Home Price Expectations and Residential Investment
I have often wondered whether the very low level of Private Residential Investment (also known as building houses) in the USA is due to unusually low expectations of long term increases in home prices. Here, I add that I would guess that the change was and end of the belief that the relative prices of houses has a strong upward trend (so houses are good investments) which belief is not supported by Robert Shiller’s data in Irrational Exuberance.
Of course I knew that, to find out, I should google something like ( Shiller house price expectations ). I forget what I told google but google sent me to this pdf.
Which you must read, but from which I will steal data on expectated house price increases over the next 10 years and this graph
yes indeed, expected appreciation of house prices has dropped dramatically as one would expect given the bursting of the bubble. The question is does this explain the low level of residential investment ?
Note that Shiller thinks the relevant variable is the expected growth of home prices minus the mortgage interest rate. Unfortunately even he only has 10 observations of the expected growth of home prices over 10 years. It is easy to fit the ratio of private residential investment to GDP with this variable, but this may just be because it is easy to fit 10 observations.
It is mildly interesting that the difference alone seems to explain the huge change in residential investment without any need to appeal to financial frictions.
The more interesting question would be whether the relationship between the variables in recent years is the same as it was before the great recession. Alternatively, it is possible that some factor other than low home price increases is needed to explain low US residential investment. The natural candidate would be unusually tight lending standards as an over-reaction to the disasters caused by the extraordinarly loose lending standards of the early 00s.
so I back-casted with the parameters of a 10 data point regression
Number of obs = 10
R-squared = 0.6312
exp10mortg Coef. t
resinvgdp .9967796 3.70
constant -1.19086 -0.97
conveniently the regression says that the expected growth of home prices minus the mortgage interest rate shifts one for one with residential investment as a percent of GDP.
The absurdly simple model (regression specification) implies that expected annualized 10 year home price appreciation is always equal to the mortgage interest rate plus the ratio of residential investment to GDP minus 1.2%.
Unfortunately, this implies absurdly high expected home price appreciation in the 1980s when mortgage interest rates were extremely high. In particular, there is one byte of information about home price expectations in the 80s in Case and Shiller’s seminal New England Economic Review article
(note how the profession is moving towards appreciation of the importance of their work — from New England Economic Review to the Brookings Papers on Economic Activity) .
* standard errors.
I think the cities which are useful when discussing nationwide housing demand are Boston and Milwaukee where the average expected annualized home price growth over 10 years was 8%.
Mortgage interest rates were around 10% in 1988, so the difference was negative. Currently it is around zero. The regression suggests that housing investment should have been much lower than the current 3.1% when it was, in fact, 4.9%.
The specification suggested by Shiller’s graph just doesn’t fit the data. Residential invesment would have to respond much more to expected house price changes than to mortgage interest rates.
Not willing to let the data convince me that my story is wrong, I tried to think of arguments why mortgage interest rates wouldn’t matter so much. I have a couple. First people might buy when mortgage interest rates are very high and plan to refinance when they fall. The option to refinance exists and is valuable (and wasn’t restricted back in the 80s). Second their is the required return on the down payment (which in the US is traditionally about 10% of the purchase price). This is an oppurtunity cost and home buyers might believe that they can’t get returns as high (and variable) as mortgage interest rates. This argument is silly for two reasons, first the down payment is usually tiny compared to the mortgage and second because long term treasury rates are not that much lower than mortgage rates and they move up and down together. But insisting on the argument, I note that the mortgage is repaid — over the life of the buyer, the mortgage goes away but the exposure to capital gains and losses doesn’t. If someone inveted in a checking account (which is crazy) putting less weight on the mortgage rate than on expected house price increases would make sense.
