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Role of cash-outs in crisis studied

Diverse pool of borrowers 'synchronized' at market peak

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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.

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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