The Lone Star Secret
It’s one of the great mysteries of the mortgage crisis: Why did Texas—Texas, of all places!—escape the real estate bust? Only a dozen states have lower mortgage foreclosure and default rates, and all of them are rural places like Montana and South Dakota, where they couldn’t have a real estate boom if they tried.
No, Texas’ 3.1 million mortgage borrowers are a breed of their own among big states with big cities. Just less than 6 percent of them are in or near foreclosure, according to the Mortgage Bankers Association; the national average is nearly 10 percent. Texas might look to outsiders an awful lot like Sunbelt sisters Arizona (13 percent) or Nevada (19)—flat and generous in letting real estate developers sprawl where they will. Texas was even the home base of two of the nation’s biggest bubble-era homebuilders, Centex and DR Horton.
Texas subprime borrowers do especially well compared with counterparts elsewhere. The foreclosure rate among subprime borrowers there, at less than 19 percent, is the lowest of any state except Alaska. Part of the state’s performance is due to the fact that Texas saw nothing like the stratospheric home-price run-ups other states experienced. On average, the 20 metro areas in the Case-Shiller Home Price Index saw their home-resale prices peak in 2006 after more than doubling since 2000. In Dallas, one of the 20, they went up just 25 percent, gradually, and have barely declined.
But there is a broader secret to Texas’s success, and Washington reformers ought to be paying very close attention. If there’s one single thing that Congress can do now to help protect borrowers from the worst lending excesses that fueled the mortgage and financial crises, it’s to follow the Lone Star State’s lead and put the brakes on “cash-out” refinancing and home-equity lending.
A cash-out refinance is a mortgage taken out for a higher balance than the one on an existing loan, net of fees. Across the nation, cash-outs became ubiquitous during the mortgage boom, as skyrocketing house prices made it possible for homeowners, even those with bad credit, to use their home equity like an ATM. But not in Texas. There, cash-outs and home-equity loans can’t total more than 80 percent of a home’s appraised value. There’s a 12-day cooling-off period after an application, during which the borrower can pull out. And when a borrower refinances a mortgage, it’s illegal to get even $1 back. Texas really means it: All these protections, and more, are in the state constitution. The Texas restrictions on mortgage borrowing date back to the first days of statehood in 1845, when the constitution banned home loans entirely.
“Delinquency and foreclosure rates are significantly lower in Texas,” boasts Scott Norman, the president of the Texas Mortgage Bankers Association. “The 80 percent loan-to-value limit—that’s the catalyst for a lot of this.”
Research from the Federal Reserve Bank of Dallas backs Norman up. Texas’ low-ish unemployment rate, 8.6 percent, is a help. But so is the fact that fewer Texans took cash out of their home equity than did borrowers in any other state—and took out less when they did. The more prevalent cash-out refinances are in a state, the more likely it is that mortgage borrowers there will run into trouble. For every 1 percentage point increase in its share of subprime mortgages that are cash-out refinances, the likelihood of foreclosure in that state goes up by one-third of a percent.
During the boom, cash-out refinancings were the unofficial currency of bubble states from Florida to California, beloved by mortgage brokers as a way to persuade existing homeowners to take out new loans repeatedly. As home values surged, the sales pitch was a slam-dunk: Borrowers could refinance their homes at extremely low interest rates, and based on newly reappraised property values get more cash in their hands than they might earn in a year. Sure, these were teaser rates that would adjust upward after two years, but brokers routinely assured borrowers they could just refinance again before that happened.
Subprime cash-out refinancings became a standard way for borrowers drowning in credit card debt to pay it off, boost their credit scores so they could qualify in a few months to refinance into a lower-rate prime mortgage, and get a big tax deduction in the bargain. Ex-New York Times Federal Reserve reporter Edmund L. Andrews recounts in his underappreciated book Busted how he conjured $50,000 this way via a mortgage from Fremont Lending & Investment.
