Variable Interest Rate Mortgages

David Leonhardt and Motoko Rich write:

The Trillion-Dollar Bet - New York Times: This year, only about $80 billion, or 1 percent, of mortgage debt will switch to an adjustable rate based largely on prevailing interest rates, according to an analysis by Deutsche Bank in New York. Next year, some $300 billion of mortgage debt will be similarly adjusted. But in 2007, the portion will soar, with $1 trillion of the nation's mortgage debt - or about 12 percent of it - switching to adjustable payments, according to the analysis. The 2007 adjustments will almost certainly be the largest such turnover that has ever occurred....

'I'm not sure that people are being counseled on really how big of a risk they are taking,' said Amy Crews Cutts, deputy chief economist at Freddie Mac, the mortgage company. Consider a typical $300,000 interest-only mortgage with fixed payments for the first five years. The homeowner would start by paying about $1,250 a month. If interest rates rise modestly over the next few years, as many forecasters expect, the payment will jump to almost $2,100 in 2010, according to Stephen Barrett, the owner of Redmond Financial, a mortgage business near Seattle....

This year's fashionable model, known as an 'option ARM,' allows borrowers to make payments with monthly rates starting as low as 1.25 percent for the first five years of the loan; the average rate on a 30-year, fixed-rate loan is about 5.6 percent. During the first quarter of 2005, 40 percent of mortgages over $360,000 issued to people with good credit were option ARM's, said David Liu, a mortgage strategy analyst with UBS in New York. Very few borrowers used option ARM's before 2003.... All of these loans come with the risk of a spike in payments sometime in the future. In particular, borrowers who have taken out an interest-only loan will see a jump in payments simply because they will start to owe principal after the interest-only period lapses. If rates rise, the payments will go even higher. Borrowers whose incomes have not risen enough or who have not planned for the higher payments could find themselves shocked....

Comments

[Ron Sturtevant-Stuart]

The real kicker is there's a 5 3/4% pre-payment charge on a lot of these loans, that's 20,000 on that 360,000 dollar loan. Makes that low interest rate look a lot larger since nobody is expecting to keep these loans for 30 years

[Tom Cecere]

Aww, the poor babies...you mean they might actually have to PAY for their houses? Instead of trading up in a never-ending series of wealth increases until they're millionaires? Do you think they can't read what they sign? Do they HAVE to buy 4000 sqft mini-mansions? As I often say to my children, I have limited sympathy for people who should know better.

[A-ro]

This sounds like the makings of a "negative shock" to the economy. 2007 seems like rather an inconvenient year for a negative shock to the economy, especially for the GOP. I wonder if it will cause the 2008 presidential election devolve into another fight over who can cut taxes more irresponsibly in an attempt to dig ourselves out of the hole?

"Tax cuts: they cure what ails ya" - GOP motto

[Ottnott]

I have a little more sympathy for the buyers than Tom does, because I'm in an area (San Diego) where >80% of mortgages are adjustable rate. Given the % of sales that are condos, an awful lot of the buyers taking the crazy risks are people buying stater condos here.

What I don't have sympathy for is a mortgage industry that is busily peddling mortgage "products" to buyers that wouldn't be allowed to touch such mortgages if they were regulated by the SEC.

I refer to these (interest-only ARM) mortgages as hghly-leveraged $500,000 futures options. The SEC has some pretty tight restrictions on who can make such investments in the regulated markets, and a broker who sold such things to an unqualified buyer could get in a lot of trouble. In the mortgage industry, a qualified buyer is one that, as one observer noted, "can fog a mirror".

[liberal]

Ottnott wrote, "I have a little more sympathy for the buyers than Tom does, because I'm in an area (San Diego) where >80% of mortgages are adjustable rate. Given the % of sales that are condos, an awful lot of the buyers taking the crazy risks are people buying stater condos here."

But isn't San Diego one of those places where it's now far cheaper to rent than to own?

[Jack]

The UK more or less only has adjustable rate mortgages and UK customers pay much more for their mortgages than US borrowers simply because it becomes almost impossible to compare deals properly and people get stuck with very uncompetitive rates when things have worn off. By contrast there is a proper competitive market for mortgages in the US.

