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Real estate.

In the 1980s there were enormous changes in the housing finance system that affected both the home-ownership rate and real house prices. In addition, housing's historic sensitivity to changes in nominal interest rates seems to have been dampened substantially. This, with the integration of national capital markets--which has reduced the ability of monetary policy to alter U.S. interest rates relative to world rates--probably brought about a significant reduction in the potency of monetary policy.

But the altered housing financing system is hardly the only factor that changed homeownership, household formation, and real house prices in the 1980s. The real costs of owning and renting housing depend on real interest rates and tax laws relating to investment in housing, and both have undergone major changes in the 1980s. (1) Moreover, household formation, homeownership, and real house prices also depend on real wages, an important determinant of the effective demands for privacy and housing.

While housing comprises over 80 percent of noncorporate real estate in the United States, the other nearly 20 percent also has undergone major changes in the 1980s. This report briefly addresses that topic, too.

Mortgage Market Changes and Housing

During the 1960s and 1970s, the U.S. government closely regulated the system of financing single-family housing in four ways. First, federally chartered depository institutions were prohibited from originating adjustable-rate mortgages (ARMs), so virtually all home-buyers were granted fixed-rate mortgages (FRMs). Second, portfolio restrictions and tax inducements led nonbank depository institutions (S&Ls and mutual savings banks) to supply two-thirds of all funds to the home mortgage market (commercial banks and the Federal National Mortgage Association--FNMA, or Fannie Mae--supplied most of the rest) and caused home mortgage rates to be roughly one-half percentage point below fair market rates during the 1970s. (2) Third, because depository institutions were funding their long-term investments (FRMs) with short-term deposits, deposit rate ceilings were introduced so that significant increases in interest rates would not cause large cash flow losses for the institutions. Fourth, because the capital market could not compete with "cheap" deposit money, few conventional mortgages were pooled into passthrough securities.

Prohibitions against ARMs, portfolio restrictions, tax inducements, and deposit rate ceilings all were lifted in the 1980s. Not surprisingly, the housing finance system changed dramatically. (3) A national primary market for ARMs developed (between early 1982 and 1989, two-fifths of all new conventional home mortgages had adjustable rates). FRMs (both whole loans and passthroughs) held by S&Ls declined by 15 to 20 percent. Moreover, the fraction of conventional FRM originations that were pooled into passthroughs rose from less than 5 percent before 1982 to over 50 percent after 1985 and to over two-thirds in 1989.

In the last dozen years, the S&L industry has been decimated. The sharp and sustained rise in interest rates in the late 1970s and early 1980s wiped out the industry economically, (4) and the recent Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) legislation is eliminating it quantitatively. The S&L share of outstanding home mortgages has fallen from 43 percent at the end of 1984 to 25 percent at the end of 1990. Over half of the decline has occurred since March 1989. The enormous losses generated by the high interest rates in the early 1980s paralyzed the thrift industry and caused home mortgage rates to go from one-half percentage point below fair market levels to one-half point above. This half point provided the stimulus for securitization of conventional FRMs, covering the start-up costs of the securitizers and providing the initial liquidity premium demanded by investors. By 1986, however, the widespread success of securitization eliminated the half-point premium. (5)

One troubling aspect of the S&L problem is the industry's continuing vulnerability to fluctuations in interest rates, which extends to recent acquirers of S&L assets. When FIRREA was passed, S&Ls were funding as many FRMs with short-term deposits as they had in 1977 ($400 billion), and they had added $325 billion in ARMs with interest rate caps. While the industry has since shrunk, and is still shrinking rapidly, the risks simply are being passed on to the depository institutions purchasing the S&Ls, and to the Resolution Trust Corporation.

The U.S. housing finance system has been transformed from a highly regulated, one-instrument (FRM), deposit-based system to an unregulated, two-instrument, mixed capital-market (FRM) and deposit-based (ARM) system. The regulated system made housing quite sensitive to increases in nominal interest rates for two reasons. First, higher interest rates raised the ratio of mortgage payments to income (for a given house and loan-to-value ratio), even when the present value of mortgage payments did not rise relative to the present value of future income. Because lenders set qualification standards in terms of the ratio of current values, and because borrowers had no alternative mortgage instrument to make housing more affordable, those unable to provide a larger down payment were constrained to purchase less costly houses (or to forgo their purchase). Second, deposit rate ceilings would bind, and credit rationing would occur (lenders effectively would require larger down payments, exacerbating the first problem).

