Long-term interest rates again

This morning's Wall Street Journal reports that long-term interest rates are at their lowest levels in months, with the ten-year Treasury at 4.55 percent. They also note:

Recent data from the Mortgage Bankers Association suggests that some families have taken advantage of a decline in long-term mortgage rates to refinance their mortgages and lock in lower payments. The association's index of mortgage refinancing applications has risen 27% since mid-July, and now stands at its highest level since February.

The MBA has been ahead of the curve in figuring out how the inverted yield curve would affect refinancing. This should help soften price declines in the housing market, particularly in markets away from the coasts.

Nevertheless, yesterday's news on prices and inventories out of NAR was ugly: prices are falling a bit, and inventories are at a high for the decade.

A Key to a Soft Landing in Housing

As I have already mentioned, the Chicago Merc housing futures market is predicting a decline in nominal house prices in several markets over the next year. While the market is still very thinly traded, it likely reflects a prevailing view among many investors and observers of the housing market.

One of the reasons for the softening of in some markets has been the increase in the federal funds rate. Some work in progress among Chris Redfearn, Stuart Gabriel and me is showing that the short end of the yield curve migh have a substantial impact on house prices in many of the coastal cities. The reason: in expensive markets, borrowers slide down to the short end of the yield curve where the cost of borrowing is generally lower. This allows borrowers to buy houses with "affordable" initial payment-to-income ratios.

The problem, of course, is that short term interest rates have been driven up by the Federal Reserve, from one percent in late 2003 to 5.25 percent today. If an Adjustable Rate Mortgage's spread over the fed funds rate is three percent (not usually the way ARMs are calculated, but lets give the example to make a point), and it amorizes over 30 years, the payment on an ARM would rise more than 50 percent per dollar of mortgage balance. This means people who could get into the housing market in a place like Los Angeles before can no longer do so, and it means many people in Los Angeles are facing payment shock. The situation is even worse for those who used "option ARMs" to finance their houses--these products allow people to pay less than the interest they owe on their mortgage every month, meaning that their loan balances are rising over time.

The good news is that long-term fixed rate mortgages, while not at rock bottom rates, remain at very low rates by the standard of the past 25 years: 30 year-fixed rate conforming mortgages last week hast week at an average rate 6.4 percent, according to Freddie Mac's survey. This means the ARM borrowers can refinance out of their ARM into a fixed rate product that is pretty reasonable. This should place a floor under house prices, particularly in an economy where unemployment is pretty low.

I think the early part of the '00s should have taught an important lesson to homebuyers--if they can't afford a house with a 30 year fixed-rate mortgage, they probably shouldn't buy a house. That is not to say the ARM isn't a good product--it is, if households use it as part of a portfolio strategy. For instance, is someone knows she is only going to live in a city for five years, it is perfectly reasonable for her to borrower with a 5/1 ARM, where the rate is fixed for only five years. Her liability, the mortgage, now matches her asset, the house, where she expects to live for five years. But when people use ARMs--especially option ARMS--to make payment-to-income ratios acceptable for a limited period of time, they are liekly looking for trouble.

America the Spacious

While those of us who live on the Eastern seaboard of the United States feel hemmed in, the fact is that by World urban standards, we have a lot of space.

One of my favorite websites is http://alain-bertaud.com/. Alain has a wonderful gathering of information on urban environments around the world. Among his many great graphs, a particularly revealing one is the one to the left: it gives average urban densities for large cities around the world.

Note that American cities are in red: the densest of this, of course, is New York. But New York is less dense than European cities, and is much less dense than Asian and African cities. My home city of Washington is practically rural compared with most large cities around the world. But then, I am sure that someone from Mumbai would consider suburban Maryland and Virginia to be the countryside.

One of the reasons American cities have so little density is that the United States has a lot of land (only about five percent of which is developed) ; another reason is that the US is a rich country, and rich people buy more stuff, including land. But these reasons are only part of the story. More to come....

