Monday, February 19, 2018

PCE Inflation

I usually update CPI inflation, since it is updated monthly.  Detailed PCE inflation is only updated quarterly, so I haven't tended to review it as often.  But, I thought it was worth checking up on.

Here is PCE (personal consumption expenditures) inflation through the end of 2017.  It follows a similar pattern as CPI inflation.  PCE core inflation is about 1.5%.  But, this consists of housing inflation above 3% and non-housing inflation of about 1%.*

It's always worth a reminder that Taylor Rule based complaints about monetary policy in the 2000s have to ignore the fact that PCE inflation never strayed far from 2%, and that non-housing core PCE inflation was below 2% for the entire period.  It is stunning to think that we live in a regime that has both (1) a central bank that explicitly runs an inflation targeting program and (2) a large contingent of economists who claim that for several years, a fundamental feature of the economy was a central bank that held the target interest rate several points below the neutral rate, creating a massive asset bubble, and the inflation rate averaged less than the consensus target rate for that entire period.  In fact, taking housing out of the measure, inflation has been below target for more than 20 years.

Why should we take housing out of the measure?  It's mostly imputed rent.

To make this easy to imagine, let's imagine a zero inflation target and zero growth.  In year 1, the average household has $50,000 income and $20,000 in cash expenses.  Additionally, the BEA notes that the household owns a home that has $15,000 in rental value, so that, while the household doesn't realize it, they have $65,000 in income and $35,000 in expenses.

In year 2, the central bank accidentally hits its target.  The household still has $50,000 income and $20,000 cash expenses.  But, the central bank notes that the household also owns a home that has $15,500 in rental value, so that, while the household doesn't realize it, they have $65,500 in income and $35,500 in expenses.

The central bank determines that they have erred by $500.  They need to pull back the amount of cash in the economy so that the household returns to a level of $65,000 and $35,000 in expenses.

Now, the problem is that the rental value has nothing to do with cash, so that the central bank can only reduce spending in other areas.  This means that when the central bank tightens policy, the household has $49,500 in income, $19,500 in cash expenses, and still has $15,500 in rental income and expense.  The central bank had to deflate the cash economy in order to meet their target.

The kicker is that the reason rent inflation is above target is because there isn't enough money to fund new construction!

*This is technically a "Housing and utilities" category, so a small part of the housing category itself is "energy", which probably adds a slight imperfection to my "PCE less food, energy, and housing" measure, which I have estimated manually.

Friday, February 16, 2018

Housing: Part 284 - No Bubbles, Only Busts

Timothy Taylor has a post up today on homeownership rates around the globe.

One of the key pieces of information that is a clue about what happened in the US is that US housing markets were not international outliers until 2007.  We had two markets - the Closed Access cities and the rest of the country.  The Closed Access cities looked like places with housing supply problems like the UK and Canada and the rest of the country looked like places that don't have housing supply problems, like Germany and Japan.

After 2007, prices in the US, along with just a couple other small countries, collapsed relative to those other places.  The Closed Access cities collapsed relative to Canada and the country's interior collapsed compared to Germany and Japan.

Benchmarking to the rest of the world, we didn't have a bubble.  We just had a bust.

Well, it turns out that this is the case if you look at homeownership rates, too.  From 1990 to 2005, homeownership here increased from 64% to 69%.  But, that was actually a slower increase than the typical country experienced over that time.  Then, after 2005, homeownership rates collapsed here, along with prices.  In the rest of the world, homeownership rates are still about where they were in 2005.

No bubbles.  Just a bust.

Side note.  Taylor's post includes this interesting bit:
Interestingly, anecdotes suggest that many German households rent their primary residence, but purchase a nearby home to rent for income (which requires a large down payment but receives generous depreciation benefits). This allows residents to hedge themselves against the potential of rent increases in a system that provides few tax subsidies to owning a home.
We have a lot to learn from Germany.  They are one of the countries with stable home prices.  The reason, broadly speaking, seems to be that we subsidize ownership relative to renting and then we put up policy gatekeepers against ownership and obstructions to new supply.  Germany taxes ownership and has fewer obstructions to supply.  We induce a bidding war on limited stock and they discourage consumption of an abundant stock.

But, this seems like it's a bit too far.  I don't think it makes much sense to have two neighbors renting to one another for a tax arbitrage.  We should do away with the subsidies to ownership, but the goal should be a neutral field.

This is one reason why I think low taxes on capital income are beneficial.  If other capital is lightly taxed, then these potential tax incongruities in housing become less important.  And, in the US, those tax incongruities are regressive and destabilizing.  They subsidize high end housing, and they force households to take out large amounts of debt to finance imputed future tax benefits.

Wednesday, February 14, 2018

January 2018 CPI

Non-shelter core CPI does continue to show some recovery.  The noisy month-over-month measure was strong and year-over-year is now up to 0.8%.  Shelter inflation remains at 3.2%.

Maybe the parallel to where we are is the late 1990s, but now a little more extreme.  Core inflation then was about 2%, which really consisted of 1.5% core non-shelter inflation, plus a 1.5% annual increase in the transfer of economic rents to real estate, which was expressed as shelter inflation.  Today, we have 0.8% core non-shelter inflation, plus a 2.5% annual increase in the transfer of economic rents to real estate, which is expressed as shelter inflation.

