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Is Financial Risk Socially Determined?

The authors of the In the Balance—Senior Economic Adviser William Emmons, Senior Analyst Lowell Ricketts and Intern Tasso Pettigrew, all with the St. Louis Fed’s Center for Household Financial Stability—found that eliminating so-called “bad choices” and “bad luck” reduced the likelihood of serious delinquency. With the exception of Hispanic families, this did not get rid of disparities in delinquency risk relative to the lower-risk reference group.

However, this exercise was based on the idea that the young (or less-educated or nonwhite) families’ financial and personal choices, behavior and exposure to luck could conform to those of the old (or better-educated or white) families. The authors suggested that such an approach may not be realistic.

A Lack of Choice?

“We believe a more realistic starting point for assessing the mediating role of financial and personal choices, behavior and luck in determining delinquency risk is a family’s peer group,” the authors wrote. They looked at how an individual family’s circumstances differ from its peer group, hoping to capture the “gravitational” effects of the peer group.

The odds are similar to those that were not adjusted, as seen in the figures below. (For 95 percent confidence intervals, see “Choosing to Fail or Lack of Choice? The Demographics of Loan Delinquency.”)

In particular, they examined how a randomly chosen family fared against the average of its peer group, such as how much debt a young black or Hispanic family with at most a high school diploma has compared to the family’s peer-group norm.

“We assume that the distinctive financial or personal traits associated with a peer group ultimately derive from the structural, systemic or historical circumstances and experiences unique to that demographic group,” the authors wrote.

When assuming that individual families’ choices extend only to deviations from peer-group averages, the authors estimated that:

A family headed by someone under 40 years old is 5.8 times as likely to become seriously delinquent as a family headed by someone 62 years old or more.

Middle-aged families (those with a family head aged 40 to 61 years old) are 4.2 times as likely to become seriously delinquent as old families.

A family headed by someone with at most a high school diploma is 1.8 times as likely to become seriously delinquent as a family headed by someone with postgraduate education.

A family headed by someone with at most a four-year college degree is 1.4 times as likely to become seriously delinquent as a family headed by someone with postgraduate education.

A black family is 2.0 times as likely to become seriously delinquent as a white family.

A Hispanic family is 1.2 times as likely to become seriously delinquent as a white family.

These demographic groups still appear to have a higher delinquency risk than older, better-educated and white families. This suggests that younger, less-educated and nonwhite families may have little choice in the matter.

“The striking differences in delinquency risk across demographic groups cannot be explained simply by referring to differences in risk preferences,” Emmons, Ricketts and Pettigrew wrote. “Instead, we suggest that deeper sources of vulnerability and exposure to financial distress are at work.”

The authors also concluded: “Families with ‘delinquency-prone’ demographic characteristics—being young, less-educated and nonwhite—did not choose and cannot readily change these characteristics, so we should refrain from adding insult to injury by suggesting that they simply have brought financial problems on themselves by making risky choices.”

Each family was assigned to one of 12 peer groups, which were defined by age (young, middle-aged or old), race or ethnicity (white or black/Hispanic) and education (at most a high school diploma or any college up to a graduate/professional degree).

The Problem Of Home Ownership

The proportion of households in Australia who own a property is falling, more a renting, or living with family or friends. We track those who are “property inactive”, and the trend, over time is consistent, and worrying.

It is harder to buy a property today, thanks to high prices, flat incomes and higher credit underwriting standards. Whilst some will go direct to the investment property sector (buying a cheaper place with the help of tax breaks); many are excluded.

This exclusion is not just an Australian phenomenon. The Federal Reserve Bank of St. Louis just ran an interesting session on “Is Homeownership Still the American Dream?” In the US the homeownership rate has been declining for a decade. Is the American Dream slipping away? They presented this chart:

A range of reasons were discussed to explain the fall. Factors included: the Great Recession and foreclosure crisis; tougher to get a mortgage now (but probably too easy before the crash); older, more diverse American population; stagnation of middle-class incomes; delayed marriage and childbearing; student loans and growing attractiveness of renting for some.

