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I wrote recently that my mind was changed by the evidence on how much underwater homes were causing a decrease in mobility which in turn was causing higher unemployment. I believe it does not explain much of the current unemployment we are seeing. A new paper defends the connection between lower equity and lower mobility. The paper, by Ferreira, Gyourko, and Tracy is an update on an earlier paper of theirs that includes 2009 American Housing Survey data and improves some coding and econometric issues highlighted by another recent paper by Schulhofer-Wohl that was critical of their work.
One criticism that FGT makes of Schulhofer-Wohl is that some observations which they code as moves are in fact temporary moves, and not permanent moves. It is strikes me as debatable as to which type of move is more relevant for labor markets, and the effects of both are worth knowing.
Another issue is that knowing who has moved today from AHS data is easier to know once future data arrives, and so you can be conservative and code censor observations where move status is unclear, waiting for future data to clarify the issue. Or you can can generate a more inclusive measure of moving and risk including false positives. As FGT state, these coding decisions are consequential for the results:
…it still is useful to understand that the potential fragility of our results (and, possibly, those who came before us) arises from the fact that it is difficult to properly measure mobility in a number of cases.
In the end, it seems likely that underwater homes are decreasing housing mobility defined as permanent moves. I also agree with FGT that the true extent of this won’t become clear until future data arrives.
However, this falls short of providing evidence that housing equity is affecting labor markets. Looking at other information from AHS data, FGT note that:
Most moves are for quality-of-life, personal/family and financial reasons, and do not appear to be primarily job-related. This is especially the case for local moves. In contrast, longer distance moves, particularly those that cross a state border tend to be job-related. One potential implication of these data is that financial frictions to household mobility are more likely to reduce local moves such as trade-up purchases that need not have any significant spillover effects for labor markets.
This, they point is, is consistent with other studies on the issue. I agree with the reasoning here, and so I think it remains safe to conclude that the evidence suggests housing equity led mobility declines are not a significant cause of unemployment.
Megan McArdle comments on the following questions
There’s a sort of fair question highlighted at Balloon Juice–why aren’t libertarians proposing solutions for the foreclosure crisis? There are serious paperwork issues, which banks seem to have tried to solve by throwing together some highly suspect legal documents. As Mistermix says, “Since the basis of libertarian philosophy is property rights, I would have expected a little more outrage from places like Reason about robo-signing”. ED Kain adds “In any case, I say mistermix’s critique is fair because it is – libertarians are not proposing meaningful solutions to the foreclosure problem as far as I can tell.”
I don’t know about the Reason guys but I can say that I was more or less hoping the whole thing would blow over and that in the wake of it we could get serious about electronic documents and get rid of the paper crap all together.
The reason I’m not more outraged is that I have seen little evidence that actual property rights were infringed. Property rights are often represented by pieces of paper but they are not created by pieces of paper. They are created by mutual consent and a meeting of minds. To my knowledge almost all of these cases involve people who believed that they were taking out a mortgage and banks who believed that they were providing a mortgage. That’s a solid transaction.
Now to the extent there were people who were tricked into certain deals, that is a problem whether the paperwork checks out or not. In those cases there was no meeting of the minds and the existence of a confirmed paper trail doesn’t change that.
I’ve long suspected that immigration amnesty would be a boon to housing markets. The idea is that illegal immigrants could be deported and so will be less willing to make the fixed investment of homeownership, and illegal status holds down wages which should also decrease the demand for housing. However I haven’t seen any persuasive studies on this issue. Today I discovered a new paper by Catalina Amuedo-Dorantes and Kusum Mundra that provides some evidence:
A significant homeownership gap still remains between natives and immigrants in most countries. Because of the many advantages of homeownership for immigrants and for the communities where immigrants reside, a variety of countries have tried to implement policies that facilitate immigrant homeownership. Many of these policies hinge on immigrants’ legal status. Yet, owing to data limitations, we still know very little about its impact on immigrant homeownership. We address this gap in the literature and find that legalization raises immigrant homeownership by 20 percentage-points even after accounting for a wide range of individual and family characteristics known to impact housing ownership. This finding underscores the importance of legal status in immigrant assimilation –housing being an important indicator of immigrant adaptation, and the need for further explorations of the impact of amnesties on the housing markets of immigrant-receiving economies.
Note that this does not address the question of whether legalization increases the demand for housing or just the type of housing. For instance, legalization may simply lead illegal renters to buy houses that are identical to the ones they were renting, which aside from potential externalities to homeownership shouldn’t affect prices. This seems unlikely to me, and I’d wager that legalization also increases the demand for housing, and therefore house prices.
I’ve argued frequently that letting in more immigrants is the last best tool we have to help increase house prices, but perhaps legalizing the immigrants we already have would help as well.