In both cases, the policy rate is rising, and I suspect will rise too much.  In 1999, the Fed had been hiking rates slowly, and they accelerated the hikes in 2000 when inflation moved higher.  The 2000 recession coincided with a hard equities crash.  I'm not sure we will see that.  But, it might be reasonable to expect a drop in yields and only a slight drop in employment and housing starts.  In fact, housing starts have already leveled off, as they had in 1998 and 1999.

On the other hand, I think capital repression has pushed low tier home prices down, making it difficult to trigger new building.  It appears that credit conditions have loosened ever so slightly, which may be allowing low tier credit to expand.  The initial effect of this may be to raise prices.  Possibly prices will need to rise 10% to 20% before they are high enough fund the development of new lots.  Maybe that means that the initial expansion of credit has more of an inflationary effect than a real effect because of household balance sheet recovery and credit creation.  That may be necessary, but on the other hand, it would probably create a negative Fed reaction.

This still seems like a race between the Fed's policy rate and the neutral rate, and if long rates can continue to stay ahead of short rates, maybe the expansion can continue.  If long rates reverse back down, that calls for defense.  And, a careful position somewhere in the real estate or construction sectors probably is useful.

In the meantime, I hear the usual talk about how deficit spending is inflationary and how the increase in Treasury supply will drive interest rates higher, etc.  It really does make sense, and it would move me if I saw any evidence of it in historical data.  Yields will mostly reflect monetary policy and sentiment.  Intrinsic value trumps supply and demand.

Tuesday, February 13, 2018

Mortgage growth

The New York Fed's Household Debt and Credit Report is out for 4Q 2017.  Mortgage growth is building.  This is in spite of rising rates and low lending growth from commercial banks.

Homeownership rates seem to have bottomed and there are some signs that home price growth has lately been stronger in low tier markets than in high tier markets.

I have been waiting for both of these things to happen - a Fed tightening cycle and a loosening of credit standards.  I think both of those things will make interest rates rise.  If loosened credit standards can lead to rising rates (from more borrowing, increased building, etc.) faster than the Fed raises the policy rate, then de facto monetary policy may not tighten so much.  The Fed would be facing a rising neutral rate.  We can hope.

But, if that is the case, home prices, borrowing, and buying by households on the margin will increase.  All of those things will trigger the same moral panic that happened in 2007, to some degree.  Will that lead to over-reaction?

This is bullish for some homebuilders.  But, if low tier home prices grow by 10% this year and entry level homebuilders start to see rising sales, the question is what will the policy response be?  There shouldn't be political risk here, but unfortunately, the public and policymakers have decided that this is an area where we should impose our will on markets.  If there is an over-reaction, interest rates will fall and homebuilders will have to wait longer for recovery.  If there is not an over-reaction, then interest rates might rise and homebuilders will see bright prospects.

There is potential for a hedged position there, between interest rates and homebuilders, and a carefully created one might provide net expected gains.  The relationship is the opposite of what we might normally think of.  Rising rates will be related to rising home sales.  But, the secret is in the timing and the choice of securities.  The last couple of weeks have not been friendly to this theory, as homebuilder stocks tumbled while interest rates rose.  The question, as always, is whether that is a rejection of the hypothesis or a buying opportunity.

Thursday, February 8, 2018

Upside-down CAPM, Part 3: Capital Growth

There are problems with the way we talk about capital and leverage.  Frequently, leverage is discussed as if it is a way to multiply the amount of capital we have in some unsustainable way.  During the housing bubble, it is homeowners taking out equity LOCs or investment banks using high levels of leverage in their business models when they were underwriting MBSs and CDOs.  But, leverage doesn't really do that.  Maybe we talk that way because we are thinking in terms of a household taking out consumer debt, or a small business owner getting a loan to make a capital investment, so that for the protagonist in the story, there is some sense of magnifying their economic ownership and risk.  Or, maybe, we are thinking of how banks can make loans, which are re-deposited in the system, seemingly creating capital out of mid-air.

But, none of those things actually increases the real stock of capital.  None of it makes a building appear or stocks a store's shelves.  To do that, capital must bid on the same stock of real inputs that existed before those loans were made.

We might think of the stock of capital something like this:

For this exercise, let's think of public debt simply as deferred taxation.  It might fund some public capital that provides public benefits, but it doesn't have to, and its value is just a claim on future taxes in either case.  So, I am not going to address public debt here.

Private capital might be broadly divided into four categories: Two debt categories that generally have nominally fixed claims and income streams, and two equity categories that generally have nominally flexible claims and income streams based on constantly changing residual income streams to the full basket of income-producing assets.

There is a consumption vs. saving decision that is important on the margin.  But, over time, the growth to the capital base largely comes from growing equity, not new saving.  (I saw a great graph on this recently that I have lost track of.  Please post in the comments if you know what I'm talking about.)  Now, here is where there is a bit of magic.  Let's say Amazon makes some transformative consumer electronics announcement tomorrow, netting $5 billion in new market capitalization.  This means that equity value grew by $5 billion above any investments that Amazon will make in new tangible assets.  I contend that this is an increase in the real capital base, even though it is intangible value.  Amazon might reinvest cash, borrow, or issue stock in order to make that investment, and those activities will affect the stock of capital in the way we normally think about it.  Yet, those are all just reinvestments and shifts in ownership claims.  One could say that the only real increase in the capital stock from that initiative is the new intangible equity value it created.

