Desire for mortgage equity withdrawal inflated the housing bubble

We are all living in our own bubbles. Each of us has a tenuous grasp on reality, and with the steady flow of bullshit and propaganda that implants gross lies into our collective consciousness, our perception of reality becomes ever more distorted. It is a difficult and often time-consuming task to find Truth and Reality buried beneath obtuse writing and intentional obfuscation.bank_robber

Bubble thinking is rampant, and the primary reason for its persistence is that people want the free spending money houses provide. The huge financial reward each bubble participant received as they went to the housing ATM gave a spender’s high like no other. Absent another housing bubble, most bubble participants will never have access to that kind of money again.

The real estate lottery

When you reflect on it, mortgage equity withdrawal is similar to state run lotteries that sell hope to the poor at a major cost. If you are a worker who doesn’t save money, you have no chance to acquire wealth. Lotteries give those who have no other opportunity for wealth a chance — slim though it may be.

If many people participate in the lottery, the payouts become enormous, and others become drawn to the action which further increases the payouts. This continues like a Ponzi Scheme until a big winner empties the lottery pool, and the game starts over.

Buying real estate is like buying a lottery ticket with important differences. When people participate in the real estate lottery, they are a guaranteed winner — for a while. Every participant gets to withdraw and spend their winnings as long as the pot grows. This makes the real estate lottery like no other, and it makes it much, much more desirable.

At some point, the real estate Ponzi Scheme collapses, the pool of equity “winnings” is emptied, and the game starts all over again. The big difference between the California lottery and the California real estate market is what happens to the losers. People who play the lottery are limited in their losses to the amount of money they invested. People who gamble in the real estate lottery have no limit to their losses; in fact, their losses may easily exceed their net worth resulting in bankruptcy. Most real estate losers also give up their homes.

The threat of foreclosure and bankruptcy doesn’t deter people from playing the game, particularly the poor who have nothing to lose anyway. Most people take the free money and don’t worry about the consequences because through either personal abdication of responsibility or a massive government bailout people will not face the consequences. Moral Hazard now rules the California real estate market.

A bubble here a bubble there

When I wrote The Great Housing Bubble, I scoured the academic journals for some insight as to why some markets bubbled and some did not. Some economists, like Paul Krugman, contend that growth restrictions that constrain supply are causal factors because the housing bubble was concentrated in coastal regions where development is more restricted than inland areas. There is some truth to the constrained supply argument; it can serve to precipitate the initial price movement that excites bubble thinking, but beyond that point, it’s pure kool aid intoxication.

The growth restriction argument does not explain the housing bubble in Florida. I have worked in the land development industry in both Florida and California, and I can tell you California’s process is much more restrictive of suburban sprawl. There was no shortage of supply in Florida as the glut of empty homes in South Florida attests to.

The growth restriction argument may explain why some some markets are more bubble prone because the restrictions are akin to lighting a match in a gas-filled cavern. The sparks may or may not cause a bigger explosion; it is merely a catalyst.

Show me the money

The real culprit in a housing bubble is expanding home mortgage balances — people take on more debt and bid up prices. The real question is, “why do people do it?” The short answer is to capture appreciation: kool aid intoxication. But the truth is more nuanced.

In order for home price appreciation to motivate people to pay stupid prices and inflate housing bubbles, they need a way to access this appreciation. The more immediate and plentiful this access to money, the more motivated buyers are to borrow and cash out. Mortgage equity withdrawal is the doorway to appreciation; it makes houses very desirable and very valuable.

Texas shows the way

To test this premise, we need to find a market with limited access to mortgage equity withdrawal and compare the home prices there to a market like California’s where there are no restrictions at all. There is such a place: Texas.

I know Texas. I spent two and one-half years living in College Station studying real estate. Texas, along with California, was a big player in the Savings and Loan disaster. They inflated a commercial real estate bubble of epic standards, and even its residential real estate was volatile during that period. Texans are certainly not immune to the temptation to take free money from lenders. However, the delivery mechanism of the Savings and Loan disaster was through commercial lending whereas the delivery mechanism during the Great Housing Bubble was residential lending. Texas has different laws governing residential lending, and these laws prevented a housing bubble there.


The Lone Star Secret

How Texas avoided the worst of the real estate meltdown.

