Homeowners Equity Hits New Peak
Should we be concerned?
Today’s post is quite long, even by recent B&B standards, for which I apologize. But there is a lot of good material here, much of it embedded in the data links, which I encourage student readers to explore when you have the time. And for the rest of you, feel free to skim this post (as I know you do) and jump around to those highlighted topics which interest you most.
US homeowners equity hit a new peak at the end of March, according to stats recently released by the Fed. At close to $28 trillion, the total value of US homeowners equity has more than tripled over the past ten years and is now twice the level in 2006, before the collapse of our last housing bubble. As you will recall, the fall in US house prices starting in 2006 triggered the events we now know as the Global Financial Crisis.
During this period, almost 25% of homeowners with mortgages had negative equity (with their homes worth less than the amount of their outstanding mortgage debt) and millions of US households lost their homes due to foreclosure. With interest rates now rising, the value of stocks and bonds plummeting, and recession risk on the horizon, should we be concerned about the health of the US housing market? And if so, what might be the impact of falling house prices on homeowners equity and real economic activity?
Let’s explore, beginning with some basics.
What is “homeowners equity? Homeowners equity is the difference between the market value of an owned home (asset value) and the amount of mortgage debt secured by that home (liability value). [Equity = Assets - Liabilities] If I own a home worth $500,000 and owe $300,000 on my mortgage, then my equity in the house is $200,000. And if the value of my house suddenly increases to $600,000 (with no change in my mortgage debt outstanding), then I will see a $100,000 increase both in the value of my house (+20%) and in my home equity (+50%). Or conversely, if the value of my house falls by $100,000 I will see a similar fall in the value of both my house (down 20%) and my equity (down 50%).
You will note that any given dollar change in house value has a disproportionate percentage impact on homeowners equity due to the amount of financial leverage (mortgage debt) employed. Think of this like a financial seesaw, with the fulcrum being the amount of debt employed. The higher the ratio of mortgage debt to house price (a ratio called “loan to value”), the larger will be the percentage moves in equity for any given dollar change in house price (or value).
For individual homeowners, an increase in home equity typically comes from both increasing house prices (house price inflation) and reductions in the outstanding principal amount of mortgage debt over time. A traditional home mortgage loan has fixed monthly payments consisting of changing amounts of interest expense and principal repayment (amortization), and is structured so that the loan is paid off entirely at the end of the stated mortgage term. [If you don’t know how this works mathematically, check out this mortgage amortization calculator.] And so it is that homeowners “build equity” in their houses by paying down debt over time, even if the value of their homes has not increased.
But of course, homeowners also build equity—at least on paper— when the market value of their house increases. And conversely, they lose equity when their house value drops. These changes in house prices (values) sometimes occur quite rapidly and unexpectedly. We saw this on the upside over the past decade (2012-21) when US house prices doubled, as they did during the last US housing bubble (1997-2006). And we saw this on the downside when the last US housing bubble popped (2006-12) and house prices fell by over 30% nationally and much more in some regional markets.
So how did the Fed come up with $28 trillion of homeowners equity? Viewed in the aggregate, the estimated market value of all US homes as of March 2022 was around $40 trillion and the outstanding amount (nominal) of US household mortgage debt at the time was $12 trillion, leaving $28 trillion of total homeowners equity. As noted above, the total amount of US homeowners equity has basically doubled since the 2006 pre-crisis peak of $14 trillion. During this period, total mortgage debt has gone up by $2 trillion or so (from roughly $10tn to $12tn). And so we see that more than 100% of the recent increase in aggregate homeowners equity ($16 trillion) has come from increased home prices.
Note here that the Fed’s estimate of aggregate homeowners equity employs a sort of modified “mark to market accounting” in which it accounts for the value of houses at their current market value, not their original cost basis (last sale price). And it does this for all houses, not just those few which have changed ownership recently. However mortgage debt is accounted for on a cost basis, that is the nominal amount of money currently owed rather than the changing market value of the underlying mortgage loans (which would reflect default risk and changes in market bond yields over time). As a result, the measure of homeowners equity employed here reflects a (rough) estimate of the changing market price (value) of a house net of the actual nominal amount of debt owed. You wouldn’t get away with this sort of fruit salad (apples and oranges) accounting in class or in most SEC filings, but that is what we are doing here.
What are the consequences of big changes in homeowners equity? A big increase in home equity may cause homeowners to feel “richer” than previously, which in turn may boost consumer spending, capital investment or other forms of economic activity. This is the so-called “wealth effect”, which is much studied and debated by economists, as in this paper by Calomiris et al, The (Mythical) Housing Wealth Effect. And if an increase in homeowners equity might be expected to boost economic activity, then it is only reasonable to expect that a fall in home equity might contract economic activity. House prices go up and down, and so does the volume of economic activity. And the two seem to be correlated to some extent, directly or indirectly, albeit with uncertain time lags.
