01 Oct 2009Working Paper Summaries

Systemic Risk and the Refinancing Ratchet Effect

by Amir E. Khandani, Andrew W. Lo and Robert C. Merton

During periods of rising house prices, falling interest rates, and increasingly competitive and efficient refinancing markets, cash-out refinancing is like a ratchet, incrementally increasing homeowner debt as real-estate values appreciate without the ability to symmetrically decrease debt by increments as real-estate values decline. This paper suggests that systemic risk in the housing and mortgage markets can arise quite naturally from the confluence of these three apparently salutary economic trends. Using a numerical simulation of the U.S. mortgage market, the researchers show that the ratchet effect is capable of generating the magnitude of losses suffered by mortgage lenders during the financial crisis of 2007-2008. These observations have important implications for risk management practices and regulatory reform. Key concepts include:

Consider the hypothetical scenario in which all homeowners decide to refinance and extract cash from any accumulated house equity so that their loan-to-value ratio is kept the same as the one for a new purchaser of that house. Suppose that the refinancing market is so competitive, i.e., refinancing costs are so low and capital is so plentiful, that homeowners can implement this refinancing each month. In this extreme case, during periods of rising home prices and falling interest rates, cash-out refinancing has the same risk effect "as if" all houses had been purchased and their mortgages originated at the peak of the housing market, thereby creating a large systemic risk exposure. Then, when home prices fall, the refinancing ratchet "locks,'' causing a systemic event with widespread correlated defaults and large losses for mortgage lenders.
While excessive risk-taking, overly aggressive lending practices, pro-cyclical regulations, and political pressures surely contributed to the recent problems in the U.S. housing market, the simulations show that even if all homeowners, lenders, investors, insurers, rating agencies, regulators, and policymakers behaved rationally, ethically, and with the purest of motives, financial crises can still occur.
The fact that the refinancing ratchet effect arises only when three market conditions are simultaneously satisfied demonstrates that the current financial crisis is subtle, and may not be attributable to a single cause.
There may be no easy legislative or regulatory solutions: Lower interest rates, higher home prices, and easier access to mortgage loans have appeared separately in various political platforms and government policy objectives over the years. Their role in fostering economic growth makes it virtually impossible to address the refinancing ratchet effect within the current regulatory framework.
We need an independent organization devoted solely to the study, measurement, and public notification of systemic risk, not unlike the role that the National Transportation Safety Board plays with respect to airplane crashes, train wrecks, and highway accidents.
The subtle and multifaceted nature of the refinancing ratchet effect is just one example of the much broader challenge of defining, measuring, and managing systemic risk in the financial system.

Author Abstract

The confluence of three trends in the U.S. residential housing market—rising home prices, declining interest rates, and near-frictionless refinancing opportunities—led to vastly increased systemic risk in the financial system. Individually, each of these trends is benign, but when they occur simultaneously, as they did over the past decade, they impose an unintentional synchronization of homeowner leverage. This synchronization, coupled with the indivisibility of residential real estate that prevents homeowners from deleveraging when property values decline and homeowner equity deteriorates, conspire to create a "ratchet" effect in which homeowner leverage is maintained or increased during good times without the ability to decrease leverage during bad times. If refinancing-facilitated homeowner-equity extraction is sufficiently widespread—as it was during the years leading up to the peak of the U.S. residential real-estate market—the inadvertent coordination of leverage during a market rise implies higher correlation of defaults during a market drop. To measure the systemic impact of this ratchet effect, we simulate the U.S. housing market with and without equity extractions, and estimate the losses absorbed by mortgage lenders by valuing the embedded put-option in non-recourse mortgages. Our simulations generate loss estimates of $1.5 trillion from June 2006 to December 2008 under historical market conditions, compared to simulated losses of $280 billion in the absence of equity extractions. Keywords: Systemic Risk; Financial Crisis; Household Finance; Real Estate; Subprime. 68 pages.