Janet Yellen completely missed the housing bubble

Economists and forecasters are wrong most of the time. The ones that last the longest learn to revise history and make it look like they were right when, in fact, they were dead wrong. Managing perception and reputation is more important that actually being right or wrong.

Many support Janet Yellen for the soon-to-be-vacated post of Chair of the Federal Reserve Board of Governors (Ben Bernanke’s job). They are trying to cast her candidacy in the best light, and in the process, they are revising history to make it look like she saw the housing bubble and bust coming. She didn’t.

Janet Yellen called the housing bust and has been mostly right on jobs. Does she have what it takes to lead the Fed?

By Neil Irwin and Ylan Q. Mui, Published: August 16 at 10:00 pm

President Obama’s choice — which appears likely to be between Yellen and combative former Treasury secretary Larry Summers — will determine what set of skills will guide the U.S. economy out of its unexpectedly long slump and grapple with whatever nasty surprises lurk along the way. …

The San Francisco Fed and the housing bubble

Yellen returned to Berkeley in 1999, then re-entered public service in 2004 as president of the Federal Reserve Bank of San Francisco, just as the housing market in California and other western states were entering a full-scale bubble.

Yellen’s economic training made her suspicious early on that the good times could not last, and she directed the bank’s research staff to drill deeper into the data: What could happen when teaser interest rates on new-fangled mortgages reset? What would become of the piggyback loans many homeowners had taken out on top of their mortgages? How leveraged had Americans become?

“Janet was very much a person who asks very probing questions, wants to understand kind of what’s below the conclusions,” said John Williams, who was head of research under Yellen and followed her as president of the San Francisco Fed.

She may have been asking questions, but as I will demonstrate later, she wasn’t coming up with any good answers.

So when the leaders of the Fed gathered around their big mahogany table overlooking the National Mall on Dec. 11, 2007, Yellen was perhaps the most gloomy.

December 11, 2007? The housing bubble peaked nationally in mid 2005. It peaked in California in mid 2006. By the end of 2007 a blind man could see the housing bubble. Not exactly prescient.

“The possibilities of a credit crunch developing and of the economy slipping into recession seem all too real,” she said, reading carefully measured words from a sheet of paper. The “shadow banking system,” the complex financial markets that funnels credit to Americans, was freezing up, she said, and the economy was likely to slow significantly.

As it turns out, the Great Recession was beginning that very month.But while Yellen voiced one of the most prescient diagnoses of the looming crisis, her position on the West Coast left her little role in sculpting the response.

She got to be the messenger who informed her colleagues that they totally screwed up. Big deal.

There was one federal reserve governor who did spot the housing bubble, and he loudly proclaimed it: Atlanta Fed President Jack Guynn called the housing bubble in 2005. Janet Yellen did not call the housing bubble. In fact, she totally accepted the idea of financial innovation (see: The Fallacy of Financial Innovation a post I published in early 2008).

From the June 2005 FOMC June meeting:


MS. YELLEN. Thank you, Mr. Chairman. I just wanted to make a couple of comments and also ask a quick question. My first comment relates to the run-up in price-rent ratios that we’ve seen. It seems to me that there might be a couple of factors that could explain at least some portion of the run-up, though probably not all of it, that weren’t mentioned in the presentations.

First, it seems to me that financial innovations affecting housing could have improved the view of households regarding the desirability of housing as an asset to be held in portfolios and thus raised the equilibrium price-to-rent relationship for residential real estate.

Yes, people were gripped by a financial mania and lost all perspective on true value. She suffers from the false assumption that people are rational.

What I’m thinking of is the idea that equity held in residential real estate is a lot more accessible today than it has been in the past.

That happens when you eliminate all lending standards.

Home equity credit at commercial banks is up fourfold since 1999, and many households obviously are now keenly aware that refinancing provides a low-cost avenue for tapping into the equity in their homes.

Lenders trained a generation of Ponzis, and the head bankers were too ignorant to see it or do anything about it.

So, in a sense, there might be less of a liquidity premium embodied in the return for housing. Also, if people feel that the liquidity constraints in holding housing as an asset are diminishing, that could explain a reduced need for precautionary saving in traditional liquid assets.

Fools were putting all their money into housing and eschewing other forms of saving and investment entirely. Rather than being alarmed by this, she thought the public was behaving rationally.

It could even make people willing to put more of their wealth into down payments on houses and may have raised prices through that mechanism.

LOL! Putting more down? People were putting nothing down. Average down payments consistently declined during the housing bubble as more and more people were allowed to put nothing down. Her statistics had to show that.

The other thing that occurred to me is that there might be effects from tax changes. We’ve had changes in the rules for tax exemption and in 1997 on capital gains from the sale of primary residences that would make holding real estate assets more attractive. And the changes in capital gains taxes more generally in 1997 and then again in 2003 would have worked in the same direction.

That much is true. Government threw fuel on the fire.

