Ten Years on...

Ten years ago today, Jim Cramer lost it on the air.  It was August 2007, and he was apoplectic about how complacent the Fed was about credit markets.  "They know nothing!", he yelled.

At the time, I thought, "Oh, there go the clowns on CNBC clowning."  I knew nothing.  In hindsight, this - both in content and in tone - was the most prescient public comment of the entire affair.  I give Jim Cramer mad props.  He earned my undying respect.  He was absolutely correct.


Watch the full rant: Cramer's 'They know nothing!' from CNBC.


Meanwhile, the Wall Street Journal was saying this:

Credit panics are never pretty, but their virtue is that they restore some fear and humility to the marketplace....

It's tempting to blame Wall Street and other bankers for all those bad residential loans, and they are paying the price now. But they were also lending into a housing asset bubble fed by easy monetary policy. Risky mortgages always look better when home prices look like they'll never decline. 

Current Fed Chairman Ben Bernanke was along for the Greenspan ride, so he's hardly blameless. No doubt he'd love to play the hero role now, signaling easier money this week.

According to Bernanke, he read the Wall Street Journal article, but purposefully avoided seeing the Cramer segment.

Housing: Part 248 - No, Phoenix didn't build too many homes.

Just a quick post so I can stick this graph here.

The one thing everyone in Phoenix knows is that we built too many homes during the bubble and that is what caused the bust.

Here is an article that claims (HT: John Wake) that, based on stable demand for 35,000 homes per year, Phoenix built 75,000 too many homes, and that was what killed the housing market here.

Here is a graph, from IRS data, of domestic migration into Phoenix, based on the number of households.  There was a massive inflow of new residents fleeing the high priced California cities.  In a normal year, net inflows into Phoenix were about 20,000 - claiming more than half of that stable demand for new housing units.  In 2004 and 2005, that shot up to more than 30,000 per year.  Then, we killed the housing market, and that flow was destroyed.  By 2008, and continuing for years, net inflows have been negligible.  (This graph stops in 2010, but migration into cities like Phoenix has continued to be stifled.)


Source: IRS - number of households filing tax returns

The supposed overbuilding was actually a response to real demand for housing.  And, when that demand collapsed, because migration collapsed, it was a double whammy.  Builders were, of course, building for that high demand.  What were they supposed to do? And, when it suddenly collapsed, it looked like they had built 75,000 too many homes.

The only reason Phoenix had a price bubble is because it couldn't meet this huge boost in demand, so the short term supply inelasticity caused prices to rise.  We can see that in this graph.  By 2005, outmigration was rising in Phoenix, because Phoenix couldn't build enough houses, and so the same migration patterns that were coming out of California started to develop in Phoenix.  People were moving away to escape rising costs.

The frustrating thing is that, during that time, builders were holding lotteries to sell newly permitted newbuilds.  That is insane.  I don't understand how that could have happened.  And, I can't get a straight answer from anybody about why.  When I ask people, they say, "Well, there were all these speculators coming in and buying up houses.  We had to limit new building because they were creating a bubble in supply."  NO!  The bubble was in prices because we were holding lotteries to sell houses.  If you're a speculator, and you see a market where the sellers say, "We are limiting the quantity that we are selling.  If you don't get chosen as a buyer this month, come back next month, where we will release some more limited supply that is guaranteed to sell at a higher price." that is a speculator's dream!  And, when I ask why we were doing that, the response I get is that we didn't want to build a bunch of houses for speculators!

Meanwhile, the migration statistics say that by the end of the bubble, 10,000 extra households were leaving town each year - for want of a house!

Contagion cities like Phoenix have been devastated by the housing bust.  Incomes compared to other cities have collapsed.  We should be outraged.  We should be marching in the streets against tight credit markets.  Instead, the consensus in Phoenix seems to be just as screwed up as it is everywhere else.  Self-flagellation.  Our greed angered the real estate gods, and this is our just due.

The only thing we did wrong was not building enough houses.

Corporate profits over time

The other day, Tyler Cowen reminded us of an old post at Philosophical Economics about corporate profits.  The post makes a lot of good points about the ways that corporate profits are mis-identified in general discourse.  For instance, comparing total corporate profits, which includes a large amount of foreign profit, to GDP is just a fairly meaningless measurement.  (It's even worse to compare stock indexes to GDP, since stock indexes as a measure of corporate value over time have a significant amount of drift over time.  They just don't work as an aggregate value measure in this way.  A distressing number of people who should know better make this mistake.)

