Monday, August 7, 2017

Alternatives to Bubbles

There was no housing bubble is, I guess, a new thing going around.  It isn't entirely new in that a few people have mentioned it or endorsed it for years, but it is new in the sense of drawing more adherents and tentative supporters these days.  Karl Smith via Alex Tabarrok is who I am responding to today.  I am going to start with his alternative theory and work backwards a little.

Let me then tie all this together by advancing a theory: there was no bubble in either housing or commercial real estate. There was, however, a massive increase in liquidity driven by financial innovation in the late 1990s and early 2000s. That increase in liquidity allowed real estate markets to behave more like stock or commodity markets. In good time, prices would rise rapidly as money poured into capital markets. During recessions, prices would retreat as money retreated to safer havens.  

Wonderful!  A direct theory we can talk about without having to infer what was really meant and end up arguing past each other because of a lack of common ground.  So my first major objection is
 During recessions, prices would retreat as money retreated to safer havens.  
A prediction.  Now Karl Smith includes in his post graphs of home prices, both real an nominal (another wonderful thing to include) covering the 'bubble' and recovery, so we can check to see if this is an accurate description of what happened.  The short answer is no, it isn't.  The graphs show nominal housing prices peaked in July 2006, and real housing prices peaked in December 2005, so real prices peaked almost 2 years prior to the start of the recession and about 20 months prior to the stock markets as the S&P peaked in October 2007.  Importantly the S&P didn't just peak a year to a year and a half later, it rose significantly during that period, from the 1260-1270 range in late 2005 to peak of over 1550 in October, more than a 20% rise no matter what you look at (peak to peak, moving averages, whatever).

That rise is significant because the two markets (housing and stock) diverged in momentum.  Housing peaked and then drifted sideways and a little down while stocks pushed quite a bit higher, it is unlikely that the two markets were responding to a single cause.  In fact if you were to oversimplify and offer two alternate explanations in this way

1.  The recession drove money out of the housing market and caused the decline
2.  The housing decline caused the recession

#1 is almost certainly false.  This is a major, but not fatal*, blow to the proposed theory.  There are logical holes in several other steps in this post along the way.  Another here

As mentioned, nominal values have rebounded strongly over the past six years, despite a weak economy, increased financial regulation, and a backlog of foreclosures. This rise in nominal values is key because it is tied to the viability of mortgage contracts. Suppose homebuyers in 2007 had gotten caught up in bubble fever, taken on a mortgage that was a bit too much for them to afford, and then watched the value of their investment collapse. Well, if they could have ridden the wave out for 10 years, then they could have gotten back out at least what they put in. Ten years is a long time, and according to the NAHB, it’s a bit less than how long the median homeowner stayed put through the 90s and early 2000s.

Followed by

Riding the bust out would have been tough, but not wildly out of the ordinary for the average homebuyer. Yet, it only took this long because inflation has been extraordinarily low, rarely rising to two percent a year. A faster rate of inflation would have brought homeowners out of the dip even sooner.
Why is Kevin Smith choosing nominal instead of real here?  Yes there is an intuition that if nominal prices rebound you can sell the house and get out from under your obligation but the real loss still exists.  In terms of opportunity costs if you held onto your house by selling stocks and bonds during this period or by not buying stocks and bonds while plowing money into your mortgage payments then you missed what has been a major run up in other markets.  Even if your choice was literally to sell the S&P at its absolute peak in 2007 to maintain your mortgage payments you have forgone a roughly 60% nominal increase on that money.

Housing has been a terrible investment for people who bought between 2000 and 2010 in opportunity cost terms.  Note this line
A faster rate of inflation would have brought homeowners out of the dip even sooner.

This is wrong on two levels.  First housing prices from 2007-2017 failed to keep pace with inflation, it is not assured that a higher inflation rate would have caused a faster rise in nominal home prices. Secondly the higher inflation rate could well have meant (and probably would have meant) larger real losses for the homeowners.

