Lots of different terms for it: Equity Stripping; Collateral Stripping; Liquefied Home Equity; all names for the process of a 'cash out' refinancing of a home when it generates money to invest elsewhere, usually in the stock market.
Not a new idea, but last week it hit the mainstream.
Jane Bryant Quinn, Newsweek's financial guru wrote her weekly column for the magazine's January 17 issue on 'The Bare Facts on Stripping, 'in which she set forth the pros and cons of the practice.
While Ms. Quinn brought it home to the general public, stripping has been on regulators' agenda for a while. The National Association of Security Dealers (NASD) was concerned enough about it in December 2004 to issue a cautionary notice to its members, and even earlier the Federal Reserve had weighed in with some warnings. And the regulators' concerns are not limited to stripping; also under scrutiny are some of the mortgage products used to facilitate it, such as 100 percent loans.
Collateralization stripping is not new. 'Google' the term and you will find several websites, most sponsored by law firms, which invite visitors to learn about and discuss ways to 'protect' their assets from lawsuits, limited partnership 'calls' and divorce settlements. Most of the methods appear to be perfectly legal, even if they seem to be heartless, slippery, or both.
The underlying idea is to make an 'on the books' asset such as a home, accounts receivable, even the 'goodwill equity' of a business essentially worthless by mortgaging or selling away its value and diverting the resulting funds into a less identifiable and attachable form ' an offshore bank account for example.
But in our context, Liquefied Home Equity, the term NASD prefers, is not sleazy, and may even be a sensible investment strategy. The concern of NASD and others is that it can be inappropriate, even dangerous, for some homeowners, and that many of them may not be informed of potential conflicts of interest when they are urged to pursue such a strategy.
Here is how it works. A homeowner, through regular monthly payments over a long period of time or because of skyrocketing home prices in a shorter period, may have built up substantial equity in his home. In certain markets, a 20 percent down payment five years ago may now have increased to as much as 50 or 60 percent equity.
That money, while it is measurable as part of the homeowner's net worth, is sitting idle. It is not earning interest, nor does it contribute anything to the homeowner's liquidity or lifestyle. There is real temptation to pull that equity out of the house and use it in a productive way.
And this temptation has led a growing number of homeowners to do exactly that. A recent Federal Reserve study found that, during the 2001-2002 period, the most recent studied, 11 percent of the total funds liquefied in mortgage refinancings were used for stock market and other financial investments. This was up from two percent for the 1998-1999 period. The amount of money liberated and used for investments during the more recent period averaged $24,000 compared to what was described by the Fed as a 'relatively small amount' during the 1998-99 period.
The Home Equity Line of Credit (HELOC) is a very popular mechanism for stripping. An equity line for $60,000 may cost the borrower nothing beyond $300 or so for an appraisal, and often banks even pick up that fee, until the money is actually drawn down from the loan. Spend the home equity on college tuition, home improvements, a second home, or buy stock in Microsoft, Merck, or Cisco. And the interest differential between a HELOC, sometimes only slightly above prime, and what one might earn in dividends or appreciation in the stock market can make this strategy even more attractive.
So, while the re-mortgaged home is busily building new equity as the value of residential property continues its unparalleled appreciation, the money stripped out will be generating a whole new stream of capital appreciation and income, which will, so the theory goes, cover the increased payments on a new mortgage or home equity loan.
Not necessarily a bad idea.
But, not necessarily a good idea either.
Quinn points out the dichotomy in her Newsweek article. To quote Ms. Quinn: 'I love the upside of stripping equity out of your home for investing, but the downside is grim.'
Should the stock market tank as it did five years ago, or if interest rates rise as they are predicted to do, or if the home appreciation bubble finally bursts, equity stripping can cost a homeowner the very roof over his head.
But how did NASD, empowered by the government to regulate the securities industry, get involved with home equity loans? Simple answer; member liability.
There have already been lawsuits involving NASD members by homeowners claiming substantial harm to their financial well being, even the loss of their homes, after they were convinced by investment brokers to refinance their homes to invest in stocks or bonds, an transaction from which, of course, the broker collects a commission. Some securities companies, such as Merrill Lynch and Smith Barney, also write home mortgages. Therein lies the possibility of a double dip ' a commission for the stockbroker who suggests the strategy and new business for the mortgage arm of the company. The stock broker may even earn a referral fee from the mortgage arm for suggesting the transaction.
So NASD issued, in early December 'Guidance' to its members about Liquefied Home Equity. The notice reminds NASD members that liquefying home equity to purchase securities might be inappropriate for some homeowners and that members should perform a careful analysis before recommending this strategy to their clients and customers and provide adequate disclosures regarding their own interest in such a transaction.
The Association stated it would not propose a specific, standardized risk disclosure document, but recommended that its members inform investors with specific information about risks and conflicts of investing equity proceeds. Among the risks specified in the NASD document are: the potential loss of one's home; that the (NASD) member, unlike a neighborhood bank or a mortgage company, may have an interest in having proceeds of the loan used for investments, and that the member or its affiliates might actually earn fees in connection with originating the loan. Customers should also be advised, NASD said, of the impact a liquefied home equity might have on a homeowner's ability to refinance or even sell his home and that any decline in home values might result in a home owner having negative equity in his home.
We will try, in the next few weeks, to revisit this topic and put some hard numbers to the concept of equity stripping. As Ms. Quinn pointed out, it has a lovable upside, and a very grim downside.