It is really odd to see the worst features of British financial services being imitated 20 years later in the US. (Private Pensions/Social Security reform being the other. Google pension misselling) Of course British financial institutions are immensely profitable yeat have not felt the need to bring their expertise to other countries in a big way. Maybe that will change if Americans adopt our mortgage and pension systems.

[Jack]

The UK more or less only has adjustable rate mortgages and UK customers pay much more for their mortgages than US borrowers simply because it becomes almost impossible to compare deals properly and people get stuck with very uncompetitive rates when things have worn off. By contrast there is a proper competitive market for mortgages in the US.

It is really odd to see the worst features of British financial services being imitated 20 years later in the US. (Private Pensions/Social Security reform being the other. Google pension misselling) Of course British financial institutions are immensely profitable yeat have not felt the need to bring their expertise to other countries in a big way. Maybe that will change if Americans adopt our mortgage and pension systems.

[tante aime]

Oh, for a HP mortgage rate v. zero down interest only v. rental plus key fee v. income tax writeoff v. implant in Greenspan's head pocket calculator!

Now, OPEC is announcing an increase in crude production of between 500,000 to 1,000,000 BPD, since Bush refuses to announce US withdrawal from Iraq (read: refuses to announce an end to deliberate suppression of Iraqi oil production - check crude prices back before GW I, when Saddam was flooding the world markets with cheap oil).

Like putting 1,000,000 new housing units on the market with a Fannie Mae Fed guarantee to sponge up the loans, underwritten by the US taxpayer.

It's not a housing bubble, it's basic rocket science.
Fuel + oxidizer = things that go up, and then go boom.
Ergo, if you're not flippin', you're trippin', homie.

[anne]

Financial service corporations in Britain or western Europe are simply not competitive in ways other than marketing or advertising. I am startled at the high cost and correspondingly poor return of financial investment services in Europe. The market for financial services in America is mixed. Many financial service companies compete only in terms of advertising, and are highly costly, but there are alternatives as Vanguard.

[jm]

But everybody says Chinese exports to the US are going to continue heir rapid growth, and that there will never be a renminbi revaluation large enough to make any difference in our trade balance. So by 2007 there will be enormous demand from China for GSE securities, and mortgage rates will be much lower.

[Matthew Saroff]

Two things:

* I thought that prepayment penalties are illegal in the US for home mortgages, if not most lones.
* Renting is typically cheaper than owning when you start out. It's just that in places like San Diego, it's now gotten WAY cheaper, or more accurately, purchasing has gotten *WAY* more expensive.

[Mark]

"...could find themsleves shocked."

How about could find themselves foreclosed.

[me2i81]

"I thought that prepayment penalties are illegal in the US for home mortgages, if not most lones."

Nope, they are legal, and available on every loan. I don't know whether any states outlaw them, but I know they're available in California.

As for the rent vs. own thing, there's an incredible cultural bias against renting. I was given no end of grief by my family for renting for longer than was considered savory before we eventually bought a house.

[amoroso]

My wife and I sold our unremarkable tract house in the San Fernando Valley (outside Los Angeles) for one million dollars two years after buying it for 600,000. We are renting a comparable house for thousands of dollars less a month than it would take to buy it. Plus, no property taxes or homeowner's insurance, and no maintanence expenses.

Ha-ha-ha-ha all the way to the bank.

[youknowit]

Its the same way in New York. I live in the sububrs and even rent has gone up so much, that its only cheaper to rent because of the insane prices of the Houses.

[William]

Re: me2i81,

"there's an incredible cultural bias against renting"

That's so true! I rent in the Portland area and I love the freedom it gives me to pick up and move when I feel like it. I enjoy experiencing different cities, neighborhoods, and houses, and have moved about once every two years. My friends and family constantly chide me for this choice, but while I can see the financial advantages of home ownership, I also hear my friends grumble about being slaves to their mortgage, yard, and home maintenance. I'm more interested in owning my time than any object.

[Mr Furious]

What is fascinating to me, is that all these people were getting mortgages during a period of historic low rates. Therefore, obviously, an adjustable rate had no where to go but up. I bought my first house in 2001 and refinaced in 2003. At no point in those transactions did I ever consider anything but 30-year fixed mortgages even though I am literally squeaking by month to month.

You'd have to be freaking crazy or expecting a windfall of new income in the future to have done otherwise.

