Bill Gross says don't expect double-digit returns anymore

He could very well be right. Part of returns come from inflation, which is currently running at an annual pace of 1.2 percent. If "normal" inflation is 3 percent, a 10 percent return in normal times is equivalent in real terms to 8 percent now. There is nothing necessarily wrong with that.

A modest step toward untangling housing markets

One of the impediments to housing transactions is appraisals. If appraisals (which are backward looking) don't support the offer price of a house, the financing for the house can disappear.

For low down payment deals, this is frustrating, but appropriate. But for deals involving a minimum of 20 percent down, it is hard to see how appraisers have a better sense of value than the potential buyer who is actually putting a lot of money at risk. It may make sense to allow buyers who put 20 percent down, and whose source of funds is well documented, to get a loan even if the appraisal comes in a little low.

At what point will short sales become meaningful to restarting the housing market?

The Washington Post today forecasts 400,000 short sales this year. Lawrence Yun says there will be 2.5 million foreclosures in 2010. So while short sales have have increased substantially, they will still be only about 1/6 the number of foreclosures.

Don't get too excited

Nick Timiraos retweets Brad Hunter: Census numbers: Single family starts up 4.3% (+/- 12.4%) Plus or minus 12.4%!! It's in the fine print of their release!

I actually try my best not too make too big a deal out of any monthly number.

To my macroeconomist friends: if you are going to do urban economics, please read the urban economics literature first.

I saw a paper from a famous macroeconomist a week or so ago that proposed that cities with high incomes relative to house prices produce more utility than those cities with low incomes realtive to house prices. Using this metric, he concluded that Flint was among the five highest utility cities in the US. This might have been a clue that there was something wrong with his utility measure.

The systems of cities literature (see Jan Brueckner's chapter in the Handbook of Urban Economics) and the quality of life literature (see Stuart Gabriel Joe Mattey & William Wascher's RSUE paper) shows that in a country with mobility, utility tends to get equalized across cities, and so that places with high house prices relative to income have more non-housing amenities than places with lower house prices. I can testify to the reasonableness of of this, as while Los Angeles is expensive (as well as congested), I do not find myself tempted to move anywhere else, suggesting that I, at least, derive a great deal of utility from living here (I recognize that lots of people are not so enamored of LA, but enough of us are to keep the price of housing high relative to other places). Other places like LA include New York, London, Paris, Singapore, Tokyo, Hong Kong, Sydney, etc.

This produces an efficient outcome, for if Los Angeles were less expensive, it would be even more congested. On the other hand, St. Louis' cheap house prices should eventually attract people back to it. But it also produces an unfair outcome, because it is very difficult for low income people in Los Angeles to find reasonably priced housing in reasonable locations. Perhaps the goal of housing policy should be to allow everyone to be able to choose the city in which to live, while at the same time distorting the relative prices of cities as little as possible. I am not sure how one does both.

While Arrow showed the impossibility of a well defined ordering of social preferences...

...we tend to act as if there is one anyway. That is, we place a lot of focus on GDP per capita when evaluating economic success. By this measure, the US is, of course, successful. By a slightly different measure from the OECD (go to page 37), average disposable income per household, the US ranks second after Luxembourg among the nations measured. Luxembourg has about the same population of Long Beach, so it is hard to worry too much about it.

But a social welfare function that looks at the lowest decile of income is just as legitimate (or perhaps I should say, illegitimate). By this measure, the US ranks 20th among countries measured, which places it toward the bottom of the OECD pack, with levels similar to Greece and Italy.

On the other hand, the top 40 percent of American household are better off than their counterparts in all other countries (with the exception of Luxembourg), reflecting a great deal of affluence across a large number of people. So where to pick? As Arrow would say, that is really impossible.

When assumptions drive the result

I have spent the past few days at the Wisconsin-St Louis Fed conference on Housing, Urban, Labor and Macroeconomics; it is a third in a series that Morris Davis had organized, and the papers were thought-provoking and well done.

