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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