Role of cash-outs in crisis studied

Diverse pool of borrowers 'synchronized' at market peak

EMBRACE. FOCUS. EXECUTE. Build your 2019 roadmap to success with 4,000+ real estate leaders.
Inman Connect New York | January 29 - February 1, 2019

A new study concludes that cash-out refinancings and home equity lines of credit played a larger role in the financial crisis than was previously understood, by greatly expanding and "synchronizing" the pool of borrowers at risk to price declines.

Academics at the Massachusetts Institute of Technology’s Sloan School of Management and Harvard University called the interplay between declining interest rates, rising property values and cash-out refinancing "virtually impossible to address" within the current regulatory framework, pointing to the need for an "independent organization" to study systemic risk.

The study, "Systemic Risk and the Refinancing Ratchet Effect," included simulations 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.

When hypothetical borrowers instead cashed out whenever it was to their advantage, as many did during the boom, the simulations estimated 18 percent of mortgages would end up underwater — a prediction born out by actual statistics.

The simulations estimated that if borrowers took every opportunity to take cash out of their homes, the expected losses for lenders, asset managers, banks, Fannie Mae and Freddie Mac would total $1.5 trillion, compared to $280 billion if homeowners never tapped their equity.

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. …CONTINUED

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.

Instead, its authors recommend the creation of an independent organization akin to the National Transportation Safety Board devoted to the study, measurement, and public notification of systemic risk.

"Successfully managing systemic will require flexible,  creative, and well-trained professionals that understand the fundamental drivers of such risk, not static rules meant to prevent history from repeating," the study concludes. The study is available from the National Bureau of Economic Research.

President Barack Obama has proposed putting the Federal Reserve in charge of regulating systemic risk, and creating a separate Consumer Financial Protection Agency with broad power over mortgage lenders (see story). That plan has the support of Rep. Barney Frank, D-Mass., whose Financial Services Committee will kick off three weeks of hearings on financial regulatory reform Wednesday.

Sen. Chris Dodd, D-Conn., has announced an alternative proposal that would merge the Federal Reserve, the Federal Deposit Insurance Corp., the Office of Thrift Supervision and the Office of the Comptroller of the Currency, creating a single bank regulator. Rep. Spencer Bachus, R-Ala., sees such consolidation as one way to avoid creating a separate Consumer Financial Protection Agency, Bloomberg reported.

***

What’s your opinion? Leave your comments below or send a letter to the editor.