The macro paper, however, was about whether government can effectively counteract negative shocks to one sector of the economy. To the standard macro model it added a friction where workers had to retrain in the event of a shock to one sector of the economy so as to be able to work in another sector. This is clever and important.

But while the model allowed for frictions, it failed to allow for involuntary unemployment, and so it found that government interventions were ineffective. Well, duh...

Is it housing or is it Boston?

David Leonhardt's excellent piece on house prices in the New York Times this morning asks a fundamental question about how to think about the future of house prices. If houses are a staple, they are currently overvalued by historical standards; if they are a luxury good, they are not.

Mr. Leonhardt's definition of a luxury good is one with an income elasticity equal to one (i.e., a good where the share of income spent on the good remains constant), whereas technically speaking, luxury goods have income elasticities greater than one (think nice vacations). But the point is still a good one--the income elasticity of demand for housing should tell us a lot about where house prices "should be" right now.

National house prices did follow income closely between 1970 and 2000, while according to Robert Shiller, they grew only by the rate of inflation before that. I wonder if the reason for the change is not that people wanted to spend a constant fraction of their income on housing, but rather that they wanted to spend a constant (or even increasing) fraction of their income on certain cities, such as Boston, New York, San Francisco and Los Angeles. These are all high amenity places, chock full of luxury goods, that have inelastic housing supply. It is possible that housing in, say, Wichita (sorry to the Kansans out there) is a staple, while Santa Barbara is a luxury.

LA commutes? Not so bad.

The average one-way LA commute is 29 minutes. This compares with 45 minutes for the UK (the whole country, not just urban areas) and 38 minutes for the EU. A variety of sources suggests that the median commuting time in Japan is greater than 30 minutes and the average is longer (because of skewed data).

European cities are great for vacations, and wealthy people in such cities can live in places that allow them to walk to work. But for average people, LA is a easier place to get around.

Ryan Avent of The Economist gets it right (h/t to Mark Thoma)

He writes:

"...it's simply not true that the administration has rolled out every programme it can think of. Economists with which administration officials are very familiar have proposed measures to deal with the real problem in housing markets: negative equity. Promising policies like mortgage cramdowns and own-to-rent programmes have yet to get a serious look from Washington leaders. But ultimately, a real fix for housing markets must address underwater mortgages. Absent some attempt to deal with negative equity, a rush of buyers into the market will accomplish little; the problem is that underwater homeowners can't afford to sell at prevailing prices. Driving those prices lower won't change that fact.

The truth is that the trouble in housing is not, for the most part, a demand-side issue. The problem is the millions of homeowners stuck in houses they can't afford to sell. These households represent a significant shadow supply of foreclosures-in-waiting. I agree that it would be silly for the administration to try to support housing prices by offering more goodies to potential homebuyers. But it doesn't follow that letting prices go their own way will magically get housing markets moving again."

John Quigley, Alan Blinder (and I for that matter) have been advocating something like a Home Owners Loan Corporation, and/or a debt equity swap for underwater mortgages for some time. We also need to deal with second liens--investors in such liens are holding up renegotiated mortgages because they will get wiped out--which is of course what is supposed to happen when one interest is subordinate to another.

(Thanks to Jim for filling me in on who RA is).

A downpayment factoid

Canada allows 95 percent LTV loans. Borrowers must get mortgage insurance, either from the government or the private sector, if the LTV exceeds 80 percent. Yet 90 day delinquencies there remain under 50 basis points. All home lenders in Canada are subject to strong regulatory oversight.

My favorite Art Goldberger quote

I saw a paper today on heritability and savings. It made me think of my econometrics teacher, Art Goldberger, who once wrote:

Professor Hans Eysenck was so moved by the twin study that he immedi- ately announced to Hodgkinson that it "really tells the [Royal] Commis- sion [on the Distribution of Income and Wealth] that they might as well pack up" (The Times, 13 May 1977). (A powerful intellect was at work. In the same vein, if it were shown that a large proportion of the variance in eyesight were due to genetic causes, then the Royal Commission on the Distribution of Eyeglasses might as well pack up. And if it were shown that most of the variation in rainfall is due to natural causes, then the Royal Commission on the Distribution of Umbrellas could pack up too.)

