Housing Tax Policy, A Series: Part 9 - Credit and Currency

Considering the rhetoric surrounding the economy over the past 20 years or so, I am surprised at how normal the trends look in monetary and credit growth.  I am not a monetary economist, so please comment if I make any important errors here.

I am using Loans and Leases in Bank Credit and Currency as my points of reference here.  I realize that these aren't necessarily typical for this kind of discussion, but I think they more or less convey the information I am looking for.  First, here is a long-term graph of the combined total of currency and credit.  Since WW II, the growth of this quantity has followed fairly tightly with an 8% annual rate, falling slightly below trend in low inflation eras and growing slightly above trend in high inflation eras.

The second graph shows rent (both owner and tenant) as a percentage of GDP since 1929.  I think what we are seeing here is that pre-WW II, less than 50% of households owned their homes.  And, those who did own real estate mostly held it in equity.  This was a cash-heavy economy.  In 1947, there were about equal quantities of currency and loans & leases in bank credit!

I am not showing the graph here, but after WW II, there was a tremendous shift in the housing economy.  Households gained access to mortgage credit, and many of them became home owners.  Average Loan to Value moved from less than 30% even in 1952 to 45% in the mid-1960s.  And, homeownership rates rose from less than 50% to the mid 60%'s over that time frame.

So, if we look at bank credit and currency, we find that during this period, currency levels were flat for 15 years.  All of the growth came from expanding bank credit.

But, after that expansion ended, bank credit assumed a less steep trend.  This graph from 1974 to present shows both currency and bank credit growing together at a very similar trend of about 2% per quarter.  What is surprising is that, despite all the loud protestations about loose money and pretend growth, there was no movement above trend in either of these quantities in the 1990's and early 2000's.  It looks likely to me that the slight rise in bank credit after 2006 was a reaction to the sharp curtailment of currency.  Households had managed the leverage in their portfolios through the housing boom, so that until the Fed gave the economy one last push off the cliff in 2008 such that even credit markets seized up, households were making up for the currency shortage by tapping their available credit.  This ended in late 2008.

I think there are several points of confusion that lead to misinterpretations, several of which I have described before.

1) This strange insistence we have of speaking of monetary policy in terms of interest rate levels.

2) In the late 1990's and early 2000's, there was a large, sustained increase in residential investment, and there was also a rise in home values (which I attribute mostly to low long term interest rates and increasing tax benefits to homeowners).  As I have discussed before, because of the way we transact and think about real estate, this causes real estate to increase in nominal value in ways that other assets don't.  This is also an asset class that more households tend to follow and be familiar with.  Also, people tend to confuse the nominal value of homes with the cost of housing.  But, as shown in the second graph above, total consumption of housing was not increasing sharply during this period.  And, more than is commonly noted, much of the rise in home values was in equity.  Loan to value levels, in aggregate, were pretty steady over this time, and below 50%.  The only way that higher nominal values of existing real estate translate into higher nominal economic consumption is through access to credit.  If households had seen home values rise another 100%, but didn't take out any more mortgages, then nominal expenditures would not have been affected.  Now, it is true that most of the growth in bank credit at the time was in mortgages, but it wasn't enough to push credit above long term trend growth.  As seen in the graph above, much of the growth in mortgage credit was countered by a relative decline in industrial credit.

Securitized mortgages not held by banks would also not lead to monetary expansion.

(As an aside, note again in the Fred graph how real estate credit seems to line up with the 1986 and 1996 tax changes.  Also, note how there was no relative growth in mortgage levels associated with the additional 2.5% of homeowners between 1994 and 1999.  I do think that, these additional home owning households tended to be more highly leveraged than average.  But, as I mentioned in the comments of the previous post, these would have been much smaller dollar amounts than average, so even by 1999, when half of the total new growth in homeownership would have already been on the books, it probably added less than 1% to the total mortgage level.  That is simply swamped by the other factors that we can see in the graph are moving mortgage levels at a much greater scale.  This simply couldn't have scaled up to a quadrupling in mortgage credit and a tripling in home prices.  The scale is too small by orders of magnitude.  The anecdotal evidence that feeds the notion of the importance of the subprime mortgage market simply doesn't account for the problem of scale.)