Yet, there is very little association between local housing-market conditions experienced during the recent boom-bust cycle and changes in attitudes toward homeownership. The desire to be a homeowner remains remarkably strong across all age, education, racial and ethnic groups. To remain a viable option for all groups, homeownership must become more affordable and sustainable.

They went on to discuss how to address the gap.

Tax benefits are “demand distortions.” Most economists agree that tax preferences for shelter (especially homeownership) push up prices: Benefits are “capitalized” into price or rent. Tax benefits of $150 bn. annually are skewed toward homeowners in high tax brackets via tax deductibility or exclusion. Tax changes likely in 2017—lower rates and higher standard deduction—will reduce tax benefits for homeownership, perhaps slowing or reducing house prices.

There also are “supply distortions” in housing that push up prices/rents. Land-use regulations/restrictive building codes increase construction costs, making housing less plentiful and less affordable. Local governments could reduce these constraints, and housing of all types and tenures would become cheaper.

Tightening Underwriting Standards. Unsuccessful homeownership experiences stem from shocks (job loss, divorce, sickness) that expose unsustainable financing—i.e., too much debt and too little homeowners’ equity (HOE). Reduce the risk of financial distress and losing a home by encouraging or requiring higher HOE and less debt. This would increase the age of first-time homebuyers and reduce homeownership but also reduce the risk of foreclosures.

You can watch the video here. But I think there are some important insights which are applicable to the local scene here. Not least, you cannot avoid the discussion around tax – both negative gearing and capital gains benefits need to be on the table. Supply side initiatives alone will not solve the problem.

US Mortgage Rates Sharply Higher

Mortgage rates in the US have risen by more than 50 basis points since the election in November.

A 30 year fixed is now 4.19%, compared with 3.59% immediately prior to the poll. The dark line shows the Freddie Mac 30 Year rate, the lighter line MND 30 Year fixed.

Further confirmation of a significant reversal in mortgage rates, thanks to the changed yield curve. Such rises will create pressure on households whose income has been static for years. Because most households are on a long-term fix, however, they will have some protection, but any new loan will be set at the higher, less affordable rate.

Of course in Australia, most households are on a variable rate – so any upward movement in rates will translate to immediate pain.

US Housing Bubble 2.0

From Zero Hedge.

US Houses have NEVER BEEN MORE EXPENSIVE to end-user, mortgage-needing shelter buyers. The recent rate surge crushed what little affordability remained in US housing. It now it requires 45% more income to buy the average-priced house than just four years ago, as incomes have not kept pace it goes without saying.

The spike in rates has taken “UNAFFORDABILITY” to such extremes that prices, rates, and/or credit are now radically out of scope. At these interest rate levels house prices are simply not sustainable even in the lower-end price bands, which were far more stable than the middle-to-higher end bands (have been under significant pressure since spring). The Data (note, for simplicity my models assume best-case 20% down and A-grade credit, which is the “minority” of lower-to-middle end buyers).

1) The average $361k builder house requires nearly $65k in income assuming a 4.5% rate, 20% down, and A-grade credit. Problem is, 20% + A-credit are hard to come by. For buyers with less down or worse credit, far more than $65k is needed. For the past 30-YEARS income required to buy the average priced house has remained relatively consistent, as mortgage rate credit manipulation made houses cheaper.

Bottom line: Reversion to the mean will occur through house price declines, credit easing, a mortgage rate plunge to the high 2%’s, or a combination of all three. However, because rates are still historically low and mortgage guidelines historically easy, the path of least resistance is lower house prices.

2) The average $274k builder house requires nearly $53k in income assuming a 4.5% rate, 20% down, and A-grade credit. Problem is, 20% + A-credit are hard to come by. For buyers with less down or worse credit, far more than $53k is needed.

For the past 30-YEARS income required to buy the average priced house has remained relatively consistent, as mortgage rate credit manipulation made houses cheaper.