One of the things that we looked at that we thought was interesting was the behavior of price-rent ratios for residential housing. … it appears that the behavior of price-rent ratios in residential housing has closely mirrored what we’ve seen in commercial office space. The ratios for both have gone up about 30 to 35 percent since around 1998….

That’s the clearest possible indicator that there was a housing bubble. Do you think you could have spotted the housing bubble in 2005 if you had access to the data below?

A second comment I wanted to make concerns the relationship of creative finance to the housing market. One view that I think is very prevalent is that the use of credit in the form of piggyback loans, interest-only mortgages, option ARMs [adjustable-rate mortgages], and so forth, involves financial innovations that are feeding a kind of unsustainable bubble.

Yes, those products clearly were fueling a housing bubble. Anyone with an understanding of Finance 101 could see that — unless they were blinded by greed or willful ignorance.

But an alternative perspective on that is that high house prices, in fact, are curtailing effective demand for housing at this point and that house appreciation probably is poised to slow. So the increasing use of creative financing could be a sign of the final gasps of house-price appreciation at the pace we’ve seen and an indication that a slowing is at hand.

She obviously believed the “alternative perspective.”

So prices won’t go down, but they won’t appreciate as fast. That’s as close as she came to recognizing the housing bubble and the imminent housing bust.

Previously, lenders applied very rigid constraints on loan-to­ value ratios, but essentially those constraints are now being eased at the margin through these creative financing techniques.

Eased at the margins? LOL! The LTV standards were completely abandoned.

And have you seen the DTIs on modified loans? Lenders didn’t care much about that either.

And that’s providing some elasticity to what was a firm roof. It may slightly diminish the price elasticity of the demand for housing, but the fact that it is blossoming now basically suggests that we really are at the ceiling where it’s binding and will ultimately constrain appreciation.

It certainly did constrain appreciation — to the tune of a 30% to 50% decline.

Finally, with those two comments, a question. It concerns the presentation by Andreas and the numbers cited on loan-to-value ratios at origination. One of the things we’re seeing in California and elsewhere in our District—and maybe this is true nationwide—is a growing use of piggyback loans. Loan-to-value ratios of 90 to 95 percent are common in California, and we’ve even seen combination loan-to-value ratios and piggyback loans going up to 125 percent. I guess that means two things, one of which is that the traditional first mortgage looks utterly conventional. Those mortgages have an 80 percent loan-to-value ratio and I suppose they are being sold off to Fannie and Freddie. The other thing is that with such conventional mortgages being sold to Fannie and Freddie, there’s no need for private mortgage insurance. So Fannie’s and Freddie’s books may look better in some sense—less risky—than they really are because of all of the second mortgages going up to possibly 125 percent.

At least she got that one right. Three years later the GSEs were taken over by the Treasury department, and the US taxpayer had to inject them with $150B to keep them afloat.

CHAIRMAN GREENSPAN. It sounds like a CDO [collateralized debt obligation]. That’s what it is, isn’t it?

MS. YELLEN. Yes. So I wondered if that was something that you’re aware of and something that is included in the numbers.

Chairman Greenspan wasn’t aware of anything.

Personally, I don’t really care who gets in at the federal reserve. The next chair will print money just like Bernanke. Some may be marginally more hawkish or dovish, but the difference on the margins will hardly be noticeable. Janet Yellen may be the best candidate, and she may get the job, but it won’t be due to her great insights into the housing bubble or bust.

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[idx-listing mlsnumber=”OC13161866″ showpricehistory=”true”]

18212 SHARON Ln Huntington Beach, CA 92648

$749,000 …….. Asking Price
$220,000 ………. Purchase Price
7/27/1988 ………. Purchase Date

$529,000 ………. Gross Gain (Loss)
($59,920) ………… Commissions and Costs at 8%
$469,080 ………. Net Gain (Loss)
240.5% ………. Gross Percent Change
213.2% ………. Net Percent Change
4.8% ………… Annual Appreciation

Cost of Home Ownership
$749,000 …….. Asking Price
$149,800 ………… 20% Down Conventional
4.59% …………. Mortgage Interest Rate
30 ……………… Number of Years
$599,200 …….. Mortgage
$155,743 ………. Income Requirement

$3,068 ………… Monthly Mortgage Payment
$649 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$156 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$150 ………… Homeowners Association Fees
$4,023 ………. Monthly Cash Outlays

($753) ………. Tax Savings
($776) ………. Principal Amortization
$257 ………….. Opportunity Cost of Down Payment
$114 ………….. Maintenance and Replacement Reserves
$2,865 ………. Monthly Cost of Ownership

Cash Acquisition Demands
$8,990 ………… Furnishing and Move-In Costs at 1% + $1,500
$8,990 ………… Closing Costs at 1% + $1,500
$5,992 ………… Interest Points at 1%
$149,800 ………… Down Payment
$173,772 ………. Total Cash Costs
$43,900 ………. Emergency Cash Reserves
$217,672 ………. Total Savings Needed
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