The Float

Just How Terrible is Housing as an Asset Class?

For some time now, we've been noting that the recently-concluded housing bubble wasn't like most of the bubbles that preceded it. Unlike the railroad, telegraph, and dot-com bubbles--which, for all their short-term wreckage, created new infrastructure of immense economic value, as Daniel Gross argues in Pop!--the housing bubble has left behind virtual ghost towns, economically useless infrastructure (e.g., roads, water, and power leading to virtual ghost towns), and a brutal overhang of household and government indebtedness.

So we were pleased to see the (sometimes breathless, often prophetic) Nouriel Roubini make special note of the unproductive nature of the U.S. housing stock. Here are the key passages from Roubini, via Naked Capitalism:

Sixth, the existence of [Government-Sponsored Enterprises,] GSEs...is a major part of the overall U.S. subsidization of housing capital that will eventually lead to the bankruptcy of the U.S. economy. For the last 70 years investment in housing –- the most unproductive form of accumulation of capital -– has been heavily subsidized in 100 different ways in the U.S.: tax benefits, tax-deductibility of interest on mortgages, use of the FHA, massive role of Fannie and Freddie, role of the Federal Home Loan Bank system, and a host of other legislative and regulatory measures.

The reality is that the U.S. has invested too much – especially in the last eight years – in building its stock of wasteful housing capital (whose effect on the productivity of labor is zero) and has not invested enough in the accumulation of productive physical capital (equipment, machinery, etc.) that leads to an increase in the productivity of labor and increases long run economic growth. This financial crisis is a crisis of accumulation of too much debt -– by the household sector, the government and the country –- to finance the accumulation of the most useless and unproductive form of capital, housing, that provides only housing services to consumers and has zippo effect on the productivity of labor. So enough of subsidizing the accumulation of even bigger [McMansions] through the tax system and the GSEs.

We're not sure that the subsidization of housing capital "will eventually lead to the bankruptcy of the U.S. economy," but we're pretty sure it's not a very good use of currently-finite resources in growing the country's real wealth. But aside from that non-trivial quibble, we think Roubini gets this under-appreciated story exactly right.

Chart of the Day

In light of today's Flow of Funds report from the Fed, which showed a substantial decline in U.S. household wealth in the most recent quarter, we thought the data presented below (courtesy Investment News) were as timely as ever. Note that for the first time in the post-war period, Americans own less than half of the estimated value of their residential real estate.

 

This chart is the inevitable product of declining prices and massive equity withdrawals. Which makes us think of Maxed Out, a documentary on Americans' ever-expanding indebtedness and some of the less savory business practices that have helped us along on that path. We recommend it--though maybe not on a full stomach.

Sources

Carlos Torres, "U.S. Household Net Worth Fell the Most in 5 Years Last Quarter," Bloomberg, June 5, 2008

"Owners' equity in household real estate, 1945-2007," Investment News, June 2, 2008

Housing and Long-Term Competitiveness

Every day brings new data on the real estate market, most of it discouraging to the realists in the crowd. The latest evidence suggests that commercial real estate is following residential into the tank. All but the most willfully obtuse Pollyannas now acknowledge that the real estate picture is bad...and likely to get worse before it gets better. Of course the universal caveat applies: Local markets will vary.

As we've written repeatedly in this space (most recently three weeks ago in this item), the mad scramble to prop real estate up may or may not be effective, but regardless of its efficacy, its wisdom is doubtful at best.

So we were pleased to see Yves Smith pass along a summary of Nouriel Roubini's recent roundtable on broad financial and economic circumstances. Here's the relevant passage from Smith's post (emphasis added in bold):

One speaker (I cannot recall which one) argued that the push for more affordable housing was to mask the political impact of stagnant wages. "We needed to show some form of economic progress to meet social goals." Yet channeling so much investment capital into housing has certainly not helped, and probably weakened US competitiveness, thus in the end making workers worse off in the long haul.

That last sentence should be distributed immediately to every member of Congress, with helpful bullet-point explanations of the difference between productivity-enhancing and productivity-draining investments.

As always, none of this should obscure the substantial dislocations (i.e., pain) caused by the bursting of the lending and real estate bubbles. But the extent of the pain this time makes an appropriate policy response that much more important--to minimize the pain next time.