3) Corporations massively deleveraged between 1980 and the present.  Most growth in corporate values has been in equity.  And, as with real estate, this should lead to a need for more currency, since aggregate added enterprise value among corporations has not led to growth in bank deposits.

4) Domestic corporate valuations have not grown as strongly as it seems because of our conventions for tracking their values.  First, since the early 1980's, there has been a significant change in capital income distribution, from dividends to buybacks.  Both methods have the same effect on the capital base.  But, dividends cause stock index values, like the S&P 500 index, to decline, whereas buybacks have no effect on the index level.  For the past 30 years, stock market indexes have been overstating growth in corporate capital by about 2% per year.  This is a large difference over time.  There is growth in the capital base outside of the indexes, from entrepreneurial activity.  But, the new tech. firms that have been replacing old capital tend to have low debt levels and hold a lot of cash.  This transition from old firms that required a lot of physical capital and utilized a lot of debt to new firms that have little debt and a lot of cash is deflationary, given a stationary currency level.

Secondly, much of the growth in corporate profits and valuations is related to foreign operations, and much of the profit from those operations is being reinvested abroad.  This also causes stock valuation indicators to overstate the nominal level of domestic activity, to the casual observer.

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Total credit + currency at the end of 2007 was $7.5 trillion.  If it had continued to grow at 8% per year, it would be up to $12.8 trillion.  Instead it's at $9.1 trillion.  That is nearly 30% below the 70 year trend!  This should be extremely deflationary.  It suggests, for starters, that if the mortgage credit market remains stuck, the entire quantity of excess reserves could be released as currency without any inflationary effects.  I don't think that is actually the case.  But the reason it isn't the case isn't because of the currency itself.  It's because the currency would probably mostly become equity in real estate, and eventually the added equity would deleverage households enough that mortgages would start to grow, too.  But, that is an assumption.  If mortgages are mostly stagnant because of an impasse between banks and regulators, then I don't think the new currency would be inflationary.

So, why aren't we experiencing extreme deflation right now?  I think the reason is because this has mostly played out through the real estate market.  So, first, there are millions of homes that haven't been built over the past decade.  The housing stock is probably something like 5% below where we might have expected it to be.  That's about 0.5% of real GDP that is just missing.  Most of the rest comes through returns to homeowners.  Most of that $3.7 trillion in missing money would have been used to bid houses up to their intrinsic values.  Because that credit went missing, houses are below their intrinsic values.  But, landlords and homeowners are still earning the same rents that they would be earning if the homes were correctly priced.  So, unless you need to sell your home, the lost liquidity is not visible to you.  In the meantime, institutional investors are buying like crazy to get those excess returns.  But, owner-occupier households have been so dominant in the single family residence category for so long - because we used to facilitate mortgage funding - that the organizational foundation for single family home rentals can only grow so quickly.

So, why hasn't this been the case in previous recessions?  Look at that first graph.  We haven't had a liquidity crisis this bad since the Great Depression.  And, since real estate was mostly owned with very little use of credit, the decline in currency filtered through the economy differently than it is today.  (Added: The recession of 1990 was associated with a brief deviation from trend that amounted to a permanent decline of nearly 20% in currency and credit.  But, inflation was running at 5% when that recession began.  And real interest rates were high and risk premiums were low.  Yet, with all that going for us, in real terms, home prices declined by 25% by 1996!  And nominal interest rates fell sharply - because not only are interest rates a terrible way to judge monetary policy, but to the extent that they are, low long term interest rates are a sign of tight money, not loose!)

Housing Tax Policy, A Series: Part 8 - The crisis didn't happen the way you think it happened.

