It stands to reason that when you suck the equity out of your home, you’re making yourself more vulnerable to going underwater on your mortgage or defaulting should the market go south in a hurry.

Surely that’s low on the list of concerns to the millions of homeowners would have been taking advantage of the never ending decline in interest rates.  No one expect that will actually happen.  Except that until it did in 2006-2007 and some five to six million families lost their homes to default and foreclosure.  No one knows how many of those could have been saved if they hadn’t cashed out equity at that time.

Conversely, restricting access to equity is an increasingly popular notion to protect against future foreclosure floods. Now an economist at the Federal Reserve Bank in Dallas has produced new evidence that shows just how effective restricting leverage can be in preventing mortgage defaults. His paper confirms many of the findings in previous studies that have shown a positive relationship between negative equity and default. However, it goes a step further by measuring the effect of a state government policy that placed explicit restrictions on home equity withdrawal.

Both theory and empirical evidence suggest that more impatient individuals tend to borrow more and are more likely to default on their debts. Thus, it might simply be the case that more impatient borrowers who are less likely to repay any type of debt choose to put less money down and extract more equity over time, creating the observed correlation between negative equity and the propensity to default.

Do home equity restrictions cause lower default rate?

The research focused on a policy enacted in the state of Texas that placed severe restrictions on the extent of home equity withdrawal. The Texas constitution, enacted in 1876, actually prohibited home equity withdrawal. The prohibition was eventually lifted in 1997 and the restrictions were further relaxed in 2003, but even in the post-2003 period, Texas law placed serious limits on equity withdrawal, which remain in effect today.¹ Subsequent to purchase, a borrower cannot take out more than 50 percent of the appraised value of the home, nor exceed 80 percent of total loan-to-value (LTV). For example, if a borrower owned a home worth $200,000 and had an outstanding mortgage balance of $140,000, the borrower would be allowed to take out only $20,000 in a cash-out refinance. It is important to note that this LTV restriction does not bind at the time of purchase, so a homebuyer in Texas could take out a zero-down-payment loan, and thus begin the homeownership tenure with an LTV ratio of 100 percent.

At first glance, the data suggest that such a sentiment may be correct. The data is certainly compelling and suggests that the home equity withdrawal restrictions in Texas had an important effect on default behavior, but a simple comparison of aggregate default rates across states really doesn’t tell us whether the policy had a causal impact on behavior. There could be other differences between Texas and its neighboring states that are driving the differences in default rates. For example, house price volatility over the course of the boom and bust was significantly lower in Texas compared to the rest of the country, which could also explain the differences in default rates that we see in the figure.

But is it a good policy?

The paper appears to confirm what previous research on the relationship between equity and mortgage default has found. However, it doesn’t mean that such a law change is necessarily good policy. While it seems to be effective in reducing defaults, it may also have some real costs. The most obvious one is the decrease in the volume of low-cost secured credit that many borrowers used to improve their circumstances during the housing boom. An unintended consequence of the policy might have been to push financially distressed households into higher-cost credit markets like credit cards or payday loans. A second drawback of the policy may have been that it increased homeowner leverage at the time of purchase. As there were no restrictions on LTV ratios at the time of purchase, many homebuyers may have decided to make lower down payments, knowing that their access to equity would be restricted in the future. It’s also possible that this may have resulted in a larger volume of subprime mortgage lending in Texas. Households with relatively high credit scores who could have obtained a prime mortgage with significant down payments (say, 20 percent), may have turned to the subprime segment of the market, where they could obtain loans with low down payments but with much more onerous contract terms.

While it’s not clear whether the actual Texas policy of restricting home equity extraction is welfare-improving, it might seem from the research that restricting borrower leverage is an effective way to reduce mortgage default rates. But limiting borrower leverage is very unpopular. After all, it is perhaps the only policy upon which both the Center for Responsible Lending (CRL) and the Mortgage Bankers Association (MBA) share the same negative view. Thus, while such policies have been adopted in other countries, don’t expect to see them adopted in the United States any time soon.