Somehow I don't see all these people having jumped up the corporate ladder in five years to handle a doubling of their mortgage payments.

[Winslow R.]

"...could find themsleves shocked."

Or likely could be lucky, as rates drop to zero over the next few years...

[anne]

While there are several reasons for low interest rates, including low inflation at present and an expectation that the Federal Reserve will keep inflation low, the international demand for American bonds from Asia is a significant part of the reason for a long term Treasury yield of 4.09%. If China were to lessen demand for American debt because of a forced increase in the value of the Yuan, we could easily find a interest rates riusing markedly.

[Barkley Rosser]

Although there was not much discussion of them per se, there has been an enormous increase in the interest-only ARMs. In the Washington metro area, they have gone from about 10% of mortgages to 54% in the latest report in the Washington Post as of a few weeks ago. A mortgage banker friend of mine there claims that the new standard is the "105% mortgage," is interest-only and covers the closing costs as well. A lot of people look to be getting set up for a bad fall.

There are further signs of the mania phase (to use Kindleberger's terminology) of the bubble, notably refusal to see reality. One of my best and smartest friends has just bought a house in Florida with an interest-only ARM for 1.3 million, with his wife quitting a good job in their previous location to go into the realting biz. I discussed it with them, and they are quite convinced there is no bubble in Florida, that prices today will "look cheap" compared to what they will be five years from now. Gag.

[anne]

Barkley Rosser

What are the terms of a typical interest only adjustable rate mortgage? Also, what sort of numbers in value of mortgages are we beginning to have given over to such loans? We must look more closely at the British mortgage system in comparison as well.

[me]

Fed Chief Questions Loan Choices
February 23, 2004 11:00 p.m. EST

Sorry folks but the higher authority claims that US homebuyers are smarter than the risk averse readers of this blog.

Greenspan Says Certainty
Of Fixed-Rate Mortgages
May Not Be Worth Cost
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL

In a rare evaluation of the interest-rate options that households face, Federal Reserve Chairman
Alan Greenspan questioned whether American homeowners are well-served by popular fixed-rate
long-term mortgages.

[Mushuweasel]

A statement like "cheaper to rent than own" is pretty much meaningless. It's about the starkest apples-to-oranges you can make.

Also, for people in the rest of the country it's pretty much impossible to fathom what something like this means to someone in CA or NY where the "typical" 300k loan would by you a shed in someone's backyard.

[Ottnott]

Higher authority, meet Alan Greenspan--the June 2005 edition, that is:
"The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages, are developments of particular concern. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is beginning to add to the pressures in the marketplace."
http://www.federalreserve.gov/boarddocs/testimony/2005/200506092/default.htm

[Quaker in a Basement]

Lessee...

Rates rise, mortgagees default, glut of available housing ensues, values plummet...cheap houses for everybody! Yaaaay!!

See? Tax cuts work!

[anne]

Me

Alan Greenspan's questioning of the need in many cases for fixed rate mortgages should be carefully considered. The last 23 years, Greenspan would have been right. Should the Federal Reserve be able to sustain cycle on cycle of moderate to low long term interest rates, then cheaper adjustable rate mortgages become reasonable. The Fed is well into this current cycle of short term rate increases, and there are signs we may have already past the peak in inflation at 2.4% for the core Consumer Price Index. We need to think carefully about this.

[Kent]

"and they are quite convinced there is no bubble in Florida, that prices today will "look cheap" compared to what they will be five years from now. Gag."

This is what mystifies me:

1. If current buyers are stretched to the limit with 105% interest only ARM loans,

2. Interest rates are at historic lows, and

3. Wages are stagnant

Seems like buyers are already maxed out beyond all reason. Who is going to be around in 5 years to pay the higher prices when interest rates are higher?

[anne]

February 23, 2004

Greenspan Says Certainty Of Fixed-Rate Mortgages May Not Be Worth Cost
By GREG IP - WALL STREET JOURNAL

In a rare evaluation of the interest-rate options that households face, Federal Reserve Chairman Alan Greenspan questioned whether American homeowners are well-served by popular fixed-rate long-term mortgages.

"American homeowners clearly like the certainty of fixed mortgage payments," Mr. Greenspan said in a speech to the Credit Union National Association in Washington.

