Conservative House Financing – Part 3

What they are saying about The Great Housing Bubble

“…the author has a background in real estate that’s far removed from the sales process, he’s able to step back and provide the sort of unemotional, macro-economic overview that seems quite atypical for a guide to investing in real estate.

…Filled with 64 exhibits, 146 footnotes and a nine-page bibliography of source material, “The Great Housing Bubble” is probably not a casual read during a day at the pool or the beach. But for real estate professionals wanting to educate themselves or their clients on how to successfully build wealth through the buying and selling of real property, this author has a lot to teach.”

Patrick S. DuffyPrincipal with MetroIntelligence Real Estate Advisors and author of The Housing Chronicles Blog.

Mortgage Equity Withdrawal

Mortgage Equity Withdrawal or MEW is the process of obtaining cash through refinancing residential real estate using the accumulated equity as collateral for the loan. Before MEW homeowners would have to wait until the property was sold to get their equity converted to cash. Apparently, this was deemed an inefficient use of capital, so lenders found ways to “liberate” this equity with home equity lines of credit or cash-out mortgage refinancing. Home equity lines of credit are popular with lenders despite the additional risk of being in the second or third lien position because borrowers are less likely to default or prepay than non-cash-out refinancing. [1] The impact of MEW on equity is obvious; it reduces equity by increasing the loan balance. It has been noted that equity is a fantasy and debt is real, and MEW is the process of living the fantasy with the addition of very real debt. MEW has been utilized by homeowners for home improvement for decades, but the widespread use of this money for consumer spending was largely an innovation of the Great Housing Bubble. [ii] Since consumer spending is almost 70% of the US economy, mortgage equity withdrawal was the primary mechanism of economic growth after the recession of 2001–a recession caused by the deflation of another asset bubble, the NASDAQ technology stock bubble.

Figure 9: Mortgage Equity Withdrawal, 1991-2006

Mortgage Equity Withdrawal 1991-2006


Many people who extracted their home equity lost their homes for lack of ability to refinance or make their new payments. After so many people lost their homes due to their own reckless borrowing, it is natural to wonder why these people did it. Why did they risk their home for a little spending money? First, it was not just a little money. Many markets saw home values increase at a rate equal to the local median income. It was as if their home was another breadwinner. The lure of this easy money was too much for many to resist. The rampant, in-your-face, marketing of these loans in every available media outlet touting the glossy “lifestyle” of over-the-top consumerism was a drug to many spending addicts. Also, during the bubble rally people really believed their house values would go up forever, and they would always have the ability to refinance enormous debts at low interest rates and maintain very low debt service costs. Most people did not think it possible they would end up in circumstances where they would lose their homes; however, they were mistaken. Given these beliefs, the equity accumulating in their house was “free money” they just needed to access in order to live and to spend like rich people. Even though they were consuming their net worth, and making themselves poor, they believed they were rich, and they wanted to spend accordingly.

Most homeowners do not save money for major improvements and required maintenance, and these homeowners often take out home equity lines of credit as a method of mortgage equity withdrawal to fund home improvement projects. The logic here is that renovations improve the property so an increase in property value offsets the additional debt. In reality, home improvement projects rarely adds value on a dollar-for-dollar basis, particularly with exterior enhancements which often only return 50 cents on the dollar in value. [iii] The home-improvement craze was so common that the term “pergraniteel” was coined to describe the Pergo fake wood floors, granite countertops, and steel appliances that defined the Great Housing Bubble era in much the same way as shag carpeting and wood wall paneling defined the interior decorating of the 1970s.

Much of the money homeowners borrowed fueled consumer spending and reinforced poor financial management techniques. It was common during the bubble rally for people to run up enormous credit card bills then refinance every year and pay them off. [iv] It is foolish enough to finance consumer spending, but it is even more foolish to pay for this spending over the 30-year term of a typical mortgage. The consumptive value fades quickly, but the debt endures for a very long time. Many people responded to the “free money” their house was earning by liberating their equity as soon as they could so they could buy cars, take vacations, and generally live the good life. This borrow-and-spend mentality was actually encouraged by lenders who were eager to make these loans and even the government which was benefiting by economic expansion and higher tax receipts.

The recession of 2001 was caused by the collapse of stock prices and the resulting diminishment of corporate investment. The recession was shallow, but the economy had difficulty recovering mostly due to continued erosion of manufacturing jobs. [v] The Federal Reserve under Alan Greenspan was desperate to reignite economic growth, so the FED funds rate was lowered to 1% and kept there for more than a year. It was hoped this increased liquidity would go into business investment to restart the troubled economy; instead, it went into mortgage loans and consumers’ pockets through mortgage equity withdrawal. Basically, the economic recovery from 2001 through 2005 was an illusion created by excessive borrowing and rampant spending by homeowners. The economy did not grow through production; it grew through consumption.

