HELOC interest deduction goes away under Republican tax "reform": Expect loan consolidation

You know the one, the one you take to help buy a car, fund tuition, or actually fix up the house.

When the credit card interest deduction went away under Ronald Reagan, consumers opened up Home Equity Lines of Credit in response, the interest on which was deductible. Now that HELOC interest deductibility is going away, expect those HELOCs to be refinanced under new first mortgages to recapture that.

Also expect this to impact consumer spending, negatively.

Reported here:

Individuals who take out home equity loans will no longer be able to deduct that interest under the new bill.

The Banks Own 32% Of The Stock Market, Households 37%

This Bank of America chart from July 2012 seen here shows bank ownership of the equity markets at 32% in Q1 2012, a stunning number rivalling the household sector's share of 37%. In 1950 households (an elastic category including much more than simply retail investors) held roughly 90% of the market in their hands (admittedly far fewer retail investors than today, but that's another story).

So you've got to ask yourself why ultra cheap loans to banks by the Federal Reserve have gone into markets in such spectacular fashion? To help them recapitalize after the housing implosion, that's why. Banks can't make money the old fashioned way anymore because the owners' equity of household real estate of consumers is down to about 45% (it had sunk as low as 39% in 2010 and 2011), a decline of over 45% since 1950. Think cash-out-refis at artificially low interest rates and HELOCS and the housing market collapse. The banks are left holding the bag, or the Feds are, on 5 million repossessed properties in the last seven years, leaving a huge capital hole in their off-balance-sheet balance sheets. Having plundered John Q. Public by selling him the rope he hung himself with (HELOC reform 1986 Tax Reform, Taxpayer Relief Act of 1997 2-Year Rule on Sale of Principal Residence, Repeal of Glass-Steagall 1999), the government-banking cartel has had to look elsewhere for profits. They're finding them.

Care to buy stocks? 

Home-Owners' Equity Hollowed Out After 1986 Tax Reform

Did the 1986 tax reform unintentionally contribute to the hollowing-out of home-owners' equity?

It sure looks like it from the graph I've created below, which is compiled from the Fed's z.1 Flow of Funds releases which I've systematically reviewed from the latest release on June 7 all the way back to December 11, 1997.

In exchange for the elimination of a tax loss expenditure important to American consumers, Americans were treated in the '86 reform to lower top marginal income tax rates which fell as low as 28 percent for a brief time under President George Herbert Walker Bush between 1988 and 1992. Unfortunately for them, however, Bill Clinton came along and did away with those low marginal rates, and raised taxes. But Americans never got back the tax loss expenditure to which I refer.

What was it?

Deductibility of interest from revolving credit. You know, credit card interest and the like.

As a compromise, however, the law was structured in such a way as to expand the scope of HELOCs, home equity lines of credit, so that Americans could deduct larger amounts of interest on their taxes from those vehicles, treated pretty much the same as the mortgage interest deduction, the home improvement loan interest deduction or the second mortgage interest deduction. It was a financial innovation which shifted revolving spending on credit cards to these expanded equity lines so that it became fairly routine to buy even cars with home equity when interest rates were low, and all kinds of other stuff. You know, college tuition, that memorable vacation to Acapulco . . . and that condo you bought as an investment property. And some people actually used their HELOCs to improve the primary dwellings they were drawn on. But most of it was pretty imprudent, even though the intention was right in shifting spending from unsecured credit to secured credit.

We call it now "amortizing spending". It's really dumb to finance spending this way because you have nothing to show for it at the end of the term, unless the spending is on an asset which retains value. (If only we could get government to do this, but that's another horror story altogether. Government doesn't just finance spending and have nothing to show for it, it never pays it off. So in addition to blowing dough, it pays for it without a termination date, which means it pays forever.)

When the bottom fell out of real estate starting in 2007, for the first time since 1986 the total value of the real estate of households declined, from the all-time high of $22.731 trillion in 2006 to $20.861 trillion in 2007. That's an 8 percent decline in one year. By 2011 the metric had fallen all the way to $16.05 trillion, almost 30 percent down, with owners' equity bottoming out at $6.231 trillion, a level last reached sometime in the year 2000.

The data show that there have been two periods of the hollowing-out, one from which we recovered and one in which we still find ourselves. In the first, the dollar value of the equity recovered even though the percentage of equity relative to total value did not. In the second, both the dollar value of the equity and the percentage of equity relative to total value have failed to recover.  

In 1990 owners' equity started to fall from $4.274 trillion the year before to $4.097 trillion in 1991, a decline of just 4 percent. But it took all the way until 1996 for owners' equity to exceed that level which it had achieved in 1989. It's pretty clear that Americans financed themselves through the recession of these years under Bush 41 and Clinton in part by using home equity. Even though home values continued to increase, owners' share of equity declined from 66 percent in 1989 to 56 percent in 1994, at which level it stabilized.

Owners' equity continued to climb in dollar terms from 1996 all the way through 2005 when it reached its zenith at $13.158 trillion, but as a percentage of total value owners' equity remained fairly stable in a range between 56 percent and 59 percent. The dollar decline from the zenith in 2005, however, to $6.231 trillion last year represents a whopper of a decline in owners' equity, nearly 53 percent, much larger than the 30 percent decline in the over-all values themselves.