Fixed-rate mortgages protect against higher rates while offering the option of refinancing should rates drop. But homeowners pay thousands of dollars a year for those benefits, he said.

With a typical fixed-rate loan, a homeowner protects himself from the risk that rates will rise sharply later but pays a higher interest rate that increases his payment. A homeowner can, of course, refinance if loan rates drop sharply. But Mr. Greenspan said homeowners may pay 0.5 to 1.2 percentage points more than they otherwise would for those benefits. The Federal Reserve staff estimates that homeowners "might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade," Mr. Greenspan said, though not if interest rates had trended "sharply upward." ...

[Uncle Jeffy]

Anne -

Isn't Alan cute? "American combat deaths in Iraq and Afghanistan could exceed 2,000 within the next few months - though not if the Iraqi insurgents all enter monasteries immediately...."

[pat]

Kent: "Seems like buyers are already maxed out beyond all reason. Who is going to be around in 5 years to pay the higher prices when interest rates are higher?"

I think this is a very good explanation to the saying that "a bubble can collapse under its own weight".

[Drfranklives]

We took the middle path. After paying on a 30-year fixed mortgage for three and a half years and watching all our friends refi like crazy, we wondered why we were sitting on a mortgage with higher rates. But I wasn't about to get an ARM, for the resons discussed in this post. I don't want to get stuck with a high rate in an economy in which I could not sell my house. I could sell it now, easily, but not in a high rate economy.

So we went for the 20-year fixed from Countrywide. Not as low a rate as the 15, but lower than the thirty, and we kept the same mortgage lender, thus waiving many of the fees and costs.

Now our payment is only a hundred and fifty more a month, and we will own our home six years earlier than we otherwise would have, at a lower rate. And if the rates go up, I'm happy to stay in my nice home that I can afford, at a rate I can afford, and pick up cheap houses after the bubble bursts to rent to all my friends who will lose their ARM-financed homes to foreclosure.

[david]

On large loans (in high cost housing markets) having an ARM is insanity. With a $400k loan, each 1% change adds about $250 to the monthly payment. Worse, the rate can adjust to the cap all at once after the fixed period ends.

I refi-ed out of one of these loans into a 5.5% fixed on a $335k loan and sleep better at night. The ARMS didn't offer much better rates.

Consumer Reports had story on ARMS and Fixed's basically saying that all the savings generated by ARMS are usually consumed by higher payments within 20, yes 20! months of payments once the adjustments start happening.

[anne]

Then the argument for a fixed rate mortgage, which I have, involves taking insurance against an interest rate increase that involves a cost of 20 months of payments over an adjustable rate mortgage. Interesting.

[Tom Cecere]

Anne, I think you're close...the argument is for buying insurance in a situation where you're maxed on the ratio of payment to income and will lose the house if the adjustments are too high. Most of the analysis here today adds up the income streams on average but you have to look at it from the point of view of the "house loser". The downside is catastrophic in a reasonable scenario (espcially in light of how kids hate to move nowadays).

[anne]

http://www.calvorn.com/gallery/photo.php?photo=4769&u=18008|25|...

Yellow-billed Cuckoo
New York City--Central Park--Wildflower Meadow.

Thanks Tom :)

[Ruy Lopez]

Greenspan recently said that he does not see a national housing bubble, but rather many local bubbles.

I found this comment rather amusing, as many local bubbles equal one big national bubble. Since almost every major population center in the country is experiencing massive real estate inflation, it is really irrelevant if some rural county is not experiencing the same boom. Greenspan’s argument is probably that historically localized employment conditions have been the major factor in real estate declines. However, in this case, interest rates may play the significant role. Never before have so many people been exposed to rising rates through their mortgages. It is a bit like a segment of the population suddenly experiencing a pay cut.

Given that the mortgage industry continues to find creative ways (ARMs, IOs, 40-yr.) to lower a borrowers current payment, I do not know how long the boom can be sustained. Many ARM borrowers will likely convert to IO mortgages at the end of their fixed rate payments.

I believe that the option of converting to interest only mortgages, wage inflation and promotions will save most borrowers. What will this mean for the growth in consumer spending in the future? It is certainly not positive.

Fed tightening works by bankrupting the marginal borrower.

How about a scenario of rising rates that causes the marginal borrower to default and consumer spending to decline. This leads to a decline in real estate values, employment and GDP growth. Will we be saved by population growth?