And that value comes from the real intangible value that Amazon's organizational capital creates.  In the aggregate, this is the primary source of capital growth, and the funding comes from future broad growth in incomes.  Over the long term, the division between capital income and labor income is quite stable.  This means that the added value to business equity that comes from future profits is a reflection of broad-based future economic growth.  In that sort of time-travel hocus pocus that modern capital markets create, the capital base largely grows from its own future intangible value.  The investment Amazon makes has to outbid some other potential use.  It is the intangible increase in value that grows the base of measured capital.

Debt has little to do with this growth.  Changing levels of debt are generally simply changes in the ownership of those future intangibles, between residual owners (equity) and owners with nominal claims and income streams that are fixed in some way (debt).  So, when economic progress happens, some of that accrues to equity.  When equity increases, that actually means that the total capital base increases.  But, when debt increases, that is simply a balance sheet decision by the firm.  The total level of capital remains the same, but the proportions by which it is divided up change.

This is the opposite of how capital seems to be generally understood.

Real estate is no different.  Changing mortgage debt levels are simply a reflection of shifting ownership between equity and debt.  Changing equity levels actually change the total level of capital.  But, the source of value in housing capital is a little tricky.  Business equity value comes from growing future real production.  But, the rent we pay for shelter appears to track pretty closely with about 19% of total personal consumption expenditures, regardless of how much real capital we invest in real estate.  In other words, demand for housing is overwhelmingly mediated by the income effect.  Future income levels are largely a product of investments outside of housing.

If we look at past consumption of housing, there was a great housing boom after World War II, where both real and nominal expenditures on housing grew.  The capital base was growing, part of that was through deferred consumption creating new real housing stock.  When housing expenditures reached about 18% of PCE, that leveled out, and both real and nominal spending on housing remained flat for 20 or 30 years.

By the 1990s, though, we had entered the age of Closed Access, and so, while nominal spending on housing remained level, the real housing stock declined.  This is the period of time where households segregate into metropolitan areas by income.  High income frequently means high rents in a Closed Access city and low income means moving to other cities.  Nominal spending on housing remains level, but Closed Access households are spending a portion of those high incomes on a stagnant housing stock.  Their real housing expenditures (size, commute, amenities) continue to grow at a slower pace than their real incomes.

We can see the shadow of this in the measure of operating surplus to housing.  This is the net income to all homeowners (equity and debt investors, for both owned and rented units) after expenses and depreciation.  Even though nominal spending on housing has been level for 40 years, income to real estate owners has captured an increasing portion of that spending.  That is because Closed Access real estate owners capture income from political exclusion instead of from building new and better units.  Notice that net operating surplus to real estate owners was starting to decline during the big, bad housing bubble.  That's no accident.  The housing bubble was largely the acceleration of the great American housing segregation event, where builders were investing in new real housing stock and households were moving out of the Closed Access cities to other cities where their rent actually paid for shelter instead of transfers to politically protected owners.

During the boom, real estate equity grew substantially - the real stock of capital grew.  But, unlike what happens when business equity grows, this wasn't because future real incomes were growing.  This was a combination of three factors.  First, finally, after decades, new housing stock was being built at a rate that maintained real housing expenditures as a proportion of real incomes.  (That maintained the size of the housing portion of the capital stock.)  This meant that the nation's interior had to build enough homes for its own population and for the Closed Access housing refugees.  Second, low real long term interest rates caused home values to rise.  (I see this mainly as a shift in proportions, similar to the shift we might see if creditors take a larger portion of the balance sheet.  Real estate equity and mortgages grew, but at the expense of business equity, in a complex mix of investment and valuation shifts.)  Third, the capitalization of future rents into Closed Access home prices increased the capital base.  (This did increase the capital base as a portion of domestic income.  But, whereas business equity grows because future incomes will grow, in this case, real estate equity - and debt - grew because they were claiming a larger portion of domestic incomes, which we see in the upward trend in housing operating surplus.)

Because of the way we tend to think about capital, consensus descriptions of the housing bubble get this all wrong.  The conclusion we came to about the bubble was that banks were creating capital by increasing the level of mortgage debt outstanding, and households were using that newly created capital to consume.  This is wrong because lending doesn't create capital, it can only reallocate it between classes of owners.  What was actually happening was that real estate owners were capitalizing their future, bloated rental claims.  The rising levels of housing equity and mortgages outstanding weren't creating capital, and on net they weren't funding unsustainable consumption.  Early in the boom, real estate owners were mostly tapping debt markets to use their capitalized rents to consume.  Non-owners and foreigners provided that capital by shifting it from other capital or by curtailing consumption.  (Foreigners were doing it by maintaining a trade surplus with us.)  But, those netted out.  For every owner shifting consumption to the present, there was another household who was consuming less.  There had to be, in the global sense.  So, real estate owners held politically exclusive assets, this raised future rental income in selected cities, which raised home prices, which raised the value of home equity, and eventually some of that equity was shifted to debt ownership because we don't have a developed system for liquidating home equity to other equity holders.  Partial liquidation of real estate holdings is typically done in debt markets.

The net effect of these shifts was a drag on long term real income expectations, which is why the marginal effect was to keep real long term interest rates low rather than high.

