Home equity spending heightened the housing bubble and compounded the crash
Bubble thinking is rampant, and the primary reason for its persistence is that people want the free spending money houses provide. The huge financial reward each bubble participant received as they went to the housing ATM gave a spender’s high like no other. Absent another housing bubble, most bubble participants will never have access to that kind of free money again.
The real estate lottery
When you reflect on it, mortgage equity withdrawal is similar to state run lotteries that sell hope to the poor at a major cost. If you are a worker who doesn’t save money, you have no chance to acquire wealth. Lotteries give those who have no other opportunity for wealth a chance — slim though it may be.
If many people participate in the lottery, the payouts become enormous, and others become drawn to the action which further increases the payouts. This continues like a Ponzi Scheme until a big winner empties the lottery pool, and the game starts over.
Buying real estate is like buying a lottery ticket with important differences. When people participate in the real estate lottery, they are a guaranteed winner – for a while. Every participant gets to withdraw and spend their winnings as long as the pot grows. This makes the real estate lottery like no other, and it makes it much, much more desirable.
At some point, the real estate Ponzi Scheme collapses, the pool of equity “winnings” is emptied, and the game starts all over again. The big difference between the California lottery and the California real estate market is what happens to the losers. People who play the lottery are limited in their losses to the amount of money they invested. People who gamble in the real estate lottery have no limit to their losses; in fact, their losses may easily exceed their net worth resulting in bankruptcy. Most real estate losers also give up their homes.
The threat of foreclosure and bankruptcy doesn’t deter people from playing the game, particularly the poor who have nothing to lose anyway. Most people take the free money and don’t worry about the consequences because through either personal abdication of responsibility or a massive government bailout people will not face the consequences. Moral Hazard now rules the California real estate market.
A bubble here a bubble there
When I wrote The Great Housing Bubble, I scoured the academic journals for some insight as to why some markets bubbled and some did not. Some economists, like Paul Krugman, contend that growth restrictions that constrain supply are causal factors because the housing bubble was concentrated in coastal regions where development is more restricted than inland areas. There is some truth to the constrained supply argument; it can serve to precipitate the initial price movement that excites bubble thinking, but beyond that point, continuing price movement is pure kool aid intoxication.
The growth restriction argument does not explain the housing bubble in Florida. I have worked in the land development industry in both Florida and California, and I can tell you California’s process is much more restrictive of suburban sprawl. There was no shortage of supply in Florida as the glut of empty homes in South Florida attests to.
The growth restriction argument may explain why some some markets are more bubble prone because the restrictions are akin to lighting a match in a gas-filled cavern. The sparks may or may not cause a bigger explosion; it is merely a catalyst. Our current market conditions have potential to precipitate another bubble. Hopefully, the new mortgage regulations will prevent it, but with the government backing our entire mortgage market, and with plenty of fees to be made, the banks have incentive to try it again.
Show me the money
The real culprit in a housing bubble is expanding home mortgage balances — people take on more debt and bid up prices. The real question is, “why do people do it?” The short answer is to capture appreciation: kool aid intoxication. But the truth is more nuanced.
In order for home price appreciation to motivate people to pay stupid prices and inflate housing bubbles, they need a way to access this appreciation. The more immediate and plentiful this access to money, the more motivated buyers are to borrow and cash out. Mortgage equity withdrawal is the doorway to appreciation; it makes houses very desirable and very valuable.
Texas shows the way
To test this premise, we need to find a market with limited access to mortgage equity withdrawal and compare the home prices there to a market like California’s where there are no restrictions at all. There is such a place: Texas.
I know Texas. I spent two and one-half years living in College Station studying real estate. Texas, along with California, was a big player in the Savings and Loan disaster. They inflated a commercial real estate bubble of epic standards, and even its residential real estate was volatile during that period. Texans are certainly not immune to the temptation to take free money from lenders. However, the delivery mechanism of the Savings and Loan disaster was through commercial lending whereas the delivery mechanism during the Great Housing Bubble was residential lending. Texas has different laws governing residential lending, and these laws prevented a housing bubble there.
In Texas, no homeowner can be extended credit secured by a personal residence in excess of 80% loan-to-value.
