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, a homeowner 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. The impact of MEW on equity is obvious; it reduces it 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 an innovation of The Great Housing Bubble. 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.

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 median income. It was as if their home was another breadwinner. The lure of this easy money was too much for many to resist. 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 did lose their homes; they were wrong, very wrong. 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 needed to spend accordingly.

Mortgage Equity Withdrawal 1991-2007

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 project rarely adds value on a dollar-for-dollar basis, particularly with exterior enhancements which often only return 50 cents on the dollar in value. 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 were popular at the time.

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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. 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 who was benefiting by economic expansion and higher tax receipts.

Gross Domestic Product with and without the effect of Mortgage Equity Withdrawal

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. The Federal Reserve under Alan Greenspan was desperate 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 consumer’s pockets through mortgage equity withdrawal. Basically, the entire recovery from 2001 through 2005 was an illusion creating 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. 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 does not have a problem with borrowing huge sums of money to keep the economic engine of consumption going. In early 2008, the Congress passed a “stimulus” package where many people would receive direct gifts of money to go spend and keep the economy going. Since the Federal Government was already running a deficit, this money was borrowed from future tax receipts and given to the populace to spend. 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.

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The best things in life are free

That's what I want

Your lovin' gives me a thrill

That's what I want

Money don't get everything, it's true

That's what I want

Money (That's What I Want) — The Beatles

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How common was this phenomenon of mortgage equity withdrawal? We have profiled many examples of it, and today's property is yet another. Now give me money, that's what I want…

Asking Price: $615,000

Income Requirement: $153,750

Downpayment Needed: $123,000

Monthly Equity Burn: $5,125

Purchase Price: $204,000

Purchase Date: 4/16/1996

Address: 29 Columbus, Irvine, CA 92620

Back on the market!!! REDUCED TO THE RIDICULOUS AND WHAT A DEAL!!!!!!!!! What an opportunity!!! Wonderful single level home with breakfast nook. Recently remodeled kitchen & bathrooms, newer carpeting and wide baseboards create a nice theme as you are warmed by the custom tuscan colors throughout in this wonderful single level. Extra LARGE living room/dining room with fireplace for those large family gatherings. Lush atrium brings the outside in. Down the street from parks and nearby schools. Turnkey!!! Preforeclosure

REDUCED TO THE RIDICULOUS AND WHAT A DEAL!!!!!!!!! It is writing with ALL CAPS and numerous exclamation points that reduces this listing to the ridiculous.

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Notice this property was purchased in 1996 for just over $200,000, and now it is a preforeclosure selling for over $600,000? How is that possible? Mortgage equity withdrawal.

• In 1996, this property was originally purchased with a first mortgage of only $142,000, and the buyer put $62,000 down.
• In early 2001, they opened a HELOC for $60,000 — their first step toward the Dark Side.
• In 2002, they refinanced for $227,000 pulling out all their equity at the time.
• In 2003 they opened another $100,000 HELOC.
• In 2004 the HELOC was $189,800.
• In 2005 the HELOC was increased again to $250,000.
• In 2007 the HELOC was increased to $318,000.

The sum of their debts appears to be $545,000, so unless their is more debt not recorded in the public record, there may still be some equity in this property. So why is it in foreclosure? The owners probably cannot make their payments. The credit crunch is a problem of borrower insolvency, and this borrower is likely insolvent. Maybe they will get lucky and sell this property to pay off their debts?

You can see the steady pattern of mortgage equity withdrawal that almost exactly mirrors the mortgage equity withdrawal chart.

Of course, these people are selling their home now, and the HELOC income stream is coming to an end. So what does this mean for our borrow-and-spend economy? It is likely we are going to experience a severe consumer spending recession. Borrowers like today's featured seller are being cut off from credit, and their wild spending is going to stop. Today's property owner is one of many who are facing the same circumstances. The cumulative impact of the loss of this massive spending stimulus from all these homeowners is going to be catastrophic to our economy. If the whole nation is going into a spending recession due to this phenomenon, imagine how bad it is going to be here in the conspicuous consumption capital of the world — Orange County, California.

Weekend open thread 3-8-2008

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The Size of the Bubble

Figure 1 – Median Home Prices 1968-2006

The Great Housing Bubble was an asset bubble of unprecedented proportions. Between 2000 and 2006 Home prices increased 45% nationally, and in California home prices increased 135%. Had this amazing price increase coincided with a period of high inflation, it may not have been indicative of a price bubble, merely the general increase in prices of all goods and services; however, inflation was low during this period. The inflation adjusted price increases nationwide were 23% and in California it was 100%.

Figure 2 – Inflation Adjusted Median Home Prices 1986-2006

There are many variables that impact house prices, and some of the variability in prices over time can be attributed to changes in these variables; however, since most houses are purchased with lender financing, and since lender financing is linked to income, the price-to-income ratio is the best metric for evaluating long-term housing price trends. The price-to-income ratio does not need to be adjusted for inflation as both prices and income will rise with the general level of inflation. Most of the fluctuations in the ratio are based on changes in financing terms, in particular interest rates, and of course, irrational exuberance.

Figure 3 – National Ratio of House Price to Income 1975-2006

When measured against historic norms of house price to income, the degree of price inflation was staggering. Nationally, the ratio of house price to income increased 30% from 4.0 to 5.2. The only way this can occur is if 30% more debt is serviced by the same income. Some of this increased ability to service debt is explained by lower interest rates, but most of increase came from people choosing to take on larger loads due to the irrational expectation of ever increasing house prices coupled with loose lending standards which enabled the populace to take on these debts. The national trends were small compared to the frenzied activities of bubble markets in California where most markets saw their house price to income ratio double.

Figure 4 – Ratio of House Price to Income in California, Orange County and Irvine 1986-2006

Buyers were never forced to buy, it was always a choice. During the market rally, greedy buyers motivated by rising prices and fueled by loose lending standards were able to bid prices up to ridiculous levels. None of them were forced to buy. The exotic financing was not a result of high prices; it was the cause of high prices. Those who were financially conservative and did not take on debt under terms which put them into bankruptcy were competing with those afflicted with a spending pathology. In retrospect, it was a competition they were better off losing. By late 2007, the market balance shifted from favoring sellers to favoring buyers. The once greedy buyers were becoming desperate sellers, their dreams of riches from perpetual appreciation was in tatters. Many were forced to sell due to their inability to make their mortgage payments. Those that hung on were homedebtors with 50% or more of their income going toward paying off an asset which was declining in value. It was not a set of circumstances to be envied.

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How big is the Universe?

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