The introduction of ARMs has given households a financing vehicle with a lower initial payment. Households switch to ARMs when FRM rates get into double digits. (6) The removal of deposit rate ceilings and the widespread securitization of FRMs means that credit rationing no longer occurs when interest rates rise. This suggests that housing starts and investment should be far less sensitive to rising nominal interest rates now than they were prior to 1980. Estimates, largely generated by researchers with the Federal Reserve System, are that housing starts and outlays have been only one-fifth to one-third as sensitive to interest rates after 1982 as before. (7)

Household Formation, Homeownership,

and Real House Prices

Household formation and homeownership among America's young are sensitive to the real costs of housing. Average real house prices seem to depend on real aftertax mortgage rates. Thus, I conclude that below-market rates on home mortgages contributed to a surge in household formation, homeownership, and real house prices in the 1970s; above-market rates played a role in the decline of all three in the first half of the 1980s.

Household formation depends on how early youth leave their parental homes and the extent to which they marry or otherwise form into groups when they leave. Recent research based on individuals in their twenties in 1987 indicates that these decisions are quite sensitive to locational differences in real housing costs. (8) Youth aged 25 in areas with low (half the sample mean) real housing costs are 20 percentage points (0.9 versus 0.7) more likely to be outside the parental home than their peers in areas with high (twice the sample mean) real costs. Similarly, 25-year-olds in areas with low real costs are 10 percentage points more likely to be married than those in areas with high real costs. (9)

Not surprisingly, youth with high-potential real wage rates (double the mean) also are significantly more likely to live outside their parents' home and to be married than youth with low-potential real wage rates. The decisions to leave home and marry also are significantly related to demographic factors, such as age, race, and sex.

Relative housing costs and potential real wage rates also are relevant to the decision of youth to buy versus rent a home. (10) Where house prices are low relative to rents, there is a 15-percentage-point higher probability of a 25-year-old owning a home than in areas with high house prices relative to rents. Similarly, 25-year-olds with high-potential real wages are 15 percentage points more likely to be owners than their peers with low-potential real wages. Again, age, race, and sex also matter.

The impact of the changing age structure of the U.S. population on real house prices is a more controversial question. N. Gregory Mankiw and David N. Weil found that age had an enormous impact on real house prices. They used the result to forecast a 47 percent decline in real house prices between 1987 and 2007. (11) I question their results for two reasons. (12) First, the relationship between real house prices and their age-related variable really holds only for the first part of the sample: the 1950s and 1960s; it does not hold for the 1970s and 1980s. When a relationship estimated over 1947-69 is used to forecast 1970-87, the increase in real house prices is 41 percent, versus the actual increase of only 10 percent.

Second, even when Mankiw and Weil hold the age-related demand for housing constant, real house prices fall by 6.5 percent annually forever. (Demand is not falling in their 1987-2007 forecast; it is simply growing at a slower rate than in prior decades. The negative 6.5 percent trend annual decline generates the 47 percent cumulative real house price decline.)

It does appear that real aftertax interest rates have played a significant role in explaining real house prices. (13) Real aftertax rates fell to unusually low levels throughout the 1970s, when the greatest increase in real house prices occurred, and rose to peak levels in the first half of the 1980s, when real prices declined.

Investment Real Estate

Earlier studies based on appraisals have reported that real estate was low risk, and that risk-adjusted returns on real estate were higher than returns on stocks and bonds. More current research debunks this result and shows that returns on real estate are far more volatile than previously believed. In fact, real estate returns may be about as volatile as the returns on equity real estate investment trusts (EREITs) are.

With K. C. Chan and Anthony B. Sanders, I examine EREIT returns on the grounds that, being transactions-based, they are the most representative real estate returns available. (14) We explain both an equally weighted monthly return index (1973-87) for about 20 EREITs and an index of equally weighted returns for companies on the NYSE. In the end, we find no evidence of excess real estate returns.