There are many theories as to the decline and fall of the Roman Empire. [vi] One of the more intriguing is the idea that Rome fell because it was weakened by the parasitic nature of Rome itself. Rome existed to consume the resources of the empire. Boats would come to the city loaded with goods and leave the city empty. Consumption kept the masses happy and thereby quelled civil unrest. The Roman Empire was the world’s only superpower with an unsurpassed military might. Equally unsurpassed was its ability to consume resources. Does any of this sound like the United States? The United States has clearly become a consumer nation, and the government continues to borrow huge sums of money to keep the economic engine of consumption going. In early 2008, Congress passed a “stimulus” package where many people would receive direct gifts of money in the hope they would spend it and keep the economy going. Since the Federal Government was already running a deficit, this money was borrowed from future tax receipts. In other words, this handout was obtained from future generations. With house prices crashing, direct handouts of borrowed government money were necessary to make up for the loss of borrowed private sector money that used to be available through mortgage equity withdrawal.

The Fallacy of Financial Innovation

The cutting edge is sharp. Innovators often pay a heavy price for attempts at advancement. Sometimes these advances lead to quantum leaps in human knowledge and understanding. Sometimes the time, effort, and money are merely thrown into the abyss. The financial innovations of the Great Housing Bubble are of the latter category. When the lending industry developed exotic loan products, they touted them as “innovation,” and they sold these toxins far and wide. [vii] Since these loans achieved the highest default rates ever recorded, it is apparent the “innovations” of the bubble rally were not entirely successful. It is amazing that a group of assumingly intelligent bankers came up with these loans and expected a positive outcome. [viii] The “innovation” meme is nothing more than a public relations effort to convince brokers the products were safe to sell and borrowers the products were safe to use. It is hard to fathom the widespread acceptance of this nonsense, but that is the nature of the pathological beliefs of a financial mania.

Many in the lending industry think their work is like science that continually advances. It is not. It is far more akin to assembly line work where the same widgets are pumped out year after year. When lenders start to innovate, trouble is brewing. The last significant advancement in lending was the widespread use of 30-year amortizing loans that came into favor after World War II. Prior to that time, home loans were interest-only, short-term loans with very high equity requirements (50% was most common). This proved problematic in the Great Depression as many out-of-work owners defaulted on their loans. A mechanism had to be found to get new buyers into the markets and allow them to pay off the loan. The answer was the 30-year, fixed-rate amortizing loan. To say this was an innovation is a stretch as this loan has been around as long as banking has existed, but it did not become widely used until equity requirements were lowered. The lenders were willing to lower the equity requirements as long as the loan was amortizing because their risk would decline as time went by and the loan balance was paid off.

Over the last 60 years since World War II ended, a number of experimental loan programs have been attempted. These include interest-only loans, adjustable rate loans, and negative amortization loans among others. It is this group of loans that has consistently failed in the past for one simple reason: if payments can adjust higher, people will default. The Option ARM is certainly the most sophisticated loan ever developed. It is also a dismal failure, not because it lacks sophistication, but because it has embedded within it the possibility (near certainty) of an increasing payment. Any loan program that has the possibility of a higher future payment will fail because there will be a certain number of people who cannot afford the higher payment.

Here is where the lenders delude themselves and deceive the general public after a financial debacle like the Savings and Loan problems of the 1980s or the Great Housing Bubble. They blame the collapse and the high default rates on some outside factor rather than the terms and conditions the lenders created all on their own. There are still many out there who believe the high default rates and problems in the housing market in the 90s in California were caused by a weak economy. This is rubbish. House prices declined for 6 years. The decline started before the economy went soft, and it continued well after it had recovered. People defaulted because they overextended themselves on loans to buy overpriced housing, and toward the end of the mania, many were using interest-only loans. Whenever lenders start loaning people money with total debt-to-income ratios over 36% people will default. Whenever lenders start loaning more than 80% of the purchase price, people can sink underwater and when they do, they will default. This is not new. It happened in the early 90s; it happened during the Great Housing Bubble, and it happened for the same reasons: lax lending standards.

Someday the lending community may actually innovate and come up with some financial product that has low default rates which most people can qualify to obtain–or not. Unless you change human nature, there are always going to be people who are too irresponsible to make consistent payments. People either do or do not make their payments. This is the key to any loan program. New terms and schedules can be reinvented over and over again, and it will always boil down to people making payments. When complicated loan programs contain provisions that make it difficult for people to make payments–like increasing payment amounts–they will default, and the loan program will fail. This is certain.

