The Daily Reckoning PRESENTS
The marriage of subprime borrowers with ARM's is hardly a match made in heaven...but does that matter if the homeowner isn't looking to sell? Dan Denning explores the bigger question - what happens when you combine falling home prices with rising monthly payments...

Low interest rates have made borrowing money easy. That has led to what I've called "flash bubbles" in all kinds of assets - mostly stocks, bonds, and commodities. But it has also affected housing values.

We will soon find out just how durable the housing boom really is. On the face of it, more Americans own homes now than ever before - some 68 percent. But if you dig into the numbers, you see some ugly omens.

First, there was nearly $3.8 trillion in mortgage origination volume in 2003, of which nearly 70 percent was refinancing. The year 2003 was big not just in the volume of mortgages, but also in the percentage of refinancing. For example, in the four quarters starting with Q4 2002, there was a total of $4.2 trillion in total mortgage originations.

That was nearly as much as the previous eight quarters from Q4 2000 to Q3 2002, during which time there was a total of $4.3 trillion in mortgage activity. And in that eight-quarter period, refinancing activity constituted, on average, less than 50 percent of the market.

Clearly, 2003 was a banner year for refinancing and locking in low rates before they began to move up. But in 2004, the incentive of rock-bottom rates began to wane. In April, the Mortgage Bankers Association saw its refinancing index fall 30 percent on a week-over week basis. That was not long after short-term bond prices cratered - and yields spiked up.

Since then, we've seen an increase in adjustable rate mortgages (ARMs) and a decrease in the percentages of refinancing originations. In plainer terms, once rates started to rise, mortgage activity shifted from healthy borrowers following the incentive of low rates to more inexperienced borrowers, often in the higher-risk or sub prime market, taking out riskier adjustable rate loans, and often paying only the interest on those loans. Why does it matter? These new borrowers are the fuel for home price growth. According to a speech by Federal Reserve Board governor Ed Gramlich, it's the subprime (higher-risk) borrowers that have driven up home ownership rates in America.

In prepared remarks delivered to the Financial Services Roundtable meeting in Chicago in May 2004, Gramlich said, "The obvious advantage of the expansion of sub-prime mortgage credit is the rise in credit opportunities and homeownership. Because of innovations in the prime and sub-prime mortgage market, nearly 9 million new homeowners are now able to live in their own homes, improve their neighborhoods, and use their homes to build wealth."

Live in their own homes, maybe. Improve their neighborhoods, perhaps. But build wealth? Only if they can avoid defaulting. And only if housing prices stay high. And only if incomes rise with housing prices to keep prices affordable. First, another quotation from Gramlich's speech: "Subprime borrowers pay higher rates of interest, go into delinquency more often, and have their properties foreclosed at a higher rate than prime borrowers."

Fact, fact, fact. Subprime delinquency rates currently run at around 7 percent, compared to 1 percent with prime mortgages. Still, you might be thinking that is surely not an awful delinquency rate. And surely the benefits of home ownership being dispersed far and wide among Americans is a good thing. It is, after all, the American Dream.

There are risks, though. Delinquency and foreclosure are risks any homeowner could run. It simply turns out that the subprime buyers have less margin for error and are therefore more marginal buyers. And it's at the margin - the margin of the entire housing picture - that the subprime buyers begin to become more important. Gramlich presents us with figures that show subprime mortgage origination rising 25 percent a year for nearly 10 years, between 1994 and 2003. Granted, prime mortgage origination rose at 18 percent a year during the same period. Everybody got in on the cheap money act.

The question today is how dependent growth in home prices is on the demand that's come largely from the subprime market. It's also alarming to note that the latest MBA figures show that adjustable rate mortgages have nearly doubled their percentage of mortgage activity. Why alarming? ARMs with interest-only provisions are a perfect send-up of high-risk borrowers. Such loans look good because the monthly payment (interest only) is typically lower than a fixed rate loan. But after the period of the fixed rate expires, then the adjustable comes in. Buyers can suddenly face a much higher payment - just to pay the interest. No equity is built. No real ownership is achieved.

Or as Freddie Mac's own chief economist, Frank Nothaft, said, "There is additional risk involved with loans of that type because the family isn't building home equity wealth through amortization of the principal. If the housing market turns weak or dips down, that could put the loan at risk."

