Homeowners and lenders may ignite another housing mania requiring a taxpayer bailout

As house prices rise and more homeowners possess equity again, some are withdrawing this money at low rates and spending it, stimulating the economy.

hungry-homeownersDuring the housing mania, people bought homes because house prices rose rapidly, and lenders gave equity to homeowners at 100%+ of the value set by recent comps. Under such circumstances, houses were very desirable, and unlimited access to home equity fueled the housing mania and funded millions of personal Ponzi schemes.

Homeowners like mortgage equity withdrawal because it provides them instant access to the free money bestowed upon them by the magic appreciation fairy. Even better, they didn’t have to sell the golden goose: they got to keep their home and wait for it to grant them even more free money. It was like owning a personal printing press.

Homeowners gladly suspended their disbelief at the too-good-to-be-true nature of free money, and if lenders willingly doled it out, homeowners eagerly accepted it. Politicians actually encouraged mortgage equity withdrawal because reckless spending boosts the economy. Economists coined a pleasant euphemism, the wealth effect, to gloss over the brazen theft that often accompanies this kind of borrowing.

Lenders believed they were underwriting profitable loans, blissfully unaware they were supporting millions of personal Ponzi schemes. The few in the lending industry that realized what they were doing didn’t care because they believed that even if the Ponzis imploded, the lenders could still foreclose and recover their capital or pass these losses off to hapless investors who thought they were buying AAA mortgage bonds.

For now, banks are being more conservative in their lending, but since lenders and investors chasing yield may become more aggressive as their confidence in rising house prices increases, rampant HELOC abuse may return. If it does, it could easily reignite the same desires that inflated the housing bubble leading to a painful crash and more taxpayer bailouts. Everyone who doesn’t want to subsidize their neighbors’ reckless spending should be wary of a return to a HELOC dependent economy and lifestyle.

Fortunately, unlike during the housing bubble, investors aren’t stupid enough to give out free money to Ponzis — at least not yet.

More homeowners cashing in on their new housing wealth

Diana Olick, Friday, 3 Mar 2017

Homeowners are opening their favorite piggy bank again — their homes.

As home values rise faster than expected, that increased homeowner wealth suddenly seems more enticing. … it also serves as a warning sign.

Ever since the epic housing crash at the end of the last decade, homeowners have been extremely conservative with their home equity. Even those who had money in their homes kept it there, fearing another downturn in prices. Now, as millions of borrowers come up from underwater on their home loans and many more see their home values jump sizably on paper, borrowing more is back in favor.

Home equity lines of credit, known as HELOCs and often serving as second loans, allow homeowners to pull cash out of their homes when they need it. HELOC volume is now up 21 percent in the past two years, to the highest level since 2008, according to Moody’s. …

“The more second liens that people take out, it adds a risk that comes from the rising home prices. The fact that people are leveraging their homes more than before makes things more risky,” said Peter McNally, senior analyst at Moody’s. …

One wrench in the run to grab equity is the fact that interest rates are rising. That makes loans more expensive and consequently takes the shine off low down-payment loans, which require added mortgage insurance. The fourth quarter of 2016 brought the first significantly higher mortgage rates in more than three years. …

I don’t think we will see the same level of theft we witnessed last time around. During the housing bubble, lenders offered borrowers the ability to refinance at lower interest rates. This allowed borrowers to extract their equity often without increasing their monthly payments. From a borrower’s perspective, this really was free money.

Since we are at the bottom of the interest rate cycle, borrowers won’t get lower interest rates to refinance and keep the same monthly payment, so HELOC booty will have a cost this time around. If the borrowed money has a real cost, far fewer people will take it, and those that do won’t be able to extract near as much because they will face qualification barriers. That should curtail Ponzi borrowing which is the behavior that inevitably leads to a crash.