Bottom line: Reversion to the mean will occur through house price declines, credit easing, a mortgage rate plunge to the high 2%s, or a combination of all three. However, because rates are still historically low and mortgage guidelines historically easy, the path of least resistance is lower house prices.

3) Bonus Chart … Case-Shiller Coast-to-Coast Bubbles

Bottom line: IT’S NEVER DIFFERENT THIS TIME. Easy/cheap/deep credit & liquidity has found its way to real estate yet again. Bubbles are bubbles are bubbles. And as these core housing markets hit a wall they will take the rest of the nation with them; bubbles and busts don’t happen in “isolation.”

Case-Shiller’s most Bubblicious Regions

Ask Yourself: If 2005-07 was the peak of the largest housing bubble in history with “affordability” never better vis a’ vis exotic loans; easy availability of credit; unemployment in the 4%’s; the total workforce at record highs; and growing wages, then what do you call “now” with house prices at or above 2006 levels; high unaffordability; tighter credit; higher unemployment; a weak total workforce; and shrinking (at best) wages?
Logical Answer: Whatever you call it, it’s a greater thing than the Bubble 1.0 peak.

The mind-numbing Case-Shiller regional charts below are presented without too much comment. The visual says it all.

To Borrow, or not to Borrow?

From The Federal Bank of St. Louis Blog.

Have you ever wondered whether it makes sense to borrow for college? Or how much debt is worth taking on to get that dream home?

Well, we at the Center for Household Financial Stability did. Accordingly, we organized, along with the Private Debt Project, a research symposium back in June to see if there exist tipping points at which taking on more debt could be too financially risky. After all, if debt doesn’t lead to more income and wealth, what’s the point? Asking these questions is one of the driving forces at the Center because we don’t think enough attention is being paid to the debt side of family balance sheets.

For the symposium, we commissioned several new papers from Fed and non-Fed economists. The papers—along with my summary and reflection—were released last week.

The research findings were both interesting and often counterintuitive. Let me mention just a few.

My colleagues Bill Emmons and Lowell Ricketts looked at loan delinquencies. Reflecting our Center’s ongoing work on the demographics of wealth, they found that younger, less-educated and nonwhite families were more likely to tip into delinquency. No huge surprise there. But then the co-authors posed what I think is a groundbreaking framing question, including for many Fed economists: Are these struggling families at this greater risk because they make riskier financial choices or because of structural, systemic forces that are largely shaping their financial behavior? In other words, is our tipping points question whether more financial education is primarily needed or whether a change in public policy is primarily needed?

Neil Bhutta and Benjamin Keys also discerned some alarming tipping points by looking at the nearly $1 trillion in home equity extractions between the boom years of 2002-2005. Extractors, they found, were more likely to default on their mortgages, even after controlling for credit scores and other risk factors. Even more surprising, extractors were more than twice as likely to become severely delinquent on their mortgage debts and almost 40 percent more likely to become delinquent on other kinds of debt.

We didn’t just look at the numbers but also the psychology of tipping points. Christopher Foote, Lara Loewenstein and Paul Willen found that, leading up to the financial crisis, excessive mortgage borrowing was fueled not by a financial indicator (the amount of income needed for a mortgage) but by a psychological one (the expected increase in future housing prices).

The symposium also opened up new ways to think about tipping points: At what point, for example, is an aspiration given up because of too much debt? And do different generations—say Gen Xers and millennials—think differently about how much debt is good or bad?

Several trends suggest families will be struggling with high debt levels for years to come, and it behooves all of us to think more about when debt goes from being productive to destructive. The financial health of families and our economy may depend on it.

I hope you’ll have a chance to read all of the papers, each one novel and forward-looking.

Additional Resources

Symposium: Tipping Points: Mapping and Understanding the Impact of Debt on Household Financial Well Being and Economic Growth

On the Economy: Mortgage Debt’s Share of Total Debt Keeps Declining

On the Economy: How Consumer Debt Has Evolved in the Nation and the Eighth District

President Trump signals a return to the Wild West days of finance

From The Conversation.

