Fuel for the Next Mortgage Bust?
Cash-out refi hype is back full-blast. And for the first time since early 2006, people are doing it in large numbers.
This is the transcript from my podcast last Sunday, THE WOLF STREET REPORT:
For a moment this morning, I thought I was back in 2005 or early 2006, when I listened to a dazzling radio show, hyping cash-out refinancing of your mortgage.
The show was funded by a shadow-bank specializing in mortgage lending. They were promoting their efficient service, that didn’t involve the normal hoops to jump through, and it was a fantastic deal, to not only refinance your mortgage to capture the lower mortgage rates currently available – the lowest since November 2016 – but also to use the home as an ATM once again to cash out the equity that the home had accumulated, due to years of sharp price increases.
That this date of November 2016 keeps popping up is interesting by itself, because on November 10, 2016, according to Freddie Mac data, the average conforming 30-year fixed rate mortgage had an interest rate of about 3.6%, same as now. But six weeks later, December 22, 2016, that average mortgage rate had jumped to 4.3%. That was a jump of three-quarters of a percentage point in just six weeks. Mortgage rates can get very jumpy when the market figures out that they’d been mispriced.
The promo this morning acknowledged this jumpiness and pushed listeners to act now on a cash-out refi at these ultralow mortgage rates, or miss out forever.
This phenomenon – these radio shows paid for by shadow lenders and mortgage brokers that are hyping cash-out refis – is now everywhere.
Of course, it makes total sense for homeowners to refinance an existing mortgage with a mortgage that has a significantly lower rate. This cuts their monthly payments and gives them some extra spending money, but it doesn’t raise the risk for the lender. And it might even lower the risks for the lender because the payments are lower.
The problem starts with cash-out refis, when the home gets leveraged up to the hilt to fund household consumption, such as vacations, home improvements, paying off credit card debt so that credit cards can be charged up and maxed out once again, and the like.
Economists and the Fed love this activity because it creates more debt-based consumption. William Dudley, when he was still president of the Federal Reserve Bank of New York a couple of years ago, exhorted Americans to do just that, to leverage up their homes and draw out those funds, and spend more on consumption, particularly on things they don’t need, because presumably, they’ve already been buying all the things they need.
The principle is this: People don’t have to be paid more for their work to spend more; they can just borrow more.
And it works great for a while, and then there is a reset of some sort. That reset last time was the Financial Crisis and mortgage crisis. And after the reset, things start from scratch.
At first, cash-out refis go unnoticed, essentially. They’re an opportunity for the finance industry to make a lot of money off of fees. And so the industry is jumping all over it, as the radio promo this morning explained. It said that it had staffed up for this boom in refis, that it had hired a bunch of people, and that they’d had a record week in terms of refinancing mortgages, but that, because their system was so efficient, and because they’d staffed up for it, wait-times hadn’t increased.
Mortgage refinancing is a huge business – with boom and bust cycles. And it is booming at the moment. According to the Mortgage Bankers Association, the refinance activity, in terms of the number of refi mortgage applications, has soared by 140% since the end of last year, with the index leaping from about 830 to over 2,000 in just seven months.
And a good part of those refis are cash-out refis.
But cash-out refis have a nefarious impact on the banking system – and these days particularly on the shadow banking system, which is now the dominant player in the mortgage business.
Wells Fargo used to be the number 1 mortgage lender in the US. As of a couple of years ago, the largest mortgage lender is Quicken Loans – a non-bank lender that does not take deposits and is therefore not regulated by banking regulators such as the FDIC and the Fed. Hence, lovingly called a “shadow bank.” And there’s a slew of these specialized shadow banks, including the one whose promo I heard this morning.
They’re making hay while the sun shines. Do your cash-out refi with us now or miss out on it forever. That was the message.
However, purchase mortgage applications – so mortgage applications by people who need the mortgage in order to purchase a home – they have essentially gone nowhere since December. This means that despite the much lower mortgage rates, potential buyers who need mortgages to buy a home have not suddenly come out of the woodwork.
That’s a huge disappointment for market prognosticators and oracles, especially those by the housing industry, who’d predicted that these lower mortgage rates would entail a surge in home sales – and a surge in home prices. That just hasn’t happened.
Then we get this: Two weeks ago, the National Association of Realtors reported that home buying in the US by non-resident foreign investors over the two-year period through March 2019 collapsed by 56%. It wasn’t just Chinese investors. It was foreign investors from all major countries, including from Canada and Mexico, that radically slashed their home buying in the US.
And so the results have been trickling in with relentless regularity: Sales of existing homes in June fell for the 16th month in a row compared to the same month a year earlier and were down about 4% from the prevailing range in 2017.
In other words, Americans are not buying more homes despite lower mortgage rates; and interest by foreign buyers has collapsed. As a result, homes sales are down despite the lowest mortgage rates since November 2016.
In some of the most expensive markets in the US, the home-price surges of recent years are already cooked. This includes the Seattle metro and most of the Bay Area. In other metros, the year-over-year price increases have been shriveling month after month. All this is happening despite the lowest mortgage rates since November 2016.
Why? Because mortgage rates are not the only factor. Home prices have been inflated for years. In a number of markets, home prices have become absurd. And there comes a time when buyers get second thoughts – when they simply cannot imagine paying this much for so little. And they refuse to buy at those prices.
The plunge in foreign buyers – they were concentrated in a relatively small number of markets – has also reduced the heat.
So it makes sense that in some markets, home prices have already peaked, and that in other markets, home prices are approaching their peak.
This brings us back to cash-out refis: Last time, they were hottest just before the market peaked. And this made the housing market so much more vulnerable.
Homeowners with lots of equity can withstand a housing downturn and are unlikely to just mail the keys to the bank. In addition, if they lose their jobs in an economic downturn and can no longer make the mortgage payments, they can sell the home that has equity in it, even after prices have dropped, and they can pay off the mortgage from the proceeds of the sale and have some cash left over to get them through the rough spot.
Homeowners who did a cash-out refi and sucked the equity out of their homes were sitting ducks in the housing bust. It didn’t take much of a price decline before they had negative equity, and they couldn’t sell their home for enough money to pay off the mortgage, and so the downward spiral toward foreclosure, bank collapses, and bank bailouts began.
Note that during the financial crisis, shadow banks were not bailed out, at least not directly. The ones that managed their risks well survived without bailout, but others were allowed to collapse.
Now cash-out refis are hot again. And with perfect timing: once again, in some metros the market has already peaked. And in other metros, the market threatens to peak. But this time, the banks are not the big partiers. Not only are they less aggressive in trying to write these cash-out refis, but they’re also offloading much of the risk to investors and government entities that guarantee or buy the mortgages and package them into mortgage backed securities.
Shadow banks also try to offload much of the risk to investors, but they’re much more aggressive in the cash-out refi department. And they’re much more vulnerable.
However that may wash out, we know one thing: the low mortgage rates that have triggered this refi boom are infusing more risks into the financial sector, and they’re encouraging households to leverage up by doing a cash-out refi, and they’re turning these households that used to be fairly low risks into households that are now suddenly vulnerable again, and they’re taking away the wriggle room these households used to have.
Currently, employment is strong and people are not losing their jobs in large numbers. Unemployment claims are near historic lows, as is the unemployment rate. And under these conditions, households are unlikely to get into trouble with their mortgages. So mortgage delinquencies are near historic lows. And we’re tempted to say, “so far, so good.” But there is an old banker saw: Bad deals are made in good times. And these are mind-numbingly good times. As in 2006, the bad deals come out of the woodwork only after the cycle turns.
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