Homeowners are clearly leaning toward more leverage, but they are doing so in a far different environment than in 2006. Mortgage underwriting is far stricter, especially for home equity loans, and borrowers must prove their ability to repay loans, including all financial documentation. Home equity continues to rise steadily, according to the Federal Reserve Board, and it is still rising faster than borrowers are withdrawing it.

I’m still amazed that we must make note of the fact that lenders now ensure borrowers can actually repay their loans.

The caution comes amid a growing concern that home prices are overheating. Tight supply, rather than income growth, is pushing prices, and that is not a sustainable scenario. … some of the hottest markets could see sizable retreats, putting pressure once again on the amount of housing wealth.

Some of the hottest markets could see sizable retreats? Is it time to be cautiously optimistic about a price correction?

HELOC Abuse Grading System

I developed a simple grading system to help people understand how foolish decisions cause people to badly manage their mortgage debt. The origin point to the left represents the total loan balance on the day the property was purchased. The lines emanating from the origin extend to the right with an angle of trajectory that either pays down a mortgage or adds to it. Each HELOC grade is separated by a psychological or behavioral threshold, and each one provides observable results.

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HELOC Abuse Grade A

Most people who borrow money do so because they need it. There is a limitation to how quickly they can repay the money, and the limit at the bottom of Grade A is the pinnacle of borrower prudence. In order to earn an A, a debtor must pay off a mortgage faster than a 30-year amortization schedule.

HELOC Abuse Grade B

Earning a B in this system requires a debtor to at least hold the line on the total debt. Anyone who does better than treading water — which puts all interest-only borrowers on the line — can earn a B. Prior to the bubble, few borrowers were near this threshold and most of the market earned a B for debt management.

Earning an A or a B is a badge of honor; the scarlet letters are coming next….

HELOC Abuse Grade C

I hate to give borrowers in this category a “passing” grade, but this is the reality for most Americans. Growing credit card or mortgage debt slowly generally can be compensated for through home price appreciation, and although I consider this a bad idea, I can’t really call it HELOC abuse, just foolish HELOC use. Is there a distinction there?

Most people fail to budget properly for unexpected expenses (they don’t save), so when they fall behind a little each month, they put the balance on a credit card and hope they can pay it back with a tax return — or during the bubble with a visit to the housing ATM. The money changers will continue to peddle this nonsense as sophisticated financial management. However, it’s a stupid way to manage debt.


HELOC Abuse Grade D

The transition between a grade C and a grade D is somewhat subjective, but it is hinged to an idea; once borrowers knowingly increase their loan balances to spend appreciation as a matter of habit, once they expect appreciation and HELOC money as a reliable source of income, they move from what some may consider legitimate use of HELOCs to Ponzi Scheme financing. This Ponzi borrowing limit is an invisible threshold borrowers do not realize they cross, but once they accept using debt to pay debt as a concept, they breach the event horizon and enter borrower oblivion.

The top of the range of D graded HELOC abusers is the limit of each borrowers self-delusion when it comes to how much appreciation they feel comfortable spending without losing their homes. People who earn a D still planned to keep their homes, they were merely misguided by their own ignorance.

HELOC Abuse Grade E

Somewhere beyond the limit of self-delusion, a borrower makes another psychological leap, they no longer worry about the consequences of their actions and they spend, spend, spend. This grading category spans the continuum from thoughtless spending to foolish and reckless self-delusion the borrower exercises no restraint at all.

HELOC Abuse Grade F

Grade F HELOC abusers are the creme-de-la-creme of their craft. These people don’t merely maximize their debt to spend recklessly — although I am sure much reckless spending occurred — grade F HELOC abusers openly game the system to strip equity while passing the losses on to lenders.

The upper limit of this boundary is determined by lender greed and stupidity as reflected through their underwriting standards. During the housing bubble, this line was pushed so far as to create categories C, D, E and F that didn’t exist before. During the bust, prudent lending standards returned, and these categories were largely eliminated — at least for now.

Home equity is the foundation for our retirement savings system and the entire housing market. We should be leery about homeowners and lenders chipping away at it.