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Archive for the ‘Housing Bubble’ Category

Above is an interesting chart. So is this one:

There clearly were many factors in the housing bubble, all of which aligned to create a perfect storm of sorts: higher levels of leverage among investment banks, a trade imbalance, reliance by institutional investors on misleading ratings by ratings agencies, inflationary monetary policy, conversion of housing assets into opaque financial instruments, reduced lending standards, the pressures of the Community Reinvestment Act, the mystique of home ownership, business models that invited fraud, and a pervasive mania of speculation. But one factor that seems increasingly undeniable is the Bush administration’s belief that Hispanics were “natural Republicans” and that the best way to get them into the fold was to give them a stake in the “ownership society” through various housing subsidies. Hispanics’ increasing numbers in the so-called “sand states” had a lot to do with the bubble’s disproportionate influence in those regions, and these subprime borrowers’ low levels of human capital and earnings eventually led to the music stopping as payments were unmade and new borrowers could not materialize to prop up the inflated housing prices. I mean, throughout the boom, no one said, “Does it make sense a sheetrocker from Chiapas making $11/hour can afford a $400K McMansion in Anaheim?”

This is what may be called an “overdetermined” event. In other words, without large levels of Hispanic immigration and Bush’s obsession with cultivating Hispanic political support, the bubble may still have happened. But it seems unlikely that it scale would have been quite so huge and the wave of defaults quite so numerous in the absence of the low-skill Hispanic immigration wave the U.S. has undergone since the 1986 amnesty. A million people per year is a lot of people. As the chart above shows, subprime lending tripled in the boom and the bulk of that expansion was increasing lending to blacks and Hispanics. Even more important, as shown in the second chart, blacks and Hispanics–according to the Boston Fed–have default rates nearly two times higher than white subprime borrowers. Of course, the media, the Democrats, and the Republicans don’t want to discuss such things; it’s not considered polite, and, thus, the greatest demographic and social change of the United States since the Civil Rights movement is thoroughly and deliberately under-analyzed and misunderstood by well-meaning (and not-so-well-meaning) political elites.

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Steve Sailer and others have observed how the combination of changing demographics, Bush’s commitment to an “ownership society,” cheap dollars, securitized mortgages, and the emerging importance of the relatively obscure Community Reinvestment Act, were major factors that in combination render the housing crisis a “diversity recession.”

Critics have countered that a lot of other factors, including rampant speculation and “greedy executives” were far more dominant factors.  Perhaps those are important factors too, but banks don’t generally lend money to losers without some external factor.  After all, as Obama liked to tell us not too long ago, these are the evil guys that invented red-lining.

Consider this chart:

cra-commitments-by-year-small2

That is some big bucks, with an order of magnitude jump right before the big bubble.  Ahuge percentage of foreclosures are substandard Alt-As and Subprime loans lent in part to avoid discrimination suits by the likes of people like Obama.  The fact that the CRA funding went from a paltry sum of several billions for two decades and jumped to several trillions in CRA funding for poor, minority homeowners right before the big bubble came on the scene, it’s hard to say that this factor is being overstated by mean conservatives who don’t believe in equality.

You’re damn right we don’t believe in equality when it comes to banks lending money.  The banks were supposed to be discriminating, not on racial grounds, but rather discriminating against bad credit risks! Concerning oneself with equality of outcome when different groups have different credit-worthiness, different habits and cultures of saving, and different levels of earnings is economic suicide, as WaMu and so many others have found out. Such new progressive banks “made history” all right, just not quite as they planned.

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Market-oriented Republicans see the housing crisis and say, “The market is working, and will, if only we let it.”  Democrats see the temporary pain of the slowdown and say that we need a stimulus.  Missing from both accounts is any talk of monteary policy; today, monetary policy is out of the hands of the domestic market and in the hands of the Federal Reserve.  It is a government agency with a twist:  with worldwide currency markets, the Fed must act like other market players at least in regard to international markets or our currency will be rejected or devalued (as it has been in recent months).  More important, like players in any other competitive market, the Fed can make mistakes, particularly as it balances its contradictory mandates of stopping inflation and keeping full employment. 

