Teenage achievement and the house price bubble

The general economic context of where and when you grow up matters. Think, for example, of those raised during the Great Depression in the US or World War II in Europe who are likely to be very careful with their spending, never through anything away and finish their plates. In this regard, what should we expect from those reaching adulthood in the past years?



Daniel Cooper and María José Luengo-Prado study the impact on teenagers of the house price boom before the current crisis in the United States on educational outcomes. Using the Panel Study of Income Dynamics (PSID), they find that a 1% higher house price at age 17 leads to a 0.8% higher income as adult if the parents owned the home, 1.2% lower if they were tenants, after conditioning for socio-economic characteristics. These are big numbers. They can be justified by the observation that higher house prices allows more collateral to borrow for education. Indeed households with a below median non-housing wealth saw even a 1.6% boost in their child's future income. To explain the impact on tenants, I suppose one can explain it with higher tuition in reaction to larger loans, which tenants cannot afford as well.



The consequences from the recent house price crash are daunting in this context. And given that state are disengaging themselves from financing their public colleges, leading to even higher tuition, the outlook is even worse.

Compartmentalized thinking in personal finances

Even before the crisis hit in the United States, there was talk about how foolish it is to get balloon mortgages, with low teaser rates for a few years. Yet people where going for them, either because they had expectations of strong income growth, or because they were time inconsistent or very impatient. Or people do not understand the true cost of the loan.

Johan Almenberg and Artashes Karapetyan document a phenomenon that is in some ways similar in Sweden. Mortgage interest is deductible from taxes for personal loans, but not when a co=op takes a loan. Yet people seem to favor financial situations that shift debt from personal to co-op loans. On average, the equivalent of US$540 a year are left on table. This can be explained by what is termed salience of debt. People only care about the costs they directly see, and the interest payments of the co-op are not itemized in the fees. The authors survey co-op apartment owners on how they think about their finances. It turns out people a very aware of their personal finances, but completely ignorant of the co-op finances. They never considered the trade-off between personal and co-op debt. That last point may indicate that ignorance may be more important than salience, though. This is reinforced by the fact that market price do not seem to reflect the tax difference.

Economists did see the bubble coming

Economists have been lambasted for not alerting the public that a bubble was in the making in US real state, except for a few oddballs. Of course everyone is wiser in hindsight, but what did economists actually say? It never hurts to look at the facts.

Martha Starr analyzes statements in 24 California newspapers from 2002 to 2007. From 1998 to 2005, the state's house prices increased by more than 10% each year. This prompted the newspaper to run 379 stories with 688 statements by economists on house prices. Academics were clearly warning that house prices were not sustainable. Economists employed in the real-industry, however, were resolutely optimistic. What emerges is a mixed message that gave no guidance to the public, which was even reassured by positive messages from the Federal Reserve.

It is entirely possible opinions could have diverged based on the same evidence. But it seems more likely the professionals were not acting in good faith. They had everything to lose from predicting an end of house price growth. The media should have learned not to trust such biased speakers, yet they continue to be interviewed. Now as to why Greenspan and then Bernanke were so optimistic is beyond me. There speeches are definitively strategic and while they may have realized there was a problem, they may have tried to prevent a bubble from bursting too brutally. Then all the credit to them for trying. But one cannot postpone indefinitely a bubble from bursting, and they knew that.

Latin American home owners are happier, unlike US ones

There is a myth saying that owning a home makes people happier and leads them to contribute more to their community. In an earlier report, I pointed out that this idea is a myth for the US homeowner. What about elsewhere?

Inder Ruprah finds that Latin American house owners are indeed happier. This is obtained from a survey where people declare how happy they are, the reliance of which many researchers have called into question. But happiness studies slowly get more acceptance, especially when results are clear cut, like here. Of course, homeownership could be correlated with some unobservables that matter a lot for happiness, for example economic and social standing. There is a variable that could capture this in the regression, "Interviewer assessment of economic situation of the household," but I have no idea how reliable it is.

PS: The pdf file is 7.3MB large. It took me five attempts to download it. There are a few very simple graphs and histograms in the paper, in other words no reason to have such a large file, but for unnecessary front and back covers. But if the IADB is willing to waste bandwidth that way, especially as its target audience in Latin America may not necessarily enjoy fast internet.