UPDATE: MorallyBankrupt provides some excellent thoughts in the comments:
I used to live in Boston. While living there, a few of my friends lived in inexpensive rental apartments where line cooks–often Brazillian–also lived. They used to pack-in pretty tight in those apartments to minimize expenses and maximize remittances. A common theme was that the men would often move out to their own place if and when their wives / girlfriends came into the country or if they formed a family locally.
I think that amnesty coupled with the ability to extend legal resident status to immediate family (spouses, children) would be a great option. Not only would the units of houses demanded per newly-legal resident probably increase, but the number of residents demanding housing would increase as well. Additional positive effects would be to move (at least some) of the consumption from those remittances into the US.
Finally, establishing residence would allow access to legal, documented earnings which would increase tax-receipts and access to credit, enabling purchases of not only housing, but also durables.
In today’s Philadelphia Inquirer I have an op-ed about how immigration could be used to increase house prices. I’ll put the whole thing below the fold, but it’s also worth noting another recent study that supports the results of the study I cite in my piece. Importantly, this study provides evidence that immigration raises house prices even in housing markets with low price inflation and rent control, and even when the immigration amounts are modest. The impact they find, which is for Switzerland, is that a 1% increase in immigration causes a 2.7% increases in home prices. To my knowledge it is still the case that every study on this issue, which is admittedly few, has found that immigration has a positive impact on house prices.
Here is what I wrote in the Inquirer, with more below the fold:
Amid reports of continuing declines in home prices, it’s safe to say that government policies designed to prop up those prices have failed. More than 14 percent of home mortgages are delinquent or in foreclosure, and 23 percent of homeowners owe more on their homes than they’re worth. At this point, it may seem as if we have to let prices fall until they find a bottom.
But we haven’t yet tried one of the easiest and least costly options for helping the housing market: more immigration.
A new NBER working paper explores this issue and argues that they can by lowering the average .
This paper explores the practice of mortgage refinancing in a dynamic competitive lending model with risky borrowers and costly default. We show that prepayment penalties improve welfare by ensuring longer-term lending contracts, which prevents the mortgage pools from becoming disproportionately composed of the riskiest borrowers over time. Mortgages with prepayment penalties allow lenders to lower mortgage rates and extend credit to the least creditworthy, with the largest benefits going to the riskiest borrowers, who have the most incentive to refinance in response to positive credit shocks. Empirical evidence from more than 21,000 non-agency securitized fixed rate mortgages is consistent with the key predictions of our model. Our results suggest that regulations banning refinancing penalties might have the unintended consequence of restricting access to credit and raising rates for the least creditworthy borrowers.
An ungated version can be found here.
Importantly, the authors argue that lenders will compensate for lack of a prepayment by charging higher premiums, which will cause more defaults on the margin. You don’t need to be persuaded that we shouldn’t regulate prepayment penalties, but just that we should be very careful when doing so, and recognize that there are real costs involved.
The debate on tax reform is starting to heat up with various proposals being debated, and many policies are being considered for the chopping block. One of them is the mortgage interest deduction (MID). I’ve covered the previous research before, which shows the deduction doesn’t increase homeownership, and now a new paper sheds further light on the losers and winners from this subsidy.
The paper comes from Christian Hilber and Tracy Turner, who compare the effect of the MID in areas with tighter regulatory restraints on housing supply, i.e. inelastic supply, to areas with less regulatory constraints, i.e. elastic supply. The idea is that in areas where supply is slow or non-responsive to increases in demand, the MID may just drive house prices up instead of increasing homeownership, and may even decrease home ownership among some groups.
Using national data from 1984 to 2007 they found that the MID did not increase overall homeownership. In areas with light land use regulation they found that homeownership among higher income families was increased, and in tightly regulated housing markets homeownership was decreased for all income groups except the lowest. The effects, both positive and negative, generally range from 3% to 5%. Regardless of the regulatory environment, homeownership among the lowest income group was not affected at all by the MID.
The authors estimate that it each additional homeowner created by the mortgage interest deduction costs the government $53,590, a number they rightly call “staggering”.
An important implication of the findings is that in urban areas, where land use regulations are typically more restrictive, homeownership is likely to be negatively impacted.
We spend around $100 billion a year on this subsidy, and to the extent that it’s defenders are correct and homeownership does have positive externalities, it is actually making urban areas worse off. Even if we want the questionable goal of encouraging homeownership, recent research from the Cleveland Fed has argued that down payment subsidies are a more efficient way to do it. If we can phase the mortgage interest deduction out slowly so that there is limited disruption to housing markets, this policy really should be the first on the chopping block.