Posted Tuesday, March 30, 2010 – 4:01pm

It’s one of the great mysteries of the mortgage crisis: Why did Texas—Texas, of all places!—escape the real estate bust? Only a dozen states have lower mortgage foreclosure and default rates, and all of them are rural places like Montana and South Dakota, where they couldn’t have a real estate boom if they tried.

No, Texas’ 3.1 million mortgage borrowers are a breed of their own among big states with big cities. Just less than 6 percent of them are in or near foreclosure, according to the Mortgage Bankers Association; the national average is nearly 10 percent. Texas might look to outsiders an awful lot like Sunbelt sisters Arizona (13 percent) or Nevada (19)—flat and generous in letting real estate developers sprawl where they will. Texas was even the home base of two of the nation’s biggest bubble-era homebuilders, Centex and DR Horton (DHI).

Texas subprime borrowers do especially well compared with counterparts elsewhere. The foreclosure rate among subprime borrowers there, at less than 19 percent, is the lowest of any state except Alaska. Part of the state’s performance is due to the fact that Texas saw nothing like the stratospheric home-price run-ups other states experienced. On average, the 20 metro areas in the Case-Shiller Home Price Index saw their home-resale prices peak in 2006 after more than doubling since 2000. In Dallas, one of the 20, they went up just 25 percent, gradually, and have barely declined.


But there is a broader secret to Texas’s success, and Washington reformers ought to be paying very close attention. If there’s one single thing that Congress can do now to help protect borrowers from the worst lending excesses that fueled the mortgage and financial crises, it’s to follow the Lone Star State’s lead and put the brakes on “cash-out” refinancing and home-equity lending.

A cash-out refinance is a mortgage taken out for a higher balance than the one on an existing loan, net of fees. Across the nation, cash-outs became ubiquitous during the mortgage boom, as skyrocketing house prices made it possible for homeowners, even those with bad credit, to use their home equity like an ATM. But not in Texas. There, cash-outs and home-equity loans can’t total more than 80 percent of a home’s appraised value. There’s a 12-day cooling-off period after an application, during which the borrower can pull out. And when a borrower refinances a mortgage, it’s illegal to get even $1 back. Texas really means it: All these protections, and more, are in the state constitution. The Texas restrictions on mortgage borrowing date back to the first days of statehood in 1845, when the constitution banned home loans entirely.

“Delinquency and foreclosure rates are significantly lower in Texas,” boasts Scott Norman, the president of the Texas Mortgage Bankers Association. “The 80 percent loan-to-value limit—that’s the catalyst for a lot of this.”

In the Great Housing Bubble, one of the regulatory reforms I proposed is very similar: “The combined-loan-to-value of mortgage indebtedness cannot exceed 90% of the appraised value of the property or the purchase price, whichever value is smaller except in specially sanctioned government programs.”

The incentive for people to spend their homes and remove their equity cushion must be removed. It makes HELOCs too desirable.

Research from the Federal Reserve Bank of Dallas backs Norman up. Texas’ low-ish unemployment rate, 8.6 percent, is a help. But so is the fact that fewer Texans took cash out of their home equity than did borrowers in any other state—and took out less when they did. The more prevalent cash-out refinances are in a state, the more likely it is that mortgage borrowers there will run into trouble. For every 1 percentage point increase in its share of subprime mortgages that are cash-out refinances, the likelihood of foreclosure in that state goes up by one-third of a percent.

During the boom, cash-out refinancings were the unofficial currency of bubble states from Florida to California, beloved by mortgage brokers as a way to persuade existing homeowners to take out new loans repeatedly. As home values surged, the sales pitch was a slam-dunk: Borrowers could refinance their homes at extremely low interest rates, and based on newly reappraised property values get more cash in their hands than they might earn in a year. Sure, these were teaser rates that would adjust upward after two years, but brokers routinely assured borrowers they could just refinance again before that happened.

Subprime cash-out refinancings became a standard way for borrowers drowning in credit card debt to pay it off, boost their credit scores so they could qualify in a few months to refinance into a lower-rate prime mortgage, and get a big tax deduction in the bargain. Ex-New York Times Federal Reserve reporter Edmund L. Andrews recounts in his underappreciated book Busted how he conjured $50,000 this way via a mortgage from Fremont Lending & Investment.