But, I think Philosophical Economics doesn't quite take it far enough.  He limits his measurement to profits after tax.  This still leaves the issue of leverage and debt expenses.  Changing interest rates and leverage levels create arbitrary changes in profit margins over time.  The better measure to use is operating profits.  Net Operating Profits After Tax (NOPAT) is an estimate of after tax profits before interest expenses.  This provides a measure of profits for the entire liability/equity side of the balance sheet.

I realized that Philosphical Economics used data from BEA table 1.14, and that I could use that table to estimate corporate profit in a way I hadn't before.  According to this measure, profit margins appear to have had a stationary mean until the financial crisis.  After that, they increased to levels similar to the 1960s, and have since declined back down to the more typical long term range.  (See addendum below.)

This is based on profits relative to revenues.  Profits, on the other hand, have risen compared to book values.  I think that is largely do to the capitalization of human capital, which does not appear on the balance sheet, through stock-based compensation and, of course, the housing problem.  High margin business are frequently located frontier sectors in the Closed Access cities, where limited housing serves as an obstacle to competition.  That obstacle is funded through rising rents, which are paid through higher wages.  So, the book value of those firms is understated, because the houses that serve as an asset base that protects them from competition don't appear on the firms' balance sheets.

Today, competitive advantage hinges on high skilled workers in ways that continue to be reflected in revenues, but not in physical corporate assets. So operating profits are normal relative to revenues and market values but high relative to book values.

Actually, there appears to have been a bit of a secular decline in profits/market value.  (Basically the inverse of Price/Equity, which has been running slightly high.)  I don't think it's as low as it is frequently made out to be, and I think these things tend to have some structural causes as opposed to reflecting the perma-bubble that seems to capture so much of the public imagination.  One reason I think P/Es might be slightly high is lower corporate leverage on an enterprise value basis.  I wonder if this human capital issue I another.  That human capital tends to be paid in stock options more than labor used to be.  Shareholders basically are selling calls on their firms.  It's insurance that has already been expensed doubly, in a way, both through an estimate of the value of the options, and through share dilution.  That lowers equity risk going forward, both on the upside and on the downside.  Depending on how that trickles through valuations, that could boost P/Es I think.  After all, in the Black-Scholes model, call sellers are willing to basically earn the risk free rate. Right? That's a high P/E.

Addendum:
I suppose if I'm going to be pedantic, I should be more careful about my data.  I think I mixed up non-financial and financial profits and value added a little bit in the graph above.  Here are graphs for both (1) domestic non-financial NOPAT and profit compared to non-financial corporate value added, and (2) domestic total corporate NOPAT and profit compared to total corporate value added.

The basic story remains the same.  By accounting for corporate operating profits that accrue to creditors, long term margins are much more stable.  Most of the supposed recent growth in profits is simply due to a reversion back to normal levels from the late 1970s and 1980s when leverage was higher on an enterprise value basis and a significant amount of interest expense was simply an inflation premium that doesn't get accounted for easily in national accounts.

Operating profits remain fairly stable through the Great Recession.  But, making these corrections, the recent boost in margins does move slightly above the peaks we saw in the 1960s - slightly higher relative to those levels than my original graph.  In both cases, margins have moved back to the top end of the long term range.

Housing: Part 247 - The elasticity of causation

Here is Matt Taibbi on the Fannie and Freddie lawsuit in Rolling Stone.  This is an interesting piece.  Taibbi is a compelling writer, and I give him props for recognizing the apparent abuse of power here.  It would probably be easier for him to take the position against the dreaded speculators and hedge funds who have sued the government.

I don't spend a lot of time reading popular assessments of the financial crisis, so it is always eye opening for me to step out of my conceptual shell and to be reminded of the things most people have come to confidently take for granted.

Here are a couple of excerpts regarding the GSEs and the crisis:

They had gone bust during the crash years for a variety of reasons, mostly due to incompetent and corrupt management. But by the summer of 2012, with the real estate market in recovery, the companies weren't bust anymore. On the contrary, they were about to start making money again – enormous piles of it, in fact...

...It should be noted that despite legends to the contrary, Fannie and Freddie's affordable housing mission did not cause the 2008 crash.

In fact, the Financial Crisis Inquiry Commission concluded that delinquency rates for GSE loans were "substantially lower" than those of the private banks and mortgage companies that were lending subprime loans to anyone with a pulse during that era.

The crash was caused by greed, not social policy...