According to a new paper from Byron Lutz, Raven Molloy, and Hui Shan from the Federal Reserve, the answer is “not as much as you might think”. They identify five channels through which low house prices can affect state and local government tax revenues:
1) property taxes
2) home sales transfer taxes
3) sales taxes via spending on construction materials
4) sales taxes via impact on consumption of lower housing wealth
5) personal income tax
Compared to the 1995-2002 trend, state tax revenues in 2009 were $31 billion below where they otherwise would be, which is 5% of total revenues. Looking at the short-run trend, the total 2005-2009 shortfall is only $15 billion.
Partly driving this result is that property taxes are based on assessments which are lagged, so that falling prices do not show up immediately. As a result, in 2008 and 2009 property taxes rose 5%. This can be seen clearly in the figure below.
This is helpful for local governments, because it means their tax base does not dry up during a recession. However, it does create something of a anti-Keynesian policy where property taxes continue to rise as prices plummet. A 5% increase in assessed value on top of a 15% decline in house prices means an $85,000 house is being taxes as a $105,000 house.
One of the political obstacles to a gas tax is that it will disproportionately harm residents of rural and suburban areas relative to cities. City residents who take public transport won’t be directly affected by gas taxes. Furthermore, in the city public transportation is a possible substitute for driving, so that even city residents who drive now will often have the choice of an alternative mode when gas prices go up. In contrast the only way rural and suburban residents can usually mitigate the effects of higher gas prices is to change their behavior in usually costly ways, like finding a new job, moving, or purchasing a higher mpg vehicle.
As a result of this disparate impact on transportation costs for city versus rural and suburban residents, one possible long run result is that people will respond to higher gas prices by moving to the city from rural areas and suburbs. This raises the question of how this will affect housing markets in these areas. A new paper sheds some light on that issue:
By raising commuting costs, an increase in gasoline prices should reduce the demand for housing in areas far from employment centers relative to locations closer to jobs. Using annual panel data on a large number of ZIP codes and municipalities from 1981 to 2008, we find that a 10 percent increase in gas prices leads to a 10 percent decrease in construction in locations with a long average commute relative to other locations, but to no significant change in house prices. Thus, the supply response may prevent the change in housing demand from capitalizing in house prices.
…However, we find suggestive evidence that house prices do respond to gas prices in locations where the supply of housing is constrained.
The Simpson-Bowles plan coming out of the deficit commission is in the headlines. There’s a lot to digest in it, but I’d like to focus particularly on the elimination of the home mortgage tax deduction. They present two possible plans for this deduction. One abolishes it entirely, and the other one eliminates it for second homes, home equity mortgages, and any mortgages over $500,000 in value. Is this a good idea?
The first question to ask is what is the goal of the deduction in the first place and how well does it achieve that goal. The tax credit is part of the larger political project of encouraging homeownership. One might think at this point in the housing recession we’ve collectively moved beyond the point where this is thought to be a good idea, but our general anger at homeownership promoting policies doesn’t change the economic argument for them, which is based on externalities.
The idea is that homeownership encourages investment in both the property and the community, and there is some evidence that both occur, and that there are positive spillovers. Others have argued that homeownership has had a positive effect on children. For example, Green and White argue that children of homeowners are 25% less likely to drop out of high school, and that there is a causal relationship.
Of course, there are potential downsides to homeowners becoming more invested in the community. For instance, some have argued that homeownership encourages people to protect housing values by reducing supply through restrictive zoning and preventing low-income housing developments. Ed Glaeser and Jesse Shapiro find support for this by looking at the relationship between homeownership rates and support for a referendum in California that sought more restrictive zoning laws. As the graph below shows, there is clearly a relationship:
And while this may not be an externality in normal times, homeownership does decrease mobility and can therefore make households less likely to relocate for a job. In a recession where output is below potential, this could exacerbate unemployment.
So given the costs and benefits of homeownership, do we want to subsidize it? This is a tricky question, and absent some convincing analysis which demonstrates that benefits outweigh costs, it would seem unwise to subsidize. I’m not familiar with most of the empirical work on homeownership and outcomes for children, but this seems like the most plausible mechanism for net positive benefits. Then again, zoning restrictions are clearly rampant and problematic, and the causal mechanism there is more obvious.
Nevertheless, in terms of the home mortgage interest deduction, it turns out that question of the desirability of homeownership isn’t really important to answer, since it is unlikely that the deduction actually increases it. Glaeser and Shapiro present a few pieces of evidence to argue this case. First is the following graph, which shows the percent of taxpayers itemizing over time and how it is related to the homeownership rate.
You would expect that if the deduction increases homeownership, then when the percent of people itemizing went up, so too would homeownership rates. This is not what is observed in the data.
Glaeser and Shapiro present further evidence, summarized in the graph below, by showing there is no relationship at the state level between changes in the average value of the mortgage deduction and homeownership rates. Their statistical results suggest that a 1% increase in the subsidy rate causes homeownership to rise by .0009%.