How to finance housing in Islamic economies

Financial markets in Islamic countries face large challenges, as the law prohibits, in principle, interest. Lenders and creditors need to go through all sorts of hoops to find a legal way to allow for something that is interest in spirit but not in fact. One consequence of these hurdles is that the mortgage market is almost non-existent, and this has translated into an absolutely desolate residential stock in many Islamic countries. Clearly, improving the lives of people goes through an proper and active mortgage market. How could this be achieved in an economically and legally reasonable way?

Zubair Hasan claims to have solved this problem. The current practice is to sell the house to a bank and then buy it back with a mark-up added. This margin corresponds of course to interest, but this practice seems very controversial in case of default, as banks insist on full payment of the debt disregarding any installments already paid. This trouble arises because of the ownership structure and this is why the idea is to propose joint ownership between the "landlord" and the bank. The latter gets gradually reimbursed for the amount of the debt and also receives rent for the share of the house it owns. This solution boils down to the same outcome as for a classic, western mortgage. The trouble is that it involves three separate contracts (joint ownership, lease and buyback), and Islamic law prohibits making a contract conditional on another one. This is very constraining.

Hasan's idea is to replace the full ownership of a share of the house by the bank by a constructive ownership, much like a stock broker possesses the stocks his clients really own. The author thinks, without being certain, that this should satisfy Islamic law. But what this highlights is that Islamic law seems to put absurd hurdles on economic activity and that, maybe, it could be adapted to modern circumstances.

Interest-only mortgages and house price bubbles

Bubbles are annoying. First because they are difficult to identify, second because they indicate that prices do not reveal the "proper" information, and third because they lead to misallocation of real resources and much hardship when they burst, which they inevitably do. You want to prevent bubbles from happening, but again they are really difficult to identify, especially in real time.

Gady Barlevy and Jonas Fisher may have figured out a clever way of identifying bubbles in house prices. Using some theory, they find that interest-only mortgages should only be used if there is a bubble. Turning to data, they find that the use of such mortgages is rather sparse through time and space, and when it is used, it corresponds pretty closely to episodes where we suspect bubbles could be happening. In particular, interest-only mortgages mere mostly used in areas with inelastic housing supply, which are more prone to bubbles.

How not to encourage home ownership

Many governments try to encourage home ownerships by various means. I am not convinced this needs encouraging, as it leads to over-acucmulation of residential capital. Additionally, it is a myth that home ownners are happier and better citizens, as I reported previously. But suppose, for a moment, that a government really wants to increase the home ownership rate. How could this be best achieved. Two recent papers look at this.

First, Emre Ergungor compares mortgage interest subsidies to mortgage down-payment subsidies, and finds the latter work better. It is clear that down-payments are a significant hurdle for first time home buyers, and the recent crisis has at least partly been attributed to too easy down-payments, so one needs to be careful with this result. This is why Ergungor looks at loan performance for low to middle incomes. He finds that a one percent interest reduction is equivalent to a $3200 down-payment subsidy in that it leads to a 75 point reduction in default rates, and the latter is much cheaper to implement.

Second, Christian Hilber and Tracy Turner make the point that the tax deduction of mortgage interest makes mortgages more affordable but also raises house values. So in the end who benefits? Apparently only higher incomes in markets with few regulations. Hilber and Turner do not try to explain why this would happen, but I suppose this has to do with the high marginal rates on tax expenditures for high incomes, although I cannot explain the regulatory impact. In any case, there is more evidence that this type of subsidy should be abandoned.

US house prices have to fluctuate more than elsewhere

In retrospect, the recent swing in house prices in the US a unusually large by international comparison. And it is not just the last swing, if you look at local markets, there have been many episodes before the current one where house prices went through a wild ride up or down. What is so special about the US? Is it irrational exuberance, like Robert Shiller has claimed? Or does this have to do with some characteristics of the US economy?

Nobuhiro Kiyotaki, Alexander Michaelides and Kalin Nikolov design a life-cycle DSGE model of the house market with land and mortgages. There is also capital that is used to build residences on land, as well as commercial real estate. The interest rate is exogenous, which allows to observe what happens when the world interest rate changes. It turns out that real estate prices then fluctuate more if land is a larger share in it value. The same happens with fluctuations in productivity. Why is that so?

