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Study Shows Reckless Cash-Out Refi Really to Blame

Sept 22, 2009 - If you tuned into conservative talk radio last year a number of hosts had vitriolic words for the Housing and Community Development Act (1992) which was inspired by the Community Reinvestment Act (CRA) of 1977 and required the Department of Housing and Urban Development (HUD) to force GSEs Fannie Mae and Freddie Mac to purchase a greater number of mortgages taken out by low and moderate income borrowers. The logic professed by the radio hosts was that this in fact had caused the mortgage crisis by making it possible for individuals to purchase homes they could not afford, ushering in the era of the sub-prime mortgage. However a new study released from MIT and Harvard University may conclusively dispel their theory.

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It seems a perfect storm was set in motion for a cash-out refinancing bonanza when the combination of declining declining mortgage rates, skyrocketing property values and easy credit became available to homeowners for a prolonged period of time. In order to achieve a lifestyle that wage growth alone could no longer provide, many Americans made the unwise decision to trade the equity savings they had built up quickly in their home for debt they could not as easily repay. This situation became progressively riskier for lenders and investors as they transitioned their portfolios over time from having pools of mortgages of varying levels of risk on their books (that is a mix of various loan-to-value ratios) to creating a situation where a disproportionate number of loans held were now cashed-out to the max as if each homeowner had purchased at the peak of the market.

Under the model that researchers created, if a theoretical homeowner continued to cash-out whenever it was possible for them to do so, the end result would leave approximately 18% of all mortgages in a negative equity situation where the home ended up at a value lower than the mortgage. The shocking conclusion of the study was that if it were not for the record level of cash-out refinancings and home equity line withdrawals, the percentage of mortgages in negative equity territory would have been at only around 3% of all outstanding mortgages. Today, some reports indicate the number of American homeowners underwater on their mortgage is closer to 25% and rising.

Not a part of the study but supporting its conclusions, the passage of the 1986 Tax Reform Act and Revenue Act of 1987, phased out the consumer interest deduction and ushered in an expansion of the home mortgage interest deduction creating an environment where the home was now to be used as the consumer's ATM machine. Up to $100,000 could be cashed-out on a tax deductible basis and while many homeowners went beyond the $100,000 maximum and also deducted amounts in excess of the value of their home, both of which are not permitted in the tax code, nothing was done to stop or curtail it. Interestingly, a shinning example of learning from ones past mistakes comes from the state of Texas which had experienced severe economic consequences from the Savings and Loan Crisis of the late 1980s and early 1990s. At the time almost half the failing institutions in the country were based in Texas, therefore the state legislature took the wise step of curtailing home equity refinancings for most purposes with the exception of money used for home improvements. Ironically, Texas, one of the largest and most populous of all states, is one of the few currently which have not been as hard hit during this economic downturn. Hopefully legislators at both the national and state levels are paying attention and taking notes this time.

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