The question then is why is such an expensive subsidy failing to encourage homeownership? The reason is because the subsidy is most valuable to high income households who were going to be homeowners with or without the subsidy. Those who are on the margin between owning and renting, young and the lower-income households, will benefit little or none from the deduction.
The Tax Foundation shows that in 2003 those filing income taxes with less than $30,000 in adjusted gross income represented just 9% of those receiving this deduction, yet they comprise over 50% of tax filers. In contrast, 36% of the deductions went to filers with more than $100,000 in income. Looking at data from 1998, Glaeser and Shapiro find that over 50% of itemized income goes to the top 10% of households. Clearly, this subsidy disproportionately benefits high income families, exactly the kind who are likely to be homeowners regardless.
Despite all of this I think we should be cautious about repealing this deduction. I strongly believe that lower house prices right now cause significant externalities. Even if this deduction occurs five years from now, the value of a house today is in part determined by it’s expected future sales price, and thus expected future price declines will be factored into today’s prices.
The externalities associated with low house prices should be less of problem for high income households, since foreclosures and labor immobility are less likely outcomes for them. This suggests there will be less of a downside, but not zero, to the second approach proposed by Simpson-Bowles, which eliminates the deductions for 2nd mortgages, home equity mortgages, and mortgages over $500,000. Alternatively, a slow decrease of the value of the deduction may limit the impact on prices.
In the long-run, the deduction should go entirely since a) it doesn’t increase homeownership, and b) it’s unclear whether we want to do that in the first place. In the short-run we should be very cautious, and make sure it is repealed it in a way that limits the impacts on home prices, especially in the relatively lower part of the price distribution where it is likely to cause externalities.
Over at Economix, Ed Glaeser discusses whether Fannie and Freddie should be privatized, abolished, or kept in government hands. This brings to mind a quick thought experiment: if you’re planning on buying a house, would you be better buying before or after Freddie and Fannie go away? The conclusion I’ll come to is common sense, but it’s worth thinking through it through analytically.
The key issue is what abolishing the GSEs would do to capitalization rates, which are also called cap rates. This is the discount rate that converts a stream of income into an asset value. In the case of housing the cap rate converts the stream of rent, which is what homeowners consume, into house prices. The price of a home is equal to the rent it could generate divided by the cap rate.
Like a discount rate, the cap rate varies by person, since the present value of a flow of housing services depends on, among other things, risk preferences, borrowing costs, and the time value of money. I haven’t seen recent data on this, but from from what I have seen, on average they tend to be in the general neighborhood of 8% for homeowners.
Whether a potential homebuyer will be better off in an post-GSE world depends on what happens to their own cap rate and everyone else’s cap rates. If borrowing costs are less important for you than for the average borrower, then your cap rate won’t be as affected when Freddie and Fannie are abolished and lending terms are more strict. This means your valuation of housing won’t go down as much. Borrowing costs could be low because of high savings, good credit, or a preference for cheap housing services relative to income.
On average, however, cap rates will go way up, as borrowing costs are important considerations for most buyers. If you need to have a 30% down payment, you’re willingness to pay for housing assets will decline greatly. This means house prices will fall. Likewise if mortgage rates increase.
So if you’re cap rate will be less affected by borrowing costs then housing may be more affordable for you in a post Fannie/Freddie world. Keep in mind that investors have cap rates as well, which means even if your cap rate goes up by less than the average homeowners’ you may be priced out of the market by investors who buy and rent housing.
I should emphasize that I’m looking at what happens along one dimension if Fannie and Freddie go away. This is not to suggest that the affects of abolishing them overnight would be modest or desirable. In fact, I believe it would be devastating and would probably make almost everyone worse off.
I once had a macro professor offhandedly suggest -in between demonstrating with Hamiltonians and representative agent models how rational bubbles could exist- that one way to identify a bubble would be the the number of complete amateurs lured into an industry. Similarly, my main data point in identifying the housing bubble was Flip That House and other shows like it.
What was happening on those shows defied everything micro theory says about how a market should behave. It wasn’t just that the behaviors couldn’t be explained by neoclassical, perfect information, Chicago School micro theory. There was no amount of information asymmetries, market power, or principal agent problems that could explain what happened on those shows. Complete novices buy a house, spend four weeks doing a shoddy remodel, and sell it for 150% what they paid for it. This was clearly Animal Spirits.
“What is happening here cannot last”, I would tell people. If there are such insanely outsized profits to be had, surely professionals will put these amateurs out of business, owners of houses in need of rehabilitation will ask higher and higher prices, and competition will drive prices down. Yet the shows went on for several seasons, with witless novices making profits that defied gravity.