I conceive that the great part of the miseries of mankind are brought upon them by false estimates they have made of the value of things. -Benjamin Franklin-

[dru]

The nonsense about whether it's cheaper to rent vs. own...

Rent is perceived as being money down the drain vs. a mortgage which gets you equity. Okay, let's look at this in the Bay Area and decide just how much money is "down the drain." Some quick back-of-the-envelope calculations:

Let's say you land a c$700K mortgage with a 10% down. That $700K gets you a two-bed house in a decent if slighly down-at-heels post-WWII neighborhood. From that, we'll graph roughly $3500/month mortgage payment for a couple with average credit. (A single individual would have to be earning north of $150K to qualify for this so it's almost certainly a couple.) Of that, you pay mostly interest, which is money down the drain. Then you have 1.02-something percent property taxes which amounts to over $7000 a year. And homeowner's insurance, and (if you can get it) earthquake insurance, another $2K/year. (Lots of folks go without the earthquake insurance, which in the Bay Area is plain stupid.)

So now you're up to...oh, over $4K a month. Oh, but tax credits, you say! All right, you get back 25% of that $4k (generously) and you're back to $3K. That's how much it's costing you in "down the drain" expenses to live there per month.

That's why renting is cheaper. Equity? As long as the market stays up, you're good, but if the market goes down and you need to sell, what then? Equity's great now. But when the median price gets close to the psychological barrier of $1M, you're going to see more reluctance to get in.

And don't even get started on maintenance paid as a homeowner. Priced a new roof lately?

Then there's the whole pressure on wages that this boom implies. What does it say when you take a salary above 95% of the rest of the country and the person still can't afford a nice home in the area? But that's another issue.

[Ottnott]

dru--
don't forget that the alternative minimum tax, which does not allow a deduction for property tax (close to $8000 in your example above), will soon be biting the backsides of any individual or couple with an income high enough to afford the mortgage payments on the home in your example.

With current low interest rates and the lowering of fed income tax rates over the past couple decades, Uncle Sam has been helping the home buyer less and less.

[Barkley Rosser]

Some further comments on all this.

To Anne. I do not know all the gory details of the interest-only ARMs, except for the crucial one: payments on prinicple kick in at a later date, the "spike" someone else noted. Most of those involved on both sides of these deals are betting on continued substantial housing appreciation, allowing for an easy later refi that avoids the problem. If rates go up and housing prices go down, trouble in River City.

Prices can most certainly go down. They are already doing so in the most extreme of the internationally bubbly housing markets, Australia, where they fell by 3% last year. Uh oh.

Bob Shiller has constructed the best series on long term housing prices of anybody, spelled out in the new edition of his Irrational Exuberance, just out a couple of months ago. Two crucial tidbits: overall nationally, the ratio of house prices to rent and house prices to income are at all time highs, based on a series going back to the 1800s. No, prices will not be much higher five years from now, except perhaps in a few locales that have not been bubbling much (Greenspan is right that these conditions vary greatly. Location, location, location has long been the realtors' mantra).

Another anecdotal tidbit. I was just driving across the country and visited my very oldest friend who happens to own a bunch of farms in Indiana. US News and World Report has labeled their area one that is not in a housing bubble, indeed possibly just the opposite. However, my friend, who just engaged in a bunch of farm real estate transactions reports that although costs and revenues in the corn-soybean belt have not changed noticeably in about a decade, prices even for farms well outside of the urban real estate shed have gone up substantially. The bubble is extending into areas and sectors where it has not been identified as doing so.

[apav]

I've done no better than break even on each house I've owned in 20 years (so my financial accumen is suspect) but I've only bought places I really liked living in. Having seen the sell side in a down market, I expect that there will be a coming slide in housing prices that will be slow and painful. I worry about the effect it will have on the labor market mobility and consumer spending as it drags on. People who can't sell:
a) don't follow work and have protracted unemployment
b) rent, flooding the rent market (less cash for them, more for the renter)
c) leave the house vacant cutting their consumer spending
d) eventually take their losses when they realize it's not going to be worth the hassle, driving down prices.

Like the stock bubble, there will be many who will try to hold on expecting an interest rate cut to bring it back. All the above cut the velocity of money. Seems like a scenario for protracted low short term interest rates. Reminiscent of Japan in the 90's but Japan could still sell to the US. Who will we sell to?