I have very little to add to this economic debate, other than to point out that whether or not increased wealth (or perceived wealth) resulting from changes in the market value of housing (or other financial assets) increases real economic activity in an empirically measurable way, there is a big and important practical difference between wealth and liquidity. Net worth (or homeowners equity) is a measure of wealth, but wealth is not cash (liquidity). And it is cash that people spend and invest in the real economy. This is a distinction that we have in mind when we talk about people being “house rich but cash poor”. These folks may own a big and valuable house on the best lot in town, but they don’t always have the cash needed to repair the roof, paint the rotting fence or sometimes even mow the lawn. (In my youth, these were the houses we called ‘haunted’ on Halloween.) And at some point, if the owners of these houses can’t raise the cash needed to maintain their homes (and preserve their value), they may just have to sell out to someone who can.
How can US homeowners convert the equity in their homes into cash, short of selling out? The answer to this question depends greatly on who we are talking about. Around one-third of total US homeowners equity is attributable to homeowners aged 62 or above. Which makes sense of course. These are the folks (my generation, the boomers) who bought their first homes decades ago and have benefited from the massive amount house price inflation during their home-owning years. Because of their age, and financial success, many of these people will have paid off most or all of their mortgage debt, leaving them with a large amount of home equity (at least on paper). And for many in this cohort, particularly those in the middle of the wealth distribution, the equity in their homes may represent the single largest component of their personal or household net worth.
For these people, an increasingly pressing question as they age will be how best to tap their homeowners equity to fund their retirement spending. Some of these folks will sell their house and downsize, hopefully taking out some money in the process. This is not always the case, however, given the big rise in the cost of smaller homes, apartments and assisted living facilities. But there are other ways to tap into one’s homeowners equity which do not involve selling (immediately) and may be more attractive financially (at least initially).
The first is simply to refinance one’s existing mortgage (or take out a new one if the old mortgage is already paid off) in what is called a “cash out refinancing”. In this form of transaction the homeowner borrows more than is needed to pay off the old mortgage and holds the balance of the loan proceeds as cash pending future use. This makes particular sense in periods where mortgage rates have fallen (ie last year, but not this year) and when the homeowner wants to raise a large sum of cash today, perhaps for funding the grandkids’ college education. But not many people want to borrow money and sit on the cash, particularly not at a time when mortgage rates exceed the rate of interest paid on cash.
[Note here that US home mortgages are generally prepayable at any time, without financial penalty, which is why so many borrowers refinance their mortgages when rates fall (but hang on to their mortgages when rates rise). And this is also a big reason why so many mortgage lenders securitize and sell their originated mortgage loans, passing this asymmetric interest rate risk on to investors who can better absorb it.]
Older homeowners who have entirely paid off their mortgage debt may instead prefer to take out a new loan structured as a reverse mortgage. In this form of borrowing, the homeowner establishes a line of credit based on the amount of equity in his home (typically capped at 80% or so of the appraised value of the home) and then draws down the loan (borrows money) as needed to fund personal expenses (including interest on the loan). In a reverse mortgage, the principal balance owed (including accrued interest) grows over time and is eventually paid off from the proceeds of the house sale when the owner dies or moves into other accommodations. Reverse mortgages are a sensible alternative for some older borrowers. But as with many financial products targeted to vulnerable retirees, one needs to be careful. Your parents (or grandparents) should not take out a reverse mortgage just because that nice man on TV, Tom Selleck, told them to do so.
The other traditional option for tapping into homeowners equity, applicable to a much broader group of borrowers, is known as a Home Equity Line of Credit (HELOC). A HELOC is a revolving line of credit which allows homeowners with an existing first mortgage, but substantial equity in the home (ie home value in excess of the first mortgage debt), to borrow directly against the equity in their home on an “as needed” basis, drawing money from the lender to fund expenses and then paying back the principal as and when excess cash becomes available. HELOCs are typically structured as floating rate lines of credit, priced at a premium to adjustable rate first mortgages, with the HELOC lender taking a secondary lien on the borrower’s home (behind that of the primary mortgage lender).
As you might imagine in today’s dynamic economy, financial entrepreneurs have also come up with other creative ways in which to help homeowners monetize the value of their home equity, including by selling minority ownership stakes to financial investors. But HELOCs, cash out refinancings and reverse mortgages remain the principal means by which homeowners cash in on their home equity, without selling the family home.