The longer the show went on the more of a bubble I assumed was building. On the more professional home renovation shows they were leveraging up big time as well. And everyone knows hows it all ended.
I was reminded of all of this today by an excellent post from Mike Konczal pointing out this exact phenomenon across bubbles and industries:
In my personal opinion, in the same way middle-class people turned amateur stock analysts was the sign of a tech bubble, or middle-class people turned amateur realtors was the sign of a housing bubble, middle-class people turned amateur credit risk analysts and credit channel intermediaries was the surest sign of a credit bubble.
The amateur credit risk analysts he is talking about are the person-to-person lending websites that were once very overhyped in terms of their potential. This is an amateur market I had not considered, but it certainly makes sense.
The lesson here is beware the amateurs. Wherever they gather in huge profitable masses a bubble has surely formed, and the longer they are able to walk around blithely picking up $100 bills off the sidewalk, the bigger the bubble is.
There is a favoritism towards renting in the economics blogosphere, perhaps reflecting some partial irrationality of homeowners, or maybe it’s just a collective cosmopolitan ethos of econ bloggers. In either case I find it interesting to consider rational economic reasons for the strong preference for homeowners that Americans display. A recent paper by Pablo Casas-Arce and Albert Saiz explores an angle I haven’t heard before. Their argument is basically that an inefficient legal system creates a cost of renting versus owning:
In this paper we argue that, lacking alternative means of enforcement such as reputations, market participants will tend to avoid the use of contracts when operating in an environment with very inefficient courts. As a result, the legal system may alter the allocation of ownership rights.
To examine this claim we consider the housing market, where these effects are most financial intermediaries emerged in India in response to Financial regulation. transparent: essentially, a user of housing services can either buy a house or rent it from another owner or landlord. Hence, studying the prevalence of rental properties will tell us about the use of rental contracts and, hence, the allocation of ownership rights in such a market. To the extent that contracts can be enforced, they will allocate these rights in an efficient manner to maximize welfare. This will involve some individuals purchasing the houses they use, while others will buy access to them from a separate owner on an occasional basis, using a rental contract. But when these temporary transfers of control are costly to enforce, we will see departures from that optimal allocation. In particular, market participants may decide to avoid contractual disputes by relying less on rental agreements and, instead choosing a market structure that displays more direct ownership by the final user.
The part of enforcing a rental contract that can be costly in an inefficient legal system is kicking out a renter, either to evict them or simply because the landlord doesn’t want to renew the lease to them for some reason. Megan McArdle’s recent problems trying to purchase a home with a current renter is a perfect example of this. As they discovered, in D.C. it can be very difficult to remove a renter:
District of Columbia Law and Superior Court Rules prohibit the execution of evictions when a 50% or greater chance of precipitation is forecasted for the next 24 hours. Additionally, if the weather forecast calls for temperatures below 32 degrees Fahrenheit over the next 24 hours, evictions other than those designated as Commercial Property will be canceled.
Official weather determinations are made daily at 8:00am., and are based on the National Weather Service Forecast for the Ronald Reagan National Airport, formerly National Airport, the official weather location for the District of Columbia.
When evictions are canceled due to weather and the Writ expires due to no fault of the U.S. Marshals Service, the Landlord will be required to re-file for an Alias Writ and a new filing fee will be required. All Writs identified as Alias Writs and those that are about to expire, will be considered for priority scheduling.
This tells us that the recent problem involving the unclear legal status of a bunch of foreclosures, if not resolved clearly and carefully, could lead to a higher rental rate. After all, this decreases the efficiency of the ownership contract relative to the renter contract.
The lesson in the long run is that if you want more renters, for reasons of labor mobility or whatever, you should make sure the legal system related to rental contracts operates efficiently. This doesn’t necessarily mean favoring landlords over renters, but rather making contract enforcement clear and easy.
Yesterday I wrote this:
If I had to play homeowner psychoanalyst I would guess that homeowners with a strong preference for homeownership saw cap rates were changing and believed house prices were heading towards a permanently higher plateau that would permanently price them out of homeownership. People who would want to buy houses in the future but were currently renting had this fear as well and rushed into the market. Risk aversion here thus did not lead to selling when prices rose as a simple model might predict.
I was drawing on the work of Todd Sinai and Nicholas Souleles who have shown that housing works as a hedge against rental volatility. My thinking was that because owners often have strong preferences for home-ownership and are not indifferent between renting and owning, that those who planned to buy a house in the future would see buying a house now as a hedge against house price risk, much in the same way as the Sinai Souleles model. Well yesterday after I wrote that I came across a brand new paper that makes a very similar argument:
Our contribution is to focus on the importance of ownership as a hedge against future house price risk as individuals move up the ladder. We use a stylized model to show that increasing house price risk acts as an incentive to become a home owner earlier in the life-cycle and, once an owner, to move more rapidly up the housing ladder.
