2002 a record year for new mortgages, refinancing

Editor's note: The following is excerpted from a March 4 speech given by Federal Reserve Board Chairman Alan Greenspan at the annual convention of the Independent Community Bankers of America in Orlando, Fla.

Last year was surely one of the most memorable years ever experienced by the home mortgage market. Owing largely to the lowest mortgage interest rates in more than three decades and rising home prices, close to 10 million of regular home mortgages were refinanced. I use the term regular mortgage to exclude both home equity and construction loans.

The outsized dollar volume of these refinancings by our estimates, $1.75 trillion net of cash-outs was an all-time record and represented almost one-third of the value of all regular home mortgages outstanding at the beginning of last year. Total regular mortgage originations, at $2.5 trillion, also proceeded at a record pace.

As part of 2002's process of refinancing, households "cashed out" almost $200 billion of accumulated home equity, net of fees, taxes, points and commissions. That represented almost 3 percent of estimated total home equity at the beginning of the year, up slightly from the 2001 share. Of 2002's cash-outs, approximately $70 billion was apparently applied to repayment of home-equity loans, and a significant part was employed to reduce higher-cost credit card debt, judging from the slowed pace of growth in installment debt outstanding.

Home equity

An even greater support to the economy than cash-outs last year was the extraction of home equity associated with a record 6.4 million existing home sales, including condos, at record prices. This pace of ownership turnover of the existing housing stock also reflected the near-record-low mortgage rates.

We estimate that mortgage originations for existing home purchases last year topped $600 billion. Subtracting the home sellers' repayments of the remaining debt of their outstanding mortgages, we infer a net increase of approximately $350 billion in debt on the homes that turned over last year. That debt increase exactly matches the extraction of previously built-up equity on those homes, plus fees and taxes folded into the loans.

In addition to the extraction of equity financed by regular mortgages last year, approximately $130 billion was drawn through a net increase of home equity loans, also a record, and also presumed to be the consequence of low mortgage rates as well as accelerated appreciation of homes.

Mortgage debt service

Mortgage debt service costs as a percentage of the disposable income of homeowners last year were little changed from 2001. The estimated 10 percent of homeowners' disposable income allocated to mortgage debt service in the third quarter of last year was well below the highs in 1991, though the ratio of homeowners' mortgage debt to their disposable income rose to a record high.

The frenetic pace of home equity extraction last year is likely to appreciably simmer down in 2003, possibly notably lessening support to household purchases of goods and services.

The very large flows of mortgage funds over the past two years have been described by some analysts as possibly symptomatic of an emerging housing bubble, not unlike the stock market bubble whose bursting wreaked considerable distress in recent years. Existing home prices (as measured by the repeat-sales index) rose by 7 percent during 2002, and by a third during the past four years. Such a pace cannot reasonably be expected to be maintained. And recently, price increases have clearly slowed.

It is, of course, possible for home prices to fall as they did in a couple of quarters in 1990. But any analogy to stock market pricing behavior and bubbles is a rather large stretch.

First, to sell a home, one almost invariably must move out and in the process confront substantial transaction costs in the form of brokerage fees and taxes. These transaction costs greatly discourage the type of buying and selling frenzy that often characterizes bubbles in financial markets.

Second, there is no national housing market in the United States. Local conditions dominate, even though mortgage interest rates are similar throughout the country.

Third, there is little indication of a supply overhang in newly constructed homes. The level of overall new home construction, including manufactured homes, appears to be well supported by steady household formation and not dependent on high and variable replacement needs or second-home demand.

In evaluating the possible prevalence of housing price bubbles, it is important to keep in mind that home prices tend to consistently rise relative to the general price level in this country.

In fact, over the past half century, the annual pace of home price increases has been approximately 1 percentage point faster, on average, than the rise in the GDP deflator.

This higher home-price inflation rate results from persistently slower productivity growth in new home construction than in the economy overall. This lag in productivity growth drives up new home prices relative to the general price level and, by arbitrage, it drives up the prices of existing homes as well.

In addition, local building and land use restrictions continue to constrain the supply of buildable land in many areas, whose price increases also tend to outstrip the rate of inflation.

Clearly, after their very substantial run-up in recent years, home prices could recede. A sharp decline, the consequences of a bursting bubble, however, seems most unlikely.

Nonetheless, even modestly declining home prices would reduce the level of unrealized capital gains and presumably dampen the pace of home equity extraction.

Should rates rise, it is entirely possible that new and existing home sales would decline, leading to a lower level of realized capital gains on homes, a further narrowed refinance spread and, as a consequence, less overall home equity extraction.

It is worth bearing in mind, however, that any sustained increase in rates presumably would occur only in the context of a more vigorous upturn in the pace of business activity, suggesting that the net effect on housing activity might be relatively limited.

Most of the aforementioned data are new and derive from a much broader home mortgage data system in the early stages of development by the Federal Reserve Board. As a consequence, all specific numbers I have cited are preliminary and subject to revision.