As the boom aged, more owners were tapping those capitalized rents by selling out and moving or renting.  During the later period, there was a transfer of homes from old owners to new owners (either new buyers or investors.)  By then, total value of real estate had peaked, so that the increase of capital in mortgages clearly wasn't increasing the capital base.  There was a large transfer of ownership from housing equity to housing debt.  Much of that transfer was from previous homeowners, tactically reinvesting away from home equity, which had ceased to be considered a safe asset class, and in that search for safety, moving down the array of asset classes, mortgage debt seemed a reasonable resting place, even if that decision was filtered through financial intermediaries rather than being a direct decision of the savers themselves.  For the households taking out that debt, there was nothing stimulative about it.  The debt was simply funding the transfer of their wages to the previous real estate owners.  Those mortgages were a reflection of the reduction in real wages created by Closed Access, manifest through higher rent expenses.

PS. The show Shark Tank is a good example of how this capital creation happens.  Someone with a good idea and little else walks onto the set.  They have very little capital.  They connect with a "Shark" that has the means to capitalize that good idea, and now, suddenly, they have hundreds of thousands of dollars in capital.  If execution of the plan goes well, they will soon have millions of dollars in capital.  That capital appeared as if out of thin air, but it really was created out of the execution of the plan that creates future consumer surplus from their good idea.  That's why it's hard to think about the offers and valuations that are given in a simple mathematical framework, because even if the presenters give up a lot of equity based on their existing business, the payoff really comes from the creation of capital, not from divvying up existing capital.  In that context, one of the "Sharks" may offer a deal that has a debt component, but their shift from an equity stake to a debt stake has little or nothing to do with the capital that will be created from their partnership.  It is just a reallocation between equity or debt forms of ownership.

PPS. These models, along with my narrower viewpoints regarding the housing market and the financial crisis specifically, lend themselves to a coherent and unique asset management process, both strategically and tactically.  I have been gauging interest in that sort of thing among some readers.  If you know of someone or if you have clients that would also be interested in a fund run on these principles, please contact me via the e-mail address in the right margin.

PPPS. So I have this conceptual framework, and I can use to it tell a story about capital.  But, I haven't debunked the other story, have I?  What if everyone else thinks mortgage lending did cause home prices to rise, increase the base of capital, make everyone feel richer, and lead to overconsumption?  Why should you care if I came up with a story?  In the end, this is all rooted in the empirical evidence I have found regarding the financial crisis and the housing bubble.  And, the core empirical evidence that confirms the conceptual model here is the realization that rents explain everything.  The empirical presumptions underlying the other story are wrong.  Not only does my conceptual framework make sense, but it rose out of the array of empirical evidence that I discovered which contradicted the presumptions of the other framework.

Tuesday, February 6, 2018

Housing: Part 283 - Lot size and construction cost

The National Association of Home Builders has a lot of great resources.  I was poking around some of their reports recently, and I think I can connect some dots regarding lot sizes, construction costs, etc.  I recently posted on the noticeable post-crisis trend in Phoenix of very small lots.  The story I told there, that credit repression in home buyer markets was the source of the trend, is borne out in NAHB survey data.

It is useful here to consider the natural regulators on home prices.  We can think of home prices as having a ceiling and a floor.  The ceiling is the present value of net future rental income on the home.  The floor is the cost of building a new home.  If the ceiling is below the floor, housing starts will be low, because existing homes would be selling at less than the cost of building.  If the ceiling is far above the floor, housing starts will usually be strong, because new homes can be built for less than the net present value of their expected rental income.  The net present value of future rents is determined by (1) real long term interest rates and (2) expected future rents on the property.

The difference between the ceiling and floor levels accrues to the value of the lot.  In Closed Access cities, starts can't increase to sustainable levels, so the lots become increasingly valuable.  In cities that allow sustainable building, the ceiling price declines when new construction brings new supply to the market, reducing future rents.  In cities where supply is unobstructed, the ceiling doesn't tend to climb very far above the floor.  Prices tend to reflect the cost of building, with relatively minor fluctuations over time.

Here is a recent special study by the NAHB on costs of construction.  Builders have been complaining about rising regulatory costs, and that shows up in the survey.  Costs associated with fees related to permits, etc. have risen substantially, but they only amount to a few percentage points of total cost.  As I have argued, while rising regulatory costs may be a valid complaint, they aren't the binding constraint in housing markets now.  If they were, then low tier housing would be selling at higher prices, relative to high tier housing.  But, low tier housing in most cities still is selling at a discount to pre-crisis prices, compared to high tier markets.  Possibly, because of new regulatory costs, it would take some extra price appreciation to trigger new building in low tier markets, but the reason there isn't more building today is because of a lack of demand for low tier housing, and that lack of demand is being created by credit market repression.

Keep in mind, the survey will be weighted toward moderately priced areas where lot prices aren't as high as in Closed Access cities.  That is because, even though Closed Access real estate represents about a quarter of total residential real estate, by value, it only accounted for about 7% of housing starts during the boom.  It is the lack of building that maintains high prices.  So, builder costs reflect cities where building happens.  And, during the boom, the extra building in affordable places was bringing down rents, as we should expect it to.  In this Fred graph, we can see the localized nature of the housing bubble, and how areas where building isn't politically obstructed followed classical economic models.  In Dallas, Atlanta, and Phoenix, new building was lowering rents, which was lowering the floor and ceiling of home values.  (Rents in Phoenix bumped up in 2005 and 2006 at the same time prices there peaked, as it was overwhelmed by Closed Access housing refugees.) 2018 - Data from USDA and NAHB
The NAHB survey confirms that homes have become larger while lots have become smaller.  Tracking costs over time, the survey indicates that lot value increased as a proportion of total building costs until 2004, then declined until 2015, and then pushed back up in 2017.  Here, I compare the finished lot cost from the NAHB survey to farmland prices from the USDA (pdf) and to real long term interest rates (30 year TIPS, inverted).  Farmland has followed the pattern we would expect, climbing as long term real interest rates decline.

