Arnold on deflating the housing bubble

Recently, I tried to think through what deflating the housing bubble would actually mean. I suggested that it woul require prices to fall back to historic norms.

Arnold Kling disagrees.

I'm sorry, but unless by "some areas" you mean areas the size of a 9-digit zip code, we're not going to see 40 percent declines in house prices.

Think of the equilibrium house price as the equilibrium rent times the equilibrium price/rent ratio. I do not see rents falling in real terms. Housing starts are below the level needed to keep supply in line with new household formation, especially in an economy with relatively low unemployment. So, if anything, rents are going to be drifting up.

I like thinking in terms of price/rent ratios, and currently they are way out of whack to historic norms. Arnold takes a "first principles" approach and comes up with a ratio of 300x. Arnold takes this to conclude that real estate is cheap today, even after all the recent appreciation.

But what of historic price/rent ratios (which were certainly not 300x)? Arnold says:

I think there is nothing sacred about historical P/E ratios, for either stocks or houses. For stocks, the realized real returns over the past 100 years have been quite high, which suggests that traditional P/E ratios were too low. I think that the same is true for houses, although to a lesser extent.

I guess this would put him in the "permanently on a higher plateau" camp.

Propping up the Housing Bubble

Yesterday, I wrote about how one critical element of deflating the housing bubble is letting prices fall back in line with historical norms. After all, if the bubble was caused by people making $X leveraging themselves to the hilt to buy a 10x$X house, then getting rid of the bubble means reducing that 10x multiplier to whatever it's been historically.

Yesterday, Bernake came out with a call for the government to come up with some new financing instrument to let borrowers, leveraged to the hilt, stay leveraged to the hilt. He was talking about option-ARMs, many of which are due to reset to higher rates in the next 18 months, but the details are less important than the underlying financial structure which is that they basically let borrowers take an even more leveraged position on their house. Any substitute to this financing, such as a new option-ARM that will reset further down the road, will essentially maintain that highly leveraged position, presumably in the hope that housing prices will go up.

As I stated earlier, I don't see how we can deflate the bubble in any serious way without actually deflating housing prices, and for houses to sell at a loss you need to have very motivated sellers. An owner-occupier, who has refinanced from their current option-ARM to the new Fed-supported option-ARM is not a motivated seller. He's a motivated non-seller, hoping that prices go up and he can cash out his highly leveraged position. A bank that owns a foreclosed home is a motivated seller. Anything that produces more of the former, and less of the latter, will extend the bubble, not deflate it.

Deflating the Housing Bubble

Now that the air has gone out of the too-cheap credit that helped inflate the housing bubble, the question becomes how to undo the bubble with as little damage as possible.

When the internet bubble popped, this happened fairly rapidly: failed dot-coms closed down, their investors took a beating, and their employees moved onto other jobs, some of them still internet related but at better firms. Some went back to grad school. The end result was that the economy overall was fine, people who had invested in internet firms lost money, and the internet overall continued to grow apace, but now focused on better companies.

I think one inevitable requirement of unwinding the housing bubble market is that housing prices have to come down to fall in line with historic trends. In some areas this means very dramatic decreases -- maybe 40%+ in real terms? I'm not sure what a "deflated housing bubble" would look like if it did not bring prices back to historic norms. We are not going to see price declines of this magnitude unless we have very very motivated sellers, which means banks for older properties (which have been foreclosed on), and builders for newer properties. If prices do not fall, then transactions will dry up. I can see the government stepping in and helping owners (and their lenders) but I'd be surprised if builders will be helped that much. This means that areas that have had the most new construction should see the most dramatic price corrections.

I would add that I'm not a fan of Freddie or Fannie stepping into the jumbo loan market. We've seen what happens when subsidized lending fuels real estate acquisition, and I thought we'd all decided we want less of that. Also, if Freddie and Fannie do step in, all the lower rates will do is enrich current homeowners (and Freddie and Fannie) at the expense of current renters by further driving up (or supporting) the price of real estate. I see no reason why those who did worst in the housing bubble should be punished further.

Life imitates the Onion

You really cannot make this up: Tiny brain no obstacle to French civil servant

Most requested language change

I would love it if the media stopped saying "people will lose their homes" and instead started saying "people will be forced to rent".

Like Vegas, without the gambling

I've often described Dubai as being like Las Vegas, but without the gambling. Now that World Dubai (a soveriegn wealth fund for Dubai's government, aka the Dubai ruling family) has bought a $5B stake in MGM Mirage -- in cash -- this may be less true.

I would have said that it will be interesting to see how this plays in the local press, since ostensibly Dubai is a muslim country and that is the only reason why they haven't built casinos there, but it's good to be King and neither of the major local english papers has any commentary on the deal.

