The Demographic and Economic Record Prior to the Housing Meltdown

“Toto, we're home. Home! And this is my room, and you're all here. And I'm not gonna leave here ever, ever again… oh, Auntie Em - there's no place like home!”

Source: IMDB.com, “Wizard of Oz (1939) – Quotes

With those words Judy Garland ended the most famous cinematic witch-hunt of the 20^th century. Today we are caught up in what may be the most vicious economic witch-hunt of the 21^st – who or what is responsible for the subprime and housing market meltdown?

But with all due respect to Dorothy Gale (and Toto, too!) I must perform a bait and switch. I will obtain the props for today’s post from Bell, Book, and Candle (Source: IMDB.com, Bell, Book, and Candle), a relatively minor cinematic sweep. Richard Quine’s 1958 romantic comedy starred James Stewart & Kim Novak (as the witch) and perhaps inspired television’s more familiar Bewitched. (Source: Wikipedia, Bell Book and Candle). Our travels along today’s road will, however, feature a glittering “rainbow” of charts to placate Dorothy’s fans.

This multi-part collection of posts will do three things:

1. Review the statistical demographic and economic record for the 20 years preceding today’s confusion. I will not be the first to suggest that what is surprising is NOT the meltdown, but the prior run-up. This should have been a signal – or bell – that our apparent prosperity was an unjustifiable mirage.
2. Identify what I believe is the most critical document – or book – authored by the most influential practicing monetarist of the 20^th century.
3. Suggest that if we are to see our way out of this morass then we must rely upon simple and transparent solutions to shed light - a candle - on the state of our markets, rather than opaque and arbitrary decisions resulting in constant confusion and surprise.

Today’s post will devote itself to just the first item in the above list. It will examine the “bell”, i.e., the signals along the way with respect to the unsustainability of recent home price increases. The “book” and the “candle” will follow.

THE BELL: RUN-UP FROM 1988 – 2008

Home Prices

Figure 1: Source: Freddie Mac, OFHEO, and S&P/Case Shiller, Author’s calculations.

The chart above simply displays the path of nominal home prices measured from 1988 through mid-year 2008, using two different measures: a) S&P Case Shiller National Home Price Index [“CS”], and b) OFHEO Purchase Only Home Price Index [“OFHEO”]. 

While both have recently experienced declines, OFHEO’s has been much more modest than CS’s. 

To briefly summarize analysis that has been performed elsewhere (including OFHEO’s own website “Revisiting the Differences between the OFHEO and S&P/Case-Shiller House Price Indexes: New Explanations January 2008”) the relative “volatility” of CS reflects its inclusion of non-conforming loans and market-weighted aggregation method. OFHEO, by contrast, excludes non-conforming loans and is population weighted. As a result, all else being equal, OFHEO gives relatively lower “weight” to what had been the phenomenally expensive East and West Coasts.

It is interesting to note, however, that while their paths have been very different over the past 20 years, they have ended up, more-or-less, in the same place. On an annual compounded basis, each has risen at a rate of roughly 4% per year. Below is a chart of the year-over-year nominal increases in each index.

Figure 2: Source: Freddie Mac, OFHEO, & S&P/Case Shiller, Author’s calculations.

Homeownership

Below is a chart of US homeownership rates. For the first six or so years in the 20 year period (1988 – 1994), homeownership rates were relatively stable at about 64.2%, just a touch below the 64.6% that they averaged in the 20 year period (1968 – 1987, not shown in chart) that preceded 1988.

Figure 3: Source: US Census Bureau CPS/HVS - Homeownership Rates for the U.S. and Regions, Table 14.

But, as the above chart makes clear, beginning in 1994 the homeownership rate began a pronounced 10-year upward march, until it reached a high of about 69% in 2004. It then “settled back” somewhat to today’s current level of just under 68%.

What could account for such an increase in homeownership?

Income Distribution

Figure 4: Source: US Census Bureau Income - Historical Income Inequality Tables, Table IE-1.

From the above, it should be clear that we won’t be able to suggest that the homeownership increase resulted from a redistribution of income from the richest 20% of the population (or quintile) to the relative poorer quntiles (i.e., quintiles 1 – 4). If anything, income became more highly concentrated in the wealthiest 20% of the population, as the fifth quintile’s share rose from 45.6% in 1985 to 50.4% in 2005.

Could the increase be tied to an increase in the “typical” or median, family income?

