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Housing, errr, Mortgage Bubble (Part 1)

June 14, 2006

Yesterday evening I introduced the Housing Bubble problem, and today I endeavor to explain it away. Kip astutely pointed out that perhaps what we’re really experiencing is more of a “mortgage bubble,” than a housing bubble, and I think that’s probably accurate. But there is a significant amount of overlap in the two markets, given the popularity of mortgages as financial instruments by which one acquires title to real property - I don’t think it’s irresponsible to posit that a mortgage bubble would have a significant ripple effect on the housing market. As a nod to Kip, my analysis is focused on the mortgage market - ant not actually on new construction. I’ve chosen the plethora of cheap financing available, and its partner-in-crime, the serial refinancer as the key problems. Let’s see how they’ve conspired to create the bubble that’s about to burst.

The low interest rates, coupled with some dangerously creative products, such as the adjustable rate mortgage, the zero-down financing being offered by many lenders, risky as they may be, have induced many, many more people into buying houses, which led to a general increase in valuation, characteristic of the “sellers’ market.” This credit-induced appreciation affected both those who would buy or sell property, and those who were content with their property, but wished to refinance. The skyrocketing property valuations affected sellers and refinancers, as we’ll see later. Today we’re concerned solely with the historically cheap credit, later I’ll discuss its offshoot, the serial refinancer.

Sooner or later, as rates fall, the only people left to borrow money are those to whom no sound banker would lend a dime under ordinary circumstances. Zero-down is problematic of its own nature, but the ARM-trend, when coupled with cheap credit is very, very bad. As rates rise, and the short-term locked in rate expires, it costs much more to service the loan - in many cases, it costs more than these previously sub-prime borrowers could’ve afforded. The difference between 5% and 7% on a $200,000 mortgage is about $4,000 annually - certainly not chump change. Now they’re struggling to stay above water. And that rate changes (upwards, for the time being) every six months.

But with rates rising, fewer of these sub-prime borrowers are going to be first-time home buyers, at least in the near future. This means fewer prospective buyers for any given property, and consequently, fewer sales, and a “buyers market,” where the lack of buyers exerts downward pressure on the price of real estate. But because the structure of the current market is comparable to Keynes’ notion of wages being sticky downwards, few of those now struggling to make payments will succesfully get out from under their mortage. The end result is foreclosure, which we’re seeing in record numbers in SE Michigan. In the end, I suppose the banks are reaping what they’ve sewn, now bearing the burden of liquidation on a grand scale.

Liquidation robs banks of their earnings - so as Kip suggsted, expect to see a sizeable devaluation of mortgage company stocks in the future.

Related posts:

1. Housing Bubble: A Primer
2. Bursting Mortgage Bubbles
3. Beat The Bubble
4. Serial Refinancing, Part 1
5. What should you do about your rising mortgage payments?

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