Home Equity Loans Caused the Housing Crisis?

According to research, it was not subprime lending that that fomented the housing bubble and ultimately led to its collapse. Rather, it was home equity lending, especially of the cash-out variety. In short, borrowers took advantage of artificially low interested rates and inflated to extract cash, and in the process, lowered the equity balances in their homes. The Federal Reserve Bank summarized this phenomenon as follows: “The rise in the market value of homes since the early 1990s has led to a substantial increase in the level of housing wealth. However, since the mid-1980s, mortgage debt has grown more rapidly than home values, resulting in a decline in housing wealth as a share of the value of homes.”

In fact, Alan Greenspan, himself, estimated that “ four-fifths of the trifold increase in American households’ mortgage debt between 1990 and 2006 resulted from ‘discretionary extraction of home equity.’ ” In other words, most new mortgage debt was created as a result of refinancing (which increased the appraised value of the properties), rather than debt to fund purchases of new homes. “In 2005 alone, U.S. homeowners extracted a half-trillion-plus dollars from their real estate via home-equity loans and cash-out refinances. Some $263 billion of the proceeds went to consumer spending and to pay off other debts.”

The link between cash-out refinancing and foreclosure is surprisingly cut-and-dried: “For every 1 percentage point increase in its share of subprime mortgages that are cash-out refinances, the likelihood of foreclosure in that state goes up by one-third of a percent.” This connection is not difficult to comprehend since borrowers with less equity will necessarily have a more difficult  time repaying their mortgages, either for lack of wherewithal or lack of motivation (perhaps resulting from being underwater).

There are very clear lessons here. First, borrowers should exercise extreme caution when increasing the balance (via a refinancing) of their primary mortgage. This is true if the funds will be pumped back into the home, and especially true if the borrower intends to withdraw some of the proceeds, since this directly increases the likelihood of default.

From a policy standpoint, it’s clear that cash out refinancing should be heavily regulated, if not banned outright. Some experts have pointed to Texas, where the incidence of both foreclosures and underwater mortgages are well below the national averages. By no coincidence, “There, Cash-outs and home-equity loans can’t total more than 80 percent of a home’s appraised value. There’s a 12-day cooling-off period after an application, during which the borrower can pull out. And when a borrower refinances a mortgage, it’s illegal to get even $1 back.” Texas takes these rules so seriously that they are enshrined in the State Constitution.

It’s unlikely that the imminent federal overhaul, in all its glory and fecklessness, will include a similar provision. That’s unfortunate, since the data clearly shows that if a repeat housing bubble is to be avoided, the most effective measure might just be to ban cash-out refinancing.