Brad DeLong got me thinking a few days ago, and not in a good way, when he quoted the brilliantly (and brilliantly-named) Cardiff Garcia:
Thus far the surging mortgage origination business at banks has been concentrated in refinancing rather than purchases. The refi boom is great but can only last so long, as Dudley writes, and from a macroeconomic perspective has less of an impact than a housing purchase and construction rebound…
I’m thinking that rather understates the case.
There are at least two of us on this blog who have benefitted from recent refis. (I won’t out the other one, save to say they got better terms than I did.) In my case, the net savings in payments was about $700/month—not exactly chump change, unless you’re Tagg Romney.
But let’s follow the flows here, pretending that all transactions are with two banks for reasons that will be clear. My refinancing means that Bank A receives a lump-sum payout of the balance of my mortgage. But then they have to put that money to work—and they are not going to receive my old interest rate on those replacement loans (if any).
Bank B is receiving current market rates on the refi. So it’s new lending to them. But that’s neutralized on the supply, replaced by Bank A having “freed up” my old loan.
Similarly, on the demand side, my demand is satisfied—and my demand now is $700/month less than it was before.
So the S-D lines are stable for the assets—or even reduced due to the decline in demand. Meanwhile, the flows into financial institutions (assets to them) are reduced.
So if A = L + E and A is reduced, what happens to Liabilities?
If you assume standard economic theory, I save that $700. (Realistically, I spend it and someone else saves it, but the net savings in the economy still goes up $700.) That savings is a Liability, let us say to the Bank A.
Bank A’s Balance Sheet is now: Assets down $700/month, Liabilities up $700/months. To balance that equation, Equity has to go down $1,400/month.
Bank B has Assets up $700/month, Liabilities unchanged, and therefore Equity up $700/month.
Net for the system is that Assets are unchanged, Liabilities are up $700/month and Equity is down $700/month.
Ceteris paribus, refinancing reduces the inefficiencies in the banking system (the above-market asset valuation is replaced by an at-market asset). In doing so, it reduces Bank Equity and increases Bank Liabilities.
Unless lending to other sectors of the economy increases, refinancings that do not take cash (“equity”) out of the property appear to be contractionary.