It's About Time, Mr. Greenspan

Fed chair Alan Greenspan finally addressed the real concern of a housing bubble, albeit just a few utterances... but compared to his virtual silence on the matter, this commentary from Mr. Greenspan comes as a welcome breath of sanity from the Federal Reserve board. From US heading for house price crash, Greenspan tells buyers: "In a pre-retirement speech to fellow central bankers at Jackson Hole, Wyoming, Mr Greenspan said that people were investing in houses as if they were a one-way bet, not allowing for the risk of price falls. He said 'history had not dealt kindly' with investors who kept ignoring risks." Well, duh.

Clearly raising interest rates aren't detering this manic housing market; in fact, mortgage rates have been dropping in spite of the Fed raising the short-term interest rates. Perhaps this is Mr. Greenspan's attempt at hoping rhetoric will help stem the bubble, since the current policy has done little to cool the tide of buyers and speculators. Personally, I think the Fed should follow up this verbage with a strong policy, raising the short-term interest rates a full half basis point as opposed to the quarter point increases that the Fed has been fond of as of late.

An economy the size of America's moves slowly. The Fed can only hope to steer it with its policy and rhetoric, but steering an economy as large as the U.S.'s is akin to steering an ocean liner or jumbo jet. If you put the jet or ocean line in a hard turn, it starts to turn, but slowly. It takes a while before the vessle starts making a sharp turn. And once that turn has begun, it takes just as long to right the ship. The Fed put this housing bubble into motion during the dot bomb era, when they flooded the marketplace with liquidity by dropping interest rates to never-before-seen levels. This was the spark that ignited the housing boom. Once the spark started the inferno, other factors helped contribute - unscrupulous lenders, offerring their option AMRs and I/O loans; speculators and flippers, pushing the price of real estate to non-sensical levels.

And now, the Fed has been pushing that rate back up, trying to sop up some of the liquid, trying to cool the housing beast they created. They don't want to plow ahead too strong, for fear that they'll oversteer the economy and burst the housing bubble. Personally I think it's too late for the Fed to have much recourse on the housing bubble one way or another. The Fed's early maneuvers put the housing market so out of whack that the only way things can be righted is through a painful recorrection. And that's not something Mr. Greenspan or his successor will be able to avoid.

The Hidden Perils of Option ARMs

Option AMRs, which I've blogged about before, are the latest craze, offerring consumers an option on how much to pay each month:

• A calculated "bare minimum" payment
• An interest-only payment
• A principal plus interest payment

These types of loans are commonly referred to as negative amortization loans because if the sucker borrower opts to make the "bare minimum" payments they'll actually owe more than what they owed at the start of the month. (That is, the "bare minimum" payment is less than the accrued, monthly interest.)

To attract the desperate and foolish, these loans come with a teaser rate, usually around 1%, which is good for the first year. However, option ARMs have a plethora of conspicuous 'gotchas,' as pointed out in the L.A. Times article The Hidden Perils of Option ARMs. These perils include:

• Pre-payment penalties - many loans these days carry pre-payment penalties in order to discourage consumers from refi-ing the loan early on in the loan's lifecycle. However, option ARMs commonly have a three-year pre-payment penalty not only for refis but also for paying the loan in full! That's right, if you take out an option ARM and want to sell your home two years down the road, you'll be stuck with thousands of dollars of penalty payments.
• Negative amortization - as aforementioned, when making the "bare minimum" payments consumers can quickly dig themselves into a deep hole, as they'll end up owing more at the end of the year than at the start of the year. These 'option payments' really only work for commissioned-based borrowers, or those who get a large windfall, say, every quarter or year. But for the average, salaried individual, making the bare minimum payments only spells disaster.
• The teaser rate - while that 1% teaser rate sounds nice, many folks don't realize that while the payment doesn't change for the first year the rate starts adjusting after the first month. To put this into perspective: "On a $1 million loan, a 1% option ARM with no points can add nearly $1,500 from negative amortization to the outstanding balance each month."
• Mortgage brokers are making out like bandits on option ARMs - lenders are giving brokers two to four times higher commissions on selling an option ARM over selling a more traditional loan vehicle. Clearly lenders are making out like bandits, too, on these risky loan products. Newsflash: someone is getting screwed, and if it isn't the lender and it isn't the broker, it's gotta be....... you.

The article concludes with a great quote from Mitch Ohlbaum, a West Hollywood mortgage broker: "People who know what they make each month have no business in a loan like this. They will get demolished."