Republicans should take notice that markets have always been vulnerable to force and fraud and do not work well when those threats are undetected and unpunished.  This is why we have laws.  This is why in the “internal market” of a corporation people are fired or rewarded for making money for the company.  Mortgage markets are vulnerable to fraud where obligations travel up a chain from buyer, to broker, to bank, and finally to some mortgage backed security holder.  The broker gets paid up front even though the real risk holder bears the cost of default down the line.  This is cause for external regulatory reform and also internal business structure reform.  For example, wouldn’t banks and brokers be more careful if they had to return some of their commission (or otherwise be penalized) if whatever they sold had to be refunded if it defaulted within, say, five years?  Alternately, they could be paid partially by a stake in the mortgage backed securities holding their notes.  Bundles of mortgages could be valued based on a particular bank, broker, zip code, or some other combination of common, information-bearing factors.  Brokers, banks, and anyone who gathers information from lendees ideally should have “skin in the game.”  

These mortgage backed security holders should not be bailed out, of course, as this conflict of interest between lender and note holder should have been apparent to anyone purchasing these instruments.  Spreading risk may still be valuable, however, and would be more so in a proper environment of incnetives, including targeted regulation.  (We should also consider how much of this craziness was a function of the rates themselves, which drove a “flip this house” culture and shook up banks’ otherwise conservative culture.  Higher rates might do much of the work of bringing banks down to earth as any specific regulation or structural reform.)

The problem today is not a lack of stimulus or demand in the economy.  Rather, we are in a classic “supply shock” correction featuring simultaneous inflation and a reduction in output.  It’s sad that the NY Times editorial on the recent slowdown is largely silent about the causes and, in particular, ignores the fact that we are reaping the rewards of an early “stimulus” policy in the form of extraordinarily cheap money from 2001-2004.  They write, in Pavlovian fashion:

The best place to start is by rethinking economic stimulus. When Congress passed the existing stimulus package, gasoline was around $3 a gallon. By the time the rebate checks start going out in May, gasoline is likely to be well on its way to $4 a gallon. At that price, much of the $100 billion or so in rebates will go to fill Americans’ tanks, a bigger boost to nations that sell oil to the United States than to the United States itself.

The next round of stimulus, which Congress should be considering now, must accomplish what the first round neglected. It must focus on bolstered unemployment compensation and bolstered food stamps, ensuring that taxpayer dollars are spent on the neediest and on programs that are proven to spur the most economic activity for every dollar provided. The nation cannot afford more misguided giveaways.

The Carter administration faced the same problem in the late 1970s.  Bound by Keynesian analysis, they simply couldn’t make sense of the simultaneous reduction in demand and inflation that signalled the supply shocks rolling in from OPEC and elsewhere.  Stimulus packages may win a vote or two, but this kind of response is simply the fiscal equivalent of the loose money policy that Treasury Secretary Paulson and Fed Chairman Bernake continue to embrace in response to the current financial crisis.  Neither the NY Times, nor Bernake and Paulson, care to acknowledge that the earlier Fed-driven inflation and the fiscal stimulus of Bush’s deficit spending are largely the reason we are where we are now. 

As the old saying goes, when you’re in a hole, the first thing you’ve got to do is stop digging.

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Treasury Secretary Henry Paulson’s proposal to consoldiate various financial regulatory agencies is uninspired and likely will prove useless.  This proposal rests on the unquestioned assumption that bad economic results should never occur, and, if they do on a large enough scale, should be bailed out by the government.  If they should be bailed out, then the federal government rightly acquires some interest in preventing them. But consolidation alone won’t do the trick, even if these flawed assumptions about the goals of economic regulation are accepted. 

