Housing's State Rebukes Fatuous Monetary Assumptions

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In the middle of last week, the Census Bureau estimated that permits to build new single-family homes declined on a year-over-year basis for the second consecutive month. That's the first time we have seen anything like that since the middle of 2011, just before this latest "surge" in housing began. This week, the National Association of Realtors (NAR) reported another significant decline in existing home sales. After falling 5.1% Y/Y in January (snow, we are told), home sales decreased 7.1% in February (some snow, we are told) and then 7.5% in March (getting ready for next winter?). If that wasn't enough, the Census Bureau reported on Wednesday that new home sales dropped by a rather stark 12.2% Y/Y, also in March.

Across the state of housing-related finance, there was little surprise to see quarterly bank reports for the first quarter show heavy, massive declines in mortgage finance. Originations at Wells Fargo (-67%), JP Morgan Chase (-68%) and Bank of America (-63%) were a cumulative $185 billion in the first quarter of 2013, but a mere $61.9 billion in this latest quarter. Most of that conclusive cessation of mortgage lending is attributable to refinancing, but more than a fair amount was once lent on the basis of home purchasing intentions (more on that below).

Total MBS issuance in June 2013 was $185.5 billion, but the latest figures for March show a 53% decline to only $87.2 billion. Institutional buying of property, as you might surmise from that last sentence, has attained more than whispers of dramatic retrenchment, becoming further and actual anecdotes. In California, the largest REO-to-rent firms, those with direct access to QE's primary "magnanimity", have scaled back purchase activity by as much as 70% in recent months. Blackstone, now the nation's largest landlord, has condensed its purchase pace in California by as much as 90%; 70% overall from last year's peak pace of more than $100 million per week.

Yet, for all that, home prices continue to move higher. The median price for new homes sold in March hit a record high of $290,000, up almost 13% Y/Y. The Case-Shiller home price indices (the latest estimates are for January) are now back at levels last seen in the middle of 2004, having jumped by more than 13% in 2013, on top of similar gains in 2012.

The only manner, speaking in terms of basic economics, where prices might rise in superheated fashion against narrowing volume is a shortage - a classic supply-side bottleneck. That is what the NAR has been proclaiming during every other commercial break on TV ("every market is different" the announcer says reassuringly, perhaps to himself?), imploring anyone even thinking about selling to do so. But that means there is a great incongruity somewhere.

As I conveyed in the opening, the pace of home construction has clearly begun to roll over. The trend of new permits to build single-family residences in the last nine months, starting in July 2013, is (in order by month): +23.3%, +15.7%, +15.9%, +8.9%, +7.7%, +9.9%, +1.5%, -1.9% and -1.2%. If there were a housing bottleneck squeezing prices higher on narrower volume, then the series of new home permits should be exactly backward. That is what basic economics teaches, something that we all hold to be intuitively correct, that when a "market" opportunity opens to such a degree, suppliers should be rushing to the prospect and closing the gap. Instead, home builders are running away.

The only possible conclusion for this is that these prices are not conveying the full picture of the housing market. Home builders must be reacting to other data beyond pure prices. No doubt they are well aware of mortgage finance in the wake of the dramatic MBS rout from the middle of last year, predicated itself on only the spoken threat of tapering QE. According to the Wall Street Journal, noting data from Credit Suisse, home buyer traffic was down by more than "a third" in March versus March 2013, which adds more than a little confirmation to the proposition that the mortgage disaster is not just refi.

There are, of course, dangers to using such statistics to build out any hardened form of analysis. A median home price across the entirety of the United States may have about as much meaning as official inflation statistics. As the Case-Shiller indices note all too well, there can be a world of difference in between cities often in close proximity. Home prices in Charlotte were up 7.2% in January, but Atlanta was more than double that at 16.8%. In fact, most of the greatest price gains were limited to those sunshine suspects from the last great housing affair.