Thinking About Housing

Some say a recession has arrived. Some say it hasn't yet but will. Some say it never will.

Notwithstanding all the disagreement about where we are not, we've detected near-unanimity on the need for the housing market to stabilize (or "bottom") before the economy stages any kind of meaningful recovery. Which, as far as it goes, is almost certainly true. But the argument has assumed a normative dimension, with many observers claiming that it would be an affirmatively good thing for housing to bottom. Alas, this a question that gets too little attention in the current debate: Should we make extraordinary efforts to force the bottom into place right here, right now?

We think the answer is a definitive no. In the long run, the U.S. economy would be better-served if home prices fell further--much further in some markets, a little further in others--in order to reach market-clearing levels without short-term gimmicks and unsustainable subsidies.

After all, the big problem these days is that too many Americans became overleveraged to acquire (or, more accurately, occupy) unproductive assets. This, we think, is a gross mis-allocation of public and private resources. And all this so Americans could stake partial/leveraged claims to an asset class that historically has been a relatively poor performer.*

Three caveats:

1. We are not of the "let them eat cake" school of economics. Not at all. But the castles-in-the-sky fantasies of the last few years served Americans of moderate means very poorly. These are people whose real wages are lower now than they were when we embarked on this outrageous real estate bubble. So bringing real estate prices back to some reasonable level of affordability, for all the dislocations it will cause in the short run, is very much in the long-term interests of working- and middle-class America.
2. We aren't reflexively anti-government. By its very existence, government "intervenes" in markets...by creating them!** We do think that extraordinary interventions should have clearly stated objectives and plausible likelihoods of achieving those objectives. But we do think it's entirely legitimate for government to try to smooth out the roughest edges, and mitigate the negative externalities, of market cycles.
3. We freely and fully acknowledge that falling home prices do and will hurt in the short run. But we'd rather take the responsible position of focusing on the long-term requirements of economic growth than just applying an expensive short-term salve to the wounds created by the last bubble.

And what are those requirements of growth? Here we'll focus on just one: A higher rate of domestic saving. By slashing interest rates, the Fed has punished saving (of which we need more) and encouraged borrowing (of which we need less). These days, the marginal spent dollar is the marginal borrowed dollar. They're the same thing!***

Only in the most short-sighted sense is a bottom in housing (which we intend to mean a stabilization in the price of residential real estate) necessary or good. A further purging of the truly perverse excesses that have barnacled the American economy over over the last few years would serve us all better in the long run. Less leverage. More affordability. Higher savings rates. More discretionary income for other stuff. More productivity.