The reason is a change in fundamentals leads to large reallocations towards real estate. If land is plentiful, so you want to use it, but this requires large amounts of capital to build all those houses, and in the meanwhile house prices go up. Things are much smoother when land is less important for real estate, like it is in Europe. And interestingly, the downpayment to obtain a mortgage has no impact on this volatility of prices, countering some recent claims.

Bubbles with collateral and infinite credit

Rational bubbles occur when people believe that prices will increase into the infinite future, which makes that they invest in more assets and prices really increase. But equilibrium models have difficulties replicating such phenomena because this increased wealth also induces, at some point, people to consume more, and then the budget constraint bites and halts the bubble. So how could one still get a rational bubble? By relaxing the budget constraint.

This is what Christopher Reicher does in a way that is reminiscent of the US before the crisis: through the provision of unlimited credit, which is possible if real estate is used as collateral. This sounds rather intuitive, as long as lenders are willing to go along. What is more interesting is that the model shows that there are monetary and fiscal policies that can prevent bubbles from happening. One is to apply the fiscal theory of the price level to credit markets, that is, to make sure the price level instantaneously responds to land prices to deflate the debt. If this is difficult to implement, and it would, another way to deflate a bubble is the make sure the returns of assets are lower by increasing interest rates of bonds, which makes them more interesting than real estate. Of course, one could also tax away the bubble. And one has first to recognize that there is a bubble.

Is it good to have a college in town?

Suppose the following experiment. A town has some open space and can choose to develop it following the pattern of the existing town or attract a college campus. Is the campus worth it? On the plus side, it should attract more educate residents and bring amenities the town does not have to pay for. On the negative side, and that is a big negative, the town will get no taxes directly from this college (the recent attempt of Pittsburgh to tax tuition has failed, sort of). And college students tend to be rowdy.

Donald Vandegrift, Amanda Lockshiss and Michael Lahr perform the kind of hedonic regressions that have been used to value various amenities and add college dummies. It turns out size matters. A college raises house values by 11%, but larger enrollments reduce house value. And in any case, the presence of a college increases the tax base by 24%. While college towns will always complain about the non0-taxable real estate, they should be happy about the general equilibrium effect from colleges, which are strongly beneficial.

Houses are a poor way to share risk

Owning a house is a terribly risky investment, not only because of the volatility of its value, but also because of the high correlation between house value and local economic conditions which also determine labor income. In other worth, owning a house you live in is among the worst things one can do in terms of diversification. Two recent papers revisit some aspects of this.

Dmytro Hryshko, María José Luengo-Prado and Bent Sørensen show that houses still provide substantial consumption smoothing ability to households suffering from a job loss. Obviously, when there is job loss and house equity loss, things look bad, but home owners still do better than renters. What this means is that the fact of holding some equity is more important that the lack of diversification. But it remains that better diversified households would still do better.

Todd Sinai and Nicholas Souleles argue that the risk is not that bad once you consider that when you sell a house you need to buy another one. So if you have to sell low, you are likely to buy low as well. This works obviously if you move locally, but appears also to work quite well for moves to another metropolitan area, as house prices across such areas in the US have an expected correlation between 0.35 and 0.60. So things are not as bad as one would have thought.

Why are bad mortgages not renegociated?

As everybody is well aware of, there are plenty of delinquent mortgages in the United States. It is also quite obvious that a home loses substantial value as soon as it is foreclosed, because of homeowner neglect and the fact that it needs to be sold rapidly. Then, why do banks not renegotiate mortgage terms to keep foreclosures from happening. It seems to be in the best interest of banks.

Manuel Adelino, Kristopher Gerardi and Paul Willen wondered about this as well and and a hard look at the data. Specifically, they analyze detailed data on mortgages from Lender Processing Services (LPS). They first reject the standard explanation: whether a mortgage has been securitized or not has no impact on renegotiation.

It turns out that the risk of default after a renegotiation of terms is very high. After all this is why there was renegotiation in the first place. Given the cost of finding new terms, banks simply do not find it worth the trouble. This is similar to the adverse selection problem in insurance. Also, those homeowners who are temporarily in difficulty and will get back on their feet will escape default anyway, and new terms would not change anything.

