Perspective on Risk - Nov. 17, 2022
More Housing; WFH & Real Estate; So This Seems Important (Treasury Market); Factor Correlation; Model Evaluation; For the FTX/Alameda Obsessed; Crypto: Let It Burn; Mostly Useless Research
More Housing
I took another look at housing. If you remember from the last post I argued that the payment shock would need to cause significant short-term pressure on house prices.
After reflection, I realized I hadn’t look at a mitigating factor: perhaps housing affordability had been particularly good before the recent increase in rates; maybe the market could adjust to the new payments without the degree of pain I envisioned. Turns out it was.
FRED has a data series on home affordability (Mortgage Debt Service Payments as a Percent of Disposable Personal Income). It does show that the share of disposable income going towards mortgage payments is currently low.
But again, that reflects the entire stock of existing homeowners; I don’t think this invalidates the earlier thinking. The marginal new buyer will pay about 30% of disposable income on their mortgage, which is implicitly what the 30 yr. 80% LTV mortgage proxied.
As an economy we have room to service more debt, but for an individual buyer, they will be constrained on the payment they can afford, which then is a function of price, rate and term. Buyers who have houses to sell may be willing to pay the inflated prices as long as they can receive a similarly inflated price for the home they are selling.
Adam Toose published Chartbook #171 Finance and the polycrisis (2) The global housing downturn1.
In this precarious moment - in the fourth quarter of 2022, two years into the recovery from COVID - of all the forces driving towards an abrupt and disruptive global slowdown, by far the largest is the threat of a global housing shock.
He includes a link to this chart from a Bloomberg article Housing Paralysis Engulfs US Buyers With Prices Starting to Fall.
This is just the more standard formulation of what I did in my last post; rather than saying how much home prices need to adjust, this shows how much more desperate someone would need to be to own a house.
Toose writes much more about international housing prices, so if you are interested click on over. He closed with this chart from the recent IMF Global Financial Stability Report. I clicked over, but there is no information on how they derived the probability distributions.
WFH & Real Estate
Two pretty good papers I wanted to point out to you on how the Covid/WFH trends have affected residential and commercial real estate.
Residential
The first paper has been around for a bit. Three economists from the FRB-SF authored Remote Work and Housing Demand2 (FRBSF).
Nearly a third of employees still worked from home part time or full time as of August 2022. This has significantly increased housing demand and is a key factor explaining why U.S. house prices grew 24% between November 2019 and November 2021. Analysis shows that the shift to remote work may account for more than half of overall house price increases and similar increases in rents.
[The data] shows that [Core-based statistical areas] CBSAs with more remote work before the pandemic saw larger increases in remote work during the pandemic.
Thus, pandemic remote work that was caused by the preexisting share of work that was remote can be used to estimate the causal effect of remote work on pandemic house price growth.
According to our data, remote work increased to 16 percentage points. Along with our estimate, this implies that remote work resulted in house prices rising by about 15% from November 2019 to November 2021, accounting for more than 60% of the overall increase in house prices.
Commercial
The commercial real estate paper, Work From Home and the Office Real Estate Apocalypse3 (NBER), calibrates a standard model with the addition of a WFH factor derived from REIT data, and vary the strength of reversion to a zero-WFH environment. It interesting shows a flight-to-quality effect in CRE.
We study the impact of remote work on the commercial office sector. We document large shifts in lease revenues, office occupancy, lease renewal rates, lease durations, and market rents as firms shifted to remote work in the wake of the Covid-19 pandemic. We show that the pandemic has had large effects on both current and expected future cash flows for office buildings. Remote work also changes the risk premium on office real estate. We revalue the stock of New York City commercial office buildings taking into account pandemic-induced cash flow and discount rate effects. We find a 45% decline in office values in 2020 and 39% in the longer-run, the latter representing a $453 billion value destruction. Higher quality office buildings were somewhat buffered against these trends due to a flight to quality, while lower quality office buildings see much more dramatic swings.
We begin by analyzing the shock to current cash flows. … We document a
17.54 percentage point decrease in lease revenue between January 2020 and May 2022. … Rents on newly-signed leases fell by 13.16% in real terms between January 2020 and December 2021 before reversing to pre-pandemic levels by the end of 2021, with meaningful heterogeneity across cities.
