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Thursday, November 7, 2013

Housing Recovery: The elephant has given birth to the mouse

Housing, like the rest of the economy: Our forecast - bouncing along the bottom with downside risks.

We have seen the Fed and others point to the housing market as the linchpin of a recovery. It is true that housing has led recoveries in the past. But blaming housing is like blaming the slow flow of water as the obstacle to irrigation downriver. It may be true, but it is not the cause. It is the collapse of the geology upstream that has dammed the river. A catastrophe is in the works if we don't address the causes.

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The economic geology that has collapsed is employment and debt. When jobs recover and/or debt levels are reduced, housing is the channel by which workers invest. As we've been harping on for ... as we've said, investment is the key. It is wrong to say that only capitalists invest, particularly these days. Workers invest, government invests, businesses invest.

In 2008 we followed the lead of Robert Kuttner and others arguing for a Home Owners Loan Corporation paired with substantial, sustained public investment in roads, schools, healthcare, energy infrastructure. The first to deal with the private debt crisis and the second to deal with the jobs crisis. Didn't happen. The Obama stimulus was offset by local and state governments contracting. We did not get the revenue-sharing we needed to make the public investment -- which was about one-third of the Obama stimulus's $700 billion -- provide anything but a bump in employment and growth.  A significant bump, but not enough to avoid being caricatured as a failure.

But what does this look like inside the Fed?

From Cleveland Fed President Sandra Pianalto: Housing in the National Economy: A Look Back, a Look Forward
A major reason why the economic recovery has been so slow and has required so much policy support has been the performance of the housing market. Ordinarily, deep recessions are followed by strong economic snap-backs. But an economist at my Bank and his co-author found two exceptions to that rule: the Great Depression and the recent recession. [see: Deep Recessions, Fast Recoveries, and Financial Crises: Evidence from the American Record]. In this last episode, the evidence points to the collapse of the housing market as the key explanation for the slow recovery. Most of the time, home construction and spending on household goods can be counted on to provide a big push to the recovery. Historically, residential investment has contributed about half a percentage point to GDP growth in each quarter during the two-year period immediately following a recession. During the first two years of this recent recovery, however, the contribution from residential investment to GDP growth was basically zero. Because the recent recession was caused in part by a housing crisis, the housing market was too damaged to provide its customary lift to GDP growth.

This is analysis? Most of the time deep recessions have sharp bouncebacks? This is looking at the economy as a kind of weather pattern. Let's see what happened in the past in a storm. But private debt is like global warming. It makes the events more severe, and can lead to a self-reinforcing downward spiral, like maybe the melting of the arctic ice. In the case of the economy, it is debt deflation.

We should notice that most recessions in the postwar -- all those that came with a sharp bounce-back -- also saw inflation reducing the real burden of debt. We have the opposite today.

Sorry, back to the Fed president:
...So that is where we have been--a housing bust followed by a recession and sluggish economic recovery that was made all the more sluggish because of the weakened housing market. Looking ahead, tight conditions in mortgage credit markets will continue to hold the housing sector and broader economy from getting back to full strength more quickly.

.... In a recent Federal Reserve survey of senior loan officers, bankers reported that credit standards for all categories of home mortgage loans have remained tighter than the standards that have prevailed on average since 2005. Financing companies no longer assume that houses will provide adequate collateral for borrowers with fragile credit histories. In addition, financial market regulators are standing vigilant to ensure there is no recurrence of the housing bubble that almost brought the financial system and global economy to its knees.
Moreover, access to mortgage credit has become far more restrictive. To get a mortgage today, it helps to have a very high credit score. Lenders are more likely to extend mortgage credit to consumers they perceive as very low risk. As a result, the pool of potential mortgage borrowers has shrunk. Households with low credit scores that were able to get credit before the crisis now are the least able to refinance their homes, or to obtain new mortgage loans. These are also the households who seem to be especially cautious in their spending these days. For these households, the days of extracting "free cash" from their homes are over. It is now mostly households with ample savings that spend and save as they normally would.
Another development that could lead to tighter credit conditions in the future involves the secondary mortgage market. The outlook for the government-sponsored enterprises Fannie Mae and Freddie Mac is uncertain. The GSEs, as they are known, had to be rescued after the financial crisis and Congress is weighing reforms that might greatly reduce the government's large position in housing finance. The housing market today is being heavily supported by Fannie and Freddie. Without the government guarantees on mortgage-backed securities, the amount of credit available for mortgage originations would be substantially smaller today.
To sum up my remarks, it was the housing bust that got us into this situation. And the lasting consequences of the bust continue to hold back the housing market and broader economy. The big picture is that many households are still adjusting to the large shock to their net worth that occurred during the financial crisis and are dealing with uncertainty over their future earnings prospects. For these reasons, consumer spending will likely continue at a moderate pace. But over time, I expect these effects to fade and credit conditions to improve.
Why? Let me see a show of hands. How many think financing conditions will come around and make housing boom again. No fair saying in ten years. The Fed has put all its efforts into financing, with the QE's, bank bailouts, and so on. None, or virtually none, have gone into the condition of the demand side of the market.

I don't see any hands.

You are seconded by a report out that says even though banks are easing lending standards, there is little demand for the loans.

Housing is an important illustration of Hyman Minsky's three financing structures:  hedge, speculation, Ponzi. In the beginning, when housing is purchased as a place to live, you have hedge financing, what we think of as investment. The investment is paid back by the services of the house. When equity increases, and home equity loans cash it out, you have a form of speculative financing (say you take out the equity to pay the mortgage), what we think of as rollover financing. When the boom comes, it becomes Ponzi financing. The house is a play on the future rise in house prices. This is the reason people bought bigger than they needed. The bigger the play, the bigger the return. There at hand was the requisite easy credit. Collateral was no problem because the house was worth more each year. No Ponzi bubble can exist without the credit. Then there was the bust. House prices receded leaving the debt exposed.