Rents differ markedly from user costs in the US

Economic theory tells us that at least in the long run and under perfect competition, marginal revenue should equal marginal cost. With free entry, one should even observe that price equals costs, as profits are driven to zero. So it is puzzling when when one observes persistent deviations from this equality.

Randal Verbrugge notes that this is the case for housing rents in the United States. Now housing is a capital good with fluid markets in the US, so one should see even less deviations. Yet they exist, in part due to large fluctuations in costs. There do not appear to be opportunities for additional profits: transaction costs are high, and fluctuations are impossible to predict. So there are no arbitrage opportunities, even if arbitrage appears to be rather slow.

Measuring the peace dividend

How costly can a conflict be? While one can measure the expenses poured into a conflict and the physical destruction that ensued, there are important indirect costs that are much harder to get to. Think about the fear, the uncertainty, and the costs of migration. Taking the example of Northern Ireland, Timothy Besley and Hannes Mueller measure violency by conflict related death in eleven regions and look at their impact on house prices, which are supposed to capitalize all costs, and in particular incorporate both immediate suffering and risk as well as the likelihood of future violence. Indeed, a casualty is often a signal about future violence to come, and thus house prices capture also the learning process about conflict violence.

Besley and Mueller model this with a Hamilton regime switching process. Whenever an event occurs, it changes the likelihood that a region is in a violent regime. And this likelihood impacts hose prices. They find that the peace dividend corresponds to about 4-12% in Belfast and 0.8-2.5% over all regions. They also find a migration effect: when violence increases in Belfast, surrounding areas gain, and this effect is even stronger than the learning effect about the region's own violence process. Thus, it looks like every region reacts differently.

Are these effects big? I would say so given that the violence has directly impacted a very small fraction of the population. In fact, the cost of conflict can be even much larger. Indeed, the study only looked at differences across regions in Northern Ireland. There can be substantial costs for the region as a whole, costs that are washed out by trends and fixed effects. For example, the recent housing price boom in the area may have reflected the new peace (along with reduced conflict related expenses by authorities).

Mortgage innovation was good for home ownership

In the United States, there have been two periods during which home ownership rates increased markedly: 1940's-1950's (47% to 65%) and since the mid 1990's (65% to now 70%). Why would there be so drastic increases interrupted by a long period of stable homeownership rates. Clearly this is difficult to justify with demographic changes, which are much more gradual than that. Another justification could be changes in the tax treatment of homeownership, but the timing is not right.

Matthew Chambers, Carlos Garriga and Donald Schlagenhauf say this is all due to innovations in mortgages. In particular, the creation of new mortgages that are more accessible to young households (low down-payment) during the 1990's help Americans to buy their first houses earlier. Also, pre-WWII, mortgages were for 10 years, interest only and thus implied a massive bill at the end. In the 1940's, the government encouraged longer maturities and amortization, which made buying a house less risky.

The real contribution of this article is to determine how much of the increase in homeownership can be attributed to new mortgage options. Chambers, Garriga and Schlagenhauf address this with a frighteningly rich model and they show that they can explain half of the ownership increase in the earlier period, and three quarters in the more recent one. So these new mortgage tools did something good, as long as we believe that home ownership should be encouraged, which is not obvious.

Explaining high unemployment and low mobility in Europe

There is an endless stream of papers trying to understand why, on average, unemployment rates are higher in Europe than in North America. I have reported here about several of the recent ones, and there seems no shortage of new explanations. In fact, if one were to build a model with all those explanations, one would probably be left to explain why after all the unemployment rate is not even higher in Europe...

So what is the latest explanation? Peter Rupert and Etienne Wasmer pick up the ball where several left it: high unemployment is due to low mobility: Europeans are much more attached to their region and are less willing to move for a new job. This begs the question as to why. This calls for a model that explains both unemployment and mobility, based on some friction that differentiates North America from Europe (and does not involve taste shocks, the catch-all for the unexplained). Rupert and Wasmer argue that differences in unemployment insurance benefits and taxes are not sufficient to explain the differential, one needs also to factor in commuting costs. While commuting time is a little shorter in, say, France, fuel costs are much higher, which explains the shorter commute and the lower mobility.