...probably because Fannie and Freddie were so unpopular after the crash – deservedly, in part, because of numerous scandals involving its executives – the companies were treated very differently than other bailout recipients.

I think this is a great example of how flexible our collective sense of morality can be.  And, I don't think there is anything unusual, here.  Taibbi is a great journalist, in part, because he has an intuition about the audience's contradictions.

Notice how easily he floats here between certainty that every problem the GSEs had was due to mismanagement and corruption and how no problem is explained by the affordability mandates.  "The crash was caused by greed, not social policy." is an axiom.  Even within paragraphs of each other, when mentioning social policy, we should note that the GSEs were quite well managed.  When mentioning management, we should note that the GSEs were managed incompetently and corruptly.

In fact, neither of these factors has much to do with anything.  The GSEs were designed to be vulnerable to one thing, and one thing only, and that is a massive, multi-sigma downturn in the housing market.  There is no other context where they would ever have failed, and there was no way for them to avoid failure in that context if the government decided to strictly invoke capital requirements.  They faced a multi-sigma downturn, the government invoked strict capital requirements, and they failed.  Everything else is noise.  Taibbi and his readers share a set of axioms, so these axioms are repeated ad nauseam until the repetition itself creates a sense of empirical fact in their minds.

Other audiences reverse this axiom and blame social policy.

The fact that, given the context and the position of the treasury in 2008, failure was inevitable, allows all axioms to be acceptable to their respective audiences.  One could argue that the cause of the collapse was a happenstance where the axioms of a plurality of Americans caused them to support liquidationism in 2007 and 2008.  This is obvious in hindsight, when the bulk of criticism toward federal officials is related to their attempts at stability rather than at the instability itself.

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One other quote from the paper:

In most versions of GSE reform currently winding their way through Congress, the same too-big-to-fail banks that blew up the mortgage markets in 2008 would assume most of the responsibilities of Fannie and Freddie. Crucially, securitized mortgages would continue to enjoy government backing under many of these proposals.

Privatized profits, socialized losses. Who doesn't love that formula?

I note this excerpt as an example of the sorts of little errors that slip into our common discourse which allow us to mend and protect our axioms.  Again, there is nothing unusual or special here.  We all have these.

Did you notice what he ignores here?  It is an uncontroversial fact that yields on these securities that have federal backing are lower because of the backing itself.  In free markets, it could be no other way.  It is impossible for markets to privatize these profits.  First, because the guarantee earns a profit over time, through fees, which Taibbi implicitly understands when he notes that the GSEs have returned to profitability.  Over the long term, they have been profitable, even after having taken nearly a quarter trillion dollars in credit losses during the bust.  (When their incompetent and corrupt management managed, somehow, to maintain those strikingly low default rates.)  Secondly, because investors bid down the yields on those guaranteed MBSs to reflect the value added of that guarantee.

"Who doesn't love that formula?"  The formula is a figment of Taibbi's imagination.  This subtle mistake, along with many others, serve to support the axiom.

You can see a similar sort of convenient error in the way everyone talks about CDOs.  The way they are always described is that they were creating AAA securities that really had hidden embedded risks.  Bankers trying to boost their yields were buying them up because they were too stupid and too greedy to understand that.  And that greed is what done us in.

Now, I have written a lot about how this is entirely wrong, anyway, because the CDOs, and especially the more exotic CDOs that had more exposure to systematic risk, were a late phenomenon that happened almost entirely after home prices and housing starts peaked, and certainly happened well after homeownership peaked. (In fact, falling home ownership was the reason they ever needed to be created in the first place).

But, ignoring all that, this way of describing CDOs is wrong in much the way Taibbi's comment above is wrong.  Yield is a reflection of risk.  If yields on the AAA securities from the CDOs were higher, it is because the market clearly recognized the potential for added risk.  The yields weren't bid down to a riskless yield level.  The mis-statement about the CDOs is usually described as "reaching for yield" which is one of those phrases I wish we could just blast from the lexicon.  That phrase really only serves one purpose, and that purpose is to promote this lie, that perceived risk and yield are somehow unconnected - that yields are just independent variables out their in the market, and greedy investors chase them up in a short-sighted attempt at capturing more income than is sustainable.

It just doesn't work that way.  All yields are codetermined with perceived risks.

This axiom is so deeply ingrained, that few noticed the severity of the dislocation in the summer of 2007.  By normal standards, things like monetary policy weren't wildly off the mark, but by August 2007, even though there were billions of dollars of savings, madly in search of safe assets - a "bubble" in AAA securities, in the common and perverse usage of that term - those securities were trading at deep discounts.  There was a massive demand for safety, and the securities meant to be safe were failing.  Then even auction rate securities markets started failing.  Again, despite billions or trillions of dollars in search of safety.

