As I have been saying since I began the blog some 4 years ago, the majority of pain that homeowners are feeling was self-inflicted. Today, Inman news reports to us on MIT’s Sloan School of business study on home-equity raping and the cause of so many foreclosures. The money shot?
estimating that without cash-out refinancings and other withdrawals of homeowner equity, only 3 percent of outstanding mortgages would have been underwater at the end of last year
Basically, mortgage borrowers bought the rope to hang themselves.
I would recommend reading the entire article, but here’s an excerpt:
The study didn’t take into account the behavior of lenders or the supply of money available to refinance, instead assuming that borrowers could refinance as often as they wished at prevailing interest rates. That may have been pretty much the case in the decade leading up to the market’s June 2006 peak, the study said, with homeowners eager to take on debt and lenders only too willing to accommodate them.
But the study illustrates a more subtle problem than the “dysfunctional individual and institutional behavior” exhibited during the boom, said authors Amir E. Khandani, Andrew W. Lo, and Robert C. Merton.
“While excessive risk-taking, overly aggressive lending practices, pro-cyclical regulations, and political pressures surely contributed to the recent problems in the U.S. housing market, our simulations show that even if all homeowners, lenders, investors, insurers, rating agencies, regulators, and policymakers behaved rationally, ethically, and with the purest of motives, financial crises can still occur,” the study said.
“Near frictionless” refinancing opportunities, when they occur simultaneously with declining interest rates and rising home prices, create a “ratchet” effect in which homeowners exchange the equity they’ve built in their homes for debt they can’t easily “unwind,” the study said.
The situation poses a risk for lenders, too. A formerly diverse pool of borrowers — some who’d had comfortable levels of equity in their homes, and loans that were well on their way to being paid off — becomes synchronized, as if each had bought their homes at the height of the market with the highest allowable loan-to-value ratios.
When home prices decline, lenders have no way to compel homeowners to add more equity, like the margin calls employed by stock brokers when investors buy shares with borrowed money. Unlike equities investors who can sell off part of their portfolio to meet a margin call, homeowners can’t sell part of their home to reduce their debt ratio.
There’s no easy way to address the “refinancing ratchet effect,” the study said, because the three factors that can lead to trouble — declining interest rates, rising home prices, and easy access to mortgage loans — are “benign market conditions” often seen as indicators of economic growth.
“No easy legislative or regulatory solutions exist, such as prohibiting the Fed from cutting interest rates below a certain threshold, or placing a ceiling on housing prices, or putting ‘sand in the gears’ of the refinancing system and limiting consumer credit,” the study said.
In the end, were using the money from refinancing to supplement declining income, as was the case of a short sale I recently went to see with Brad Davidson (co-blogger and Broker at We-Help-U-Buy). The homeowner had purchased some 20+ years earlier, but had withdrawn over $500K in the last decade. Meanwhile, not a cent was put into home maintenance as the entire place was original. In fact, she had cost the home probably $10K in damage to the in-ground pool draining too quickly because the pool pump broke and she didn’t have $800 to replace it. (Hydrostatic pressure will do some interesting things to concrete when the opposing force is removed.
The most amazing thing to me during the housing downturn is the number and amount of refis that I have seen. It seems MOST of Southern California took out several hundred thousand dollars each from their houses; enough to buy entire houses outright in most other places in the country. Some of the most amazing and bizarre examples have been in the wealthiest enclaves, likely in an attempt to keep up with the Jones’. This kind of insanity is well-documented in IrvineRenter’s Southern California’s Cultural Pathology.
The road ahead is still going to be fraught with disaster, as it will take us decades to rebuild our consumer balance sheets after having pulled so much of our income forward through equity withdrawals. Let’s hope that we can do it sooner than later.
