When, Not If – The Inevitable End to the Refinancing Boom Requires Attention

For anybody closely watching economic growth in recent years, it must have literally seemed like a house of cards. Throughout the recession and the “job loss” recovery the housing market stayed unexpectedly strong, and fuelled an extraordinary refinancing boom. However, the refinancing boom is showing signs of slowing. In its survey of its 12 regional banks, the Fed’s so-called Beige Book, which was released yesterday reported that “home mortgage lending continued to fall due to lower refinancing activity” in the past two months. When the overheated housing market cools further, it will not only slow growth in home values, but it will also help to reduce consumption due to an end of the refinancing boom. Whether, at that point, other economic factors will replace housing as an engine for growth is an open question.

By many accounts, a correction in the housing market appears unavoidable. For the past eight years, home prices have exceeded inflation. Price increases have been especially pronounced in California and the East Coast north of Washington, D.c= These extraordinary price increases cannot be explained by standard economic arguments such as more rapidly rising immigration, limited supplies of urban land, environmental restrictions on building, and growing incomes of homebuyers. None of these trends are new to the period since 1995, as Dean Baker, co-director of the Center for Economic and Policy Research, argues. If fundamental economic changes cannot explain abnormal price increases, we must find ourselves, by definition, in a bubble period.

The last price bubble and its bursting still conjure painful images of deflated mutual funds and depleted retirement accounts. When the housing bubble ends, home values will either grow slowly for a long period or, if worst comes to worst, deflate quickly. Moreover, consumption will also slow down if there is no source of funds, ideally income, to replace the positive impulse emanating from the refinancing boom.

Consumption comprises more than two-thirds of the U.S. economy. For the past three years, when the rest of the economy found itself in a slump, consumers never slowed the pace of their spending. Because the labor market was in a slump, consumption gains depended largely on gains in housing wealth, rather than increases in income. When a household sees its wealth increase due to rising prices on the stock market or the housing market, the need to save declines and more money is available for spending. Researchers, including Yale University’s Robert Shiller of “Irrational Exuberance” fame, have estimated that the wealth effect resulting from housing wealth is larger than the wealth effect from stock market wealth.

Already a large share of consumption in the late 1990s, prior to the stock market crash, was fuelled by the run-up in stock prices. Similarly, the housing bubble has put fuel on the fire of consumption. For every dollar increase in housing wealth, households are expected to increase their consumption by 4-6 cents. And this “wealth effect” is not the only link between housing wealth and consumption. Households have also ramped up their borrowing because they now had more collateral to borrow against at historically low interest rates. In fact, households borrowed about $550 billion more in additional mortgages than they spent on their homes in the first two years of the recovery. Moreover, households spent all of this additional money rather than to pay down other debt or increase their savings.

A number of signs suggest that the housing boom is slowing. Both building permits and new home sales fell behind expectations in recent months, refinancing activities appear to have slowed, and the Office of Federal Housing Enterprise Oversight (OFHEO), which regulates Fannie Mae and Freddie Mac, reports that house price growth has “moderated significantly” in the past year.

A further slow down in the housing market could be precipitated by continued increases in rental vacancies. Increasingly, those shopping for a home find more alternatives in the rental market as rental vacancies are at historically high levels. At some point, the gap between owning and renting will be too large to ignore, attracting people away from the overpriced housing market.

There is no way to predict how the housing bubble will end. Will it simply deflate with slow price gains to allow incomes and other prices to catch up, or, in a worst case scenario, will it burst with tumbling house prices? Although the answer is unclear, there are options for public policy to prepare for the fallout. The biggest immediate concern is that the housing bubble will no longer fuel consumption. Thus, consumption either needs to be driven by other sources, such as income, or other sectors of the economy, most notably exports and investment, have to replace the role that consumption has played for growth. Income could be boosted through a number of policy measures, such as extended long-term unemployment benefits or minimum wage increases. Additionally, exports could be boosted through active engagement with trading partners, specifically China, on suspected currency manipulations to reduce the U.S. trade deficit and give the U.S. an export boost, which should result in faster job growth, particularly in the struggling manufacturing sector. Regardless of the difficulties associated with these policy choices, it should be clear that doing nothing is not a viable alternative. When the refinancing boom comes to an end, it will leave a hole that needs to be filled quickly.

  • Additional Resources from Mortgages Relative to Personal Disposable Income, 1952 to 2003
    Due to higher house prices, households had more collateral. Borrowing was also facilitated by low interest rates. Consequently, households increased their mortgages by larger amounts than they raised their spending on their homes. By June 2003, the additional funds amounted to 4.9% of disposable income. Put differently, households had about 5% more money to spend on items other than their homes thanks to the housing finance boom. From June 2001 to June 2003 alone, households thus got an additional $545 billion, which was largely used for consumption.
    Source: Author's calculations. Board of Governors, Federal Reserve System, Flow of Funds Accounts of the United States.
  • Rental Vacancy Rate for the U.S. , 1956 to 2003
    As house prices are soaring, potential house buyers increasingly have an alternative in the rental market. Rental vacancies reached a record high of 9.9% in the third quarter of 2003.
    Source: Bureau of the Census, Rental Vacancy Rates, Historical Tables.

Dr. Christian Weller is a senior economist at the Center for American Progress.