This is recognized as a regime shift from greed to fear.  That's truish, as far as it goes.  But, what if the description of reality was closer to having moved from normalcy to fear.  Even if one concedes that 2005 could be characterized by "greed", certainly that hadn't been the case for some time by 2007.  In fact, the regime shift in 2007 was probably from fear to crisis.  We had already passed clean through normal.

But, in a paradigm that sees only two regimes - greed and fear - fixing the fear problem necessarily means creating a greed problem.  We didn't fix the problem because that meant we'd go back to the greed regime, and that's what caused all our problems, right?  Reaching for yield.  Privatized gains and socialized losses.  We had to avoid those things.  And, weren't those incompetent and corrupt managers the source of the problem, anyway?  We're just supposed to let them off the hook?  Our axioms demanded, "No way."

Housing: Part 246 - Funny Real Estate Quote from 3 Days Ago

This recent post at Calculated Risk is a good example of Our Problem.

He links to a quote from 10 years ago, June 2007 when home prices in most places were still pretty stable but sales and starts had been in steep decline for more than a year:

Ten years ago, NAR's senior economist said: "It is too early to say if home sales have already passed bottom," said Lawrence Yun, the senior economist for the group in the report. "Still, major declines in home sales are likely to have occurred already and further declines, if any, are likely to be modest given the accumulating pent-up demand."

That silly senior economist!  Didn't he know that the future was already written?


Here is a graph of housing starts.  Housing starts (which trend with existing home sales) had been in decline for about a year and a half when he said that, and they hit and fell through the bottom of the long term range around the end of 2007.  (And, by the way, even in 2005, housing units per adult or per capita were similar or lower than at any time since the 1980s.  Outside of some depopulating Rust Belt cities, no city had too many homes.  No city needed a collapse in homebuilding.)


Source

If only Mr. Yun could have been the senior economist for the realtors of Canada or Australia, which also have had a housing "bubble".  Then, he could have been a brilliant prognosticator.  But, alas, he was the senior economist for the US National Association of Realtors, which means he was a silly, silly man, because the US housing collapse was years from turning back up.  And, this was already pre-determined.  Smart people know that.  The coming collapse of the private mortgage securities market, the federal takeover of the GSEs and its extreme tightening of credit standards, the decision by the Fed for 6 months after this prediction to continue to refer to housing market trends as an ongoing "correction" and to broadcast fears of inflation, its discretionary tightening in September 2008 because of inflation fears - two weeks after the feds forced the GSEs to take massive write downs in anticipation of future foreclosures.  None of those things had anything to do with the continued collapse.  Those were simply reasonable policies enacted because smart people should have known in June 2007 that the worst was yet to come.  It would have been irresponsible of us to expect anything else.  And, you and me, we're not silly like that senior economist.  We know a bubble when we see it.  Policies based on an expectation and acceptance of a collapse are simply the only prudent response.  The witches were triggering hallucinations.  I suppose you wouldn't have burned them at the stake?  It's easy for you to complain after we solved the problem.

We never had too many houses.  That's not our problem, by a long shot.  You know what our problem is?  Our problem is that we've got a country full of smart people - not those silly people.  A country full of people that know the value of things.  A country full of people who feel a smug self-satisfaction when markets collapse, prices decline, and those irresponsible, silly speculators, lenders, and builders go bankrupt.  Bill McBride at Calculated Risk is a smart guy.  Most of my neighbors are smart.  Most economists (unlike that NAR guy) are smart.  The Fed is smart.  Teachers and doctors and plumbers - smart people all over.  So many people are so smart that when I suggest all of this mess wasn't inevitable to strangers on a plane or acquaintances at school functions, I usually get a slightly confused look and then a comment about those terrible bankers that did this to us.  I think they just think they misunderstood me, and they assume if they reply with something that smart people all know, the misunderstanding will clear up.

A country full of people ready to claim "I told you so" whenever everything breaks is a country destined to break.  How can it be any other way?