Since Texas residents couldn’t easily obtain and spend their home equity, and since property tax rates are nearly double in Texas what they are in California, Texans had no incentive to bid up prices, so they didn’t. It really is that simple. No access to home equity means no housing bubble. Can you imagine how Californians would react if you told them they couldn’t extract and spend their home equity?
HELOC abuse made the crash worse
The desire for home equity spending was the reason people were willing to pay insane prices to own real estate. But the spending itself is what made the crash so bad. If there were no mortgage equity withdrawal, the only people who would have been underwater and at risk of losing their homes would have been the late buyers. However, that isn’t what happened. As it turns out over 40% of those who lost their homes bought before 2004. Those buyers would never have sunk beneath their debts or struggled to make payments if they hadn’t gone to the home ATM machine.
The conventional wisdom of the housing crisis goes something like this: Too many people bought homes as the housing bubble inflated. Some were unlucky in their timing, while others overextended themselves by putting too little money down. All of these top-of-the-market purchases led to an explosion of foreclosures once home prices dropped sharply and the economy hit the skids.
… a paper published in March that challenges conventional wisdom by showing that a significant share of foreclosures came from people who bought their homes before 2004.
So why did so many people who bought their homes before the housing bubble fully inflated end up losing their homes anyway?
The answer: These homeowners aggressively used their homes as ATMs, extracting cash by refinancing into larger loans or using home-equity loans.
The paper, published by Steven Laufer of the Federal Reserve Board, examined a sample of homeowners from Los Angeles County and found that 40% of defaulting homeowners had purchased their homes before 2004. Home prices had risen so far in California that even after a 30% decline, prices in recent years have been roughly at levels equal to 2004. For more than nine in 10 of these borrowers, their original mortgage balances should have been less than the current value of their homes, leaving them with positive equity.
90% of those who lost their homes from HELOC abuse wouldn’t have lost their homes if they hadn’t gone to the home ATM — 90%. Anyone who considers taking out a HELOC or refinancing with cash out should consider that excessive mortgage equity withdrawal leads to a 90% chance of foreclosure.
Enter the home-equity loan and the cash-out refinance, in which borrowers refinanced into a larger loan, extracting equity to fund everything from college tuition and medical bills to dinners out and vacation trips.
The list makes it sound like people spent on essentials. They didn’t. Most people pissed away this money on conspicuous consumption and keeping up with the Joneses.
In his Los Angeles sample, Mr. Laufer finds that borrowers ended up with loan-to-value ratios that were, on average, 50 percentage points higher than they would have been. (The study follows on earlier work that reached similar conclusions, including a 2009 paper that also examined Southern California.)
One quarter of borrowers who purchased their homes between 2000 and 2003 had loan-to-value ratios of 140% when they ultimately defaulted, while 10% of borrowers had loan-to-value ratios exceeding 170% (that is, they owed 70% more than the value of their house). Without any equity extraction, the majority of homeowners would have had loan-to-value ratios of 60%, and fewer than 10% of borrowers would have been underwater.
The bottom line: equity extraction was responsible for around 80% of defaults among homeowners who purchased their homes before 2004, representing around 30% of all defaults between 2006 and 2009.
How much more damning can those facts be? At least 25% of all mortgage defaults would not have occurred if not for mortgage equity withdrawal. Further, since house prices wouldn’t have been bid up so high and crashed so hard which imperiled our financial system and lead to the Great Recession, I would argue that the entire mess of the last seven years could have been avoided if prudent restrictions on mortgage equity withdrawal were in place.
No mortgage equity withdrawal means no housing bubble. No housing bubble means no housing crash. No housing crash means our banking and financial system remains solvent and we avoid the Great Recession.
What about job loss and other income shocks—didn’t those ultimately account for a greater share of defaults? Not necessarily, says Mr. Laufer. Equity extraction led homeowners to take on larger mortgage balances and required larger monthly payments. His analysis finds that after holding constant for equity extraction, income shocks and borrower-liquidity constraints accounted for only 30% of defaults following the home-price decline.