[elizabeth_a]

Couple of things:

Atlantic Monthly has a nice graphic this month that demonstrates the wide disparity in housing valuation across the country. The most overheated of 142 markets is Las Vegas (followed by DC) and the most underpriced is Boise City.

Secondly

UK mortgage rates-- based on this mysterious thing called the Base Rate set by bank of england. More and more banks are offering fixed rates for a short period (2-5 years). Major prepayment penalties apply.

[GAB]

"Amy Crew Cutts." Are you kidding me? Amy Crew married a guy named Cutts? What the hell was she thinking?

[anne]

Barkley

Thank you :)

Friends in rural areas have sent me similar notes about rising land prices.

Then, look to the Vanguard REIT Index as an example of reflected real estate values. The price earning ratio of the REIT Index is 38.7, while the earning growth rate is a remarkable -4.7%. The earning growth rate covers the last 3 years and it is really -4.7%. The earning growing rate has been negative for about 3 years. The adjusted dividend at 4% is the lowest I have ever noticed. REITs are making money increasingly on property price increases relative to operating earnings.

http://flagship2.vanguard.com/VGApp/hnw/FundsByName

[howard]

anne/berkley: any chance those rural land price rises are baby boomers looking for affordable second homes?

[Barkley Rosser]

Howard,
Could be more generally, but not in the cases I was citing. Those involved were real farmers buying the land to produce. However, I suspect that in the background is the possibility of sale to homeowners of some sort of at least small parcels.

[aiontay]

I work for the city government of a suburb of Oklahoma City. It is currently one of the "hot" housing markets in the area. In 2002, when the building boom started, a little over 400 new houses were built. Last year over 800 new houses were built. Dru will probably either laugh or cry with disbelief, but the average house here sells for $144K; it wouldn't be hard to pick up a brand new 3-bedroom house for that much. Of course, the average household income around here is a lot less than 150K. Where I work it is a little over 53,000 and for the state a little over 43,000.

Now Alan Greenspan would look at the cost of housing and average income, and not see any froth, let alone a bubble, but some of us around here aren't so sure. Housing prices in both the Tulsa and Oklahoma City metro area have been going up at a healthy clip, even if they haven't been increasing as much as the East and West coasts, but there doesn't seem to be any reason for it, other than the fact that interest rates are low. The economy is OK, but certainly not booming and we aren't seeing an overall population influx from out of state. It largely just people moving within the metro areas.

This spring I was up in Tulsa, my hometown, and while my older brother and I were getting my dad's garden ready to plant we got to talking. My brother, who has always been pretty thrifty, was-and still is-looking to move. Since my niece, his only child is going to graduate school this fall, my brother wants to sell his house, which is in an older neighborhood, and buy a smaller house. He was looking at a smaller house, but one that is in an upscale neighborhood in Tulsa which actually was more expensive than his current house. I kind of shocked that my brother would think of buying a more expensive house. That is definitely a switch from his norm. My brother's justification was that he could get a low, fixed rate mortagage. He also pointed out that the local housing market was not as crazy as California. He didn't buy the house, but when my thrifty brother is justifying buying a house that costs more because houses aren't as expensive in Tulsa as they are in California, I think there might be a problem.

[knut wicksell]

Re: a post further up the thread. I'm thinking about Martha Olney's book on the effect of the spread of installment credit in the 1920s on the contracton of aggregate demand in the early 1930s. People will stop eating to save their houses. If interest rates ever go up (contrary to the long rate prediction), we could see a real crunch. Of course, it all depends what proportion of aggregate income is affected by ARM obligations. Is it big? Is it small? What do the numbers look like. We all know the signs; what are the magnitudes? Anyone here have estimates?

[anne]

Howard

The notion from friends is local residents are buying more rural land when they can. I will ask more questions, but remember this is local perception.

[Alex]

In the early 90s the UK had an eerily similar experience: there was the late-80s consumer/property price boom, with an overvalued currency (fixed at 2.95DM). When the balance of payments went out of kilter, because the £ was on a fixed exchange rate, the adjustment mechanism was the rate of interest.

