Can we look at the rate that people are refinancing their mortgages and conclude this will or even could cause a housing market crash? Some people do, although it makes no sense.
The 2007 housing market crash still haunts many people it seems. This did indeed spawn an economic event of catastrophic proportions, so it’s at least somewhat understandable that some may be a little on edge given that housing prices have well surpassed the levels we had prior to this crash.
We did end up recovering very well from this mess, although it did claim the lives of some very big financial institutions, and had even bigger ones needing to be rescued. This is certainly a scenario which no one wants to happen again in their lifetimes.
The causes of this meltdown are both well-known and documented. In a nutshell, the demand for mortgages just want off the scale due to a big expansion of the securitization of this debt. Lenders scurried to hand out mortgages to just about anyone, turning a blind eye to risk, because they could just sell them to the market and it didn’t matter. These new lenders, common people really, just weren’t aware of how much junk was pumped into these normally rock-solid securities, and just kept buying the junk, until it all collapsed.
Rating agencies, who are supposed to be the protectors of debt securities, still stuck to their AAA ratings, as good as it gets, even though the risk involved wasn’t just high, it was extreme. This bubble was a huge accident waiting to happen, where the only thing that was keeping things from crashing down was increasing equity, with far too many people refinancing just to be able to make payments they could not otherwise make.
This is not a situation that would ever develop without our simply being deceived into grossly underestimating the amount of risk involved. It really had nothing to do with home prices being so high, and that’s actually a good thing normally, or even home prices collapsing. The mortgage market can normally well handle both, as long as the amount of junk mortgages does not rise sky-high like it did then.
If your mortage payment is set at a certain amount when you take it out, presumably you can afford this amount, and the lender has a duty to reasonably ensure that you do. This is why we look at capacity when we offer a mortgage, and if this risk management is practiced properly, it should not matter what the home is worth because that does not affect your mortgage payment at all.
People’s capacity to manage their other debts can suffer when housing prices goes down, things like loans as well as balances on lines of credit and credit cards, and by losing the potential to borrow against home equity, this can lead to more defaults with these credit lines.
This can also have a restraining effect on money supply and economic growth, because people have less capacity to borrow when their equity is reduced by lower home prices, and borrowing is what makes the economic world go around. This also reduces wealth and causes a number of other undesirable consequences, but creating mass defaults is not one of them.
Mortgage Refinancing Doesn’t Cause Crashes
The worry here though as far as the prospects of another crash isn’t from the normal ups and downs of the economic cycle that we invariably see, it’s from the fear that the sort of mass mortgage defaults that we saw in 2007 and 2008 would happen again.
We know that these variations don’t affect the mortgage default rate in a substantial way, because the risk of a large amounts of default would be managed by lenders. This especially does not have the power to cause so many defaults that the world’s economy is brought down, although there are still some people who worry about this. We may see growth slow down a bit, with prices still rising, and there will be some who may see this as some sort of prognostication of doom.
We also see paranoia from another camp, those who look at how much equity take-out we’re seeing now, see that mortgage refinancing rates were high prior to the crash, and then reason that since they are high now this caused the event back then and will cause another one.
It is hard to imagine how anyone could ever think such a thing, and we of course cannot rely on the faulty logic that has us assuming a causal relationship between mortgage refinancing and default rates such that this could ever cause a massive amount of defaults.
We would have to demonstrate this alleged causal relationship for this to hold any water, but it isn’t just that this is unlikely, the two aren’t really much related at all, let alone be bound to a degree to cast us into another economic crisis.
A lot of people take a dimmer view of refinancing, and don’t seem to realize that in most cases, the refinance actually improves the financial situation of the borrower, by consolidating existing debt at a lower or much lower rate. It also serves to free up cash, where someone may not be able to make their minimum payments before the refinance, and may be saved by these deals.
Sure, some people use equity take out to spend more, and some may actually overdo this and spend more than they can afford to pay back. The unsecured debt always defaults first though because losing your credit rating is less onerous than losing your home. The mortgage will therefore be the last thing to go. Sometimes it is left for dead, but not at a rate that is normally in any way alarming and also not in a way that will lead to a mass domino effect where lower home prices in themselves will cause defaults.
Too Many Bad Mortgages Do Cause Crashes
That’s really what happened in 2007, and for the increasing rate of refinancing to cause a housing crash, we need to have not only the refinancing precipitating a massive amount of defaults we also need to see lower home prices cause more defaults and lead to an avalanche. There is no good reason to think that either condition would be met, and we need both.
If we cut the value of everyone’s home by half for instance, by the waving of a magic wand, people might not be able to borrow as much, but they still have their payments and this would not affect their ultimate capacity to repay their mortgage, not even in a small way.
Refinances generally improve people’s capacity significantly, over what it would be if the refinance did not happen. Given that a serious reduction in capacity is needed to cause a default, we may then rightly ask where this risk of mass default is supposed to come from.
There is no doubt that equity take-out does increase default risk to some degree. All borrowing involves risk and more borrowing of any type increases the risk it may not be paid back. Even when we consolidate debt, we do trade the advantages of this with the disadvantage that one cannot just walk away from the debt that was added to the mortgage anymore, even though it has been amortized for a much longer period generally and the increase in mortgage payments may be fairly modest.
The risks present in adding to these mortgages are vetted and approved by lenders though, and while some lenders may have lower standards and higher rates than others, in order for another meltdown to occur, we are talking about a much bigger scale event than just normal increases in default rates that we see when we increase the load like this.
Mortgage refinances are generally healthy for the borrower, the lender, and the economy, as is borrowing itself. If we are to borrow a certain amount, it is also better for us that we pay the lower rates that mortgage refinancing involves. Some people do use this to increase their lifestyle over what they can afford, but this is not being done in such a manner that it would be expected to send default rates soaring.
It is quite absurd therefore to portray mortgage refinancing as such an evil that it may cause or even significantly contribute to another financial meltdown like we saw in 2007. It’s hard to even imagine that happening again under any circumstances, given that this cat is well out of the bag, and especially not just from people taking advantage of their home equity in a responsible manner, as is the case with most people and is also required by most lenders.
If we are looking to understand the risk here, we need to look at the number of mortgages out there that involve setting people up for failure, the ones that people need the continual favor of the invisible hand of the market to help them pay back, and compare then to now. There is no comparison.