Hey, you working class families in New York and San Francisco, and Los Angeles!  Remember in 2007 when that silly economist claimed there was pent up demand for housing?  Remember that silly guy?  You know better, don't you!  You know they're practically giving houses away!  Got so many, they don't know what to do with them!  Silly economists.  "Pent up demand."  What planet was he on?  We hadn't even begun to enforce the correction.  Good thing we've got some smart people in charge to keep these things from getting even more out of control than they did.  We'd be like that green line or that red line in the graph instead of the black line.  In Canada and Australia - countries apparently full of silly people - they literally are buried in houses by now.  Opening a checking account?  Here, have a house!  Oh, you want 4 scoops of ice cream?  That comes with a house!  That's what it's like in those countries.  That's what you get when you don't let the smart folk keep things honest and prudent.  They are soooo going to feel dumb when they realize they've got waaay too many houses.  They'll probably beg us to take them.  But, we're not chumps.  We're prudent.  We know the value of things.  Things are too expensive.  Have been as long as I can remember.  We don't want their bubble houses.  Prudent people go without.  Prudent people make others go without.  If you don't, next thing you know the silly ones are running the show.

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Imagine what a world it would be if instead of thinking "I told you so." we had a country full of people who, upon seeing that quote from June 2007 and the graph of housing starts since then, thought, "Good Lord, what have we done?"

Housing: Part 245 - Foreign buyers

There is a lot going on in this New York Times post "When the (Empty) Apartment Next Door Is Owned by an Oligarch".

This struck me:

Anger at who is causing that harm can stray uncomfortably close to xenophobia. But politicians and anxious residents often add that their real grievance is with foreign money, not foreigners. And maintaining that distinction is important if cities that have long prided themselves on being cosmopolitan want to continue embracing immigration while curbing speculation. 

This really is a window into our time.  At a time when so many forms of prejudice are becoming cardinal sins, all is forgiven if prejudice can be framed in terms of money.  Since this is the case, it is striking how explicit and unapologetic prejudice in these terms is stated.  Here, we can see it stated in the positive.  "We're not engaging in the cardinal sin of prejudice against foreigners.  We're engaging in the acceptable prejudice against money."

This prejudice has infected the humanities.  An example I noticed a while back was in a Slate.com review of the book "Empire of Cotton: A Global History", where the reviewer wrote:

Less than a decade ago, a historian interested in the rise of capitalism would have a difficult time finding a job in a history department. The closest thing scholars wrote about capitalism was called labor history, the story of the working class. Almost no one bothered writing about the flip side, elite capitalists; to do so suggested sympathy for the enemy.

Imagine being so blind to your own prejudices that you would say such a thing - as a historian, no less.  (Of course, none of us is immune to this, and we are all most ignorant of our personal prejudices where they are the strongest.)  It is understandable, given the statement above, that something like Nancy MacLean's "Democracy in Chains" could be published.  I'm sure she felt quite justified and professional while she was writing.  Tyler Cowen has said the use of villains in our narratives about the world lowers our IQ by 10 points or more.  This is an understatement.  It saddens me to think of the potential insights about economic history that are missed because the academy has become so blinded by this sort of Marxian sectarianism.

The tone of books like MacLean's, or of others like Naomi Klein, remind me of my youth when certain evangelical preachers would write or give sermons about how, say, Dungeons & Dragons was a tool of Satan.  Their description of the supposed vice was so tainted by their fundamentalism that it was humorous to anyone with a passing familiarity of it.  It is similar with Klein's and MacLean's work for anyone with a passing familiarity of Milton Friedman or James Buchanan.  In Klein and MacLean's case, it's a little less funny because they are attacking actual people, both soon after their deaths, who whether one agreed with them or not, were clearly engaged in a sincere attempt to make the world a broadly better place to live.

In any case, these works are so fevered, and so defined by their propagandist techniques, that, as with those sermons about D & D, they leave the realm of criticism or argumentation.  There is little chance that their authors will adjust to reasoned criticism.

The universality of this prejudice is really at the heart of our self-destructive policy choices during the housing boom and bust.  Money was to blame.  Hunting season was on.  The Wall Street Journal could literally ask for a financial panic with no sense of shame.  Across the political spectrum in 2007 and 2008, the only acceptable position to hold was that somehow markets needed to be stabilized without stabilizing the financial positions of speculators and lenders.  Even after the series of panics and collapses, public officials have to pepper their memoirs with apologies about "bailouts" and self-defense along the lines of, "Ya gotta believe me.  We stabilized financial markets because we had to, not because we wanted to."

In Geithner's memoir, he says,“Nothing we did during the financial crisis was motivated by sympathy for the banks or the bankers. Our only priority was limiting the damage to ordinary Americans and people around the world.”  And, Geithner is considered to be among the more aggressive policy makers regarding stability.