No self-respecting elected official will touch this argument, and we understand why. But let's be honest: That doesn't make it any less compelling.

~~~~~~~~~~~~~~~~

* Thanks in part to exceptionally high "expense ratios." If we included the true costs of homeownership (interest payments, property taxes, maintenance, &c.), the return on equity from residential real estate would, in all but the most unusual circumstances (of the sort we witnessed from 2000 to 2005), be remarkably low, even negative in many instances. That doesn't mean real estate is inherently a "bad investment." For several reasons, economic and otherwise, we like the idea of homeownership as much as anyone. But it does mean that as an investment per se, residential real estate isn't especially attractive.

** Through the establishment and preservation of physical and intellectual property rights, the enforcement of contracts, and the maintenance of infrastructure and public safety, among other things. 

*** Those stimulus checks now flying toward a mailbox near you? Those are borrowed too, and the feds want you to spend 'em.

Sources

Alison Vekshin, "U.S. House Passes Anti-Foreclosure Bill Facing Bush Veto Threat," Bloomberg, May 9, 2008

The Right Word

Late yesterday afternoon we ran across a jarring item on the real estate carnage in California. Writing at Slate, Mark Gimein shares some anecdotal but presumably representative examples of dramatic declines in asking prices. He then writes this:

Unfortunately, when it comes to the California crash, these striking numbers are not the end. They are the beginning. (To give Paulson his due, he said that, too.) Which brings us to the other scary part of the California story: a coming wave of interest-rate resets in prime loans given to people with good credit that are just as bad, or worse, than we've seen in subprime.

The most common subprime loans were known as "2/28" in the industry: 30 years, including a two-year teaser rate before the interest rate rose. Now these loans have reset, and we're seeing the fallout.

But prime borrowers, too, got loans that started out with low payments; if you bought or refinanced your house in the last few years, it's not unlikely that you have one. With an "option ARM" loan you have the "option" (which most borrowers happily take) of paying less than the interest; the magic of "negative amortization." The loan grows until you hit a specified point--the exact point varies with the lender; with Countrywide, it'll come after about four and a half years--when the payment resets to close to twice where it was on Day 1.

Just two banks, Washington Mutual and Countrywide, wrote more than $300 billion worth of option ARMs in the three years from 2005 to 2007, concentrated in California. Others--IndyMac, Golden West (the creator of the option ARM, and now a part of Wachovia)--wrote many billions more. The really amazing thing is that the meltdown in California is already happening and virtually none of these loans have yet reset.

Option ARM loans were heavily marketed to upper-tier home buyers in California. It's hard to know how bad the option ARM crisis will be before it actually happens, but Moe Bedard, an advocate in Southern California who advises homeowners on foreclosure and blogs about the crisis at Loansafe.org says that the difference in the time until the rate rises is the main reason that upper-middle-class Orange County (now facing foreclosures at a rate merely twice the national average) hasn't yet been hit as badly as places like Riverside.

All of which is interesting and important. But what really got our attention is a later passage concerning the inaccuracy of the term "homeowners" when referring to house-occupiers who are leveraged beyond recognition (we mentioned this conceit yesterday). Here's Gemein:

If you're one of the "homedebtors" (a fantastic neologism coined by the anonymous blogger IrvineRenter on the Irvine Housing Blog) in this position, you might start thinking very seriously about just how attached you are to the wisteria vine snaking over the basketball hoop on your garage. That's what a lot of other California borrowers will be doing.

Homedebtors. We like that. We don't like the fact the condition is so widespread; we like the word's descriptiveness. And we're strongly partial to linguistic precision.

Sources

Mark Gemein, "Here Comes the Next Mortgage Crisis," Slate, April 15, 2008

George Orwell, "Politics and the English Language," 1946

Two Housing Crises

With the whole world watching, the U.S. housing market continues to weaken. Official Washington's insistence that the bottom was in sight many months ago seemed like Wonderland nonsense even then. Today it's simply laughable. Inevitably, the financial wreckage has been extensive: consumer spending, Wall Street's too-clever innovations, household and corporate balance sheets, employment...all have taken major hits. And the bludgeoning isn't over.

That's our acute housing crisis: The rapid, ongoing decline is residential real estate prices. But there's another, more chronic crisis out there: Our excessive allocation of resources to residential real estate in the first place. Partly a function of public policy (i.e., the home mortgage interest deduction, local governments' dependence on development fees, local officials' dependence on developers' campaign contributions) and partly (more importantly?) a function of our acquisitive culture, we've devoted far too much of our national wealth to our personal castles.

