Leveraged to the max

General Glut's Globblog has laid out some interesting statistics about the current housing bubble. Is it a bubble or perfectly normal effervescence? Well as he points out things are certainly getting frothy, and he also notes that those blaming the phenomenon on low interest rates are mistaken because in reality the real interest rate (which is the nominal rate adjusted for inflation) has been very steady.

While I agree with the later point in principle I would say that I believe the average person does not think, or even know, about things like nominal vs. real interest rates. They just see that APR figure and think "Crikey, that's low" and off they go and refinance or buy property. They also do not think about such things when trying to figure out if they should make extra payments against their capital.

More frightening to me are the statistics the General presents about the massive increase in people using adjustable rate mortgages (ARMs) to finance their home purchases, and the increase in loan to value ratios. I first learned about this in the late nineties when a friend of mine gave me doom and gloom predictions about people using ARMs and then getting into trouble or even foreclosed after the initial ARM fixed rate expired and rates went up through the roof. Typical ARM periods are five, three or even on years so that would have meant someone refinancing at the end of the dot com bubble years would have already or would be about to have this problem.

However since then nominal rates have collapsed and almost anyone who can will have refinanced to a significantly lower rate. For instance my first mortgage in May 2000 was a 7 7/8 percent 5-year ARM, but now I have a 5 1/4 fixed rate. But I do know a good many people who never took the chance to switch to a fixed rate and was sucked into another ARM in the last year netting rates down to 4% or below.

The really scary thing is that its pretty much unthinkable that nominal rates will ever be lower than they have been in the last year. So in one, three or five years if people have not sold their properties will find themselves adjusting up to significantly higher rates. Sure inflation may be higher then which means they will have more money in their pockets and more interest income to offset the increases, but isn't it a chicken and egg problem? Even if inflation isn't higher then if interest rates are higher that will surely drive up the cost of housing and rents and cause cost-push inflation?

My trusty mortgage calculator over at bankrate.com tells me that if I had a Bay Area typical $400,000 jumbo 5/1 ARM mortgage at 4.25% (about the lowest it got in the last two years) I'd be paying $1967 a month. In five years say the rate adjusts up to 6.5% (significantly less than its peak in the bubble years), now I'd be paying something like $2528 a month - at 29% increase in monthly payments. Ouch. That would also be the increase in monthly payments if I had to sell my house and by another house with similar loan size.

With such a scenario one had better hope that either mortgage interest rates either stay low or that wages have increase sufficiently beyond inflation to provide enough extra cash to make the higher payments when ARMs start adjusting. And I don't even want to think about what will happen if property values are lower than they are now in three to five years. Then people who leveraged to the max with ARMs may well find themselves with sharply higher payments to make and in a negative equity situation. In such a scenario there will be no borrowing against property value to make payments and no selling to buy a cheaper property. People will just have to sit tight and scrimp and scrape to make payments, or find themselves facing foreclosure and possibly bankruptcy. Neither of which is good for the economy and certainly not condusive of such Republican miracles of recovery as euphoric consumer spending and blind faith credit binges...