Brad DeLong's Semi-Daily Journal (2004)

perhaps there is a lag effect where refi cash-outs burn holes in pockets before enough first-time buyers confront their situations.

granting the plural of anecdote caveat, friends of mine currently are considering a 2000-mile move in large part because they cannot afford a first home in the Bay Area.

I am not an economist, but it seems to me that markets only account for future costs that fall within a certain window, perhaps 5-10 years. Gasoline prices for example have not risen on global warming fears or on fears of running out in 50-70 years. likewise, future homebuyers are not saving, b/c they figure they can afford it when they need to.

Yeah, I cant wait to mortgage my future and 30 years of toiling away in a office just to have some crappy box that Centex or Ryland put up. Sorry folks, it just aint worth it.

Jealous of folks with a place to store their toys? Sure. Jealous of their jobs and financial obligations? No.

Homeownership is fine for some, but it aint for everyone. Whats interesting to me is the cultural change recently whereby homeownership is no longer 'the american dream', but not owning a home has become 'the american nightmare'

Isn't it expected that people make irrational short-term decisions? They don't save enough for retirement either.

The question that I had was this:

Prospective homebuyers calculate their ability to buy a home based on their monthly payments. They may flinch at the absolute price tag, but what really matters is what the monthly number is (and to that end, banks do the same thing when evaluating credit worthiness).

So if the rate falls by 2 points, sellers can comfortably add 15% or 20% to the sale price of the home. This would be the 'interest rate premium,' paid for by the buyer to get the cheaper loan.

In 5 years the ex-buyer-now-seller goes into a market for which the interest rate has gone back up by 2 points. After adjusting for the appreciation in the value of the asset, they now have to deduct the premium that they paid 5 years prior, right?

I keep floating this idea by people and every one of them has responded by saying: "Saam, people don't like to do math."

It's safer to say that the value of the house in the future will be whatever consumers are willing to pay for it, and leave it at that.

The people who are going to buy my house 30 years from now are 5 years old and can't save. They can't reduce consumption. They don't earn anything, now. The people who can buy my house 7 years from now are 28. They better have good, secure jobs for quite some time. But they don't really have to save all that much, because in California banks will finance for very little down. They need cash flow. Without factoring in any inflation or price appreciation, they will need to gross $15,000+ a month between them. God bless them. My wife and I couldn't buy into our neighborhood today -- as opposed to 9 years ago when we bought the house. The only thing that doesn't freak me out about the coming "adjustment" in prices I keep reading about is that we have an outlandish paper equity cushion. I just can't believe that home prices can keep going up at these rates.

I tell people that your house is not worth what any of your neighbors can sell their houses for, but only what you can. That is the danger of the equity loan, you feel your house has appreciated so you borrow more money. There is no real appreciation, just a speculation of appreciation. SOmetime in the future when you sell your home it may or may not be worth you current mortgage. Whatever its value you still have to pay off your note.

Brad: The answer to your question is at least two-pronged:

(1) ignorance
(2) moral hazard

Moral hazard comes in different flavors, but in your example two forms are:

(2a) on the part of the homeowner doing a cashout refi: "I'm just doing what everybody is doing. When push comes to shove, the government/Fed is not going to let us down."

(2b) on the part of the future buyer: "I'm just like everybody else. Let's spend as long as we have it, when it comes to buying a house, they will cost whatever ordinary people can afford."

(I'm not sure whether (2b) is really a bonafide moral hazard.)

As I remarked shortly ago in a thread that seems to have been pulled already, I talked to somebody who bought a house recently, and he gave me (2a) pretty much in the form I stated it, only he did not refinance, but took out a large ARM. Actually he phrased it in a more sophisticated way -- "politicians are not going to do anything that will screw two-thirds of the population" (perhaps as a reference to the "consumer class"). I heard similar things from a number of people who explained to me why they have ARMs (mostly 5/1). It's always "in X years I'm going to trade up", or "in X years interest rates will be low again and I can refinance, there is always a cycle" for varying values of X.

Bottom line, they are willing to play the game because they assume that Uncle Sam will always have to accomodate, lest the economy go down the drain. I think they are in principle right, only the game has a "house limit", although nobody knows how high it is.

rc: "SOmetime in the future when you sell your home it may or may not be worth you current mortgage. Whatever its value you still have to pay off your note."

There is another form of moral hazard -- the idea of simply walking away from your debt with impunity, effectively sticking it to somebody else.

chris: "30 years of toiling away in a office"

What, you plan not to toil? Do you have rent-free lodging? But then a rent is not a millstone around your neck.