I understand that the argument stems from a simplified view of the housing bubble, but Smith here is using slight of hand to waive away the costs.  Yes if someone held onto their house they probably could have eventually sold it and not taken a nominal loss, and fully repaying their mortgage a decade or so later.  However this is just shifting the losses that investors took on the securities and shifting them onto the homeowners.  The fact that 10 years later homeowners are still realizing real losses (and not just opportunity cost losses which are much larger, simple inflation adjusted losses), and eyeballing the trend line from the 2012 trough it would be reasonable to expect at least another 4-5 years before those real losses hit zero, is a major point of strength for the housing bubble side.

Buying into a bubble suggests that you are paying irrationally high prices that are premised only on the notion of “some-greater-fool” coming along and rescuing from your mistake. As we can see that is not the case. 
This statement only makes sense if you assume that those who held onto their house could do so at no cost.  The bigger fool in this case is the fool who held onto his house for 10 years so that he could then sell it at no gain, rather than invest more profitably in virtually any other asset class over that period.

*  It has been noted by some that the housing price fall was fairly modest up through August 2008 and fell aggressively as the financial crisis unfolded, which allows for a theory along the lines of "the decline in housing wasn't enough to start the recession, but the crisis was enough to drive housing far lower".  I find this unconvincing as the financial crisis was actually initiated by investors demanding that additional collateral be put up by major institutions (along with some actual fraud), which is a direct way of saying that the market was anticipating a greater chance of a failed repayment than it had done in the recent past.  It is hard for me to believe that recession is the direct cause of the housing decline when the most important events for the housing decline preceded the corresponding portions of the recession.

Friday, July 7, 2017

Risk Neutral

An expansion on some thoughts in response to a comment by Kevin Erdman on Arnold Kling's blog.

Kevin highlight's a point about risk which is valuable, that people who buy debt (ie bonds) are generally risk averse and people who buy equity (ie stocks) are generally risk tolerant.  The conclusion though is incorrect because he looks only at the buyers, and not the sellers of the assets.  If buying bonds is risk aversion then selling bonds should be seen as risk tolerance, with the opposite relationship for equity, let's look at both how this is true and the implications.

First why are bonds less risky than equity?  First it is because they (typically) have a claim on the underlying capital.  If you buy equity in Ford and they go belly up then your equity will be wiped out.  If you buy debt from ford and they go belly up your debt will be converted to equity and you are now a proud new owner of a fraction of Ford's physical capital, their manufacturing plants, their patents, and anything else worth selling or using.  So you have this natural buffer where even if the overall business fails there is some value to be extracted from the ruins, which an equity holder doesn't have.  Secondly it takes a much larger blow to the company to decrease the coupon payments.  A decline in sales will take a whack at the equity, and the market value of bonds, but the actual income stream won't be effected until the blow is large enough to interrupt the coupon payments.

That is from the investor's perspective, now from the companies perspective this is reversed.  When a company sells equity they give up a ownership stake in exchange for cash, if the stock price falls afterwards the company doesn't have to give part of that cash back.  A stock issuance is low risk from the companies perspective, the total market capitalization could fall to a single penny and they don't have to repay a cent of it, the investor takes on all of that risk.  Now a bond issuance, they borrow money and promise to pay it back with the company assets as collateral.  If they cannot make the payments the entire company is potentially forfeit.  Any risk that the investor is insulated from must be passed on to the company.

This inverse relationship is pretty straightforward.  If Ford wants to build a new assembly line they can fund it through debt or equity, but funding from one or the other doesn't (shouldn't) alter the risk inherent in that capital expenditure, what funding from one or the other does is shift the risk and reward profile.  If they issue through debt and it is a huge success the bondholders get their coupon payments and Ford gets all the upside of a major and profitable investment.  If they fund through equity the shareholders get the upside of that profit stream.  If it is a failure Ford has risked the company's assets and will have to sell them off to make their bondholders whole.  If it fails and they have funded through equity the share holders take the (majority of the) loss, and the company retains all its other assets.

In a perfect world/market these things balance out perfectly every time.  Total risk is constant, and distribution of risk is matched with compensation for exposure to it.  Where it is a problem is when one group can offload risk onto a third party without compensation.