Jan092017

How rising mortgage rates erode homeowner equity

One man’s mortgage debt is an entire neighborhood’s equity. Higher mortgage rates put pressure on the size of mortgage balances, potentially eroding homeowner equity.

When a buyer purchases a house, their purchase sets a standard by which the value of other houses is inferred. When a house sells for a high price, the new sale boosts the value every property in the neighborhood. Of course, as many lamented during the bust, when a house sells for a new low price, the sale drags down neighborhood values as well.

When prices rise, neighbors cheer each new high comparable sale because it adds to their net worth, illusory though it might be. Many people enjoy checking their Zillow Zestimate, particularly during a boom, because it makes them feel rich.

While everyone wants to be rich, what lenders did during the housing mania really increased the desirability of homeownership: they allowed cash-out mortgage equity withdrawal at 100% of a home’s value. Home equity lines of credit (HELOCs) flourished, and many people responded by borrowing and spending their home equity. In short, increasing home values gave everyone free money, and lenders allowed them to spend it.

As word spread about free money, homeownership became very popular, and understandably, the homeownership rate rose sharply. Those who bought late in the market rally were not worried because they knew an endless supply of greater fools also wanted their turn at free money. With no impeding lending standards and an eagerness among investors to fund the madness, actual demand as measured by dollars was very high as well. No surprisingly, we ended up with a massive housing bubble.

When the housing bubble collapsed, prudent lending standards returned, and prices dropped precipitously. During the bubble, unstable loan products allowed borrowers to obtain loans at eight to ten times their yearly income. When these loans collapsed, buyers could not borrow the prodigious sums previously made available to them to bid up prices. When conventional loan terms were applied to verifiable incomes, typical loan balances were reduced nearly 40%.

The smaller available loan balances put banks in a bind. Since borrowers were unable to support such large loan balances, they couldn’t support house prices, and the collateral that backed bubble-era loans decline in value far below the outstanding balance of the loan. With equity gone, homeowners became underwater loan owners.

The price collapse put between a quarter and a third of American homeowners underwater, and if the banks were forced to liquidate, it would cause hundreds of billions in losses bankrupting our banking system and triggering a deep economic depression. Something had to give.

The US government and the federal reserve took a number of steps to solve the problem. First, in early 2009, regulators relaxed mark-to-market accounting rules allowing banks to hold bad loans on their books at a fantasy value to avoid loss recognition. This bought the banks time.

Further, in order to placate pressure from underwater borrowers to “do something” and to provide lenders with a few additional debt service payments on these bad loans, the government embarked on a series of failed loan modification programs. These were sold to the public as ostensibly helping struggling borrowers, but they were really designed to allow banks to kick-the-can on loan recognition and squeeze a few more payments out of hopeless borrowers before they imploded. For borrowers, these programs proved an abject failure, but for bankers, it was a boon because they obtained operating cash while delaying loss recognition.

Ultimately, banks don’t want to recognize losses. They would far rather delay their necessary foreclosures until the houses were worth more than the outstanding balanc on the loan, which allows them to recover their capital. However, since the bust pushed price too low to recover the outstanding debt, the bubble needed to be reflated before the foreclosures could go forward.

To facilitate reflation of the housing bubble, the federal reserve lowered interest rates to zero, and embarked on a program of buying 10-year Treasuries (operation Twist) and directly buying mortgage-backed securities to ensure the flow of capital into the housing market and dramatically lower mortgage interest rates. At the peak of the housing bubble, mortgage interest rates were between 6% and 6.5%. They ultimately fell to 3.35% — nearly a 50% reduction! These super-low interest rates gave buyers the ability to borrow amounts commensurate with peak prices under stable loan terms.

Prices rose rapidly from 2012 through mid-2013 when the so-called “taper tantrum” caused mortgage rates to rise from 3.5% to 4.5% in about six weeks. House prices kept rising after that, but at a much slower pace, often boosted by a downward drift in rates over the next three years back near record lows.

Some dubbed the recent move in rates from 3.7% to 4.3% the “Trump tantrum.” Since it happened during a seasonally slow time of year, we can’t conclude this will hurt sales in 2017, or if rates won’t drift back down again like they did last time; however, it is cause for concern.

When unstable loan terms were removed during the housing bust, loan balances fell, and house prices fell along with them. This more than eroded homeowner equity, it crushed it into oblivion. The taper tantrum removed the momentum from an undervalued market, but slowing rising prices over the last three years brought the market back to fair value.

What will rising rates do at this point?

While I don’t believe a crash is on the horizon, rising mortgage rates will put pressure on loan balances, and since one man’s debt is an entire neighborhood’s equity, that can’t be a plus for existing homeowners.

The attachment I can’t let go of

I’ve long known that being attached to possessions or outcomes leads to suffering. The older I get, the easier I find it to let go of my attachments, and as I do, my anxiety level drops. However, I must admit I have one attachment I can’t let go of: I love watching the Green Bay Packers play winning football.

Green Bay Packers, 38: New York Giants, 13. Go Packers!


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