Softening up
November 12, 2005
In the US, we can finance our houses with thirty,
and now forty-year mortgages. But what is really neat is that homeowners
can lock in the interest rate on their mortgages for the entire
term of the mortgage. So today, for example, I could buy a house
and get a thirty-year mortgage with a fixed interest rate for around
6.25%. That is a fantastic deal, if you think about it. What is
the likelihood that interest rates will remain as low as they are
for the next, oh, fifteen years? Over the course of a thirty-year
mortgage a fixed interest rate loan in the low 6% level is almost
free money. The limit to the benefit is, of course, that few people
live in one house for more than about five years nowadays, because
by then they want to move into a nicer, newer, bigger house. Over
the past decade that worked out well since real estate prices were
rising and interest rates were falling. But real estate prices have
gone up so much that it is becoming almost impossible for homebuyers
to afford the homes they want.
According the Mortgage Bankers Association there has
been a significant (and alarming, depending on your point of view)
increase in adjustable rate and interest only mortgages. If you
want to buy a house but cannot afford a fixed rate mortgage, you
can always get an adjustable rate mortgage. Because the interest
rate in an adjustable rate mortgage will increase when interest
rates rise, the lenders do not have to protect themselves against
possible interest rate hikes. Therefore the current interest rate
for adjustable rate mortgages is lower than comparable fixed rate
mortgages (because the borrower takes the risk).
However, because short-term interest rates have been
rising faster than long-term interest rates, the difference between
fixed rate mortgages and adjustable rate mortgages has been narrowing,
and that means Joe Spender just cannot afford that nice house that
he just cannot afford but must have. Not to worry Joe, the banks
have a solution: interest only mortgages.
As their name suggests, holders of interest only mortgages
don’t have to pay back any principal during the initial term
of the mortgage, only the interest. There are even optional interest
only mortgages: with those you don’t have to pay all the interest;
the interest that you don’t pay accrues as principal on your
mortgage.
There is no doubt that the real estate boom has fueled
consumer spending and boosted economic growth in the United States.
The rising value of their homes made Americans feel very wealthy
and people who feel wealthy tend to spend money freely. The sad
truth is, that while Americans on average may be wealthier than
many other people across the globe, they are also up to their eyeballs
in debt.
In August Freddie Mac announced that 74% of all the
mortgage loans it refinanced resulted in an increase in loan amounts,
which means the borrowers were cashing out the increase in their
homes’ value. What do they do with the money? Harvard’s
Joint Center for Housing Studies reports that Americans spent $133
billion on home improvements during the 12 months that ended on
June 30, 2005. Of course, some people spent their extra cash on
vacations, new cars, shopping mall excursions or to consolidate
credit card debt that they could no longer pay. The nice thing about
consolidating your credit card debt by refinancing your house is
that you instantly have thousands of dollars of credit available
again.
Given that the real estate boom has been such a boon
for the US economy as a whole, it was no surprise to see the market
get whacked when Toll Brothers, a luxury home builder in Pennsylvania,
cut its earnings guidance for the current fiscal year. Toll Brothers
reported that its orders rose only 1% in its fiscal fourth quarter
that ended on October 31. Its orders fell 10% in the Mid-Atlantic,
5% in the Midwest and 50% in the West. Now, that is only one homebuilder
out of many, but it was enough to cause a decline in the general
stock market and send home building and home improvement stocks
into a tailspin. The Wall Street Journal reported that D.R. Horton
fell 9.8%, Pulte Homes dropped 8.5%, Centex declined 6.4% and Home
Depot gave up 2.2%.
Robert Toll, the Chief Executive Officer of Toll Brothers,
attributed the softening to a significant decline in consumer confidence
during the past two months fueled in part by the hurricanes and
in part by higher gasoline prices, among other things.
The decline in consumer confidence could be a short-term
reaction, but I have long felt that the American economy is endangered
by irresponsible debt accumulation and asset price inflation, both
of which are the result of historically low interest rates. Now
that interest rates are rising, consumer confidence is waning, and
that is a longer-term phenomenon.
The Conference Board Consumer Confidence Index
plummeted in September and declined again in October. If consumer
confidence continues to erode it will curb the uninhibited spending
that we have come to rely on, and that will not only lead to slower
economic growth in the US, but throughout the world.
Paul van Eeden
Paul van Eeden works primarily to find investments
for his own portfolio and shares his investment ideas with subscribers
to his weekly investment publication. For more information please
visit his website (www.paulvaneeden.com)
or contact his publisher at (800) 528-0559 or (602) 252-4477.
Paul van Eeden works primarily to find investments for his
own portfolio and shares his investment ideas with subscribers to his weekly
investment publication. For more information please visit his website (www.paulvaneeden.com)
or contact his publisher at (800) 528-0559 or (602) 252-4477.
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