The consequences of this imbalance have been substantial. The arms race in residential real estate--Bigger! Newer! Fancier!--has driven prices beyond the reach of rank-and-file workers. In certain parts of the country, housing (even rental property in some cases) has become genuinely unaffordable. But people need places to live, of course, so they stretch their ex-housing budgets with leverage against their homes and, for renters and "owners" alike, the excessive use of credit card debt.

Taking a broader macro view, housing simply isn't a productive resource. In fact, it's a dead end and often (especially in the cases of far-flung exurbs) a terrible drain on public finances, to say nothing of the environmental costs of leapfrog development. Unlike investment in education, capital stock, research and development, and various kinds of commerce-related infrastructure, housing is pretty much a black hole in terms of long-term productivity growth.

And notwithstanding the realtors' absurd claims of long-term appreciation rates, housing, in most places at most times, isn't a compelling personal investment either. At times, no doubt, homeowners can and will earn a decent return on their residential assets. But most estimates wildly underestimate the true costs of ownership, and thus overestimate the financial returns to such ownership.

We understand the significant toll the recent downturn in residential real estate has taken on many millions of people here in the U.S. and around the world. But even as we try to muddle our way through the financial aftermath of yet another bursting bubble, it would be smart--no, it would be more than smart; it would be wise--to think about the true costs and benefits of our dysfunctional relationship to our real estate.

This episode calls out for wise leadership, for a kind of societal intervention. But who's willing and able to sit us down on the couch and help us think more clearly about our chronic housing crisis? Who's capable of shaking us out of our co-dependent relationship with our homes? Unfortunately, the narrow interests threatened by a rationalized real estate market are unlikely to stand idly by while we recalibrate. And, in a classic collective action problem, the broad interests that would be served by such a rationalization are too inchoate to effect real change.

In the absence of wise leadership on this issue, our process of muddling through will be more muddled than it needs to be.

"Dilute the Shareholders"

Getting public policy just right is never easy. But getting it less wrong than this should be. From Slate's Daniel Gross, writing of proposed legislation pending in the Senate:

The bill includes several items that are likely not to do much harm--boosting deductions for property taxes, tax-exempt bonds for local housing agencies, and modest tax credits for people who buy homes out of foreclosure. But it also includes a provision, detailed in this Associated Press story, that is perverse, absurd, and unwarranted. In short, I don't think it's a good idea.

Under the proposal, the AP reports, "companies would for two years be allowed to carry back losses incurred in 2007 and 2008 against profits accrued over the previous five years, instead of the usual two year timeframe." Under current rules, companies can effectively call up the Internal Revenue Service and declare a do-over, applying losses racked up in 2008 against income reported in 2007 and 2006, and then claim a retroactive tax refund. The utility of this benefit rises as the size of the loss increases. If, for example, you're forced drastically to write down the value of land you've acquired, the loss in 2008 could easily swamp the profits reaped in 2007, 2006, and several years before.

The technical term for this is a tax-loss carryback. But it should perhaps be known as a bubble-head tax break. Companies that vaulted into a hot sector and then used lots of leverage to increase their profits in said sector (the Internet, real estate) light up the charts during the boom years. But come the pop, their fortunes plummet rapidly down the same steep slope. And because accounting rules require companies to mark assets to market, erstwhile high-flyers frequently report massive losses.

...

Homebuilders argue that they need relief because their sector, which provides a great deal of domestic employment, is on the ropes, and they're finding it more difficult to raise capital. Which is as it should be. After bubbles pop, those who screwed up really badly fail and get taken over by creditors or opportunistic investors. Those who have sound underlying franchises but merely got a little carried away can survive if they take painful restructuring moves. This is what is known as market capitalism. For all the talk of a credit crunch, capital is still available—it's just not available on the easy terms managers had come to expect during the late Greenspan years. Citigroup, Merrill Lynch, and plenty of other firms tied to the mortgage/finance complex have taken steps to shore up their balance sheets and replenish lost capital. But investors, having been burned, demand more downside protection and better guaranteed returns. Thornburg Mortgage was forced to pay 18 percent interest for an emergency round of capital raising that allowed it to stave off bankruptcy. This is also what is known as market capitalism.

The proposal to give new tax breaks to homebuilders and banks is yet another example of the pernicious trend of privatizing profit and socializing losses, which is gnawing away at faith in the system. Dilute the shareholders, not the taxpayers.

Dilute the shareholders? You mean like this?

Sources

Daniel Gross, "A Tax Break for Bubble Heads," Slate, April 7, 2008

Jonathan Stempel, "WaMu gets $7 billion infusion, cuts jobs, sees big loss," Reuters, April 8, 2008

More Toles