"Whats interesting to me is the cultural change recently whereby homeownership is no longer 'the american dream', but not owning a home has become 'the american nightmare'"

I don't see this phenomenon. But I have sure heard "what are we doing wrong", and have on occasions said it myself. When I look at the moral hazards that others are engaging in with their home financing, I don't know whether I should be afraid for them for when this thing blows up in their face, or for myself, on whom the fallout will be dumped in the form of inflation and other nasties. The nightmare is more that you see how attaining any kind of dream that includes an owned home becomes impossible at reasonable comfort as the required personal risk level reaches ever more exorbitant heights.

No-one has mentioned inheritance here.
My guess would be that
(a) a whole bunch of youngsters imagine they'll get rich when their parents die and they can sell that house while
(b) a whole lot of parents plan to reverse mortgage that house down to zero dollars of equity by the time they die.

Is this, in fact, an accurate summary---that reverse mortgages are changing the flow of funds through generations for the middle class, in a way that promises substantial future wealth discrepancies?

The value is denominated in Hong Kong dollar because I am a Hong Kong people,

Assume I have one million to make first installment
and make a 25 year mortgage. If I continue to pay $10K
every month, I can afford a 3.35 million house under a
2% interest rate.

When the interest rate go up by one percent to 3% and
all the above assumption keeps unchange, I can only
afford a 3.1 million house.

When the interest rate go up by one percent to 5% and
all the above assumption keeps unchange, I can only
afford a 2.72 million house.

So, Let's put it in a simple sentence,
If the interest rate go up by one percent, anyone own
a 3 million dollar house in Hong Kong would probably
loose 200K and monthly payment increase by 1K. So the
house price at least go down by 200K for a 3 million
house.

If the interest rate go down by one percent, anyone
can probably buy a 150K more expensive house with the
same monthly payment. So the house price at least go
up by 150K.

Since we’re talking about Hong Kong, perhaps someone can explain something to me, because it’s making my head hurt.

Hong Kong has a currency board –the only big one left, I believe- which pegs at 7.8 $HK to 1 $US. Until recently the $HK was overvalued and they had years of rising unemployment and falling prices (house prices down 70% since 1997, for example). Now that the $US has fallen we have had falling unemployment, deflation has almost ended and we are in the middle of an asset price boom (in February apartment prices rose more than 4% in a single week according to the South China Morning Post).

Presumably, if you have a currency board and the currency is pegged below its equilibrium level then there will be money supply growth. What I would like to know is this: if the US dollar stays low will Hong Kong continue to recover regardless of what happens to US interest rates? Or will we get thrown into recession again when the Federal Reserve puts up interest rates? Is a high interest rate deflationary in itself, or only through its effect on the money supply?

Where can I read about currency boards. I have been trying to find out about this for a couple of months.

It's late, too late for nuances. But it seems there is some confusion here between equity and appreciation. If housing prices stay stagnant (like in many areas of the Dakotas) and money stays cheap (because mortgage rates are national) then the only people who suffer from refinancing are the previous holders of the mortgage. If my $100,000 house (and you can buy a lot of house for $100,000 in North Dakota) will be worth $99,999 in ten years my refi from a 7.5% 30 to a 5.0% 15 still means big bucks in my pocket, and does not put any future buyer at any disadvantage whatsoever.

Your putative offset between current owner and future buyer, however relevant in Westminster, is kind of meaningless here.

(And though I live in Western Washington and not the Dakotas I did switch from a 7.5% 30 to a 5.0% 15 and just added a big extra principal payment, and am adding equity like crazy and not adversely affecting anyone at all - except my lender)

Why would a future home buyer assume that interest rates in 2004 have much to do with the cost of housing in 2034? Housing bubbles don't generally last 30 years, and interest rates are bound to rise by then.

If I'm right, the losers would then be the refinancers, not the future buyers. But you'd think they would know better, given that finance is their business.

I'll take a stab at it.

-Technical change & associated increases in wealth have increased the value of the housing stock in places like Calif & NY (but not MS or ND).

-These location rents are being driven by those successful in the current economy; they are the bidders.

-Owners not on the economy's cutting edge, like my dear old aunt in San Mateo, enjoy some of the wealth increase due to their stake in their homes. She can relocate and triple her consumption if she wishes.

-If it were not for my aunt's attachment to her home and environs, it would be rational for her to sell and relocate. Younger re-financers in a similar position to my aunt (well placed, but not high income earners) are rationally adjusting their consumption mix.

