The Breakdown | Explaining Southern California's economy
Business & Economy

Visual Aid: Is declining financial stress helping the housing market to recover?

The Kansas City Financial Stress Index is trending back down to levels where investors have been historically comfortable taking on more risk.
The Kansas City Financial Stress Index is trending back down to levels where investors have been historically comfortable taking on more risk.
Federal Reserve Bank of Kansas City

The U.S. housing market seems to be improving, after completely collapsing in 2007-08. The Case-Shiller index, which tracks prices in 20 cities, is indicating that we've finally found a bottom for prices and could conceivably look forward to sustained price increases in the future. The foreclosure crisis is gradually working itself out — although it's still got a long way to go — and in the process benefitting the rental market, as people who've lost their homes take to renting as a transitional strategy. 

The stage is now set for consumers who've spent the past four or five years in a state of fear to begin buying houses again. Prices are low and interest rates are, too — as low as they've ever been. So why have people been so afraid? They haven't wanted to tie up their money. Cash is king in a crisis. If you're worried that you might lose your job, you don't want to be cash-poor and potentially confronting a stack of unpaid bills. 

So you stay liquid, as economist say. If you don't have cash, you hold stocks and bonds — assets you can easily and quickly sell to raise cash. 

Houses are relatively illiquid assets. You can make a lot of money off them, but a house is tough to sell in a hurry. 

The chart above is from the Federal Reserve Bank of Kansas City. It's the Kansas City Financial Stress Index, and as you can see, stress was never higher than in the Great Recession. You can also see that it spiked recently, but that it's fallen below the zero-level (the basis or starting reference point for the index, representing a neutral level of financial stress) of late, into territory similar to previous periods of low financial stress.

This is from the paper that the Kansas City Fed released when the KCFSI was introduced:

A final sign of financial stress is a sharply decreased willingness to hold illiquid assets. An illiquid asset is one that the owner cannot be confident of selling at a price close to its fundamental value if faced with a sudden and unexpected need for cash. In some cases, an asset is illiquid because the secondary market for the asset is thin, so that selling a substantial amount of the asset has a large effect on the price. In other cases, an asset may be illiquid because it is of above-average quality and an asymmetry of information between buyers and sellers prevents the owner from selling the asset at a price close to its fundamental value...

With what the KC Fed calls a "flight to liquidity" abating, you can see why people in the market for a house might feel that their stress has eased to a point where the risk of illiquidity is something they can handle. This would be very helpful to the California housing market, for a number of reasons. It would get prices moving up again and, because the state suffers from a lack in housing inventory, it would spur new homebuilding and finally start reducing unemployment in the construction business.

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