation.  Then, that means that in all cities, home prices rise significantly when interest rates fall.  And, then, there are cities where housing starts can rise, cyclically, pulling those prices back down.  And, there are cities where housing starts can't rise, cyclically, so that the full effect of falling rates is felt.