How Using Homes as ATMs Fueled Foreclosures

How the Home Crisis Happened

The conventional wisdom of the housing crisis goes something like this: Too many people bought homes as the housing bubble inflated. Some were unlucky in their timing, while others overextended themselves by putting too little money down. All of these top-of-the-market purchases led to an explosion of foreclosures once home prices dropped sharply and the economy hit the skids.

Amid the current debate about whether a new bubble is forming in the housing market, it’s worth looking at a paper published in March that challenges conventional wisdom by showing that a significant share of foreclosures came from people who bought their homes before 2004.

So why did so many people who bought their homes before the housing bubble fully inflated end up losing their homes anyway?

The answer: These homeowners aggressively used their homes as ATMs, extracting cash by refinancing into larger loans or using home-equity loans.

The paper, published by Steven Laufer of the Federal Reserve Board, examined a sample of homeowners from Los Angeles County and found that 40% of defaulting homeowners had purchased their homes before 2004. Home prices had risen so far in California that even after a 30% decline, prices in recent years have been roughly at levels equal to 2004. For more than nine in 10 of these borrowers, their original mortgage balances should have been less than the current value of their homes, leaving them with positive equity.

Enter the home-equity loan and the cash-out refinance, in which borrowers refinanced into a larger loan, extracting equity to fund everything from college tuition and medical bills to dinners out and vacation trips. In his Los Angeles sample, Mr. Laufer finds that borrowers ended up with loan-to-value ratios that were, on average, 50 percentage points higher than they would have been. (The study follows on earlier work that reached similar conclusions, including a 2009 paper that also examined Southern California.)

One quarter of borrowers who purchased their homes between 2000 and 2003 had loan-to-value ratios of 140% when they ultimately defaulted, while 10% of borrowers had loan-to-value ratios exceeding 170% (that is, they owed 70% more than the value of their house). Without any equity extraction, the majority of homeowners would have had loan-to-value ratios of 60%, and fewer than 10% of borrowers would have been underwater.

The bottom line: equity extraction was responsible for around 80% of defaults among homeowners who purchased their homes before 2004, representing around 30% of all defaults between 2006 and 2009.

What about job loss and other income shocks—didn’t those ultimately account for a greater share of defaults? Not necessarily, says Mr. Laufer. Equity extraction led homeowners to take on larger mortgage balances and required larger monthly payments. His analysis finds that after holding constant for equity extraction, income shocks and borrower-liquidity constraints accounted for only 30% of defaults following the home-price decline.

What are policy makers to do? One solution would be to impose a limit on the amount of debt that homeowners could take on when extracting equity through refinancing or obtaining junior liens. For example, states could prohibit cash-out refinances from exceeding 80% loan-to-value ratios (Texas already does this).

Mr. Laufer finds that had this been in place during the bubble in Los Angeles, it would have reduced the amount of equity extracted during the boom by 23%. Because that would have reduced the collateral value of housing, home prices would have been around 14% lower. Defaults would have been around 28% lower thanks to lower home prices and the inability to take on more debt. Consumption would have increased by around 3.2%, Mr. Laufer estimates, due to the ability of more households to purchase homes at lower prices.

The paper raises broader questions over what degree the overzealous pursuit of homeownership played in creating the foreclosure crisis. Instead, overzealous equity extraction and unsound lending practices could have played an equally significant role in driving more households to the brink of foreclosure.

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