Let's Classify this Under the 'Duh' Department

From Do financial homework before taking mortgage

Most interest-only payment plans are offered on adjustable-rate mortgages, but they can also be found on fixed-rate loans. "The name is misleading," says Keith Gumbinger, a vice president and analyst at HSH Associates, a mortgage-information publisher. "There is no such thing as an interest-only mortgage because eventually youll have to pay the loan principal as well. The standard payment on a 6 percent, 30-year $100,000 loan is about $600," he says. Of that, $500 is interest. "So if you opt for an interest-only loan," he says, "you're reducing your payment by only $100 a month and youre not building equity."

Well, duh. The mortgages are called interest-only for a reason, no? And might that reason be because you are paying not your principal, but, rather, interest only? What's especially devious are these negative amortization loans, which allow you to make payments so small that you're actually losing ground each month, owing more each month than you did the previous month. (Of course, eventually the debt-to-valuation ratio becomes too great and the mortgage automatically switches over to a more conventional fixed-rate mortgage, thereby brining in dramatic increases to the monthly costs... but we're credit-hungry Americans, remember, and price things in terms of "How much down, and how much per month?"

"Everybody is betting on the future that were going to have these big price appreciations in housing, that were all going to get big raises," says Craig Jarrell, president of the Dallas region of Pulaski Mortgage Co. "What if you dont get promoted? What if you dont get a raise? What if your house doesnt appreciate?" He and other mortgage experts say interest-only mortgages are best suited for home buyers who plan to move before the principal comes due, for those who expect their incomes to rise strongly over time, and for those who get the bulk of their income in bonuses.

Guess what, Mr. and Mrs. Average American - that ain't you! Personally, I have a 30-year fixed mortgage, but since listening to Dave Ramsey I wish I had taken a 15-year loan. No worries, though, I'm paying down additional amounts on the principal each month, but I still can't fathom those who do these 10-year I/O loans, especially considering that we're now enjoying the lowest interest rates in modern history. That means there's only one way interest rates can go - up.

Like interest-only mortgages, so-called option adjustable-rate mortgages are enjoying a surge in popularity. But these, too, require caution, the experts say. "This kind of mortgage gives borrowers the option to pay less than the interest charged on their loans by deferring part of that payment and adding it to the original loan balance. The lure is a lower payment. On the other hand, if you choose that option, you will end up owing more than your original balance. Why would you take a loan product that goes backwards?" Jarrell asks. "That's just insane. There are also mortgage products that allow you to put nothing down, which also slow your ability to accumulate equity."

"That's just insnae." Couldn't have put it better myself.

I pity those recent homebuyers that decided to go via the I/O or ARM route for a home they could ill afford. I feel sorry for those who decided to finance 100% or 110% of their house purchase, or those that used a credit card or other foolhearty approach to make a down payment. Your day of reckoning is coming, I'm afraid. At the risk of sounding selfish, I'm hoping that there's enough people who fell into this trap to bring house prices down to realistic levels, and enough financially sane people to keep our world's economy afloat through what is bound to be some troubling times ahead.

The Price of Prosperity

Things are going to get sticky sooner than later for those home buyers who over-extended themselves with the financing of their American dream. Those who financed 100% of the loan and/or those who used exotic financing options - interest only loans, option ARMs, or, hell, even just regular ARMs - are going to be in for a shocker when interest rates rise and their rates finally start readjusting on a monthly or annual basis. An article aptly titled The Price of Prosperity sheds light on this upcoming problem:

This seems to be a problem with adjustable-rate mortgages, as well. We know homeowners who are facing the increases now and are not able to come up with the additional funds. That means more foreclosures are on the way. It's sad, but true.

As the ARMs taken out during the first part of this century start to amortize on a monthly basis - inconveniently coinciding with higher interest rates - what will our nation of house-rich, cash-poor denizens do? Sell at a loss? Hand over the keys to the bank? In either case, I we'll undoubtably see a decline in the over-inflated prices currently in the 'hot' real estate markets. A return to sanity, as I like to think.

And for those that think real estate "only goes up," your memory is very short-term, indeed. One need not look far back in history to see the downside of real estate. A great source on anecdotal rememberences of downturns in the real estate market can be found in the comments of this blog entry: Do You Remember the Last Bubble?. Definitely worth reading, especially if, even with the clear signs of our current bubble, are considering purchasing property.

Mortgage Rates Hit Highs

With the Fed steadily raising long-term interest rates, we're finally starting to see an uptick in mortgage rates. From Mortgage Rates Hit Highs

Mortgage rates rose again this week with 30-year mortgages hitting their highest level in four months and one-year adjustable rate mortgages rising to the highest level in more than three years. In its weekly survey, mortgage giant Freddie Mac reported Thursday that rates on 30-year, fixed-rate mortgages rose to a nationwide average of 5.89 percent, up from 5.82 percent last week. For oneyear adjustable rate mortgages, rates rose to 4.57 percent, up from 4.47 percent last week.

