Everyone knows home prices escalated through the first half of the decade, but there is less agreement about the cause. Certainly, a big part of the price rise was fueled by falling interest rates between 2000 and 2004: Lower mortgage rates made higher priced homes more affordable. But there was also an element of mania in the market as speculators and even traditional buyers tried to get ahead of the wave. Job gains, though modest, also added to demand, as did immigration.
But prices continued to rise even after mortgage rates steadied and started to creep back up. The mania was still there, at least until recently. Mortgage bankers managed to offer lower rates even as their costs leveled off by using more and more so-called exotic mortgages. These mortgages—traditional adjustable-rate (ARM), interest-only, and option-ARMs—allow borrowers to pay less at the beginning of their loans. Sure, they might have to pay more tomorrow. But many buyers were convinced they would be gone—or rich—by the time tomorrow came.
Now, tomorrow is getting closer. With the mania having been drained from the housing market, prices have started to soften, even if in most places they have yet to decline. And many who bought homes in the last three or five years are still paying low initial mortgage rates. But that will soon change as the volume of mortgage resets reach unprecedented heights in the next couple of years. This means that buyers will be faced with much higher payments. The question is will this phenomenon, by itself or by unleashing negative consumer sentiment momentum, hurt the new-home market? What's more, are high-volume builders who've been jumping through hoops to make sales at almost any cost particularly susceptible as loans reset, monthly payments jump, and home buyers feel the pinch of higher costs on all fronts?
While a dire scenario may be easily sketched, borrowers will more likely be able to absorb the immediate hit of their mortgage rate resets. Just how those resets will affect market psychology is less knowable and more worrisome. While there is no available data for national builders in particular, they could be more vulnerable, depending on the extent that their buyers may have been more speculative than the norm. By the same token, they have deeper resources and a more diversified portfolio of homes than the norm as well.
The doomsday scenario goes something like this: Over the past two to three years, home prices nationally grew faster than interest rates fell, making home prices less affordable. Houses had already been growing less affordable in hot markets, such as Washington, D.C., and Southern California, but affordability pressures have spread to the rest of the nation, according to the Joint Center for Housing Studies at Harvard University.
Home buyers scrambled to keep up; they managed to purchase ever more expensive homes by shifting from traditional 30-year fixed-rate loans to exotic mortgages. These alternative mortgage products allowed buyers to “afford” the homes they bought as their initial payments were kept relatively low.
But in another sense, these buyers could not afford these homes, at least they could not afford the payments that would come due in a year's time (or three years or five years). The buyers didn't care because they were convinced that when the bigger bills arrived the house would be worth a lot more, and they could always refinance or sell at a large profit. Housing bears say there was a more than a little chicanery at work. “They weren't real sales because the buyers weren't real buyers. The buyers were flippers,” says Peter Schiff, CEO of Euro Pacific Capital and longtime housing market bear.
In just two years, interest-only loans, which defer principal payments for a set number of years, went from relative obscurity to accounting for 26 percent of all loans by dollar volume in the fourth quarter of 2005, according to the Mortgage Bankers Association (MBA). Option-ARMs, which allow borrowers to pay little or no principal and even a minimal amount of interest (with unpaid interest added to the principal at the borrower's option), accounted for 8 percent of the market by dollar volume. Adjustable-rate loans (not including interest-only loans, which are generally adjustable) accounted for more than a third of all loans issued last year.
Interest-only loans, and especially option-ARMs, are nearly twice as large on average compared with 30-year fixed-rate loans, according to MBA data for 2005. A study by Christopher Cagan, director of research and analytics for First American Real Estate Solutions, finds that adjustable rate borrowers have substantially less equity in their homes, which is explained in part by the fact that these borrowers as a group purchased their homes more recently.