Final answer:
Cash-out refinancing is a mortgage strategy less sensitive to mortgage rates, closely linked to housing prices, often utilized even during periods of rising mortgage rates. This was influenced by historical lending practices prior to the 2008-2009 Great Recession, where banks issued risky loans under the assumption that housing prices would always rise, eventually causing severe financial instability when the market collapsed.
Step-by-step explanation:
The concept under discussion deals with cash-out refinancing and its viability even in a scenario of rising mortgage rates and the inclusion of transaction costs. Cash-out refinancing allows a homeowner to refinance their mortgage for more than they currently owe, then receive the difference in cash. Often, this is compared to refinancing due to a turnover in housing, as it is closely tied to housing prices and tends to be less sensitive to changes in mortgage rates. This financial behavior is influenced by historical elements, such as the housing boom prior to the 2008-2009 Great Recession.
During the housing market growth, low-interest rates and high demand for housing led to financial institutions issuing subprime loans, which required low to no down payment and had an initial period of very low payments. These terms were sustainable under the belief that housing prices would continually rise, allowing homeowners to refinance before higher payments set in. Risky lending practices, such as NINJA loans, compounded the financial vulnerability.
However, when housing prices plummeted, the value of many homes fell below the amount owed, leading to financial distress for both banks and households. Banks had mistakenly assumed that by selling loans and buying mortgage-backed securities, they were diversifying their risk, but these securities turned out to be far more volatile, contributing to the economic downturn and subsequent recession.