Without new rules and expanded authority–which Paulson  has renounced–it’s unlikely any consolidation of the SEC, CFTC, OCC, and other regulatory agencies can yield better results than today.  This is the same logic behind joining various agencies under the Department of Homeland Security, which has accomplished little more than these agencies could in the past working seperately because of old fashioned rules on profiling and the lack of increased border infrastructure.  The case for consolidation is even less compelling in the case of finanical regulators, as poor inter-agency communication was widely reputed to be one factor in the 9/11 attacks.  By contrast, no one thinks that the current mortgage crisis is the result of some regulatory gaps or bad communication between the agencies.  Rather, investment banks, hedge funds, and other unregulated organizations now control huge amounts of the lending going on today and largely do their work off of the regulators’ radar. 

Investors know that these organizations are less regulated and more opaque than the regulated alternatives in the form of commercial banks and publicly traded companies.  The reason people still invest in these entities in spite of these demerits is a greater anticipated yield.  But everything comes at a price.  Investors of capital overseas, for instance, take the risk of other countries’ screwed up legal systems and greater degrees of corruption.  This is as it should be.  The whole point of regulation is to promote the proper pricing of risk and divert capital into safer investments at home to further American economic enterprise.  Bailing out investment banks and other holders of subprime mortgage instruments would instead reward high risk speculators, bailing them out of their risky choices, even as Paulson eschews more regulatory authority.

If the DHS is a good analogy to the proposed regulatory consoldiation, the best analogy for the Federal Reserve’s bailout of failing investment banks is the failed IMF strategy of bailing out the central banks of corrupt nations during the Asian currency crisis of the late 90s.  There, as in the US today, under-regulated high risk investments overseas attracted too much capital that underestimated the risks.  Investors seemingly forgot that the Third World is impoverished for a reason.  This led to a number of investment and monetary bubbles, which in turn burst.  Instead of allowing the devaluation to run its course, which it eventually did, the IMF at first bailed out Asian central banks and their investors leading to continued over-investment in “emerging markets.”  It would have been preferable if investors were forced to take their lumps as regimes as varied as China and Indonesia suffered the painful “correction” they deserved because of their instability and corruption. 

Our own Indonesia, the free-wheeling world of hedge funds and subprime securitized mortgages, needs to be shaken out so that in the future capital will not be invested to an irrationally high degree in high risk, underregulated investments.  Consolidating regulators and bailing out the failed investors is the worst of both worlds:   it increases public exposure without any concomitant increase in regulatory authority over the high risk institutions involved.

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Economic ignorance in the Wall Street Journal shouldn’t be too surprising.  After all, these are the guys that forget the law of supply and demand applies to labor markets. But the scale of ignorance in “journalism major” Holman Jenkins’ recent editorial is staggering.  He says:

No wonder economists of diverse ideological stripes are lining up behind a taxpayer bailout of homeowners and lenders, fearing the alternative is a global inflation crisis. But another option has hardly been considered in Washington, though it’s old hat in the sticks: Using tax dollars to buy and demolish foreclosed, unoccupied or half-built houses in selected markets.

This isn’t as wild-eyed as it sounds. Ben Bernanke pointed out in a footnote to a recent speech that such programs already are at work in the Midwest. “In highly depressed housing markets, the worst-quality units are often demolished to mitigate safety hazards and reduce supply.”

This is a variation of the hoary idea that a “war is good for the economy,” itself a species of the broken window fallacy.  Consider his reasoning.  Home prices are too high.  Existing homes have value.  But that value is stagnant or declining because of too much inventory is on the market. Some people–like young people and renters–benefit by lower prices.  Other people–home owners and banks–benefit from higher prices. Therefore, the government should destroy homes to raise prices.  That’s his argument.  

Lateral economic transfers–in this case from home owners to would-be home owners through falling market prices–usually do not concern economists.  Economists are concerned with wealth maximization for the whole society, which generally consists of getting willing buyers and sellers together at some price:  any price.  