As far as I can tell, just about everyone agrees on the following series of events:

1) House prices driven up by predatory lenders, or public pressure to expand home ownership, or both, pushed low income households in homes they couldn't afford.

2) As rates rose, low income households with unsustainable ARM mortgages couldn't afford their mortgage payments.  Delinquencies started to pile up.  Home prices started to collapse as a result of families losing their homes in foreclosures, and the wider economy and labor market finally collapsed under the weight of it.


Let's check this narrative:

1) House prices driven up by predatory lenders, or public pressure to expand home ownership, or both, pushed low income households in homes they couldn't afford.

The first culprit in this step of the plot is the new Community Reinvestment Act of 1994 that is said to have pressured expanding banks to make more loans to marginalized neighborhoods.  And, the data suggests that this rule may have been significant in pushing up homeownership rates.  Beginning in 1994, there is a marked increase in homeownership rates, which had moved in a tight range around 64% for 10 years.

But, the timing just doesn't fit the story.  The ownership rate maxed out at a temporary spike of 69.4% in 2Q 2004.  A total rise of 4.3% from the flat trend of 1984-1994.  But, half of the rise had already been realized by 4Q 1998, when the ownership rate was at 66.5%.  And, as of that point, there had been no rise in inflation adjusted home prices.

Then, between 4Q 1998 and the peak of ownership in 2Q 2004, the Case-Shiller 10 city index rose 86 points.

But, prices didn't peak until 2Q 2006, by which time the Case-Shiller index had risen another 51 points.

So, half of the rise in home ownership came with no effect on home prices, and more than 1/3 of the rise in prices came after home ownership rates peaked.  In fact, the steepest period of rising homeownership rates came with no rise in prices and the steepest period of rising prices came with no rise in homeownership rates.

Now, there was a period of 5 years where homeownership rates rose along with home prices.  It is certainly plausible that some portion of the rise in prices is related to this portion of homeownership expansion.  But, considering there were a total of 6 years before and after that where there was no connection between these trends at all, the proportion of the price movement related to pressing marginal first-time homeowners into questionable mortgages is highly suspect.

I would have even believed very easily that desperate mortgage brokers might have been bottom feeding to keep their business plans intact as the boom stalled.  But, even that notion is betrayed by the data.  No net marginal households were purchasing homes for two entire years before prices peaked.

I would like to make two more points here, also.

First, we are talking about a rise in homeownership from 64% to 69%.  Or, put conversely, the marginal non-homeowning household at the beginning of the period was at the 36%, and by the peak, was at the 31%.  This is a marginal change.  While I don't doubt that many anecdotes about reckless mortgage brokers are true, the notion that the boom was built on wide-spread new ownership by households far outside the typical range of home-owning households doesn't seem to pass the smell test.  In 2011, the 36th percentile household income was about $35,000 and the 31st percentile household income was just over $30,000.  Households don't line up cleanly by income to be the marginal homebuyer, but this gives a sense of scale regarding the relative incomes associated with this expansion of households.

Secondly, between 1994 and 1999, about 3 million marginal households (on net) became home owners.  Those households experienced extremely profitable gains on their new homes.  Even today, their aggregate home values are more than double what they were at the times of their purchases.  For half of the new marginal home owners, homeownership was an extremely profitable decision.  I wonder if there are any stories in the Washington Post where these homeowners gush about what a great service their bankers provided for them.

In fact, today's housing price level is higher than the price level was in 2004 when the last net marginal household became a homeowner.  And, except for the last 1% of net marginal owners in the last year before the peak, aggregate nominal home prices never declined below the level at the time of the original purchase.


2) As rates rose, low income households with unsustainable ARM mortgages couldn't afford their mortgage payments.  Delinquencies started to pile up.  Home prices started to collapse as a result of families losing their homes in foreclosures, and the wider economy and labor market finally collapsed under the weight of it.

Well, wait a minute.  The homeownership rate topped out because ARM mortgage rates started to rise, causing borrowers to default on unsustainable mortgages.  Right?