Increases in volatility are shown to increase ownership and to increase the quantity of housing wealth conditional on ownership in earlier periods of the life-cycle. We then establish that these relationships hold empirically using panel data on families in different geographic markets in Britain and in the US.
The authors use data from the UK and US to provide empirical support for their model. This is an under-explored causal mechanism for the bubble: house price risk went up, people bought homes to insure against that risk, which drove prices up, which increased perceived house price risk, etc. The cascading nature of this is clear, and it’s not hard to see how this could create a bubble.
So housing risk makes people want housing even more. I’m not sure if this will comfort or aggravate people like Felix Salmon and Ryan Avent who have been arguing that households are too risky in their housing consumption/investment decisions, but it should help explain why what looks to them like overly risky behavior is in fact caused partly by risk aversion.
However, this explanation for the behavior does offer a potential solution. Local REITs could be created for very small geographic areas designed to help young households who want to insure against price increases in a specific neighborhood but do not yet want to take the large risks of buying a house. They could even be metro area REITs that are heavily weighted in a particular submarket.
If Felix and Ryan want to get households to stop overleveraging themselves in housing debt, maybe their best option is to start looking for venture capital.
Let me try to rephrase me previous post to make the point more clearly, and -taking off my William Jennings Bryan hat- with less populist righteousness. Cost-of-living measures attempt to look at quality adjusted price changes. When the rents in a given city increase, the housing portion of the CPI goes up and by that measure so has the cost of living. But this increase can simply reflect the positive amenity value of the city going up; less crime, better parks, etc. If you really wanted to do quality-controlled measure of cost-of-living you would control for the fact that higher priced cities reflect higher amenity values.
So when people say well $250k isn’t a lot when you look at the cost of living in that area, that higher cost of living does not reflect complete controls for quality but in fact measures the higher amenity value of the city. This is just consuming a better, and so more expensive good.
There was an article last week in the New York Times about economists calling for the government to simply allow house prices fall and reach their bottom, an idea which is gathering more and more support. I think this is a bad idea because the real costs falling home prices are obvious, likely, and severe, while the benefits are vague and speculative.
For starters, as the following chart from Calculated Risk shows, in Q1 2010 there were millions of homeowners who are in a negative equity position. If prices fall another 5%, each of these bars will shift to the left one position. If prices drop 10%, they will shift two.
Lets make the conservative assumption that there are as many people right now in the 0% to +5%, +5% to + 10%, and +10% to +15% bins as there are in the -5% to 0% bin. This means we’ll get another 1.8 million borrowers underwater for each 5% fall in prices. If they fall 15%, that means 5.4 million more.
As you can see though, the numbers of homeowners in each category get larger as they approach zero, going from 1.1, to 1.3, to 1.5, to 1.8 million in the last 4 bins. So it’s likely we’ll actually get upwards of 6 million more homeowners underwater.
In addition, a fall of 15% would push around 1.9 million more homeowners into 50% or more of negative equity, driving this number up to around 6 million. These large increases in total negative equity will drive a wave of foreclosures. The best evidence indicates that foreclosures, in turn, will decrease nearby home values by 1% to 2%, which could exacerbate the foreclosure blights many neighborhoods are already facing.
Why are these foreclosures a problem? Most economically literate readers will be familiar with Bernanke’s famous paper on non-monetary causes of the Great Depression, where he makes the case that an increase in the cost of credit intermediation worsened the Great Depression. In contrast to the argument for how bad things can get when banks fail, few seem to focus on aspect of Bernanke’s paper that focused on defaults and bankruptcies as a mechanism for deepening the depression. In fact Bernanke even discusses the drying up of credit for homeowners as one of the important channels through which the credit system was failing:
Home mortgage lending was another important area of credit activity. In this sphere, private lenders were even more cautious after 1933 than in business lending. They had a reason for conservativism; while business failures fell quite a bit during the recovery, real estate defaults and foreclosures continued high through 1935….
To the extent that the home mortgage market did function in the years immediately following 1933, it was largely due to the direct involvement of the federal government.
Removing the existing government supports for the housing market now will allow this important channel of credit to dry up. As Bernanke recognized, this could worsen and lengthen our recession.
Another problem is that when a buyer defaults they lose a real asset: their credit. As near as I can tell from Googling around, credit scoring agencies have not adjusted their models to decrease the damage that a foreclosures does to your credit score. This seems puzzling to me as economists seem to agree that the huge fall in house prices was largely unpredictable when many of these mortgages were made. Defaulting on a mortgage in 2010, one would think, is not nearly as much of an indicator of lacking creditworthiness as defaulting on a mortgage in, say, 2005.