It is not news to readers here that there are bad incentives in the system. Free money was being given out, and people took it.

Homeowners and mortgage brokers weren’t alone in their addiction to the cash that flowed from homes-as-ATMs. The entire U.S. economy was right there with them. One of Alan Greenspan’s lesser-known contributions to the annals of the credit crisis was a pair of studies he co-authored for the Fed, sizing up exactly how much Americans borrowed against their home equity in the bubble and what it was they were spending their newfound (phantom) wealth on. Greenspan estimated that four-fifths of the trifold increase in American households’ mortgage debt between 1990 and 2006 resulted from “discretionary extraction of home equity.” Only one-fifth resulted from the purchase of new homes. In 2005 alone, U.S. homeowners extracted a half-trillion-plus dollars from their real estate via home-equity loans and cash-out refinances. Some $263 billion of the proceeds went to consumer spending and to pay off other debts.

I have written about our HELOC economy. Calculated Risk has been updating mortgage equity withdrawal as it has fallen off a cliff:


As home prices skyrocketed in many markets, cash-out refinancings became standard, even in the relatively sober world of Fannie Mae and Freddie Mac. By 2006, Freddie Mac reported that 88 percent of refinance mortgages that it purchased were for amounts at least 5 percent higher than borrowers’ previous loan balances. Subprime, in insane pursuit of risk, piled on with cash-out refinances for high-risk borrowers, often approaching the entire appraised value of the home.

But not in Texas. A borrower there can secure a home-equity line of credit from a bank. And she can refinance her mortgage or take out a home-equity loan. But the total amount of debt on a home cannot exceed 80 percent of its appraised value, and any proceeds cannot be used to pay off other debts.

… Not everyone loves the state’s rules. Financial services companies have periodically lobbied to scale back the restrictions on home-equity borrowing, noting that the costs of compliance increase borrowers’ interest rates. But another reason the loans are more costly is that the Texas rules are unique in the nation, giving borrowers less opportunity to shop around.

… Despite these advantages, Texas-style brakes on home-equity withdrawals are not likely to get a welcome reception in Washington. For starters, they’re out of bounds for the proposed consumer agency now under consideration on the Hill. Both the House and Senate versions of the financial reform bill follow a ground rule straight out of the Obama administration’s financial reform blueprint: The agency can only take action on a product or practice when it determines that the harm the practice causes to consumers isn’t outweighed by benefits to consumers “or to competition.” This narrow lens allows lenders to argue, credibly, that their home-equity loans are a boon to consumers, who benefit from ready access to home equity. It’s only in the long term, and the big picture, that the terrible tradeoffs become clear.

Lenders dislike laws that restrict lending, no matter the obvious public good. Their lobbying efforts are maddening but not surprising. They want to continue putting borrowers into profitable loans irrespective of whether or not the borrower benefits. Now that the government is backstopping their foolishness, they don’t have to be constrained by the threat of bad loans.

Lenders will make any loan if they believe someone else has the risk. During the bubble lenders thought this risk was disbursed through derivative trades, but now we know the US taxpayer is assuming all the risk, so responsible lending is no more. Given our current state of affairs, we should see some really looney loan products once the economy picks up again.

Economists at the Fed and Treasury are no more likely than Congress to entertain cutting off the tap that until now has kept consumer spending flowing, just when the economy desperately needs that jolt. But the truth is that plummeting home prices have sucked the mortgage equity withdrawal well dry. Mimicking Texas would be the perfect opportunity to get our home-equity debt addiction under control and learn to live as an 80 percent nation.

An 80% nation? California borrowers must be aghast at the idea. How will we live without the free money from our houses? The owners of today’s featured property will need to adjust their lifestyles significantly.


Today’s sordid story is another where a woman spent her home after a divorce. You must admit, withdrawing money from the housing ATM is much easier than working. Why slave away to earn an income when the house can provide? Particularly if you are a divorcee and you have become accustomed to certain entitlements from the marriage. The temptation to sustain the entitled lifestyle would be great, especially when all the friends are doing the same. It sets up a nasty fall from entitlement.