-Their unanticipated wealth increase is offset by a decline in saving post-refinance. So far so good, but full rationality would seem to imply that by reducing saving, they are probably forcing themselves to move in the future.

If the Fed's current interest rate stance were the only influence on interest rates in the 10 to 30-year range, then I, too, also be bewildered by the Fed's huge control over the intertemporal structure of rates. But the Fed's past efforts also come into play. A sizable price was paid in the early 1980s to kick off a long-term decline in inflation. The Fed's past behavior is now paying benefits through reduced inflationary expectations. In addition, employment growth remains stalled, and the latest Fed borrowing data show that corporations accumulation of debt has been very slow, even though government and household debt is galloping along. Savings overseas is still adequate to finance US borrowing - today's data from Treasury will tell us how that borrowing went in January. So there are more influences over mortgage rates than just the Fed funds rate.

As to lenders not stocking up on savings for future homes, well, home ownership is already near a record level. Those who can afford mortgages mostly already have them. In addition, there is evidence from the Reagan-era piling up of future tax obligations that consumers don't do what economists inter-period models predict they should. There is also a good likelihood that the near-record share of US households that are in the process of paying down real-estate debt see themselves as saving when they do that. Kick all assets when calculating US debt and asset standings and we find that US households are piling up assets pretty quickly, which is the point to saving, after all.

Saam & cm,

There are some mortgages that for a rate premium follow you to a new house. I know ETrade has them under the name "Mortgage on the Move". Pretty much with a traditional fixed mortgage, if you plan to stay in your house for 30 years, the only party which gets burned by the high purchase price low rate situation is the lender. Most people understand that the loan will not follow them and so maybe they feel comfortable with an ARM, but what they forget is that if the economy tightens they are on the hook for financing a new home with the proceeds from the old one. I imagine that at some point there are going to be a lot of people with fixed mortgages who will be reluctant to move and give up their rate.

As for the security of being part of a large group of ARM takers, I imagine that if it comes to the point where purchasing power needs to be taken out of the economy, and you volunteer to be part of the group that gets screwed first, it is probably better to be part of a larger group than to be the only person who signs up.

To Matthew Bristow,

I am living in Hong Kong. Let me tell you the answer, Hong Kong interest rate is simply the same as the Fed rate. If Fed rate is 5% and Hong Kong interest rate is 4.9%. What will you do? You will simply convert all HK dollar into US dollar to earn a higher interest rate without any exchange rate risk as HKD is fixed to USD. So they are just the same.

Although Hong Kong is not a province of the United State, Hong Kong economy is definitely decided by the Fed because it simply has no monetary policy available.
This is what I learn from macro 101 in HKUST.

You can check out http://www.info.gov.hk/hkma/eng/currency/link_ex/

To Matthew Bristow,

I am living in Hong Kong. Let me tell you the answer, Hong Kong interest rate is simply the same as the Fed rate. If Fed rate is 5% and Hong Kong interest rate is 4.9%. What will you do? You will simply convert all HK dollar into US dollar to earn a higher interest rate without any exchange rate risk as HKD is fixed to USD. So they are just the same.

Although Hong Kong is not a province of the United State, Hong Kong economy is definitely decided by the Fed because it simply has no monetary policy available.
This is what I learn from macro 101 in HKUST.

You can check out http://www.info.gov.hk/hkma/eng/currency/link_ex/

To Matthew Bristow,

I am living in Hong Kong. Let me tell you the answer, Hong Kong interest rate is simply the same as the Fed rate. If Fed rate is 5% and Hong Kong interest rate is 4.9%. What will you do? You will simply convert all HK dollar into US dollar to earn a higher interest rate without any exchange rate risk as HKD is fixed to USD. So they are just the same.

Although Hong Kong is not a province of the United State, Hong Kong economy is definitely decided by the Fed because it simply has no monetary policy available.
This is what I learn from macro 101 in HKUST.

You can check out http://www.info.gov.hk/hkma/eng/currency/link_ex/

Why spend now? Well, with the value of assets (equities and real estate) inflating, it's not an unreasonable deduction that prices generally (and, in particular, prices for consumable items) will have to go up a lot in the not-so-distant future. Therefore, spend (and, if possible, accumulate) now, while consumables are cheap.

Are the lending institutions at some risk? Now they can pay 2% on a CD and collect 5% on a mortgage. If inflation returns and they have to pay 6%+ on a CD, don't the financial institutions lose money? It seems that people are making bets on future interest rates/inflation that may or may not hold.