A key parameter that affects the change in office valuations due to remote work is the persistence of remote/hybrid work practices. We back out this parameter from the (un-levered) observed stock return on NYC-centric office REITs between January and December 2020.
Along the average path, office occupancy stabilizes and the economy returns to the no-WFH state with some probability. These mean-reversion forces push office valuations towards an average value in 2029 is about 39.18% below 2019 values. Along paths where the economy remains in the WFH state for ten years, office values in 2029 are 59.86% below their 2019 values.
[I]f the entire office stock of NYC had been publicly listed, its value would have
fallen by 44.80% in 2020. This same decline was 27.13% for the A+ office sector, illustrating the relative safety of A+ office.
I think the key takeaway from the CRE paper is that the capital structures of CRE are unsustainable, and as the next ‘wall of maturities’ arrives we will be seeing some significant write-downs and consessions.
So This Seems Important
A host of Federal agencies have released a report titled ENHANCING THE RESILIENCE OF THE U.S. TREASURY MARKET: 2022 STAFF PROGRESS REPORT. This is a follow-up to Recent Disruptions and Potential Reforms in the U.S. Treasury Market: A Staff Progress Report that was released last November.
There are five workstreams:
improving resilience of market intermediation,
improving data quality and availability,
evaluating expanded central clearing,
enhancing trading venue transparency and oversight, and
examining effects of leverage and fund liquidity risk management.
The report considers mandating centralized clearing with standardized margining rates to limit settlement risk. The first stream, however, is where the primary action is. It is motivated by the disruptions in the Treasury markets, most recently witnessed in March 2020, due in large part to dealer balance sheet constraints and the growth in Treasury outstanding relative to GDP. Or as the report puts it:
in several stress episodes preceding that report, demand for intermediation in the Treasury market surged beyond the market’s capacity for intermediation.
I imagine, unstated, is also consideration of the size of Treasury issuance over the next few years, and the capacity for the market to intermediate the flows. Within that first workstream are several elements, but the one gathering attention is the consideration of all-to-all trading.
The IAWG staffs are studying how Treasury market structure influences intermediation capacity, with an initial focus on the potential benefits and costs of more widespread all-to-all trading.
All-to-all trading is a form of trading that, in concept, allows any participant in a financial market to trade with any other market participant. … All-to-all trading can be contrasted with dealer-intermediated markets where most participants trade with dealers that hold inventories of assets on their balance sheets.
The staff report makes explicit reference to an October NY Fed staff report All-to-All Trading in the U.S. Treasury Market. All-to-all trading appears to have some significant behind-the-scenes intellectual support; looking at footnote 2 of the NY Fed staff report cites papers by Duffie, Parkinson and Liang, and the G30. There has clearly also already been significant staff outreach, with footnote 6 noting “IAWG staff conducted 19 outreach discussions, including discussions with representatives of trading platforms, dealers, hedge funds, principal trading firms, asset managers, and academia.” In addition, Paul Davies has written a supportive article in Bloomberg The $24 Trillion Treasury Market Needs More Than Just Clearing. Andy Ackerman and Jon Hilsenrath also wrote a piece for the WSJ Regulators Look to Lessen Treasury Market Reliance on Big Bank Dealers.
The paper does a nice job of describing the market microstructure of secondary trading and clearing in Treasuries. In particular, it highlights the relationship between dealers and principal trading firms that provide significant intraday liquidity with limited capital bases. One highlight that I had not understood before is:
the expansion of PTFs’ role in the interdealer cash market beginning in the mid2000s resulted in an increasing fraction of interdealer trades not being centrally cleared. In recent years, just over half of interdealer cash trades have not centrally cleared, compared with central clearing of virtually all interdealer trades before the entry of PTFs in the interdealer market. As a result, about three-fourths of the entire Treasury market is now not centrally cleared.
This, of course, plays out that the banks argue that the post GFC rule revisions, in particular the leverage ratio and the supplementary liquidity ratio, have made them unable to intermediate sudden spikes in flows.
One question, unaddressed, is whether this devalues the Primary Dealer franchise, and whether than has negative effects.
The principal issues around all-to-all trading tend to align with requirements of central clearing, and the possible barriers to entry that this entails. The proposed solutions also have a difficult time handling off-the-run securities.
Watch this space - this stuff matters.
