A Bubble With a Fuse

Starting this year and picking up speed in 2007, as much as $2.5 trillion of non-conventional mortgage debt is scheduled to be repriced. Millions of Americans will soon face significantly higher mortgage payments. Unfortunately, many can barely afford their current payment.

Why is this happening? What will be the consequences?

In a bid to keep business booming, banks and mortgage lenders in recent years have found “creative” ways to make home loans more affordable—even to people with spotty credit histories or weak credit. By issuing “hybrid” mortgages that typically have low interest rates in the first two years, lenders have been able to entice otherwise unqualified buyers into buying a home. However, the initial low “teaser” rates must eventually be adjusted to the fully indexed level of whatever index is specified in the loan agreement. These adjustments are coming due in a big way, this year and next. That means mortgage payments are set to climb hundreds of dollars a month for a substantial number of Americans!

In the past, when these mortgages were “reset,” it didn’t cause a lot of disruption to the economy. One reason was that the sub-prime market—borrowers with weak credit who could least afford the payment hikes—was proportionately a much smaller share of the overall market. Not so anymore.

According to Barron’s (February 13), the amount of sub-prime loans issued in 2004 and 2005 was $540 billion and $628 billion, respectively. Barron’s estimates that a whopping $600 billion is scheduled to be adjusted higher in the next two years! Fannie Mae figures almost two thirds of all sub-prime loans will be reset in 2006 and 2007. Remember, that’s just the sub-prime market—those who could barely afford a home loan to begin with. Senior economist Michael Fratantoni at Mortgage Bankers Association estimates that in 2007 alone, more than one trillion dollars of all hybrid mortgages in the U.S. are going to be reset higher.

That is going to impact the pocketbooks of millions of Americans to a degree that many are not expecting. A typical hybrid mortgage contract is indexed to some type of money-market benchmark like the six-month London interbank offered rate (libor). In the last two years, the libor rate has risen more than 3 percent and is heading for a 4 percent increase! Even if a mortgage contract has an annual cap limiting interest rate hikes to 2 or 3 percent, many Americans have no idea how much their mortgage interest rate is shortly going to escalate—perhaps 2 or 3 percent this year or next, and more in subsequent years, according to how the index rises.

What may currently be a 5 percent teaser rate (or 7 percent for sub-prime borrowers) will shortly be reset to 7 or 8 percent (9 or 10 percent for sub-prime loans) and most likely higher after that. That means these mortgage payments will go up by hundreds of dollars a month.

All this is coming due at a time when Americans’ discretionary income (after more or less fixed costs of taxes, housing, healthcare, auto, energy, etc.) is declining while debt levels are mounting, interest rates are climbing, sales of existing homes are sinking, inventories of unsold homes are building (especially in areas of the country that led the recent housing boom), federal regulators are pushing for stricter lending standards, and houses are greatly overvalued.

National City is a top originator of prime mortgages. This company incorporates a very sophisticated methodology in its valuation studies. Its latest survey as of the third quarter of 2005 shows “38 percent of the U.S. housing market is at an ‘extreme’ overvaluation level of 30 percent or higher. … [S]uch levels of overvaluation are typically followed by price declines of about 15 percent that take an average of three years to unfold” (Barron’s, February 13; emphasis ours).

As many homeowners face rapidly rising mortgage payments in the next couple of years, all indications are that a lot of them will not be able to refinance to get out of their predicament this time around. Look for foreclosures and bankruptcies to soar.

The end of the housing boom will be very detrimental to the U.S. economy.

In the last few years, the housing boom has accounted for about 40 percent of all new American jobs created in the private sector. According to the Economist, “[T]he global housing boom [led by the U.S.] is the biggest financial bubble in history. The bigger the boom, the bigger the eventual bust” (June 16, 2005).

We are moving ever closer to that day of reckoning. As we do, it becomes evident that the housing bubble appears to have a burning fuse sticking out of it that makes it look more like a bomb than a bubble.

Are you prepared for the explosion?