Photographer: Andrew Harrer/Bloomberg

An anti-foreclosure demonstration outside Fannie Mae headquarters.

Update: Fannie Mae today reported a record 17.2 billion profit for 2012, underlining the dilemma Clea Benson explained in yesterday’s story.

If there’s such a thing as too big to fail, no one qualifies more clearly than Fannie Mae and Freddie Mac. Together the two agencies own or guarantee more than $5 trillion in mortgages. After they were taken over by the government, the consensus was that we’re certainly not going to let the government take the risk of losses on the entire mortgage market again.

Not so fast. Bloomberg’s Clea Benson today reports that the government is trying to figure out what to do with the substantial profits collected by Fannie and Freddie. The two have now given back $50 billion to the government out of $187.5 billion in bailout costs. The question is how the government plans to run a profitable business that it never wanted to be in.

From the beginning, discussions of what to do with Fannie and Freddie have focused on getting the government out of the business of unlimited guarantees. A Treasury report on reforming the housing market two years ago outlined the problems with the agencies succinctly, noting their “profit-maximizing structure undermined their public mission.” Telling the agencies to do anything they could to make a profit, while also asking them to avoid irresponsible risks, plainly didn’t work.

What would be better? As yet, there’s no really good answer. One option is just to split up Fannie and Freddie into smaller pieces. That won’t be enough. It’s often claimed that lenders act recklessly when they’re too big to fail and can count on the government to step in when they get in trouble. The evidence for that is slim: the mass of smaller companies in the subprime industry happily drove themselves into oblivion with no expectations of government help (Roger Lowenstein has made a similar point). The problem with smaller financial companies, whether you talk about subprime lenders or, to go back in history, savings-and-loans, is that most of them make similar mistakes at the same time. When they fail, they all fail at once.

The invisible hand of the market alone isn’t going to fix that. Benson writes that proposals now focus on developing a private mortgage market, with a final backstop of direct government guarantees. Like it or not, some version of that last part is always going to be in play.

Photographer: Laura Segall/Bloomberg

In Phoenix, competition among investors has driven home prices up 35 percent, but it’s now sending rents downward.

Judging by investment news, there seems to be every sign that the housing market is heating up. Home prices are drifting upwards, cities like Phoenix are saturated with investors, mortgage-backed securities are back. Blackstone Group LP, the country’s biggest real estate investor–which has already invested $3.5 billion to buy 20,000 single-family homes – has obtained a credit line of $2.1 billion to buy even more. Meanwhile KKR & Co. just raised a $500 million fund for real estate investments. There seems to be no shortage of folks willing to provide money to invest in a housing upturn.

Only one thing is missing here: individual home buyers. Bloomberg’s John Gittelsohn and Prashant Gopal yesterday dove deeper into the housing revival, and found a market driven by big investors competing against each other. Some tellings stats: in Miami last year, institutional investors accounted for 30 percent of home purchases; in Phoenix it was 23 percent.

This latest report helps unravel a paradox of the current housing economy: With all the real estate investment action, you’d expect the number of new mortgage loans to be shooting upwards. No such luck. Look at the chart below, which shows new purchase mortgages through the 3rd quarter of 2012, using data from the Mortgage Bankers Association. For that quarter, buyers took out $129 billion in purchase loans. Not only is that much lower than the numbers from the boom, but it’s less the post-crash levels of 2009. You need to go back to the mid-1990s to get back to numbers like those (and they’re not adjusted for inflation).

In an earlier version of this post, for the TMN newsletter, I suggested that Blackstone has made a sophisticated move here, funding a bet on the long-term value of property by renting in the short term to buyers still locked out of the housing market. Gopal and Gittelsohn’s newest reporting, however, raises some questions about this strategy. Other investors are also crowding into rental housing. The consequence is that, as the story explains, rental prices are falling even as sales prices for the kinds of houses Blackstone wants — three bedrooms, built after 1990 — rise.

The bet on rentals does at least give big institutional investors an out if the housing recovery is not sustained. I suspect that’s a possibility many eager individual investors haven’t really considered. Every bust does reach a trough, but not every market climbs back to its boom-time high. Think of Nasdaq after the tech crash.