Lot prices for homes were climbing before the crisis and then declined.  In the meantime, according to the NAHB, builders are facing a shortage of available lots.  But, this is strange.  With such low long term real interest rates, lots should be a larger portion of total housing costs than they ever were.  They should be following along with farmland prices.  The reason lot supply is low is because the price is low.  Why don't builders bid up the price, inducing more supply?  Because there is no demand for it.  The reason there is no demand for it is because of capital repression that prevents qualified buyers from getting mortgages.  The price of the physical home itself is not sensitive to interest rates, so the physical home is more affordable than ever for those who can qualify for a mortgage.  So, buyer money plows into the physical home, and builders put larger homes on smaller lots, and complain that there aren't enough lots available, because they can't make a profit if they bid the prices of lots high enough to trigger supply being shifted from other markets like farming.

This is why the key to near term economic growth is mortgage regulations.  If they remain where they are, interest rates will remain low, rents will continue to rise, and there will be a limit to how quickly homebuilding can continue to recover.  If regulations in lending could be relaxed, and if the public would be willing to allow lending to happen and to allow markets to equilibrate under those conditions, it would trigger a tremendous amount of pent up demand for homeownership, pushing up real interest rates, pushing lot prices up and farmland prices down, increasing housing starts and home prices, decreasing rents again.  It would be a win-win-win-win win, except for farmland owners.  But, the public wouldn't stand for it.  There would be near unanimity that the Fed and regulators were creating new asset bubbles with loose money and reckless credit, the Fed would be pressured into hawkish policy postures until prices and housing starts declined, and we would be left with a bubble in the one area that we actually have a bubble and where households are being squeezed - high rents.  This is basically what we did to ourselves in 2007 and 2008, and until we learn the right lessons about that, I don't see how that can change.

Monday, February 5, 2018

Housing: Part 282 - Borrower characteristics

The Urban Institute does some great work on housing markets.  Here is a link to their monthly housing update, which is full of great information.

These are old points that I have made before, but looking at the charts in the report, I think they may be worth repeating.

First, here is a chart of mortgages outstanding, by type.  What is important to note here is that Ginnie Mae is basically the public conduit for subprime mortgages.  A decent estimate of the size of the subprime market is the combined total of private subprime mortgages and Ginnie Mae (FHA) mortgages.  When we look back at the boom period, that category of total subprime was surprisingly level.  Adding private subprime and FHA together, there wasn't much growth.  The rise in private subprime basically came at the expense of FHA volume.

One of the responses to the crisis that I think is backwards is the idea that public mortgage conduits added to the amount of risk that was taken.  On the contrary, public conduits behaved counter-cyclically during the boom - especially FHA/Ginnie Mae.  It would have been preferable for FHA to have been more aggressive during the boom.  The privately securitized loans tended to have terms that added systematic risk to the market - loans that were set up to be frequently refinanced, MBS packages that didn't have public credit guarantees, etc.  There isn't any question that if those loans had remained in the Ginnie Mae conduit instead of the private markets that developed, the bust would have been less disruptive.

The correct lesson from the boom is that FHA and the GSEs should have been making more loans in 2004-2007.

Since the growth wasn't coming from subprime, where was it coming from?  It came from the sharp rise in Alt-A loans, which were being utilized by households with high incomes and the ability to pay, who lived in housing constrained cities where housing expenses are very high.

Here is another graph from the report.  It appears that working class/entry level housing markets have been showing some strength recently.  Prices in low tier markets seem to be rising at a slightly higher rate than in high tier markets.  I would expect this to be reflected in credit markets, but mortgage growth remains low.  And, according to the Urban Institute data, it doesn't look like there has been much of a retreat in FICO scores of average buyers.  DTI levels have risen recently, though.  So, recent market moves seem to be coming from improved sentiment from highly qualified borrowers, who are willing to take on more debt in order to purchase.  Maybe this is related to the continuing reversal of negative equity, and some qualified households who have been stuck in homes with negative or negligible equity are now escaping those homes, and taking out mortgages reflecting the high LTV they have been stuck with in homes that continue to be priced too low because of public credit policies.

One additional random tidbit:  One of the pieces of evidence regarding lending excess during the boom is that credit spreads were low.  But, if those spreads are measured as the difference between risky mortgages and conventional mortgages, really those spreads are a reflection of the lack of aggressive lending at the FHA and GSEs.

Here is a graph comparing 30 year conventional mortgage rates to the 10 year treasury rate.  This has bee relatively high since the 1990s.  Remember that the GSEs were under pressure in 2003 and 2004.  And, as shown above, FHA was in retreat throughout the boom.  Spreads between GSE loans and jumbo loans were low during the boom also.  This is because it was GSE rates that were unusually high.  That remains the case today.  Today, rates remain high largely because of guarantee fees.  The UI report notes that guarantee fees at the GSEs remain very high - more than 50 basis points, which is double what they normally would be.  This is a primary source of very high profits at the GSEs.  Banks should be raking in market share under these conditions, but they face pressure from the CFPB.

Especially considering the lack of significant pre-payment risk at current rates, mortgage spreads should be much lower than they are.  High guarantee fees and high spreads are a political outcome, not a market outcome.  If they were a market outcome, the outcry about greedy bankers would be deafening.  Since they are a political outcome, those profits get pocketed by lenders and the GSEs while activists and pundits nod in support of our wisdom and prudence.