Home equity borrowing exploded during the last US housing bubble (1997-2006), when the outstanding balance of HELOCs increased by a factor of 6x ($500bn). This was the period when homeowners—and lenders as well—increasingly viewed houses as giant ATMs. As you would expect, this activity came to a grinding halt during the financial crisis, as is described in this retrospective study by the NY Fed (Liberty Street Economics), Houses as ATMs No Longer.
How important is homeowners equity to US household wealth? The Fed publishes quarterly estimates of US household balance sheets, itemizing major categories of household assets and liabilities, which is quite interesting (even surprising) and which I encourage you to explore (link above). The total net worth of all US households is currently around $140 trillion. “Net worth” as used here means the same thing as “wealth” or “equity”—it is the difference between household asset values and liability amounts. The total (market) value of assets owned by US households is roughly $158 trillion and the total (nominal) amount of household liabilities is $18 trillion, leaving $140 trillion of aggregate household net worth. And of this $140 trillion, only about 20% ($28 trillion) comes from homeowners equity. So what accounts for the balance?
To answer this question, we need to look at both the asset and liability side of the aggregate US household balance sheet. Of the $158 trillion of total assets, only 30% ($47 trillion) comes from non-financial assets (real and personal property), of which the biggest component is owned real estate ($40 trillion). Over 70% of the total ($110 trillion) comes from financial assets, the largest components of which are corporate equities and mutual funds ($40 trillion), pension entitlements and life insurance reserves ($33 trillion), cash and debt securities ($18 trillion) and equity in non-corporate businesses ($15 trillion). And on the liability side of the balance sheet, two-thirds of the total household debt ($18 trillion) is attributable to home mortgages ($12 trillion), with the balance coming primarily from other forms of consumer credit (eg auto loans, student loans and credit card debt).
And so we see that while homeowners equity is an important part of our national household wealth, at just 20% of the total it is far from the largest component. Viewed in the aggregate, homeowners equity (and even the total value of homes) is dwarfed in the national accounts by financial investments like stocks and bonds. And this is why the press and policymakers are so focused on what is happening currently in the stock and bond markets.
Of course this picture will look very different when we examine individual household balance sheets rather than the national aggregate data. Most US households own very little in the way of directly-held financial assets—although we should not ignore the stocks and bonds held by the pension plans and insurance companies which serve this same population— and for these folks the family home is likely to be the single biggest asset by value and the biggest contributor to household net worth. And for this (and other) reason(s), policymakers will also be concerned about developments in the housing market, and the impact on homeowners equity.
Which begs the question: How is our national household wealth distributed?
How is our national household wealth distributed? The short answer is “very unequally”. Approximately 32% of total US wealth is owned by just 1% of the population and another 38% is owned by the next 9% of the population. This means that 70% of our national wealth is held by just 10% of the population, with only 30% of the wealth held by the other 90%. And the bottom 50% of the population owns less than 3% of our collective national wealth. There are about 330 million people living in the US, and about 130 million households, if you want to calculate the raw numbers of people and households at these various percentiles. (I do not know if average household size varies across the wealth distribution, but it might.)
If this data shocks you, good. The issue of economic inequality in our country is an important and pressing one, and the more we know about the basic facts the better informed our public discourse will be. So let’s probe a bit deeper.
In 2020, the median US household net worth was around $120,000 and the average (mean) was around $750,000, reflecting a very skewed distribution of wealth. If your family has a household net worth of $1.2 million—10x the national median but only 60% above the national average—this would put you into the top 10% of the national wealth distribution. At $12mm you would be in the top 1%, and at $50mm you would be in the top 0.1%. But to be in the ultra-exclusive billionaires club (with 700+ other members) you would need a net worth ($1+ billion) more than 20x that of those in the 99.9th percentile. And to be at the very very top, along with individuals like Jeff Bezos and Elon Musk, your personal net worth would need to be in the neighborhood of $100 billion, even after this year’s big fall in the stock market.
[Musk alone has lost something like $80bn in net worth this year, with Tesla’s share price down 40%. And this is before he burns even more money buying Twitter (if he does). As they used to say about airlines, the easiest way to become a billionaire in today’s market is to start with tens of billions of dollars and buy an EV manufacturer or a social media network.]
And what about the wealth (or lack thereof) of those in the middle or bottom of the distribution? As noted, the national average (mean) net worth is around $750,000 but the median (50th percentile) is much lower at $120,000. And at the 25th percentile, the amount falls by 90% to $12,000. Twelve thousand dollars may seem like a lot to a student just graduating college, but it is not much on which to support a family—just about enough to buy a good used car but most likely not enough for the downpayment on a house. Which goes a long way to explaining why less than 2/3 of American households live in their own(ed) home and why social policies to increase home ownership rates are doomed to financial failure.