Whenever lenders create new, “sophisticated” loan programs that require advanced financial management on the part of the borrower, both the lenders and the borrowers fall victim to the Lake Wobegon effect. [ix] Everyone thinks they have above average abilities when it comes to managing their finances. In reality, perhaps 2% of borrowers have the financial discipline to handle an Option ARM loan. Unfortunately, 80% of borrowers think they are in this 2%. The reason for this comes from the inherent conflict between emotions and intellect. Eighty percent of borrowers may understand the Option ARM loan (or think they do,) but when the pressures of daily life create emotional demands for spending money on one’s lifestyle, the intellectual knowledge that this money should go toward a housing payment is conveniently set aside. It is this 2% of the most disciplined borrowers who will cut back on discretionary spending to make their full housing payment. Everyone else will make the minimum payment, fall behind on their mortgage, and end up in foreclosure.

It seems lenders forget basic facts about lending every so often and create a new financial bubble. Perhaps they succumb to the pressure of the investment community or their own shareholders, or perhaps they just start believing their own “innovation” marketing pitch and forget the basics of sound lending practices. This is why there are recessions at the end of a business cycle. These pathologic lending practices must be purged from the system or else they will survive to build an even bigger and costlier bubble. Although it is difficult to imagine a bubble bigger than the Great Housing Bubble, it is still possible.

In the aftermath of a financial fiasco, lenders return to the practices that did not fail them in the past. The only program lenders know empirically to be stable is a 30-year, fixed-rate, conventionally amortizing loan based on 80% of appraised value taking no more than 28% of a borrower’s gross income (36% maximum total debt). The credit crunch facilitated the decline in housing prices after the Great Housing Bubble. Large downpayments came back, and government assisted financing became widely used by first-time homebuyers to overcome the high equity requirements. The credit crunch was not caused by some unexpected or unknown factor; it was caused by the failure of lenders. Credit continued to tighten until lenders stopped making bad loans. The bad loans did not disappear until lenders returned to the stable loan programs with a proven track record. That is how the credit cycle works. [x]


To be financially conservative is to accumulate wealth and to be risk adverse. It requires managing equity, paying down a mortgage loan, and allowing net worth to accumulate rather than depleting it via consumer spending through mortgage equity withdrawal. Many people do not realize the risk they take on when they use some of the innovative loan programs developed during the bubble. Exotic financing terms are not exotic anymore. Interest-only, adjustable rates and negative amortization have become so ubiquitous that nobody seems to remember why 30-year fixed-rate mortgages are used. A home should be financed with a fixed-rate conventionally-amortized mortgage and a sizable downpayment. The reason for this is simple stress management: nobody wants to spend the next several years worried about a loan reset or the need for increasing house values or future salary increases. People should not buy with the desire to make a fortune in real estate. Instead, they should purchase with the intent to have a stable housing payment, and a stress-free life.

[1] The conclusion of the paper Subprime Refinancing: Equity Extraction and Mortgage Termination (Chomsisengphet & Pennington-Cross, 2006) is as follows, “Consistent with survey evidence the propensity to extract equity while refinancing is sensitive to interest rates on other forms of consumer debt. After the loan is originated, our results indicate that cash-out refinances perform differently from non-cash-out refinances. For example, cash-outs are less likely to default or prepay, and the termination of cash-outs is more sensitive to changing interest rates and house prices.” The sensitivity to changes in interest rates is not surprising as borrowers will take the money if it is a good deal, and they will repay it when the deal is less favorable. The observation that these loans have lower default rates and are less likely to be paid back early is quite surprising. This may have been an artifact of the bubble rally, and future data may show these loans do not perform as well as in previous years.

[ii] Robert Shiller wrote a paper on Household Reactions to Changes in Housing Wealth (Shiller, Household Reaction to Changes in Housing Wealth, 2004). He reached no definitive conclusions concerning the reactions to households to increasing home prices. At the time of his writing, the bubble was inflated enough to be obvious to him, and he does mention the bubble and its potential problems. The impact of mortgage equity withdrawal had not reached absurd height in early 2004, but by 2006, the pattern of household spending had become fairly obvious. In 2007 Oxford professor John Muellbauer wrote Housing, Credit and Consumer Expenditures (Muellbauer, 2007). His conclusion is that the spending “wealth effect” was insignificant in the past due to more restrictive credit policies which limited access to home equity (financial prudence on the part of lenders.) After the “liberalization” of credit markets and the dramatic increase in prices of the housing bubble, the consumer spending brought about by the wealth effect became pronounced. The wealth effect observed in the Great Housing Bubble was much larger than the wealth effect of the stock market bubble which preceded, and the effect was twice as large in the United States as it was in Great Britain.