Right now we’re in the midst of a sharp decline in the home ownership rate. That might mark a temporary blip, or the beginning of a long period in which it is harder to secure a mortgage. If it’s the second, then players like Blackrock that are focused on properties they can rent at least have a backstop, while smaller investors counting on selling their properties in a big new housing boom will get burned.

Photograph by Christian Heeb/laif/Redux

The San Remo apartment building, on New York’s Upper West Side.

The most expensive apartment in the twin towered Art Deco masterpiece looking out over Central Park, the San Remo, rented for $900 a month. The tenant was a stockbroker named Meno Henschel who, according to what he told the Census Bureau, lived in his apartment together with his wife, a cook and two maids. Henschel had one of only two apartments that rented for more than $600. Another, with room for a family of five, plus the requisite cook, butler and maid, rented for $540.

The year was 1940, and that $540 is what would now generally be referred to as about $8,850 in today’s dollars. Except it’s  almost impossible to find an apartment like that to rent today. Like most  of the great prewar luxury Manhattan buildings, the San Remo has long since been converted into a co-op, owned by the residents.

Very rarely an apartment there will come up for a short-term rental. There is one listed now. The asking price is $29,750 a month.

At first glance, this may strike you as the kind of problem that rich people file under “even richer people’s problems.” So the price of Central Park views has gone up? Feh, probably you can find yourself another park to look at. You might assume that the price of living in one of New York’s most expensive buildings tells us nothing of value to most Americans, who (a) don’t live in New York, (b) don’t live in rentals, and (c) couldn’t come close to affording that kind of price.

In fact, it tells us a lot. Extraordinary as a rent of $29,750 a month may seem, the rise in the price of a rental at the San Remo is not exceptional. You can find similar or even bigger increases at every level of the market, down to the most ordinary middle-class apartments. Looking closely at rents at the San Remo and other places in New York opens up questions about whether we’re measuring inflation accurately. And those questions, in turn, have big implications for how we understand the cost of living and quality of life—not only of those who live in the San Remo, but of the middle class.

Nationally, according to U.S. inflation data, since 1940 rents have risen 1,014 percent, so they have gone up about 11-fold. For the New York area alone, the increase is a little higher, 1,250 percent. Though those are big numbers, they’re actually lower than the overall 1,536 percent rise in prices reported by the Bureau of Labor Statistics, the agency that gauges inflation.

Most New Yorkers, however, would guess that the price of housing has risen much faster. Diving deep into old records bears that out. The 1940 census found the median rent in New York City to be $38.10. In 2011, that was $1,100. That’s an increase of 2,787 percent—close to twice the rate of inflation. And when you start comparing specific apartments, delving into the newly released 1940 census forms in which I found how much Meno Henschel paid for his apartment, the differences are even starker.

At the San Remo the price increase is greater than 50 times. It’s a good example, because the San Remo is one of very few buildings not to have changed in character over 70 years. It was, as Dennis Hughes, the real estate agent handling the listing puts it, an “iconic” building then, and it remains so now. It’s a time capsule of luxury living. But that kind of increase hasn’t happened just at the top. You can see the same pattern in much more modest places.

One is the one-bedroom apartment I lived in from 2004 through 2009 in Williamsburg, Brooklyn. Back in 1940, as I found from the handwritten (and recently digitized) census forms, most of the tenants were Italian. Several were truck drivers; it’s not hard to imagine that one settled there and his friends followed. The rent was $18 to $24 a month. The upper end of that is $369 in current dollars. When I moved in late in 2004, the real estate broker cautioned me that it “wasn’t a luxury building.” Indeed, it wasn’t, as the broken front door lock suggested and the heat inspectors could confirm, but the rent was $1,500 a month, and later it rose to $1,615.

So what’s happening here? Most conventional stories of inflation hold that the consumer price index tends to overestimate how much prices rise. For a long time, the index, the government’s main inflation yardstick, didn’t adjust for changes in quality, and many economists believe that it still doesn’t do it enough.

With rent, it’s a different story. Rent is a particularly important piece of the consumer price index. The government uses data on rents not only to estimate inflation for those who actually rent their homes, but also to separate out the investment value of homes and derive a measure of how much homeowners pay to keep a roof over their heads. Together, “rent” and “owner’s equivalent rent” make up about 30 percent of the inflation measure.