Destroying homes to raise prices is senseless and, as the destruction itself visibly attests, not wealth maximizaing.  Underused and foreclosed home assets still have value.  Of course, as asset values drop, some banks and holders of mortgage-backed securities will be under-securitized and left holding the bag for bad notes.  But no bank would willingly destroy its own security in the form of an undervalued home.  Such a hair-brained scheme would cause the bank to lose not only the differential of the home value and the face value of the mortgage note, but the value of the underlying security as well.    

Government-created artificial scarcity is an old trick long denounced by economists as wealth-reducing on net. Since when can assets not be sold at a loss?  What principle says that banks and speculators who made bad bets can’t be held to account for their improvidence (or bad luck)?  Who said that home owners are more worthy of their wealth than would-be homeowners and renters?  Why does the Journal only cheer the law of Supply and Demand when it raises the prices of things that the Journal’s staff and customers already own?  (Well, that last question answers itself.)

The author cites housing destruction in Baltimore as this enlightened process in action, but the example is a bad one.  It’s one thing to say a vacant, old home is a nuisance that should be bulldozed for the common good, but it’s quite another to destroy a perfectly good assets to affect market prices.  A new home, unlike a crack house, takes minimal investment to be maintained.  It can always be sold at a loss or even given away if the cost of maintenance is too high.  The faster housing prices drop, the faster people waiting in the wings with capital can get a home mortgage and buy both a home the old fashioned way, acquiring housing and an appreciating asset in the process. 

The idea of destroying assets to raise prices comes in part from the mistaken view that deflation was the big threat during the Great Depression and that assets had to be destroyed to “keep up prices.”  In fact, the liquidation process is a key to economic recovery after an inflationary bubble, such as what occurred during the 1920s.  This correction requires such drops in prices, and artificially propping up inflated prices through such means as price floors and cartel pricing only delays the inevitable, as witnessed by the elongated depression of the 1930s, where such measures were commonplace.

 
As an example, consider the destruction of perfectly good milk featured above–a lunatic enterprise undertaken frequently during the 1930s while other starved.  The same price supporting logic undergirds the multibillion dollar farm subsidy programs that the government maintains today.  Recall they pay farmers not to farm and are designed to raise prices.  If only farm subsidies were as manifestly stupid as bulldozing perfectly suitable new homes (or destroying healthy milk), perhaps there would be some hope of reigning in our behemoth and misguided government and restoring sanity to its economic policies.

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One thing that struck me during the height of the housing boom was how out of wack housing prices were with income.  At the time, I owned a modest condo in Dallas with a nominal value equal to a little more than 1.25 of one year’s income for me.  I remember thinking:  who can afford $300K or $600K notes, particularly for a first home, as folks were doing in places like California and Northern Virginia?  In response I’d hear dazzling tales of “interest only” loans, the value of leverage, a “new paradigm,” “free money,” blah blah blah.  As much as it was mystifying, it all sounded more than a little fishy and unsustainabe.  If for years and years the vast majority of housing values were in the $75-200K range (in real dollars), which was roughly in the 2-4X annual income range for most homeowners, how could it now make sense that homes were valued at 10X or 20X the annual income for the average homeowner?

 Well, they didn’t. And, in fact, income/housing price disparity is one of the great predictors of high foreclosure rates:

If you are looking at the worst zip codes in the country for foreclosures, they all tend to share some of the same characteristics. The homes values are slightly below the state averages in terms of value while the income level of the residents are significantly below the state average income levels.

This price/income gap is in my view a very sensible indicator of a potential “bear” local real estate market going forward, including where I now live in Florida.  Orlando has an average local income maybe .75 of what was normal in Dallas, but where housing values are probably 1.25X to 2X the Dallas values.  Things will bottom out, I believe, at somewhere close to historical levels, which have gotten very out of kilter:

  

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