RBA badly misreads bubble dynamics

Yesterday in the RBA’s housing data dump, the RBA’s Head of Financial Stability, Luci Ellis co-authored a paper entitled Property Market Cycles as Paths to Financial Distress, which makes a series of very questionable claims about the role played by responsive housing supply in causing financial instability in the US. It began:

…many authors have observed that price booms tend to be larger in markets where the supply of property is constrained, as seems to be the case in the United Kingdom, for example. It seems an obvious point that the steeper the supply curve in the property market, the more property prices will increase after some positive demand shock…

Absolutely. Basic economics tells us that policies that restrict housing supply steepens the supply curve, which makes house prices far more sensitive to changes in demand and increases the likelihood of the housing market experiencing boom/bust price cycles as demand rises/falls.

This is a topic that I have written about many times before, for example here and here. It is also a view supported by research. For example, a recent Journal of Urban Economics paper by Haifang Huanga and Yao Tang suggests the link between higher house price volatility and non-responsive housing supply (e.g. due to restrictive land use regulations) has become more pronounced in the US [my emphasis]:

Abstract: “In a sample covering more than 300 cities in the US from January 2000 to July 2009, we find that more restrictive residential land use regulations and geographic land constraints are linked to larger booms and busts in housing prices. The natural and man-made constraints also amplify price responses to the subprime mortgage credit expansion during the decade, leading to greater price increases in the boom and subsequently bigger losses.

And in a detailed examination of studies in this area, Harvard’s Edward Glaeser and Warton’s Joseph Gyourko also concluded that tight land/housing supply leads to greater price booms and busts:

Recent research also indicates that house prices are more volatile, not just higher, in tightly regulated markets …. price bubbles are more likely to form in tightly regulated places, because the inelastic supply conditions that are created in part from strict local land-use regulation are an important factor in supporting ever larger price increases whenever demand is increasing.

…. It is more difficult for house prices to become too disconnected from their fundamental production costs in lightly regulated markets because significant new supply quickly dampens prices, thereby busting any illusions market participants might have about the potential for ever larger price increases.

Yet despite the compelling research in this area, the Ellis paper takes an opposing view, arguing that more responsive housing supply increases financial instability:

In this paper we show, however, that this need not imply that the subsequent decline in prices will also be more damaging for financial stability. The price cycle by itself can be a misleading statistic of risks to financial stability, partly because debt dynamics result from a combination of both price and quantity dynamics, and partly because the distribution of debt is far more important in creating financial distress than is its aggregate value. We show that when property supply is more flexible, the distribution of debt at the end of a boom is more likely to trigger episodes of financial distress and instability.

The differing experiences of housing markets in US cities during the recent boom–bust cycle are a case in point. Housing supply in Atlanta, for example, is known to be quite flexible. As Figure 1 shows, Atlanta experienced only a small run-up in prices during the boom compared to other cities. However, the price bust has been large: housing prices in Atlanta were 36 per cent below their peak, using Case-Shiller data up to early 2012, a slightly larger fall than the 20-city composite index, and only a few percentage points less than the 40 per cent decline in Los Angeles. Importantly, prices in Atlanta are below their 2000 levels, implying that some homeowners who purchased more than a decade ago are now holding a property worth less than they paid for it.

The paper’s claim that Atlanta housing has experienced similar losses in value to the key US bubble cities is very misleading. While percentage losses have been similar, actual dollar (equity) losses in Atlanta have been moderate compared with the bubble cities, because Atlanta’s homes were relatively affordable to begin with, due predominantly to its abundant and responsive land supply (see below chart).

While an average home owner in Atlanta has lost -$83,000 in home equity since prices peaked, home owners in Los Angeles have lost -$308,000, those in Phoenix have lost -$230,000, and home owners in Miami have lost -$267,000.

Back to the Ellis paper:

The latest available New York Fed data (for late 2010) suggest that the fall in Atlanta has indeed resulted in high rates of negative equity, and thus arrears and foreclosures: on average, Georgia counties in the Atlanta region had arrears rates 2 percentage points above the national average of 5.3 per cent. At 21.8 per cent, the 90-day arrears rate on subprime loans in Georgia, using available state-level data, was at a level similar to those in states most associated with the bubble (California, Nevada and Arizona), and noticeably above the national average (17.9 per cent), while for prime mortgages, the arrears rate in Georgia (3.4 per cent) was actually above that in Florida (3.2 per cent) and Arizona (2.9 per cent).

Data supplied by the Federal Reserve Bank of New York (FRBNY), shows that the percentage of mortgage debt balances that are more than 90 days delinquent is far lower in Georgia than the key bubble states of California, Nevada, Arizona and Miami (see below chart).