Think of how bizarre this is.  Imagine describing your policymaking approach regarding any other group by insisting - in your defense - that you had no sympathy.  "No, really, you shouldn't be so critical of me!  I'm a good guy, just like you.  I don't have sympathy, you see!"  I am especially sensitive to this because when I looked at the evidence, I concluded the unthinkable - that "money" in a broad sense, really had little to do with the housing boom.  Once I came to that conclusion, all of the sanguine attitudes about collapsing home equity and failing investment banks, all of the explicit demands for "Wall Street" to suffer for their sins, have become shocking.  Is it really that different than, say, being sanguine about the AIDS epidemic because it arose from "sinful" behavior?  I suspect many readers will blanch at that comparison.  How dare I compare a prejudice that is a cardinal sin to an acceptable prejudice?

One prejudice might have slowed the development of a cure.  The other prejudice might have led to a generation defining financial crisis and recession.  If you can see the fingerprints of prejudice in one, you should be able to see it in the other.  If your response to that is, "The difference is that Wall Street really did cause the recession because of the sin of greed." are you sure that your conclusion is independent of your prejudice?  Don't take this as an attempt to sway you.  I realize this would be counterproductive.  You don't win people over to a point of view by calling them prejudiced.

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Back to the issue of foreign buyers, the post mentions a paper that tries to model the effects of non-resident real estate buyers.  The authors estimate that out-of-town buyers in New York City have increased New York home prices by a whopping 1.1%.

The post suggests a tax on foreign buyers, as has been implemented in Vancouver, which might seem harmless enough.  We might be able to agree that the priority in housing policy should be to provide residential units over vacation homes or second homes.  I would agree that this would be far from the worst policy we have implemented in housing markets.

But, I think this is a good example of the depth of the problem of unintended consequences.  Let me preface this by saying that there are many cities that have many foreign buyers and that don't have a problem with out of control prices - places like Houston and Dallas - and they don't have to tax foreign investors.  They manage to build some blanking houses to meet demand.  Crazy, I know.

But, I think this unnecessary housing bust is really damaging because a housing boom is actually one of the more effective ways to deal with the demographic bulge.  The problem with the coming bulge of retirees is that, in any given period, most of what we consume must be produced.  If a large proportion of the population is out of the labor force, then there are many more consumers than there are producers.  You can't solve much of that problem by saving in preparation.  Whatever you do, when the time comes, you're still going to have "x" people vying for "y" consumption goods.

Housing is one very effective way to shift consumption over time because, as consumed, it is almost purely capital.  It doesn't have to be produced in the same period that it is consumed - in fact very little of it is.  That means that secular shifts in construction employment could really help to smooth consumption as baby boomers retire.  A lot of homes can be built now, when boomers are still in the labor force, and consumed later when boomers are retired.  Some of that macro-level consumption smoothing might even come in the form of multiple properties - homes that are vacation homes or second homes today, but that could become primary residences in 30 years when retired boomers lead workers to shift to consumption goods instead of durable goods.  The household today with a vacation home may be indirectly helping workers in 30 years to maintain a stable amount of consumption.

Prices are information, and so things like interest rates naturally feed these sorts of self moderating trends in a way that we can't really ever fully appreciate.  So, while we have been in a housing depression for a decade, one could argue that in an unencumbered economy, we would naturally be building too many houses - and that would be a good thing.  Unfortunately, in finance, we can play God.  We have the apparatus in place, and we have given ourselves broad moral authority to impose our will.  We will not be enjoying a housing boom any time in the near future.  We will make sure of it.

Housing: Part 244 - Moral hazard in securitizations

Here is an interesting working paper from John Krainer and Elizabeth Laderman at the Federal Reserve Bank of San Francisco. (pdf)

The abstract:

We compare the ex ante observable risk characteristics, the default performance, and the pricing of securitized mortgage loans and mortgage loans retained by the original lender. We find that privately securitized fixed and adjustable-rate mortgages are riskier ex ante than lender retained loans or loans securitized through the government sponsored agencies. We do not find any evidence of differential loan performance for privately securitized fixed-rate mortgages. However, we do find evidence that privately securitized adjustable-rate mortgages performed worse than retained mortgages, even after controlling for a large number of risk factors. Despite the higher measures of ex ante risk, the loan rates on privately securitized adjustable-rate mortgages were lower than for retained mortgages.