As mortgage rates continue to rise the cost for speculators will increase. Too, those with adjustable rate mortgages have more to fear once their fixed, introductory period ends. Right now it's painfully clear that home prices in many markets are simply out of line. As I blogged about earlier, the mortgage-to-rent ratio is out of whack, as are the income-to-mortgage ratios. Clearly something has to give, but what will precipitate this necessary change? Interest rates may be one such triggering factor. Only time will tell, but the higher the mortgage rates rise, the less interested buyers will be and the more in trouble those with ARMs will find themselves in.

Quite the Distinction for San Diego

According to the article Busting the Housing Bubble, the LoanPerformance LLC group reports that last year San Diego led the nation in the percentage of interest-only loans with a whopping 48% of loans issued during 2004 in San Diego being interest only! Eep.

Here are a breakdown of the top offenders for 2004:

• San Diego, 48%
• Atlanta, 46%
• San Francisco, 45%
• Denver, 43%
• Oakland, 43%

I think my sentiment is best captured by the article Interest Building in Interest Only Morgages: "You'd have to revisit the pre-Depression 1920s to find a time when interest-only mortgages were as popular as they are today among U.S. home buyers."

When the bubble bursts and those who used interest-only (or option ARM) vehicles to finance their debt, we're going to hear a lot (and I mean a lot) of whining from those getting stung. They'll say how "everyone" told them it was the smart move; how "everyone" said house prices would keep going up. Of course, not "everyone" is saying interest-only loans are smart, or that home prices will keep heading north. Read any article that touts interest-only loans and the obligatory "pro" quotes always come from either real estate agents or bankers, the exact people who are profiting from the ill advised growth in interest-only loans.

The more research I do into this housing bubble the more assured I become that the proverbial shit is going to hit the fan. Personally, I am really hoping for a sharp decline in home prices sooner than later, but without affecting the overall economy. Unlikely, if not impossible, I know. Regardless of my personal, selfish wants, though, I really do expect something is going to give and it's going to hurt more than people had or are or will be anticipating.

We've Seen This Before

Forbes Online had a recent article titled Wall Street's Fate Caught Up With Housing that, among other things, noted the eerie similarities between the current real estate bubble and the dot bomb bubble of the late 90s.

While oil prices, rate hikes and the dollar dominate most U.S. headlines, we believe the greater risks lie in when and how this housing boom cools. ... Can the Fed negotiate a soft landing for real estate, or will their ongoing tightening prick a bubble and cause a hard crash in housing prices? ... Unfortunately, parabolic rises do not come down gently. And if our Bellwether Index for the housing bubble comes down hard, then so will the housing sector itself. We don’t think housing prices will tumble, but they will likely experience the first nationwide decline since the 1930s. More dangerous will be the unwinding of the excess leverage and collapse in psychology. The loss of confidence alone could send the U.S. into the next recession.

The article also includes a graph showing Forbes's Housing Bubble Bellweather Index's growth from 2000-2005 alongside the Internet Index from 1995-2000. Hrm, I think I see some faint similarity between the two..... and we all know how the Internet stocks played out at the start of this century!

Protecting Yourself from a Housing Bubble

BankRate.com recently added an article that addresses the reality of the market we find ourselves in and attempts to educate the average consumer as to how they can protecte themselves from the housing bubble. The article has five bits of advice that would make Dave Ramsey proud:

1. Don't borrow against your home's equity,
2. Build equity through principal repayment,
3. Move away from adjustable rate mortgages,
4. If buying a home, make a large, significant down payment, and
5. Live in your home for the longer haul.
   

These bits of advice, sadly, are rarely heard in today's consumerist market where the average American carries nearly $9,000 in credit card debt and people are buying homes with interest-only and negative amortization loans. Personally this advice seems very common sense to me, and maybe that's why I live in a 1,000 sq. ft. condo as opposed to a larger house. The market will soften, though, and that home, while not currently an option, will definitely be one down the road once the market rights itself.

If I could add an additional piece of advice to the list it would be this: If you are a first-time home buyer, wait out the market, if possible, especially if you live in a grossly overheated market. Rents are so out of whack with the cost of ownership that it doesn't make sense not to rent at this point in time. Home ownership is a great goal and benefits both the owner and community on a number of levels, but the benefits can't outweight basic math and financial sense.