Bakho: I think banks are all about fees. They generate fees now for each transaction. That is an immediate hit to the bottom line. Most of the loans are then bundled and securitized. The loan goes off the books as an asset and risk is spread through the greater market.

"But why haven't those who will buy your house in thirty years and their parents cut back on spending by an equal amount as they strive to accumulate the bigger nest egg that they will need?"

Nobody in America thinks 30 years ahead about anything.

Interesting to hear Charles Lam and the HK view. How many other foreign currencies and economies are linked to what most of us think about as a domestic problem?
Also interesting to see the other side of the refi issue: those using the drop in rates to put equity back into their house. They are the genuine savers I guess. And how 'smart' is this given the fact that real estate land values continue to outpace those properties with improvements ( bldgs)? In any case, they are a small minority,no?
Today, we hear the answer to bakho's " Are the financial institutions at risk?" when Fannie discloses some of it's derivative positions. That may be $25B of bad news without enteraining the notion of a 6% CD rate.
Some other views surprise me. This one, in particular: Brad writes
"...people are going to be living in it, enjoying it, and deriving utiolity from it for the next fifty years at least"
That number, 50, is way high (in my neighbouthood,atleast). The price of the land is so dear compared to the building that it is not uncommon to see houses less than 20 years old demolished.
But not in North Dakota?

"No-one has mentioned inheritance here." --Maynard Handley--

Maynard, here is something from the Public Policy Institute on the subject.

http://www.research.aarp.org/econ/dd90_pennies.pdf

Your puzzlement puzzles me. Is this heavy irony?

The argument yuo made is completely abstruse to a non-economist. Someone can have an OK understanding of supply and demand, comparative advantage, marginalism, money supply and inflation, etc., and not understand what you just said.

So the people who are going to be worse off in the future don't know that yet. When the future hits them they'll be dumbfounded.

I really don't think that this is a time to talk about irrational consumers. It seems to me that here we have a sort of structural deception. What Cal said seems to the point. There's nothing seven-year-olds can do to prepare for something that's going to happen down the road, and the 28-year olds are probably just assuming that the future will be quite a bit like the present.

I'd also like to note that popular irrationality only is mocked when it hurts the economy. Awhile back when institutional investors created a crash, small investors saved the day by continuing to invest. Did these small investors get burned with the so-called "dotcom bust"? (BTW, shouldn't that be called a "fraud bust"? --Enron wasn't a dotcom). Likewise, "consumer confidence" is probably higher than it should be, and consumers are certainly taking on more debt than they should. That's irrational all right, but from what I read, the economy NEEDS them to be irrational.

In California you have this tremendous generational divide. A 30-year-old and a 60-year-old from similiar backgrounds working in the same industry have completely different situations. Making all assumptions in favor of my hypothesis (but realistically) this is the worst-case:

60-year-old: retired with a pension from a union job, bought a house cheap and has seen its value explode, paying frozen tax rates until he dies, safe Social Security and medicare benefits, sent his kids to good public schools and a good, affordable college.

30-year-old: hired to a second-tier job with a lower pay scale, no pension, no union, and less security, buying a house at an exorbitant rate if at all (with high taxes wired in), sending his kids to poor public schools with poor prospects for college, and fully expecting his Social Security and Medicare benefits to be weakened.

Yeah, there are good things happening elsewhere in the system, but the 30/60 threshold I described is real. This is (of course) a class thing, not an individual thing. A 30 year old individual didn't lose anything he never had. But here we have two very similiar large categories where one is treated very differently than the other.

And the bad things, as I keep saying, happen above all to labor. Just now a lot of high-tech libertarian whizzes found out that they, too, are disposable labor. Ha ha ha.

If, thirty years from now, the proportion of the population in labor is still as high as it's traditionally been (well more than 50%, including retirees and dependents), and if the status of American labor continues to decline as it has, we will be looking at an enormously different society and polity. And the America of that restratified future might be, per-capita, better off than it ever has been, while the majority of people are worse off.

Whenever I hear people raging about Mexican immigrants, I try to explain to them that they are just a premonition of the American labor force of the future. Not Mexicans per se: just people with low-wage, part-time-temp, no-benefit jobs.

North Dakota! Someone else said it first. My pet idea.

In North Dakota you can buy a livable house for $3,000. My brother's brother-in-law did it.

Best state in the country for low crime, low unemployment, good public high schools, and a long life expectancy.

