Did Home Refinancing Boom Trigger the Financial Crisis?
The residential housing market can burn down even when bankers restrain their lending, financial regulators dutifully police their beats and government officials tweak the right monetary dials.
That's the conclusion of an interesting new study by economists including Nobel laureate Robert Merton of Harvard and Andrew Lo of the MIT Sloan School of Management. Under certain conditions, all it takes to fan the flames is for a critical mass of people to extract money from their homes in the form of home equity loans, sales and "cash-out" refinancing. When that happens, the interplay of rampant mortgage refinancing, falling interest rates and rising home prices becomes a dangerous feedback loop.
Each of these three trends is systemically neutral or positive when considered in isolation, but when they occur simultaneously as they did over the past decade, the results can be explosive. In particular, we show that reï¬?nancing-facilitated home-equity extractions alone can account for the dramatic increase in systemic risk posed by the U.S. residential housing market, which was the epicenter of the Financial Crisis of 2007â€"2008.Here's how the trap works. When money is cheap, refinancing costs are low and real estate is appreciating, as they were in the years leading up to the subprime bust, homeowners repeatedly borrow against the rising value of their homes. Folks not only feel better off -- on paper they are better off. In that context, it's economically rational for folks to leverage their biggest financial asset -- a home -- to support themselves in part by siphoning off equity (or capital gains). In this scenario, refinancing becomes a "ratchet" for driving up wealth. Put another way, homeowners get increasingly indebted at successively lower interest rates.
Until the party ends. When property prices fall, huge numbers of people now carrying added debt start to fall behind on their loans, causing bankruptcies, defaults and foreclosures. And unlike with stocks, homeowners can't grab a lifeline by selling off a portion of their investments. Similarly, lenders can't make a margin call to recoup some value in their loans. The ratchet locks.
The really insidious thing is that the conditions outlined above -- low interest rates, rising home prices, cheap refinancing -- offer no warning that it's time to get out of the water. They are, in fact, markers of economic health, as well as explicit goals of government policy. It's like eating well, exercising and getting plenty of rest only to discover that all of this causes cancer. Worse, the disease is contagious. Note the following:
If the re�nancing market is so competitive and efficient that homeowners re�nance frequently, this pattern of behavior has a similar effect on systemic risk as if these homeowners all purchased their homes at the same time, at peak prices, with newly issued mortgages at the highest allowable loan-to-value ratios. A coordinated increase in leverage among homeowners during good times will lead to sharply higher correlations in defaults among those same homeowners in bad times.Since June 2006, this refinancing effect has led to a $1.5 trillion loss in the housing market, according to the study. That compares with a $280 billion loss if no equity had been removed from U.S. residential real estate during the period.
These findings don't of course expiate reckless lending, lax regulation, political indifference and head-in-the-sand monetary policy as causes of the financial crisis. But they do raise important questions about whether the germs of future systemic financial crises are effectively encoded within the system.
