You don’t hear too much about equity cushions anymore, that term popularized by the Greenspan Fed five or six years ago as they marveled at the rapid increase in housing prices and wondered (just a little bit) what a reversal might lead to. Back around the middle of the last decade, the  consensus within the central bank was that homeowners had sufficient equity in their homes to prevent anything really bad from happening.

Obviously, they were wrong, and the debate continues about who should be blamed for the near collapse of the global financial system, central bank economists still denying any part played by low interest rates. While most economists dare not criticize the Fed for fear of a stunted career (an act akin to underlings criticizing the Pope), others have been pointing to low short-term interest rates as one of the proximate causes for our current troubles, the latest being this article by Heleen Mees about how interest rates factored into the home equity “extraction” craze that was all the rage here in the U.S. just a few short years ago.

In recent research (Mees 2011), I show that the Fed’s easy monetary policy, rather than the housing boom, as asserted by Taylor (2007), sparked the refinancing boom. While mortgages for purchase do not respond significantly to changes in the fed funds rate but instead to changes in long-term interest rates, I find that mortgages for refinance are significantly responsive to both changes in the fed funds rate and changes in long-term interest rates, especially so in the period 2000 – 2008. Between Q1 2003 and Q2 2004, the time when the FOMC held the fed funds rate steady at 1%, two-thirds of all mortgage originations were for home refinance.

Spending money that had been raised through home equity extraction – or remortgaging – amounted to more than 4% of GDP in 2005. From the FOMC transcripts in 2003 and 2004, it emerges that the FOMC in general looked favourably upon home equity extraction as a source of personal consumption expenditure. In his 2005 Sandridge lecture, Bernanke boasted of the depth and sophistication of the country’s financial markets that allowed households easy access to rising housing wealth. The possibility that the housing boom could one day turn to bust, leaving many homeowners in negative equity, seems not to have set off any alarm bells at the Federal Reserve.

Mees goes on to make a number of other points and provides a few charts in support, all of which seem to make a good deal of sense. When you could take out a HELOC and pay, say, $50 a month to service an extraction of $50,000, this can act on a powerful drug  to those who thought they’d never really have to ever pay the money back, a good number of these types taking that home equity and using it to go out and buy a second home, or a third.