Tom Toles, from Monday's Washington Post...

And from Sunday...

The Day (So Far) in Headlines

A parade of horribles (with an assist from Calculated Risk)...

• U.S. Economy: Confidence Declines, Producer Prices Increase
• OFHEO: Widepread House Price Declines in Q4
• S&P Case-Shiller: Prices Fall Sharply in Q4 2007
• Home Depot Has First Annual Sales Decline
• FDIC Readies for a Rise in Bank Failures

...is apaprently no match for an upbeat forcast from IBM...

• IBM Plans $15 Billion Stock Buyback, Boosts Forecasts

...which has 'em buying everything in sight...

Note: We reserve the right to revise this post at the end of the day!

Negative Feedback

We've noticed an uptick in recognition--or at least public acknowledgement--of the negative feedback effects at work in a credit-dependent economy slogging through a period of credit contraction.

First, from Edward Hadas of breakingviews.com, in yesterday's Wall Street Journal:

The specter of deleveraging still haunts the financial markets. Rightly so, for the removal of credit from the global economy is a process that feeds on itself. That means that the credit crunch could easily turn into something much nastier.

Before the deleveraging came the leveraging. Take the U.S. The ratio of all sorts of debt to gross domestic product rose to 342% at the end of September 2007 from 160% in 1975. Through 2000, debt increased by 2.4 percentage points a year faster than GDP. But after the turn of the millennium, the rate accelerated almost to 3.7 percentage points a year.

While it was happening, only a few sourpusses complained. Increasing debt was seen as a natural trend. As economies get richer, they have more need for debt-financed investments and inventories. But lending grew much faster after 2000 than even the most gifted apologist could explain away. It was a bubble, which has now been popped.

In a credit bubble, one thing leads to another. You can bid more for a house because banks are willing to lend more. So house prices rise, giving the banks more confidence about lending yet more. So you build an addition or buy a new car.

Multiply that by a few hundred million borrowers and presto, asset prices go up and economic growth is high. Banks rejoiced. They set up off-balance-sheet vehicles that piled on debt. Leveraged-buyout groups borrowed to take companies private; hedge funds borrowed to invest in assets. And so on.

In deleveraging, too, one thing leads to another. Start with a bank that has lost a few billion dollars on subprime mortgages. The bosses are likely to decide that troubled times call for higher capital ratios. That means calling in lines of credit. Some borrowers are forced to sell assets, pulling down prices. The banks then look at the value of their collateral and think: "Oh my god, it's not worth what we thought." They then cut their credit again -- giving another turn of the deleveraging screw.

The housing market was just the start. A series of debt mountains -- credit cards, car loans, LBO loans -- risk being leveled. The credit contraction strikes down financial arrangements that once looked solid -- from structured investment vehicles to auction-rate securities.

If the original debt helped fuel consumption, deleveraging will feed into lower economic activity. If the original debt fueled asset purchases, the consequence will be lower asset prices. There could be a dual effect because lower asset prices can make people feel poorer and less willing to spend money. This is especially the case with people's homes.

How far can this go? Historical parallels aren't terribly comforting. In Japan, a boom in the 1980s was followed by a painful deleveraging. Despite massive government borrowing and five years of a near-zero interest rate on overnight borrowing, the prices of shares and real estate declined by 40% to 70%. The U.K. did better in its deleveraging after 1990 -- house prices dropped by 40%, after taking inflation into account, but share prices rose.

Politicians and central bankers are alarmed by the rapid shift to deleveraging. There are limits to what they can do. Sharp interest-rate cuts may not be enough to make banks abandon their newfound caution in lending, especially if loan losses are rising. Higher government deficits may not help either. In a deleveraging world, the government may borrow so much it crowds out private borrowers seeking funds.

The deleveraging snowball will eventually reach the bottom of the mountain. Banks will start to see opportunities, and borrowers will become more courageous. But it could be a long and painful wait.

Next, from Christian Weller at Credit Slips:

We are headed for the Great Deflation – a period spanning a decade or more of very slow growth, rising unemployment, flat or falling real wages, fewer employer-provided benefits and increasing pressures on government finances.

People borrowed money because they had to. Income growth simply did not keep pace with prices in housing, health care, transportation, energy and food. Much of the debt that families borrowed to finance their consumption came from overseas, which contributed to record high trade deficits. And, the situation is further exacerbated by the fact that productivity growth, the battery in the Energizer Bunny, seems to be running out of juice, since businesses haven’t invested enough in the face of lower demand for their products.

The chickens are coming home to roost. Families either default or repay their debt. Either way, they consume less and economic growth slows. This slowdown can last for some time, just like the run-up in debt did.