There is a lot of talk about how the securitization boom created moral hazard, how you used to go to the bank and get a mortgage and the bank giving you the loan was the one you would be paying, but now they sell the mortgage off and it gets sliced and diced among a million investors who have no idea how good of a credit risk you are, and so the bankers are willing to underwrite garbage, and this caused the whole system to collapse in a heap of greed.

Great story.  Very plausible.  It just didn't happen.  There was no significant increase in securitization as a whole during the housing boom.  The private securitization boom largely happened after prices peaked.  There is a brief period - lasting months really - between the rise of private securitization and the implementation of Fed rate hikes where some markets appeared to have some extra price appreciation.

In the Krainer and Laderman paper, which is based on a large data set from California, from 2000 to 2007, they find some evidence that privately securitized mortgages tended to have somewhat riskier characteristics, but it really doesn't amount to that much - certainly not enough to be the defining development of a massive bubble.  They report: "Indeed, observable risk factors such as current LTV and the subprime and documentation status are estimated to have a much much larger effect on the default hazard than investor type." (page 23)

Here is a graph of defaults, from the paper.  The blue line is retained mortgages, the red line is privately securitized mortgages, and the black line is mortgages securitized with the GSEs.  The GSEs had default rates much lower than either retained or privately securitized mortgages.  And, while privately securitized mortgages defaulted at a faster rate, by the end of the period analyzed here, default rates of retained and privately securitized loans were similar.

This doesn't look very promising for the "moral hazard" view.

In fact, I wonder if one effect of the GSEs is to provide a securitization market for the least risky loans, which would, ironically, leave the banks worse off, because there are many mortgages which can be reasonably made which don't happen to conform to GSE standards.  Those loans could be reasonable, and yet, they will inevitably be more risky than conforming loans.  What we have here is the opposite of moral hazard.  The banks are left with a riskier retained portfolio because of the GSEs.

Might we speculate that this would have led to constrained lending among more marginal borrowers, and private securitization provided an outlet for banks to realign their retained portfolios to be more like the neutral portfolios they would have been in a market without the GSEs?

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Richard K. Green and Susan M. Wachter have a paper with some international comparisons.  Now, clearly, if you limit access to liquidity for a given asset, the market price of that asset will decline.  This is conventional financial theory.  Where I part ways which so much analysis about the housing bubble is the universal knee-jerk reaction to blame growing mortgages and expanding credit for rising prices, with little accounting for scale, alternative hypotheses, etc.

Green and Wachter briefly describe the mortgage markets of several nations.

United Kingdom, Canada and Japan do not have significant securitization markets.  Two bubble markets and one market that did not have a bubble.

The US, Denmark, and Germany have significant securitization markets.  Two bubble markets and one market that didn't have a bubble.

The funny thing is, some of these countries tend to have strict down payment requirements while others do not.  Some have recourse loans others do not.  Some tend to have fixed rate.  Others do not.  Some have balloon payments, others have long amortizations.  Some allow pre-payments without penalties.  Others do not.

Now, there are some correlations, like countries with higher down payments appear to tend to have lower prices.  But, there is no obvious pattern with these mortgage market characteristics and housing bubbles.  This was true within the US, too.  There were some areas where private securitizations might have tweaked the market a bit, but for the most part the US market has relatively uniform characteristics.  Yet, homes in a few cities became much, much more expensive than homes in most cities.

Everyone understands that those high prices are triggered by supply constraints.  Yet, in all of these countries, from the US, to Canada, to Australia, debates rage about how to curb lending or keep out foreign investors, etc., as if the mortgage market is the causal factor, and prices are rising, unmoored from rational rental value, because of it.  Yet, if we look at Germany and Japan compared to the UK or Australia.  Or, if we look at Dallas vs. San Francisco.  Clearly supply constraints are a universal factor.  Strange that there are many articles about all that China money flowing to Australia or San Francisco, or Vancouver.  Why are they flying over Seoul and Tokyo to get to those other cities?

(This NAR report suggests that there are as many buyers in places like Florida and Texas as there are in California and New York.)

I don't know about Japan, but Germany and Switzerland appear to have tax policies that don't favor homeowners.  In the US, I find that the monetary value of the GSE subsidy is basically a rounding error compared to the income tax benefits.  So, of the three major sources of price inflation, the order of importance seems to be - supply, taxes, and lending policies.  Securitization is a single factor within the factor that is of least importance.