What are policy makers to do? One solution would be to impose a limit on the amount of debt that homeowners could take on when extracting equity through refinancing or obtaining junior liens. For example, states could prohibit cash-out refinances from exceeding 80% loan-to-value ratios (Texas already does this).
States? How about federal regulations on this matter? We have a national mortgage market, and we can’t allow individual states — like California — to enact laws that encourage housing bubbles and Ponzi schemes that steal from taxpayers and ultimately impoverish its own citizens. Starting with policies at the GSEs and FHA and extending to all mortgage regulation through the CFPB, we need a national crackdown on mortgage equity withdrawal.
Mr. Laufer finds that had this been in place during the bubble in Los Angeles, it would have reduced the amount of equity extracted during the boom by 23%. Because that would have reduced the collateral value of housing, home prices would have been around 14% lower. Defaults would have been around 28% lower thanks to lower home prices and the inability to take on more debt.
His estimate that house prices would have been 14% lower understates how much kool aid intoxication and the desire for mortgage equity withdrawal motivated buyers. People would have paid any price to obtain their personal ATM machines. Without the incentive for mortgage equity withdrawal, we wouldn’t have had a real estate bubble, and prices would have been 30% to 50% less at the peak.
Consumption would have increased by around 3.2%, Mr. Laufer estimates, due to the ability of more households to purchase homes at lower prices.
I like that he is looking for good arguments to support his conclusions, but this one is silly. Only an academic would overlook the huge amount of consumption that occurred because of the Ponzi borrowing. Where does he think all that money went?
The paper raises broader questions over what degree the overzealous pursuit of homeownership played in creating the foreclosure crisis. Instead, overzealous equity extraction and unsound lending practices could have played an equally significant role in driving more households to the brink of foreclosure.
There is an element of tragedy in every disaster, but financial bubbles are some of the most interesting because they are completely man made. They are created by the accumulation of individual decisions of buyers who are motivated by greed, foolish pride, and a false sense of security. Each of these people should have known better.
At this point, it seems pretty obvious that Ponzi borrowing was at the core of our financial problems. Recessions are supposed to correct these problems by wiping out Ponzi schemes both personal and business. However, the federal reserve and government regulators seem more intent on preserving the old, broken system and its associated Ponzi schemes. Perhaps regulators will see the wisdom of avoiding this kind of debacle again in the future and enact rules, laws, and procedures that limit mortgage equity withdrawal to 80% of the value of a property.
I’m not holding my breath.
That $130,000 in free money cost them their house
They took out their first small HELOC in 2005, but in late 2007, they refinanced their first mortgage and added a large HELOC. Apparently, they couldn’t afford the payments without more Ponzi money. They imploded sometime last year and were foreclosed on early this year.
[idx-listing mlsnumber=”SR13100270″ showpricehistory=”true”]
$479,900 …….. Asking Price
$365,000 ………. Purchase Price
10/7/2003 ………. Purchase Date
$114,900 ………. Gross Gain (Loss)
($38,392) ………… Commissions and Costs at 8%
$76,508 ………. Net Gain (Loss)
31.5% ………. Gross Percent Change
21.0% ………. Net Percent Change
2.8% ………… Annual Appreciation
Cost of Home Ownership
$479,900 …….. Asking Price
$16,797 ………… 3.5% Down FHA Financing
3.90% …………. Mortgage Interest Rate
30 ……………… Number of Years
$463,104 …….. Mortgage
$124,691 ………. Income Requirement
$2,184 ………… Monthly Mortgage Payment
$416 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$100 ………… Homeowners Insurance at 0.25%
$521 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$3,221 ………. Monthly Cash Outlays
($524) ………. Tax Savings
($679) ………. Principal Amortization
$22 ………….. Opportunity Cost of Down Payment
$140 ………….. Maintenance and Replacement Reserves
$2,180 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$6,299 ………… Furnishing and Move-In Costs at 1% + $1,500
$6,299 ………… Closing Costs at 1% + $1,500
$4,631 ………… Interest Points at 1%
$16,797 ………… Down Payment
$34,026 ………. Total Cash Costs
$33,400 ………. Emergency Cash Reserves
$67,426 ………. Total Savings Needed