The Mortgage-Refinancing Boom and the Consumer Confidence Game

We like to think of the ups and downs of the economy working in a synchronous way, the peaks and troughs clearly defined. But of course that isn't how it works at all.

Instead, it's much more of a jumble. Ohio may be skirting recession while Wisconsin is growing much too fast. Wheat is up, pork bellies are down, specialty steel makers are hiring, iron mines are cutting back. And this is important to remember during this time when the Federal Reserve is cutting interest rates. There's an old saying about how rate cuts work with a lag, and that's true if you're talking about the economy at large. But there are areas of the economy that respond right away.

Since the Fed's first easing in January there has been a boom in mortgage refinancing, with many homeowners taking advantage of lower rates to cut their monthly payments. The Mortgage Bankers Association's refinancing index has climbed more than threefold and is at its highest level since October 1998. The sharp rise in refinancing activity could lead to some areas of the economy recovering much more quickly than Wall Street expects.

Spending Money

By refinancing the mortgages at a lower rate, homeowners reduce monthly payments, leaving more free cash for other items. Some choose to speed that free cash to their wallet with what's called a "cash out" refinancing, increasing the amount of their loan. About one-third of the homeowners that refinanced in the 1998-1999 refinancing boom did that, according to a recent Fed study, raising $54.5 billion. With homeowners again heading to the refinancing till, there are a lot of people with more cash on hand than they had just a couple of months ago.

Whether extra money will burn holes in their pockets, however, is an open question. The U.S. savings rate turned negative in the middle of last year -- people have been spending more than saving -- and it's possible that many consumers will use the money they got from mortgage refinancing to help shore up their finances.

"If consumers have reliquified their balance sheet, then refunding can help," says one portfolio manager. "But that hasn't really happened yet, so refunding may not have the same impact as in the past. I'm still on the side that's skeptical that consumers are going to come back a week from Sunday."

Worries over the future may also limit homeowners' readiness to put their new funds to work. Consumer confidence levels have dipped much lower than in the fall of 1998, when worries about fallout from the Russian debt crisis were much more profound on Wall Street than on Main Street.

"The whole question is how confident people are," says Merrill Lynch chief quantitative strategist Rich Bernstein. "If they're less confident and they get a little cash flow, they'll probably hoard it."

Turning It Around

But will they hoard all of it? Will they put every cent of mortgage refinancing funds toward putting their finances back in order? Perhaps they would if humans were perfect financial robots, balancing every spending decision carefully, only paying for what is really needed, never buying any scotch. That's just not the way it works, however. To some unknown degree, some of the money from refinancing is going to get spent. "It's not going to be a major force in turning the situation around," says Chase Fleming Asset Management chief market analyst Don Fine. "But at the margin, this helps."

Something that helps the whole economy at the margin, however, may be helping specific areas of the economy greatly. According to Fed-sponsored surveys, homeowners put the largest portion of the money they got from cash-out refinancings in late 1998 and early 1999, some $18 billion, toward home improvements.

"When you refinance, you remodel your home," says Salomon Smith Barney homebuilding analyst Stephen Kim. Of the companies he follows -- a group that includes everything from homebuilders like Toll Brothers (TOL Quote) to hammer-makers like Stanley Works (SWK Quote) -- Kim reckons that home-improvement product manufacturer Masco (MAS Quote) is the most likely to benefit from the refinancing boom. (Kim lowered his rating on Masco to hold from buy in early January after the company warned on fourth-quarter earnings. Salomon Smith Barney has done underwriting for the company.) Other obvious beneficiaries of the refinancing boom are companies like Home Depot (HD Quote).

Though buying these companies' stock just because there's a lot of refinancing going on is not necessarily a sound idea -- Masco obviously has had some issues and Home Depot, too, recently warned on earnings, as did its largest competitor, Lowe's (LOW Quote) -- watching how they're doing to get a bead on how the consumer at large is doing probably is. If business begins to improve markedly, that will be a good sign that homeowners are again putting a good-size chunk of the money they got from refinancing to work. Such confidence in turn would suggest that the jumbled mess of things we like to call the economy is finally on the mend.