High five for the refi

Refinancings have had a powerful impact on an otherwise moribund economy. This article shows how refinancing activity has affected the economy and quantifies the refi boom's national and regional economic contribution.

A rusty economy is cleaning up its act--painfully slowly, and not quickly enough to induce businesses to resume hiring. Unemployment thus continues to edge higher.

The one steady bright light through all of the economy's difficulties has been the nation's housing and mortgage markets. Home sales and mortgage origination volumes have never been stronger and single-family homebuilding and real house price gain are as strong as they have been in a quartet century.

The housing and mortgage markets have been instrumental in supporting the broader economy. The 2001 recession would have been substantially more severe and the tepid recovery even weaker if not for the strength of these markets. Almost one-third of the nation's economic growth since the beginning of this decade is attributable to the impacts of the strong housing and mortgage markets

Although the economic contribution of housing activity is well documented, the contribution of refinance activity to the national economy is not. Nearly $2.5 trillion in mortgages will be refinanced this year in addition to the $1.6 trillion refinanced last year, and $1.2 trillion the year before that. The refinancing boom is enabling many homeowners to lower their debt payments, while enabling others to raise cash to finance more spending. Other homeowners who refinanced are restructuring their liabilities by reducing the duration of their higher-cost mortgages and locking in historically tow long-term interest rates. Still others with new refinanced mortgages are saving enough to do all of these things.

Overall, the economic benefits of the refinancing boom are widespread, reaching every region of the country.

Refi boom. The current mortgage refinancing boom is unprecedented. Since it began two and a half years ago, close to $4.5 trillion in mortgage debt has been refinanced, equal to approximately two-thirds of all mortgage debt outstanding (see Figure 1). The previous refinancing record was set in 1998 when some $800 billion in mortgage debt was refinanced, about 20% of the mortgage debt outstanding in that year.

There have been three refinancing booms in recent years, defined as periods in which more than half of mortgage originations are refinancings. The booms occurred in 1992-1993, 1998, and currently (see Figure 2).

The current refinancing boom is taking place from coast to coast. The most substantial increases in activity have been in the Northeast corridor, from Boston to Washington, D.C., and in Southern California. Long Island has experienced a nearly six-fold increase in refi activity during the past two years. Extraordinarily strong refi gains have also been experienced in metropolitan areas scattered across the country, including Minneapolis, Miami, Orlando, Milwaukee, and Chicago.

Fueling this boom is a dramatic decline in mortgage rates, with fixed mortgage rates sliding to a more than 40-year low of near 5.5% and rates on adjustable mortgages falling to a record low 3.5% (see Figure 3). Mortgage transaction costs also have declined substantially. Fees and points have recently fallen below 40 basis points, compared to 100 basis points in the mid-1990s and 1.50 basis points a decade ago (see Figure 4).

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With mortgage rates falling so substantially, a large number of homeowners have discovered that the present discounted value of the after-tax cost saving on a new, lower-rate loan would be much greater than the transaction costs involved with the refinancing. At the start of the refi boom two years ago, nearly all of the just over $6 trillion in mortgage debt outstanding could be profitably refinanced by homeowners at a 5.5% mortgage rate. That means mortgage borrowers could recoup the transaction costs involved in the refinancing from the lower after-tax interest costs within one year of the refinancing.

Facilitating the soaring refinancing activity have been very strong gains in house prices. Given booming housing demand and shortages of land zoned and available for development in high-growth markets, the value of housing has soared by close to $5 trillion during the past five years, a whopping annualized increase of nearly 10%. The average homeowner has thus experienced more than a $55,000 increase in home value during this period.

Rising housing values have allowed mortgage lenders to more easily accommodate refinancing homeowners, as lenders have become more confident in the creditworthiness of borrowers. This is particularly true in the Northeast and California, regions of the country in which lenders had been reluctant to refinance loans during the 1998 refinancing boom. These regions had experienced falling or flat housing values throughout much of the early and mid-1990s. Indeed, despite the economy's recent difficulties, the weakening in mortgage credit quality to date has been very modest, particularly in the Northeast and California.

Homeowners also have become more willing and able to tap the rising equity in their homes through increased mortgage borrowing through cash-out refinancings. Cash-outs are refinancings in which borrowers increase their mortgage balance by more than the transaction costs involved in the refinancing. Freddie Mac estimates that well over half of refinanced mortgages in the past two years are cash-outs, that is, the new mortgage balance is more than 5% greater than the original balance.

Mortgage borrowing has become an increasingly attractive method for raising cash, as credit card interest rates have remained very high. While the interest rate on credit card debt being assessed has fallen from close to 16% at the start of the decade, according to the Federal Reserve Board, it remains at just under 13% currently. Given that mortgage interest payments are tax deductible and credit card interest payments are not, the financial advantages of mortgage borrowing are obvious. Credit card debt outstanding will experience its slowest growth on record, except during 1980 when credit controls were temporarily imposed.

Economic impact. The refinancing boom has been instrumental in supporting the economy's performance during the past two years. The con dints through which the refinancing boom impact the economy are severalfold. To date, the most important link has been through the cash raised in cash-out refinancings. More than $200 billion is estimated to have been raised through cash-outs during the first half of this year, up from $142 billion in 2002 and $100 billion in 2001 (see Figure 5).