A more interesting question is, why did Dubai World buy into MGM Mirage? To be honest, I think it's because it was big, shiny, and luxurious, and right now Dubai (by which I mean the ruling family, and the other rich families who are close to the ruling family) are in this delightfully old-fashioned competition to buy the biggest, best, and brightest of everything. Fiscal sense really does not come into it, it's for bragging rights, and the rest of us can enjoy this gauche excess by going skiing, buying an island or going up the world's tallest building.

Credit Markets

I'm way over my head in the current credit turmoil that seems to be roiling the markets, and I certainly sympathize with Friedrich von Blowhard's concern that "the Fed seems to be working its limited rhetorical tropes pretty hard to avoid the suspicion that they're acting to bail out people in the financial service industry who have made pots of money making, securitizing and investing in ridiculously lax loans to questionable borrowers".

Cure, in the comments section, has a good response where essentially he says that the Fed's interventions are similar to the government stepping in to prevent a bank run. True crises of liquidity, where the underlying assets are sound, are different from crises of insolvency, where the underlying assets are not sound. In the former case, it makes sense to offer short term loans to smooth over the bank run, in the latter case, it makes sense to liquidate the assets so they can be put productive use somewhere else.

I don't know how to judge Cure's comments, they seem quite reasonable, and I also very much liked liked Tanta's post on Calculated Risk. In particular, she makes it very clear that the underlying asset here is a mortgage, and those rooting for a "let the defaults default" approach are grabbing the wrong end of the political stick.

Do you really want to live in a world in which mortgage servicers--I'm talking mortgages, kids, the loan for the roof over the family's heads here, not your basic yacht financing--work on the "collect payments or foreclose, no judgement exercised" basis? You like doing business with outfits like that? You happy calling up the customer service line and getting some untrained bored squirrel on the other side who tells you nothing can be done if you're not late, but that nothing can be done if you are late? You like paying .25-.50 extra in interest every month so that your mortgage servicer can act like Major Major? You think it's not bad enough that we made 100% loans to people, giving them little incentive to repay the debt, we should make it worse by giving them no hope if they try to pay it? You think people who are asking for forbearance should be told just to walk away?

Great point.

It's clear from a public opinion perspective who the winners and losers should be. Everyone feels sorry for the low income borrower who bet on their house price rising, and is now stuck with a monthly mortgage they cannot repay. No one feels sorry for rich financiers who get paid big buck$ just for showing up. I have no idea how you help group A without bailing out group B.

I would also add that the above analysis leaves out the lowly renter. Homeowners make up about 70% of the US population, leaving a reasonable chunk of people who rent. I've argued earlier that renters are essentially short housing, and they've done very badly in the great housing run-up of 2001-2006. If house prices do not return to their historic levels, these folks will bear a permanent loss.

Farewell to alms

David Warsh takes issue with Gregory Clark's economic history book: Farewell to Alms. Clark essentially says that the UK industrialized through Darwinian improvement in the population -- rich people (with good habits, abilities etc.) produced more chidren than poor people (with bad habits, abilities etc.) eventually leading to a "higher quality" population which could then industrialize and modernize.

I find this rather extraordinary claim hard to believe. I am not an evolutionary biologist, but I find it tough to swallow that "bad" human traits could be bred out within the 6-7 generations that lead up to, and through, the industrial revolution. I also observe that the modernization of the Far East, Japan, China, India, Ireland etc. have occured without any obvious genetic alteration whatsoever, certainly in China with its one child policy, and so do not understand why the UK needs this special driver.

Warsh has different issues with the piece. The first is that Clark self-aggrandizes too much (I cannot judge this claim in any way). The second is that Warsh does not like the policy prescription implicit in the book's message:

[Clark] castigates the community of development economists in general, and the "cult centers" of the World Bank and the International Monetary Fund, in particular, for their failure to recognize that culture -- "socially induced lethargy" -- is the problem. . "[L]ike physicians of the pre-scientific era who prescribed bloodletting as the cure for ailments they did not understand, the modern economic doctors continue to prescribe the same treatment year after year" -- namely, democracy, public health, openness, the rule of law and education -- for countries that lack the social (and perhaps biological?) capacity to take advantage of modern institutions.

History shows, as we have seen repeatedly in this book, that the West has no model of economic development to offer the still-poor countries of the world. There is no simple economic medicine that will guarantee growth, and even complicated economic surgery offers no clear prospect of relief for societies afflicted with poverty. Even direct gifts of aid have proved ineffective in stimulating growth. In this context the only policy the West could pursue that will ensure gains for at least some of the poor of the Third World is to liberalize immigration from these countries..."