Figure 5: Source: US Census Bureau: CPS - Annual Social and Economic Supplement Table FINC-01; Federal Reserve Bank of Cleveland (CPI), and Author’s calculations.

The three charts above show the annual increase in a) median family income; b) median family income and inflation (CPI); and finally c) the real inflation adjusted change in median family income, which is just the difference between the change in the reported median family income and the inflation rate.

I’ve added a “red line” at zero, and my eye suggests that – in real (“inflation adjusted” terms) median family income didn’t budge over the twenty year period from 1988 – 2008.

Figure 6: Source: US Census Bureau, CPS - Annual Social and Economic Supplement Table FINC-01; and Federal Reserve Bank of Cleveland, CPI, Author’s calculations.

The chart above includes both the nominal and inflation adjusted, or real, median family income, and confirms my suggestion. When compared with the nominal figures, the real inflation adjusted, median family income has hardly moved in 20 years. While there was a slight increase between 1994 and 1998, real median family income in 2008 is at – more or less – the level it reached in 1998. There has been little change over the past 10 years. So perhaps the early increase in homeownership (between 1994 – 1998) is somehow related to this slight increase in real income.

But we still have not “explained” (or accounted for) the post-1998 increase in home ownership.

Compensating Factors

To do that, we would need to consider items or factors that are much more difficult to chart but relatively easy to review. Simply put, a combination of two factors enabled the post 1998 home price rise. They were a) the embrace of alternative mortgage products and the relaxation of underwriting standards; and b) generally favorable interest rate environment.

Initially, “alternative mortgage products” were simply adjustable rate loans, which offered relatively low initial rates. Over time, the products became much more esoteric (to include AltA, Subprime, Interest Only, and Option ARMs) and the underwriting followed in kind.   

Thirty year conventional conforming fixed rates, that had topped 10.00% in 1988, broadly fell throughout the 20 year period, so that by 2008 they averaged roughly 6.00%. 

The following two charts are “suggestive” of the rise in “alternative product” market share and general decline in rates that made homes more “affordable” despite - as we have seen – relatively inhospitable income growth and distribution fundamentals.

Figure 8: Source: 30 Year Conventional Fixed Rate, from Federal Reserve H15 Website.

The Run-up, Concluded (Alarm Bell)

The unprecedented home price run-up that more-or-less ended in the summer of 2006 is distinctive in that it occurred during a period marked by virtually no real growth in family income and little change in the distribution of income. Two factors supported home price increases. First, the embrace of “alternative products”, which differed from the “traditional” 30 year fixed rate loan. Second, a generally declining rate environment. The sustainability of home prices depended upon continued access to alternative products bearing relatively low or declining interest rates.

During the 1988-2008 period income did not keep pace with the rise in home prices. Below is a chart of nominal (i.e., non-inflation adjusted) home prices and median family income in which all have been rebased so that 1988=100.

Figure 9: Source: See Figure 1 and Figure 6.

With 1988 as a base of 100, home prices are at about 220 (using either CS or OFHEO). The corresponding median income figure (also rebased to 1988) is about 187.  

In order to achieve some sort of rough parity between home prices and income (of the sort that prevailed from 1988 to 2001), let’s assume that:

a)     income is NOT reduced by the recession that I believe (see prior post, “Learning Curves”) began one year ago;

b)     the “product innovation” associated with subprime and AltA loans does not reassert itself, and

c)     interest rates do not continue to drop. 

If so, then the chart suggests that home prices will need to drop by an additional 15% from their current levels to re-establish their historical relationship with income.

THE NEXT POST – THE “BOOK”…

Our next post will start with a look at what I believe is the most critical document - or book - authored by the most influential practicing monetarist of the 20th century.

- - - - - - - -

DISCLOSURE

While I own, and am in process of paying off the mortgage on, the house in which I live, I have not hedged my exposure to home prices using S&P Case Shiller, RadarLogic RPX, or any other home price derivatives or indices.

REFERENCES [Accessed 2 Nov 2008]

Federal Reserve Bank of Cleveland – US Inflation.

Freddie Mac CMHPI.

OFHEO Home Price Index.

OFHEO, Revisiting the Differences between the OFHEO and S&P/Case-Shiller House Price Indexes: New Explanations January 2008.

S&P/Case Shiller Home Price Indices.

US Census Bureau, Housing Vacancy Survey, Homeownership Rates for US & Regions - Table 14.

US Census Bureau, Income - Table IE-1.