Here is a graph of the Fed Funds Rate and the Real Estate Delinquency Rate.....

Short term rates began to rise in 2Q 2004, topped out in 3Q 2006, and remained there until 2Q 2007.
In 2Q 2007, the single family home delinquency rate was at 2.3%.  Please note how starkly the consensus narrative differs from reality.

In 2Q 2007, at 2.3%, single family home delinquency rates were still at the level we saw throughout the 1990's, which ranged between 2% and 3.4%.  Short term interest rates had been rising for 3 years and had been at this level for 1 year, so rate resets would have been well-baked in by this time.

At this point, the relationship between single family home delinquencies and interest rates was typical.  In 2Q 2000, the yield curve inverted, and delinquencies began to rise.  By 2Q 2001 delinquencies hit 2.4% and leveled out.  In 1Q 1989, the yield curve inverted, and delinquencies began to rise.  By 4Q 1990, they topped out at 3.4%.

In 2007, at the supposed end of the biggest, baddest housing bubble since the tulip craze of 1637, at the end of the rate tightening cycle, the delinquency rate was 2.3%.  By 3Q 2007, both the Fed Funds Rate and long term rates were in free-fall.  There is no question that by this time, the liquidity crunch was in full swing.

Home prices were still near their peak at this point.  Homeownership rates were down to 68.3%.  Home prices, even now, were 44% higher than they had been in 3Q 2003, when homeownership had last been 68.3%.  Can we attribute home prices in 2Q 2007 to loose monetary policy, a year into the yield curve inversion, and on the cusp of a demand collapse?

The next few graphs looks pretty clear to me.  Note that in the rates & delinquencies graph, the home price index is inverted to help see the parallels in the trends.  I have also added unemployment, which bottomed in 4Q 2006, after the yield curve inverted - just like it had in 1989 and 2000.  In 4Q 2006, when unemployment bottomed, delinquencies were at 2.0% and home prices were still at their peak.

So, the consensus narrative is that loose money, greedy bankers, and enthusiastic bureaucrats combined to create a housing bubble.  Despite these policies, the unsustainability of dicey mortgages caused millions of households to default because they couldn't keep up with rising rates, and this led to the crash of the bubble, despite efforts by the Fed to prop up this pretend economy.

The actual order of events is quite the opposite.  (1) Tight monetary policy.  (2) Rising Unemployment & Collapsing prices.  (3) Delinquencies.

In the 18 months after 2Q 2007, to 4Q 2008, home prices dropped by 25%!  In those 18 months, delinquencies rose from 2.3% to 6.9%.  Unemployment also rose to 6.9%.  In the following year, while home prices would find their bottom, unemployment would top out at about 10%.  Soon after, delinquencies on single family homes would top out at 11.3%

Here is one last graph, comparing delinquencies on single family homes, all real estate loans, and all loans at commercial banks.  We don't see delinquencies on single family homes rising, leading to problems in other areas.  We see all three measures rising at once, as if moved by some singular exterior force.  The only difference in behavior is after 2010, when policies regarding bank regulation, foreclosure processes, continued timid monetary policy, and persistent unemployment  continue to create frictions in the owner-occupier home market.  Again, the problems distinct to single family homes are, if anything, the lagging factor.

Two last graphs.  This is a graph of currency and bank credit.  Currency began to fall from trend as early as 2003 & 2004.  This might be reasonable because households were sitting on a lot of home equity, although total bank credit was not outside the typical range of its long term trend in the 2000s.  And, nominal home values had topped out by the end of 2005.  But, currency continued to fall from trend until late 2008.  The rise in bank credit doesn't line up with the housing boom.  It looks to me like it is more of a reaction to the Fed's tight money policy at the end of the housing boom.  Household equity % had been steady for a decade, and had been growing since 2003.  Home prices topped out at the end of 2005, and homeowner's equity began to fall precipitously while home prices held steady.  At this point, after currency had been growing at 8% annually for decades, it was now growing at less than 3%.  At this point, households were desperate for liquidity.  They had held equity steady throughout the boom.  In early 2006, they were done bidding on real estate, but they were desperate for cash.  This was happening by 1Q 2006.  As late as April 2008 - more than two years after this clamoring for liquidity began - the Fed had pushed the YOY change in currency down to 0.6%!

