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Cash-Out Refinancing and Housing Speculation

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Cash-Out Refinancing and Housing Speculation Cash-out Refinancing and Housing Speculation Tong-yob Nam∗ Abstract Cash-out mortgage refinancing increased dramatically as the mortgage market expanded rapidly in the early 2000s. I examine how households utilized money from cash-out refinancing, using household level data from the Panel Study of Income Dynamics (PSID). Cashed-out households reduce their home equity actively, thus rebalancing their portfolios. This rebalancing effect, however, is offset due to aggressive investment in other real estate. As households increased their real estate holdings using cashed-out home equity, they enjoyed a greater leveraging effect in real estate investment during the booming housing market, while household portfolios became more vulnerable to housing market risk. This rebalancing behavior helps explain the recent housing market bubble and collapse. ∗Office of the Comptroller of the Currency, U.S. Department of the Treasury, e-mail:[email protected] 1 1 Introduction During the housing market boom in early 2000s, U.S. households experienced a significant appreci- ation in their home value and a remarkable drop in mortgage interest rate at the same time (Figure 1). Because of the increased home value and low interest rates, homeowners had a great incentive to refinance their mortgages and pull out some portion of their home equity during this period. As shown in Figure2, the mortgage refinancing increased dramatically since 2001, and the total amount of refinanced mortgage was almost twice as much as the amount of new origination. In particular, a significant amount of money has been cashed out from home equity through mortgage refinanc- ing during this period (Figure3). Total home equity cashed out has dramatically increased from 2001 and reached its peak at 2006, right before the mortgage crisis. This huge amount of money from cashed-out home equity would have been transferred to consumption or any other types of assets including risky and risk-free assets. The usage of this cashed-out home equity is important in understanding household saving and investment decision and macroeconomic dynamics during this period. In this paper, I examine how households used this cashed-out home equity during 2000s with a particular focus on asset reallocation. For many homeowners, the housing asset accounts for the largest portion of their total assets, and therefore, variations in house value can significantly affect household consumption as well as saving and investment decision. In the literature, the effect of housing asset on consumption has been examined from various perspectives. The wealth effect caused by an appreciation in house value increases household consumption (Case, Quigley, and Shiller, 2005; Campbell and Cocco, 2007; Bostic, Gabriel, and Painter, 2009; Carroll, Otsuka, and Slacalek, 2011). Additionally, change in house value has effect on household borrowing constraint, which results in change in consumption (Cooper, 2009, 2013). The effect of housing asset on household saving and investment decision also has been examined in many studies. A large investment in housing asset can crowd out the opportunity in investment in other assets. Household portfolio choice can also be affected by homeownership status, the share of housing asset, and mortgage debt (Flavin and Yamashita, 2002; Cocco, 2005; Yao and Zhang, 2005; Chetty and Szeidl, 2010). These studies conclude that housing assets affect household consumption and saving decision directly or indirectly. The effect of cash-out refinancing on household consumption and savings is more direct and 2 immediate because households actively and voluntarily engage in the transaction. Previous studies have focused on the direct effect of cash-out refinancing on consumption. Hurst and Stafford(2004) show that liquidity-constrained homeowners use their home equity to smooth their consumption by refinancing their mortgages. Their perspective is supported by the data from the Panel Study of Income Dynamics (PSID), showing how an unemployment shock is related to the propensity to refinance and reduce home equity, controlling for other variables such as household income, demographics, and the present value of financial gain to refinance. On the other hand, Chen, Michaux, and Roussanov(2013) use macro level data to describe the relationship between cash-out refinancing and consumption smoothing motive at the aggregate level. They conclude that the portion of households that increase their mortgage balance as they refinance is related to macro variables including interest rate, industrial production, and income growth. However, considering the dramatic increase in the amount of home equity cashed out during the housing market boom in the early 2000s, it is likely that the cashed-out money was transferred to other asset accounts besides consumption. In this paper, I examine how households use the funds from cash-out refinancing based on household level micro data from the Panel Study of Income Dynamics (PSID). I particularly focus on cash-out refinancing behavior of financially unconstrained households. During the housing market boom and burst in 2000’s, these households cashed out a large amount of money relative to their income and wealth. These households, although they pulled out a large amount of home equity, were not likely to increase their consumption, and less probable to invest in stocks and IRA accounts. Instead, they used the cashed-out home equity to invest in other real estate such as second home and rental properties, and improved their main residence. In other words, the financially unconstrained households cashed out home equity and used this fund to invest aggressively in real estate market, increasing the portion of real estate in their total wealth. Cash-out refinancing is an important tool for households to adjust the share of home equity in total wealth. The mortgage gives homeowners a chance to adjust home equity not only at the time of home purchase, but also throughout the period of home ownership. The house is differentiated from other assets because of its role as a residential unit. Homeowners can enjoy the benefit of living in that dwelling and investing in it at the same time. On the other hand, unlike other assets, homes cannot be divided so that homeowners cannot easily realize a gain when their house price 3 rises. A homeowner faces only two choices: sell the home or keep the home. Therefore, realizing a gain implies that they need to find another place to live, which involves relatively large transaction costs such as taxes, realtor fees, and the cost of relocating. Even though homeowners cannot easily sell or buy their houses due to various frictions, they instead use mortgage refinancing to adjust the portion of the housing asset in their total portfolio. While many have studied the role of mortgage in facilitating home ownership, few have explored the potential of mortgages to act as a tool for controlling home equity levels in what, for most people, is their greatest asset. As house prices rises dramatically during housing market boom, housing assets are likely to take more portion in household’s total wealth. In that case, households can increase a mortgage balance so as to decrease the portion of home equity in total wealth. In other words, the cash-out refinancing can be used as the tool for rebalancing home equity share in total assets. Using the PSID data, this paper finds that during the housing market boom, cashed-out house- holds more actively reduced the home equity share responding to passive increase in home equity share. However, an investment in other real estate increased the share of real estate in total wealth, which offsets the rebalancing effect of cash-out refinancing. Investing in other real estate using cased-out home equity makes households enjoy a greater leverage effect on real estate investment, but vulnerable to the shock in real estate market. That is, the cash-out refinancing did not effec- tively reduce the exposure to housing market risk and rather encouraged speculative households to invest more aggressively in housing market. Therefore, cashed-out households that invested in other real estate experienced a greater appreciation in the value of total wealth during the housing market boom, while they suffered more from the drop in asset value during the financial crisis. Much research has been done on the effect of housing asset on households saving and invest- ment decision (Flavin and Yamashita, 2002; Cocco, 2005; Yao and Zhang, 2005; Chetty and Szeidl, 2010). However, most of the previous studies focus on how households adjust the stock share in the presence of housing assets, while the possibility that households can adjust their home equity share by changing the leverage in housing investment are overlooked. This paper focuses on the role of cash-out refinancing as a tool for adjusting home equity share. Calvet, Campbell, and Sodini(2009) examine households’ portfolio rebalancing behavior using detailed Swedish data. They show that households negatively respond to passive stock share change to restore the previous stock share. However, they only consider the stock share in financial asset. This paper extends the concept of 4 portfolio rebalancing to home equity share rebalancing. Cashed-out households negatively respond to the passive increase in home equity share. However, due to the increase in other real estate share, the rebalancing effect is offset, while the leverage effect is magnified. By examining the active rebal- ancing behavior in real estate investment, this paper contributes to heighten our understanding in the effect of housing investment and mortgage on household finance and macroeconomics dynamics, especially during the housing market boom and burst in 2000’s. This paper is organized as follows. Section 2 describes the data that are used for analysis in detail. In section 3, I summarize the cash-out refinancing statistics in 2000’s. Section 4 examines the usage of cashed-out home equity. In section 5, I examine how households rebalance their home equity share using cash-out refinancing.
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