I'll leave it to others to figure out just how much of this nearly $7 trillion has been simply lost from the balance sheet and how much was extracted to help people get themselves through this Bush/Obama depression, but you get the idea. America's forced savings in the form of home equity was coaxed out by financial innovation brought to you by politicians intent on reforming the tax code. And, of course, they did this with the help of private sector actors who profited from the operation. 

Americans might want to think harder about it the next time politicians come promising lower tax rates in exchange for a similar thrilling game of tax reform Russian Roulette. Think the mortgage interest deduction itself, which many Republicans and libertarians today want to end. I think it's easy to imagine from recent history how we might be persuaded to give up the mortgage interest deduction today in exchange for lower tax rates which some future government will only end up raising just like Clinton did, at which time we'll be out both the lower rates and the deductions which offered us some protections from the greedy spending bastards who populate both political parties.

The great achievement of the debacle of the 1930s was amortizing mortgages over 30 years, forcing Americans to save in the form of owners' equity. The debacle of the late 20th century was letting politicians convince us it was time to spend it.      

Create a graph

HELOC Required Payments Are Set To Explode Between 2012-2018

Today, just $11 billion in home equity lines of credit require both principal and interest payments. By 2018 the number will be ten times that, $111 billion.

The four biggest banks alone hold HELOCs with credit lines approaching $300 billion.

Gretchen Morgenson has many of the details at The New York Times, here.

It is unclear from the story just how many first mortgages already underwater also have HELOCs. It is widely estimated that 25 percent of firsts are underwater. Add HELOCs on top of any of those and both lenders and borrowers are back in a world of hurt, as if they had actually gone anywhere but the purgatory we now inhabit.

Remembering the $Trillions Withdrawn from the Housing ATM

Boy, don't we wish we had those back today.

Consider The Washington Post, May 30, 2007, here:

According to Fed data, homeowners' equity -- the value of their homes minus mortgage debt -- grew to nearly $11 trillion at the end of [2006], or double the value at the end of 1998. ...

[T]he housing boom ... fueled spending directly by turning homes into cash machines. As prices rose and interest rates fell, Americans extracted trillions of dollars in extra cash through home sales, mortgage refinancings and home equity loans.

Homeowners gained an average of nearly $1 trillion a year in extra spending money from 2001 through 2005 -- more than triple the rate in the previous decade -- according to a study by former Federal Reserve chairman Alan Greenspan and Fed economist James E. Kennedy. That's the "free cash," as the authors call it, left over after closing costs and other fees deducted from equity withdrawals.

Most of the money extracted during those boom years, nearly two-thirds, came from home sales, the authors found. Another 21 percent came from home equity lines of credit, while 15 percent came from mortgage refinancings.

About a third of the free cash gained during this period was used to buy other homes, they calculated. About 29 percent was used to acquire stocks and other assets. About 12 percent went to home improvements. And nearly a fourth, 23 percent, went to consumer spending, including paying credit card bills and reducing other non-mortgage debts.

Translated into dollars, a trillion dollars a year for five years over 2001 through 2005 is $5 trillion nominal in extra spending money, nearly a quarter of which, $1.15 trillion, was simply blown. Some people literally ate it, drank it, and danced the night away with it. If the study is correct, the extra spending money in the 1990s from our homes came to an additional $3 trillion. I can only guess about the 1980s, but even if only $1.5 trillion, this means Americans have easily extracted almost $10 trillion from home equity over the course of 30 years.

A review of the latest Federal Reserve data here shows that net worth of owners' equity in household real estate has fallen $7 trillion just since 2005. Falling from $13.2 trillion in 2005 to $6.2 trillion as of the end of Q2 2011, this is a decline of 53 percent. This metric pretty perfectly mirrors the bubble in housing which began in earnest in 1997, coincident with the change in the tax law permitting capital gains tax free every two years up to $500K with conditions. Except that the measure hasn't yet quite reached what it was in 1997. We're still about a trillion dollars shy of that mark in nominal terms.

Total real estate valuation over the same period has fallen less, from $22.1 trillion to $16.2 trillion, or 27 percent. But equity as a percentage of value has fallen more than valuation, 35 percent.

A longer term chart of the latter phenomenon found here shows that since 1980 home equity as a percentage of value has been under constant pressure, most probably from what is called portfolio shifting, debt expenditures from car loans and credit cards, college tuition, stock investing and second, third and fourth home investing piling into HELOCs, 2nds, refis and the like. The interest on all that stuff before 1986 was tax deductible in its own right, but after Reagan's famous tax reform, deductibility was restricted to interest from home equity loans and lines of credit only. That arrangement was formalized at levels up to $100K in 1987, precisely after which as shown in the chart the decline in owners' equity commenced with new vigor. So people who could financed everything they could through HELOCs, cash out refinancing and the like in order to continue to be able to deduct the interest expense on their tax returns.

As a result of this and the collapse in the real estate bubble, today we are faced with the dramatic all time low of 38 percent in owners' equity as a percentage of value, a decline of nearly 47 percent since 1982.