Tuesday, January 30, 2018

Housing: Part 281 - Milking the underclass

I have previously linked to some Atlanta properties to show how much of a premium homeowners are capturing in low end markets.  But, Atlanta is a relatively successful city right now, and it is growing.

The cities where I should have been looking are the rustbelt cities.  Cleveland, for instance, is full of homes that are practically free.

Here is a home that rents for $800 per month and Zillow estimates its value at $19,000, so that monthly mortgage expenses would be $75.

Here is a home that would rent for $1,000, worth $72,000, with monthly mortgage payments of $285.

Here is a home that would rent for $1,800, worth $212,000, with monthly mortgage payments of $838.

Here is the pattern.  (All data from Zillow.)

At the high end in Cleveland, Price/Rent is about 11x, but it declines sharply as you move down-market.  At the low end it is less than 6x.

If we graph rent versus price, we can see that, using the top half of the market as the benchmark, there is an extreme premium on rent in the bottom half of the market.  Basically, a $500/month floor.

As I have noted before, the issue here is that regulators aren't in the business of kicking tenants out of their homes.  That would be cruel.  Regulators are in the business of preventing tenants from owning their homes.

In practice, what that means is that the CFPB enforces a non-owning class, and if households in that class, whose membership is determined by the CFPB, want to live in a house in Cleveland, the first thing they have to do is write a check for $500/month to someone who the CFPB has decided can be in the ownership class.  The CFPB has created a very effective system for transferring $6,000 per year from the pockets of tenants in Cleveland into the pockets of owners in Cleveland.  (edit: As Shiyu points out in the comments, this is a bit of an overstatement, because there is some level of maintenance required on homes at very low price levels that would require expenses that are somewhat fixed relative to the home price.  The landlord only keeps a portion of that $6,000.)

This, of course, doesn't show up in any tables anywhere of federal revenues and expenditures.  It doesn't show up as a decrease in net incomes after federal transfers, because it just looks like it's a natural part of the cost of living in Cleveland.  But, it is not.  It is a regulatory burden.

This Price/Rent relationship exists to some extent in every city.  Most cities only have a few zip codes at the peak Price/Rent level.  So, the Price/Rent graph above for most cities looks more like a straight, upward sloping line with just a few zip codes on the horizontal line at the top.  For most cities, that inflection point where Price/Rent levels out is more like $400,000 or $500,000.

The interesting thing about Cleveland is that it has a pattern similar to the Closed Access cities, in that a large portion of the homes in the city sit at the peak Price/Rent level, because the inflection point in Cleveland is under $200,000.  More work needs to be done to understand what causes these differences between cities.  But, the fact that this pattern shows up in Cleveland means that during the boom, Cleveland home prices would have had a pattern similar to Closed Access cities.

And, here we see that they did.  There was a somewhat systematic pattern in Cleveland where low end homes increased in price more than high end homes did.  This has been attributed to credit access.  And, in a way, I'm sure it was.  But the key here is that those prices hadn't become unmoored from fundamentals.  They were a reflection of this systematic pattern.  Home values at the top of the Cleveland market in 2005 increased proportionately with rising Price/Rent level.  At the low end, as home prices appreciated, the Price/Rent ratio increased even more.  We can think of the Price/Rent chart above.  They were slowly marching up that Price/Rent hill.

So, it isn't as extreme as in the Closed Access cities - maybe amounting to a 10% boost to low end home prices in Cleveland compared to high end prices.  But, let's say that the increase in home prices was entirely the result of loose lending.  (It wasn't, but let's just say it was.)  That means that, for the marginal buyer in Clevcland in 2005, loose lending meant that the family renting that $1,000/month house had to spend, maybe, $500/month on mortgage payments.  The family renting that $800/month house had to spend, maybe $200/month on mortgage payments.

Yes, getting rid of obstacles to ownership might have some minor effects on price.  The liquidity premium is conventional finance.  The introduction of liquidity can increase the price of an asset, and this can be a sign that the price is a more efficient reflection of intrinsic value than it was before, because reasonable buyers who were blocked from the market now have access.

When we think about lending markets during the boom, we need to keep in mind the difference between housing consumption and home ownership, and the relationship between the two.  Even in 2005, for tenants at the low end of the market, ownership would have been much more affordable than tenancy.  So, what if prices go up a little when ownership is expanded?  If we allowed those households to buy today, it would necessarily be related to some sharp increases in home prices at the low end of the market.  This would be widely derided as a new bubble that has to be popped.  But, those rising prices would be an unalloyed good thing.  The reason prices are low now is because landlords are capturing massive transfers of income from the CFPB-determined peasant class.  Rents in those homes reflect basic supply and demand for the use of housing.  So, rents will be fairly stable.  But, if those houses are going to cease to be conduits for a massive regressive redistribution program, mathematically, they will have to sell for more higher prices.

This should be easy.  Mortgage access would lower the cost of living for low-tier tenants who have stable tenancy.  It would raise prices, lifting the net worth of low-tier owner-occupiers.  The only natural opponents to this shift would be landlords, who would lose their gravy train.  But, they would receive a one-time capital gain as their homes appreciated in value.

There is a kernel of truth to the teeth-gnashing about the "bubble economy" and the attempt to boost wealth and income through empty inflationary growth.  That's not what this is, though.  Not all rising prices are unsustainable bubbles.  These rising prices would reflect real progress.

