Thursday, March 1, 2012

Benn Steil and I debate house prices

Last week Benn Steil wrote a very interesting oped on housing. (Originally at Financial News) He unearthed the amazingly large number of young people who bought houses in the boom, and then lost a lot when house prices fell. One quote:
What effect did the housing bust have on them? Household balance sheets among the Facebook generation were the hardest hit: between 2007 and 2009, half of those under the age of 35 lost over 25% of their wealth. A quarter of those under 35 lost over 86% of their wealth. Not surprisingly, they have been badly hit by the foreclosure tsunami; the median head of household in foreclosure being eight years younger than the median not in foreclosure. Younger households typically started off with less wealth than older ones and, following the bust, ended up with much less.

This bodes badly for their future, and the country’s
I wrote back, and the following exchange might be useful for blog readers here.  We don’t come to hard and fast answers, but I think we clarified a lot of channels that do and don't work.

Your oped was very interesting, but I have to disagree with a basic point.  Lower house prices are great news for the majority of young households.
They either don’t own a house or are looking to trade up. Cheap stocks are also great news for them. Even those that lost money in one house will still want to live in houses for a long time, so they can buy a new house for the same low price that they sell their old houses for.  Lower prices are only bad news for old people who want to downsize.

For those that did buy – a lot – the data I cite say they’re in bad shape.  For those that didn’t, you surely have a point, with the major caveat that credit standards are much, much tighter now (I’ve been through a mortgage and a refinancing over the past 2 years, and they were hell).  You yourself have commented several times on the great rates that no one seems to have access to.

The ones who bought surely are in bad shape, at least on paper.  A young person who bought stocks on margin leveraged 90% in 2006 would also have lost a lot of money!  But together with a collapse in wealth, there also has been a big decline in the cost of living – houses are cheaper. They don’t need as much wealth as before.

View it another way. They still have the house. If you bought a house in 2006, and you’re still employed, by and large your wages haven’t shrunk. You can have exactly the standard of living you had planned for in 2006, and it doesn’t matter a whit that the resale value of your house has declined. Really, look at it: same wage, same mortgage payment, same prices for stuff. So what if the house price went down?  And even if you want to move - - again, you buy a new house for the same low price you sell your old hose. You can keep the planned standard of living.

OK the ones who are not employed have trouble. Or the ones whose wages are cut. But really, employment is the source of their trouble, not that the value of their house has gone down. 

If your net wealth, including home value, was $100,000 in 2006 and $10,000 today, you could still “have exactly the standard of living you had planned for in 2006”?

If you can afford to buy the same basket of goods, you have the same standard of living.

Basically, it’s deflation. The deflation is not yet recorded in statistics because they use the rental equivalent measure of housing costs.  If your net worth goes from $100,000 to $10,000 but there is a 90% deflation you are exactly as before.

As an extreme, suppose technical improvement makes housing free – we figure out how to grow houses from chia pets in a week. The price of existing houses goes to zero. There are winners and losers here too. But obviously as a society we are much better off.

If I lose 90% on a stock am I no worse off because the broader index is also down 90%?

You don’t live in stocks…

So,  yes. If you lose 90% on a stock, but the stream of dividends is completely unchanged, then yes, you’re just as well off as before. If before you were planning to live off that stream of dividends, you can still do so. If before you were going to exchange the stock for a different one that gave a similar stream of dividends, you can still do so.

The key difference: Stocks typically fall when there is a big bad shift to the expected stream of dividends. When your house price falls, there is absolutely no effect whatsoever on its value to you as living space.

As with houses, you’re worse off if you were just about to switch from stocks to bonds. And you’re better off if you were young and about to invest in stocks, as now you get to buy the same dividends much cheaper.

(In retrospect I’m being a bit too strong, as usual. The fall in house prices comes with a lot of foreclosures and neighborhoods that are no longer great places to live.  A lot of  the houses are now in the “wrong places,” so genuinely less valuable. But for the argument here, that’s really about foreclosures costs, and the rise and fall of neighborhoods, i.e. collateral damage from house prices, not the direct effect of house price falls per se. Also, if you don't have the cash to pay off a mortgage and take the loss, moving is tough.)

