Thursday, May 22, 2008

RCM Op-ed "A Tale of Two (Housing) States"

There is never a problem so small that central planners cannot make far worse. So-called “Smart Growth” regulations have crippled the market’s ability to produce a stable home price environment and have aided the housing and credit crises.

In the ‘90s, urban sprawl became a buzzword amongst environmentalists and the urban planning community. It was supposedly ugly, polluting, and destroying open space. The most objectionable quality, however, was that our cities did not fit the idyllic patterns of the Europe experienced on college semesters abroad. Parts of the country, notably California, gave license to urban planners to force new development patterns mimicking those of centuries past. By employing a myriad of limits and mandates, the plans forced growth into dense urban centers. The ideas hopped the pond and spread the world over.

Not understanding that the economics of home construction will not match a predetermined plan, new myopic regulations ran amok. The supply of new homes in these Smart Growth markets began to slow. By rationally responding to this new artificial restriction on supply, home prices rose rapidly. For a while, Smart Growth was making many people very rich on paper.

Other cities, however, imbibed much less of the Smart Growth kool-aid and prices stayed low.
According to the S&P Case-Shiller Index, home prices in the Los Angeles and San Diego metros soared by 18% and 15% annually between 2001 and mid-2006. At the same time in the Atlanta and Dallas metros prices grew a mere 4.4% and 3% annually. Index data prior to 2001 is unavailable for Dallas, but home prices in Atlanta grew at the same 4.4% between 1991 and 2001. Adding to this price paradox is that Atlanta and Dallas were consistently among the fastest growing metropolitan areas in the United States.

It was then in mid-2006 that home prices in many of the highflying cities hit their all-time highs. Afterwards, home prices began to ease in L.A., San Diego, and San Francisco all before the foreclosures began to rise. The stock price of Countrywide hit an all-time high on Feb 2, 2007, showing that mortgage-lending investors had little idea of what was coming.

Home prices when rising at double-digit rates in a liquid market allow many to avoid foreclosure. Equity was growing too quickly to catch many people underwater on their mortgage. When home prices rose to more than ten times median income in California, demand simply could not continue to rise. Flat and then falling prices revealed how many people really could not afford to own a home.

For California, RealtyTrac data shows that foreclosures did not appreciably rise until August of 2006, but home prices were already flat in L.A. and falling in San Diego and San Francisco. Within six months, foreclosures in California grew by 30% and then a whopping 256% more within a year. The massive wave of foreclosures did not occur until nearly a year after prices had already started to drop.

The credit crisis began in part by the way that mortgage-backed securities are priced and by the highly leveraged nature of the mortgage lending industry. This home price boom wreaked havoc on a financial system unaccustomed to such volatility. Ratings are given to mortgage-backed securities based on backward looking analysis of defaults. In an environment where rapidly rising home prices mask foreclosures, risk premiums were too low and values too high on these securities. This practice had been a reliable model due to decades of steady trends. The mortgage lending business model was based on borrowing at low interest rates, lending to consumers at higher rates, and reselling the overpriced mortgage bundles to institutional investors. This system was unprepared for the fundamental changes brought by Smart Growth.

Defaults began to climb as prices fell, causing both the rate and severity of foreclosures to increase. At the same time interest rates were rising. The margins for mortgage lenders disappeared, and some companies collapsed. Any company or hedge fund that leveraged itself assuming faulty valuations of mortgage-backed assets was suddenly in trouble as well.

With less demand for their mortgage bundles, fewer loans were arranged. A vicious cycle set in where falling prices left more people underwater on their loans leading to more foreclosures. More foreclosures increased the supply of homes on the market leading to falling prices.

Painting Smart Growth as the culprit becomes inevitable because other theories on the housing crisis offer no explanation for geography. The Dallas metro was not experiencing the same surging prices as Los Angeles, but the differences do not stop there. Foreclosure rates in Texas have remained flat in the last two and a half years. Even with all the alleged and rampant fraud, resetting of ARMs, and irresponsible borrowers, Texas saw no surge in foreclosures. The only effect seen is slower sales after tightened credit requirements late in 2007. In Texas, there never was a bubble nor would there ever have been a credit crisis.

The only rational explanation for the differences between cities experiencing the housing crisis, and those that are not, is the prevalence of “Smart Growth” legislation. Sinister mortgage lenders and reckless borrowers are not the culprits. This housing crisis is an unprecedented disaster because of unprecedented meddling in the economics of housing development by the peddlers of “Smart Growth”. This scenario will happen again and again if its distortions are not removed.

5 comments:

Market Urbanism said...

Why did you use the cities you chose? Why not Miami, Phoenix, or Boston?

Are you saying you exhausted all other possible causes for the "correlation" and came up with none?

How about geographic constraints, such as an ocean or mountains?

Are there differences in availability of infill development sites? And restrictive zoning that prevents multifamily, mixed uses and higher density on those infill sites?

Could there be any cross-correlation between the data of San Diego and Los Angeles?

Can you describe the methods "Smart Growth" uses to restrict development?

Brian Shelley said...

I chose Los Angeles and Dallas because they had the data I needed, they fairly closely fit my assumptiosn, and there is already a built in rivalry between the two states that makes the article more interesting. If this were an academic paper, the public interest would have been less of a concern.

I wouldn't say that I exhausted all other possibilities, but none of the explanations that I had read anywhere else accounted for differences in geography. The reasons that I discount because of that are: fraudulent lending practices, reckless investors, and federal reserve action.

