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“People with mortgages are still renters…”

April 11, 2010 Leave a comment

An incisive comment about people’s misunderstanding of what a mortgage represents: it is a promise to pay back a creditor a lump sum plus interest payments. In what real sense, then, is a mortgage holder an owner of a piece of property?

Via Felix Salmon’s Twitter feed.

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Shocker: Real Estate Prices and Interest Rates are Inversely Related!

April 11, 2010 Leave a comment

One of the more annoying things about reading about residential real estate is this repeated claim by those who should know better that real estate is an inflation hedge.

But, if you stop and think about it for a moment, you will quickly realize that’s a foolish argument. Residential real estate is principally financed by debt; therefore, its price should move inversely to inflation, just as do other debt securities such as bonds.

In any event, it’s very refreshing to see the New York Times accurately reporting on the relationship between real estate prices and interest rates:

The impact of higher rates is likely to be felt first in the housing market, which has only recently begun to rebound from a deep slump. The rate for a 30-year fixed rate mortgage has risen half a point since December, hitting 5.31 last week, the highest level since last summer.

Along with the sell-off in bonds, the Federal Reserve has halted its emergency $1.25 trillion program to buy mortgage debt, placing even more upward pressure on rates.

“Mortgage rates are unlikely to go lower than they are now, and if they go higher, we’re likely to see a reversal of the gains in the housing market,” said Christopher J. Mayer, a professor of finance and economics at Columbia Business School. “It’s a really big risk.”

Each increase of 1 percentage point in rates adds as much as 19 percent to the total cost of a home, according to Mr. Mayer.

The Mortgage Bankers Association expects the rise to continue, with the 30-year mortgage rate going to 5.5 percent by late summer and as high as 6 percent by the end of the year.

I would say that I hope this augurs financial literacy on the part of buyers of residential real estate, but even I am not that optimistic.

Real Estate and its Consequences

April 7, 2010 Leave a comment

One of the interesting things about thinking about finance in terms of cognitive bias is that you suddenly see how pervasive certain biases are. In real estate, confirmation bias seems pervasive. For young professionals in their 20s or 30s, the thinking goes something like this: My parents bought real estate in the late 1970s or early 1980s and have made a lot of money on paper (or have sold real estate multiple times); therefore, it’s a great investment over the long term. Or, real estate flippers reason: My friend acquired multiple pieces of property and put his kids through college with the proceeds; surely, I am smarter than him.

The problem with this kind of thinking is that it ignores the underlying economy. If the economy does not grow, then real estate prices don’t grow. Real estate prices, over the long term, are a good proxy for an economy’s trajectory. If real estate prices are increasing, the economy is growing because personal incomes are growing and capital is cheap.

The other problem with the real-estate-is-a-good-investment thesis is that bankrupt municipalities and state governments do not make for places where people want to live. Or, rather, owning real estate in states and municipalities that can’t pay their bills is a troublesome concept. Just think of what happened to New York City real estate prices during its fiscal crisis of the late 1970s.

So, there are a lot of problems with owning residential real estate. The most important of these problems, and the one least in control of the homeowner, is the fiscal stability of the local and state government.

But, beyond those factors, about which much more could be written, lie a number of other troubling aspects.

Felix Salmon writes eloquently:

Homeownership is, if anything, a drag on the economy, since it funnels resources into unproductive overconsumption, and helps to impede labor mobility. There is absolutely no reason to believe that countries with high levels of homeownership, like the U.S., have better economies than those with low levels of homeownership, like Germany.

The survey just gets more depressing from there. Americans think now is a good time to buy a house, largely because they think it’s always a good time to buy a house. And they reckon — even now — that house prices are going up, or will at least stay stable.

Of course, free marketers will argue that people ought to be free to spend money on whatever they please, and if real estate pleases people, so be it. This is true. But it’s also important to remember that the real estate market is neither a free market nor a liquid one. One’s real estate follies can’t as easily be reversed as one’s foolish investment in overpriced Apple stock. The real estate market is also manipulated by the government, firstly by allowing homeowners to deduct interest from their taxes, and secondly by serving as a backstop in the form of Freddie Mac. Indeed, it has been the explicit social policy of the United States government over several decades to encourage homeownership, especially among the poor. While its origins have a laudable goal–encourage access to responsible use of credit–the practical realities of expanding homeownership to ever-greater numbers of people has been that many people who are not able to parse the terms of a mortgage document, or build a loan amortization table, or earn enough money on a monthly basis to service the debt inherent in taking on a mortgage, have become homeowners. Not all of these people should own homes. We’ve moved from being a society where housing is seen as a civil right to where homeownership is seen as a civil right. The former makes sense; the latter does not.

Finally, a note on rentals. Megan McArdle notes that rental prices in many metro areas have been increasing recently. Arguably, this bodes well for the economy: if rental prices are picking up, it means that tenants feel that they can pay more because they are more secure in their jobs. However, she also notes that rental price increases may also be a consequence of the government’s intervention into the housing market, which intervention has kept housing prices artificially high. This of course raises the question: if the government’s explicit policy is to encourage homeownership, why does the government also intervene to keep market prices high? The answer to this is obvious: the government likes to have its cake and eat it, too.

