Tale of Two Housing Markets

Figure 1. Source: http://www.census.gov/construction/nrs/

Here's an economic data series to watch in 2014. The mean home price for homes paid for in cash shot above the mean home price for homes financed by conventional mortgages in the second and third quarters of 2013. (Later data is not yet available, and the 2013Q3 data is still preliminary.) The mean price for a cash purchase was $408,200, compared to $338,900 for a conventional mortgage. These figures refer to new one-family homes. The ratio of number of new homes purchased with cash to number of new homes financed by a conventional mortgage is just above 10%, more than double its value in the mid-2000s, but still below the early 1990s (Figure 2, below).

In the 1990s and most of the early 2000s, homes financed with conventional mortgages consistently sold for a higher mean price than homes finances with cash--around $20,000 higher. Now, homes financed with a conventional mortgage are about $69,000 less than cash-financed homes.

In real terms, the mean price of a home purchased with cash is nearly as high as its record in the third quarter of 2007. Right in the thick of the housing crisis, cash purchase prices spiked above conventional mortgage prices in 2007Q2 and Q3. Towards the end of the 2007Q3, the Federal Reserve made its first rate cut in four years, and the cash purchase price fell sharply in 2007Q4. 

The spike in the mean home price for cash financing in the most recent two quarters was of similar magnitude to the spike in 2007Q2-3. I will be watching the next few releases of this data with interest, as I think it provides some indication of the uneven nature of the housing recovery, and will be informative about the impacts of tapering. The housing market is rather segmented, and Fed policy has differential impacts on cash-in-hand investors and "typical" households. According to the Wall Street Journal,

"The pool of potential buyers is being limited thanks to a combination of tight lending standards and rising interest rates, experts say. `Cash is king in hot markets where getting the sale done now matters and where investors are driving price recovery,' says Susan M. Wachter, professor of real estate and finance at The Wharton School at the University of Pennsylvania. Cash’s dominance is a sign of the fact that it’s more costly and hard to get financing, she says, 'that’s a bad thing.'"

Cleveland Fed President Sandra Pianalto remarked in November 2013 that "Over the past year,...housing has been a relative star performer in the economy. Prices, starts, and sales are up. But despite this progress, the housing sector still has a way to go to regain the vitality it enjoyed prior to the recession." She added:

Looking ahead, tight conditions in mortgage credit markets will continue to hold the housing sector and broader economy from getting back to full strength more quickly... In a recent Federal Reserve survey of senior loan officers, bankers reported that credit standards for all categories of home mortgage loans have remained tighter than the standards that have prevailed on average since 2005...Financial market regulators are standing vigilant to ensure there is no recurrence of the housing bubble that almost brought the financial system and global economy to its knees. 

Moreover, access to mortgage credit has become far more restrictive. To get a mortgage today, it helps to have a very high credit score. Lenders are more likely to extend mortgage credit to consumers they perceive as very low risk. As a result, the pool of potential mortgage borrowers has shrunk. Households with low credit scores that were able to get credit before the crisis now are the least able to refinance their homes, or to obtain new mortgage loans.

Figure 2. Source: http://www.census.gov/construction/nrs/

Real Estate Monetary Standard: the New Wildcat Banking?

Michael Sankowski at Monetary Realism suggests that we may be on a "real estate monetary standard." He writes:

Much like how we can use assets like gold to create a commodity money system, it seems like we operate our current monetary system as a real estate standard.
Banks create money against real estate assets. We use this money in our day-to-day transactions, without much thought about what stands behind this money, but most loans are for residential and commercial real estate.

He makes the comparison to a gold standard, but I suggest another analogy: the Free Banking Era. The Free Banking Era refers to the period from 1837 to 1863. Prior to free banking, opening a bank was a difficult process that involved obtaining a charter from a state legislature, and the Second Bank of the United States required state banks to keep an adequate supply of specie on hand, thereby limiting the amount of notes that they could issue. When the Second Bank closed, states needed to make bank entry easier to fill the void in banking services. New York and Michigan were early adopters of free banking laws, which allowed anyone to operate a bank as long as notes were redeemable on demand and backed by state bonds held at the state auditor's office. Eventually, 18 states adopted free banking laws. I would like to compare the state bond-backed monetary system to what Sankowski calls our real estate monetary standard.

With the passage of the free banking laws, many new banks opened and a plethora of different kinds of banknotes circulated as currency. An expansion of the banking sector in that era has its analogue in the expansion of mortgage lending, including subprime lending, from around 2003-2007, when there was also large growth in non-bank independent mortgage originators. (See Joshua Wojnilower's post on how tax policies created a real estate monetary standard.)

The Free Banking Era is notorious for a large number of bank failures, which often resulted in losses to noteholders. The conventional explanation for the problems of free banking is also a common explanation for the bank failures of recent years: fraud and greed. The evil bankers of those days were called “wildcat bankers." In a well known 1974 paper, Hugh Rockoff explains the link between wildcat banking and free banking laws. Some states allowed banks to issue notes equal to the face value, instead of the market value, of the bonds backing. So wildcat bankers could buy state bonds that had depreciated, deposit them with the state auditor, and issue currency amounting to the face value, rather than the depreciated value, of the bonds. They could then circulate these notes to the public, in exchange for specie and investments worth more than what they paid for the state bonds, forfeit the bonds and run off with the bank’s assets. Sound familiar? Consider Felix Salmon's description of the "enormous mortgage bond scandal."

