Cash-Out Refinancing During Bubble Years Will Lead to Disaster

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Nearly all analysts who write about the housing bubble have focused on the purchasing madness that occurred. While this is important, it overlooks the refinancing insanity of 2004-2007. This refinancing lunacy will devastate mortgage and housing markets for years to come.

You may wonder why I choose to focus on bubble era refinancing. After all, refinancing happens all the time.

Here is why: California was the nation's epicenter for the refinancing madness. During the bubble years, roughly five times as many refinanced first liens were originated there as were purchase loans.

Millions of homeowners refinanced once, twice, even three times or more while their homes soared in value. These became known as “cash-out refis,” where the borrower refinanced for a larger amount than the previous loan. A California home that may have been purchased for $200,000 in 1997 could easily have had a $600,000 refinanced loan in 2006. When home prices began to tumble, they found themselves trapped in a badly underwater property.

There were roughly 20 million homeowners who refinanced during the bubble years. At least one-third of them also had second liens on their property. When housing markets weaken, millions of them will face significant debt burdens. This horde of refinanced homes will cause the debacle of 2008-2010 to resume.

Enormity of bubble era cash-out refinancing

Cash-out refinancing caused millions of homeowners to lose their property. The owner cashed out the growing value of the house by taking out a mortgage larger than the previous one and pocketing the difference. Hence, many of these borrowers ended up with mortgages much larger than their original one.

Refinancing started in 2003 after the Fed began lowering interest rates. Approximately 15 million mortgages were refinanced that year for a total of $2.5 trillion. Cash-out refinances were relatively modest that year because the housing market bubble had just begun.

Things began to heat up in 2004. Numerous major metros were showing double-digit home-price increases with the hottest ones sporting gains of 30% or more. Speculative fever spread throughout the nation. The urge to tap this growing equity with a cash-out refinance was met by accommodating lenders who lowered underwriting standards and accepted loose appraisals. According to Freddie Mac, roughly 46% of all homeowners who refinanced in 2004 pulled money out of their refinanced mortgages. This soared to 61% by the third quarter of 2004.

Rising interest rates in 2005 did not prevent homeowners from using their increasingly valuable houses as a piggy bank. Roughly 72% of all homeowners who refinanced that year pulled cash out of their homes to the tune of $262 billion. Cash-out refinancing peaked in 2006 when 86% of all homeowners who refinanced pulled cash out of their house – nearly $320 billion.

In the peak bubble years of 2004-2006, a total of 28 million mortgages were refinanced.

Source: Black Box Logic

California metros do not appear on the list because the servicers have modified more than 40% of all California non-agency mortgages. That is a much higher percentage than any other state.

Take a look at this next table showing how long the borrowers in the worst states have been delinquent.

Nationwide, in August 2012 a mere 2% of these bubble-era loans had been delinquent for more than five years. Two years later, that percentage had soared to 21%. Hordes of underwater borrowers had simply stopped paying their mortgage. Homeowners found out that the servicers were not foreclosing and realized that they had little to lose by defaulting.

By August 2016, the nationwide percentage of borrowers who had not paid their mortgage for five years or more has climbed to 29%. In three states and Washington DC, it is more than half. Most of these delinquent homeowners are very likely still living in these houses. If you know that the mortgage servicers are not foreclosing, why not wait until they take action before moving out?