Now we have too much debt and incomes that are sagging, and no prospect of jobs taking off.

Let's be clear, an economic downturn can turn hedge into rollover into Ponzi. But let us also be clear, there is no problem with hedge financing. Investment that creates value from which the investment is repaid is exactly what we want. Workers can do it, business can do it, the government can do it. If the government does not invest, but chooses instead to return taxes to the public to promote consumption, and in the presence of over-capacity, we are no closer to recovery. It does not take all workers to create all consumption goods. That is a zero sum game, and it becomes negative when profits are necessary.

Profits that are simple rents on market control, like in health care, for example, or even technology patents, do not create jobs, do not grow economies, do not prepare for the future.

It is absolutely absurd to favor the one percent so they can make profits on rents, as if that is going to in any way, form or fashion create jobs.

Since we're taking pot-shots at the banks and the wealthy, we have to remark on the $13 billion settlement by JP Morgan.

In a Ponzi bubble, particularly one where credit is so easy, it is literally being forced on all those who don't willfully refuse it, there will be fraud. What is curious to us is that there are these cases where banks -- JP Morgan, Bank of America, Barclays, and their ilk, who settle without admitting fraud. Or like SAC Capital Advisers, where fraud is admitted by the company, but not by the chief fraudster, Stephen Cohen.

Does anybody really believe, as Elliott Morss says, that when JPM can afford the best lawyers in the world, the company would settle without there being solid evidence of fraud. $13 billion is a lot of money. Health care for kids was vetoed by Bush because $2.5 billion was too much.

Morss goes into detail, which I will excerpt here:
First, he asks 
"whether the buying and selling of mortgage packages could constitute fraud/solid evidence when they buyers and sellers were all quite knowledgeable and “playing the same game”. Fraud is defined as “deceit or trickery perpetrated for profit”. But what if both parties to an alleged fraud know what is up? That is, they all knew there were very risky mortgages in the packages they were buying and selling.
The key players:
"There are two types of mortgage writers: those with their own money and those that must sell off their mortgages (mortgage companies). Banks have their own money (deposits) as do private equity, hedge, and other funds. In contrast, mortgage companies don’t have their own money and are dependent on their being buyers for the mortgages they write. It turns out the vast majority of mortgages originated in banks are not held by the banks that originated them but are instead securitized and sold as securities to investors.
So both the banks and the mortgage companies use the same financial model: earn commissions by selling off mortgages they write. One can draw two inferences from such a model: Banks won’t care as much about the quality of the mortgages as they would if they planned to hold them to maturity; and a certain amount of misrepresentation can be expected when the banks sell off mortgages and mortgage packages.
So who are the buyers? Back in 2005-2007, the biggest buyers were the Feds – Freddie Mac and Fanny Mae who both work under the Federal Housing Finance Agency (FHFA) umbrella. Under law, they are not allowed to purchase mortgages or mortgage packages that do not have well-documented income with upper limits on mortgage size based on income. So what happened? The Feds ended up buying high-risk packages and according to news reports, are only now are suing for misrepresentation.
 It is hard to believe the Feds did not know what they were getting at the time. One would hope they were doing some sampling of the packages they were buying to insure they were as represented. Maybe not. But I just cannot imagine working for one of these agencies where all you were doing was buying this stuff and not asking what you were getting.

A piece by Piskorski, Seru, and Witkin[1] (PSW) identifies two types of misrepresentation.

“More than 6% of mortgage loans reported for owner-occupied properties were given to borrowers with a different primary residence, while more than 7% of loans (13.6% of loans using a broader definition) stating that a junior lien is not present actually had such a second lien. Alternatively put, more than 27% of loans obtained by non-owner occupants misreported their true purpose and more than 15% of loans with closed-end second liens incorrectly reported no presence of such liens.”
Lehman Brothers was in a class by itself on misrepresentations. But when the misrepresentations of the financial firms acquired by Bank of America (BAC) and JPM are included, JPM tops the list. However, the precedents for misrepresentation suits are increasing. That means Barclays, HSBC, Citigroup, Deutche Bank, UBS, Nomura, RBS , and Morgan Stanley can also expect misrepresentation lawsuits soon. And it won’t just be the Feds initiating lawsuits. Other levels of government and private firms are watching the growth of precedents with great care.
[These could] well be the “tip of the iceberg” in terms of misrepresentations, as the piece notes, because the authors looked only at two types of misrepresentations, this number likely constitutes a conservative, lower-bound estimate of the fraction of misrepresented loans.”
It is quite likely that even greater misrepresentations were made by mortgage writers on borrowers’ income and by assessors on real estate values. And misrepresentations on these items could also constitute grounds for legal actions. And there are real grounds for damages. For example PSW pointed out that on the misrepresentations uncovered, delinquencies were 60% higher “when compared to otherwise similar loans”.
Were Both Parties to These Transactions Aware of the Risks?
PSW: “Lenders seem to be partly aware of this risk, charging a higher interest rate on misrepresented loans relative to otherwise similar loans, but the interest rate markup on misrepresented loans does not fully reflect their higher default risk”.

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We aim to demystify and diversify economics in the public eye; to educate ourselves and other students in a more reflective economics; to inspire divergent economists to engage with one another in debate; and to promote a politics of responsibility with academic economists.

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