This is where things get positively evil. The investment banks didn't mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren't going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker. In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors. 

However, as the Economist notes, there has been "a lot of debate over whether blame [for the recent financial crisis] should be assigned to deliberate fraud by financial-industry actors, or whether the whole phenomenon was simply an unfortunate catastrophe based on systemic miscalculations. General opinion settled on the unfortunate-catastrophe thesis." Likewise regarding the free banking era, later authors such as Gerald Dwyer and Arthur Rolnick and Warren Weber argue that most bank closings and noteholder losses were not caused by fraudulent wildcat banks, but rather by capital losses due to drops in state bond prices. There were systemic miscalculations concerning state bonds like there were with mortgage-backed securities. And in fact, they were eerily similar.

State governments at the time were in the business of building roads and canals, running up big debts to do so. It seemed like a great investment, given New York's success with the Erie Canal. States expected to be able to service debt with the revenue proceeds of an expanding tax base; the land boom of the 1830s seemed to promise growing property tax revenues. Plus, the roads and canals that they were borrowing to build were expected to bring in even more revenue. So state bonds were presumably extremely safe assets. It was very similar to the subprime loans made during the housing bubble: even though borrowers didn't have the income they would need to pay their mortgages, they were allowed to borrow because home values were expected to keep rising. But just as AAA-rated subprime-mortgage-backed securities were downgraded to junk status when borrowers started defaulting, the state bonds also sunk in value when many states went into default.

Then as now, leverage mattered. Nine of the ten states with the highest per capita debts defaulted; none of the states with below median per capita debts defaulted. The defaults of course caused financial turmoil and also adversely impacted the real economy. And although the pros and cons of free banking were not well understood until well over a century later, policymakers were fairly quick to impose new regulations. The Free Banking Era came to an end with the passage of the National Bank Acts of 1863 and 1864, which set up a national system of banking with federally issued charters and a uniform national currency backed by Treasury securities. The Comptroller of the Currency was established as a supervisor in 1863; the Federal Housing Finance Agency was established in 2008 to supervise secondary mortgage market components. The parallels are so interesting--this is why I love economic history!

FOMC Transcripts: Housing Edition

The transcripts from the 2007 Federal Open Market Committee (FOMC) have just been released. These transcripts are released with a five-year lag. Naturally, economists and pundits are excited to see what people at the Fed did or did not know back then about the state of the economy and impending financial crisis.

The transcript from the January 30-31 meeting includes multiple discussions of the housing sector that suggest awareness of problems, but underestimation of their depth and duration. I've pasted some interesting housing remarks from the transcript at the end of this post. To accompany those, I took a look at what was actually forecast about housing, both at the Fed and by professional forecasters.

Fed forecasts in the Greenbook are also only available with a five-year lag, but the Survey of Professional Forecasters forecasts are available with hardly any lag. In the graph below, the thick navy line is actual housing starts (in millions of units) per quarter. The green line is the Fed's Greenbook forecast made one year earlier for housing starts in that quarter. The dashed line is the same forecast, made by professional forecasters (the median SPF forecast).

You can see that throughout the housing boom, both Fed and professional forecasters consistently underestimated housing starts. Housing starts started to fall in the second quarter of 2006 and have yet to recover to anywhere near their 2006 peak. Look at 2007 in the graph. The blue line is below the red line and far below the green line, which were the forecasts made in 2006 about 2007. I'll update the graph with Greenbook forecasts made in 2007 about 2008 when those are put online.

Here is another graph that shows Greenbook forecasts for housing starts made at multiple horizons. If you draw a vertical line up from a particular date, you will see forecasts made 1 quarter, 1 year, and 7 quarters earlier about housing starts at that date.

Quotes about housing starts in the January 30-31 transcripts:

Mr. Slifman: As I noted earlier, the leveling-off of home sales, the uptrend in mortgage applications, and the improvement in homebuying attitudes suggest that housing demand may be leveling off... cyclical recoveries in sales and starts have generally been fairly coincident historically...Accordingly, we think that the recent stabilization of sales should be accompanied soon by a stabilization of starts.

Mr. Stockton: As Larry said, even given the overall dimensions of the housing shock, we've been encouraged about our story of stabilization.  But I remember that, as we went into the investment shock earlier in this decade, we just didn't have enough imagination about how bad things could get, and we kept thinking that we were seeing signs of slowing or stabilization, that the new technology was still great, and that there should be reasons or underlying motivation for investment.  Perhaps what we've seen recently as stabilization are the beneficial effects of the drop in long-term interest rates that occurred from last summer into the fall and pulled some people forward, but really we may not have fully made the adjustment yet.  The overhang of unsold homes out there is very large, and we could be underestimating the size and duration of that.     

Mr. Stern: The housing sector is subdued, but the District data on sales and starts suggest stabilization, as do the national data.  The data on the inventory of unsold homes perhaps are contradictory to that statement because there are still a lot of unsold properties; at least those data suggest that it will be some time before there is any pickup in housing activity.  In any event, as Bill Dudley mentioned, mortgage delinquencies and foreclosures are rising, albeit starting from a fairly low level, and though that probably won’t have a significant effect on economic performance, it could be a political issue in Minnesota and elsewhere in the District.

Mr. Fisher: I did talk to two of the top five housing CEOs and a third one, a smaller company.  They seem to confirm the sense of the staff in that they feel that the housing situation is bottoming out, but they continue to caution that any reading of the housing industry between Thanksgiving and the Super Bowl is of questionable value.