No cash-out refinancing for Ponzi borrowers… yet
Homeowners cash-out their home equity to supplement their incomes reminiscent of the bad behavior that spiraled out of control during the housing mania.
Lenders offer homeowners nearly free money, so unsurprisingly, borrowers take the money. During the housing mania, bankers offered this money without regard to the borrower’s ability to repay, an open invitation to steal that many took advantage of.
Mortgage equity withdrawal dried up during the bust, partly because borrowers lacked equity, but partly because lenders refused to support the personal Ponzi schemes of so many people. As conditions improve, lenders underwrite these loans again, but so far, they employ conservative underwriting standards and limit the cash-out to a reasonable loan-to-value ratio.
Over time, lenders naturally become more aggressive to deploy more capital. As their confidence in rising house prices grows, their complacency increases, and standards fall. With falling standards, lenders provide money to borrowers more likely to run personal Ponzi schemes, leading inevitably to large lender losses.
As lenders make cash-out refinancing easier, more borrowers succumb to the temptation to borrow their nest egg and spend it. At first, this is often limited to ostensibly value-adding items like kitchen renovations, but once borrowers enjoy this relatively painless free money, they quickly justify spending it to consolidate credit cards, fund vacations, and other dubious uses of borrowed money.
The free-money orgy of the housing mania left millions trapped underwater in their homes, and it required a massive taxpayer bailout of borrowers and bankers alike. Everyone who doesn’t want to subsidize their neighbors reckless spending should be wary of a return to a HELOC dependent economy and lifestyle.
But while affordability for buyers is weakening, rising home values are benefiting homeowners who chose to stay put. They cashed out $22.6 billion in home equity in the second quarter of this year, the largest amount since the middle of 2009, according to Black Knight Financial Services. That may sound like a lot, but it is still nearly 80 percent less than the peak of cash-out refinances in the third quarter of 2005, the height of the housing boom. It is not even close to what borrowers could have taken out.
“Given that we saw over $550 billion in tapable equity growth last year alone, this equates to borrowers only tapping into 15 percent of the growth in equity over the past 12 months, without even touching the $4.5 trillion balance in tappable equity available,” said Ben Graboske, executive vice president of Black Knight Data & Analytics.
Fifteen percent of a single year’s growth is still a significant sum. That’s $150 of every $1,000 in free money created by the magic appreciation fairy. Nobody earned this money by adding value to anything. It’s free money created from nothing other than financial voodoo.
“All in all, it’s clear that cash-outs are helping to prop up the refinance market — their 42 percent share is up from only 30 percent in early 2015 when interest rates had also dropped.”
Not only are today’s borrowers far more conservative, it is just plain harder to qualify for a cash-out refinance today than it was during the loose lending days of 2005. The average FICO credit score among cash out refinancers today is about 748, well above the average score.
After a credit crunch, lenders limit their offerings to those least likely to need or want it. People with very high credit scores generally don’t run personal Ponzi schemes. It’s when those credit score standards drop that lenders start providing money to people who use it to pay other debts and supplement their lifestyles — that’s when it becomes a real problem.
Mortgage rates remain near record lows and show little sign of any major gains. This should keep refinance volume elevated, as homeowners priced out of a move up decide to take cash out to remodel.
Remodel? Yeah, right.
Will HELOC abuse come back in full force?
I doubt we witness the same level of theft observed last time around. During the housing bubble, lenders offered borrowers the ability to refinance at lower interest rates, allowing 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. That means HELOC booty will have a cost this time around. If borrowers face real costs, fewer people will partake, and those who borrow won’t extract nearly as much due to the higher interest costs.
We will almost certainly see a continuation of debt consolidation loans on HELOCs. Borrowers often feel wise when they consolidate high-interest credit card debt on a low-interest HELOC; however, borrowers were extremely foolish to run up the credit card debt in the first place. Financing short-term consumption with long-term debt is never a good idea. Debt consolidation is a one-time fix for those who see the light and stop using their credit cards, but it’s a terrible way to routinely plan finances.
I think most HELOC money in the future will go toward debt consolidation and home improvements, a tolerable though foolish use of consumer debt. Although I think all consumer debt is bad, the debt industry will continue to tout its benefits while they enslave another generation.