May 27, 2017

The Question Lingering Behind Every Headline

A weekend topic starting with KGW in Oregon. “‘I was on the edge of a cliff, hanging by my fingernails, fearing that my kids and I would have to leave Portland,’ Roscoe Ryan remembers. The 41-year-old single mother had been renting a home in Portland’s St. Johns neighborhood for three years when the bad news came. ‘The landlady told me she wanted to sell the house, and I would have to move,’ she recalls.”

“Then the owner offered to sell the 800-square-foot house to Ryan for $290,000. Ryan, who earns $30,000 a year working at an organic grocery store, initially was hopeful. But when lenders told her she’d need to make a $35,000 down payment to qualify for a mortgage, she balked. Scraping together a down payment bigger than her annual salary seemed impossible. Ryan began scrambling for alternatives. At $290,000, the price tag on Ryan’s home is an anomaly in Portland. The city’s current median home price is $422,450. A down payment of 10 percent on a house of that value pencils out to $42,000 — more than half the $73,000 annual earnings for a median-income family of four. That’s a lot to save when rents are exploding and incomes are stagnating, says Chris Bonner, director of the city’s Bureau of Planning.”

“Ryan eventually purchased her home with the help of a modest inheritance, plus a coveted, publicly funded $15,000 down-payment-assistance grant and counseling from Portland Housing Center. She is near her financial limit, with housing costs that consume well over half her earnings and exceed what she was paying for rent.”

“But Ryan believes the benefits are worth the costs. ‘I’m happy,’ she says. ‘My kids, who are 8 and 11, can stay at James Johns Elementary School, and I can walk three blocks to work. I love our whole St. Johns neighborhood.’”

From Neel Kashkari, president of the Federal Reserve Bank of Minneapolis. “Everyone can recognize a bubble after it bursts, and then many people convince themselves that they saw it on the way up. Michael Lewis’ highly entertaining book, ‘The Big Short,’ is a perfect example. With the benefit of hindsight, Lewis picked four guys who happened to be right this time. It would have been far more impressive if Lewis had identified and written about them when the housing bubble was forming. Why didn’t he?”

“Because on any given day, there are lots of people predicting various doomsday scenarios. How do you know which one is right among all the cranks? And maybe today’s crank will look brilliant tomorrow. As they say about broken clocks…”

“Monetary policy is a blunt instrument: We set the overnight interest rate, and it then affects rates all across the country, across different asset classes. That’s one of the biggest challenges in trying to use monetary policy to change asset prices. The Fed also has regulatory and supervisory tools that it can use to change the behavior of the financial institutions it supervises.”

“While the Fed can limit the amount of debt used to buy stocks, some countries can also adjust the loan-to-value (LTV) requirements of mortgages. By increasing the down payment requirement (lowering LTVs), those countries could directly target the housing market if it were showing signs of overheating. This is an example of a highly targeted tool that, in theory, should be effective in slowing down the housing market without slowing down the entire economy the way raising rates would.”

“My takeaway from these countries’ experiences is that when asset prices are climbing rapidly, they can be very difficult to slow down, even with policy tools that are targeted squarely at the asset class. That suggests to me that if central bankers were to try to use monetary policy to slow those bubbles down, the rate increases necessary to be effective would likely be large, resulting in high economic cost to the rest of the economy.”

“My takeaway from the varied costs of false negatives is that we must first try to assess the cost of a correction before we determine whether to try to address asset prices that appear elevated. What determines if an asset price correction will trigger a crisis or just a milder downturn? Debt seems to be a key factor. Housing is a huge, highly leveraged market. The mortgage market is roughly a $10 trillion market.”

“Today, people often buy homes with 20% as a down payment. Going into the financial crisis, people were putting little to nothing down with those infamous no-doc loans. Those loans were bundled into mortgage-backed securities, which were then bundled into collateralized debt obligations, and then banks bought them with yet more borrowed money. It was leverage on top of leverage with little equity supporting it all.”

“It’s the Fed’s job to put the brakes on the economy before it overheats, which almost by definition will be unpopular with many people. So why should public awareness matter to the Fed? Regulators don’t exist in a vacuum. The Fed ultimately gets its power from the American people, through authorities granted to it by their elected representatives. Yes, the Fed must make tough, sometimes unpopular choices, but the ability of the Fed to impose and sustain steep costs on the economy and Main Street is limited by the willingness of the people to accept those costs.”

“This essay has been pretty skeptical about the powers of the Fed to identify and slow down bubbles. But there is something we can do that does not require us to identify bubbles in the first place. We can make sure our financial institutions are sound and can withstand the shock of asset price corrections.”

From CBC News. “It’s the question lingering behind every headline. It’s whispered among homeowners, would-be buyers and sellers, economists and policy-makers. What actually happens if Canadian real estate prices crash? On the one hand, a crash might be good for some Canadians already priced out of the market. And even a dramatic 40 per cent drop in prices would set homeowners in markets like Toronto or Vancouver back, what, two or three years?”

“But there are broader concerns for the market and the economy itself that could prove devastating. Home prices are notoriously off the charts. Everyone from the governor of the Bank of Canada to the chatty guy in your local cafe has said, repeatedly, that this increase in prices is not sustainable. But what that means, precisely, is vague.”

“First of all, what is a real crash? Think Toronto in 1989. Prices fell off a cliff. The average cost of a home in Toronto hit a whopping $273,698, a 30-year high. Then the bottom fell out. By 1996, that average had fallen to $198,150. (Yes, you read that right, you could buy a home in Toronto for a mere fraction of the $920,000 it costs today.)”

“Benjamin Tal, deputy chief economist at CIBC World Markets, says the important question isn’t how far prices would fall, but why they fell in the first place. If prices fell because Toronto’s well established supply issue was sorted out, that could actually prove positive for the economy. But if they fell as a result of a quick rise in interest rates, as happened in the United States in 2006, the impact could be severe.”

“‘The higher interest rate environment would lead to a significant increase in debt financing as opposed to other spending,’ says Tal. That would require people to spend more covering their mortgage and leave them with less to spend elsewhere in the economy. ‘Then you get into a consumer-led recession. And this would lead to increased unemployment and people defaulting and continued decline in prices. That’s the worst scenario.’”

“Based on this theory, it’s not hard to see why a double-digit correction in prices could cascade through other parts of the economy, ‘and that can feed on itself,’ says Tal.”

“On the upside, just about everyone agrees that nightmare scenario is still unlikely. Prices are slowing in Toronto and Vancouver. And Tal says one big difference between today’s situation and the U.S. housing crash is that everyone in this country is trying to slow down the market. ‘It’s banks, even developers, clearly policy-makers. You don’t have the situation where banks are seeing green and trying to maximize profits. In fact they are really trying to slow it down. Regulators are trying to slow it down and more is coming.’”