The other statistic ND is tops in is emigration. This has been true for 50-80 years. One of my high school teachers told me that during the Depression North Dakota hitchhikers were willing to go in either direction, as long as they got out of N.D.

Conclusion? People want crime, unemployment, stupidity, and early death. No other conclusion possible.

Some say that living on a flat treeless plain at -40 degrees with a 30 mph wind has something to do with it. Nah.

N.D. is the America conservatives pretend that they want. Hard-working, frugal, sober, sensible, culturally-conservative people. The conservatives oughta put up or shut up. Forget about the bling-bling and the poontang and go live in North Dakota where they belong.

Not gonna happen.

Charles Lam: price scaling with interest rate

What you are saying is basically right, but things are further distorted by supply & demand. In a high-demand situation people have to accept higher mortgage payments as compared to their income (i.e. higher risk); it makes a difference whether your monthly payment is 25, 30, or 35% of your income. To the extent people are willing to accept this (lest they choose not to own a house), prices will not scale exactly as you state.

A lot of people at my work bring their lunch every day to scrimp on the $5-7 they would otherwise have to fork out (including gas money). This tells me that their cost of living is too high, and there is a large correlation between lunch-bringers and homeowners.

Charles Lam: price scaling with interest rate

What you are saying is basically right, but things are further distorted by supply & demand. In a high-demand situation people have to accept higher mortgage payments as compared to their income (i.e. higher risk); it makes a difference whether your monthly payment is 25, 30, or 35% of your income. To the extent people are willing to accept this (lest they choose not to own a house), prices will not scale exactly as you state.

A lot of people at my work bring their lunch every day to scrimp on the $5-7 they would otherwise have to fork out (including gas money). This tells me that their cost of living is too high, and there is a large correlation between lunch-bringers and homeowners.

Zizka,

Can I just forego the bling-bling and call it good?

On the subject of mortgages and who dictates the shape of the curve, the BoJ is reportedly considering ending "large-scale" fx intervention by the end of this month. Hmmm. Worth noting, though, is that this seems vaguely tied to an assumption that the yen will stop firming all by itself.

can anyone tell me why the bls has revised its calculation for the ppi? this from today's wall street journal afternoon report:

"When the Fed policy makers discuss inflation tomorrow, they will likely turn to today's Empire State survey from the New York fed -- especially since the federal government has been unable to release its own measurements of producer prices for the past two months, citing problems with changes to how the Labor Department calculates the numbers. The New York Fed said factory activity continued to expand this month, but at a much slower pace. Yet it reported record levels for manufacturers' price paid and prices received. The prices paid index rose nearly 20 points to a reading of 50, reflecting reports of higher prices from half of all respondents, and no reports that factories experienced lower prices."

what's going on here? why a change in the ppi? and is it politically motivated?

Askew but important:

http://www.nytimes.com/2004/03/15/national/15FOST.html

Medicare Actuary Known for Strong Beliefs
By LYNETTE CLEMETSON

WASHINGTON — Richard S. Foster's disagreements with Medicare officials over projections of the costs of the program began almost as soon as he took over as its chief actuary in 1995.

Mr. Foster, a no-nonsense mathematician with a reputation for being careful in his assessments, delivered an estimate on the long-term condition of the Medicare trust fund that indicated worsening problems in the future financing of the program. Bruce C. Vladeck, who ran the program during the Clinton administration, said in a telephone interview on Sunday that he worried that Mr. Foster's outlook would fuel Republican efforts to cut Medicare benefits in the 1995-96 budget.

Hoping for a more optimistic take, Mr. Vladeck suggested to his new hire that the assumptions he had used in preparing the estimate of future income for the trust fund might have been too conservative. After several detailed debates with Mr. Foster on the issue, Mr. Vladeck conceded defeat.

"I lost," he said. "He's not volatile, not very emotional. But when he says X as opposed to Y, he already has a well-reasoned purpose for saying X, and he will tell you that. We came to disagree regularly, and I always got out-argued."

That Mr. Foster — who has created a political controversy with charges that Bush administration officials threatened to fire him if he shared data with Congress on the costs of new Medicare legislation — differed in opinion with his bosses is not surprising, said some who know him.

That the unassuming numbers cruncher would be caught in a public firestorm over those disagreements, most conceded, is shocking....

http://www.nytimes.com/2004/03/14/politics/14MEDI.html

Democrats Demand Inquiry Into Charge by Medicare Officer
By ROBERT PEAR

WASHINGTON — Democrats called Saturday for an investigation of charges that the Bush administration threatened to fire a top Medicare official if he gave data to Congress showing the high costs of hotly contested Medicare legislation.