In any case, when defaults happen a real asset which gives borrowers access to credit goes away and the cumulative creditworthiness of U.S. households falls. In a recession, when borrowing and investing are important means of driving economic activity, this is not a good thing.
I believe the reason that falling home prices are getting support is what Karl calls The Pain Bias. Somehow, falling prices feel like tough love, and it feels like borrowers will be more confident. And it may be the case that another 15% fall in prices will convince people that prices are at a bottom. But along the way to that bottom real economic damage will be done. If that damage is great enough, and hurts economic growth, those rock bottom prices may fall even further.
Some time ago there was a blogospheric debate about whether a house should be considered an investment. I contended that almost necessarily it has a large investment component, and should be thought of as such. In addition, for many people -although I don’t know how many- housing can be a good investment. Felix Salmon and Ryan Avent disagreed, with Ryan arguing housing was an investment, but rarely a good one, and Felix arguing that it was not an investment at all. Today, esteemed economist Karl E. Case of Case/Shiller fame weighs in on the housing as an investment debate:
But for people with a more realistic version of the American dream, buying a house now can make a lot of sense. Think of it as an investment. The return or yield on that investment comes in two forms. First, it provides what is called “net imputed rent from owner-occupied housing.” You live in the house and so it provides you with a real flow of valuable services. This part of the yield is counted as part of national income by the Commerce Department. It is the equivalent of about a 6 percent return on your investment after maintenance and repair, and it is constant over time in real terms. Consider it this way: when Enron went belly up, shareholders ended up with nothing, but when the housing market drops, homeowners still have a house. And this benefit is tax-free…
…This financial crisis has made us all too aware that we live in a Catch-22 world: the performance of the housing market drives the economy, and the performance of the economy drives the housing market. But housing has perhaps never been a better bargain, and sooner or later buyers will regain faith, inventories will shrink to reasonable levels, prices will rise and we’ll even start building again. The American dream is not dead — it’s just taking a well-deserved rest.
Karl wants you to think of housing as an investment, and he wants you to invest. I’ll agree with him on the first point, and remain agnostic on the second.
He also makes an important point about how housing lacks any true fundamentals like financial investments do:
Real estate sales are unlike other financial transactions. You can place a rough inherent value on a stock or bond by looking at fundamentals: a company’s profits, price-to-earnings ratios, quality of its products and management, and so forth. But a house is worth what someone is willing to pay for it. That’s a very personal, emotional decision….
This lack of solid fundamentals is an important problem with identifying housing bubbles. It is entirely possible for there to be an exogenous increase in the preference for home ownership that will drive up the prices of housing, as well as the price to rent ratio. Capitalization rates, which determine how an individual translates a flow of housing services into a house price, differ among individuals. Demographics can shift in ways that will affect cap rates, for instance average income or age can increase, but so too can the raw preference for home ownership. So house prices went up 15% while rental rates remained constant; what just happened? Is this irrational speculation, or did preferences for home ownership increase?
UPDATE: Felix does some real reporting and gets Case on the phone. I am apparently interpreting his use of “investment” too literally.
Calculated Risk tells us the key to fixing the housing market:
The key to the housing market is to absorb the excess inventory. That means more households and fewer new housing units. Luckily housing starts are very low right now, but unfortunately there is very little job growth (and therefore little new household formation).
But job growth is not the only way to get new household formation, as I’ve argued again and again, we have immigration at our disposal. Of course, there are the usual complaints about jobs. But the weakness of this argument can be seen in a new paper Felix Salmon directs us to:
Statistical analysis of state-level data shows that immigrants expand the economy’s productive capacity by stimulating investment and promoting specialization. This produces efficiency gains and boosts income per worker. At the same time, evidence is scant that immigrants diminish the employment opportunities of U.S.-born workers.
It is well understood that the removing capital tariffs and protectionism would increase overall efficiency and incomes. Since immigration restrictions are labor market protectionism we shouldn’t be surprised to see that is has similar positive effects.
Unfortunately, journalists and pundits don’t seem to oppose labor protectionism nearly as much as they oppose capital protectionism. We would see an outcry among op-eds and pundits if we were seeing a worldwide rise in capital protectionism, because they recognize that beggar-thy-neighbor policies make everyone worse off. But no similar reaction has come from the rise in global labor protectionism. Here is how a recent report from the Migration Policy Institute describes the situation:
Confronted with the most severe economic crisis in decades and rising unemployment, governments in locations across the globe embraced a range of policies to suppress the inflow of migrants, encourage their departure, and protect labor markets for native-born workers.