Changes in rent, though, are not easy to measure. Rents tend to rise slowly over time, and a lot of what makes a home desirable changes, too—think “location, location, location.” Those difficuties have led to some awkward results. Mike Shedlock, a well-regarded blogger who looks at economic trends, has tracked how the rents the government measured barely budged during the housing boom and rose afterwards even as real estate agents wrung their hands over falling prices.

Perceptive recent work on rent comes from three economists who worked together at the Philadelphia Federal Reserve, Theodore Crone, Leonard Nakamura, and Richard Voith (Nakamura is a vice president of the Philadelphia Fed). Their research makes a good starting point for figuring out the rent puzzle.

The most important insight in their work is that for decades the inflation measures skipped over the cases in which a tenant moves out. Think about that for a second: A landlord avoids raising the rent for a decade for a good tenant, then when the tenant moves, ups the rent to a market rate. Or, as is common in New York, rent regulations keep rent from rising until a tenant moves out. Those are precisely the units in which the rent is most likely to rise, and for some four decades they weren’t counted in inflation.

Crone, Nakamura and Voith estimate that this and other problems bring down the government’s measure of rent increases by about 1.4 percent a year for the whole period that runs from 1942 to 1985. Nakamura outlines these findings in a very readable paper published by the Philadelphia Fed. Over such a long period, 1.4 percent into a really big number. Add that in, and instead of falling 20 percent in real-dollar terms over six decades, rents rise 50 percent.

Think about what that means for the middle class. Since 1970, the average hourly earnings of American workers (excluding managers) have stayed almost exactly flat by the official inflation measure. If, however, the cost of housing has risen faster than those measures say, then that means that many folks are actually worse off than they were then. You can see how that matters, and not just to the people in the San Remo with Central Park views.

Source: Google Street View

The building in Brooklyn I lived in from 2004 to 2009. Not exactly a model of luxury.

The reason I started with the San Remo wasn’t just to get you to marvel at how much a fancy apartment in New York costs these days. OK, that was part of it; it’s not an accident that Robin Leach’s show wasn’t called “Lifestyles of the Average to Upper Middle Class.” The other reason for focusing on the San Remo, though, is that in most buildings and neighborhoods, so much changes that it’s hard to compare prices over extremely long periods of time.

Often when you read stories about the economy they’ll translate a price from decades ago into “today’s dollars.” By that measure, the $540 that a San Remo apartment rented for in 1940 is $8,856 in today’s dollars. Except that it’s clearly not: If you’re talking about rent, it’s $29,750 in today’s dollars. We know that because that’s what a San Remo apartment rents for today.

If we work off that $540 price for a San Remo apartment (one of the more expensive ones then; many rented for less than $400), that’s an increase of 5,409 percent.

Notably, that number is a lot higher the calculations of Leonard Nakamura and his collaborators. By their measure, rents from 1940 to 2000 increased about 15-fold. That would make the increase in rent higher than the overall inflation rate—but still well below the change in median New York City rents. Even with this effort to fix the data, we still don’t get close to the kind of inflation you see for many New York apartments, those long turquoise and magenta lines at the bottom of the chart.

So what else is at play here? We just don’t know. It’s tempting to explain the San Remo by looking at the rise in income at the top. That’s the market for four bedroom apartments with park views. Strangely, however, the change in the price of a fancy Manhattan apartment is actually lower than the 67-fold increase in the price of the underheated Brooklyn walkup I lived in for five years.

It’s difficult to judge the degree to which that Brooklyn apartment—unlike the four-bedroom in the San Remo—is “the same” as it  was in 1940. The heat may have worked more reliably then, and the building had not yet been blessed with its current asbestos-shingled facade. On the other hand, it wasn’t within throwing distance of about half a million trendy restaurants, as it is now. How do you calculate the value of those kinds of changes and plug them into the inflation model?

“The main thing we cannot take into account [in measuring inflation],” says Leonard Nakamura, “is how a city changes over time.” That’s certainly part of the rent puzzle. In the post-war years there has been a major national transition from renting to home ownership. In New York, as in many parts of the country, many of the most desirable properties in most desirable neighborhoods can no longer be rented at all. This is essentially the case with the San Remo. As the San Remo and buildings like it turned owner-occupied, they’ve dropped out of the inflation measure.