Even in early 2008, after 2 years of liquidity starvation and home prices down 15%, delinquencies were under 4%.  Yet, after all of this, in the infamous September 2008 FOMC meeting, the Fed held rates steady to signal that inflation was their primary concern.  They soon dropped rates to the zero lower bound.  Delinquencies in 3Q 2008 were still at 5.2%.  Two-thirds of the rise in delinquencies happened after that meeting, with short term rates (presumably including ARM rates) near their lower bound.  However, equity as a proportion of real estate began rising again in 1Q 2009, when the Fed finally reversed course and implemented QE1.

Housing Tax Policy, A Series: Part 7 - The mortgage inflation premium as savings, revisited

I described mortgages as a sort of planned savings program.  The mortgage payment includes an inflation premium.  All else equal, in the typical year, in aggregate, real estate should appreciate by roughly the rate of inflation, which increases the owner's equity.  In addition, a homeowner pays some principal on the mortgage amount.  The homeowner also pays interest on the mortgage.  The real part of the interest is a cost-of-capital payment to the lender.  The inflation premium portion of the interest payment is really another portion of the homeowner's equity accumulation, because the mortgage principal remains fixed in nominal terms, which means that it declines in real terms.

Neither the increase in the home's market value nor the inflation portion of the mortgage payment are generally treated as household savings, which is one reason why much of the data and discourse about household savings is non-informative.

In the early 1980's, effective aggregate mortgage rates hit 10% (7% inflation premium + 3% real) and mortgages amounted to about 30% of GDP.  By the late-1990's, before the housing boom, the effective average mortgage rate was down to 7% (3% inflation premium + 4% real) and mortgages amounted to about 43% of GDP.

In the 1980s, until about 1989, homes were gaining about 7% in nominal value, annually.  But, prices topped out, and for the next decade, nominal home values were stagnant.  Aggregate owner-occupied home values were roughly equal in value to annual GDP during this period, coincidentally.

So, with regard to home owning households that aren't engaged in real estate transactions or active re-leveraging, in the 1980's, households were saving about 9% of GDP each year (7%*30% + 7%).  But, in the 1990's, households were only saving 1.3% of GDP (3%*43% + 0%).  in expected terms, in the 1980's households were saving 2% of GDP (7%*30%) and in the 1990's they were saving 1.3% (3%*43%).  In actual terms, 1980's households were saving 7% and 1990's were not saving anything beyond their principal payments.  (edit: sorry.  My original version double-counted by confusing expected returns with actual returns.)  This was a huge shift in household financial behavior.  And, it happened without any conscious change in savings behavior!

This passive shift in saving behavior should put upward or downward pressure on the level of mortgages.  I believe we can see the basic expected effects of this process in the historical data.  Compared to what we might expect, shifts in mortgage and equity levels are unusually high in the 1980s and 1990s because of tax changes and unusually low in the 2010s because of the liquidity crisis.

This passive saving issue should have a significant effect on monetary policy.  The inflation rate has little effect on lenders.  Their capital base will grow at the real interest rate regardless of inflation.  But, inflation does have a significant effect on homeowner behavior.  This is largely passive savings which households treat as deferred consumption.  As they pay down their mortgages, unless banks reallocate capital into new mortgages or other sectors, there would be a decline in bank credit outstanding.

Because owner-occupied home equity is tax advantaged, there is no tax arbitrage advantage for households to re-leverage.  And the additional equity has very little effect on consumption.  So, in real estate, there is probably a mitigating downward influence on aggregate demand when inflation rates are high.