  • This property was purchased for $420,000 in 1990. The couple got divorced in 2003, and probably as part of the settlement to pay off the husband, the wife took out a first mortgage of $543,750 and a second mortgage of $36,250. It is possible that she simply wanted the money and this was her first infusion of cash. There is no way to know.
  • Two months later on 8/20/2003, she opened a $25,000 HELOC.
  • On 12/2/2004 she opened a $19,750 HELOC and a $44,000 HELOC.
  • On 12/7/2004 she refinanced her first mortgage for $656,250. This sequence of loans looks suspicious to me. The HELOCs are at a different bank than the first mortgage. I looks as if she ran the applications in parallel so the loans would not show up on the underwriting. It doesn’t matter though because she made things worse later.
  • On 2/15/2006 she refinanced her first mortgage for $750,000.
  • On 3/9/2006 she opened a $130,000 HELOC
  • Total property debt is $880,000.
  • Total mortgage equity withdrawal from just the x-wife is $300,000.

She pulled out $100,000 a year for three years. Who wouldn’t want some of that action?

How desirable are HELOCs?

In the post California Personal Finance: Ponzi Style I discussed the reason HELOCs are so helpful to a family’s income statement:



Examine the graphic above. The first column shows a graphical breakdown of the income of a typical homeowner. Total home related debt (including taxes, insurance, HOA and other monthly expenses) is limited to 28% of gross income. Consumer debt including all other debt service payments is limited to 8%. Taxes take up about 24% (depending on income and tax bracket), and the remaining 40% is disposable income to cover the other expenses of daily life.

The second column shows what happens as people start to stretch to buy a home in a financial mania. The increasing home debt reduces the tax burden a little, but the increased consumer spending and home debt takes a big chunk out of disposable income. The recession of the early 90s lingered for so long here in California because the people who bought in the frenzy of the late 1980s found themselves with crushing debts and greatly reduced disposable income. Prior to the increase in housing debt, this disposable income would have been spent in the local economy; instead, this money was sent out of state to the creditor who made the loan.

The big financial innovation—if you want to call it that—of the Great Housing Bubble was the nearly unrestricted use of cash-out refinancing and HELOCs to tap into home price appreciation. The third column shows the impact this new source of credit had on personal income statements. HELOC money allowed people to pay off their consumer debt while only modestly increasing their home debt. Since this income was untaxed (borrowed money is not truly income), the extracted money was entirely converted to disposable income. This incredible influx of disposable income caused our economy to explode.

Unfortunately, as is documented in the post Our HELOC Economy, the loss of this HELOC income is having devastating effects on local tax revenues and our economy. When you examine the personal income statements of borrowers in column four, you see that home debt and consumer debt have now become so burdensome that there is no longer enough disposable income to cover life’s basic needs; borrowers are insolvent.

Think about the system here in California; imagine an isolated neighborhood of 20 homes similar today’s featured property. Imagine they were new builds and purchased at the same time for $100,000.

It is five years later, and someone buys a house in the neighborhood for $130,000. The home value of the other 19 houses is now $130,000. This gives each homeowner in the neighborhood $30,000 they can withdraw from their housing ATM and spend. As we have witnessed repeatedly here at the IHB, many of those neighbors will do just that.

Since everyone knows that established owners obtain this monetary benefit of ownership, houses become very, very desirable. Lenders then eliminated all barriers to acquiring real estate including the down payment which essentially makes the house free. Who wouldn’t want a free ATM machine capable of churning out hundreds of thousands of dollars?

Once prices start going up, comparable sales values justifies ever-larger mortgages, and with loan qualification standards eliminated through liar loans, there was no practical limit to loan balances. The resulting frenzy is a housing bubble.

Do we want to stop the music?

I see no movement in either State or Federal government to change this system. I have no doubt that if California limited mortgage equity withdrawal to an 80% LTV or even a 90% LTV we would no longer have severe housing bubbles. What surprises me is that everyone seems to want housing bubbles!

Housing bubbles encourage spending and investment that otherwise would not have occurred. We built many houses in Riverside County and the High Desert that never should have been built. We employed many people and enriched many others while building unnecessary housing. The people who benefited from this activity have no desire to see it curtailed. Besides most of those fools don’t realize the bubble was abnormal; they think that is the way things are supposed to be.

We created our own monster, and we have the power to slay it. I simply don’t see the desire.