The official, Richard S. Foster, chief actuary of the Medicare program, said he had been formally told not to provide the information to Congress. Moreover, he said, he was told that "the consequences of insubordination would be very severe."

Senior officials at the Medicare agency made it clear that "they would try and fire me" for responding directly to inquiries from Congress, Mr. Foster said in an interview on Saturday.

Mr. Foster said he had received that message from Thomas A. Scully, who was then administrator of the Medicare program. Mr. Scully denies threatening Mr. Foster but confirms having told him to withhold certain information from Congress....

http://www.nytimes.com/pages/politics/index.html

U.S. Videos, for TV News, Come Under Scrutiny
By ROBERT PEAR

Investigators are scrutinizing TV segments in which the Bush administration paid people to pose as journalists praising the new Medicare law.

Why should anybody buy your super-appreciated house in the future? Why not just build another one down the road on cheap land, with new trees and cheap labor from Mexico?

calmo writes:
>
> The price of the land is so dear compared to the building that
> it is not uncommon to see houses less than 20 years old
> demolished. But not in North Dakota?

Evidently not. Nor in many other places where housing places have gone below (sometimes way below) new building costs. That this is a very bad thing for the community involved is pretty obvious. Nobody develops anything new in such a place, and the downward spiral can be breathtaking (see whole neighborhoods in Saint Louis, for example).

I think what is less well understood is that the opposite problem (housing costs far and away in excess of builidng costs) is, in general, also a very bad thing. Yes, there are places like La Jolla where real estate is and should be very expensive because you're basically buying acreage in Paradise, and anybody with enough money will want some. But I am now seriously worried about the prospects for real estate prices in many places where buying is driven more by other issues. Housing prices pushed solely by low interest rates or a new building shortage or the expectation of (say) cheap tuition at a UC school all all things that could show sudden reversals. (And so you'll hit the tri-fecta in the Inland Empire when interest rates and fuel prices go up while UC tuition goes up to levels of a comparable private school and there are more than enough houses like yours on the market.)

This is why I feel just a little bit better out here in Columbia, MO. Housing prices could fall a bit or stagnate, but the fact that you can always convert medicore pasture land into new subdivisions keeps values fairly stable, even if the city does grow by 30% or more this decade (and there's still a big danger of that). I can expect my house to sell for the real price I paid for it plus a still small but increasing premium for the neighborhood being close enough to everything so that traffic issues will be minor compared to some people I know in the more distant burbs.

Yesh writes:
> Why should anybody buy your super-appreciated house in the
> future? Why not just build another one down the road on
> cheap land, with new trees and cheap labor from Mexico?

I guess that's shorter me. :-) La Jolla will never be cheap because we'ver run out of "down the beach". My house will never sell for the half-million it would in Boston because you can go two miles west and turn your plowshares into pavement machine. Which still leaves us with how the heck a $300K+ condo in greater Riverside is going to do in the future.

what's going on here? why a change in the ppi? and is it politically motivated?

Posted by jake at March 15, 2004 10:22 AM

It's a technical issue related to a changeover in the industrial classification method, see:

http://www.bls.gov/ppi/delaynotice.htm

---
Why should anybody buy your super-appreciated house in the future? Why not just build another one down the road on cheap land, with new trees and cheap labor from Mexico?

Posted by Yesh at March 15, 2004 10:34 AM

To some extent, it's location, location, and location. There are potentially material costs (unproductive time spent in the car instead of making money or at leisure) to being "down the road" if you have to go more than a couple miles to find developable land. Plus, a lot of the most appreciated property has features that are not cheaply replicated with new materials and cheap labor, and some of us are crazy enough to have tastes for such things.

K Harris

Superb comments as usual.

"Kick all assets when calculating US debt and asset standings and we find that US households are piling up assets pretty quickly, which is the point to saving, after all."

Just so, this increase in home prices is allowing a piling up of assets in so many urban households. Just in time for baby boomers needs.

No! No! No! No Free Lunch! Brad answered the wrong question, and the discussion has then gone astray!
The direct question the correspondent asked was, "Is there a Free Lunch"?

When you take out a mortgage, you promise to pay a fixed rate (you're short a 30-year bond). You receive cash and buy a house (long home-equity).
But, you have the right to buy that bond back at par should rates go down (you're long a call).