The same concept can be applied to corporate debt

The inflation premium is a sort of pre-planned savings for corporate debt, too.  In fact, the inflation premium on corporate debt is like the debt equivalent of share buybacks.  In both cases, some portion of nominal earnings is used to repurchase some portion of the claim on future profits, and remaining shareholders have a higher ownership share in the firm's operations, which is manifest through unrealized capital gains.

There is a difference between corporate and real estate debt, though. Whereas owner-occupied real estate confers several tax advantages to the owner, whether ownership is weighted to debt or equity funding, corporations have a clear tax advantage to debt-based funding.  This is especially true in high inflation (high interest rate) contexts.  So, where households would tend to accumulate equity in a passive asset for deferred consumption, corporations would tend to re-leverage as the real level of debt decreases through inflation.

I think we can see this difference in the comparison between the late 1970's and the 2000's.  In both cases, real risk free interest rates were very low and risk premiums were high, which would tend to pull capital out of corporate equities, into real estate and corporate debt.  However, inflation premiums were high in the 1970's and low in the 2000's.  Because of the different effects of the inflation premium, outlined above, this would tend to pull capital into corporate debt in the 1970's.  But, in the 2000's the low inflation would keep corporate interest rates low, reducing the incentive for corporate debt, and leading to more capital being allocated to real estate (both equity and debt) and, to a lesser extent, corporate equity ownership.

Further, because the passive savings from the high inflation premium is so strong, I wonder if the low real rates of the late 1970's were, in large part, caused by the high inflation.  In the 2000's, I have assumed that the low real interest rates were a result of excess savings coming out of demographics and developing economies.  But, as I walk through this topic, I am starting to think that the low real interest rates of the 2000's were exacerbated by tax policies in housing that have pulled so much household capital into real estate and pushed down pre-tax required real rates of return in so much of the single family home market.  (Note how many articles there are complaining about low distribution of stock ownership among households, and how little emphasis is given to housing tax incentives as a cause.  And, how often is the solution redistribution through higher taxes on capital income and high compensation income?  I have posed this question before.  When these taxes induce even more household capital into the tax-preferred deferred consumption of home-ownership, what would be the effect on the breadth of stock ownership and the long term employment and productivity of middle income workers?  Of course, then we will see more articles about how high house prices and low industrial employment are squeezing the middle class.)

At the other end of the business cycle, the 1990's were economically strong - strong wage and capital income.  Low equity risk premiums, falling inflation, and high real interest rates were associated with stagnation in real estate capital levels and a boom in corporate capital, concentrated in equity.  This is just as we should expect.  Note from the graph above that dividend yields were low in both the 1960's and 1990's.  A lot of unnecessary gravitas is usually ascribed to corporate payout ratios.  But, looking at this through a risk-trading paradigm, in those periods, corporate equity would have been attracting capital, and most corporations would find themselves under-allocated to equity compared to the optimal level.  Lowering the payout ratio would be the most efficient way of approaching the optimal allocation.

PS:  There are a lot of ideas floating around here, so I apologize if this series is occasionally scattershot or repetitive.

PPS: I start to wonder if, at some point, some readers start to think something along the lines of, "Well, duh.  He's just talking about what Sanchez and McGillicuddy worked out in their seminal 1995 paper." Or worse, "Uh.  I thought Sanchez and McGillicuddy put an end to this sort of misinformed nonsense with their seminal 1995 paper."  Either way, when you think that, please give me a reading reference in the comments.

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

December 2014 JOLTS

Still lookin' good.

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

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

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

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

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

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

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

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

Keystone Pipeline: Politics is not about policy

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

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

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

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

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

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

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

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

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

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

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


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

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

We are the 100%...

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

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

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

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

ERP Source

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

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

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

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

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


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

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

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

A brief rant on monetary policy

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

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

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

Later:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

(Follow up post)

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

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

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

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

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

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

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

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

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

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

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

The Public Policy Implications

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

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

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

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

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

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


The Numbers

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

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

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

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

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