From "Heritability," Economica, 1979, 46, 327-47.

Do low rates make house prices more volatile?

Over at the FT blog, Cardiff Garcia has a nice summary of three papers that attempt to explain the run-up in house prices before 2007. It particularly approves of the work of my friend and co-author Susan Wachter and Andrew Levitan, who argue that a supply-side credit bubble produced the housing bubble.

As I read the piece, though, I couldn't help but think that while it is unlikely that low interest rates would explain prices, they might explain volatility. When nominal interest rates are low, a small change in price expectations can lead to a large change in prices.

Consider the Gordon Growth model, where Value = dividend/(i-g), where in this case the dividend is the value of living in a house, i is the interest rate and g is the expected growth rate of the dividend. Let everything be real (i.e., not nominal) Consider two worlds: 2 percent real interest rate world and a 4 percent world. Now let expectations about growth vary from negative one percent to positive one percent. In the two percent world, the upside scenario produces three times the value of the downside scenario. In the four percent world, the upside produces 67 percent greater value than the downside. Hence small changes in expectations have a much larger impact in a low interest rate environment than a high interest rate environment. It may be hard to pick this up because expectations are so difficult to measure.

Just a thought.

The wonders of academia

I became a full professor at the University of Wisconsin-Madison in 2001. Among the responsibilities of full professors are (1) to evaluate whether professor at schools other than ours merit promotion and (2) to chair and serve on promotion committees at our own schools.

So far as I can tell, senior faculty take these responsibilities very seriously. The strange part is that we take promotions of people at other schools very seriously, even though we compete with those very schools. I suppose one could make an argument that we at USC should try to blow up the cases of those who we deem to be good at other schools in California, while also waxing enthusiastic about weaker faculty at these schools. It is as if Honda were telling Toyota who to promote, and vice versa.

In the end, though, faculty at one school tend to recommend that faculty they deem meritorious at another receive promotion. While the process is certainly less than perfect, the good faith that most faculty show in these affairs helps explain why the US still has the best research universities in the world.

Did Californians break their contract?

Mark Thoma, whom I admire, approvingly posts Michael O'Hare's letter to his students. Professor O'Hare says something that really bothers me:

...for a variety of reasons, California voters realized that while they had done very well from the existing contract, they could do even better by walking away from their obligations and spending what they had inherited on themselves. “My kids are finished with school; why should I pay taxes for someone else’s? Posterity never did anything for me!”

As Professor O'Hare correctly notes in the header to his blog, "everyone is entitled to his own opinion, but not his own facts."

So before we accuse middle-aged Californians of being greedy, we should consider four things. First, California ranks 4th in state and local per capita spending in the country (and number one is Alaska, where the tax price of government service is essentially zero). Second, about 2/3 of California bond referenda that go to the public receive the 2/3 super-majority necessary to get passed. Third, we in Los Angeles County voted two years ago, in the middle of a recession, to tax ourselves to pay for transportation infrastructure. Finally, we absorb more people from the rest of the world relative to our population than any other state. These facts are more consistent with generosity than greed.

I understand Professor O'Hare's frustration with California's state budget process and with the threats against the wonderful UC and Cal State systems. Those who know me know that I enthusiastically support all kinds of public spending. But Professor O'Hare's rhetoric could well alienate many whom he wants on his side, and may actually give aid and comfort to the Sarah Palins and Glenn Becks of the world.

Maybe we are more like Homer Simpson than Spock

I saw Juan Carrillo of the USC economics department present a very nice paper testing auction theory using experimental data. The only problem was that the people in the experiment were Cal Tech students, who are not exactly representative. But even Cal Tech students, while likely more rational than the general population, and who certainly understand experiments better than the general population, are still far less than perfectly rational.

What is the correct downpayment?