Is the ability to borrow against my appreciated home worth nothing, then?

Now I have to give in a bit. Yes, this is a good point, and I ignored your credit point above. 

Remember though that borrowing has to be paid back. So you bought a $100,000 house in 2005 with $10,000 down, and $1,000 per month mortgage.  It goes up to $200,000. Great! Now you can refinance and take an extra $90,000 out of the house and go on that round the world cruise you had been hoping for. (Or start a business, or whatever.)

Whoops.  Except now you have to pay the loan back. You have to pay $2,000 per month on your bigger mortgage. As long as you want to live in the house – or another one of the same size – you didn’t get any more wealth.  “Removing a borrowing constraint” is different from “having more wealth.”

So you are better off, but only if you knew you were going to get a big raise, so that you wanted to borrow a lot of money but the bank wouldn’t let you.   That might be true for a lot of people. On the other hand, we are perhaps becoming skeptical that it is such a great idea for young people to pile on a huge amount of debt, so perhaps not such a social tragedy that they can’t do it as easily any more.

But don’t confuse the size of a possible borrowing / collateral constraint with “wealth.”

That’s part of the transfer question. Those who rented did worse when house prices went up, and do better when house prices go down.  There’s no question that It’s better to be a renter if you know prices are going down and vice versa. Just as it’s better to be out of the stock market when prices are going down.

My point is precisely that the young, as a group, are worse off (irrespective of what they thought they knew about where prices were headed).  I think there’s more than a fair debate to be had about the macroeconomic effects of this going forward.  But surely what I’ve found on the demographics must be relevant to the question – so at least worth raising.  No? . . .

Yes indeed!  I think we’ve talked about all sorts of interesting channels by which some groups benefitted, some were made worse off, and we all were made worse off by the end of the housing boom. Less collateral (for better or worse), houses built in the wrong places, half-finished houses, foreclosure externalities, the difficulty of young people starting carrers and so on.

 But let’s also steer clear of the things that aren’t true, like the idea that just because the resale value of your house declines, you are automatically a lot poorer, especially if you are young and going to live in the house for a long time.  

(A special thanks to Benn for graciously agreeing to let me post our exchange.)


  1. Prof Cochrane -

    Is there a leverage effect to be accounted for here? For example:

    Scenario 1: all houses cost $100. Person A buys a house with cash. Now all houses drop to 90. I agree with you he's no worse off. He can sell the house for 90 and buy another house if he wants.

    Scenario 2: all houses cost $100. Person A buys a house but only puts 10 down (borrowing the other 90). All houses go to 90. He sells his house, repays his mortgage, and has nothing left. He can't buy another house.

    Seems like the deflation hurts him on the second case, even if all he buys is equivalent houses his whole life.

    1. Only if he can't borrow $90, which he was able to access before

    2. What I mean is say that in scenario 2 all the houses stayed at $100. He sells the house, pays back the $90, and is left with $10. He still needs access to a credit market to buy that $100 house. i.e. he has to borrow $90 again. So it is the credit market that makes the difference here.

  2. The credit hit cannot be overstated. A person who now owes more on his mortgage than his house is worth cannot move and buy another house. He either has to sell short, damaging his credit and ability to obtain a new loan for the cheaper house, or stay put and watch his new neighbors buy his same model across the street at half the price he paid. True, there is a benefit to those lucky enough to have stayed out of the frenzy who can now jump in with lower prices. But we can't say those who bought at the peak enjoy the same utility by staying in their house. Overall, my view as a real estate lawyer at ground zero Las Vegas, is that this was a net loss.

    1. He can sell the house for less than the mortgage and pay off the mortgage principal from other assets. It was debt after all, which you are supposed to repay.

      If you borrow money to buy stocks and the stocks go down, we don't all take it for granted that you call up your broker and default on the debt ("short sale" of the stock portfolio and only pay back half the margin loan.)

      I know many people don't do this, but it's worth remembering that it is physically possible to pay your debts!

  3. What about the savings aspect to owning a house. I pay my $1,000 a month mortgage (on my house worth $100,000), but I am hopeful that I am building some equity in the process. Enter the bust, and now my house is worth $10,000. Yes, I can still pay my mortgage (I still have a job), but the notion that I am building any equity (savings) is gone... its like I am renting. So now I realize I have to save extra on top of my mortgage, so my disposable monthly income goes down because I feel I need to save more. Isn't this relevant.