Now that rates have gone down, you can exercise the call and buy back your old bond (which is now worth, say 20% more), which nets a profit. {Usually you turn around and borrow again, unless you decide to sell your house and rent.}

The lunch is not free, as the cost of the refinancing option is incorporated in a higher rate (i.e. above that of a collateralized loan).

Brad's point is well taken, too - you have also invested in house, which is sensitive to the real interest rate and inflation, and supply and demand. (Maybe think of it as an inflation linked bond, for simplicity). So if rates go down, you benefit on both your asset and your hedge! But the question seemed to be more about the hedge than the capital appreciation.

Agreed, but real estate has been a fine long term hedge for 50 years.

Actually, the low home mortgage interest rates is one of the few positives of the Bush tenure. By keeping unemployment high, Mr Bush has pressured the Fed to keep interest rates low.

Thanks Uber, for getting the discussion back on an understandable track. I thought Brad kinda muddled it all up with his questions about whether 30-years-in-the-future buyers were doing the rational thing to deal with this current situation and after re-reading his post I still don't quite understand what he's getting at. Your explanation was clear.

Now here's my other food for thought. Those that were able to "buy back their bond" and net a profit... now obviously that entire profit doesn't all go into the costs of the new loan. And isn't this sort of trading a zero-sum game? Who did the person get their profit from? My thought is that since the lender now is earning less on this loan, they were the loser, but the story doesn't seem like it should end there... Shouldn't they be trying to pass this "loss" on somehow?

I'm not an economist (stating the most obvious first!), but I'd like to take a stab at the correspondant's question. Of course, my answer should be taken with a big pile of salt.

The correspondant wants to know where the money from refinancing comes from. The short answer is, from himself. The clause which permits refinancing meant that he was paying a slightly higher interest rate than he would have, had he chosen a loan where refinancing wasn't possible. Refinancing is an option - the ability (but not the obligation) to get the current market interest rate for the remainder of a loan. When interest rates go lower, the option is in the money and can and should be exercised. All options have a cost, however, and this cost is rolled into the initial rate at which he was supposed to pay back the mortgage. Instead of 6%, he was (say) paying back 6.5%.

Now somebody wrote (sold) that option. Say it's the neighborhood bank. If they don't turn around and unload it by buying it from someone else, they may earn or lose money on what they lent you. If interest rates go down quickly, they lose. If they go down only after many years, or never go down, so the bank has lots of opportunity to collect that extra 0.5% of interest, they win. When I say "win" or "lose", I mean on your particular loan. The bank may in fact have other obligations which offset whatever they win or lose on you. For instance, they may hold onto treasury bonds. If they lose on you because interest rates go down fast, they earn money from the treasury bond, which picks up in value.

I apologize, but this is approximate. In fact an interest-rate option, which you hold, cannot be hedged perfectly by a static (constant) holding of treasury bonds. The bank, to match its liability to you, theoretically has to buy and sell Treasury bonds, according to whether interest rates go up and down. (And even this is an approximation - my apologies again.)

Now usually banks don't hold onto loans which do not offset other parts of their books. They sell them off, to one of the Fannies (such as Fannie Mae). Fannie Mae keeps a large number of these loans on their books. Because Fannie Mae holds so many of them, it can theoretically hedge pretty accurately. It has a good (!) idea of what percentage of people will refinance should interest rates go lower a certain amount, and so it can decide how many treasury bonds (or such) it must buy in order to offset the loss it would make when people decide to refinance. Of course, if its formulas are wrong, it might make or lose more money than it hopes in any particular scenario. As long as this is within reason, it only impacts the profits paid out to shareholders. If they are ever seriously wrong, and lose lots of money on the loans they have bought from banks, then they could go belly up because they are not well capitalized, and then things become very interesting.

Fannie doesn't hold all its loans on its books. It also sells them in specially constructed bonds to investors. These bonds carry with them the prepayment risk from which you benefit; but because each bond combines many, many loans, your particular loan - and your decision whether to refinance or not - has by itself very little impact. In any case, investors receive a higher interest rate than they would have, had the bonds not carried this prepayment risk. If more people refinance than supposed, then investors earn less money from their investments.

Who holds these? Pension funds for one, insurance companies are another. Any large institution who needs to hold long-dated obligations in dollars, probably holds some. They are the losers, again not if people refinance, but if they refinance more quickly than the higher rate of interest on the bond warrants.

I hope this helps, and I hope I didn't make too many mistakes!