A stream of commentary has set out to explain the electoral success of Donald Trump as a reaction to globalisation and neoliberalism. It points to a thread of populist anti-capitalism running from the President-elect to Bernie Sanders.

To the extent that this is true, however, Trump voters may be in for a surprise. One of the headline reforms of the incoming administration will be the undoing of regulatory responses to the 2008 financial crisis. This is not just inconsistent with pre-election rhetoric, but highly significant for financial markets.

Releasing financial actors from the shackles of regulation may sound appealing for business, but will also increase the risk of another financial crisis. Trump policies are likely to create a more dynamic, but crucially more risk-prone financial system, not only in the US, but globally.

In particular, he has spoken of dismantling the Dodd-Frank Act, which introduced extensive regulation of the financial industry in the wake of the global financial crisis. This is pleasing the markets, but may lead to the same kind of risk-taking that precipitated the 2008 crisis.

Ending state intervention

The President-elect’s newly-established transition website declares: “The Dodd-Frank economy does not work for working people.” Bureaucratic red tape and Washington mandates, according to Trump, have hindered America’s economic recovery. The new administration promises to dismantle Dodd-Frank and replace it with new policies to encourage economic growth and job creation.

Yet, it was exactly this type of deregulation between the 1980s and the middle of the 2000s that was a principal cause of the crisis. This is why the Dodd-Frank Act included provisions that affected virtually every financial market and granted new authority to nearly every federal financial regulation agency in the US.

It was designed to prevent excessive risk-taking by companies and investors. It introduced greater regulation of Wall Street and increased the government’s power to intervene in the event of a repeat crisis.

It also created a consumer watchdog to oversee the sale and marketing of financial services to consumers, such as the mortgage companies and pay-day lenders that profited prior to the crisis. This was the idea of liberal Democratic Senator Elizabeth Warren and has been singled out as a source of wrath for Republicans as it is emblematic of state intervention in financial markets.
Tough on banks: Democratic Senator Elizabeth Warren. EPA/Michael Reynolds
On the chopping block

Scant detail of what Dodd-Frank will be replaced with is available at the moment. Some indication comes from Republican Party proposals to undermine post-crisis regulation, which culminated in a bill introduced by House Financial Services Committee Chairman Jeb Hensarling earlier this year.

The Hensarling plan would place heightened restrictions on financial regulators trying to write new rules, and give large financial institutions a way to ease their regulatory burden. Such institutions would be given the option to opt out of some government oversight if they agree to hold on to larger amounts of capital.

Huge portions of Dodd-Frank are up for elimination including the “orderly liquidation authority” through which regulators can shut down ailing banks. Perhaps more emblematically, the “Volcker Rule”, which bars banks from engaging in profit-seeking activity known as proprietary trading, would also be repealed. And Congress could also cripple the new consumer watchdog by taking control of both its budget and management. It may also lose the ability to ban financial products it deems to be “abusive”, and its ability to gather consumer financial data.

Expecting the unexpected

Isn’t an attack on government agencies and “bureaucracy” part and parcel of a Republican administration? Perhaps. But during the long electoral campaign many unexpected things happened in this new populist phase of American politics.

For example the Republicans joined forces with the left of the Democrats in asking for the restoration of the Glass-Steagall Act. This was one of the most important legislative responses to the failures that led to the Great Depression, particularly in the banking sector. The act’s backers were convinced that the banks had played a significant role in promoting unsustainable booms in the real estate and securities markets during the 1920s.
Market reaction to Trump’s election win. EPA/Justin Lane
Glass-Steagall prevented commercial banks from making unsound loans and investments that can lead to a housing market bubble. It also discouraged banks from making investments in securities that undermine their solvency during stock market downturns and stopped them from making loans to finance the purchase of securities.

It takes a few intellectual leaps to go from advocating the return of 1930s regulation to dismantling post-2008 crisis responses. Yet this is the direction that Trump’s team appears to have taken.

The markets, unsurprisingly, have reacted well. This should leave nobody wondering. With regulations up for the chop, banks reduce their compliance costs and can increase profit margins. The financial industry had a look at the first pronouncements of America’s new rulers, and liked what it saw.