    1. Yes. Houses are terrible savings vehicles, but people do look at them that way.
      This is interesting though because it's much less relevant for young people, the subject of Benn's post. Old people are closed to cashing in the big house, downsizing, and living off the difference. Young people are mostly buying a house for the "dividends," the value of living in it, and by definition didn't have much equity to start with.

  4. One of the main points i think we are forgetting is many young households didn't buy with 20% down into fixed rate mortgages. So when their mortgage "resets" they can't make the payment. And as prices drop,they can't refinance because they don't have enough (any equity). So even if, to your point, your 2006 "wages haven't shrunk" your mortgage payments have increased and therefore you are worse off, and you have less spending power (unless your wages have increased at a greater nominal amount than the increase in your monthly mortgage payment, which I doubt is the case for most young people).

    Now i am not going to get into a moral argument as to whose fault it is for getting an adjustable rate mortgage with little equity. Mostly it is the borrower's fault for not being educated. And financial education among young people in this country is abysmal. But, precisely because they are young, they also have little "other assets to sell" to pay off their debt.

    So, basically, the problem is leverage, and we all unfortunately feel the effect as people wind down their debt because they spend less which leads to slower economic growth. Debt service payments eat up larger parts of their income even if their 2006 wages haven't shrunk. And so all those older people who want to sell and "downsize" will also feel the effects in that there wil be less younger buyers for their homes, and the prices will be lower.

    So really the only people who win were younger people who didn't buy houses during the boom, which is a small population compared to those who did, and compared to thoses older owners who now want to sell. And, as mentioned above, it is much harder even for these younger people who sat on the sidelines, to buy anything now.

  5. “So, yes. If you lose 90% on a stock, but the stream of dividends is completely unchanged, then yes, you’re just as well off as before. If before you were planning to live off that stream of dividends, you can still do so. If before you were going to exchange the stock for a different one that gave a similar stream of dividends, you can still do so.”

    I think this is interesting to think about because houses and stocks as investments seem different to me. You buy the stock up front (we are not assuming most young people are buying stocks on borrowed money) and your investment then increases or decreases, but the worst it can go to is zero. You own the asset outright, you expect the dividend streams, you take the risk.

    Your comparison of a house to a stock is direct if a young person bought the house fully, with cash. You can rent the house out to someone in the future- these are your dividends. And if the underlying value appreciates, even better. It’s like buying a stock whose price appreciates and who continuously increases its dividend.

    But most young house buyers didn’t do this. Most borrowed to buy a house.

    Let’s say you borrowed a fixed rate mortgage. And the value of the house goes down. Your stream of (monetary) dividends is not the same. Your only hope of meaningful dividends in any scenario where you borrow to buy a house is through the house appreciating in price at a rate greater than inflation, or the ability to rent the house at a greater price than your monthly payments, which is usually not the case (but we may be approaching this scenario soon, which is interesting to think about).

    In fact, you, the buyer, are the stream of dividends to the bank who is holding the mortgage. You are essentially “the stock” for the bank. The bank can lose 90% of the value of the house, but your income to them is the same, so they benefit from the dividend stream, not you. Essentially, the bank is buying your ability to pay dividends when it gives you a mortgage, they could care less about the value of the property, except as a piece of collateral.

    Further, let’s assume a buyer buys a floating rate mortgage. The buyer is still “the stock” in the eyes of the bank. Let’s say the property value falls 90%. Now, with an adjustable rate mortgage, you are more like a derivative to the bank. The property value decreases, but your interest rate resets higher, so the bank makes an even greater dividend off you. True, their cost of funding might change as well, but with the good old Federal Reserve stepping in to help them keep it as low as possible, this shouldn’t be a problem.

    The more I think about it, the true investor in the purchase of a house is the bank, and the house buyer’s ability to pay is the true asset being valued. The monthly mortgage payments are dividends to the bank. The piece of property is only collateral in the case of default.

