This article examines the impact of home equity borrowing on the current real estate market bust, and the indicators of an unhealthy amount of home equity borrowing as a warning system for future housing recessions.

As everyone who keeps an eye on the news knows, the real estate market, still slogging its way through the mire towards a price bottom, is a hot topic. Analysts looking to the past see the causes rooted in loose lending standards coupled with over-eager, over-consuming homeowners and buyers, and rightfully so. Although many reports correctly focus blame for the real estate bust on the flood of subprime and prime first time homebuyers who overpaid for their homes funded by short-term financing (adjustable rate mortgages [ARMs]) during 2002-2008 (peaking in early 2006), they were not the only culprits feeding the great real estate bust.

A study performed by Atif Mian and Amir Sufi of the University of Chicago Booth School of Business  entitled “House Prices, Home Equity-Based Borrowing, and the U.S. Household Leverage Crisis” and reported in the September 5, 2009 issue of “The Economist” indicates that the new and financially over-extended buyers (and their lenders, and the ever-insidious speculators) coming into the market  were not the only ones to blame for the eventual price nosedive. Mian and Sufi’s study point a finger towards existing homeowners pulling equity out of their homes for personal consumption as equally responsible for the home price crash and the ensuing economic repercussions.

The root for most equity loans are found in the 1986 permissive federal law allowing homeowners to extract money from their homes for consumption of consumer items. Further, tax law then accommodated the rule of equity loans by allowing interest on personal consumption loans to become deductible, subsidizing personal spending.

The link between home equity borrowing and consumer spending

Mian and Sufi sampled roughly 67,000 individuals across the nation who owned their homes in 1997 and remained in their homes through the 2002-2006 boom, and through the current downturn (with home prices already back to 2002 levels or worse). The subjects were then sorted by whether the local area could add new homes on vacant land to meet demand, called neighborhood elasticity.  This ability to add housing, reasoned Mian and Sufi, would give a relative measure of how quickly and by how much prices increased during the boom.

Homeowners were further sorted into groups according to strong versus weak credit histories to determine (or perhaps reinforce) the relationship between credit histories and spending habits.

Mian and Sufi then followed the spending habits of these homeowners who extracted money through home equity loans during the recent 2002-2006 housing price boom, and again through the current recessionary price adjustment period which began in 2007.  Their goal: to track the relationship between home prices and home equity borrowing and then determine how the home equity money was spent. All this is a reflection of the past and confirms what mortgage loan brokers and real estate agents observed at the time. Long-term asset equity was being converted via 15-year equity loans to purchase short-term consumable assets (or pay off credit card debt).

The home equity hemorrhage  

The authors’ research showed that the housing prices in the fully developed neighborhoods surveyed across the nation grew over 100% from 2001 to 2006. In contrast, neighborhoods containing readily developable land where supply could easily and quickly be built to meet demand saw little, if any, increase in housing prices.  Home equity borrowing followed suit:  those in fully-developed neighborhoods who experienced house price improvements were five times more likely to borrow against their equity as those in neighborhoods surrounded by readily developable land.

More importantly, the findings highlight the fact that those who borrowed most against their artificial equity were those who could least afford it, i.e., the borrowers with weaker credit histories in fully developed neighborhoods where home prices were more likely to be inflated — areas identified as subprime.

Nor did those who borrowed most heavily against their home equity channel their home equity loans or credit lines into their financial growth, e.g., investment properties, investment products or paying down existing consumer debt. Instead, the authors’ findings are in keeping with other referenced studies which find anywhere from 40-50% of home equity funds were poured into home improvement and consumer spending.

Additionally, as home equity borrowing increased in the fully developed neighborhoods, the reported incomes of individuals in these neighborhoods decreased, suggesting that consumer spending was subsidized by home equity credit.

The increased home prices, rather than encouraging the traditional goal of owning a home free and clear — remember the celebration of mortgage-burning parties? — were being wasted on ephemeral consumer goods and over-improvements to properties in neighborhoods which would not reflect the value of the further investment.

(…and defaults came tumbling after)

When the implosion came, the first borrowers to default on their homes were those who had borrowed most heavily against them.  From 2005 to 2008, weak credit borrowers in fully developed neighborhoods saw a 12% increase in defaults.  They went from being the most apt to borrow and spend to those who were deepest underwater and least apt to borrow or spend.

California is a sterling example of this real estate market movement.  One need only look at housing price fluctuations in some of the prevalent housing markets of the state to see the wide difference in price movement between the low-tier properties (typically the “petri dish” properties for subprime borrowers) and high-tier properties. The same charts provide an illustration of the great leap in prices from 2002 through 2006, and the ensuing crash back to reality — no optimists or pessimists in today’s environment, only realists. [See first tuesday Market Chart, “California Tiered Home Pricing”]

According to a study performed by CNW Marketing Research, 30% of new car purchases in California in 2007 were made with funds from home equity lines.  Thus, more cars were sold than Californians could afford as 30-year loans “pulled cash” to pay for five-year assets (cars). This is in comparison to 12% for the nation during the same period.  Clearly, California is no stranger to the house-ATM syndrome, and, true to the authors’ findings, California is experiencing one of the most violent real estate price corrections in the nation.  At least Californians won’t be losing their cars with the loss of their homes.

Hindsight as foresight

Overall, Mian and Sufi estimate that 45% of the total mortgage defaults in the nation stem from home equity-based borrowing.  This is a considerable slice of the default pie, and speaks to the unsustainability of the spending patterns of a large portion of homeowners — even prior to the great home price peak.  In a more traditional real estate market, lenders, borrowers and all parties to a real estate transaction would be reined in by the traditional, time-honored fundamentals of real estate valuation and lending.  The fact that such a vast swathe of the nation’s defaults trackback to over-lending and borrowing on homes is a striking illustration of how far the real estate industry strayed from pricing fundamentals, and how far owners strayed from viewing their homes as a nest, rather than an investment.

Regulators face a most difficult challenge in this recovery.  The reckless lending and borrowing patterns which evolved since 1980 and dangerously fueled consumer spending must be curtailed in the return to real estate valuation and lending fundamentals; that much is certain.  Less certain, and certainly less popular, will be the effect of the resulting decrease in consumer spending on the health of the overall economy, and for those of us in real estate related services, the volume of sales and fees once the REO binge has passed.

One relatively unmentioned remedy available to lenders on equity extraction loans — refinancing, home equity lines of credit (HELOCs) and equity loans — is their recourse nature and the money judgments permitted for any deficiency in property value on default. So far lenders have stuck with trustee’s sales as the quick and inexpensive way to foreclose, which bars them from seeking a deficiency judgment. Legislative interference with trustee’s foreclosure periods may make judicial foreclosure and deficiency the unintended consequences, which would deepen this real estate recession and further lengthen its recovery. The wiped-out second trust deeds for other than purchase-assist loans could rear up and become judgments to enforce collection over the next four years.