Your neighbor’s debt creates your home equity

The more new buyers borrow to buy neighborhood properties, the more home values go up, and the more home equity appears out of the ether.

home_price_appreciation_fairyWhere does home equity come from? Does it appear by magic, a gift of the appreciation fairy? Does it accumulate by discipline through paying down a mortgage? Both factors are at work, but unless you believe the appreciation fairy listens to your prayers, the only factor that builds home equity you have control over is the amount of debt encumbering the property.

So how does the appreciation fairy work? In concept house prices should rise gently over time to match the growth of wages in the area. In practice house prices rise and fall violently with changes in financing costs, economic upheavals, a downward substitution effect in supply-constrained markets, and kool-aid intoxication, or as economists prefer to call it, animal spirits.

The underlying determinant of home equity is the difference between the resale value and the debt on the property, or more accurately put, an appraiser’s interpretation of resale value because if an owner wants to refinance and obtain that equity (a bad idea I call HELOC abuse), then the appraiser determines how much equity is available.

So how do appraisers determine value? They rely on recent comparable sales. And what is the largest determinant of the resale price of neighboring homes? The amount the buyer borrowed. In other words, the biggest determinant of your home equity as a homeowner is the amount of debt someone was willing and able to borrow to buy in your neighborhood.


When a property sells for a new high price, it doesn’t just affect the value of that property, it impacts the value on all similar properties within a mile of the new sale. During the housing bubble, neighbors cheered each new higher comp because it added to their (illusory) net worth. With unrestricted access to equity with no-doc loans and 100% LTV HELOCs, everyone near a new high comp was basically given free money.bagholder

The late arrivals all eagerly waited a greater fool to come along and buy at an even higher price so they could get their share of the HELOC booty too. Obviously, under such circumstances, the desire for real estate was very high, and with no impeding lending standards and an eagerness from investors to fund new loans, actual demand as measured by dollars was very high as well; therefore, we ended up with a massive housing bubble.

Since the housing bubble collapsed, prudent lending standards returned, and prices dropped precipitously largely because buyers could not borrow the prodigious sums previously made available to them to bid up prices, putting the banks in a bind as the huge reduction in collateral value backed the bad loans they made during the bubble era.


The price collapse put between a quarter and a third of American loanowners 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.

amend-extend-pretendThe 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 loanowners 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. These programs have been an abject failure for loanowners, but it has been successful for bankers in getting a little operating cash while delaying loss recognition.

Ultimately, banks don’t want to recognize losses. They would far rather delay their necessary foreclosures until the loans had collateral backing which will allow them to recover their capital. However, since potential buyers of these properties couldn’t afford to pay an amount which would recover the outstanding debt, the bubble needed to be reflated before the foreclosures could go forward.a_house_deflation

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 bottomed out near 3.35% in 2012 — a near 50% reduction. These super-low interest rates gave buyers the ability to borrow amounts commensurate with peak prices under stable loan terms.

Due to the collapse of prices when the housing bubble burst, comparable sales were far below peak prices, and continued foreclosure processing was keeping prices down. The solution was simple; stop foreclosure processing and restrict inventory until the housing bubble reflates. Once the problem of excessive MLS inventory was resolved, we quickly reflated the bubble to allow lenders to recover capital at peak prices, mostly through equity sales.

Lenders stopped foreclosure processing to dry up the inventory. Loanowners are in no hurry to list their properties because if they wait, they might get out without a ding to their credit scores, so both foreclosures and short sales are in short supply. Foreclosures used to be a third of the market, and with many owners underwater, much of the supply was removed. The few organic sellers are also have incentive to wait because they will make more money by selling later. The result was a huge decline in inventories and rapidly rising prices.


There is one major problem with reducing mortgage rates to record lows merely to reflate the old housing bubble: when rates rise, borrowers will endure reduced borrowing power, home sales volumes decline, resale values may fall, and home equity may be reduced.

Perhaps wages will rise faster than mortgage rates, but it’s unlikely that wages would rise 12% or more to offset the impact of a 1% rise in mortgage rates. In short, future buyers will likely be less leveraged, and although price declines are not certain, rapidly rising house prices seem an unlikely possibility.

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