Well that was feeble. While sure I have convinced no one, I consider long term expected home price appreciation minus long term expected consumer price inflation. Fortunately it is possible to cheat on this, because the long term expected CPI inflation was always almost exactly 2.5% during the 10 years with home price expectations data. So the regression is just a regression of housing investment on expected home price increases
Again the fit looks nice. the back cast regression is
. reg exp10 resinvestpercentgdp
Number of obs = 10 R-squared = 0.7688
exp10 | Coef. t –
resinvestp~p | 1.408554 5.16
_cons | 2.456457 1.96
Average long term expected CPI inflation in the Livingston and Blue chip surveys was 4.3 to 4.35 % (different surveys in 1988) so 1.8 to 1.85 percent should be added if one wants to claim that what matters is expected home price inflation minus expected consumer price inflation.
update: Some arithmatic corrected below.
Residential investment was 4.9% of GDP so the fitted value for home price inflation (with no correction for changes in expected inflation) is about 2.5+1.4*4.9 = 9.2%
adding 4.3% – 2.5% = 1.8% gives 11% which is well within the range of expected home price inflation in the 1988 sample. The sample does include two cities chosen for their housing bubbles.
So if, for some reason, expected real mortgage interest rates don’t matter too much, then low expected home price appreciation could explain low housing investment with no need to appeal to unusually severe financial frictions.
That’s a big “if” and that’s where I (finally) stop typing.
Rates are certainly important but their effect is muted by supply and demand coupled with money supply.
During the bubble, the banks actually increased the number of AAA buyers(thanks to the ratings firms). Combine that with the fact that the vast majority of the money supply is restricted to AAA investments, and we had a lot of buyers and more than enough cash to complete a deal. Greater demand, higher price.
Now we have investors that are scared to death of anything the banks issue privately; reduced number of AAA buyers(cause now they are real AAA buyers); changes in the TILA that restrict profits to the banks on mortgages which makes the bank reluctant to get too involved; the continuation of income stagnation for the vast amount of Americans; and the continued entry into the housing market of potential buyers burdened by their student loan mortgages.
I think the bubble covered up the ongoing changes in the housing market caused by the evolving abilities and amount of potential buyers. Trying to compare the 80s with the present is comparing apples to oranges.
Humorously, the banks are now driving towards a further reduction in regulation by pushing changes in the reps and warranties on MBSs. Basically saying, “Hey, look. We are not going to take a chance on any private securities unless the chances of investor claims of fraud are reduced.”
One possibility for the difference between 1980s and 2000s was the housing bubble which you mention.
But looking inside the housing bubble we find the distortions caused by mortgage backed securities. If you were an investment banker selling these securities, you needed mortgages and lots of them. These were obtained from mortgage brokers who found that they could sell any mortgage and so they drove their employees to write more of them. And the mortgage brokers and their employees found that steering borrowers into subprime mortgages was more profitable. It was said that ‘if you could fog a mirror then you could get a mortgage’. And you could get a mortgage that was NOT as limited by your income, as in the past. And once the process was in full swing, then came the fraud.
I believe that the result of that system would have been to increase the sales of new homes as newly qualified buyers were discovered. And the price of new homes would have increased more rapidly than in the past. Simple supply and demand at work.
Now, does anyone really believe that home builders were prepared to significantly drop their prices after the housing/debt bubble ended? How long would it take for stagnant wages to catch up to home builders’ expectations?
A feature of subprime mortgages was that they were adjustable rate mortgages. Usually adjusting in 3 years, this caused only minimally qualified borrowers to be pushed over the edge. Remember that some borrowers were not really qualified at all. The inevitable was postponed by refinancing, but when the defaults started to increase, refinancing became impossible.
The banks were quickly in trouble. Bear Stearns, the investment banker, was in serious trouble by July 2007. Later we began to hear about foreclosed homes which were never taken out of the names of the original borrowers so that the banks could avoid the taxes and fees. (And control their REO numbers.) Next we began to hear about borrowers who stopped making payments and stayed in their homes until evicted, which could take years.
Delay, delay, delay. When will the residential housing market really represent reality? The last year or two with ridiculously low interest rates don’t seem to qualify.
