Interesting times
July 4, 2005

What caught my attention this week was that the US economy grew faster than expected in the first quarter, fueled by the housing market.

The government’s initial estimate of economic growth for the first quarter of the year was 3.1%, which would have been the weakest growth in two years. Instead, gross domestic product (GDP) increased by 3.8%. The unexpected increase in economic growth was due almost entirely to higher residential investment. While residential investment makes up only 5% of the US GDP, the increase in residential investment during the first quarter contributed 0.64% to the overall increase in gross domestic product. That is incredible if you stop and think about it.

Fannie Mae, the largest buyer of mortgages in the US, issued a report warning that the probability of a housing bust has risen sharply in certain parts of the country. Fannie Mae blames the increase in risk on looser lending practices. This can be seen in the increased popularity of interest only loans and the increase in loan approvals that are not backed by full documentation of the borrower’s income and assets.

That last bit is quite interesting. Fannie Mae and Freddie Mac financed about 43% of new home mortgages last year, down from 53% the year before. Part of the decline in their market share is due to lenders selling more mortgages to “private labels” with less stringent lending standards. These new mortgage buyers take on more risk and therefore allow real estate buyers with blemished credit records or dubious income and assets to qualify for mortgages. What is really troubling is that nearly 24% of the sub-prime loans sold to private label buyers in 2004 were adjustable rate mortgages with an interest only feature. Also noteworthy is the fact that these mortgages are not restricted to less expensive houses. The share of “jumbo” mortgages (mortgages for more than $359,650) issued without full documentation increased from 27% in 2001 to 51% in 2004.

According to Fannie Mae the real estate collapse of the late 1980s was preceded by similar patterns.

Fortunately Alan Greenspan is not worried. He recently said that the housing market is a “collection of only loosely connected local markets” that have no direct pricing relationship and therefore harbor little national risk of a bubble.

Why anyone would believe what Alan Greenspan says is beyond me. Last year, just before he started aggressively raising interest rates, he urged US homebuyers to take out adjustable rate mortgages instead of fixed rate mortgages. Perhaps he did not anticipate his impending campaign of raising interests rates. Perhaps he thought that consumers could increase their spending and help the economy if their monthly mortgage payments were a little lower. Who knows? What I do know is that the Federal Reserve Board Chairman should refrain from giving advice to homebuyers about adjustable rate mortgages: since last year when he urged homebuyers to take out adjustable rate mortgages the interest rate on those mortgages increased by 20%.

Now Greenspan is saying that we need not worry about real estate prices because it is a loosely connected market that poses no real risk. This loosely connected market IS the market. Just twenty-two of the most expensive metropolitan markets account for 35% of the total value of the country’s residential real estate. We have already seen that real estate investment has made a significant contribution to first quarter GDP growth and now we find that more than one third of the value of all residential real estate is confined to only twenty-two markets. If prices in these “unconnected” markets were to fall would that not impact US economic growth or US consumer sentiment? Remember that two thirds of US economic activity is consumer spending.

Greenspan says that exceptionally low long-term interest rates are fuelling real estate prices while Fannie Mae blames looser lending standards. The data most certainly supports Fannie Mae’s assertion, but low mortgage rates, which are due to low long-term interest rates, have certainly played a major role as well. As readers of these commentaries know, I believe that the future of US interest rates is not in the hands of US policy makers. China and Japan will decide what our interest rates will be, but apparently Greenspan does not perceive that to be a risk to the real estate market or the economy as a whole.

Real estate prices have increased to the point where people can no longer afford to buy homes. This is, of course, not true for all markets but it is most certainly true in many of the metropolitan areas, especially in the twenty-two markets that make up 35% of the total value of all the residential real estate. According to the California Association of Realtors, only 18% of the households in California can afford to buy a median priced home with a conventional 30-year fixed-rate mortgage.

The solution? Adjustable rate mortgages, interest only mortgages and 40-year mortgages. Because lenders do not have to take the risk that interest rates will rise when a buyer takes out an adjustable rate mortgage, the initial interest rate on adjustable rate mortgages is lower than on fixed rate mortgages. The lower interest rate translates into a lower monthly payment and with a lower monthly payment the buyer can afford a more expensive house. The fact that the buyer may not be able to make his mortgage payments in the event that interest rates do rise does not factor into the equation (although it should).

To further reduce the monthly payment, adjustable rate mortgages with initial interest rates as low as 1%, interest only mortgages in which the principle becomes due only after ten or fifteen years and even mortgages where the buyer does not have to pay all the interest (the unpaid interest accumulates as additional debt until a later date when both the accumulated, unpaid interest and the principle become due) are available. These types of mortgages are all predicated on a real estate market in which prices always go up. In reality, markets seldom always go up. In some cases the increase in mortgage payments when the principle and any unpaid interest comes due can be as much as 50% to 90%. Remember though, that these mortgages are typically issued to people who currently cannot afford a 30-year fixed-rate mortgage with an interest rate of around 6% on their property.

Long-term US interest rates are at historically low levels. Any increase in interest rates will have dire consequences for people with adjustable rage mortgages. The real estate market in the US, while not homogenous, is in awful shape. In California interest only mortgages accounted for 61% of all mortgages in the first two months of this year. That is up from 47% for 2004 and less than 2% in 2002. The Mortgage Bankers Association estimates that 40% to 50% of all mortgages nationwide will be adjustable rate mortgages this year.

As is the case in most markets, the top usually occurs when unsophisticated investors get sucked in because they believe prices will always rise. A study by the National Association of Realtors found that 23% of the homes purchased last year were for investment, while an additional 13% were vacation properties.

Here is more food for thought. Refinancing of existing mortgages currently represented about 40% of all mortgage applications and 65% of those who refinanced drew equity out of their homes. Freddie Mac estimates that about $46 billion in home equity was cashed out in the first quarter of 2005.

The broadest measure of money supply is M3 and M3 grew by $88 billion during the first quarter. That means that more than 50% of the increase in the money supply during the first quarter of this year was due solely to homeowners cashing out equity in their homes. If that doesn’t shock you, nothing will.

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.

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