The unholy marriage of ARMs with subprime borrowers is hardly a foundation of strength on which a new housing rally can be built. But so what? Home purchases are a function of affordability. And even if rates rise and the marginal buyer is wiped out, it's not going to put everyone under water.

Well, that's exactly the question. If everyone who refinanced in the last three years sits tight as rates rise, makes payments, and doesn't look to flip or sell the home, then falling home prices won't matter too much, will they? Who cares about liquidity when you're not looking to sell? True. Falling prices hurt less when you're comfortably paying your mortgage. But what happens when you combine falling home prices with rising monthly payments? Danger. Danger.

First, let's look at a sane example. The median price of an existing single-family home in the Midwest is $157,000. Even with increases in monthly payments, buyers of a median home in the Midwest pay only around 15 percent of their income for a mortgage payment. Not a problem.

In the West, however - and, presumably, this is driven by California - the median home price is $275,900. Given the median income in the West, a principal-and-interest monthly mortgage payment on the median home value suddenly eats up 28 percent of a homebuyer's income. You don't mind paying nearly 30 percent of your income for your mortgage if (1) your home is going up in value and (2) so is your income. But if your income is flat, as it is for the average American worker, and if you are the buyer who's driving home prices up, then paying 30 percent of your income for a home that's falling in market value suddenly becomes... less of a good idea.

Now, have I missed something? California has an endless supply of new buyers because of its high population of immigrants. Isn't that enough to sustain rising values? Not if home prices continue to rise faster than income, I say. Won't incomes grow, at least nominally, as inflation takes hold in the economy, erasing the affordability gap?

Maybe. Yet even if the liability changes in value (through being paid off in a weaker dollar), the value of the asset may fall, too. There are a lot of statistical side roads we can wander down, but my main observation is this: Easy money caused home price inflation just as it caused stocks to rise in the 1990s. I'm not saying no one has a right to make money selling a house. But the very idea of home ownership as a means to financial wealth - as Gramlich specifically said - encourages people to treat mortgages not as an asset to amortize, but as a means to speculate on higher home prices. Sure, it can work for a while. But the people who lose the most are always the ones who can least afford to lose anything . . . and get in near the end of the game.

America is at least $33 trillion in debt. The only real question is whether the money borrowed was used to build factories and income-producing assets or simply wagered on higher financial asset prices. To be sure, some of it was invested rather than gambled away.

But much of this debt was money borrowed to buy other financial assets, namely, stocks and bonds. And that's why you find that the other measure of a financial economy, stock market capitalization as a percentage of GDP, is still dangerously out of whack by all historical standards. By the way, for a great description of how this works, pick up a copy of Where the Money Grows and Anatomy of the Bubble, by Garet Garrett (John Wiley, 1997).

Historically, the total market cap of the stock market is about 58 percent of GDP. At the height of the bubble in the Nasdaq, stocks were nearly 185 percent of GDP. That means that while the total value of goods and services in the economy was about $7 trillion, the stock market, on paper at least, was worth $14 trillion. Evidently, the discounted value of America's future earnings was twice as much as the present value. How's that for optimism in the future?

The bear market erased about $7 trillion in stock market wealth before investors counterattacked with the present rally that began in March 2003. Total market cap is about 100 percent of GDP today. In other words, total market cap of around $11 trillion equals total GDP of around $11 trillion. If stocks returned to their historic average, and did it all at once, you'd see a $4.6 trillion loss in market cap, or a 42 percent decline, from current levels.

It probably won't happen all at once. But I'm fairly certain it will happen. And when it does, it will set unprepared investors back eight years, erasing what they've managed to make up in the last two to three years, and then some. You might be able to afford that, dear reader. And if you can, more power to you. But I can't.

© 2005 Dan Denning
The Daily Reckoning Archives

www.dailyreckoning.com
Dan Denning is the editor of Strategic Investment, one of the most respected "big-picture" investment newsletters on the market. A former specialist in small-cap stocks, Dan has been at the helm of Strategic Investment since 1999 - where, drawing from his network of global contacts, he has designed an investment strategy that takes into account global political and economic trends. His weekly e-mails and monthly newsletter give investors the most complete picture of what's shaping investment markets, what's coming next, and exactly what to do today You can sign up for a free subscription to the Daily Reckoning here: http://www.dailyreckoning.com. This essay was originally published in The Daily Reckoning.