Geographic constraints will affect the entire West Coast, but Florida and D.C. are into the "Smart Growth" and they have no real geographic constraints. I don't consider the ocean much of a constraint unless it's on a peninsula or island like NY. Houston is fairly close to the Gulf of Mexico and it seems to mirror Dallas which has none.

Availability of infill. Physically, there might be differences, but this is really where Smart Growth kills a city. Houston has very little rules on infill and is experiencing widespread infill, with prices staying relatively low even in the central city. Part of Smart Growth is form based zoning. They want to funnel all dense development into a few key areas so they prevent dense development in most areas to create a false demand in the "islands" of density. Because Houston has no zoning and has especially light rules on infill I would have preferred to use them in the article, but Case-Shiller doesn't track them for some reason.

Cross-correlation? Possibly. I could have thrown San Fran in there as well. I actually think that Las Vegas and Phoenix have been heavily influenced by the massive outflow migration from LA and SD to those cities.

Market Urbanism said...

How can you completely dismiss geographic constraints? Growth is absolutely prohibited on one entire side of those cities by an ocean. The CBDs tend to be near the oceans as well, preventing growth on one side of employment centers. And growth is restricted in the further areas by mountains that surround them.

Miami has no geographic constraints? There is an ocean on one side and everglades on the other. Miami is also a victim of exclusionary zoning over the past 50 years just like California.

Growth in DC is prevented by height restrictions more than Smart growth policy. DC has also seen tremendous employment growth over the period of big government expansion.

Boston saw huge run-ups in housing prices. In the urban areas it was partly because of anti-growth NIMBYism. And in the suburban areas, restrictions that prevent more than a certain number of homes/acre.

You discount the proliferation of sub-prime lending fueled by easy money fed policy, and you attribute a nationwide housing bubble to the relatively recent popularity of "Smart Growth" policy of certain cities. However, anti-growth policies have proliferated for the past 60+ years in the form of exclusionary zoning that prevents anything other than a certain number of single family homes per acre. These policies have been nearly ubiquitous in all suburbs for a long time and certainly more widespread than the more recent smart growth initiatives of some cities. If they are as responsible for the bubble, as you suggest, it's a really big bubble that hasn't even begun to deflate.

For an example of the exclusionary attitudes of planners in some areas see this video on the Beverly Hills Planning department website:
http://beverlyhills.granicus.com/MediaPlayer.php?view_id=17&clip_id=100


How do they funnel density? By restricting it elsewhere or by permitting it and letting the market decide if density is better, but only for certain areas?

I don't disagree that planners have caused many problems, I just think that "Smart Growth" is relatively benign compared with the exclusionary zoning that has been considered the norm in most areas. Thus, "Smart Growth" alone, cannot be to blame.

Brian Shelley said...

I usually think of exclusionary zoning as going hand in hand with Smart Growth. If apartments and high density development is allowed to build away from transit corridors then it would lessen the demand for such buildings in the desired areas along the transit lines. What I think of as Smart Growth may blur the lines with other land-use regulations.

I don't dismiss geographic constraints. Prices, even without land-use regulations would be higher in LA and SF when compared to Dallas would likely be higher.

The fast growth in D.C. doesn't sway me. Growth is faster in Dallas, Atlanta, and Houston and their price gains are slow.

The Miami situation as the exception, but in general I don't consider being next to water being much of a constraint. Did Chicago, Detroit and Cleveland have historically high land values compared to some other cities because they are constrained by water? Philadelphia doesn't have sky high prices, yet is on the water. I don't see how Boston, SF, and San Diego could have skyrocketing prices caused by geographic constraints when their populations are not growing very much, if at all.

I also don't want people to misunderstand that I am against density. I am in favor of density, and I actually think that a completely distortion free market would produce cities more dense than they are today.

Market Urbanism said...

We are in complete agreement that completely distortion free market would produce cities more dense than they are today.

However, I don't think attacking "Smart Growth" so specifically is treating the whole picture appropriately. Some people have choosen to attack "smart growth" by itself, but not the exclusionary zoning that protects the value of their single family homes. Smart Growth is a specific planning term that tends to favor density, so people may misinterpret what you are trying to convey as favoring sprawl development.

The fact is that supply constraints, whether physical or governmental cause prices to rise.

Looking at data, you'll find that in supply constrained markets, prices are more volatile, which is at least partly because the market cannot make adjustments to shocks quickly through development. When development is constrained or delayed by public process, volatility is further exacerbated.

Higher volatility usually means higher returns/appreciation inherent with higher risk.

You'll see that prices in mid west cities are less volatile than coastal cities. This is mostly because of less constraints plus other macro effects.

Chicago and other mid west cities, while constrained on one side, are not very supply constrained markets. Go to Chicago, and you'll see plenty of infill sites ready to develop. Some experts say Chicago may become "constrained" in 10-15 years, but currently there are low barriers to entry compared to most cities. Appreciation in Chicago was very modest compared with Coastal cities.

I'm not familiar with Philadelphia, but assume it saw much higher appreciation than Dallas, Atlanta, or Chicago.

I don't see how Boston, SF, and San Diego could have skyrocketing prices caused by geographic constraints when their populations are not growing very much, if at all.
You might want to check on that. But, I didn't claim Boston was restrained only by geography. It's mostly constrained by politics very unfriendly to development.