Nov132014

More homeowners restart personal Ponzi schemes

As home prices go up, homeowners can’t resist tapping their home equity to restart their personal Ponzi schemes.

When the credit crunch of 2007 abruptly curtailed the flow of money into residential mortgages, every homeowner who ran a personal Ponzi scheme was suddenly cut off. Many perished financially; they lost their homes in foreclosure because they couldn’t afford to make payments or pay bills without the infusions of borrowed money — the essence of a Ponzi scheme.

But now lenders underwrite HELOCs again, and many homeowners take advantage of the free money at very low rates. Lenders today evaluate repayment capacity better than before, and lending standards remain prudent and loss averse; however, lenders succumb to competitive pressure to reduce standards over time, and they risk future losses by restarting the personal Ponzi schemes that lay dormant for the last seven years.

Many people irresponsibly run up $10,000 to $15,000 per year in credit card debt because they fail to live within their means. During the bubble, loan owners raided the housing ATM machine, extracted enough cash to pay off their credit card debt, and quickly depended on this yearly cash infusion. Rather than viewing their annual $10,000 to $15,000 spending as irresponsible, they embraced their house as another breadwinner and they demanded the yearly ATM visit as an entitlement. The connection was lost between the foolish action — spending their home equity on consumer goods — and the consequences of their actions — the pain of insolvency and losing their homes.

Those of us who chose not to run personal Ponzi schemes were forced to pay for the foolish mistakes of others, and to make matters worse, the bailouts we funded encourages more of this foolish behavior. The powers-that-be even coined a polite euphemism, the wealth effect, to make this idiocy sound reasonable and respectable. For the first time in our history, parties to private contracts now have direct access to our pocketbooks through our taxpayer funded 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. Our economy depended on HELOC abuse for growth during the 00s, and the withdrawal of this stimulus is a large part of the malaise we endured since 2007.

There is one main difference between today and the housing bubble era that I believe will prevent HELOC abuse from getting out of control: rising interest rates. During the housing bubble, lenders offered borrowers the ability to refinance at ever-decreasing interest rates, so borrowers extracted 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; therefore, HELOC booty will have a cost this time around. Fewer people will want costly loans, and those that do won’t be able to extract near as much because they will face qualification barriers including income verification and FICO score requirements.

More refinancing borrowers cash out home equity

Amy Hoak, Published: Nov 10, 2014

As home values have increased and mortgage rates have remained low, it appears that more borrowers are now tapping their home equity through refinancing — a way, perhaps, to use home equity to pay down higher interest loan debt or fund home renovations.

Or, perhaps, to restart their old Ponzi schemes.

Borrowers extracted an estimated $8 billion in home equity through cash-out refinancing of conventional mortgages in the third quarter, up from $5.6 billion in the second quarter and $6.1 billion in the third quarter of last year — according to Freddie Mac’s quarterly refinancing report. About 28% of refinancing borrowers took cash out in the third quarter, compared with 21% in the second quarter and 14% in the third quarter of 2013. …

HELOC abuse is growing steadily.

Granted, it’s a far cry from the peak of cash-out volume, $84 billion, in the second quarter of 2006, during the housing boom. At that time, 89% of borrowers cashed out home equity when refinancing.

It has plenty of room to grow, right?

But it is notable. Today’s bump in cash-out refinancing is a result of both the increase in equity in people’s homes — to the point that a cash-out refinance is possible — as well as the fact that they can have a mortgage rate that is the same or slightly lower, said Steve Calk, chairman and chief executive of The Federal Savings Bank, based in Chicago. …

Another reason people are cashing out: They’re dusting off shelved remodeling projects, perhaps considering the kitchen and bathroom updates that were put off until the housing market recovered and the economy improved, or making renovations that will increase their home’s appeal so they can sell in the spring, said Dan Gjeldum, senior vice president of Guaranteed Rate, based in Chicago.

Notice how everyone needs to provide a veneer of respectability to HELOC abuse, making it look like it is going to something other than mindless consumerism, which is where it really goes.

Taking cash out at refinancing can be more appealing than a home-equity line of credit for people who want a fixed rate; many times HELOCs come with a variable rate that can change over time, Gjeldum said.

It was easy to recognize the HELOC abusers back in 2005 and 2006. If you drove down a residential street, you can tell by the quality of the houses and the cars in the driveway the general level of income in a neighborhood. Oftentimes you could drive by a house and see two new luxury cars in the driveway even in less affluent neighborhoods, a classic sign of HELOC abuse. Most people would park their luxury cars in the garage, but if the garage is full of useless crap bought with HELOC money, the owners would be forced to park their fancy cars outside. Some may not have had garages full of HELOC booty. Some probably parked these outside to show off to the neighbors. Losers with a capital “L.”

Borrowers doing cash-out refinances have been taking out, on average, about $19,000 in home equity over the last quarter, Calk said, citing data from The Federal Savings Bank.

But any increase in cash-out refinancing from here on out will likely be very gradual — and, perhaps, short-lived, said Frank Nothaft, chief economist for Freddie Mac.

“As we see gradual appreciation [in housing markets] we’ll see some gradual uptick in the dollar amount of cash-out refis,” Nothaft said. But as mortgage rates start moving higher, the interest in cashing out will be less and less because people will not want to forgo their extraordinarily low rates of about 4% or lower. Instead, people who want to use some of their home equity might opt to take out a second mortgage (using a HELOC or closed-end home-equity loan), “so you can preserve that first mortgage with the cheap mortgage rate,” he said.

Not many people will take out a HELOC at 7% when they have a 4% mortgage. Unlike cash-out refinances of the housing bubble that often had no net increase in payments due to falling rates, the HELOCs of tomorrow will have significant and immediate costs, making them much less desirable — and useless for running a long-term Ponzi scheme.

It’s also worth pointing out that those refinancing under the government’s Home Affordable Refinance Program — generally people who have high loan-to-value ratios or perhaps are underwater on their mortgages — aren’t eligible for a cash-out refinance, Nothaft said.

No kidding? So people actually must have equity before extracting it from their house? What a concept!

A word of caution for those interested in extracting home equity by cashing out: “In any refinance situation, it needs to be done with the overall financial picture in mind,” Gjeldum said. “If it’s a cash-out refinance to pay off credit cards, that would be a smart decision — if you don’t run up the credit cards again. If the money is being taken out to make improvements on your home, make sure that the improvements actually have an impact on the home [value],” he said, since some improvements have a better return on investment than others.

When people are offered what looks like free money, they aren’t the slightest bit interested in evaluating their overall financial picture.

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Did We Replace Welfare with Home Ownership and HELOC Abuse?

Here is a crazy idea for your amusement. Democrat Bill Clinton promised to “end welfare as we know it.” Newt Gingerich as part of the Republican Contract With America agreed. Together they passed the Personal Responsibility and Work Opportunity Act of 1996. Since poor people could no longer count on the government for ongoing support payments, they needed a new source of spending money. The government eager to avoid civil disorder came up with an idea: make all these people home owners to make them feel vested in the community, and give them home equity they can convert to spending money to make up for the lost welfare money.

This legislation does correspond to the beginning of the housing bubble and the dramatic rise in home ownership rates (see below), and the cause and effect is plausible. Also, during the bubble rally, there were certainly many poor subprime borrowers who got to take a ride on the HELOC gravy train. I don’t happen to think this correlation is causation, but it is something to think about. It is certainly more plausible than most of the nonsense coming out of the Right-wing narratives I have read.

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