If required down-payments are too low, we get the nonsense of the past several years. I am reasonably sure zero is too low. If required down-payments are too high, we, among other things, perpetuate wealth disparities (i.e., the only people who get credit are those that don't need it). I am reasonably sure that 25 percent is too high.

What is both socially optimal and just? We need to try to figure this out, but it would involve knowing the correct social loss function and then minimizing it. Social welfare functions are very, very tricky businesses.

In praise of Lawrence Yun

As Robbie Whelen notes in the Wall Street Journal, it could not have been fun to be Lawrence Yun, the National Association of Realtors chief economist, today. As Whelen notes, he must "toe the line between housing industry economist and housing industry motivational speaker."

I think Lawrence does this well--he is clearly on the side of the people who pay him, but he also takes his positions honestly. I assume that he had something to do with NAR's decision not to advocate for an extension of the home buying tax credit. More important, he is in charge of the data that NAR puts out, and bad days like today essentially prove that the data are credible (full disclosure: I, along with Orawin Velz and Kevin Thorpe, helped design the methods by which the Existing Home Sales data are produced, but I have nothing to do with the monthly estimates that NAR puts out). I am guessing that one or two members of NAR wish he would fudge the data, but he does not.

No more goosing with tax credits please.

The July Existing Home Sales number of 3.8 million units was abysmal--it was 1980s bad. I am guessing that a lot is it is that July gave back the tax credit driven boost of spring. If we look at average sales for the year, it is 5.1 million, which is pretty much normal. March, April, May and June were above normal, but all of that "strength" was given back in July. Credits just pull sales forward--they don't change the underlying dynamic, and they add to the deficit.

Is housing the best way for low-income people to build wealth?

I was thrilled to be invited to the Future of Housing Finance conference held at the Treasury Department and co-sponsored by HUD this week. It was particularly nice to be seated next to Self-Help's Martin Eakes, whom I have admired for some time. Like Elizabeth Warren, Eakes long ago had insights into sub-prime lending that I wish more of us had taken seriously.

At the conference, Martin worried about a conversation that emphasized the need for robust underwriting standards for the mortgage market going forward. The three most important standards are loan-to-value ratio, payment-to-income ratio, and credit history. As Martin pointed out, African-Americans have less wealth available for down-payment than others (even after controlling for income), and have lower FICO scores than others, and therefore will be denied access to credit at a greater rate than others if underwriting standards are tough and uniform. Because much of the reason that African-Americans lack wealth is because they have been systematically stripped of wealth for many generations, policies that reduce access to credit disproportionately for African-Americans violate fairness.

The events of the past six or seven years show that loose underwriting does nobody any favors, either. Foreclosures are terrible things for the families who experience them and for the communities that have large numbers of them. The whole point of underwriting is to prevent default and foreclosure, and the unpleasant fact is that downpayment and FICO are predictors of likelihood of default.

In the era where almost all mortgages were self-amortizing, housing allowed families to build wealth because mortgages were a form of forced saving. Those who got a 20 year mortgage in 1960 owned their house free and clear in 1980; households gained wealth not because housing was such a great investment, but because they built equity, month after month. Housing was a particularly attractive way for those of modest means to save, because they could live in the very piggy bank they were building. In principle, however, these households could have rented and taken the difference between a mortgage payment and a rental payment and put it in another investment (a small business or the stock market). But we know that in the absence of nudges, people tend to save less.

Perhaps, then, the government could come at the savings issue more directly by giving low-income people a nudge toward saving. Suppose it developed a 401(k) type plan that matched the savings of those with below-median incomes at 2 to 1. This would encourage savings that then could be used for a down payment or a host of other investments (say a Vanguard index fund). This would cost taxpayers money, but perhaps less than mortgage programs built on thin underwriting standards. At the same time, getting people into the habit of savings could produce other social benefits as well. I am not sure such a plan is practical, but I think we do need to think about how we can help people who have been denied wealth for generations how to start accumulating assets without relying entirely on the housing finance system to do it.