From Malaysia and Thailand to Kazakhstan, Taiwan, Australia, South Korea, and Russia, many governments have sought to restrict access to their labor markets by halting, or at least decreasing, the numbers of work permits for foreigners. Others, such as the United Kingdom, tightened admission requirements. And while the policy focus of many of these countries was on reducing the entry of low-skilled workers, the United States placed restrictions on some companies seeking to bring in the highly skilled.
In addition to the results from Felix above, the wider literature on the issue tells us the quantifiable impact on wages is likely to be minimal compared to the impact on house prices. For instance, research from economist Albert Saiz found
“…a very robust impact on rents and housing prices that is an order of magnitude bigger than the estimates from the wage literature. Immigration inﬂows equal to 1% of a city’s population were associated with increases in average or median housing rents and prices of about 1%.”
Emphasis his. In previous research, Saiz used a classic example of exogenous immigration from the literature and found effects of a similar magnitude. Looking at the Mariel boatlift, a sudden inflow of immigrants from Cuba which increased the population of Miami by 4%, Saiz found that rents in Miami increased 8%. Overall, there appears to be a robust relationship between immigration and housing prices.
Calculated Risk tells us that “Usually housing is a key engine of recovery, especially for jobs. But this time housing is going to follow the economy.” But this is not because of economics, but politics. Instead of waiting around for the labor market to lead housing recovery, let’s use the tools we have to help housing recovery lead.
I don’t have some all encompassing narrative of the housing bubble to weave you, or an airtight case that government policies caused the bubble, didn’t cause the bubble, etc. I just want to comment on a few points in the debate.
The argument is frequently made that Fannie and Freddie were minor securitizers by the time the bubble came to a full boil in 2006, therefore they didn’t “cause” the bubble. But the fact that private companies were able to push them out of the market doesn’t tell us anything about the initiation of the bubble. The fact is that as early as August 2002 Dean Baker, who many credit as having “called the bubble”, was saying that prices were becoming divorced from fundamentals. As you can see from Karl’s chart, this is still during a time period when GSEs constituted the vast majority of MBS issuance and were quickly ramping up:
So was Dean Baker identifying a bubble in late 2002 that wasn’t there, or were Fannie and Freddie the majority MBS issuers when the bubble started?
A lot of focus goes into who issued the subprime loans which are now defaulting and much less discussion occurs about what caused the initial divorce of house prices from fundamentals. I think Jim Hamilton’s explanation of the run-up in oil prices that led to the beginning of this recession has some applicability to what happened in the housing market. In short, prices skyrocketed because market participants (and academics) no longer knew the value of a key parameter. When demand did not subside even as oil prices went above historical levels, market participants began to wonder “what exactly is the price elasticity of oil at this level?”. As Hamilton put it:
Just as academics may debate what is the correct value for the price elasticity of crude oil demand, market participants can’t be certain, either. Many observers have wondered what could have been the nature of the news that sent the price of oil from $92/barrel in December 2007 to its all-time high of $145 in July 2008. Clearly it’s impossible to attribute much of this move to a major surprise that economic growth in 2008:H1 was faster than expected or that the oil production gains were more modest than anticipated. The big uncertainty, I would argue, was the value of ε. The big news of 2008:H1 was the surprising observation that even $100 oil was not going to be sufficient to prevent global quantity demanded from increasing above 85.5 mb/d.
Once the ratio of house prices to rents and other fundamentals became indisputably divorced from historical levels, market participants had to wonder what are the new underlying parameters were. Dean Baker said from the start that the historical levels were correct, and nothing has changed. Economists overall were agnostic. But from 2002 until 2007, those who bet optimistically were rewarded and those who bet pessimistically were punished or ignored as prices increased quickly.
If Fannie and Freddie drove the initial divorce of prices from their historical relationship with fundamentals, than they are an important causal factor. Yes, markets that myopically rewarded the most optimistic assessments of the new parameter values were a necessary condition for us to arrive at the hugely frothy markets of 2006, but so too was some first mover to push prices above historical levels.
Perhaps some of that divorce from fundamentals was real, in the sense that the equilibrium price to rent ratio grew as a result of a change in capitalization rates driven by income growth. If this is the case, then those who want to claim that the bubble was “called”, especially by Dean Baker, or that bubbles are identifiable, have a harder story to tell about when you know that a bubble has formed. What level of divorce from historical values is acceptable as real and at what level do you call it a bubble?
It must be, because what else explains this ridiculous optimism?
In an annual survey conducted by the economists Robert J. Shiller and Karl E. Case, hundreds of new owners in four communities — Alameda County near San Francisco, Boston, Orange County south of Los Angeles, and Milwaukee — once again said they believed prices would rise about 10 percent a year for the next decade.
With minor swings in sentiment, the latest results reflect what new buyers always seem to feel. At the boom’s peak in 2005, they said prices would go up. When the market was sliding in 2008, they still said prices would go up.