Diminished Housing Wealth Effect Keeps Pressure on Fed to Ease

The wealth effect from rising house prices may not be as effective as it once was in spurring the U.S. economy.

Rather than using their properties as ATM machines to boost spending, homeowners increasingly are paying down the principal and shortening the maturities of their mortgages in a move Florida banker Rob Nunziata calls "forced savings." Cash-in refinancings – in which borrowers invest more of their own money in the house – outnumbered cash-outs by more than two-to-one in the fourth quarter, according to Freddie Mac.

The wealth effect "is much smaller," said Amir Sufi, professor of finance at the University of Chicago Booth School of Business. Sufi, who participated in last year’s central-bank conference at Jackson Hole, Wyoming, reckons that each dollar increase in housing wealth may yield as little as an extra cent in spending. That compares with a 3-to-5-cent estimate by economists prior to the recession.

Many homeowners are finding they can't refinance their mortgages because banks have tightened credit conditions so much they’re not eligible for new loans. Most who can refinance are opting not to withdraw equity after the first nationwide decline in house prices since the Great Depression reminded them home values can fall as well as rise.

"We don’t see a lot of cash-out refis," said Nunziata, who is co-chief executive officer of Orlando-based FBC Mortgage LLC, a retail mortgage banker mainly serving the southeastern U.S. "What we’re seeing a lot of people do is shorten the term" of their mortgages so they build equity quicker.

Rising Equity

Homeowner equity rose to $8.2 trillion in the fourth quarter of last year from a low of $6.2 trillion in the first quarter of 2009, as house prices have begun to recover, according to data compiled by the Federal Reserve. The total still is below the record $13.5 trillion reached in 2006 during the housing boom.

Under the wealth-effect hypothesis, climbing prices for homes and equities increase consumption because they buttress household balance sheets and make people more comfortable with their finances, leading them to spend more and save less. The S&P/Case-Shiller index of property values in 20 cities rose 9.3 percent in February from the same month in 2012, the biggest year-to-year advance since May 2006, while the Standard & Poor's 500 Index of stocks has climbed 76 percent since the 18-month slump ended in June 2009.

Bigger Impact

Research by economists Karl Case and Robert Shiller, founders of the home-price indexes that bear their names, concluded that changes in housing wealth have a much bigger impact on spending than do variations in financial wealth. The volatility of stock prices and the fact that equity holdings are concentrated among the rich are behind the difference.

Consumer spending has grown at a 2.1 percent annual rate since the end of the recession, down from a 3.2 percent average for the 20 years preceding the slump, based on Commerce Department data.

The dwindling wealth effect has implications for Fed Chairman Ben S. Bernanke. If rising asset prices don't pack the same wallop they once had, the Fed may have to push them even higher to get the economy moving faster.

"You need an even bigger bull market," said Neal Soss, chief economist at Credit Suisse Group AG in New York and a former central-bank official. "That means the Fed has to stay easier for longer."

Easy-Money Policy

The central bank’s easy-money policy – it said last week it will keep buying $85 billion of securities a month – is helping the stock market, said John Stoltzfus, chief equity strategist at Oppenheimer & Co. in New York.

"We are very positive on equities," he said in an April 30 interview on Bloomberg Radio. The S&P 500 rose 1.1 percent on May 3 to 1,614.42 at 4 p.m. in New York, topping 1,600 for the first time.

The Cheesecake Factory Inc. is among businesses taking note of the changed attitude among consumers.

"People are using cash; they’re not living on credit that they think they're going to get out of their house," Chief Executive Officer David Overton said in an April 24 conference call with analysts, in seeking to explain why traffic at the Calabasas Hills, California, company's restaurants still was shy of pre-recession levels.

Home-equity lines of credit dropped to a seasonally adjusted $505 billion in March, an almost four-year low, according to Fed statistics.

Shorter Terms

Borrowers who refinanced last year took $29 billion of equity out of their properties, down from a peak of $321 billion in 2006 at the height of the house-price boom, according to McLean, Virginia-based Freddie Mac. Close to 30 percent chose to shorten the terms of their loans.

Darvin Boothe, a Tampa, Florida, businessman, refinanced into a 15-year loan last month from a 30-year, while reducing the interest rate on his $690,000 mortgage to 3.25 percent from 4.75 percent.

"Having a house paid off by the time I’m 55 and the kids are out of school, I don’t think it gets any better than that," said Boothe, 40, who runs a recruiting company and has two children, a 5-year-old and a 9-year-old.

Sufi said his research shows that homeowners with low credit scores were most prone to pulling money out of their properties during the housing boom. Since then, some have lost their houses to foreclosure: The share of Americans who own their own dwelling fell to 65 percent in the first quarter, the lowest in almost 18 years and down from a high of more than 69 percent in 2004.

Tighter Credit

Others are finding it difficult to refinance because credit has become a lot harder to come by. And that situation could worsen as banks respond to stepped-up government oversight.

"Credit is going to get tighter before it gets easier," said David Stevens, president and chief executive officer of the Washington-based Mortgage Bankers Association.

Rules created by the 2010 Dodd-Frank Act, including measures to prevent mortgage abuses, are just starting to take effect, and lenders are awaiting even more regulations before the end of the year, Stevens said in an interview at a Bloomberg Government breakfast in Washington on May 1.

Another estimated 10 million homeowners can't get cash from their properties through home-equity loans because they owe more on their mortgages than their houses are worth, said Frank Nothaft, chief economist at Freddie Mac.

Credit-Constrained Households

"Households that have been through foreclosure or have underwater mortgages or are otherwise credit-constrained are less able than other households to take advantage" of low interest rates, Fed Governor Sarah Bloom Raskin said in an April 18 speech in New York.

The average rate for a 30-year fixed mortgage fell to 3.35 percent in the week ended May 2 from 3.4 percent the previous week, according to Freddie Mac. The average 15-year rate decreased to 2.56 percent, a record low, from 2.61 percent.

Meanwhile, borrowers with better credit scores who can refinance at the lower rates have been more inclined to pay down principal than withdraw equity. Twenty-eight percent of refinances last year were for a lower loan amount than the original mortgage, compared with 17 percent that were for 5 percent or more, Freddie Mac statistics show.

"Cash-in refinance has replaced cash-out as the new term," said Chris Brown, a certified mortgage-planning specialist in Lake Mary, Florida.

Put it all together, and the impact of rising house prices on consumption is smaller than it was before. Calculations by Soss and his Credit Suisse colleague Henry Mo suggest the wealth effect from housing has fallen to just over 3 cents on the dollar from 5 cents. The effect on consumption from rising stock prices also has dropped, to just over 1 cent from 1.5 cents, they found.

"The wealth effect hasn’t disappeared," Soss said. "It's just smaller. You need a bigger increment of wealth" to get the same impact on the economy.

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