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Wednesday, March 05, 2003

Greenspan on Mortgage Refinancing

Here are some extracts from the Greenspan speech referred to in the last post. As he says, last year was an incredible year for US housing finance, with over 10 million regular home mortgages refinanced, and 1.75 trillion dollars of cashouts, representing almost one third of all regular mortgages held by US citizens.However, despite the large equity drawdown, net equity actually increased due to a 7% price increase in housing. This price push has, in my opinion, some connection with the flight from the equity markets and the very low interest rates which makes holding cash seem unattractive. Just how important this connection is is impossible to say at this stage. Two things, however, are clear: this equity withdrawal has been fuelling a not unimportant part of US consumption of late, and this rate of price increase is unlikely to be sustained. Quite what the consequences will be for aggregate consumption remains to be seen, but the danger of a negative shock stemming from this source should be a cause for concern.

Last year was surely one of the most memorable years ever experienced by the home mortgage market. Owing largely to the lowest mortgage interest rates in more than three decades and rising home prices, close to 10 million regular home mortgages were refinanced. I use the term regular mortgage to exclude both home equity and construction loans. The outsized dollar volume of these refinancings--by our estimates, $1-3/4 trillion net of cash-outs--was an all-time record and represented almost one-third of the value of all regular home mortgages outstanding at the beginning of last year. Total regular mortgage originations, at $2-1/2 trillion, also proceeded at a record pace.

As part of 2002's process of refinancing, households "cashed out" almost $200 billion of accumulated home equity, net of fees, taxes, points, and commissions. That represented almost 3 percent of estimated total home equity at the beginning of the year, up slightly from the 2001 share. In no year prior to 2001, as best we can judge, did cash-outs exceed 1-3/4 percent of total home equity. Of last year's cash-outs, approximately $70 billion was apparently applied to repayment of home-equity loans, and a significant part was employed to reduce higher-cost credit card debt, judging from the slowed pace of growth in installment debt outstanding.
All in all, the amount of previously built-up equity extracted from owner-occupied homes last year, net of fees and taxes, totaled $700 billion by our calculations, or more than 10 percent of estimated equity at the beginning of the year. Home equity extraction for the economy as a whole is, of necessity, financed by debt. In fact, the $700 billion of equity extraction is similar to the increase in mortgage debt last year.

Despite the exceptionally large extraction of equity, the total remaining equity at the end of 2002 was higher in dollar terms than at the beginning of the year, owing to a 7 percent increase in existing home prices over the four quarters of last year and $300 billion in new home construction, net of mortgage extensions on those homes. Mortgage debt as a percent of the market value of homes accordingly rose somewhat more than 1 percentage point during the year.

The very large flows of mortgage funds over the past two years have been described by some analysts as possibly symptomatic of an emerging housing bubble, not unlike the stock market bubble whose bursting wreaked considerable distress in recent years. Existing home prices (as measured by the repeat-sales index) rose by 7 percent during 2002, and by a third during the past four years. Such a pace cannot reasonably be expected to be maintained. And recently, price increases have clearly slowed.

In evaluating the possible prevalence of housing price bubbles, it is important to keep in mind that home prices tend to consistently rise relative to the general price level in this country. In fact, over the past half century, the annual pace of home price increases has been approximately 1 percentage point faster on average than the rise in the GDP deflator. This is apparently the result of productivity growth on largely custom built new home construction persistently lagging productivity in the economy overall. This lag in productivity growth drives up new home prices relative to the general price level and, by arbitrage, it drives up the prices of existing homes as well. In addition, local building and land use restrictions continue to constrain the supply of buildable land in many areas, whose price increases also tend to outstrip the rate of inflation.

Clearly, after their very substantial run-up in recent years, home prices could recede. A sharp decline, the consequences of a bursting bubble, however, seems most unlikely. Nonetheless, even modestly declining home prices would reduce the level of unrealized capital gains and presumably dampen the pace of home equity extraction. Home mortgage cash-outs and home equity loan expansion would likely decline in the face of declining home prices. However, the five-year old home building and mortgage finance boom is less likely to be defused by declining home prices than by rising mortgage interest rates.

Should rates rise, it is entirely possible that new and existing home sales would decline, leading to a lower level of realized capital gains on homes, a further narrowed refinance spread and, as a consequence, less overall home equity extraction. It is worth bearing in mind, however, that any sustained increase in rates presumably would occur only in the context of a more vigorous upturn in the pace of business activity, suggesting that the net effect on housing activity might be relatively limited.

Home equity extraction directly finances household purchases of goods and services by liquefying previously illiquid assets. It also indirectly finances such purchases by facilitating outlays financed by credit card and other nonmortgage consumer debt. Equity extraction has been a major source of repayment of such debt.

Borrowing against home equity has been a staple of household finance for decades, but as I noted earlier, it has been only in the past decade or so that such practices have been encouraged by lenders. We need to far better understand the economics of this major addition to household finance and its impact on the economy. One hopes, new data will form the basis of better insights.

There can be little doubt that the availability of a ready source of home equity has reduced the costs and uncertainties associated with income volatility, retirement, unexpected medical bills and a host of other life events that can unexpectedly draw down savings. Home equity extraction may be the household sector's realization of the benefit of a rapidly evolving financial intermediation system.
Source: Federal Reserve

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