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The Root Cause of the Housing Bubble
(And No, This Is Not An Ad Parody)   (July 6, 2006)


Here is an actual scan of a flyer I recently received in the mail. It neatly captures both the root causes of the housing bubble and its extreme precariousness. (Note: the formatting has been changed to fit this page.)

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This ad (and no, it is not a parody) reveals the complete abandonment of lending standards which has fueled the housing boom. As the flyer clearly states, It's almost impossible not to qualify.

The ability of subprime borrowers to get a mortgage of $300,000 for less than $1,000 a month (not much more than the take-home pay of a minimum wage worker in California) with no down payment had the obvious effect of flooding the market with ready buyers. Classic economics predicts the result: when demand exceeds supply, prices rise.

The ability to get a mortgage with no down payment created a new class of real estate investor/gambler. The siren song of rapid appreciation attracted many "investors"--about 40% of all new home purchases have been "second homes" or "vacation properties"--who were able to buy their second, third, fourth or fifth house with no money down. ("Flippers" may once again refer to someone flipping burgers rather than "investment properties," as the real estate flipper becomes the burger flipper.)

"Borrow up to 125% of the value of your home and take cash out for any purpose." And those homeowners who needed extra money for college costs, vacations, remodels, etc. found they could borrow vast sums of money via re-financing their home--and lower their payment to boot once they accepted the rationale behind an adjustable rate mortgage (ARM): interest rates will stay cheap while the value of your house will only rise.

The asterisk by the teaser interest rate is a meta-message of sorts: it's telling you there is something fishy about the interest rate being offered. And we can all guess what it is: a big re-set in the near future. I eventually found the asterisked footnote on the back of the flyer in print so tiny I needed my photographic lupe to even read it. Yes, this is an adjustable rate mortgage which re-sets shortly to a much higher rate--like some 70% of recent loans in hot markets.

Here are the actual terms of this amazing mortgage offering:
"The payment examples are based on a fixed pay option ARM with a 30 year loan term and has a fixed initial payment based on a 1.00% minimum payment rate for the first year. The fully indexed rate is based on a fixed initial interest rate of 5.25%, 5.54% APR for the first 12 months and may increase or decrease after the fixed period."
Do you reckon this makes perfect sense to an inexperienced new home buyer anxious to join the American Dream, or a newbie "flipper" anxious to join the automatic wealth generation machine of rapid appreciation? This goes a long way toward explaining the abundance of shocked and dismayed homeowners in news stories proclaiming their ignorance of re-sets which have taken their interest rate from 5% to 9%.

The pundits predicting a "soft landing" in the housing market would do well to read this flyer carefully, and ponder what will happen to the millions of recent buyers when the re-set tsunami hits. If you couldn't afford to buy the house with a 20% down payment and a legitimate fixed-rate loan, then you won't be able to hold onto said house when your loan payment goes up 50% or even 100%. As I have said here before--what happens to prices when millions of ARM buyers can't make their payments and suffer foreclosure?

Classic economics has the answer: when supply exceeds demand, prices drop. Please review previous entries listed under "Housing Bubble Watch" in the lefthand sidebar of my weblog.


For more on this subject and a wide array of other topics, please visit my weblog.

                                                           


copyright © 2006 Charles Hugh Smith. All rights reserved in all media.

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