Just think how much better off we would be today if we hadn't tapped all that equity over those three decades, especially in inflation-adjusted terms. We truly have been the squanderers.

So present household real estate valuation at $16.2 trillion represents a level last seen in 2003 in nominal terms. But adjusted for inflation, that's $13.7 trillion, which was actually the total nominal value of household real estate last seen in 2001. To get to the pre-bubble valuations of 1996, today's number would have to fall yet further to $11.8 trillion.

In other words, to erase completely the effects of the bubble on valuations, adjusted for inflation, would imply that total real estate valuation would need to fall another 27 percent from here, or $4.4 trillion.

The American dream nightmare.

The Big Fat Idiot Establishment Republicans Like Rush Limbaugh Won't Replace Your Tax Deductions

When deductibility of interest expenses in a wide variety of vehicles was eliminated for income tax purposes in the tax reform act of 1986 under Ronald Reagan, those deductions ended up being replaced by deductibility of interest if incurred through HELOCs (home equity lines of credit) shortly thereafter.

Deductibility of interest expense on consumer loans, car loans and credit cards went the way of the dodo, only to be shifted to HELOCs. It was a fateful decision which made overleveraging of housing as routine as taking out the trash. But that's an entirely different kettle of fish.

In 1987 Congress quickly acted to expand deductibility of HELOC interest expense because the 1986 act cut people off at the knees and they didn't like it one bit. It was a consumer society accustomed to deducting credit card interest, and it didn't like the new rules at all. The 1986 act quickly proved to be a futile attempt to curb consumer spending and encourage savings. The political fallout was so great that the interest expense from HELOC borrowing was dramatically expanded to fill the gap the next year.

I quote from The New York Times, here, February 2, 1988:

BORROWINGS AGAINST EQUITY: In addition, homeowners will be allowed to claim mortgage deductions for up to $100,000 in borrowings against the equity in their house - no matter what the loan is used for. 

A veritable chorus of voices today on the right and left, including Rush Limbaugh who is simply phoning it in these days, is appealing to this period to urge the country to get behind a Republican Super Committee plan to raise revenues by closing loopholes like the mortgage interest deduction for wealthier taxpayers, "just like we did in 1986."

Oh yeah? What's in it for us?

Once the camel gets its nose under this tent in the name of making the rich pay more, you can bet the precedent will be used down the road to deprive the middle class also of the deductibility of interest on a home mortgage.

And you'll get nothing to replace it except an empty promise to lower your overall tax rate, which the next Congress will rescind in a heartbeat. Few of you remember that the top tax bracket from 1988 to 1992 was 28 percent. Bill Clinton and the Democrats made short work of that.

Real conservatism is about using federal tax policy to promote property ownership, ordered existence and family formation. The current crop of establishment Republicans, including Rush Limbaugh, is a bunch of phonies. Rush can't even remember 1986:

The Republicans are offering a plan which would take away itemized deductions for anybody making over $174,400 a year. In exchange for that they would lower the top tax rate from the current 35 down to 28%. We've done this before. We did this in 1986. This was part of Reagan tax reform except the top marginal rate then was 50. Wait a minute. No. All itemized deductions for people who make the... Stick with me on this. All itemized deductions for everybody who makes $174,000 or more -- home mortgage interest, charities, all of that, gone in exchange for a lowered rate from 38, 28%. Now, we've done this before.  Back in 1986, top rate was 50, took it down to 28, there was a bubble of 31 percent for few people, and we got rid of some deductions.

There will be no future America without the traditional family.

Too bad Rush Limbaugh has never had one.

Unemployed? To Megan McArdle You're Just A Depreciating Asset

Here:

"Human capital is like almost any other form of capital: it is a depreciating asset."

In other words, your worth as a human being is purely economic.

Megan may have a job, but it masks a poverty of soul which lies at the heart of America's problems, where everything is fungible, including your house, and now you.

Want a vacation? Write a check on your HELOC account. Pregnancy inconvenient for your career? End it. Old people cost too much to take care of? Withhold food and water. 14 million unemployed?

"[W]hat are we going to do with all these people?"

Why, liquidate them, of course, like any other asset.

Anyone who will do anything for a job will do . . . anything.

Save your self. 

The Nation Rips Bill Clinton a New One for Enabling Financial De-Regulation Under Gingrich

An argument, here, with which we happily agree, except there's no discussion of the de-regulation of the homeowner, who, since 1997, has been able to forego taxes on up to $500,000 of gains on the sale of a principal residence every two years.

Smart couples plausibly have been able to milk this provision very profitably by flipping homes up to five times since then, until everything fell apart in 2008.

And don't forgot all those HELOCs whose capital was misallocated to financing automobile purchases, vacations, and other consumption not even remotely having to do with "home improvement."

The current housing debacle shows among other things, as Chris Whalen has suggested, how the entire post-war commitment to housing was a giant, civilizational misallocation of capital. More than anything, it was a failure of a sentimentality which developed in the wake of the de-moralization which forever destroyed the naivete of a nation. The de-regulation of the financial industry at the end of that road was only the logical conclusion of this process, its final outworking, not its cause.