The local newspaper ran a featured piece documenting the percentage change in the median price of homes sold from 2007 to 2012. In one community that drop was 40%. Out of over 100 communities, only a few saw any increase in median price. This was not in the ‘sand’ states where some large corrections were to be expected. This was in the midwest.
Now here is my point. Assessing home price expectations 10 years from now, seems to be a wild ass guess, if one does not understand the lasting effects of the housing/debt bubble. How many of those surveyed really understood the full breadth of the destruction of demand, or the previous overbuilding, or the prevalence of stagnant wages? Garbage in-garbage out.
You are putting the cart is front of the horse, Jim.
The fraud created the mortgages. The mortgages then created the securities.
As soon as I hit send, I realized that my comment was focused on the next 10 years.
But the view from 2003 forward was not any better. How many of those surveyed in 2003 understood the breadth of the developing housing bubble, or the magnitude of the developing debt bubble, or the prevalence of stagnant wages?
All of these factors were apparent in the statistics by 2003.
“The fraud created the mortgages. The mortgages then created the securities.”
The fraud, which I was adding, was that done by those outside the system. Buy a home. Make some trivial improvement, sell the home to a collaborator for more than it was worth, repeat, repeat. Buy another home, repeat, repeat.
I added that fraud because it did impact other home prices, since each of those sales would become a comparable to be used by appraisers.
“The fraud, which I was adding, was that done by those outside the system.”
geez
Another take on the “Hairdressers of the world outsmarted Goldman Sachs” meme.
Didn’t happen.
What happened was what the banks wanted to happen.
“Didn’t happen.”
That fraud by those outside the system happened. Locally and across the nation.
The banks blamed their problems on the Community Reinvestment Act, and Fannie Mae and Freddie Mac which was complete nonsense.
But the banks can not be blamed when outsiders took advantage of very lax underwriting and committed out and out fraud.
Here is one example from 2001 to 2006
http://www.fbi.gov/cincinnati/press-releases/2011/cincinnati-real-estate-agent-charged-with-committing-6.9-million-mortgage-fraud
Here is another example from 2006 to 2007.
http://www.fbi.gov/cincinnati/press-releases/2013/third-defendant-sentenced-in-15-million-mortgage-fraud-scheme
Of course they can be blamed. They are the experts.
I was in lending for over 30 years. DId I get scammed? Of course. Once in ten thousand.
Just like the banks in this past case.
Oh, btw.
You do know that if a bank is scammed and file charges they lose all fiscal responsibility for that deal?
This is as ludicrous as the “CRA, GSE did it” meme.
So you are comparing expected CHANGE in prices with the long term interest rate. But according to the efficient markets hypothesis, the expected change in prices should always be 2% a year + the real appreciation of land and houses – houses depreciate and long term statistics suggest that the long term appreciation of land approximately matches the growth of real income (so 0).
So what you are really saying is
1. the efficient markets hypothesis doesn’t work here
2. house prices (really land prices) are still too high.
Here are some of those “collaborators”. And a writer who actually knows who they were.
“The Wall Street Journal Still Refuses to Grasp Accounting Control Fraud via Appraisal Fraud
By William K. Black
Kansas City, MO: December 2, 2014
The Financial Crisis Inquiry Commission (FCIC) report described one of three epidemics of accounting control fraud that drove the financial crisis in these terms.
“Some real estate appraisers had also been expressing concerns for years. From 2000 to 2007, a coalition of appraisal organizations circulated and ultimately delivered to Washington officials a public petition; signed by 11,000 appraisers and including the name and address of each, it charged that lenders were pressuring appraisers to place artificially high prices on properties. According to the petition, lenders were ‘blacklisting honest appraisers’ and instead assigning business only to appraisers who would hit the desired price targets” [FCIC 2011: 18].
The FCIC Report then documents scale of this epidemic of loan origination fraud.
“One 2003 survey found that 55% of the appraisers had felt pressed to inflate the value of homes; by 2006, this had climbed to 90%. The pressure came most frequently from the mortgage brokers, but appraisers reported it from real estate agents, lenders, and in many cases borrowers themselves. Most often, refusal to raise the appraisal meant losing the client” [FCIC 2011: 91].