These wealth distribution statistics may be shocking, but they should not really surprise us. As has been widely reported, something like one-third of Americans do not have enough cash to cover unexpected expenses of just $400. And while cash is not the same thing as net worth, we can see from the published data that these folks do not have much net worth either. Tens of millions of American households are not “house rich but cash poor”, they are just poor. At least by American standards.
How secure is today’s homeowners equity? This of course is the $28 trillion question. During the last financial crisis, we saw the total value of US homeowners equity fall by about 40% ($5.6 trillion) from 2006-2011. This was the result of falling house prices, which were down 25-30% nationally (and more in some over-built or over-hyped regional markets), combined with substantially increased financial leverage in the mortgage lending market. In the years leading up to the financial crisis, an estimated $5+ trillion of sub-prime and Alt-A mortgage loans were issued, accounting for roughly 50% of all outstanding US residential home mortgages.
Needless to say, this represented a huge change from traditional mortgage lending practices and it did not turn out well. Mortgage delinquency rates skyrocketed as did home foreclosures, which we not exclusively or even primarily associated with sub-prime mortgages, but were highly concentrated in borrowers (even prime borrowers) with negative equity in their homes. (Read here to learn more.) And the US stock market fell 50% to boot.
Which of course raises the question: Could this happen again? Is it likely that house prices will fall say 20%, as has already been the case with stocks, wiping out $8 trillion or so of aggregate homeowners equity over the next few months or years? I suspect not, although there is some reason for concern.
The price of US houses has recently increased at a fast (and unsustainable) pace, doubling over the past ten years as it did in the lead up to the financial crisis. A big reason for this latest increase in house prices has been the unprecedented low level of interest rates orchestrated by the Fed and other central banks in response to the financial crisis and then covid. But the Fed has now reversed course and is raising rates quite aggressively, triggering a big increase in mortgage rates from under 3% a year ago to well over 5% today. And mortgage rates may still have a ways to go as the Fed continues to tighten and as the QE unwinding kicks in. (Today’s increased mortgage rates are still lower than during our last housing bubble, when 30-year fixed rate mortgage rates were in the range of 6-7+%). And when mortgage rates go up, house prices (and housing activity more generally) tend(s) to go down. So it would not be unreasonable to think that with a big jump in mortgage rates, US house prices may also fall.
But there are also strong arguments suggesting this may not happen, at least not to the same extent as the last time around. The US housing market is today much less leveraged than it was 14 years ago, which will reduce the hit to home equity resulting from any given fall in house prices. It doesn’t take much to bankrupt an over-stretched homeowner who is leveraged at 95% or more on an interest-only or negative amortization teaser rate ARM, but this is much less of a concern for those homeowners who borrowed only 80% of their purchase price in a traditional 30-year fixed rate or 10-year adjustable mortgage and who have paid down their mortgage debt over time. (The total value of US houses is $40 trillion, secured by $12 trillion of mortgage debt, for an aggregate loan to value ratio of just 30%.) It may also be the case that today’s house prices will continue to be supported by the continuing dearth of new housing supply and the big increase in general price inflation, although I am not so sure about the later point. (If the cost of maintaining a home goes up, along with interest rates, taxes and insurance premiums, it is hard to see how house values will remain elevated.)
So should we be concerned? Now back to my opening question: Should we be concerned about the recent rise in house prices and homeowners equity? I think the answer is yes, but perhaps not for the reasons you would expect. I think it is unlikely (though not impossible) that we will have a major near-term housing market collapse, as we did over a decade ago. But I do think that we have a significant house price affordability (and availability) problem in this country, and this won’t be resolved by a minor correction in house prices, at least not with mortgage rates and the other costs of home ownership increasing dramatically and NIMBY development constraints still in full force in much of the country.
I also think that we have a major economic inequality problem in this country, attributable in part to several decades of aggressive (even irresponsible) monetary and fiscal policy under various Fed chairs and both Republican and Democratic administrations. For pretty much all of my working life the rich have gotten richer in this country, much more so than in other countries, but this increased wealth has not been widely shared. And I don’t see how this is going to hold for much longer without increased social unrest. (Yes, even more than we have today.)
My hope is that our inflated American wealth bubble will deflate slowly, not pop suddenly, and that we will once more become a country where “the American dream” is alive and well for large portions of the population, not just those at the very top.
But I wouldn’t bet on it.
Links:
US Home Equity Hits New Record, WSJ, 14 June 2022
US Household Balance Sheets, FRED data