    So your statement about losing 90% of a stock but dividends staying he same is true for only two categories that I can see: Someone who owns a house with no mortgage, or the bank who provides the mortgage. Weird.

  6. John - First, glad I found your blog. Well done thus far. I'm only an armchair economist (be gentle) so I'm hoping you can help me connect the dots here:

    Let's say I'm young (33 is still young, right?), gainfully employed, and intend to live in my current home (which I bought 5 years ago) for a while (say 15+ years). I bought it at X and now it's market value is 1/2x. Interest rates aside (due to ability to refinance), I'm still paying for an asset at 2x its market value; this isn't just an unrealized gain/loss, it's a real cash flow savings that I would have if I were able to transact in today's market. This potential cash could be directed anywhere (durable goods, investments, etc).

    Said differently, to Benn's point, if feels that in the long run I will be worse off because there is cash I could have redirected to investments (let's say in companies with high dividends) but instead have tied up in an asset that may never be worth the amount I am paying for it. Considering this, I can't say I'm sold on your closing paragraph.

    Also, it seems that the subset of people that you single out (young, employed, etc) are exactly the type of folks who you want to be market makers in the long run, but now they're a group that are not able to participate in the market because they can't abandon their current positions in underwater mortgages (if they could, then I'd agree that you're selling low and buying low, so no big deal there). Perhaps the group is statistically insignificant, but I can't understand why tying the hands of that group is unimportant.

    From a macroecon perspective, do you just consider this household cash flow this a net zero transfer in the same way that job creation (unless it's a new to the world job) is not or economic benefit to society? Color me confused.

    Thanks for your time,


    1. Perhaps a better perspective is to stop using dollars as the measure of wealth and start using things. If house prices decline 50%, that does not change the number of houses or the "services" they can provide one bit.

      A related issue is a decline in stocks. That does not change the number of material things, hence does not change aggregate wealth.

      The problem with both scenarios is the change in behavior that occurs that effects future output.

  7. National real estate busts in modern economies are terrible events, regardless of age groups. The obvious reason is that real estate is leveraged (banks get hurt bad), and residential real estate is a large part of household wealth. See Japan for real estate busts that were never reflated. Down 80 percent in last 20 years and still falling. The nation is shrinking.

    For the USA, the immediate response to a real estate bust should be 1) stop them from happening in the first place, then 2) reflate as quickly as possible.

    Fannie and Freddie and CRA may be bad ideas; lop 'em off if you want to. But remember, there was an equal bust in commercial real estate, and no Fannie or Freddie. Why?

    Fed policy was too tight. The Fed tightened in in 2008 in a Quixotic and ill-timed venture to quash global commodities inflation. They dented commodities prices (since largely reflated) but put a torpedo into the side of the USA economy from which we have not yet recovered.

    Lesson learned, I hope.

    What to do now? As Milton Friedman advised (, print money until we get robust growth (the Fed has failed) and the keep printing until you get past certain annual inflation levels (I would suggest five percent). Alan Meltzer and John Taylor also advised this course of action for Japan. As did Ben Bernanke.

    Yes, it is so, so wrong, except everybody has recommended this course of action.

    A long sustained dose of real estate appreciation and inflation, and several years of robust growth and moderate general inflation, is the tonic we need. Would help the nation delevarge too--and the wealthy pay the income taxes, which is how we will pay down the national debt.

    Thus, using QE to monetize the debt, and inflation to reduce the debt might allow for the cutting of income taxes on the wealthy, which is evidently the point of life for many.

  8. This comment has been removed by the author.

  9. Quoting from the post: "Even those that lost money in one house will still want to live in houses for a long time, so they can buy a new house for the same low price that they sell their old houses for."

    This is the simple, key point that most "lay" people miss. And it's an excellent point, of course. However, I think it's more tricky than it appears. This argument assumes that you know the difference between the high price (in 2006, say) and the low price (in 2012, say) for BOTH the old house you sell and the new one you buy.

    Now, for sure you know the former: you know the price you paid in 2006, and you know the price you are selling for 2012. But the latter is uncertain: you know the price you are paying in 2012 but you don't know how much you would have paid that *specific* house in 2006.

    This can make a big difference if people are risk-averse, don't you think?


Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.