NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Refinancing Boom and the Financial Crisis

Rising home prices, falling mortgage rates, and more efficient refinancing … lured masses of homeowners to refinance their homes and extract equity at the same time, increasing systemic risk in the financial system.

Three trends in the U.S. housing market combined to dramatically magnify the losses of homeowners between 2006 and 2008 and to increase the systemic risk in the financial system. Individually, these trends – rising home prices, falling mortgage rates, and more efficient refinancing – were neutral or positive for the economy. But together, they lured masses of homeowners to refinance their homes and extract equity at the same time (“cash-out” refinancing), increasing the risk in the financial system, according to Amir Khandani, Andrew Lo, and Robert Merton. Like a ratchet tool that could only adjust in one direction as home prices were rising, the system was unforgiving when prices fell. In Systemic Risk and the Refinancing Ratchet Effect (NBER Working Paper No. 15362), these researchers estimate that this refinancing ratchet effect could have generated potential losses of $1.5 trillion for mortgage lenders from June 2006 to December 2008 – more than five times the potential losses had homeowners avoided all those cash-out refinancing deals.

Over the past twenty years, the growth and increasing efficiency of the refinancing business have made it easier for Americans to take advantage of falling interest rates and/or rising home values. Other researchers have noted the declining equity that homeowners had in their homes, chalking up much of it to the popularity of cash-out refinancing, home-equity lines of credit, and outright sales of homes to extract equity. These authors concentrate on the previously unstudied interplay of this growth in refinancing with falling interest rates and rising home values. Benign in isolation, the three trends can have explosive results when they occur simultaneously. “We show that refinancing-facilitated home-equity extractions alone can account for the dramatic increase in systemic risk posed by the U.S. residential housing market, which was the epicenter of the Financial Crisis of 2007-2008.”

Using a model of the mortgage market, this study finds that had there been no cash-out refinancing, the total value of mortgages outstanding by December 2008 would have reached $4,105 billion on real estate worth $10,154 billion for an aggregate loan-to-value ratio of about 40 percent. With cash-out refinancing, loans ballooned to $12,018 billion on property worth $16,570 for a loan-to-value ratio of 72 percent.

When home values began to fall, lenders and borrowers had trouble reducing their risk exposures for two reasons. First, frequent cash-out refinancing changed the normal mix of mortgage-holders and created an unintentional synchronization of homeowner leverage and mortgage duration, causing correlated defaults when the problem hit. Second, once a home is bought, the debt can’t be incrementally reduced because homeowners can’t sell off portions of their home -- homes are indivisible and the homeowner is the sole equity holder in the house.

This ratchet effect can create a dangerous feedback loop of higher-than-normal foreclosures, forced sales, and, ultimately, a market crash. With home values falling from the peak of the market in June 2006, the study’s simulation suggests that some 18 percent of homes were in negative-equity territory by December 2008. Without cash-out refinancing, that figure would have been only 3 percent.

“The most insidious aspect of this phenomenon is its origin in three benign market conditions, each of which is usually considered a harbinger of economic growth,” the authors write. “[T]heir role in fostering economic growth makes it virtually impossible to address the refinancing ratchet effect within the current regulatory framework.”

-- Laurent Belsie

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