Although it is a depressing fact, I also think it is fair to say that the West has no model of economic development to offer still-poor countries. Latin America lags, Africa lags, Central Asia lags. The IMF and World Bank have been around for almost 70 years, rich countries have pumped $B of aid to poorer countries, and yet there seems to be little improvement. I respect Warsh's position, but it seems reasonable to say that the help offered to the developed world by the developing world has not helped. Certainly the portions of the world that have developed: China, India, Japan, Hong Kong, Singapore, South Korea, etc. have all done so without any obvious help from external bodies. I cannot think of a single example of an undeveloped country that has become a developed country primarily because through the help of external bodies -- but I'd love to be set straight here.

Credit Tightens

The big financial story of the past week or so has been the tightening of credit standards, falling stocks, and hedge-fund bail outs. I am no financial expert, but I have been following the housing market pretty closely, and was actually at a hedge fund in 1998, the last time that industry blew up.

Firstly, it's easy to vilify banks for "predatory lending" practices when they sold strange and exotic mortgages to homeowners, but I don't think that's fair. "Predatory lending" kind of makes sense when your interest rate is usuriously high, and the borrower has no other options, but it boggles the mind to use that phrase when the interest rate turns out to be too low. Let me put it another way -- if a car dealer gives you absolutely cut price financing on a new car, are they "preying" on you in any way, or are you "preying" on their desire to make a sale?

When you buy a house you are doing two things: 1) paying rent to yourself instead of someone else (and forgoing the opportunity for someone else to pay that rent to you), and 2) taking a long position in the asset class that is real estate in your local area. The type of mortgage you take out has no bearing on the rent you are "saving" (or forgoing) but it has everything to do with how levered your long position is in the asset class that is real estate. While the details of ARMs, neg-am mortgages, NINJA loans, no-money down deposits etc. are complex, essentially they all add leverage to that position. This is fine when prices are rising, but it also means you will lose all of your money (equity) when prices fall. Historically, home prices have never fallen, but they have never had such leveraged financing either.

And we still have about 6 months until the ARMs start resetting at their higher rate.

Ultimately, I don't think that defaults etc. are all that bad for homeowners. If the value of the house is lower than their mortgage, they will take the credit hit and hand the keys back to the bank. They will have lost whatever equity they had in the house, although that amount was probably quite small given how levered the invest was. As total housing stock has gone up, these individuals will simply rent until they have enough money and credit to purchase real estate again. Renting is not the end of the world.

The hedge fund turmoil is something else. I'll post on this soon.

UPDATE: I don't agree with everything RGE says, but this post on how leverage magnifies gains on the upside and losses on the downside is very good.

Rise and Fall of the CD

This good article details the rise and fall of the CD. Initially a great windfall for the recording industry, "giving away the master tapes" may have proved to be a bad strategy after all.

Yet in some ways the CD contained the seeds of its own destruction. One of the few industry moguls to raise his voice against the digital format in its early days was the late Maurice Oberstein, an American who was latterly head of the Polygram UK (later Universal) label. "Do you realise we are giving away our master tapes here?" he asked at an industry event. At the time, everybody was too busy counting the cash to listen. But as the advent of recordable CDs kickstarted a black economy in counterfeits in the 1990s, Oberstein was proved right.

Traditional broadcast marketing seems to have become less important in music faster than in other areas, with the chart success of the Darkness, Enter Shikari, and Arctic Monkeys being fan, not label, driven.

The article ends by noting the increase in the popularity and ticket prices of live shows. It's certainly true that CDs and concerts are complements, so if the price of one falls the quantity of the other may increase, but they are also substitutes (why go to the concert when you can just listen to the CD?) so the argument could just as easily go the other way. The increase in ticket prices could just be more efficient market mechanisms for pricing, as the cut made by scalpers goes to the venue itself through online auctions. As staging concerts becomes more profitable, more concerts would be staged, resulting in higher concert attendance as well.

Google Phone

First Apple shows the world how voice mail and three way conferencing should be done with the iPhone, and now there is a Google phone in the works.

I doubt that Google's hardware will be as spectacular as Apple's, whose industrial design has been fantastic since the old iMac in the late 90s, but I'm intrigued by what the pricing will be like. Apple is selling very expensive hardware, plus the usual expensive voice/data plan, plus vendor lock-in, while Google will subsidize service with ads other stuff tied to the rules they asked for the upcoming spectrum auction (which I currently have not looked at, and do not understand).

And on more telco news, ooma (who I first learned about many months ago while they were still very stealthy) has finally launched. David Pogue, of the NYTimes, describes it as a $400-$600 box which, lets you place free calls all over the US (so long as it does not get out of business, and so long as it can get 1,500 boxes installed for free). It requires landline phone service, which I have not had for almost a year, as landline phone service is ludicrously expensive.

I'll say more about ooma and the google phone in a future post.

Ratatouille

Ratatouille is a fantastic movie. Everything about it is great, from the wonderful cooking scenes in the kitchen, to the rats' fur, to the cafe racer ridden around by Colette. Strongly recommended.