June 2017 CPI

The story continues.  Shelter inflation (YOY) remains at 3.3% and core minus shelter inflation remains at 0.6%.  Core minus shelter inflation has been in a fairly steady decline since the first rate increase in December 2015.  It seems increasingly plausible that the target Fed rate is above the natural rate so that inflation will continue to decline unless the target rate is decreased.  That isn't going to happen.  The available choices appear to be either raising the Fed Funds rate or keeping it at about 1%.  If it needs to be decreased, the Fed will be behind the curve.  I continue to tentatively expect a slow-motion contraction, although without much movement in prices of the major asset classes.  Bond yields don't have much room to fall, housing is being held in depression mode by credit policies, and I don't see any reason at this point for equities to collapse, although that would depend on global economies, future NGDP shifts, etc.

Hsieh and Moretti have made several attempts at estimating the loss of economic activity due to Closed Access housing policies, ranging from around 10% to much higher estimates.

It seems to me that simply comparing consumer inflation with and without shelter inflation gives a good first estimate of the lower range of this cost.  There was a jump in the late 1970s of about 10% in consumer costs due to rent inflation and since the mid 1990s, there has been another rise of 10% to 15%, with a brief pause from 2008 to 2012 because of the foreclosure crisis.  Considering that this doesn't reflect any particular rise in building costs, this seems like a decent estimate of the payment of economic rents to Closed Access real estate owners.

That is just the measure of the extra costs to workers and firms that reside in those cities.  There are additional costs to the US economy due to the exclusion of workers from those cities - workers that didn't have the opportunity to earn additional income which would then be funneled to urban real estate owners because the high cost led them to remain in other cities.  Maybe the higher estimates from Hsieh and Moretti of something like 50% since the mid 1960s aren't out of line.

Housing: Part 243 - A Brilliant Argument for More Regulation

I finally got around to watching "Inside Job", the documentary that putatively is about the danger of financial deregulation.  The show was surprisingly effective.

Now, as you might expect, the surface content itself was not particularly moving.  The documentary format made it difficult to go into the details of various regulatory regimes, so this complex topic was diluted down to a simple binary ideal of "regulation" versus "deregulation" that is essentially devoid of meaning.  There was no mention of the importance of housing supply constraints, which is to be expected in such a production.  The focus on CDOs as the core trigger of the housing bubble is obviously problematic since almost all mortgage-based CDO activity happened after home prices had peaked.  And apart from the introductory focus on Iceland, no attempt is made to explain how these deregulatory trends could have happened simultaneously in Canada, the UK, Australia, etc. and would apparently continue to be important factors in those countries.  No mention is made of CDO markets in those countries, though one must assume that its explanatory power in the US is such that it would surely be paralleled in those markets.

But, that is what was brilliant about the documentary.  In spite of all of those weaknesses, the material was compelling and convincing.  The material about sex and drugs on Wall Street effectively packaged the villains of the production for an audience who would already be prone to accept them as villains.  This allowed the effective use of the visual medium to imply causation by mentioning activities of the villains over time alongside selected economic data.

As the viewer proceeds through the production, the subtle brilliance of the director's framing becomes more clear.  Documentary filmmaking is a nearly completely unregulated industry.  We don't even have a regulatory body charged with the review of the content in these sorts of productions.  Yet, clearly, this is a dangerous and powerful medium, capable of molding the consensus of an electorate that understandably will not be able to check the veracity of the information that has been presented.  Documentaries of this type clearly do need to be regulated.  In fact, considering the potential power of the imagery, and the difficulty of dealing with subtle or deep facets of the subject matter, it is probably advisable to simply ban the medium altogether.  Do I even need to mention the famous problem of the abuse of sex and drugs in the film industry?

The weaknesses of the film, then, becomes an ironic defense of regulation that is an even more powerful argument than the actual content of the film.  Brilliant.

I had to check imdb to see if Charlie Kaufman was involved.  It should not go unnoticed that Kaufman has little or no credited professional activity in 2010 when the film was released.  I suspect that he was intimately involved with the project in an uncredited capacity.

A classic signature of Kaufman's handiwork is that the near universal praise for the film among critics and viewers actually ends up serving the ironic point of the film.  This may be his best work, taking the meta-irony even deeper than "Synecdoche, New York" or "Adaptation".  It's enough to make you wonder if Kaufman found a secret portal into credited director, Charles Ferguson's, psyche on the 7½ floor of the Mertin-Flemmer Building.

Economics Detective Podcast

Garrett Peterson over at the Economics Detective kindly asked me to be a guest on his podcast.  We had a great conversation.  I think Garrett managed to help me hit most of the main points of my housing research.

Podcast at the link.