Jon Stewart on Social Foment

We saw Jon Stewart at Merriweather Post Pavillion last night. He articuated well why many of us can't get organized about expressing our frustration at policy and policy makers. The rallying cry of "be reasonable" somehow does not have an inspirational ring to it.

Credit to Francois Ortalo-Magne

It occurs to me that I might never have come up with the idea in the previous post had it not been for a conversation I had with Francois Ortalo-Magne at an NBER conference around a month ago. Francois pointed out the selectivity problem in Levitt's work.

Do Real Estate Brokers Shirk?

Steve Levitt is an incredibly smart guy (he has a Clark Medal, the prize for best economist under 40, to prove it) and, according to the people I know who know him, a very nice guy. Freakonomics is fun to read, and I liked it enough to use it for a seminar I taught last summer.

A reason the book is so much fun is that it is provocative, and challenges us to think about things from perspectives we had not before considered. It asks why drug dealers live with their mothers; whether Roe v Wade was responsible for the falling crime rate in the 1990s; whether Sumo Wrestlers cheat; and whether real estate agents shirk.

Levitt sets up the real estate agent-house seller relationship as a classical principal-agent problem: the agent is like anyone else: he has an incentive to do as little work as possible in exchange for as much commission as possible. Therefore, Levitt conjectures that real estate agents have an incentive to get sellers to take the first offer they receive from buyers. Because commissions are based on the entire price of the house, the fact of a sale gives agents a large benefit. If the seller refuses an offer, the agent has to do more work, but gets very little added compensation. For example, if there is a $490,000 offer on a house that could ultimately sell for $500,000, and the agent gets a 1.5 percent cut, from the standpoint of the agent, the benefit of waiting is only $150. The agent will almost certainly have to do a lot more work for the $150, and so has an incentive to encourage the buyer to take the $490k.

This would be a powerful argument for an incentive problem if agents were playing a one-shot game. But they are not--they are playing a repeated game. Agents rely on listings to make money, and listings come from referrals. Agents--good ones anyway--have an incentive to make sellers very happy, because happy sellers drive future business.

So now let's get to the evidence that Levitt provides to show that agents shirk: he shows that agents leave their own houses on the market longer and sell them for higher prices than the houses that they sell for others. This is an interesting fact, but is not necessarily explained by agents' shirking. Rather, it could be that the houses agents own themselves are different in unobserved characteristics from the houses that they sell to others. Or it could be that agents are different as human beings--they are more risk taking, and more entrepreneurial. For all we know, sellers ignore the advice of their agents and sell more quickly than they should, because they are relieved at the prospect of a sale and don't care so much about the marginal benefit they would get for waiting. In order to disentangle this, we would need to know something about the unobserved characteristics of people who become real estate agents--and of people who don't.

Full disclosure: while I was writing my dissertation in the late 1980s, I worked doing research for the Wisconsin Realtors Association. I had fun while I was there. Believe me, the Realtors are different with respect to their attitude toward risk taking from the rest of us.

Ofheo House Price Index Flattens

See http://www.ofheo.gov/media/pdf/2q06hpi.pdf. House prices rose only 1.17 percent in the second quarter, according to the index. This is an increase that more or less keeps pace with inflation.

The Ofheo house price index is not, however, completely representative of the housing market. Ofheo tracks prices on houses financed by Fannie Mae and Freddie Mac; Fannie and Freddie may only finance "conforming" loans, which are in 2006 defined as loans whose value is less than 417,000. This limit shuts Fannie and Freddie off from large parts of the California, Boston, New York and Washington housing markets; consequently, should these large markets go into the tank, their impact on the index will be muted.

The Case, Shiller, Weiss (http://www2.standardandpoors.com/servlet/Satellite?pagename=sp/Page/PressSpecialCoveragePg&c=sp_speccoverage&cid=1143857726920&r=1&l=EN&b=4index ) doesn't have this issue; nor, presumably, do the indexes that one can find in Zillow. The CSW Composite Index for 10 cities was completely flat in June.