Comments

[gabe borens...:]

The spike in the home ownership has a much simpler explanation.
Sometimes after September 11,Mr.Greenspan had decided that the deflation not inflation is the real risk.Accordingly ,under Mr.Greenspan's leadership,the FED had lowered the FF to 1% creating the largest rate implosion since the Geat Depression. The almost record decompression had allowed lending institutions to create unprecedented low level of the mortgage rates(floating) causing the massive hike in the home ownership.
Low rates had encouraged the sub-prime lending(homes).
By the end of 2006 20% of allof the homes were financed by the subprime loans.
I have issued back then a warning about the vulnearability of the housomg sector.
Comes Mtr.Bernanke who is concerned about inflation.
The FED under his leadeship drives the FF to 5.5% driving the mortgage rates substantially higher and jeopardizing significant segment of the housing industry.
The current turmoil is a reflection of the latter monetary blunder.
Now ,the various policies in place will contribute to stability in housing and the economic base from which we are about to witness a major economic rebound- housing sector included(slight lag).
That is the synopsis of the real story.

2008 Nov 03 10:45 AM

[ebreen:]

You neglect to discuss the effect of tax law change on home ownership during your sample period. Housing has long been the most popular tax shelter for the common man because the mortgage interest is deductible from earned income and the capital gains had been deferred until retirement with a high deductible on those gains. This feature becomes more important during times of high inflation as the inflation pushes the common man into higher tax brackets. The scheme was made even more attractive in 1996 when the tax law was changed to exempt the first $500,000 of capital gains from primary residences on a current basis so that there was no need to wait until retirement to capture the deferment and the mortgage interest remained deductible. The 1996 tax change had a significant effect on the appreciation of home prices during the period 1998 to 2008.

With regard to Gabe's comment above, the real mistake that Greenspan made was not so much his reducing the interest rate to 1% after he had made a deflationary mistake the collapsed the Asian Currencies the Argentine peso and the US manufacturing base...after all there was no real inflation during the period Greenspan left the FFR at 1%...the real mistake was the way he raised the rate, experimenting with "Gradualism". Greenspan theorized that by telegraphing to the market that he would raise rates incrementally by .25% each month as he sought to find the holy grail of interest rate 'neutrality' (don't ask Alan what it is but be sure he will know it when he gets there). This was terrible mistake as it was based on a rate raising policy that was supposed to fight an inflation that was not present but had the unintended effect of causing future transactions to move forward in a way that created inflation. Stated differently, by telling the market that he would raise rate a little bit each month indefinitely, he encouraged all potential borrowers and developers to move thier plans forward in order to avoid the promised higher rates. This exarcerbated the housing demand and refinancing demand that was already being pushed by low interest rates and tax law subsidy and drove a housing appreciation bubble. It also put false information about supply and demand into the market encouraging builders to overbuild to meet the false demand that was actually a pulling forward of future demand. When the trough finally hit as the rate increase accumulated we were in a terribly overbuilt and overbought situation. The evolution of mortgage backed securities during this period turned the real estate bust into what has now become a credit collapsed fueled by asset collateral destruction.

2008 Nov 05 01:03 PM

[joof:]

Greenspan did gradualism in 04 in part to permit carry trade in the mortgage security business , and in funding mortgage bankers, to unwind over time rather than all at once . Of course there would have been much less carry trade if he hadn't kept the short rate too low for too long, and there would have been fewer crappy ARM mortgages if short rates had been higher . So you would have had a lower bid for mortgage packages, and the rates on the mortgages would have been higher,\. That capital rationing could have stopped the bubble in 03 or o4, before the wild excess of 05 and 06 - the latter is what caused the catastrophe.

2008 Nov 05 06:40 PM

[Ira Artman:]

I'm finding myself becoming more and more sympathetic to Chairman Greenspan while others seem to becoming less and less or critical.

Why?

I've been thinking about it, and below is best that I can do re: why I'm becoming more appreciative of him.

First, I wonder if the Chairman, who devoted more than a generation of his life to public service (think about that ...!) may simply have under-estimated greed or self-destructive nature of other "market participants."

If so, not sure that it is/was "his fault." When lemmings dive off a cliff, and you watch them, is that "your fault?" Don't know.

Second, if monetary policy acts with long and variable lags [i.e., you NEVER know how long things will take to respond, only guess] then the simplicity + clarity of his choice of tools (as opposed to those in play currently) stands out in my mind as the biggest difference between his choices and choices of current Fed Chairman. Why so much complexity now?

2008 Nov 06 06:32 AM