A clarification is in order. The “client” was rarely the buyer because, for obvious reasons, we do not allow the borrower to select the appraiser. Even moderately-sized lenders have vastly greater power to successfully extort appraisers than does any residential borrower. It may be true that “many” borrowers tried to “pressure” appraisers to increase the appraisal, but the overwhelming source of such pressure was from lenders and their agents and virtually all of the successful pressure came from lenders and their agents.
Then New York State Attorney General Andrew Cuomo’s investigation confirmed that the largest mortgage lenders were leading the extortion of the appraisers to inflate appraised values.
“[I]n 2007the New York State attorney general sued First American: relying on internal company documents, the complaint alleged the corporation improperly let Washington Mutual’s loan production staff ‘hand-pick appraisers who bring in appraisal values high enough to permit WaMu’s loans to close, and improperly permit WaMu to pressure …. appraisers to change appraisal values that are too low to permit loans to close’” [FCIC 2011: 92].
These three findings allow us to understand a great deal about the appraisal fraud epidemic.
Appraisal fraud was endemic
Appraisal fraud was led by the controlling officers of lenders and their agents
No honest lender would ever coerce, or permit, the inflation of the appraised value because the home’s true value provides a critical protection to the lender
The lenders’ controlling officers were deliberately creating a “Gresham’s” dynamic in which bad ethics drives good ethics out of the appraisal profession
Honest lenders’ controlling officers could easily block such a Gresham’s dynamic by creating desirable financial incentives and internal controls that will block inflated appraisals
Appraisal fraud optimizes accounting control fraud by lenders (and loan purchasers).”
http://neweconomicperspectives.org/2014/12/wall-street-journal-still-refuses-grasp-accounting-control-fraud-via-appraisal-fraud.html
A vigorous housing market needs more and better paying jobs. Customers who expect to stay employed long term.
@reason
the expected cost of the services provided by a house are equal to it’s price times th interest rate minus expected capital gains (this is from the Belman equation) so the increase in the price and the price times the interest rate appear on the right hand side. Dividing and multiplying by the price gives the cost is equal to the price times (inerterest minus the expected rate of capital gans) . This is why Shiller looks at the expected rate of capital gains (from his survey) minus the mortgage interest rate.
My regression is very crude. I only have 10 data points. but the logic of combining an interest rate and the rate of change of a price is very srong.
I don’t know from where idea that the relative price of housing should grow at the same rate as real GDP came, but it is radically wildly totally rejected by the data. According to Shiller’s data in “Irrational Exuberance” the price of a house with fixe characteristics divided by the CPI was about the same in 1900 and 2000. Real GDP increased over this period.
You might know that the relative price of housing should trend up, but according to Shiller the 20th century data show no trend (the relative price declined during the depression and returned to roughly the 1900 level during WWII when many prices but not house prices were controlled.
ISTM that the main reason that residential investment is low is big oversupply* in housing created during the RE bubble…There are still mostly dark condo towers and plenty of empty SFHs in areas hit hard by the bubble.
*yes there are plenty of homeless, but we’re just not going to fill those “luxury condos or McMansions with them.
As for appraisal fraud, if the banks were lending their own money, or even if they simply kept the mezannine tranche after they sold all the bonds, they would sure come up with ways of getting accurate appraisals. But when the appraisal is just the V in the LTV number for loans that are sold, OF COURSE they are incentivised to get high appraisals. And those incentives, like poo, roll downhill.
Jim A
Sorry doesn’t work. The current supply is well below trend now.
Robert
I was basing my correlation with income (should be medium income – not GDP) with the general observation that house prices tend to a fixed multiple of household income in the long run. That is – quality was not assumed to be constant.
Robert
the other part of my comment was just to point out that if house prices are not expected to rise, then people must still view current house prices as too high. (The 2% inflation was based on the tongue in cheek view that the FED would take their inflation target seriously, rather than as an upper limit).