By Karen Shaw Petrou
The ability of U.S. borrowers to refinance their residential mortgages may seem like a small matter when considering economic inequality, but it’s actually a critical question given the central importance of homes to wealth accumulation for all but the richest Americans. Some have suggested that mortgage refinancings (refis) simply be banned for lower-income households to prevent wealth-destroying equity extraction, while others have claimed that refis not only promote home ownership and economic growth, but also validate the equality benefits of post-crisis monetary policy. A new paper from the Federal Reserve Bank of Philadelphia demonstrates that refis aren’t economic equality curses or blessings – instead, they’re procyclical accelerants that put vulnerable borrowers at risk in booms when credit flows far too freely and that then excludes those most in need of lower-cost loans as post-crisis loans go only to the wealthiest households in the highest-priced homes. The Philadelphia Story
Refinancing is, as the paper demonstrates, essential for low-and-moderate income (LMI) households because 1) lower-cost mortgages reduce default risk and thus enhance personal and macroeconomic stability; 2) lower-cost mortgages promote personal consumption and thus enhance macroeconomic growth; and 3) home ownership is an essential source of wealth equality. However, this paper also rightly notes that refis can also put borrowers at heightened risk if cash-outs endanger stable housing by adding closing costs to new loans and increasing principal obligations that place borrowers at still more risk in a housing downturn. As this paper shows, 70% of subprime borrowers in 2007-08 were refinancing through cash-out structures versus 45% of lower-risk borrowers. These refi totals are astonishing and help to explain why mortgage-lending practices leading up to the crash proved to be both acutely procyclical and wealth-destructive.
Using a comprehensive data set of randomly-sampled first liens and their loan-level performance, Equifax credit scores and loan-application information, and HMDA data, the Philadelphia paper finds that, after the subprime refi bubble right before the crisis, borrowers continued to seek refis, but subprime borrowers current on their loans regardless of LTV were less likely than prime or super-prime borrowers to receive refi loans (shown below) even though the higher-scored borrowers may or may not have been current and lower rates of course enhance repayment potential.
Black and Hispanic borrowers are also less likely to refi than any subprime or prime borrowers. Although the HARP refi program was intended for subprime borrowers, eligibility was skewed heavily towards prime borrowers at the expense of subprime, black, and Hispanic ones as shown below.
Importantly, the paper concludes that:
After 2009, the distribution of FICO scores for conventional refinance mortgages jumps significantly, with more than 50 percent of conventional refinance mortgages having credit scores of above 740 — analogous to our super-prime category. Although there is some variation over time, only a small share — approximately 5 percent — of refinance mortgages go to borrowers with credit scores under 640 While few would advocate a return to the underwriting standards prevalent during the subprime boom, failing to address the consequences of the extremely tightened mortgage market will only exacerbate wealth inequalities, especially for black and Hispanic borrowers who were more likely to receive a higher-priced mortgage. The potential magnitude of refinancing on the wealth gap is large. Homeowners in our sample who refinanced between 2007 and 2009 saved an average of $1,290 in interest payments each year, whereas those who refinanced between 2010 and 2013 saved an average of $4,050. Over the course of 10 years, this could result in a $40,000 equity gap for those who were unable to refinance.
What to Do?
The Philadelphia paper’s empirical findings show clearly that QE in concert with ultra-low rates have not spurred the refinancing often cited by those refuting the inequality impact of unconventional monetary policy. Neither the excess lending capacity theoretically sparked by large inflows of cash to banks following Fed asset purchases nor ultra-low rates create sufficient credit availability to support refis for the borrowers most in need of lower-cost homeownership who have demonstrable capacity to meet their mortgage commitments, especially when refis convert these commitments into lower-cost mortgages.
However, post-crisis monetary policy alone is not the cause of heightened wealth inequality due to credit barriers that stymie sustainable homeownership. The post-crisis regulatory framework – most notably the qualified-mortgage standards, put-back risk, and GSE pricing overlays that penalize subprime borrowers – exacerbate monetary-policy obstacles to credit availability in this critical arena. As a result, new mortgage products, better-targeted consumer protections, and reduced dependence on the GSEs and FHA all are essential to realigning U.S. mortgage finance so that the long-hyped “American dream of home ownership” isn’t just a fantasy for those most in need of sustainable mortgage credit.
Food for Thought
Do post-crisis data simply show a return to prudent underwriting? If so, this may suggest that subprime borrowers are just too risky to refi or perhaps to obtain a mortgage at all. If only higher-income Americans with pristine credit can get a mortgage and own a home, where do the rest of Americans find housing? If the answer is in rental housing, economic inequality will only worsen as the best way for most Americans – and LMI households in particular – to build wealth is outside their reach. How to employ prudent underwriting and encourage LMI homeownership without still larger government subsidies remains one of the largest unanswered questions almost a decade after the housing bubble burst.