[iii] There is a lack of scholarly studies on the financial results of home improvement projects (Baker & Kaul, 2002). Builder behavior is often revelatory of the state of the market. In most markets new home builders do not put in rear yard landscaping because they are not able to obtain a return on the investment. Also, the fact that builders have multitudes of upgrade options from a base package indicates the premium finishes do not provide a market return unless specifically requested by a purchaser. Builders can profit in that circumstance.

[iv] The evidence of consistent refinancing is anecdotal, but it is reinforced by national statistical trends from the US Governments Flow of Funds accounting.

[v] In the paper (Leamer, Housing Is the Business Cycle, 2007), the author has graphs showing the loss of manufacturing jobs after the recession of 2001.

[vi] (Gibbon, 1999)

[vii] In the paper Innovations in Mortgage Markets and Increased Spending on Housing (Doms & Krainer, Innovations in Mortgage Markets and Increased Spending on Housing, 2007), Mark Doms and John Krainer document how financial innovation helped facilitate the housing bubble. Their abstract is as follows: “Innovations in the mortgage market since the mid-1990s have effectively reduced a number of financing constraints. Coinciding with these innovations, we document a significant change in the propensity for households to own their homes, as well as substantial increases in the share of household income devoted to housing. These changes in housing expenditures are especially large for those groups that faced the greatest financial constraints, and are robust across the changing composition of households and their geographic location. We present evidence that young, constrained households may have used newly designed mortgages to finance their increased expenditures on housing.” Notice the “innovation” reduced financing constraints. This is the definition of loose credit. They also note the increase in home ownership and the increase in debt-to-income ratios. The latter is a telltale sign of a housing market bubble. The exotic loans tended to be concentrated in younger households who used to be excluded from the housing market due to lack of downpayments and insufficient income. Basically, exotic loans were given to persons who were not ready for home ownership, and the high default rates among this group should not have been a surprise.

[viii] In response to the dramatic increase in subprime delinquencies in 2007, the Federal Reserve Bank of San Francisco commissioned a report on Subprime Mortgage Delinquency Rates (Doms, Furlong, & Krainer, Subprime Mortgage Delinquency Rates, 2007). The report’s conclusions were as follows: “First, the riskiness of the subprime borrowing pool may have increased. Second, pockets of regional economic weakness may have helped push a larger proportion of subprime borrowers into delinquency. Third, for a variety of reasons, the recent history of local house price appreciation and the degree of house price deceleration may have affected delinquency rates on subprime mortgages. While we find a role for all three candidate explanations, patterns in recent house price appreciation are far and away the best single predictor of delinquency levels and changes in delinquencies. Importantly, after controlling for the current level of house price appreciation, measures of house price deceleration remain significant predictors of changes in subprime delinquencies. The results point to a possible role for changes in house price expectations for explaining changes in delinquencies.” In later sections the relationship between default rates and default losses is explored. When prices decline, default losses increase because lenders get less money from the collateral in a foreclosure. This report from the FRBSF demonstrates that lenders also face higher default rates, probably due to borrowers “giving up” when they owe more on their mortgage than their house is worth. These two phenomenon have a negative synergy. In a related report by Kristopher Gerardi, Adam Hale Shapiro, and Paul S. Willen titled Subprime Outcomes: Risky Mortgages, Homeownership Experiences, and Foreclosures (Gerardi, Shapiro, & Willen, 2007), the authors make the following observations, “First, homeownerships that begin with a subprime purchase mortgage end up in foreclosure almost 20 percent of the time, or more than 6 times as often as experiences that begin with prime purchase mortgages. Second, house price appreciation plays a dominant role in generating foreclosures. In fact, we attribute most of the dramatic rise in Massachusetts foreclosures during 2006 and 2007 to the decline in house prices that began in the summer of 2005.”

[ix] In the paper Unskilled and Unaware of It: How Difficulties in Recognizing One’s Own Incompetence Lead to Inflated Self-Assessments (Kruger & Dunning, 1999), the authors noted the tendency of individuals to overestimate their own competence and abilities. Their primary conclusion is as follows “People tend to hold overly favorable views of their abilities in many social and intellectual domains. The authors suggest that this overestimation occurs, in part, because people who are unskilled in these domains suffer a dual burden: Not only do these people reach erroneous conclusions and make unfortunate choices, but their incompetence robs them of the metacognitive ability to realize it.” It is a perfect description of the general public and their relationship to complex financial agreements like Option ARMs.

[x] The author is a believer in the Austrian School of Economics. Two of the sources of research and understanding on the credit cycle are The Hedge Fund Edge: Maximum Profit / Minimum Risk Global Trend Trading Strategies (Boucher, 1999), and Money, Bank Credit, and Economic Cycles (Soto, 2006).