At the same time, the structural weaknesses will exacerbate the long-term outlook. Specifically, businesses will have no incentive to invest more if their customers are paying back debt instead of going shopping, thus contributing to less productivity growth. And government revenues will shrink because economic activity is slowing, resulting in less spending, including on education, thereby contributing to the slowdown in innovation. Yet, without faster productivity growth, our competitiveness will suffer and it will be harder to reduce our trade deficit through export growth.

And finally, for now anyway, from Scott Patterson in today's Wall Street Journal:

Economists have a term to describe what it means when things keep going from bad to worse: negative-feedback loop. One day's problems create a broad set of behaviors that only make the problems worse.

Consider housing. As home prices fall, more families see the values of their homes decline to less than the amount of money they have to pay back on their mortgages. That gives them an incentive to walk away from their mortgages and leave their homes empty, which puts more downward pressure on home prices, drawing more households into the loop.

Housing turmoil, in turn, causes consumers to pull back, hurting the broader economy, which puts more downward pressure on home prices. Banks, worried about mortgages going bad, tighten lending standards, shutting some new buyers out of the market and further depressing home prices.

Negative-feedback loops can be pernicious when an economy depends heavily on borrowed money. Total outstanding household debt rose to $13.6 trillion by the third quarter of 2007 from $7.2 trillion at the beginning of 2001 -- a 10% annual growth rate. Mortgage borrowing more than doubled in this stretch. One out of every seven dollars of disposable income earned by Americans now goes toward paying down debt -- near a record.

Corporate borrowing was modest for most of the decade, then started rising at double-digit rates in 2006 and 2007, amid a wave of private-equity buyouts and debt-financed share buybacks. Meantime, Wall Street juices returns by making investments with borrowed money.

Yale economist John Geanakoplos's concept of the leverage cycle shows how negative-feedback loops are driving today's economy. When times are good, credit is ample, causing the economy to heat up. When the cycle shifts, lenders tighten standards and become more demanding about the collateral they hold, feeding into the negative-feedback loops hitting the economy.

He says shifts in this cycle can happen suddenly, catching investors and policy makers off guard. "When the world seems more uncertain, everyone wants a lot of collateral and the economy goes from highly leveraged to no leverage very quickly," he says.

"When things go bad, people have to sell assets to raise collateral," says Gregg Berman, co-head of the risk management unit of RiskMetrics Group. Selling reduces the value of the very assets borrowers have used as collateral against loans -- such as homes. "The more leverage is built into the system, the more the cascade effect is magnified," Mr. Berman says.

Individual banks might be acting rationally when demanding more or better collateral. Trouble is, when every lender does this at once, it becomes self-destructive, triggering shock waves that threaten the banks themselves.

The trick for policy makers is to break the loop. "A macroeconomic downturn tends to diminish the value of many forms of collateral...reinforcing the propagation of the adverse-feedback loop," Federal Reserve Governor Frederic Mishkin said in a January speech. Aggressive Fed interest-rate cuts help by reducing the cost of all of this borrowing.

The psychology of risk aversion behind these negative loops is hard to alter once it sets in. That is why breaking the chain this time could be harder than anyone expected.

We don't see Hy Minsky's name in the press or blogosphere much these days, but his work seems more apt every day.

Sources

Edward Hadas, "Tight Credit Poses Risks," Wall Street Journal, February 19, 2008 (subscription only)

Scott Patterson, "Housing Cycle Is Caught In Vicious Circle," Wall Street Journal, February 20, 2008 (subscription only)

We are headed for the Great Deflation – a period spanning a decade or more of very slow growth, rising unemployment, flat or falling real wages, fewer employer-provided benefits and increasing pressures on government finances.

People borrowed money because they had to. Income growth simply did not keep pace with prices in housing, health care, transportation, energy and food. Much of the debt that families borrowed to finance their consumption came from overseas, which contributed to record high trade deficits. And, the situation is further exacerbated by the fact that productivity growth, the battery in the Energizer Bunny, seems to be running out of juice, since businesses haven’t invested enough in the face of lower demand for their products.

The chickens are coming home to roost. Families either default or repay their debt. Either way, they consume less and economic growth slows. This slowdown can last for some time, just like the run-up in debt did.

At the same time, the structural weaknesses will exacerbate the long-term outlook. Specifically, businesses will have no incentive to invest more if their customers are paying back debt instead of going shopping, thus contributing to less productivity growth. And government revenues will shrink because economic activity is slowing, resulting in less spending, including on education, thereby contributing to the slowdown in innovation. Yet, without faster productivity growth, our competitiveness will suffer and it will be harder to reduce our trade deficit through export growth.