So - overvalued currency+big mortgages+rising interest rates=carnage. The property market tanked, and good. A lot of people, especially in the southeast, ended up with houses worth less than the mortgage. And the high interest rate and high £ did export industries a power of no good, so unemployment spiked.

It was pretty grim, and didn't get any better until well after the September '92 devaluation.

[Jennifer]

That housing prices have risen broadly since the beginning of 2000 does not in itself seem threatening, but the extent of the increase has been driven not just by low long term interest rates but questionable extention of credit. The questionable credit extention may be a significant problem if interest rates increase meaningfully or even if the economy slows. There is the source of considerable concern, and there is a need to gauge investments in a way in which we can be insulated from an economic downturn spurred by a housing downturn.

[Jennifer]

Extension is not and will not be extention.

Alex, please continue your interesting example.

[anne]

http://www.nytimes.com/2005/06/17/business/17insider.html

The Hot Investment Flavor Now: The Super-REIT
By JENNY ANDERSON

FINANCE is often a fad business. The latest fad is private equity firms getting into the world of real estate investment trusts.

This week, the KKR Financial Corporation and the Deerfield Triarc Capital Corporation are on the road separately seeking to raise a total of $1 billion from investors for two mortgage real estate investment trusts, or REIT's. The money raised will be added to the private money that was raised last fall, leveraged - or borrowed against - to the moon and used to buy real-estate-related securities, like residential mortgages. At first glance, these REIT's may seem like plain-vanilla investments.

But these REIT's can also put about a quarter of their assets in more complex and arcane investments like collateralized debt obligations, junk bonds and mezzanine debt.

In other words, the managers have the capital to play in the blazing debt markets as well as the red-hot real estate market. That's where the deal-making expertise of some of their affiliates comes in. Deerfield Triarc Capital is managed by Deerfield Capital Management, which is majority-owned by the Triarc Companies of Nelson Peltz. KKR Financial is an affiliate of Kohlberg Kravis Roberts & Company.

They are super-REIT's....

[tante aime]

If you read Dr. Delong's posted PDF yesterday, from 1990, developing the calculus of the rational investor as they are submerged and subsumed under the noise investors, as the risk percentage of an asset class becomes overpriced, then you already know what's going to happen, or at least you know why it's going to happen, when it does, finally.

What was that Madonna song about Argentina?

[Barkley Rosser]

Regarding the low mortgage rates, the only serious defense of current (or last year's, actually) real estate prices was in a paper fromo one of the Baby Feds (sorry, forget which one or the authors) that argued not totally unconvincingly that the high price to income and rent ratios could be justified due to real mortgage rates being exceptionally low. Why did they fall last year? (they did) Because of the uptick of inflation due to rising oil prices. So, we have people justifying current real estate prices on the basis of rising oil prices. Ouch!

Regarding the rate of increase since 2000, of course this is driving many buyers, and we know that buying because prices are rising is one of those sure fire signs of a speculative bubble. In Shiller's new edition of his Irrational Exuberance he shows that the rate of increase in real estate prices since 2000 has been matched only one other time in US history, the period of the late 1940s right after WW II. Of course that one reflected some real fundamentals: no housing was built at all during WW II except for that related to the military, and there was a huge pent-up demand from returning soldiers who produced the baby boom in all that housing they bought at those rapidly rising prices. No such fundamentals have been going on at all since 2000. Bubble, bubble, toil and trouble...

[anne]

Remember that the 1940s produced the most successful "welfare program" we have ever experienced, the GI Bill. Houses could be bought with long term fixed rate GI mortgages at astonishingly low interest rates with little or even no money down.

[seamus]

American Heresy: Maybe I Should Rent
http://3martini.typepad.com/3martini/2005/03/american_heresy.html

I got married just over a year ago, and my wife and I earn big, corporate salaries in the SF Bay. And we're not buying. No way.

The "cultural bias in favor of owning" is absolutely alive, but it's based on a 1970's-era aphorism when high inflation was eating up monthly payments. When we can pay $1,700/month to rent a place that would cost us $4,500/month to buy, it doesn't make sense anymore.

My friend and relatives back in Florida are absolutely living in bubble-land. Lots of people are quitting their jobs to go into real estate, and lots more are buying "investment properties," lured by the stories of their friends and relatives who have earned quick and fat payoffs on condos and houses, often selling to other flippers.

In the meantime, we'll keep renting.