Factor Correlation
This graph from CounterPoint Funds looked interesting. Factor returns look more highly correlated than one would traditionally suspect. Worth keeping an eye on.
If you also look closely, the recent 20bp drop in CPI seems to have a strong effect across all factors.
Model Evaluation
This paper, Model Evaluation, Model Selection, and Algorithm Selection in Machine Learning, will be of interest to your folks working in machine learning, and to your model validators (if you still have any). I’m not an expert here by any stretch, but the parts I understood made sense.
The correct use of model evaluation, model selection, and algorithm selection techniques is vital in academic machine learning research as well as in many industrial settings. This article reviews different techniques that can be used for each of these three subtasks and discusses the main advantages and disadvantages of each technique with references to theoretical and empirical studies. Further, recommendations are given to encourage best yet feasible practices in research and applications of machine learning
For the FTX/Alameda Obsessed
This blog post What happened at Alameda Research gives a lot of coherent detail.
Crypto: Let It Burn
I agree 100% with Cecchetti and Schoenholtz Let crypto burn (FT)
In the aftermath of the collapse of FTX, authorities should resist the urge to create a parallel legal and regulatory framework for the crypto industry. It is far better to do nothing, and just let crypto burn.
Actively intervening would convey undeserved legitimacy upon a system that does little to support real economic activity. It also would provide an official seal of approval to a system that currently poses no threat to financial stability and would lead to calls for public bailouts when crypto inevitably erupts again.
Mostly Useless Research
Spurious Correlation
Chocolate consumption and Nobel Prizes: A bizarre juxtaposition if there ever was one4
Attractive Female Students Saw Grades Drop After Switch To Online Learning During Pandemic
Student beauty and grades under in-person and remote teaching5
When education is in-person, attractive students receive higher grades. The effect is only present in courses with significant teacher–student interaction. Grades of attractive females declined when teaching was conducted remotely. For males, there was a beauty premium even after the switch to online teaching.
Naps
I’ve come to espouse the unintuitively named ‘coffee nap.’ Your drink your coffee, and then take a 15-30 minute nap, and come away refreshed and energized. It works.
In the past I highlighted research on the value of drinking coffee before your nap. Now @emollick points to research on the optimal nap length for different types of recuperation.
Here is the study by Brooks and Black A Brief Afternoon Nap Following Nocturnal Sleep Restriction: Which Nap Duration is Most Recuperative?
Polycrisis is the new favorite term of the chattering class. It was first popularized by Tooze in Chartbook #73: Crisis Pictures (Krisenbilder) - mapping the polycrisis. It probably went more viral when he wrote Welcome to the world of the polycrisis in the FT.
He goes on in Chartbook #165: Polycrisis - thinking on the tightrope to quote Janzwood and Homer-Dixon’s definition of a polycrisis as:
We define a global polycrisis as any combination of three or more interacting systemic risks with the potential to cause a cascading, runaway failure of Earth’s natural and social systems that irreversibly and catastrophically degrades humanity’s prospects. A systemic risk is a threat emerging within one natural, technological, or social system with impacts extending beyond that system to endanger the functionality of one or more other systems. A global polycrisis, should it occur, will inherit the four core properties of systemic risks—extreme complexity, high nonlinearity, transboundary causality, and deep uncertainty—while also exhibiting causal synchronization among risks.
Since then, Christopher Hobson, Matthew Davies, Larry Summers, and Sahay and Mackenzie have all adopted the term and framework. Just to further reinforce the point, folks like Noah Smith are not debating whether or not we are in a polycrisis with his recent substack Against "polycrisis"/ Craig Berry writes We do not yet know what the polycrisis is
Polycrisis people like to draw maps like this:
I now understand why most of America thinks us coastal elites are crazy. I will hopefully try and avoid the term.
Not, of course, to be confused with a polycule, which was the polyamorous relationships the FTX folks had in their penthouse in the Bahamas.
Kmetz, Mondragon, Johannes Wieland; Remote Work and Housing Demand; FRBSF Economic Letter
Gupta, Mittal, Van Nieuwerburgh, WORK FROM HOME AND THE OFFICE REAL ESTATE APOCALYPSE, NBER
Jogalekar, Chocolate consumption and Nobel Prizes: A bizarre juxtaposition if there ever was one, Scientific American
Mehic, Student beauty and grades under in-person and remote teaching, Economic Letters