Three macroeconomic factors consistently drive both real estate and stock market returns: changes in the risk structure of interest rates; changes in the term structure; and unexpected inflation. The impacts of these factors on real estate returns consistently are around 60 percent of the impacts on corporate stock returns generally. Moreover, for lightly leveraged EREITs, the impacts are even less. Thus, real estate is substantially less risky than corporate stocks. However, real estate does not appear to be any better hedge against inflation than corporate stock is; unexpected inflation has a negative impact on both NYSE stock and EREIT returns.

Chan, Sanders, and I also explore the possibility that the same forces that drive discounts on closed-end stock funds affect returns on EREITs. Such a relationship seems plausible, because EREITs are closed-end mutual funds invested in real estate assets. In fact, we uncover the relationship in the data. When the equally weighted EREIT return index is regressed on the change in the closed-end stock fund discount, we obtain a coefficient of 0.5, further reinforcing the view that real estate is less risky than common stocks are.

Recent data on EREITs, especially in 1990, suggest that real estate returns have deteriorated relative to what we have predicted. It appears that the failure of construction to retrench in the second half of the 1980s, because of continued 100 percent financing of developers by S&Ls that are in trouble, is finally having a negative impact on the value of existig, high-quality real estate. Given the widespread excess capacity by type of use and geographic locale, a substantial impact should be expected.

(1) P. H. Hendershott and J. Peek, "Interest Rates in the Reagan Years," NBER Working Paper No. 3037, July 1989, and in The Economic Legacy of the Reagan Years: Euphoria or Chaos? Sahn and Tracy, eds., New York: Praeger, 1991; and J. R. Follain, P. H. Hendershott, and D.C. Ling, "Understanding the Real Estate Provisions of the Tax Act: Motivation and Impact," NBER Reprint No. 1010, June 1988, and National Tax Journal, (September 1987), pp. 303-372.

(2) P. H. Hendershott and R. VanOrder, "Integration of Mortgage and Capital Markets and the Accumulation of Residential Capital," NBER Reprint No. 1334, December 1989, and Regional Science and Urban Economics 19 (May 1989), pp. 364-378.

(3) P. H. Hendershott, "The Market for Home Mortgage Credit: Recent Changes and Future Prospects," NBER Working Paper No. 3548, December 1990, and in Recent Changes in the Market for Financial Services, Gilbert, ed., St. Louis: Economic Policy Conference, Federal Reserve Bank of St. Louis, 1991.

(4) E. J. Kane, The S&L Insurance Mess: How Did It Happen? Washington, DC: Urban Institute Press, 1989.

(5) Hendershott and VanOrder, op. cit.

(6) J. K. Brueckner and J. R. Follain, "ARMs and the Demand for Housing," Regional Science and Urban Economics 19 (May 1989), pp. 163-187.

(7) These studies are surveyed in P. H. Hendershott, "An Altered U.S. Housing Finance System: Implications for Housing," in The Economics of Housing in Japan and the United States, J. M. Poterba, ed., Chicago: University of Chicago Press, forthcoming 1992.

(8) D. R. Haurin, P. H. Hendershott, and D. Kim, "The Impact of Real Rents and Wages on Household Formation," NBER Working Paper No. 3309, March 1990, revised December 1990.

(9) Haurin, Hendershott, and Kim, op. cit.

(10) D. R. Haurin, P. H. Hendershott, and D. Kim, "Tenure Choice of American Youth," NBER Working Paper 3310, March 1990.

(11) N. G. Mankiw and D. N. Weil, "The Baby Boom, the Baby Bust, and the Housing Market," NBER Reprint No. 1357, March 1990, and Regional Science and Urban Economics 19 (May 1989).

(12) P. H. Hendershott, "Are Real House Prices Likely to Decline by 47 Percent?" Regional Science and Urban Economics 21 (June 1991).

(13) P. H. Hendershott, "An Altered U.S. Housing Finance System," op. cit.

(14) K. C. Chan, P. H. Hendershott, and A. B. Sanders, "Risk and Return on Real Estate: Evidence from Equity REITs," AREUEA Journal 18, 4 (Fall 1990).
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Title Annotation:housing finance system in the 1980s
Author:Hendershott, Patric H.
Publication:NBER Reporter
Date:Mar 22, 1991
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