A Paper on Market Reaction to 9/11 by Kallberg, Liu and Pasquariello

I really like this paper:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=716721

Abstract:

This study analyzes how three groups of market participants - insiders, analysts, and investors - revised their expected returns on New York Real Estate Investment Trusts (REITs) in response to the catastrophic events of September 11, 2001. The attack on the WTC represents a unique experimental setting to evaluate financial markets' reaction to external shocks for several reasons. First, these events, of a totally unanticipated and unprecedented nature, could not have been built into the market's expectations; hence, market participants had to learn something new rather than just recalibrate their expectations on past occurrences. Second, unlike other studies of market reactions, the impact of the terrorist attacks on REIT returns was ambiguous, since it was uncertain if the effect of reduced supply of office space in New York would outweigh the impact of the negative shocks to the local and national economy on its demand. Finally, the period of market closure that followed 9/11 gave these players ample opportunity to reassess their expectations. Our analysis reveals that, on the day when markets reopened, REITs with significant exposure to the New York area outperformed a broad REIT office index by 4.1%. However, we find that, according to several metrics of real market behavior, this anticipated superior performance of New York office properties did not materialize. Consistent with notions of market efficiency, we find that insiders were the first to lower their expectations (99.9% of their trades in REITs with New York exposure were sales in the month following 9/11), followed by analysts (the vast majority of them revised downward their expectations of NY REIT performance in the first weeks of November 2001), and finally market prices adjusted to reflect the underlying real market behavior; indeed, abnormal REIT returns had disappeared by mid November 2001.

While the paper is principally about information diffusion, it also presents some very nice data on the resiliency of the New York employment market in the wake of 9/11. New York's refusal to be cowed may be the greatest victory we have had over Al-Qaeda. But that refusal also speaks volumes about why New York became a great city in the first place.

The Chicago Merc Housing Futures Market

Chip Case and Robert Shiller have created a housing futures market for 10 US cities, along with a composite of those cities, that trades on the Chicago Mercantile exchange. If it works, it will allow homeowners to diversify some of their risk, and presumably make the market more liquid.

Owners who have lots of of home equity are long in the housing market. This may be fine, but it also may be that their length in housing means that they are not as diversified into other assets as they may wish. The CME index can help.

Here is how it works. Suppose you own a house in Washington, D.C. The most recent index value for Washington is from June, and is 250.39. The next futures contract is for November, and currently has a price of 247.8. If you take a short position for November, you have the right to sell the Washington index at 247.8 per unit. If the value of your house us perfectly correlated with the index, you can completey immunize yourself from swings in the market, outside of the difference between the June index and November price. If the price falls below 247.8, the profit on your short position will offset the loss in house value; if the price rises above the 247.8, your house offsets the loss on your short position. All of this assumes that there are no tax implications, but even with taxes, the index enables homeowners to at least partially hedge their risk.

All of this should actually make houses more valuable, because it should increase liquidity in the housing market. There remain some issues--chief among them is the lack of a true spot market in housing, because of the lag in the time between when a house receives an offer and when it actually settles. I'll discuss this further in another post. I will also discuss what the futures markets are saying about the future of house prices, and the implications for the own-rent decision.

A discussion on the Income Distirbution

From Brad Delong's Blog:

http://delong.typepad.com/sdj/2006/09/making_em_feel_.html

The first comment from readers seems on target to me. If we wish to encourage innovation, but discourage "spiteful" consumption, then using a luxury tax, instead of a more progressive income tax, makes sense. But does this mean that people would have to pay a tax for going to Greg Mankiw's high tuition university, but not pay that tax for going to Brad Delong's low-tuition university?

Some Reading for Friday's Commercial Real Estate "bootcamp" at GW.

Here are a first set of readings. More readings and commentary will be coming shortly.

http://www.irei.com/uploads/marketresearch/65/marketResearchFile/SORetail_Mkt_Inv_Opp7-06.pdf
http://www.irei.com/uploads/marketresearch/35/marketResearchFile/Pru_USQuarterly_July%2006.pdf

http://www.irei.com/uploads/marketresearch/10/marketResearchFile/RealEstateCapRates.pdf