Homeowners and mortgage brokers weren’t alone in their addiction to the cash that flowed from homes-as-ATMs. The entire U.S. economy was right there with them. One of Alan Greenspan’s lesser-known contributions to the annals of the credit crisis was a pair of studies he co-authored for the Fed, sizing up exactly how much Americans borrowed against their home equity in the bubble and what it was they were spending their newfound (phantom) wealth on. Greenspan estimated that four-fifths of the trifold increase in American households’ mortgage debt between 1990 and 2006 resulted from “discretionary extraction of home equity.” Only one-fifth resulted from the purchase of new homes. In 2005 alone, U.S. homeowners extracted a half-trillion-plus dollars from their real estate via home-equity loans and cash-out refinances. Some $263 billion of the proceeds went to consumer spending and to pay off other debts.
As home prices skyrocketed in many markets, cash-out refinancings became standard, even in the relatively sober world of Fannie Mae and Freddie Mac. By 2006, Freddie Mac reported that 88 percent of refinance mortgages that it purchased were for amounts at least 5 percent higher than borrowers’ previous loan balances. Subprime, in insane pursuit of risk, piled on with cash-out refinances for high-risk borrowers, often approaching the entire appraised value of the home.
But not in Texas. A borrower there can secure a home-equity line of credit from a bank. And she can refinance her mortgage or take out a home-equity loan. But the total amount of debt on a home cannot exceed 80 percent of its appraised value, and any proceeds cannot be used to pay off other debts.
Until 1998, Texans couldn’t take out home-equity loans at all. The roots of this fierce resistance to debt’s temptations go deep in Texas history. Seven years before the republic joined the union in 1845, a bank panic and resulting foreclosures lost many homesteaders their property. Drawing from Mexican codes protecting landholders—much beloved by flocks of U.S. debtors who had taken refuge from creditors by relocating to Texas homesteads—the new constitution of the state of Texas forbade lenders from peddling mortgages to homesteaders.
There are reasonable exceptions to the constitution’s restrictions on home-mortgage borrowing. Starting in the 1870s, homeowners could take out mortgages to buy a home, or pay for improvements or property taxes. And once a homeowner has paid down debts below 80 percent of a home’s value, they can borrow against that.
What the rest of us can learn
Not everyone loves the state’s rules. Financial services companies have periodically lobbied to scale back the restrictions on home-equity borrowing, noting that the costs of compliance increase borrowers’ interest rates. But another reason the loans are more costly is that the Texas rules are unique in the nation, giving borrowers less opportunity to shop around.
As Texas is now discovering, increased costs are a small price to pay for one of the lowest foreclosure rates in the country. The home-equity restrictions have not only helped keep cash-out refinances a rare breed in Texas; other risky mortgages were scarce there, too. The home-equity borrowing restrictions helped keep home prices from overinflating, and homebuyers therefore didn’t need to turn to exotic mortgages with features like 2/28 ARMs, interest-only payments, or negative amortization in order to purchase a home. Even when they did, Texas law requires these risky features to be clearly disclosed. Fewer than 20 percent of Texas subprime mortgages included any of them.
That’s not to say that Texas borrowers didn’t get into bubble trouble. Plenty bought overpriced houses, which is why 1 in 8 Texans now owe more than their home is worth. And it was easy enough for lenders to get around the home-equity borrowing limits by using creative appraisals that pretend a home is worth more than it really is. But the casualties are orders of magnitude less than they would have been without the home-equity limits.
Despite these advantages, Texas-style brakes on home-equity withdrawals are not likely to get a welcome reception in Washington. For starters, they’re out of bounds for the proposed consumer agency now under consideration on the Hill. Both the House and Senate versions of the financial reform bill follow a ground rule straight out of the Obama administration’s financial reform blueprint: The agency can only take action on a product or practice when it determines that the harm the practice causes to consumers isn’t outweighed by benefits to consumers “or to competition.” This narrow lens allows lenders to argue, credibly, that their home-equity loans are a boon to consumers, who benefit from ready access to home equity. It’s only in the long term, and the big picture, that the terrible tradeoffs become clear.
Economists at the Fed and Treasury are no more likely than Congress to entertain cutting off the tap that until now has kept consumer spending flowing, just when the economy desperately needs that jolt. But the truth is that plummeting home prices have sucked the mortgage equity withdrawal well dry. Mimicking Texas would be the perfect opportunity to get our home-equity debt addiction under control and learn to live as an 80 percent nation.