High prices in Closed Access cities are another story.  Those prices should be lower, and they should be made to go lower by introducing new housing supply into those cities.  The aggregate values of those homes is the source of rising debt levels and most of the other signatures of the housing bubble.  Sucking cash from financially marginalized families in Cleveland is one hell of a terrible way to address that problem.

PS. Look at the last graph.  As with all other cities, if we look at relative price levels, by late 2008 prices had declined significantly, and price levels among all quintiles had reconverged.  That is because prices had slid back down the Price/Rent curve and were back to where they had been, relatively, in 1996.  Any divergence in prices had been erased by late 2008.

Notice that at that point, high end markets stabilized somewhat.  But, just like in every other city, it was after that period - after Fannie and Freddie were taken over, and after Dodd-Frank (passed in 2010) established lending standards - that the low end tanked.  The low end didn't tank because predatory lenders set up borrowers to default in 2007.  It tanked because the CFPB codified the membership of the peasant class in 2010.

None of that has anything to do with housing affordability, because affordability is about rental expense, not price.
PPS. The new Census report on vacancies and homeownership does provide hopeful news.  It does appear that homeownership has bottomed out. And low end markets have been recovering somewhat.

Friday, January 26, 2018

Housing: Part 280 - Mood, priors, conclusions, and epistemic closure

Here is a new NBER working paper from  Edward Wolf:
The inequality of net worth, after almost two decades of little movement, went up sharply from 2007 to 2010, and relative indebtedness for the middle class expanded. The sharp fall in median net worth and the rise in overall wealth inequality over these years are largely traceable to the high leverage of middle class families and the high share of homes in their portfolio. There are also significant racial components here.  Net worth generally moved in tandem until 2007. Then after the financial crisis, young families and minorities took a hit, largely because leveraged homeownership was a larger portion of their portfolios.

Wolf is commendably restrained, mostly sticking to the facts.  But overwhelmingly this paper will be treated as yet another in the endless pieces of evidence that leverage was the problem, that they did this to us, that the bankers in 2005 pushed loans onto Hispanic and black households that inevitably led to this, and that access to credit is the problem to be avoided.

This is a good example of how decent, factual work, now filtered through the wrong presumptions, serves to give a false sense of factual depth to the wrong conclusions.  The reason young and minority households took a hit to net worth is because we made a severe public policy choice to stop lending to potential buyers in neighborhoods where young and minority households would buy, and, after 2008, quite apart from any of the initial collapse of the subprime market, etc., those homes lost 15-30% of their value, across the board, relative to homes in neighborhoods purchased by older, wealthier households.

But, the wrong presumptions have created a decade of boiling anger.  People are committed to that anger, and if they see evidence that changes the cause of this dislocation from bankers to popular public policy, it will feel like the anger must be redirected at uncomfortable targets.  It would be more appropriate to have avoided the sense of anger all along, but here we are.  And, I suspect, as this sort of evidence mounts in the social consciousness, it will require a more complete set of evidence to overcome the sense of opposition to redirecting that anger.  It will take more evidence than a person can handle easily in a single exposure.  And, I suspect for many who see my evidence, it will be like attending a well-performed magic show.  They will see something unbelievable.  They will have no explanation for it.  And, they will have the intuition that a sophisticated observer will leave it at that.  A respectable person doesn't stand up at a magic show and yell, "Oh my God!  He's cutting her in half! Arrest this man!"

I have been fortunate to have patient and curious readers, but this blog sort of attracts a peculiar audience.  I will be interested to see the reactions this story elicits as it reaches a broader audience.


On a semi-related note, I was pleased to see, on a recent visit, ample building in the DC metro area, although MSA level data shows there is much room for more.  In an Uber car this morning in DC, I said to the driver, "Wow.  There are a lot of new buildings going up around here."  She shook her head in despair.  "A bunch of expensive condos.  Rents are going up.  It's making the whole place unaffordable.  They tear down affordable homes to put up these expensive high rise condo buildings."

She wasn't misstating what she saw.   She was missing the broader picture in a common way.  The problem remains that the broad solution, even as it is implemented, is routinely misunderstood and opposed.  Note, displacement of existing tenants is challenging, but she wasn't complaining about being displaced.  She was complaining about this at the macro level.  She saw a few places with lower rents taken down and replaced with a lot of places with high rents, and she concluded, analytically, that this meant rents were higher in her town.  She was one of the beneficiaries of this building.  Her rents have likely been stabilized by the addition of new units.  But, that benefit was outweighed, in her estimation, by simply seeing new buildings going up that had high rent levels.  This is a powerful and common reaction, pushing back against the solution.  It is understandable.  You can see where it comes from even while realizing it is wrong.  The challenges on this issue are difficult.


Here is a graph of housing permit rates and rent inflation.  Washington is basically tracking with the US average on new housing units, and has been for some time, which is why it isn't a basket case like the Closed Access cities.  Rent inflation in Washington has been below the US average for four years.

Here is a business article on the Washington housing market:
But analysts, brokers and lenders in the region are starting to see unwanted side effects—specifically, too much supply. As  new properties come online in previously untapped markets, oversupply is causing lenders to scale back on construction financing.... Going forward, developers are scaling back and waiting for the market to absorb the new supply glut.
The developers are afraid rents are going down.  But, they agree with my Uber driver that there are too many new units.  Everyone always agrees there are too many units; the less units there are, the more they all agree on that.  We're the anti-Lake Wobegon.  All of our housing markets are below average.