Update: Matthew Yglesias makes some very perceptive comments about how Greenspan & Bernanke egged the housing bubble on.

Loss Aversion

March 31, 2010 Leave a comment

Felix Salmon has a rather interesting blog post about loss aversion and sovereign investors:

Much has been written on the behavioral economics of loss aversion, where the pain of losing a certain amount of money is nearly always greater than the pleasure of gaining an identical amount. And what’s true of a country’s citizens is often true of its government, which is why the question of whether or not governments are making a profit on their bank bailouts is an interesting and important one.

He continues:

But the point is that if Treasury continues to speculate now, it’s mere speculation. When it was underwater on its investment, it at least could say that it was holding on to its stake until the share price rose enough that it could get its money back. Yes, that’s a form of speculation too. But it’s somehow a more acceptable form of speculation to hold onto an investment in the hope that you won’t lose money than it is to hold onto a profitable investment in the hope that you’ll make even more money.

Indeed, the whole argument about whether or not banks should mark their assets to market is at heart an argument about this very question. If banks hold loans on their books at par, even if they could never get 100 cents on the dollar for those loans in the secondary market, they’re essentially speculating that the value of the loans will return, over time, to more than they lent out in the first place. But they don’t call it speculation, they call it “commitment to our valued clients through thick and thin”, or something like that.

This is all very interesting, and I think Felix (and the behavioral economists) are correct when they say that the pain of a loss exceeds the pleasure of a gain. At least, intuition suggests that that is how man thinks. But, this makes me wonder: if man is so averse to losses, why is there such a clamor for short sales and mortgage cram-downs? Those are nothing if not recognition of losses made on a crappy investment.

A side question about real estate: Given that debt-financed assets lose value as interest rates increase, and most residential real estate is financed with debt, why do people claim that real estate is an inflation hedge? The likely answer is that most people who acquire real estate don’t really know what they’re buying and don’t understand its underlying economics.

On Housing and Bears

March 26, 2010 Leave a comment

I’ve long been bearish on residential real estate in the United States. There is too much leverage and too much cheap capital for housing prices to stay at their present levels. I believe this is true even of decimated areas such as Phoenix and Imperial County, CA.

The Economist reports:

IN ITS early days, the Obama administration argued over whether the financial system or the real economy should be the economic priority. Critics disputed the premise. They argued that no lasting recovery would be possible until housing markets were healthier.

Yet the housing-market recovery has almost run out of steam. Sales of new and existing homes have fallen for three consecutive months. As a result inventories have grown, putting downward pressure on home values. According to some measures, prices are dropping again: the Federal Housing Finance Agency reported national declines in December and January.

Things looked rosier last autumn. An $8,000 homebuyer tax credit helped stabilise both prices and sales, while Federal Reserve purchases of mortgage-backed securities held down mortgage rates. House values climbed across the country, and existing-house sales hit levels not seen since the end of the boom in early 2007. By September building-industry confidence had more than doubled from January’s all-time record low, generating optimism about new employment. Anxious to keep the recovery going, Congress extended the tax-credit programme to the end of April this year. But the magic has not survived the winter.

America’s weak labour market deserves much of the blame. Job losses continue to drive loan defaults. Foreclosures declined from January to February, but remained above 300,000 for a 12th consecutive month. Bank sales of foreclosed properties are depressing prices further and dampening the industry’s hopes (see chart). The latest data show declines in both builder confidence and new housing starts.

I don’t think this tells the entire story, however. The problem with residential real estate is that many, if not most, people who buy houses and apartments don’t really seem to know much about finance and economics, and assume that housing prices will continue to go up. The veneration for real estate is a bad sign: when it becomes a commonplace that “financially responsible people own homes” you need to question the unstated assumption, which is that it is financially responsible to own a home.

As I see it, there are two main arguments against home ownership. One is moral, and the other financial. The moral argument merely rests on the idea that mortgage debt ought not be tax-deductible. I ought not have to subsidize your purchase of a house merely because the government has declared that the interest on your debt is tax-deductible.

The more practical argument against home ownership is this: it encourages the use of cheap capital and leverage to buoy prices. Home owners buy houses by putting down anywhere from 0 to 20%, and then increase their equity stake over time by paying down the mortgage principal and accumulated interest.

But, in order for the home owner to make a positive return on this investment, he has to assume that, at some point down the road, someone else will pay substantially more for the place. The homeowner may be lulled into thinking “I am buying this house for $150,000; if I can get someone to buy it for $200,000 five years from now, I will have made money!”

But here’s the rub. You can’t calculate the return on investment in housing like you can for a stock. Housing has significant carrying costs: annual taxes, maintenance, and insurance are all significant expenses not normally budgeted into the home ownership decision, but which surprise and confound many a new home owner. Add to this the interest that compounds on the mortgage principal over the life of the mortgage, and you have a very large expense that you need to deduct from your returns calculations.

A final note on interest rates. The US government has undergone a massive borrowing binge; the only way to pay it off is to inflate it away or increase tax rates significantly. If interest rates increase, that will put downward pressure on residential real estate. As interest rates rise, capital, in the form of mortgage debt, becomes more expensive and so each dollar of debt buys less than before. The greater fool down the road cannot be counted on any more.