That may have pushed down measured rent in New York and many other places as well. As the upper and middle class have moved to home ownership over the last decades, it’s possible that the the homes and neighborhoods that have stayed rentals are the ones that have been less desirable in hard-to-measure ways. That might help explain the enormous divergence between New York rents and the inflation yardstick, but it’s hard to test without a much deeper dive into real estate records.

1940 census forms from tenants at the San Remo. You can see Meno Henschel’s $900 rent at the left, the highest at the time.

Complaining about inflation can seem like an old person’s diversion; yes, at some point a steak dinner did cost three bucks and penny candy was a penny. So what?

With rent, however, the intuition that prices have risen faster than the inflation data appears very robust not only to laypeople, but to professional economists as well. Robert Gordon is an economist known for his pioneering work on how we’ve overstated inflation in durable goods, such as cars, which have improved over time. He suspects that housing may be different. As Gordon writes in an e-mail, ”the low prices my parents paid in the 1950s for a lot, a house, my Harvard education … seem unbelievably cheap by today’s standards.”

If rent has indeed risen more than the usual inflation measures indicate, it would help explain why many families have the sense that they are working ever harder to afford to live in what they think of as a nice neighborhood. More generally, understanding what’s happened to the price of shelter is key to the current debate on inequality and how we answer the question that gets asked (rightly) in every election year: “Are we better off?”

The other takeway from New York rents is that when you think about inflation, you may consider asking “inflation in what?” and “inflation for whom?” We are so used to talking about the headline inflation number that comes out each month that we tend to forget it includes changes in literally thousands of prices. The increase in rent at the San Remo is not the same as the increase at a new college grad’s shared apartment across the river in Brooklyn, or at a public housing complex in the Rockaways—or in a different city. Nor is it the same as the change in the price of steak or childrens’ clothes.

And because inflation isn’t the same for different items in the consumer basket, it’s not the same for different people, either. It may, for instance, be higher for the wealthy, who are competing for the same few ultraluxury properties. It may be lower for older people, who don’t worry about moving. And it may be higher for those who have to move often. Measuring inflation accurately is a hard problem, and over the years economists both inside and outside the government have made great efforts (and strides) to get it right. The evidence of New York is that we’re not there yet.

Already the national discussion has turned from talking about inflation in general to focusing on specifics, like the costs of education and health care. It may be time to start cutting up the data in even more granular ways to get more specific answer to those questions of “inflation in what?” and “for whom?” That may pose some questions for government policies. In return, it’s likely to offer up some answers to why we live the way we do up and down the economic ladder.

Bloomberg News/ Laura Segall

A development in Gibert, Arizona, in the Phoenix metro area

Welcome to the Phoenix, Arizona, edition of The Market Now. Two Bloomberg stories in the past two days included powerful on-the-ground reporting in Phoenix. They make for a telling study in contrasts.

Today, Heather Perlberg reports on the Phoenix homeowners emerging from underwater mortgages. Perlberg kicks off the narrative with a homeowner who finally saw prices recover enough that she could sell the house her family had outgrown, pay off the mortgage and upgrade to a larger place. Though prices are still well below their 2006 peak in Phoenix, they’re recovering fast.

Also from Phoenix comes yesterday’s article by Jeff Green and Amanda J. Crawford about the increase in the payroll tax. They pull in tight on a high school teacher whose $60 a month payroll-tax increase means cutting bills by shopping for groceries in the junk-food aisles of the dollar store. Dinners out are out of the question.

The two stories together neatly sum up the mixed economy. Investors and homeowners have benefitted from low interest rates and the Fed’s efforts to jump-start the housing market. Big investors in Phoenix have known that for a while, as this Bloomberg story noted in October. Those improvements in the investment climate haven’t been matched by gains in middle-class income.

The chart above, using Phoenix data from the St. Louis Federal Reserve, gives you some idea of the long-term trend in incomes and home prices. The black line in Phoenix’s per capita income, the red is home prices. You can see just how far home prices outstripped incomes in the boom. There’s room for a recovery, but not to anything like those boom-era levels.

That’s the reason that, as regular readers know, The Market Now has been skeptical of the housing rebound. Low rates will boost housing, and perhaps easier mortgage standards may too as banks turn on the lending spigot. Over the long term, though, home prices will keep rising only if disposable incomes do, too.

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