Wither the Equity Cushion

Who knows, maybe this week's posts will have a common theme too - last week it was movies, so far this week it's retrospectives. Yesterday the "incredible shrinking dollar" talk of two years ago was recalled and today the idea of "equity cushions", popularized during the height of the housing boom last year, are the subject of discussion.

You don't hear too much about "equity cushions" anymore.

It was just over a year ago when the term was first stumbled upon here. It had been used judiciously by Federal Reserve officials and others in the latter part of 2005 when falling home prices were still just a twinkle in the eyes of housing bubble bloggers.

At the time, the mainstream media still anxiously awaited every word that outgoing Fed Chairman Alan Greenspan uttered, such as "froth" sightings in local housing markets (the mainstream media has a decidedly different take on the old man's work today).

As the story goes, back in the first half of the decade, rising property values had created an "equity cushion" for nearly all homeowners. A cushion that would protect homeowners from many ills including the adverse effects of falling home prices, that is, in the hypothetical case where prices might actually decline.

A website for real estate agents has an interesting definition of the term:
Hmmm...

As most people probably no longer keep up with the latest in neighborhood home price trends (kind of like looking at brokerage statements in 2001), many homeowners probably don't even know their equity cushion is now withering away.

In the Beginning

As it relates to the housing boom, the term "equity cushion" appears to have its origins in this speech by San Francisco Fed Governor Susan Schmidt Bies in April of last year.

Another concern is that house prices will reverse and erase a considerable amount of home equity built up in recent years. Recent gains in house prices have been notable: the average house price rose 11 percent in 2004, and cumulative gains since 1997 now top 65 percent... It is true that some households have considerably less equity in their homes, and these households tend to have lower income and fewer other financial assets to cushion shocks.

This address by Fed Chairman Greenspan last September appears to have formalized the term, defining both its size (sizeable) and its primary usage (absorbing declining home prices).

In summary, it is encouraging to find that, despite the rapid growth of mortgage debt, only a small fraction of households across the country have loan-to-value ratios greater than 90 percent. Thus, the vast majority of homeowners have a sizable equity cushion with which to absorb a potential decline in house prices.

Shortly after the Fed chairman's comments above, Ms. Bies was again at it with this speech.

Despite the apparent decline in underwriting standards, less than 5 percent of outstanding mortgages have a loan-to-value ratio greater than 90 percent, which means that the vast majority of homeowners have a significant equity cushion; in the event prices fall, only a very small percentage of owners are likely to see their debts exceed the value of their homes.

At about that same time last year, the story of Ms. Rodriguez and her equity cushion showed up in the LA Times. In the post "Equity Cushion Possibilities", alternatives to the rosy scenario of perpetual equity cushion inflation were considered (Oops! Almost forgot - rising house prices don't count as inflation).

How Times Have Changed

Today there is a real problem with the "cushion" metaphor for home equity - a problem that is only seen when the amount of home equity changes from a positive number to a negative one, as is the case for many 2005 home buyers.

Earlier this morning it was learned that median home prices are down 3.5 percent nationally from year ago levels. In some parts of the country, prices are down ten percent or more from this time last year and given the lax lending standards in recent years, where many homebuyers put no money down, many new homeowners are "upside down" today.

The problem with "equity cushions" is that once the amount of home equity passes from positive to negative, the metaphor fails. In the case of zero equity, a flat seat cushion presents the proper picture. What was once a comfortable spot for someone's derriere is now a hard flat surface, inflexible and unyielding to the shapes and contours that are placed on it.

Uncomfortable, but not problematic.

But, for the case of negative home equity, how can more stuffing be removed from the "cushion" than the cushion had to begin with? Further, what would happen if you sat on an "equity cushion" that was in this condition?

When market forces or financial innovations such as mortgage equity withrawal have caused the removal of more stuffing than the cushion contained, a physicist might argue that the stuffing has to come from somewhere. Maybe parts of the chair become transformed from wood into stuffing causing the chair to become less stable - less likely to support the weight that it used to.

Who knows.

Another metaphor is clearly needed - equity cushions are so "2005".