Back to the Ellis paper:

… We show that a more responsive supply of property to prices can generate dynamics which are more likely to generate financial distress. If the flow of new property supply is highly responsive, the price response will be smaller in a boom than if supply were inflexible (Paciorek 2012). This may suggest that the downswing might be less likely to create financial distress, but we show that this is not always the case. If supply is quite responsive, large amounts of new property will be constructed during the boom, creating an overhang of excess supply once the boom ends. Prices will then fall further, potentially putting even those who bought prior to the boom into negative equity. In addition, more of the loan book will be accounted for by borrowers who bought at or near the price peak – because of the increased flow of new property purchases in those periods. Therefore if supply is more responsive, more of the loan book is liable to be in negative equity, a necessary condition of default. The effect of a highly responsive supply on loan performance is exacerbated when there are time-to-build lags, that is, if production is highly responsive to changes in price but adds to supply periods later…

If supply is inflexible, the increase in demand manifests as a price boom more than a quantity boom, but a smaller fraction of the loan book is originated at boom-time prices. Flexible supply, on the other hand, absorbs much of the demand shock, so the price effect is smaller in the boom. In the bust phase, however, the larger supply overhang induces prices to undershoot their pre-boom level by more than if supply is fairly inflexible. This can push even cohorts who bought their property before the boom into negative equity.

More importantly, the more responsive is supply, the more property is transacted at boom prices. The fraction of the loan book liable to fall into negative equity, and perhaps default, is higher. While this finding can be partly offset by existing owners trading up, it remains true that the net addition to the stock of property must be bought by someone. Therefore the fraction of the loan book accounted for by new borrowers with higher leverage (and hence greater vulnerability to price falls) will always be greater when supply is more responsive. These effects are exacerbated by time-to-build lags, which accentuate the price cycle.

Again, the paper’s claims are not backed up by the data. The FRBNY provides time series data on mortgage debt levels and delinquencies for a range of US states. While Georgia is not included in this sample, other states with responsive housing supply are, namely: Texas, Pennsylvania, Ohio and Michigan. These are presented below against the key bubble states of the US – California, Nevada, Arizona, and Florida – where housing supply was restricted either by urban containment policies (“smart growth”) in the case of California and Florida, or government monopoly control (and restriction) of supply, as was the case in Nevada and Arizona.

First, consider mortgage debt levels in the various markets:

As you can see, debt levels are far lower in the markets where housing supply is abundant and responsive. Why? Because low-cost housing has always been available to would-be buyers in these states, meaning that households never had to take on huge sums of debt in order to purchase a home, unlike their counterparts in the supply-restricted states. In addition, there was never as great an incentive to speculate in the housing market in these states because the ready availability of new supply kept expectations of capital growth in check.

It’s a similar story with mortgage arrears, with the supply-responsive states fairing much better than the bubble states (see below charts).

Clearly, by focusing on Atlanta only, and by cherry-picking mortgage delinquencies data from the FRBNY, Ms Ellis has produced an erroneous argument to support the view that restrictions on housing supply, as exist across Australia, are beneficial for financial stability.

Nothing could be further from the truth. The fact remains that supply-side restrictions – such as restrictive zoning, urban growth boundaries, up-front development charges, slow land release by government, etc – act to make housing both more unaffordable and prone to vicious boom/bust cycles.

To illustrate this point, consider the below charts showing Median Multiples (median house prices divided by median household income) in a sample of cities deemed by Demographia and/or the Brookings Institution as having restrictive land-use regulations versus those with more responsive land-use regulations.

First, the cities with restrictive land-use regulations:

Second, the cities with more responsive land-use regulations:

As you can see, the cities with more responsive land-use regulations (planning systems) have achieved both more affordable housing and lower levels of house price volatility than those with more onerous requirements (tighter planning).

Why? Because when supply is unable to respond quickly to changes in demand, the housing market becomes overly sensitive to demand shocks, resulting in greater price volatility and boom/bust cycles as demand rises/falls. During an upswing, the extra demand will automatically feed into higher home prices rather than new construction. In turn, the price rises and perceived scarcity will encourage speculative demand and ‘panic buying’ from first-time buyers, which helps to drive prices up even further. The opposite holds during a downturn, where unresponsive supply will help to accentuate price falls as new housing planned years ago continues to hit the market.

This is basic logic and economics. We should expect greater rigour from the RBA.

Twitter: Leith van Onselen. Leith is the Chief Economist of Macro Investor, Australia’s independent investment newsletter covering trades, stocks, property and yield. Click for a free 21 day trial.