Apart from geography, there also cuts a stratification in these "markets" through price itself. The existing home sales data from the NAR showed a nasty 17% Y/Y decline in sales below $100,000 (on top of an 18% decline in February). In the $100,000 to $250,000 segment, sales were down just under 10% in March (-7.2% in February). But sales at the other end of the scale surged, as they have rather steadily for some time. In houses priced above $1mm, volume grew by 7.8% Y/Y in March, after jumping 14.4% in February. It makes for quite the contrast.

That certainly has to add to the spectrum of factors home builders are considering, as such stratification would clearly have an upward bias on something like a median price. It speaks to both the messiness of the real world beyond a simplistic pricing ideal and the lumpiness to which it all gets sorted out.

In a broader view of the housing market as it relates to policy, the implications are generally favorable, at first. In January, it was estimated that the number of homeowners "deeply underwater" fell to 9.3 million. That meant 19% of all homes with a mortgage owed at least 25% more than the assumed or estimated value of their property. That was actually quite an improvement, as the price gains of 2013 moved more than 1.5 million of these "deeply underwater" situations to something less dire. In other words, these "unfortunate" borrowers did nothing but allow prices to rise around them without having to directly participate (through foreclosure).

It is widely believed that the foreclosure landslide begins with such negative equity. Once a "trigger event" is unleashed, any rational person in that situation might easily choose to simply walk away from the property. With positive equity, it's not nearly so straightforward. From a policy standpoint, that is what we are really talking about, namely "correcting" the psychology of foreclosures. By encouraging a set of circumstances in real estate markets that fosters "improving" prices, the tide of negative factors, particularly this massive overhang of the last bubble, might be successfully mitigated, perhaps even curtailed toward something more reasonably resembling a functioning market again.

To some high degree, that also exposes the frailty of current prices, as has the contemporary state of the housing market. There is also a great danger of using marginal transactions to set prices. While prices have been rising steadily in the past two years or so, they have done so on relatively limited volume. As the Case-Shiller index has indicated moving back to what we saw in 2004, prices have done so on two-thirds less volume. The pace of new home sales in the middle of 2004 was about 1.25 million (SAAR); more recently it has averaged only 475k.

That would seem to indicate some urgency on the part of those that want to reverse the slide in foreclosures. Such a narrow channel of home "liquidity", for lack of a better description, would simply be overwhelmed by any renewed effort on the foreclosure front. It is thus imperative, from a conventional policy standpoint, to seek and engage this kind of pricing anomaly.

We know it is an anomaly because of everything I have just described. The Fed, through its artificial price intrusion in the MBS portion of QE, essentially handed financial institutions an arbitrage opportunity - make money buying up foreclosed properties to help "clear" them out and at the same time begin to move systemic prices through these tapered marginal transactions. The monetary aspect continued with both cheap financing and leverage opportunities embedded deep within QE operationally, thus favoring institutional investment of this kind. It is no accident that Blackstone is the nation's largest landlord now, but hadn't even been mentionable prior.

This is a microcosm of the Keynesian belief that policy can, "fill in troughs without shaving off peaks." That has been the assertive doctrine behind the rise of monetarism since the 1970's. It has become an unchallenged and unqualified assertion, particularly with its first widespread use by Greenspan's regime. That was the whole idea, spoken throughout the 1990's as gospel, that monetary policy could "banish the business cycle." Where once some may have thought monetarists and Keynesians parted company in significant fashion, there is truly no real distinction between them.

The key element to all of it was and is rational expectations theory. Economists were very much troubled by the Great Inflation, particularly with the apparent failure of the Phillips Curve to hold in the longer run. To explain the concurrent rise of both unemployment and inflation required some finesse in order to keep the paradigm from crumbling with the economy. Orthodox economists rendered a short-term limitation to the Phillips Curve, and then asserted a rational expectations canon.

The primary monetary plague of the 1970's, as critiqued afterward, was the stop-go nature of policy. The Fed exhibited a hard tendency to reduce interest rates into recession, only to raise them afterward. Rational expectations theory suggested that economic agents were working in anticipation of policy, thus thwarting its potential to be effective toward reducing inflation. In asserting this expectations explanation, it began the trend of removing money from monetary policy in order to focus almost exclusively on psychology.