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Based on recent surveys conducted by the Federal Reserve and Fannie Mac, it is safe to conclude that well over half of the cash being raised is used to directly finance mote spending. This would include everything from home improvement to vehicle purchases, vacations, education, and medical expenses; and, given that many households are hard pressed by the soft economy, the cash is used even for general living expenses (see Figure 6). Much of this additional spending would likely not have occurred otherwise, as most homeowners taking cash out of their homes probably view the cash as a windfall and not as a substitute for other sources of cash or income.

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Nearly a third of the cash raised in cash-outs is being used to repay other higher-cost credit card, other installment, and even second-mortgage debt. The significant amount of cash freed by refinancing's combined effect of lower debt payments and relatively slight mortgage balance increases also supports spending. Indeed, refinanced households are saving an estimated $10 billion in annual interest payments on their mortgage and consumer installment liabilities.

The remaining cash raised through cash-outs is being used to finance other investments, many of which are likely to be other real estate assets. This is thus further supporting housing demand, house price gains, and even more spending through the resulting lift to household net worth. Magnifying the importance of this positive wealth effect is that it is helping to offset the negative effects of the recent substantial declines in stock values.

The current refinancing boom will also support the economy's longer-term performance, as it allows mortgage borrowers to lock in very low long-term interest rates. The vast majority of those refinancing are taking down fixed-rate mortgages--even those whose original mortgage was an adjustable-rate loan. About 20% of all household liabilities--composed largely of mortgage and consumer installment debt-have interest rates that adjust within one year of a change in market interest rates. This compares to 25% of liabilities in the mid-1990s and 33% a decade ago (see Figure 7). The refinancing boom is thus largely responsible for allowing households to insulate themselves from the potential negative financial effects of rising interest rates. This may very well have key positive macroeconomic implications when interest rates ultimately do rise.

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Regional impact. The refinancing boom has provided a much-needed lift to economies from coast to coast. Every region is benefiting.

The most significant economic contribution has been in the Northeast and on the West coast. The refinancing boom has been particularly helpful to the hard-pressed Boston economy. With house prices in the metro area doubling since tire mid-1990s, homeowners are tapping a significant amount of homeowners' equity. The additional spending this has prompted has been instrumental in ensuring that the metro area's economy doesn't fall back into recession under the weight of the contracting technology and financial services industries.

The soft West Coast economy has also benefited enormously from the refinancing boom. This is particularly true in the region extending from Seattle to the Bay Area of California. That the Portland and San Francisco metro area economies will expand at all this year is due to surging refinancing activity. The Seattle and San Jose economies will contract again this year given tire problems in aerospace and technology industries, but the downturn in these economies would be substantially more debilitating if not for the ability and willingness of homeowners to refinance.

The central part of the country has benefited from tire refinancing boom, but less so. This is largely due to the far inure modest gains in house prices these regions experienced in recent years.

Risks. The refinancing boom could quickly moderate in the coming year if mortgage rates rise even modestly. At the current fixed mortgage interest rate of about 5.5%, the bulk of mortgages outstanding could be profitably refinanced (see Figure 8). At a 6.5% fixed rate, however, less than a third of borrowers are able to profitably refinance, and at a 7% fixed rate, the pool of available refiers largely evaporates.

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Even if mortgage rates do rise soon, however, the economic benefits of the current refinancing activity will linger on for some time. Those homeowners with lower monthly mortgage payments will be able to spend more of their budgets on other things, and many cash-out borrowers are only now receiving checks, which they will spend well into next year.

There is also worry over the potential for heightened credit risk posed by tire increased mortgage debt loads of cash-out borrowers. Households' mortgage liabilities have been growing at a near double-digit pace during the refinancing boom, more than twice the growth in household incomes. That households are under some financial stress is evident from an erosion in various measures of mortgage credit quality during the past two years.

This risk is at least partially mitigated, however, by recent strong house price gains. Despite the strong growth in mortgage debt, this growth has until very recently largely just kept pace with the growth in housing values. While any substantial and sustained decline in house prices would negatively impact mortgage loan performance, a broad-based decline in national house prices remains highly unlikely. This is not to say that various metro areas--particularly those where the dramatic house price gains of recent years are difficult to explain by underlying housing demand and supply factors--will not experience house price declines and thus heightened mortgage credit problems.

Conclusions. The mortgage refinance boom of the past two and a half years has exerted a substantial positive impact on the economy. The 2001 recession would have been substantially more severe and the subsequent recovery measurably weaker if not for the refinancing boom. The economic benefits have been widespread and enjoyed in every region of the country particularly in California and the Northeast.

The refinancing activity has allowed some homeowners to lower their debt payments, while allowing others to raise cash to finance more spending, and still others to restructure their liabilities by reducing their higher-cost liabilities and locking in historically low long-term interest rates. For some homeowners the interest rate savings on their new refinanced mortgages are so substantial they are able to do all of these things.

Even if refinancing activity were to weaken soon, the positive benefits of the refinancing boom of the past two years will continue to support the economy well into next year. This is of course necessary to ensure that consumers remain stalwart spenders long enough to allow businesses to step up their activities and propel the currently fragile recovery into a sustained economic expansion.

Zandi can be reached at mzandi@economy.com.

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