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
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 works primarily to find investments for his
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