Extrapolations of such a theoretical notion can be extreme. If you believe that agents are actively seeking to take measures in advance of expected policy changes, it is not a very big leap to attempting a kind of control over behavior. In other words, if you as a policymaker begin to mold policy as a tool to influencing the expectations of agents, then you might actually believe you can actually influence behavior.

What monetary policy attempts now is exactly that. No less than Paul Krugman offers a fuller explanation from 2010:

"But if the Fed can promise not to raise rates at that point, to wait until inflation has risen substantially, it can affect long-term inflation expectations - which is what matters for investment. And higher long-term inflation expectations can boost the economy now.

"The tricky part is, how does the Fed commit itself now to not raising rates in the future - after all, when the time comes, the economy will be in good shape, and all the Fed's central-bankerly instincts will be to take away the punch bowl. Yet if people believe that will happen, there will be no rise in expected inflation now."

That is absolutely the path chosen, particularly as the FOMC shifts ever moreso into forward guidance. I suppose, pace Krugman, that one such way to remove those "bankerly instincts" would be for the economy to remain stuck in a slow-drift back toward contraction as it is, including housing and real estate. However, I doubt that was the intent of policy at its outset, to actively seek out the Japanese pattern, just inevitability.

The drawback of contemporizing future inflation expectations through threats or talking about future policy trajectories is that there is a lot of room between A and B. If the goal is to influence people's behavior (B) based on what you want them to think about the future of policy (A), there is no straight line between that and what economic agents will actually do in the aggregate (B).

Inflation, or even behavior based on some kind of expectation of it, is inherently redistributive. That is the whole nature of inflation itself, including its tendency to concentrate activity and "success" toward the financial. Policy and monetarism posits this as a positive factor that will spin in a net positive direction over time - a kind of bastardized trickle down. In the narrow case of the mini-housing bubble, it means building more houses (particularly at the $1mm level) and apartments with millions already sitting idle and vacant from the last bubble. We end up with a distortion to the efficient flow of resources, not the least of which is labor.

And that nullifies over time, quite dramatically and convincingly, the second part of the Keynesian formulation. There is little doubt that monetarists and their part of central planning can influence agent behavior (rational expectations) and that such influence might in some circumstances "fill in the trough" of recession, but there is nothing to suggest that the attempt and effort will not "shave off the peaks."

The commonly cited example for this theory is the Great "Moderation", but that only fits the description if you both end your examination at the apex of the housing bubble and never move beyond the surface. Everything we know about the economy's behavior in this century, where bubbles have been so very evident in their aftermath, shows an obvious deceleration or reduction in activity at the peaks. In fact, if you plot major economic accounts on a chart you see exactly the opposite of this mainstream exhortation - there are indeed peaks having been shaved.

That is a decided problem for this policy faith, not the least of which is the concurrent belief in the plucking model. The recession/recovery cycle has usually featured symmetry, as when a small or minor recession is followed by a relatively small and minor recovery. The larger the recession, then, the larger the recovery; except that has been conspicuously absent in the current cycle, thus adding even more weight to the evidence against the "not shaving off peaks." (a fuller discussion of the plucking model and negative trend growth is here).

The Keynesian model is simply too smooth in its assumptions, amounting to nothing more than a glossed overview of the economic and financial world. There is a texture and granularity to the real world that opens up so many complications, leaks and distortions to function, including permanent belying all assertions of neutrality, that destroys all illusions of orthodox understanding leading to the idea that an economy can be controlled - and through psychological manipulation of all means.

That is what the current state of housing is not only showing, but screaming in enthusiastic rebuke of all these fatuous monetary assumptions. As I have said on numerous occasions now, perhaps too many, the level of decline and collapse in mortgage finance, and now housing, is conspicuously incongruent to the small rise in nominal rates that the FOMC actively courted (as it again sought to manipulate expectations). What it suggests actually inverts the Keynesian hubris to something more like "reduce all the peaks and create deeper troughs", which would be consistent with the Summers/Krugman idea of a negative "natural" interest rate. That certainly preserves the idea of, and need for, symmetry, only in the exact wrong direction.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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