Thursday, January 18, 2018

Housing: Part 279 - Building homes helps households with low incomes.

One of the many arguments against building homes in Closed Access cities is that market rate homes have very high rents and prices, and they are just bought up by rich outsiders.  This leads to complaints of "trickle down" economics.

Two things are happening here.
  1. Households react differently to housing deprivation depending on their incomes.  Households with high incomes can adjust their real housing consumption until their spending is at a relatively comfortable and normal level, by living in a smaller unit with a longer commute, etc.  As a household's income declines, they have less flexibility in this regard.  So, the adjustment households with the lowest incomes make is to move out of town.  New units means higher quantity and more moderate rents.  This means that the natural result of building new units in a housing deprived city will be that households with high incomes expand their housing consumption into the new units and households with low incomes make no change in their housing consumption.  This looks like failed "trickle down" economics.  But, the status quo was tens of thousands of lower income households moving away.  This is actually a vast improvement that favors households with lower incomes.  Not the sort of evidence that will convince naysayers, though.
  2. The other issue is that the Closed Access cities are so bad that the entire stock of housing is unaffordable for a normal family, unless it is subsidized.  So, new "market rate" units are treated by opponents as if they mean nothing to normal families.  Only subsidized units actually increase the housing that is available for the typical family.  This rhetorical treatment, which is technically true while missing the point entirely, leads to a paradigm where the market literally cannot fix the housing shortage.  There is no mechanism in this paradigm for markets to lead to an outcome that includes more housing units.  The possibility has been exorcised from the set of observable outcomes.
I decided that American Community Survey (ACS) data might help us in this regard.  Here I am using the largest 30 metro areas.  The Closed Access cities will be shown in red (here, including NYC, LA, Boston, San Francisco, San Diego, and San Jose).  These are for cumulative or annual numbers from 2005-2014.

First, as I have mentioned previously, we have a perverse migration pattern in this country where households move away from prosperity.  There is a sharp negative relationship between metro area incomes and net domestic migration.  This perversity is largely due to the Closed Access cities.  The city at the upper right, which has high incomes and high in-migration is Austin, TX.  Seattle is the city with incomes above $80,000 and in-migration of more than 0.5% annually.  That is how it is supposed to work.

How about we compare the incomes of in-migrants and out-migrants in each MSA.  All of these are expressed as a % of the MSA average income.

The incomes of migrants in general tend to be lower than average because movers tend to be young renters with lower incomes.  Interestingly, there is no systematic difference between cities of in-migrant incomes.  They tend to be about 85% of the MSA average regardless of housing policy.  This is somewhat surprising, since the Closed Access cities are the source of many complaints about wealthy outsiders buying up status units.  Some of that could be because absentee owners would not show up as migrants.  But, in terms of actual residents, there isn't much to see here.

Out-migrants on the other hand, skew poorer in cities with high rates of new out-migration.  This is entirely due to the Closed Access cities.  Here, also, if we remove the Closed Access cities, there is no relationship between net migration rates and migrant income.  But, in the set of cities with peculiarly low rates of housing starts, high average incomes, and significant out-migration, the out-migrants tend to have low incomes.

And, if we look at migration rates, by city size, rates of in-migration of Closed Access cities look fairly normal while rates of out-migration are high.  This surprised me a little bit.  I had thought that there would be more reduced in-migration in the Closed Access cities.  But, according to this data, it is the existing Closed Access households with lower incomes who bear the worst burden of housing deprivation.

I will look at another pair of graphs.  Here, I have made an adjustment for city size to estimate the unusual amount of in-migration or out-migration for each MSA.

Regarding in-migration, again, the Closed Access cities are quite normal, and again, across the board, there is no systematic relationship between relative incomes of in-migrants and the rate of in-migration.

Regarding out-migration, however, there is a strong relationship between the rate of out-migration and the relative incomes of the migrating households.  The Closed Access cities dominate the sorry end of the distribution, but they aren't outliers in terms of the relationship. It appears that wherever there are an unusual number of households moving away from a city, the movers from those cities tend to have low incomes.

By the way, whereas the Closed Access cities had normal in-migration rates for their sizes and high out-migration, Austin and Seattle have normal out-migration rates for their size and high in-migration rates.  Again, that is how it is supposed to work.

Outside the Closed Access cities, the in-migration patterns are basically what you would expect.  There is unusually low in-migration into cities like Cincinnati, Cleveland, Detroit, Pittsburgh, and St. Louis.  There is unusually high in-migration into Austin, Denver, Phoenix, and Riverside.

The rust belt cities also tend to have low levels of out-migration for their size, while the Closed Access cities have unusually high levels of out-migration.

Just for good measure, these last two graphs use housing permits per resident, which I have previously collected for 22 of these cities.  In the first graph, the scatterplot regresses outmigrant incomes against the rate of housing permits from 2005 to 2014.  The second scatterplot regresses the size-adjusted rate of outmigration against the rate of housing permits from 2005 to 2014.

By the way, in both cases, there is no relationship if you remove the Closed Access cities.  The trendlines are flat without the Closed Access cities.

This is real simple.  If you don't build enough houses, poor households will be systematically displaced.  If you do build houses, they won't be.  And, there are 5 major metropolitan areas that systematically displace their poorer residents because they don't allow enough housing units to be built.  They are outliers in this regard, and don't let anyone tell you that building houses won't solve the problem.