Calibrating this labor search model, Rupert and Wasmer find that indeed they can explain both the unemployment rate and mobility differentials. But I have a feeling this is not the end of the story. If the cost of commuting is so high, why not move closer to the job? European housing markets are much less liquid than in the US. Why? It seems the economic force discussed here should make them more liquid.

Housing market boom-bust cycles and monetary policy

The preceding boom and current bust in the housing market have been blamed on the false expectations of market participants that house prices would always increase. While this expectation was historically correct (the Case-Shiller for the United States never decreased until now), this is obviously wrong for local markets. So, it cannot be true that everyone would buy the myth of ever increasing house prices. Can boom and bust then still happen?

Hajime Tomura shows that it is possible even when market participants have heterogeneous beliefs. And these fluctuations also impact the rest of the economy, just like we observe now. The model is rich enough to show that a monetary policy that is actively fighting inflation exacerbates these boom-bust cycles. So maybe it is a good idea that many central banks are putting aside inflation considerations for the moment.

Housing is not the business cycle

There is a widespread belief that the housing market is closely linked to the business cycle. In particular, housing starts are a major component of the leading indicator index, meaning that housing start statistics tends to precede whatever happens to the business cycle. This belief is grounded on the analysis of national data. What about the local level?

Andra Ghent and Michael Owyang compare permits issued with labor market data in 26 US metropolitan areas. They find, after controlling for national effects, that the local housing markets are very poor predictors for local labor markets. The critical aspect here is to control for interest rates.

I learn from this that housing as a leading indicator should be considered with a grain of salt. But it is not quite clear to me what this means in terms of our understanding of the economy. The measure here is the number of permits issued. Is the reason this does not explain subsequent labor market outcomes that fluctuations in interest rates are really driving the execution of those permits, and thus the labor market?

The American Dream is a nightmare

A major part of the American Dream is home ownership and this dream is heavily supported by public policy through mortgage rate tax deductability, support for first time buyers, other tax advantages, and recent bailouts. So why do we have all this support for home owners? Does ownership make people happier? Does it make a better society? Yes in both cases according to popular belief, but is this actually true?

Grace Wong Bucchianeri addresses these questions using a survey conducted in Franklin County, Ohio. This survey has time use data, include various measures of happiness throughout a sample day for women in rented or owned single houses. Along with all sorts of other controls, the focus here is to determine whether home owners are different from renters. And the results are:

• Happiness: home owners are not happier in any dimension. In fact, they appear to suffer more pain from house and home than renters.
  
• Self-esteem: no difference between ownership categories.
  
• Health: home owners are less satisfied about their health, and for a good reason: they a fatter, for an average of twelve pounds.
  
• Time use: home owners have less leisure, spend less time friends, and like it less when they do.
  
• Relationship: home owners are less happy with their partner, and with other people in general.
  
• Participation in civic activities: no differences.
  
• Neighborhood: home owners suffer less pain from their neighborhood. Finally a positive...
  

So why is the American Dream so heavily subsidized again?

Momentum traders and the housing market bubble

Bubbles are very difficult to recognize, by definition: you need prices to depart from fundamentals, and in the case of housing, expectations of fundamentals play the most important role. Determining whether expectations are overblown is thus quite subjective. But I think we have now a wide consensus that there has been a bubble in the housing market for several countries. The question is obviously how this could happen.

Monika Piazzesi and Martin Schneider argue that very little is required to get a bubble. A small number of so-called momentum-traders is sufficient. Using the Michigan Survey of Consumer, they find that there are always households who think is to a good idea to buy because price will rise further, but there number doubled during the bubble. They then proceed to write down a simple search model where they demonstrate that these momentum traders, even if outnumbered, have a strong impact on prices.

This is not unlike the rise of chartists on stock and currency markets who believe that future asset prices can be determined by past trends. Eventually markets started behaving in the way they were predicting once a sufficient, but not large, number of investors where following these rules. But once these self-fulfilling propecies start deviating too far from fundamentals, the markets correct themselves and get back to fundamentals. We have seen this again and again, but some people are always going to follow Mickey Mouse financial strategies, and unfortunately they seem to influence markets.