I'll finish with a digression. The Fannies have an implicit guarantee from the federal government. The federal government from time to time tries to deny it, but the Fannies are so big, it is very difficult to imagine the government would just let them fail, because if they ever did, that would spell financial catastrophe, not just for the U.S., but for the world. This allows the Fannies to sell its bonds to investors more expensively than they really should; i.e. interest rates on homes are lower than they really should be. Who pays for this? The U.S. taxpayer, who has to shoulder the risk of saving the financial system should things go bust. This is just another way that non-homeowners are subsidizing homeowners.

chris brandow states: "markets only account for future costs that fall within a certain window, perhaps 5-10 year"

Here's a possible formalization of this idea. Think of information about future interest rates being represented in some "infinitesimal" object such as a tangent space of a 1-dimensional manifold (I know these are trivial but I'm just thinking out loud). This affects the dynamics of consumers on the 1-dimensional manifold locally.

Alternatively, consider a formulation involving various time scales (one such formulation can be done using something like nonstandard analysis -- deLong you've got a colleague in your dept that's an expert on this!) which permit formulation of a theory with various interest rates for various "runs"
short run, medium run and the infamous long run.

"My thought is that since the lender now is earning less on this loan, they were the loser, but the story doesn't seem like it should end there...."

Well, leanders borrow even more cheaply then the lowered rates they are charging. The spread of rates is the point for lenders. Borrow short and lend long, and be careful to protect against a quick back-up in rates.

Andrew Boucher: "The Fannies have an implicit guarantee from the federal government. The federal government from time to time tries to deny it, but the Fannies are so big, it is very difficult to imagine the government would just let them fail, ..."

This is the same moral hazard that I was referring to above, i.e. "they won't allow _us_ to get into deep shit, because otherwise _everybody_ would be in deep shit". Thanks for explaining the whole mechanism, it sounds plausible and I don't think you made a mistake. It comes down to the socialization of risk.

One reason that German workers are often criticized as being too immobile (and the critics like to contrast the situation to the US) is that this Fannie/Freddy-style risk socialization mechanism doesn't exist, i.e. mortgages generally carry a significant prepayment penalty and thus tend to lock people in more.

The lenders don't lose. Consider that a refinanceds mortgage with lower interest rates, probably are less risky. People who lower their payments are less likely to default. Thus, the lender reduces risk, and takes fees.

The lender is borrowing short and lending long, and profits from the spread in rates.

Past performance does not guarantee future gains!

The average home buyer stays in their home for only 3.5 years. Given the current and likely future economy, that's not going to lengthen. The average house sale tacks 8% onto the asking price of the house (or else it comes out of the seller's anticipated "riches"). Every 3.5 years. Property taxes keep right up with that. Add to those commodity and land prices that are surging in the tens of percent per year. Add to that the falling US$ raising the prices of everything that's not made of PRC dark-plastic. Granite counter tops $67 a *square foot*!! That means in 30 years, your national average $250,000 house today is going to cost far more than $1,000,000, or, as is far more probably the case, you will, as one friend put it, "die in our house before we can sell it". All the Fed did was sucker the sheep into the shearing shed. Which, truth be told, is better than living in a cardboard box with $250,000 in the bank losing 40% per year.

Sampleminded writes
" People who lower their payments are less likely to default. Thus, the lender reduces risk, and takes fees."
And so Greenspan's recent recommendation ( switch to ARMs) to those holding fixed ( and I guess long term ) mortgages makes sense to you?
The lender reduces only Short Term risk and this at the cost of the reduced spread, no?
The other term, the Long Term, which is getting less popular with each passing day,( ARMs as a share of the market is growing) is neglected. The current 2% spread between an ARM and a 30 yr fixed term is, unbelievably, too wide to persuade folks to go Long.

Lara Grast says: Property taxes keep right up with that.

Except in California. *cough*

He who borrows short and lends long get his arse in a sling when the rate move up. Of course that hasn't happened but once in the last 20 years!!!!

housing prices rise as interest rates fail because of inelasticity of supply

if you go to rural america, when land and materials are always available, you will see that drops in interest rates do not result in rises in housing prices. in fact, i know of many properous communities where no custom home (almost all homes are custom) has ever sold for its construction cost.

people will instead build their own, new home, if they can wait 90/180 days for construction

How many people do you know that put money away today so that they can buy a house for _cash_ in thirty years? How many people out of all the buyers are paying cash for a house saved using your example, Dr. Delong?

It's an interesting mental exercise, but it doesn't reflect the reality today, nor I suspect that of thirty years from now.

QM