Author: Ioannis Glinavos, Senior Lecturer in Law, University of Westminster

Federal Reserve Board orders JPMorgan Chase & Co. to pay $61.9 million civil money penalty

The US Federal Reserve Board on Thursday ordered JPMorgan Chase & Co. to pay a $61.9 million civil money penalty for unsafe and unsound practices related to the firm’s practice of hiring individuals referred by foreign officials and other clients in order to obtain improper business advantages for the firm.

In levying the fine on JPMorgan Chase, the Federal Reserve Board found that the firm’s Asia-Pacific investment bank operated an improper referral hiring program. The firm offered internships, trainings, and other employment opportunities to candidates who were referred by foreign government officials and existing or prospective commercial clients to obtain improper business advantages.

The Federal Reserve found that the firm did not have adequate enterprise-wide controls to ensure that referred candidates were appropriately vetted and hired in accordance with applicable anti-bribery laws and firm policies.

The Federal Reserve’s order requires JP Morgan Chase to enhance the effectiveness of senior management oversight and controls relating to the firm’s referral hiring practices and anti-bribery policies. The Federal Reserve is also requiring the firm to cooperate in its investigation of the individuals involved in the conduct underlying these enforcement actions and is prohibiting the organizations from re-employing or otherwise engaging individuals who were involved in unsafe and unsound conduct.

The Federal Reserve is imposing the fine and requiring the firm to modify its practices concurrently with actions by the U.S. Department of Justice and the Securities and Exchange Commission.

Trump and Reaganomics

The Economist has highlighted that whilst much is yet to be revealed, the Trump administration-in-waiting seem to imply an expectation of a Ronald Reaganesque turn in American fiscal policy. Yet, they say, any resemblance that Mr Trump’s plans may bear to Reaganomics is as much a cause for concern as for optimism. They call out three areas of risk.

The first is financial instability. The Federal Reserve has prepared markets for a gradual pace of monetary tightening. Should higher inflation convince the Fed that more interest-rate hikes are needed sooner, many investors in emerging markets could be caught off guard. A bout of chaotic capital flight could threaten shakier banks or induce governments to adopt capital controls. America, which eventually intervened to help manage the Latin American debt crisis, will probably be slower to lend a hand under Mr Trump.

Second, faster growth and higher interest rates might attract foreign capital and place upward pressure on the dollar, which has indeed been rising since the election. That will help exporters to America and hamper a manufacturing revival in the struggling towns that helped Mr Trump win. In fact, the Mexican peso has fallen by about 10% against the dollar since the election, boosting the competitiveness of Mexican firms relative to their American counterparts. Yet Mr Trump will find responding to these shifts to be trickier than did Reagan. Sprawling supply-chains mean that punitive tariffs are less obviously useful to domestic firms than they once were. A battle over exchange rates between America and China could prove far more dangerous, both economically and geopolitically, than Mr Baker’s negotiations.

Third, further cuts may deliver a smaller boost to growth as a result. Inequality is far higher now than it was in the early 1980s; slashing tax rates on the rich while unravelling recent financial regulation could push economic divisions to unprecedented, politically toxic levels.

The global economy could use more fiscal stimulus. A raft of regressive tax cuts from a protectionist-minded American administration is, to put it mildly, a risky way to provide it.

Trump hasn’t derailed Chinese homebuyers’ obsession

From South China Morning Post.

Donald Trump’s presidency won’t hurt the rising tide of Chinese investment into the United States – in fact, the level of cash may actually increase, according to Knight Frank.
new-york-8

Trump’s shock election last week rattled markets around the world and analysts continue to disagree on what the Republican candidate’s victory means or how it will affect the US property market, the No 1 destination for Chinese capital. “The short answer is I am not worried about Trump’s impact on Chinese flows into America,” Knight Frank’s global capital markets head Peter MacColl told the Post during a visit to Hong Kong last week.

“Whilst he’s come out with a lot of rhetoric, what might be considered to be barmy ideas that might have an impact on the geopolitical scene globally, the American system of checks and balances through Congress, through all the advisory parties that any change has to go through, means any really radical things won’t happen overnight,” he said.

“I don’t think there will be a big downturn in the property market because of Trump, and if anything, there could be a bit of an upturn because of his policies towards business generation and self responsibility.”

In the short term, MacColl expects there to be a bit of “waiting in the wings and seeing what’s going to happen”.

“A bit of caution, a bit of a slowdown just in terms of making decisions – which is understandable – until maybe the new year when things start to pan out a bit.”

But MacColl said he didn’t see a lot of risk to mainland Chinese investors in the US from Trump’s presidency and expected the US to remain the favoured destination for Chinese capital.
There wasn’t just a pull factor, there was also a push factor, with Chinese investors keen to take their money out of the country as the yuan continued to be devalued, he said.

The total volume of Chinese outbound real estate investment between January and October is slightly down on the same period last year, according to Knight Frank research.

But not everyone was so positive. Jefferies equity analyst Mike Prew said the combination of a possible post-election Federal Reserve rate rise in December and rising bond yields compared with property yields could have an effect on the returns in the US’s $27 trillion residential market.

“Things could get messy for real estate,” he said.
He tipped Canadian residential markets of Toronto, Montreal and Vancouver to be the big property winners following the US election.

Simon Smith, head of research and consultancy for Savills, agreed that investors would stay cautious for the rest of this year and capital volumes might be more muted.

“The uncertainty continues to drive people to the United Kingdom,” he said, noting that Brexit had also worked out positively for the British property market thanks to the falling pound – something which hadn’t happened to the US dollar. “It looks like the UK remains a net beneficiary of what’s been happening.”

Trump’s indication that he would invest in infrastructure was judged as positive by investors, but question marks remain over the wider policy direction of his presidency.

“I don’t think the clouds have parted quite yet on Trump and what election promises he may or may not choose to enact. We’re still asking ourselves: is this soft Trump or hard Trump?”
New York real estate company CityRealty’s director of research Gabby Warshawer said it was difficult to predict the long-term implications of Trump’s presidency on New York property,
which was the top destination for Chinese capital investment in the first six months of this year.

“If the stock market were to be extremely unsettled for a long period of time, that would have a clear effect on real estate — for example, following the financial crisis in late 2008, it took more than three years for New York real estate prices and sales volume to bounce back,” she said in an emailed response to questions from the Post.

“That being said, analysts have not been predicting a protracted doomsday scenario for the markets following this election.”
She said it was unlikely there would be significant change in Chinese investment following the election as the buying spree had a lot to do with property market conditions in China.

“If there is significant turmoil and the United States is no longer considered as safe for real estate investments as it has been in recent years, then that would impact all international buyers,” Warshawer said.“The New York City real estate market is stable and exceptional enough that it is still generally seen as a safe long and medium-term investment by most buyers, regardless of campaign rhetoric.”

The Great Interest Rate Pivot

Following the news from the US last week, the yield on the benchmark 10-Year bond has risen. This may signal the end of ultra-low interest rates and low inflation, and may create new challenges for central banks.

This is because the US benchmark has impact on the global capital markets, and will push other rates higher. This may see stock markets fall. Inflation may rise.

So, in Australia, we are probably at the bottom of the rate cycle, and the next move will be up. But meantime, as banks continue to rely on the international capital markets for some of their funding, expect out of cycle rate rises. Some fixed rate mortgages have already risen. Most households are on a variable rate mortgage, so would feel a rise straight away.

However, it may be good news for savers because conceivably savings rates will also begin to improve.

The sleeper of course is the potential hit on international trade should the US start a trade war. The fallout of a trade tariff argument between USA and China could hit Australia hard. If it did, we have little left in rate cuts to stimulate further, so employment may fall.

But given household debt is high, and mortgage repayments already large, any rise in rates would reduce household spending and lift delinquencies higher. Both depressive on house prices.

The next few months will be “interesting”!